Chapter 1

Getting
Started
Principles of
Finance
Slide Contents

Learning Objectives
Introduction
1. Finance: An Overview
2. Three Types of Business Organizations
3. The Goal of the Financial Manager
4. The Five Basic Principles of Finance
Key Terms

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Learning Objectives

1. Understand the importance of finance in

your personal and professional lives and
identify the three primary business
decisions that financial managers make.

2. Identify the key differences between the

three major legal forms of business.

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Learning Objectives (cont.)

3. Understand the role of the financial

manager within the firm and the goal for
making financial choices.

4. Explain the five principles of finance that

form the basis of financial management for
both businesses and individuals.

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 1.1 FINANCE:
AN OVERVIEW

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What is Finance?

Finance is the study of how people and

businesses evaluate investments and raise
capital to fund them.

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Three Basic Questions Addressed by
the Study of Finance:

1. What long-term investments should the

firm undertake?
2. How should the firm raise money to fund
these investments?
3. How can the firm best manage its cash
flows as they arise in its day-to-day
operations?

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Why Study Finance?

Knowledge of financial tools is critical to

making good decisions in both corporate
world and personal lives.

How will GMs strategic decision to invest $740

million to produce the Chevy Volt require the
expertise of different disciplines within the
business school?

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 1.2 THREE TYPES OF
BUSINESS ORGANIZATIONS

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Business Organizational Forms

Business
Forms

Sole
Partnerships
Proprietorships Corporations

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Sole Proprietorship

It is a business owned by a single individual

who is entitled to all of the firms profits and
is responsible for all of the firms debt.

The sole proprietors typically raise money

by investing their own funds and by
borrowing from a bank.

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Sole Proprietorship (cont.)

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
The business ceases on the death of the
proprietor
Harder to raise money

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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.

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Partnership (cont.)

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
It is not always easy to transfer ownership

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Partnership (cont.)

In limited partnerships, there are two

classes of partners: general and limited.

The general partner runs the business and

faces unlimited liability for the firms debts,
whereas the limited partner is only liable up
to the amount the limited partner invested.

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Private Limited Company (Sdn Bhd)

Separate Legal Entity : Unlike sole

proprietorship, a private limited company is
a separate legal identity. It can acquire
assets, go into debt, enter into contracts,
sue or be sued in its own name and has a
perpetual succession until the directors and
shareholders decide to dissolve the
company.

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Sdn Bhd (cont.)

Limited Liability: The liability of the

members/owners is limited to the amount
that they each have contributed as capital
to the company. There is a separation
between the owners and its personal assets.
If the company fails to meet its liabilities,
the creditors will not be able to go after the
owners personal assets.

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Sdn Bhd (cont.)

Credibility: A private limited company (Sdn

Bhd) gives credibility to the business
owners.

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Sdn Bhd (cont.)

Usually entrepreneurs toy between setting

up a private limited company (Sdn Bhd) and
a sole proprietorship. The impression of sole
proprietorship is the impermanence of such
a set-up. Sole proprietorship can be closed
down by merely filing a form to the
Registrar informing the cessation of
business. Furthermore, death of the owner
will also cause the sole proprietorship to be
terminated.

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Corporation

If very large sums of money are needed to

build a business, then the typical
organizational form chosen is the corporation.
The corporation is legally owned by its current
set of stockholders, or owners.

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Corporation (cont.)

Corporation legally functions separately and

apart from its owners (the shareholders).
Corporation can individually sue and be
sued.

The Board of directors are elected by the

shareholder, and the board appoints the
senior management of the firm.

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Corporation (cont.)

Advantages
Liability of owners is 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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Limited Liability Company (LLC)

Limited liability company (LLC) combines

the tax benefits of a partnership (no double
taxation of earnings) with the limited liability
benefit of corporation (the owners liability is
limited to what they invest).

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Figure 1.1 Characteristics of
Different Forms of Business

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Figure 1.2 How the Finance Area
Fits into a Corporation

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 1.3 THE GOAL OF THE
FINANCIAL MANAGER

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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,
which is to maximize shareholders wealth.

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Coca-Colas Vision Statement

To achieve sustainable growth, we have

established a vision with clear goals for:
Profit
People
Portfolio
Partners
Planet

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Corporate Mission

While managers have to cater to all the

stakeholders (such as consumers,
employees, suppliers etc.), they need to pay
particular attention to the 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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Ethics in Finance

What do we mean by Ethics?

Give examples of recent financial scandals

and discuss what went wrong from an
ethical perspective.

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Sarbanes-Oxley Act (SOX)

SOX Act was passed in 2002 to protect

investors by improving the accuracy and
reliability of corporate disclosures made
pursuant to the securities laws, and for
other purposes.

SOX Act mandates senior executives to take

responsibility for the accuracy and
completeness of financial reports.

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 1.4 THE FIVE BASIC
PRINCIPLES OF FINANCE

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PRINCIPLE 1:Money Has a Time
Value

A dollar received today is worth more than a

dollar received in the future.

We can invest the dollar received today to

earn interest. Thus, in the future, you will
have more than one dollar, as you will
receive the interest on your investment.

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PRINCIPLE 2: There is a Risk-Return
Trade-off

We wont take on additional risk unless we

expect to be compensated with additional
return.

Higher the risk, higher will be the expected

return. Note expected return may not be
equal to the realized rate of return.

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Figure 1.3 There Is a Risk-Return
Tradeoff

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PRINCIPLE 3: Cash Flows Are the
Source of Value

Profit is an accounting concept and

measures a businesss performance. Cash
flow is the amount of cash that can actually
be taken out of the business.

It is possible for a firm to report profits but

have no cash.

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Incremental Cash Flow

Financial decisions in a firm should consider

incremental cash flow i.e. the difference
between the cash flows the company will
produce with the potential new investment
and what it would make without the
investment.

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PRINCIPLE 4: Market Prices Reflect
Information

Investors react quickly to news/information

and decisions made by managers.

Good News ==> Higher stock prices

Bad News ==> Lower stock price.

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PRINCIPLE 5: Individuals Respond
to Incentives

Managers (as agents) respond to incentives

they are given in the workplace. If their
incentives are not properly aligned with those
of the firms stockholders (the principal) they
may not make decisions that are consistent
with increasing shareholder value leading to
agency costs.

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PRINCIPLE 5: Individuals Respond
to Incentives (cont.)
The agency problems/costs can be mitigated through:
1. Compensation plans that reward managers when
they act to maximize shareholder wealth
2. Monitoring by the board of directors
3. Monitoring by financial markets (such as auditors,
bankers, security analysts, credit agencies)
4. The underperforming firms seeing their stock
prices fall and face threat of being taken over and
have their management teams replaced.

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Key Terms

Agency problem
Capital budgeting
Capital structure
Corporation
Debt
Dividends
Equity

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Key Terms (cont.)

Financial markets
General partner
General partnership
Limited liability company (LLC)
Limited partner
Limited partnership
Opportunity cost

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Key Terms (cont.)

Partnership
Shareholders
Shares
Sole proprietorship
Stockholders
Working capital management

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