BUS 650 Week 1 Responses Needed

Chapter 1

A Financial Model of the Corporation

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Learning Objectives

A�er studying this chapter, you should be able to:

Understand the importance of corporate finance in professional and everyday life. Iden�fy how products, bonds, stock, and people factor into the opera�on of corpora�ons. Describe the financial balance sheet, and understand its significance to corporate ac�vity and decision making. Explain the financial goal of the corpora�on and how it is achieved. Describe how informa�on asymmetry and the agency problem pose challenges to corpora�ons. Compare other forms of business organiza�on with corpora�ons, and describe the benefits and drawback of each.

Ch. 1 Introduction

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 sec�on of the chapter describes why finance is an important part of your business educa�on and why the corpora�on was chosen as the vehicle for studying finance. Next, some important features of corporate products, bonds, and stocks are discussed, along with characteris�cs of the people whose ac�ons affect corpora�ons. A model of the corpora�on, called the financial balance sheet, is presented in the third sec�on 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 sec�on covers the financial goal of the corpora�on—shareholder wealth maximiza�on. Some of the problems encountered by corpora�ons in a�aining this goal and the effec�veness of corpora�ons as a means of crea�ng wealth are also covered in this sec�on of the chapter. The influence of society, markets, and government on corpora�ons' ac�vi�es are introduced in the concluding sec�on of the chapter.

Throughout the book are exercises and features to help the readers understand the key concepts of managerial finance. These include:

In Focus Videos. These short videos are at the start of each chapter and cover some of the main points in each chapter, specifically focusing on the Financial Balance Sheet. Field Trips. Found throughout the book, these feature boxes have web links to give students a chance to visit related sites to help exemplify concepts and ideas. Applying Finance. Found throughout the book, these feature boxes provide exercises for students to prac�ce key skills related to managerial finance. PowerPoint® Slideshows. Found near the end of chapters, these features help students review key topics covered. Pre and Post Tests. These non-graded self-assessment quizzes are to help students review what points they know and what they need more work on. Cri�cal thinking ques�ons that guide readers in their analysis of topics explored in the chapters. Key terms lists that define the key terms discussed in each chapter. Click on any term in the book's Key Terms sec�on to see the defini�on. Web resources that present readers with addi�onal resources that expand on topics discussed in the chapters.

Financial management involves planning, forecas�ng, analysis and evalua�on, as well as understanding legal and regulatory issues. Throughout this text, we will explore the crucial role financial managers play in achieving a firm's financial success.

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

Radius/SuperStock

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 cer�ficates of deposit. You may be choosing what type and amount of life insurance coverage you should purchase to protect your family. At work you may find that making a sale depends on your ability to show that your product is a cost-effec�ve investment for your customer. You may be asked to structure a contract that ensures that all par�es to the agreement are properly compensated and mo�vated. Key elements of all these decisions are financial in nature.

The skills and intui�on you will be developing through your study of finance are cri�cal 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 covered in this text will simply add a coherent structure to the intui�on you have developed through experience. From your day-to-day ac�vi�es as a consumer, employee, and student, you possess a large part of the intui�on upon which financial theory is based.

Developing financial intui�on by understanding the underlying theory will give you a founda�on for dealing with many problems. The alterna�ve is memorizing specific facts that can become obsolete 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 securi�es, hedge funds, and exchange traded funds either didn't exist or were brand new. Developing intui�on and understanding 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 corpora�on. Other choices were available. Examples are public finance, which studies how governments raise and disburse funds, and personal finance, which concentrates on individual financial decisions like shopping for life insurance and personal inves�ng. Corporate finance was chosen for several reasons. First, many of you will be, or currently are, working for corpora�ons. Understanding key financial considera�ons in corporate decision making will aid in advancing your career regardless of your posi�on. Second, as an individual, you will be making personal investment decisions. Corporate securi�es, such as stocks and bonds, make up a large propor�on of the investment opportuni�es you will have. And last, the same financial approach to problems used in corporate finance is also properly used to make personal, partnership, or public financial decisions. In effect, you are ge�ng the most "bang for your buck" by studying corporate finance.

Role of Financial Management

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

Imaginechina/Associated Press

1.2 Corporations: Products, Bonds, Stocks, and People

This book focuses on corpora�ons. Corpora�ons are associated with the products they produce and the securi�es they issue. For example, we know that Pepsi produces so� 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 segment of the popula�on.

The goods and services produced by corpora�ons are almost endless in their diversity. Each corpora�on a�empts to match its exper�se with consumers' needs in order to produce successful products. Thus, ConAgra Foods processes and sells a variety of agricultural products. General Electric makes and sells refrigerators, radios, and aircra� engines. Yamaha sells motorcycles as well as pianos. Some�mes a corpora�on'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 perceived a need for more hamburgers, but because they sa�sfy 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 con�nued employment and job security. Communi�es in which the corpora�on is located benefit from a strong economic base. Investors who hold corporate securi�es are also rewarded. Stocks and bonds represent the overwhelming majority of these securi�es. The money made by corpora�ons is distributed to owners of these securi�es, the stockholders and bondholders, providing them with returns on their holdings.

