1.1 Corporate Finance and the Financial Manager
Corporate finance is the study of how to answer three fundamental questions that every business must face. In a large corporation, the owners (stockholders) hire managers to run the firm, and the financial manager is responsible for making decisions that address these questions. The top financial officer is typically the Chief Financial Officer (CFO), who oversees the treasurer and the controller.
The Three Key Financial Management Decisions
Financial management can be broken down into three main areas:
- Capital Budgeting: This is the process of planning and managing a firm's long-term investments. Financial managers aim to identify investment opportunities that are worth more than they cost to acquire. This involves evaluating the size, timing, and risk of future cash flows. For example, deciding whether to open a new store would be a capital budgeting decision.
- Capital Structure: This refers to the specific mix of long-term debt and equity a firm uses to finance its operations. The key questions are how much the firm should borrow and what the least expensive sources of funds are. The chosen mix affects the firm's risk and value.
- Working Capital Management: This involves managing a firm's short-term assets (like inventory) and liabilities (like money owed to suppliers). It is a day-to-day activity that ensures the firm has enough resources for its operations without costly interruptions. Questions include how much cash and inventory to keep on hand and whether to sell on credit.
1.2 Forms of Business Organization
There are three main legal forms of business organization: the sole proprietorship, the partnership, and the corporation. As a firm grows, the advantages of the corporate form often outweigh its disadvantages.
| Form | Advantages | Disadvantages |
|---|---|---|
| Sole Proprietorship | Simple to start, least regulated, owner keeps all profits. | Unlimited liability for debts, life is limited to owner's lifespan, difficult to raise capital, ownership is hard to transfer. |
| Partnership | Easy to form, more capital available than a sole proprietorship. | Unlimited liability for general partners, partnership terminates on death or withdrawal of a partner, difficult to transfer ownership. |
| Corporation | Limited liability for owners, unlimited life, ease of ownership transfer, superior for raising capital. | More complex to start, double taxation (profits taxed at corporate level and dividends taxed at personal level). |
Hybrid Forms: The LLC and Benefit Corporation
A Limited Liability Company (LLC) is a popular hybrid form that is taxed like a partnership but provides limited liability for its owners. A newer form, the benefit corporation, is a for-profit company with additional legal attributes: providing a public benefit, accountability to all stakeholders, and transparency in reporting on its social and environmental performance.
1.3 The Goal of Financial Management
While goals like "maximize profit" or "minimize costs" seem intuitive, they are not precise enough objectives. Profit maximization, for instance, is an unclear goal because it doesn't specify a time frame and accounting profits can be misleading.
The appropriate goal for a financial manager is to make decisions that increase the value of the firm's stock. Therefore, the goal of financial management is to maximize the current value per share of the existing stock. For businesses without traded stock, this goal can be stated more generally as: Maximize the market value of the existing owners' equity.
This goal is appropriate because stockholders are residual owners; they are only entitled to what is left after all other claimants (employees, suppliers, creditors) have been paid. If stockholders are benefiting, it implies that everyone else is also being paid their due.
Sarbanes-Oxley Act (SOX)
Enacted in 2002 in response to corporate scandals, the Sarbanes-Oxley Act (SOX) is intended to protect investors from corporate abuses. It makes company management directly responsible for the accuracy of financial statements. For example, officers must review, sign, and explicitly declare that annual reports are free of false statements or material omissions. Compliance can be costly, leading some smaller firms to "go dark" and delist from major stock exchanges.
1.4 The Agency Problem
In large corporations, ownership is often spread among many stockholders, while management effectively controls the firm. The relationship between stockholders (the principal) and management (the agent) is called an agency relationship. A potential conflict of interest between these two parties is known as an agency problem.
The costs of this conflict are called agency costs. These can be indirect, such as a lost opportunity when management avoids a risky but valuable project to protect their jobs. They can also be direct, such as the cost of an unnecessary corporate jet (benefiting management) or the cost of paying auditors to monitor management's actions.
Do Managers Act in Shareholders' Interests?
Managers have significant incentives to act in the interests of stockholders for two main reasons:
- Managerial Compensation: Top management's compensation is often tied to financial performance and share value. Managers are frequently given stock options or restricted stock units (RSUs), which become more valuable as the stock price rises.
