Lecture 1 notes

Management and Finance

One of the most important areas in management is strategy. Thinking about business strategy
without simultaneously thinking about financial strategy is an excellent recipe for disaster, and, as a
result, management strategists must have a very clear understanding of the financial implications of
business plans. In broader terms, management employees of all types are expected to have a strong
understanding of how their jobs affect profitability, and they also are expected to be able to work
within their areas to improve profitability. This is precisely what studying finance teaches you: What
are the characteristics of activities that create value?

What Is Business Finance?

Imagine you were to start your own business. No matter what type of business you started, you
would have to answer the following three questions in some form or another:

1. What long-term investments should you take on? That is, what lines of business will you be in,
and what sorts of buildings, machinery, and equipment will you need?

2. Where will you get the long-term financing to pay for your investments? Will you bring in other
owners, or will you borrow the money?

3. How will you manage your everyday financial activities, such as collecting from customers and
paying suppliers?

These are not the only questions, but they are among the most important. Business finance, broadly
speaking, is the study of ways to answer these three questions. We’ll be looking at each of them in
the chapters ahead.

The Financial Manager

The financial management function is usually associated with a top officer of the firm, often called
the chief financial officer (CFO) or vice president of finance. The figure below is a simplified
organizational chart that highlights the finance activity in a large firm.

As shown, the vice president of finance coordinates the activities of the treasurer and the
controller.
The controller’s office handles cost and financial accounting, tax payments, and management
information systems.

The treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning,
and its capital expenditures.

These treasury activities are all related to the three general questions raised above, and the chapters
ahead deal primarily

with these issues. Our study thus bears mostly on activities usually associated with the treasurer’s
office. In a smaller firm, the treasurer and controller might be the same person, and there would be
only one office.

Financial Management Decisions

the financial manager must be concerned with three basic types of questions.

 Capital Budgeting

The first question concerns the firm’s long-term investments. The process of planning and
managing a firm’s long-term investments is called capital budgeting.

In capital budgeting, the financial manager tries to identify investment opportunities that are worth
more to the firm than they cost to acquire. Loosely speaking, this means that the value of the cash
flow generated by an asset exceeds the cost of that asset.

Regardless of the specific investment under consideration, financial managers must be concerned
with:

1. how much cash they expect to receive,

2. when they expect to receive it,

3. and how likely they are to receive it.

Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. In fact,
whenever we evaluate a business decision, the size, timing, and risk of the cash flows will be, by far,
the most important things we will consider.

 Capital Structure

The second question for the financial manager concerns how the firm obtains the financing it needs
to support its long-term investments. A firm’s capital structure (or financial structure) refers to the
specific mixture of long-term debt and equity the firm uses to finance its operations.

The financial manager has two concerns in this area:

1. How much should the firm borrow?

2. What are the least expensive sources of funds for the firm?

In addition to deciding on the financing mix, the financial manager has to decide exactly how and
where to raise the money. The expenses associated with raising long-term financing can be
considerable, so different possibilities must be evaluated carefully. Also, businesses borrow money
from a variety of lenders in a number of different ways. Choosing among lenders and among loan
types is another job handled by the financial manager.
  Working Capital Management

The third question concerns working capital man-agement. The term working capital refers to a
firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to
suppliers. Managing the firm’s working capital is a day-to-day activity that ensures the firm has
sufficient resources to continue its operations and avoid costly interruptions.

This involves a number of activities related to the firm’s receipt and disbursement of cash. Some
questions about working capital that must be answered are the following:

(1) How much cash and inventory should we keep on hand?

(2) Should we sell on credit to our customers?

(3) How will we obtain any needed short-term financing?

(4) If we borrow in the short term, how and where should we do it?

This is just a small sample of the issues that arise in managing a firm’s working capital.

Conclusion The three areas of corporate financial management we have described—capital

budgeting, capital structure, and working capital management—are very broad categories. Each
includes a rich variety of topics, and we have indicated only a few of the questions that arise in the
different areas. The chapters ahead contain greater detail.

FORMS OF BUSINESS ORGANIZATION

We examine the three different legal forms of business organization—sole proprietorship,

partnership, and corporation—to see why this is so.

1. Sole Proprietorship

A sole proprietorship is a business owned by one person. This is the simplest type of business to start
and is the least regulated form of organization. For this reason, there are more proprietorships than
any other type of business, and many businesses that later become large corporations start out as
small proprietorships.

The owner of a sole proprietorship keeps all the profits. That’s the good news. The bad news is that
the owner has unlimited liability for business debts. This means that creditors can look to the
proprietor’s personal assets for payment. Similarly, there is no distinction between personal and
business income, so all business income is taxed as personal income.

