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 Selected material from

Fundamentals of Corporate Finance

Third Edition
Richard A. Brealey
Bank of England and London Business School

Stewart C. Myers
Sloan School of Management
Massachusetts Institute of Technology

Alan J. Marcus
Wallace E. Carroll School of Management
Boston College

with additional material from

Fundamentals of Corporate Finance, Alternate Fifth Edition

Essentials of Corporate Finance, Second Edition

Stephen A. Ross, Massachusetts Institute of Technology

Randolph W. Westerfield, University of Southern California
Bradford D. Jordan, University of Kentucky

UNIVERSITY OF PHOENIX

Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. Louis
Bangkok Bogotá Caracas Lisbon London Madrid
Mexico City Milan New Delhi Seoul Singapore Sydney Taipei Toronto
Selected material from
FUNDAMENTALS OF CORPORATE FINANCE, Third Edition
with additional material from
FUNDAMENTALS OF CORPORATE FINANCE, Alternate Fifth Edition
ESSENTIALS OF CORPORATE FINANCE, Second Edition

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Ex-
cept as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distrib-
uted in any form or by any means, or stored in a data base retrieval system, without prior written permission of the pub-
lisher.

This book contains select material from:

Fundamentals of Corporate Finance, Third Edition by Richard A. Brealey, Stewart C. Myers, and Alan J. Marcus. Copyright
© 2001, 1999, 1995, by The McGraw-Hill Companies, Inc.
Fundamentals of Corporate Finance, Alternate Fifth Edition by Stephen A. Ross, Randolph W. Westerfield, and Bradford D.
Jordan. Copyright © 2000, 1998, 1995, 1993, 1991 by The McGraw-Hill Companies, Inc.
Essentials of Corporate Finance, Second Edition by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan.
Copyright © 1999 by The McGraw-Hill Companies, Inc. Previous edition © 1996 by Richard D. Irwin, a Times Mirror
Higher Education Group, Inc. company.
All reprinted with permission of the publisher.

ISBN 0-07-553109-7

Sponsoring Editor: Christian Perlee

Production Editor: Nina Meyer
Contents
SECTION 1 1
The Firm and the Financial How to Value Perpetuities 50
How to Value Annuities 51
Manager 3 Annuities Due 54
Organizing a Business 4 Future Value of an Annuity 57
Sole Proprietorships 4
Inflation and the Time Value of Money 61
Partnerships 5
Real versus Nominal Cash Flows 61
Corporations 5
Inflation and Interest Rates 63
Hybrid Forms of Business Organization 6
Valuing Real Cash Payments 65
The Role of the Financial Manager 7 Real or Nominal? 67
The Capital Budgeting Decision 8 Effective Annual Interest Rates 67
The Financing Decision 9
Summary 69
Financial Institutions and Markets 10 Related Web Links 69
Financial Institutions 10 Key Terms 70
Financial Markets 11 Quiz 70
Other Functions of Financial Markets and Practice Problems 72
Institutions 12 Challenge Problems 75
Who Is the Financial Manager? 13 Solutions to Self-Test Questions 77
Careers in Finance 15 Minicase 79

Goals of the Corporation 17 Financial Planning 81

Shareholders Want Managers to Maximize What Is Financial Planning? 82
Market Value 17 Financial Planning Focuses on the Big Picture 83
Ethics and Management Objectives 19 Financial Planning Is Not Just Forecasting 84
Do Managers Really Maximize Firm Value? 21 Three Requirements for Effective Planning 84
Snippets of History 25
Financial Planning Models 86
Summary 25 Components of a Financial Planning Model 87
Related Web Links 28 An Example of a Planning Model 88
Key Terms 28 An Improved Model 89
Quiz 28
Practice Problems 29 Planners Beware 93
Solutions to Self-Test Questions 31 Pitfalls in Model Design 93
The Assumption in Percentage of Sales Models 94
The Time Value of Money 33 The Role of Financial Planning Models 95
Future Values and Compound Interest 34 External Financing and Growth 96
Present Values 38 Summary 100
Finding the Interest Rate 44 Related Web Links 101
Multiple Cash Flows 46 Key Terms 101
Future Value of Multiple Cash Flows 46 Quiz 101
Present Value of Multiple Cash Flows 49 Practice Problems 102
Challenge Problems 106
Level Cash Flows: Perpetuities and Annuities 50 Solutions to Self-Test Questions 106

