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CH1 The Firm and the Financial Manager

FINA3313 Business Finance

Spring 2006

Instructor: Bing Y. Du ©2006

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Topics covered

• Forms of business: -sole proprietorship, -partner, -corporation, -hybrid forms;• Role of financial manager: -financing decision -and capital budgeting decision,• Goal of firm: -maximize shareholder’s wealth, -however, agency problems inevitable.

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1. Forms of a business

• Sole proprietorship• Partnership• Corporation• Hybrid forms (LLP,…)

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1.Forms of a business -Sole Proprietorships• Sole owner of the a business, no partners and no shareholders. • The proprietor is personally responsible for all the firm’s obligation

• Advantages: 1)easy to start up and manage the business, 2)no regulations governing it, 3)only taxed once (your personal income tax), 4)good for small business at early stage.• Disadvantages: 1)difficult to raise fund, 2)limited life of business, 3)unlimited liability, very risky for the owner,

* Unlimited liability: The owners of a business are personally responsible for its obligations; Limited liability: The owners of a business are not personally responsible for its obligations;

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1.Forms of a business -Partnership• Partnership- business owned by two or more persons who agree to

abide by a partnership. A partnership is an agreement between sole proprietors to pool their assets and talents in a business.

• Similar to sole proprietorships except that the business is shared by several persons, thus more capital can be raised.

• Advantages: 1)pool money, and share expertise with friends or business

associates, 2)suitable to professional business, like accounting firm; no

corporation tax, only taxed once.• Disadvantages: 1)limited life time, 2)unlimited liability for all partners.

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1.Forms of a business -Corporations• Corporation-business organized as a separate legal entity owned by

stockholders.• Characteristics of corporation: - Independent legal entity, - Separation of ownership and management, - Limited liability. - Double taxation. - Agency problems.

• Advantages: 1) Possible to raise large amount of capital (if go public) 2) Low risk for owners (limited liability), 3) Perpetual lifetime because of the separation of ownership and

management 4) Possible to make a business running in a large scale

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1.Forms of a business -Corporations (Cont’d)

• Disadvantages: 1) double taxation, 2) high legal cost and management cost, 3) agency problems.

• Differences between the corporation and sole proprietorship and partnership

-Corporations are taxable entities, have perpetual lives, and are able to combine the capital of many shareholders, have greater organizational and legal costs, but are more likely to raise capital in financial markets.

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1.Forms of a business -Hybrid forms of business

• A limited partnership (LP) has both limited (limited liability) partners and, at least, one general (unlimited liability) partner, who is the primary manager.

• A limited liability partnership (LLP) is a partnership that enables all partners to have limited liability similar to corporation stockholders, but partners are taxed as individuals, avoiding double taxation.

• The professional corporation (PC), used by doctors and other professionals, has limited liability for owners, except in the area of malpractice.

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1.Forms of Business-Characteristics of business organizations

Sole Proprietorshi

p

Partnership

Corporation

Owners The manager Partners Shareholders

Legal Identity No No Yes

Separation of management and ownership

No No Usually

Owner’s Risk (Liability) Unlimited Unlimited Limited

Agency problem Low Low High

Are the owner and business taxed separately? (Taxation)

No No Yes (Double Taxation)

Bankruptcy Code CH7 CH7 CH11

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2.Role of Financial Manager

• Production cycle

Sell Product/ service Buy real assets

Inv

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tme

nt

de

cis

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What business to enter

Ho

w to

pa

y fo

r?

Fin

an

cin

g

de

cis

ion

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Producing

Value added

Div

ide

nd

p

olic

y

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2.Role of Financial Manager

• Real Assets:

- Assets can be used to produce goods and services, like land, building, assembly line, office,

- Real assets also can be categorized into tangible assets and intangible assets. Tangible assets like land, building, etc; Intangible assets like trademark, patents, etc;

• Financial Assets:

- Claims to the income generated by the real assets, also called securities, like stocks, bonds, promissory note.

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2.Role of Financial Manager

• Flow of cash between investors and the firm’s operations

Financial

Manager

Firm's

operations Investors

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)Real assets

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2.Role of Financial Manager

• Two decisions that financial manager should make: 1) Financing Decision: How should funds can be raised to finance

real investments? Such as borrowing from bank, issuing stocks and bonds, or borrowing from international markets. (how to raise money);

2) Capital budgeting Decision (Investment decision): What real assets should the firm acquire? Such as opening a new plant, investing overseas, expansion of assembly line, (how to invest money in real assets?),

• Keep in mind, the whole corporate finance can be summarized in

one short word “how to raise money and how to use money efficiently”.

