lecture one: introduction to foundations of finance Flashcards
what is the goal of the firm
-the goal of the firm is to create value for firms owners: maximising shareholder wealth by maximising price of existing common stock
-good financial decisions will increase stock price whereas bad financial decisions will decrease stock price
what is the first principle that forms the foundations of finance
-cash flow is what matters
-accounting profits do not equal cash flows. firms can generate accounting profits and not have any cash or can generate cash and not report accounting profits in the books
-cash flow, not profit, is what drives business value
-must determine incremental/marginal cash flow when making financial decisions
-incremental cash flow is difference between projected cash if the project is selected vs if the project is not selected
what is the second principle that forms the foundations of finance
-money has a time value
-a dollar today is worth more than a dollar received tomorrow
-because you can earn interest on money, it is best to receive money sooner rather than later
-opportunity cost: it is a cost of making a choice in terms of the alternative that must be foregone
-e.g. lending at 0% ir has an opportunity cost of 1% that could be earned by depositing money in a bank
what is the third principle that forms the foundations of finance
-risk requires a reward
-investors will not take on additional risk unless they expect to be compensated by additional reward/return
-investors expect to be compensated for “delayed consumption” and taking on risk
-thus:
-delayed consumption: investors expect to be compensated when they deposit money into a savings account
-taking on risk: investors expect a higher rate of return when investing in stocks than depositing money into a savings account
risk-return trade off
-expected return on y axis, risk on x axis
-horizontal line above zero which highlights expected return for delayed consumption
-diagonal line above which highlights expected return for taking on added risk
what is the fourth principle that forms the foundations of finance
-market prices are generally right
-in efficient markets, market prices of all trades assets fully reflect all information available
-thus stock prices are a good indicator of the value of a firm. price changes reflect changes in expected future cash flows. good decisions tend to increase stock prices
-behavioural biases: inefficiencies that may distort market prices from asset values
what is the first principle that forms the foundations of finance
-conflicts of interest cause agency problems
-separation of management and ownership of the firm cause agency problems. managers may make decisions not consistent with goal of maximising shareholder wealth
-reduced by: monitoring (annual reports), compensation (stock options) and market mechanisms (takeovers)
how finance area fits into the firm
from top:
board of directors
CEO
VP of market= VP of production and operations= VP of finance (or CFO- diverse financial planning, strategic planning, cash flow control)
treasurer (credit/cash management, capital expenditure, raising capital, financial planning)= controller (taxes, financial statements, data processing)
legal forms of business organisation
-sole proprietorship
-partnership
-corporation
sole proprietorship
-firm owned by individual
-firm maintains title to assets and profits
-unlimited liability
-termination occurs at death/choice
partnership
-two or more people come together as co-owners
-general partnership: all partners fully responsible for liabilities incurred by partnership
-limited partnership: one or more partners may have limited liability (no involvement in management of firm/ no name at top of firm) restricted at amount of capital invested in the partnership. at least one partner must have unlimited liability
corporation
-legally functions as single entity apart from its owners. can sue, be sued, buy/sell/purchase property
-owners (shareholders) dictate direction and control policies often through elected board of directors
-shareholder liability limited to investment into corporation
-life of corporation not depend on owners, still run by managers through transfer/sale.inheritance
trade-offs: corporate form
-benefits: limited liability, easy to transfer ownership/ raise capital, unlimited life (unless bankruptcies/mergers)
-drawbacks: no secrecy of info, delays in decision making, greater regulation, double tax
double taxation
-assume earnings before tax= 1000
-federal tax at 25%: 250, after tax income is 750
-assume corporation distributes profits as dividends to shareholders they will be taxed again
-15% dividend tax: 15% of 750= 112.5
-total tax is 362.5 (36.25%)
