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Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr. Chapter 1 An Introduction to the Foundations of Financial Management – The Ties that Bind. Identify the goal of the firm.

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foundations of finance arthur j keown john d martin j william petty david f scott jr

Foundations of FinanceArthur J. Keown John D. MartinJ. William Petty David F. Scott, Jr.

Chapter 1

An Introduction to the Foundations of Financial Management – The Ties that Bind

chapter objectives
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.

Chapter Objectives

Foundations of Finance

the goal of the firm
The Goal of the Firm
  • The goal of the firm is maximization of shareholder wealth


  • Maximization of the price of the existing common stock

Foundations of Finance

profit maximization
Profit Maximization
  • Stresses the efficient use of capital resources
  • Not specific to time frame for profits to be measured
  • Goals are not precise, allow for misinterpretation
  • Ignores uncertainty and timing

Foundations of Finance

benefits of maximizing shareholder wealth
Benefits of Maximizing Shareholder Wealth
  • Good decisions are those that create wealth for the shareholder
  • Societal benefits as businesses compete to create wealth
  • Includes effects of all financial decisions

Foundations of Finance

legal forms of business organization
Legal Forms of Business Organization
  • Sole Proprietorship
  • Partnership
  • Corporation

Foundations of Finance

sole proprietorship
Sole Proprietorship
  • Business owned by an individual
  • Owner maintains title to assets and profits
  • Unlimited liability
  • Termination occurs on owner’s death or by owner’s choice

Foundations of Finance

  • General Partnership
    • Each partner is fully responsible for liabilities
  • Limited Partnerships
  • Two or more owners

Foundations of Finance

  • Limited Partnership and Limited Liability Company
    • Allows one or more partners limited liability based on amount of capital invested
    • Must have one general partner with unlimited liability
    • Names of limited partners may not appear in name of firm
    • Limited partners may not participate in management decisions.

Foundations of Finance

  • Legally functions separate and apart from its owners
    • Can sue, be sued, purchase, sell, and own property
  • Owners who dictate direction and policies
    • Elect a board of directors
  • Investors liability is restricted to amount of investment in company
  • Life continues with transfer of ownership
  • Taxed separately

Foundations of Finance

comparison of organizational forms
Comparison of Organizational Forms
  • Large growing firms choose the corporate form
    • Ease in raising capital
    • Limited liability
    • Transfer of ownership is simple

Foundations of Finance

comparison of organizational forms12
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

Foundations of Finance

organizational form and taxes
Organizational Form and Taxes
  • Corporation
    • Double taxation of dividends
    • Tax act of 2003 limited tax rate on dividends to stimulate the economy
      • Ends in 2008 unless Congress takes action

Foundations of Finance

organizational form and taxes14
Organizational Form and Taxes
  • S-Type Corporations
    • Benefits
      • Limited liability
      • Taxed as partnership
    • Limitations
      • Owners must be people
      • Can’t be used for joint ventures between two corporations

Foundations of Finance

organizational form and taxes15
Organizational Form and Taxes
  • Limited Liability Corporations
    • Benefits
      • Limited liability
      • Taxed like a partnership
    • Limitations
      • Qualifications vary from state to state
      • Can’t appear like corporation otherwise will be taxed like one

Foundations of Finance

the role of the financial manager in a corporation
The Role of the Financial Manager in a Corporation


Foundations of Finance

objectives of income taxation
Objectives of Income Taxation
  • Raise revenues for government expenditures
  • Achieve socially desirable goals
  • Economic stabilization

Foundations of Finance

types of taxpayers
Types of Taxpayers
  • Individuals
    • employees, self-employed persons, members of partnerships
    • Report income on personal tax return
  • Corporations
    • separate legal entity
    • Report income on corporate tax return
    • Distributed dividends taxed to shareholders
  • Fiduciaries
    • estates and trusts
    • Pay taxes on undistributed income

Foundations of Finance

computing taxable income
Computing Taxable Income
  • Taxable Income
    • Gross income less tax deductible expenses, plus interest income and dividend income
  • Gross 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

Foundations of Finance

computing taxable income 000 s
Computing Taxable Income ($000’s)

Sales $50,000

Cost of Goods Sold 23,000

Gross Profit $27,000

Operating Expenses

Administrative Expenses $4,000

Depreciation Expense 1,500

Marketing Expenses 4,500

Total Operating Expenses $10,000

Operating Income $17,000

Other Income 0

Interest Expense 1,000

Taxable Income $16,000

Foundations of Finance

corporate tax rates
Corporate Tax Rates

Income Rate

$ 0 - $50,000 15%

$50,001 - $75,000 25%

$75,001 - $10,000,000 34%

Over $10,000,000 35%

Additional surtax:

  • 5% on income between

$100,000 and $335,000

  • 3% on income between

$15,000,000 and $18,333,333

Foundations of Finance

marginal tax rates
Marginal Tax Rates
  • Rates applicable to next dollar of income
  • Used in financial decision-making

Foundations of Finance

other corporate tax considerations
Other Corporate Tax Considerations
  • Dividend Exclusion
    • A corporation may typically exclude 70% of any dividend received from another corporation.
  • Depreciation Expense
    • A corporation may expense an asset’s cost over its useful life
  • Capital Gains and Losses
    • Capital Gains taxed as ordinary income. Capital losses cannot be deducted from ordinary income.

Foundations of Finance

ten principles that form the foundations of financial management

Ten Principles That Form 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
Principle 1: The Risk-Return Trade-off
  • We won’t take on additional risk unless we expect to be compensated with additional return.
  • Investment alternatives have different amounts of risk and expected returns.
  • The more risk an investment has, the higher its expected return will be.

Foundations of Finance

principle 2 the time value of money
Principle 2: The Time Value of Money
  • A dollar received today is worth more than a dollar received in the future.
  • Because we can earn interest on money received today, it is better to receive money earlier rather than later.

Foundations of Finance

principle 3 cash not profits is king
Principle 3: Cash—Not Profits—Is King
  • Cash Flow, not accounting profit, is used as our measurement tool.
  • Cash flows, not profits, are actually received by the firm and can be reinvested.

Foundations of Finance

principle 4 incremental cash flows
Principle 4: Incremental Cash Flows
  • It is only what changes that counts
  • 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.

Foundations of Finance

principle 5 the curse of competitive markets
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, Service and Quality can insulate products from competition

Foundations of Finance

principle 6 efficient capital markets
Principle 6: Efficient Capital Markets
  • The markets are quick and the prices are right.
  • The values of all assets and securities at any instant in time fully reflect all available information.

Foundations of Finance

principle 7 the agency problem
Principle 7: The Agency Problem
  • Managers won’t work for the owners unless it is in their best interest
  • 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.

Foundations of Finance

principle 8 taxes bias business decisions
Principle 8: Taxes Bias Business Decisions
  • The cash flows we consider are the after-tax incremental cash flows to the firm as a whole.

Foundations of Finance

principle 9 all risk is not equal
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 project’s or an asset’s risk is very difficult.

Foundations of Finance

Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance
  • Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing

Foundations of Finance

finance and the multinational firm
Finance and the Multinational Firm
  • U.S. corporations are looking to international expansion
    • Collapse of communism
    • Acceptance of free market system developing in the Third World countries
    • PC’s and the internet
    • Freer access to international markets

Foundations of Finance