Bonds represent loans made by investors to the corpora�on. Thus, bonds are a form of corporate debt. The firm is obligated to pay its bondholders a fixed series of payments un�l the bonds mature. These payments, generally made semiannually, are called coupon payments. At maturity, the corpora�on 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 corpora�on'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 corpora�on. The corpora�on then repays the $1,000 face value along with the last $30 coupon. Note that although we are highligh�ng bonds, one should not forget that other forms of borrowing are also available to the corpora�on, such as loans from banks. The ability of the corpora�on to meet these obliga�ons hinges on its success in making and selling products or services.

Corporate common stock represents an equity or ownership interest in the firm. If a corpora�on has 100 shares of common stock outstanding, then an owner of 1 share owns 1% of that corpora�on, and one holding 10 shares of this stock owns 10% of the corpora�on. Stockholders receive payments from the corpora�on in the form of dividends, usually paid quarterly. Dividends, unlike coupon interest payments on bonds, are not fixed. Dividends may be raised, lowered, or not paid at all at the discre�on of the corpora�on. Amazon is a large and well-known corpora�on 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 en�tles its holder to vote for directors at the corpora�on's annual shareholders' mee�ng. Because most shareholders of large corpora�ons do not a�end these annual mee�ngs, most vote through the proxy process, similar to the absentee-ballot system used in governmental elec�ons. The board of directors governs the corpora�on on behalf of the shareholders, determining the dividends to be paid that year, hiring and firing top management, approving corporate strategic decisions, and making compensa�on decisions.

Corporate finance is, in large part, the study of the interac�on between products, stocks, bonds, and the people who make decisions affec�ng them. Microso� Corpora�on is an excellent example of this interplay. Microso�'s Windows program is pervasive, and millions of investors own shares of the corpora�on's stock. Bill Gates provided the entrepreneurial 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, consumers, and corporate employees. One assump�on underlying finance is that people act in their own self-interest. This is considered to be economically ra�onal 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�ons. They buy stocks and bonds to increase their wealth. People work to make a living; some people desire power and pres�ge. People make product purchases to fulfill needs and desires. Some may boyco�, strike, vote, or pe��on because they perceive injus�ce. In corporate finance, it is important to recognize that the self-interest of individuals mo�vates their ac�ons.

People also are assumed to act ra�onally. Ra�onality means that people will, by and large, make the correct decisions that lead toward fulfilling their self-interest. Departures from ra�onality are eventually corrected by the compe��ve marketplace. Compe��on 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 sidewalk, although it is occasionally dropped. The reason is that many people are interested in increasing their wealth, and the ra�onal thing to do is to pick up the money!

The le�-hand side of the financial balance sheet deals with investments made by the corpora�on, including tangible and intangible assets.

1.3 The Financial Balance Sheet

The authors of this text have a�empted to make it interes�ng and useful to you. We have also tried to make your job easier. Whenever possible, we illustrate key concepts and theories with easily understood examples. Further, these concepts and theories are put into context throughout the text so you be�er understand why the topic is important and where it fits into the discipline of corporate finance. To achieve a coherent 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 accoun�ng balance sheet. The FBS is a model of the corpora�on that serves several purposes. It is useful for visualizing the financial func�ons of the firm and its objec�ves. Theories and concepts can be introduced using the FBS—thereby maintaining a coherent structure throughout the book. Its use helps answer ques�ons such as, why are we studying this? Also, because it is similar to an accoun�ng balance sheet, accoun�ng 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 contras�ng it with its accoun�ng counterpart. As Figure 1.1 demonstrates, the le�-hand side (LHS) of the financial balance sheet contains the investments made by the firm (as opposed to assets listed in an accoun�ng 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 corpora�on. 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 op�mal 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 be�er u�lized 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 sea�ng capacity), whereas too low an investment might lead to lost sales (insufficient sea�ng capacity).

Figure 1.1: Le�-hand side of the financial balance sheet

The le�-hand side of the financial balance sheet includes all the accounts appearing on the accoun�ng 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 accoun�ng balance sheet are of this type. Intangible assets include patents and copyrights but go well beyond that. This category includes investments that are o�en just as important to the firm as the more obvious investments in factories and inventory.

Assets and Expenditures

Tangible (fixed) vs. intangible (nonphysical) are two aspects of understanding assets. Three elements of costs involving assets are capital and revenue, expenditures, and deprecia�on. What examples of intangible assets can you think of? Why should a financial manager know how to recognize these different assets?

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

One of the most important intangible assets is human resources. Investment in this asset can produce excellent returns. Recrui�ng and training programs are costly, but the payoffs, in the form of employee produc�vity, loyalty, and the quality service provided to customers, may make such investments worthwhile. Other intangibles that create value for the corpora�on may include establishing the firm's reputa�on for product quality, ethical behavior, community involvement, environmental stewardship, research and development, and establishing brand recogni�on.

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 ini�al cost of the investment. Therefore, the corpora�on strives to invest in tangible assets, like factories, and intangible assets, like employee training, whose value to the business is greater than their cost.

