man fin assign 1

Learning Objectives

After studying this chapter, you should be able to:

• Understand the importance of corporate finance in professional and everyday life.

• Identify how products, bonds, stock, and people factor into the operation of corporations.

• Describe the financial balance sheet, and understand its significance to corporate activity and decision making.

• Explain the financial goal of the corporation and how it is achieved.

• Describe how information asymmetry and the agency problem pose challenges to corporations.

• Compare other forms of business organization with corporations, and describe the benefits and drawback of each.

Getty Images News/Getty Images1

A Financial Model of the Corporation

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CHAPTER 1Pre-Test

Introduction

Figure 1.0: Chapter 1 in focus

Investments made by the firm

Products

Customers Investors

Capital supplied to the firm

Cash

The Financial Balance Sheet

Cash

Chapter 1 develops the financial perspective of business by introducing the financial balance sheet.

Chapter 1 is an overview of corporate finance and provides you with important building blocks for the rest of your study of finance. The first section of the chapter describes why finance is an important part of your business education and why the corporation was chosen as the vehicle for studying finance. Next, some important features of corporate products, bonds, and stocks are discussed, along with characteristics of the people whose actions affect corporations. A model of the corporation, called the financial balance sheet, is presented in the third section of the chapter. This model is the centerpiece of Chapter 1 and is designed to assist you in visualizing the financial concepts and decisions that you will study throughout this book. The fourth section covers the financial goal of the corporation—shareholder wealth maximization. Some of the problems encountered by corporations in attaining this goal and the effectiveness of corporations as a means of creating wealth are also covered in this section of the chapter. The influence of society, markets, and government on corporations’ activities are introduced in the concluding section of the chapter.

Pre-Test

1. Public finance will be the model used to illustrate financial principles throughout this text.

a. True b. False

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CHAPTER 1Section 1.1 Why Corporate Finance?

2. The typical corporate bond pays coupon payments and eventually returns its face value to the bondholder.

a. True b. False

3. Common stock can be considered a fixed claim on company cash flows. a. True b. False

4. The timing of a cash flow has no impact on the value of an investment. a. True b. False

5. Part of the Dodd-Frank legislation is the say-on-pay provision that allows share- holders to cast an advisory vote in executive compensation.

a. True b. False

6. A sole proprietorship will probably have less information asymmetry between ownership and management than corporations will have.

a. True b. False

Answers 1. b. False. The answer can be found in Section 1.1. 2. a. True. The answer can be found in Section 1.2. 3. b. False. The answer can be found in Section 1.3. 4. b. False. The answer can be found in Section 1.4. 5. a. True. The answer can be found in Section 1.5. 6. a. True. The answer can be found in Section 1.6.

1.1 Why Corporate Finance?

Soon you may be deciding whether to rent or buy a home and whether to invest your savings in the stock market or certificates of deposit. You may be choosing what type and amount of life insurance coverage you should purchase to protect your fam- ily. At work you may find that making a sale depends on your ability to show that your product is a cost-effective investment for your customer. You may be asked to structure a contract that ensures that all parties to the agreement are properly compensated and motivated. Key elements of all these decisions are financial in nature.

The skills and intuition you will be developing through your study of finance are critical for making decisions throughout your life. Our aim in this textbook is to enhance your financial reasoning ability.

Much of finance may already be familiar to you. The theories, tools, and concepts cov- ered in this text will simply add a coherent structure to the intuition you have developed through experience. From your day-to-day activities as a consumer, employee, and stu- dent, you possess a large part of the intuition upon which financial theory is based.

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CHAPTER 1Section 1.2 Corporations: Products, Bonds, Stocks, and People

Developing financial intuition by understanding the underlying theory will give you a foundation for dealing with many problems. The alternative is memorizing specific facts that can become obso- lete or will not prepare you for a rapidly changing financial environment. For example, in the 1980s, adjustable rate mortgages and money market accounts were new financial products, and in the 1990s, mortgage-backed securities, hedge funds, and exchange traded funds either didn’t exist or were brand new. Developing intuition and under- standing the underlying economic theory of finance gives you the flexibility to deal with new, unusual problems as they emerge.

As a vehicle for learning the principles of finance, this text focuses on the corporation. Other choices were available. Examples are public finance, which studies how governments raise and dis- burse funds, and personal finance, which con- centrates on individual financial decisions like shopping for life insurance and personal invest- ing. Corporate finance was chosen for several reasons. First, many of you will be, or currently are, working for corporations. Understanding key financial considerations in corporate decision making will aid in advancing your career regard- less of your position. Second, as an individual, you will be making personal investment decisions. Corporate securities, such as stocks and bonds, make up a large proportion of the investment opportunities you will have. And last, the same financial approach to problems used in corporate finance is also prop- erly used to make personal, partnership, or public financial decisions. In effect, you are getting the most “bang for your buck” by studying corporate finance.

1.2 Corporations: Products, Bonds, Stocks, and People

This book focuses on corporations. Corporations are associated with the products they produce and the securities they issue. For example, we know that Pepsi pro-duces soft drinks and Boeing manufactures airplanes. The stocks and bonds of these firms are discussed on a daily basis in the media and are closely followed by a large seg- ment of the population.

The goods and services produced by corporations are almost endless in their diver- sity. Each corporation attempts to match its expertise with consumers’ needs in order to produce successful products. Thus, ConAgra Foods processes and sells a variety of

Finance plays a pivotal role in many aspects of life. How do you think an education in corporate finance will benefit the choices you make in your personal life?

Radius/SuperStock

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CHAPTER 1Section 1.2 Corporations: Products, Bonds, Stocks, and People

The classic logo of McDonald’s is easily recognizable even in a remote region of China. McDonald’s reputation is so renowned that it is popular throughout the world.

Imaginechina/Associated Press

agricultural products. General Electric makes and sells refrigerators, radios, and aircraft engines. Yamaha sells motorcycles as well as pianos. Sometimes a corporation’s primary products are not what they may first appear to be. McDonald’s sells hamburgers, but they also sell uniform quality and service. Why has McDonald’s been successful? Is it because their hamburgers are superior or because consumers know what to expect when they enter any McDonald’s? McDonald’s, we could argue, is successful not because they per- ceived a need for more hamburgers, but because they satisfy a need for a fast, affordable, uniform hamburger, consistently delivered in a clean environment.

Good product decisions are rewarding. Consumers benefit as their needs and wants are met. Employees are rewarded with continued employment and job security. Communities in which the corporation is located bene- fit from a strong economic base. Investors who hold corporate securities are also rewarded. Stocks and bonds represent the overwhelming majority of these securities. The money made by corporations is distributed to owners of these securities, the stockholders and bondholders, providing them with returns on their holdings.

Bonds represent loans made by investors to the corporation. Thus, bonds are a form of cor-

porate debt. The firm is obligated to pay its bondholders a fixed series of payments until the bonds mature. These payments, generally made semiannually, are called coupon pay- ments. At maturity, the corporation must repay the bondholder the face amount, or par value, of the bond, usually $1,000. For example, a bond may have a $1,000 face value and a 6% annual coupon rate, make payments semiannually, and mature in 20 years. This bond represents the corporation’s promise to pay the bondholder 40 coupon payments (one every 6 months) of $30 each. At the end of the 20-year period, the bond matures and is returned to the issuing corporation. The corporation then repays the $1,000 face value along with the last $30 coupon. Note that although we are highlighting bonds, one should not forget that other forms of borrowing are also available to the corporation, such as loans from banks. The ability of the corporation to meet these obligations hinges on its success in making and selling products or services.

