Chapter 1 - The World of Finance...

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Unformatted text preview: The World of Finance ( We begin our study of financial management with a look at what the field of finance is all about and the environment in which financial managers operate. Chapter 1 introduces you to finance, explains what financial managers do, states the objective of financial management, and describes the four basic forms of business commonly encountered in the U.S. Chapter 2 introduces you to the financial environment in which the firm operates. The financial system is explained, along with the various financial markets and the securities that are bought and sold there. The importance of financial markets to the firm is emphasized. Chapter 2 finishes with a discussion of interest rates, which represent the price of credit in the financial markets. Chapter 3 continues with descriptions of the various types of financial institutions through which buyers, sellers, borrowers, and lenders gain access to the financial markets. These three chapters set the stage for your study of the principles and practice of managing an individual company’s finances. 1 CHAPTERS 1 Finance and the Firm 2 Financial Markets and Interest Rates 3 Financial Institutions Finance and the Firm “The race is not always to the swift, nor the battle to the strong, but that is the way to bet.” —Rudyard Kipling Finance Grabs the Business Headlines Headlines from the front pages of some recent newspapers. • Why the Fed Had to Bail Out Bear Stearns (Slate, Mar 18, 2008) • How to Fix Fannie Mae and Freddie Mac: Nationalize ‘em (Los Angeles Times, Jul 10, 2008) • Treasury Set to Bail Out Fannie Mae and Freddie Mac (MarketWatch, Sep 6, 2008) • Merrill Lynch Sold, AIG Restructures Amid Losses (NPR, Sep 15, 2008) • Lehman Files for Bankruptcy, Merrill Sold, AIG Seeks Cash (Wall Street Journal, Sep 16, 2008) People wanted to own their own homes. The government wanted to encourage this. Real estate agents, appraisers, title insurance companies, home inspectors, mortgage brokers, and interior decorators, to name just a few, profited from this. So too did the “smart guys” on Wall Street who bundled mortgages and sold these packages to others. Everyone who was making money from home purchases could make even more money if people who hadn’t qualified for mortgage loans could get qualified. Thus was born the sub-prime mortgage, which is a mortgage loan made to a person with a low credit rating. Although these mortgage loans were riskier than traditional mortgages they paid a higher interest rate, and after all, “riskier” is a relative term. The absolute level of risk was widely seen as being very low, since everyone knows, housing prices 2 ( always go up. When this happens, there is always enough value in the house to cover even sub-prime mortgages in the unlikely event that a few might go into default. Huge government-sponsored enterprise companies with private sector stockholders, with names such as Fannie Mae and Freddie Mac, bought many of these mortgages and bundled them into mortgage-backed securities. Fannie Mae and Freddie Mac lowered the standards for the types of mortgages they would buy. Fannie Mae and Freddie Mac got effectively nationalized in late 2008 when they went broke. There were insurance companies such as AIG that sold an insurance-like product called a credit default swap to protect those holding these mortgage-backed securities in the event of defaulting mortgages. The fees were collected by AIG, and it sold way more credit default swaps than it could pay off on. AIG got effectively nationalized in early 2009. Everything would have been great if only housing prices and continued to go up as they had for about twenty five years. Executives at big financial firms received big bonuses if they could report big profits. It didn’t matter if the profits were really there, as long as the accountants signed off on the numbers. You had the potential to make much higher profits if you borrowed a lot of money (leverage is the polite financial term) to invest more than what your own money would allow. Lehman Brothers, a very old and prestigious firm, did this. It went bankrupt in late 2008 and doesn’t exist anymore. Also in 2008 venerable Merrill Lynch sold itself to Bank of America at a bargain basement price so as to avoid collapse. Bear Sterns did the same as Merrill Lynch when it sold itself to JPMorgan. 3 Learning Objectives After reading this chapter, you should be able to: 1. Describe the field of finance. 2. Discuss the duties of financial managers. 3. Identify the basic goal of a business firm. 4. List factors that affect the value of a firm. 5. Discuss the legal and ethical challenges financial managers face. 6. Identify the different forms of business organization. 4 Part I The World of Finance Housing prices had been going up much more quickly than personal income for several decades. If you didn’t buy that house soon, it would just be more expensive later. The people on the selling side were only too happy to encourage you to jump in and buy before it was too late and that house went beyond what your income could support. Even those mortgage-backed securities, including those with lots of sub-prime mortgages in them, had been given very high ratings by firms with venerable names such as Moody’s, Standard and Poor’s, and Fitch. Surely, there was no reason to worry. Then the unthinkable happened. Housing prices started to go down. Many of these houses had been bought with little or no money down. This meant that small decreases in the price of the home could create an “under water” situation where the amount of the mortgage balance was greater than the value of the home. When some homeowners defaulted, those holding the mortgages lost money. The people holding the mortgages were not, of course, the people who had originally lent the money. Those mortgages had been sold to others, and these mortgages were now held by the “smart guys” who had bought them as part of the mortgage-backed securities that had become so popular, complete with a high credit rating and insurance. It’s interesting that the Main Street mortgage brokers, real estate agents, appraisers, and home inspectors already had their money. These defaults did not directly affect the “hicks” who lived outside the hallowed halls of giant Wall Street firms. Who were the real dumb guys here? What happens when you buy a billion dollars worth of mortgage-backed securities using five percent of your own money and ninety-five percent borrowed money and then have those mortgages go down in value more than five percent? The answer is you are in big trouble. What happens if the insurance company that sold you the insurance that would pay off if your mortgage-backed securities were to default, doesn’t have enough resources to pay off the claims? The answer is both you and the insurance company are in big trouble. What if lots of big “sophisticated” firms did this all at the same time? The answer is that we, as taxpayers, have to step forward to keep the whole financial system from falling like a bunch of dominoes. Many of these companies were “too big to be allowed to fail.” They had been operating on the edge. When one of these big firms failed, other big firms the first firm owed money to (in big money sophisticated