Foundations of Finance

Foundations of Finance Tenth Edition Arthur J. Keown John D. Martin J.William Petty

Solutions Manual 1 / 4

1-1 Copyright © 2020 Pearson Education, Inc.

CHAPTER 1

An Introduction to the Foundations of Financial Management

CHAPTER ORIENTATION

This chapter lays a foundation for what will follow. First, it focuses on the goal of the firm, followed by the five principles that form the foundations of financial management and the role of finance in business. The chapter then reviews the legal forms of business organization and discusses the tax implications relating to financial decisions. Finally, the chapter discusses the multinational firm and its role in finance.

CHAPTER OUTLINE

• The Goal of the Firm
• In this book, we will designate maximization of shareholder wealth to be the goal of the

firm, by which we mean maximization of the total market value of the firm’s common stock.

• We have chosen the goal of shareholder wealth maximization because the effects of all

financial decisions are included in this goal.

• In order to employ this goal, we need not consider every price change to be a market

interpretation of the worth of our decisions. What we do focus on is the effect that our decision should have on the stock price if everything were held constant.II. Five Principles That Form the Foundations of Finance

• Principle 1: Cash Flow Is What Matters. In measuring value, we will use cash flows

rather than accounting profits because it is only cash flows that the firm receives and is able to reinvest. In addition, in making business decisions, we will concern ourselves with only what happens as a result of that decision.

B. Principle 2: Money Has a Time Value. Almost all financial decisions involve

comparing money in different periods, perhaps investing today and receiving returns later, or borrowing money today and paying it off later. A dollar received today is worth more than a dollar received in the future because of the time value of money. 2 / 4

1-2  Keown/Martin/Petty Instructor’s Solutions Manual Copyright © 2020 Pearson Education, Inc.

• Principle 3: Risk Requires a Reward. There is a risk-return trade-off in finance—

typical risk-averse investors won’t take additional risk unless they expect to be compensated with additional return. Almost all financial decisions involve some sort of risk-return trade-off.

• Principle 4: Market Prices Are Generally Right. In general, financial markets are

quick to impound new information into stock prices, and the prices tend to be correct.

• Principle 5: Conflicts of Interest Cause Agency Problems. Self-interested managers

will not work for the owners’ best interest unless it is in the managers’ best interest as well. The corporate agency problem is a result of the separation of ownership from the decision makers of the firm. As a result, managers may make decisions that are not in line with the goal of maximization of shareholder wealth.

• The Essential Elements of Ethics and Trust. Ethical behavior is doing the right thing,

and ethical dilemmas are everywhere in finance. Ethical behavior is important in financial management, just as it is important in everything we do. Businesses cannot interact unless they trust each other. Unfortunately, precisely how we define what is and is not ethical behavior is sometimes difficult. Nevertheless, we should not give up the quest.III. The Role of Finance in Business

• Three basic types of issues are addressed by the study of finance.
• What long-term investments should the firm undertake? This area of finance is

generally referred to as capital budgeting.

• How should the firm raise money to fund these investments? The firm’s funding

choices are generally referred to as capital structure decisions.

• How can the firm best manage its cash flows as they arise in its day-to-day

operations? This area of finance is generally referred to as working capital management.

• Why Study Finance?

Every area of business involves making choices that relate to the management of money over time. A basic knowledge of finance is necessary even for nonfinance majors. An understanding of finance is also important for management of personal finances.

• The Role of the Financial Manager

Firms have many different organizational structures. Financial officers may fill any of the following roles: vice president for finance, chief financial officer (CFO), treasurer, or controller.IV. The Legal Forms of Business Organization

• Sole Proprietorships
• Sole proprietorship: A business owned by a single individual, which has a minimum

amount of legal structure

• The predominant form of business organization in the United States in total numbers

is the sole proprietorship. 3 / 4

Foundations of Finance, Tenth Edition  1-3 Copyright © 2020 Pearson Education, Inc.

• There are several advantages of sole proprietorships.
• They are easily established with few complications.
• There are minimal organizational costs.
• The owner does not have to share profits or control with others.
• There are some disadvantages of sole proprietorships.
• The owner has unlimited liability.
• The owner must absorb all losses.
• Equity capital is limited to the owner’s personal investment.
• The business terminates immediately upon the owner’s death.
• Partnerships
• Partnership: An association of two or more individuals coming together as co-

owners to operate a business for profit

• Partnerships come in two types.
• General partnership: This is a partnership in which all partners are fully liable for

the indebtedness incurred by the partnership. The relationship between partners is dictated by the partnership agreement.(l) General partnerships have some advantages.(a) The organizational requirements are minimal.(b) The government regulations are negligible.(2) General partnerships have some disadvantages.(a) All partners have unlimited liability.(b) It can be difficult to raise large amounts of capital.(c) The partnership is dissolved by the death or withdrawal of the general partner.

• Limited partnership: This is a partnership in which one or more of the partners has

limited liability, restricted to the amount of capital he or she invests in the partnership.(l) Limited partnerships have some advantages.(a) For the limited partners, liability is limited to the amount of capital invested in the company.(b) The withdrawal or death of a limited partner does not affect the continuity of the business.(c) Limited partners have a stronger incentive to invest, improving the partnership’s ability to raise capital.(2) Limited partnerships have some disadvantages.

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