Chapter 21 - Business (Corporate) Finance

INTRODUCTION TO

CORPORATE FINANCE

Laurence Booth • W. Sean Cleary

Chapter 2 – Business (Corporate) Finance

Prepared by

Ken Hartviksen

CHAPTER 2

Business (Corporate)

Finance

Lecture Agenda

• Learning Objectives

• Important Terms

• Types of Business Organizations

• Goals of the Corporation

• Role of Management and Agency Issues

• Corporate Finance

• Finance Careers

• Organization of the Finance Function

• Sample Problems

CHAPTER 2

– Business (Corporate) Finance

2 - 3

Learning Objectives

1.

The advantages of disadvantages of four different ways to organize a business

2.

Some of the pressures exerted on corporations by various stakeholders

3.

What the ultimate objective of a firm is and why this is a logical objective

4.

Why agency costs arise and how they can reduce shareholder wealth

5.

The main types of decisions made by corporations regarding the financial management of their real and financial assets, as well as the associated corporate financing decisions

6.

Some of the major types of finance jobs available with financial and non-financial companies

CHAPTER 2


2 - 4

Important Chapter Terms

• Account managers

• Agency costs

• Agency problems

• Agency relationships

• Analysts

• Associates

• Banking associates

• Capital budgeting

• Chief financial officer

• Controller

• Corporate finance

• Corporate finance associates

• Corporate financing

• Corporations

• Financial and investment analysts

• Financial management

• Fixed income or equity traders

• Income and royalty trusts

• Limited liability

• Managers

• Partnership

• Portfolio managers

• Private bankers

• Retail brokers

• Sales and trading people

• Security analysts

• Senior vice-president of finance

• Sole proprietorship

• Treasurer

• Trust

• Unlimited liability

CHAPTER 2


2 - 5

Types of Business Organizations

• Sole proprietorships

• Partnerships

• Trusts

• Corporations

CHAPTER 2


2 - 6


Sole Proprietorships - Characteristics

Nature of the Business

– A business owned and operated by one person

– Legally inseparable from the person who owns and operates the business

– Report income (gross and net) on personal income tax return

– Net business income is taxed at the person’s marginal tax rate

Financing

– Limited to the resources of the individual owning and operating the business and their personal capacity to borrow

Formality

– Business records must be maintained for reporting to Canada Revenue

Agency like any other business

– Owners may wish to register the business with the Province

– If employing persons, the owner must obtain a employer number, deduct and remit income taxes as well as make employer contributions to CPP and Employment Insurance.

CHAPTER 2


2 - 7


Sole Proprietorships

Advantages Disadvantages

• Easy to start

• Little formality – but must maintain business records like any other business

• Unlimited legal liability

• Net income taxed at personal marginal tax rate

• Financing is limited to the resources of the single owner

CHAPTER 2


2 - 8


Partnership Characteristics


– Involves two or more partners

– Must have at least one general partner who holds unlimited legal liability for the activities of the business

Financing

– A function of the combined resources of the partners

– Can attract additional resources through limited partner contributions

Formality

– Must be registered under provincial partnership legislation

– Should be formalized through a partnership agreement outlining partner responsibilities, how partners enter and cash out of the business, and division of net business income

CHAPTER 2


2 - 9


Limited Liability Partnerships (LLP)

• New form of organization for professional firms

• Partners have limited legal liability

• Partner’s income included as ordinary income and filed using an individual tax return.

• This form of business organization is used by

Canadian legal and accounting firms

CHAPTER 2


2 - 10


Examples of LLPs in Canada

Table 2-1 Canadian Law and Accounting Firms, 2004

Law Firms

McCarthy Tetrault LLP

Gowling Lafleur Henderson LLP

Borden Ladner Gervais LLP

Fasken Martineau DuMoulin LLP

Accounting Firms

Deloitte & Touche LLP

KPMG LLP

PricewaterhouseCoopers LLP

Ernst & Young LLP

Grant Thornton LLP

So urce: Financial P o st , FP 500, 2004.

Employees

1,250

1,181

1,290

936

Lawyers

712

698

679

583

Partners

379

353

395

348

Sales Partners Professional

($ million) Staff

1,024

729

698

556

315

512

433

430

266

349

4,603

3,163

2,640

2,081

2,166

CHAPTER 2


2 - 11


Limited and General Partnerships

Used for tax purposes

– Limited partners are often able to use unused non-cash deductions such as ‘depreciation’ and/or business losses to offset personal tax liabilities.

