Ch. 1 - Introduction to Financial Management 2000, Prentice Hall, Inc.

Ch. 1 - Introduction to Ch. 1 - Introduction to Financial ManagementFinancial Management

2000, Prentice Hall, Inc.

Goal of the FirmGoal of the Firm

1) Profit Maximization?1) Profit Maximization?

this goal ignores:this goal ignores:

a) TIMING of Returnsa) TIMING of Returns(Time Value of Money - Ch. 6)(Time Value of Money - Ch. 6)

b) UNCERTAINTY of Returnsb) UNCERTAINTY of Returns(Risk - Ch. 7)(Risk - Ch. 7)

Goal of the FirmGoal of the Firm

2) Shareholder Wealth 2) Shareholder Wealth Maximization?Maximization?

this is the same as:this is the same as:

a) Maximizing Firm Valuea) Maximizing Firm Value

b) Maximizing Stock Priceb) Maximizing Stock Price

Legal Forms of Business

1) Sole Proprietorship1) Sole Proprietorship A business owned by a single individual.A business owned by a single individual. Owner maintains title to the firm’s assets.Owner maintains title to the firm’s assets. Owner has unlimited liability.Owner has unlimited liability.

2) Partnership2) Partnership Similar to a sole proprietorship, except Similar to a sole proprietorship, except

that there are two or more owners.that there are two or more owners.


2a) General Partnership2a) General Partnership All partners have unlimited liability.All partners have unlimited liability.

2b) Limited Partnership2b) Limited Partnership Consists of one or more general partners, Consists of one or more general partners,

who have unlimited liability, andwho have unlimited liability, and One or more limited partners (investors) One or more limited partners (investors)

whose liability is limited to the amount of whose liability is limited to the amount of their investment in the business.their investment in the business.


3) Corporation3) Corporation A business entity that legally functions A business entity that legally functions

separate and apart from its owners.separate and apart from its owners. Owners’ liability is limited to the amount Owners’ liability is limited to the amount

of their investment in the firm.of their investment in the firm. Owners hold common stock certificates, Owners hold common stock certificates,

and ownership can be transferred by and ownership can be transferred by selling the certificates.selling the certificates.

Corporate Income Tax RatesCorporate Income Tax RatesSince 1993Since 1993

Taxable Income Corporate Tax RateTaxable Income Corporate Tax Rate

$1 - $50,000 15%$1 - $50,000 15%

$50,001 - $75,000 25%$50,001 - $75,000 25%

$75,001 - $10 million 34%$75,001 - $10 million 34%

over $10 million 35%over $10 million 35%

andand

$100,000 - $335,000 5% surtax$100,000 - $335,000 5% surtax

$15m - $18.333 m 3% surtax$15m - $18.333 m 3% surtax

Corporate Income TaxesCorporate Income Taxes 4 important considerations:4 important considerations:


dividend incomedividend income - -


dividend incomedividend income - 70% is exempt from - 70% is exempt from federal taxation.federal taxation.



Net operating lossesNet operating losses - -



Net operating lossesNet operating losses - may be carried back - may be carried back 2 years or forward up to 20 years.2 years or forward up to 20 years.




Net capital gainsNet capital gains - -




Net capital gainsNet capital gains - taxed as ordinary - taxed as ordinary income.income.




Net capital gainsNet capital gains - taxed as ordinary - taxed as ordinary income.income.

Net capital lossesNet capital losses - -



Net operating lossesNet operating losses - may be carried back 2 - may be carried back 2 years or forward up to 20 years.years or forward up to 20 years.

Net capital gainsNet capital gains - taxed as ordinary income. - taxed as ordinary income. Net capital lossesNet capital losses - may be carried back 3 - may be carried back 3

years or forward up to 5 years and applied years or forward up to 5 years and applied against net capital gains.against net capital gains.

