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INTRODUCTION TO FINANCIAL MANAGEMENT

What is Finance?
Goal of the Firm

Legal Forms of Business Organization


The Tax Environment Ten Principles that Forms the Basics of Financial Management

What is Finance?
Financial management is concerned with the maintenance and creation of economic value or wealth Financial management is concerned with investment, financing, and management of assets with some overall goal in mind Investment decision: total assets needed (the lefthand side of the balance sheet) Financing decision: total debts and equities (the right-hand side of balance sheet) Assets management decision: How to manage assets efficiently

Investment decision
Large capital expenditure Research and development Merger and aquisition Ownership structure Capital efficiency Working capital management

Financing Decision
Capital structure Dividend policy Lease vs borrow Risk management Auditing and reporting Planning (business, tax)

Management Decision
Performance measurement Budget Incentive design Investor relation Regulatory requirement

Goal of the Firm


Profit Maximization - current vs some longer period? - Ignore uncertainty - Ignore the timing of the projects return - Ignore cost of equity Maximization of Shareholder Wealth - use the market value of the shareholders common stock as a proxy - It include the effect of all financial decision - The price of a stock fluctuates, however over long run, price equals value

Legal Forms of Business Organization


Sole proprietorship - a business owned by a single individual
- the proprietor is entitled to the profits and absorb any losses - termination occurs on the owners death or by the owners choice

Partnership - An association of two or more individuals joining


together as co-owners to operate a business for profit - general partner: fully responsible for the liabilities incurred by the partnership - Limited partner: have limited liabilities, restricted to the amount of capital invested

Legal Forms of Business Organization


Corporation
An entity that legally function separate and apart from its owners The investors liabilities is confined to the amount of the investment in the company Ownership is reflected in common stock certificates # shares owned relative to the total # of share outstanding determines the stockholders proportionate ownership

Owners dictated the direction and policies of the corporation


Because limited liability, the ease of transferring ownership, and the flexibility in dividing the share, the corporation is the ideal business entity in term of attracting new capital

The Tax Environment


Objective of income taxation: (1) the provision of revenues for government expenditure, (2) the achievement of socially desirable goals, and (3) economic stabilization Type of taxpayers: individuals, corporations, and fiduciaries (such as estates and trusts) Computing taxable income
Marginal tax rates: the tax rate that would be applied to the next dollar of income

Table 1.1 J and S Corporation Taxable Income Sales Cost of goods sold Gross profit Operating expenses Administrative expenses Depreciation expenses Marketing expenses Total operating expenses Operating Income (EBIT) Other income Interest expenses Taxable income 50,000,000 -23,000,000 27,000,000 4,000,000 1,500,000 4,500,000 -10,000,000 17,000,000 0 -1,000,000 16,000,000

Corporate Tax Rates Rates 15% 25% 34% 39% Income Level Rates $0-$50,000 34% $50,001-$75,000 35% $75,001-$100,000 38% 100,001-$335,000 35% Income Level $335,001-$10,000,000 $10,000,001-$15,000,000 $15,000,001-$18,333,333 over $18,333,333

Tax Calculations Earnings $50,000 $75,000-$50,000 $100,000-$75,000 $335,000-$100,000 $10,000,000-$335,000 $15,000,000-$10,000,000 $16,000,000-$15,000,000 Total Tax Liability X Marginal Tax Rate Taxes x 15% $7,500 x 25% 6,250 x 34% 8,500 x 39% 91,650 x 34% 3,286,100 x 35% 1,750,000 x 38% 380,000 $5,530,000

Principle 1: The risk-return trade-off, we wont take on additional risk unless we expect to be compensated with additional return
- Investment alternatives have different amount of risk. The more risk an investment has the higher will be its expected return

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

Principle 3: Cash not profits is king


- it is the cash flows, not profits, that are actually received by the firm and can be reinvested

Principle 4: Incremental cash flows, its only what changes that counts
- the difference between the cash flows if the project is taken on versus what they will be if the project is not taken on

Principle 5: The curse of competitive markets, why its hard to find exceptionally profitable project
- If an industry is generating large profits, new entrants are usually attracted.

Principle 6: Efficient capital markets, the markets are quick and the prices are right
- investor competing for profits ensure that security prices appropriately reflect the expected earnings and risks involved and thus the true value of the firm

Principle 7: The agency problem, managers wont work for owners unless its in their best interest
- Problem resulting from conflict of interest between the manager and the stockholder - Manager may make decision that are not in line with the goal of maximization of shareholder wealth

Principle 8: Taxes bias business decision


- returns from an investment should be measured on an aftertax basis - Government uses taxes to encourage spending in certain way, such as offering an investment tax credit for R&D investment

Principle 9: All risk is not equal, some risk can be diversified away, and some cannot
Diversification allow good and bad event to cancel out, thereby reducing total variability (risk) without affecting expected return A projects risk changes depending on whether you measure it standing alone or together with other projects

Principle 10: Ethical behavior is doing the right thing, and the ethical dilemmas are everywhere in finance
- unethical behavior eliminate trust, and without trust business cannot interact

Board of Director
Chief Executive Officer
Vice PresidentMarketing

Vice President-Finance or Chief Financial Officer Duties:


Oversee financial planning Corporate strategic planning Control corporate cash flow

Vice PresidentProduction and Operation

Treasurer
Duties: Cash management, credit mgt Capital expenditures, raising capital, financial planning, mgt of foreign currencies

Controller
Duties: Taxes, financial statement, cost accounting, data processing

The Corporation and the Financial Markets: The Interaction


Primary Markets

Cash Corporation Securities


Cash reinvested in the corporation

Investors Secondary markets

Corporation invests in returngenerating assets

Cash flow from operations Taxes

Cash distributed back to investors

Securities traded among investors

Government