General Partner

– There must be one general partner (responsible for operating the business)

– Unlimited legal liability

– Often the general partner is a corporation

Limited Partners

– Passive investors

– Contribute money only to the business, and share in the profits

CHAPTER 2


2 - 12


General Partnerships

Advantages

• Harnesses the combined talents and energies of all the partners

• Potentially taps the greater combined financial resources of the partners

• Spreads liability across the partners (jointly and severally)

Disadvantages

• Income is taxed at the individual’s marginal tax rate

• Governed by provincial partnership legislation – so some formality does exist – and probably should exist through a formal partnership agreement

• Unlimited legal liability

• Under law, non-partnership business arrangements can be deemed a partnership under the law

• It can be legally challenging to disassociate ones’ self from and/or dissolve a partnership arrangement

CHAPTER 2


2 - 13


Trust Characteristics


– Trusts are used to separate ownership from control

– Controlled by a trustee in accordance with the trust documents for the benefit of the named beneficiary(ies)

– Income that passes through the trust without any taxes payable at the trust level – income from the trust is taxed in the hands of the beneficiary/unitholder

Examples

– Intervivos and testamentary trusts for estate and tax planning purposes

– Open-ended mutual funds organized as unit trusts

– Many corporations have restructured themselves as income and royalty trusts

Formality

– Established through a formal trust agreement naming trustee, beneficiary.

CHAPTER 2


2 - 14


Income and Royalty Trusts


– Invest in both shares and debt of one company

– All net cash flows from the business operations pass through the trust without taxation

Purpose of the Structure

– To see as much of the cash flow generated by the underlying business, pass to the unitholders in the trust without income taxation.

– Tax efficiency – more cash flow passes to the unitholders than through a traditional common stock investment in the same enterprise.

Status

– Total market capitalization $192 billion (March, 2006)

– TSX incorporate trusts into the S&P/TSX Composite Index as of March

2006

– Finance Minister Flaherty announced on October 31, 2006 an intent to tax any newly established Income and Royalty Trust as a corporation.

Previously-established Trusts will be taxed effective 2011.

CHAPTER 2


2 - 15


Trusts


• No taxation of funds flowing through the trust

• Separates ownership and control

• Governance structure may only be appropriate for well established firms with little further capital investment needs

CHAPTER 2


2 - 16


Corporation Characteristics


– A separate legal entity (person) under the law

• Incorporated either federally or provincially

– Governed by the Board of Directors, managed by professional managers and owned by shareholders

Financing

– Highly flexible and long term including issuing stocks, bonds and other hybrid securities to raise capital for research and development and overall corporate growth

Formality

– Articles of Incorporation, bylaws, practices are governed by corporate and securities law

CHAPTER 2


2 - 17


Corporations


• Immortal – issue securities with very long terms to maturity

• Potential to attract great amounts of financing by expanding the base of shareholders

• Potential to attract and use expertise of its board of directors

• Potential to hire professional managers to build value

• Formality and structure may slow the speed of response of the organization

• Corporate taxation means that shareholder income

(dividends) are paid out after-tax and then are taxed in the hands of shareholders when received.

CHAPTER 2


2 - 18

Governance of the Corporation

Corporations

• Shareholders are the owners of the corporation

– Residual claims to profits and assets

– Rights to vote to:

• Elect the board of directors

• Adopt the financial statements

• Approve the auditors for the coming year

• Board of Directors and Managers are responsible for day-to-day operation of the corporation in accordance with standards set out in the corporations act.

CHAPTER 2


2 - 19


Director and Officer Responsibilities

Canada Business Corporations Act (CBCA

S122.1)

Every director and officer of a corporation in exercising their powers and discharging their duties shall: a) Act honestly and in good faith with a view to the best interests of the corporation, and b) Exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.

CHAPTER 2


2 - 20


Separation of Ownership and Management

• In the modern publicly-traded corporation, professional managers and directors manage the corporation; they are agents of the shareholders who are the principal owners

• It is possible for agents (management) to pursue their own goals at the expense of the principal (shareholder).

• The fact that owners (shareholders) have limited access to information about the company they own, and managers and the board hold superior information, creates further potential for conflict.

• Corporate law anticipates the potential for principal/agent conflict and imposes responsibilities and reporting controls on management to reduce the

2 - 21


Information Asymmetry

The fact that owners (shareholders) have limited access to information about the company they own, and managers and the board hold superior information, creates the potential for abuse of position by management.

To reduce the potential for conflict arising out of information asymmetry corporate and securities law requires regular release of information about corporate performance and the right to require approval from shareholders for major changes in the corporation including:

• Annual shareholders meetings required by proper notice

• Audited financial statements

• Approval of auditors for the coming year

• Shareholder approval for changes to bylaws and articles of incorporation

CHAPTER 2


2 - 22

The Goals of the Corporation

Separation of Ownership and Management in the Corporation

There is a separation between ownership and management

Shareholders - Principal

Shareholders

Elect the Board

Board of Directors

Chief Executive Officer

The Board of Directors and Management are

Chief Financial

Officer

Agents of the Shareholders

Vice President

Operations

Vice President

Marketing

CHAPTER 2


2 - 23


Profit Maximization

Profit maximization is an inadequate goal to guide officers and directors of the corporation.