Financial Management AxiomsFinancial Management Axioms 1) Risk - return trade-off1) Risk - return trade-off 2) Time value of money2) Time value of money 3) Cash is king3) Cash is king 4) Incremental cash flows count4) Incremental cash flows count 5) It’s hard to find really profitable projects5) It’s hard to find really profitable projects 6) Efficient capital markets6) Efficient capital markets 7) The agency problem7) The agency problem 8) Taxes bias business decisions8) Taxes bias business decisions 9) All risk is not equal9) All risk is not equal 10) Ethical dilemmas are everywhere in finance10) Ethical dilemmas are everywhere in finance

Tax Examples:Tax Examples:

Space Cow Computer has sales of Space Cow Computer has sales of $32 $32 millionmillion, cost of goods sold at , cost of goods sold at 60%60% of of sales, cash operating expenses of sales, cash operating expenses of $2.4 $2.4 millionmillion, and , and $1.4 million$1.4 million in in depreciation expense. The firm depreciation expense. The firm received received $400,000$400,000 in dividend income, in dividend income, and has and has $12 million$12 million in in 9.5%9.5% bonds bonds outstanding. The firm will pay outstanding. The firm will pay $500,000$500,000 in dividends to its common in dividends to its common stock holders.stock holders.

Calculate the firm’s tax liability.Calculate the firm’s tax liability.

SalesSales $32,000,000$32,000,000

Cost of Goods SoldCost of Goods Sold (19,200,000)(19,200,000)

Operating ExpensesOperating Expenses (2,400,000)(2,400,000)

Depreciation ExpenseDepreciation Expense (1,400,000) (1,400,000)

EBIT or NOIEBIT or NOI 9,000,0009,000,000

Dividend Income Dividend Income $400,000$400,000

less 70% less 70% (280,000)(280,000) 120,000120,000

Interest ExpenseInterest Expense (1,140,000)(1,140,000)

Taxable IncomeTaxable Income 7,980,000 7,980,000

Income Income tax rate tax rate tax paymenttax payment

$50,000 x .15 = $50,000 x .15 = $ 7,500$ 7,500

$25,000 x .25 = $25,000 x .25 = 6,2506,250

$7,905,000 x .34 = $7,905,000 x .34 = 2,687,7002,687,700

surtax:surtax:

$235,000 x .05 = $235,000 x .05 = 11,750 11,750

Total Tax payment Total Tax payment $2,713,200$2,713,200

short cut:short cut: $7,980,000 x .34 = $7,980,000 x .34 = $2,713,200$2,713,200

Barn Yard Brewery has sales of Barn Yard Brewery has sales of $40 million$40 million, , cost of goods sold of cost of goods sold of $19.5 million$19.5 million, cash , cash operating expenses of operating expenses of $3 million$3 million, and , and $1 $1 millionmillion in depreciation expense. The firm in depreciation expense. The firm received received $50,000$50,000 in dividend income. Also, in dividend income. Also, the firm sold the firm sold 5,0005,000 shares of AT&T stock shares of AT&T stock for for $76$76 that it had purchased for that it had purchased for $55$55 four four years ago, and sold property for years ago, and sold property for $4 million$4 million that originally cost the firm that originally cost the firm $3.5 million$3.5 million..

Calculate the firm’s tax liability.Calculate the firm’s tax liability.

SalesSales $40,000,000$40,000,000


Deprec. & Operating ExpensesDeprec. & Operating Expenses (4,000,000)(4,000,000)

EBIT or NOIEBIT or NOI 16,500,00016,500,000Dividend Income 50,000Dividend Income 50,000

less 70% (35,000)less 70% (35,000) 15,000 15,000

Ordinary IncomeOrdinary Income $16,515,000$16,515,000

Capital Gains:Capital Gains:

stock: 5,000 ($76-$55)stock: 5,000 ($76-$55) 105,000105,000

property: $4m - $3.5mproperty: $4m - $3.5m 500,000 500,000

Taxable Income Taxable Income $17,120,000 $17,120,000

IncomeIncome tax ratetax rate tax paymenttax payment

$50,000 x .15 = $50,000 x .15 = $ 7,500$ 7,500

$25,000 x .25 = $25,000 x .25 = 6,2506,250

$9,925,000 x .34 = $9,925,000 x .34 = 3,374,5003,374,500

$7,120,000 x .35 = $7,120,000 x .35 = 2,492,0002,492,000

surtaxes:surtaxes:

