Financial Management 2

An Introduction to the Foundations of
Financial Management
The Ties that Bind
Chapter 1
Learning Objectives
1.
2.
3.
4.
5.
6.
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.
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.
Keown, Martin, Petty - Chapter 1
Slide Contents
1.
2.
3.
4.
5.
6.
The Goal of the Firm

Legal Forms of Business Organization
Role of Financial Manager in a
Corporation
Income Taxation
Ten Principles of Finance
Finance and Multinational Firm
1. The Goal of the Firm
The Goal of the Firm
The goal of the firm is to maximize

shareholder wealth.
Shareholder wealth is measured by share
prices. Thus shareholder wealth maximization
would imply maximizing the price of common
stock.
Part of Coca-Colas Vision
Maximizing return to shareowners while

being mindful of our overall
responsibilities.
http://www.thecoca-colacompany.com/ourcompany/mission_vision_values.html
(retrieved March 13, 2007)
Benefits of Maximizing
Shareholder Wealth
Good corporate decisions are those that

create wealth for the shareholder.
Society benefits as scarce resources are
directed to the most profitable use by
businesses competing to create wealth.
Share Price Changes (during last

two years as of June 29, 2007)
Google: Share price increased by nearly $200

or around 67% (from around $300 to $500)
wealth created.
Yahoo: Share price decreased by nearly $8 or

around 23% (from around $35 to $27)
wealth destroyed.
Why is Profit Maximization not

the appropriate goal?
Profit maximization goal is unclear about the

time frame over which profits are to be
measured.
It is easy to manipulate the profits through

various accounting policies.
Profit maximization goal ignores risk and timing
of cash flows.
2. Legal Forms of Business

Organization
Legal Forms of Business

Organization
Sole Proprietorship
Partnership
Corporation
11
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
12
Partnerships
Partnership: Two or more persons come

together as co-owners.
Two types of partnership: General or Limited
13
Partnership - General
All partners are fully responsible for

liabilities incurred by the partnership.
14
Partnerships - Limited
One or more partners can have limited

liability
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.
15
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
16
Corporation
Legally functions separate and apart from its

owners
Corporation can sue, be sued, purchase, sell,
and own property
Owners (shareholders) dictate direction and
policies of the corporation.
Shareholders liability is restricted to the
amount of investment in company.
Life of corporation does not depend on the
status of its owners. Ownership can be easily
transferred.
17
The Trade-offs:
Corporate Form
Benefits:
Limited liability
Easy to transfer ownership
Unlimited life (unless the firm goes through corporate
restructuring such as mergers and bankruptcies)
Drawbacks:
No secrecy of information
Maybe delays in decision making
Greater regulation
Double taxation
18
Double Taxation example
Income
Federal Tax @25%
After tax Income
= $1,000
= $250
= $750
What will be the total tax if the

company chooses to distribute the
after-tax profits to shareholders as
dividends?
19
Double taxation
If corporation distributes the profits as

dividends to shareholders, shareholders will
have to pay taxes on dividends.
Assume shareholders are taxed @20% on

dividend income or 20% of $750 = $150
Total tax = 250 + 150 = $400 or 40%
20
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
21
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
22
3. Role of Financial Manager in a

Corporation
The Role of the Financial Manager in

a Corporation (figure 1.1)
HOW THE FINANCE AREA FITS INTO A CORPORATION
24
The Role of the Financial Manager in

a Corporation (figure 1.1)
In this textbook, we focus on the duties

generally associated with the treasurer
and how investment decisions are
made.
25
4. Income Taxation
Income Taxation
Objectives:
Raise revenues for government

expenditures
Achieve socially desirable goals
Economic stabilization
27
Types of Taxpayers
Individual
Corporation
Includes employees, self-employed persons,

members of partnerships
Reports income on personal tax return
Reports its income and pays tax on profits

Distributed dividends taxed to shareholders
Fiduciaries
Such as estates and trusts pay taxes on income

generated by the estate or trust that is not
distributed to a beneficiary
28
Computing Taxable Income

for Corporation
Taxable Income
Gross Income
Gross income less tax deductible expenses, plus interest

income and dividend 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
29
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
$50,000
23,000
$27,000
$4,000
1,500
4,500
$10,000
$17,000
0
1,000
$16,000
30
Corporate Tax Rates

Income
$ 0 - $50,000
$50,001 - $75,000
$75,001 - $10,000,000
Over $10,000,000
Rate
15%
25%
34%
35%
Additional surtax:
5% on income between $100,000 and $335,000
3% on income between $15,000,000 and $18,333,333
31
Example: Computing taxes on

taxable income of $16m
$50,000
$25,000
$9,925,000
$6,000,000
Surtax
*
*
*
*
.15
.25
.34
.35
.05*($335K-$100K)
.03*($16m - $15m)
Total Tax
=
=
=
=
7,500
6,250
3,374,500
2,100,000
= 11,750
= 30,000
= $5,530,000
32
Marginal Tax Rates
Refers to the tax rate applicable to next dollar

of income.
In the previous example, the marginal tax rate is

38% since $16m falls into the 35% tax bracket
with a 3% surtax.
In financial decision-making, marginal tax

rate is more relevant than average tax rate.
33
Other Corporate Tax

Considerations
Dividend Exclusion
Depreciation Expense
A corporation may typically exclude 70% of any dividend

received from another corporation.
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.
34
5. Ten Principles:
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
Would you invest your savings in the

stock market if it offered the same
expected return as your bank?
We wont take on additional risk unless

we expect to be compensated with
additional return.
Higher the risk of an investment, higher

will be its expected return.
36
The Risk-Return Trade-off
37
Principle 2:
The Time Value of Money
A dollar received today is worth more than a

dollar to be received in the future.
Because we can earn interest on money received

today, it is better to receive money earlier rather
than later.
38
Principle 3:
CashNot ProfitsIs King
In measuring wealth or value, we use cash

