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Chapter 1

Finance Notes - Chapters 1 and 2.pdf

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York University
FINE 2000
Alan Marshall

FINE2000 Chapter Notes Jessica Gahtan Chapter 1 Corporations A corporation is a permanent entity, legally distinct from its owners, who are called shareholders or stockholders. A corporation confers limited liability to its owners: shareholders cannot be held personally responsible for the corporations’ debts; they only stand to lose their investment. To incorporate, you work with a lawyer to prepare articles of incorporation , which set out the purpose of the business and how it is to be financed, managed, and governed. You may incorporate your firm federally under the Canadian Business Corporation Act , or provincially, under the relevant provincial laws. The corporation is considered a resident of its jurisdiction. Public company: corporation whose shares are listed for trading on a stock exchange. Private company: corporation whose shares are privately owned. More than 2,000 public companies exist in Canada. Public companies can offer shares for sales to raise financing, and in return they provide detailed financial information in their annual reports and make timely disclosure of significant corporate events. Private companies are not required to do this. All corporations have a board of directors, selected by shareholders and given responsibility of overseeing the activities of the corporation. The legal separation of ownership and management is one distinctive feature of corporation. Separation gives corporations permanence; however the extent of this separation differs. In a private corporation, the shareholders are on the board of directors and often are also top managers. In public corporations, this is neither feasible for desirable; large, public corporations have thousands of shareholders. One reason not all companies incorporate is cost, in both time and money, of managing the corporation’s legal machinery. A disadvantage for corporations is double taxation. Corporations pay tax on their profits, then shareholders are taxed on the dividends they receive or if they sell their shares at a profit. For public corporations, the additional disadvantages are the expense of maintaining a stock listing, compliance with government requirements and securities laws, and sharing of information with the p ublic. A sole proprietorship is a business owned and operated by one individual. The proprietor is personally liable for all the firm’s obligations (unlimited liability). Advantages are the ease with which it can be established and the lack of regulations governing it. More suited for a small company. Taxed only once as personal income. A partnership is a business owned by two or more people who are personally respons ible for all its liabilities. The partnership agreement will set out how management decisions are to be made and the proportion of profits for each partner. The partners then pay personal income taxes on their share of the profits. Sole proprietorships and partnerships are flow-through entities because they do not pay income tax on operating profits and do not file tax returns, unlike corporations. Partnerships have the disadvantage of unlimited liability. Many professional business are organized as partnerships, such as accounting, legal, and management consulting firms. Hybrid forms of business organization : in a limited partnership, partners are classified as general or limited. General partners manage the business and have unlimited personal liability, and limited partners are liable only for the money they contributed and cannot take part in the day-to-day management of the partnership. There are also limited liability partnerships (LLPs), or limited liability companies (LLCs), in which both partners have limited liability. Limited partnerships and limited liability partnerships are flow -through entities. A professional corporation (PC) is commonly used by doctors, lawyers, and accountants, and has limited liability and is taxed as a corporation. However, the professionals can still be sued personally. Another is an income trust, which is an investment fund legally known as a mutual fund trust. Mutual fund trusts sell units to investors to raise money o purchase shares and debt of operating businesses. 2014-01-07 1 Ch. 1 and 2 FINE2000 Chapter Notes Jessica Gahtan They are flow-through entities. An income trust invests in only one company, making a unit similar to a share. This cleverl y reduces the taxes paid by the underlying business enterprise. One way this was accomplished was by having the income trust own both the debt and the equity of the underlying corporation. This allowed the corporation to be financed with a lot of debt, thereby reducing the taxes paid by the corporation. The Canadian federal government changed the tax rules on income trusts in 2006, ending the income trust boom. The capital budgeting decision or investment decision is the decision as to which real assets the firm should acquire. The investment decision starts with the identification of capital investment projects, or investment opportunities. Today’s capital investments generate future returns. The financial manager needs a way of placing a value on the uncertain future cash inflows generated by capital investment projects. This value should account for the amounts, timing, and risk of the future cash flows. If a project’s value is greater than its required investment, then the project is attractive financially. Often the final investment decision is made by senior nonfinancial management. Most investment decisions are small and