Introduction to Corporate Finance

Chapter 1 Introduction to Corporate Finance To survive and prosper, a company must satisfy its customers. It must also produce and sell products and services at a profit. In order to produce, it needs many assets—plant, equipment, offices, computers, technology, and so on. The company has to decide (1) which assets to buy and (2) how to pay for them. The financial manager plays a key role in both these decisions. The investment decision (decision to invest in assets like plant, equipment, and know-how) is in large part a responsibility of the financial manager. So is the financing decision, the choice of how to pay for such investments.

Starting by explaining how businesses are organized. A brief introduction to the role of the financial manager has been provided and why corporate managers need a sophisticated understanding of financial markets has also been explained. Next discussion turns to the goals of the firm and what makes for a good financial decision. Is the firm’s aim to maximize profits?

Organizing a Business

SOLE PROPRIETORSHIPS

A SOLE OWNER OF A BUSINESS WHICH HAS NO PARTNERS AND NO SHAREHOLDERS. THE PROPRIETOR IS PERSONALLY LIABLE FOR ALL THE FIRM’S OBLIGATIONS.

A sole proprietor is responsible for all the business’s debts and other liabilities. If the business borrows from the bank and subsequently cannot repay the loan, the bank has a claim against proprietor’s personal belongings. It could force

1 proprietor into personal bankruptcy if the business debts are big enough. Thus a sole proprietor has unlimited liability.

Q.1. Who is a sole proprietor?

Ans.1. A sole owner of a business which has no partners and no shareholders. The proprietor is personally liable for all the firm’s obligations.

Q.2. A sole proprietor has ______liability.

Ans.2. unlimited

PARTNERSHIPS

BUSINESS IS OWNED BY TWO OR MORE PERSONS WHO ARE PERSONALLY RESPONSIBLE FOR ALL ITS LIABILITIES.

Partners, like sole proprietors, have the disadvantage of unlimited liability. If the business runs into financial difficulties, each partner has unlimited liability for all the business’s debts, not just his or her share.

Q.3. What is partnership?

Ans.3. In partnership, business is owned by two or more persons who are personally responsible for all its liabilities.

Q.4. In partnership business each partner has ______liability.

Ans.4. unlimited

CORPORATIONS

BUSINESS IS OWNED BY STOCKHOLDERS WHO ARE NOT PERSONALLY LIABLE FOR THE BUSINESS’S LIABILITIES.

2 Unlike a proprietorship or partnership, a corporation is legally distinct from its owners. It is based on articles of incorporation that set out the purpose of the business, how many shares can be issued, the number of directors to be appointed, and so on. These articles must conform to the laws of the state in which the business is incorporated. The corporation is owned by its stockholders and they get to vote on important matters. Unlike proprietorships or partnerships, corporations have limited liability, which means that the stockholders cannot be held personally responsible for the obligations of the firm. The most a stockholder can lose is the amount invested in the stock. While the stockholders of a corporation own the firm, they do not usually manage it. Instead, they elect a board of directors, which in turn appoints the top managers. The board is the representative of shareholders and is supposed to ensure that management is acting in their best interests. This separation of ownership and management is one distinctive feature of corporations. In other forms of business organization, such as proprietorships and partnerships, the owners are the managers. The separation between management and ownership gives a corporation more flexibility and permanence than a partnership. Even if managers of a corporation quit or are dismissed and replaced by others, the corporation can survive. Similarly, today’s shareholders may sell all their shares to new investors without affecting the business. In contrast, ownership of a proprietorship cannot be transferred without selling out to another owner-manager. Given these advantages, you might be wondering why all businesses are not organized as corporations. One reason is the time and cost required to manage a corporation’s legal machinery. When a corporation is established, the shares may all be held by a small group, perhaps the company’s managers and a small number of backers

3 who believe the business will grow into a profitable investment. Shares are not publicly traded and company is closely held. Eventually, when the firm grows and new shares are issued to raise additional capital, the shares will be widely traded. Such corporations are known as public companies. Most well-known corporations are public companies.

The financial managers of a corporation are responsible, by way of top management and the board of directors, to the corporation’s shareholders. Financial managers are supposed to make financial decisions that serve shareholders’ interests. Table 1.1 presents the distinctive features of the major forms of business organization.

Table 1.1 Characteristics of business organizations Sole Proprietorship Partnership Corporation __

Q.5. What is a corporation?