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 financing. As shown in Figure 1.2, the RHS records the sources of cash that finance the investments reflected on the LHS. The �tle "Sources of Financing" contrasts with the "Liabili�es and Owner's Equity" �tle commonly used on the tradi�onal accoun�ng 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 corpora�on'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 en�re firm (as might occur in the case of a liquida�on or a takeover) or through the sale of a division of the corpora�on. When these cash flows are generated, by whatever means, their distribu�on 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

Fixed claims receive a contracted or fixed amount of cash. If fixed claimants (e.g., bondholders or employees) receive less than this amount, they have legal recourse to force the firm to meet these fixed obliga�ons. 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 �mely manner, the bank or bondholder may seek full payment through the legal system. In this case, the corpora�on that has not met its obliga�ons is in default on its payments and may be forced into bankruptcy. Bankruptcy can lead to reorganizing the firm and even liquida�ng (selling off) its assets in order repay its fixed claims.

Suppliers of inventory to the corpora�on may also help finance the firm by not demanding immediate payment for the goods they have delivered. The firm, therefore, has made an investment in inventory that, for a period of �me, the supplier is financing. The claim that reflects this financing is an account payable. If the account is not fully paid on �me, 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 organiza�ons pay their employees on a weekly basis, while other firms pay biweekly or monthly. The employees' labor may be invested in finished goods inventory, while financing for that labor is being supplied by the workers themselves for a period of a week, two weeks, or a month, depending 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 �mely basis, they may sue the firm for their wages.

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

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

ZUMA Press/Corbis

Besides legal recourse for payment, a dis�nguishing characteris�c of fixed claims is that, if the firm is extraordinarily profitable 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 protec�on 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 protec�on, fixed claimants s�ll are exposed to the risk of loss. There is no guarantee that normal business or even a forced liquida�on of a firm will generate enough cash to sa�sfy all of the fixed claims. Fixed claim investors assess the likelihood of loss when arranging the terms of loans to the corpora�on.

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 le� over once fixed claims are paid. If, in any year, a corpora�on generates cash in excess of that required to pay fixed-claim obliga�ons, 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 poten�al size of these residual cash flows is unlimited.

Unlike bills to suppliers, wages to employees, or other fixed claims, dividends to shareholders are not mandatory or contractual. Every year the board of directors decides whether to issue dividends and how large they should be. This is en�rely a discre�onary 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�al returns, must also bear a greater risk of losses because of their lower priority.

Figure 1.3: Interac�on between the right- and le�-hand sides of the financial balance sheet

At this point, we have modeled the corpora�on's basic func�ons. Capital is supplied to the firm, crea�ng claims on the firm's future cash flows. These claims are conceptually recorded on the RHS of the financial balance sheet. The corpora�on 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 corpora�on or may be reinvested in the company. This interac�on 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 accoun�ng. First, finance focuses on cash flow, while accoun�ng focuses on profit or net income. You should remember that accoun�ng net income includes deduc�ons that involve no outlay of cash— deprecia�on being the classic example. A corpora�on, therefore, may have an accoun�ng loss in a year (nega�ve net income), yet the firm may have generated enough cash flow to meet its fixed claims and, perhaps, even make cash distribu�ons to its residual claimants. Thus, we focus on cash in finance because ul�mately only cash can pay the bills or be invested.

A second dis�nguishing 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,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 accoun�ng 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 some�mes 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�ons 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 accoun�ng 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 intui�on is one of the objec�ves of this book.

Understanding the interac�on of the three methods of capital acquisi�on is important to financial managers.

Table 1.1 summarizes these three differences between accoun�ng and finance.

Table 1.1: Accoun�ng statements versus the financial balance sheet

Accoun�ng 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 condi�on is determined by analysis. Accoun�ng statements act as clues/evidence of the true financial condi�on of the corpora�on.

Representing Acquisition of Capital on the Financial Balance Sheet

Let us return to the financial balance sheet. The corpora�on's investments, reflected on the LHS of the financial balance sheet, are financed via three methods: trade credit, sale of securi�es (including loans), and retained residual cash flows.

The first method is spontaneously generated loans or trade credit such as payables to suppliers or employees, and taxes payable. The firm has LHS investments, such as inventory, a por�on of whose costs are borne for a period by suppliers who do not demand immediate 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 �me the credit is granted.

The second method of raising cash is issuing and selling securi�es to individuals and ins�tu�ons. Firms are able to a�ract this capital because LHS investments are expected to yield returns that are equally or more a�rac�ve than alterna�ve investment opportuni�es available to these suppliers of capital. Such securi�es may represent fixed claims on cash flows, such as bonds and bank loans, or common stock that represents a residual claim.

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 corpora�on.

Once issued and sold, the corpora�on's outstanding securi�es, par�cularly its stock and long-term bonds, are ac�vely traded among individual and ins�tu�onal investors. Such trading produces changes in the prices of the firm's outstanding securi�es, reflec�ng either changes in the a�rac�veness of compe�ng investments or changes in investors' expecta�ons of the returns the firm's investments will generate, or a combina�on of both factors. This secondary trading of securi�es produces no addi�onal 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 corpora�on's future prospects.

The final method for acquiring capital is through the reten�on 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 interac�on of the methods of capital acquisi�on in the context of the financial balance sheet.

Figure 1.4: Three methods of capital acquisi�on

It is helpful to view the corpora�on as a conduit that acquires capital from individual and ins�tu�onal investors and invests this capital in promising projects on behalf of these claimants. Subsequent buying and selling of the corpora�on's securi�es 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 a�rac�veness of the LHS investments, the value of which underlies the prices of the RHS claims. The prices of the firm's securi�es act as on-going "report cards" on the effec�veness of the corpora�on's decision making and management. Increases in the prices of traded claims provide claimants with increases in wealth. Price

apprecia�on, along with payments received directly from the corpora�on (i.e. dividends and interest), provides investors with a return on their investment in corporate securi�es.

