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Test Bank for Foundations of Finance 10th Edition by Arthur J. Keown
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Summary FinanceChapter 1: introduction to the foundations of financial management
Goal of the firm:
Create value for firm owners (shareholders)
o In other words, maximize shareholders wealth
Maximize the price of the current stocks
Good financial decisions increasing stock prices
Bad/poor financial decisions decline stock prices
Five principles that form foundations of finance
1. Cashflow is what matters
2. Money has a time value
3. Risk requires a reward
4. Market prices are generally right
5. Conflicts of interest cause agency problems.
Principle 1: cashflow is what matters
Accounting profits = the cashflows
o Generate accounting profits without cash or the possibility to generate cashflows
Cashflow drive the value of the business not the PROFIT
Determine incremental or marginal cashflow by taking a financial decision
o Incremental difference between the expected cash flow if the project is selected
and the cash flow the project will have if it is not selected.
Principle 2: money has a time value
Dollar received today more worth than in the future
o Earn interest on received money of today better receiver sooner rather than later
Opportunity costs cost of making a choice in terms of next best alternative that
forgone
o Lending money to a friend at zero interest opportunity cost 1% potentially be
earned by depositing the money in a savings account in a bank
Benefits or cashflows outweigh the costs project creates wealth and should be
accepted
o Costs or outflows outweigh benefits or cash inflows project destroys wealth and
should be rejected
Principle 3: risk requires a reward
Investors don’t take additional risk unless expect compensated with additional reward or
return
Investors expect be compensated for ‘delaying consumption’ and ‘taking on a risk’
o Investors expect return when deposit their savings in a bank (delayed consumption)
o Expect earn relatively higher rate or return on stocks compared to bank savings
account (taking on risk)
1
, Look at figure 1.1 investor’s rate of return should equal a rate of return of delaying
consumption + additional return van assuming risk
Principle 4: market prices are generally right
Efficient market market prices of all traded assets (stocks/bonds) fully reflect all
available information at any moment in time
Stock prices are a useful indicator of the value of the firm
Price changes reflect changes in expected future cashflows
Good decisions tend to increase stock price and visa versa
Note inefficiencies in the market may distort market prices from value of assets
o Often caused by behavioral biases
Principle 5: conflicts of interest are agency problems
Separation of management and ownership of the firm creates agency problems
Managers can make decisions which not consistent with the goal of maximizing
shareholder wealth
Agency conflict is reduced through monitoring (annual reports), compensation schemes
(stock options) and market mechanisms (takeovers)
Essential elements of ethics and trust
Missing out of ethics and trust nothing works
Everything we do involves some dependence on others
Ethical behavior right thing
Ethical dilemma every person has his or her own set of values form the basis for
personal judgments about what’s the right thing
Sound ethical standards are important for business and personal success
Unethical decisions destroy shareholder wealth (Enron scandal)
Role of finance in business
Basic issues addressed by study of finance
o What long-term investments should the firm undertake (capital budgeting decision)
o How should the firm raise money to fund these investments (capital structure
decision)
o How should cash flows arising from day-to-day operations be managed (working
capital decision)
Knowledge financial tools is relevant for decision making in all areas of business (
marketing, production etc.) also in managing personal finances
Why study finance
Not planning a career in finance working knowledge of finance will take you far in
both personal and professional life
Finance is primarily about management of money, a key component of finance is the
management and the interpretation of information
Persue carreer in management information systems of accounting finance managers
are likely most important clients
Student with entrepreneurial asportations understanding finance is essential
If you can’t manage your finances won’t be in business very long
2
,The role of the financial manager
Firm can assume many different organizational structures figure 1.2 = typical
presentation of how the finance area fits into a firm
CFO serves under the firm’s CEO responsible for overseeing financial planning,
strategic planning and controlling the firm’s cashflow
Treasurer and controller under the CFO in a small firm same person fill both roles
Legal forms of business organization
Fall into 3 categories
o The sole proprietorship, the partnership, and the corporation
Sole proprietorship
Business owned by an individual
Owner retains title of business’s assets and is responsible, general without limitation for
liabilities incurred
Proprietor is entitling to profits from the business, but must also absorb any losses
Partnership
Association of 2 or more persons coming together co-owners for purpose of operating
a business for profit into two types
o General partnership each partner is fully responsible for liabilities incurred by the
partnership
o Limited partnership state statutes permit one or more of the partners to have
limited liability, restricted to the amount of capital invested in the partnership
Corporations
Corporation legally functions separate and apart from its owners
Individually sue and be sued and purchase or own property personnel are subject to
criminal punishment for crimes
Ownership reflected in common stock certificates
o Each designated the number of shares outstanding determines the stockholder’s
proportionate ownership in the business
Organizational form and taxes: double taxation on dividends and passthrough entitles
Occurs when a corporation earns a profit, pays taxes on those profits and pays some of
those profits back to shareholders in form of dividends the same shareholders pay
personal income taxes on those dividends
Current law qualified dividends from domestic corporation and qualified foreign
corporations are now taxed at maximum rate of 20%
New tax law impact pass-through entities
o Products from the business flow through the business owner’s personal tax return a
then are taxed ordinary income tax rates
S-corporations and limited liability companies (LLCs)
Limited liability while allowing business’s owners to be taxed as if they were a
partnership
Cross between partnership en corporation
3
, Difference with S-corporation runs and taxed like a partnership
o More flexibility than the S-corporation
2 variants because business owners face the problem, they need benefits of the
corporate from the expand double taxation or earnings come with corporate makes it
difficult to accumulate the necessary wealth of expansion
LOOK AT TABLE 1.1
Finance and multinational firm: new role
Coca cola significant profits from overseas sales
U.S. going abroad many foreign firms making their mark in the United States
o Think of the car industry dominated by Toyota, BMW, and Nissan
Risks and challenges of going abroad:
o Country risk changes in government regulations, unstable government, economic
changes in foreign country
o Currency risk fluctuations in exchange rates
o Cultural risk differences in language, traditions, ethical standards etc.
Developing skills for your career
Finance skill needed regardless of career choice here we learn:
o Excel skills
o Data analysis skills
o Collaboration and communication skills
Chapter 2: financial markets and interest rates
Financing of business: the movement of funds through the economy
Financial markets critical role capitalist economies
o Help facilitate transfer of funds from ‘saving surplus’ units ‘saving deficit’ transfer
money from those who have the money to those who need it
Look at figure 2.1 3 ways to transfer capital in the economy
o Direct transfer
Firm seeking’s cash sells it securities directly to savers (investors) who are willing
the purchase them in hopes of earning a large return
New business directly to wealthy private investor called an angel investor or
business angel for funds, or may go to a venture capitalist for early funding
o Indirect transfer using the investment banker
Financial institution helps companies raise capital, trades in securities and provides
advice advice on transactions such as mergers en acquisitions
o Indirect transfer using the financially intermediary
Type of system in which life insurance companies, mutual funds and pension funds
operate
Public offerings versus private placements
Corporation decides to raise external capital can be obtained by making public
offering or private placement
Both individual and institutional investors opportunity to purchase securities
Private placement (direct placement) securities offered and sold directly to a limited
number of investors
4
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