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Foundations of Finance Summary chapter 1t/m 13
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Test Bank For Foundations of Finance, 10TH Edition By Keown/Martin/Petty
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Finance 2.1Chapter1
The goal of the financial manager is to create wealth for the shareholders, by making decisions that
will maximize the price of the existing common stock.
Share holders are the legal owners of the firm.
5 Principles that form the foundations of Finance.
* Cash flow is what matters
* Money has a time value
* Risk requires a reward
* Market prices are generally right
* Conflicts of interest cause agency problems
Cash flow is what matters
- It is cash flow, not profits that determines the value of a business.
- Accounting profits are not equal to cash flows.
- It is possible for a firm to generate accounting profits but not have cash or to generate cash
flows but not report accounting profits in the books
- 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.
Money has a time value
- A euro received today is worth more than a euro received in the future, (Interest)
- Opportunity cost is the difference between the highest valued alternative and the thing you
have decided, that you had give up when you made the choice.
Risk requires a reward
- Investors expect a return when they put their savings in a bank (delay consumption) and
they expect to earn a higher rate of return on stocks relative to bank savings account (taking
on risk)
Market prices are generally right
- In an efficient market, the prices of all traded assets (such as stocks and bonds) reflect all
available information at any time.
- Stock prices are a useful indicator of the value of the firm. Prices changes reflect changes in
expected future cash flows. Good decisions will tend to increase the stock prices.
Conflicts of interest cause agency problems
- Agency problems are problems and conflicts resulting from the separation of the
management and owners of the firm
- Agency conflict is reduced through monitoring ( Annual reports), compensation schemes
( stock options), and market mechanisms ( Takeovers)
- Ethical behaviour is doing the right thing!
- Ethical dilemma - Each person has his or her own set of values, which forms the basis for
personal judgments about what is the right thing.
- Sound ethical standards are important for business and personal success. Unethical
decisions can destroy shareholder wealth
, The Role of Business in Finance
- Knowledge of financial tools is relevant for decision making in all areas of business
(be it marketing, production etc.)
- Decisions involve an element of time and uncertainty financial tools help adjust
for time and risk.
- Decisions taken in business should be financially feasible financial tools help
determine the financial viability of decisions
.1 What long term investments should the firm undertake
Capital budgeting the decision making process with respect to investment in fixed assets.
.2 How should the firm raise money to fund these investments??
Capital structure decision the decision making process with funding choices and the mix of long term
sources of funds.
.3 How can the firm best manage its cash flows as they arise in its day-to-day operations??
Working capital management the management of the firm's current assets and short term
financing.
Financial markets is a institutions and procedures that facilitate financial transactions
The Legal Forms of Business Organization
- Sole proprietorship
- Partnership
- Corporations
Sole proprietorship a business owned by a single individual
Partnership an association of two or more individuals joining together as co-owners to operate a
business for profit.
- General partnership a partnership in which all partners are fully liable for the
ineptness incurred by the partnership.
- Limited partnership a partnership in which one partner has limited liability ,
restricted to the amount of capital he invests in the partnership
Corporation an entity that legally functions separate and apart from his owners.
- Legally functions separate and apart from its owners
- Corporation can sue, be sued, purchase, sell, and own property
- Owners (shareholders) dictate direction and policies of the corporation, oftentimes
through elected board of directors
- Shareholder’s liability is restricted to amount of investment in company
- Life of corporation does not depend on the owners … corporation continues to exist through
easy transfer of ownership
- Every owner (sharholder) will be taxed separately
- Benefits: Limited liability (), Easy to transfer ownership, Easier to raise capital,
unlimited life (unless the firm goes through corporate restructuring such as mergers
bankruptcies)
- Drawbacks: No secrecy of information, maybe delays in decision making, Greater
regulation, double taxation.
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