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

The details of corporate governance are complex. Understanding the interac�on between management and the board of directors is essen�al.

1.4 The Financial Goal of the Corporation

The financial balance sheet models the corpora�on's financial ac�vi�es. In this sec�on, these ac�vi�es are linked to management's goal. Because managers direct the corpora�on, 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 effec�ve.

Management's Job

Managers make two types of important financial decisions (see Figure 1.5). First, managers 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' objec�ves be as they make these decisions?

Figure 1.5: Managerial decisions and the financial balance sheet

To help us answer this ques�on, recall that a corpora�on'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 investment will grow; that is, shareholders invest to increase their wealth. Therefore, as employees 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 corpora�on for the money that they are owed. Residual claimants have no such rights. The protec�on for residual claimants is their ownership, which enables them to elect the board of directors who may, for example, fire management if such ac�on is judged to be in the shareholders' best interest.

Figure 1.6: Corporate governance

The job of managers, as employees of the stockholders, is to maximize the wealth of these residual claimants. If the cash generated by produc�ve LHS investments is to be large enough to flow to residual claims, there must also be more than enough cash to sa�sfy 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 shi� wealth from suppliers and lenders and employees to shareholders, but this is not true. The goal of managers of the corpora�on should be the maximiza�on of long-term shareholder wealth or long-term firm value. "Long-term" is important, because corporate managers cannot use decei�ul means over an extended period of �me to take advantage of stakeholders' trust. To do so would ruin those rela�onships. The company (and thereby shareholders) would suffer because the terms of trade or the rela�onships with stakeholders would change, as stakeholders protected themselves from being exploited by corporate managers. The no�on that corporate managers must behave fairly with all stakeholders does not imply that they have to be more generous than is necessary. It implies fair dealing and maintaining honest, open rela�onships with stakeholders.

Creating Wealth

Managers can meet their objec�ve of maximizing shareholder wealth by making investments (on the LHS) whose value is greater than the amount of capital u�lized (from the RHS) to finance these investments. Therefore, managers must have the ability to assess the value of poten�al LHS investments and to make the lowest cost RHS capital- acquisi�on decision.

Let's illustrate wealth crea�on 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 claimants. Management correctly iden�fies the a�rac�ve 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 le� over once all claims are repaid. These addi�onal funds accrue to the residual claimants. These le�over 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 informa�on regarding 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 corpora�on, is traded among individuals. These investors set the price of the stock based on their beliefs regarding the security's a�rac�veness. 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 Corpora�on Illustra�ng the Wealth-Building Process feature outlines the progression of wealth-building for this example project.

A Three-Minute Corpora�on Illustra�ng the Wealth-Building Process

Minute 0 A project is iden�fied requiring a $100 investment by the firm.

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

Minute 1 Sources of capital are iden�fied:

A 1-minut e 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.

The Three-Minute Corpora�on example is greatly simplified, and we will take the rest of the book to fully develop your understanding of wealth crea�on 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 factor that must be considered when es�ma�ng value is the �ming 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 par�cular investment also depends on how a�rac�ve that investment is vis-à-vis alterna�ve investments.

Managers must, therefore, consider the size of a project's expected cash flows, their �ming, the riskiness of these cash flows, and the returns available to shareholders on alterna�ve investments as they assess value in pursuit of stockholder wealth maximiza�on. 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 alterna�ve, similar investments

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

It is important to understand the differences in informa�on available to corporate insiders and outsiders.

Regula�ons have been established to protect company outsiders from informa�on disadvantage. Martha Stewart was imprisoned for lying about her

1.5 The Role of Information

Informa�on plays an important role in corporate finance. One of the difficul�es claimants have in assessing how well management is doing in achieving its goal of shareholder wealth maximiza�on is a lack of informa�on. In large corpora�ons, neither the board of directors nor the stockholders can review all of management's decisions. Thus, managers have much more informa�on than those individuals who are not involved in the day-to-day opera�ons of the firm

Information Asymmetry

This rela�onship is characterized as informa�on asymmetry between corporate insiders and outsiders because the two groups do not have equal (or symmetric) informa�on (Dierkens, 1991). Managers, as insiders, have a pre�y clear view of both the RHS and the LHS of the financial balance sheet. Claimants who are not also employees of the corpora�on can observe the RHS sources of capital because most of these claims are represented by ac�vely traded securi�es (bonds and stocks), but LHS investments may only be viewed obscurely. Thus, outsiders have less informa�on to use in drawing conclusions about the value of the ac�vi�es of the corpora�on than do insiders. See Figure 1.7.

Figure 1.7: Informa�on asymmetry

The degree of informa�on asymmetry is largely dependent on the size, complexity, and organiza�onal structure of the corpora�on. Large, widely held corpora�ons with stock held by millions of investors are characterized by a separa�on of ownership (held by the common stockholders) and control (held by managers). Stockholders of such giant companies individually own a very small propor�on of the corpora�on; thus, they have li�le incen�ve to closely scru�nize managerial ac�on. Addi�onally, with such a small stake, individual shareholders have li�le vo�ng power with which to affect a change if they are dissa�sfied with the management and the board. These shareholders tend to simply sell their shares in the corpora�on if they are unhappy. Consequently, widely dispersed ownership can lead to a poten�ally high degree of informa�on asymmetry.