transactions called swaps), would fail too. Those other firms that were like dominoes down the line are called counter parties. These downstream firms held securities that relied on the firms upstream being able to pay what had been promised. Nothing would go wrong unless lots of these assets dropped significantly in value at the same time. Such a thing was thought to be impossible. This was called “systematic risk.” Systematic risk is covered in detail in Chapter 7. If you put all your eggs into a hundred different baskets you are well diversified, unless the baskets are defective and their bottoms all break at the same time. We will weave throughout this book what finance can bring to the table to help us understand what went wrong and how optimal financial decision making can take place. This is only possible if we make an attempt to understand what went so wrong in what is widely referred to as the financial crisis. What do all these stories have in common? They deal with finance. Finance has been the focus of the world’s attention over the past several years. Not all Chapter 1 Finance and the Firm this attention has been welcome by people in this field. Finance helps us solve problems. If done poorly finance can become the problem. The part of finance known as Wall Street has been the object of much scorn and criticism due to the spread of the problems of major Wall Street firms to banks and insurance companies around the world, in addition to the economic problems that some blame Wall Street for. Companies cutting costs, companies reporting profits or losses, governments concerned about interest rates—this is just a sampling of business stories involving finance that appear every day in the press. Finance is at the heart of business management. No business firm—or government, for that matter—can exist for long without following at least the basic principles of financial management. This book is designed to introduce you to basic financial management principles and skills. Some of these concepts and skills are surprisingly straightforward; others are quite challenging. All, however, will help you in the business world, no matter what career you choose. Chapter Overview In this chapter we introduce financial management basics that provide a foundation for the rest of the course. First, we describe the field of finance and examine the role of financial management within a business organization. Then we investigate the financial goal of a business firm and the legal and ethical challenges financial managers face. We end with a description of four forms of business in the U.S. economy: sole proprietorship, partnership, corporation, and limited liability company. The Field of Finance In business, financial guidelines determine how money is raised and spent. Although raising and spending money may sound simple, financial decisions affect every aspect of a business—from how many people a manager can hire, to what products a company can produce, to what investments a company can make. For example, on March 31, 2009, Google announced it was entering the venture capital (VC) game. It indicated that it would be investing up to $100 million in new companies in an attempt to find “the next big thing.”1 Money continually flows through businesses. It may flow in from banks, from the government, from the sale of stock, and so on; and it may flow out for a variety of reasons—to invest in bonds, to buy new equipment, or to hire top-notch employees. Businesses must pay constant attention to ensure that the right amount of money is available at the right time for the right use. In large firms it may take a whole team of financial experts to track the firm’s cash flows and to develop financial strategies. For instance, when Bank of America acquired Merrill Lynch on January 1, 2009, teams of financial analysts had to work on every detail of the federally assisted deal that involved Bank of America offering its shares Source: Jessica E. Vascellaro, “Google to Commit $100 Million to Venture Capital Fund in its First Year,” The On-line Wall Street Journal (March 31, 2009). 1 5 6 Part I The World of Finance to acquire the shares of Merrill Lynch. There were fears that Merrill Lynch would go under, as did Lehman Brothers, if this acquisition of Merrill Lynch by Bank of America had not been executed.2 Finance Career Paths Finance has three main career paths: financial management, financial markets and institutions, and investments. Financial management, the focus of this text, involves managing the finances of a business. Financial managers—people who manage a business firm’s finances—perform a number of tasks. They analyze and forecast a firm’s finances, assess risk, evaluate investment opportunities, decide when and where to find money sources and how much money to raise, and decide how much money to return to the firm’s investors. Bankers, stockbrokers, and others who work in financial markets and institutions focus on the flow of money through financial institutions and the markets in which financial assets are exchanged. They track the impact of interest rates on the flow of that money. People who work in the field of investments locate, select, and manage income-producing assets. For instance, security analysts and mutual fund managers both operate in the investment field. Table 1-1 summarizes the three main finance career paths. Financial Management Financial management is essentially a combination of accounting and economics. First, financial managers use accounting information—balance sheets, income statements, and statements of cash flows—to analyze, plan, and allocate financial resources for business firms. Second, financial managers use economic principles to guide them in making financial decisions that are in the best interest of the firm. In other words, finance is an applied area of economics that relies on accounting for input. Because finance looks closely at the question of what adds value to a business, financial managers are central to most businesses. Let’s take a look at what financial managers do. The Role of the Financial Manager Financial managers measure the firm’s performance, determine what the financial consequences will be if the firm maintains its present course or changes it, and recommend how the firm should use its assets. Financial managers also locate external financing sources and recommend the most beneficial mix of financing sources while focusing on the financial expectations and risk tolerances of the firm’s owners. All financial managers must be able to communicate, analyze, and make decisions based on information from many sources. To do this, they need to be able to analyze financial statements, forecast and plan, and determine the effect of size, risk, and timing of cash flows. We’ll cover all of these skills in this text. Finance in the Organization of the Firm Financial managers work closely with other types of managers. For instance, they rely on accountants for raw financial data and 2 “Google Ventures Into VC,”, March 31, 2009. Chapter 1 Finance and the Firm Table 1-1 Careers in the Field of Finance Career Area Function Financial management Manage the finances of a business firm. Analyze, forecast, and plan a firm’s finances; assess risk; evaluate and select investments; decide where and when to find money sources, and how much