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FIN 320 Chapter 1

Intro to Financial Management

QuestionAnswer
Principle 1: The Risk-Return Trade-Off We won't take on additional risk unless we expect to be compensated with additional return. Higher the risk of an investment, higher the 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. Opportunity costs--interest.
Principle 3: Cash--Not Profits--Is King In measuring wealth or value, we use cash flow, not accounting profit, as our measurement tool.
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 industry is generating large profits, new entrants attracted, adds competition, drives profits down. Product differentiation and cost advantages can help.
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. Good decisions drive up the stock price and vice versa.
Principle 7: The Agency Problem The separation of management and the ownership of the firm creates the agency problem. Managers may make decisions that are not in line with the goal of the firm (maximizing shareholder wealth).
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. Diversifying can reduce risk, and measuring a project/asset's risk is very difficult.
Principle 10: Ethical Behavior is Doing the Right Thing, and Ethical Dilemmas are Everywhere in Finance Each person's set of values forms the basis for personal judgments about what is the right thing. Unethical decisions can destroy shareholder wealth
What is the Goal of the Firm? To maximize shareholder wealth. Shareholder wealth measured by share prices.
Sole Proprietorship Business owned by individual. Unlimited liability. Termination by choice or death.
General Partnerships All partners are fully responsible for liabilities incurred by the partnership.
Limited Partnerships One or more partners can have limited liability. 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 name of firm.
Corporation Legally functions separate and apart from its owners. Owners (shareholders) dictate direction and policies of the corp. Shareholder's liability restricted to amount of investment in company
Benefits and Drawbacks of a Corporation Benefits: Limited liability, Easy to transfer ownership, Unlimited life Drawbacks: No secrecy of information, Maybe delays in decision making, Greater regulation, Double taxation
Double Taxation When corporation distributes dividends to shareholders, they are taxed, even though the corp already paid taxes on that amount.
Objectives of Income Taxation Raise revenues for government expenditures. Achieve socially desirable goals. Economics stabilization.
Capital Gains Profits from investments (over a year)
How do you compute the Federal tax liability for a corporation? (Steps) 1. Determine the "Taxable Income" 2. Using the Taxable Income and Federal Tax Tables, compute tax liability
Compute Taxable Income Gross income less tax deductible expenses, plus interest income and dividend income. Sales - Cost of Goods Sold = Gross Profit - Operating Expenses = Operating Income - Interest Expense
Compute 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 tax deductible.
Created by: cre8nmydestiny