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wk1dstlkch1.docx
Ch1
introduction to
financial management
Do you know: What finance entails? How financial management functions within the business world? Why you might benefit from studying financial principles? This chapter is the ideal place to get answers to those questions. Finance is the study of applying specific valueto things we own, services we use, and decisions we make. Examples are as varied as shares of stock in a company, payments on a home mortgage, the purchase of an entire firm, and the personal decision to retire early. In this text, we focus primarily on one area of finance, financial management, which concentrates on valuing things from the perspective of a company, or firm.
Financial management is critically important to the success of any business organization, and throughout the text we concentrate on describing the key financial concepts in corporate finance. As a bonus, you will find that many tools and techniques for handling the financial management of a firm also apply to broader types of financial problems, such as personal finance decisions.
In finance, cash flow is the term that describes the process of paying and receiving money. It makes sense to start our discussion of finance with an illustration of various financial cash flows. We use simple graphics to help explain the nature of finance and to demonstrate the different subareas of the field of finance.
After we have an overall picture of finance, we will discuss four important variables in the business environment that can and do have significant impact on the firm’s financial decisions. These are (1) the organizational form of the business, (2) the agency relation ship between the managers and owners of a firm, (3) ethical considerations as finance is applied in the real world, and (4) the source and implications of the current financial crisis.
LEARNING GOALS
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Define the major areas of finance as they apply to corporate financial management. |
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Show how finance is at the heart of sound business decisions. |
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Learn the financial principles that govern your personal decisions. |
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Examine the three most common forms of business organization in the United States today. |
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Distinguish among appropriate and inappropriate goals for financial managers. |
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Identify a firm’s primary agency relationship and discuss the possible conflicts that may arise. |
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Discuss how ethical decision making is part of the study of financial management. |
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Describe the complex, necessary relationships among firms, financial institutions, and financial markets. |
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Explain the fundamental causes of the financial crisis that started in 2006. |
viewpoints
business APPLICATION
Caleb has worked very hard to create and expand his juice stand at the mall. He has finally perfected his products and feels that he is offering the right combination of juice and food. As a result, the stand is making a nice profit. Caleb would like to open more stands at malls all over his state and eventually all over the country.
Caleb knows he needs more money to expand. He needs money to buy more equipment, buy more inventory, and hire and train more people. How can Caleb get the capital he needs to expand?
Page 4FINANCE IN BUSINESS AND IN LIFE LG1-1
As you begin this course, what is your first impression of the world of finance? No doubt you’ve experienced the current economic recession firsthand and read, perhaps in detail, about the financial crisis that peaked in the fall of 2008. An understanding of cause, effect, and future impact will be important as we go forward, so please see the nearby Finance at Work reading and the section on the financial crisis at the end of this chapter for brief background information and some analyses to set the stage for more complete explanations to come. But setting aside thoughts of recession and indulging in a quick look at popular culture, you’ll recognize that other influences have been at work for some time. Your opinions already may have been negatively skewed by entertainment. Many movies have portrayed finance professionals as greedy and unethical (see, for example, Wall Street, 1987; Barbarians at the Gate, 1993; Boiler Room, 2000; and Wall Street: Money Never Sleeps, 2010). While colorful characters make for good entertainment, fictional depictions do not reflect reality when it comes to what finance professionals actually do and how they contribute to society. The more you study managerial finance, the more you’ll appreciate this discipline’s broad potential to power the managerial decision making that moves our economy forward.
And what exactly makes up this engine of financial decision making? Successful application of financial theories helps money flow from individuals who want to improve their financial future to businesses that want to expand the scale or scope of their operations. These exchanges lead to a growing economy and more employment opportunities for people at all income levels. So, two important things result from this simple exchange: the economy will be more productive as a result, and individuals’ wealth will grow into the future.
In this first section, we develop a comprehensive description of finance and its subareas, and we look at the specific decisions that professionals in each subarea must make. As you will see, all areas of finance share a common set of ideas and application tools.
What Is Finance?
To get the clearest possible picture of how finance works, let’s begin by grouping all of an economy’s participants along two dimensions. The first dimension is made up of those who may have “extra” money (i.e., money above and beyond their current spending needs) for investment. The second dimension is made up of those who have an ability to develop viable business ideas, a sense of business creativity. Both money and ideas are fuel for the financial engine. In our simple model, these two dimensions result in four groups representing economic roles in society, as shown in Figure 1.1 . Of course, people can move from one group to another over time.
Type 1 people in our model do not lend significant sums of money (capital) or spend much money in a business context, so they play no direct role in financial markets , the mechanisms by which capital is exchanged. Although these people probably play indirect roles by providing labor to economic enterprises or by consuming their products, for simplicity we focus on those who play direct roles. Therefore, type 1 participants will be asked to step aside.
FIGURE 1.1 Participants in Our Hypothetical Economy
Four groups form according to the availability of money and ideas.
Page 5personal APPLICATION
Dagmar is becoming interested in investing some of her money. However, she has heard about several corporations in which the investors lost all of their money. In the past decade, Dagmar has heard that Lehman Brothers (2008), Chrysler (2009), and Six Flags (2009) have all filed for bankruptcy. These firms’ stockholders lost their entire investments in these firms.
Many of the stockholders who lost money were employees of these companies who had invested some of their retirement money in the company stock. Dagmar wonders what guarantee she has as an investor against losing her money.
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What is the best way for Dagmar to ensure a happy retirement? Scan the QR code for an extended look. Turn to the back of the book for solutions to these applications. |
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Type 4 people use financial tools to evaluate their own business concepts and then choose the ideas with the most potential. From there, they create their own enterprises to implement their best ideas efficiently and effectively. Type 4 individuals, however, are self-funded and do not need financial markets. The financial tools they use and the types of decisions they make are narrowly focused or specific to their own purposes. For our discussion, then, type 4 individuals also are asked to move to the sidelines.
Now for our financial role players, the type 2 and type 3 people. Financial markets and financial institutions allow these people to participate in a mutually advantageous exchange. Type 2 people temporarily lend their money to type 3 people, who put that money to use with their good business ideas.
In most developed economies, type 2 participants are usually individual investors . You will likely be an individual investor for most of your life. Each of us separately may not have a lot of extra money at any one time, but by aggregating our available funds, we can provide sizable amounts for investment.
FIGURE 1.2 Capital Flow from Investors to Companies
Investors are people or groups who need ideas to make more money, and companies are groups who need money to develop the ideas they do have.
