Corporations: Legal Entities and Liabilities

Corporations: Legal Entities with Limited Liability

• Corporations are legal entities created through incorporation, with articles defining the business's purpose, governance, and operation.
• Shareholders own corporations, but the corporation is legally distinct from them.
• Shareholders have limited liability, meaning they are not personally responsible for the corporation's debts.
• Corporations have a separation of ownership and control.
• Shareholders exercise voting rights in shareholder meetings.
• A board of directors is elected, which appoints top managers (CEOs), advises them, and monitors their performance.

Other Forms of Business Administration

• Sole proprietorships are common for smaller businesses.
• Partnerships involve proprietors who voluntarily hold unlimited liability.
• Limited partnerships feature some partners with unlimited liability involved in management and others with limited liability who contribute funding.

Measuring a Corporation's Activity

• Metrics to measure a business's size and performance include:
  • Market capitalization
  • Assets
  • Sales or revenue
  • Earnings, profit, or net income
  • Number of employees
• A company's size in one aspect does not guarantee its size in another.

Key Roles in a Corporation

• CEO: Chief Executive Officer
• CFO: Chief Financial Officer or Financial Manager
• COO: Chief Operating Officer

The Financial Manager

• The CFO oversees all financial staff.
• Below the CFO are the treasurer and controller.
• The treasurer manages cash, raises capital, and maintains relationships with banks and investors.
• The controller prepares financial statements, manages budgets and accounting, and handles tax matters.
• The treasurer obtains and manages the firm's capital, while the controller ensures efficient use of money.
• Financial managers are responsible for investment or financing decisions, often tied to product development, production, and marketing.

Goal of the Financial Manager

• The financial manager acts as an intermediary between the firm and outside investors.
• For large corporations, separation of ownership and management is essential.
• Shareholders delegate decision-making with a common goal: to maximize the market value of their investment in the firm.
• Maximizing market value is a sensible goal when shareholders have access to well-functioning financial markets.

Profit Maximization vs. Value Maximization

• Profit maximization isn't a well-defined corporate objective.
• Maximizing current profits at the expense of long-term profits is not beneficial.
• Sacrificing dividends for low-return reinvestment is not in shareholders' best interest.
• Maintaining or maximizing value is necessary for the long-run survival of the corporation.

Value Maximization

• Investments that offer higher returns than the opportunity cost of capital increase market value.
• The hurdle rate or opportunity cost of capital is the minimum acceptable rate of return.
• Corporations increase value by accepting projects that earn more than the opportunity cost of capital.
• The opportunity cost of capital depends on the risk of the proposed investment project.
• Financial markets provide information to managers about investors’ opportunity cost of capital.

Agency Problems

• Managers may act in their own interests rather than maximize shareholder value due to the separation of ownership and control.
• Conflicts of interest arising from this separation are called agency problems.
• Losses in value from agency problems or mitigation costs are called agency costs.
• Corporations mitigate agency problems through:
  • Internal controls
  • Executive compensation
  • Corporate governance (laws, regulations, institutions, and practices)

The Ethics of Maximizing Value

• Maximizing shareholder value may conflict with the interests of other stakeholders.
• Valuable firms have satisfied customers and loyal employees; reputation is important.
• Corporate decisions that ignore society can lead to scandals.

Socially Responsible Investment (SRI)

• SRI is a practice that benefits shareholders and stakeholders, including society.
• Focuses on Environmental, Social, and Governance (ESG) criteria.
• SRI allows investors to evaluate and invest in companies promoting environmental care, consumer protection, or human rights.
• Financial returns are a secondary consideration after moral values.
• SRI reduces the cost of capital for socially responsible firms and increases it for harmful firms.

SRI Investment Criteria

• SRI is done through different choices to discriminate investment opportunities:
  • Excluding unacceptable activities
  • Selecting firms that meet an ESG benchmark
  • Assessing compliance with ESG norms
  • Incorporating ESG information to assess expected returns
  • Investing in funds targeting sustainable firms
  • Generating specific social or environmental effects
  • Active engagement for fostering best ESG practices

Sustainable Bonds

• Sustainable bonds are those whose payoffs depend on the issuer meeting sustainability criteria.
• Proceeds are employed in sustainable, "Green" or "Social" investments.
  • Green bonds finance climate or environmental projects.
  • Blue bonds finance marine and ocean projects.
  • Social bonds finance projects with positive social outcomes.