Emphasize that “business finance” is just another name for the “corporate finance” mentioned under the four basic types. Students often get confused by the terminology, especially when different terms are used to refer to the same thing.
Video Note: This video looks at the changing role of the Chief Financial Officer (CFO) at the Fortune 500 company, Abbot Laboratories.
Provide some examples of capital budgeting decisions, such as what product or service will the firm sell, should we replace old equipment with newer, more advanced equipment, etc. Be sure and define debt and equity. Provide some examples of working capital management, such as who should we sell to on credit, how much inventory should we carry, when should we pay our suppliers, etc.
www: Click on the “web surfer” for more information about sole proprietorships. If you click on the “--Sole Proprietorship” link, you will be taken to an index that will provide a link to information about husband and wife sole proprietorships.
www: Click on the “web surfer” for more information about partnerships. If you click on the “—Partnerships” link, you will go to an index that provides links to additional information about limited partnerships, partnership agreements and buy-sell agreements. Note that unlimited liability applies to all partners in a general partnership and only the general partners in a limited partnership Written agreements are essential due to the unlimited liability. Limited partners cannot be involved in the business or else they may be deemed as general partners.
www: Click on the “web surfer” to go to a page that discusses corporations. If you click on the “—Corporations” link it will take you back to an index that provides links to additional information on corporations as well as limited liability corporations. Discuss how separation of ownership and management can be both an advantage and a disadvantage: Advantages You can benefit from ownership in several different businesses (diversification) You can take advantage of the expertise of others (comparative advantage) Easier to transfer ownership Disadvantage Agency problems if management goals and owner goals are not aligned The instructors manual provides additional discussion of limited liability companies and S-corporations
Try and have the students discuss each of the goals above and the inherent problems of the first three goals: Maximize profit – Are we talking about long-run or short-run profits? Do we mean accounting profits or some measure of cash flow? Minimize costs – We can minimize costs today by not purchasing new equipment or delaying maintenance, but this may not be in the best interest of the firm or its owners. Maximize market share – This has been a strategy of many of the dot.com companies. They issued stock and then used it primarily for advertising to increase the number of “hits” to their web sites. Even though many of the companies have a huge market share (I.e. Amazon) they still do not have positive earnings and their owners are not happy. Maximize the current value of the company’s stock There is no short run vs. long run here. The stock price should incorporate expectations about the future of the company and consider the trade-off between short-run profits and long-run profits. The purpose of a for-profit business should be to make money for its owners. Maximizing the current stock price increases the wealth of the owners of the firm. This is analogous to maximizing owners’ equity for firms that do not have publicly traded stock. Non-profits can also follow the same principle, but their “owners” are the constituencies that they were created to help. The instructors manual provides a letter to stockholders that was written by former Coca-Cola CEO Roberto Goizueta. There is also a brief discussion of an article that appeared in Fortune magazine that discusses Coke vs. Pepsi and their different philosophies on business in the early 1990’s. Ethics Note: See the instructor’s manual for a discussion of Dow-Corning, silicone breast implants and the ethics involved with pursuing owners’ wealth at all costs.
Video Note: This video focuses on how one company handled the tough decision to cut jobs and managed to successfully increase shareholder value. It features ABT Co. in Canada. A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyers agent and a sellers agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyers price range. Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the sensor razor. Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs. Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.
Incentives – discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forego projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive.
Corporate control – ask the students why the threat of a takeover might make managers work towards the goals of stockholders. Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interest.
AD 311 Business Finance
Lect 1: Introduction to
(ref. Ch 1)
Know the basic types of financial
management decisions and the role of the
Know the financial implications of the
different forms of business organization
Know the goal of financial management
Understand the conflicts of interest that
can arise between owners and managers
Understand the various types of financial
Some important questions that are
answered using finance
What long-term investments should the
firm take on?
Where will we get the long-term
financing to pay for the investment?
How will we manage the everyday
financial activities of the firm?
Financial managers try to answer some or
all of these questions
The top financial manager within a firm is
usually the Chief Financial Officer (CFO)
Treasurer – oversees cash management,
credit management, capital expenditures and
Controller – oversees taxes, cost accounting,
financial accounting and data processing
Financial Management Decisions
What long-term investments or projects
should the business take on?
How should we pay for our assets?
Should we use debt or equity?
Working capital management
How do we manage the day-to-day
finances of the firm?
Forms of Business Organization
Three major forms in the United
Limited liability company29/01/15 6
A business form for which there is one owner.
This single owner has unlimited liability for all
debts of the firm.
Oldest form of business organization.
Business incomeBusiness income is accounted for on your
personalpersonal income tax formincome tax form.
