GB6030 FUNDAMENTALS OF FINANCE LECTURE NOTES SPRING 2011 10 AXIOMS OF FINANCE 1. Role of financial management in the firm?

m? Making decisions that either maintain or create economic value or wealth For example, when to invest, what to invest in, when to borrow, when to buy, when to sell, etc. Goal of firm maximization of shareholder/stakeholder wealth Define shareholder, stakeholder Why is profit not the goal?

Timing of profits can be manipulated year to year (fraud) Long term success may require short term risk, spending Timing of cash flow versus profit recognition Maximization of shareholder wealth involves: Decisions which maximize value of common stock Decisions which are for the good of all shareholders Bad decisions decrease value/wealth

2. Legal forms of business organizations Sole proprietorship Partnership Corporation Separate legal entity Owners are common stock shareholders Shareholders elect board of directors Directors represent shareholders, hire management Shareholder liability limited to amount invested Can transfer ownership by selling stock Benefits of the Corporate form of business: Ease of raising capital based on assets, value of firm Limited liability of investors (cant be sued) Ease of transfer of ownership (can get out whenever they want) Investors can choose any level of ownership (No. of shares) Role of the financial manager in a Corporation Treasurer (Finance) versus Controller (Accounting) 3. Federal Income Taxation Must be considered when making business decisions Consult tax experts for impact criteria

Computing taxable income and taxes owed; J & S Corporate tax table Other tax considerations Putting it all together 4. Ten axioms/Bases for good business decisions 1. Risk-Return trade off

The more risk, the more return required and vice-versa I.e., horse race example, junk bonds 2. Time value of money

A dollar received today worth more than a dollar received in the future Bus. Decisions require knowledge of present and future value of investment returns I.e., a 21 year old invests $12K @10%, at age 65, worth over $1 million
3.

Cash is King (not profits)

Cash can be spent (profit is a paper number) Cash does not equal profit depr., borrowing, issue stock, invest, dividend pymts, etc.
4.

Consider incremental cash flow only

Its only what changes that counts, i.e. diff between cash flow with and without the project I.e., new model brief case 5. Curse of the competitive market High profits are hard to find and maintain Competition will find a way Competitive advantage can be maintained by: Differentiation quality; name Kleenex, Xerox; Patents; service; advertising Lower cost Scale; Off shore mfrg; downsize; technology; i.e. PCs, Cell phones 6. Efficient Capital Markets

The markets are quick and the prices are right Information is instantly reflected in the stock price Can the prices ever be wrong? Yes, if info is wrong, or market hype
7.

Agency problem who is management working for?

Incentives must ensure interests of management and shareholder the same If not, management focus is on the short term

Solutions stock options, grants 8. Taxes bias business decisions

Value of investment measured by PV of after-tax cash flows Taxes represent negative cash flow; i.e. 10% return = 6% after tax if rate is 40% 9. Not all risk is equal
10.

Some risk can be diversified away, some cannot Diversification can help Ethical dilemmas are everywhere in finance

Ethical behavior means doing the right thing Ethical errors tend to end careers Loss of public confidence very hard to repair Social responsibility of firms to stakeholders The good - Bristol Meyers Squibb; The bad Johns Manville; the ugly Florida election, Ford/Firestone, Enron Is it wrong to tell a lie?