money to raise; and determine how much money to return to investors in the business Financial markets and institutions Handle the flow of money in financial markets and institutions, and focus on the impact of interest rates on the flow of that money Investments Locate, select, and manage money-producing assets for individuals and groups on marketing managers for information about products and sales. Financial managers coordinate with technology experts to determine how to communicate financial information to others in the firm. Management experts in the area of supply chain work are also part of this team. Financial managers provide advice and recommendations to top management. Figure 1-1 shows how finance fits into a typical business firm’s organization. The Organization of the Finance Team In most medium-to-large businesses, a chief financial officer (CFO) supervises a team of employees who manage the financial activities of the firm. One common way to organize a finance team in a medium-to-large business is shown in Figure 1-2. In Figure 1-2 we see that the chief financial officer (CFO) directs and coordinates the financial activities of the firm. The CFO supervises a treasurer and a controller. The treasurer generally is responsible for cash management, credit management, and financial planning activities, whereas the controller is responsible for cost accounting, financial accounting, and information system activities. The treasurer and the controller of a large corporation are both likely to have a group of junior financial managers reporting to them. At a small firm, one or two people may perform all the duties of the treasurer and controller. In very small firms, one person may perform all functions, including finance. The Basic Financial Goal of the Firm The financial manager’s basic job is to make decisions that add value to the firm. When asked what the basic goal of a firm is, many people will answer, “to make a lot of money” or “to maximize profits.” Although no one would argue that profits aren’t important, the singleminded pursuit of profits is not necessarily good for the firm and its owners. We will explain why this is so in the sections that follow. For now, let’s say that a better way to express the primary financial goal of a business firm is to “maximize the wealth of the firm’s owners.” This is an extremely important, even crucial, point, so we will say it again: The primary financial goal of the business firm is to maximize the wealth of the firm’s owners. 7 8 Part I The World of Finance Board of Directors Chief Executive Officer (CEO) VP for Finance (Chief Financial Officer, CFO) Figure 1-1 The Organization of a Typical Corporation Figure 1-1 shows how finance fits into a typical business organization. The vice president for finance, or chief financial officer, operates with the vice presidents of the other business teams. Take Note: The point about cash received sooner being better than cash received later works in reverse too. It is better to pay out cash later rather than sooner (all other factors being equal, of course). VP for Human Resources (Personnel) VP for Technology and Information Systems VP for Marketing (Sales, Advertising, Product Development) VP for Engineering and Research VP for Production (Manufacturing, Services) Everything the financial manager does—indeed, all the actions of everyone in the firm—should be directed toward this goal, subject to legal and ethical considerations that we will discuss in this chapter and throughout the book. Now, what do we mean by wealth? Wealth refers to value. If a group of people owns a business firm, the contribution that firm makes to that group’s wealth is determined by the market value of that firm. This is a very important point: We have defined wealth in terms of value. The concept of value, then, is of fundamental importance in finance. Financial managers and researchers spend a lot of time measuring value and figuring out what causes it to increase or decrease. In Search of Value We have said that the basic goal of the business firm is to maximize the wealth of the firm’s owners—that is, to maximize the value of the firm. The next question, then, is how to measure the value of the firm. The value of a firm is determined by whatever people are willing to pay for it. The more valuable people think a firm is, the more they will pay to own it. Then the existing owners can sell it to investors for more than the amount of their investment, thereby increasing current owner wealth. The financial manager’s job is to make decisions that will cause people to think more favorably about the firm and, in turn, to be willing to pay more to purchase the business. For companies that sell stock to the general public, stock price can indicate the value of a business because stockholders—people who purchase corporate shares of stock—become part owners of the corporation. (We will discuss stock in greater detail in Chapter 2.) People will pay a higher price for stock—that is, part ownership of a Chapter 1 9 Finance and the Firm Chief Financial Officer (CFO) Treasurer Controller Figure1-2 An Example of How to Organize a Finance Team Cash Management Credit Management Financial Planning Cost Accounting Financial Accounting Information Systems business—if they believe the company will perform well in the future. For instance, Google went public on August 18, 2004 at an initial price of $85 per share. (A share is one unit of ownership.) Because of the potential of its on-line advertising, it was worth $369 per share in April 2009. For businesses that sell stock publicly, then, the financial manager’s basic role is to help make the firm’s stock more valuable. Although some businesses do not sell stock to the general public, we will focus on stock price as a measure of the value of the firm. Keep in mind, however, that investing in one share (one unit) of stock means the investor only owns one small piece of a firm. Many firms sell hundreds of thousands or millions of shares of stock, so the total value of the firm is the equivalent of the sum of all the stock shares’ values.3 Next, let’s look closely at three factors that affect the value of a firm’s stock price: amount of cash flows, timing of cash flows, and the riskiness of those cash flows. The Importance of Cash Flow In business, cash is what pays the bills. It is also what the firm receives in exchange for its products and services. Cash is, therefore, of ultimate importance, and the expectation that the firm will generate cash in the future is one of the factors that gives the firm its value. We use the term cash flow to describe cash moving through a business. Financial managers concentrate on increasing cash inflows—cash that flows into a business—and decreasing cash outflows—cash that flows away from a business. Cash outflows will be approved if they result in cash inflows of sufficient magnitude and if those inflows have acceptable timing and risk associated with them. Google had traded at a high near $800 per share before the market crash of 2008 - 2009. This illustrates that the stock market can be a risky place to invest your money! (More about this in Chapter 7.) 