The life of a sole proprietorship is limited to the owner’s life span, and, importantly, the amount of
equity that can be raised is limited to the proprietor’s personal wealth. This lim-itation often means
that the business is unable to exploit new opportunities because of insufficient capital. Ownership of
a sole proprietorship may be difficult to transfer because this requires the sale of the entire business
to a new owner.

2. Partnership

A partnership is similar to a proprietorship, except that there are two or more owners (partners). In a
general partnership, all the partners share in gains or losses, and all have unlimited liability for all
partnership debts, not just some particular share.
The way partnership gains (and losses) are divided is described in the partnership agreement. This
agreement can be an informal oral agreement, such as “let’s start a lawn mowing business,” or a
lengthy, formal written document.

In a limited partnership, one or more general partners will run the business and have unlimited
liability, but there will be one or more limited partners who do not actively participate in the
business.

A limited partner’s liability for business debts is limited to the amount that partner contributes to
the partnership. This form of organization is common in real estate ventures, for example.

The advantages and disadvantages of a partnership are basically the same as those for a
proprietorship.

Partnerships based on a relatively informal agreement are easy and inexpensive to form. General
partners have unlimited liability for partnership debts, and the partnership terminates when a
general partner wishes to sell out or dies. 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. Ownership by
a general partner is not easily transferred because a new partnership must be formed. A limited
partner’s interest can be sold without dissolving the partnership, but finding a buyer may be difficult.

Because a partner in a general partnership can be held responsible for all partnership debts, having a
written agreement is very important. Failure to spell out the rights and duties of the partners
frequently leads to misunderstandings later on. Also, 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. The reason is that if things go badly, you may be deemed to be a general partner
even though you say you are a limited partner.

Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as
forms of business organization are (1) unlimited liability for business debts on the part of the owners,
(2) limited life of the business, and (3) difficulty of transferring ownership. These three disadvantages
add up to a single, central problem: The ability of such businesses to grow can be seriously limited
by an inability to raise cash for investment.

3. Corporation

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. Corporations can borrow money and own property,
can sue and be sued, and can enter into contracts. A cor-poration can even be a general partner or a
limited partner in a partnership, and a corpora-tion can own stock in another corporation.

Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms
of business organization. Forming a corporation involves preparing articles of incorporation (or a
charter) and a set of bylaws. The articles of incorporation must contain a number of things, including
the corporation’s name, its intended life (which can be for-ever), its business purpose, and the
number of shares that can be issued. This information must normally be supplied to the state in
which the firm will be incorporated. For most le-gal purposes, the corporation is a “resident” of that
state.
The bylaws are rules describing how the corporation regulates its own existence. For example, the
bylaws describe how directors are elected. The bylaws may be amended or extended from time to
time by the stockholders.

In a large corporation, the stockholders and the managers are usually separate groups. The
stockholders elect the board of directors, who then select the managers. Management is charged
with running the corporation’s affairs in the stockholders’ interests. In principle, stockholders control
the corporation because they elect the directors.

As a result of the separation of ownership and management, the corporate form has several
advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of the
corporation is, therefore, not limited. The corporation borrows money in its own name. As a result,
the stockholders in a corporation have limited liability for corpo-rate debts. The most they can lose is
what they have invested.

The relative ease of transferring ownership, the limited liability for business debts, and the unlimited
life of the business are the reasons the corporate form is superior when it comes to raising cash. If a
corporation needs new equity, it can sell new shares of stock and attract new investors. The number
of owners can be huge; larger corporations have many thousands or even millions of stockholders.
For example, the General Electric Company (better known as GE) has about 8.7 billion shares
outstanding and 4 million shareholders.

The corporate form has a significant disadvantage. 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. This is double taxation, meaning that corporate profits are taxed
twice: at the corporate level when they are earned and again at the personal level when they are
paid out.

Today, enacted laws allowing for the creation of a relatively new form of business organization, the
limited liability company (LLC). The goal of this entity is to operate and be taxed like a partnership but
retain limited liability for owners. Thus, an LLC is essentially a hybrid of a partnership and a
corporation. Although states have differing definitions for LLCs, the more important scorekeeper is
the Internal Revenue Service (IRS). The IRS will consider an LLC a corporation, thereby subjecting it to
double taxation,

unless it meets certain specific criteria. In essence, an LLC cannot be too corporation-like, or it will be
treated as one by the IRS. LLCs have become common. For example, Goldman Sachs, one of Wall
Street’s last remaining partnerships, decided to convert from a private partnership to an LLC (it later
“went public,” becoming a publicly held corporation). Large accounting firms and law firms by the
score have converted to LLCs.

