Chapter 1A Financial Model of the CorporationGey Imag.docx

Chapter 1
A Financial Model of the Corporation
Ge�y Images News/Ge�y Images
Learning Objectives
A�er studying this chapter, you should be able to:
Understand the importance of corporate finance in professional
and everyday life.
Iden�fy how products, bonds, stock, and people factor into the
opera�on of corpora�ons.
Describe the financial balance sheet, and understand its
significance to corporate ac�vity and decision making.
Explain the financial goal of the corpora�on and how it is
achieved.
Describe how informa�on asymmetry and the agency problem
pose challenges to corpora�ons.
Compare other forms of business organiza�on with
corpora�ons, and describe the benefits and drawback of
each.
Ch. 1 Introduction
Chapter 1 is an overview of corporate finance and
provides you with important building blocks for the rest
of your study of finance. The first sec�on of the chapter
describes

why finance is an important part of your business
educa�on and why the corpora�on was chosen as the
vehicle for studying finance. Next, some important features
of
corporate products, bonds, and stocks are discussed, along
with characteris�cs of the people whose ac�ons affect
corpora�ons. A model of the corpora�on, called the
financial balance sheet, is presented in the third sec�on
of the chapter. This model is the centerpiece of Chapter 1
and is designed to assist you in visualizing the financial
concepts and decisions that you will study throughout this
book. The fourth sec�on covers the financial goal of the
corpora�on—shareholder wealth maximiza�on. Some of
the problems encountered by corpora�ons in a�aining this
goal and the effec�veness of corpora�ons as a means of
crea�ng wealth are also covered in this sec�on of the
chapter. The influence of society, markets, and government
on corpora�ons' ac�vi�es are introduced in the
concluding sec�on of the chapter.
Throughout the book are exercises and features to help
the readers understand the key concepts of managerial
finance. These include:
In Focus Videos. These short videos are at the start of each
chapter and cover some of the main points in each chapter,
specifically focusing on the Financial Balance
Sheet.
Field Trips. Found throughout the book, these feature boxes
have web links to give students a chance to visit related sites to
help exemplify concepts and ideas.
Applying Finance. Found throughout the book, these feature
boxes provide exercises for students to prac�ce key skills
related to managerial finance.
PowerPoint® Slideshows. Found near the end of chapters, these
features help students review key topics covered.

Pre and Post Tests. These non-graded self-assessment quizzes
are to help students review what points they know and what
they need more work on.
Cri�cal thinking ques�ons that guide readers in their analysis
of topics explored in the chapters.
Key terms lists that define the key terms discussed in each
chapter. Click on any term in the book's Key Terms sec�on to
see the defini�on.
Web resources that present readers with addi�onal resources
that expand on topics discussed in the chapters.
Financial management involves planning, forecas�ng,
analysis and
evalua�on, as well as understanding legal and regulatory
issues. Throughout
this text, we will explore the crucial role financial
managers play in
achieving a firm's financial success.
Finance plays a pivotal role in many
aspects of life. How do you think an
educa�on in corporate finance will benefit
the choices you make in your personal
life?
Radius/SuperStock
1.1 Why Corporate Finance?
Soon you may be deciding whether to rent or buy a home
and whether to invest your savings in the stock market or
cer�ficates of
deposit. You may be choosing what type and amount of

life insurance coverage you should purchase to protect
your family. At work
you may find that making a sale depends on your ability
to show that your product is a cost-effec�ve investment
for your customer.
You may be asked to structure a contract that ensures
that all par�es to the agreement are properly compensated
and mo�vated.
Key elements of all these decisions are financial in
nature.
The skills and intui�on you will be developing through
your study of finance are cri�cal for making decisions
throughout your life. Our
aim in this textbook is to enhance your financial
reasoning ability.
Much of finance may already be familiar to you. The
theories, tools, and concepts covered in this text will
simply add a coherent
structure to the intui�on you have developed through
experience. From your day-to-day ac�vi�es as a consumer,
employee, and
student, you possess a large part of the intui�on upon
which financial theory is based.
Developing financial intui�on by understanding the
underlying theory will give you a founda�on for dealing
with many problems. The
alterna�ve is memorizing specific facts that can become
obsolete or will not prepare you for a rapidly changing
financial environment.
For example, in the 1980s, adjustable rate mortgages and
money market accounts were new financial products, and
in the 1990s,
mortgage-backed securi�es, hedge funds, and exchange

traded funds either didn't exist or were brand new.
Developing intui�on and
understanding the underlying economic theory of finance
gives you the flexibility to deal with new, unusual
problems as they emerge.
As a vehicle for learning the principles of finance, this
text focuses on the corpora�on. Other choices were
available. Examples are
public finance, which studies how governments raise and
disburse funds, and personal finance, which concentrates
on individual
financial decisions like shopping for life insurance and
personal inves�ng. Corporate finance was chosen for
several reasons. First,
many of you will be, or currently are, working for
corpora�ons. Understanding key financial considera�ons in
corporate decision
making will aid in advancing your career regardless of
your posi�on. Second, as an individual, you will be
making personal investment
decisions. Corporate securi�es, such as stocks and bonds,
make up a large propor�on of the investment
opportuni�es you will have. And last, the same financial
approach to
problems used in corporate finance is also properly used
to make personal, partnership, or public financial
decisions. In effect, you are ge�ng the most "bang for
your buck"
by studying corporate finance.
Role of Financial Management

The classic logo of McDonald's is easily recognizable even
in a
remote region of China. McDonald's reputa�on is so
renowned that
it is popular throughout the world.
Imaginechina/Associated Press
1.2 Corporations: Products, Bonds, Stocks, and People
This book focuses on corpora�ons. Corpora�ons are
associated with the products they produce and the
securi�es they issue. For example, we know that Pepsi
produces so�
drinks and Boeing manufactures airplanes. The stocks and
bonds of these firms are discussed on a daily basis in the
media and are closely followed by a large segment of the
popula�on.
The goods and services produced by corpora�ons are
almost endless in their diversity. Each corpora�on
a�empts to match its exper�se with consumers' needs in
order to
produce successful products. Thus, ConAgra Foods
processes and sells a variety of agricultural products.
General Electric makes and sells refrigerators, radios, and
aircra�
engines. Yamaha sells motorcycles as well as pianos.
Some�mes a corpora�on's primary products are not what
they may first appear to be. McDonald's sells hamburgers,
but
they also sell uniform quality and service. Why has
McDonald's been successful? Is it because their
hamburgers are superior or because consumers know what

to expect
when they enter any McDonald's? McDonald's, we could
argue, is successful not because they perceived a need for
more hamburgers, but because they sa�sfy a need for a
fast, affordable, uniform hamburger, consistently delivered
in a clean environment.
Good product decisions are rewarding. Consumers benefit
as their needs and wants are met. Employees are
rewarded with con�nued employment and job security.
Communi�es in which the corpora�on is located
benefit from a strong economic base. Investors who hold
corporate securi�es are also rewarded. Stocks and
bonds represent the overwhelming majority of these
securi�es. The money made by corpora�ons is distributed
to owners of these securi�es, the stockholders and
bondholders, providing them with returns on their holdings.
Bonds represent loans made by investors to the
corpora�on. Thus, bonds are a form of corporate debt.
The
firm is obligated to pay its bondholders a fixed series of
payments un�l the bonds mature. These payments,
generally made semiannually, are called coupon payments.
At maturity, the corpora�on must repay the
bondholder the face amount, or par value, of the bond,
usually $1,000. For example, a bond may have a
$1,000 face value and a 6% annual coupon rate, make
payments semiannually, and mature in 20 years. This
bond represents the corpora�on's promise to pay the
bondholder 40 coupon payments (one every 6 months)
of $30 each. At the end of the 20-year period, the bond
matures and is returned to the issuing corpora�on.
The corpora�on then repays the $1,000 face value along
with the last $30 coupon. Note that although we are
highligh�ng bonds, one should not forget that other forms

