Download treasurer- manager responsible for financing, cash management

Chapter 1
Introduction to Corporate Finance
To survive and prosper, a company must satisfy its customers. It must also
produce and sell products and services at a profit. In order to produce, it needs
many assets—plant, equipment, offices, computers, technology, and so on. The
company has to decide (1) which assets to buy and (2) how to pay for them. The
financial manager plays a key role in both these decisions. The investment
decision (decision to invest in assets like plant, equipment, and know-how) is in
large part a responsibility of the financial manager. So is the financing decision,
the choice of how to pay for such investments.
Starting by explaining how businesses are organized. A brief introduction to the
role of the financial manager has been provided and why corporate managers
need a sophisticated understanding of financial markets has also been explained.
Next discussion turns to the goals of the firm and what makes for a good financial
decision. Is the firm’s aim to maximize profits?
Organizing a Business
SOLE PROPRIETORSHIPS
A SOLE OWNER OF A BUSINESS WHICH HAS NO PARTNERS AND NO
SHAREHOLDERS. THE PROPRIETOR IS PERSONALLY LIABLE FOR ALL THE FIRM’S
OBLIGATIONS.
A sole proprietor is responsible for all the business’s debts and other liabilities. If
the business borrows from the bank and subsequently cannot repay the loan, the
bank has a claim against proprietor’s personal belongings. It could force
1
proprietor into personal bankruptcy if the business debts are big enough. Thus a
sole proprietor has unlimited liability.
Q.1. Who is a sole proprietor?
Ans.1. A sole owner of a business which has no partners and no shareholders. The
proprietor is personally liable for all the firm’s obligations.
Q.2. A sole proprietor has __________ liability.
Ans.2. unlimited
PARTNERSHIPS
BUSINESS IS OWNED BY TWO OR MORE PERSONS WHO ARE PERSONALLY
RESPONSIBLE FOR ALL ITS LIABILITIES.
Partners, like sole proprietors, have the disadvantage of unlimited liability. If the
business runs into financial difficulties, each partner has unlimited liability for all
the business’s debts, not just his or her share.
Q.3. What is partnership?
Ans.3. In partnership, business is owned by two or more persons who are
personally responsible for all its liabilities.
Q.4. In partnership business each partner has _________ liability.
Ans.4. unlimited
CORPORATIONS
BUSINESS IS OWNED BY STOCKHOLDERS WHO ARE NOT PERSONALLY LIABLE FOR
THE BUSINESS’S LIABILITIES.
2
Unlike a proprietorship or partnership, a corporation is legally distinct from its
owners. It is based on articles of incorporation that set out the purpose of the
business, how many shares can be issued, the number of directors to be
appointed, and so on. These articles must conform to the laws of the state in
which the business is incorporated. The corporation is owned by its stockholders
and they get to vote on important matters. Unlike proprietorships or
partnerships, corporations have limited liability, which means that the
stockholders cannot be held personally responsible for the obligations of the firm.
The most a stockholder can lose is the amount invested in the stock. While the
stockholders of a corporation own the firm, they do not usually manage it.
Instead, they elect a board of directors, which in turn appoints the top managers.
The board is the representative of shareholders and is supposed to ensure that
management is acting in their best interests. This separation of ownership and
management is one distinctive feature of corporations. In other forms of business
organization, such as proprietorships and partnerships, the owners are the
managers. The separation between management and ownership gives a
corporation more flexibility and permanence than a partnership. Even if managers
of a corporation quit or are dismissed and replaced by others, the corporation can
survive. Similarly, today’s shareholders may sell all their shares to new investors
without affecting the business. In contrast, ownership of a proprietorship cannot
be transferred without selling out to another owner-manager. Given these
advantages, you might be wondering why all businesses are not organized as
corporations. One reason is the time and cost required to manage a corporation’s
legal machinery. When a corporation is established, the shares may all be held by
a small group, perhaps the company’s managers and a small number of backers
3
who believe the business will grow into a profitable investment. Shares are not
publicly traded and company is closely held. Eventually, when the firm grows and
new shares are issued to raise additional capital, the shares will be widely traded.
Such corporations are known as public companies. Most well-known corporations
are public companies.
The financial managers of a corporation are responsible, by way of top
management and the board of directors, to the corporation’s shareholders.
Financial managers are supposed to make financial decisions that serve
shareholders’ interests. Table 1.1 presents the distinctive features of the major
forms of business organization.
Table 1.1
Characteristics of business organizations
Sole
Proprietorship
Partnership
Corporation __
Who owns the business?