Ans.5. In a corporation, business is owned by stockholders who are not personally liable for the business’s liabilities.

4 Q.6. Corporations have ______liability.

Ans.6. limited

Q.7. Who owns a sole proprietor business?

Ans.7. Manager owns a sole proprietor business.

Q.8. Who owns a partnership business?

Ans.8. Partners own a partnership business.

Q.9. Who owns a corporation?

Ans. Shareholders own a corporation.

Q.10. Are managers and owner(s) separate in a sole proprietorship? Ans.10. No. Q.11. Are managers and owner(s) separate in a partnership? Ans.11. No. Q.12. Are managers and owner(s) separate in a corporation? Ans.12.Usually

The Role of the Financial Manager

To carry on business, companies need an almost endless variety of real assets. Many of these assets are tangible, such as machinery, factories, and offices; others are intangible, such as technical expertise, trademarks, and patents. All of them must be paid for. To obtain the necessary money, the company sells financial assets, or securities.

REAL ASSETS- USED TO PRODUCE GOODS AND SERVICES.

5 Q.13.What is real assets?

Ans.13. Real assets are used to produce goods and services. Many of these assets are tangible, such as machinery, factories, and offices; others are intangible, such as technical expertise, trademarks, and patents.

FINANCIAL ASSETS- CLAIMS TO THE INCOME GENERATED BY REAL ASSETS. ALSO CALLED SECURITIES.

Q.14.What is financial assets?

Ans.14. Financial assets claim to the income generated by real assets. Also called securities.

These pieces of paper have value because they are claims on the firm’s real assets and the cash that those assets will produce. For example, if the company borrows money from the bank, the bank has a financial asset. That financial asset gives it a claim to a stream of interest payments and to repayment of the loan. The company’s real assets need to produce enough cash to satisfy these claims.

FIGURE 1.1

(2) (1)

(3) (4a)

Financial managers stand between the firm’s real assets and the financial markets in which the firm raises cash. The financial manager’s role is shown in Figure 1.1, which traces how money flows from investors to the firm and back to investors again. The flow starts when financial assets are sold to raise cash (arrow 1 in the

6 figure). The cash is employed to purchase the real assets used in the firm’s operations (arrow 2). Later, if the firm does well, the real assets generate enough cash inflow to more than repay the initial investment (arrow 3). Finally, the cash is either reinvested (arrow 4a) or returned to the investors who contributed the money in the first place (arrow 4b). Of course the choice between arrows 4a and 4b is not a completely free one. For example, if a bank lends the firm money at stage 1, the bank has to be repaid this money plus interest at stage 4b.

This flow chart suggests that the financial manager faces two basic problems. First, how much money should the firm invest, and what specific assets should the firm invest in? This is the firm’s investment, or capital budgeting decision. Second, how should the cash required for an investment be raised? This is the financing decision.

FINANCIAL MARKETS- MARKETS IN WHICH FINANCIAL ASSETS ARE TRADED.

CAPITAL BUDGETING DECISION- DECISION AS TO WHICH REAL ASSETS THE FIRM SHOULD ACQUIRE.

FINANCING DECISION- DECISION AS TO HOW TO RAISE THE MONEY TO PAY FOR INVESTMENTS IN REAL ASSETS.

Q.15. What is Financial Markets?

Ans.15. Financial market is a market in which financial assets are traded.

THE CAPITAL BUDGETING DECISION

Capital budgeting decisions are central to the company’s success or failure. For example, in the late 1980s, the Walt Disney Company committed to construction of a Disneyland Paris theme park at a total cost of well over $2 billion. Instead of

7 providing profits on the investment, accumulated losses on the park were more than $200 million. Contrast that with Boeing’s decision to “bet the company” by developing the 757 and 767 jets. Boeing’s investment in these planes was $3 billion. By 1997, estimated cumulative profits from this investment were approaching $8 billion and the planes were still selling well.

Disney’s decision to invest in Euro Disney and Boeing’s decision to invest in a new generation of airliners are both examples of capital budgeting decisions. The success of such decisions is usually judged in terms of value. Good investment projects are worth more than they cost. Adopting such projects increases the value of the firm and therefore the wealth of its shareholders. For example, Boeing’s investment produced a stream of cash flows that were worth much more than its $3 billion outlay.

Q.16. What is a capital budgeting decision?

Ans.16. Decision as to which real assets the firm should acquire is called capital budgeting decision.