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CHAPTER 1Section 1.2 Corporations: Products, Bonds, Stocks, and People

Corporate common stock represents an equity or ownership interest in the firm. If a cor- poration has 100 shares of common stock outstanding, then an owner of 1 share owns 1% of that corporation, and one holding 10 shares of this stock owns 10% of the corporation. Stockholders receive payments from the corporation in the form of dividends, usually paid quarterly. Dividends, unlike coupon interest payments on bonds, are not fixed. Divi- dends may be raised, lowered, or not paid at all at the discretion of the corporation. Ama- zon is a large and well-known corporation that has never paid a dividend. General Motors paid dividends since 1922, but suspended its dividend payment in 2008.

As owners, common stockholders elect a board of directors. Each share of common stock entitles its holder to vote for directors at the corporation’s annual shareholders’ meet- ing. Because most shareholders of large corporations do not attend these annual meet- ings, most vote through the proxy process, similar to the absentee-ballot system used in governmental elections. The board of directors governs the corporation on behalf of the shareholders, determining the dividends to be paid that year, hiring and firing top man- agement, approving corporate strategic decisions, and making compensation decisions.

Corporate finance is, in large part, the study of the interaction between products, stocks, bonds, and the people who make decisions affecting them. Microsoft Corporation is an excellent example of this interplay. Microsoft’s Windows program is pervasive, and mil- lions of investors own shares of the corporation’s stock. Bill Gates provided the entrepre- neurial vision for the company and is now a face as recognizable as the president’s.

Finance, therefore, includes the study of investors, managers, corporate directors, con- sumers, and corporate employees. One assumption underlying finance is that people act in their own self-interest. This is considered to be economically rational behavior. It does not pretend to explain the complexity of human behavior, but it does allow us to explain how people are likely to behave when making financial decisions and market transac- tions. They buy stocks and bonds to increase their wealth. People work to make a living; some people desire power and prestige. People make product purchases to fulfill needs and desires. Some may boycott, strike, vote, or petition because they perceive injustice. In corporate finance, it is important to recognize that the self-interest of individuals motivates their actions.

People also are assumed to act rationally. Rationality means that people will, by and large, make the correct decisions that lead toward fulfilling their self-interest. Departures from rationality are eventually corrected by the competitive marketplace. Competition exists when many individuals are seeking to achieve the same personal goals (in finance, that goal would be increasing wealth). For example, we seldom see money lying on the side- walk, although it is occasionally dropped. The reason is that many people are interested in increasing their wealth, and the rational thing to do is to pick up the money!

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CHAPTER 1Section 1.3 The Financial Balance Sheet

1.3 The Financial Balance Sheet

The authors of this text have attempted to make it interesting and useful to you. We have also tried to make your job easier. Whenever possible, we illustrate key con-cepts and theories with easily understood examples. Further, these concepts and theories are put into context throughout the text so you better understand why the topic is important and where it fits into the discipline of corporate finance. To achieve a coher- ent structure, we have incorporated a visual financial model of the firm, which we call the financial balance sheet. This tool will be used throughout the text to introduce and link topics as we study corporate finance.

You are already familiar with the balance sheet that accountants use to report the status of a firm in its annual report. The financial balance sheet (FBS) is a conceptual counterpart to the accounting balance sheet. The FBS is a model of the corporation that serves several purposes. It is useful for visualizing the financial functions of the firm and its objectives. Theories and concepts can be introduced using the FBS—thereby maintaining a coher- ent structure throughout the book. Its use helps answer questions such as, why are we studying this? Also, because it is similar to an accounting balance sheet, accounting and financial decision making can be contrasted and clarified.

The Left-Hand Side of the Financial Balance Sheet Let’s begin by describing a simple financial balance sheet and contrasting it with its accounting counterpart. As Figure 1.1 demonstrates, the left-hand side (LHS) of the finan- cial balance sheet contains the investments made by the firm (as opposed to assets listed in an accounting balance sheet). It is important to note that LHS accounts are investments— that is, they reflect carefully considered decisions, which, as the term investments implies, should produce some payoff for the corporation. As a simple example, consider the cash account. The level of cash does not happen by accident—the cash is there to help produce more cash. A fast-food restaurant that begins each day with only $10 in the cash register has not made an optimal investment in cash. It will surely lose some customers because the restaurant cannot make proper change. At the other extreme, if each day is begun with $10,000 in the cash register, the restaurant has overinvested in cash. The excess funds could be better utilized by paying off a loan, thus saving interest expense (or worse, the restaurant could be robbed). For the fast-food restaurant, the same logic applies to other investment accounts. Too high an inventory of hamburger buns would result in unused and stale bread; too low an inventory would result in lost sales. Too large an investment in furniture and fixtures is wasted money (i.e., too much seating capacity), whereas too low an investment might lead to lost sales (insufficient seating capacity).

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CHAPTER 1Section 1.3 The Financial Balance Sheet

Figure 1.1: Left-hand side of the financial balance sheet

The Financial Balance Sheet

Investments made by the corporation

• Tangible investments (for example, cash, inventory, factory)

• Intangible investments (for example, R&D, product development, reputation for quality and service, quality control, human resources)

The left-hand side of the financial balance sheet deals with investments made by the corporation, including tangible and intangible assets.

The left-hand side of the financial balance sheet includes all the accounts appearing on the accounting statement (cash, inventory, furniture and fixtures, property, plant, etc.) because these are all investments. It is useful, however, to categorize investments into two types: tangible and intangible assets. Tangible assets include those things you can touch—bricks and mortar as the saying goes. Most of the assets associated with the accounting bal- ance sheet are of this type. Intangible assets include patents and copyrights but go well beyond that. This category includes investments that are often just as important to the firm as the more obvious investments in factories and inventory.

One of the most important intangible assets is human resources. Investment in this asset can produce excellent returns. Recruiting and training programs are costly, but the pay- offs, in the form of employee productivity, loyalty, and the quality service provided to cus- tomers, may make such investments worthwhile. Other intangibles that create value for the corporation may include establishing the firm’s reputation for product quality, ethical behavior, community involvement, environmental stewardship, research and develop- ment, and establishing brand recognition.

Both tangible and intangible investments require an outlay of cash that is expected to produce future cash inflows. If the cash outlay is a good financial decision, the cash flows received should have value greater than the initial cost of the investment. Therefore, the corporation strives to invest in tangible assets, like factories, and intangible assets, like employee training, whose value to the business is greater than their cost.

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CHAPTER 1Section 1.3 The Financial Balance Sheet

The Right-Hand Side of the Financial Balance Sheet The right-hand side (RHS) of the financial balance sheet reflects the firm’s sources of financ- ing. As shown in Figure 1.2, the RHS records the sources of cash that finance the invest- ments reflected on the LHS. The title “Sources of Financing” contrasts with the “Liabilities and Owner’s Equity” title commonly used on the traditional accounting balance sheet. A second difference between the two statements is that the financial balance sheet accounts are divided into two types of claims: residual claims and fixed claims. Each of these types of accounts has a claim on the cash flows generated by the corporation’s investments. These cash flows may be generated via the normal cycle of producing and selling products and services. Cash may also be generated through the sale of the entire firm (as might occur in the case of a liquidation or a takeover) or through the sale of a division of the corporation. When these cash flows are generated, by whatever means, their distribution is dependent on the type of claim held by the supplier of financial resources.

Figure 1.2: Right-hand side of the financial balance sheet

The Financial Balance Sheet

Sources of Financing

• Fixed claims (for example, accounts payable, short-term loans, bonds)

• Residual claims (for example, common stock)

The right-hand side of the financial balance sheet deals with sources of financing, including fixed and residual claims.

