CHAPTER 1

Overview of Financial
Management and the Financial
Environment

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Topics in Chapter
 Forms of business organization
 Objective of the firm: Maximize wealth

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Why is corporate finance
important to all managers?
 Corporate finance provides the skills
managers need to:
 Identify and select the corporate strategies
and individual projects that add value to
their firm.
 Forecast the funding requirements of their
company, and devise strategies for
acquiring those funds.

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Business Organization from Start-
up to a Major Corporation
 Sole proprietorship
 Partnership
 Corporation

(More . .)

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Starting as a Proprietorship
 Advantages:
 Ease of formation
 Subject to few regulations
 No corporate income taxes
 Disadvantages:
 Limited life
 Unlimited liability
 Difficult to raise capital to support growth

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Starting as or Growing into a
Partnership
 A partnership has roughly the same
advantages and disadvantages as a sole
proprietorship.

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Becoming a Corporation
 A corporation is a legal entity separate
from its owners and managers.
 File papers of incorporation with state.
 Charter

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Advantages and Disadvantages of
a Corporation
 Advantages:
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Ease of raising capital
 Disadvantages:
 Double taxation(corporate taxes & income
taxes)
 Cost of set-up and report filing
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How does a corporation enter
the Stock Market
 It contacts an investment bank and the
bank performs a feasibility study for the
company
 The investment bank authorizes the
company to issue a certain number of
shares and buys them at a low price
from the company

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How does a corporation enter
the Stock Market
 The investment bank sells the stocks or
shares it has bought (underwritten
stocks) to the public at a higher price
 The public (investors) later sell these
underwritten stocks in the stock market
by contacting a stock broker
 This whole process is known as “Initail
Public Offering” for the corporation
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Becoming a Public Corporation
and Growing Afterwards
 Initial Public Offering (IPO) of Stock
 Raises cash
 Allows founders and pre-IPO investors to
“harvest” some of their wealth

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Agency Problem
 Since a corporation is a separate legal
entity its managers are different from
owners, therefore there is conflict of
interest between both parties
 The manager wants higher salaries and
more prestige. They want to become
well-known by all that they increased
the profits of the company.
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Agency Problem
 As a result managers will not distribute
profits to shareholders (Dividends) and
leave the profits for future investment
in projects (Retained Earnings) that will
bring higher profits
 Shareholders or owners of the
corporation want to receive a large
percentage of company profits as
dividends. 13
Agency Problem
Could this conflict of interest or “Agency
Problem” be resolved?
YES

HOW?

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Resolving Agency Problem
 Shareholders owning more than 50% of
company shares could force managers
to distribute more dividends. They could
also fire or hire managers as they
please
 Managerial compensation: managers
could be given a small percentage of
company shares.
 Corporate Governance 15
Agency Problems and
Corporate Governance
 Agency problem: managers may act in their
own interests and not on behalf of owners
(stockholders)
 Corporate governance is the set of rules that
control a company’s behavior towards its
directors, managers, employees,
shareholders, creditors, customers,
competitors, and community.
 Corporate governance can help control
agency problems.
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What should be management’s
primary objective?
 The primary objective should be
shareholder wealth maximization, which
translates to maximizing the
fundamental stock price.
 Should firms behave ethically? YES!
 Do firms have any responsibilities to
society at large? YES! Shareholders are
also members of society.

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