of borrowing are also available to the corpora�on,
such as loans from banks. The ability of the corpora�on
to meet these obliga�ons hinges on its success in
making and selling products or services.
Corporate common stock represents an equity or ownership
interest in the firm. If a corpora�on has 100
shares of common stock outstanding, then an owner of 1
share owns 1% of that corpora�on, and one holding 10
shares of this stock owns 10% of the corpora�on.
Stockholders receive payments from the corpora�on in the
form of dividends, usually paid quarterly. Dividends, unlike
coupon interest payments on bonds, are not fixed.
Dividends may be raised, lowered, or not paid at all at
the discre�on of the corpora�on. Amazon is a large and
well-known corpora�on that has never paid a dividend.
General Motors paid dividends since 1922, but suspended
its dividend payment in 2008.
As owners, common stockholders elect a board of directors.
Each share of common stock en�tles its holder to vote
for directors at the corpora�on's annual shareholders'
mee�ng. Because most shareholders of large corpora�ons
do not a�end these annual mee�ngs, most vote through
the proxy process, similar to the absentee-ballot system
used in governmental elec�ons. The board of directors
governs the corpora�on on behalf of the shareholders,
determining the dividends to be paid that year, hiring and
firing top management, approving corporate strategic
decisions, and making compensa�on decisions.
Corporate finance is, in large part, the study of the
interac�on between products, stocks, bonds, and the people
who make decisions affec�ng them. Microso� Corpora�on
is
an excellent example of this interplay. Microso�'s

Windows program is pervasive, and millions of investors
own shares of the corpora�on's stock. Bill Gates provided
the
entrepreneurial vision for the company and is now a face
as recognizable as the president's.
Finance, therefore, includes the study of investors,
managers, corporate directors, consumers, and corporate
employees. One assump�on underlying finance is that
people act
in their own self-interest. This is considered to be
economically ra�onal behavior. It does not pretend to
explain the complexity of human behavior, but it does
allow us to
explain how people are likely to behave when making
financial decisions and market transac�ons. They buy
stocks and bonds to increase their wealth. People work to
make
a living; some people desire power and pres�ge. People
make product purchases to fulfill needs and desires. Some
may boyco�, strike, vote, or pe��on because they
perceive injus�ce. In corporate finance, it is important to
recognize that the self-interest of individuals mo�vates
their ac�ons.
People also are assumed to act ra�onally. Ra�onality
means that people will, by and large, make the correct
decisions that lead toward fulfilling their self-interest.
Departures
from ra�onality are eventually corrected by the
compe��ve marketplace. Compe��on exists when many
individuals are seeking to achieve the same personal goals
(in
finance, that goal would be increasing wealth). For
example, we seldom see money lying on the sidewalk,
although it is occasionally dropped. The reason is that

many people
are interested in increasing their wealth, and the ra�onal
thing to do is to pick up the money!
The le�-hand side of the financial balance sheet deals
with investments made by the corpora�on, including
tangible and intangible assets.
1.3 The Financial Balance Sheet
The authors of this text have a�empted to make it
interes�ng and useful to you. We have also tried to make
your job easier. Whenever possible, we illustrate key
concepts
and theories with easily understood examples. Further,
these concepts and theories are put into context throughout
the text so you be�er understand why the topic is
important and where it fits into the discipline of corporate
finance. To achieve a coherent structure, we have
incorporated a visual financial model of the firm, which
we call
the financial balance sheet. This tool will be used
throughout the text to introduce and link topics as we
study corporate finance.
You are already familiar with the balance sheet that
accountants use to report the status of a firm in its
annual report. The financial balance sheet (FBS) is a
conceptual
counterpart to the accoun�ng balance sheet. The FBS is a
model of the corpora�on that serves several purposes. It
is useful for visualizing the financial func�ons of the
firm
and its objec�ves. Theories and concepts can be

introduced using the FBS—thereby maintaining a coherent
structure throughout the book. Its use helps answer
ques�ons
such as, why are we studying this? Also, because it is
similar to an accoun�ng balance sheet, accoun�ng and
financial decision making can be contrasted and clarified.
The Left-Hand Side of the Financial Balance Sheet
Let's begin by describing a simple financial balance sheet
and contras�ng it with its accoun�ng counterpart. As
Figure 1.1 demonstrates, the le�-hand side (LHS) of the
financial balance sheet contains the investments made by
the firm (as opposed to assets listed in an accoun�ng
balance sheet). It is important to note that LHS accounts
are
investments—that is, they reflect carefully considered
decisions, which, as the term investments implies, should
produce some payoff for the corpora�on. As a simple
example, consider the cash account. The level of cash
does not happen by accident—the cash is there to help
produce more cash. A fast-food restaurant that begins each
day
with only $10 in the cash register has not made an
op�mal investment in cash. It will surely lose some
customers because the restaurant cannot make proper
change. At the
other extreme, if each day is begun with $10,000 in the
cash register, the restaurant has overinvested in cash. The
excess funds could be be�er u�lized by paying off a
loan,
thus saving interest expense (or worse, the restaurant
could be robbed). For the fast-food restaurant, the same
logic applies to other investment accounts. Too high an
inventory of hamburger buns would result in unused and
stale bread; too low an inventory would result in lost

sales. Too large an investment in furniture and fixtures is
wasted money (i.e., too much sea�ng capacity), whereas
too low an investment might lead to lost sales
(insufficient sea�ng capacity).
Figure 1.1: Le�-hand side of the financial balance sheet
The le�-hand side of the financial balance sheet includes
all the accounts appearing on the accoun�ng statement
(cash, inventory, furniture and fixtures, property, plant,
etc.)
because these are all investments. It is useful, however, to
categorize investments into two types: tangible and
intangible assets. Tangible assets include those things you
can
touch—bricks and mortar as the saying goes. Most of the
assets associated with the accoun�ng balance sheet are of
this type. Intangible assets include patents and
copyrights but go well beyond that. This category includes
investments that are o�en just as important to the firm as
the more obvious investments in factories and
inventory.
Assets and Expenditures
Tangible (fixed) vs. intangible (nonphysical) are two
aspects of
understanding assets. Three elements of costs involving
assets are capital
and revenue, expenditures, and deprecia�on. What
examples of intangible
assets can you think of? Why should a financial manager
know how to

recognize these different assets?
The right-hand side of the financial balance sheet deals
with sources of financing, including fixed and residual
claims.
One of the most important intangible assets is human
resources. Investment in this asset can produce excellent
returns. Recrui�ng and training programs are costly, but
the
payoffs, in the form of employee produc�vity, loyalty,
and the quality service provided to customers, may make
such investments worthwhile. Other intangibles that create
value for the corpora�on may include establishing the
firm's reputa�on for product quality, ethical behavior,
community involvement, environmental stewardship, research
and development, and establishing brand recogni�on.
Both tangible and intangible investments require an outlay
of cash that is expected to produce future cash inflows. If
the cash outlay is a good financial decision, the cash
flows received should have value greater than the ini�al
cost of the investment. Therefore, the corpora�on strives
to invest in tangible assets, like factories, and intangible
assets, like employee training, whose value to the business
is greater than their cost.
The Right-Hand Side of the Financial Balance Sheet
The right-hand side (RHS) of the financial balance sheet
reflects the firm's sources of financing. As shown in
Figure 1.2, the RHS records the sources of cash that
finance the
investments reflected on the LHS. The �tle "Sources of
Financing" contrasts with the "Liabili�es and Owner's