- Control of the Firm: Control ultimately rests with stockholders, who elect the board of directors that hires and fires management. Unhappy stockholders can engage in a proxy fight, where they solicit votes to replace the existing board. Additionally, poorly managed firms are more attractive for takeovers, giving management another incentive to perform well to avoid being replaced.
It's also important to recognize stakeholders—employees, customers, suppliers, and the government—who have a financial interest in the firm and may also try to exert control.
1.5 Financial Markets and the Corporation
Financial markets enhance the advantages of the corporate form by making it easier to transfer ownership and raise money. These markets bring buyers and sellers of debt and equity securities together.
The flow of cash between the firm and the financial markets. A firm issues securities to raise cash, invests in assets which generate cash flow. After paying taxes, cash is either reinvested or returned to investors.
Primary versus Secondary Markets
The primary market refers to the original sale of securities by corporations to raise money. This can be done through a public offering (like an IPO) to the general public or a private placement, which is a negotiated sale to a specific buyer.
The secondary market is where these securities are bought and sold after their original sale. These transactions involve one owner selling to another, providing liquidity and a means to transfer ownership. An active secondary market makes investors more willing to buy securities in the primary market.
Dealer versus Auction Markets
Secondary markets can be organized in two ways:
- Dealer Markets: Dealers buy and sell for themselves at their own risk. These are often called over-the-counter (OTC) markets. The large OTC market for stocks is the Nasdaq.
- Auction Markets: An auction market has a physical location and its primary purpose is to match buyers with sellers. Dealers play a limited role. The largest auction market in the U.S. is the New York Stock Exchange (NYSE).
Chapter Review and Critical Thinking Questions
Solution: The three types are: 1. Capital Budgeting (e.g., deciding whether to open a new factory), 2. Capital Structure (e.g., deciding whether to issue new stock or borrow money), and 3. Working Capital Management (e.g., deciding how much inventory to hold).
Solution: Four primary disadvantages are unlimited liability, limited life, difficulty transferring ownership, and difficulty raising capital. Benefits include being simple to start, having less regulation, and the owners keeping all profits.
Solution: The primary disadvantage is double taxation. Two advantages are limited liability for owners and ease of ownership transfer.
Solution: A company might "go dark" to avoid the high costs of complying with SOX's reporting requirements. The costs of this action include losing access to public capital markets and reduced liquidity for its shares.
Solution: The treasurer and the controller report to the CFO. The treasurer's group is the focus of corporate finance, as it deals with capital budgeting, capital structure, and cash management.
Solution: The goal should always be to maximize the current value per share of the existing stock, or more generally, to maximize the market value of the owners' equity.
Solution: The stockholders own a corporation. They control management by electing a board of directors. An agency relationship exists because the people running the firm (managers) are not the owners. Problems arise when managers' interests (like job security) conflict with shareholders' interests (wealth maximization).
Solution: An IPO is a primary market transaction. The company is selling its shares to raise capital for itself. Subsequent trading occurs in the secondary market.
Solution: The NYSE is an auction market because it has a physical location where buyers and sellers are matched. Dealer markets, like Nasdaq, are electronic networks of dealers who buy and sell for their own inventory. Nasdaq is a dealer market.
Solution: The goals would be related to the organization's mission, such as maximizing the value of services provided to the community, while maintaining financial stability and operating within a budget.
Solution: This statement is incorrect. The current stock value reflects the market's assessment of a firm's future prospects, not just its short-term profits. Focusing on the current stock value forces managers to consider the long-term effects of their decisions.
Solution: The goal of maximizing stock value should not conflict with ethical behavior. In the long run, unethical actions damage a firm's reputation and value. Subjects like employee safety and environmental concerns are crucial for long-term sustainability and are therefore consistent with maximizing shareholder value.
Solution: The goal would be the same: maximize owner wealth. However, the path to achieving it might differ due to different cultural norms, laws, and tax systems in foreign countries.
Solution: It depends. Management might be acting in shareholders' best interests if they believe they can get a higher offer or that the company's stock is worth more than \$35. However, if management is fighting the takeover to protect their own jobs, it is an agency problem.
Solution: Agency problems may be less severe in countries like Germany and Japan where ownership is more concentrated among large institutions, which have a greater ability and incentive to monitor management. The rise of large institutional investors in the U.S. could lead to similar reductions in agency problems.
Solution: Whether such amounts are excessive is a matter of debate. High compensation is designed to attract top talent and align management's goals with shareholder interests. The compensation levels are often comparable to those of top performers in other fields like entertainment and sports.