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Fundamentals of Corporate Finance

Fourth Edition

Chapter 1

Corporate Finance and the Financial Manage

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Chapter Outline

1.1 Why Study Finance?

1.2 The Four Types of Firms

1.3 The Financial Manager

1.4 The Financial Manager’s Place in the Corporation

1.5 The Stock Market

1.6 Financial Institutions

Learning Objectives (1 of 2)

Grasp the importance of financial information in both your personal and business lives

Understand the important features of the four main types of firms and see why the advantages of the corporate form have led it to dominate economic activity

Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the three main types of decisions a financial manager makes

Learning Objectives (2 of 2)

Know how a corporation is managed and controlled, the financial manager’s place in it, and some of the ethical issues financial managers face

Understand the importance of financial markets, such as stock markets, to a corporation and the financial manager’s role as liaison to those markets

Recognize the role that financial institutions play in the financial cycle of the economy

1.1 Why Study Finance? (1 of 2)

Individuals are taking charge of their personal finances with decisions such as:

When to start saving and how much to save for retirement

Whether a car loan or lease is more advantageous

Whether a particular stock is a good investment

How to evaluate the terms of a home mortgage

1.1 Why Study Finance? (2 of 2)

In your business career, you may face such questions such as:

Should your firm launch a new product?

Which supplier should your firm choose?

Should your firm produce a part or outsource production?

Should your firm issue new stock or borrow money instead?

How can you raise money for your start-up firm?

1.2 The Four Types of Firms (1 of 14)

Sole Proprietorships

Partnerships

Limited Liability Companies

Corporations

Figure 1.1 Types of U.S. Firms

There are four major types of firms in the United States. As (a) and (b) show, although the majority of U.S. firms are sole proprietorships, they generate only a small fraction of total revenue, in contrast to corporations.

Source: www.irs.gov.

1.2 The Four Types of Firms (2 of 14)

Sole Proprietorship

Straightforward and many new businesses use this organizational form

Principal limitation is that there is no separation between the firm and the owner

The firm can have only one owner

1.2 The Four Types of Firms (3 of 14)

Sole Proprietorship

The owner has unlimited personal liability for the firm’s debts

The life of a sole proprietorship is limited to the life of the owner

It is difficult to transfer ownership of a sole proprietorship

1.2 The Four Types of Firms (4 of 14)

Partnership

More than one owner

All partners are liable for the firm’s debt

A lender can require any partner to repay all the firm’s outstanding debts

The partnership ends on the death or withdrawal of any single partner

Partners can avoid liquidation if the partnership agreement provides for alternatives such as a buyout of a deceased or withdrawn partner

1.2 The Four Types of Firms (5 of 14)

Partnership

A limited partnership is a partnership with two kinds of owners, general partners and limited partners

General partners

Have the same rights and privileges as partners in any general partnership

Are personally liable for the firm’s debt obligations

Limited partners

Have limited liability and their ownership interest is transferable

They have no management authority

1.2 The Four Types of Firms (6 of 14)

Limited Liability Companies (LLC)

No general partner

All the owners have limited liability, but they can also run the business

1.2 The Four Types of Firms (7 of 14)

Corporations

A corporation is a legally defined, artificial being, separate from its owners

It has many of the legal powers that people have

It can enter into contracts, acquire assets, incur obligations, and it enjoys protection under the U.S. Constitution against the seizure of its property

1.2 The Four Types of Firms (8 of 14)

Corporations

A corporation is solely responsible for its own obligations

The owners of a corporation are not liable for any obligations the corporation enters into

The corporation is not liable for any personal obligations of its owners

1.2 The Four Types of Firms (9 of 14)

Corporations

Formation of a Corporation

Must be legally formed

Must be chartered in the state in which it is incorporated

Corporate charter specifies the initial rules that govern how the corporation is run

More costly than setting up a sole proprietorship

1.2 The Four Types of Firms (10 of 14)

Corporations

Ownership of a Corporation

No limit on the number of owners

The entire ownership stake of a corporation is divided into shares known as stock

The collection of all the outstanding shares of a corporation is known as the equity of the corporation

1.2 The Four Types of Firms (11 of 14)

Corporations

Ownership of a Corporation

An owner of a share of stock in the corporation is known as a shareholder, stockholder, or equity holder

Shareholders are entitled to dividend payments

Usually receive a share of the dividend payments that is proportional to the amount of stock they own

No limitation on who can own its stock

1.2 The Four Types of Firms (12 of 14)

Tax Implications for Corporate Entities

A corporation’s profits are subject to taxation separate from its owners’ tax obligations

Shareholders of a corporation pay taxes twice

The corporation pays tax on its profits

When the remaining profits are distributed to the shareholders, the shareholders pay their own personal income tax on this income

Example 1.1 Taxation of Corporate Earnings (1 of 3)

Problem

You are a shareholder in a corporation. The corporation earns $5.00 per share before taxes. After it has paid taxes, it will distribute the rest of its earnings to you as a dividend (we make this simplifying assumption, but should note that most corporations retain some of their earnings for reinvestment). The dividend is income to you, so you will then pay taxes on these earnings. The corporate tax rate is 40% and your tax rate on dividend income is 15%. How much of the earnings remains after all taxes are paid?

