Chapter 1

Introduction to Financial
Management
 Additional Activities and Materials

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Forms of Business Organizations

ACTIVITY
Identify if the given information pertains to
Sole Proprietorship (SP), Partnership (P),
Corporation (C)

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Forms of Business Organizations

 unincorporated business owned by a single individual

SP (definition)
 non-corporate business conducted by two or more
persons
P (definition)
 legal entity created by state, separate and distinct
from its owners
C (definition)
 easily formed and inexpensive, with fewest gov’t
regulations, avoids corporate income taxes
SP (advantages)

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Forms of Business Organizations

 unlimited life, easy transferability of ownership, limited

liability, ease in raising capital
C (advantages)
 low cost and ease of formation, avoids corporate
income taxes (for a general professional form; for a
regular form in the conduct of business, taxation is
similar with a corporation)
P (advantages)
double taxation, more complex, more time consuming in
formation
C (disadvantages)

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Forms of Business Organizations

 difficult to obtain large capital compared to partnership

(owners of this form are unable to sell interest or
shares to raise capital; to raise new capital, change in
the structure is needed), unlimited liability (no personal
asset protection), limitation of life
SP (disadvantages)
 unlimited liability, limited life, difficulty in transferring
ownership, difficulty in raising large amounts of capital
compared to corporation
P (disadvantages)
SEC
P and C (registration)
DTI
SP (registration) 1-5
Forms of Business Organizations

 S Corporations
 for small businesses (C Corporation for large
businesses
 Taxed as partnership (general professional); no
corporate income tax; stockholders are taxed;
 with no more than 100 stockholders;
 generally, stockholders are individuals, not
corporations, partnership and non-resident aliens

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Forms of Business Organizations

 Limited Liability Companies (LLCs)/ Limited Liability

Partnerships (LLP)
 New type of organization
 Hybrid of partnership and corporation (limited
liability for members like corporation but taxed like
general professional partnership)
 LLPs for professional firms (accountants, lawyers,
architects); LLCs for others businesses

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Forms of Business Organizations

 S Corporation vs LLC
 Unlike S Corporation, LLC can be owned by
corporations, partnerships and non-resident aliens
 Limited Partnership vs. LLP
 Unlike in Limited Partnership, all partners in LLP
have limited liabilities; LLP partners are liable for
their own acts of malpractice but not for those of
other partners

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 Determinants of Intrinsic Values and
Stock Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political Climate

“True” Investor “True” “Perceived”

“Perceived” Investor
Cash Flows/Return Risk Risk
Cash Flows/Return

Stock’s Stock’s
Intrinsic Value Market Price

Market equilibrium:
Intrinsic Value = Stock Price
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Identifying the Marginal Investor in your firm…

Percent of Stock Percent of Stock held by Marginal Investor

held by Insiders
Institutions
High Low Institutional Investor

High High Institutional Investor, with

insider influence
Low High (held by Tough to tell; Could be insiders
founder/manager of firm) but only if they trade. If not, it
could be individual investors.
Low High (held by wealthy Wealthy individual
individual investor) investor, fairly diversified

Low Low Small individual investor

with restricted diversification
Some Important Business Trends

 Corporate scandals have reinforced the importance

of business ethics, and have spurred additional
regulations and corporate oversight.
 Increased globalization of business (improvement
in transportation; lower cost of business overseas-
BPO: Acctg., IT, Customer Service)
 The effects of ever-improving information
technology have had a profound effect on all
aspects of business finance.
 Stockholders now have more control of corporate
governance.

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Business Ethics

 Standards of conduct; towards people (e.g.

customers, employees, stockholders, community)
 Code of conduct; Profit or Ethics?
 Consequences of unethical behavior:
bankruptcies, lost of investor’s faith (e.g.
medical, environmental)
 Employees’ action or response:
 Do the right thing and loose job or
 Secure job, ok with boss, emotional stress, down
fall of company, go to job; (own experience)
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Agency Relationship and Conflict

 Agency relationship: principal and agent; delegation

 Managers and shareholders: managers act/handles the
company in behalf of the shareholders
 Shareholders and bond holders: shareholder ensures
debt capital borrowed is effectively utilized without
reduction in the wealth of the bondholders.
Bondholders are the principal whose wealth is
influenced by the value of the bond and the number of
bonds held.
 Agency problem (manager vs. shareholder): manager
owns less than 100% of the CS; if 100%, you have
manager-owner, no problem
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Agency Relationship and Conflict

 Agency problem (shareholder vs. bondholder):

Shareholders take action which will reduce the market
value of the bond
a) Disposal of assets used as collateral for the debt; loss of
source of cash payment in case of liquidation;
b) Investment in risky projects: If successful, gain goes to
shareholders but not to creditors (fixed interest income);
c) Payment of high dividends: lower capital from
reinvestment which may lower market value of shares and
bonds

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Agency Relationship and Conflict

d) Additional debt or borrowing more capital:

 increases the risk on the side of the
borrower/corporation thus increases the corp.’s risk
and its ability to pay the creditors;
 borrowing more debt using the same asset as a
collateral for the new debt. The value of the old
bond or debt will be reduced if the new debt takes a
priority on the collateral in case the firm is
liquidated.
 borrowing to repurchase of stocks (increase
leverage): increase in rate of return for shareholders
but may be the same for creditors
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Solution to Agency Problems (Between
Managers and Shareholders)
1) Managerial Compensation
 compensation package: annual salary, bonus (based
on profitability or stock price but not sales),
performance shares, stock options
 performance shares: executive receives shares based
on company’s performance
 stock options: option to buy stock at a future date
and given price; managers will increase value to gain
in buying shares; not one time but phased through
number of years so that stock’s performance will
increase in the long run not only on the exercise
date
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Solution to Agency Problems (Between
Managers and Shareholders)
2) Shareholder Intervention
 Shares before are generally owned by individuals;
now some or majority are owned by institutional
investors (e.g. insurance co., mutual fund, pension
fund)
 Institutional investors can influence
firm’s operations
by making suggestions and voting for major
decisions
3) Threat of Firing
 removalby a higher management over the lower
management

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Solution to Agency Problems (Between
Managers and Shareholders)
4) Hostile Takeover
 acquisition
of the company over the opposition of
the management; due to management’s poor
performance
 Firm is acquired and previous management
(executives) is fired
 corporate raider: individuals who target a
corporation for a takeover because the latter is
undervalued; will do a hostile takeover and replace
the target executives
 Incentive to managers: maximize the stock price
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Solution to Agency Problems (Between
Stockholders and Creditors)
1) Restrictive covenants on debt agreements
 Issuance of new bond should be subordinated to
existing debt
 This will prevent the increase in riskiness of the
existing debt by issuing new bonds with a superior,
or equal claim on the firm’s assets
 Other covenants may prohibit the issuance of new
debt unless the firm maintains certain prescribed
financial ratios (tangible net worth and long-term
debt, tangible assets and long-term debt, income
and interest charges

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Solution to Agency Problems (Between
Stockholders and Creditors)
2) Refuse to deal
3) Increase in interest rate
 to compensate for additional risk

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