2. Chapter 1
Goals and Governance Of the Firm
What is business?
Business is theactivity of making one's living or making money by producing or
buying and selling products (goods and services). Simply put, it is "any activity or
enterprise entered into for profit.
What are the three forms of business organizations?
1. Sole proprietorship
The vast majority of small businesses startout as sole proprietorships. These
firms are owned by one person, usually the individual who has day-to-day
responsibility for running the business. Soleproprietorships own allthe assets of
the business and the profits generated by it. They also assumecomplete
responsibility for any of its liabilities or debts. In the eyes of the law and the
public, you are one in the same with the business.
Advantages of a Sole Proprietorship
• Easiestand least expensive formof ownership to organize.
• Sole proprietors arein complete control, and within the parameters of the law,
may makedecisions as they see fit.
• Profits fromthe business flow-through directly to the owner’s personaltax
• The business is easy to dissolve, if desired.
Disadvantages of a Sole Proprietorship
• Sole proprietors haveunlimited liability and are legally responsiblefor all debts
against the business. Their business and personalassets are at risk.
• May be at a disadvantagein raising funds and are often limited to using funds
frompersonalsavings or consumer loans.
• May have a hard time attracting high-caliber employees, or those that are
motivated by the opportunity to own a part of the business.
• Someemployee benefits such as owner’s medical insurancepremiums are not
3. directly deductible frombusiness income(only partially as an adjustmentto
In a Partnership, two or more people shareownership of a single
business. Likeproprietorships, thelaw does not distinguish between the
business and its owners. The Partners should havea legal agreement that sets
forth how decisions will be made, profits will be shared, disputes will be
resolved, how future partners will be admitted to the partnership, how
partners can be boughtout, or whatsteps will be taken to dissolvethe
partnership when needed; Yes, its hard to think about a “break-up” when the
business is justgetting started, but many partnerships splitup at crisis times
and unless there is a defined process, there will be even greater
problems. They also must decide up front how much time and capital each
will contribute, etc.
Advantages of a Partnership
• Partnerships arerelatively easy to establish; however time should be
invested in developing the partnership agreement.
• With more than one owner, the ability to raisefunds may be increased.
• The profits fromthe business flow directly through to the partners’ personal
• Prospectiveemployees may be attracted to the business if given the
incentive to become a partner.
• The business usually will benefit from partners who havecomplementary
Disadvantages of a Partnership
• Partners arejointly and individually liable for the actions of the other
• Profits mustbe shared with others.
• Since decisions are shared, disagreements can occur.
• Someemployee benefits are not deductible frombusiness incomeon tax
4. • The partnership may have a limited life; it may end upon the withdrawalor
death of a partner.
A Corporation, chartered by the state in which it is headquartered, is
considered by law to be a unique entity, separate and apart fromthosewho
own it. A Corporation can be taxed; it can be sued; it can enter into
contractual agreements. The owners of a corporation are its
shareholders. Theshareholders elect a board of directors to overseethe
major policies and decisions. The corporation has a life of its own and does
not dissolvewhen ownership changes.
Types of Corporations
Limited Liability Corporations (LLC)
Advantages of a Corporation
• Shareholders havelimited liability for the corporation’s debts or judgments
against the corporation.
• Generally, shareholders can only be held accountable for their investment in
stock of the company. (Note however, thatofficers can be held personally
liable for their actions, such as the failure to withhold and pay employment
• Corporations can raiseadditional funds through the sale of stock.
• A Corporation may deduct the costof benefits it provides to officers and
• Can elect S Corporation status if certain requirements are met. This election
enables company to be taxed similar to a partnership.
5. Disadvantages of a Corporation
• The process of incorporation requires more time and money than other
forms of organization.
• Corporations aremonitored by federal, state and somelocal agencies, and as
a result may have more paperwork to comply with regulations.
• Incorporating may resultin higher overall taxes. Dividends paid to
shareholders arenot deductible frombusiness income; thus this income can
be taxed twice.
