An Introduction to the Foundations of Finance

Lecture 1: Learning Objectives

1. Identify the goal of the firm.
2. 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.
3. Describe the corporate tax features that affect business decisions.
4. Describe the corporate tax features that affect decisions.
5. Explain the 10 principles that form the foundations of financial management.
6. Explain what has led to the era of the multinational corporation.
Contents
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 maximize shareholder wealth.
• Shareholder wealth is measured by share prices. Thus, shareholder wealth maximization would imply
maximizing the price of common stock.
• Part of Coca-Cola’s Vision: “Maximizing return to shareowners while being mindful of our overall
responsibilities.” Our vision is to craft the brands and choice of drinks that people love, to refresh them in body &
spirit. And done in ways that create a more sustainable business and better shared future that makes a difference in
people's lives, communities and our planet.
• Starbucks highlights its mission as “to inspire and nurture the human spirit – one person, one cup and one
neighborhood at a time.” And its vision is to “treat people like family, and they will be loyal and give their all.”9
• Microsoft's corporate vision is “to help people and businesses throughout the world realize their full potential.”
Benefits of Maximizing Shareholder Wealth
• Good corporate decisions are those that create wealth for the shareholder.
• Society benefits as scarce resources are directed to the most profitable use by businesses competing to create
wealth.
Share Price Changes (during last two years as of June 29, 2007)
• Google: Share price increased by nearly $200 or around 67% (from around $300 to $500) … wealth created.
• Yahoo: Share price decreased by nearly $8 or around 23% (from around $35 to $27) … wealth
destroyed.
“The back-and-forth for the title of the richest person in the world between Amazon founder Jeff Bezos
and LVMH chief Bernard Arnault has taken another turn: For the third time this week, Arnault has
overtaken Bezos forthe No. 1 spot, with an estimated net worth of $190.1 billion, compared to Bezos’
$188.5 billion as of 12:45 pm ET.
 On Monday morning, Arnault started the week as the richest person on the planet, with $186.3 billion—
just $300 million more than Bezos—but Amazon shares picked up after markets opened in New York,
and Bezos regained the title within a few hours. The same thing happened on Tuesday: Arnault started the
day richer than Bezos, until the Amazon boss quickly retook the lead. It’s a familiar pattern by now: On at
least two other occasions since 2019, Arnault has briefly been richer than Bezos before ultimately falling
again by the time the markets closed”
Why is Profit Maximization not the appropriate goal?
• Profit maximization goal is unclear about the time frame over which profits are to be measured.
• It is easy to manipulate the profits through various accounting policies.
• Profit maximization goal ignores risk and timing of cash flows.
2. Legal Forms of Business Organization
1. Sole Proprietorship
2. Partnership
3. Corporation
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
Partnerships
• Partnership: Two or more persons come together as co-owners.
• Two types of partnership: General or Limited
Partnership - General
• All partners are fully responsible for liabilities incurred by the partnership.
Partnerships - Limited
• One or more partners can have limited liability
• 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.
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
• 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.
• Shareholder’s liability is restricted to the amount of investment in company.
• Life of corporation does not depend on the status of its owners. Ownership can be easily transferred.
The Trade-offs:
Corporate Form
• Benefits:
• Limited liability
• Easy to transfer ownership
• Unlimited life (unless the firm goes through corporate restructuring such as mergers and
bankruptcies)
• Drawbacks:
• No secrecy of information
• Maybe delays in decision making
• Greater regulation
• Double taxation
Double Taxation example
• Income = $1,000
Federal Tax @25% = $250
After tax Income = $750
• What will be the total tax if the company chooses to distribute the after-tax profits to shareholders as dividends?
If corporation distributes the profits as dividends to shareholders, shareholders will have to pay taxes on
dividends.
• Assume shareholders are taxed @20% on dividend income or 20% of $750 = $150
• Total tax = 250 + 150 = $400 or 40%
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
• 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
3. Role of Financial Manager in a Corporation
(Figure 1.1)
How the finance area fits into a corporation:

4. Income Taxation
Objectives:
• Raise revenues for government expenditures
• Achieve socially desirable goals
• Economic stabilization
Types of Taxpayers
• Individual
• Includes employees, self-employed persons, members of partnerships
• Reports income on personal tax return
• Corporation
• Reports its income and pays tax on profits
• Distributed dividends taxed to shareholders
• Fiduciaries
 • Such as estates and trusts pay taxes on income generated by the estate or trust that is not distributed to a
beneficiary
Computing Taxable Income for Corporation
• 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
Marginal Tax Rates
• Refers to the tax rate applicable to next dollar of income.
• In the previous example, the marginal tax rate is 38% since $16m falls into the 35% tax bracket with a
3% surtax.
• In financial decision-making, marginal tax rate is more relevant than average tax rate.
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.
5. Ten Principles: 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