The manager
Partners
Shareholders
Are managers and owner(s)
separate?
No
No
Usually
What is the owner’s?
liability?
Unlimited
No
Unlimited
Limited
Are the owner and
business taxed separately?
taxed separately?
No
No
Yes
Q.5. What is a corporation?
Ans.5. In a corporation, business is owned by stockholders who are not personally
liable for the business’s liabilities.
4
Q.6. Corporations have __________ liability.
Ans.6. limited
Q.7. Who owns a sole proprietor business?
Ans.7. Manager owns a sole proprietor business.
Q.8. Who owns a partnership business?
Ans.8. Partners own a partnership business.
Q.9. Who owns a corporation?
Ans. Shareholders own a corporation.
Q.10. Are managers and owner(s) separate in a sole proprietorship?
Ans.10. No.
Q.11. Are managers and owner(s) separate in a partnership?
Ans.11. No.
Q.12. Are managers and owner(s) separate in a corporation?
Ans.12.Usually
The Role of the Financial Manager
To carry on business, companies need an almost endless variety of real assets.
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. To obtain the necessary money, the company sells
financial assets, or securities.
REAL ASSETS- USED TO PRODUCE GOODS AND SERVICES.
5
Q.13.What is real assets?
Ans.13. Real assets are used to produce goods and services. Many of these assets
are tangible, such as machinery, factories, and offices; others are intangible, such
as technical expertise, trademarks, and patents.
FINANCIAL ASSETS- CLAIMS TO THE INCOME GENERATED BY REAL ASSETS. ALSO
CALLED SECURITIES.
Q.14.What is financial assets?
Ans.14. Financial assets claim to the income generated by real assets. Also called
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 from the bank, the bank has a financial asset. That financial asset gives it a
claim to a stream of interest payments and to repayment of the loan. The
company’s real assets need to produce enough cash to satisfy these claims.
FIGURE 1.1
(2)
Firm’s operations
(a bundle of real
assets)
(1)
Financial
manager
(3)
(4b)
Financial markets
(investors holding
financial assets)
(4a)
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 Figure 1.1,
which traces how money flows from investors to the firm and back to investors
again. The flow starts when financial assets are sold to raise cash (arrow 1 in the
6
figure). The cash is employed to purchase the 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 first place (arrow 4b). Of course the 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 stage 4b.
This flow chart suggests that the financial manager faces two basic problems.
First, how much money should the firm invest, and what specific assets should the
firm invest in? This is the firm’s investment, or capital budgeting decision. Second,
how should the cash required for an investment be raised? This is the financing
decision.
FINANCIAL MARKETS- MARKETS IN WHICH FINANCIAL ASSETS ARE TRADED.
CAPITAL BUDGETING DECISION- DECISION AS TO WHICH REAL ASSETS THE FIRM
SHOULD ACQUIRE.
FINANCING DECISION- DECISION AS TO HOW TO RAISE THE MONEY TO PAY FOR
INVESTMENTS IN REAL ASSETS.
Q.15. What is Financial Markets?
Ans.15. Financial market is a market in which financial assets are traded.
THE CAPITAL BUDGETING DECISION
Capital budgeting decisions are central to the company’s success or failure. For
example, in the late 1980s, the Walt Disney Company committed to construction
of a Disneyland Paris theme park at a total cost of well over $2 billion. Instead of
7
providing profits on the investment, accumulated losses on the park were more
than $200 million. Contrast that with Boeing’s decision to “bet the company” by
developing the 757 and 767 jets. Boeing’s investment in these planes was $3
billion. By 1997, estimated cumulative profits from this investment were
approaching $8 billion and the planes were still selling well.
Disney’s decision to invest in Euro Disney and Boeing’s decision to invest in a new
generation of airliners are both examples of capital budgeting decisions. The
success of such decisions is usually judged in terms of value. Good investment
projects are worth more than they cost. Adopting such projects increases the
value of the firm and therefore the wealth of its shareholders. For example,
Boeing’s investment produced a stream of cash flows that were worth much more
than its $3 billion outlay.
Q.16. What is a capital budgeting decision?
Ans.16. Decision as to which real assets the firm should acquire is called capital
budgeting decision.
THE FINANCING DECISION
The financial manager’s second responsibility is to raise the money to pay for the
investment in real assets. This is called financing decision.
The decision to invest in a new factory or to issue new shares of stock has longterm consequences. But the financial manager is also involved in some important
short-term decisions. For example, she needs to make sure that the company has
enough cash on hand to pay next week’s bills and that any spare cash is put to
work to earn interest. Such short-term financial decisions involve both investment
8
(how to invest spare cash) and financing (how to raise cash to meet a short-term
need).