Equity" �tle commonly used on the tradi�onal accoun�ng
balance sheet. A second difference between the two
statements is that the financial balance sheet accounts are
divided into two types of claims: residual claims and fixed
claims. Each of these types of accounts has a claim on
the cash flows generated by the corpora�on's investments.
These cash flows may be generated via the normal cycle
of
producing and selling products and services. Cash may
also be generated through the sale of the en�re firm (as
might occur in the case of a liquida�on or a takeover) or
through the sale of a division of the corpora�on. When
these cash flows are generated, by whatever means, their
distribu�on is dependent on the type of claim held by the
supplier of financial resources.
Figure 1.2: Right-hand side of the financial balance sheet
Fixed claims receive a contracted or fixed amount of
cash. If fixed claimants (e.g., bondholders or employees)
receive less than this amount, they have legal recourse to
force
the firm to meet these fixed obliga�ons. Bank loans and
bonds are two examples of fixed claims. Both require
contractually specified payments of interest and principal.
If
these payments are not made in a �mely manner, the
bank or bondholder may seek full payment through the
legal system. In this case, the corpora�on that has not
met its
obliga�ons is in default on its payments and may be
forced into bankruptcy. Bankruptcy can lead to reorganizing
the firm and even liquida�ng (selling off) its assets in
order
repay its fixed claims.

Suppliers of inventory to the corpora�on may also help
finance the firm by not demanding immediate payment for
the goods they have delivered. The firm, therefore, has
made an investment in inventory that, for a period of
�me, the supplier is financing. The claim that reflects
this financing is an account payable. If the account is not
fully
paid on �me, then the supplier can legally seek
repayment. Similarly, workers supply financing to the firm
in the form of wages payable. It's no accident, for
instance, that
some organiza�ons pay their employees on a weekly
basis, while other firms pay biweekly or monthly. The
employees' labor may be invested in finished goods
inventory,
while financing for that labor is being supplied by the
workers themselves for a period of a week, two weeks, or
a month, depending on the firm's payroll policy. In order
not
to help finance the firm, employees would need to be
paid at the end of each day. Again, if employees are not
paid on a �mely basis, they may sue the firm for their
wages.
Cash generated by investments occurs on the le�-hand
side of the financial balance sheet, while capital used
to pay for those investments occurs on the right-hand
side.
Corpora�ons in default must declare bankruptcy and
liquidate their
inventory in order to pay back the money owed. Are there
any

other op�ons companies might employ to repay their fixed
claims?
ZUMA Press/Corbis
Besides legal recourse for payment, a dis�nguishing
characteris�c of fixed claims is that, if the firm is
extraordinarily profitable in any period, the fixed claimants
receive no more than the amount they are owed.
For example, when a business has a good year, no bank
expects the firm to repay more than the amount of
the loan and accrued interest. Fixed claims, therefore,
have legal protec�on against losses but do not share in
profits. The amount of a fixed claim is limited to the
amount of the loan or the value of the resources provided
to the firm.
Even with legal protec�on, fixed claimants s�ll are
exposed to the risk of loss. There is no guarantee that
normal business or even a forced liquida�on of a firm
will generate enough cash to sa�sfy all of the fixed
claims. Fixed claim investors assess the likelihood of loss
when arranging the terms of loans to the corpora�on.
This brings us to residual claims, best represented by
common stock. Residual claims, as the name implies, are
those that common stockholders have on cash flows that
are le� over once fixed claims are paid. If, in any
year, a corpora�on generates cash in excess of that
required to pay fixed-claim obliga�ons, then that residual
cash belongs to the firm's common stockholders—the
residual claimholders. These cash flows may be
distributed in the form of dividends or retained by the
company to help it grow and thereby increase the value
of the stockholders' ownership stakes. The poten�al size

of these residual cash flows is unlimited.
Unlike bills to suppliers, wages to employees, or other
fixed claims, dividends to shareholders are not mandatory
or contractual. Every year the board of directors decides
whether to issue dividends and how large they should be.
This is en�rely a discre�onary decision on the part of
the board of directors. Fixed claims, therefore, take
priority
over residual claims when cash flows are distributed.
Residual claims, with their greater upside poten�al returns,
must also bear a greater risk of losses because of their
lower priority.
Figure 1.3: Interac�on between the right- and le�-hand sides of
the financial
balance sheet
At this point, we have modeled the corpora�on's basic
func�ons. Capital is supplied to the firm, crea�ng claims
on the firm's future cash flows. These claims are
conceptually
recorded on the RHS of the financial balance sheet. The
corpora�on uses this capital to make investments that will
generate cash flows in the future from the sale of goods
and services. These investments are shown on the LHS of
the financial balance sheet, and the cash flows they
generate will be distributed to claimants who have
supplied
capital to the corpora�on or may be reinvested in the
company. This interac�on between the LHS and RHS of
the financial balance sheet is captured in Figure 1.3.
The Financial Balance Sheet Versus the Accounting Balance
Sheet

We must pause to highlight three features of finance that
differ from accoun�ng. First, finance focuses on cash flow,
while accoun�ng focuses on profit or net income. You
should remember that accoun�ng net income includes
deduc�ons that involve no outlay of cash— deprecia�on
being the classic example. A corpora�on, therefore, may
have
an accoun�ng loss in a year (nega�ve net income), yet
the firm may have generated enough cash flow to meet its
fixed claims and, perhaps, even make cash distribu�ons to
its residual claimants. Thus, we focus on cash in finance
because ul�mately only cash can pay the bills or be
invested.
A second dis�nguishing feature is that accountants record
the historical cost of assets on the LHS and the historical
amount of capital contributed in the RHS accounts. In
finance,we are more concerned with the current value of
these accounts. An example illustrates why. Consider a
firm that invested in undeveloped real estate in downtown
Houston in 1950. If the property cost $10,000 in 1950, it
would appear on the LHS of 2012's accoun�ng balance
sheet at its original cost of $10,000. What is its true
value?
The current value might be $1,000,000. Which figure is
relevant for decision-making purposes? The opposite
some�mes holds true as well: A manufacturer may have
an
inventory of stereos with CD players in which it
historically invested $1,000,000, but today stereos with
docking sta�ons dominate the market. What is the current
value of
these CD stereos—more than the original $1,000,000
investment or less? Again, which number is relevant?

The third point we want to make is that an accoun�ng
balance sheet is readily available for all to see, whereas
the financial balance sheet is a conceptual construct—you
won't find it printed in an annual report. Sharp managers
and financial analysts, however, have a clear mental
picture of the FBS and understand how decisions will
affect its
accounts. The development of that same mental picture
and intui�on is one of the objec�ves of this book.
Understanding the interac�on of the three methods of
capital acquisi�on is important to financial managers.
Table 1.1 summarizes these three differences between
accoun�ng and finance.
Table 1.1: Accoun�ng statements versus the financial
balance sheet
Accoun�ng statements Financial balance sheet
Records net income, profits, earnings Records cash flows.
Records assets at their historical cost and claims at the
historical amount contributed.
Records the current value of LHS investments made by
the firm and the current RHS claims.
Reported in audited financial statements. Not observable;
its condi�on is determined by analysis. Accoun�ng
statements act as clues/evidence
of the true financial condi�on of the corpora�on.

