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Chapter 1 AN INTRODUCTION TO FI NANCIAL MANAGEMENTTHE TIES THAT BIND
Foundations of FinanceArthur J. Keown John D. MartinJ. William Petty David F. Scott, Jr.
Chapter 1
An Introduction to the Foundations of
Financial Management The Ties that
Bind
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Chapter Objectives
Identify the goal of thefirm.
Compare the various legalforms of business
organization and explainwhy the corporate form ofbusiness is the most logicalchoice for a firm that islarge or growing.
Describe the corporate taxfeatures that affect
business decisions.
Describe the corporate taxfeatures that affectdecisions.
Explain the 10 principlesthat form the foundationsof financial management.
Explain what has led to theera of the multinationalcorporation.
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The Goal of the Firm
The goal of the firm is maximization ofshareholder wealth
or
Maximization of the price of the existingcommon stock
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Profit Maximization
Stresses the efficient use of capitalresources
Not specific to time frame for profits to bemeasured
Goals are not precise, allow formisinterpretation
Ignores uncertainty and timing
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Benefits of MaximizingShareholder Wealth
Good decisions are those that createwealth for the shareholder
Societal benefits as businesses compete tocreate wealth
Includes effects of all financial decisions
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Legal Forms of BusinessOrganization
Sole Proprietorship
Partnership
Corporation
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Sole Proprietorship
Business owned by an individual
Owner maintains title to assets andprofits
Unlimited liability
Termination occurs on owners deathor by owners choice
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Partnerships
General Partnership Each partner is fully responsible
for liabilities
Limited Partnerships
Two or more owners
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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.
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Corporation
Legally functions separate and apart from its owners
Can sue, be sued, purchase, sell, and ownproperty
Owners who dictate direction and policies
Elect a board of directors
Investors liability is restricted to amount of investmentin company
Life continues with transfer of ownership Taxed separately
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Comparison of OrganizationalForms
Large growing firms choose thecorporate form
Ease in raising capital
Limited liability
Transfer of ownership is simple
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Comparison of OrganizationalForms
Sole Proprietorship and GeneralPartnership
Unlimited liabilities Not as easy to raise capital
Limited Partnership
Limited liability for partners Practical number of partners restricted
Restricted marketability of interest inpartnership
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Organizational Form and Taxes
Corporation
Double taxation of dividends
Tax act of 2003 limited tax rate ondividends to stimulate the economy
Ends in 2008 unless Congress takes action
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Organizational Form and Taxes
S-Type Corporations
Benefits
Limited liability
Taxed as partnership
Limitations
Owners must be people Cant be used for joint ventures between
two corporations
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Organizational Form and Taxes
Limited Liability Corporations
Benefits
Limited liability
Taxed like a partnership
Limitations
Qualifications vary from state to state Cant appear like corporation otherwise
will be taxed like one
C 1 O C O O C G S
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The Role of the FinancialManager in a Corporation
HOW THE FINANCE AREA FITS INTO A CORPORATION
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Chapter 1 AN INTRODUCTION TO FI NANCIAL MANAGEMENTTHE TIES THAT BIND
Ten Principles That Form The
Foundations of FinancialManagement
although it is not necessary to
understand finance in order to understand
these principles, it is necessary tounderstand these principles in order to
understand finance.
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Principle 1: The Risk-ReturnTrade-off
We wont take on additional risk unless weexpect to be compensated with additional
return.
Investment alternatives have differentamounts of risk and expected returns.
The more risk an investment has, thehigher its expected return will be.
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Principle 2: The Time Value ofMoney
A dollar received today is worth more thana dollar received in the future.
Because we can earn interest on moneyreceived today, it is better to receivemoney earlier rather than later.
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Principle 3: CashNotProfitsIs King
Cash Flow, not accounting profit, isused as our measurement tool.
Cash flows, not profits, are actuallyreceived by the firm and can be
reinvested.
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Principle 4: Incremental CashFlows
It is only what changes that counts
The incremental cash flow is thedifference between the projected cashflows if the project is selected, versus
what they will be, if the project is notselected.
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Principle 5: The Curse ofCompetitive Markets
It is hard to find exceptionally profitable projects
If an industry is generating large profits, new
entrants are usually attracted. The additionalcompetition and added capacity can result in profitsbeing driven down to the required rate of return.
Product Differentiation, Service and Qualitycan insulate products from competition
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Principle 6: Efficient CapitalMarkets
The markets are quick and theprices are right.
The values of all assets andsecurities at any instant in time fully
reflect all available information.
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Principle 7: The AgencyProblem
Managers wont work for the ownersunless it is in their best interest
The separation of management andthe ownership of the firm creates anagency problem. Managers may make decisions that are
not in line with the goal ofmaximization of shareholder wealth.
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Principle 8: Taxes BiasBusiness Decisions
The cash flows we consider are
the after-tax incremental cashflows to the firm as a whole.
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Principle 9: All Risk is NotEqual
Some risk can be diversified away,
and some cannot The process of diversification can
reduce risk, and as a result,measuring a projects or an assetsrisk is very difficult.
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Principle 10: Ethical Behavior Is Doingthe Right Thing, and Ethical Dilemmas
Are Everywhere in Finance
Each person has his or her own set of
values, which forms the basis forpersonal judgments about what isthe right thing
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Finance and the Multinational Firm
U.S. corporations are looking tointernational expansion
Collapse of communism Acceptance of free market system
developing in the Third World countries
PCs and the internet
Freer access to international markets