Type 3 participants, the idea generators, may be individuals, but they are more commonly corporations or other types of companies with research and development (R&D) departments dedicated to developing innovative ideas. It’s easy to see that investors and companies can help one another. If investors lend their “extra” capital to companies, as shown in Figure 1.2 , then companies can use this capital to fund expansion projects. Economically successful projects will eventually be able to repay the money (plus profit) to investors, as Figure 1.3 shows.
Of course, not all of the cash will return to the investors. In reality, sources of friction arise in this system, and the amount of capital returned to investors is reduced. Two primary sources of friction are retained earnings , which are basically funds the firm keeps for its ongoing operations, and taxes, which the government imposes on the company and individuals to help fund public services. Figure 1.4 shows an analysis of cash flows with the associated retained earnings and tax payments. In a very simple way, this figure provides an intuitive overall explanation of finance and of its major subareas. For example, individuals must assess which investment opportunities are right for their needs and risk tolerance; financial institutions and markets must efficiently distribute the capital; and companies must evaluate their potential projects and wisely decide which projects to fund, what kind of capital to use, and how much capital to return to investors. All of these types of decisions deal with the basic cash flows of finance shown in Figure 1.4 , but from different perspectives.
finance The study of applying specific value to things we own, services we use, and decisions we make
financial management The process for and the analysis of making financial decisions in the business context.
financial markets The places and processes that facilitate the trading of financial assets between investors.
investors Those who buy securities or other assets in hopes of earning a return and getting more money back in the future.
retained earnings The portion of company profits that are kept by the company rather than distributed to the stockholders as cash dividends.
FIGURE 1.3 Return of Capital to Investors
In this basic process, the company can expand its business, hire more employees, and create a promising future for its own growth. Meanwhile, the investor can increase wealth for the future.
Page 6finance at work //:markets
The Financial Crisis: Introduction and Overview
At the time of this writing, the world economy has been reeling for over six years from the effects of the worst financial crisis since the Great Depression of the 1930s. By mid-March 2009, the Dow Jones Industrial Average (DJIA) had fallen in value 53.8 percent in less than 1½ years’ time, larger than the decline during the market crash of 1937–1938 when it fell 49 percent. Though the Dow has since recovered much of those losses, the markets continue to be very volatile and unsettled: On May 6, 2010, just after 2:30 pm EST, the Dow plunged by 998.50 points, a loss of 9.2 percent and the biggest one-day fall ever.
The commonly accepted cause of the crisis was the collapse of U.S. home prices in late 2006 and early 2007, but the problem has since spread to affect every part of the economy: The investment banking industry saw the failure or acquisition of all but two of its major firms (Goldman Sachs and Morgan Stanley), and these two firms converted to commercial bank holding companies (i.e., banks much like your neighborhood bank that tend to be safer and less profitable than investment banks). AIG, one of the largest insurance companies in the United States, survived only because of a federal government bailout. Commercial banking giant Citigroup required a massive government guarantee against losses and an injection of cash to prevent failure. The crisis spread internationally, too. Real estate markets fell in many countries across the world. The crisis had a profound impact on the financial health of banks, especially in Europe. In 2010, the unemployment rate had risen to over 10 percent. By 2012, it was still over 8 percent.
The exact mechanisms by which falling home prices led to such dramatic changes in the economic landscape are complicated and have yet to be covered in this book, so we will delay an in-depth discussion of the crisis until later, but we did feel that this is a good place to touch upon the ways that the fallout from the financial crisis are going to affect you, the student, in the years and decades to come.
First, those of you who hoped to fund your education with student loans may be finding it difficult to obtain such loans, especially at favorable rates. If so, thank the financial crisis: Lenders are much more leery about lending money due to the uncertain economic future they (and you, in your hopeful future employment) face. (And we won’t even get into the whole idea of your parents taking out a home equity loan to help you through. . .)
Second, as you’ve no doubt noticed, jobs are scarce, primarily due to companies’ uncertainty about the future. We expect it to stay this way for a while, though the impending retirement of the baby boomers will eventually benefit you.
Third, once you do make it through school and start your career, you may want to hold off on buying a home for a while. Most of the reasons are probably obvious, but compounding the uncertainty about being able to eventually unload any house you buy is the fact that lenders have greatly cut back on the availability of credit, asking for substantial down payments and loan servicing fees when they do lend.
By now, you’re probably starting to wonder if you missed the part about Eeyore (the gloomy donkey in the Winnie-the-Pooh books) being one of the coauthors of this book. Don’t despair: The current financial crisis does have potential silver linings to offer to those who are prepared and educated enough to take advantage of them.
After the extent of the crisis had started to become evident to everyone, one of the authors of this book was asked by a television reporter, “Why would anyone want to study finance now?!?! ” Well, on the one hand, and in the words of the Spanish-born American philosopher and poet George Santayana, “Those who do not learn from history are doomed to repeat it.” You really don’t want to go through this type of thing again, do you?
Another reason to study finance is that some of those silver linings we referred to are beginning to peek through the clouds: For example, in the aftermath of the crisis, more firms in general (and financial institutions in particular) are much more focused on the concepts of measuring and managing risks than ever before, and to effectively do so they need a trained and informed workforce.
Want to know more?
Key Words to Search for Updates: housing bubble, subprime lending, mortgage-backed securities, AIG, Countrywide Financial
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FIGURE 1.4 The Complete Cash Flows of Finance
All the subareas of the financial system interact, with retained earnings and taxes playing a role in the flows.
Subareas of Finance
Investments is the subarea of finance that involves methods and techniques for making decisions about what kinds of securities to own (e.g., bonds or stocks), which firms’ securities to buy, and how to pay the investor back in the form that the investor wishes (e.g., the timing and certainty of the promised cash flows). Figure 1.5 models cash flows from the investor’s perspective. The concerns of the investments subarea of finance are shown (with the movement of red arrows) from the investor’s viewpoint (seen as the blue box).
FIGURE 1.5 Investments
Investors mark the start and end of the financial process; they put money in and reap the rewards (or take the risk).
Financial management is the subarea that deals with a firm’s decisions in acquiring and using the cash that is received from investors or from retained earnings. Figure 1.6 depicts the financial management process very simply. As we know, this text focuses primarily on financial management. We’ll see that this critical area of finance involves decisions about:
• How to organize the firm in a manner that will attract capital.
• How to raise capital (e.g., bonds versus stocks).
• Which projects to fund.
• How much capital to retain for ongoing operations and new projects.
• How to minimize taxation.
• How to pay back capital providers.
All of these decisions are quite involved, and we will discuss them throughout later chapters.
