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Chapter 1

Getting

Started—Principles of

Finance

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Slide Contents

Introduction

1.inance! An "vervie#

2.$hree $ypes o% &usiness "rgani'ations

(.$he )oal o% the inancial *anager4.$he ive &asic Principles o% inance

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1.1 FINANCE: AN OVEVIE!

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!hat is Finance"

+ inance is the study o% ho# people andusinesses evaluate investents and raisecapital to %und the.

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#hree $asic %&estions Addressed '(

the St&d( of Finance:

1. /hat long-ter investents should the%ir undertae

2. o# should the %ir raise oney to %undthese investents

(. o# can the %ir est anage its cash

%lo#s as they arise in its day-to-dayoperations

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!h( St&d( Finance"+ no#ledge o% %inancial tools is critical to

aing good decisions in oth corporate

#orld and personal lives.

5 o# #ill )*6s strategic decision to invest 7840illion to produce the Chevy 9olt re:uire the

e;pertise o% di%%erent disciplines #ithin theusiness school

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1.) #*EE #+PES OF

$,SINESS OGANI-A#IONS

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$&siness Organiational For/s

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Sole Proprietorship

+ It is a usiness o#ned y a single individual#ho is entitled to all o% the %ir6s pro%its andis responsile %or all o% the %ir6s det.

+ $he sole proprietors typically raise oney yinvesting their o#n %unds and y orro#ing%ro a an.

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Sole Proprietorship 0cont.

+ Advantages!5 Easy to start

5 >o need to consult others #hile aing decisions

5 $a;ed at the personal ta; rate

+ ?isadvantages!

5 Personally liale %or the usiness dets

5 $he usiness ceases on the death o% theproprietor

5 arder to raise oney

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Partnership

A general partnership is an association o%t#o or ore persons #ho coe together asco-o#ners %or the purpose o% operating ausiness %or pro%it.

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Partnership 0cont.

+ Advantages!5 @elatively easy to start

5 $a;ed at the personal ta; rate

5 Access to %unds %ro ultiple sources or partners

+ ?isadvantages!

5 Partners ointly share unliited liaility

5 It is not al#ays easy to trans%er o#nership

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Partnership 0cont.

+ In li/ited partnerships, there are t#oclasses o% partners! general and liited.

+ $he general partner runs the usiness and%aces unliited liaility %or the %ir6s dets,#hereas the liited partner is only liale upto the aount the liited partner invested.

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Corporation

I% very large sus o% oney are needed touild a usiness, then the typicalorgani'ational %or chosen is the corporation.$he corporation is legally o#ned y its currentset o% stocholders, or o#ners.

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Corporation 0cont.

+ Corporation legally %unctions separately andapart %ro its o#ners Bthe shareholders.Corporation can individually sue and esued.

+ $he &oard o% directors are elected y theshareholder, and the oard appoints the

senior anageent o% the %ir.

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Corporation 0cont.

+ Advantages5 Diaility o% o#ners is liited to invested %unds

5 Di%e o% corporation is not tied to the o#ner

5  Easier to trans%er o#nership

5 Easier to raise Capital

+ ?isadvantages

5 )reater regulation

5 ?oule ta;ation o% dividends

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2i/ited 2ia'ilit( Co/pan( 022C

2i/ited lia'ilit( co/pan( BDDC coinesthe ta; ene%its o% a partnership Bno doule

ta;ation o% earnings #ith the liited liailityene%it o% corporation Bthe o#ner6s liaility isliited to #hat they invest.

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Fig&re 1.1 Characteristics of3ifferent For/s of $&siness

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Fig&re 1.) *o4 the FinanceArea Fits into a Corporation

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1.5 #*E GOA2 OF #*EFINANCIA2 6ANAGE 

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#he Goal of the Financial 6anager$he goal o% the %inancial anager ust econsistent #ith the ission o% the corporation,#hich is to a;ii'e shareholder6s #ealth.

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Corporate 6ission

+ /hile anagers have to cater to all thestaeholders Bsuch as consuers,eployees, suppliers etc., they need to payparticular attention to the shareholders.

+ I% anagers %ail to pursue shareholder#ealth a;ii'ation, they #ill lose the

support o% investors and lenders. $heusiness ay cease to e;ist and ultiately,the anagers #ill lose their os

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Ethics in Finance

Although ethics is not one o% the principleso% %inance, ethic is %undaental to the notiono% trust and is there%ore essential to doingusiness.

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1.7 #*E FIVE $ASICPINCIP2ES OF FINANCE

C i

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PINCIP2E 1:6one( *as a #i/eVal&e

+ A dollar received today is #orth ore than adollar received in the %uture.

+ /e can invest the dollar received today toearn interest. $hus, in the %uture, you #illhave ore than one dollar, as you #illreceive the interest on your investent.

PINCIP2E ) #h i i 8

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PINCIP2E ): #here is a is89et&rn#rade9off 

+ /e #on6t tae on additional ris unless #ee;pect to e copensated #ith additionalreturn.

+ igher the ris, higher #ill e the e;pectedreturn. >ote e;pected return ay not ee:ual to the reali'ed rate o% return.

Fi 1 5 #h I i 8 t

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Fig&re 1.5 #here Is a is89et&rn#radeoff 

PINCIP2E 5 C h Fl A th

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PINCIP2E 5: Cash Flo4s Are theSo&rce of Val&e

+ Pro%it is an accounting concept andeasures a usiness6s per%orance. Cash%lo# is the aount o% cash that can actuallye taen out o% the usiness.

+ It is possile %or a %ir to report pro%its uthave no cash.

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Incre/ental Cash Flo4

inancial decisions in a %ir should consider Fincreental cash %lo#G i.e. the di%%erenceet#een the cash %lo#s the copany #illproduce #ith the potential ne# investent

and #hat it #ould ae #ithout theinvestent.

PINCIP2E 7 6 8 t P i fl t

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PINCIP2E 7: 6ar8et Prices eflectInfor/ation

Investors react :uicly to ne#sHin%orationand decisions ade y anagers.

)ood >e#s J igher stoc prices&ad >e#s J Do#er stoc price.

PINCIP2E I di id l d

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PINCIP2E : Indi;id&als espondto Incenti;es

*anagers Bas agents respond to incentivesthey are given in the #orplace. I% theirincentives are not properly aligned #ith thoseo% the %ir6s stocholders Bthe principal they

ay not ae decisions that are consistent#ith increasing shareholder value leading toagency costs.

PINCIP2E I di id l d

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PINCIP2E : Indi;id&als espondto Incenti;es 0cont.

$he agency prolesHcosts can e itigated through!1.Copensation plans that re#ard anagers #henthey act to a;ii'e shareholder #ealth

2.*onitoring y the oard o% directors

(.*onitoring y %inancial arets Bsuch as auditors,aners, security analysts, credit agencies

4.$he underper%oring %irs seeing their stoc prices%all and %ace threat o% eing taen over and have their

anageent teas replaced.