Businesses are inherently risky, but the financial manager needs to ensure that
risks are managed. For example, the manager will want to be certain that the firm
cannot be wiped out by a sudden rise in oil prices or a fall in the value of the
dollar.
Q.17. What is a financing decision?
Ans.17. Decision as to how to raise the money to pay for investments in real
assets is called financing decision.
Financial Institutions and Markets
If a corporation needs to borrow from the bank or issue new securities, then its
financial manager had better understand how financial markets work. The capital
budgeting decision also requires an understanding of financial markets. A
successful investment is one that increases firm value.
FINANCIAL INSTITUTIONS
Most firms are too small to raise funds by selling stocks or bonds directly to
investors. When these companies need to raise funds to help pay for a capital
investment, the only choice is to borrow money from a financial intermediary like
a bank or insurance company. The financial intermediary, in turn, raises funds,
often in small amounts, from individual households. For example, a bank raises
funds when customers deposit money into their bank accounts.
9
FINANCIAL INTERMEDIARY – FIRM THAT RAISES MONEY FROM MANY SMALL
INVESTORS
AND
PROVIDES
FINANCING
TO
BUSINESSES
OR
OTHER
ORGANIZATIONS BY INVESTING IN THEIR SECURITIES.
Q.18. Explain to financial intermediary.
Ans.18. Firm that raises money from many small investors and provides financing
to businesses or other organizations by investing in their securities is called
financial intermediary.
FINANCIAL MARKETS
As firms grow, their need for capital can expand dramatically. At some point, the
firm may find that “cutting out the middle-man” and raising funds directly from
investors is advantageous. At this point, it is ready to sell new financial assets,
such as shares of stock, to the public. The first time the firm sells shares to the
general public is called the initial public offering, or IPO. Investors who buy shares
are contributing funds that will be used to pay for the firm’s investments in real
assets. In return, they become part-owners of the firm and share in the future
success of the enterprise.
A new issue of securities increases both the amount of cash held by the company
and the amount of stocks or bonds held by the public. Such an issue is known as a
primary issue and it is sold in the primary market. But in addition to helping
companies raise new cash, financial markets also allow investors to trade stocks
or bonds between themselves. For example, Smith might decide to raise some
cash by selling her AT&T stock at the same time that Jones invests his spare cash
in AT&T. The result is simply a transfer of ownership from Smith to Jones, which
has no effect on the company itself. Such purchases and sales of existing
10
securities are known as secondary transactions and they take place in the
secondary market.
PRIMARY MARKET- MARKET FOR THE SALE OF NEW SECURITIES BY
CORPORATIONS.
SECONDARY MARKET- MARKET IN WHICH ALREADY ISSUED SECURITIES ARE
TRADED AMONG INVESTORS.
Q.19. What is a primary market?
Ans.19. Primary market is a market for the sale of new securities by corporations.
Q.20. Explain to secondary market.
Ans.20. Secondary market is a market in which already issued securities are
traded among investors.
OTHER FUNCTIONS OF FINANCIAL MARKETS AND INSTITUTIONS
Financial markets and institutions provide financing for business. They also
contribute in many other ways to individual’s well-being and the smooth
functioning of the economy. Here are some examples.
The Payment Mechanism. Think how inconvenient life would be if you had to pay
for every purchase in cash or if General Motors had to ship truckloads of hundreddollar bills round the country to pay its suppliers. Checking accounts, credit cards,
and electronic transfers allow individuals and firms to send and receive payments
quickly and safely over long distances. Banks are the obvious providers of
payment services.
11
Borrowing and Lending. Financial institutions allow individuals to transfer
expenditures across time. If you have more money now than you need and you
wish to save for a rainy day, you can (for example) put the money on deposit in a
bank. If you wish to anticipate some of your future income to buy a car, you can
borrow money from the bank. Both the lender and the borrower are happier than
if they were forced to spend cash as it arrived. Of course, individuals are not alone
in needing to raise cash from time to time. Firms with good investment
opportunities raise cash by borrowing or selling new shares.
In principle, individuals or firms with cash surpluses could take out newspaper
advertisements or surf the Net looking for counterparts with cash shortages. But
it is usually cheaper and more convenient to use financial markets or institutions
to link the borrower and the lender. For example, banks are equipped to check
the borrower’s creditworthiness and to monitor the use of the cash.