Financial institutions and markets make up another major subarea of finance. These two dynamic entities work in different ways to facilitate capital flows between investors and companies. Figure 1.7 illustrates the process in which the firm acquires capital and investors take part in ongoing securities trading to increase that capital. Financial institutions, such as banks and pension administrators, are vital players that contribute to the dynamics of interest rates.
FIGURE 1.6 Financial Management
Financial managers make decisions that should benefit both the company and the investor.
investments The analysis and process of choosing securities and other assets to purchase.
financial institutions and markets The organizations that facilitate the flow of capital between investors and companies.
Page 8
FIGURE 1.7 Financial Institutions and Markets
Financial institutions and markets facilitate the flows of money between investors and companies.
International finance is the final major subarea of finance we will study. As the world has transformed into a global economy, finance has had to become much more innovative and sensitive to changes in other countries. Investors, companies, business operations, and capital markets may all be located in different countries. Adapting to this environment requires understanding of international dynamics, as Figure 1.8 shows. In the past, international financial decisions were considered to be a straightforward application of the other three financial subareas. But experience has shown that the uncertainty about future exchange rates, political risk, and changing business laws across the globe adds enough complexity to these decisions to classify international finance as a subarea of finance in its own right.
Application and Theory for Financial Decisions
Cash flows are neither instantaneous nor guaranteed. We need to keep this in mind as we begin to apply finance theory to real decisions. Future cash flows are uncertain in terms of both timing and size, and we refer to this uncertainty as risk . Investors experience risk about the return of their capital. Companies experience risk in funding and operating their business projects. Most financial decisions involve comparing the rewards of a decision to the risks that decision may generate.
Risk tolerance varies among individuals.
Comparing rewards with risks frequently involves assessing the value today of cash flows that we expect to receive in the future. For example, the price of a financial asset , something worth money, such as a stock or a bond, should depend on the cash flows you expect to receive from that asset in the future. A stock that’s expected to deliver high cash flows in the future will be more valuable today than a stock with low expected future cash flows. Of course, investors would like to buy stocks whose market prices are currently lower than their actual values. They want to get stocks on sale! Similarly, a firm’s goal is to fund projects that will give them more value than their costs.
Most financial decisions involve comparing the rewards of a decision to the risks that decision may generate.
Page 9
FIGURE 1.8 International Finance
Laws, risks, and business relationships are variable across different countries but can interact profitably.
Financial assets are normally grouped into asset classes according to their risk and return characteristics. The most commonly accepted groups of asset classes are stocks, bonds, money market instruments, real estate, and derivative securities, all of which we will discuss in more detail later in the book. As the risk and return profiles of each of these asset classes differ widely between classes, the mathematical models, terminology, and expertise of each class tend to be very specialized and trading tends to happen in distinct, separate financial markets for each asset class.
Despite the large number of stories about investors who’ve struck it rich in the stock market, it’s actually more likely that a firm will find “bargain” projects, projects that may yield profit for a reasonable investment, than investors will find under-priced stocks. Firms can find bargains because business projects involve real assets trading in real markets (markets in tangible assets). In the real environment, some level of monopoly power, special knowledge, and expertise possibly can make such projects worth more than they cost. Investors, however, are trading financial assets in financial markets, where the assets are more likely to be worth, on average, exactly what they cost.
time out!
1-1 What are the main subareas of finance and how do they interact?
The method for relating expected or future cash flows to today’s value, called present value, is known as time value of money (TVM) . Chapters 4 and 5 cover this critical financial concept in detail and apply it to the financial world (as well as daily life). Since the expected cash flows of either a business project or an investment are likely to be uncertain, any TVM analysis must account for both the timing and the risk level of the cash flows.
Finance versus Accounting
In most companies, the financial function is usually closely associated with the accounting function. In a very rough sense, the accountant’s job is to keep track of what happened in the past to the firm’s money, while the finance job uses these historical figures with current information to determine what should happen now and in the future with the firm’s money. The results of financial decisions will eventually appear in accounting statements, so this close association makes sense. Nevertheless, accounting tends to focus on and characterize the past, while finance focuses on the present and future.
THE FINANCIAL FUNCTION LG1-2
As we said previously, this text focuses primarily on financial management, so we will discuss the particular functions and responsibilities of the firm’s financial manager. We will also explain how the financial function fits in and interacts with the other areas of the firm. Finally, to make this study as interesting and as relevant as possible, we will make the connections that allow you to see how the concepts covered in this book are important in your own personal finances.
international finance The use of finance theory in a global business environment.
risk A potential future negative impact to value and/or cash flows. It is often discussed in terms of the probability of loss and the expected magnitude of the loss.
financial asset A general term for securities like stocks, bonds, and other assets that represent ownership in a cash flow.
asset classes A group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations.
real assets Physical property like gold, machinery, equipment, or real estate.
real markets The places and processes that facilitate the trading of real assets.
time value of money (TVM) The theory and application of valuing cash flows at various points in time.
The Financial Manager
The firm’s highest-level financial manager is usually the chief financial officer, or CFO. Both the company treasurer and the Page 10controller report to the CFO. The treasurer is typically responsible for:
• Managing cash and credit.
• Issuing and repurchasing financial securities such as stocks and bonds.
• Deciding how and when to spend capital for new and existing projects.
• Hedging (reducing the firm’s potential risk) against changes in foreign exchange and interest rates.
In larger corporations, the treasurer may also oversee other areas, such as purchasing insurance or managing the firm’s pension fund investments. The controller oversees the accounting function, usually managing the tax, cost accounting, financial accounting, and data processing functions.
Finance in Other Business Functions
Although the CFO and treasurer positions tend to be the firm’s most visible finance-related positions, finance affects the firm in many ways and throughout all levels of a company’s organizational chart. Finance permeates the entire business organization, providing guidance for both strategic and day-to-day decisions of the firm and collecting information for control and feedback about the firm’s financial decisions. Operational managers use finance daily to determine how much overtime labor to use, or to perform cost/benefit analysis when they consider new production lines or methods. Marketing managers use finance to assess the cost effectiveness of doing follow-up marketing surveys. Human resource managers use finance to evaluate the company’s cost for various employee benefit packages. No matter where you work in business, finance can help you do your job better.
Finance in Your Personal Life LG1-3
Finance can help you make good financial decisions in your personal life. Consider these common activities you will probably face in your life:
• Borrowing money to buy a new car.
• Refinancing your home mortgage at a lower rate.
• Making credit card or student loan payments.
• Saving for retirement.