iii
IV CONTENTS

APPENDIX A 109
Financial Statement Analysis 133
Accounting and Finance 111 Financial Ratios 134
The Balance Sheet 112 Leverage Ratios 138
Book Values and Market Values 115 Liquidity Ratios 139
Efficiency Ratios 141
The Income Statement 117
Profitability Ratios 143
Profits versus Cash Flow 118
The Du Pont System 145
The Statement of Cash Flows 119
Other Financial Ratios 146
Accounting for Differences 121
Using Financial Ratios 147
Taxes 123 Choosing a Benchmark 147
Corporate Tax 123
Measuring Company Performance 150
Personal Tax 125
The Role of Financial Ratios 151
Summary 126
Related Web Links 127 Summary 153
Key Terms 127 Related Web Links 155
Quiz 127 Key Terms 155
Practice Problems 128 Quiz 155
Challenge Problem 131 Practice Problems 157
Solutions to Self-Test Questions 131 Challenge Problem 158
Solutions to Self-Test Questions 159
Minicase 160

SECTION 2 163
Working Capital Management and Bank Loans 185
Commercial Paper 186
Short-Term Planning 165
Secured Loans 186
Working Capital 167
The Cost of Bank Loans 187
The Components of Working Capital 167
Simple Interest 187
Working Capital and the Cash Conversion Cycle 168
Discount Interest 188
The Working Capital Trade-Off 171
Interest with Compensating Balances 189
Links between Long-Term and Short-Term
Summary 190
Financing 172
Related Web Links 191
Tracing Changes in Cash and Working Capital 175 Key Terms 191
Quiz 191
Cash Budgeting 177
Practice Problems 192
Forecast Sources of Cash 177
Challenge Problem 194
Forecast Uses of Cash 179
Solutions to Self-Test Questions 195
The Cash Balance 179
Minicase 197
A Short-Term Financing Plan 180
Options for Short-Term Financing 180
Cash and Inventory Management 201
Evaluating the Plan 184 Cash Collection, Disbursement, and Float 202
Float 203
Sources of Short-Term Financing 185
Valuing Float 204
 CONTENTS V

Managing Float 205 Credit Analysis 232

Speeding Up Collections 206 Financial Ratio Analysis 233
Controlling Disbursements 209 Numerical Credit Scoring 233
Electronic Funds Transfer 210 When to Stop Looking for Clues 234

Inventories and Cash Balances 211 The Credit Decision 236

Managing Inventories 212 Credit Decisions with Repeat Orders 237
Managing Inventories of Cash 215 Some General Principles 238
Uncertain Cash Flows 216
Collection Policy 239
Cash Management in the Largest Corporations 217
Investing Idle Cash: The Money Market 218 Bankruptcy 240
Bankruptcy Procedures 241
Summary 219
The Choice between Liquidation and
Related Web Links 220
Reorganization 242
Key Terms 220
Quiz 220 Summary 244
Practice Problems 221 Related Web Links 245
Challenge Problem 224 Key Terms 245
Solutions to Self-Test Questions 224 Quiz 245
Practice Problems 246
Credit Management and Collection 227 Challenge Problems 248
Terms of Sale 229 Solutions to Self-Test Questions 249
Minicase 250
Credit Agreements 231

