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Chapter 1

Getting
Started
Principles of
Finance

Slide Contents
Introduction
1.Finance: An Overview
2.Three Types of Business Organizations
3.The Goal of the Financial Manager
4.The Five Basic Principles of Finance

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1.1 FINANCE: AN OVERVIEW

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What is Finance?
Finance is the study of how people and
businesses evaluate investments and raise
capital to fund them.

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Three Basic Questions Addressed by


the Study of Finance:
1. What long-term investments should the
firm undertake?
2. How should the firm raise money to fund
these investments?
3. How can the firm best manage its cash
flows as they arise in its day-to-day
operations?

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Why Study Finance?


Knowledge of financial tools is critical to
making good decisions in both corporate
world and personal lives.
How will GMs strategic decision to invest $740
million to produce the Chevy Volt require the
expertise of different disciplines within the
business school?

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1.2 THREE TYPES OF


BUSINESS ORGANIZATIONS

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Business Organizational Forms

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Sole Proprietorship
It is a business owned by a single individual
who is entitled to all of the firms profits and
is responsible for all of the firms debt.
The sole proprietors typically raise money by
investing their own funds and by borrowing
from a bank.

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Sole Proprietorship (cont.)


Advantages:
Easy to start
No need to consult others while making decisions
Taxed at the personal tax rate

Disadvantages:
Personally liable for the business debts
The business ceases on the death of the
proprietor
Harder to raise money
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Partnership
A general partnership is an association of
two or more persons who come together as
co-owners for the purpose of operating a
business for profit.

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Partnership (cont.)
Advantages:
Relatively easy to start
Taxed at the personal tax rate
Access to funds from multiple sources or partners

Disadvantages:
Partners jointly share unlimited liability
It is not always easy to transfer ownership

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Partnership (cont.)
In limited partnerships, there are two
classes of partners: general and limited.
The general partner runs the business and
faces unlimited liability for the firms debts,
whereas the limited partner is only liable up
to the amount the limited partner invested.

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Corporation
If very large sums of money are needed to
build a business, then the typical
organizational form chosen is the corporation.
The corporation is legally owned by its current
set of stockholders, or owners.

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Corporation (cont.)
Corporation legally functions separately and
apart from its owners (the shareholders).
Corporation can individually sue and be
sued.
The Board of directors are elected by the
shareholder, and the board appoints the
senior management of the firm.

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Corporation (cont.)
Advantages

Liability of owners is limited to invested funds


Life of corporation is not tied to the owner
Easier to transfer ownership
Easier to raise Capital

Disadvantages
Greater regulation
Double taxation of dividends

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Limited Liability Company (LLC)


Limited liability company (LLC) combines
the tax benefits of a partnership (no double
taxation of earnings) with the limited liability
benefit of corporation (the owners liability is
limited to what they invest).

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Figure 1.1 Characteristics of


Different Forms of Business

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Figure 1.2 How the Finance


Area Fits into a Corporation

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1.3 THE GOAL OF THE


FINANCIAL MANAGER

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The Goal of the Financial Manager


The goal of the financial manager must be
consistent with the mission of the corporation,
which is to maximize shareholders wealth.

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Corporate Mission
While managers have to cater to all the
stakeholders (such as consumers,
employees, suppliers etc.), they need to pay
particular attention to the shareholders.
If managers fail to pursue shareholder
wealth maximization, they will lose the
support of investors and lenders. The
business may cease to exist and ultimately,
the managers will lose their jobs!
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Ethics in Finance
Although ethics is not one of the 5 principles
of finance, ethic is fundamental to the notion
of trust and is therefore essential to doing
business.

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1.4 THE FIVE BASIC


PRINCIPLES OF FINANCE

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PRINCIPLE 1:Money Has a Time


Value
A dollar received today is worth more than a
dollar received in the future.
We can invest the dollar received today to
earn interest. Thus, in the future, you will
have more than one dollar, as you will
receive the interest on your investment.

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PRINCIPLE 2: There is a Risk-Return


Trade-off
We wont take on additional risk unless we
expect to be compensated with additional
return.
Higher the risk, higher will be the expected
return. Note expected return may not be
equal to the realized rate of return.

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Figure 1.3 There Is a Risk-Return


Tradeoff

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PRINCIPLE 3: Cash Flows Are the


Source of Value
Profit is an accounting concept and
measures a businesss performance. Cash
flow is the amount of cash that can actually
be taken out of the business.
It is possible for a firm to report profits but
have no cash.

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Incremental Cash Flow


Financial decisions in a firm should consider
incremental cash flow i.e. the difference
between the cash flows the company will
produce with the potential new investment
and what it would make without the
investment.

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PRINCIPLE 4: Market Prices Reflect


Information
Investors react quickly to news/information
and decisions made by managers.
Good News ==> Higher stock prices
Bad News ==> Lower stock price.

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PRINCIPLE 5: Individuals Respond


to Incentives
Managers (as agents) respond to incentives
they are given in the workplace. If their
incentives are not properly aligned with those
of the firms stockholders (the principal) they
may not make decisions that are consistent
with increasing shareholder value leading to
agency costs.

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PRINCIPLE 5: Individuals Respond


to Incentives (cont.)
The agency problems/costs can be mitigated through:
1.Compensation plans that reward managers when
they act to maximize shareholder wealth
2.Monitoring by the board of directors
3.Monitoring by financial markets (such as auditors,
bankers, security analysts, credit agencies)
4.The underperforming firms seeing their stock prices
fall and face threat of being taken over and have their
management teams replaced.

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