Semih Yildirim ADMS Chapter 1 The Firm and the Financial Manager Chapter Outline  Organizing a Business  Sole Proprietorships  Partnerships  Corporations  Hybrids: Limited Partnerships, LLP,LLC,PC  The Role of the Financial Manager  Who is the Financial Manager?  Goals of the Corporation

Semih Yildirim ADMS Organizing a Business 1. Sole Proprietorships  One individual starts a business with no partners or shareholders.  That individual bears all the costs, but also keeps all of the net profits.  Advantages: Ease of establishment and lack of regulation; it is well-suited to small companies.  Disadvantages: Unlimited liability – that individual is personally liable for all of the firm’s liabilities.

Semih Yildirim ADMS Organizing a Business 2. Partnerships  A business owned by two or more people who are called partners.  The partners share the business decisions, the costs, and the net profits as set out in the partnership agreement.  They pay personal income tax on their share of profits  Disadvantages: Unlimited liability – each partner is personally liable for all of the firm’s liabilities, not just his or her share.

Semih Yildirim ADMS Organizing a Business 3. Corporations  A business which is legally distinct from its owners, who are called shareholders (SH).  Advantages: Limited liability – the shareholders can lose only the amount they have invested in the company’s shares (stock).  Disadvantages: Double taxation – the government taxes corporate earnings and the dividends paid out of those earnings to the shareholders.

Semih Yildirim ADMS Organizing a Business One of the key features of a corporation is the separation of ownership and management. In proprietorships and partnerships, the owners are usually the managers. In a corporation, SHs own the firm, but they do not usually manage it. So, how is a corporation managed? The SHs elect a Board of Directors which appoints management. The Board is supposed to:  Represent the shareholders’ interests.  Ensure that management is running the firm in the shareholders’ best interests. Separation of ownership and management allows a corporation more flexibility and permanence than other types of business organization:  Managers may leave, or be replaced, but the firm continues.  A SH may buy/sell shares without affecting the operation of business.

Semih Yildirim ADMS Organizing a Business Corporations BOARDMANAGEMENT Elect CORPORATION Manages Profits Appoints SHAREHOLDERS

Semih Yildirim ADMS Organizing a Business

Semih Yildirim ADMS Organizing a Business Other Hybrid Forms of Organization  Limited partnership: Partners are classified as general or limited. Limited partners don’t manage the business closely but they have limited liability.  LLP: Limited liability partnerships, for professionals such as accountants or lawyers. The firm can meet losses using its assets and insurance policies  LLC: Limited liability corporation. A LLC provides protection from personal liabilities like a corporation and the tax advantages of a partnership.  PC :Professional corporation. The business has limited liability not the professionals.

Semih Yildirim ADMS The Role of the Financial Manager Financial managers are supposed to make financial decisions that serve SHs’ interests.  Firms need assets to generate income to provide profits for the shareholders.  These assets must be paid for.  The role of the financial manager is to determine: What operating assets to invest in – the capital budgeting decision. How to pay for those assets – the financing decision.

Semih Yildirim ADMS Role of the Financial Manager Capital Budgeting Decision  Successful financial managers purchase assets which generate cash flows greater than the cash needed to buy them. Boeing $3 BILLION CASH FLOW OUT 757 and 767 jets TO PURCHASE A PRODUCTIVE ASSET WHICH CREATES CASH FLOW IN $8 BILLION CASH FLOW IN By 1997

Semih Yildirim ADMS Role of the Financial Manager Capital Budgeting Decision  Unsuccessful financial managers purchase assets which generate cash flows less than the cash needed to buy them. Walt Disney $2 Billion CASH FLOW OUT Disneyland Paris TO CONSTRUCT THE THEME PARK LESS THAN $1.8 BILLION ON CASH FLOW IN

Semih Yildirim ADMS Role of the Financial Manager 1. Capital Budgeting Decision  The financial manager is concerned with: 1.The size of the future benefits which will be produced by the asset. The bigger, the better! 2.The timing of the future benefits which will be received. The sooner, the better! 3.The risks associated with realizing those future benefits. The greater the certainty that they will be realized, the better! 2. Financing Decision  Once the capital budgeting decision is made, the financial manager must determine how to pay for those assets.  The financial manager has two choices: Purchase the assets using the firm’s own funds, that is, by using internal financing. Purchase them using external financing, that is, by raising money from financial institutions or markets.

Semih Yildirim ADMS The Role of the Financial Manager (1) Cash raised from investors (financing decision) (1) (2) Cash invested in operating assets (capital budgeting decision) (2) (3) Cash generated by operations (3) Financial managers Firm's operations Financial markets (4b) Cash returned to investors (interest payments/dividends) (4b) (4a) Cash reinvested (retained earnings / internal financing) (4a)

Semih Yildirim ADMS Who is the Financial Manager? Chief Financial Officer TreasurerController Anyone responsible for the capital budgeting and/or the financing decision is known as a financial manager

Semih Yildirim ADMS Goals of the Corporation  BCE is a corporation with thousands of shareholders.  There is no way they could all be actively involved in running the company – there would be chaos!  Instead, shareholders delegate the task of operating the company to the firm’s managers.  However, such delegation can work only if the shareholders share a common objective.  How is that possible when the shareholders have different tastes, needs, time horizons, wealth and personal opportunities?

Semih Yildirim ADMS Goals of the Corporation Maximization of Market Value  Fortunately, there is a common financial objective on which most shareholders can agree: Maximization of the current market value of their investment. How does “Maximization of Market Value” work?  Increasing market value increases the wealth of the shareholders.  Each shareholder can then use that increased wealth for whatever purposes s/he wishes.  Successful financial managers make decisions which increase the current value of the company’s shares. Does this mean managers should do anything and everything to maximize market value?

Semih Yildirim ADMS Goals of the Corporation Agency Problems  Conflicts of interest between the firm’s owner-shareholders and its managers are known as agency problems.  Agency problems can be reduced in several ways: Tying the compensation of the manager to the success of the firm. Monitoring management behaviour. Threatening management with replacement if the firm is under performing.

Semih Yildirim ADMS The End