Fixed claims receive a contracted or fixed amount of cash. If fixed claimants (e.g., bond- holders or employees) receive less than this amount, they have legal recourse to force the firm to meet these fixed obligations. Bank loans and bonds are two examples of fixed claims. Both require contractually specified payments of interest and principal. If these payments are not made in a timely manner, the bank or bondholder may seek full payment through the legal system. In this case, the corporation that has not met its obligations is in default on its payments and may be forced into bankruptcy. Bankruptcy can lead to reorganizing the firm and even liquidating (selling off) its assets in order repay its fixed claims.

Suppliers of inventory to the corporation may also help finance the firm by not demand- ing immediate payment for the goods they have delivered. The firm, therefore, has made an investment in inventory that, for a period of time, the supplier is financing. The claim that reflects this financing is an account payable. If the account is not fully paid on time, then the supplier can legally seek repayment. Similarly, workers supply financing to the firm in the form of wages payable. It’s no accident, for instance, that some organizations pay their

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CHAPTER 1Section 1.3 The Financial Balance Sheet

employees on a weekly basis, while other firms pay biweekly or monthly. The employees’ labor may be invested in fin- ished goods inventory, while financing for that labor is being supplied by the workers them- selves for a period of a week, two weeks, or a month, depend- ing on the firm’s payroll policy. In order not to help finance the firm, employees would need to be paid at the end of each day. Again, if employees are not paid on a timely basis, they may sue the firm for their wages.

Besides legal recourse for pay- ment, a distinguishing charac- teristic of fixed claims is that, if the firm is extraordinarily prof- itable in any period, the fixed claimants receive no more than the amount they are owed. For example, when a business has a good year, no bank expects the firm to repay more than the amount of the loan and accrued interest. Fixed claims, therefore, have legal protection against losses but do not share in profits. The amount of a fixed claim is limited to the amount of the loan or the value of the resources provided to the firm.

Even with legal protection, fixed claimants still are exposed to the risk of loss. There is no guarantee that normal business or even a forced liquidation of a firm will generate enough cash to satisfy all of the fixed claims. Fixed claim investors assess the likelihood of loss when arranging the terms of loans to the corporation.

This brings us to residual claims, best represented by common stock. Residual claims, as the name implies, are those that common stockholders have on cash flows that are left over once fixed claims are paid. If, in any year, a corporation generates cash in excess of that required to pay fixed-claim obligations, then that residual cash belongs to the firm’s common stockholders—the residual claimholders. These cash flows may be distributed in the form of dividends or retained by the company to help it grow and thereby increase the value of the stockholders’ ownership stakes. The potential size of these residual cash flows is unlimited.

Unlike bills to suppliers, wages to employees, or other fixed claims, dividends to sharehold- ers are not mandatory or contractual. Every year the board of directors decides whether to issue dividends and how large they should be. This is entirely a discretionary decision on the part of the board of directors. Fixed claims, therefore, take priority over residual claims when cash flows are distributed. Residual claims, with their greater upside poten- tial returns, must also bear a greater risk of losses because of their lower priority.

Corporations in default must declare bankruptcy and liquidate their inventory in order to pay back the money owed. Are there any other options companies might employ to repay their fixed claims?

ZUMA Press/Corbis

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CHAPTER 1Section 1.3 The Financial Balance Sheet

Figure 1.3: Interaction between the right- and left-hand sides of the financial balance sheet

The Financial Balance Sheet

Cash supplied

Investments made by the corporation

Cash generated

Fixed claims

Residual claims

Cash generated by investments occurs on the left-hand side of the financial balance sheet, while capital used to pay for those investments occurs on the right-hand side.

At this point, we have modeled the corporation’s basic functions. Capital is supplied to the firm, creating claims on the firm’s future cash flows. These claims are conceptually recorded on the RHS of the financial balance sheet. The corporation uses this capital to make investments that will generate cash flows in the future from the sale of goods and services. These investments are shown on the LHS of the financial balance sheet, and the cash flows they generate will be distributed to claimants who have supplied capital to the corporation or may be reinvested in the company. This interaction between the LHS and RHS of the financial balance sheet is captured in Figure 1.3.

The Financial Balance Sheet Versus the Accounting Balance Sheet We must pause to highlight three features of finance that differ from accounting. First, finance focuses on cash flow, while accounting focuses on profit or net income. You should remember that accounting net income includes deductions that involve no outlay of cash— depreciation being the classic example. A corporation, therefore, may have an accounting loss in a year (negative net income), yet the firm may have generated enough cash flow to meet its fixed claims and, perhaps, even make cash distributions to its residual claimants. Thus, we focus on cash in finance because ultimately only cash can pay the bills or be invested.

A second distinguishing feature is that accountants record the historical cost of assets on the LHS and the historical amount of capital contributed in the RHS accounts. In finance,

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CHAPTER 1Section 1.3 The Financial Balance Sheet

we are more concerned with the current value of these accounts. An example illustrates why. Consider a firm that invested in undeveloped real estate in downtown Houston in 1950. If the property cost $10,000 in 1950, it would appear on the LHS of 2012’s account- ing balance sheet at its original cost of $10,000. What is its true value? The current value might be $1,000,000. Which figure is relevant for decision-making purposes? The opposite sometimes holds true as well: A manufacturer may have an inventory of stereos with CD players in which it historically invested $1,000,000, but today stereos with docking sta- tions dominate the market. What is the current value of these CD stereos—more than the original $1,000,000 investment or less? Again, which number is relevant?

The third point we want to make is that an accounting balance sheet is readily available for all to see, whereas the financial balance sheet is a conceptual construct—you won’t find it printed in an annual report. Sharp managers and financial analysts, however, have a clear mental picture of the FBS and understand how decisions will affect its accounts. The development of that same mental picture and intuition is one of the objectives of this book.

Table 1.1 summarizes these three differences between accounting and finance.

Table 1.1: Accounting statements versus the financial balance sheet

Accounting statements Financial balance sheet

Records net income, profits, earnings. Records cash flows.

Records assets at their historical cost and claims at the historical amount contributed.

Records the current value of LHS investments made by the firm and the current RHS claims.

Reported in audited financial statements. Not observable; its condition is determined by analysis. Accounting statements act as clues/ evidence of the true financial condition of the corporation.

Representing Acquisition of Capital on the Financial Balance Sheet Let us return to the financial balance sheet. The corporation’s investments, reflected on the LHS of the financial balance sheet, are financed via three methods: trade credit, sale of securities (including loans), and retained residual cash flows.

The first method is spontaneously generated loans or trade credit such as payables to sup- pliers or employees, and taxes payable. The firm has LHS investments, such as inventory, a portion of whose costs are borne for a period by suppliers who do not demand immedi- ate payment. These types of fixed claims held by suppliers are usually short term. They are spontaneous because the firm does not have to seek approval for such loans formally each time the credit is granted.

The second method of raising cash is issuing and selling securities to individuals and insti- tutions. Firms are able to attract this capital because LHS investments are expected to yield returns that are equally or more attractive than alternative investment opportunities available to these suppliers of capital. Such securities may represent fixed claims on cash flows, such as bonds and bank loans, or common stock that represents a residual claim.

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CHAPTER 1Section 1.3 The Financial Balance Sheet

Notes payable are short-term fixed claims, term loans are usually intermediate term, and bonds generally are long term. Common stock is a perpetual claim because it might never be repaid by the corporation.

Once issued and sold, the corporation’s outstanding securities, particularly its stock and long-term bonds, are actively traded among individual and institutional investors. Such trading produces changes in the prices of the firm’s outstanding securities, reflecting either changes in the attractiveness of competing investments or changes in investors’ expectations of the returns the firm’s investments will generate, or a combination of both factors. This secondary trading of securities produces no additional capital for the firm, but it reflects the traders’ refined opinions of the firm’s value and so acts as a measure of how investors regard the corporation’s future prospects.

