Corporate Finance Textbook PDF - Overview & Introduction

Here is the converted markdown format of the image you sent: # Part 1 Overview of Corporate Finance ## 1 Introduction to Corporate Finance **Page 1** ### LEARNING OBJECTIVES After studying this chapter, you should be able to: - [x] **LO1** Define the basic types of financial management decisio...

Here is the converted markdown format of the image you sent: # Part 1 Overview of Corporate Finance ## 1 Introduction to Corporate Finance **Page 1** ### LEARNING OBJECTIVES After studying this chapter, you should be able to: - [x] **LO1** Define the basic types of financial management decisions and the role of the financial manager. - [x] **LO2** Explain the goal of financial management. - [x] **LO3** Articulate the financial implications of the different forms of business organization. - [x] **LO4** Explain the conflicts of interest that can arise between managers and owners. --- IN 2009, Adam Neumann and a business partner opened the first WeWork space in New York's Little Italy. WeWork provided shared office space for businesses, who would rent space as needed, sometimes only for a day. By 2019, WeWork operated in more than 111 cities in 29 countries. Revenues had grown to about $3 billion, but the company was still losing money. Early in 2019, the giant tech investor SoftBank made a major bet on WeWork, which valued the company at $47 billion. Unfortunately, everything was not rosy at WeWork. In the middle of 2019, the company filed to go public in an IPO, but then changed its mind. In late 2019, Softbank agreed to another major investment, but it pulled the deal in 2020. What happened? Among other things, the COVID-19 pandemic hit, calling into question the company's entire business model of shared, face-to-face meeting spaces. Understanding WeWork's story as it progressed from a start-up to a multi-billion dollar enterprise and its subsequent struggles takes us into issues involving the corporate form of organization, corporate goals, and corporate control, all of which we discuss in this chapter. For updates on the latest happenings in finance, visit fundamentalsofcorporatefinance.blogspot.com. --- To begin our study of modern corporate finance and financial management, we need to address two central issues. First, what is corporate finance and what is the role of the financial manager in the corporation? Second, what is the goal of financial management? To describe the financial management environment, we consider the corporate form of organization and discuss some conflicts that can arise within the corporation. We also take a brief look at financial markets in the United States. **Page 2** --- ## 1.1 Finance: A Quick Look Before we plunge into our study of "corp fin," we think a quick overview of the finance field might be a good idea. Our goal is to clue you in on some of the most important areas in finance and some of the career opportunities available in each. We also want to illustrate some of the ways finance fits in with other areas such as marketing, management, accounting, and technology. FINANCE: THE FIVE MAIN AREAS Financial topics are usually grouped into five main areas: 1. Corporate finance 2. Investments 3. Financial institutions 4. International finance 5. Fintech We discuss each of these next. **Page 3** For job descriptions in finance and other areas, visit www.careers-in-business.com. Corporate Finance The first of these five areas, corporate finance, is the main subject of this book. We begin covering this subject in our next section, so we will wait until then to get into any details. One thing we should note is that the term corporate finance seems to imply that what we cover is only relevant to corporations, but almost all of the topics we consider are broader than that. Maybe business finance would be more descriptive, but even this is too narrow because at least half of the subjects we discuss in the pages ahead are basic financial ideas and principles applicable across all the various areas of finance and beyond. Investments Broadly speaking, the investments area deals with financial assets such as stocks and bonds. Some of the more important questions include: 1. What determines the price of a financial asset, such as a share of stock? 2. What are the potential risks and rewards associated with investing in financial assets? 3. What is the best mixture of financial assets to hold? Students who specialize in the investments area have various career opportunities. Being a financial advisor is one of the most common. Advisors often work for large companies such as Merrill Lynch, advising customers on what types of investments to consider and helping them make buy and sell decisions. --- Portfolio management is a second investments-related career path. Portfolio managers, as the name suggests, manage money for investors. For example, individual investors frequently buy into mutual funds. Such funds are a means of pooling money that is then invested by a portfolio manager. Portfolio managers also invest and manage money for pension funds, insurance companies, and many other types of institutions. Security analysis is a third area. A security analyst researches individual investments, such as stock in a particular company, and makes a determination as to whether the price is right. To do so, an analyst delves deeply into company