simple, such as a truck, machine tool, or computer system. Most firms make thousands of small ones every year. The financing decision is the decision as to how to raise the money to pay for investments in real assets. This can be in two ways: 1) sell shares of stock to investors who become equity investors and contribute equity financing; or 2) borrow from debt investors, who one day must be repaid. The choice between debt and equity financing is often called the capital structure decision, and it refers to long-term financing. “Raising capital” refers to long-term financing. There are short-term financing decisions (how to raise cash to meet a short-term need) and short- term investment decisions (how to invest spare cash for brief periods). Financial managers also have to identify risks and make sure they are managed properly, such as defending against a rise in oil prices or a fall in the dollar. Money flows from investors to the firm and back to investors again. The flow starts when cash is raised from investors. The cash is used to pay for the investment projects needed for the firm’s operations. Later, if the firm does well, the operations generate enough cash inflow to more than repay the initial investment. Finally, the cash is either a) reinvested, or b) returned to the investors who furnished the money in the first place, remembering of course that they m ay be constrained by promises made when the cash was raised in the first place. Real assets are assets used to produce goods and services, including tangibles and intangibles, whereas financial assets are claims to the income generated by real assets, also called securities, including a share of stock or a bank loan. A financial manager is anyone responsible for a significant corporate investment or financing decisions. However no single person is responsible for all these decisions. The treasurer is the manager most directly responsible for financing, cash management, and relationships with financial markets and institutions. Larger corporations also have a controller, an officer responsible for budgeting, accounting, auditing. The treasurer’s ma in function is to obtain and manage the firm’s capital, whereas the controller ensures that the money is used efficiently. The largest firms usually appoint a chief financial officer (CFO) , an officer who oversees the treasurer and controller and sets the overall financial strategy. The natural financial objective on which almost all shareholders can agree is to maximize the current value of their investment. A smart and effective financial manager makes decisions that increase the current value of the company’s shares and the wealth of its shareholders. That increased wealth can then be put to whatever purposes the shareholders want. The natural financial objective of the corporation is to maximize current market value. Managers who consistently ignore this objective are likely to be replaced. 2014-01-07 2 Ch. 1 and 2 FINE2000 Chapter Notes Jessica Gahtan For a public company, maximizing current market value means maximizing today’s stock prices. Companies such as WorldCom, Enron, and Nortel concealed expenses and caused bankruptcy. Some idealists say that financial managers should not be obliged to act in the selfish interests of their stockholders. Some realists argue that, regardless of what managers ought to do, they in fact look after themselves rather than their shareholders. Modern finance does no t condone attempts to pump up stock price by unethical means. But there need be no conflict between ethics and value maximization. Reputation is important in finance. Major banks and securities firms protect their reputations by emphasizing their long h istory and responsible behaviours to new customers. The costs can be enormous if this reputation is compromised. Agency problems: conflict of interest between the firm’s owners and managers. They might act in ways that are not in the best interests of t he owners, such as indulgent expenses, shying away from attractive investments, or engaging in empire building. Stakeholders are anyone with a financial interest in the firm. All these stakeholders are bound together in a complex web of contracts and understandings, but you can’t devise written rules to cover every possible future event, so they are supplemented by understandings. An example of an understanding is in return for a big salary, they are expected to work hard and not waste money on personal luxuries. There are several arrangements to help ensure that shareholders and managers are working towards common goals: Compensation plans: incentive schemes can provide big returns to managers if shareholders gain but are valueless if they do not. An example is stock options. Some criticize stock options for being too favourable for managers and for distorting management’s incentives. Ther e may also be problems with backdating, when the date on the options is not the actual date of the option grant but a date in the past when the price was lower. The board of directors: when company performance starts to slide, and managers don’t offer a credible recovery plan, boards act. If shareholders believe that the corporation is underperforming and that the board of directors is not sufficiently aggressive in holding managers to task, they can try to replace the board in the next election. The ne w board may then replace current management. Takeovers: poorly performing companies are also more likely to be taken over by another firm. The old management team may then find itself out of a job. Specialist monitoring : managers’ actions are monitored by the security analysts who advise inves
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