1-1
Chapter 1
The Firm and the Financial Manager
Chapter Outline

Organizing a Business
Sole Proprietorships
Partnerships
Corporations
Hybrids: Limited Partnerships, LLP,LLC,PC




The Role of the Financial Manager
Who is the Financial Manager?
Goals of the Corporation
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1-2
Organizing a Business
1. Sole Proprietorships



One individual starts a business with no
partners or shareholders.
That individual bears all the costs, but also
keeps all of the net profits.
Advantages:


Ease of establishment and lack of regulation; it is
well-suited to small companies.
Disadvantages:
liability – that individual is personally liable
for all of the firm’s liabilities.
 Unlimited
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Organizing a Business
2. Partnerships




A business owned by two or more people who are
called partners.
The partners share the business decisions, the
costs, and the net profits as set out in the
partnership agreement.
They pay personal income tax on their share of
profits
Disadvantages:
liability – each partner is personally liable for
all of the firm’s liabilities, not just his or her share.
 Unlimited
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1-4
Organizing a Business
3. Corporations


A business which is legally distinct from its
owners, who are called shareholders (SH).
Advantages:
liability – the shareholders can lose only the
amount they have invested in the company’s shares
(stock).
 Limited

Disadvantages:
taxation – the government taxes corporate
earnings and the dividends paid out of those
earnings to the shareholders.
 Double
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Organizing a Business
•
One of the key features of a corporation is the separation of
ownership and management.
•
In proprietorships and partnerships, the owners are usually the managers. In a
corporation, SHs own the firm, but they do not usually manage it.
So, how is a corporation managed?
• The SHs elect a Board of Directors which appoints management.
• The Board is supposed to:


•
Represent the shareholders’ interests.
Ensure that management is running the firm in the shareholders’ best
interests.
Separation of ownership and management allows a corporation more
flexibility and permanence than other types of business organization:


Managers may leave, or be replaced, but the firm continues.
A SH may buy/sell shares without affecting the operation of business.
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Organizing a Business
• Corporations
SHAREHOLDERS
MANAGEMENT
Elect
Manages
BOARD
CORPORATION
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Organizing a Business
Who owns the
business?
Sole
Proprietorship
Partnership
Corporation
The manager
Partners
Shareholders
No
Usually
Unlimited
Limited
No
Yes
No
Are managers
and owners
separate?
Unlimited
What is the
owner’s
liability?
Are the owner & No
business taxed
separately?
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Organizing a Business
Other Hybrid Forms of Organization




Limited partnership: Partners are classified as general
or limited. Limited partners don’t manage the
business closely but they have limited liability.
LLP: Limited liability partnerships, for professionals
such as accountants or lawyers. The firm can meet
losses using its assets and insurance policies
LLC: Limited liability corporation. A LLC provides
protection from personal liabilities like a corporation
and the tax advantages of a partnership.
PC :Professional corporation. The business has limited
liability not the professionals.
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The Role of the Financial Manager
• Financial
managers are supposed to make
financial decisions that serve SHs’ interests.



Firms need assets to generate income to provide
profits for the shareholders.
These assets must be paid for.
The role of the financial manager is to determine:
What operating assets to invest in – the capital
budgeting decision.
 How to pay for those assets – the financing decision.

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Role of the Financial Manager
•
Capital Budgeting Decision

Successful financial managers purchase
assets which generate cash flows greater
than the cash needed to buy them.
$3 BILLION CASH FLOW OUT
Boeing
TO PURCHASE A
PRODUCTIVE ASSET WHICH
CREATES CASH FLOW IN
757 and
767 jets
$8 BILLION CASH FLOW IN By 1997
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Role of the Financial Manager
•
Capital Budgeting Decision

Unsuccessful financial managers purchase
assets which generate cash flows less
than the cash needed to buy them.
$2 Billion CASH FLOW OUT
Walt
Disney
TO CONSTRUCT THE THEME
PARK
Disneyland
Paris
LESS THAN $1.8 BILLION ON CASH FLOW IN
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Role of the Financial Manager
1. Capital Budgeting Decision

The financial manager is concerned with:
1.The size of the future benefits which will be produced by the asset.
 The bigger, the better!
2.The timing of the future benefits which will be received.
 The sooner, the better!
3.The risks associated with realizing those future benefits.
 The greater the certainty that they will be realized, the better!
2. Financing Decision


Once the capital budgeting decision is made, the financial
manager must determine how to pay for those assets.
The financial manager has two choices:
 Purchase the assets using the firm’s own funds, that is, by using
internal financing.
 Purchase them using external financing, that is, by raising money
from financial institutions or markets.
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The Role of the Financial Manager
(2)
(1)
Financial
managers
Firm's
operations
(3)
(4a)
Financial
markets
(4b)
(1)
Cash raised from investors (financing decision)
(2)
Cash invested in operating assets (capital budgeting decision)
(3) Cash generated by operations
(4a) Cash reinvested (retained earnings / internal financing)
(4b) Cash returned to investors (interest payments/dividends)
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Who is the Financial Manager?
Anyone responsible for the capital budgeting and/or the
financing decision is known as a financial manager
Chief Financial
Officer
Treasurer
Controller
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Goals of the Corporation





BCE is a corporation with thousands of
shareholders.
There is no way they could all be actively involved in
running the company – there would be chaos!
Instead, shareholders delegate the task of operating
the company to the firm’s managers.
However, such delegation can work only if the
shareholders share a common objective.
How is that possible when the shareholders have
different

tastes, needs, time horizons, wealth and personal
opportunities?
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Goals of the Corporation
• Maximization

Fortunately, there is a common financial objective on
which most shareholders can agree:

•
Maximization of the current market value of their investment.
How does “Maximization of Market Value” work?



•
of Market Value
Increasing market value increases the wealth of the
shareholders.
Each shareholder can then use that increased wealth for
whatever purposes s/he wishes.
Successful financial managers make decisions which increase
the current value of the company’s shares.
Does this mean managers should do anything and
everything to maximize market value?
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Goals of the Corporation
• Agency


Problems
Conflicts of interest between the firm’s
owner-shareholders and its managers are
known as agency problems.
Agency problems can be reduced in several
ways:
 Tying
the compensation of the manager to the
success of the firm.
 Monitoring management behaviour.
 Threatening management with replacement if the
firm is under performing.
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The End
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