You will be able to perform all of these tasks better after learning about finance. Recent changes throughout our economy and the U.S. business environment make knowledge of finance even more valuable to you than before. For example, most companies have switched from providing defined benefit retirement plans to employees to offering defined contribution plans (such as 401k plans) and self-funded plans like Individual Retirement Accounts (IRAs) . Tax changes in the early 1980s made this switch more or less inevitable. It appears that each of us will have to ensure adequate funds for our own retirement—much more so than previous generations.
defined benefit plan A retirement plan in which the employer funds a pension generally based on each employee’s years of service and salary.
defined contribution plan A retirement plan in which the employee contributes money and directs its investment. The amount of retirement benefits are directly related to the amount of money contributed and the success of its investment.
401k plan A defined contribution plan that is sponsored by corporate employers.
Individual Retirement Account (IRA) A self-sponsored retirement program.
sole proprietorship A business entity that is not legally separate from its owner
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EXAMPLE 1-1 |
Finance Applications LG1-3 |
Scan the code or log in to Connect for access to the interactive guided examples
Chloe realizes how important finance will be for her future business career. However, some of the ways that she will see financial applications seem way off in the future. She is curious about how the theory applies to her personal life, both in the near term and in the long term.
SOLUTION:
Chloe will quickly find that her financial health now and in the future will depend upon many decisions she makes as she goes through life—starting now! For example, she will learn that the same tools that she applies to a business loan analysis can be applied to her own personal debt. After this course, Chloe will be able to evaluate credit card offers and select one that could save her hundreds of dollars per year. When she buys a new car and the dealership offers her a low-interest-rate loan or a higher-rate loan with cash back, she will be able to pick the option that will truly cost her the least. Also, when Chloe gets her first professional job, she will know how to direct her retirement account so that she can earn millions of dollars for her future. (Of course, inflation between now and when she retires will imply that Chloe’s millions won’t be worth as much as they would today.)
Page 11
time out!
1-2 How might the application of finance improve your professional and personal decisions?
BUSINESS ORGANIZATION LG1-4
In the United States, people can structure businesses in any of several ways; the number of owners is the key to how business structures are classified. Traditionally, single owners, partners, and corporations operate businesses. We can express the advantages and disadvantages of each organizational form through several dimensions:
• Who controls the firm.
• Who owns the firm.
• What are the owners’ risks.
• What access to capital exists.
• What are the tax ramifications.
Recently, small businesses have adopted hybrid structures that capture the benefits from multiple organizational forms, and we’ll discuss those hybrid structures after we cover the more common, traditional types of business organizations.
“The owner, or sole proprietor, of the business has complete control of the firm’s activities. The owner also receives all of the firm’s profits and is solely responsible for all losses.”
Venture capital helped Starbucks become a success story.
Sole Proprietorships
The sole proprietorship represents, by far, the most common type of business in the United States. 1 A sole proprietorship is defined as any unincorporated business owned by a single individual. 2 Perhaps these businesses are so popular because they are relatively easy to start, and they’re subject to a much lighter regulatory and paperwork burden than other business forms. The owner, or sole proprietor, of the business has complete control of the firm’s activities. The owner also receives all of the firm’s profits and is solely responsible for all losses.
The biggest disad vantage that sole proprietor-ships carry relative to other organizational forms is that they have unlimited liability for their companies’ debts and actions. The owner’s personal assets may be confiscated if the business fails. The law recognizes no distinction between the owner’s business assets and personal assets. The income of the business is also added to the owner’s personal income and taxed by the government at the appropriate personal tax rate. Finally, sole proprietors have a difficult time obtaining capital to expand their business operations. Banks and other lenders are not typically interested in lending much money to sole proprietors because small firms have only one person liable for paying back the debt. A sole proprietor could raise capital by issuing equity to another investor. Angel investors and venture capitalists exchange capital for ownership in a business. But this requires re-forming the business as a partnership and the sole proprietor must give up some of the ownership (and thus control) of the firm. Table 1.1 summarizes sole proprietorships’ characteristics, along with those of the three other business organizations we will study.
unlimited liability A situation in which a person’s personal assets are at risk from a business liability.
equity An ownership interest in a business enterprise.
angel investors Individuals who provide small amounts of capital and expert business advice to small firms in exchange for an ownership stake in the firm.
venture capitalists Similar to angel investors except that they are organized as groups of investors and can provide larger amounts of capital.
Page 12Partnerships
A general partnership , or as it is more commonly known, a partnership, is an organizational form that features multiple individual owners. Each partner can own a different percentage of the firm. Firm control is typically determined by the size of partners’ ownership stakes. Business profits are split among the partners according to a prearranged agreement, usually by the percentage of firm ownership. Received profits are added to each partner’s personal income and taxed at personal income tax rates.
The partners jointly share unlimited personal liability for the debts of the firm and all are obligated for contracts agreed to by any one of the partners. Banks are more willing to lend to partnerships than to sole proprietorships, because all partners are liable for repaying the debt. Partners would have to give up some ownership and control in the firm to raise more equity capital. In order to raise enough capital for substantial growth, a partnership often changes into a public corporation.
Corporations
A public corporation is a legally independent entity entirely separate from its owners. This independence dramatically alters the firm’s characteristics. Corporations hold many rights and obligations of individual persons, such as the ability to own property, sign binding contracts, and pay taxes. Federal and state governments tax corporate income once at the corporate level. Then shareholders pay taxes again at the personal level when corporate profits are paid out as dividends. This practice is generally known as double taxation .
Corporate owners are stockholders, also called shareholders. Public corporations typically have thousands of stockholders. The firm must hire managers to direct the firm, since thousands of individual shareholders could not direct day-to-day operations under any sort of consensus. As a result, managers control the company. Strong possibilities of conflicts of interests arise when one group of people owns the business, but another group controls it. We’ll discuss conflicts of interest and their resolution later in the chapter.
As individual legal entities, corporations assume liability for their own debts, so the shareholders have only limited liability . That is, corporate shareholders cannot lose more money than they originally paid for their shares of stock. This limited liability is one reason that many people feel comfortable owning stock. Corporations are thus able to raise incredible amounts of money by selling stock (equity) and borrowing money. The largest businesses in the world are organized as corporations.
Hybrid Organizations
To promote the growth of small businesses, the U.S. government allows for several types of business organizations that simultaneously offer limited personal liability for the owners and provide a pass-through of all firm earnings to the owners, so that the earnings are subject only to single taxation.
Hybrid organizations offer single taxation and limited liability to all owners. Examples are S corporations, limited liability partnerships (LLPs), and limited liability companies (LLCs). Others, called limited partnerships (LPs), offer single taxation and limited liability to thelimited partners, but also have general partners, who benefit from single taxation but also must bear personal liability for the firm’s debts.