THE FINANCING DECISION

The financial manager’s second responsibility is to raise the money to pay for the investment in real assets. This is called financing decision.

The decision to invest in a new factory or to issue new shares of stock has long- term consequences. But the financial manager is also involved in some important short-term decisions. For example, she needs to make sure that the company has enough cash on hand to pay next week’s bills and that any spare cash is put to work to earn interest. Such short-term financial decisions involve both investment

8 (how to invest spare cash) and financing (how to raise cash to meet a short-term need).

Businesses are inherently risky, but the financial manager needs to ensure that risks are managed. For example, the manager will want to be certain that the firm cannot be wiped out by a sudden rise in oil prices or a fall in the value of the dollar.

Q.17. What is a financing decision?

Ans.17. Decision as to how to raise the money to pay for investments in real assets is called financing decision.

Financial Institutions and Markets

If a corporation needs to borrow from the bank or issue new securities, then its financial manager had better understand how financial markets work. The capital budgeting decision also requires an understanding of financial markets. A successful investment is one that increases firm value.

FINANCIAL INSTITUTIONS

Most firms are too small to raise funds by selling stocks or bonds directly to investors. When these companies need to raise funds to help pay for a capital investment, the only choice is to borrow money from a financial intermediary like a bank or insurance company. The financial intermediary, in turn, raises funds, often in small amounts, from individual households. For example, a bank raises funds when customers deposit money into their bank accounts.

9 FINANCIAL INTERMEDIARY – FIRM THAT RAISES MONEY FROM MANY SMALL INVESTORS AND PROVIDES FINANCING TO BUSINESSES OR OTHER ORGANIZATIONS BY INVESTING IN THEIR SECURITIES.

Q.18. Explain to financial intermediary.

Ans.18. Firm that raises money from many small investors and provides financing to businesses or other organizations by investing in their securities is called financial intermediary.

FINANCIAL MARKETS

As firms grow, their need for capital can expand dramatically. At some point, the firm may find that “cutting out the middle-man” and raising funds directly from investors is advantageous. At this point, it is ready to sell new financial assets, such as shares of stock, to the public. The first time the firm sells shares to the general public is called the initial public offering, or IPO. Investors who buy shares are contributing funds that will be used to pay for the firm’s investments in real assets. In return, they become part-owners of the firm and share in the future success of the enterprise.

A new issue of securities increases both the amount of cash held by the company and the amount of stocks or bonds held by the public. Such an issue is known as a primary issue and it is sold in the primary market. But in addition to helping companies raise new cash, financial markets also allow investors to trade stocks or bonds between themselves. For example, Smith might decide to raise some cash by selling her AT&T stock at the same time that Jones invests his spare cash in AT&T. The result is simply a transfer of ownership from Smith to Jones, which has no effect on the company itself. Such purchases and sales of existing

10 securities are known as secondary transactions and they take place in the secondary market.

PRIMARY MARKET- MARKET FOR THE SALE OF NEW SECURITIES BY CORPORATIONS.

SECONDARY MARKET- MARKET IN WHICH ALREADY ISSUED SECURITIES ARE TRADED AMONG INVESTORS.

Q.19. What is a primary market?

Ans.19. Primary market is a market for the sale of new securities by corporations.

Q.20. Explain to secondary market.

Ans.20. Secondary market is a market in which already issued securities are traded among investors.

OTHER FUNCTIONS OF FINANCIAL MARKETS AND INSTITUTIONS

Financial markets and institutions provide financing for business. They also contribute in many other ways to individual’s well-being and the smooth functioning of the economy. Here are some examples.

The Payment Mechanism. Think how inconvenient life would be if you had to pay for every purchase in cash or if General Motors had to ship truckloads of hundred- dollar bills round the country to pay its suppliers. Checking accounts, credit cards, and electronic transfers allow individuals and firms to send and receive payments quickly and safely over long distances. Banks are the obvious providers of payment services.

11 Borrowing and Lending. Financial institutions allow individuals to transfer expenditures across time. If you have more money now than you need and you wish to save for a rainy day, you can (for example) put the money on deposit in a bank. If you wish to anticipate some of your future income to buy a car, you can borrow money from the bank. Both the lender and the borrower are happier than if they were forced to spend cash as it arrived. Of course, individuals are not alone in needing to raise cash from time to time. Firms with good investment opportunities raise cash by borrowing or selling new shares.

