An Introduction to the Foundations of Financial Management Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 1 An Introduction to the Foundations of Financial Management The Ties that Bind

Chapter Objectives Identify the goal of the firm. Compare the various legal forms of business organization and explain why the corporate form of business is the most logical choice for a firm that is large or growing. Describe the corporate tax features that affect business decisions. Explain the 10 principles that form the foundations of financial management. Explain what has led to the era of the multinational corporation.

The Goal of the Firm The goal of the firm is maximization of shareholder wealth or Maximizing the price of the existing common stock

Profit Maximization Stresses the efficient use of capital resources Not specific to time frame for profits to be measured Goals are not precise, allow for misinterpretation Ignores uncertainty and timing

Benefits of Maximizing Shareholder Wealth Good decisions are those that create wealth for the shareholder Societal benefits as businesses compete to create wealth Includes effects of all financial decisions

Legal Forms of Business Organization Sole Proprietorship Partnership Corporation

Sole Proprietorship Business owned by an individual Owner maintains title to assets and profits Unlimited liability Termination occurs on owner’s death or by owner’s choice

Partnerships Two or more owners General Partnership Each partner is fully responsible for liabilities Limited Partnerships

Partnerships Limited Partnership and Limited Liability Company Allows one or more partners limited liability based on amount of capital invested Must have one general partner with unlimited liability Names of limited partners may not appear in name of firm Limited partners may not participate in management decisions

Corporation Legally functions separate and apart from its owners Can sue, be sued, purchase, sell, and own property Owners who dictate direction and policies Elect a board of directors Investors liability is restricted to amount of investment in company Life continues with transfer of ownership Taxed separately

Comparison of Organizational Forms Large growing firms choose the corporate form Ease in raising capital Limited liability Transfer of ownership is simple

Comparison of Organizational Forms Sole Proprietorship and General Partnership Unlimited liabilities Not as easy to raise capital Limited Partnership Limited liability for partners Practical number of partners restricted Restricted marketability of interest in partnership

Organizational Form and Taxes Corporation Double taxation of dividends Tax Act of 2003 limited the tax rate on dividends to stimulate the economy Ended in 2008. Congress took action and extended until 2012.

Organizational Form and Taxes S-Type Corporations Benefits Limited liability Taxed as partnership Limitations Owners must be people Can’t be used for joint ventures between two corporations

Organizational Form and Taxes Limited Liability Corporations Benefits Limited liability Taxed like a partnership Limitations Qualifications vary from state to state Can’t appear like corporation otherwise will be taxed like one

The Role of the Financial Manager in a Corporation HOW THE FINANCE AREA FITS INTO A CORPORATION

Objectives of Income Taxation Raise revenues for government expenditures Achieve socially desirable goals Economic stabilization

Types of Taxpayers Individuals Corporations Fiduciaries Employees, self-employed persons, members of partnerships Report income on personal tax return Corporations Separate legal entity Report income on corporate tax return Distributed dividends taxed to shareholders Fiduciaries Estates and trusts Pay taxes on undistributed income

Computing Taxable Income Gross income less tax deductible expenses, plus interest income and dividend income Gross Income Dollar sales from a product or service less cost of production or acquisition Tax Deductible Expenses Operating expenses (marketing, depreciation, administrative expenses) and interest expense Dividends paid are not deductible

Computing Taxable Income ($000’s) Sales $50,000 Cost of Goods Sold 23,000 Gross Profit $27,000 Operating Expenses Administrative Expenses $4,000 Depreciation Expense 1,500 Marketing Expenses 4,500 Total Operating Expenses $10,000 Operating Income $17,000 Other Income 0 Interest Expense 1,000 Taxable Income $16,000

Corporate Tax Rates Income Rate Additional surtax: $0 - $50,000 15% $0 - $50,000 15% $50,001 - $75,000 25% $75,001 - $10,000,000 34% Over $10,000,000 35% Additional surtax: 5% on income between - $100,000 and $335,000 3% on income between - $15,000,000 and $18,333,333

Marginal Tax Rates Rates applicable to next dollar of income Used in financial decision-making

Other Corporate Tax Considerations Dividend Exclusion A corporation may typically exclude 70% of any dividend received from another corporation. Depreciation Expense A corporation may expense an asset’s cost over its useful life Capital Gains and Losses Capital Gains taxed as ordinary income. Capital losses cannot be deducted from ordinary income.

Principle 2: The Time Value of Money A dollar received today is worth more than a dollar received in the future. Because we can earn interest on money received today, it is better to receive money earlier rather than later.

Ten Principles That Form The Foundations of Financial Management “…although it is not necessary to understand finance in order to understand these principles, it is necessary to understand these principles in order to understand finance.”

Principle 3: Cash - not Profits - is King Cash Flow, not accounting profit, is used as our measurement tool. Cash flows, not profits, are actually received by the firm and can be reinvested.

Principle 1: The Risk-Return Trade-off We won’t take on additional risk unless we expect to be compensated with additional return. Investment alternatives have different amounts of risk and expected returns. The more risk an investment has, the higher its expected return will be.

Principle 4: Incremental Cash Flows It is only what changes that counts The 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.

Principle 5: The Curse of Competitive Markets It is hard to find exceptionally profitable projects If an industry is generating large profits, new entrants are usually attracted. The additional competition and added capacity can result in profits being driven down to the required rate of return. Product Differentiation, Service and Quality can insulate products from competition

Principle 7: The Agency Problem Managers won’t work for the owners unless it is in their best interest The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not in line with the goal of maximization of shareholder wealth.

Principle 8: Taxes Bias Business Decisions The cash flows we consider are the after-tax incremental cash flows to the firm as a whole.

Principle 6: Efficient Capital Markets The markets are quick and the prices are right. The values of all assets and securities at any instant in time fully reflect all available information.

Principle 9: All Risk is Not Equal Some risk can be diversified away, and some cannot The process of diversification can reduce risk, and as a result, measuring a project’s or an asset’s risk is very difficult.

Principle 10: Ethical Behavior Is Doing the Right Thing Principle 10: Ethical Behavior Is Doing the Right Thing. Ethical Dilemmas Are Everywhere in Finance Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing

Finance and the Multinational Firm U.S. corporations are looking to international expansion Collapse of communism Acceptance of free market system developing in the Third World countries PC’s and the internet Freer access to international markets