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2.The Capital Budgeting Decision

(Investment Decision)

• Capital budgeting decisions are key to the success of a company.• A good investment project should be able to increase the value of

the firm and therefore increase the wealth of shareholders.• The success of such decisions are judged in terms of value. Good

projects are worth more than they cost. • Another important aspect of the investment decision is the factor of

time. We want our investment and the profits or benefits to return back as soon as possible.

• Financial manager must consider the investment decision in an uncertain environment. Risks are always with the investment.

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2.The Financing decision

• Financing decision: How to raise the money to pay for the investments in real assets.

• Long Term Financing: The choice of the long term financing mix is called CAPITAL STRUCTURE decision. Capital refers to the firm’s sources of long-term financing.

- How to raise capital? Issuing stocks or borrowing from lenders, or borrowing from bank, borrowing at home or borrowing at abroad.

• Short Term Financing: short term decisions, such as liquidity problem, and spare money .

• Risks: Business inherently are risks. Financial manager should also be able to manage risks, like hike of the oil price or downfall of the dollar value .

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2.Who is the financial manager?

• The financial manager refers to anyone responsible for a significant corporate investment or financing decision.

• The classic financial manager titles are the treasurer and the controller, with the former being more associated with financing, cash management, and financial market relationships, and the latter being associated with more traditional accounting functions of financial statements, budgeting, and auditing.

• The chief financial officer (CFO), in larger firms, oversees the treasurer and controller and is involved in formulating corporate strategy and financial policy

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2.Who is the financial manager?

Chief Financial OfficerFinancial policy

Corporate planning

TreasurerCash Management

Banking and other investor relationships

Raising capital

ControllerPreparation of financial statement

Accounting

Taxes

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3.The Goals of Corporation

• SHAREHOLDERS WANT MANAGERS TO MAXIMIZE CURRENT MARKET VALUE

• How can shareholders decide how to delegate decision making when they all have different tastes, wealth, time horizons, and personal opportunities? Delegation can work only if the shareholders have a common objective.

• Fortunately, there is a natural financial objective on which almost all shareholders can agree: maximize the current market value of shareholder’s investment in the firm

• “Profit maximization” is not a well-defined objective. Profit can be manipulated in different years.

• IN A FREE Market ECONOMY, A FIRM IS UNLIKELY TO SURVIVE IF IT PURSUE GOALS THAT REDUCE FIRM’S VALUE.

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3.Do Managers really maximize value?- Agency problems

• The goal of maximizing the firm’s market value cannot always be achieved because of the agency problems; Agency problems will prevent this goal being reached;

• Agency Problems: the interests conflict between the agent and principal.

• Stockholders are principals. Managers acting as the agents for stockholders, may act in their own interests rather than the interests of the shareholders, maximizing the firm value.

- buy luxurious corporate jets, -expensive dinner - shy away from the attractive but risky projects because they are worried more about the safety of their jobs rather than the potential for superior profits.

• Such problems can arise because the mangers of the firm, who are hired as “AGENT” of the owners, may have their own axes to grind (own interest), therefore these problems are called: Agency PROBLEMS

• Agency problem is a hindrance to achieving a firm’s goal.

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3.Ways to reduce agency problem

• Agency problems are mitigated in practice in several ways: -Management Compensation Plans: Compensation plans align interests of the managers with the

fortunes of the firm; Executives compensation plan usually includes basic salary, bonus, and stock options;

-Specialist Monitoring by lenders, stock market analysts, and investors;

-The Board of Directors -Takeovers -External Auditing

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3.Corporation as an apple pie

• The net revenue of a corporation is like a big pie, which is divided among a number of claimants.

• These include the management, work forces, lenders, governments and shareholders to put up the money to establish and maintain business. These claimants are called STAKEholders in the firm. Each has a stake in the firm. The stakeholder's interest may not coincide.

-Government levy corporate taxes -Lenders are concerned about if they can have their loans and

interest back safely - Managers worried about if they can keep their job next year - Shareholders only take an eye at the market value of the firm• Different claimants here have their own consideration in the firm,

and their interest usually have conflicts. Thereafter, agency costs and legal costs are huge in corporations

• These different parties are bound together in complex web of contracts and understandings

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3.Corporation as an apple pie

Shareholders: dividend

Lenders: repayment of interests and principals

Managers: compensations and job safety

Government: Tax

Stakeholders of a corporation: Lenders, stockholders, Employees, Managers, Government, etc, who have a stake in the company.

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4. Summary

• Forms of business: -sole proprietorship, -partner, -corporation, -hybrid forms;• Role of financial manager: -financing decision -and capital budgeting decision,• Goal of firm: -maximize shareholder’s wealth, -however, agency problems inevitable.