The final method for acquiring capital is through the retention of residual cash flows. These cash flows belong to the stockholders, but the firm may choose not to pay out all of this cash as dividends, deciding instead to retain the cash and reinvest it in promising LHS projects.

Figure 1.4 shows the interaction of the methods of capital acquisition in the context of the financial balance sheet.

Figure 1.4: Three methods of capital acquisition

The Financial Balance Sheet

1. Spontaneously generated financing (for example, payables)

3. Retained and reinvested residual cash flows

2. Issue and sale of securities (for example, notes, loans, bonds, stock)

Investments made by the corporation

Cash flows generated by the corporation’s investments

Cash to claimants

Understanding the interaction of the three methods of capital acquisition is important to financial managers.

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CHAPTER 1Section 1.4 The Financial Goal of the Corporation

It is helpful to view the corporation as a conduit that acquires capital from individual and institutional investors and invests this capital in promising projects on behalf of these claimants. Subsequent buying and selling of the corporation’s securities produces changes in the prices of these claims.

These price changes produce no capital for the firm; nonetheless, they play an important role in corporate finances. Price changes reflect claimants’ ongoing judgment regarding the attractiveness of the LHS investments, the value of which underlies the prices of the RHS claims. The prices of the firm’s securities act as on-going “report cards” on the effec- tiveness of the corporation’s decision making and management. Increases in the prices of traded claims provide claimants with increases in wealth. Price appreciation, along with payments received directly from the corporation (i.e. dividends and interest), provides investors with a return on their investment in corporate securities.

1.4 The Financial Goal of the Corporation

The financial balance sheet models the corporation’s financial activities. In this sec-tion, these activities are linked to management’s goal. Because managers direct the corporation, they must have a clear understanding of the corporate goal. They must understand for whom they work and what their job is if they are to be effective.

Management’s Job Managers make two types of important financial decisions (see Figure 1.5). First, manag- ers choose which investments the firm makes (LHS decisions). Second, managers choose the sources of capital used to finance these investments (RHS decisions). What should managers’ objectives be as they make these decisions?

Figure 1.5: Managerial decisions and the financial balance sheet

Management

Right-hand side decisions: How should needed financing be acquired?

• A bank loan?

• Sell bonds?

• Retain cash flow?

• A mix of these?

Left-hand side decisions: Which investment should be made?

• Build a new factory?

• Increase expenditures on employee training?

• Develop a new product or service?

Two types of managerial decisions correspond to the left-hand side and right-hand side of the financial balance sheet: what investments to make, and how they should be financed.

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CHAPTER 1Section 1.4 The Financial Goal of the Corporation

To help us answer this question, recall that a corporation’s management team operates the company on behalf of its owners, the stockholders. Stockholders invest their money and accept the risk of being a residual claimant because they hope the value of their invest- ment will grow; that is, shareholders invest to increase their wealth. Therefore, as employ- ees of the stockholders, managers must make decisions that they expect will increase shareholder wealth. Figure 1.6 illustrates the basic control mechanisms and rights that fixed and residual claimants have in the corporate structure. This system of control is known as corporate governance. Note that fixed claimants are protected by law. If they are not paid as promised, these claimants can sue the corporation for the money that they are owed. Residual claimants have no such rights. The protection for residual claimants is their ownership, which enables them to elect the board of directors who may, for example, fire management if such action is judged to be in the shareholders’ best interest.

Figure 1.6: Corporate governance

Management

Fixed claims

Residual claims

Legal remedies

The board hires, fires, compensates,

and directs management

Election of directors who promote and protect shareholders’ interests

Board of directors

The details of corporate governance are complex. Understanding the interaction between management and the board of directors is essential.

The job of managers, as employees of the stockholders, is to maximize the wealth of these residual claimants. If the cash generated by productive LHS investments is to be large enough to flow to residual claims, there must also be more than enough cash to satisfy the fixed claims. Therefore, maximizing shareholder wealth will generally be in the interest of fixed claimants as well.

Some people interpret maximizing shareholder wealth to mean that corporate managers should use every possible method to shift wealth from suppliers and lenders and employ- ees to shareholders, but this is not true. The goal of managers of the corporation should be the maximization of long-term shareholder wealth or long-term firm value. “Long-term” is important, because corporate managers cannot use deceitful means over an extended

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CHAPTER 1Section 1.4 The Financial Goal of the Corporation

period of time to take advantage of stakeholders’ trust. To do so would ruin those relation- ships. The company (and thereby shareholders) would suffer because the terms of trade or the relationships with stakeholders would change, as stakeholders protected them- selves from being exploited by corporate managers. The notion that corporate managers must behave fairly with all stakeholders does not imply that they have to be more gener- ous than is necessary. It implies fair dealing and maintaining honest, open relationships with stakeholders.

Creating Wealth Managers can meet their objective of maximizing shareholder wealth by making invest- ments (on the LHS) whose value is greater than the amount of capital utilized (from the RHS) to finance these investments. Therefore, managers must have the ability to assess the value of potential LHS investments and to make the lowest cost RHS capital-acquisition decision.

Let’s illustrate wealth creation with a very simple example. Consider a firm that has the opportunity to invest in a single project whose value is greater than its cost. At the end of this project, the firm will be liquidated, and all cash will be distributed to the claim- ants. Management correctly identifies the attractive project and finds sources of capital to finance the cost of the project. The investment is made and almost instantly generates the expected cash flows. Because the value of the investment is greater than its cost, the cash flows more than cover the amount necessary to repay all of both the fixed claims and residual claims used to finance the project. Because the project has more value than cost, there are funds left over once all claims are repaid. These additional funds accrue to the residual claimants. These leftover or residual cash flows, therefore, increase stockholders’ wealth beyond that originally contributed to finance the project.

If this project’s payoff was certain, investors had full access to all information regard- ing the project, and the payoff was almost immediate, then shareholder wealth would increase as soon as the investment in the project was made—even before the cash flows were distributed. Recall that stock, once issued and sold by the corporation, is traded among individuals. These investors set the price of the stock based on their beliefs regard- ing the security’s attractiveness. If they knew, with certainty, the stock for which they paid $50 a share would soon distribute $54 a share, what would be the value of that stock to the investors? Clearly, the price of the stock would immediately increase to very near $54 per share. Thus, when the company’s managers make decisions that maximize the wealth of residual claimants, they also maximize the price of the company’s common stock. The A Three-Minute Corporation Illustrating the Wealth-Building Process feature outlines the pro- gression of wealth-building for this example project.

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CHAPTER 1Section 1.4 The Financial Goal of the Corporation

The Three-Minute Corporation example is greatly simplified, and we will take the rest of the book to fully develop your understanding of wealth creation through corporate decision making. You must learn how the value of an investment project depends not only on the size of the cash flows that it is expected to generate (as in our preceding example), but also on the degree of confidence claimants have that those cash flows will be achieved. In other words, value also depends on the risk associated with the investment. Another fac- tor that must be considered when estimating value is the timing of the cash flows that an investment generates. Claimants prefer to receive cash flows earlier rather than later. The longer claimants wait for a given payoff, the less valuable that payoff is to them, all else being the same. Last, the value of a particular investment also depends on how attractive that investment is vis-à-vis alternative investments.

Managers must, therefore, consider the size of a project’s expected cash flows, their timing, the riskiness of these cash flows, and the returns available to shareholders on alternative invest- ments as they assess value in pursuit of stockholder wealth maximization. Table 1.2 lists factors that impact an investment’s value and their effects.

Table 1.2: Factors determining an investment’s value

Factors Impact

Expected level of cash flows The higher the expected cash flows are, the higher the value of the investment will be, all else being the same.