THE GOAL OF FINANCIAL MANAGEMENT

Profit Maximization

Profit maximization would probably be the most commonly cited business goal, but this is not a very
precise objective. Do we mean profits this year? If so, then actions such as deferring maintenance,
letting inventories run down, and other short-run, cost-cutting measures will tend to increase profits
now, but these activities aren’t necessarily desirable.
The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but it’s
unclear exactly what this means. First, do we mean something like accounting net income or
earnings per share? As we will see, these numbers may have little to do with what is good or bad for
the firm. Second, what do we mean by the long run? As a famous economist once remarked: “In the
long run, we’re all dead!” More to the point, this goal doesn’t tell us the appropriate trade-off
between current and future profits.

The goal of financial management is to maximize the current value per share of the existing stock.

Maximize the market value of the existing owners’ equity.

THE AGENCY PROBLEM AND CONTROL OF THE CORPORATION

The financial manager in a corporation acts in the best interests of the stockholders by taking actions
that increase the value of the firm’s stock.

However, in large corporations, ownership can be spread over a huge number of stockholders. This
dispersion of ownership arguably means that management effectively controls the firm. In this case,
will management necessarily act in the best interests of the stockholders?

Put another way, might not management pursue its own goals at the stockholders’ expense? We
briefly consider some of the arguments in this section.

Agency Relationships

The relationship between stockholders and management is called an agency relationship. Such a
relationship exists whenever someone (the principal) hires another (the agent) to represent his or
her interest. For example, you might hire someone (an agent) to sell a car that you own while you are
away at school. In all such relationships, there is a possibility of conflict of interest between the
principal and the agent. Such a conflict is called an agency problem.

Suppose you hire someone to sell your car and you agree to pay her a flat fee when she sells the car.
The agent’s incentive in this case is to make the sale, not necessarily to get you the best price. If you
paid a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might
not exist. This example illustrates that the way an agent is compensated is one factor that affects
agency problems.

Management Goals

To see how management and stockholder interests might differ, 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. This is one example of an agency
cost.

It is sometimes argued that, 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, cases where management is
accused of overpaying to buy another company just to increase the size of the business or to
demonstrate corporate power are not uncommon. Obviously, if overpayment does take place, such a
purchase does not benefit the owners of the purchasing company.

Our discussion indicates that management may tend to overemphasize organizational survival to
protect job security. Also, management may dislike outside interference, so independence and
corporate self-sufficiency may be important goals.

Do Managers Act in the Stockholders’ Interests?

Whether managers will, in fact, act in the best interests of stockholders depends on two factors.
First, how closely are management goals aligned with stockholder goals? This question relates to the
way managers are compensated. Second, can management be replaced if they do not pursue
stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of
reasons to think that, even in the largest firms, management has a significant incentive to act in the
interests of stockholders.

Managerial Compensation

Management will frequently have a significant economic incentive to increase share value for two
reasons. 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. The second incentive managers have relates to 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.

Control of the Firm

Control of the firm ultimately rests with stockholders. They elect the board of directors, who, in turn,
hires and fires management. The mechanism by which unhappy stockholders can act to replace
existing management is called a proxy fight. A proxy is the authority to vote someone else’s stock. A
proxy fight develops when a group solicits proxies in order to replace the existing board, and thereby
replace existing management.

For example, in July 2017, Trian Partners, headed by activist investor Nelson Peltz, engaged in a proxy
fight with Procter & Gamble in an attempt to gain a seat on the board of directors. This was the
largest proxy fight in history, with Trian owning $3.3 billion worth of shares in the $223 billion
company. Peltz cited disappointing financial results, weak shareholder returns, deteriorating market
share, and excessive cost and bureaucracy as reasons for the proxy fight. P&G had fought off a
previous proxy fight in 2012 when William Ackman attempted to gain a seat on the board. Ackman
ultimately lost his battle and sold the last of his P&G stock in May 2014.

Another way that management can be replaced is by takeover. Firms that are poorly managed are
more attractive as acquisitions than well-managed firms because a greater profit potential exists.
Thus, avoiding a takeover by another firm gives management another incentive to act in the
stockholders’ interests. Unhappy prominent shareholders can suggest different business strategies to
a firm’s top management. For example, in June 2017, Verizon completed its $4.5 billion takeover of
Yahoo! The management of Yahoo! had been under fire for several years due to the company’s poor
performance. Verizon hoped that the combined company could create a third alternative in the
digital advertising market to challenge Google and Facebook. Yahoo! CEO Marissa Mayer wasn’t part
of the plans going forward, although she did receive $127 million when she was let go.