and industry reports, along with a variety of other information sources. Frequently, financial advisors and portfolio managers rely on security analysts for information and recommendations. These investments-related areas, like many areas in finance, share an interesting feature. If they are done well, they can be very rewarding financially (translation: You can make a lot of money). The bad news, of course, is that they can be demanding and competitive, so they are not for everybody. Financial Institutions Financial institutions are businesses that deal primarily in financial matters. Banks and insurance companies would probably be the most familiar to you. Institutions such as these employ people to perform a variety of finance-related tasks. For example, a commercial loan officer at a bank would evaluate whether a particular business has a strong enough financial position to warrant extending a loan. At an insurance company, an analyst would decide whether a particular risk was suitable for insuring and what the premium should be. **Page 3** International Finance International finance isn't so much an area as it is a specialization within one of the main areas we described earlier. In other words, careers in international finance generally involve international aspects of either corporate finance, investments, or financial institutions. For example, some portfolio managers and security analysts specialize in non-U.S. companies. Similarly, many U.S. businesses have extensive overseas operations and need employees familiar with such international topics as exchange rates and political risks. Banks frequently are asked to make loans across country lines, so international specialists are needed there as well. Fintech Finance has always been an early adopter of faster, cheaper technologies. The combination of technology and finance is called fintech. Fintech is a broad term for a company that uses the internet, mobile phones, software, and/or cloud services to provide a financial service. We discuss fintech in more detail in the next section. WHY STUDY FINANCE? Who needs to know finance? In a word, you. In fact, there are many reasons you need a working knowledge of finance even if you are not planning a finance career. We explore some of these reasons next. Marketing and Finance If you are interested in marketing, you need to know finance because, for example, marketers constantly work with budgets, and they need to understand how to get the greatest payoff from marketing expenditures and programs. Analyzing costs and benefits of projects of all types --- is one of the most important aspects of finance, so the tools you learn in finance are vital in marketing research, the design of marketing and distribution channels, and product pricing, to name a few areas. Financial analysts rely heavily on marketing analysts, and the two frequently work together to evaluate the profitability of proposed projects and products. As we will see in a later chapter, sales projections are a key input in almost every type of new product analysis, and such projections are often developed jointly between marketing and finance. Beyond this, the finance industry employs marketers to help sell financial products such as bank accounts, insurance policies, and mutual funds. Financial services marketing is one of the most rapidly growing types of marketing, and successful financial services marketers are very well compensated. To work in this area, you obviously need to understand financial products. Accounting and Finance For accountants, finance is required reading. In smaller businesses in particular, accountants often are required to make financial decisions as well as perform traditional accounting duties. Further, as the financial world continues to grow more complex, accountants have to know finance to understand the implications of many of the newer types of financial contracts and the impact they have on financial statements. Beyond this, cost accounting and business finance are particularly closely related, sharing many of the same subjects and concerns. Financial analysts make extensive use of accounting information; they are some of the most important end users. Understanding finance helps accountants recognize what types of information are particularly valuable and, more generally, how accounting information is actually used (and abused) in practice. Management and Finance One of the most important areas in management is strategy. Thinking about business strategy without simultaneously thinking about financial strategy is an excellent recipe for disaster, and, as a result, management strategists must have a very clear understanding of the financial implications of business plans. In broader terms, management employees of all types are expected to have a strong understanding of how their jobs affect profitability, and they also are expected to be able to work within their areas to improve profitability. This is precisely what studying finance teaches you: What are the characteristics of activities that create value? Technology and Finance STEM (Science, Technology, Engineering, and Math) classes have become more important in recent years. Finance is considered a STEM discipline, especially at the graduate level. As we discussed, fintech is the area in finance that focuses on the STEM side of things. We'll consider a few