3 This chart shows how to organize a finance team in a medium-to-large business. Most teams include both a finance function (on the left) and an accounting function (on the right). The chief financial officer usually reports to the CEO, as shown in Figure 1-1. Take Note: If the company is organized in the form of a corporation then the company’s value is determined by the value of the corporation’s common stock and the focus of the company’s managers is on maximizing the value of that stock. 10 Part I The World of Finance It is important to realize that sales are not the same as cash inflows. Businesses often sell goods and services on credit, so no cash changes hands at the time of the sale. If the cash from the sale is never collected, the sale cannot add any value to the firm. Owners care about actual cash collections from sales—that is, cash inflows. Likewise, businesses may buy goods and services to keep firms running but may make the purchases on credit, so no cash changes hands at that time. However, bills always come due sooner or later, so owners care about cash expenditures for purchases—cash outflows. For any business firm (assuming other factors remain constant), the higher the expected cash inflows and the lower the expected cash outflows, the higher the firm’s stock price will be. The Effect of Timing on Cash Flow Valuation The timing of cash flows also affects a firm’s value. To illustrate, consider this: Would you rather receive $100 cash today and $0 one year from now, or would you rather receive $0 cash today and $100 one year from now? The two alternatives follow: Today One Year from Today Alternative A +$100 $0 Alternative B $0 +$100 Both alternatives promise the same total amount of cash, but most people would choose Alternative A, because they realize they could invest the $100 received today and earn interest on it during the year. By doing so they would end up with more money than $100 at the end of the year. For this reason we say that—all other factors being equal—cash received sooner is better than cash received later. Owners and potential investors look at when firms can expect to receive cash and when they can expect to pay out cash. All other factors being equal, the sooner a company expects to receive cash and the later it expects to pay out cash, the more valuable the firm and the higher its stock price will be. The Influence of Risk We have seen that the size of a firm’s expected cash inflows and outflows and the timing of those cash flows influence the value of the firm and its stock price. Now let us consider how risk affects the firm’s value and its stock price. Risk affects value because the less certain owners and investors are about a firm’s expected cash inflows, the lower they will value the company. The more certain owners and investors are about a firm’s expected cash inflows, the higher they will value the company. In short, companies whose expected future cash flows are doubtful will have lower values than companies whose expected future cash flows are virtually certain. What isn’t nearly as clear as the way risk affects value is how much it affects it. For example, if one company’s cash inflows are twice as risky as another company’s cash inflows, is its stock worth half as much? We can’t say. In fact, we have a tough time quantifying just how risky the companies are in the first place. We will examine the issue of risk in some detail in Chapter 7. For now, it is sufficient to remember that risk affects the stock price—as risk increases, the stock price goes down; and conversely, as risk decreases, the stock price goes up. Chapter 1 Finance and the Firm Table 1-2 summarizes the influences of cash flow size, timing, and risk on stock prices. Profits versus Company Value Earlier in the chapter, we said that the single-minded pursuit of profits is not necessarily good for the firm’s owners. Indeed, the firm’s owners view company value, not profit, as the appropriate measure of wealth. Company value depends on future cash flows, their timing, and their riskiness. Profit calculations do not consider these three factors. Profit, as defined in accounting, is simply the difference between sales revenue and expenses. If all we were interested in were profits, we could simply start using high-pressure sales techniques, cut all expenses to the bone, and then point proudly to the resulting increase in profits. For the moment, anyway. In all probability, managers practicing such techniques would find their firm out of business later, when the quality of the firm’s products, services, and workforce dropped, eventually leading to declining sales and market share. It is true that more profits are generally better than less profits. But when the pursuit of short-term profits adversely affects the size of future cash flows, their timing, or their riskiness, then these profit maximization efforts are detrimental to the firm. Concentrating on company value, not profits, is a better measure of financial success. Legal and Ethical Challenges in Financial Management Several legal and ethical challenges influence financial managers as they pursue the goal of wealth maximization for the firm’s owners. Examples of legal considerations include environmental statutes mandating pollution control equipment, workplace safety standards that must be met, civil rights laws that must be obeyed, and intellectual property laws that regulate the use of others’ ideas. Ethical concerns include fair treatment of employees, customers, the community, and society as a whole. Indeed, many businesses have written ethics codes that articulate the ethical values of the business organization. Three legal and ethical influences of special note include the agency problem, the interests of non-owner stakeholders, and the interests of society as a whole. We will turn to these issues next. Agency Issues The financial manager, and the other managers of a business firm, are agents for the owners of the firm. An agent is a person who has the implied or actual authority to act on behalf of another. The owners whom the agents represent are the principals. For example, the board of directors and senior management of IBM are agents for the IBM stockholders, the principals. Agents have a legal and ethical responsibility to make decisions that further the interests of the principals. The interests of the principals are supposed to be paramount when agents make decisions, but this is often easier said than done. For example, the managing director of a corporation might like the convenience of a private jet on call 24 hours a day, but do the common stockholder owners of the corporation receive enough value to justify 11 12 Part I The World of Finance Table 1-2 Accomplishing the Primary Financial Goal of the Firm The Goal: Maximize the wealth of the firm’s owners Measure of the Goal: Value of the firm (measured by the price of the stock on the open market for corporations) Factor Effect on Stock Price Size of expected future cash flows Larger future cash inflows raise the stock price. Larger future cash outflows lower the stock price. Smaller future cash inflows lower the stock price. Smaller future cash outflows raise the stock price. Timing of future cash flows Cash inflows expected sooner result in a higher stock price. Cash inflows expected later result in a lower stock price. (The opposite effect occurs for future cash outflows.) Riskiness of future cash flows When the degree of risk associated with future cash flows goes down, the stock price