Representing Acquisition of Capital on the Financial Balance
Sheet
Let us return to the financial balance sheet. The
corpora�on's investments, reflected on the LHS of the
financial balance sheet, are financed via three methods:
trade credit,
sale of securi�es (including loans), and retained residual
cash flows.
The first method is spontaneously generated loans or trade
credit such as payables to suppliers or employees, and
taxes payable. The firm has LHS investments, such as
inventory, a por�on of whose costs are borne for a
period by suppliers who do not demand immediate
payment. These types of fixed claims held by suppliers
are usually
short term. They are spontaneous because the firm does
not have to seek approval for such loans formally each
�me the credit is granted.
The second method of raising cash is issuing and selling
securi�es to individuals and ins�tu�ons. Firms are able
to a�ract this capital because LHS investments are
expected
to yield returns that are equally or more a�rac�ve than
alterna�ve investment opportuni�es available to these
suppliers of capital. Such securi�es may represent fixed
claims
on cash flows, such as bonds and bank loans, or common
stock that represents a residual claim.
Notes payable are short-term fixed claims, term loans are
usually intermediate term, and bonds generally are long
term. Common stock is a perpetual claim because it might
never be repaid by the corpora�on.

Once issued and sold, the corpora�on's outstanding
securi�es, par�cularly its stock and long-term bonds, are
ac�vely traded among individual and ins�tu�onal
investors.
Such trading produces changes in the prices of the firm's
outstanding securi�es, reflec�ng either changes in the
a�rac�veness of compe�ng investments or changes in
investors' expecta�ons of the returns the firm's
investments will generate, or a combina�on of both
factors. This secondary trading of securi�es produces no
addi�onal
capital for the firm, but it reflects the traders' refined
opinions of the firm's value and so acts as a measure of
how investors regard the corpora�on's future prospects.
The final method for acquiring capital is through the
reten�on of residual cash flows. These cash flows belong
to the stockholders, but the firm may choose not to pay
out all
of this cash as dividends, deciding instead to retain the
cash and reinvest it in promising LHS projects.
Figure 1.4 shows the interac�on of the methods of capital
acquisi�on in the context of the financial balance sheet.
Figure 1.4: Three methods of capital acquisi�on
It is helpful to view the corpora�on as a conduit that
acquires capital from individual and ins�tu�onal investors
and invests this capital in promising projects on behalf of
these claimants. Subsequent buying and selling of the
corpora�on's securi�es produces changes in the prices of
these claims.

These price changes produce no capital for the firm;
nonetheless, they play an important role in corporate
finances. Price changes reflect claimants' ongoing judgment
regarding the a�rac�veness of the LHS investments, the
value of which underlies the prices of the RHS claims.
The prices of the firm's securi�es act as on-going "report
cards" on the effec�veness of the corpora�on's decision
making and management. Increases in the prices of traded
claims provide claimants with increases in wealth. Price
apprecia�on, along with payments received directly from
the corpora�on (i.e. dividends and interest), provides
investors with a return on their investment in corporate
securi�es.
Two types of managerial decisions correspond to the le�-
hand side and right-hand side of the financial
balance sheet: what investments to make, and how they
should be financed.
The details of corporate governance are complex.
Understanding the interac�on between management and
the board of directors is essen�al.
1.4 The Financial Goal of the Corporation
The financial balance sheet models the corpora�on's
financial ac�vi�es. In this sec�on, these ac�vi�es are
linked to management's goal. Because managers direct the
corpora�on, they must have a clear understanding of the
corporate goal. They must understand for whom they work
and what their job is if they are to be effec�ve.

Management's Job
Managers make two types of important financial decisions
(see Figure 1.5). First, managers choose which investments
the firm makes (LHS decisions). Second, managers
choose the sources of capital used to finance these
investments (RHS decisions). What should managers'
objec�ves be as they make these decisions?
Figure 1.5: Managerial decisions and the financial balance sheet
To help us answer this ques�on, recall that a
corpora�on's management team operates the company on
behalf of its owners, the stockholders. Stockholders invest
their
money and accept the risk of being a residual claimant
because they hope the value of their investment will
grow; that is, shareholders invest to increase their wealth.
Therefore, as employees of the stockholders, managers
must make decisions that they expect will increase
shareholder wealth. Figure 1.6 illustrates the basic control
mechanisms and rights that fixed and residual claimants
have in the corporate structure. This system of control is
known as corporate governance. Note that fixed claimants
are protected by law. If they are not paid as promised,
these claimants can sue the corpora�on for the money
that they are owed. Residual claimants have no such
rights.
The protec�on for residual claimants is their ownership,
which enables them to elect the board of directors who
may, for example, fire management if such ac�on is
judged
to be in the shareholders' best interest.

Figure 1.6: Corporate governance
The job of managers, as employees of the stockholders, is
to maximize the wealth of these residual claimants. If the
cash generated by produc�ve LHS investments is to be
large enough to flow to residual claims, there must also
be more than enough cash to sa�sfy the fixed claims.
Therefore, maximizing shareholder wealth will generally be
in
the interest of fixed claimants as well.
Some people interpret maximizing shareholder wealth to
mean that corporate managers should use every possible
method to shi� wealth from suppliers and lenders and
employees to shareholders, but this is not true. The goal
of managers of the corpora�on should be the
maximiza�on of long-term shareholder wealth or long-term
firm
value. "Long-term" is important, because corporate
managers cannot use decei�ul means over an extended
period of �me to take advantage of stakeholders' trust. To
do so
would ruin those rela�onships. The company (and thereby
shareholders) would suffer because the terms of trade or
the rela�onships with stakeholders would change, as
stakeholders protected themselves from being exploited by
corporate managers. The no�on that corporate managers
must behave fairly with all stakeholders does not imply
that they have to be more generous than is necessary. It
implies fair dealing and maintaining honest, open
rela�onships with stakeholders.
Creating Wealth

Managers can meet their objec�ve of maximizing
shareholder wealth by making investments (on the LHS)
whose value is greater than the amount of capital u�lized
(from
the RHS) to finance these investments. Therefore,
managers must have the ability to assess the value of
poten�al LHS investments and to make the lowest cost
RHS capital-
acquisi�on decision.
Let's illustrate wealth crea�on with a very simple
example. Consider a firm that has the opportunity to
invest in a single project whose value is greater than its
cost. At the
end of this project, the firm will be liquidated, and all
cash will be distributed to the claimants. Management
correctly iden�fies the a�rac�ve project and finds sources
of
capital to finance the cost of the project. The investment
is made and almost instantly generates the expected cash
flows. Because the value of the investment is greater
than its cost, the cash flows more than cover the amount
necessary to repay all of both the fixed claims and
residual claims used to finance the project. Because the
project
has more value than cost, there are funds le� over once
all claims are repaid. These addi�onal funds accrue to the
residual claimants. These le�over or residual cash flows,
therefore, increase stockholders' wealth beyond that
originally contributed to finance the project.
If this project's payoff was certain, investors had full
access to all informa�on regarding the project, and the
payoff was almost immediate, then shareholder wealth
would

increase as soon as the investment in the project was
made—even before the cash flows were distributed. Recall
that stock, once issued and sold by the corpora�on, is
traded among individuals. These investors set the price of
the stock based on their beliefs regarding the security's
a�rac�veness. If they knew, with certainty, the stock for
which they paid $50 a share would soon distribute $54 a
share, what would be the value of that stock to the
investors? Clearly, the price of the stock would
immediately
increase to very near $54 per share. Thus, when the
company's managers make decisions that maximize the
wealth of residual claimants, they also maximize the price
of the
company's common stock. The A Three-Minute Corpora�on
Illustra�ng the Wealth-Building Process feature outlines
the progression of wealth-building for this example
project.
A Three-Minute Corpora�on Illustra�ng the Wealth-Building
Process
Minute 0 A project is iden�fied requiring a $100
investment by the firm.
The project will produce $105 in cash flows 1 minute
a�er the firm makes its investment.
Minute 1 Sources of capital are iden�fied:
A 1-minut e loan of $50 bearing an interest rate of
$1/minute can be obtained.
Stock can be sold for $50.
Minute 2 $100 of capital is raised from the two sources.

