Introduction to

corporations and
financial decision
making
LECTURE 1
WEEK 1
 Learning Objectives

1. Understand the importance of financial management

2. Identify key financial decisions faced by financial managers
3. Identify basic forms of firm types and compare between each type
4. Understand the rationale of firms’ goals
5. Understand the importance of ethics and good corporate governance in a firm
 Introduction to financial management
• Financial management involves understanding why and how financial decisions are made as well as
managing financial resources to meet firms’ objectives and goals.
• To sustain a business, corporations require a variety of long-term real assets
• Tangible assets: Plant, machinery etc.
• Intangible assets: Patents, R&D, brand names etc.

• Corporations pay for these assets by selling claims on them and the cash flow that they will generate
• Claims are referred to financial securities that are traded in the financial markets (i.e., bonds &
shares)

• Therefore, in a corporation, the CFO/financial manager faces two broad questions

(1) What investments should the corporation make?
(2) How should it pay for the investments?
Key financial decisions:
Corporate investment & Important financing questions raised by Chief Financial Officer/ Financial
manager
financing decisions

• Financial managers are concerned with three fundamental types of decisions:

CFO/ Financial manager

Make Investment Make Financing

Decisions Cash management
decisions

“What to invest in?” “How to pay?” “Do we have enough funds for
short-term needs to pay our bill
• Capital budgeting • Decide how to pay short- and suppliers”
 Selecting value and long-term financing
creating long-term • Should we use internal or • Ensure there is sufficient
projects external financing? Or working capital to ensure
both? (Capital structure) short-term obligations &
goals are met

• Finally, financial managers also make decisions on the payout of dividend

 Key financial decisions:
Putting it in perspective How the financial manager’s decisions affect the balance sheet

Assets Liabilities

Working capital management decisions

Current assets • Deal with day-to-day financial matters Current liabilities
(Cash, inventory, and and affect current assets, current (short-term debt and
Short-term Short-term
accounts receivables) liabilities and net working capital accounts payable)

Capital budgeting decisions

• Determines what long-term Long-term debt
productive assets the firm will (debt with maturity of over
purchase one year
Long term productive (e.g. Corporate bonds)
assets
(plants, machinery, Financing decisions
Long-term intangible ) Long-term
• Determines the firm’s capital
structure- the combination of long- Equity
term debt and equity that will be used
to finance the firm’s long-term
Internal: Retained Earnings
productive assets
External: Shares
Key financial decisions:
Corporate investment & Financing Decisions: Sources of funds
financing decisions

Financial
Raise short-term sources markets Raise long-term sources
of liquidity of funds

Money market Capital markets

E.g., Treasury bills

Commercial notes
Debt Equity

• Bonds • Stocks
Key financial decisions:
Corporate investment &
Examples of Investments and Financing Decision by
financing decisions Major Public Corporations

Company Investment Decision Financing Decisions

McDonalds (U.S) Announces plans to expand 2,000 Issues C$1 billion of Canadian
restaurants in China dollar bonds

Tesla Motors (U.S) Starts battery cell production at its Raises about $250 million by the
new Gigafactory in Nevada sale of new shares

Lenovo (China) Announces plans to build a new Issues $850 million of 5-year
manufacturing facility in India to Dollar bonds
produce PCs and smartphones

GlaxoSmithKline (U.K) Spends $3.6 billion on research and Issues additional short-term euro
development for new drugs debt
Legal forms of business
organization Corporations and other types of firms

• Corporation
• Sole proprietorship
• Partnership
• Limited Liability Company
Legal forms of business
organization
(1) Corporations

• Corporations are established through a legal process called incorporation and

involves legal documentations.
• A legal entity established by individuals and shareholders
• Legally functions separately and apart from its owners (shareholders) and management
(Board of Directors)
• BoD are a group of individuals elected to represent shareholders and task to
make important decisions on behalf shareholders
• Ownership is transferable as it is dictated by shareholdings
• Corporation type business offers a distinct feature that protects its owners from
being personally liable in legal lawsuit matters.
Legal forms of business
organization
(1) Corporations (Con’t)

Characteristics
• Ownership Represented by shares of stocks
• Owner of stock is called shareholder/stockholders/equity holder
• Sum of all ownership value is called equity (external equity)
• There is no limit to the number of shareholders, and thus the amount of funds a
company can raise by selling stock
• Stock owner is entitled to dividend payments

Advantages Disadvantages
• Greater access to sources of funds • Corporations must be legally formed. A legal
• Easy transfer of ownership through documented is created upon the formation of
shares the corporation
• Limited liability – not personally liable • Expensive; legal and accounting, audit fees
for losses • Heavy taxes
Legal forms of business
organization Ownership versus control of corporations
In corporation type entity, ownership and direct control are typically separate ownership & management

Elected by shareholders (owners) & have

ultimate decision-making authority

Makes the key financial decisions

Legal forms of business
organization (2) Sole Proprietorship

• Typically, a business owned by one individual; simplest type of business

• Does not have separate legal identity; Business owner has full control over
business decisions and operations
• Business is fully liable for any liabilities incurred
• Offers the least financial and legal protection to business owner

Advantages Disadvantages
• Easy to start • Unlimited personal liability
• Full control over business • Limited business continuity
operations • Difficult to transfer ownership
• Less taxes
Legal forms of business
organization (3) Partnerships

• Partnership is owned by two or more people

• Ownership in partnership have joint responsibilities for the firm
• All partners are personally liable for all the firm’s debts. A lender can require any
partner to repay all of the firms’ outstanding debts
• In terms of business continuity, the partnership ends with the death or
withdrawal of any single partnership
Legal forms of business
organization (3) Partnership (cont.’)