In principle, individuals or firms with cash surpluses could take out newspaper advertisements or surf the Net looking for counterparts with cash shortages. But it is usually cheaper and more convenient to use financial markets or institutions to link the borrower and the lender. For example, banks are equipped to check the borrower’s creditworthiness and to monitor the use of the cash.

Almost all financial institutions are involved in channeling savings toward those who can best use them. Pooling Risk. Financial markets and institutions allow individuals and firms to pool their risks. Insurance companies are an obvious example. Here is another. Suppose that you have only a small sum to invest. You could buy the stock of a single company, but then you could be wiped out if that company went belly-up. It’s generally better to buy shares in a mutual fund that invests in a diversified portfolio of common stocks or other securities. In this case you are exposed only to the risk that security prices as a whole may fall.

Who Is the Financial Manager?

The term financial manager is used to refer to anyone responsible for a significant corporate investment or financing decision. But except in the smallest firms, no

12 single person is responsible for all the decisions. Responsibility is dispersed throughout the firm. Top management is of course constantly involved in financial decisions. But the engineer who designs a new production facility is also involved: the design determines the kind of asset the firm will invest in. Likewise the marketing manager who undertakes a major advertising campaign is making an investment decision: the campaign is an investment in an intangible asset that will pay off in future sales and earnings.

Q.21. Who is the Financial Manager?

Ans.21. Financial manager is a person responsible for a significant corporate investment or financing decision.

FIGURE 1.2

Nevertheless, there are managers who specialize in finance, and their functions are summarized in Figure 1.2. The treasurer is usually the person most directly responsible for looking after the firm’s cash, raising new capital, and maintaining relationships with banks and other investors who hold the firm’s securities.

13 For small firms, the treasurer is likely to be the only financial executive. Larger corporations usually also have a controller, who prepares the financial statements, manages the firm’s internal accounting, and looks after its tax affairs. It can be seen that the treasurer and controller have different roles: the treasurer’s main function is to obtain and manage the firm’s capital, whereas the controller ensures that the money is used efficiently.

The largest firms usually appoint a chief financial officer (CFO) to oversee both the treasurer’s and the controller’s work. The CFO is deeply involved in financial policymaking and corporate planning. Often he or she will have general responsibilities beyond strictly financial issues.

TREASURER- MANAGER RESPONSIBLE FOR FINANCING, CASH MANAGEMENT, AND RELATIONSHIPS WITH FINANCIAL MARKETS AND INSTITUTIONS.

CONTROLLER- OFFICER RESPONSIBLE FOR BUDGETING, ACCOUNTING, AND AUDITING.

CHIEF FINANCIAL OFFICER- (CFO) OFFICER WHO OVERSEES THE TREASURER AND CONTROLLER AND SETS OVERALL FINANCIAL STRATEGY.

Usually the treasurer, controller, or CFO is responsible for organizing and supervising the capital budgeting process. However, major capital investment projects are so closely tied to plans for product development, production, and marketing that managers from these other areas are inevitably drawn into planning and analyzing the projects. If the firm has staff members specializing in corporate planning, they are naturally involved in capital budgeting too.

14 Because of the importance of many financial issues, ultimate decisions often rest by law or by custom with the board of directors. For example, only the board has the legal power to declare a dividend or to sanction a public issue of securities. Boards usually delegate decision-making authority for small or medium-sized investment outlays, but the authority to approve large investments is almost never delegated.

Q.22. Who is a Treasurer?

Ans.22. Manager responsible for financing, cash management, and relationships with financial markets and institutions is known as Treasurer.

Q.23. Who is a Controller?

Ans.23. Officer responsible for budgeting, accounting, and auditing is known as Controller.

Q.24. Who is a Chief Financial Officer?

Ans.24. Officer who oversees the treasurer and controller and sets overall financial strategy is known as Chief Financial Officer.

Q.25. In corporation stockholders cannot be held personally responsible for the obligations of the firm. (True)

Q.26. Separation of ownership and management is one distinctive feature of corporations. (True)

Q.27. Even if managers of a corporation quit or are dismissed and replaced by others, the corporation ______survive.

Ans.27. Can

15 Q.28. Shareholders may not sell all their shares to new investors without affecting the business. (False)

Ans.28. Shareholders may sell all their shares to new investors without affecting the business.

Q.29. Financial managers are not supposed to make financial decisions that serve shareholders’ interests. (False)

Ans.29. Financial managers are supposed to make financial decisions that serve shareholders’ interests.