The $100 investment in the project is made by the firm.
Minute 3 The project generates the $105 cash flow.
The fixed claim of $51 (the 1-minute loan) is paid in
full: $50 principal and $1 interest.
The residual cash flow of $54 is paid to stockholders,
increasing their wealth by $4.
The Three-Minute Corpora�on example is greatly
simplified, and we will take the rest of the book to fully
develop your understanding of wealth crea�on through
corporate
decision making. You must learn how the value of an
investment project depends not only on the size of the
cash flows that it is expected to generate (as in our
preceding
example), but also on the degree of confidence claimants
have that those cash flows will be achieved. In other
words, value also depends on the risk associated with the
investment. Another factor that must be considered when
es�ma�ng value is the �ming of the cash flows that an
investment generates. Claimants prefer to receive cash
flows earlier rather than later. The longer claimants wait
for a given payoff, the less valuable that payoff is to
them, all else being the same. Last, the value of a
par�cular
investment also depends on how a�rac�ve that investment
is vis-à-vis alterna�ve investments.
Managers must, therefore, consider the size of a project's
expected cash flows, their �ming, the riskiness of these
cash flows, and the returns available to shareholders on
alterna�ve investments as they assess value in pursuit of
stockholder wealth maximiza�on. Table 1.2 lists factors

that impact an investment's value and their effects.
Table 1.2: Factors determining an investment's value
Factors Impact
Expected level of cash flows The higher the expected cash
flows are, the higher the value of the investment will be,
all else being the same.
Riskiness of cash flows The more uncertain the expected
cash flows are, the lower the value of the investment will
be, all else being
the same.
Timing of cash flows The longer it takes to receive cash
flows, the lower the value of the investment will be, all
else being the same.
Returns available on alterna�ve, similar
investments
If similar investments offer higher returns, the value of
the investment will decrease, all else being the same.
It is important to understand the differences in
informa�on available to corporate insiders and outsiders.
Regula�ons have been established to
protect company outsiders from
informa�on disadvantage. Martha Stewart
was imprisoned for lying about her

1.5 The Role of Information
Informa�on plays an important role in corporate finance.
One of the difficul�es claimants have in assessing how
well management is doing in achieving its goal of
shareholder wealth maximiza�on is a lack of informa�on.
In large corpora�ons, neither the board of directors nor
the stockholders can review all of management's decisions.
Thus, managers have much more informa�on than those
individuals who are not involved in the day-to-day
opera�ons of the firm
Information Asymmetry
This rela�onship is characterized as informa�on asymmetry
between corporate insiders and outsiders because the two
groups do not have equal (or symmetric) informa�on
(Dierkens, 1991). Managers, as insiders, have a pre�y
clear view of both the RHS and the LHS of the financial
balance sheet. Claimants who are not also employees of
the
corpora�on can observe the RHS sources of capital
because most of these claims are represented by ac�vely
traded securi�es (bonds and stocks), but LHS investments
may
only be viewed obscurely. Thus, outsiders have less
informa�on to use in drawing conclusions about the value
of the ac�vi�es of the corpora�on than do insiders. See
Figure
1.7.
Figure 1.7: Informa�on asymmetry
The degree of informa�on asymmetry is largely dependent
on the size, complexity, and organiza�onal structure of

the corpora�on. Large, widely held corpora�ons with stock
held by millions of investors are characterized by a
separa�on of ownership (held by the common
stockholders) and control (held by managers). Stockholders
of such giant
companies individually own a very small propor�on of the
corpora�on; thus, they have li�le incen�ve to closely
scru�nize managerial ac�on. Addi�onally, with such a
small
stake, individual shareholders have li�le vo�ng power
with which to affect a change if they are dissa�sfied
with the management and the board. These shareholders
tend to
simply sell their shares in the corpora�on if they are
unhappy. Consequently, widely dispersed ownership can
lead to a poten�ally high degree of informa�on
asymmetry.
Small, closely held corpora�ons o�en have fewer
shareholders, each having a large financial stake in the
firm. These claimants
have a greater incen�ve to monitor decision making. The
closer scru�ny of outsiders reduces the degree of
informa�on asymmetry.
In the extreme case, insiders may own a very large stake
in the corpora�on, and informa�on asymmetry is
minimized. Many small
businesses are organized as corpora�ons. O�en there is
only one residual claimant who holds all of the common
stock and also
manages the business. In such a case, there is no
informa�on asymmetry between management and the
residual claimant because
they are one and the same. Even here, some asymmetry
exists because fixed claimants remain corporate outsiders
(e.g., suppliers

and bankers) and so have less informa�on about the
company than does the owner/manager.
There are costs associated with informa�on asymmetry.
Corporate insiders, for example, may trade the firm's
outstanding securi�es
and reap huge profits based on their superior knowledge
of the firm's prospects. The cost associated with insider
trading (King,
Roell, Kay, & Wyplosz, 1988) would eventually be borne
by society. Outsiders would soon lose faith in the fairness
of trading the
company's securi�es because of their informa�on
disadvantage. The ability of the firm to raise capital
would be hampered as
poten�al capital suppliers became reluctant to commit
their funds for fear they were paying too much. Lack of
financing would
leave promising investment projects untouched, leading to
a stagnant economy or one in decline. To protect the
integrity and
fairness of the security markets, society has legislated
strict regula�ons on the trading of corporate securi�es by
insiders. These
laws were at work when Martha Stewart, the famous
television personality, was sentenced to prison �me for
lying to a grand jury
during an inves�ga�on of insider trading.
CEOs of large corpora�ons, like GE's Jack Welch, have
been scandalized in
the news when the public learns the extent of their
corporate perquisites.
Do you think that corporate managers deserve to receive

so many benefits?
What can financial managers do to keep excessive perks
in check?
knowledge of a viola�on of these
regula�ons.
Associated Press
Other informa�on asymmetry costs are borne by the
corpora�on. A good example is audited financial
statements. Corpora�ons
hire reputable accoun�ng firms to examine and, following
well-defined standards, a�est to the accuracy of
informa�on reported by
insiders (the firm's management). Banks supplying
financing to the corpora�on generally require that certain
condi�ons be met by
the firm throughout the life of the loan. For example, to
ensure that these protec�ve covenants are being met, banks
may require
that the firm regularly provide audited financial statements.
Such statements reduce informa�on asymmetry between the
firm and these fixed claimants. Restric�ve
covenants are also included in bond agreements, while
audited financial statements are a repor�ng requirement
for virtually all ac�vely traded corporate securi�es.
In the 1980s an interes�ng phenomenon took place with a
frequency never before seen. Many large, complex, and
widely held corpora�ons' stocks were purchased in their
en�rety by rela�vely small groups of individuals or
ins�tu�ons in a process known as a leveraged buyout. In
essence, widely held firms were transformed into closely
held

