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Chapter 2
Financial
Management
Chapter 2 Outline
2.4 Financial
Management
2.1 FORMS OF
BUSINESS
ORGANIZATIO
NS
2
2.2 The Goals
of the Business
Enterprise
2.3 The Role of
Management
and Agency
Issues
2.1 Forms of Business
Organizations
1. Sole proprietorship
2. Partnership
3. Limited liability company
4. Corporation
Sole Proprietorship
A sole proprietorship is a business owned and
operated by one person.


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The main advantage of a sole proprietorship is that
setting one up is easy—no paperwork is involved,
and the owner needs only to start doing business.
This accountability is unlimited liability because an
owner is liable not only to the extent of what is
invested in the business but also for any other
assets owned.
Sole Proprietorship
Advantages
Disadvantages
Easy to form
Unlimited liability
Business income is taxed
once, at the individual’s
personal level
Lack of continuity
Limited access to additional
funds
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Partnerships
A partnership is a business owned and operated
by two or more people.


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A partnership can be formalized by having a lawyer
create a partnership agreement, which establishes
how decisions are made, such as how each partner
can buy out the other in the event that one wants to
dissolve the partnership.
The partnership agreement stipulates how the
partnership’s income is allocated among the
partners.
Types of Partnerships
 General
partnership: partners share the
management and income of the business
 Limited liability partnership (LLP) or
simply limited partnership- at least one
general partner who manages the
business, but there may be any number of
limited partners, who are passive investors.
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Types of Partnerships
 As long as the limited partners are not active
in the business, they have the advantage of
limited liability; the most they can lose is their
initial investment.
 The general partner, conversely, has unlimited
liability as the operator of the business.
 In practice, however, many general partners
are corporations (discussed later) and
indirectly benefit from limited liability.
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Partnerships
Advantages
Disadvantages
Easy to form
Unlimited liability for general
partners
Business income is taxed
once, at the individual
partners’ level
Lack of continuity
Limited access to additional
funds
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Corporations
 A corporation is a business organized
as a separate
legal entity under corporation law, with ownership
divided into transferable shares.

In tax law, such a business is generally taxed as a C
corporation (C corp).
 A corporation is easy to recognize because it has Inc.
for incorporated, Ltd. for limited, or, in Europe, PLC
for private limited corporation or AG for
Aktiengesellschaft, after its name.
 Owners have the benefit of limited liability: the
maximum that owners can lose is their investment.
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Corporations
 A corporation is usually formed by filing articles of
incorporation and receiving a certificate of
incorporation from the state.
 The articles of incorporation indicate the most
basic information about the company, such as its
mailing address, name, line of business, number
of shares issued, names and addresses of the
officers of the company, and so on.
 The critical feature is that the corporation is a
distinct legal entity.
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Corporations
 In corporations, the owners are the owners of the
ownership interests—that is, the shareholders—
who elect members of the board of directors, who
in turn hire and monitor the company’s
management.
 For smaller companies, the separation of
management and ownership isn’t a problem, but
for larger companies, it becomes a serious
concern.
 This division is the fundamental problem of the
governance structure of large companies
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Corporations
Advantages
Disadvantages
Limited liability
Income taxed at the
corporate level and at the
owners’ level, when
distributed
Unlimited life
Separation of owners and
management
Access to capital
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Limited Liability Companies
A
limited liability company (LLC) is a
business organized as a separate legal
entity in which owners have limited
liability, but the income is passed through
to the owners for tax purposes.
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Limited Liability Companies
Advantages
Disadvantages
Limited liability for the
owners
Separation of owners and
management
Unlimited life
Access to capital
Income taxed only at the
owners’ level
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Subchapter S Corporations


