OM FINAL

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

CHAPTER ONE: CORPORATE GOVERNANCE

Yi Zhou

Associate Professor Department of Finance

College of Business San Francisco State University

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

INTRODUCTION

Corporate governance is the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form.

The quality of a corporation’s corporate of governance affects the risks and value of the corporation. Effective, strong corporate governance is essential for the efficient functioning of markets.

There are inherent conflicts of interest in corporations in which the ownership and management are separate. The separation of ownership and management is the basis for the agency relationship between managers (agents) and owners (principals).

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

OBJECTIVES CORE ATTRIBUTES

OBJECTIVES

To eliminate or mitigate conflicts of interest, particularly those between corporate managers and shareholders; and

To ensure that the assets of the company are used efficiently and productively and in the best interests of its investors and other stakeholders.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

OBJECTIVES CORE ATTRIBUTES

CORE ATTRIBUTES

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

SUMMARY OF FORMS OF BUSINESS SOLE PROPRIETORSHIP GENERAL PARTNERSHIP LIMITED PARTNERSHIP CORPORATION

SUMMARY OF FORMS OF BUSINESS

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

SUMMARY OF FORMS OF BUSINESS SOLE PROPRIETORSHIP GENERAL PARTNERSHIP LIMITED PARTNERSHIP CORPORATION

SOLE PROPRIETORSHIP

A sole proprietorship is a business owned by one person.

The simplest type of business. The least regulated form of organization. The most numerous in terms of number of businesses.

Little separation between the owner and the manager(s) of the business. Virtually no conflict of interest between the owner and manager(s).

The owner keeps all the profits and has unlimited liability for business debts. −→ Creditors can look to the proprietor’s personal assets for payment. There is no distinction between personal and business income, so all business income is taxed as personal income.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

SUMMARY OF FORMS OF BUSINESS SOLE PROPRIETORSHIP GENERAL PARTNERSHIP LIMITED PARTNERSHIP CORPORATION

GENERAL PARTNERSHIP

All the partners share gains or losses, and all have unlimited liability for all partnership debts. The way partnership gains (and losses) are divided is described in the partnership agreement.

The partnership terminates when a general partner wishes to sell out or dies. Ownership by a general partner is not easily transferred because a new partnership must be formed.

All income is taxed as personal income to the partners, and the amount of equity that can be raised is limited to the partners’ combined wealth.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

SUMMARY OF FORMS OF BUSINESS SOLE PROPRIETORSHIP GENERAL PARTNERSHIP LIMITED PARTNERSHIP CORPORATION

LIMITED PARTNERSHIP

One or more general partners will run the business and have unlimited liability.

One or more limited partners will not actively participate in the business and have limited liability to the amount that partner contributes to the partnership.

If you are a limited partner, you must not become deeply involved in business decisions unless you are willing to assume the obligations of a general partner.

A limited partner’s interest can be sold without dissolving the partnership, but finding a buyer may be difficult.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

SUMMARY OF FORMS OF BUSINESS SOLE PROPRIETORSHIP GENERAL PARTNERSHIP LIMITED PARTNERSHIP CORPORATION

CORPORATION

A corporation is a business created as a distinct legal entity owned by one or more individuals or entities, with major decisions made by the board of directors.

The members of the board of directors are elected by shareholders. The board of directors monitor the company’s management on behalf of the shareholders.

Potential conflicts between the agents (the management and the members of the board of directors) and the owners (the shareholders).

The corporation is the most important form (in terms of size) of business organization in the United States.

A corporation is a legal “person” separate and distinct from its owners, and it has many of the rights, duties, and privileges of an actual person. It can borrow money and own property, can sue and be sued, and can enter into contracts. It can even be a general partner or a limited partner in a partnership, and a corporation can own stock in another corporation.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

SUMMARY OF FORMS OF BUSINESS SOLE PROPRIETORSHIP GENERAL PARTNERSHIP LIMITED PARTNERSHIP CORPORATION

THE ADVANTAGES

Owners not managers. The stockholders and the managers are usually separate groups. The stockholders elect the board of directors, who then select the managers. Management is responsible of running the corporation’s affairs in the stockholders’ interests. In principle, stockholders control the corporation because they elect the directors.