– It fails to consider the risks undertaken by the firm in pursuit of profit

– Its focus is on accounting profit

– Its focus is on one year’s accounting profit, potentially at the expense of longer-term interests of the shareholder

CHAPTER 2


2 - 24


Pressures on Management

Professional managers of corporations face pressures and have responsibilities to many different ‘stakeholders’

(See Figure 2-1 on the following slide.)

CHAPTER 2


2 - 25

LABOUR


The Firm As an Input-Output Function

FIGURE 2-2

SOCIAL PRESSURES

SUPPLIERS

CAPITAL

MANAGERS

PRODUCT/

CONSUMERS

FREE GOODS

FREE GOODS

GOVERNMENTS

CHAPTER 2


2 - 26


Shareholder Wealth Maximization

Shareholder wealth maximization is considered the most appropriate goal to guide officers and directors of the corporation.

– Its focus is on genuine economic profit

– It reflects the value of all economic profits of the corporation now and into the future.

CHAPTER 2


2 - 27


Shareholder Wealth Maximization and Negative Externalities

Despite the attention given to major corporations because of negative externalities, the agents of the corporation must:

– Operate legally and in compliance with contractual responsibilities,

– In the interests of its owners by creating value for them.

CHAPTER 2


2 - 28

Role of Management and Agency Issues

Definitions

• Agency Relationship

– Managers work on behalf of the shareholders

• Agency Problems

– Problems that arise due to potential divergence of interest between managers, shareholders and creditors

• Agency Costs

– The costs associated with agency problems

CHAPTER 2


2 - 29

Agency Costs

Direct Costs

• Direct Agency Costs

– Arise because suboptimal decisions are made by managers when the act in a manner that is not in the best interests of shareholders

– Examples:

• Managers avoiding high risk projects because they have an undiversified stake in the health of the corporation (they could lose their job if the outcome is negative)

• Managers spending corporate resources on luxurious offices, executive aircraft, pension plans and poison pills that favour their own self interest at the expense of shareholders

CHAPTER 2


2 - 30

Agency Costs

Indirect Costs

• Indirect Agency Costs

– Are incurred by the corporation in the attempt to avoid direct agency costs

– Examples:

• Shareholder approval required before management can change the articles of incorporate or bylaws or make major changes in share capital

• Reporting requirements placed on management including, annual report, audited financial statements, requirements for notice of annual and special shareholders meetings

• Elaborate compensation schemes including use of stock options used to try to align the interests of managers with shareholders.

CHAPTER 2


2 - 31

Agency Costs

Areas of For Potential Disagreement

• Managers and shareholders may have differing goals, attitudes toward risk, and differential access to information.

– This can lead to areas of disagreement

See Table 2-2 on the following slide.

CHAPTER 2


2 - 32


Areas of Disagreement between Shareholders and Managers

Table 2-2 Areas of Disagreement

Performance Appraisal

Investment Analysis

Financing

Risk

Managers

Accounting

ROI/cash

IRR of best division

Retentions

Debt

New Equity

Preservation of firm

Shareholders

Market Prices

WACC external

Debt

Retentions

New equity

Portfolio

CHAPTER 2


2 - 33

Agency Costs

Executive Compensation

• In an attempt to align managements interests with shareholders, Boards of Directors have tried to tie compensation to performance measures.

• These compensation schemes are not always effective in achieving their goal and have lead to concerns about excessive management compensation.

See Table 2-3 on the following slide.

CHAPTER 2


2 - 34


Compensation Arrangements for CEOs

Table 2-3 Canadian Executive Compensation, 2005

CEO Company

Hank Swartout Precision Drilling Trust

Hunter Harrison Canadian National Railway Co.

Mike Zafirovski Nortel Networks Corp.

John Hunkin CIBC

James Buckee Talisman Energy Inc.

William Doyle Potash Corp. of Saskatchewan Inc.

Donald Walker Magna International Inc.

Andre Desmarais Power Corp. of Canada

Gwyn Morgan EnCana Corp.

Richard Waugh Bank of Nova Scotia

Salary

($million)

0.84

Bonus

($million)

Shares/

Options

3.36

($million)

55.03

Other

($million)

15.59

Total

($million)

74.82

1.67

0.31

0.75

1.10

1.15

0.20

0.91

1.48

1.00

4.67

0.00

0.00

1.99

1.28

6.06

0.70

2.66

1.50

48.18

8.42

28.72

20.09

19.53

13.26

16.69

13.87

14.40

1.71

28.70

0.00

0.15

0.16

0.04

0.55

0.16

0.28

56.22

37.43

29.47

23.33

22.13

19.56

18.84

18.16

17.18

Source: "Executive Compensation 2005." Report on Business w ebsite: <w w w .globeandmail.com>.