goes up. When the degree of risk associated with future cash flows goes up, the stock price goes down. the cost of a jet? It looks like the interests of the managing director (the agent) and the interests of the common stockholder owners (the principals) of the corporation are in conflict in this case Executive compensation has also become a lightning rod issue due to the large bonuses paid by some large companies receiving government bailouts in 2009. Some AIG exectives had been promised large bonuses before this huge insurance company ran into financial trouble and required federal government assistance to stay in business. Should there be limits on bonuses given to executives of companies receiving federal financial aid? Is it right to abrogate signed employment contracts that had been entered into before the company accepted federal financial aid? What should be the guidelines for determining executive salaries and bonuses at private sector companies that do not receive government money? These issues relate to the agency problem addressed in the next section. The Agency Problem When the interests of the agents and principals conflict, an agency problem results. In our jet example, an agency problem occurs if the managing director buys the jet, even though he knows the benefits to the stockholders do not justify the cost. Another example of an agency problem occurs when managers must decide whether to undertake a project with a high potential payoff but high risk. Even if the project is more likely than not to be successful, managers may not want to take a risk that owners would be willing to take. Why? An unsuccessful project may result in such significant financial loss that the managers who approved the project lose their jobs—and all the income from their paychecks. The stockholder owners, however, may have a much smaller risk because their investment in company stock represents only a small fraction Chapter 1 Finance and the Firm of their financial investment portfolio. Because the risk is so much larger to the manager as compared to the stockholder, a promising but somewhat risky project may be rejected even though it is likely to benefit the firm’s owners. There can also be an agency problem if the non-owner, or small stake owner managers, have an incentive to take too much risk. A manager may qualify for a huge bonus if a large return is earned on a company investment. This manager may borrow lots of money, leverage the company to high levels, in an attempt to achieve this big payoff. If this big gamble with the owners’ funds pays off the manager can take the big bonus and retire. If the big gamble doesn’t pay off the manager can leave for another job and leave the owners holding the bag for the losses. The agency problem can be lessened by tying the managers’ compensation to the performance of the company and its stock price. This tie brings the interests of the managers and those of the firm’s owners closer together. That is why companies often make shares of stock a part of the compensation package offered to managers, especially top executives. If managers are also stockholders, then the agency problem should be reduced. It is clear that the agency problem has been grossly underestimated and that it is a big part of the reason we experienced the economic and financial crises of 2007 through 2009 and beyond. Many big risks were assumed by managers and many of these risks didn’t pay off. It was the shareholders, and in many cases the taxpayers, who absorbed the brunt of the downside. Board members and the stockholders who elected them, mainly large institutional investors, failed to properly monitor these executives and to give them incentives that were aligned with shareholder interests. It is clear that these issues will be closely examined to reduce the chances of another crisis of this magnitude. Agency Costs Sometimes firms spend time and money to monitor and reduce agency problems. These outlays of time and money are agency costs. One common example of an agency cost is an accounting audit of a corporation’s financial statements. If a business is owned and operated by the same person, the owner does not need an audit—she can trust herself to report her finances accurately. Most companies of any size, however, have agency costs because managers, not owners, report the finances. Owners audit the company financial statements to see whether the agents have acted in the owners’ interests by reporting finances accurately. The Interests of Other Groups Stockholders and managers are not the only groups that have a stake in a business firm. There are also non-manager workers, creditors, suppliers, customers, and members of the community where the business is located. These groups are also stakeholders— people who have a “stake” in the business. Although the primary financial goal of the firm is to maximize the wealth of the owners, the interests of these other stakeholders can influence business decisions. As the federal government takes ownership interests in companies such as AIG, Fannie Mae, Freddie Mac, and Citigroup the interests of taxpayers will obviously be given weight when executives of these companies make decisions. We are all owners of those companies that have received financial bailouts in return for government 5 But see the discussion that follows on general and limited partners. 6 In legal terms this concept is called “joint and several liability.” 13 14 Part I The World of Finance ownership interests. In effect there are no “other interest groups” for those companies with government investments that were the result of government aid to failing companies. When almost everyone has a stake in a company, how do you decide whose interests receive priority? How these companies with both private and public shareholders balance the interests of their various constituencies when making company decisions will be an area of close scrutiny as the country works its way out of the economic and financial crises. The Interests of Society as a Whole Sometimes the interests of a business firm’s owners are not the same as the interests of society. For instance, the cost of properly disposing of toxic waste can be so high that companies may be tempted to simply dump their waste in nearby rivers. In so doing, the companies can keep costs low and profits high, and drive their stock prices higher (if they are not caught). However, many people suffer from the polluted environment. This is why we have environmental and other similar laws—so that society’s best interests take precedence over the interests of individual company owners. When businesses take a long-term view, the interests of the owners and society often (but not always) coincide. When companies encourage recycling, sponsor programs for disadvantaged young people, run media campaigns promoting the responsible use of alcohol, and contribute money to worthwhile civic causes, the goodwill generated as a result of these activities causes long-term increases in the firm’s sales and cash flows, which can translate into additional wealth for the firm’s owners. Although the traditional primary economic goal of the firm is to maximize shareholder wealth, the unbridled pursuit of value is too simplistic a view of this goal. Firms often take into account ethical factors, the interests of other