Transferable ownership interests. Ownership (represented by shares of stock) can be readily transferred, and the life of the corporation is not limited. The corporation borrows money in its own name. As a result, the stockholders in a corporation have limited liability for corporate debts. The most they can lose is what they have invested.

Easy to raise capital. If a corporation needs new equity, it can sell new shares of stock and attract new investors.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

SUMMARY OF FORMS OF BUSINESS SOLE PROPRIETORSHIP GENERAL PARTNERSHIP LIMITED PARTNERSHIP CORPORATION

THE DISADVANTAGES

Double taxation. Because a corporation is a legal person, it must pay taxes. Moreover, money paid out to stockholders in the form of dividends is taxed again as income to those stockholders. −→ Corporate profits are taxed twice: at the corporate level when they are earned and again at the personal level when they are paid out.

More highly regulated. For example, in the U.S. there are State laws pertaining to corporations and the Securities and Exchange Commission requires specific disclosures.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

THE GOAL OF FINANCIAL MANAGEMENT SARBANES-OXLEY ACT THE AGENCY PROBLEM MANAGING MANAGERS

THE GOAL OF FINANCIAL MANAGEMENT

Maximize shareholder wealth: The goal of financial management in a corporation is to maximize the current value per share of the existing stock. It doesn’t matter whether the business is a proprietorship, a partnership, or a corporation. For each of these, good financial decisions increase the market value of the owners’ equity and poor financial decisions decrease it.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

THE GOAL OF FINANCIAL MANAGEMENT SARBANES-OXLEY ACT THE AGENCY PROBLEM MANAGING MANAGERS

SARBANES-OXLEY ACT

In response to corporate scandals involving companies such as Enron, WorldCom, Tyco, and Adelphia, Congress enacted the Sarbanes-Oxley Act in 2002. The act, which is better known as “Sarbox,” is intended to strengthen protection against corporate accounting fraud and financial malpractice. Key elements of Sarbox took effect on November 15, 2004.

Sarbox contains a number of requirements designed to ensure that companies tell the truth in their financial statements. For example, the officers of a public corporation must review and sign the annual report. They must attest that the annual report does not contain false statements or material omissions and also that the financial statements fairly represent the company’s financial results. In essence, Sarbox makes management personally responsible for the accuracy of a company’s financial statements.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

THE GOAL OF FINANCIAL MANAGEMENT SARBANES-OXLEY ACT THE AGENCY PROBLEM MANAGING MANAGERS

THE AGENCY PROBLEM

Managerial goals may be different from shareholder goals. Imagine that a corporation is considering a new investment. The new investment is expected to favorably affect the stock price, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the share value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity.

Increased growth and size are not necessarily equivalent to increased shareholder wealth. If left to themselves, managers would tend to maximize the amount of resources over which they have control, or, more generally, business power or wealth. This goal could lead to an overemphasis on business size or growth. For example, management overpays to buy another company just to increase the size of the business or to demonstrate corporate power.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE

INTRODUCTION OBJECTIVES AND GUIDING PRINCIPLES

FORMS OF BUSINESS ORGANIZATION THE GOAL OF FINANCIAL MANAGEMENT

THE GOAL OF FINANCIAL MANAGEMENT SARBANES-OXLEY ACT THE AGENCY PROBLEM MANAGING MANAGERS

MANAGING MANAGERS

Incentives can be used to align management and stockholder interests

First, managerial compensation, particularly at the top, is usually tied to financial performance in general and oftentimes to share value in particular. For example, managers are frequently given the option to buy stock at a fixed price. The more the stock is worth, the more valuable is this option.

Second, job prospects. Better performers within the firm will tend to get promoted. More generally, those managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

YI ZHOU CHAPTER ONE: CORPORATE GOVERNANCE