Example 1.1 Taxation of Corporate Earnings (2 of 3)

Solution

Plan

Earnings before taxes: $5.00

Corporate tax rate: 40%

Personal dividend tax rate: 15%

To calculate the corporation’s earnings after taxes, first we subtract the taxes paid at the corporate level from the pretax earnings of $5.00. The taxes paid will be 40% (the corporate tax rate) of $5.00. Since all of the after-corporate tax earnings will be paid to you as a dividend, you will pay taxes of 15% on that amount. The amount leftover is what remains after all taxes are paid.

Example 1.1 Taxation of Corporate Earnings (3 of 3)

Execute

$5.00 per share × 0.40 = $2.00 in taxes at the corporate level, leaving $5.00 − $2.00 = $3.00 in after-corporate tax earnings per share to distribute.

You will pay $3.00 × $2.00 = $0.45 in taxes on that dividend, leaving you with $2.55 from the original $5.00 after all taxes.

Evaluate

As a shareholder, you keep $2.55 of the original $5.00 in earnings; the remaining $2.00 + $0.45 = $2.45 is paid as taxes. Thus, your total effective tax rate is

Example 1.1a Taxation of Corporate Earnings (1 of 4)

Problem:

You are a shareholder in a corporation. The corporation earns $10 per share before taxes. After it has paid taxes, it will distribute the rest of its earnings to you as a dividend (we make this simplifying assumption, but should note that most corporations retain some of their earnings for reinvestment). The dividend is income to you, so you will then pay taxes on these earnings. The corporate tax rate is 35% and your tax rate on dividend income is 10%. How much of the earnings remains after all taxes are paid?

Example 1.1a Taxation of Corporate Earnings (2 of 4)

Solution:

Plan:

Earnings before taxes: $10

Tax Rate: 35%

Personal Dividend Tax Rate: 10%

We need to first calculate the corporation’s earnings after taxes by subtracting the taxes paid at the corporate level from the pre-tax earnings of $10. The taxes paid will be 35% (the corporate tax rate) of $10. Since all of the after-tax earnings will be paid to you as a dividend, you will pay taxes of 10% on that amount. The amount leftover is what remains after all taxes are paid.

Example 1.1a Taxation of Corporate Earnings (3 of 4)

Execute:

$10 per share × 0.35 = $3.50 in taxes at the corporate level, leaving $10 − $3.50 = $6.50 in after-tax earnings per share to distribute.

You will pay $6.50 × 0.10 = $0.65 in taxes on that dividend, leaving you with $5.85 from the original $10 after all taxes.

Example 1.1a Taxation of Corporate Earnings (4 of 4)

Evaluate:

As a shareholder you keep $5.85 of the original $10 in earnings; the remaining $3.50 + $0.65 = $4.15 is paid as taxes. Thus, your total effective tax rate is

1.2 The Four Types of Firms (13 of 14)

Tax Implications for Corporate Entities

S Corporations

The firm’s profits/losses are not subject to corporate taxes

Instead profits/losses are allocated directly to shareholders based on their ownership share

Shareholders must include these profits as income on their individual tax returns, even if no money is distributed to them

1.2 The Four Types of Firms (14 of 14)

Tax Implications for Corporate Entities

C Corporations

Most corporations are C corporations.

Must pay corporate taxes on its profits.

Since individuals must pay personal income taxes on these dividends, shareholders in a C corporation effectively must pay taxes twice

Example 1.2 Taxation of S Corporation Earnings (1 of 4)

Problem

Rework Example 1.1, assuming the corporation in that example has elected subchapter S tax treatment and your tax rate on non-dividend income is 30%.

Example 1.2 Taxation of S Corporation Earnings (2 of 4)

Solution

Plan

Earnings before taxes: $5.00

Corporate tax rate: 0%

Personal tax rate: 30%

In this case, the corporation pays no taxes. It earned $5.00 per share. In an S corporation, all income is treated as personal income to you, whether or not the corporation chooses to distribute or retain this cash. As a result, you must pay a 30% tax rate on those earnings.

Example 1.2 Taxation of S Corporation Earnings (3 of 4)

Execute

Your income taxes are 0.30 × $5.00 = $1.50, leaving you with $5.00 − $1.50 = $3.50 in after-tax earnings.

