Mini Case: Introduction to the Foundations of Financial Management.By: Rayne Everage

The final stage in the interview process for an assistant financial analyst at Caledonia Products involves a test of your understanding of basic financial concepts. You are given the following memorandum and asked to respond to the questions. Whether you are offered a position at Caledonia will depend on the accuracy of your response.

To: Applicants for the position of Financial Analyst

From: Mr. V. Morrison, CEO, Caledonia Products

Re: A test of your understanding of basic financial concepts and of the corporate tax code.

Mini Case

Overview Goal of a Firm Risk-Return-Trade-Off Importance of Cash Flows Efficient Market Hypothesis Agency Problem Ethics & Finance Sole Proprietorship Partnership Corporation Questions

Goal of a Firm Capitalist Society: there is private

ownership of goods and services by individuals. Those individuals own the means of

production to make money. The profits from the businesses in the economy accrue to the individuals.

The fundamental goal of a business is to create value for the company’s owners.

Goal of a Firm Also known as “maximizing shareholder wealth”.

The effects of all the financial decisions ultimately affect the firm’s stock price.

As the stock price increases, the individual who holds the stock wealth increases. As the stock price goes up, the value of the firm increases and the net worth of the individual who owns the stock increases.

To employ this goal, we do not need to consider every change in stock price. What we do need to focus on is the effect that a decision should have on the stock price if everything else were held constant.

Goal of a Firm Agency Problem

Conflict between the managers of a firm and the Board of Directors.

Important to resolve this quickly as it can impede on performance.

Social Responsibility Need to be socially responsible to exist and

profit in the long run.

Risk-Return-Trade-Off Defined as: The principal that return arises with an

increase in risk. Low levels of uncertainty render low potential returns, whereas high levels or uncertainly render high potential returns.

*Source: www.investopedia.com

Risk-Return-Trade-Off Investors will not invest unless they know they

will receive a return on their investment.

A return for delaying consumption: the money an investor may provide, could be invested elsewhere, therefore investors expect a return (opportunity cost).

Importance of Cash Flows “Revenue is vanity, Cash Flow is sanity, but Cash

is king”

Cash flows are necessary for the firm to survive and prosper.

Cash flows represent money that can be spent, and determines the value of a business. Focus on this, not profits.

Incremental cash flow: the difference between the cash flows a company will produce both with and without the investment it is thinking about making.

Efficient Markets Hypothesis http

://www.investopedia.com/video/play/efficient-market-hypothesis/

Agency Problem “A conflict of interest inherent in any

relationship where one party is expected to act in another's best interests. The problem is that the agent who is supposed to make the decisions that would best serve the principal is naturally motivated by self-interest, and the agent's own best interests may differ from the principal's best interests. The agency problem is also known as the "principal–agent problem”

(www.investopedia.com/terms/a/agencyproblem.asp).

Agency Problem & Solution

Most commonly found between the board or directors and the management. The management acts as the shareholders agent to maximize their wealth, however management’s best interest is to maximize individual wealth.

It is not possible to eliminate the problem completely, however management can be motivated, by incentives, direct influence of shareholders, threat of termination or takeovers.

Ethics & Finance Ethical issues in finance affect everyone, even if

you don’t work in the field you are a consumer of its services.

It appears the financial industry is full of scandals and is possibly the most unethical field.

Greed is a powerful emotion. If pursuing a career in the financial field it is crucial that one understands the basics and principals of finance to understand how to deal with particular situations

Ethics & Finance Material Non-Public Information

EX. CEO explains in meeting that upcoming earnings will be disappointing. You own stock in the company. It is important you do not inform your broker and sell the stock, this is considered insider trading.

The High Road You may not be involved in an unethical

situation, however, if you knowingly allow it to continue, you could be held accountable also.

Sole Proprietorship Not a legal entity

One person owns the business and is personally responsible for its debts

Popular business form due to ease of set up and nominal cost.

Register name and secure local licenses

Many business begin as Sole Proprietorship and then evolve into more complex business form as business develops.

Sole ProprietorshipAdvantages Disadvantages

Establish instantly, easily and inexpensively

Unlimited personal liabilities for debts, losses and liabilities of the business

Carry little, if any ongoing formalities

Cannot raise capital by selling and interest in the business

Does not need to pay unemployment tax on him/herself

Rarely survive the death or incapacity of their owners, so do not retain value

May freely mix business and personal assets

Partnership “A legal form of business operation between two or

more individuals who share management and profits. The federal government recognizes several types of partnerships. The two most common are general and limited partnerships” (www.entrepreneur.com)

General LimitedPartners manage company and assume responsibility for the partnership’s debts and other obligations.

Has general and limited partners. General partners own and operate the business and assume liability for the partnership. Limited partners serves as investors, who have no control over the company and are not subject to same liabilities.

Partnership Major advantage of a partnership is the tax

treatment. It does not pay tax on its income but “passes through” any profits or losses to the individual partners.

Still high amount of personal liability, and it only takes one partner to make financial decisions which could effect all partners involved.

Expensive to establish due to legal and accounting services.

Corporation “A legal entity that is separate and distinct from

its owners. Corporations enjoy most of the rights and responsibilities that an individual possesses; that is, a corporation has the right to enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes”(www.investopedia.com)

Created by large group of shareholders who have ownership based on their holding of common stock

Corporation Shareholders elect a board of directors who

oversee management.

Corporations do not have to be for profit, majority of them have a goal of maximizing shareholder wealth.

Questions? Thank you!!