SECTION 3 253
Valuing Bonds 255 Book Values, Liquidation Values, and Market
Values 283
Bond Characteristics 256
Reading the Financial Pages 257 Valuing Common Stocks 287
Today’s Price and Tomorrow’s Price 287
Bond Prices and Yields 259 The Dividend Discount Model 288
How Bond Prices Vary with Interest Rates 260
Yield to Maturity versus Current Yield 261 Simplifying the Dividend Discount Model 291
Rate of Return 265 The Dividend Discount Model with No Growth 291
Interest Rate Risk 267 The Constant-Growth Dividend Discount Model 292
The Yield Curve 268 Estimating Expected Rates of Return 293
Nominal and Real Rates of Interest 268 Nonconstant Growth 295
Default Risk 270 Growth Stocks and Income Stocks 296
Valuations in Corporate Bonds 273 The Price-Earnings Ratio 298
Summary 273 What Do Earnings Mean? 298
Related Web Links 274 Valuing Entire Businesses 301
Key Terms 274
Summary 301
Quiz 274
Related Web Links 302
Practice Problems 275
Key Terms 302
Challenge Problems 277
Quiz 302
Solutions to Self-Test Questions 277
Practice Problems 303
Valuing Stocks 279 Challenge Problems 306
Solutions to Self-Test Questions 307
Stocks and the Stock Market 280
Reading the Stock Market Listings 281
VI CONTENTS

Introduction to Risk, Return, and the Risk and Diversification 324

Diversification 324
Opportunity Cost of Capital 311
Asset versus Portfolio Risk 325
Rates of Return: A Review 312 Market Risk versus Unique Risk 330

Seventy-Three Years of Capital Market Thinking about Risk 331

History 313 Message 1: Some Risks Look Big and Dangerous but
Market Indexes 314 Really Are Diversifiable 331
The Historical Record 314 Message 2: Market Risks Are Macro Risks 332
Using Historical Evidence to Estimate Today’s Cost of Message 3: Risk Can Be Measured 333
Capital 317 Summary 334
Measuring Risk 318 Related Web Links 334
Variance and Standard Deviation 318 Key Terms 334
A Note on Calculating Variance 322 Quiz 335
Measuring the Variation in Stock Returns 322 Practice Problems 336
Solutions to Self-Test Questions 338

SECTION 4 339
Net Present Value and Other Investment Challenge Problems 373
Solutions to Self-Test Questions 373
Criteria 341
Net Present Value 343
Using Discounted Cash-Flow Analysis to
A Comment on Risk and Present Value 344 Make Investment Decisions 377
Valuing Long-Lived Projects 345 Discount Cash Flows, Not Profits 379
Other Investment Criteria 349 Discount Incremental Cash Flows 381
Internal Rate of Return 349 Include All Indirect Effects 381
A Closer Look at the Rate of Return Rule 350 Forget Sunk Costs 382
Calculating the Rate of Return for Long-Lived Include Opportunity Costs 382
Projects 351 Recognize the Investment in Working Capital 383
A Word of Caution 352 Beware of Allocated Overhead Costs 384
Payback 352
Book Rate of Return 355 Discount Nominal Cash Flows by the Nominal Cost
of Capital 385
Investment Criteria When Projects Interact 356
Mutually Exclusive Projects 356 Separate Investment and Financing Decisions 386
Investment Timing 357 Calculating Cash Flow 387
Long- versus Short-Lived Equipment 359 Capital Investment 387
Replacing an Old Machine 361 Investment in Working Capital 387
Mutually Exclusive Projects and the IRR Rule 361 Cash Flow from Operations 388
Other Pitfalls of the IRR Rule 363
Example: Blooper Industries 390
Capital Rationing 365 Calculating Blooper’s Project Cash Flows 391
Soft Rationing 365 Calculating the NPV of Blooper’s Project 392
Hard Rationing 366 Further Notes and Wrinkles Arising from Blooper’s
Pitfalls of the Profitability Index 3667 Project 393
Summary 367 Summary 397
Related Web Links 368 Related Web Links 398
Key Terms 368 Key Terms 398
Quiz 368 Quiz 398
Practice Problems 369
 CONTENTS VII