Example 1.2 Taxation of S Corporation Earnings (4 of 4)

Evaluate

The $1.50 in taxes that you pay is substantially lower than the $2.45 you paid in Example 1.1. As a result, you are left with $3.50 per share after all taxes instead of $2.55. However, note that in a C corporation, you are only taxed when you receive the income as a dividend, whereas in an S corporation, you pay taxes on the income immediately regardless of whether the corporation distributes it as a dividend or reinvests it in the company.

Example 1.2a Taxation of S Corporation Earnings (1 of 4)

Problem:

Rework Example 1.1a assuming the corporation in that example has elected subchapter S treatment and your tax rate on non-dividend income is 28%.

Example 1.2a Taxation of S Corporation Earnings (2 of 4)

Solution:

Plan:

Earnings before taxes: $10

Corporate Tax Rate: 0%

Personal Tax Rate: 28%

In this case, the corporation pays no taxes. It earned $10 per share. In an S corporation, all income is treated as personal income to you, whether or not the corporation chooses to distribute or retain this cash. As a result, you must pay a 28% tax rate on those earnings

Example 1.2a Taxation of S Corporation Earnings (3 of 4)

Execute:

Your income taxes are 0.28 × $10 = $2.80, leaving you with $10 − $2.80 = $7.20 in after-tax earnings

Example 1.2a Taxation of S Corporation Earnings (4 of 4)

Evaluate:

The $2.80 in taxes that you pay is substantially lower than the $4.15 you paid in Example 1.1a.

As a result, you are left with $7.20 per share after all taxes instead of $5.85.

However, note that in a C corporation, you are only taxed when you receive the income as a dividend, whereas in an S corporation, you pay taxes on the income immediately regardless of whether the corporation distributes it as a dividend or reinvests it in the company.

Characteristics of the Different Types of Firms (1 of 2)

Table 1.1 Characteristics of the Different Types of Firms

blank	Number of Owners	Liability for Firm’s Debts	Owners Manage the Firm	Ownership Change Dissolves Firm	Taxation
Sole Proprietorship	One	Yes	Yes	Yes	Personal
Partnership	Unlimited	Yes; each partner is liable for the entire amount	Yes	Yes	Personal
Limited Partnership	At least one general partner (GP), no limit on limited partners (LP)	GP-Yes LP-No	GP-Yes LP-No	GP-Yes LP-No	Personal

Characteristics of the Different Types of Firms (2 of 2)

Table 1.1 [Continued]

blank	Number of Owners	Liability for Firm’s Debts	Owners Manage the Firm	Ownership Change Dissolves Firm	Taxation
Limited Liability Company	Unlimited	No	Yes	No*	Personal
S Corporation	At most 100	No	No (but they legally may)	No	Personal
C Corporation	Unlimited	No	No (but they legally may)	No	Double

*However, most LLCs require the approval of the other members to transfer your ownership.

1.3 The Financial Manager (1 of 5)

The financial manager has three main tasks:

Make investment decisions

Make financing decisions

Manage short-term cash needs

1.3 The Financial Manager (2 of 5)

Making Investment Decisions

The financial manager must weigh the costs and benefits of each investment or project

They must decide which investments or projects qualify as good uses the money stockholders have invested in the firm

1.3 The Financial Manager (3 of 5)

Making Financing Decisions

The financial manager must decide whether to raise more money from new and existing owners by selling more shares of stock (equity) or to borrow the money instead (bonds and other debt)

1.3 The Financial Manager (4 of 5)

Managing Short-Term Cash Needs

The financial manager must ensure that the firm has enough cash on hand to meet its obligations from day to day

This job is also known as managing working capital

Page 11

1.3 The Financial Manager (5 of 5)

The Goal of the Financial Manager

The overriding goal of financial management is to maximize the wealth of the owners, the stockholders

1.4 The Financial Manager’s Place in the Corporation (1 of 3)

Stockholders own the corporation but rely on financial managers to actively manage the corporation

The board of directors and the management team headed by the CEO possess direct control of the corporation

1.4 The Financial Manager’s Place in the Corporation (2 of 3)

The Corporate Management Team

Board of Directors

A group of people elected by shareholders who have the ultimate decision-making authority in the corporation

Chief Executive Officer (CEO)

The person charged with running the corporation by instituting the rules and policies set by the board of directors

Figure 1.2 The Financial Functions Within a Corporation

Board of Directors

Chief Executive Officer

Chief Financial Officer

Controller

Accounting

Tax Department

Treasurer

Capital Budgeting

Risk Management

Credit Management

Chief Operating Officer

1.4 The Financial Manager’s Place in the Corporation (3 of 3)

Ethics and Incentives in Corporations

Agency Problems

When managers put their own self-interest ahead of the interests of the shareholders

The CEO’s Performance

When the stock performs poorly:

The board of directors might react by replacing the CEO

A corporate raider may initiate a hostile takeover

Page 14

1.5 The Stock Market (1 of 5)

Corporations can be private or public

A private corporation has a limited number of owners and there is no organized market for its shares

A public corporation has many owners and its shares trade on an organized market, called a stock market

Figure 1.3 Worldwide Stock Markets Ranked by Volume of Trade

The bar graph shows the 10 biggest stock markets in the world ranked by total value of shares traded on exchange in 2015.

