Foundations of Finance: An Introduction To The Foundations of Financial Management - The Ties That Bind

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND
Foundations of Finance
Arthur J. Keown J. William Petty John D. Martin David F. Scott, Jr.
Chapter 1 An Introduction to the Foundations of Financial Management The Ties that Bind
Chapter Objectives
Identify the goal of the firm. Compare the various legal forms of business organization and explain why the corporate form of business is the most logical choice for a firm that is large or growing. Describe the corporate tax features that affect business decisions.
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Describe the corporate tax features that affect decisions. Explain the 10 principles that form the foundations of financial management. Explain what has led to the era of the multinational corporation.
Pearson Prentice Hall
The Goal of the Firm
The goal of the firm is maximization of shareholder wealth or
Maximization of the price of the existing common stock

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Profit Maximization
Stresses the efficient use of capital resources Not specific to time frame for profits to be measured
Goals are not precise, allow for misinterpretation Ignores uncertainty and timing
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Benefits of Maximizing Shareholder Wealth

Good decisions are those that create wealth for the shareholder Societal benefits as businesses compete to create wealth Includes effects of all financial decisions
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Legal Forms of Business Organization

Sole Proprietorship
Partnership
Corporation
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Sole Proprietorship
Business owned by an individual Owner maintains title to assets and profits Unlimited liability Termination occurs on owners death or by owners choice
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Partnerships
Two or more owners General Partnership Each partner is fully responsible for liabilities
Limited Partnerships
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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 own property Owners who dictate direction and policies Elect a board of directors Investors liability is restricted to amount of investment in company Life continues with transfer of ownership Taxed separately
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Comparison of Organizational Forms

Large growing firms choose the corporate form
Ease in raising capital Limited liability Transfer of ownership is simple
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Comparison of Organizational Forms

Sole Proprietorship and General Partnership
Unlimited liabilities Not as easy to raise capital
Limited Partnership
Limited liability for partners Practical number of partners restricted Restricted marketability of interest in partnership
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Organizational Form and Taxes Corporation

Double taxation of dividends Tax act of 2003 limited tax rate on dividends 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
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The Role of the Financial Manager in a Corporation

HOW THE FINANCE AREA FITS INTO A CORPORATION
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Objectives of Income Taxation

Raise revenues for government expenditures Achieve socially desirable goals
Economic stabilization
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Types of Taxpayers
Individuals
employees, self-employed persons, members of partnerships Report income on personal tax return
Corporations
separate legal entity Report income on corporate tax return Distributed dividends taxed to shareholders
Fiduciaries
estates and trusts Pay taxes on undistributed income
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Computing Taxable Income

Taxable Income
Gross income less tax deductible expenses, plus interest income and dividend income
Gross Income
Dollar sales from a product or service less cost of production or acquisition
Tax Deductible Expenses

Operating expenses (marketing, depreciation, administrative expenses) and interest expense
Dividends paid are not deductible

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Computing Taxable Income ($000s)
Sales Cost of Goods Sold Gross Profit Operating Expenses Administrative Expenses Depreciation Expense Marketing Expenses Total Operating Expenses Operating Income Other Income Interest Expense Taxable Income
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$50,000 23,000 $27,000

$4,000 1,500 4,500 $10,000 $17,000 0 1,000 $16,000
Corporate Tax Rates

Income $ 0 - $50,000 $50,001 - $75,000 $75,001 - $10,000,000 Over $10,000,000 Additional surtax: 5% on income between $100,000 and $335,000 3% on income between $15,000,000 and $18,333,333
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Rate 15% 25% 34% 35%
Marginal Tax Rates

Rates applicable to next dollar of income Used in financial decision-making
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Other Corporate Tax Considerations

Dividend Exclusion
A corporation may typically exclude 70% of any dividend received from another corporation.
Depreciation Expense
A corporation may expense an assets cost over its useful life
Capital Gains and Losses

Capital Gains taxed as ordinary income. Capital losses cannot be deducted from ordinary income.
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Ten Principles That Form The Foundations of Financial Management
although it is not necessary to understand finance in order to understand these principles, it is necessary to understand these principles in order to understand finance.
Principle 1: The Risk-Return Trade-off

We wont take on additional risk unless we expect to be compensated with additional return. Investment alternatives have different amounts of risk and expected returns. The more risk an investment has, the higher its expected return will be.
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Principle 2: The Time Value of Money

A dollar received today is worth more than a dollar received in the future. Because we can earn interest on money received today, it is better to receive money earlier rather than later.
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Principle 3: CashNot ProfitsIs King

Cash Flow, not accounting profit, is used as our measurement tool. Cash flows, not profits, are actually received by the firm and can be reinvested.
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Principle 4: Incremental Cash Flows

It is only what changes that counts
The incremental cash flow is the difference between the projected cash flows if the project is selected, versus what they will be, if the project is not selected.
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Principle 5: The Curse of Competitive Markets

It is hard to find exceptionally profitable projects If an industry is generating large profits, new entrants are usually attracted. The additional competition and added capacity can result in profits being driven down to the required rate of return. Product Differentiation, Service and Quality can insulate products from competition
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Principle 6: Efficient Capital Markets

The markets are quick and the prices are right. The values of all assets and securities at any instant in time fully reflect all available information.
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Principle 7: The Agency Problem

Managers wont work for the owners unless it is in their best interest
The separation of management and the ownership of the firm creates an agency problem.
Managers may make decisions that are not in line with the goal of maximization of shareholder wealth.
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Principle 8: Taxes Bias Business Decisions

The cash flows we consider are the after-tax incremental cash flows to the firm as a whole.
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Principle 9: All Risk is Not Equal

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 assets risk is very difficult.
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Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance
Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing
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Finance and the Multinational Firm

U.S. corporations are looking to international expansion
Collapse of communism Acceptance of free market system developing in the Third World countries PCs and the internet Freer access to international markets
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

The Goal of the Firm

The goal of the firm is maximization of shareholder wealth or

Maximization of the price of the existing common stock

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Benefits of Maximizing Shareholder Wealth

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Legal Forms of Business Organization

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Comparison of Organizational Forms

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Comparison of Organizational Forms

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Organizational Form and Taxes Corporation

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Organizational Form and Taxes S-Type Corporations

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Organizational Form and Taxes Limited Liability Corporations

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

The Role of the Financial Manager in a Corporation

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Objectives of Income Taxation

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Computing Taxable Income

Tax Deductible Expenses

Dividends paid are not deductible

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Computing Taxable Income ($000s)

$50,000 23,000 $27,000

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Corporate Tax Rates

Rate 15% 25% 34% 35%

Pearson Prentice Hall

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT THE TIES THAT BIND

Marginal Tax Rates

Pearson Prentice Hall