Riskiness of cash flows The more uncertain the expected cash flows are, the lower the value of the investment will be, all else being the same.

Timing of cash flows The longer it takes to receive cash flows, the lower the value of the investment will be, all else being the same.

Returns available on alternative, similar investments

If similar investments offer higher returns, the value of the investment will decrease, all else being the same.

A Three-Minute Corporation Illustrating the Wealth-Building Process

Minute 0 A project is identified requiring a $100 investment by the firm.

The project will produce $105 in cash flows 1 minute after the firm makes its investment.

Minute 1 Sources of capital are identified: • A 1-minute loan of $50 bearing an interest rate of $1/minute can be obtained. • Stock can be sold for $50.

Minute 2 $100 of capital is raised from the two sources.

The $100 investment in the project is made by the firm.

Minute 3 The project generates the $105 cash flow.

The fixed claim of $51 (the 1-minute loan) is paid in full: $50 principal and $1 interest.

The residual cash flow of $54 is paid to stockholders, increasing their wealth by $4.

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CHAPTER 1Section 1.5 The Role of Information

1.5 The Role of Information

Information plays an important role in corporate finance. One of the difficulties claim-ants have in assessing how well management is doing in achieving its goal of share-holder wealth maximization is a lack of information. In large corporations, neither the board of directors nor the stockholders can review all of management’s decisions. Thus, managers have much more information than those individuals who are not involved in the day-to-day operations of the firm

Information Asymmetry This relationship is characterized as information asymmetry between corporate insid- ers and outsiders because the two groups do not have equal (or symmetric) information (Dierkens, 1991). Managers, as insiders, have a pretty clear view of both the RHS and the LHS of the financial balance sheet. Claimants who are not also employees of the corpora- tion can observe the RHS sources of capital because most of these claims are represented by actively traded securities (bonds and stocks), but LHS investments may only be viewed obscurely. Thus, outsiders have less information to use in drawing conclusions about the value of the activities of the corporation than do insiders. See Figure 1.7.

Figure 1.7: Information asymmetry

Investments made by the firm

Fixed claims

Residual claims

Insiders

Outsiders

It is important to understand the differences in information available to corporate insiders and outsiders.

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CHAPTER 1Section 1.5 The Role of Information

Regulations have been established to protect company outsiders from information disadvantage. Martha Stewart was imprisoned for lying about her knowledge of a violation of these regulations.

Associated Press

The degree of information asymmetry is largely dependent on the size, complexity, and organizational structure of the corporation. Large, widely held corporations with stock held by millions of investors are characterized by a separation of ownership (held by the common stockholders) and control (held by managers). Stockholders of such giant com- panies individually own a very small proportion of the corporation; thus, they have little incentive to closely scrutinize managerial action. Additionally, with such a small stake, individual shareholders have little voting power with which to affect a change if they are dissatisfied with the management and the board. These shareholders tend to simply sell their shares in the corporation if they are unhappy. Consequently, widely dispersed own- ership can lead to a potentially high degree of information asymmetry.

Small, closely held corporations often have fewer shareholders, each having a large financial stake in the firm. These claimants have a greater incentive to monitor decision making. The closer scrutiny of outsiders reduces the degree of infor- mation asymmetry. In the extreme case, insiders may own a very large stake in the corporation, and information asymmetry is minimized. Many small businesses are organized as corporations. Often there is only one residual claimant who holds all of the common stock and also manages the business. In such a case, there is no informa- tion asymmetry between management and the residual claimant because they are one and the same. Even here, some asymmetry exists because fixed claimants remain corporate outsiders (e.g., suppliers and bankers) and so have less informa- tion about the company than does the owner/ manager.

There are costs associated with information asym- metry. Corporate insiders, for example, may trade the firm’s outstanding securities and reap huge profits based on their superior knowledge of the firm’s prospects. The cost associated with insider trading (King, Roell, Kay, & Wyplosz, 1988) would eventually be borne by society. Outsiders would soon lose faith in the fairness of trading the com- pany’s securities because of their information dis- advantage. The ability of the firm to raise capital

would be hampered as potential capital suppliers became reluctant to commit their funds for fear they were paying too much. Lack of financing would leave promising investment projects untouched, leading to a stagnant economy or one in decline. To protect the integ- rity and fairness of the security markets, society has legislated strict regulations on the trading of corporate securities by insiders. These laws were at work when Martha Stew- art, the famous television personality, was sentenced to prison time for lying to a grand jury during an investigation of insider trading.

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CHAPTER 1Section 1.5 The Role of Information

Other information asymmetry costs are borne by the corporation. A good example is audited financial statements. Corporations hire reputable accounting firms to examine and, following well-defined standards, attest to the accuracy of information reported by insiders (the firm’s management). Banks supplying financing to the corporation gener- ally require that certain conditions be met by the firm throughout the life of the loan. For example, to ensure that these protective covenants are being met, banks may require that the firm regularly provide audited financial statements. Such statements reduce informa- tion asymmetry between the firm and these fixed claimants. Restrictive covenants are also included in bond agreements, while audited financial statements are a reporting require- ment for virtually all actively traded corporate securities.

In the 1980s an interesting phenomenon took place with a frequency never before seen. Many large, complex, and widely held corporations’ stocks were purchased in their entirety by relatively small groups of individuals or institutions in a process known as a leveraged buyout. In essence, widely held firms were transformed into closely held firms. One important rationale for these billion-dollar transactions was the reduction of infor- mation asymmetry. How can a reduction of this information gap translate into the wealth creation that apparently motivated these megadeals?

Agency Costs To answer that question, we must more fully understand the costs that accompany infor- mation asymmetry and the separation of ownership and control. As we noted earlier, managers control the firm, whereas shareholders own the firm. Managers are acting as the agents of the firm’s principals or owners. Managers are hired to act on the owners’ behalf, maximizing shareholders’ wealth and—in the process—satisfying the corporation’s fixed obligations. However, managers are also concerned with their own welfare and act in their own self-interest. At times managers, acting to satisfy their own desires, may take actions that are costly to claimants yet produce no wealth for these suppliers of capital. Such actions may be characterized as investments whose value is less than their cost and are, therefore, in direct conflict with the goal of maximizing shareholder wealth. Some corporate expenditures on perquisites may contradict shareholder wealth maximization.

Perquisites (or perks) are benefits to employees beyond their compensation packages and are often cost-effective investments. Many executives, for example, are supplied a company-owned car. Shareholders may benefit from such investment—it may be less costly to supply the corporate president with a vehicle than to reimburse her for mile- age. The company-owned car also assures stockholders that the corporate reputation for being a quality institution is enhanced by having clients met in a clean, comfortable mode of transportation. On the other hand, what if the president of the firm is supplied with a $200,000 Rolls-Royce rather than a $60,000 Lincoln? Will the decision to supply her with the Rolls produce additional value greater than the cost differential of $140,000? The Rolls seems to be a questionable investment. This is an example of an excessive perquisite, an expense that benefits an executive while producing no increase in shareholder wealth. On whose judgment does the authorization of such expenses fall? Ordinarily management makes these decisions. This is an example of an agency cost (Jensen, 2005), a cost that arises because of the separation of principals and agents in large corporations (see Figure 1.8).

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CHAPTER 1Section 1.5 The Role of Information

A corporation is highly dependent on the trustworthiness of the management it hires. Dennis Kozlowski, former Tyco CEO, shirked his duty by extravagantly spending the company’s money.

Associated Press

Figure 1.8: Agency costs

Sources of financing

$

$

$

$ ManagementAgency costs

Waste

Cash flow generated

Retained cash

To claimantsFactory

Investments made by the corporation

The agency problem creates costs for the business, wasting corporate resources.