stakeholders, and the long-term interests of society.4 Figure 1-3 summarizes the various influences that financial managers may consider in their pursuit of value. Forms of Business Organization Businesses can be organized in a variety of ways. The four most common types of organization are proprietorships, partnerships, corporations, and limited liability companies (LLCs). The distinguishing characteristics give each form its own advantages and disadvantages. The Proprietorship The simplest way to organize a business is to form a proprietorship, a business owned by one person. An individual raises some money, finds a location from which to operate, and starts selling a product or service. The profits or losses generated are reported on a form called Schedule C of the individual’s Form 1040 income tax return. The sole proprietor is responsible for any tax liability generated by the business, and the tax rates are those that apply to an individual. The sole proprietor has unlimited liability for matters relating to the business. This means that the sole proprietor is responsible for all the obligations of the business, Not everyone agrees with this approach. the late Milton Friedman, Nobel laureate in economics, claimed that any action taken by a manager that is not legally mandated and that reduces the value available to the owners, is theft. 4 Chapter 1 Finance and the Firm 15 Cash Flow Timing Cash Flow Size Interests of Employees, Customers, Community, etc. Risk Financial Managers Interests of Society Legal Constraints Figure 1-3 Influences on Financial Managers Ethical Constraints VALUE even if those obligations exceed the amount the proprietor has invested in the business. If a customer is injured on the company premises and sues for $1 million, the sole proprietor must pay that amount if the court awards it to the plaintiff customer. This is true even if the total amount invested by the sole proprietor in the business is only $10,000. Although unlimited liability is a major disadvantage of a proprietorship, liability insurance is often available to reduce the risk of losing business and non-business assets. However, the risk always remains that the business will be unsuccessful and that the losses incurred will exceed the amount of the proprietor’s money invested. The other assets owned by the proprietor will then be at risk. The Partnership Two or more people may join together to form a business as a partnership. This can be done on an informal basis without a written partnership agreement, or a contract can spell out the rights and responsibilities of each partner. This written contract is called the articles of partnership and is strongly recommended to lessen the likelihood of disputes between partners. The articles of partnership contract generally spells out how much money each partner will contribute, what the ownership share of each partner will be, how profits and losses will be allocated among partners, who will perform what work for the business, and other matters of concern to the partners. The percent of ownership for each partner does not have to be the same as the percent each partner invests in the partnership. Interactive Module Go to www.textbookmedia. com, then to the Book List. Find Financial Management: Principles and Practice, 5th edition by Timothy Gallagher. Download the free companion material you find there. For Chapter 1 there will be a link that will point you to additional information on the advantages and disadvantages of different forms of business organization. 16 Part I The World of Finance Each partner in a partnership is usually liable for the activities of the partnership as a whole.5 This is an important point. Even if there are 100 partners, each one is technically responsible for all the debts of the partnership.6 If 99 partners declare personal bankruptcy, the hundredth partner still is responsible for all the partnership’s debts. Special Kinds of Partnerships Some partnerships contain two different classes of partners, general partners and limited partners. These are called limited partnerships, or LPs. In a limited partnership, the general partners usually participate actively in the management of the business, whereas limited partners usually do not. Limited partners usually contribute capital and share in the profits but take no part in running the business. As a result, general partners usually contract for a more favorable allocation of ownership, profits, and losses compared with limited partners. General partners have unlimited liability for the partnership’s activities. Limited partners are only liable for the amount they invest in the partnership. If you are a limited partner who invests $5,000 in the business, then $5,000 is the most you can lose. For this reason, every partnership must have at least one general partner (a partnership could have all general partners, but it could not have all limited partners). In some states, attorneys and accountants organize their businesses into what is called a limited liability partnership, or LLP. This is simply a general partnership that is allowed to operate like a corporation, with limited liability features much like those of a corporation (more about limited liability in the next section). A partner’s profits and losses are reported on Schedule K-1. The dollar figure from Schedule K-1 is entered on the appropriate line of each partner’s individual 1040 income tax return. The partners pay any taxes owed. The partnership itself is not taxed because the income merely passes through the partnership to the partners, where it is taxed. The Corporation The third major form of business organization is the corporation. Unlike proprietorships and partnerships, corporations are legal entities separate from their owners. To form a corporation, the owners specify the governing rules for the running of the business in a contract known as the articles of incorporation. They submit the articles to the government of the state in which the corporation is formed, and the state issues a charter that creates the separate legal entity. Corporations are taxed as separate legal entities. That is, corporations must pay their own income tax just as if they were individuals.7 This is where the often-discussed “double taxation” of corporate profits comes into play. First, a corporation pays income tax on the profit it earns. Then the corporation may distribute to the owners the profits that are left after paying taxes. These distributions, called dividends, count as income for the owners and are taxed on the individual owners’ income tax returns. Thus, the IRS collects taxes twice on the same income. Double taxation of dividends is bad news for the owners of corporations, but there is good news as well. Stockholders, the corporation’s owners, have limited liability for the corporation’s activities. They cannot lose more than the amount they paid to buy 5 But see the discussion that follows on general and limited partners. 6 In legal terms this concept is called “joint and several liability.” 