The U.S. government typically restricts hybrid organization status to relatively small firms. The government limits the maximum number of shareholders or partners involved,3 the maximum amount of investment capital allowed, and the lines of business permitted. These restrictions are consistent with the government’s stated reason for allowing the formation of these forms of business organization—to encourage the formation and growth of small businesses.
general partnership A form of business organization where the partners own the business together and are personally liable for legal actions and debts of the firm.
public corporation A company owned by a large number of stockholders from the general public.
double taxation A situation in which two taxes must be paid on the same income.
limited liability Limitation of a person’s financial liability to a fixed sum or investment.
hybrid organizations Business forms that have some attributes of corporations and some of proprietorships/partnerships.
time out!
1-3 Why must an entrepreneur give up some control of the business as it grows into a public corporation?
1-4 What advantages does the corporate form of organization hold over a partnership?
TABLE 1.1 Characteristics of Business Organization
Page 13FIRM GOALS LG1-5
Tens of thousands of public corporations operate in the United States. Many of them are the largest business organizations in the world. Because U.S. corporations are so large and because there are so many of them, corporations have a tremendous impact on society. Given the power that these huge firms wield, many people question what the corporate goals should be. Two different, well-developed viewpoints have arisen concerning what the goal of the firm should be. The owners’ perspective holds that the only appropriate goal is to maximize shareholder wealth . The competing viewpoint is from the stakeholders’ perspective, which emphasizes social responsibility over profitability. This view maintains that managers must maximize the total satisfaction of all stakeholders in a business. These stakeholders include the owners and shareholders, but also include the business’s customers, employees, and local communities.
maximization of shareholder wealth A view that management should first and foremost consider the interests of shareholders in its business decisions.
stakeholder A person or organization that has a legitimate interest in a corporation.
While strong arguments speak in favor of both perspectives, financial practitioners and academics now tend to believe that the manager’s primary responsibility should be to maximize shareholder wealth and give only secondary consideration to other stakeholders’ welfare. One of the first, and most well-known, proponents of this viewpoint was Adam Smith, an 18th-century economist who argued that, in capitalism, an individual pursuing his own interests tends also to promote the good of his community. 4
finance at work //: corporate
Google Buys YouTube
In November 2006, Web search leader Google purchased the online video-sharing phenomenon YouTube for $1.65 billion. Google bought the firm by giving YouTube owners shares of Google stock in exchange for their ownership in YouTube. YouTube was a private corporation owned primarily by cofounders Chad Hurley and Steve Chen, who each received over $300 million of Google stock. Venture capital firm Sequoia Capital had backed YouTube and received $442 million of Google stock. Two dozen YouTube employees also had ownership stakes; some of them became millionaires from the deal.
YouTube was founded in February 2005. Imagine starting a business that was purchased for $1.65 billion less than two years later! Consider how many finance people and applications were needed to organize the buyout. Google’s CFO George Reyes and team had to determine the value that YouTube could bring to Google. They also had to convince their own Google stockholders that Google did not overpay for the purchase. To do so, auditors had to evaluate YouTube’s cash flows and the riskiness of those cash flows. The CFO, along with investment banker advisors, had to decide how to pay for YouTube. Google swapped its own stock for the firm but could have paid all cash or used a combination of cash and stock.
YouTube owners also had to assess the value of their stock to ensure that they received a fair price. Google’s offer had to be compared to alternatives. For example, YouTube could have waited for a better offer from Google or sought an offer from another firm. Or YouTube owners could have decided to take the company public and sold shares to public investors.
This chapter illustrates the kinds of issues that finance addresses. The rest of the book describes the theories and tools needed to make these judgments. The practice of finance isn’t just about numbers—the results of financial analysis are very dynamic and exciting!
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Key Words to Search for Updates: Google, YouTube
Page 14Smith argued that the invisible hand of the market, acting through competition and the free price system, would ensure that only those activities most efficient and beneficial to society as a whole would survive in the long run. Thus, those same activities would also profit the individual most. When companies try to implement a goal other than profit maximization, their efforts tend to backfire. Consider the firm that tries to maximize employment. The high number of employees raises costs. Soon the firm will find that its costs are too high to allow it to compete against more efficient firms, especially in a global business environment. When the firm fails, all employees are let go and employment ends up being minimized, not maximized.
Regardless of whether you believe Smith’s assertion or not, a more pragmatic reason supports the argument that maximizing owners’ wealth is an admirable goal. As we will discuss, the owners of the firm hire managers to work on their behalf, so the manager is morally, ethically, and legally required to act in the owners’ best interests. Any relationships between the manager and other firm stakeholders are necessarily secondary to the goal that shareholders give to their hired managers.
Maximizing owners’ equity value means carefully considering:
• How best to bring additional funds into the firm.
• Which projects to invest in.
• How best to return the profits from those projects to the owners over time.
For corporations, maximizing the value of owners’ equity can also be stated as maximizing the current value per share, or stock price, of existing shares. To the extent that the current stock price can be expected to include the present value of any future expected cash flows accruing to the owners, the goal of maximizing stock price provides us with a single, concrete, measurable gauge of value. You may be tempted to choose several other potential goals over maximizing the value of owners’ equity. Common alternatives are:
• Maximizing net income or profit.
• Minimizing costs.
• Maximizing market share.
Although these may look appealing, each of these goals has some potentially serious shortcomings. For example, net income is measured on a year-by-year or quarter-by-quarter basis. When we say that we want to maximize profits, to which net income figure are we referring? We can maximize this year’s net income in several legitimate ways, but many of these ways impose costs that will reduce future income. Or, current net income can be pushed into future years. Neither of these two extremes will likely encourage the firm’s short-term and long-term stability. One more likely goal would be to maximize today’s value of all future years of net income. Of course, this possible goal is very close to maximizing the current stock price, without the convenient market-oriented measure of the stock price. Another problem with considering maximizing all future profits as the goal is that net income (for reasons we’ll go into later) does not really measure how much money the firm is actually earning.
Minimizing costs and maximizing market share also have fundamental problems as potential goals. Certainly minimizing costs would not make some stakeholders, such as employees, very happy. In addition, without spending the money on R&D and new product development, many companies would not survive long in the ever-evolving economy without improving their products. A firm can always increase market share by lowering price. But if a firm loses money on every product sold, then selling more products will simply drive the firm into fiscal distress.
time out!
1-5 Describe why the primary objective of maximizing shareholder value may actually be the most beneficial for society in the long run.
