1. Financial Management: Principles & Applications
Thirteenth Edition
Chapter 1
Getting Started— Principles of Finance
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved

2. Learning Objectives (1 of 2)
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 among the three major legal forms of business.

3. Learning Objectives (2 of 2)
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.

4. 1.1 FINANCE: AN OVERVIEW

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

6. Three Basic Questions Addressed by the Study of Finance:
What long-term investments should the firm undertake? (capital budgeting decision)
How should the firm raise money to fund these investments? (capital structure decision)
How can the firm best manage its cash flows as they arise in its day-to-day operations? (working capital management)

7. 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 $500 million in Lyft, the ride-hailing start-up, require the expertise of different disciplines within the business school?

8. 1.2 THREE TYPES OF BUSINESS ORGANIZATIONS

9. Business Organizational Forms
Business Forms
Sole
Proprietorships
Partnerships
General
Limited
Corporations

10. Sole Proprietorship—Meaning
It is a business owned by a single individual who is entitled to all of the firm’s profits and is also 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.

11. Sole Proprietorship—Advantages
Easy to form
No need to consult others while making decisions
Profits are taxed at the owner’s tax rate

12. Sole Proprietorship—Disadvantages
Personally liable for the business debts
The business ceases on the death of the proprietor
Limited access to external sources of financing

13. Partnership—Meaning
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.

14. Partnership—Advantages & Disadvantages
Relatively easy to start
Taxed at the personal tax rate
Access to funds from multiple partners
Disadvantages:
Partners jointly share unlimited liability
It is not always easy to transfer ownership

15. Limited Partnerships
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 liable only up to the amount the limited partner invested. The life of the partnership is tied to the life of the general partner.

16. Corporation
If very large sums of money are needed to build a business, then the typical organizational form chosen is the corporation. Corporation legally functions separately and apart from its owners (the shareholders). Corporation can individually sue and be sued and can purchase, sell, or own property.
The corporation is legally owned by its current set of stockholders, or owners. The Board of directors are elected by the shareholder, and the board appoints the senior management of the firm.

17. Corporation—Advantages
Liability of owners is limited to invested funds
Life of corporation is not tied to the status of the investors
Easier to raise Capital

18. Corporation—Disadvantages
Greater regulation
Double taxation of dividends

19. 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 invested).

20. Figure 1.1 Characteristics of Different Forms of Business (1 of 2)
Business Form
Number of
Owners
Are Owners
Liable for the
Firm’s Debts?
Do Owners
Manage the
Firm?
Does an Ownership Change Dissolve the Firm?
Access to Capital
Taxation
Sole
Proprietorship
One
Yes
Very limited
Personal Taxes
Partnership
Unlimited
Yes; each partner has unlimited
Liability
Limited
(with General
Partners [GPs]
and Limited
Partners [LPs])
At least one
GP, but no
limit on LPs
GPs—unlimited
liability LPs—limited liability
GPs—manage
the firm LPs—no role in management
GPs—yes
LPs—no, can
change1
1It is common for LPs to require approval from the other partners before a partner’s ownership can be transferred.

21. Figure 1.1 Characteristics of Different Forms of Business (2 of 2)
Business Form
Number of
Owners
Are Owners
Liable for the
Firm’s Debts?
Do Owners
Manage the
Firm?
Does an Ownership Change Dissolve the Firm?
Access to Capital
Taxation
Limited
Liability
Company (LLC)
Unlimited No
Yes
Dependent
on size
Personal Taxes
Corporation
No—although
managers
generally have
an ownership
Stake2
Very easy
Access
Double Taxation:
Earnings taxed
at corporate level
Dividends taxed at
personal level
2Owners are not prohibited from managing the corporation.

22. Figure 1.2 How the Finance Area Fits into a Corporation

23. 1.3 THE GOAL OF THE FINANCIAL MANAGER

24. 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.
While shareholder wealth maximization is included in Coca-Cola’s vision statement, it also includes other broader goals (such as social responsibility) that will ultimately benefit shareholders in the long-run.

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

26. 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!

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

28. Enron’s Scandal
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29. Enron’s Scandal A 70 billion dollar company – 7th largest in USA
The biggest financial scandal in American history.
20,000 jobs lost
2 billion dollar lost
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30. Enron’s Scandal
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31. Enron’s Scandal
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32. Enron’s Scandal
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33. Enron’s Scandal Mark to Market accounting
Made a contract with Blockbuster Company and showed the projected revenue of $100 M
Arthur Endersen – one of the five biggest auditing company in US (Deloitte, KPMG, PwC, Ernst & Young)- company was closed.
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34. The 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 individual responsibility for the accuracy and completeness of the firm’s financial reports.

35. 1.4 THE FIVE BASIC PRINCIPLES OF FINANCE

36. Principle 1: Money Has a Time Value
A dollar received today is worth more valuable than a dollar received in the future.
We can invest the dollar received today to earn interest. Thus, in the future, we will have more than one dollar, as we will have earned interest on the investment.

37. Principle 2: There is a Risk—Return Trade—off
Investors tend to be risk-averse and prefer certain return to an uncertain return. Investors will hold risky investments if they 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. Thus higher risk does not guarantee higher rate of return.

38. Figure 1.3 There is a Risk-Return Trade—off

39. 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.
Company’s profits can differ dramatically from its cash flows. It is possible for a company to report profits without generating any cash.

40. Incremental Cash Flow
Financial decisions in a firm should consider marginal, or “incremental”, cash flows i.e. the difference between the cash flows the company will produce with the potential new investment and the cash flows that would be produced without the investment.

41. Principle 4: Market Prices Reflect Information
Investors respond to new information by buying and selling their investments. The speed of investor reaction and speed of price adjustment determines the efficiency of market. Release of Good News ==> Higher stock prices Release of Bad News ==> Lower stock price

42. Principle 5: Individuals Respond to Incentives
Managers (as agents) respond to incentives they are given in the workplace. If the 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.

43. Mitigating Agency Costs
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.

44. Key Terms (1 of 3) Agency problem Capital budgeting Capital structure
Corporation
Debt
Dividends
Equity

45. Key Terms (2 of 3) Financial markets General partner
General partnership
Limited liability company (LLC)
Limited partner
Limited partnership
Opportunity cost

46. Key Terms (3 of 3) Partnership Shareholders Shares Sole proprietorship
Stockholders
Working capital management

47. Copyright