A subchapter S corporation (Sub S) is a corporation that
elects to be taxed as a partnership.
So how does a Sub S compare with an LLC? Let’s consider
their basic characteristics:
Characteristic
Sub S
LLC
Taxation
Pass-through
Pass-through
Ownership
Maximum of 100
shareholders
No maximum
Liability
Limited liability
Limited liability
Life
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Perpetual
Limited
LLC v. Sub S v. C corp. v. ?
 An LLC can choose to be taxed as a Sub S
 Venture
capitalists prefer C corporations
 Retaining profits? Use a C corp.
 LLCs can have more than one class of stock; Sub
S’s cannot.
 Losses? You can pass through more losses through
an LLC than with a Sub S.
 Distributing income? Must be by number of
shares for a Sub S, but can be disproportionate for
an LLC.
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LLC v. Sub S v. C corp. v. ?
 Sub S limited to 100 shareholders and all must be US
citizens or permanent residents.
 Sub S and C corp requires board of directors, annual
reports, records of meetings, and other regulatory
compliance; with LLC just need an operating
agreement (may be informal).
 LLC has a limited life; Sub S and C corp are perpetual.
 Owners of LLCs must pay SE tax; Sub S and C corp
distributions may be dividends, but reasonable
compensation is required.
 Some states do not recognize Sub S status and some
18 tax double (NY: Sub S profits and s/h share of profits).
Distribution of Number of Businesses
and Revenues of Business by Form
19
Source of data: Internal Revenue Service, Statistics of Income
Form of business
Initial form of business
Sole
proprietorship
33%
The predominant
forms of business
are the sole
proprietorship, the
limited liability
company, and the
Subchapter S
corporation.
Limited liability
company
32%
Other
0%
Limited
partnership
2%
General
partnership
3%
C Corporation
9%
Source of data: The Kaufman Foundation
Subchapter S
21%
Form of business over time
Start-up
companies
begin their
existence as
sole
proprietorships,
limited liability
companies, or
Sub S
corporations.
Partnerships
and C
Corporations
are rare.
Portion of all start-ups
Following the companies in their first 6 years
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Other
Limited partnership
General partnership
C Corporation
Subchapter S
Limited liability
company
Sole proprietorship
Initial
2
4
6
Year in the life of a business
Source of data: The Kaufman Foundation
How do they finance the business?
The first 6 years
Note that
venture
capital
investors and
angel investors
do not play a
large role in
most start-ups.
100%
Portion of all start-ups
Start-up
companies
are largely
funded by the
owners
themselves. As
the business
generates
cash flows,
fewer tap
outside
sources of
funds.
90%
Other
80%
Venture capital
70%
60%
Government
50%
Investment
companies
Angel investors
40%
30%
Parents
20%
10%
Spouse
0%
Owners
Initial
1
2
3
4
5
6
Year in the life of a business
How do owners get their funds?
The first 6 years
100%
The
percentage of
owners who
rely on credit
card funding –
personal and
business – is
high.
Portion of all start-ups
90%
80%
70%
60%
Other sources
50%
Personal loan - other
Personal loan - Family
40%
Personal loan - Bank
30%
Personal credit card
20%
Business credit card
10%
0%
Initial 1
2
3
4
5
6
Year in the life of a business
Who gets venture capital?
Initial year
Construction
Manufacturing
Though a
limited source
of funding,
manufacturing
receives more
of the venture
capital than
other industries
Wholesale trade
Retail stores
Delivery and storage
Information
Finance and insurance
Scientific and technical
services
Waste management and
remediation
Health care
Arts, Entertainment and
recreation
Example: Facebook
Founded by Zuckerberg,
Saverin, Moskovitz and
Hughes
Feb 2004
Incorporated in
Delaware, with
headquarters in
Palo Alto, CA
Dec. 2004
VC Peter Thiel
invests $500,000
June 2004
25
Initial public
offering
May 2012
[$114 billion]
2.2 The Goals of the Business
Enterprise
26
Stakeholder
 A stakeholder of a business is a party that is
affected by the decisions and operations of the
business entity.
 Stakeholders include not only the owners, but also
the creditors, the employees, the suppliers, and
the customers.
27
The Business Entity and Its
Stakeholders
28
Primary Corporate Goal
 The
goal of the company is to maximize the
market value of the equity interest or,
alternatively, maximize shareholder value.
 The company should take resources and create
products that society values more highly than it
values the inputs.
 The company should operate legally and in
compliance with its contractual responsibilities, in
the interests of its owners, by creating value for
them.
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2.3 The Role of Management
and Agency Issues




30
Managers are employees and as such are agents
working on behalf of the shareholders.
We refer to this relationship as agency relationship.
Despite the fact that managers have a duty to
shareholders, there is always the possibility that
managers will act in their own self-interest. This is the
classic agency problem associated with the separation
of ownership from management.
The costs associated with the agency problem are
referred to as agency costs.
Aligning Managers’ and
Owners’ Interests
 The different perspectives of managers and
shareholders are evident in terms of
performance measurement.

For example, when being appraised, managers want
to be judged relative to accounting numbers, such
as profits and return on investment (ROI), because
they can control these numbers to some extent.
 In contrast, shareholders are interested in
stock market performance because they want
managers to create shareholder value.
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Aligning Managers’ and
Owners’ Interests
 Shareholders
and managers also differ in
their approach to risk and financing:
 Shareholders take a portfolio approach because
they hold many assets. This allows them to
reduce risk by diversifying (that is, invest in
assets whose returns are not perfectly in synch
with one another), whereas managers may see
their careers totally tied up with the company
and tend to act more conservatively.
32
Aligning Managers’ and
Owners’ Interests
 The challenge
is to design compensation
schemes that encourage managers to act
in the best interest of shareholders.
 The elements that are typically included
are salary, bonus, and options.
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CEO Compensation (2012)
1-Year Pay 5 Year Pay
($mil)
($mil)
131.19
285.02
66.65
204.06
64.40
60.94
60.94
55.79
96.11
51.52
100.21
50.18
90.3
48.83
169.3
Shares
Owned
($mil)
51.9
5,010.4
171.7
8,582.3
21.5
47.3
128.2
155.8
Rank
1
2
3
4
5
6
7
8
Name
John H Hammergren
Ralph Lauren
Michael D Fascitelli
Richard D Kinder
David M Cote
George Paz
Jeffery H Boyd
Stephen J Hemsley
Company
McKesson
Ralph Lauren
Vornado Realty
Kinder Morgan
Honeywell
Express Scripts
Priceline.com
UnitedHealth Group
9
Clarence P Cazalot Jr
Marathon Oil
43.71
67.23
30.3
10
John C Martin
Gilead Sciences
43.19
214.92
90.9
34
Source: Forbes.com
Aligning Managers’ and Owners’
Interests


Notice that in all cases in the previous table, the salary
compensation is relatively low compared with the total
package. This is likely the result of the limitation of $1
million per executive for the deductibility of compensation
for tax purposes.
Annual bonuses are generally somewhat larger, but the
largest component, by far, is share compensation.