firms. One important ra�onale for these billion-dollar
transac�ons was the reduc�on of informa�on asymmetry.
How can a reduc�on of this informa�on gap translate
into
the wealth crea�on that apparently mo�vated these
megadeals?
Agency Costs
To answer that ques�on, we must more fully understand
the costs that accompany informa�on asymmetry and the
separa�on of ownership and control. As we noted earlier,
managers control the firm, whereas shareholders own the
firm. Managers are ac�ng as the agents of the firm's
principals or owners. Managers are hired to act on the
owners' behalf, maximizing shareholders' wealth and—in
the process—sa�sfying the corpora�on's fixed obliga�ons.
However, managers are also concerned with their own
welfare and act in their own self-interest. At �mes
managers, ac�ng to sa�sfy their own desires, may take
ac�ons that are costly to claimants yet produce no wealth
for
these suppliers of capital. Such ac�ons may be
characterized as investments whose value is less than their
cost and are, therefore, in direct conflict with the goal of
maximizing shareholder wealth. Some corporate
expenditures on perquisites may contradict shareholder
wealth maximiza�on.
Lavish Golden Parachutes
Perquisites (or perks) are benefits to employees beyond
their compensa�on packages and are o�en cost-effec�ve
investments. Many execu�ves, for example, are supplied a
company-owned car. Shareholders may benefit from such

investment—it may be less costly to supply the corporate
president with a vehicle than to reimburse her for
mileage. The company-owned car also assures stockholders
that the corporate reputa�on for being a quality
ins�tu�on is enhanced by having clients met in a clean,
comfortable mode of transporta�on. On the other hand,
what if the president of the firm is supplied with a
$200,000 Rolls-Royce rather than a $60,000 Lincoln? Will
the
decision to supply her with the Rolls produce addi�onal
value greater than the cost differen�al of $140,000? The
Rolls seems to be a ques�onable investment. This is an
example of an excessive perquisite, an expense that
benefits an execu�ve while producing no increase in
shareholder wealth. On whose judgment does the
authoriza�on of
such expenses fall? Ordinarily management makes these
decisions. This is an example of an agency cost (Jensen,
2005), a cost that arises because of the separa�on of
principals and agents in large corpora�ons (see Figure
1.8).
Figure 1.8: Agency costs
The agency problem creates costs for the business,
was�ng corporate resources.
A corpora�on is highly dependent on the trustworthiness
of the
management it hires. Dennis Kozlowski, former Tyco CEO,
shirked
his duty by extravagantly spending the company's money.

Associated Press
Another source of agency costs is shirking by top
management. A corpora�on's top managers are selected
and highly compensated because the board feels they have
the
talent and will expend the effort to seek out value-
crea�ng investment projects. But only the managers know
precisely how much effort they are direc�ng to their job.
Since
managerial effort is difficult to monitor, managers can
reduce their efforts (i.e., shirk) and thereby generate costs
for shareholders with no offse�ng benefits. Such managers
may choose to take a three-hour lunch, for which they are
richly compensated but which produces no increase in
shareholder wealth. Shirking by top management sets a
costly example because the behavior may percolate down
through the corpora�on. A noteworthy example of the
abuse of corporate power at shareholders' expense is the
case of Dennis Kozlowski, the CEO of Tyco from 1992 to
2002. The firm paid for Kozlowski's $30 million New
York apartment, which featured a shower curtain cos�ng
$6,000!
Studies have shown that top execu�ves' pay is posi�vely
correlated with the size of the corpora�on. Some
incen�ve, therefore, exists for chief execu�ve officers
(CEOs) to engage in empire building. A firm may expand
in size (add LHS investments) with less regard to the
value of these investments than to the impact that a
larger firm has on the CEO's pay, power, and pres�ge.
Empire-building has been documented as one of the
most damaging agency costs in its impact on shareholder
wealth.

As part of the 2010 Dodd-Frank legisla�on, shareholders
now have the right to cast an advisory vote on
execu�ve compensa�on, called say on pay. This can be
viewed as an effort to �e compensa�on more closely to
performance and help to mi�gate the agency problem
between management and owners.
An important characteris�c of these examples of the
agency problem is that they would not exist if
informa�on
asymmetry did not also exist. The megamergers of the
1980s o�en were economically linked to the reduc�on
of agency costs. By replacing wasteful management, by
increasing the accountability of management to a
smaller group of claimants whose stake was high enough
to mo�vate close monitoring of the firm, and through
dismantling ill-conceived and inefficient empires, wealth
gains were achieved as many corpora�ons became
closely held through buyouts in the 1980s.
1.6 Organizational Forms
Even with the problems inherent in the widely held
corpora�on—problems such as informa�on asymmetry and
agency costs—the modern corpora�on dominates the
economic landscape (Helwege, Pirinsky, & Stulz, 2007).
The bulk of sales (80%) and net income (60%) are
generated by the corpora�on form of business
organiza�on. In this
sec�on, we look at the different organiza�onal forms in
comparison with the corpora�on and explore the
corpora�on's role in society.
Sole Proprietorships and Partnerships Versus Corporations

To be sure, sole proprietorships and partnerships are also
important—they perhaps best embody the entrepreneurial
spirit and o�en are the spawning ground for major
corporate en��es. Proprietorships and partnerships also
have less significant agency problems than do widely held
corpora�ons. These organiza�onal forms are also
a�rac�ve
because of their rela�vely low organiza�onal costs, and
their owners may benefit from lower taxes. Corporate cash
flows to residual claimants (dividends) are subject to
double taxa�on—once at the corporate level and again at
the individual level—while proprietorship and partnership
income is taxed only once as part of the owner's
personal tax return. Table 1.3 compares the taxa�on of
corpora�ons against that of partnerships and
proprietorships.
Table 1.3: Tax advantages of partnerships and
proprietorships
Taxa�on Partnerships and proprietorships Corpora�ons
Income before business-level taxes $1000 $1000
Corporate Income tax rate 0% 20%
Corporate Income tax payable $0 $200
Income to owners before personal income taxes $1000 $800
Personal income tax rate 25% 25%
Personal income tax payable $250 $200
A�er-tax cash flow to owners $750 $600

Note: Assuming a corporate tax rate of 20% and a
personal tax rate of 25%, the corpora�on's owners are at
a tax disadvantage because their income is subject to
double taxa�on.
But the corpora�on has a�ributes that offset the
advantages of proprietorships and partnerships. These
a�ributes are par�cularly important for large firms,
requiring large
amounts of capital. To raise the huge sums necessary to
finance large-scale businesses, en��es must accept the
difficul�es inherent in the separa�on of ownership and
control because few individual investors have sufficient
personal wealth, exper�se, and the willingness to both
own and manage a corporate giant. Thus, to finance big
businesses, it is o�en necessary to have many owners
(stockholders) who are willing to relinquish control to
hired managers. Now let us consider the characteris�cs of
the
corporate form of organiza�on that enable it to dominate
alterna�ve organiza�onal structures.
First, through the issuance of common stock, a highly
transferable security is used as the medium for exchanging
ownership interests in the business. The ability of
stockholders to sell their shares easily is important if
individuals are to be persuaded to take an ownership
interest in a firm over which they have limited control.
Such
claimants, as men�oned earlier, can "vote with their feet,"
selling their shares when they wish. Moreover, if many
stockholders become dissa�sfied, then selling pressure,
behaving in accordance with the law of supply and
demand, will drive down share prices. The supply of such
a corpora�on's stock available for sale on the secondary

market
will increase while demand for the securi�es decreases.
This decline in the price of the corpora�on's securi�es
indicates to the board of directors that ac�on needs to be
taken. By contrast, partnership and proprietorship
ownership interests are less transferable and marketable.
For example, partnerships o�en require the approval of
remaining partners before a dissident partner can sell his
or her interest to a third party. In the end, many partners
are stuck with their investment and powerless to change
it. Thus, the ease with which stock may be bought and
sold (its marketability) is a strong advantage of the
corpora�on, aiding its ability to raise capital when
compared to
alterna�ve business forms.
A second contras�ng characteris�c is the liability of
owners. Par�cipants of sole proprietorships and
partnerships (with the excep�on of limited partnerships)
not only risk
their original investments in a business but must stand
ready to use their personal resources to meet any shor�all
the enterprise experiences in mee�ng its fixed obliga�ons.
For example, a large legal judgment against a
proprietorship or partnership may lead to the personal
bankruptcy of its owners. This is not the case with the
corporate form
of organiza�on. Stockholders have limited liability,
meaning that they can lose no more than the amount they
have invested in the stock. In a corpora�on, residual
claimants
cannot be forced to make up shor�alls in mee�ng fixed
claims once corporate assets have been fully liquidated.
Again, this corporate a�ribute is especially cri�cal in
larger
firms with diffuse ownership. Few individuals would be