Small, closely held corpora�ons o�en have fewer shareholders, each having a large financial stake in the firm. These claimants have a greater incen�ve to monitor decision making. The closer scru�ny of outsiders reduces the degree of informa�on asymmetry. In the extreme case, insiders may own a very large stake in the corpora�on, and informa�on asymmetry is minimized. Many small businesses are organized as corpora�ons. O�en 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�on 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�on about the company than does the owner/manager.

There are costs associated with informa�on asymmetry. Corporate insiders, for example, may trade the firm's outstanding securi�es 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 company's securi�es because of their informa�on disadvantage. The ability of the firm to raise capital would be hampered as poten�al 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 integrity and fairness of the security markets, society has legislated strict regula�ons on the trading of corporate securi�es by insiders. These laws were at work when Martha Stewart, the famous television personality, was sentenced to prison �me for lying to a grand jury during an inves�ga�on of insider trading.

CEOs of large corpora�ons, like GE's Jack Welch, have been scandalized in the news when the public learns the extent of their corporate perquisites. Do you think that corporate managers deserve to receive so many benefits? What can financial managers do to keep excessive perks in check?

knowledge of a viola�on of these regula�ons.

Associated Press

Other informa�on asymmetry costs are borne by the corpora�on. A good example is audited financial statements. Corpora�ons hire reputable accoun�ng firms to examine and, following well-defined standards, a�est to the accuracy of informa�on reported by insiders (the firm's management). Banks supplying financing to the corpora�on generally require that certain condi�ons be met by the firm throughout the life of the loan. For example, to ensure that these protec�ve covenants are being met, banks may require

that the firm regularly provide audited financial statements. Such statements reduce informa�on asymmetry between the firm and these fixed claimants. Restric�ve covenants are also included in bond agreements, while audited financial statements are a repor�ng requirement for virtually all ac�vely traded corporate securi�es.

In the 1980s an interes�ng phenomenon took place with a frequency never before seen. Many large, complex, and widely held corpora�ons' stocks were purchased in their en�rety by rela�vely small groups of individuals or ins�tu�ons in a process known as a leveraged buyout. In essence, widely held firms were transformed into closely held firms. One important ra�onale for these billion-dollar transac�ons was the reduc�on of informa�on asymmetry. How can a reduc�on of this informa�on gap translate into the wealth crea�on that apparently mo�vated these megadeals?

Agency Costs

To answer that ques�on, we must more fully understand the costs that accompany informa�on asymmetry and the separa�on of ownership and control. As we noted earlier, managers control the firm, whereas shareholders own the firm. Managers are ac�ng 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—sa�sfying the corpora�on's fixed obliga�ons. However, managers are also concerned with their own welfare and act in their own self-interest. At �mes managers, ac�ng to sa�sfy their own desires, may take ac�ons that are costly to claimants yet produce no wealth for these suppliers of capital. Such ac�ons 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 maximiza�on.

Lavish Golden Parachutes

Perquisites (or perks) are benefits to employees beyond their compensa�on packages and are o�en cost-effec�ve investments. Many execu�ves, 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 mileage. The company-owned car also assures stockholders that the corporate reputa�on for being a quality ins�tu�on is enhanced by having clients met in a clean, comfortable mode of transporta�on. 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 addi�onal value greater than the cost differen�al of $140,000? The Rolls seems to be a ques�onable investment. This is an example of an excessive perquisite, an expense that benefits an execu�ve while producing no increase in shareholder wealth. On whose judgment does the authoriza�on 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 separa�on of principals and agents in large corpora�ons (see Figure 1.8).

Figure 1.8: Agency costs

The agency problem creates costs for the business, was�ng corporate resources.

A corpora�on 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

Another source of agency costs is shirking by top management. A corpora�on's top managers are selected and highly compensated because the board feels they have the talent and will expend the effort to seek out value-crea�ng investment projects. But only the managers know precisely how much effort they are direc�ng to their job. Since managerial effort is difficult to monitor, managers can reduce their efforts (i.e., shirk) and thereby generate costs for shareholders with no offse�ng benefits. Such managers may choose to take a three-hour lunch, for which they are richly compensated but which produces no increase in shareholder wealth. Shirking by top management sets a costly example because the behavior may percolate down through the corpora�on. A noteworthy 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 cos�ng $6,000!

Studies have shown that top execu�ves' pay is posi�vely correlated with the size of the corpora�on. Some incen�ve, therefore, exists for chief execu�ve 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 pres�ge. 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 legisla�on, shareholders now have the right to cast an advisory vote on execu�ve compensa�on, called say on pay. This can be viewed as an effort to �e compensa�on more closely to performance and help to mi�gate the agency problem between management and owners.

An important characteris�c of these examples of the agency problem is that they would not exist if informa�on asymmetry did not also exist. The megamergers of the 1980s o�en were economically linked to the reduc�on of agency costs. By replacing wasteful management, by increasing the accountability of management to a smaller group of claimants whose stake was high enough to mo�vate close monitoring of the firm, and through dismantling ill-conceived and inefficient empires, wealth gains were achieved as many corpora�ons became closely held through buyouts in the 1980s.