35
This comes in two forms: grants of restricted stock awarded under
incentive plans, and stock options, for which if the company’s stock
price goes above a certain level, the executive gets the right to buy the
stock at a fixed lower price, referred to as the exercise or strike price.
The idea behind share incentive plans is simply to affiliate the best
interests of CEOs and senior managers with those of shareholders.
Problems Aligning Managers’
and Owners’ Interests



36
Few companies require executives to own the stock
after exercising an option, so often the shares.
obtained with an option exercise are sold immediately
Some companies re-price the options if the stock’s
price is far under the original exercise price, setting
the exercise price much below the original price.
It is challenging to establish a plan that compensates
executives for making long-term strategy and
investment decisions today that take the long-run
view of maximizing owners’ equity.
Aligning Managers’ and
Owners’ Interests
 Corporate governance is the set of processes and
procedures established to manage the
organization in the best interests of its owners.
 In addition to the compensation structure,
corporate governance includes


37
the composition and processes of the compensation
committee of the company’s board of directors,
the composition of the committee that selects and
oversees the work of the independent auditor and the
transparency of financial reporting.
Aligning Managers’ and
Owners’ Interests
 The compensation committees of the board of
directors that design compensation systems
were not always completely independent of
the CEOs who received the compensation, but
this changed with the Sarbanes-Oxley Act of
2002 (SOX Act).
 As a result of the SOX Act, publicly-traded
companies in the U.S. must now have
compensation committees that comprise
independent directors.
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2.4 Financial Management
Financial management is the management of the
financial resources of a business or government
entity, where financial resources include both the
investments of the entity, but also how the entity
finances these assets.
39
Investment Decisions
 Capital budgeting
or capital expenditure
analysis- the framework for analyzing longterm investment or asset decisions

Some of the most important decisions a company
can make
 These long-term investments include building
a new plant, introducing a new product, and
acquiring another company. Without capital
investments, the company will not continue as
a going concern.
40
Investment Decisions
 Evaluating capital budgets requires analyzing
the future incremental cash flows that a
project is expected to generate, considering
the project’s cost of capital.
 In most cases, a capital investment requires a
substantial outlay at the beginning, but the
investment is expected to generate
incremental cash flows for a number of
periods into the future.
41
Long-term vs. Short-term
Investments
 Long-term investments make up only 16%
of total assets, on average, for U.S.
business entities.
 However, if we break this down by
industry, we get a different picture: the
investment of companies’ assets varies by
industry.
42
Asset Composition for CSX, Wal-Mart
Stores, and Darden Restaurants
43
Financing Decisions
 The
financing decisions of a company involve the
management of short-term obligations, such as
bank loans, and long-term financing, which may
be debt and/or equity.
 The management of short-term obligations
requires understanding the needs of the company
throughout the year for short-term borrowing and
trade credit.
 There are many forms of short-term financing,
and the financial manager must evaluate the cost
of each available type.
44
Financing Decisions
 An important decision of a
company regards its
capital structure.
 A company’s capital structure is the mix of debt
and equity that the company uses to finance its
business.
 Debt capital consists of interest-bearing debt
obligations, which may be notes or bonds,
whereas equity capital consists of stock issues
and retained earnings and is the ownership
interest in a business enterprise.
45
Capital Composition for CSX, WalMart Stores, and Darden Restaurants
46
Corporate Finance
 Corporate finance
is the financial management of
assets and corporate financing decisions.
 Five major questions:
How does a company decide between raising money through
debt or through equity?
2. In terms of equity, how does a company raise the equity:
through retaining earnings or through issuing new equity?
3. Why does a company decide to go public and issue shares to
the general public vs. remaining a non-traded private
company?
4. If a company decides to issue debt, what determines whether
it is bank debt or bonds issued to the public debt market?
5. What determines whether a company accesses the shortterm money market vs. borrowing from a bank?
1.
47
Summary
 There are many
different ways of
organizing businesses, including the sole
proprietorship, partnership, corporate, and
limited liability company forms of business.
 Considerations in evaluating the form of
business enterprise include liability,
taxation, control, and continuity.
48
Summary, continued
 The management
of a company should
make decisions that maximize owners’
wealth, though this is not always the case.
 In large corporations, in which there is
separation between management and owners,
motivating management to act in the owners’
best interest is challenging.
 Agency
costs may arise because managers
may not act in the best interests of
shareholders or because they must be
induced to act optimally.
49
Summary, continued
 The primary
decisions made by
corporations involve the financial
management of the company’s real and
financial assets, as well as the associated
corporate financing decisions.
50