Chapter 1 Learning Objectives 1. Give examples of the investment and financing decisions that financial managers make. 2. Distinguish between real and financial assets. 3. Cite some of the advantages and disadvantages of organizing a business as a corporation. 4. Describe the responsibilities of the CFO, treasurer, and controller. 5. Explain why maximizing market value is the logical financial goal of the corporation. 6. Explain why value maximization is not inconsistent with ethical behavior. 7. Explain how corporations mitigate conflicts and encourage cooperative behavior.

Goals and Governance of the Corporation This chapter introduces the corporation, its goals, and the roles of financial managers. Chapter 1 Outline Investment and Financing Decisions The Corporation The Financial Managers Goals of the Corporation Value Maximization Corporate Governance Note: What are the primary differences among the various legal forms of business? Source: U.S. Census 2008 SUSB Annual Data 5 5 5 6 5 5

Investment and Financing Decisions The Investment Decision Real Assets The Financing Decision Financial Assets The Investment Decision – Decision to invest in tangible or intangible assets. Also known as the “capital budgeting” or “CAPEX” decision. The Financing Decision – The form and amount of financing of a firm’s investments. Real Assets – Assets used to produce goods and services. Financial Assets – Financial claims to the income generated by the firm’s real assets. 5 5 5 6 5 5

Investment and Financing Decisions Are the following capital budgeting or financing decisions? Apple decides to spend $500 million to develop a new iPhone. GE borrows $400 million from bond investors. Microsoft issues 100 million shares to buy a small technology company. When Apple spends $500 million to develop a new iPhone it is investing in real assets and is making a capital budgeting decision. When GE borrows $400 million from bond investors it is investing in financial assets and is making a financing decision. When Microsoft issues 100 million shares to buy a smaller company it is investing in both financial and real assets. It is making both a capital budgeting and financing decision.

What is a Corporation? Corporation-A business organized as a separate legal entity owned by stockholders. Types of Corporations: Public Corporations Private Corporations Corporation – A business organized as a separate legal entity owned by stockholders. Public Company – A corporation whose shares are traded in public markets such as the New York Stock Exchange or NASDAQ. Private Corporation – A corporation whose shares are not traded publicly.

Benefits of the Corporation Limited liability Infinite lifespan Ease of raising capital Limited Liability – The owners of a corporation are not personally liable for its obligation.

Drawbacks of the Corporation Corporations face the problem of double taxation Improper corporate structures may lead to “Agency Problems” Double Taxation – Corporations pay taxes on their profits and the shareholders are taxed again when they receive dividends or realize capital gains. Agency Problem – Managers are agents of the shareholders, but the managers may act in their own interests rather than maximize value.

Goals of The Corporation Shareholders want wealth maximization Wealth maximization vs. profit maximization: Pitfall: Profits from which period? Pitfall: Cutting dividends to increase cash reserves The ideal goal of any firm is simple: Maximize the current market value of shareholders’ investment in the firm; not simply to maximize profits. Potential pitfalls in profit maximization: Which period’s profits should be maximized? A corporation can make short term wasteful investments to increase profits, but long-term profits and value will be damaged. Cut dividends to increase cash reserves? A company may increase future profits by cutting today’s dividend and reinvesting the cash in the firm. In most cases, this decreases the value of shareholder investment in the firm. 17

The Ethics of Maximizing Value Does value maximization justify unethical behavior? Recent examples: Enron WorldCom Bernard Madoff 18

Agency Problem Do managers really maximize value? Agency Problems Managers are agents for stockholders, but the managers may act in their own interests rather than maximizing value Shareholders vs. Stakeholders Agency Problem – Managers are agents for stockholders, but the managers may act in their own interests rather than maximizing value. Stakeholder – anyone with a financial interest in the firm. Note: Managers may act in ways that are not in the best interests of shareholders. This is known as an “agency problem.” Note: Shareholders want managers to maximize the market value of the firm. However, managers are often obliged to appease not only the shareholders but all of the stakeholders as well. 3 3 3 4 3 3

Different Information Agency Problem Different Information Stock prices vs. returns Dividend Policy Financing Decisions Different Objectives Managers vs. shareholders Top managers vs. lower managers Stockholders vs. banks and lenders

Agency Problem Solutions Compensation plans Board of Directors Blockholders Potential agency problem solutions: Compensation plans – Provide managers with incentive schemes that produce big returns if shareholders gain but little or nothing if they do not. Board of directors – The Sarbanes-Oxley Act has led to more independent control of corporation Boards. Through a vote, the board of directors gives shareholders an opportunity to have a say in the operations of a firm. Blockholders – Individual investors who hold 5% or more of the company. These blockholders may offer some solutions to agency problems by closely monitoring the firm. Takeovers - Poorly performing companies are more likely to be taken over by another firm. The further a company’s stock price falls, the easier it is for another company to buy up a majority of its shares. Specialist monitoring - Managers are subject to the scrutiny of specialists. Their actions are monitored by the security analysts who advise investors to buy, hold, or sell the company’s shares. Regulatory requirements - CEOs and financial managers have a legal duty to act responsibly and in the interests of investors. 18

Agency Problem Solutions Takeovers Specialist Monitoring Legal and Regulatory Requirements Potential agency problem solutions: Compensation plans – Provide managers with incentive schemes that produce big returns if shareholders gain but little or nothing if they do not. Board of directors – The Sarbanes-Oxley Act has led to more independent control of corporation Boards. Through a vote, the board of directors gives shareholders an opportunity to have a say in the operations of a firm. Blockholders – Individual investors who hold 5% or more of the company. These blockholders may offer some solutions to agency problems by closely monitoring the firm. Takeovers - Poorly performing companies are more likely to be taken over by another firm. The further a company’s stock price falls, the easier it is for another company to buy up a majority of its shares. Specialist monitoring - Managers are subject to the scrutiny of specialists. Their actions are monitored by the security analysts who advise investors to buy, hold, or sell the company’s shares. Regulatory requirements - CEOs and financial managers have a legal duty to act responsibly and in the interests of investors. 18

Role of the Financial Manager (1) (2) (3) (4a) (4b) Real assets Investors Assets Firm’s Operations Cash raised from investors (how?) Cash invested in firm Cash generated by operations 4A. Cash reinvested in the firm 4B. Cash returned to investors 6 6 6 11 10 6

Most large companies have 3 top-level financial managers: The Financial Manager Most large companies have 3 top-level financial managers: Chief financial officer (CFO) Oversees the treasurer and controller. Responsible for setting the overall financial strategy of the firm. Treasurer Responsible for financing, cash management, and maintaining relationships with banks and other financial institutions. Controller Responsible for budgeting, accounting, and taxes. 3 3 3 4 3 3

Appendix: Careers in Finance