Chapter 1 An introduction to the foundations of financial management
The goal of the firm = maximize shareholder wealth
The goal of the firm is to create value for the firm’s legal owners (that is, its shareholders).
Thus the goal of the firm is to “maximize shareholder wealth” by maximizing the price of the
existing common stock.
Good financial decisions will increase stock price, and poor financial decisions will lead to a
decline in stock price.
Five Principles that form the foundations of finance:
Principle 1: Cash flow is what matters
Accounting profits are not equal to cash flows. It is possible for a firm to generate accounting
profits but not have cash or to generate cash flows but not report accounting profits in the
books.
Cash flow, and not profits, drive the value of a business.
We must determine incremental or marginal cash flows when making financial decisions.
o 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.
Principle 2: Money has a time value
A dollar received today is worth more than a dollar received in the future.
o Since we can earn interest on money received today, it is better to receive money
sooner rather than later.
o Opportunity cost = the cost of making a choice in terms of next best alternative that
must be foregone.
o Example: By lending money to your friend at zero percent interest, there is an
opportunity cost of 1% that could potentially be earned by depositing the money in a
savings account in a bank.
Principle 3: Risk required a reward
Investors will not take on additional risk unless they expect to be compensated with
additional reward or return.
Investors expect to be compensated for “delaying consumption” and “taking on risk”.
o Thus, investors expect a return when they deposit their savings in a bank (ex.
delayed consumption) and they expect to earn a relatively higher rate of return on
stocks compared to a bank savings account (ex. taking on risk).
Principle 4: Market prices are generally right
In an efficient market, the market prices of all traded assets (such as stocks and bonds) fully
reflect all available information at any instant in time.
, Thus stock prices are a useful indicator of the value of the firm. Price changes reflect changes
in expected future cash flows. Good decision will tend to increase in stock price and vice
versa.
Note there are inefficiencies in the market that may distort the market prices from value of
assets. Such inefficiencies are often caused by behavioural biases.
Principal 5: Conflicts of interest cause problems
The separation of management and the ownership of the firm creates an agency problem.
Managers may make decisions that are not consistent with the goal of maximizing
shareholder wealth.
o Agency conflict is reduced through monitoring (ex. annual reports), compensation
schemes (ex. stock opinions), and market mechanisms (ex. takeovers).
Ethics and trust in business
Ethical dilemma = Each person has his or her own set of values, which forms the basis for
personal judgments about what is the right thing.
Sound ethical standards are important for business and personal success. Unethical decisions
can destroy shareholder wealth (e.g., Enron scandal).
The Role of Business in Finance
Three basic issues addressed by the study of finance:
What long-term investments should the firm undertake? (Capital budgeting decision).
How should the firm raise money to fund these investments? (Capital structure decision).
How to manage cash flows arsing from day-to-day operations? (Working capital decision).
The Legal Forms of Business Organization
Sole proprietorship -> you own your own business
Owner maintains title to assets and profits.
Unlimited liability.
Termination occurs on owner’s death or by owner’s choice.
Partnership -> business with two or more persons.
General partnership: All partners are fully responsible for liabilities incurred by the
partnership.
Limited partnership: One or more partners can have limited liability, restricted to the amount
of capital invested in the partnership. There must be at least one general partner with
unlimited liability. Limited partners cannot participate in the management of the business
and their names cannot appear in the name of the firm.
Corporation -> legally functions separate and apart from its owners.
Owners (shareholders) dictate direction and policies of the corporation, oftentimes through
elected board of directors.
Shareholder’s liability is restricted to amount of investment in company.
Life of corporation does not depend on the owners. Corporation continuous to be run by
managers after transfer of ownership through sale or inheritance.
Corporate form
o Benefits: Limited liability, easy to transfer ownership, easier to raise capital,
unlimited life (unless the firm goes through corporate restructuring such as mergers
and bankruptcies).
o Drawbacks: No secrecy of information, maybe delays in decision making, greater
regulation, double taxation.
, Double taxation example
$ 1.000
Federal Tax: $1.000 * 25% = $250
Dividend Tax: $750 * 15% = $112.50
Total Tax: 250 + 112.50 = $362.50 or 36.25%
S-Type Corporations
o Benefits: Limited liability, taxed as partnership (no double taxation).
o Limitations: Owners must be people so cannot be used for a joint ventures between
two corporations.
Limited Liability Companies (LLC)
o Benefits: Limited liability, taxed like a partnership.
o Limitations: Qualifications vary from state to state, cannot appear like a corporation
otherwise it will be taxed like one.
Why do companies go abroad?
To increase revenues
To reduce expenses (land, labor, capital, raw material, taxes)
To lower governmental regulation standards
To increase global exposure
Risk/challenges of going aboard
Country risk (changes in government regulations, unstable government, economic changes in
foreign country).
Currency risk (fluctuations in exchange rates).
Cultural risk (differences in language, traditions, ethical standards, etc.)
Vocabulary
Incremental cash flow The difference between the cash flows the company will produce
both with and without the investment it’s thinking about making.
Opportunity cost The highest-valued alternative that you had to give up when you
made the choice.
Efficient market One where the price of the assets traded in that market fully reflect
all available information at any instant in time.
Agency problem Problems and conflicts resulting from the separation of the
management and ownership of the firm.
Capital budgeting The decision-making process with respect to investment in fixed
assets.
Capital structure decision The decision-making process with funding choices and the mix of
long-term sources of funds.
Working capital The management of the firm’s current assets and short-term
management financing.
Financial markets Institutions and procedures that facilitate financial transactions.
