Chapter 1 Getting Started— Principles of Finance

Slide Contents Learning Objectives Introduction Key Terms Finance: An Overview Three Types of Business Organizations The Goal of the Financial Manager The Five Basic Principles of Finance Key Terms

Learning Objectives Understand the importance of finance in your personal and professional lives and identify the three primary business decisions that financial managers make. Identify the key differences between the three major legal forms of business.

Learning Objectives (cont.) Understand the role of the financial manager within the firm and the goal for making financial choices. Explain the five principles of finance that form the basis of financial management for both businesses and individuals.

1.1 FINANCE: AN OVERVIEW

What is Finance? Finance is the study of how people and businesses evaluate investments and raise capital to fund them.

Three Basic Questions Addressed by the Study of Finance: What long-term investments should the firm undertake? How should the firm raise money to fund these investments? How can the firm best manage its cash flows as they arise in its day-to-day operations?

Why Study Finance? Knowledge of financial tools is critical to making good decisions in both corporate world and personal lives. How will GM’s strategic decision to invest $740 million to produce the Chevy Volt require the expertise of different disciplines within the business school?

1.2 THREE TYPES OF BUSINESS ORGANIZATIONS

Business Organizational Forms Business Forms Proprietorships Sole Partnerships Corporations

Sole Proprietorship It is a business owned by a single individual who is entitled to all of the firm’s profits and is responsible for all of the firm’s debt. The sole proprietors typically raise money by investing their own funds and by borrowing from a bank.

Sole Proprietorship (cont.) Advantages: Easy to start No need to consult others while making decisions Taxed at the personal tax rate Disadvantages: Personally liable for the business debts The business ceases on the death of the proprietor Harder to raise money

Partnership A general partnership is an association of two or more persons who come together as co-owners for the purpose of operating a business for profit.

Partnership (cont.) Advantages: Disadvantages: Relatively easy to start Taxed at the personal tax rate Access to funds from multiple sources or partners Disadvantages: Partners jointly share unlimited liability It is not always easy to transfer ownership

Partnership (cont.) In limited partnerships, there are two classes of partners: general and limited. The general partner runs the business and faces unlimited liability for the firm’s debts, whereas the limited partner is only liable up to the amount the limited partner invested.

Corporation If very large sums of money are needed to build a business, then the typical organizational form chosen is the corporation. The corporation is legally owned by its current set of stockholders, or owners.

Corporation (cont.) Corporation legally functions separately and apart from its owners (the shareholders). Corporation can individually sue and be sued. The Board of directors are elected by the shareholder, and the board appoints the senior management of the firm.

Corporation (cont.) Advantages Disadvantages Liability of owners is limited to invested funds Life of corporation is not tied to the owner Easier to transfer ownership Easier to raise Capital Disadvantages Greater regulation Double taxation of dividends

Limited Liability Company (LLC) Limited liability company (LLC) combines the tax benefits of a partnership (no double taxation of earnings) with the limited liability benefit of corporation (the owner’s liability is limited to what they invest).

Figure 1.1 Characteristics of Different Forms of Business

Figure 1.2 How the Finance Area Fits into a Corporation

1.3 THE GOAL OF THE FINANCIAL MANAGER

The Goal of the Financial Manager The goal of the financial manager must be consistent with the mission of the corporation, which is to maximize shareholder’s wealth.

Coca-Cola’s Vision Statement To achieve sustainable growth, we have established a vision with clear goals for: Profit People Portfolio Partners Planet

Corporate Mission While managers have to cater to all the stakeholders (such as consumers, employees, suppliers etc.), they need to pay particular attention to the shareholders. If managers fail to pursue shareholder wealth maximization, they will lose the support of investors and lenders. The business may cease to exist and ultimately, the managers will lose their jobs!

Ethics in Finance What do we mean by Ethics? Give examples of recent financial scandals and discuss what went wrong from an ethical perspective.

Sarbanes-Oxley Act (SOX) SOX Act was passed in 2002 “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes”. SOX Act mandates senior executives to take responsibility for the accuracy and completeness of financial reports.

1.4 THE FIVE BASIC PRINCIPLES OF FINANCE

PRINCIPLE 1:Money Has a Time Value A dollar received today is worth more than a dollar received in the future. We can invest the dollar received today to earn interest. Thus, in the future, you will have more than one dollar, as you will receive the interest on your investment.

PRINCIPLE 2: There is a Risk-Return Trade-off We won’t take on additional risk unless we expect to be compensated with additional return. Higher the risk, higher will be the expected return. Note expected return may not be equal to the realized rate of return.

Figure 1.3 There Is a Risk-Return Tradeoff

PRINCIPLE 3: Cash Flows Are the Source of Value Profit is an accounting concept and measures a business’s performance. Cash flow is the amount of cash that can actually be taken out of the business. It is possible for a firm to report profits but have no cash.

Incremental Cash Flow Financial decisions in a firm should consider “incremental cash flow” i.e. the difference between the cash flows the company will produce with the potential new investment and what it would make without the investment.

PRINCIPLE 4: Market Prices Reflect Information Investors react quickly to news/information and decisions made by managers. Good News ==> Higher stock prices Bad News ==> Lower stock price.

PRINCIPLE 5: Individuals Respond to Incentives Managers (as agents) respond to incentives they are given in the workplace. If their incentives are not properly aligned with those of the firm’s stockholders (the principal) they may not make decisions that are consistent with increasing shareholder value leading to agency costs.

PRINCIPLE 5: Individuals Respond to Incentives (cont.) The agency problems/costs can be mitigated through: Compensation plans that reward managers when they act to maximize shareholder wealth Monitoring by the board of directors Monitoring by financial markets (such as auditors, bankers, security analysts, credit agencies) The underperforming firms seeing their stock prices fall and face threat of being taken over and have their management teams replaced.

Key Terms Agency problem Capital budgeting Capital structure Corporation Debt Dividends Equity

Key Terms (cont.) Financial markets General partner General partnership Limited liability company (LLC) Limited partner Limited partnership Opportunity cost

Key Terms (cont.) Partnership Shareholders Shares Sole proprietorship Stockholders Working capital management