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  • Shareholders react to poor investment decisions by causing the value of the stock to fall. Shareholders react to good decisions by pushing up the stock’s price. There’s a direct benefit to shareholders if the objectives are wealth maximization. Society benefits as businesses compete to create wealth – resources are allocated to their most productive use.
  • Most important form of business. Shareholders have the ultimate power Shareholder’s maximum loss = what he paid for the stock Corporate fraud issues – most involved directors not doing their jobs. Many acted like wall flowers rather than as man-eating plants.
  • It’s not my intent to make you “taxis” as I used to call the Ford tax lawyers.
  • Unlike depreciation must use same method for inventories for taxes and book Text mentions carrybacks and carryforwards. Allows firms with losses in one year to offset income in other years. Text is out of date. Now can apply losses against income eared only in last three years and get a refund. Carryforward now up to 15 years.
  • This will complicate things when we get to the dividend chapter.
  • Risk exists because of uncertainty. The R/R concept is easy but projecting the risk and return is more difficult because it lacks certainty. You won’t make risky investments unless you are adequately compensated. Your expected return is high enough to get you to take on the risk. Follow with Fig 1.1
  • The point is that TVM techniques permit you to compare cash flows received in different periods on a logical basis.
  • This summer I did lots of reading. I was amazed how often the phrase “Cash is King” came up Problem is that our accrual accounting system measures when profits are earned, not when they are collected. CF is important because only cash can be invested to earn a return.
  • Followed by Fig 1.2 overhead Diversification accomplished by buying a variety of securities. Analogy: The best way to prevent the eggs in your basket from getting scrambled is to spread them about. Be like the Easter Bunny – he doesn’t put them all in one place.
  • Notre Dame Athletic Director Coulter – this stuff is real! BofA Chair, now Citibank’s Vice Chairman? Follow with Ali.
  • FCPA. Same? Or go/flow standards? Ali-general-WSJ-$1 mil-Lockheed fined $25. Other cos

Chapter_1.ppt Chapter_1.ppt Presentation Transcript

  • Chapter 1 Introduction to Financial Management
    • Key sections:
      • What is financial management?
      • Legal forms of business
      • Principles of taxation
      • Shareholder wealth, not profit, maximization is goal
      • The ten principles of financial management
  • What is Financial Management?
    • Tools and decision making processes to maintain/create economic value and shareholder wealth
    • What investments to make and how to finance them
    • Allocation of scarce resources based on uncertain costs/benefits
  • Goal of the Firm
    • Maximize shareholder wealth
      • Measured by market value of stock
      • Includes effect of all financial decisions
    • Shareholder wealth max  profit maximization
      • PM ignores risk/timing of cash flows
      • Increase current profits by cutting R&D and maintenance??? (Probably not good idea)
    • How should stock price be affected ?
  • Legal Forms of Business
    • Proprietorship – unincorporated, one individual, personally responsible for all its debts and losses
    • Partnership – two or more co-owners governed by an agreement
      • General partnership – each partner fully liable
      • Limited – one GP and LP’s with limited liability
      • Various other types of partnerships
    • Corporations
  • Corporations
    • Composed of owners (shareholders)
      • Elect directors who appoint managers
      • Function separately and apart from owners
    • Shareholder’s maximum loss – amount paid for shares
    • Advantages: limited liability, transferability, funding availability, no upside limit on potential
    • Disadvantages: double taxation, expensive to form
  • Taxation
    • Our emphasis – how taxes affect decisions through expense deductions
    • Taxes based on profits: sales and other income less allowable expenses and exclusions
      • Cost of producing, marketing, admin expense, depreciation and interest (but not dividends)
    • Progressive rates – more earned, higher the marginal rate
      • Marginal, not average, rate relevant
  • Other Tax Considerations
    • 70% of dividends from another corporation excluded from taxable income (sometimes 100%)
    • Depreciation – asset’s value expensed over its life
      • Different methods used – total expense the same but not the timing
      • Often straight line for financials, accelerated for taxes
    • Capital gains/losses – taxed as ordinary income for corporations; cap gains and dividend taxes recently changed by Congress for individuals
  • Tax Implications
    • Measure returns on after-tax basis using marginal, not average, tax rates
    • Taxes affect capital structure – interest, but not dividends, tax deductible
    • New tax law: for individuals both dividends and long-term capital gains taxed at 15%
  • The Ten Principles
    • These are statements of common sense
      • Provide logic behind rest of this course
    • #1 Risk/return tradeoff
      • Won’t take additional risk unless compensated; we are risk adverse
      • Greater risk, greater expected return
      • Key concept in valuing all assets
      • Almost every decision involves tradeoffs
  • Risk-Return Relationship
  • # 2 Time Value of Money- TVM
    • A dollar received today is worth more than a dollar received in the future
    • Earn more interest on money received sooner
    • Brings future benefits and costs back to present time – makes them comparable
    • Assumes cost of money determined by risks and returns (more risk, higher returns)
  • #3 Cash, not Profit, is King
    • Can only use cash flows, not profits
      • Cash, but not profits, can be reinvested
    • Accounting profits shown when earned; cash flows occur when collected
    • Capital expenditures occur immediately; accounting records depreciation over many years
  • #4 Incremental Cash Flows (Only what changes counts)
    • Think incrementally.
    • Will the project make a difference?
    • Not all cash flows are incremental
      • New product may cannibalize an old product
  • #5 Curse of Competitive Markets
    • Hard to find exceptionally profitable projects
    • Large profits attract new competitors
    • Can’t last long if markets competitive
    • Barriers to entry and product differentiation
      • Brand name, service, quality, patents, advertising
      • Cost advantages – economies of scale, proprietary technology, etc.
  • #6 Markets Assumed Efficient
    • Values fully reflect all available information at any point in time
    • You can’t expect to beat the market
    • Efficiency determined by speed new info is reflected in prices
    • Market prices reflect expected cash flows
  • #7 Agency Problems
    • Management won’t work for owners unless it is in their interest
    • Arises from separation between decision makers and owners (“the corporate jet problem”)
    • Why isn’t management fired if don’t act in shareholders’ interest?
    • Need to align interests (monitoring, auditing, options, bonuses)
  • #8 Taxes Bias Business Decisions
    • Must consider after-tax incremental cash flows
    • Tax incentives – deductions and credits (R&D spending)
    • Interest – a deductible expense; dividends not deductible; may affect capital structure
  • #9 Not All Risk Is Equal
    • Some can be diversified away, some cannot
    • Diversification – multiple investments; reduces risk
      • One investment’s gain offsets another’s loss
    • Reduces total variability without reducing returns (providing returns don’t move together)
  • Reduce Risk - Diversify
  • #10 Ethical Behavior “Doing the Right Thing”
    • Ethical errors are NEVER forgiven
    • Unethical behavior eliminates trust
      • Without trust, companies can’t interact
    • Loss of confidence in company’s ethical behavior – extremely damaging
    • Social responsibility – goes beyond shareholder wealth maximization
  • Multinational Corporations (MNC’s)
    • Operations in more than one country
    • Began after WWII devastation; accelerated by fall of communism, acceptance of free markets, and information technology
    • Coke earns more in Japan than in US; Dow, Colgate, 3M, HP more than half profits from overseas
    • Many US firms owned by foreign interests