willing to expose their resources to risk, without direct
control over how those capital contribu�ons are u�lized,
if
their liability is unlimited.
The last advantage of the corporate form is its
conceptually unlimited life. Partnerships depend on a team
ac�ng as both owners and managers. Like any team, the
loss of a
key player or players can destroy its effec�veness. In
proprietorships, this difficulty is exacerbated because the
team consists of one player, the loss of whom completely
changes the character of the en�ty. To replace players in
partnerships or proprietorships, an individual must be
sought with the wealth, exper�se, and willingness to be
both
a manager and an owner. If such an individual cannot be
located, the business must be liquidated. Corpora�ons, on
the other hand, are faced with less cri�cal problems of
this nature. Replacing lost owners is rela�vely simple
because of marketability of the stock, as already
discussed. Loss of key management personnel, although
poten�ally
difficult, is less of a problem than it is in other
organiza�onal forms because the replacement does not
necessarily also need to become a major owner, as a
proprietorship or
partnership requires.
Limited Liability Companies Versus Corporations
Facebook went public on May 18, 2012. Why do you
think
companies like Facebook eventually decide to go public?

Paul Taggart/Corbis
A rela�vely recently developed form of organiza�on is
the limited liability company, or LLC. LLCs are the
business form of choice for many small businesses because
they
combine corporate-like limited liability with lower costs of
organiza�on, flexibility, and ease of regulatory compliance.
For example, an LLC may elect to be taxed as a
corpora�on or as a partnership, and it can be managed by
its owners or by professional managers.
Table 1.4 looks at some of the key characteris�cs of the
organiza�onal forms we have discussed.
Table 1.4: Key characteris�cs of the forms of business
organiza�on
Business characteris�c Corpora�ons Partnerships
Proprietorships Limited liability corpora�on
Taxa�on Twice—once at the business
level and once at the
individual level
Once at the individual level Once at the individual level
Flexible—corporate or
partnership
Liability Limited to amount invested Unlimited Unlimited
Limited to amount invested
Ownership and control Separated—majority of

stockholders are not usually
management
Partners own and control
enterprise
Ownership and control are in
the hands of a single
individual
Flexible—partners own
enterprise, and may control
enterprise or hire professional
managers
Transferability of ownership Rela�vely easy through sale
of
stock
Poten�ally difficult Poten�ally difficult Rela�vely easy
Access to capital Best Moderate Most restric�ve Moderate
Informa�on asymmetry and
agency costs
Poten�ally high Rela�vely low if all partners
are equal and ac�ve
Very li�le, as there is not
separa�on of ownership and
control
Flexible—depends on
ownership structure.
Professional management

leads to high informa�on
asymmetry. Partner
management leads to low
informa�on asymmetry.
In terms of numbers, most businesses are small and
closely held. These businesses are o�en ini�ally financed
by the owners' own out-of-pocket equity. For these
companies,
borrowing takes the form of loans rather than bonds
because the legal expenses and regulatory issues associated
with bonds make their issuance generally too costly for
small enterprises. Both equity and debt may be raised by
appealing to family and friends, called FF financing, and
individual independent investors, called angel investors.
There are also organiza�ons that pool funds to help
small, new enterprises with their funding needs. These
kinds of investments are referred to as venture capital. If
successful, many small entrepreneurial firms eventually
adopt the corporate form of organiza�on and sell stock
and bonds in the broader securi�es market a�er they "go
public" with an ini�al public offering (IPO) of their
shares. For example, in 2012, Facebook went public. Its
IPO spread some of its ownership from a small group of
founders
and other owners to the general inves�ng public.
Venture capital, angel inves�ng, and the financial
par�cipa�on of friends and family are extremely risky but
can
reap big rewards. Cau�on is advised, par�cularly with FF
financing because many �mes these investments may
jeopardize personal rela�onships, a risk well beyond
tradi�onal financial risk.
Over the past century, advances in technology, more cost-

effec�ve means of transporta�on and distribu�on,
communica�ons advances, a rising standard of living, and
the globaliza�on of markets have provided many
investment opportuni�es for corpora�ons, requiring large
amounts of capital to finance their growth.
Organiza�ons have sought the most efficient means of
mee�ng these needs. Many would argue that the
advantages of corporate organiza�onal forms outweigh the
disadvantages as firms become large.
Corporations and Society
The rela�ve efficiency of the corporate form of
organiza�on has led to its being the structure of choice
for
firms foreseeing a�rac�ve growth opportuni�es. The
efficiency of corpora�ons has led to cri�cism as well.
Corpora�ons are o�en portrayed as cold-hearted in their
pursuit of economic gains. They have been charged
with ignoring the communi�es in which they operate,
lacking concern for the welfare of their customers, and
even ignoring the planet in their relentless
pursuit of profits.
Some cri�cs of corpora�ons charge that the goal of
shareholder wealth maximiza�on is too narrow for the
good of society. These cri�cs contend that corpora�ons
should act in a socially responsible manner. Although
social responsibility has different meanings to different
people, circumstances exist when the good of society is
at odds with the welfare of corporate shareholders. For
example, in its manufacturing endeavors a firm may
produce externali�es, such as air pollu�on, while the cost
of cleaning up this dirty air may be borne not by the
corpora�on but by society. Thus, shareholders receive

higher returns as society bears some of the costs of
producing the product.
These charges are o�en true on a case-by-case basis and
must be taken seriously by all corpora�ons, even
non-offenders, because corpora�ons as legal en��es exist
at the pleasure of society. Should society see
pervasive abuses, it will surely restrict the freedom of
corpora�ons to act.
Corpora�ons and society are o�en at odds due to the
outcomes of
corporate externali�es such as pollu�on caused by
factories. Do
you think corpora�on cri�cs are jus�fied in their
accusa�ons?
Sam Ki�ner/Na�onal Geographic Stock
Businesses, and corpora�ons in par�cular, are remarkably
resilient. Abuses of labor, unethical securi�es
prac�ces, and consumer fraud have led to major
legisla�ve ini�a�ves that restrict the freedom of firms.
Yet the
compe��ve drive toward shareholder wealth maximiza�on
has allowed corpora�ons to meet society's legal
mandates and con�nue to thrive.
Ch. 1 Conclusion
In this chapter, several key concepts that underlie finance
were introduced. These are the blocks on which the bulk

of this book is built. The chapter began by introducing
the
financial balance sheet as a model of how financial
managers view the corpora�on. The financial balance sheet
will be used throughout the text to illustrate how topics
fit
into the "financial picture" introduced in this chapter.
This chapter also presented shareholder wealth
maximiza�on as the overarching goal of business and then
discussed factors (such as cash flows and risk) that must
be
considered as firms strive to create value for their owners.
You learned that the choice of organiza�onal form can
have a drama�c effect on risk and the a�er-tax cash
flows
that a business produces. Finally, the agency problem and
the challenges presented by informa�on asymmetry were
introduced.
In Chapter 2, we will focus on extending these
fundamental concepts to the economic environment in
which a firm operates.
Financial Balance Sheet, Part I
Click here
(h�ps://media.thuze.com/MediaService/MediaService.svc/const
ella�on/book/AUBUS650.13.1/{pdfs}financial_balance_sheet_
p1.pdf) to download a pdf of this slideshow.
SLIDE 1 OF 8
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eet_p1.pdf

