Chapter 1

Goals and
Governance of the 9e
Book Cover
Corporation

1- 1
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Topics Covered

Investment and Financing Decisions

What is a Corporation?
Who Is the Financial Manager?
Goals of the Corporation
Agency Problems, Executive Compensation,
and Corporate Governance
Careers in Finance

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 2

Investment and Financing Decisions (1 of 6)

 Capital Budgeting Decision

– Decision to invest in tangible or intangible
assets
 …also called
– Investment Decision
– Capital Expenditure (CAPEX) decision

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 3

 Investment and Financing Decisions (3 of 6)

 Financing Decision
– Decision on the sources and amounts of financing
 Capital Structure
– The mix of long-term debt and equity financing

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 4

 Investment and Financing Decisions (4 of 6)

ASSETS FIRM

Investment Decision
Debt Equity

Financing Decision

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 5

 Investment and Financing Decisions (5 of 6)

 Real Assets
– Assets used to produce goods and services
 Financial Assets
– Financial claims to the income generated by the
firm’s real assets.

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 6

 Investment and Financing Decisions (6 of 6)

 Are the following capital budgeting or

financing decisions?
a. Intel decides to spend $7 billion to develop a new
microprocessor
b. BMW borrows 350 million euros (€350 million) from
Deutsche Bank
c. Royal Dutch Shell constructs a pipeline to bring natural
gas onshore from a production platform in Australia
d. Avon spends €200 million to launch a new range of
cosmetics in European markets
e. Pfizer issues new shares to buy a small biotech company

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 7

 What Is a Corporation? (2 of 4)
 Types of Business Organizations
– Sole Proprietorships
– Partnerships
– Corporations

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 8

 What Is a Corporation? (1 of 4)

 Corporation
– A business organized as a separate legal entity
owned by stockholders
 Types of Corporations
– Public Companies
– Private Corporations
– Limited Liability Corporations (LLC)

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 9

 Types of Business Organization

There are three legal forms of business, each having

certain advantages and disadvantages, are
proprietorships, partnerships, and corporations.

Proprietorships: Business owned by one individual

Partnerships: Business owned by more than one owner.
It is established by written contract.
Corporations: Legal entity created under Capital Market
law (‫)هيئة ا لسوقا لما لية‬in Saudi Arabia. It is separate from owner
and managers.
1- 10
Advantages of sole Disadvantages of sole
proprietorships proprietorship:

 One Individual Owner & Responsible for

 Unlimited Liability: you have total
firms policies
responsibility for all debts and liabilities of
 Owns its assets
the company
 Ease of start up
 Difficulty in raising financial capital
 Ease of Management
(cannot issue shares)
 You keep all profits
 Limited size and efficiency
 You do not have to pay any business
 Limited managerial experience
taxes

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 11

 Partnerships (More than one-Owner and
written contract)

Advantages of Partnerships: Disadvantages of

 Low Cost and Ease of Partnerships
establishment  Unlimited liability: Each
 Ease of Management: each
partner is personally
partner has different things to offer
responsible for all debts
 No special business taxes

 Easier to raise financial capital  Limited Life

 Larger than sole proprietorship  Conflict between partners

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 12

Corporation

A corporation is a legal entity created under provincial or

federal law. It is separate from its owners and managers.
Shareholders
Owners
Board of Directors

Managers

1- 13
 Corporations
Advantages of a corporation:
Disadvantages of a
Ease of raising financial corporation:
capital (main advantage)
–Selling stock to investors
–Selling bonds: a written Start up expenses are high.
promise to repay a loan on a
specific date Profits are taxed at high rate
Ease of transferring
Corporations are subject to
ownership:. Buying and selling
stock is easy and is done millions more government
of times a day
Limited liability regulations than sole
Unlimited life
proprietors or partners

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 14

 What Is a Corporation? (3 of 4)

Sole Partnership Corporation

Proprietorship
Who owns the business? The manager Partners Stockholders
Are managers and owners No No Usually
separate?
What is the owner’s liability? Unlimited Unlimited Limited
Are the owner and business No No Yes
taxed separately?

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 15

 What Is a Corporation? (4 of 4)

Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships

Limited Liability
Corporations Corporate tax on profits +
personal tax on dividends

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 16

Who Is the Financial Manager? (1 of 3)

Chief Financial
Officer

Treasurer Controller

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 17

Who Is the Financial Manager? (2 of 3)
 Chief Financial Officer (CFO)
– Supervises all financial functions and sets
overall financial strategy
 Treasurer
– Responsible for financing, cash management,
and relationships with banks and other
financial institutions
 Controller
– Responsible for budgeting, accounting, and
taxes

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 18

Who Is the Financial Manager? (3 of 3)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 19
 Goals of the Corporation (1 of 2)

 Shareholders desire wealth maximization

 Profit maximization
– Maximize profits? Which year’s profits?
– Earning manipulation
 Opportunity cost of capital
– The minimum acceptable rate of return on capital
investment is set by the investment opportunities
available to shareholders in financial markets

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 20

 Agency Problem (1 of 5)

 Do managers maximize shareholder wealth or

manager wealth?
 Mangers have many constituencies called
“stakeholders”
 Stakeholder
– Anyone with a financial interest in the corporation

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 21

 Agency Problem (2 of 5)

 Agency problem
– Managers are agents for stockholders and are
tempted to act in their own interests rather than
maximizing value
 Agency cost
– Value lost from agency problems or from the cost
of mitigating agency problems

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 22

 Agency Problem (4 of 5)

 Corporate governance
– The laws, regulations, institutions, and
corporate practices that protect shareholders
and other investors

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 23

 Agency Problem (5 of 5)

Elements of good corporate governance

1. Legal requirements
2. Board of directors
3. Activist shareholders
4. Takeovers
5. Information for investors

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved 1- 24