AGENCY THEORY LG1-6
Whenever one party (the principal) hires someone else (the agent) to work for him or her, their interaction is called an agency relationship. The agent is always supposed to act in the principal’s best interests. For example, an apartment complex manager should ensure that tenants aren’t doing willful damage to the property, that fire codes are enforced, and that the vacancy rate is kept as low as possible, because these are best for the apartment owner.
Agency Problem
In the context of a public corporation, we have already noted that stockholders hire managers to run the firm. Ideally, managers will operate the firm so that the shareholders realize maximum value for their equity. But managers may be tempted to operate the firm to serve their own best interests. Managers could spend company money to improve their own lifestyle instead of earning more profits for shareholders. Sometimes the manager’s best interest does not necessarily align with shareholder goals. This creates a situation that we refer to as the agency problem .
invisible hand A metaphor used to illustrate how an individual pursuing his own interests also tends to promote the good of the community.
agency problem The difficulties that arise when a principal hires an agent and cannot fully monitor the agent’s actions.
Page 15
Perks can range from extra vacation to private transportation.
For example, suppose it is time to buy a new corporate car for the firm’s chief executive officer (CEO) . Assuming that the CEO has no extraordinary driving requirements, shareholders might wish for the CEO to buy a nice, conservative domestic sedan. But suppose that the CEO demands the newest, biggest luxury car available. It’s tempting to say that the shareholders could just tell the CEO which car to buy. But remember, the CEO has most of the control in a public corporation. Organizational behavior specialists have identified three basic approaches to minimize this conflict of interest. First, ignore it. If the amount of money involved is small enough relative to the firm’s cash flows, or if the suitability of the purchase in question is ambiguous enough, shareholders might be best served to simply overlook the problem. A good deal of research literature suggests that allowing the manager a certain amount of such perks (perquisites) might actually enhance owner value, in that such items may boost managers’ productivity. 5
The second approach to mitigating this conflict is to monitor managers’ actions. Monitoring at too fine a level of detail is probably counterproductive and prohibitively expensive. However, major firm decisions are usually monitored at least roughly through the accounting auditing process.
In addition, concentrated ownership in the firm by large stakeholders such as financial institutions, investment companies, individual block holders, or debt holders give those large stakeholders increased incentives to monitor the activities of management. These incentives are often driven by both economies of scale in monitoring and by the claim of the stakeholder having a different risk/return profile than the claim of other stakeholders.
To see the impact of economies of scale in monitoring costs, consider a simple example: Suppose that it costs $3.00 each way (i.e., $6.00 round-trip) for a shareholder in a firm to hop on the subway and ride down to the firm’s offices in order to go through the firm’s financial statements, and that the most savings to shareholders that could possibly result from this monitoring would be $5.00 per share. Would anyone owning a single share ever take the ride to check up on the firm? No, because it would cost a certain $6.00 in order to save a possible $5.00. However, someone owning 100 shares in the firm would find it worthwhile to pay for the subway ride, assuming that the chance of saving $5.00 × 100 = $500 is large enough.
To envision the effect of one stake-holder having a different claim than others, consider the position of a bond-holder in a firm where there isn’t much free cash flow in the firm above and beyond that which is needed to make the interest payments on her bond. If the manager of the firm is going to spend an extra $20,000 to buy an unnecessarily luxurious company car, that $20,000 is very likely to come out of the bondholder’s pocket, so she will definitely have a heightened incentive to monitor the manager’s company car purchase. On the other hand, if the firm had so much free cash flow available that the expenditure of the extra $20,000 is unlikely to affect the payment of the bond interest, then the bondholder would have much less incentive to monitor. 6
The final approach for aligning managers’ personal interests with those of owners is to make the managers owners—that is, to offer managers an equity stake in the firm so that management participates in any equity value increase. Many corporations take this approach, either through explicitly granting shares to managers, by awarding them options on the firm’s stock, or by allowing them to purchase shares at a subsidized price through an employee stock option plan (ESOP) . When firm managers are also firm owners, their incentives are more likely to align with stockholders’ best interests.
chief executive officer (CEO) The highest-ranking corporate manager.
perks/perquisites Nonwage compensation, often in the form of company car, golf club membership, etc.
economies of scale Cost advantages when fixed costs are spread over a large number of units.
option The opportunity to buy stock at a fixed price over a specific period of time.
employee stock option plan (ESOP) An incentive program that grants options to employees (typically managers) as compensation.
Page 16Corporate Governance
We refer to the process of monitoring managers and aligning their incentives with shareholder goals as corporate governance . Theoretically, managers work for shareholders. In reality, because shareholders are usually inactive, the firm actually seems to belong to management. Generally speaking, the investing public does not know what goes on at the firm’s operational level. Managers handle day-to-day operations, and they know that their work is mostly unknown to investors. This lack of supervision demonstrates the need for monitors. Figure 1.9 shows the people and organizations that help monitor corporate activities.
The monitors inside a public firm are the board of directors , who are appointed to represent shareholders’ interests. The board hires the CEO, evaluates management, and can also design compensation contracts to tie management’s salaries to firm performance.
The monitors outside the firm include auditors, analysts, investment banks, and credit rating agencies. Auditors examine the firm’s accounting systems and comment on whether financial statements fairly represent the firm’s financial position. Investment analysts follow a firm, conduct their own evaluations of the company’s business activities, and report to the investment community. Investment banks , which help firms access capital markets and advise managers about how to interact with those capital markets, also monitor firm performance. Credit analysts examine a firm’s financial strength for its debt holders. The government also monitors business activities through the Securities and Exchange Commission (SEC) and the Internal Revenue Service (IRS).
The Role of Ethics LG1-7
Ethics must play a strong role in any practice of finance. Finance professionals commonly manage other people’s money. For example, corporate managers control the stockholder’s firm, bank employees manage deposits, and investment advisors manage people’s investment portfolios. These fiduciary relationships create tempting opportunities for finance professionals to make decisions that either benefit the client or benefit the advisors themselves. Professional associations (such as for treasurers, bank executives, investment professionals, etc.) place a strong emphasis on ethical behavior and provide ethics training and standards. Nevertheless, as with any profession with millions of practitioners, a few are bound to act unethically.
corporate governance The set of laws, policies, incentives, and monitors designed to handle the issues arising from the separation of ownership and control.
board of directors The group of directors elected by stockholders to oversee management in a corporation.
auditor A person who performs an independent assessment of the fairness of a firm’s financial statements.
FIGURE 1.9 Corporate Governance Monitors
Corporate governance balances the needs of stockholders and managers. Inside the public firm, the members of the board of directors monitor how the firm is run. Outside the firm, auditors, analysts, investment banks, and credit rating agencies act as monitors.