Flow, not accounting profit, as our
measurement tool.
Cash flows are actually received by the firm and

can be reinvested. On the other hand, profits are
recorded when they are earned rather than when
money is actually received.
It is possible for a firm to show profits on the

books but have no cash!
39
Principle 4:
Incremental Cash Flows
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.
This difference reflects the true impact of a

decision.
40
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 (through Service, Quality)

and cost advantages (through economies of Scale)
can insulate products from competition.
41
Principle 6:
Efficient Capital Markets
The values of securities at any instant in time

fully reflect all publicly available information.
Prices reflect value and are right.
Price changes reflect changes in expected
cash flows (and not cosmetic changes such
as accounting policy changes). Good
decisions drive up the stock prices and vice
versa.
42
Principle 7:
The Agency Problem
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.
Agency conflict reduced through monitoring (ex.
Annual reports), compensation schemes (ex. stock
options), and market mechanisms (ex. Takeovers).
43
Principle 8:
Taxes Bias Business Decisions
The cash flows we consider for

decision making are the after-tax
incremental cash flows to the firm as
a whole.
44
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. A projects risk changes depending
on whether you measure it standing alone or
together with other projects the company may
take on.
45
All Risk is Not Equal
46
Principle 10:
Ethical Behavior Is Doing the Right Thing, and Ethical

Dilemmas Are Everywhere in Finance
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.
Ethics are relevant in business and unethical
decisions can destroy shareholder wealth (ex.
Enron Scandal).
47
6. Finance and Multinational Firm
Finance and the Multinational Firm
U.S. corporations are looking to international expansion to

discover profits
For example, Coca-Cola earns over 80% of its profits from

overseas sales
In addition to US firms going abroad, we have also witnessed

many foreign firms making their mark in the United States (ex.
the domination of the auto industry by Honda, Toyota, and
Nissan)
International movement has been spurred by:
Collapse of communism
Acceptance of free market system developing in Third World
countries
Technology and communication (PCs and the internet)
Improved transportation
49
Why do companies go abroad?
To increase revenues
To obtain cheaper resources (land, labor,

capital, raw material)
To reduce the burden of government
regulation (ex. Environmental laws, taxes,
labor laws)
To increase global exposure
50
Risks/challenges
Country risk (changes in government

regulations, unstable government, economic
changes)
Currency risk (fluctuations in exchange rates)

Cultural risk (differences in language,
traditions, ethical standards etc.)
51

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Financial Management 2

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An Introduction to the Foundations of

Identify the goal of the firm.

The Goal of the Firm

1. The Goal of the Firm

The Goal of the Firm

The goal of the firm is to maximize

Keown, Martin, Petty - Chapter 1

Part of Coca-Colas Vision

Maximizing return to shareowners while

Keown, Martin, Petty - Chapter 1

Good corporate decisions are those that

Keown, Martin, Petty - Chapter 1

Share Price Changes (during last

Google: Share price increased by nearly $200

Yahoo: Share price decreased by nearly $8 or

Keown, Martin, Petty - Chapter 1

Why is Profit Maximization not

Profit maximization goal is unclear about the

It is easy to manipulate the profits through

2. Legal Forms of Business

Legal Forms of Business

Keown, Martin, Petty - Chapter 1

Business owned by an individual

Owner maintains title to assets and profits

Termination occurs on owners death or by

Keown, Martin, Petty - Chapter 1

Partnership: Two or more persons come

Keown, Martin, Petty - Chapter 1

All partners are fully responsible for

Keown, Martin, Petty - Chapter 1

One or more partners can have limited

Sole Proprietorship and General Partnership

Limited liability for partners

Keown, Martin, Petty - Chapter 1

Legally functions separate and apart from its

Double Taxation example

What will be the total tax if the

If corporation distributes the profits as

Assume shareholders are taxed @20% on

Organizational Form and Taxes

Owners must be people

Organizational Form and Taxes

Limited Liability Corporations

Qualifications vary from state to state

3. Role of Financial Manager in a

The Role of the Financial Manager in

Keown, Martin, Petty - Chapter 1

The Role of the Financial Manager in

In this textbook, we focus on the duties

Keown, Martin, Petty - Chapter 1

Raise revenues for government

Achieve socially desirable goals

Keown, Martin, Petty - Chapter 1

Includes employees, self-employed persons,

Reports its income and pays tax on profits

Such as estates and trusts pay taxes on income

Computing Taxable Income

Gross income less tax deductible expenses, plus interest

Tax Deductible Expenses

Operating expenses (marketing, depreciation, administrative

Keown, Martin, Petty - Chapter 1

Computing Taxable Income ($000s)

Keown, Martin, Petty - Chapter 1

Corporate Tax Rates