1. 1 Chapter 1 Introduction to Financial Management Key sections: –What is financial management? –Legal forms of business –Principles of taxation –Shareholder wealth, not profit, maximization is goal –The ten principles of financial management

2. 2 What is Financial Management? Tools and decision making processes to maintain/create economic value and shareholder wealth What investments to make and how to finance them Allocation of scarce resources based on uncertain costs/benefits

3. 3 Goal of the Firm Maximize shareholder wealth –Measured by market value of stock –Includes effect of all financial decisions Shareholder wealth max  profit maximization –PM ignores risk/timing of cash flows –Increase current profits by cutting R&D and maintenance??? (Probably not good idea) How should stock price be affected?

4. 4 Legal Forms of Business Proprietorship – unincorporated, one individual, personally responsible for all its debts and losses Partnership – two or more co-owners governed by an agreement –General partnership – each partner fully liable –Limited – one GP and LP’s with limited liability –Various other types of partnerships Corporations

5. 5 Composed of owners (shareholders) –Elect directors who appoint managers –Function separately and apart from owners Shareholder’s maximum loss – amount paid for shares Advantages: limited liability, transferability, funding availability, no upside limit on potential Disadvantages: double taxation, expensive to form

6. 6 Taxation Our emphasis – how taxes affect decisions through expense deductions Taxes based on profits: sales and other income less allowable expenses and exclusions –Cost of producing, marketing, admin expense, depreciation and interest (but not dividends) Progressive rates – more earned, higher the marginal rate –Marginal, not average, rate relevant

7. 7 Other Tax Considerations 70% of dividends from another corporation excluded from taxable income (sometimes 100%) Depreciation – asset’s value expensed over its life –Different methods used – total expense the same but not the timing –Often straight line for financials, accelerated for taxes Capital gains/losses – taxed as ordinary income for corporations; cap gains and dividend taxes recently changed by Congress for individuals

8. 8 Tax Implications Measure returns on after-tax basis using marginal, not average, tax rates Taxes affect capital structure – interest, but not dividends, tax deductible New tax law: for individuals both dividends and long-term capital gains taxed at 15%

9. 9 The Ten Principles These are statements of common sense –Provide logic behind rest of this course #1 Risk/return tradeoff –Won’t take additional risk unless compensated; we are risk adverse –Greater risk, greater expected return –Key concept in valuing all assets –Almost every decision involves tradeoffs

10. 10 Risk-Return Relationship

11. 11 # 2 Time Value of Money- TVM A dollar received today is worth more than a dollar received in the future Earn more interest on money received sooner Brings future benefits and costs back to present time – makes them comparable Assumes cost of money determined by risks and returns (more risk, higher returns)

12. 12 #3 Cash, not Profit, is King Can only use cash flows, not profits –Cash, but not profits, can be reinvested Accounting profits shown when earned; cash flows occur when collected Capital expenditures occur immediately; accounting records depreciation over many years

13. 13 #4 Incremental Cash Flows (Only what changes counts) Think incrementally. Will the project make a difference? Not all cash flows are incremental –New product may cannibalize an old product

14. 14 #5 Curse of Competitive Markets Hard to find exceptionally profitable projects Large profits attract new competitors Can’t last long if markets competitive Barriers to entry and product differentiation –Brand name, service, quality, patents, advertising –Cost advantages – economies of scale, proprietary technology, etc.

15. 15 #6 Markets Assumed Efficient Values fully reflect all available information at any point in time You can’t expect to beat the market Efficiency determined by speed new info is reflected in prices Market prices reflect expected cash flows

16. 16 #7 Agency Problems Management won’t work for owners unless it is in their interest Arises from separation between decision makers and owners (“the corporate jet problem”) Why isn’t management fired if don’t act in shareholders’ interest? Need to align interests (monitoring, auditing, options, bonuses)

17. 17 #8 Taxes Bias Business Decisions Must consider after-tax incremental cash flows Tax incentives – deductions and credits (R&D spending) Interest – a deductible expense; dividends not deductible; may affect capital structure

18. 18 #9 Not All Risk Is Equal Some can be diversified away, some cannot Diversification – multiple investments; reduces risk –One investment’s gain offsets another’s loss Reduces total variability without reducing returns (providing returns don’t move together)

19. 19 Reduce Risk - Diversify

20. 20 #10 Ethical Behavior “Doing the Right Thing” Ethical errors are NEVER forgiven Unethical behavior eliminates trust –Without trust, companies can’t interact Loss of confidence in company’s ethical behavior – extremely damaging Social responsibility – goes beyond shareholder wealth maximization

21. 21 Multinational Corporations (MNC’s) Operations in more than one country Began after WWII devastation; accelerated by fall of communism, acceptance of free markets, and information technology Coke earns more in Japan than in US; Dow, Colgate, 3M, HP more than half profits from overseas Many US firms owned by foreign interests