examples next. As we'll see, fintech companies can often provide cheaper, faster, and more convenient services than brick-and-mortar setups. **Page 4** Banking Fintech Fintech companies are beginning to compete with traditional bank roles. Mobile payments are a fast-growing form of fintech. Companies such as Venmo and PayPal permit users to transfer money directly from one person to another. These companies have reduced the need for more traditional payment methods, such as checks. In 2019, more than $1 trillion was transferred by mobile payment companies. Crowdfunding companies like Kickstarter and GoFundMe allow users to raise money directly from other people. Variations exist in these crowdfunding companies: Kickstarter participants are often --- buying a product before it comes to market, while GoFundMe is used to raise money for a cause. Fintechs such as Kabbage, Lendio, and Accion have been created to establish marketplaces to provide companies with working capital. These companies have a more streamlined process compared to banks and are willing to fund working capital for start-ups, which are often unable to find funding through more traditional means. Other fintech companies, such as Upstart and Prosper, have become marketplaces for direct lending to consumers. Customers of these companies apply for loans, which are funded directly by other participants, usually individuals. In a traditional bank loan, much of the decision is determined by a credit score and previous credit history. These marketplaces allow for loans to be funded based off other factors. Blockchain and Cryptocurrency Blockchain is at the heart of many new fintech services. Blockchain is a list of records, called blocks, that are used to record transactions. Each block contains a cryptographic hash of the previous block, a time stamp, and transaction data. By design, blockchain is resistant to alteration and thus provides an accurate record of transactions. Cryptocurrency is a digital asset designed to act like currency but is not controlled by any centralized monetary authority. Bitcoin, the first cryptocurrency, was released in 2009. Since then, more than 4,000 variations have been released. Insurance Insurance technology, or insurtech, allows customers to research, compare, and purchase insurance online without physically visiting an insurance agent. Insurtech has streamlined the processes of claims management and evaluating and pricing risks, driving down costs. Insurtech companies are expanding into all areas of insurance, from Lemonade, which offers homeowners and renters insurance, and Oscar Health, which specializes in health insurance, to Trōv, which allows you to insure a single item for any time period right from your mobile phone. Robo-advising and Stock Trading Traditionally, if you invested through a broker, the broker The would advise you on a good asset allocation. Robo-advisors provide investment advice based on mathematical rules or algorithms. This means there is minimal human interaction between the investor and an advisor. **Page 5** Stock trading apps, such as Robinhood, allow investors to trade stocks commission free. Other apps, like Acorns, allow investors to invest small amounts, often as low as $1. These apps allow small investors to participate in the stock market much more easily (and cheaply). Budgeting Apps Perhaps the most common use of fintech is through budgeting apps used by consumers. Budgeting apps allow people to keep track of income, monthly payments, expenditures, and more, right on a mobile phone. These apps allow people more insight into their finances and help with creating financial plans for the future. You and Finance Perhaps the most important reason to know finance is that you will have to make financial decisions that will be important to you personally. Today, for example, when you go to work for almost any type of company, you will be asked to decide how you want to invest your retirement funds. We'll see in a later chapter that what you choose to do can make an enormous difference in your future financial well-being. --- On a different note, is it your dream to start your own business? Good luck if you don't understand basic finance before you start; you'll end up learning it the hard way. Want to know how big your student loan payments are going to be before you take out that next loan? Maybe not, but we'll show you how to calculate them anyway. These are just a few of the ways that finance will affect your personal and business lives. Whether you want to or not, you are going to have to examine and understand financial issues, and you are going to have to make financial decisions. We want you to do so wisely, so keep reading. ### Concept Questions | | | | :-- | :------------------------------------------------------------------------- | | 1.1a| What are the major areas in finance? | | 1.1b| Besides wanting to pass this class, why do you need to understand finance? | --- ## 1.2 Corporate Finance and the Financial Manager In this section, we discuss where the financial manager fits in the corporation. We start by defining corporate finance and the financial manager's job. WHAT IS CORPORATE FINANCE? Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another: **Page 6** 1. What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need? 2. Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money? 