Page 17
time out!
1-6 What unethical activities might managers engage in because of the agency problem?
1-7 Explain how the corporate governance system reduces the agency problem.
The agency relationship between corporate managers and stockholders can create ethical dilemmas. Sometimes the corporate governance system has failed to prevent unethical managers from stealing from firms, which ultimately means stealing from shareholders. Governments all over the world have passed laws and regulations meant to ensure compliance with ethical codes of behavior. 7 And if professionals don’t act appropriately, governments have set up strong punishments for financial malfeasance. In the end, financial managers must realize that they not only owe their shareholders the very best decisions to further shareholder interests, but they also have a broader obligation to society as a whole.
investment analyst A person who analyzes a company’s business prospects and gives opinions about its future success.
investment banks Banks that help companies and governments raise capital.
credit analyst A person who analyzes a company’s ability to repay its debts and reports the findings as a grade.
ethics The study of values, morals, and morality.
fiduciary A legal duty between two parties where one party must act in the interest of the other party.
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EXAMPLE 1-2 |
Executive Compensation LG1-6 |
Scan the code or log in to Connect for access to the interactive guided examples
In 2005, firms in the Standard & Poor’s 500 Index paid their CEOs, on average, $13.51 million—a 16.1 percent increase over the previous year. So the average CEO compensation was 411 times the average employee’s compensation. In 2006, the increase in CEO pay was 8.9 percent. Every year, the controversy over CEO pay arises again. What arguments could be made for each side?
SOLUTION:
Many people believe that CEOs are paid too much for the services they provide. They receive compensation that is far higher than workers’ pay within their firms. Over the years, executive compensation has also increased at a faster and higher rate than has the value of the stockholders’ wealth. For example, the return for stockholders of the S&P 500 Index firms was 15.6 percent in 2006 and 4.9 percent in 2005, compared to CEO pay increases of 8.9 percent and 16.1 percent, respectively. Each firm’s board of directors sets CEO compensation. However, CEOs may have undue influence over director selection, tenure, and committee assignments—even over selecting the compensation advisors. This practice creates an unhealthy conflict of interest.
Others believe that a skilled CEO can positively affect company performance and that, therefore, the firm needs to offer high compensation and a bundle of perquisites to attract the best talent. To overcome agency problems, managers must be given incentives that pay very well when the company performs very well. If CEOs create a substantial amount of shareholder wealth, then who is to say that they are overpaid?
Page 18finance at work //: corporate
The Amazing Story of Apple Inc. and Steve Jobs
Steven Jobs and Stephen Wozniak started Apple Computer in 1976 as an equal partnership. Together, they built 50 computers in a garage using money borrowed from family, the proceeds from the sale of a VW bus, and credit from the parts distributor.
Jobs and Wozniak then designed the Apple II computer. But a higher production level to make more than 50 computers required more space and employees. They needed much more capital. They could not get a loan until angel investor Mike Markkula (an Intel executive) became a partner in the firm. He invested $92,000 and his personal guarantee induced a bank to loan Apple $250,000. As production ramped up in 1977, Apple Computer incorporated. Most shares were owned by Jobs, Wozniak, and Markkula, but the principals made some shares available to employees. They also hired an experienced manager (Mike Scott) to be the CEO and run the firm. Note that as the firm expanded, Jobs’ ownership level and control got diluted. By 1980, Apple Computer had sold a total of 121,000 computers—against a potential demand of millions more. Apple needed even more capital.
At the end of 1980, Apple became a public corporation and sold $65 million worth of stock to public investors. Steve Jobs, cofounder of Apple, still owned more shares than anyone else (7.5 million), but he owned less than half of the firm. He gave up a great deal of ownership to new investors in exchange for the capital to expand the firm. Unhappy with Mike Scott’s leadership, Steve Jobs also became CEO of Apple.
After a couple of years, Apple’s board of directors felt that Jobs was not experienced enough to steer the firm through its rapid expansion. They hired John Sculley as CEO in 1983. In 1985, a power struggle ensued for control of the firm, and the board backed Sculley over Jobs. Jobs was forced out of Apple and no longer had a say in business operations, even though he was the largest shareholder and an original cofounder of the firm.
So, Steve Jobs bought Pixar in 1986 for $5 million and founded NeXT Computer. Over the next 10 years, Jobs’ Pixar produced mega hit movies like Toy Story, A Bug’s Life, and Monsters, Inc. This time, he kept 53 percent ownership of Pixar to ensure keeping full control. In the meantime, Apple Computer began to struggle, with losses of $800 million in 1996 and $1 billion in 1997. To get Steve Jobs back into the firm, Apple bought NeXT for $400 million and hired him as Apple’s CEO. Over the next few years, Jobs introduced the iMac, iPod, and iTunes, and Apple became very profitable again! Jobs was given the use of a $90 million Gulfstream jet as a perk. To realign his incentives, he became an Apple owner again via com pensation that included options on 10 million shares of stock and 30 million shares of restricted stock . Then in 2006, Disney bought Pixar by swapping $7.4 billion worth of Disney stock for Pixar stock. When the deal closed, Steve Jobs became the largest owner of Disney stock (7 percent) and joined Disney’s board of directors.
Wow! What a story of accessing capital, business organizational form, company control, and corporate governance.
want to know more?
Key Words to Search for Updates: Steve Jobs, Apple Computer, Pixar
FINANCIAL MARKETS, INTERMEDIARIES, AND THE FIRM LG1-8
Astute readers will note that our emphasis on the role of financial markets and intermediaries grew throughout this chapter. This emphasis is intentional, as we feel that you must understand the role and impact of these institutions on the firm if you are to grasp the context in which professionals make financial management decisions.
We want to emphasize one other important point about these financial institutions (FI). Very astute readers may wonder how, if financial markets are competitive, investment banks Page 19and other financial institutions are able to make such impressive profits. Although FIs assist others with transactions involving financial assets in the financial markets, they do so as paid services. Successful execution of those services takes unique assets and expertise. As shown in Figure 1.10 , it’s the use of those unique assets and expertise that provides financial institutions with their high profit margins.
time out!
1-8 What is the role of financial institutions in a capitalist economy?
THE FINANCIAL CRISIS LG1-9
It would be impossible to write a new edition of this book without mentioning the 800-pound gorilla in the room that is the financial crisis. We will be discussing aspects of the crisis throughout the book, but we give you a little bit of insight concerning the causes of the crisis here to provide a foundation that we can refer to later.