Another source of agency costs is shirking by top management. A corporation’s top managers are selected and highly com- pensated because the board feels they have the talent and will expend the effort to seek out value-creating investment projects. But only the manag- ers know precisely how much effort they are directing to their job. Since managerial effort is difficult to monitor, manag- ers can reduce their efforts (i.e., shirk) and thereby generate costs for shareholders with no offsetting benefits. Such manag- ers may choose to take a three- hour lunch, for which they are richly compensated but which

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CHAPTER 1Section 1.6 Organizational Forms

produces no increase in shareholder wealth. Shirking by top management sets a costly example because the behavior may percolate down through the corporation. A note- worthy example of the abuse of corporate power at shareholders’ expense is the case of Dennis Kozlowski, the CEO of Tyco from 1992 to 2002. The firm paid for Kozlowski’s $30 million New York apartment, which featured a shower curtain costing $6,000!

Studies have shown that top executives’ pay is positively correlated with the size of the corporation. Some incentive, therefore, exists for chief executive officers (CEOs) to engage in empire building. A firm may expand in size (add LHS investments) with less regard to the value of these investments than to the impact that a larger firm has on the CEO’s pay, power, and prestige. Empire-building has been documented as one of the most damaging agency costs in its impact on shareholder wealth.

As part of the 2010 Dodd-Frank legislation, shareholders now have the right to cast an advisory vote on executive compensation, called say on pay. This can be viewed as an effort to tie compensation more closely to performance and help to mitigate the agency problem between management and owners.

An important characteristic of these examples of the agency problem is that they would not exist if information asymmetry did not also exist. The megamergers of the 1980s often were economically linked to the reduction of agency costs. By replacing wasteful man- agement, by increasing the accountability of management to a smaller group of claim- ants whose stake was high enough to motivate close monitoring of the firm, and through dismantling ill-conceived and inefficient empires, wealth gains were achieved as many corporations became closely held through buyouts in the 1980s.

1.6 Organizational Forms

Even with the problems inherent in the widely held corporation—problems such as information asymmetry and agency costs—the modern corporation dominates the economic landscape (Helwege, Pirinsky, & Stulz, 2007). The bulk of sales (80%) and net income (60%) are generated by the corporation form of business organization. In this section, we look at the different organizational forms in comparison with the corporation and explore the corporation’s role in society.

Sole Proprietorships and Partnerships Versus Corporations To be sure, sole proprietorships and partnerships are also important—they perhaps best embody the entrepreneurial spirit and often are the spawning ground for major corporate entities. Proprietorships and partnerships also have less significant agency problems than do widely held corporations. These organizational forms are also attractive because of their relatively low organizational costs, and their owners may benefit from lower taxes. Corporate cash flows to residual claimants (dividends) are subject to double taxation—once at the corporate level and again at the individual level—while proprietorship and part- nership income is taxed only once as part of the owner’s personal tax return. Table 1.3 compares the taxation of corporations against that of partnerships and proprietorships.

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CHAPTER 1Section 1.6 Organizational Forms

Table 1.3: Tax advantages of partnerships and proprietorships

Taxation Partnerships and proprietorships Corporations

Income before business-level taxes

$1000 $1000

Corporate income tax rate 0% 20%

Corporate income tax payable $0 $200

Income to owners before personal income taxes

$1000 $800

Personal income tax rate 25% 25%

Personal income tax payable $250 $200

After-tax cash flow to owners $750 $600

Note: Assuming a corporate tax rate of 20% and a personal tax rate of 25%, the corporation’s owners are at a tax disadvantage because their income is subject to double taxation.

But the corporation has attributes that offset the advantages of proprietorships and partnerships. These attributes are particularly important for large firms, requiring large amounts of capital. To raise the huge sums necessary to finance large-scale businesses, entities must accept the difficulties inherent in the separation of ownership and control because few individual investors have sufficient personal wealth, expertise, and the will- ingness to both own and manage a corporate giant. Thus, to finance big businesses, it is often necessary to have many owners (stockholders) who are willing to relinquish control to hired managers. Now let us consider the characteristics of the corporate form of organi- zation that enable it to dominate alternative organizational structures.

First, through the issuance of common stock, a highly transferable security is used as the medium for exchanging ownership interests in the business. The ability of stockholders to sell their shares easily is important if individuals are to be persuaded to take an owner- ship interest in a firm over which they have limited control. Such claimants, as mentioned earlier, can “vote with their feet,” selling their shares when they wish. Moreover, if many stockholders become dissatisfied, then selling pressure, behaving in accordance with the law of supply and demand, will drive down share prices. The supply of such a corpora- tion’s stock available for sale on the secondary market will increase while demand for the securities decreases. This decline in the price of the corporation’s securities indicates to the board of directors that action needs to be taken. By contrast, partnership and propri- etorship ownership interests are less transferable and marketable. For example, partner- ships often require the approval of remaining partners before a dissident partner can sell his or her interest to a third party. In the end, many partners are stuck with their invest- ment and powerless to change it. Thus, the ease with which stock may be bought and sold (its marketability) is a strong advantage of the corporation, aiding its ability to raise capital when compared to alternative business forms.

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CHAPTER 1Section 1.6 Organizational Forms

A second contrasting characteristic is the liability of owners. Participants of sole propri- etorships and partnerships (with the exception of limited partnerships) not only risk their original investments in a business but must stand ready to use their personal resources to meet any shortfall the enterprise experiences in meeting its fixed obligations. For example, a large legal judgment against a proprietorship or partnership may lead to the personal bankruptcy of its owners. This is not the case with the corporate form of organization. Stockholders have limited liability, meaning that they can lose no more than the amount they have invested in the stock. In a corporation, residual claimants cannot be forced to make up shortfalls in meeting fixed claims once corporate assets have been fully liqui- dated. Again, this corporate attribute is especially critical in larger firms with diffuse own- ership. Few individuals would be willing to expose their resources to risk, without direct control over how those capital contributions are utilized, if their liability is unlimited.

The last advantage of the corporate form is its conceptually unlimited life. Partnerships depend on a team acting as both owners and managers. Like any team, the loss of a key player or players can destroy its effectiveness. In proprietorships, this difficulty is exacer- bated because the team consists of one player, the loss of whom completely changes the character of the entity. To replace players in partnerships or proprietorships, an individual must be sought with the wealth, expertise, and willingness to be both a manager and an owner. If such an individual cannot be located, the business must be liquidated. Corpora- tions, on the other hand, are faced with less critical problems of this nature. Replacing lost owners is relatively simple because of marketability of the stock, as already discussed. Loss of key management personnel, although potentially difficult, is less of a problem than it is in other organizational forms because the replacement does not necessarily also need to become a major owner, as a proprietorship or partnership requires.

Limited Liability Companies Versus Corporations A relatively recently developed form of organization is the limited liability company, or LLC. LLCs are the business form of choice for many small businesses because they com- bine corporate-like limited liability with lower costs of organization, flexibility, and ease of regulatory compliance. For example, an LLC may elect to be taxed as a corporation or as a partnership, and it can be managed by its owners or by professional managers.

Table 1.4 looks at some of the key characteristics of the organizational forms we have discussed.