7 Corporations file their income tax returns using Form 1041. Chapter 1 Finance and the Firm the stock. This makes the corporate form of organization very attractive for owners who desire to shelter their personal assets from creditors of the business. Corporations have other benefits too. For example, because they exist separately from their owners, they can “live” beyond the death of their original owners. Another benefit of the corporate form of business is that corporations generally have a professional management team and board of directors, elected by the owners. It is the board’s job to look out for the interests of the owners (the stockholders). Stockholders, especially in the case of large corporations, usually do not take an active role in the management of the business, so it is the board of directors’ job to represent them. Special Kinds of Corporations Some corporations are owned by a small number of stockholders and do now extend ownership opportunities to the general public. These are called closely held or close corporations. Often these corporations are family owned. Some are owned by a small group of investors who intend to sell the shares to the public at some future time. Closely held corporations are private. Private companies are usually, but not always, small. Cargill and Fidelity Investments are examples of large private companies. Since corporations are created by the various states the rules for forming a closely held corporation vary. The shares are not traded on organized exchanges nor on an organized over the counter market such as Nasdaq. Shares of closely held corporations are usually sold informally on a person-to-person basis. Usually corporate rules require approval of other shareholders before a current shareholder of a closely held corporation sells shares to a new investor. Frequently, existing shareholders are given a right of first refusal if one among their ranks wishes to sell shares. In contrast to closely held corporations there are publicly traded corporations. These are generally large companies that offer their shares to anyone wishing to buy them on an exchange or over the counter market. Publicly traded corporations can raise capital by issuing new shares of common stock to the public. Since shares are made available to the general public there are reporting and disclosure requirements imposed on publicly trade corporations that are not imposed on closely held corporations. These requirements include releasing annual audited financial statements. These are included in what is called a 10-K report submitted to the Securities and Exchange Commission (SEC). In addition to audited financial statements, 10-K reports contain a wealth of additional information about the company. 10-K reports can be found on the Web at <>. “Regular” corporations are often referred to as C corporations, as they are defined in the United States tax code.8 Another classification in the code is called the S corporation (after subchapter S in the code). S corporations do not pay income tax themselves; instead, they pass their income through to the owners, who report it on their individual tax returns. S corporations are generally very small; in fact, this form of business ownership was created to relieve small businesses from some of the rules that large Subchapter C corporations must follow. S corporations can have no more than 100 shareholders, and the shareholders must be individuals (rather than organizations such as other corporations). The stockholders of S corporations also have limited liability. Professional corporations, or PCs, are special corporations for businesses that provide “professional services,” such as medical, legal, accounting, or architectural The complete reference is Title 26—Internal Revenue Code, Subtitle A—Income Taxes, Chapter 1, Normal Taxes and Surtaxes, Subchapter S—Tax treatment of S corporations and their shareholders. Oddly enough, C corporations are defined in Subchapter S. 8 17 18 Part I The World of Finance services. Only members of the profession may be shareholders in the corporation. As with any other corporation, shareholders share limited liability for the corporation’s debts. Note, however, that PC status does not protect the firm from malpractice claims. Limited Liability Companies (LLCs) Limited liability companies, or LLCs, are hybrids between partnerships and corporations. LLCs pass their profits and losses through to their owners, without taxation of the LLC itself, as partnerships do. They also provide limited liability for their owners, like corporations. S corporations and limited partnerships share these characteristics, but unlike S corporations, LLCs are actually non-corporate entities. The owners of LLCs are called members and they can be individuals or organizations (corporations, other LLCs, trusts, pension plans, and so on). LLCs can also have more than 75 owners. LLCs are popular because they provide the “best of both worlds” between partnerships and corporations. That is, they avoid the double taxation C corporations face while shielding the owners from personal liability. Table 1-3 summarizes the advantages and disadvantages of the various forms of business ownership. What’s Next In this book we will look at how firms raise and allocate funds, and how firms invest in assets that generate returns at a reasonable risk. In Part 1 of the text, we discuss the environment in which financial managers make decisions. In Chapter 2, we will examine how funds are raised in the financial marketplace. In Chapter 3, we’ll explore how financial institutions and interest rates affect financial decisions. Summary 1. Describe the field of finance. Finance is important to business people. Financial decisions about how to raise, spend, and allocate money can affect every aspect of a business—from personnel to products. Finance also offers career opportunities in three main areas: financial management, financial markets and institutions, and investments. Financial management focuses on managing the finances of a business. 2. Discuss the duties of financial managers. Financial managers use accounting information and economic principles to guide their financial decisions. They measure the firm’s financial condition, forecast, budget, raise funds, and determine the financial goals of the firm’s owners. They also work closely with other managers to further the firm’s goals. At medium and large firms, more than one person usually handles the financial management duties. In some firms a chief financial officer (CFO) supervises the financial activities, including cash and credit management, financial planning, and accounting. Chapter 1 19 Finance and the Firm Table 1-3 Characteristics of Business Ownership Forms Proprietorship Partnership Corporation LLC Ease of formation Very easy Relatively easy More difficult Relatively easy Owners’ liability Unlimited Unlimited for general partners Limited Limited Life of firm Dies with owner, unless heirs continue operating or sell the business Surviving partners must deal with the deceased partner’s heirs Can live beyond owners’ lifetimes Dies with owner, heirs may continue operating the business Separate legal entity? No No Yes Yes Degree of control by owners Complete May be limited for individual partner May be very limited for individual stockholder Depends on the number of owners 3. Identify the basic goal of a business firm. The basic goal of the business firm is to maximize the wealth of the firm’s owners by adding value; it is not to maximize profits. The value of a firm is measured by the price investors are willing to pay to own the firm. For businesses that sell stock to the general public, stock price indicates the firm’s value because shares of stock are units of ownership. So the basic financial goal of such firms is to maximize the price of the firm’s stock. 