Conclusion

The available theory and evidence are consistent with the view that stockholders control the firm
and that stockholder wealth maximization is the relevant goal of the corporation. Even so, there will
undoubtedly be times when management goals are pursued at the expense of the stockholders, at
least temporarily. Agency problems are not unique to corporations; they exist whenever there is a
separation of ownership and management. This separation is most pronounced in corporations, but
it certainly exists in partnerships and proprietorships as well.

Stakeholders

Our discussion thus far implies that management and stockholders are the only parties with an
interest in the firm’s decisions. This is an oversimplification, of course. Employees, customers,
suppliers, and even the government all have a financial interest in the firm.

These various groups are called stakeholders in the firm. In general, a stakeholder is someone other
than a stockholder or creditor who potentially has a claim on the cash flows of the firm. Such groups
also will attempt to exert control over the firm, perhaps to the detriment of the owners.

FINANCIAL MARKETS AND THE CORPORATION

We’ve seen that the primary advantages of the corporate form of organization are that ownership
can be transferred more quickly and easily than with other forms and that money can be raised more
readily. Both of these advantages are significantly enhanced by the existence of financial markets,
and financial markets play an extremely important role in corporate finance

Cash Flows to and from the Firm

The interplay between the corporation and the financial markets is illustrated in Figure below. The
arrows trace the passage of cash from the financial markets to the firm and from the firm back to the
financial markets.
Suppose we start with the firm selling shares of stock and borrowing money to raise cash. Cash flows
to the firm from the financial markets (A). The firm invests the cash in current and fixed (or long-
term) assets (B). These assets generate some cash (C), some of which goes to pay corporate taxes
(D). After taxes are paid, some of this cash flow is reinvested in the firm (E). The rest goes back to the
financial markets as cash paid to creditors and shareholders (F).

A financial market, like any market, is a way of bringing buyers and sellers together. In financial
markets, it is debt and equity securities that are bought and sold. Financial markets differ in detail,
however. The most important differences concern the types of securities that are traded, how
trading is conducted, and who the buyers and sellers are. Some of these differences are discussed
next.

Primary versus Secondary Markets

Financial markets function as both primary and secondary markets for debt and equity securities.
The term primary market refers to the original sale of securities by governments and corporations.
The secondary markets are those in which these securities are bought and sold after the original sale.
Equities are, of course, issued solely by corporations. Debt securities are issued by both governments
and corporations. In the discussion that follows, we focus on corporate securities only.

Primary Markets In a primary market transaction, the corporation is the seller, and the transaction
raises money for the corporation. Corporations engage in two types of primary market transactions:
public offerings and private placements. A public offering, as the name suggests, involves selling
securities to the general public, whereas a private placement is a negotiated sale involving a specific
buyer.

By law, public offerings of debt and equity must be registered with the Securities and Exchange
Commission (SEC). Registration requires the firm to disclose a great deal of information before selling
any securities. The accounting, legal, and selling costs of public offerings can be considerable.

Partly to avoid the various regulatory requirements and the expense of public offerings, debt and
equity often are sold privately to large financial institutions such as life insurance companies or
mutual funds. Such private placements do not have to be registered with the SEC and do not require
the involvement of underwriters (investment banks that specialize in selling securities to the public).

Secondary Markets A secondary market transaction involves one owner or creditor selling to
another. It is, therefore, the secondary markets that provide the means for transferring ownership of
corporate securities. Although a corporation is only directly involved in a primary market transaction
(when it sells securities to raise cash), the secondary markets are still critical to large corporations.
The reason is that investors are much more willing to purchase securities in a primary market
transaction when they know that those securities can be resold later if desired.

Dealer Versus Auction Markets There are two kinds of secondary markets: auction markets and
dealer markets. Generally speaking, dealers buy and sell for themselves, at their own risk. A car
dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and
sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for
example, does not normally buy and sell houses. Dealer markets in stocks and long-term debt are
called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter.
The expression over the counter refers to days of old when securities were literally bought and sold
at counters in offices around the country. Today, a significant fraction of the market for stocks and
almost all of the market for long-term debt have no central location; the many dealers are connected
electronically. Auction markets differ from dealer markets in two ways. First, an auction market, or
exchange, has a physical location (like Wall Street). Second, in a dealer market, most of the buying
and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to
match those who wish to sell with those who wish to buy. Dealers play a limited role.