Practice Problems 200 Calculating Company Cost of Capital as a Weighted

Challenge Problems 402 Average 440
Solutions to Spreadsheet Model Questions 403 Market versus Book Weights 441
Solutions to Self-Test Questions 404 Taxes and the Weighted-Average Cost of Capital 442
Minicase 405 What If There Are Three (or More) Sources of
Financing? 443
Risk, Return, and Capital Budgeting 407 Wrapping Up Geothermal 444
Measuring Market Risk 408 Checking Our Logic 445
Measuring Beta 409
Measuring Capital Structure 446
Betas for MCI WorldCom and Exxon 411
Portfolio Betas 412 Calculating Required Rates of Return 447
The Expected Return on Bonds 448
Risk and Return 414
The Expected Return on Common Stock 448
Why the CAPM Works 416
The Expected Return on Preferred Stock 449
The Security Market Line 417
How Well Does the CAPM Work? 419 Big Oil’s Weighted-Average Cost of Capital 450
Using the CAPM to Estimate Expected Returns 420 Real Oil Company WACCs 450

Capital Budgeting and Project Risk 422 Interpreting the Weighted-Average Cost of
Company versus Project Risk 422 Capital 451
Determinants of Project Risk 423 When You Can and Can’t Use WACC 451
Don’t Add Fudge Factors to Discount Rates 424 Some Common Mistakes 452
How Changing Capital Structure Affects Expected
Summary 425
Returns 452
Related Web Links 426
What Happens When the Corporate Tax Rate Is Not
Key Terms 426
Zero 453
Quiz 426
Practice Problems 427 Flotation Costs and the Cost of Capital 454
Challenge Problem 432
Summary 454
Solutions to Self-Test Questions 432
Related Web Links 455
Key Terms 455
The Cost of Capital 435 Quiz 455
Geothermal’s Cost of Capital 436 Practice Problems 456
Challenge Problems 458
Calculating the Weighted-Average Cost of
Solutions to Self-Test Questions 458
Capital 438
Minicase 459

SECTION 5 463
Project Analysis 465 NPV Break-Even Analysis 475
Operating Leverage 478
How Firms Organize the Investment Process 466
Stage 1: The Capital Budget 467 Flexibility in Capital Budgeting 481
Stage 2: Project Authorizations 467 Decision Trees 481
Problems and Some Solutions 468 The Option to Expand 482
Abandonment Options 483
Some “What-If ” Questions 469 Flexible Production Facilities 484
Sensitivity Analysis 469 Investment Timing Options 484
Scenario Analysis 472
Summary 485
Break-Even Analysis 473 Related Web Links 485
Accounting Break-Even Analysis 474 Key Terms 485
VIII CONTENTS

Quiz 485 Quiz 512

Practice Problems 486 Practice Problems 513
Challenge Problems 489 Solutions to Self-Test Questions 514
Solutions to Self-Test Questions 489
Minicase 491
How Corporations Issue Securities 517
Venture Capital 519
An Overview of Corporate
Financing 493 The Initial Public Offering 520
Arranging a Public Issue 521
Common Stock 494
Book Value versus Market Value 496 The Underwriters 526
Dividends 497 Who Are the Underwriters? 526
Stockholders’ Rights 497 General Cash Offers by Public Companies 528
Voting Procedures 497 General Cash Offers and Shelf Registration 528
Classes of Stock 498 Costs of the General Cash Offer 529
Corporate Governance in the United States and Market Reaction to Stock Issues 530
Elsewhere 498
The Private Placement 531
Preferred Stock 499
Summary 532
Corporate Debt 500 Related Web Links 533
Debt Comes in Many Forms 501 Key Terms 533
Innovation in the Debt Market 504 Quiz 534
Convertible Securities 507 Practice Problems 534
Challenge Problem 536
Patterns of Corporate Financing 508 Solutions to Self-Test Questions 537
Do Firms Rely Too Heavily on Internal Funds? 508 Minicase 537
External Sources of Capital 510
Appendix: Hotch Pot’s New Issue Prospectus 539
Summary 511
Related Web Links 512
Key Terms 512

APPENDIX B 545
Leasing 547 Lease or Buy? 555
Leasing versus Buying 548 A Preliminary Analysis 555
Operating Leases 548 Three Potential Pitfalls 555
Financial Leases 549 NPV Analysis 556
Tax-Oriented Leases 549 A Misconception 556
Leveraged Leases 550 Leverage and Capital Structure
Sale and Leaseback Agreements 550 559
Accounting and Leasing 550 The Capital Structure Question 560
Taxes, the IRS, and Leases 552 The Effect of Financial Leverage 560
The Impact of Financial Leverage 560
The Cash Flows from Leasing 553 Financial Leverage, EPS, and ROE:
The Incremental Cash Flows 553 An Example 561
A Note on Taxes 554 EPS versus EBIT 561
 CONTENTS IX

