Chapter 1 Notes
The firm and the financial manager face two basic decisions:
• The Capital Budgeting Decision
• Which operating (real) assets to invest in
• The assets need to generate expected cash flows that are greater than the cash
needed to buy them
• In order to achieve this, the manager needs to account for the:
• Amounts of the benefits
• Timing of the benefits
• Risks associated with the benefits
• The Financing Decision
• How to pay for the assets
• Internally generated funds (i.e., retained earnings)
• Externally generated funds
• Debt financing
• Borrow from bank or other institution
• Issue Debt (sell bonds)
• Equity financing
• Issue Stock
• The choice between Debt and Equity is the Capital Structure Decision
• It is important to understand the distinction between Real and Financial Assets
• Real Assets
• Assets used to produce goods and services
• Tangible assets - Machinery, factories
• Intangible assets – patents, trademarks, technical knowledge
• Financial Assets
• Financial claims to the income generated by the firm’s real assets
• Shares of stock, Bonds, Bank loans
What is a Corporation?
• A business owned by shareholders who are not personally liable for the business’s
liabilities (Limited Liability)
• Shareholders are owners, but the corporation is run by employees led by the CEO
• Separation of ownership and management adds flexibility to the operation and gives
permanence to the corporation
• Ownership or management can change, but the business continues
• A corporation can sue or be sued
• Shareholders can sell shares (ownership)
• A corporation has a Board of Directors
• Elected by the shareholders
• Oversees activities of corporation
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• Appoints and monitors top management
A corporation can be costly, in both time and money
• Public corporations pay exchanges to list their shares
• Public corporations must abide by the rules of exchanges, accounting standards,
and securities laws
• Must share information with shareholders
Corporate income is taxed twice
• The corporation is taxed on its corporate profits
• The shareholders are taxed on dividends and capital gains received from the
corporation
Goals of the Corporation
• Shareholders (owners) want managers to maximize the market value of the firm
• Increasing market value increases shareholder wealth
• Maximizing market value is equivalent to maximizing current share price
• Maximizing profit does not necessarily increase overall market value
• If a firm maximizes profit, which year’s profit is being maximized
• Reinvesting in the firm may increase profit, but not necessarily at a sufficiently high
rate
• Profit depends on the accounting methods used
• Higher profit might mean higher risk
• In most public companies, the managers are not the owners and they may not always
act in the best interest of the owners
• The owners of the firm are the Principals
• Managers are hired as the agents of the owners
• When the personal goals of these agents create conflict in their roles in the
corporation, they create Agency Problems
• Managers may overindulge in unnecessary expenses
• Managers may shy away from attractive, but risky, projects
• Managers may engage in empire building
• Agency problems can be reduced in several ways:
• Compensation plans
• Employee stock options tie compensation to company value
• Board of Directors
• Voted in by shareholders to represent their interests
• Ensures management is running the firm in shareholders’ best interests
• Threat of takeovers
• If firm value is not maximized, the firm becomes a potential target for
takeover since the value could be increased by better management
• Current management may lose their jobs if taken over
• Specialist monitoring
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• Firms are monitored and rated by security analysts, lending institutions,
and rating agencies
Shareholder pressure
• Shareholders can try to replace board (who in turn would replace
management)
• Shareholders can sell shares – if enough do, the price will fall
Legal and Regulatory requirements
• Firms must abide by reporting requirements and standards
• Prohibition against insider trading
Forms of Business Organization
Sole Proprietorship
A business owned by a
single individual
Partnership
A business formed by
two or more co-owners
Pros
• Simplest form of
business to start and is
the least regulated
• Owner keeps all
profits
• Simplest form of
business to start with
little regulation
• Owners keep all
profits
• Access to more
human and financial
capital
• Limited partners(s)
have limited liability
Cons
• Owner has unlimited
liability for business
debts
• Business income taxed
as personal income
• Life of soleproprietorship limited
to life of owner
• Limited ability to raise
financing
• Difficulty in
transferring
ownership of a sole
proprietorship
• General partner(s)
have unlimited
liability for business
debts
• Business income
taxed as personal
income
• Life of partnership
limited to lives of
owners
• Difficulty in
transferring
ownership
• Possible
disagreements over
partnership
Definition
Corporation
A business created as a
distinct legal entity
owned by one or more
individuals or entities
• Ownership can be
easily transferred
• Life of corporation not
limited to lives of
owners or managers
• Corporation has
limited liability
• Ability to raise and
access large sums of
capital in both debt
and equity markets
• Double taxation
• Lenders sometimes
view the limited
liability as a
disadvantage and
require the owners of
small corporations to
make personal
guarantees
• More complex and
expensive form of
organization to
establish