What Started It
Signs of significant problems in the U.S. economy arose in late 2006 and the first half of 2007, when home prices plummeted and defaults by subprime mortgage borrowers (i.e., those borrowers charged higher interest rates because of their higher chance of default) began to affect the mortgage lending industry as a whole, as well as other parts of the economy noticeably. Mortgage delinquencies, particularly on subprime mortgages, surged in the last quarter of 2006 through 2008 as home owners who stretched themselves financially to buy a home or refinance a mortgage in the early 2000s fell behind on their loan payments. Foreclosure filings jumped 93 percent in July 2007 over July 2006. Between August 2007 and October 2008, an additional 936,439 homes were lost to foreclosure.
These problems arose after one of the largest periods of home-ownership growth in U.S. history, with the seasonally adjusted home ownership rate reaching a peak of 69.2 percent in the first quarter of 2005. To fund this unprecedented growth, mortgage lenders had increasingly started to sell the rights to the payments on the loans they had originated to other financial institutions or investors. This process is called securitization .
As a result, when mortgage borrowers started to default on their mortgages in late 2006, it was not just the lenders who had originated the mortgages who were affected, but also the broad variety of individual investors, pension funds, insurance companies, and many others who had invested heavily in such mortgage-backed securities .
restricted stock A special type of stock that is not transferable from the current holder to others until specific conditions are satisfied.
subprime mortgage borrowers Borrowers charged higher interest rates because of their higher chance of default.
securitization A process where loan originators sell the rights to the payments on the loans to other financial institutions or investors.
mortgage-backed securities Securities that represent a claim against the cash flows from a pool of mortgage loans.
FIGURE 1.10 Financial Institutions’ Cash Flows
The unique services and products that financial institutions provide allow them to make money.
Page 20Why It Got Worse
The widespread effects of the collapse of the housing bubble damaged financial institutions severely, raising questions about solvency even for those institutions that survived the bubble. As a result, the surviving institutions tightened their lending standards, making credit less available for both consumers and businesses in the economy.
This decreased availability of credit, along with damaged investor confidence, led businesses to reduce their forecasted sales and revenue figures. In turn, lower forecasted demand for products in the economy led employers to reduce their work-forces, resulting in double-digit unemployment figures and further eroding consumer confidence.
The Effect on the Public Sector
In the aftermath of the housing bubble collapse, the federal government took extensive steps to stimulate the economy to provide for an economic “soft landing.” The American Recovery and Reinvestment Act, passed by the U.S. Congress on February 13, 2009, devoted $308.3 billion to appropriations spending, including $120 billion on infrastructure and science and more than $30 billion on energy-related infrastructure projects. Another $267 billion would go for direct spending, including increased unemployment benefits and food stamps. Finally, $212 billion was set aside for tax breaks for individuals and businesses.
By the summer and fall of 2009, the economy appeared to be slowly beginning to recover. Pending home sales and residential construction both posted significant increases, the unemployment rate dropped below 10 percent, GDP was once again increasing, and consumer spending was once again on the rise. Unfortunately, state and local governments have continued to struggle with the aftermath of the crisis, enduring both reduced income tax revenues and decreasing property tax revenues caused by property reappraisals. So the economy never experienced the typical post-recession high-growth rebound and has been sputtering ever since.
Looking Ahead
At the time of this writing, the financial crisis appears to be getting somewhat better. Increasing consumer demand and diminishing unemployment point to better times ahead. However, both lenders’ and consumers’ tendencies to be more cautious, along with the continuing fiscal problems facing state and local municipalities in the foreseeable future, are likely to make the road to recovery a long and slow one.
Page 21Your Turn...
Questions
1. Describe the type of people who use the financial markets. ( LG1-1 )
2. What is the purpose of financial management? Describe the kinds of activities that financial management involves. ( LG1-1 )
3. What is the difference in perspective between finance and accounting? ( LG1-2 )
4. What personal decisions can you think of that will benefit from your learning finance? ( LG1-3 )
5. What are the three basic forms of business ownership? What are the advantages and disadvantages to each? ( LG1-4 )
6. Among the three basic forms of business ownership, describe the ability of each form to access capital. ( LG1-4 )
7. Explain how the founder of a business can eventually lose control of the firm. How can the founder ensure this will not happen? ( LG1-4 )
8. Explain the shareholder wealth maximization goal of the firm and how it can be measured. Make an argument for why it is a better goal than maximizing profit. ( LG1-5 )
9. Name and describe as many corporate stakeholders as you can. ( LG1-5 )
10. What conflicts of interest can arise between managers and stockholders? ( LG1-6 )
11. Figure 1.9 shows firm monitors. In your opinion, which group is in the best position to monitor the firm? Explain. Which group has the potential to be the weakest monitor? Explain. ( LG1-6 )
12. In recent years, governments all over the world have passed laws that increased the penalties for executives’ crimes. Do you think this will deter unethical corporate managers? Explain. ( LG1-6 )
13. Every year, the media report on the vast amounts of money (sometimes hundreds of millions of dollars) that some CEOs earn from the companies they manage. Are these CEOs worth it? Give examples. ( LG1-6 )
14. Why is ethical behavior so important in the field of finance? ( LG1-7 )
15. Does the goal of shareholder wealth maximization conflict with behaving ethically? Explain. ( LG1-7 )
16. Describe how financial institutions and markets facilitate the expansion of a company’s business. ( LG1-8 )
1 According to the IRS’ SOI Tax Stats—Integrated Business Data for 2007, 78.21 percent of all businesses in the U.S. were sole proprietorships.
2 However, if you are the sole member of a domestic limited liability company (LLC, discussed below), you are not a sole proprietor if you elect to treat the LLC as a corporation.
3 For example, current federal regulations limit the number of shareholders in an S corporation to no more than 100.
4 See Book IV of his The Wealth of Nations.
5 See, for example, Raghuram Rajan and Julie Wulf, “Are Perks Really Managerial Excess?” Journal of Financial Economics 79(1), 2006, 1–33.
6 In case you are wondering why the stockholders—who would be the eventual recipients of such “extra” free cash flow—wouldn’t then have increased incentives to monitor, they would. But, considering that the typical bond sells for $1,000 or more while the typical share of stock sells for much less, and taking into account that bond ownership tends to be much more concentrated than stock ownership in many firms, ask yourself whether bondholders or stockholders are more likely to enjoy economies of scale in monitoring.
7 The Sarbanes-Oxley Act of 2002 was passed in response to a number of recent major corporate accounting scandals including those affecting Enron, Tyco International, and WorldCom. The goal of the act was to make the accounting and