SECTION 6 565
Mergers, Acquisitions, and Corporate Related Web Links 592
Key Terms 592
Control 567
Quiz 592
22.1 The Market for Corporate Control 569 Practice Problems 593
Method 1: Proxy Contests 569 Challenge Problems 594
Method 2: Mergers and Acquisitions 570 Solutions to Self-Test Questions 595
Method 3: Leveraged Buyouts 571 Minicase 595
Method 4: Divestitures and Spin-offs 571
International Financial
22.2 Sensible Motives for Mergers 572 Management 597
Economies of Scale 573
23.1 Foreign Exchange Markets 598
Economies of Vertical Integration 573
Combining Complementary Resources 574 23.2 Some Basic Relationships 602
Mergers as a Use for Surplus Funds 574 Exchange Rates and Inflation 602
Inflation and Interest Rates 606
22.3 Dubious Reasons for Mergers 575
Interest Rates and Exchange Rates 608
Diversification 575
The Forward Rate and the Expected Spot Rate 609
The Bootstrap Game 575
Some Implications 610
22.4 Evaluating Mergers 577 23.3 Hedging Exchange Rate Risk 612
Mergers Financed by Cash 577
Mergers Financed by Stock 579 23.4 International Capital Budgeting 613
A Warning 580 Net Present Value Analysis 613
Another Warning 580 The Cost of Capital for Foreign Investment 615
Avoiding Fudge Factors 616
22.5 Merger Tactics 582
Who Gets the Gains? 584 23.5 Summary 617
Related Web Links 618
22.6 Leveraged Buyouts 585 Key Terms 618
Barbarians at the Gate? 587 Quiz 618
22.7 Mergers and the Economy 588 Practice Problems 619
Merger Waves 588 Challenge Problem 621
Do Mergers Generate Net Benefits? 589 Solutions to Self-Test Questions 621
Minicase 623
22.8 Summary 590

APPENDIX C 625
Glossary 635
Section 1
The Firm and the Financial Manager

The Time Value of Money

Financial Statement Analysis

THE FIRM AND THE
FINANCIAL MANAGER
Organizing a Business Who Is the Financial
Sole Proprietorships Manager?
Partnerships Careers in Finance

Corporations Goals of the Corporation

Hybrid Forms of Business Organization Shareholders Want Managers to Maximize
Market Value
The Role of the Financial
Ethics and Management Objectives
Manager
Do Managers Really Maximize Firm
The Capital Budgeting Decision
Value?
The Financing Decision
Snippets of History
Financial Institutions and Summary
Markets
Financial Institutions
Financial Markets
Other Functions of Financial Markets
and Institutions

A meeting of a corporation’s directors.

Most large businesses are organized as corporations. Corporations are owned by stockholders,
who vote in a board of directors. The directors appoint the corporation’s top executives and
approve major financial decisions.
Comstock, Inc.

3
 his material is an introduction to corporate finance. We will discuss the

T various responsibilities of the corporation’s financial managers and

show you how to tackle many of the problems that these managers are
expected to solve. We begin with a discussion of the corporation, the finan-
cial decisions it needs to make, and why they are important.
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 de-
cide (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, that is, the decision to in-
vest 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.
We start by explaining how businesses are organized. We then provide a brief intro-
duction to the role of the financial manager and show you why corporate managers need
a sophisticated understanding of financial markets. Next we turn to the goals of the firm
and ask what makes for a good financial decision. Is the firm’s aim to maximize prof-
its? To avoid bankruptcy? To be a good citizen? We consider some conflicts of interest
that arise in large organizations and review some mechanisms that align the interests of
the firm’s managers with the interests of its owners. Finally, we provide an overview of
what is to come.
After studying this material you should be able to
䉴 Explain the advantages and disadvantages of the most common forms of business
organization and determine which forms are most suitable to different types of
businesses.
䉴 Cite the major business functions and decisions that the firm’s financial managers
are responsible for and understand some of the possible career choices in finance.
䉴 Explain the role of financial markets and institutions.
䉴 Explain why it makes sense for corporations to maximize their market values.
䉴 Show why conflicts of interest may arise in large organizations and discuss how cor-
porations can provide incentives for everyone to work toward a common end.