Source : www.world-exchanges.org.

1.5 The Stock Market (2 of 5)

Primary Versus Secondary Markets

Traditional Trading Venues

NYSE and NASDAQ

Market Makers

Specialists

Bid-Ask Spread

Bid price

Ask price

Liquidity

Transaction Cost

1.5 The Stock Market (3 of 5)

New Competition and Market Changes

Limit Order

Limit Order Book

Market Orders

High Frequency Traders (HFTs)

Dark Pools

Do not make their limit order books visible

Figure 1.4 Distribution of Trading Volume

Distribution of trading volume for NYSE-listed (left panel) and NASDAQ-listed (right panel) stocks. NYSE Arca is the electronic trading platform of the NYSE. BATS and Direct Edge merged in 2014; these new electronic exchanges now handle about 20% of all trades. Other venues, including internal dealer platforms and so called “dark pools,” accounted for almost 40% of all trades in 2015.

Source : J. Angel, L. Harris, and C. Spatt, “Equity Trading in the 21st Century: An Update,” Quarterly Journal of Finance 5 (2015): 1–39.

1.5 The Stock Market (4 of 5)

Listing Standards

Outlines of the requirements a company must meet to be traded on the exchange

The NYSE’s listing standards are more stringent than those of NASDAQ

1.5 The Stock Market (5 of 5)

Other Financial Markets

Bond Market

Foreign Exchange Market

Commodities Market

Derivative Securities

1.6 Financial Institutions (1 of 5)

Financial Institutions

Entities that provide financial services, such as taking deposits, managing investments, brokering financial transactions, or making loans

1.6 Financial Institutions (2 of 5)

The Financial Cycle

In the financial cycle:

People invest and save their money

Through loans and stock, that money flows to companies who use it to fund growth through new products, generating profits and wages

The money then flows back to the savers and investors

(Suppliers of funds Vs User of funds)

Figure 1.5 The Financial Cycle

Consumers

Business/ Borrowers

1.6 Financial Institutions (3 of 5)

Types of Financial Institutions

Banks and Credit Unions (deposits )

Insurance Companies (monthly premiums)

Mutual Funds (investment funds)

Pension Funds (monthly deposits)

Hedge Funds (investment funds)

Venture Capital Funds (investment funds)

Private Equity Funds (investment funds)

1.6 Financial Institutions (4 of 5)

Types of Financial Institutions

Financial conglomerates/financial services firms combine more than one type of institution

1.6 Financial Institutions (5 of 5)

Role of Financial Institutions

Financial institutions:

Move funds from savers to borrowers

Move funds through time

Help spread out risk-bearing

Financial Institutions and Their Roles in the Financial Cycle (1 of 2)

Table 1.2 Financial Institutions and Their Roles in the Financial Cycle

Institution	Source of Money	Use of Money
Banks and Credit Unions Examples: Wells Fargo, SunTrust	Deposits (savings)	Loans to people and businesses
Insurance Companies Examples: Liberty Mutual, Allstate	Premiums and investment earnings	Invests mostly in bonds and some stocks, using the investment income to pay claims
Mutual Funds Examples: Vanguard, Fidelity	People’s investments (savings)	Buys stocks, bonds, and other financial instruments on behalf of its investors
Pension Funds Examples: CalPERS, REST	Retirement savings contributed through the workplace	Similar to mutual funds, except with the purpose of providing retirement income

Financial Institutions and Their Roles in the Financial Cycle (2 of 2)

Table 1.2 [Continued]

Institution	Source of Money	Use of Money
Hedge Funds Examples: Bridgewater, Citadel	Investments by wealthy individuals and endowments	Invests in any kind of investment in an attempt to maximize returns
Venture Capital Funds Examples: Kleiner Perkins, Sequoia Capital	Investments by wealthy individuals and endowments	Invests in start-up, entrepreneurial firms
Private Equity Funds Examples: TPG Capital, KKR	Investments by wealthy individuals and endowments	Purchases whole companies by using a small amount of equity and borrowing the rest

Chapter Quiz (1 of 2)

What are the advantages and disadvantages of organizing a business as a corporation?

What are the main types of decisions that a financial manager makes?

How do shareholders control a corporation?

What is the importance of a stock market to a financial manager?

Chapter Quiz (2 of 2)

What are the three main roles financial institutions play?

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