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Chapter 1Introduction to Financial

Management• Key sections:

– What is financial management?– Legal forms of business– Principles of taxation– Shareholder wealth, not profit, maximization is goal– The ten principles of financial management

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What is Financial Management?

• Tools and decision making processes to maintain/create economic value and shareholder wealth

• What investments to make and how to finance them

• Allocation of scarce resources based on uncertain costs/benefits

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Goal of the Firm

• Maximize shareholder wealth

– Measured by market value of stock

– Includes effect of all financial decisions

• Shareholder wealth max profit maximization

– PM ignores risk/timing of cash flows

– Increase current profits by cutting R&D and maintenance??? (Probably not good idea)

• How should stock price be affected?

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Legal Forms of Business

• Proprietorship – unincorporated, one individual, personally responsible for all its debts and losses

• Partnership – two or more co-owners governed by an agreement– General partnership – each partner fully liable

– Limited – one GP and LP’s with limited liability

– Various other types of partnerships

• Corporations

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Corporations

• Composed of owners (shareholders)– Elect directors who appoint managers– Function separately and apart from owners

• Shareholder’s maximum loss – amount paid for shares

• Advantages: limited liability, transferability, funding availability, no upside limit on potential

• Disadvantages: double taxation, expensive to form

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Taxation

• Our emphasis – how taxes affect decisions through expense deductions

• Taxes based on profits: sales and other income less allowable expenses and exclusions– Cost of producing, marketing, admin expense,

depreciation and interest (but not dividends)

• Progressive rates – more earned, higher the marginal rate– Marginal, not average, rate relevant

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Other Tax Considerations

• 70% of dividends from another corporation excluded from taxable income (sometimes 100%)

• Depreciation – asset’s value expensed over its life– Different methods used – total expense the same but

not the timing

– Often straight line for financials, accelerated for taxes

• Capital gains/losses – taxed as ordinary income for corporations; cap gains and dividend taxes recently changed by Congress for individuals

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Tax Implications

• Measure returns on after-tax basis using marginal, not average, tax rates

• Taxes affect capital structure – interest, but not dividends, tax deductible

• New tax law: for individuals both dividends and long-term capital gains taxed at 15%

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The Ten Principles

• These are statements of common sense– Provide logic behind rest of this course

• #1 Risk/return tradeoff– Won’t take additional risk unless compensated; we

are risk adverse

– Greater risk, greater expected return

– Key concept in valuing all assets

– Almost every decision involves tradeoffs

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Risk-Return Relationship

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# 2 Time Value of Money- TVM

• A dollar received today is worth more than a dollar received in the future

• Earn more interest on money received sooner

• Brings future benefits and costs back to present time – makes them comparable

• Assumes cost of money determined by risks and returns (more risk, higher returns)

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#3 Cash, not Profit, is King

• Can only use cash flows, not profits– Cash, but not profits, can be reinvested

• Accounting profits shown when earned; cash flows occur when collected

• Capital expenditures occur immediately; accounting records depreciation over many years

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#4 Incremental Cash Flows(Only what changes counts)

• Think incrementally.

• Will the project make a difference?

• Not all cash flows are incremental– New product may cannibalize an old product

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#5 Curse of Competitive Markets

• Hard to find exceptionally profitable projects• Large profits attract new competitors• Can’t last long if markets competitive• Barriers to entry and product differentiation

– Brand name, service, quality, patents, advertising

– Cost advantages – economies of scale, proprietary technology, etc.

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#6 Markets Assumed Efficient

• Values fully reflect all available information at any point in time

• You can’t expect to beat the market

• Efficiency determined by speed new info is reflected in prices

• Market prices reflect expected cash flows

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#7 Agency Problems

• Management won’t work for owners unless it is in their interest

• Arises from separation between decision makers and owners (“the corporate jet problem”)

• Why isn’t management fired if don’t act in shareholders’ interest?

• Need to align interests (monitoring, auditing, options, bonuses)

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#8 Taxes Bias Business Decisions

• Must consider after-tax incremental cash flows

• Tax incentives – deductions and credits (R&D spending)

• Interest – a deductible expense; dividends not deductible; may affect capital structure

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#9 Not All Risk Is Equal

• Some can be diversified away, some cannot

• Diversification – multiple investments; reduces risk– One investment’s gain offsets another’s loss

• Reduces total variability without reducing returns (providing returns don’t move together)

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Reduce Risk - Diversify

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#10 Ethical Behavior“Doing the Right Thing”

• Ethical errors are NEVER forgiven

• Unethical behavior eliminates trust– Without trust, companies can’t interact

• Loss of confidence in company’s ethical behavior – extremely damaging

• Social responsibility – goes beyond shareholder wealth maximization

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Multinational Corporations (MNC’s)

• Operations in more than one country• Began after WWII devastation; accelerated

by fall of communism, acceptance of free markets, and information technology

• Coke earns more in Japan than in US; Dow, Colgate, 3M, HP more than half profits from overseas

• Many US firms owned by foreign interests