Chapter 1 – Introduction to Finance
FIN2102 –
Financial
Management
Learning Objectives
Identify the goal of the firm.
Understand the five basic principles of finance
and business.
Distinguish between the different legal forms of
business.
Explain what has led to the era of the
multinational corporation.
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Slide Contents
1. What is Finance?
2. The Goal of the Firm
3. Five Principles of Finance
4. Legal Forms of Business Organization
5. Finance and Multinational Firm
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1. What is Finance?
• Finance
Study of how people and businesses evaluate
investments and raise capital to fund them.
(How to get and use money)
• Financial management
Efficient and effective management of money to
accomplish the objective of the organization.
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2. 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.
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3. 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
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Five Principles
“…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.”
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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.
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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.
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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)
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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.
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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
(ex. Takeovers)
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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)
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4. The Legal Forms of
Business Organization
Business
Forms
Sole Corporation
Partnership
Proprietorship
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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
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Partnerships
Two or more persons come together as co-owners
General Partnership: All partners are fully responsible for
liabilities incurred by the partnership.
Limited Partnerships: One or more partners can have limited
liability, restricted to the amount of capital invested in the
partnership. There must be at least one general partner with
unlimited liability. Limited partners cannot participate in the
management of the business and their names cannot appear
in the name of the firm.
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Corporation
Legally functions separate and apart from its owners
Corporation can sue, be sued, purchase, sell, and own property
Owners (shareholders) dictate direction and policies of the
corporation, oftentimes through elected board of directors.
Shareholder’s liability is restricted to amount of investment in
company
Life of corporation does not depend on the owners …
corporation continues to exist through easy transfer of
ownership
Taxed separately
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5. Finance and the Multinational Firm:
The New Role
Internationalization of business has been
spurred by:
Collapse of communism
Acceptance of free market system
Technology
Improved transportation
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Why do companies
go abroad?
To increase revenues
To reduce expenses (land, labor, capital, raw
material, taxes)
To lower governmental regulation standards (ex.
Environmental, labor)
To increase global exposure
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Risks/challenges
Country risk (changes in government regulations,
unstable government, economic changes in
foreign country)
Currency risk (fluctuations in exchange rates)
Cultural risk (differences in language, traditions,
ethical standards etc.)
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