Ch. 1 Learning Resources
Key Ideas
The financial balance sheet illustrates the firm's capital
acquisi�on and investment ac�vi�es.
Residual and fixed claims' characteris�cs include the priority of
claims, default and legal recourse, and vo�ng rights.
Shareholder wealth maximiza�on is the financial goal of the
corpora�on.
Wealth crea�on is achieved by corporate investment in a
project whose value is greater than its cost.
A project's value is dependent on the size of expected cash
flows, the riskiness of those cash flows, their �ming, and the
returns available on alterna�ve investments of
similar risk.
Agency costs and informa�on asymmetry are impediments to
maximizing shareholder wealth.
Compe�ng forms of business organiza�on were compared to
the corporate form. These include sole proprietorships,
partnerships, and limited liability companies.
Corpora�ons exist at society's pleasure and must be sensi�ve to
social concerns.
Cri�cal Thinking Ques�ons
1. Economists who favor strictly free markets may oppose
insider trading laws because these laws do not allow prices to
fully reflect all informa�on that is available (namely,
prices won't reflect that informa�on that is held exclusively by
the firm's insiders). They could argue that prices can best
allocate capital to its best use if all informa�on is
reflected in the price and therefore the laws prohibi�ng trading
by insiders who use their special knowledge should be repealed.

Other economists disagree. They believe that
the economy is be�er off with these insider trading
prohibi�ons. Supply their side of this argument.
2. Why do residual claimants have the right to elect the board of
directors? Why don't fixed claimants have the same right?
3. In theory, the maximiza�on of shareholder wealth also
contributes to the well-being of other stakeholders. Explain this
asser�on.
4. Which do you think is the biggest agency cost: excessive
perquisites, shirking, or empire building? Explain your
reasoning.
5. Some observers could argue that without limited liability we
would not have large corpora�ons like Bri�sh Petroleum.
Explain what you think is the ra�onale behind this
asser�on.
Key Terms
Click on each key term to see the defini�on.
agency cost
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�o
ns/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/b
ooks/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.
13.1/sec�ons/fro
A cost that occurs when control of corporate assets is
held by management and is separated from the ownership
of those assets. The cost is considered a waste of
investors'
money because it is being used to benefit the management
but not to create wealth for shareholders. An example
could be excessive managerial perquisites like luxury
condominiums supplied to CEOs at the firm's expense.

Sole proprietorships have no agency costs because the
owner of the business has direct control of the business
assets,
and by defini�on, you can do what you like with your
own money.
angel investors
13.1/sec�ons/fro
Anyone who invests his or her money in an
entrepreneurial company (unlike ins�tu�onal venture
capitalists who invest other people's money).
bankruptcy
13.1/sec�ons/fro
The quality or state of being insolvent.
bonds
13.1/sec�ons/fro
The security that represents the issuer's promise to pay a
predetermined amount of interest over a fixed term and to
repay the principal on the security's maturity date.
board of directors

13.1/sec�ons/fro
A panel of individuals, elected by the stockholders, who
act as their (the owners') representa�ves. The board's
du�es include direc�ng the strategic ac�vi�es of the
corpora�on, including the hiring and firing and
compensa�on of top management, and ra�fying major
corporate decisions such as the payment of dividends.
cash flow
13.1/sec�ons/fro
The amount of money that passes through a corpora�on.
Residual cash flow, for example, refers to the amount of
money that stockholders have a claim on a�er all other
claims have been paid.
closely held corpora�ons
13.1/sec�ons/fro
Corpora�ons whose stock is not publicly traded and is
held by only a few shareholders. Because each shareholder
owns a substan�al part of the company, they have a
greater incen�ve to pay a�en�on to corporate ac�vity
resul�ng in low informa�on asymmetry and lower agency
costs. One problem for the closely held corpora�on is
that
there is no ac�ve market for its stock so it becomes

difficult to raise addi�onal equity capital.
common stock
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t_matter/books/AUBUS650.13.1/sections/front_matter/books/A
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.13.1/sections/front_matter#

A security that represents a residual claim on the firm's
earnings and an ownership share of the company.
corporate governance
13.1/sec�ons/fro
A general term used to describe the decision making

within a corpora�on, par�cularly at the top levels of
management and the board of directors.
corpora�on
13.1/sec�ons/fro
The form of business organiza�on where ownership is
held by the common stockholders who own a propor�onal
share of the business depending on the percentage of
outstanding shares they own. They exercise control of the
company through their elected representa�ves, the board of
directors.
coupon payments
13.1/sec�ons/fro
A stream of regular (usually semiannual) interest payments
from a bond issuer to the bondholders. Each payment is
determined by taking the product of the coupon rate
�mes the bond's par value (and then divided by two if
payments are made semi-annually).
default
13.1/sec�ons/fro
Missing a scheduled payment to a fixed claimant, such as
a coupon payment on a bond, or a loan payment on an

equipment loan. This can lead to bankruptcy.
dividends
13.1/sec�ons/fro
Payments made to stockholders by the corpora�ons.
Regular cash dividends are typically paid quarterly. An
increase in the regular cash dividend is generally
considered a
signal of the company's improving profitability. Stock
dividends are addi�onal shares of stock issued to current
shareholders on a propor�onal basis.
externali�es
13.1/sec�ons/fro
Nega�ve externali�es are unwanted byproducts of
produc�on, the costs of which are not borne by the
business but by other par�es. For example, a factory
burning fossil
fuels may be crea�ng health problems for people living
downwind from the factory who must pay for their added
medical costs and the indirect costs of irritated eyes and
lungs. There are posi�ve externali�es in some cases as
well, where a third party benefits from another's ac�vity
but does not pay for the benefit, as in the case of when
an
unsightly building is torn down across the street from
your house causing your property value to increase.

FF financing
13.1/sec�ons/fro
Capital investments made by friends and family of a
business owner.
financial balance sheet
13.1/sec�ons/fro
A conceptual tool used in this text to illustrate financial
thinking and decision making and contrasted to the
familiar accoun�ng balance sheet. For example, the
financial
balance sheet lists Investments Made by the Firm on its
le�-hand side in contrast to Assets listed on an
accoun�ng statement. In finance, these accounts are valued
at their
market values rather than the book values or historical
costs used in accoun�ng.
fixed claims
13.1/sec�ons/fro
Securi�es like bonds, bank loans, and wages payable,
which are en�tled to a fixed payment and receive their
payments prior to any payments to the owners of the
business.

informa�on asymmetry
13.1/sec�ons/fro
The difference between the knowledge of the corpora�on
held by insiders and known by outsiders. For example, the
average stockholder in Microso� knows much less about
the company and its opera�ons and performance than Bill
Gates knows so there is significant informa�on asymmetry
in that case.
insiders
13.1/sec�ons/fro
Typically refers to corporate management and other
employees who have greater knowledge about the
opera�ons and performance of the company than the
firm's outsiders
do (outsiders are those without that knowledge).
insider trading
13.1/sec�ons/fro
Trading by insiders who have an informa�on advantage
over the typical investor. Insider trading is restricted by
law and trading by insiders who u�lize their privileged
informa�on to profit (or to avoid losses) is illegal.

intangible assets
13.1/sec�ons/fro
Assets recorded on the le�-hand side of the financial
balance sheet that include brand name recogni�on, human
resources, and the firm's reputa�on.

Chapter 1A Financial Model of the CorporationGey Imag.docx

Chapter 1A Financial Model of the CorporationGey Imag.docx

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