Organizing a Business
SOLE PROPRIETORSHIPS
In 1901 pharmacist Charles Walgreen bought the drugstore in which he worked on the
South Side of Chicago. Today Walgreen’s is the largest drugstore chain in the United
States. If, like Charles Walgreen, you start on your own, with no partners or stockhold-
ers, you are said to be a sole proprietor. You bear all the costs and keep all the profits
4
 The Firm and the Financial Manager 5

SOLE PROPRIETOR after the Internal Revenue Service has taken its cut. The advantages of a proprietorship
Sole owner of a business are the ease with which it can be established and the lack of regulations governing it.
which has no partners and This makes it well-suited for a small company with an informal business structure.
no shareholders. The As a sole proprietor, you are responsible for all the business’s debts and other liabil-
proprietor is personally liable ities. If the business borrows from the bank and subsequently cannot repay the loan, the
for all the firm’s obligations. bank has a claim against your personal belongings. It could force you into personal
bankruptcy if the business debts are big enough. Thus as sole proprietor you have un-
limited liability.

PARTNERSHIPS
Instead of starting on your own, you may wish to pool money and expertise with friends
or business associates. If so, a sole proprietorship is obviously inappropriate. Instead,
you can form a partnership. Your partnership agreement will set out how management
PARTNERSHIP decisions are to be made and the proportion of the profits to which each partner is en-
Business owned by two or titled. The partners then pay personal income tax on their share of these profits.
more persons who are Partners, like sole proprietors, have the disadvantage of unlimited liability. If the busi-
personally responsible for all ness runs into financial difficulties, each partner has unlimited liability for all the busi-
its liabilities. ness’s debts, not just his or her share. The moral is clear and simple: “Know thy partner.”
Many professional businesses are organized as partnerships. They include the large
accounting, legal, and management consulting firms. Most large investment banks such
as Morgan Stanley, Salomon, Smith Barney, Merrill Lynch, and Goldman Sachs started
life as partnerships. So did many well-known companies, such as Microsoft and Apple
Computer. But eventually these companies and their financing requirements grew too
large for them to continue as partnerships.

CORPORATIONS
As your firm grows, you may decide to incorporate. Unlike a proprietorship or part-
nership, a corporation is legally distinct from its owners. It is based on articles of in-
CORPORATION corporation that set out the purpose of the business, how many shares can be issued, the
Business owned by number of directors to be appointed, and so on. These articles must conform to the laws
stockholders who are not of the state in which the business is incorporated. For many legal purposes, the corpo-
personally liable for the ration is considered a resident of its state. For example, it can borrow or lend money,
business’s liabilities. and it can sue or be sued. It pays its own taxes (but it cannot vote!).
The corporation is owned by its stockholders and they get to vote on important mat-
ters. Unlike proprietorships or partnerships, corporations have limited liability, which
LIMITED LIABILITY means that the stockholders cannot be held personally responsible for the obligations of
The owners of the the firm. If, say, IBM were to fail, no one could demand that its shareholders put up
corporation are not more money to pay off the debts. The most a stockholder can lose is the amount invested
personally responsible for its in the stock.
obligations. 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 corpora-
tions. 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 flex-
ibility and permanence than a partnership. Even if managers of a corporation quit or are
6 SECTION ONE