The goal of the firm = maximize shareholder wealth
The goal of the firm is to create value for the firm’s legal owners (that is, its shareholders).
Thus the goal of the firm is to “maximize shareholder wealth” by maximizing the price of the
existing common stock.
Good financial decisions will increase stock price, and poor financial decisions will lead to a
decline in stock price.
Five Principles that form the foundations of finance:
Principle 1: Cash flow is what matters
Accounting profits are not equal to cash flows. It is possible for a firm to generate accounting
profits but not have cash or to generate cash flows but not report accounting profits in the
books.
Cash flow, and not profits, drive the value of a business.
We must determine incremental or marginal cash flows when making financial decisions.
o 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.
Principle 2: Money has a time value
A dollar received today is worth more than a dollar received in the future.
o Since we can earn interest on money received today, it is better to receive money
sooner rather than later.
o Opportunity cost = the cost of making a choice in terms of next best alternative that
must be foregone.
o Example: By lending money to your friend at zero percent interest, there is an
opportunity cost of 1% that could potentially be earned by depositing the money in a
savings account in a bank.
Principle 3: Risk required a reward
Investors will not take on additional risk unless they expect to be compensated with
additional reward or return.
Investors expect to be compensated for “delaying consumption” and “taking on risk”.
o Thus, investors expect a return when they deposit their savings in a bank (ex.
delayed consumption) and they expect to earn a relatively higher rate of return on
stocks compared to a bank savings account (ex. taking on risk).
Principle 4: Market prices are generally right
In an efficient market, the market prices of all traded assets (such as stocks and bonds) fully
reflect all available information at any instant in time.
, Thus stock prices are a useful indicator of the value of the firm. Price changes reflect changes
in expected future cash flows. Good decision will tend to increase in stock price and vice
versa.
Note there are inefficiencies in the market that may distort the market prices from value of
assets. Such inefficiencies are often caused by behavioural biases.
Principal 5: Conflicts of interest cause problems
The separation of management and the ownership of the firm creates an agency problem.
Managers may make decisions that are not consistent with the goal of maximizing
shareholder wealth.
o Agency conflict is reduced through monitoring (ex. annual reports), compensation
schemes (ex. stock opinions), and market mechanisms (ex. takeovers).
Ethics and trust in business
Ethical dilemma = Each person has his or her own set of values, which forms the basis for
personal judgments about what is the right thing.
Sound ethical standards are important for business and personal success. Unethical decisions
can destroy shareholder wealth (e.g., Enron scandal).
The Role of Business in Finance
Three basic issues addressed by the study of finance:
What long-term investments should the firm undertake? (Capital budgeting decision).
How should the firm raise money to fund these investments? (Capital structure decision).
How to manage cash flows arsing from day-to-day operations? (Working capital decision).
The Legal Forms of Business Organization
Sole proprietorship -> you own your own business
Owner maintains title to assets and profits.
Unlimited liability.
Termination occurs on owner’s death or by owner’s choice.
Partnership -> business with two or more persons.
General partnership: All partners are fully responsible for liabilities incurred by the
partnership.
Limited partnership: One or more partners can have limited liability, restricted to the amount
of capital invested in the partnership. There must be at least one general partner with
unlimited liability. Limited partners cannot participate in the management of the business
and their names cannot appear in the name of the firm.
Corporation -> legally functions separate and apart from its owners.
Owners (shareholders) dictate direction and policies of the corporation, oftentimes through
elected board of directors.
Shareholder’s liability is restricted to amount of investment in company.
Life of corporation does not depend on the owners. Corporation continuous to be run by
managers after transfer of ownership through sale or inheritance.
Corporate form
o Benefits: Limited liability, easy to transfer ownership, easier to raise capital,
unlimited life (unless the firm goes through corporate restructuring such as mergers
and bankruptcies).
o Drawbacks: No secrecy of information, maybe delays in decision making, greater
regulation, double taxation.
, Double taxation example
$ 1.000
Federal Tax: $1.000 * 25% = $250
Dividend Tax: $750 * 15% = $112.50
Total Tax: 250 + 112.50 = $362.50 or 36.25%
S-Type Corporations
o Benefits: Limited liability, taxed as partnership (no double taxation).
o Limitations: Owners must be people so cannot be used for a joint ventures between
two corporations.
Limited Liability Companies (LLC)
o Benefits: Limited liability, taxed like a partnership.
o Limitations: Qualifications vary from state to state, cannot appear like a corporation
otherwise it will be taxed like one.
Why do companies go abroad?
To increase revenues
To reduce expenses (land, labor, capital, raw material, taxes)
To lower governmental regulation standards
To increase global exposure
Risk/challenges of going aboard
Country risk (changes in government regulations, unstable government, economic changes in
foreign country).
Currency risk (fluctuations in exchange rates).
Cultural risk (differences in language, traditions, ethical standards, etc.)
Vocabulary
Incremental cash flow The difference between the cash flows the company will produce
both with and without the investment it’s thinking about making.
Opportunity cost The highest-valued alternative that you had to give up when you
made the choice.
Efficient market One where the price of the assets traded in that market fully reflect
all available information at any instant in time.
Agency problem Problems and conflicts resulting from the separation of the
management and ownership of the firm.
Capital budgeting The decision-making process with respect to investment in fixed
assets.
Capital structure decision The decision-making process with funding choices and the mix of
long-term sources of funds.
Working capital The management of the firm’s current assets and short-term
management financing.
Financial markets Institutions and procedures that facilitate financial transactions.
