Chapter 1 An Introduction to the Foundations of Financial Management

1. FINN 3120 -005 Financial Management, Fall 2014 Chapter 1An Introduction to the Foundations of Financial Management FINN 3120

2. Outline Goal of the firm Five principles Role of Finance in Business Legal Forms of Business Organization FINN 3120

3. The Goal of the Firm Part of Coca-Cola’s Vision: “Maximize long-term return to shareowners whilebeing mindful of our overall responsibilities.” http://www.thecoca-colacompany.com/ourcompany/mission_vision_values.html FINN 3120

4. The Goal of the Firm • The goal of the firm is to create value for the firm’s legal owners (that is, its shareholders). • The goal of the firm is to maximize shareholder wealth. • Shareholder wealth is measured by share prices. Thus shareholder wealth maximization would imply maximizing the price of existing common stocks. FINN 3120

5. The Goal of the Firm • The effects of all financial decisions ultimately affect the stock price of the firm • Good decisions create wealth for shareholders. • We focus on the effect that the decision should have on the stock price, if everything else were held constant. FINN 3120

6. The Goal of the Firm Which of the following goals of the firm are synonymous (equivalent) to the maximization of shareholder wealth? A) profit maximization B) risk minimization C) maximization of the total market value of the firm's common stocks D) none of the above FINN 3120

7. Five principles that form the Foundation of Finance Cash flow is what matters Money has a time value Risk requires a reward Market prices are generally right Conflicts of interest cause agency problems FINN 3120

8. Principle 1Cash flow is what matters • Accounting profits are not equal to cash flows. • It is possible for a firm • to generate cash flows but not accounting profits. • Cash flow, not profits, drive the value of a business FINN 3120

9. Principle 1Cash flow is what matters • We must determine incremental cash flows when making financial decisions. • Incremental cash flow is the difference between the projected cash flows • if the project is selected, • versus what they will be, if the project is not selected. FINN 3120

10. Principle 2Money has a time value • A dollar received today is worth more than a dollar received in the future. • Since we can earn interest on money received today, it is better to receive money earlier rather than later. • Question: What if the risk-free interest rate were zero? FINN 3120

11. Principle 2Money has a time value • Opportunity Cost – It is the cost of making a choice in terms of next best alternative that must be foregone. • Example: By lending money to your friend at zero percent interest, there is an opportunity cost of 1% that could potentially be earned by depositing the money in a savings account in a bank. FINN 3120

12. Principles 1&2Example A financial manager is evaluating a project which is expected to generate profits of $100,000 per year for the next 10 years. The project should be accepted if A) the cost of the project is less than $1,000,000. B) the cost of the project is less than the present value of $100,000 per year for 10 years. C) this project's expected profits are higher than any other projects the corporation has available. D) the present value of the project's cash inflows exceeds the present value of the project's cash outflows. FINN 3120

13. Principle 3Risk requires a Reward • We won’t take on additional risk unless we expect to be compensated with additional reward or return. • Investors expect to be compensated for “delaying consumption” and “taking on risk”. FINN 3120

14. Principle 3Risk requires a Reward The larger the risk, the higher the return required FINN 3120

15. Principle 3Example Joe, a risk-averse investor, is trying to choose between investment A and investment B. If investment A is riskier than investment B and Joe selects investment A anyway, then A) the actual return for investment A will be higher than the actual return for investment B. B) the actual return for investment A will be higher than the expected return for investment B. C) the expected return for investment A will be higher than the actual return for investment B. D) the expected return for investment A will be higher than the expected return for investment B. FINN 3120

16. Principle 4 -Market Prices are generally Right • In an efficient market, the prices of all traded assets (such as stocks and bonds) at any instant in time fully reflect all available information. • Thus stock prices are a useful indicator of the value of the firm. Price changes reflect changes in expected future cash flows. Good decisions will tend to increase the stock price and vice versa. • Note there are inefficiencies in the market that may distort the prices. FINN 3120

