Finance 300 Chapter 1

Corporate form of organization

superior to other forms when it comes to raising money and transferring ownership interests, but it has the significant disadvantage of double taxation

Control of the firm

ultimately rests with stockholders, they elect the board of directors, who in turn and and fire managers.

Advantages of Corporations

Ownership (represented in shares of stock) are easily transferable and therefore life of corp not limited. Stockholders have limited liability for corporate debt, the most they can lose is what they invested

Goal of financial managment in a for-profit business

make decisions that increase the value of stock, or more generally, increase the market value of the equity book definition "the goal of financial management is to maximize the current value per share of the existing stock."

Primary disadvantages of partnerships and proprietorships are

1. Unlimited liability for business debts on the part of the owners 2. Limited life of the business 3. Difficulty of transferring ownership iv. One main problem: the ability of such businesses to grow can be seriously limited by an inability to raise cash for investment.

What goal should always motivate the actions of a firm's financial manager.

6. To maximize the current market value (share price) of the equity of the firm (whether it's publicly traded or not).

You've probably noticed coverage in the financial press of an initial public offering (IPO) of a company's securities. Is an IPO a primary market transaction or a secondary market transaction.

A primary market transaction

LLC

Goal is to operate and be taxed like a partnership but retain limited liablity for owners, so an LLC is essentially hybrid of proprietorship and corporation. The IRS will consider an LLC a corporation, thereby subjecting it to double taxation, unless it meets certain specific criteria.

There is the possibility of conflicts between stockholders and management in a large corporation. What's this called

agency problem

dealer markets

buys and sells themselves at their own risk Dealer markets in scots and long term debt are called over-the-counter OTC markets. Most trading in debt securities happens over the counter. No location, done electronically

Corporate finance has three main areas of concern

capital budgeting capital structure working capital management

What is being bought and sold in financial markets

debt and equity securities

stakeholders

employees, customers, suppliers, and even the government all have a financial interest in the firm.

The advantages of the corporate form are enhanced by

existence of financial markets. Financial markets function as both primary and secondary markets for corporate securities and can be organized as either dealer or auction markets.

Auction markets differ in two ways

has a physical location and second, the primary purpose is to match byers and sellers.

Corporation

i. A business created as a distinct legal entity composed of one or more individuals or entities. ii. A corporation is a legal "person" separate and distinct from it's owners, and it has many of the rights, duties, and privileges of an actual person. iii. Forming a corporation involves preparing articles of incorporation (charter) and a set of bylaws. iv. In principle, the stockholders control the corporation because they elect the directors.

Advantages of Partnership

i. Advantages/disadvantages similar to proprietorship 1. Easy and inexpensive to form ii. A partner in a general partnership can be held responsible for all debts, so having a written agreement beforehand is important.

Partnership

i. two or more owners (partners). ii. General partnership all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. iii. Limited partnership, one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business. 1. A limited partner's liability for business debts is limited to the amount that partner contributes to the partnership.

Why are secondary markets important to corps even though they are not directly selling in it

investors are much more willing to purchase securities in a primary market transaction when they know that those securities can later be resold if desired.

Primary vs secondary?

primary market refers to the original sale of securities by governments and corporations. The seoncdary markets are those in which these securities are bought and sold after the original sale. Equities issued solely by corporations. Debt issued by both gov and corp. EQUITIES ISSUED SOLELY BY CORPORATIONS. DEBT ISSUED BY BOTH GOV AND CORP.

capital budgeting

what long term investments should the firm take? 1. Process of planning and managing a firm's long term investments 2. FM tries to identify investment opportunities that are worth more to the firm than they cost to acquire. 3. Must worry not only on how much cash they receive, but when they'll receive it and how likely it is they will receive it 4. Evaluate the size, timing, and risk (most important to consider)

capital structure

where will the firm get the long-term financing to pay for its investments? In other words, what mixture of debt and equity should the firm use to fund operations? a. How much should we borrow? b. What are the least expensive sources of funds for the firm c. If firm is a pie, then capital structure determines how that pie is sliced, in other words, what percentage of the firm's cash flow goes to creditors and what goes to shareholders.

partly to avoid the various regulatory requirements and the expense of public offerings, debt and equity are often sold privately to large financial institutions such as life insurance and companies or mutual funds. Such private placements do not have to be registered with the SEC and do not require the involvement of underwriters

(investment banks that specialize in selling securities to the public)

Can our goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? Think of some specific scenarios to illustrate your answer.

