7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 1/35

Getting Started:Principles of Finance

Chapter 1

1.1 FINANCE:AN OVERVIEW

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 2/35

1-2

What is Finance?

• Finance is the study of how people andbusinesses evaluate investments and raisecapital to fund them.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 3/35

1-3

Three Questions Addressed by theStudy of Finance:

1. What long-term investments should thefirm undertake? (capital budgetingdecisions)

2. How should the firm fund theseinvestments? (capital structure decisions)

3. How can the firm best manage its cashflows as they arise in its day-to-dayoperations? (working capital management decisions)

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 4/35

1-4

Why Study Finance?

• Knowledge of financial tools is critical tomaking good decisions in both professionalworld and personal lives.

• Finance is an integral part of corporateworld.

• Many personal decisions require financial

knowledge (for example: buying a house,planning for retirement, leasing a car)

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 5/35

1.2 THREE TYPESOF BUSINESSORGANIZATIONS

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 6/35

1-6

FINC-301, Chapter 1, Russel

Business Organizational Forms

BusinessForms

Sole

Proprietorships

Partnerships

  Corporations  Hybrids

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 7/35

1-7

Sole Proprietorship

• It is a business owned by a single individualthat is entitled to all the firm’s profits and isresponsible for all the firm’s debt. 

• There is no separation between the businessand the owner when it comes to debts orbeing sued.

• Sole proprietorships are generally financed bypersonal loans from family and friends andbusiness loans from banks.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 8/35

1-8

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– Ceases on the death of the propreitor

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 9/35

1-9

Partnership

• A general partnership is an associationof two or more persons who come togetheras co-owners for the purpose of operating

a business for profit.

• There is no separation between thepartnership and the owners with respect todebts or being sued.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 10/35

1-10

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

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 11/35

1-11

Partnership (cont.)

• In limited partnerships, there are twoclasses of partners: general and limited.

• The general partners runs the business

and face unlimited liability for the firm’sdebts, while the limited partners areonly liable on the amount invested.

• One of the drawback of this form is that

it is difficult to transfer the ownership of the general partner.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 12/35

1-12

Corporation

• Corporation is “an artificial being, invisible,intangible, and existing only in thecontemplation of the law.”  

• Corporation can individually sue and besued, purchase, sell or own property, andits personnel are subject to criminalpunishment for crimes committed in the

name of the corporation

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 13/35

1-13

Corporation (cont.)

• Corporation is legally owned by its currentstockholders.

• The Board of directors are elected by thefirm’s shareholders. One responsibility of the board of directors is to appoint thesenior management of the firm.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 14/35

1-14

Corporation (cont.)

• Advantages

– Liability of owners 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

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 15/35

1-15

Hybrid Organizations

• These organizational forms provide a crossbetween a partnership and a corporation.

• Limited liability company (LLC)

• S-type corporation • Both combine the tax benefits of a

partnership (no double taxation of earnings) and limited liability benefit of 

corporation (the owner’s liability is limitedto what they invest).

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 16/35

1-16

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 17/35

1-17

How Does Finance Fit into the Firm’s

Organizational Structure?

• In a corporation, the Chief Financial Officer(CFO) is responsible for managing thefirm’s financial affairs. 

• Figure 1-2 shows how the finance functionfits into a firm’s organizational chart. 

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 18/35

1-18

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 19/35

1.3 THE GOAL OFTHE FINANCIAL

MANAGER 

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 20/35

1-20

The Goal of the Financial Manager

• The goal of the financial manager must beconsistent with the mission of thecorporation.

• What is the generally accepted mission of a corporation?

•To maximize firm value shareholder’s

wealth (as measured by share prices)

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 21/35

1-21

Corporate Mission

• While managers have to cater to all thestakeholders (such as consumers, employees,suppliers etc.), they need to pay particularattention to the owners of the corporation i.e.

shareholders.

• If managers fail to pursue shareholder wealthmaximization, they will lose the support of 

investors and lenders. The business may cease toexist and ultimately, the managers will lose their jobs!

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 22/35

1-22

Ethics in Finance

• What do we mean by Ethics?

• Give examples of recent financial scandals

and discuss what went wrong from anethical perspective.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 23/35

1-23

Agency Considerations in CorporateFinance

• Agency relationship exists when one ormore persons (known as the principal)contracts with one or more persons (the

agent) to make decisions on their behalf.

• In a corporation, the managers are theagents and the stockholders are theprincipal.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 24/35

1-24

Agency Considerations in CorporateFinance (cont.)

• Agency problems arise when there is conflict of interest between the stockholders and themanagers. Such problems are likely to arise morewhen the managers have little or no ownership in

the firm.• Examples:

– Not pursuing risky project for fear of losing jobs, stealing,expensive perks.

• All else equal, agency problems will reduce the firmvalue.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 25/35

1-25

How to Reduce Agency Problems?

1. Monitoring

(Examples: Reports, Meetings, Auditors, board of directors, financial markets, bankers, credit agencies)

2. Compensation plans 

(Examples: Performance based bonus, salary, stockoptions, benefits)

3. Others

(Examples: Threat of being fired, Threat of takeovers,Stock market, regulations such as SOX)

The above will help to reduce agencyproblems/costs.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 26/35

1.4 THE FOUR BASIC PRINCIPLES

OF FINANCE

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 27/35

1-27

PRINCIPLE 1: Money Has a TimeValue.

• A dollar received today is more valuablethan a dollar received in the future.

– We can invest the dollar received today to earn

interest. Thus, in the future, you will havemore than one dollar, as you will receive theinterest on your investment plus your initialinvested dollar.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 28/35

1-28

PRINCIPLE 2: There is a Risk-ReturnTrade-off.

• We only take risk when we expect to becompensated for the extra risk withadditional return.

• Higher the risk, higher will be the expectedreturn.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 29/35

1-29

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 30/35

1-30

PRINCIPLE 3: Cash Flows Are TheSource of Value.

• Profit is an accounting concept designed tomeasure a business’s performance over aninterval of time.

• Cash flow is the amount of cash that canactually be taken out of the business overthis same interval.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 31/35

1-31

Profits versus Cash

• It is possible for a firm to report profits buthave no cash.

• For example, if all sales are on credit, thefirm may report profits even though nocash is being generated.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 32/35

1-32

Incremental Cash Flow

• Financial decisions in a firm shouldconsider “incremental cash flow” i.e. thedifference between the cash flows the

company will produce with the potentialnew investment it’s thinking about makingand what it would make without theinvestment.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 33/35

1-33

PRINCIPLE 4: Market Prices ReflectInformation.

• Investors respond to new information by buyingand selling their investments.

• The speed with which investors act and the waythat prices respond to new informationdetermines the efficiency of the market. Inefficient markets like United States, this processoccurs very quickly. As a result, it is hard to profit

from trading investments on publicly releasedinformation.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 34/35

1-34

PRINCIPLE 4: Market Prices ReflectInformation. (cont.)

• Investors in capital markets will tend toreact positively to good decisions made bythe firm resulting in higher stock prices.

• Stock prices will tend to decrease whenthere is bad information released on thefirm in the capital market.

7/27/2019 FM1C 01 Introduction

http://slidepdf.com/reader/full/fm1c-01-introduction 35/35

1-35

Summary 

• Introduction

1.Finance: An Overview

2.Three Types of Business Organizations

3.The Goal of the Financial Manager

4.The Four Basic Principles of Finance