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CHAPTER 1Section 1.6 Organizational Forms

Table 1.4: Key characteristics of the forms of business organization

Business characteristic

Corporations Partnerships Proprietorships Limited liability corporation

Taxation Twice—once at the business level and once at the individual level

Once at the individual level

Once at the individual level

Flexible—corporate or partnership

Liability Limited to amount invested

Unlimited Unlimited Limited to amount invested

Ownership and control

Separated— majority of stockholders are not usually management

Partners own and control enterprise

Ownership and control are in the hands of a single individual

Flexible—partners own enterprise, and may control enterprise or hire professional managers

Transferability of ownership

Relatively easy through sale of stock

Potentially difficult

Potentially difficult Relatively easy

Access to capital Best Moderate Most restrictive Moderate

Information asymmetry and agency costs

Potentially high Relatively low if all partners are equal and active

Very little, as there is not separation of ownership and control

Flexible—depends on ownership structure. Professional management leads to high information asymmetry. Partner management leads to low information asymmetry.

In terms of numbers, most businesses are small and closely held. These businesses are often initially financed by the owners’ own out-of-pocket equity. For these companies, borrowing takes the form of loans rather than bonds because the legal expenses and regu- latory issues associated with bonds make their issuance generally too costly for small enterprises. Both equity and debt may be raised by appealing to family and friends, called FF financing, and individual independent investors, called angel investors. There are also organizations that pool funds to help small, new enterprises with their funding needs. These kinds of investments are referred to as venture capital. If successful, many small entrepreneurial firms eventually adopt the corporate form of organization and sell stock and bonds in the broader securities market after they “go public” with an initial public offering (IPO) of their shares. For example, in 2012, Facebook went public. Its IPO spread some of its ownership from a small group of founders and other owners to the general investing public.

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CHAPTER 1Section 1.6 Organizational Forms

Facebook went public on May 18, 2012. Why do you think companies like Facebook eventually decide to go public?

Paul Taggart/Corbis

Venture capital, angel investing, and the financial participation of friends and family are extremely risky but can reap big rewards. Caution is advised, particularly with FF financing because many times these investments may jeopardize personal relation- ships, a risk well beyond tradi- tional financial risk.

Over the past century, advances in technology, more cost- effective means of transportation and distribution, communica- tions advances, a rising standard of living, and the globalization of markets have provided many investment opportunities for corporations, requiring large

amounts of capital to finance their growth. Organizations have sought the most efficient means of meeting these needs. Many would argue that the advantages of corporate orga- nizational forms outweigh the disadvantages as firms become large.

Corporations and Society The relative efficiency of the corporate form of organization has led to its being the structure of choice for firms foreseeing attractive growth opportunities. The efficiency of corporations has led to criticism as well. Cor- porations are often portrayed as cold-hearted in their pursuit of economic gains. They have been charged with ignoring the com- munities in which they operate, lacking concern for the welfare of their customers, and even ignor- ing the planet in their relentless pursuit of profits.

Some critics of corporations charge that the goal of share- holder wealth maximization is too narrow for the good of society. These critics contend that corporations should act in a socially responsible manner. Although social responsibility has different meanings to different people, circumstances

Corporations and society are often at odds due to the outcomes of corporate externalities such as pollution caused by factories. Do you think corporation critics are justified in their accusations?

Sam Kittner/National Geographic Stock

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CHAPTER 1Post-Test

exist when the good of society is at odds with the welfare of corporate shareholders. For example, in its manufacturing endeavors a firm may produce externalities, such as air pollution, while the cost of cleaning up this dirty air may be borne not by the corporation but by society. Thus, shareholders receive higher returns as society bears some of the costs of producing the product.

These charges are often true on a case-by-case basis and must be taken seriously by all corporations, even non-offenders, because corporations as legal entities exist at the plea- sure of society. Should society see pervasive abuses, it will surely restrict the freedom of corporations to act.

Businesses, and corporations in particular, are remarkably resilient. Abuses of labor, unethical securities practices, and consumer fraud have led to major legislative initiatives that restrict the freedom of firms. Yet the competitive drive toward shareholder wealth maximization has allowed corporations to meet society’s legal mandates and continue to thrive.

Conclusion

In this chapter, several key concepts that underlie finance were introduced. These are the blocks on which the bulk of this book is built. The chapter began by introducing the financial balance sheet as a model of how financial managers view the corpora- tion. The financial balance sheet will be used throughout the text to illustrate how top- ics fit into the “financial picture” introduced in this chapter.

This chapter also presented shareholder wealth maximization as the overarching goal of business and then discussed factors (such as cash flows and risk) that must be considered as firms strive to create value for their owners. You learned that the choice of organiza- tional form can have a dramatic effect on risk and the after-tax cash flows that a business produces. Finally, the agency problem and the challenges presented by information asym- metry were introduced.

In Chapter 2, we will focus on extending these fundamental concepts to the economic environment in which a firm operates.

Post-Test

1. Public finance will be the model used to illustrate financial principles throughout this text.

a. True b. False

2. The typical corporate bond pays coupon payments and eventually returns its face value to the bondholder.

a. True b. False

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CHAPTER 1Post-Test

3. Common stock can be considered a fixed claim on company cash flows. a. True b. False

4. The timing of a cash flow has no impact on the value of an investment. a. True b. False

5. Part of the Dodd-Frank legislation is the say-on-pay provision that allows share- holders to cast an advisory vote in executive compensation.

a. True b. False

6. A sole proprietorship will probably have less information asymmetry between ownership and management than corporations will have.

a. True b. False

7. Which of the following is NOT discussed as a reason to study corporate finance? a. Its principles are applicable to other financial decisions. b. It may help benefit your career. c. It will be helpful in personal investment choices. d. It is the basis for American capitalism.

8. Which of the following is NOT true of bonds? a. They are a form of debt. b. They are a form of equity. c. They must be repaid upon maturity. d. They represent a promise to the bondholder.

9. When a firm spends significant cash in training, it can be viewed from the per- spective of the financial balance sheet as

a. a tax-deductible expense. b. an investment in a tangible asset. c. an effort to improve its public image. d. an investment in its human resources.

10. What does corporate governance refer to? a. The interaction between the government and the corporation b. The policies of the firm that protect stockholders and other claimants c. The legal liability of investors holding different types of claims d. The legal liability of managers

11. Which of the following is NOT an agency problem discussed in this chapter? a. Shirking b. Extortion c. Empire building d. Excessive perquisites

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CHAPTER 1Critical Thinking Questions

12. Which of the following is NOT a form of business organization that offers its owners limited liability?

a. A limited partnership b. An LLC c. A corporation d. A general partnership

Answers 1. b. False. The answer can be found in Section 1.1. 2. a. True. The answer can be found in Section 1.2. 3. b. False. The answer can be found in Section 1.3. 4. b. False. The answer can be found in Section 1.4. 5. a. True. The answer can be found in Section 1.5. 6. a. True. The answer can be found in Section 1.6. 7. d. It is the basis for American capitalism. The answer can be found in Section 1.1. 8. b. They are a form of equity. The answer can be found in Section 1.2. 9. d. an investment in its human resources. The answer can be found in Section 1.3. 10. b. The policies of the firm that protect stockholders and other claimants. The answer can be found

in Section 1.4. 11. d. Extortion. The answer can be found in Section 1.5. 12. d. A general partnership. The answer can be found in Section 1.6.

Key Ideas

• The financial balance sheet illustrates the firm’s capital acquisition and invest- ment activities.

• Residual and fixed claims’ characteristics include the priority of claims, default and legal recourse, and voting rights.

• Shareholder wealth maximization is the financial goal of the corporation. • Wealth creation is achieved by corporate investment in a project whose value is

greater than its cost. • A project’s value is dependent on the size of expected cash flows, the riskiness

of those cash flows, their timing, and the returns available on alternative invest- ments of similar risk.

• Agency costs and information asymmetry are impediments to maximizing share- holder wealth.

• Competing forms of business organization were compared to the corporate form. These include sole proprietorships, partnerships, and limited liability companies.

• Corporations exist at society’s pleasure and must be sensitive to social concerns.

