FNC 2013

Principle of Finance
Chapter 1
An Introduction to Financial
Management

Overview
1.What is Finance
2.Goal of the firm
3.Legal forms of Business Organizations
4.The Goal of the Financial Manager
5.The Four Basic Principles of Finance

Learning Objectives
1. Identify the goal of the firm.
2. Identify the key differences between 3
major legal forms of business.
3. Understand the role of the financial
manager within the firm and the goal for
making financial choices.
4. Memorize the 4 principles of finance that
form the basis of financial management
for both businesses and individuals.
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What is Finance?
Finance is the study of how people and
businesses evaluate investments and
raise capital to fund them. (-- How to get
and use money)
Three questions addressed by the study of
finance
1. What long-term investments should the firm
undertake? (capital budgeting decisions
how to spend the money?)
2. How should the firm fund these investments?
(capital structure decisions -- How to get the
money?)
3. How can the firm best manage its cash flows
as they arise in its day-to-day operations?
(working capital management decisions
how to manage cash (liquid) money?)

Why study finance

Marketing
Budgets, marketing research, marketing financial
products
Accounting
Dual accounting and finance function, preparation of
financial statements
Management
Strategic thinking, job performance, profitability
Personal finance
Budgeting, retirement planning, college planning, dayto-day cash flow issues
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Goal of the firm

The goal of the firm is maximization of
shareholder wealth
or
Maximization of the price of the existing
common stock

Three Types of Business

Organizations

Sole Proprietorship
It is a business owned by a single individual that is
entitled to all the firms profits and is responsible for all
the firms debt.
There is no separation between the business and the
owner when it comes to debts or being sued.
Sole proprietorships are generally financed by
personal loans from family and friends and business
loans from banks.

Advantages:

Easy to start
No need to consult others while making decisions
Taxed at the personal tax rate

Disadvantages:

Personally liable for the business debts

Ceases on the death of the proprietor
FIN3000, Liuren Wu

Partnership
A general partnership is an association of two or more
persons who come together as co-owners for the
purpose of operating a business for profit.
There is no separation between the partnership and the
owners with respect to debts or being sued.
Advantages:
Relatively easy to start
Taxed at the personal tax rate
Access to funds from multiple sources or partners
Disadvantages:
Partners jointly share unlimited liability
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Limited Partnership
In limited partnerships, there are two
classes of partners: general and limited.
The general partners runs the business
and face unlimited liability for the firms
debts, while the limited partners are only
liable on the amount invested.
One of the drawback of this form is that it
is difficult to transfer the ownership of the
general partner.
FIN3000, Liuren Wu

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Corporation
Corporation is an artificial being, invisible,
intangible, and existing only in the contemplation
of the law.
Corporation can individually sue and be sued,
purchase, sell or own property, and its personnel
are subject to criminal punishment for crimes
committed in the name of the corporation.
Corporation is legally owned by its current
stockholders.
The Board of directors are elected by the firms
shareholders. One responsibility of the board of
directors is to appoint the senior management of
the firm.
FIN3000, Liuren Wu

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Corporation Pros & Cons

Advantages
Liability of owners limited to invested funds
Life of corporation is not tied to the owner
Easier to transfer ownership
Easier to raise Capital
Disadvantages
Greater regulation
Double taxation of dividends

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Hybrid Organizations
These organizational forms provide a cross
between a partnership and a corporation.
Limited liability company (LLC) combines the
tax benefits of a partnership (no double taxation of
earnings) and limited liability benefit of
corporation (the owners liability is limited to what
they invest).
S-type corporation provides limited liability while
allowing the business owners to be taxed as if
they were a partnership that is, distributions
back to the owners are not taxed twice as is the
case with dividends in the standard corporate
form.
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FIN3000, Liuren Wu

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The Goal of the Financial Manager

The goal of the financial manager must be consistent with
the mission of the corporation.

To maximize firm value shareholders wealth (as

measured by share prices).
While managers have to cater to all the stakeholders (such
as consumers, employees, suppliers etc.), they need to
pay particular attention to the owners of the corporation,
i.e., shareholders.
If managers fail to pursue shareholder wealth
maximization, they will lose the support of investors and
lenders. The business may cease to exist and ultimately,
the managers will lose their jobs!

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Corporate Mission Statements:

Examples
To achieve sustainable growth, we have established a
vision with clear goals: Maximizing return to
shareholders while being mindful of our overall
responsibilities (part of Coca-Colas mission statement)
Our final responsibility is to our stockholders when
we operate according to these principles, the
stockholders should realize a fair return (part of
Johnson & Johnsons credo)
Optimize for the long-term rather than trying to produce
smooth earnings for each quarter -- Google.
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The Four Basic Principles of

Finance
1.

Money has a time value.

A dollar received today is more valuable than a dollar received in the
future (due to interests, investment returns,)
2. There is a risk-return trade-off.
One shall take extra risk only if one expects to be compensated for extra
return.
3. Cash flows are the source of value.
Profit is an accounting concept designed to measure a businesss
performance over an interval of time.
Cash flow is the amount of cash that can actually be taken out of the
business over this same interval.
4. Market prices reflect information.
Investors respond to new information by buying and selling their
investments.

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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 Profits

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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