An argument can be made either way. At the one extreme, we could argue that in a market economy, all of these things are priced. There is thus an optimal level of, for example, ethical and/or illegal behavior, and the framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are noneconomic phenomena and are best handled through the political process. A classic (and highly relevant) thought question that illustrates this debate goes something like this: "A firm has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability claims. What should the firm do?"

What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant.

Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding whether to issue new equity and use the proceeds to retire outstanding debt), and working capital management (modifying the firm's credit collection policy with its customers)

What are the four primary disadvantages of the sole proprietorship and partnership forms of business organization

Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, difficulty in raising capital funds. Some advantages: simpler, less regulation, the owners are also the managers, sometimes personal tax rates are better than corporate tax rates.

Are these large CEO salaries fair?

How much is too much? Who is worth more, Lawrence Ellison or Tiger Woods? The simplest answer is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align stockholder and management interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes argued that much of this reward is simply due to rising stock prices in general, not managerial performance. Perhaps in the future, executive compensation will be designed to reward only differential performance, that is, stock price increases in excess of general market increases.

working capital management

How should the firm manage its everyday financial activities short term asset and liabilities a. How much cash should we keep on hand b. Should we sell on credit? c. How will we obtain any needed short term financing?

What does it mean when we say the New York Stock Exchange is an auction market? How are auction markets different from dealer markets? What kind of market is NASDAQ

In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to match buyers and sellers of assets. Dealer markets like NASDAQ consist of dealers operating at dispersed locales who buy and sell assets themselves, communicating with other dealers either electronically or literally over-the-counter.

In response to the Sarbanes-Oxley Act, many small firms in the US have opted to 'go dark' and delist their stock. Why might a company choose this route? What are the costs of 'going dark'?

In response to Sarbanes-Oxley, small firms have elected to go dark because of the costs of compliance. The costs to comply with Sarbox can be several million dollars, which can be a large percentage of a small firm's profits. A major cost of going dark is less access to capital. Since the firm is no longer publicly traded, it can no longer raise money in the public market. Although the company will still have access to bank loans and the private equity market, the costs associated with raising funds in these markets are usually higher than the costs of raising funds in the public market.

Who owns a corporation? Describe the process whereby the owners control the firm's management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context what kinds of problems arise?

In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm's management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else's best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.

Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false.

Sole Proprietorship

Simplest type of business to start and is the least regulated iMore proprietorship models than any others Owner keeps all profits, but also has unlimited liability for business debts. So creditors can look beyond business assets to the prprietors personal assets for payments. All business income taxed as personal. Transfer requires sale of entire business to a new owner

Disadvantage

Since it's a separate entity, must pay taxes. Moreover, money paid out to stockholders in the form of dividens is taxed again as income to stockholders. This is double taxation, menaning that corporate profits are taxed twice: at the corporate level when they are earned and again at the personal level when they are paid out.

Suppose you were the financial manager of a not-for-profit business (a not for profit hospital, perhaps). What kinds of goals do you think would be appropriate?

Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is revenue minimization; that is, provide whatever goods and services are offered at the lowest possible cost to society. A better approach might be to observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to maximize the value of the equity.

Suppose you own stock in a company. The current price per share is 25 dollars. Another company has just announced that it wants to buy your company and will pay 35 dollar per share to acquire all the outstanding stock. Your company's management immediately begins fighting off this hostile bid. Is management acting in the shareholder's best interests? Why or why not?

The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this.

Would our goal of maximizing the value of the stock be different if we were thinking about financial management in a foreign country? Why or why not?

The goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions.

What is the primary disadvantage of the corporate form of organization? Name at least two advantages of corporate organization.

The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life.

In a large corporation, what are the two distinct groups that report to the chief financial officer? Which group is the focus of corporate finance?

The treasurer's office and the controller's office are the two primary organizational groups that report directly to the chief financial officer. The controller's office handles cost and financial accounting, tax management, and management information systems, while the treasurer's office is responsible for cash and credit management, capital budgeting, and financial planning. Therefore, the study of corporate finance is concentrated within the treasury group's functions.

question 15

We would expect agency problems to be less severe in countries with a relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions' deeper resources and experiences with their own management. The increase in institutional ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.S. corporations and a more efficient market for corporate control.