Critical Thinking Questions

1. Economists who favor strictly free markets may oppose insider trading laws because these laws do not allow prices to fully reflect all information that is available (namely, prices won’t reflect that information that is held exclusively by the firm’s insiders). They could argue that prices can best allocate capital to its best use if all information is reflected in the price and therefore the laws prohib- iting trading by insiders who use their special knowledge should be repealed. Other economists disagree. They believe that the economy is better off with these insider trading prohibitions. Supply their side of this argument.

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CHAPTER 1Key Terms

agency cost A cost that occurs when con- trol of corporate assets is held by manage- ment and is separated from the ownership of those assets. The cost is considered a waste of investors’ money because it is being used to benefit the management but not to create wealth for shareholders.

angel investors Anyone who invests his or her money in an entrepreneurial com- pany (unlike institutional venture capital- ists who invest other people’s money).

bankruptcy The quality or state of being insolvent. Involves the transfer of con- trol of assets from the residual claimants (i.e., shareholders) to fixed claimants (i.e., lenders).

bonds The security that represents the issuer’s promise to pay a predetermined amount of interest over a fixed term and to repay the principal on the security’s maturity date.

board of directors A panel of individu- als, elected by the stockholders, who act as their (the owners’) representatives. The board’s duties include directing the strate- gic activities of the corporation, including the hiring and firing and compensation of top management, and ratifying major corporate decisions such as the payment of dividends.

cash flow The amount of money that passes through a corporation. Residual cash flow, for example, refers to the amount of money that stockholders have a claim on after all other claims have been paid.

closely held corporations Corporations whose stock is not publicly traded and is held by only a few shareholders. Because each shareholder owns a substantial part of the company, they have a greater incen- tive to pay attention to corporate activity resulting in low information asymmetry and lower agency costs. One problem for the closely held corporation is that there is no active market for its stock so it becomes difficult to raise additional equity capital.

common stock A security that represents a residual claim on the firm’s earnings and an ownership share of the company.

corporate governance A general term used to describe the decision making within a corporation, particularly at the top levels of management and the board of directors.

corporation The form of business orga- nization where ownership is held by the common stockholders who own a propor- tional share of the business depending on the percentage of outstanding shares they own. They exercise control of the company through their elected representatives, the board of directors.

2. Why do residual claimants have the right to elect the board of directors? Why don’t fixed claimants have the same right?

3. In theory, the maximization of shareholder wealth also contributes to the well- being of other stakeholders. Explain this assertion.

4. Which do you think is the biggest agency cost: excessive perquisites, shirking, or empire building? Explain your reasoning.

5. Some observers could argue that without limited liability we would not have large corporations like British Petroleum. Explain what you think is the rationale behind this assertion.

Key Terms

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CHAPTER 1Key Terms

coupon payments A stream of regular (usually semiannual) interest payments from a bond issuer to the bondholders. Each payment is determined by taking the product of the coupon rate times the bond’s par value (and then divided by two if payments are made semi-annually).

default Missing a scheduled payment to a fixed claimant, such as a coupon payment on a bond, or a loan payment on an equip- ment loan. This can lead to bankruptcy.

dividends Payments made to stockhold- ers by the corporations. Regular cash dividends are typically paid quarterly. An increase in the regular cash dividend is generally considered a signal of the com- pany’s improving profitability. Stock divi- dends are additional shares of stock issued to current shareholders on a proportional basis.

externalities Negative externalities are unwanted byproducts of production, the costs of which are not borne by the busi- ness but by other parties. Positive exter- nalities occur when a third party benefits from another’s activity but does not pay for the benefit.

FF financing Capital investments made by friends and family of a business owner.

financial balance sheet A conceptual tool used in this text to illustrate financial thinking and decision making and con- trasted to the familiar accounting balance sheet.

fixed claims Securities like bonds, bank loans, and wages payable, which are entitled to a fixed payment and receive their payments prior to any payments to the owners of the business.

information asymmetry The difference between the knowledge of the corporation held by insiders and known by outsiders.

insiders Typically refers to corporate man- agement and other employees who have greater knowledge about the operations and performance of the company than the firm’s outsiders do (outsiders are those without that knowledge).

insider trading Trading by insiders who have an information advantage over the typical investor. Insider trading is restricted by law and trading by insiders who utilize their privileged information to profit (or to avoid losses) is illegal.

intangible assets Assets recorded on the left-hand side of the financial balance sheet that include brand name recogni- tion, human resources, and the firm’s reputation.

limited liability A characteristic of the corporate, limited partnership, and LLC forms of business organization, which limits the maximum loss one can take in a business to the amount one contributes.

limited liability company (LLC) an orga- nizational form that can combine the fea- tures of limited liability and professional management but avoid the double taxation of income that plagues the corporate form of organization.

limited partnership A partnership with a general partner who manages the business and a group of general partners whose liability is limited to the amount that they invest but who must remain uninvolved in the day-to-day management of the business.

outsiders See insiders.

partnerships When two or more individ- uals join to pursue a business venture.

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CHAPTER 1Key Terms

par value Value of a bond equal to the amount that will be paid to the bond- holder on the bond’s maturity date. Corpo- rate bonds often have a par value equal to $1,000. Also known as the face amount or maturity value of a bond.

perquisites Benefits of employment beyond direct monetary compensation. These commonly include health insurance, vacation, company cars, and day care. Excessive perquisites are those which do not contribute to corporate value by moti- vating employees or other means. Also known as perks.

protective covenants Portions of the loan agreement that limit certain actions a com- pany may take during the term of the loan to protect the lender’s interests.

proxy A mechanism for shareholders to vote at the corporation’s annual meet- ing when they cannot attend in person. A proxy statement is sent to all shareholders prior to the meeting and lists the individu- als who are running for election to the board of directors as well as other issues being voted on like amendments to the corporate charter. Signing and returning the proxy designates someone to vote in the shareholder’s place at the annual meeting.

residual claims Securities, like common stock, that receive the cash left over after fixed claims have been paid. Because of their lower priority for payment, residual claims are riskier than fixed claims.

say on pay The ability of shareholders in a corporation to actively vote on executive compensation. Corporate laws provide this power to shareholders.

secondary trading The buying and sell- ing of publicly owned securities in second- ary markets.

securities Documents representing claims on the firm’s cash flows and assets. Stocks and bonds are both securities.

sole proprietorship The form of busi- ness organization where the owner is also the manager. Characterized by low infor- mation asymmetry, no agency problem between owners and managers (since they are the same), but a limited organizational life and a difficult time raising funding from outside sources.

tangible assets Assets recorded on the left-hand side of the financial balance sheet that include land, cash, inventory, factory, and equipment investments.

trade credit Credit extended by one firm to another in the normal course of buying/ selling inventory.

venture capital Funds provided by inves- tors to startup firms and small businesses with perceived long-term growth poten- tial. Due to the lack of access to capital markets, venture capital is a very impor- tant source of funding for startups. Ven- ture capital investments are characterized as high risk for the investor but have the potential for above-average returns.

widely held corporations Corporations whose stock is owned by a large and diverse group of shareholders and is gen- erally publicly traded. Characterized by a liquid secondary market for the company’s stock but plagued by problems of informa- tion asymmetry and large potential agency costs.

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CHAPTER 1Web Resources

Web Resources

Learn more about the NYSE by visiting its website. www.nyse.com

Learn more about the NASDAQ by visiting its website. www.nasdaq.com

Learn more about bankruptcy by visiting the American Bankruptcy Institute (ABI) website. The ABI is the largest multidisciplinary, nonpartisan organization dedicated to research and education on matters related to insolvency. www.abiworld.org

Learn more about corporate social responsibility here: www.csrhub.com

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