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01_IM_CHAPTER1 - CHAPTER 1 An Introduction to Financial...

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CHAPTER 1 An Introduction to Financial Management CHAPTER ORIENTATION This chapter lays a foundation for what will follow. First, it focuses on the goal of the firm, followed by a review of the legal forms of business organization. Ten principles that form the foundations of financial management then follow. CHAPTER OUTLINE I. Goal of the firm A. In this book we will designate maximization of shareholder wealth, by which we mean maximization of the total market value of the firm's common stock, to be the goal of the firm. To understand this goal and its inclusive nature it is first necessary to understand the difficulties involved with the frequently suggested goal of profit maximization. B. While the goal of profit maximization stresses the efficient use of capital resources, it assumes away many of the complexities of the real world and for this reason is unacceptable. 1. One of the major criticisms of profit maximization is that it assumes away uncertainty of returns. That is, projects are compared by examining their expected values or weighted average profit. 2. Profit maximization is also criticized because it assumes away timing differences of returns. C. Profit maximization is unacceptable and a more realistic goal is needed. II. Maximization of shareholder wealth A. We have chosen the goal of shareholder wealth maximization because the effects of all financial decisions are included in this goal. B. 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. 1
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C. The agency problem is a result of the separation between the decision makers and the owners of the firm. As a result managers may make decisions that are not in line with the goal of maximization of shareholder wealth. III. Legal forms of business organization A. The significance of different legal forms 1. The predominant form of business organization in the United States in pure numbers is the sole proprietorship. B. Sole proprietorship: A business owned by a single person and that has a minimum amount of legal structure. 1. Advantages a. Easily established with few complications b. Minimal organizational costs c. Does not have to share profits or control with others 2. Disadvantages a. Unlimited liability for the owner b. Owner must absorb all losses c. Equity capital limited to the owner's personal investment d. Business terminates immediately upon death of owner C. Partnership: An association of two or more individuals coming together as co-owners to operate a business for profit. 1. Two types of partnerships a. General partnership: Relationship between partners is dictated by the partnership agreement.
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