17. Principle 4 –an example Suppose XYZ Corporation is traded on the New York Stock Exchange. XYZ's closing price on Monday is $20 per share. After the market closes on Monday, XYZ makes a surprise announcement that it has obtained a major new customer. XYZ's stock will likely A) open at $20 per share on Tuesday and then increase as more investors read the announcement in the Wall Street Journal. B) remain at $20 per share because in efficient markets the price already reflects all information. C) open above $20 because the positive news will result in a higher valuation even though the stock has not yet traded. D) open below $20 because the surprise announcement creates more uncertainty. FINN 3120

18. Principle 5 - Conflicts of interest cause agency problems • The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth. • Agency conflict is reduced through monitoring (ex. Annual reports), compensation schemes, etc. FINN 3120

19. Principle 5 - Example In which of the following cases will the agency problem between shareholders and managers be the greatest? A) 100% of the common stock is owned by the founder of the company who decided to retire and hired a manager to run his business for him. B) The Johnson family owns 50% of the common stock of the company. The other 50% is owned by 5 mutual funds. C) The common stock of the company is owned by many diverse shareholders, with no shareholder owning more than 1% of the outstanding stock. D) All top managers in the company own significant amounts of stock and stock options. FINN 3120

20. Ethics and trust in business • Ethical behavior is doing the right thing! … but what is the right thing? • Ethical dilemma - Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing. • Sound ethical standards are important for business and personal success. Unethical decisions can destroy shareholder wealth. FINN 3120

21. The role of finance in business • Three broad issues addressed by the study of finance: • Capital Budgeting: What long-term investments should the firm undertake? (where to invest?) • Capital Structure Decisions: How should the firm raise money to fund these investments? (how to raise capital?) • Working Capital Management: How can the firm best manage its cash flows as they arise in its day-to-day operations? (how to manage cash flow?) FINN 3120

22. The role of the financial manager FINN 3120

23. Legal Forms of Business Organization Sole Proprietorship Partnership Corporation FINN 3120

24. Sole Proprietorship • Business owned by an individual • Advantages • Easily established with few complications • Minimal organizational costs • Does not have to share profits or control with others • Disadvantages • Unlimited liability for the owner (responsible for all debts) • Owner must absorb all losses • Equity capital limited to the owner’s personal investment • Termination occurs on owner’s death or by owner’s choice FINN 3120

25. Partnership • A partnership: an association of two or more persons coming together as co-owners for the purpose of operating a business for profit. • Two types of partnership: General & Limited FINN 3120

26. Partnership: General • All partners are fully responsible for liabilities incurred by the partnership • Advantages: • Minimal organizational requirements • Disadvantages: • All partners have unlimited liability (responsible for all debts) • Difficult to raise large amounts of capital FINN 3120

27. Partnership: Limited • One or more partners can have limited liability (called limited partners), at least one general partner • Advantages: • For the limited partners: liability restricted to the amount of capital invested in the partnership. • Withdrawal or death of a limited partner does not affect continuity of the business • Disadvantages: • There must be at least one general partner with unlimited liability (responsible for all debts). • Limited partners may not participate in the management of the business • Names of limited partners cannot appear in the name of the firm. FINN 3120

28. Corporation • This (impersonal) entity legally functions separate and apart from its owners • Corporation can sue, be sued, purchase, sell, and own property • Owners (shareholders) dictate direction and policies of the corporation. • Ownership is reflected in common stock certificates • The number of shares owned/total number of shares outstanding determines the proportionate ownership of the stockholder in the business. • Owners elect a board of directors whose members select the president, vice president, secretary, and treasurer. FINN 3120

29. The Trade-offs: Corporate Form • Benefits: • Limited liability, restricted to the amount invested in the company (not responsible for debts) • Easy to transfer ownership • Unlimited life (unless the firm goes through corporate restructuring such as mergers and bankruptcies) • Drawbacks: • Maybe delays in decision making • Heavy regulation • Double taxation FINN 3120

30. Double Taxation: an example • Corporate Income = $1,000 • Corporate income Tax @25% = $250 • After tax Income = $750 • What will be the total tax if the company chooses to distribute the after-tax profits to shareholders as dividends, assume shareholders are taxed @20% on dividend income? Answer: 40% FINN 3120

31. Example Which of the following categories of owners enjoy limited liability? A) all partners in a limited partnership B) common shareholders of a corporation C) in a partnership, only the general partners D) only B and C above FINN 3120

32. Question? FINN 3120