Introduction to Financial Management

Forms of Businesses Goals of the Corporation Stock Prices and Intrinsic Value Some Recent Trends Conflicts Between Managers and

Shareholders

Alternative Forms of Business Organization

Proprietorship Partnership Corporation

Proprietorships & Partnerships Advantages

Ease of formation Subject to few regulations No corporate income taxes

Disadvantages Difficult to raise capital Unlimited liability Limited life

Corporation Advantages

Unlimited life Easy transfer of ownership Limited liability Ease of raising capital

Disadvantages Double taxation Cost of set-up and report filing

Double Taxation of Corporate Profits/IncomeAssume Corporate and Individual Tax = 50%Earnings Before Taxes $100 EBT

($50) Corporate TaxNet Income After Tax $50 NIAT (Profits)Assume 100% Div. Payout $50 Dividend Income

($25) Personal Income Tax$25 After-tax Income

New Tax Code (2003): Max. Tax Rate of 15% for DIVEarnings Before Taxes $100 EBT

($50) Corporate TaxNet Income After Tax $50 NIAT Assume 100% DIV $50 Dividend Income

($7.50) Income Tax @ 15%$42.50 After-tax Income

Corporate Income Taxes – 2006

More than But not more than Then the tax is of the amount over $0 $50,000 15% $0

$50,000 $75,000 $7,500 + 25% $50,000

$75,000 $100,000 $13,750 + 34% $75,000

$100,000 $335,000 $22,250 + 39% $100,000

$335,000 $10 million $113,900 + 34% $335,000

$10 million $15 million $3,4 million + 35% $10 million

$15 million $18.33 million $5.15 million + 38% $15 million

$18.33 million --35% --

2005 federal personal income tax ratesOrdinary taxable income for use in filing returns due April 15, 2006.

Tax rate Single filers Married filing jointly Married filing separately Head of household 10% Up to $7,300 Up to $14,600 Up to $7,300 Up to $10,450

15% $7,301 - $29,700 $14,601 - $59,400 $7,301 - $29,700 $10,451 - $39,800

25% $29,701 - $71,950 $59,401 - $119,950 $29,701 - $59,975 $39,801-$102,800

28% $71,951 - $150,150 $119,951 - $182,800 $59,976 - $91,400 $102,801 - 166,450

33% $150,151 - $326,450 $182,801 - $326,450 $91,401 - $163,225 $166,451 - $326,450

35% $326,451 or more $326,451 or more $163,226 or more $326,451 or more

Alternative Forms of Business Organization

Sole proprietorship – 73% of firms, but only 7% of sales revenue

Partnership – 7% of firms, 5% of sales

Corporation – 20% of firms, but 88% of sales revenue.

Financial Goals of the Corporation The primary financial goal is shareholder

wealth maximization, which translates to maximizing stock price. Do firms have any responsibilities to society at

large? Is stock price maximization good or bad for

society? Should firms behave ethically?

Factors that affect stock price Projected cash

flows to shareholders

Timing of the cash flow stream

Riskiness of the cash flows

Stock Prices and Intrinsic Value In equilibrium, a stock’s price should equal its

“true” or intrinsic value. To the extent that investor perceptions are

incorrect, a stock’s price in the short run may deviate from its intrinsic value.

Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run.

Determinants of Intrinsic Value and Stock Prices (Figure 1-1)

Some Important Trends Recent corporate scandals have

reinforced the importance of business ethics, and have spurred additional regulations and corporate oversight.

The effects of changing information technology have had a profound effect on all aspects of business finance.

The continued globalization of business.

Financial Management Issues of the New Millennium

The effect of changing technology

The globalization of business1. Improvements in communications and transportation – lower transactions cost

2. Increased power of consumers – more choice, consumer sovereignty3. Increased cost of developing new products – global markets spread fixed costs over more units4. MNCs must be able to shift production globally to take advantage of cost efficiencies.

Percentage of Revenue and Net Income from Overseas Operations for 10 Well-

Known Corporations, 2001

Company % of Revenue from overseas

% of Net Income from overseas

Coca-Cola 60.8 35.9

Exxon Mobil 69.4 60.2

General Electric 32.6 25.2

General Motors 26.1 60.6

IBM 57.9 48.4

JP Morgan Chase & Co.

35.5 51.7

McDonald’s 63.1 61.7

Merck 18.3 58.1

3M 52.9 47.0

Sears, Roebuck 10.5 7.8

Conflicts Between Managers and Stockholders

Managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders).

But the following factors affect managerial behavior: Managerial compensation plans Direct intervention by shareholders The threat of firing The threat of takeover

Responsibility of the Financial Staff Maximize stock value by:

Forecasting and planning Investment and financing decisions Coordination and control Transactions in the financial markets Managing risk