1.6 Organizational Forms

Even with the problems inherent in the widely held corpora�on—problems such as informa�on asymmetry and agency costs—the modern corpora�on dominates the economic landscape (Helwege, Pirinsky, & Stulz, 2007). The bulk of sales (80%) and net income (60%) are generated by the corpora�on form of business organiza�on. In this sec�on, we look at the different organiza�onal forms in comparison with the corpora�on and explore the corpora�on'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 o�en are the spawning ground for major corporate en��es. Proprietorships and partnerships also have less significant agency problems than do widely held corpora�ons. These organiza�onal forms are also a�rac�ve because of their rela�vely low organiza�onal costs, and their owners may benefit from lower taxes. Corporate cash flows to residual claimants (dividends) are subject to double taxa�on—once at the corporate level and again at the individual level—while proprietorship and partnership income is taxed only once as part of the owner's personal tax return. Table 1.3 compares the taxa�on of corpora�ons against that of partnerships and proprietorships.

Table 1.3: Tax advantages of partnerships and proprietorships

Taxa�on Partnerships and proprietorships Corpora�ons

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

A�er-tax cash flow to owners $750 $600

Note: Assuming a corporate tax rate of 20% and a personal tax rate of 25%, the corpora�on's owners are at a tax disadvantage because their income is subject to double taxa�on.

But the corpora�on has a�ributes that offset the advantages of proprietorships and partnerships. These a�ributes are par�cularly important for large firms, requiring large amounts of capital. To raise the huge sums necessary to finance large-scale businesses, en��es must accept the difficul�es inherent in the separa�on of ownership and control because few individual investors have sufficient personal wealth, exper�se, and the willingness to both own and manage a corporate giant. Thus, to finance big businesses, it is o�en necessary to have many owners (stockholders) who are willing to relinquish control to hired managers. Now let us consider the characteris�cs of the corporate form of organiza�on that enable it to dominate alterna�ve organiza�onal 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 ownership interest in a firm over which they have limited control. Such claimants, as men�oned earlier, can "vote with their feet," selling their shares when they wish. Moreover, if many stockholders become dissa�sfied, then selling pressure, behaving in accordance with the law of supply and demand, will drive down share prices. The supply of such a corpora�on's stock available for sale on the secondary market will increase while demand for the securi�es decreases. This decline in the price of the corpora�on's securi�es indicates to the board of directors that ac�on needs to be taken. By contrast, partnership and proprietorship ownership interests are less transferable and marketable. For example, partnerships o�en 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 investment and powerless to change it. Thus, the ease with which stock may be bought and sold (its marketability) is a strong advantage of the corpora�on, aiding its ability to raise capital when compared to alterna�ve business forms.

A second contras�ng characteris�c is the liability of owners. Par�cipants of sole proprietorships and partnerships (with the excep�on of limited partnerships) not only risk their original investments in a business but must stand ready to use their personal resources to meet any shor�all the enterprise experiences in mee�ng its fixed obliga�ons. 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 organiza�on. Stockholders have limited liability, meaning that they can lose no more than the amount they have invested in the stock. In a corpora�on, residual claimants cannot be forced to make up shor�alls in mee�ng fixed claims once corporate assets have been fully liquidated. Again, this corporate a�ribute is especially cri�cal in larger firms with diffuse ownership. Few individuals would be willing to expose their resources to risk, without direct control over how those capital contribu�ons are u�lized, if their liability is unlimited.

The last advantage of the corporate form is its conceptually unlimited life. Partnerships depend on a team ac�ng as both owners and managers. Like any team, the loss of a key player or players can destroy its effec�veness. In proprietorships, this difficulty is exacerbated because the team consists of one player, the loss of whom completely changes the character of the en�ty. To replace players in partnerships or proprietorships, an individual must be sought with the wealth, exper�se, and willingness to be both a manager and an owner. If such an individual cannot be located, the business must be liquidated. Corpora�ons, on the other hand, are faced with less cri�cal problems of this nature. Replacing lost owners is rela�vely simple because of marketability of the stock, as already discussed. Loss of key management personnel, although poten�ally difficult, is less of a problem than it is in other organiza�onal 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

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

Paul Taggart/Corbis

A rela�vely recently developed form of organiza�on is the limited liability company, or LLC. LLCs are the business form of choice for many small businesses because they combine corporate-like limited liability with lower costs of organiza�on, flexibility, and ease of regulatory compliance. For example, an LLC may elect to be taxed as a corpora�on 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 characteris�cs of the organiza�onal forms we have discussed.

Table 1.4: Key characteris�cs of the forms of business organiza�on

Business characteris�c Corpora�ons Partnerships Proprietorships Limited liability corpora�on

Taxa�on 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 Rela�vely easy through sale of stock

Poten�ally difficult Poten�ally difficult Rela�vely easy

Access to capital Best Moderate Most restric�ve Moderate

Informa�on asymmetry and agency costs

Poten�ally high Rela�vely low if all partners are equal and ac�ve

Very li�le, as there is not separa�on of ownership and control

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

In terms of numbers, most businesses are small and closely held. These businesses are o�en ini�ally 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 regulatory 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 organiza�ons 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 organiza�on and sell stock and bonds in the broader securi�es market a�er they "go public" with an ini�al 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 inves�ng public.