dismissed and replaced by others, the corporation can survive. Similarly, today’s share-
holders may sell all their shares to new investors without affecting the business. In con-
trast, ownership of a proprietorship cannot be transferred without selling out to another
owner-manager.
By organizing as a corporation, a business may be able to attract a wide variety of
investors. The shareholders may include individuals who hold only a single share worth
a few dollars, receive only a single vote, and are entitled to only a tiny proportion of the
profits. Shareholders may also include giant pension funds and insurance companies
whose investment in the firm may run into the millions of shares and who are entitled
to a correspondingly large number of votes and proportion of the profits.
Given these advantages, you might be wondering why all businesses are not organ-
ized as corporations. One reason is the time and cost required to manage a corporation’s
legal machinery. There is also an important tax drawback to corporations in the United
States. Because the corporation is a separate legal entity, it is taxed separately. So cor-
porations pay tax on their profits, and, in addition, shareholders pay tax on any divi-
dends that they receive from the company.1 By contrast, income received by partners
and sole proprietors is taxed only once as personal income.
When you first establish a corporation, the shares may all be held by a small group,
perhaps the company’s managers and a small number of backers who believe the busi-
ness will grow into a profitable investment. Your shares are not publicly traded and your
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.2

To summarize, the corporation is a distinct, permanent legal entity. Its

advantages are limited liability and the ease with which ownership and
management can be separated. These advantages are especially important for
large firms. The disadvantage of corporate organization is double taxation.

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 pre-
sents the distinctive features of the major forms of business organization.

HYBRID FORMS OF BUSINESS ORGANIZATION

Businesses do not always fit into these neat categories. Some are hybrids of the three
basic types: proprietorships, partnerships, and corporations.
For example, businesses can be set up as limited partnerships. In this case, partners
are classified as general or limited. General partners manage the business and have un-
limited personal liability for the business’s debts. Limited partners, however, are liable
only for the money they contribute to the business. They can lose everything they put
in, but not more. Limited partners usually have a restricted role in management.
In many states a firm can also be set up as a limited liability partnership (LLP) or,
equivalently, a limited liability company (LLC). These are partnerships in which all

1 The United States is unusual in its taxation of corporations. To avoid taxing the same income twice, most
other countries give shareholders at least some credit for the taxes that their company has already paid.
2 For example, when Microsoft was initially established as a corporation, its shares were closely held by a

small number of employees and backers. Microsoft shares were issued to the public in 1986.
 The Firm and the Financial Manager 7

TABLE 1.1
Characteristics of Sole
business organizations Proprietorship Partnership Corporation

Who owns the business? The manager Partners Shareholders

Are managers and owner(s)

No No Usually
separate?

What is the owner’s

Unlimited Unlimited Limited
liability?

Are the owner and business

No No Yes
taxed separately?

partners have limited liability. This form of business organization combines the tax ad-
vantage of partnership with the limited liability advantage of incorporation. However,
it still does not suit the largest firms, for which widespread share ownership and sepa-
ration of ownership and management are essential.
Another variation on the theme is the professional corporation (PC), which is com-
monly used by doctors, lawyers, and accountants. In this case, the business has limited
liability, but the professionals can still be sued personally for malpractice, even if the
malpractice occurs in their role as employees of the corporation.

䉴 Self-Test 1 Which form of business organization might best suit the following?
a. A consulting firm with several senior consultants and support staff.
b. A house painting company owned and operated by a college student who hires some
friends for occasional help.
c. A paper goods company with sales of $100 million and 2,000 employees.

The Role of the Financial Manager

To carry on business, companies need an almost endless variety of real assets. Many of
REAL ASSETS Assets these assets are tangible, such as machinery, factories, and offices; others are intangi-
used to produce goods and ble, such as technical expertise, trademarks, and patents. All of them must be paid for.
services. To obtain the necessary money, the company sells financial assets, or securities.3
These pieces of paper have value because they are claims on the firm’s real assets and
FINANCIAL ASSETS the cash that those assets will produce. For example, if the company borrows money
Claims to the income from the bank, the bank has a financial asset. That financial asset gives it a claim to a
generated by real assets.
Also called securities. 3 For present purposes we are using financial assets and securities interchangeably, though “securities” usu-
ally refers to financial assets that are widely held, like the shares of IBM. An IOU (“I owe you”) from your
brother-in-law, which you might have trouble selling outside the family, is also a financial asset, but most peo-
ple would not think of it as a security.
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