Easiest to start
Single owner keeps
all the profits
Taxed once as
Limited to life of
limited to owner’s
Difficult to sell
A business form in which two or more individuals
act as owners.
Business incomeBusiness income is accounted for on each
partner’s personalpersonal income tax formincome tax form.
General PartnershipGeneral Partnership -- all partners have unlimited
liability and are liable for all obligations of the
Limited PartnershipLimited Partnership -- limited partners have liability
limited to their capital contribution (investors only). At
least one general partner is required and all general
partners have unlimited liability.
Two or more
Relatively easy to
Income taxed once
as personal income
dissolves when one
partner dies or
wishes to sell
Difficult to transfer
A business form that legally separate from
An artificial entity that can own assets and
Business incomeBusiness income is accounted for on the
income tax form of the corporationincome tax form of the corporation.
Separation of ownership and management
ownership is easy
Easier to raise
(income taxed at
the corporate rate
and then dividends
taxed at the
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Goal Of Financial Management
What should be the goal of a
Maximize sales or market share?
Maintain steady growth?
Maximize the current value of the
Shortcomings of Alternative
Minimize costs – We can minimize
costs today by not purchasing new
equipment or delaying maintenance,
but this may not be in the best
interest of the firm or its owners...
Shortcomings of Alternative
Profit maximizing: Maximizing a firm’s
earnings after taxes.
Long-term or short-term?
Do we mean accounting profits or some measure of
Could increase current profits while harming firm (e.g.,
Shortcomings of Alternative
Maximize market share – This has
been a strategy of many of the
dot.com companies. They issued
stock and then used it primarily for
advertising to increase the number of
“hits” to their web sites. Many firms
failed to translate those ‘hits’ to
money to pay the expenses etc...
From a stockholder perspective, the purpose of
a for-profit business should be to make money
for its owners. How? Maximizing the current
stock price increases the wealth of the owners of
The more general goal is: Maximize the current
value of the owner’s equity.
There is no short run vs. long run here. The stock
price should incorporate expectations about the future
of the company and consider the trade-off between
short-run profits and long-run profits.
Maximization of Shareholder Wealth!
Do not forget that if stockholders win
(residual owners), it must be true that
everyone else is winning also.
This goal does not imply that the financial
manager should take illegal or unethical
actions in the hope of increasing the value
of the equity.
The Agency Problem
Principal hires an agent to represent his/her interests
Stockholders (principals) hire managers (agents) to run the
Conflict of interest between principal and agent
Management goals and agency costs
Direct costs: unneeded expenses for management,
monitoring costs (auditors)
Indirect costs: sub optimal decisions, lost oppotunities
• Incentives can be used to align management
and stockholder interests
• The incentives need to be structured carefully
to make sure that they achieve their goal
Incentives include, stock optionsstock options,, perquisitesperquisites,,
Control of the firm rests with stockholders.
They elect the board of directors, who in turn
hire and fire managers.
Ways of replacing managers:
Stakeholders (customers, suppliers,
government) sometmes may attempt to
exercise cotrol on the firm as well.
Businesses interact continually with the financialfinancial
Financial MarketsFinancial Markets are composed of all
institutions and procedures for bringing buyers
and sellers of financial instruments together.
The purpose of financial markets is to efficiently
allocate savings to ultimate users.
Financial markets and the corporation
What are some types of Markets?
A market is a method of exchanging one asset
(usually cash) for another asset.
Physical assets vs. financial assets
Debt and equity securities are bought and sold
Financial markets differ in detail:
Type of securities traded: debt, equity, derivatives, ...
How trading is conducted? outcry auction, electronic
Who the buyers and sellers are?
Primary versus Secondary Markets
Financial markets function as both primary
and secondary markets.
Primary market: original sales of securities by
corporations (or governments).
The transaction raises money for the corporation.
Secondary markets: securities are bought and
sold after the original sale.
The transaction does not raise money for the
How are secondary markets organized?
By the way that orders from buyers and sellers
An auction market has a physical location like
Wall Street or Istanbul Stock Exchange (ISE).
Buyers and sellers are matched directly.
Dealers buy and sell for themselves, at their own
Like car dealers; opposite of real-estate agents.
Most dealer markets are called over-the-counter
NYSE and AMEX are the two largest
auction markets for stocks.
NYSE is a modified auction, with a
Specialist is a market maker.
Dealers buy and sell for themselves, at
their own risk.
Dealers are connected electronically.
Computerized quotation system keeps
track of bid and ask prices, but does not
automatically match buyers and sellers.
NASDAQ: National Association of
Securities Dealers Automated Quotation