Venture capital, angel inves�ng, and the financial par�cipa�on of friends and family are extremely risky but can reap big rewards. Cau�on is advised, par�cularly with FF financing because many �mes these investments may jeopardize personal rela�onships, a risk well beyond tradi�onal financial risk.

Over the past century, advances in technology, more cost-effec�ve means of transporta�on and distribu�on, communica�ons advances, a rising standard of living, and the globaliza�on of markets have provided many investment opportuni�es for corpora�ons, requiring large amounts of capital to finance their growth. Organiza�ons have sought the most efficient means of mee�ng these needs. Many would argue that the advantages of corporate organiza�onal forms outweigh the disadvantages as firms become large.

Corporations and Society

The rela�ve efficiency of the corporate form of organiza�on has led to its being the structure of choice for firms foreseeing a�rac�ve growth opportuni�es. The efficiency of corpora�ons has led to cri�cism as well. Corpora�ons are o�en portrayed as cold-hearted in their pursuit of economic gains. They have been charged with ignoring the communi�es in which they operate, lacking concern for the welfare of their customers, and even ignoring the planet in their relentless

pursuit of profits.

Some cri�cs of corpora�ons charge that the goal of shareholder wealth maximiza�on is too narrow for the good of society. These cri�cs contend that corpora�ons should act in a socially responsible manner. Although social responsibility has different meanings to different people, circumstances 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 externali�es, such as air pollu�on, while the cost of cleaning up this dirty air may be borne not by the corpora�on but by society. Thus, shareholders receive higher returns as society bears some of the costs of producing the product.

These charges are o�en true on a case-by-case basis and must be taken seriously by all corpora�ons, even non-offenders, because corpora�ons as legal en��es exist at the pleasure of society. Should society see pervasive abuses, it will surely restrict the freedom of corpora�ons to act.

Corpora�ons and society are o�en at odds due to the outcomes of corporate externali�es such as pollu�on caused by factories. Do you think corpora�on cri�cs are jus�fied in their accusa�ons?

Sam Ki�ner/Na�onal Geographic Stock

Businesses, and corpora�ons in par�cular, are remarkably resilient. Abuses of labor, unethical securi�es prac�ces, and consumer fraud have led to major legisla�ve ini�a�ves that restrict the freedom of firms. Yet the compe��ve drive toward shareholder wealth maximiza�on has allowed corpora�ons to meet society's legal mandates and con�nue to thrive.

Ch. 1 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�on. The financial balance sheet will be used throughout the text to illustrate how topics fit into the "financial picture" introduced in this chapter.

This chapter also presented shareholder wealth maximiza�on 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�onal form can have a drama�c effect on risk and the a�er-tax cash flows that a business produces. Finally, the agency problem and the challenges presented by informa�on asymmetry were introduced.

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

Financial Balance Sheet, Part I

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SLIDE 1 OF 8

Ch. 1 Learning Resources

Key Ideas

The financial balance sheet illustrates the firm's capital acquisi�on and investment ac�vi�es. Residual and fixed claims' characteris�cs include the priority of claims, default and legal recourse, and vo�ng rights. Shareholder wealth maximiza�on is the financial goal of the corpora�on. Wealth crea�on 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 �ming, and the returns available on alterna�ve investments of similar risk. Agency costs and informa�on asymmetry are impediments to maximizing shareholder wealth. Compe�ng forms of business organiza�on were compared to the corporate form. These include sole proprietorships, partnerships, and limited liability companies. Corpora�ons exist at society's pleasure and must be sensi�ve to social concerns.

Cri�cal Thinking Ques�ons

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

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 maximiza�on of shareholder wealth also contributes to the well-being of other stakeholders. Explain this asser�on. 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 corpora�ons like Bri�sh Petroleum. Explain what you think is the ra�onale behind this

asser�on.

Key Terms

Click on each key term to see the defini�on.

agency cost (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A cost that occurs when control of corporate assets is held by management 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. An example could be excessive managerial perquisites like luxury condominiums supplied to CEOs at the firm's expense. Sole proprietorships have no agency costs because the owner of the business has direct control of the business assets, and by defini�on, you can do what you like with your own money.

angel investors (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Anyone who invests his or her money in an entrepreneurial company (unlike ins�tu�onal venture capitalists who invest other people's money).

bankruptcy (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The quality or state of being insolvent.

bonds (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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 (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A panel of individuals, elected by the stockholders, who act as their (the owners') representa�ves. The board's du�es include direc�ng the strategic ac�vi�es of the corpora�on, including the hiring and firing and compensa�on of top management, and ra�fying major corporate decisions such as the payment of dividends.

cash flow (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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

closely held corpora�ons (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Corpora�ons whose stock is not publicly traded and is held by only a few shareholders. Because each shareholder owns a substan�al part of the company, they have a greater incen�ve to pay a�en�on to corporate ac�vity resul�ng in low informa�on asymmetry and lower agency costs. One problem for the closely held corpora�on is that there is no ac�ve market for its stock so it becomes difficult to raise addi�onal equity capital.

common stock (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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

corporate governance (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A general term used to describe the decision making within a corpora�on, par�cularly at the top levels of management and the board of directors.

corpora�on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The form of business organiza�on where ownership is held by the common stockholders who own a propor�onal share of the business depending on the percentage of outstanding shares they own. They exercise control of the company through their elected representa�ves, the board of directors.