Almost all financial institutions are involved in channeling savings toward those
who can best use them. Pooling Risk. Financial markets and institutions allow
individuals and firms to pool their risks. Insurance companies are an obvious
example. Here is another. Suppose that you have only a small sum to invest. You
could buy the stock of a single company, but then you could be wiped out if that
company went belly-up. It’s generally better to buy shares in a mutual fund that
invests in a diversified portfolio of common stocks or other securities. In this case
you are exposed only to the risk that security prices as a whole may fall.
Who Is the Financial Manager?
The term financial manager is used to refer to anyone responsible for a significant
corporate investment or financing decision. But except in the smallest firms, no
12
single person is responsible for all the decisions. Responsibility is dispersed
throughout the firm. Top management is of course constantly involved in financial
decisions. But the engineer who designs a new production facility is also involved:
the design determines the kind of asset the firm will invest in. Likewise the
marketing manager who undertakes a major advertising campaign is making an
investment decision: the campaign is an investment in an intangible asset that will
pay off in future sales and earnings.
Q.21. Who is the Financial Manager?
Ans.21. Financial manager is a person responsible for a significant corporate
investment or financing decision.
FIGURE 1.2
Chief Financial Officer (CFO)
Responsible for:
Financial policy
Corporate planning
Treasurer
Responsible for:
Cash management
Raising capital
Banking
relationships
Controller
Responsible for:
Preparation of financial
statements Accounting
Taxes
Nevertheless, there are managers who specialize in finance, and their functions
are summarized in Figure 1.2. The treasurer is usually the person most directly
responsible for looking after the firm’s cash, raising new capital, and maintaining
relationships with banks and other investors who hold the firm’s securities.
13
For small firms, the treasurer is likely to be the only financial executive. Larger
corporations usually also have a controller, who prepares the financial
statements, manages the firm’s internal accounting, and looks after its tax affairs.
It can be seen that the treasurer and controller have different roles: the
treasurer’s main function is to obtain and manage the firm’s capital, whereas the
controller ensures that the money is used efficiently.
The largest firms usually appoint a chief financial officer (CFO) to oversee both the
treasurer’s and the controller’s work. The CFO is deeply involved in financial
policymaking and corporate planning. Often he or she will have general
responsibilities beyond strictly financial issues.
TREASURER- MANAGER RESPONSIBLE FOR FINANCING, CASH MANAGEMENT,
AND RELATIONSHIPS WITH FINANCIAL MARKETS AND INSTITUTIONS.
CONTROLLER- OFFICER RESPONSIBLE FOR BUDGETING, ACCOUNTING, AND
AUDITING.
CHIEF FINANCIAL OFFICER- (CFO) OFFICER WHO OVERSEES THE TREASURER AND
CONTROLLER AND SETS OVERALL FINANCIAL STRATEGY.
Usually the treasurer, controller, or CFO is responsible for organizing and
supervising the capital budgeting process. However, major capital investment
projects are so closely tied to plans for product development, production, and
marketing that managers from these other areas are inevitably drawn into
planning and analyzing the projects. If the firm has staff members specializing in
corporate planning, they are naturally involved in capital budgeting too.
14
Because of the importance of many financial issues, ultimate decisions often rest
by law or by custom with the board of directors. For example, only the board has
the legal power to declare a dividend or to sanction a public issue of securities.
Boards usually delegate decision-making authority for small or medium-sized
investment outlays, but the authority to approve large investments is almost
never delegated.
Q.22. Who is a Treasurer?
Ans.22. Manager responsible for financing, cash management, and relationships
with financial markets and institutions is known as Treasurer.
Q.23. Who is a Controller?
Ans.23. Officer responsible for budgeting, accounting, and auditing is known as
Controller.
Q.24. Who is a Chief Financial Officer?
Ans.24. Officer who oversees the treasurer and controller and sets overall
financial strategy is known as Chief Financial Officer.
Q.25. In corporation stockholders cannot be held personally responsible for the
obligations of the firm. (True)
Q.26. Separation of ownership and management is one distinctive feature of
corporations. (True)
Q.27. Even if managers of a corporation quit or are dismissed and replaced by
others, the corporation ________ survive.
Ans.27. Can
15
Q.28. Shareholders may not sell all their shares to new investors without affecting
the business. (False)
Ans.28. Shareholders may sell all their shares to new investors without affecting
the business.
Q.29. Financial managers are not supposed to make financial decisions that serve
shareholders’ interests. (False)
Ans.29. Financial managers are supposed to make financial decisions that serve
shareholders’ interests.
16