CHAPTER 2


2 - 35

What Is Corporate Finance?

• The financial management of assets and corporate financing decisions

(See Table 2-4 on the following slide for a snapshot of the Canadian Corporate Balance Sheet)

CHAPTER 2


2 - 36

Corporate Finance

Corporate Balance Sheet

Table 2-4 Non-Financial Corporate Canada Balance Sheet, 2005

Assets ($ billion) Liabilities ($billion)

Real Assets

Buildings

Machinery and Equipment

Inventories

Land

Financial Assets

Deposits

Receivables

Paper

Debt

Claims

Other

815

362

191

281

259

249

29

22

509

294

Payables

Loans

Paper

Mortgages

Bonds

Claims

Shares

Other

203

321

53

114

321

296

1659

44

Source: Statistics Canada. National Balance Sheet Accounts, Quarterly Estimates, Fourth Quarter 2005.

Ottaw a: Minister of Industry, 2006 (Catalogue No. 13-214-XIE).

CHAPTER 2


2 - 37

Corporate Finance

What Senior Managers Do

• Financial Management of Assets

– Capital budgeting decisions

• Analysis and decision making with respect to asset investment, acquisition, and replacement

– Credit decisions, cash management, investment decisions

• Corporate Financing Decisions

– Ratio of debt and equity, raising equity capital through profit retention or new share issues, dividend policy, borrowing decisions, liability management

CHAPTER 2


2 - 38

Finance Careers

In Non-Financial Firms

• Chief Financial Officer (CFO)/Senior vicepresident of finance

• Treasurer (pure finance)

– Forecasting, pension management, capital budgeting, cash management, credit management, financing, risk management

• Controller (finance and accounting)

– Compliance, tax management, systems, internal audit, accounting, budgeting

(See Figure 2-2 on the following slide)

CHAPTER 2


2 - 39

Organization of the Finance Function

Finance in the Non-Financial Company

FIGURE 2-1

CFO

TREASURER CONTROLLER

Compliance

Tax Management

Systems / MIS

Internal Audit

Accounting

Budgeting

Forecasting

Pension Management

Capital Budgeting

Cash Management

Credit Management

Financing

Risk Management

CHAPTER 2


2 - 40

Finance Careers

In Financial Institutions

• Analysts

• Associates

• Managers

• Account Managers

• Banking Associates

• Security Analysts

• Sales and Trading people

• Private Bankers

• Retail Brokers

• Financial and Investment

Analysts

• Portfolio Managers

• Fixed income or equity traders

• Corporate finance associates and consultants

CHAPTER 2


2 - 41

Internet Links

•

• TSX – http://www.tsx.com

Report on Business website – http://www.globeandmail.com

• Statistics Canada http://www.statcan.ca/

• Small Business Canada – incorporating a company http://sbinfocanada.about.com/od/incorporation/index_r.htm

• Industry Canada - Corporations Canada Site http://strategis.ic.gc.ca/epic/site/cd-dgc.nsf/en/home?OpenDocument

• Department of Finance Canada http://www.fin.gc.ca/

CHAPTER 2


2 - 42

Summary

• In this chapter you have learned:

– About alternative ways to organize business enterprises

– About the pressures on corporations to create shareholder value

– That agency relationships pose unique challenges on corporations that result in additional costs to be borne by the firm

– About the major decisions facing financial managers, and

– About the major types of finance jobs in financial and nonfinancial companies.

CHAPTER 2


2 - 43

Copyright

Copyright © 2007 John Wiley & Sons Canada, Ltd.

All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons

Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

CHAPTER 2


2 - 44

Chapter 21 - Business (Corporate) Finance

CORPORATE FINANCE

CHAPTER 2

Business (Corporate)

Finance

Governance of the Corporation

Separation of Ownership and Management

The Goals of the Corporation

The Goals of the Corporation

Role of Management and Agency Issues

• The financial management of assets and corporate financing decisions

Related documents

Products

Support

Chapter 21 - Business (Corporate) Finance

CORPORATE FINANCE

CHAPTER 2

Business (Corporate)

Finance

Governance of the Corporation

Separation of Ownership and Management

The Goals of the Corporation

The Goals of the Corporation

Role of Management and Agency Issues

• The financial management of assets and corporate financing decisions

Related documents

Add this document to collection(s)

Add this document to saved

Suggest us how to improve StudyLib