coupon payments (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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 �mes the bond's par value (and then divided by two if payments are made semi-annually).

default (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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

dividends (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Payments made to stockholders by the corpora�ons. Regular cash dividends are typically paid quarterly. An increase in the regular cash dividend is generally considered a signal of the company's improving profitability. Stock dividends are addi�onal shares of stock issued to current shareholders on a propor�onal basis.

externali�es (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Nega�ve externali�es are unwanted byproducts of produc�on, the costs of which are not borne by the business but by other par�es. For example, a factory burning fossil fuels may be crea�ng health problems for people living downwind from the factory who must pay for their added medical costs and the indirect costs of irritated eyes and lungs. There are posi�ve externali�es in some cases as well, where a third party benefits from another's ac�vity but does not pay for the benefit, as in the case of when an unsightly building is torn down across the street from your house causing your property value to increase.

FF financing (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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

financial balance sheet (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A conceptual tool used in this text to illustrate financial thinking and decision making and contrasted to the familiar accoun�ng balance sheet. For example, the financial balance sheet lists Investments Made by the Firm on its le�-hand side in contrast to Assets listed on an accoun�ng statement. In finance, these accounts are valued at their market values rather than the book values or historical costs used in accoun�ng.

fixed claims (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Securi�es like bonds, bank loans, and wages payable, which are en�tled to a fixed payment and receive their payments prior to any payments to the owners of the business.

informa�on asymmetry (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The difference between the knowledge of the corpora�on held by insiders and known by outsiders. For example, the average stockholder in Microso� knows much less about the company and its opera�ons and performance than Bill Gates knows so there is significant informa�on asymmetry in that case.

insiders (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Typically refers to corporate management and other employees who have greater knowledge about the opera�ons and performance of the company than the firm's outsiders do (outsiders are those without that knowledge).

insider trading (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Trading by insiders who have an informa�on advantage over the typical investor. Insider trading is restricted by law and trading by insiders who u�lize their privileged informa�on to profit (or to avoid losses) is illegal.

intangible assets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Assets recorded on the le�-hand side of the financial balance sheet that include brand name recogni�on, human resources, and the firm's reputa�on.

limited liability (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A characteris�c of the corporate, limited partnership, and LLC forms of business organiza�on, which limits the maximum loss one can take in a business to the amount one contributes.

limited liability company (LLC) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

an organiza�onal form that can combine the features of limited liability and professional management but avoid the double taxa�on of income that plagues the corporate form of organiza�on.

limited partnership (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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 (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

See insiders.

partnerships (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

When two or more individuals join to pursue a business venture.

par value (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Value of a bond equal to the amount that will be paid to the bondholder on the bond's maturity date. Corporate bonds o�en have a par value equal to $1,000. Also known as the face amount or maturity value of a bond.

perquisites (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Benefits of employment beyond direct monetary compensa�on. These commonly include health insurance, vaca�on, company cars, and day care. Excessive perquisites are those which do not contribute to corporate value by mo�va�ng employees or other means. Also known as perks.

protec�ve covenants (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Por�ons of the loan agreement that limit certain ac�ons a company may take during the term of the loan to protect the lender's interests.

proxy (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A mechanism for shareholders to vote at the corpora�on's annual mee�ng when they cannot a�end in person. A proxy statement is sent to all shareholders prior to the mee�ng and lists the individuals who are running for elec�on 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 mee�ng.

residual claims (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Securi�es, like common stock, that receive the cash le� over a�er fixed claims have been paid. Because of their lower priority for payment, residual claims are riskier than fixed claims.

say on pay (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The ability of shareholders in a corpora�on to ac�vely vote on execu�ve compensa�on. Corporate laws provide this power to shareholders.

secondary trading (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The buying and selling of publicly owned securi�es in secondary markets.

securi�es (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Documents represen�ng claims on the firm's cash flows and assets. Stocks and bonds are both securi�es.

sole proprietorship (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The form of business organiza�on where the owner is also the manager. Characterized by low informa�on asymmetry, no agency problem between owners and managers (since they are the same), but a limited organiza�onal life and a difficult �me raising funding from outside sources.

tangible assets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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

trade credit (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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

venture capital (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Funds provided by investors to startup firms and small businesses with perceived long-term growth poten�al. Due to the lack of access to capital markets, venture capital is a very important source of funding for startups. Venture capital investments are characterized as high risk for the investor but have the poten�al for above-average returns.

widely held corpora�ons (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Corpora�ons whose stock is owned by a large and diverse group of shareholders and is generally publicly traded. Characterized by a liquid secondary market for the company's stock but plagued by problems of informa�on asymmetry and large poten�al agency costs.

Web Resources

Learn more about the NYSE by visi�ng its website. www.nyse.com (h�p://www.nyse.com)

Learn more about the NASDAQ by visi�ng its website. www.nasdaq.com (h�p://www.nasdaq.com)

Learn more about bankruptcy by visi�ng the American Bankruptcy Ins�tute (ABI) website. The ABI is the largest mul�disciplinary, nonpar�san organiza�on dedicated to research and educa�on on ma�ers related to insolvency. www.abiworld.org (h�p://www.abiworld.org)

Learn more about corporate social responsibility here: www.csrhub.com (h�p://www.csrhub.com)