Foundations of Finance Arthur Keown John D. Martin J. William Petty

An Introduction to the Foundations of Financial Management – The Ties that Bind Chapter 1

Keown, Martin, Petty - Chapter 13 Learning Objectives 1. Identify the goal of the firm. 2. 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. 3. Describe the corporate tax features that affect business decisions. 4. Describe the corporate tax features that affect decisions. 5. Explain the 10 principles that form the foundations of financial management. 6. Explain what has led to the era of the multinational corporation.

Keown, Martin, Petty - Chapter 14 Slide Contents 1. The Goal of the Firm 2. Legal Forms of Business Organization 3. Role of Financial Manager in a Corporation 4. Income Taxation 5. Ten Principles of Finance 6. Finance and Multinational Firm

1. The Goal of the Firm

Keown, Martin, Petty - Chapter 16 The Goal of the Firm 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 common stock.

Keown, Martin, Petty - Chapter 17 Part of Coca-Cola’s Vision “Maximizing return to shareowners while being mindful of our overall responsibilities.” — (retrieved March 13, 2007)

Keown, Martin, Petty - Chapter 18 Benefits of Maximizing Shareholder Wealth Good corporate decisions are those that create wealth for the shareholder. Society benefits as scarce resources are directed to the most profitable use by businesses competing to create wealth.

Keown, Martin, Petty - Chapter 19 Share Price Changes (during last two years as of June 29, 2007) Google: Share price increased by nearly $200 or around 67% (from around $300 to $500) … wealth created. Yahoo: Share price decreased by nearly $8 or around 23% (from around $35 to $27) … wealth destroyed.

Keown, Martin, Petty - Chapter 110 Why is Profit Maximization not the appropriate goal? Profit maximization goal is unclear about the time frame over which profits are to be measured. It is easy to manipulate the profits through various accounting policies. Profit maximization goal ignores risk and timing of cash flows.

2. Legal Forms of Business Organization

Keown, Martin, Petty - Chapter 112 Legal Forms of Business Organization Sole Proprietorship Partnership Corporation

Keown, Martin, Petty - Chapter 113 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

Keown, Martin, Petty - Chapter 114 Partnerships Partnership: Two or more persons come together as co-owners. Two types of partnership: General or Limited

Keown, Martin, Petty - Chapter 115 Partnership - General All partners are fully responsible for liabilities incurred by the partnership.

Keown, Martin, Petty - Chapter 116 Partnerships - Limited One or more partners can have limited liability There must be at least one general partner with unlimited liability. Limited partners cannot participate in the management of the business and their names cannot appear in the name of the firm.

Keown, Martin, Petty - Chapter 117 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

Keown, Martin, Petty - Chapter 118 Corporation 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. Shareholder’s liability is restricted to the amount of investment in company. Life of corporation does not depend on the status of its owners. Ownership can be easily transferred.

Keown, Martin, Petty - Chapter 119 The Trade-offs: Corporate Form Benefits: Limited liability Easy to transfer ownership Unlimited life (unless the firm goes through corporate restructuring such as mergers and bankruptcies) Drawbacks: No secrecy of information Maybe delays in decision making Greater regulation Double taxation

Keown, Martin, Petty - Chapter 120 Double Taxation example Income = $1,000 Federal = $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?

Keown, Martin, Petty - Chapter 121 Double taxation If corporation distributes the profits as dividends to shareholders, shareholders will have to pay taxes on dividends. Assume shareholders are on dividend income or 20% of $750 = $150 Total tax = = $400 or 40%

Keown, Martin, Petty - Chapter 122 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

Keown, Martin, Petty - Chapter 123 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

3. Role of Financial Manager in a Corporation

Keown, Martin, Petty - Chapter 125 The Role of the Financial Manager in a Corporation (figure 1.1) HOW THE FINANCE AREA FITS INTO A CORPORATION

Keown, Martin, Petty - Chapter 126 The Role of the Financial Manager in a Corporation (figure 1.1) In this textbook, we focus on the duties generally associated with the treasurer and how investment decisions are made.