4. List factors that affect the value of a firm. The value of a firm is affected by the size of future cash flows, their timing, and their riskiness. • Cash inflows increase a firm’s value, whereas cash outflows decrease it. • The sooner cash flows are expected to be received, the greater the value. The later those cash flows are expected, the less the value. • The less risk associated with future cash flows, the higher the value. The more risk, the lower the value. 5. Discuss the legal and ethical challenges financial managers face. • Legal and ethical considerations include the agency problem, the interests of other stakeholders, and the interests of society as a whole. • The agency problem exists when the interests of a firm’s managers (the agents) are in conflict with those of the firm’s owners (the principals). • Other stakeholders whose interests are often considered in financial decisions include employees, customers, and members of the communities in which the firm’s plants are located. • Concerns of society as a whole—such as environmental or health problems—often influence business financial decisions. 20 Part I The World of Finance 6. Identify the four different forms of business organization. The four most common forms of business organization are the proprietorship, the partnership, the corporation, and the limited liability company. • Proprietorships are businesses owned by one person. The owner is exposed to unlimited liability for the firm’s debts. • Partnerships are businesses owned by two or more people, each of whom is responsible for the firm’s debts. The exception is a limited partner, a partner who contracts for limited liability. • Corporations are separate legal entities. They are owned by stockholders, who are responsible for the firm’s debts only to the extent of their investment. • Limited liability companies are hybrids between partnerships and corporations. Self-Test ST-1. ST-2. ST-3. What are the three main areas of career opportunities in finance? What are the primary responsibilities of a person holding the title of treasurer at a large corporation? Who is a “principal” in an agent–principal relationship? ST-4. ST-5. ST-6. What legal and ethical factors may influence a firm’s financial decisions? What is a Subchapter S corporation? What is an LLC? Review Questions 1. How is finance related to the disciplines of accounting and economics? 2. List and describe the three career opportunities in the field of finance. 3. Describe the duties of the financial manager in a business firm. 4. What is the basic goal of a business? 5. List and explain the three financial factors that influence the value of a business. 6. Explain why striving to achieve accounting profits and maximizing stock value are not the same. 7. What is an agent? What are the responsibilities of an agent? 8. Describe how society’s interests can influence financial managers. 9. Briefly define the terms proprietorship, partnership, LLC, and corporation. 10. Compare and contrast the potential liability of owners of proprietorships, partnerships (general partners), and corporations. Chapter 1 21 Finance and the Firm Build Your Communication Skills CS-1. Divide into small groups. Each small group should then divide in half. The first group should defend the idea that managers of a firm should consider only the interests of stockholders, subject to legal constraints. The other group should argue that businesses should consider the interests of other stakeholders of the firm and society at large. CS-2. Assume you work for WealthMax Corporation in New York City. You’ve noticed that managers who work late charge the corporation for their dinners and transportation home. You’ve also noticed that almost all employees from these managers’ departments take office supplies, ranging from pens to computer software, for personal use at home. You estimate the costs of this pilfering at a shocking $150,000 a year. Your boss, the chief financial officer for WealthMax, asks you to write a memo to the offending managers describing why their actions and those of their employees violate their duties and conflict with the goal of the firm. Write this memo. Problems 1-1. Explain the difference between what an accountant does and what a financial analyst does. The Field of Finance 1-2. Describe the basic role of a financial manager in a firm that sells stock publicly. The Basic Financial Goal of a Firm 1-3. How would the value of a firm be affected by the following events? a. The introduction of a new product designed to increase the firm’s cash inflows is delayed by one year. The size of the expected cash flows is not affected. b. A firm announces to the press that its cash earnings for the coming year will be 10 percent higher than previously forecast. c. A utility company acquires a natural gas exploration company. After the acquisition, 50 percent of the new company’s assets are from the original utility company and 50 percent from the new exploration company. Factors Affecting the Value of a Firm 1-4. According to federal law, federally chartered banks are permitted to bypass state usury and other laws that would hamper their ability to do business. This makes it possible for loan outlets in some states to offer “quickie” loans of $300 that must be paid back in two weeks with the principal plus $51, which is equivalent to an annual interest rate of over 400 percent. Banks engaged in this practice say they are merely giving people access to emergency credit. Others say the practice is unethical.* State your opinion on this issue and justify it. Legal and Ethical Challenges * Source: “Exploiting a Loophole, Banks Skirt State Laws on High Interest Rates,” by Paul Beckett, The Wall Street Journal, (May 25, 2001): 1. 1-5. Limited liability companies are said to be hybrids between partnerships and corporations. Explain why. Forms of Business Organization 22 Part I The World of Finance Answers to Self-Test ST-1. Financial management, financial markets and institutions, and investments. ST-2. The treasurer of a large corporation is responsible for cash management, credit management, and financial planning. ST-3. A principal in an agent–principal relationship is the person who hires the agent to act on the principal’s behalf. The principal is the person to whom the agent owes a duty. ST-4. Legal and ethical factors influence businesses. Examples of legal constraints include environmental, safety, and civil rights laws. Examples of ethical considerations include fair treatment of workers, environmental sensitivity, and support for the community. ST-5. A Subchapter S corporation is a small corporation that is taxed as if it were a partnership. As a result, the owners of a Subchapter S corporation avoid double taxation of corporate income paid to stockholders. ST-6. LLCs, or limited liability companies, are hybrids between partnerships and corporations. LLCs pass their profits and losses through to their owners, as partnerships do, without taxation of the LLC itself, and they provide limited liability for their owners, as corporations do. ...
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