$235,000 x .05 = $235,000 x .05 = 11,75011,750

$2,120,000 x .03 = $2,120,000 x .03 = 63,600 63,600

Total taxes paid: $5,955,600Total taxes paid: $5,955,600

Short cut:

IncomeIncome tax ratetax rate tax paymenttax payment

$10,000,000 x .34 = $10,000,000 x .34 = 3,400,0003,400,000

$7,120,000 x .35 = $7,120,000 x .35 = 2,492,0002,492,000surtax:surtax:

$2,120,000 x .03 = $2,120,000 x .03 = 63,600 63,600

Total taxes paid: $5,955,600Total taxes paid: $5,955,600

Last year, Seaside Corporation had sales of Last year, Seaside Corporation had sales of $50 million$50 million. The firm’s cost of goods sold . The firm’s cost of goods sold amounted to amounted to 44%44% of sales, and cash of sales, and cash operating expenses amounted to operating expenses amounted to 14%14% of of sales. Seaside has sales. Seaside has $17.5 million$17.5 million in in equipment that it will depreciate using equipment that it will depreciate using simplified straight line over the next simplified straight line over the next 77 years. Seaside sold years. Seaside sold 10,00010,000 shares of IBM shares of IBM stock for stock for $110$110 per share that it had per share that it had purchased earlier for purchased earlier for $90$90 a share. a share. Unfortunately, the firm also sold property Unfortunately, the firm also sold property for for $3.5 million$3.5 million that it had bought years that it had bought years earlier for earlier for $4 million$4 million. Seaside received . Seaside received $80,000$80,000 in common stock dividend income, in common stock dividend income, and paid and paid $120,000$120,000 in cash dividends to its in cash dividends to its own shareholders. Seaside has own shareholders. Seaside has $6.55 $6.55 millionmillion in in 8%8% coupon bonds outstanding. coupon bonds outstanding. Calculate the firm’s tax liability.Calculate the firm’s tax liability.

SalesSales $50,000,000$50,000,000


Operating ExpensesOperating Expenses (7,000,000)(7,000,000)

Depreciation ExpenseDepreciation Expense (2,500,000)(2,500,000)

EBIT or NOIEBIT or NOI 18,500,00018,500,000

Dividend Income Dividend Income $80,000$80,000

less 70% less 70% (56,000)(56,000) 24,000 24,000

Interest ExpenseInterest Expense (524,000) (524,000)

Taxable IncomeTaxable Income 18,000,000 18,000,000


$50,000 x .15 = $50,000 x .15 = $ 7,500$ 7,500

$25,000 x .25 = $25,000 x .25 = 6,2506,250

$9,925,000 x .34 = $9,925,000 x .34 = 3,374,5003,374,500

surtax:surtax:

$235,000 x .05 = $235,000 x .05 = 11,75011,750

$8,000,000 x .35 = $8,000,000 x .35 = 2,800,0002,800,000

surtax:surtax:

$3,000,000 x .05 = $3,000,000 x .05 = 90,000 90,000

Total Tax payment $6,290,000Total Tax payment $6,290,000

Short cut:Short cut:


$10,000,000 x .34 = $10,000,000 x .34 = $3,400,000$3,400,000

$8,000,000 x .35 = $8,000,000 x .35 = 2,800,0002,800,000

surtax:surtax:

$3,000,000 x .05 = $3,000,000 x .05 = 90,000 90,000

Total Tax payment $6,290,000Total Tax payment $6,290,000

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Ch. 1 - Introduction to Financial Management 2000, Prentice Hall, Inc.

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