What are the three types of businesses?
1. Service Business
A servicetype of business provides intangible products (products with no
physicalform). Servicetype firms offer professionalskills, expertise, advice,
and other similar products. Examples of service businesses are: salons, repair
shops, schools, banks,accounting firms, and law firms.
2. Manufacturing Business
Unlike a merchandising business, a manufacturing business buys products with
the intention of using them as materials in making a new product. Thus, there
is a transformation of the products purchased.
A manufacturing business combines raw materials, labor, and factory
overhead in its production process. Themanufactured goods will then be sold
3. Merchandising business
This type of business buys products atwholesaleprice and sells the same at
retail price. They are known as "buy and sell" businesses. They makeprofit by
selling the products at prices higher than their purchasecosts. A
merchandising business sells a productwithout changing its form. Examples
are: grocery stores, conveniencestores, distributors, and other resellers.
6. What is role of the financial manager?
Who’s a financial manager?
A financial manager is referred to anyoneresponsiblefor a significantinvestment
or financing decision but except in a single firm no one person is responsiblefor
decision making responsibility is dispersed throughoutthe firm.
The treasurer is usually the person mostdirectly responsiblefor looking after the
firm’s cash, raising new capital, and maintaining relationships with banks and
other investors who hold the firm’s securities.. Its main aim is to manage firms
He is the one who prepares financial statements does the accounting and
manages the firms internal budgets and taxes. Its main aim is to assurethe
capital is used efficiently
3. Chief financial officer CFO
Large organs appointa Cfo TO look after the work of treasurer and Controller.
He is responsiblefor financial planning and corporateplanning
Types of Assets
To carry on business, companies need an almost endless variety of real assets.
used to producegoods and services. Many of these assets are tangible, such as
machinery, factories, and offices; others are intangible, such as technical
expertise, trademarks, and patents. All of them must be paid for.
7. Financial Assets
Claims to the income generated by real assets. To obtain the necessary money,
the company sells financial assets, or securities. These pieces of paper have
value because they are claims on the firm’s real assets and the cash that those
assets will produce. For example, if the company borrows money fromthe
bank, the bank has a financial asset. That financial assetgives it a claim to a
streamof interest payments and to repaymentof the loan. The company’s real
assets need to produce enough cash to satisfy theseclaims
What is a financial market?
The market where financial assets aretraded
What is Capital Budgeting?
how much money should the firm invest, and what specific assets should the
firm investin? This is the firm’s investment, or capital budgeting, decision. This
is also called the investment decision. OR Decision as to which real assets
(Tangible or Intangible) the firm should acquire.
What is the financing decision?
The financial manager’s second responsibility is to raise the money to pay for
the investmentin real assets. This is the financing decision. When a company
needs financing, it can invite investors to put up cash in return for a shareof
profits or it can promiseinvestors a series of fixed payments. Itis Decision as
to how to raisethe money to pay for investments in real assets.
What is capital structure decision?
The capital structure is how a firm finances its overall operations and growth
by using different sources of funds ORits he choice of the long-term financing
mix is often called the capital structuredecision, since capital refers to the
firm’s sources of long-termfinancing, and the markets for long-term financing
are called capital markets.5
8. Financial managers stand between the firm’s real assets and the financial
markets in which the firm raises cash. The financial manager’s role is shown in
Figure1.1, which traces how money flows frominvestors to the firmand back
to investors again. The flow starts when financial assets aresold to raise cash
(arrow 1 in the figure). The cash is employed to purchasethe real assets used
in the firm’s operations (arrow 2). Later, if the firm does well, the real assets
generate enough cash inflow to more than repay the initial investment (arrow
3). Finally, the cash is either reinvested (arrow 4a) or returned to the investors
who contributed the money in the firstplace (arrow 4b). Of coursethe choice
between arrows 4a and 4b is not a completely free one. For example, if a bank
lends the firm money at stage 1, the bank has to be repaid this money plus
interest at stage4b.