• Would you invest your savings in the stock market if it offered the same expected return as your bank?
• We won’t take on additional risk unless we expect to be compensated with additional return.
 • Higher the risk of an investment, higher will be its expected return.
Principle 2: The Time Value of Money
• A dollar received today is worth more than a dollar to be received in the future.
• Because we can earn interest on money received today, it is better to receive money earlier rather than later.
Principle 3: Cash—Not Profits—Is King
• In measuring wealth or value, we use cash flow, not accounting profit, as our measurement tool.
• Cash flows are actually received by the firm and can be reinvested. On the other hand, profits are recorded when
they are earned rather than when money is actually received.
• It is possible for a firm to show profits on the books but have no cash!
Principle 4: Incremental Cash Flows
• 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.
• This difference reflects the true impact of a decision.
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 (through Service, Quality) and cost advantages (through economies of Scale)
can insulate products from competition.
Principle 6: Efficient Capital Markets
• The values of securities at any instant in time fully reflect all publicly available information.
• Prices reflect value and are right.
• Price changes reflect changes in expected cash flows (and not cosmetic changes such as accounting policy
changes). Good decisions drive up the stock prices and vice versa.
Principle 7: The Agency Problem
• 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.
• Agency conflict reduced through monitoring (ex. Annual reports), compensation schemes (ex. stock
options), and market mechanisms (ex. Takeovers).
Principle 8: Taxes Bias Business Decisions
• The cash flows we consider for decision making are the after-tax incremental cash flows to the firm as a whole.
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. A project’s risk changes depending on whether you measure it standing alone or together
 with other projects the company may take on.

Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance
• 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.
• Ethics are relevant in business and unethical decisions can destroy shareholder wealth (ex. Enron Scandal).
The story of Enron Corporation depicts a company that reached dramatic heights only to face a dizzying
fall. The fated company's collapse affected thousands of employees and shook Wall Street to its core. At
Enron's peak, its shares were worth $90.75; just prior to declaring bankruptcy on Dec. 2, 2001, they were
trading at $0.26.1 To this day, many wonder how such a powerful business, at the time one of the largest
companies in the United States, disintegrated almost overnight. Also difficult to fathom is how
itsleadership managed to fool regulators for so long with fake holdings and off-the-books accounting.
KEY TAKEAWAYS
• Enron's leadership fooled regulators with fake holdings and off-the books accounting practices.
• Enron used special purpose vehicles (SPVs), or special purposes entities (SPEs), to hide its mountains of
debt and toxic assets from investors and creditors.

6. Finance and Multinational FirmFinance and the Multinational Firm

• U.S. corporations are looking to international expansion to discover profits
• For example, Coca-Cola earns over 80% of its profits from overseas sales
• In addition to US firms going abroad, we have also witnessed many foreign firms making their mark in the
United States (ex. the domination of the auto industry by Honda, Toyota, and Nissan)
• International movement has been spurred by:
• Collapse of communism
• Acceptance of free market system developing in Third World countries
• Technology and communication (PC’s and the internet)
• Improved transportation
Why do companies go abroad?
 • To increase revenues
• To obtain cheaper resources (land, labor, capital, raw material)
• To reduce the burden of government regulation (ex. Environmental laws, taxes, labor laws)
• To increase global exposure
Risks/challenges
• Country risk (changes in government regulations, unstable government, economic changes)
• Currency risk (fluctuations in exchange rates)
• Cultural risk (differences in language, traditions, ethical standards etc.)
Lecture Summary
1. The goal of the firm is to maximize shareholder wealth.

2. A sole proprietorship and general partnership have unlimited liabilities and it is not as easy to raise capital.
Meanwhile, a limited partnership offers limited liability for partners, but has the practical number of
partners and marketability of interest in partnership restricted.

A corporation is the most logical choice for a firm that is large or growing because it legally functions
separate and apart from its owners, and because it can sue, be sued, purchase, sell, and own property.
Furthermore, owners (shareholders) dictate direction and policies of the corporation. In addition,
Shareholder’s liability is restricted to the amount of investment in company. Also, the life of corporation does
not depend on the status of its owners. Ownership can be easily transferred.

3. Describe the corporate tax features that affect business decisions.

4. Describe the corporate tax features that affect decisions.

5. The 1st principle is The Risk-Return Trade-off which explains that the higher the risk, the higher the returns.
The 2nd principle is the Time value of money which explains that money received now has more value than
money received in the future. The 3rd principle would be Cash-not profits- is king. It highlights that it is
possible for a firm to show profits on the books but have no cash.

The 4th principle would be Incremental Cash Flows it is the difference between the projected cash flows if
the project is selected, versus what they will be, if the project is not selected. The 5th principle would be the
Curse of Competitive Markets, it means that industries generating large profits always attracts new entrants.
This creates additional competition and can result in profits being driven down.

The 6th principle is Efficient Capital Markets it states that the values of securities at any instant in time fully
reflect all publicly available information. Additionally, it states that good decisions drive up the stock prices
and vice versa. The 7th principle is The Agency Problem which shows that managers may make decisions
that are not in line with the goal of maximization of shareholder wealth.

The 8th principle would be Taxes Bias Business Decisions it shows that the cash flows we consider for
decision making are the after-tax incremental cash flows to the firm as a whole. The 9th principle states that
All Risk is Not Equal. Some risk can be diversified away, and some cannot. The 10th principle is Ethical
Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance. Ethics are
relevant in business as it can make or break shareholder wealth as shown by the Enron Scandal.

6. The collapse of communism, acceptance of free market system developing in Third World countries, the
development of technology and communication (PC’s and the internet), and improved transportation led to
the era of multinational corporations.