Limited partnership has two types of owners

(1) General partnership

• Have the same rights and liability as partners in a “regular” partnership (personally liable for firm’s debt
obligations.

(2) Limited Partnership

• This partnership has at least one general partner which takes on the unlimited liability for the partnership
• Limited partners have no personal liabilities
• Have no management authority and cannot legally be involved in the managerial decision making for the
business

Advantages Disadvantages
• Better access to capital and skills • Challenging and costly to dissolve because when
• Subjected to fewer regulations one partner leaves, assets must be value
• Shared control and profit
Legal forms of business (4) Limited Liability Company (LLC)
organization

• Limited liability Companies combines aspects of few business types like partnership or
sole proprietorship and corporation
• The defining advantage of this type of business type is that business owners have limited
liability
• Not share traded
• For example, Google. Google’s shares are no longer traded but they are owned by
Alphabet Co
Legal forms of business
organization Comparing different firm types

Consider
• Organization requirements and costs
• What are the legal, management, consulting fees?
• Liability of owners
• What is the extent of liability of the owners? Limited vs unlimited?
• Continuity of business
• How prepared is the firm to navigate in difficult and unprecedented situations?
• Transferability of ownership
• How easy is it to transfer ownership in the business?
Legal forms of business
organization Comparison of organizational forms (cont’)

• Management control
• Who makes the decisions?

• Ease of capital raising

• How easy it to obtain financing?

• Income taxes
• How different is the taxes paid between business types?
Goal of firms
Profit maximization vs Shareholders’ wealth
maximization?
• In a corporation, shareholders’ delegate company’s management to professional managers
• Should a corporation focus on profit maximization vs maximization of shareholders’ wealth?

• Accounting profit differs from cash flows (TR > TC)

Profit
• Profit earned may not equal cash received – Cash not
maximization
received cannot be used to pay its expenses
• The strategy ignores the timing of future cash flows

Maximizing • Future cash flows are considered

shareholders’ • The timing of future cash flows is considered
wealth • The risks associated with having to wait for
cash flows are considered
Goal of firms Maximizing shareholders’ wealth

• Corporations tend to be growth-oriented, and therefore prioritize maximizing shareholders’

wealth
• Tend to care about timing of cash flows
• Net present value (NPV) is used in capital budgeting and investment planning to analyze the
profitability of a projected investment on a project
• Evaluates the present values of cash inflows and cash outflows over a period of time
• If project yield a positive NPV  Accept project

• Ultimately, shareholders want the financial manager to increase the value of corporation and its
current stock price
• They do this by undertaking positive value creating projects and investments
 Goal of firms
Cash flow is king

• Positive residual cash flows may be paid to firm owners as dividends or invested
in the firm
• The larger the positive residual cash flow, the greater the value of firm
• Negative residual cash flows – over the long – leads to bankruptcy or business
closures
 Maximizing firm and share value: Link between project & share
Goal of firms
value

Apple (APPL) Inc.’s stock price performance, 1988 - 2020

What did Apple do

differently that change its
trend from 2000s?

Innovation through
value positive
projects
Ethics and incentives in
firms Ethics and incentives within Corporations

• Agency problems arises when managers act in their own interest than in the best interest of the shareholders.

Management Shareholders
Agency Problem vs
(Agent) (Principal)

Wants higher salary + Want company value +

Bonus + benefits returns + dividends

• Prefer projects that generate quick returns compared to longer-term projects with potentially
higher return – Poor strategic choices
• Quick short-term profits but long-term consequences may be potentially damaging to
shareholder value – can destroy firm value
Ethics and incentives in
firms How should CEO performance be measured?

CEO performance
If a CEO is performing poorly:
• Shareholders can express their dissatisfaction by selling their shares. This selling pressure will drive the
stock price down
• Hostile Takeover
• Low stock prices may entice a corporate raider to buy enough stock so that they have enough control
to replace current management. The stock price will rise after the new management team “fixes” the
company
• Alternatively, Shareholders could pressure the board to reappoint a new CEO

• Therefore, corporations must combine governance rules and procedures with appropriate incentives to
ensure that managers and employees work together to increase firm value.

Can agency problems occur in other firm types?

 Summary
In this lecture we covered

1. Importance of financial management to achieve company’s short & long-term

goals
2. Identify key financial decisions faced by financial managers
3. Identify basic forms of firm types and compare between each type
4. Understand the rationale of firms’ goals
5. Understand the importance of ethics and good corporate governance in a
corporation