An Introduction to the Foundations of Financial Management
Identify the goal of the firm.
Understand the five basic principles of finance and business, the consequences of forgetting those basic principles of finance, and the importance of ethics and trust in business. Describe the role of finance in business.
Distinguish between the different legal forms of business.
Explain what has led to the era of the multinational corporation.
1. The Goal of the Firm
2. Legal Forms of Business Organization
3. Role of Financial Manager in a Corporation
4. Income Taxation
5. Ten Principles of Finance
6. Finance and Multinational Firm
1. The Goal of the Firm
The goal of the firm is to create value for the firm’s legal owners (that is, its shareholders). Thus the goal of the firm is to “maximize shareholder wealth” by maximizing the price of the existing common stock. 2. Five Foundational Principles of Finance
Cash flow is what matters
Money has a time value
Risk requires a reward
Market prices are generally right
Conflicts of interest cause agency problems
“…while 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: Cash flow is what matters
Accounting profits are not equal to cash flows. It is possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books. Cash flow, and not profits, drive the value of a business.
We must determine incremental cash flows when making financial decisions. 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.
Principle 2: Money has a time value
A dollar received today is worth more than a dollar received in the future. Since we can earn interest on money received today, it is better to receive money earlier rather than later. Principle 3: Risk requires a Reward
We won’t take on additional risk unless we expect to be compensated with additional reward or return. Investors expect to be compensated for “delaying consumption” and “taking on risk”. Thus investors expect a return when they put their savings in a bank (i.e. delay consumption) and they expect to earn a higher rate of return on stocks relative to bank savings account (i.e. taking on risk) Figure 1-1
Principle 4: Market Prices are generally Right
In an efficient market, the prices of all traded assets (such as stocks and bonds) at any instant in time fully reflect all available information. Thus stock prices are a useful indicator of the value of the firm. Prices changes reflect changes in expected future cash flows. Good decisions will tend to increase the stock prices and vice versa. Note there are inefficiencies in the market that may distort the prices. Principle 5: Conflicts of interest cause agency problems
The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth. Agency conflict is reduced through monitoring
(ex. Annual reports), compensation schemes
(ex. stock options), and market mechanisms
Ethics and business
Ethical behavior is doing the right thing! … but what is the right thing? Ethical dilemma - Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing. Sound ethical standards are important for business and personal success. Unethical decisions can destroy shareholder wealth (ex. Enron Scandal)
3. The Role of Finance in Business
Three broad issues addressed by the study of finance:
Where to Invest? (Capital budgeting decision)
How to raise money to fund the investment? (Capital structure decision) How to...
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