9. Financial Markets
The firsttime the firm sells shares to the general public is called the initial public
offering, or IPO. Financial Market refers to a marketplace, wherecreation and
trading of financial assets, such as shares, debentures, bonds, ..etc takeplace.
There are two types of markets
1. Primary Market
Market for the sale of new securities by corporations.
2. Secondary market
Market in which already issued securities are traded among investors.
What are the goals of the corporation?
For small firms, shareholders and management may be one and the same. But
for large companies, separation of ownership and management is a practical
necessity. How can shareholders decidehow to delegate decision making
when they all have different tastes, wealth, time horizons, and personal
opportunities? Delegation can work only if the shareholders havea common
objective. Fortunately there is a natural financial objective on which almost all
shareholders can agree. This is to maximize the current value of their
investment. A smartand effective financial manager makes decisions which
increase the currentvalue of the company’s shares and thewealth of its
stockholders. Whatever their personaltastes or objectives, they can all do
more when their shares areworth more. Sometimes you hear managers speak
as if the corporation has other goals. For example, they may say that their job
is to “maximize profits.” That sounds reasonable. After all, don’t shareholders
want their company to be profitable?
Conflict of interest between the firm’s owners and managers. Sincethe managers
are not the owners they may act In ways thatare not in the best interest of the
organ which may lead to agency problems . As they are the agents of the owners
they should maximise value rather than exploit the resources.
10. The net income is distributed to not only the shareholders butalso the employees
in the formof salaries to the indirect labors and even the governmentin the form
of taxes all such are reffered as the stakeholders of the company each has a stake
in the firm
Solutions for agency problems
1. Compensation plans : Managers are spurred on by incentive schemes that
providebig returns if shareholders gain but are valueless if they do not.
2. Board of directors: Boards of directors are sometimes portrayed as passive
supporters of top management. But when company performancestarts to
slide, and managers don’toffer a credible recovery plan, boards do act
3. Takeovers: . Poorly performing companies are also more likely to be taken
over by another firm. After the takeover, the old management team may
find itself out on the street.
4. Specialist monitoring: Finally, managers are subjectto the scrutiny of
specialists. Their actions are monitored by the security analysts who advise
investors to buy, hold, or sell the company’s shares. They arealso reviewed
by banks, which keep an eagle eye on the progress of firms receiving their
5. Legal and regulatory requirement
Ethics and management objectives
managers should try to maximize market value. But someidealists say that
managers should not be obliged to act in the selfish interests of their
stockholders. Somerealists arguethat, regardless of whatmanagers ought to do,
they in fact look after themselves rather than their shareholders. By striving to
enrich themselves and their shareholders, businesspeoplehaveto providetheir
customers with the products and services they truly desire. Of courseethical
issues do arise in business as in other walks of life. So when we say that the
objective of the firm is to maximize shareholder wealth, we do not mean that
anything goes. In part, the law deters managers fromblatantly illegal action. But
when the stakes are high, competition is intense, and a deadline is looming, it’s
easy to blunder, and not to inquire as deeply as they should about the legality or
morality of their actions. Written rules and laws can help only so much. In
business, as in other day-to-day affairs, therearealso unwritten rules of behavior.
11. These work becauseeveryoneknows that such rules are in the general interest.
But they are reinforced becausegood managers know that their firm’s reputation
is one of its mostimportant assets and thereforeplaying fair and keeping one’s
word are simply good business practices. Thus hugefinancial deals are regularly
completed on a handshakeand each side knows that the other will not renege
later if things turn sour.1Thereaction of honestfinancial firms is to build long-
term relationships with their customers and establish a name for fair dealing and
financial integrity. Major banks and securities firms know that their most valuable
assetis their reputation and they emphasize their long history and their
responsiblebehavior when seeking new customers. When something happens to
undermine that reputation the costs can be enormous.
Corporate structure or financial structure= liabilities + Capital