4. Income Taxation

Keown, Martin, Petty - Chapter 128 Income Taxation Objectives: Raise revenues for government expenditures Achieve socially desirable goals Economic stabilization

Keown, Martin, Petty - Chapter 129 Types of Taxpayers Individual Includes employees, self-employed persons, members of partnerships Reports income on personal tax return Corporation Reports its income and pays tax on profits Distributed dividends taxed to shareholders Fiduciaries Such as estates and trusts pay taxes on income generated by the estate or trust that is not distributed to a beneficiary

Keown, Martin, Petty - Chapter 130 Computing Taxable Income for Corporation 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

Keown, Martin, Petty - Chapter 131 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 Income0 Interest Expense 1,000 Taxable Income $16,000

Keown, Martin, Petty - Chapter 132 Corporate Tax Rates IncomeRate $0 - $50,00015% $50,001 - $75,00025% $75,001 - $10,000,00034% Over $10,000,00035% Additional surtax: 5% on income between $100,000 and $335,000 3% on income between $15,000,000 and $18,333,333

Keown, Martin, Petty - Chapter 133 Example: Computing taxes on taxable income of $16m $50,000 *.15 = 7,500 $25,000 *.25= 6,250 $9,925,000 *.34= 3,374,500 $6,000,000 *.35= 2,100,000 Surtax.05*($335K-$100K) = 11,750.03*($16m - $15m)= 30,000 Total Tax= $5,530,000

Keown, Martin, Petty - Chapter 134 Marginal Tax Rates Refers to the tax rate applicable to next dollar of income. In the previous example, the marginal tax rate is 38% since $16m falls into the 35% tax bracket with a 3% surtax. In financial decision-making, marginal tax rate is more relevant than average tax rate.

Keown, Martin, Petty - Chapter 135 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.

5. Ten Principles: 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.”

Keown, Martin, Petty - Chapter 137 Principle 1: The Risk-Return Trade-off Would you invest your savings in the stock market if it offered the same expected return as your bank? We won’t take on additional risk unless we expect to be compensated with additional return. Higher the risk of an investment, higher will be its expected return.

Keown, Martin, Petty - Chapter 138 The Risk-Return Trade-off

Keown, Martin, Petty - Chapter 139 Principle 2: The Time Value of Money A dollar received today is worth more than a dollar to be received in the future. Because we can earn interest on money received today, it is better to receive money earlier rather than later.

Keown, Martin, Petty - Chapter 140 Principle 3: Cash—Not Profits—Is King In measuring wealth or value, we use cash Flow, not accounting profit, as our measurement tool. Cash flows are actually received by the firm and can be reinvested. On the other hand, profits are recorded when they are earned rather than when money is actually received. It is possible for a firm to show profits on the books but have no cash!

Keown, Martin, Petty - Chapter 141 Principle 4: Incremental Cash Flows 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. This difference reflects the true impact of a decision.

Keown, Martin, Petty - Chapter 142 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 (through Service, Quality) and cost advantages (through economies of Scale) can insulate products from competition.

Keown, Martin, Petty - Chapter 143 Principle 6: Efficient Capital Markets The values of securities at any instant in time fully reflect all publicly available information. Prices reflect value and are right. Price changes reflect changes in expected cash flows (and not cosmetic changes such as accounting policy changes). Good decisions drive up the stock prices and vice versa.

Keown, Martin, Petty - Chapter 144 Principle 7: The Agency Problem 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. Agency conflict reduced through monitoring (ex. Annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. Takeovers).

Keown, Martin, Petty - Chapter 145 Principle 8: Taxes Bias Business Decisions The cash flows we consider for decision making are the after-tax incremental cash flows to the firm as a whole.

Keown, Martin, Petty - Chapter 146 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. A project’s risk changes depending on whether you measure it standing alone or together with other projects the company may take on.

Keown, Martin, Petty - Chapter 147 All Risk is Not Equal

Keown, Martin, Petty - Chapter 148 Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance 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. Ethics are relevant in business and unethical decisions can destroy shareholder wealth (ex. Enron Scandal).

6. Finance and Multinational Firm

Keown, Martin, Petty - Chapter 150 Finance and the Multinational Firm U.S. corporations are looking to international expansion to discover profits For example, Coca-Cola earns over 80% of its profits from overseas sales In addition to US firms going abroad, we have also witnessed many foreign firms making their mark in the United States (ex. the domination of the auto industry by Honda, Toyota, and Nissan) International movement has been spurred by: Collapse of communism Acceptance of free market system developing in Third World countries Technology and communication (PC’s and the internet) Improved transportation

Keown, Martin, Petty - Chapter 151 Why do companies go abroad? To increase revenues To obtain cheaper resources (land, labor, capital, raw material) To reduce the burden of government regulation (ex. Environmental laws, taxes, labor laws) To increase global exposure

Keown, Martin, Petty - Chapter 152 Risks/challenges Country risk (changes in government regulations, unstable government, economic changes) Currency risk (fluctuations in exchange rates) Cultural risk (differences in language, traditions, ethical standards etc.)