3. How will you manage your everyday financial activities such as collecting from customers and paying suppliers? These are not the only questions by any means, but they are among the most important. Corporate finance, broadly speaking, is the study of ways to answer these three questions. Accordingly, we'll be looking at each of them in the chapters ahead. THE FINANCIAL MANAGER A striking feature of large corporations is that the owners (the stockholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation employs managers to represent the owners' interests and make decisions on their behalf. In a large corporation, the financial manager would be in charge of answering the three questions we raised in the preceding section. For current issues facing CFOs, see ww2.cfo.com. The financial management function is usually associated with a top officer of the firm, such as a vice president of finance or the chief financial officer (CFO). Figure 1.1 is a simplified organizational chart that highlights the finance activity in a large firm. As shown, the vice president of finance Coordinates the activities of the treasurer and the controller. The controller's office handles cost and financial accounting, tax payments, and management information systems. The treasurer's office is responsible for managing the firm's cash and credit, financial planning, and capital expenditures. These treasury activities are all related to the three general questions raised earlier, and the chapters --- ahead deal primarily with these issues. Our study thus bears mostly on activities usually associated with the treasurer's office. The image displays an organizational chart called "A Sample Simplified Organizational Chart". The chart starts with the "Board of directors" at the top, followed by "Chairman of the board and chief executive officer (CEO)", then "President and chief operations officer (COO)". Below the COO are three Vice Presidents for marketing, finance (CFO), and production. The CFO has two subordinate positions: Treasurer and Controller. The Treasurer manages "Cash", "Credit", and "Tax". He also supervises "Capital expenditures" and "Financial planning". The controller has supervisory responsibility for "Cost accounting manager", "Financial accounting manager" and "Data processing manager". **Page 7** ### FINANCIAL MANAGEMENT DECISIONS As the preceding discussion suggests, the financial manager must be concerned with three basic types of questions. We consider these in greater detail next. Capital Budgeting The first question concerns the firm's long-term investments. The process of planning and managing a firm's long-term investments is called capital budgeting. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow generated by an asset exceeds the cost of that asset. The types of investment opportunities that would typically be considered depend in part on the nature of the firm's business. For a large retailer such as Walmart, deciding whether to open another store --- would be an important capital budgeting decision. Similarly, for a software company such as Oracle or Microsoft, the decision to develop and market a new spreadsheet program would be a major capital budgeting decision. Some decisions, such as what type of computer system to purchase, might not depend so much on a particular line of business. Regardless of the specific nature of an opportunity under consideration, financial managers must be concerned not only with how much cash they expect to receive, but also with when they expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. In fact, as we will see in the chapters ahead, whenever we evaluate a business decision, the size, timing, and risk of the cash flows will be by far the most important things we will consider. Capital Structure The second question for the financial manager concerns ways in which the firm obtains and manages the long- term financing it needs to support its long- term investments. A firm's capital structure (or financial structure) is the specific mixture of long- term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First, how much should the firm borrow? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm. Second, what are the least expensive sources of funds for the firm? If we picture the firm as a pie, then the firm's capital structure determines how that pie is sliced-in other words, what percentage of the firm's cash flow goes to creditors and what percentage goes to shareholders. Firms have a great deal of flexibility in choosing a financial structure. The question of whether one structure is better than any other for a particular firm is the heart of the capital structure issue. In addition to deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money. The expenses associated with raising long- term financing can be considerable, so different possibilities must be carefully evaluated. Also, corporations borrow money from a variety of lenders in a number of different, and sometimes exotic, ways. Choosing among lenders and among loan types is another job handled by the financial manager. Working Capital Management The third question concerns working capital management. The term working capital refers to a firm's short-term assets, such as inventory, and its short- term liabilities, such as money owed to suppliers. Managing the firm's working capital is a day-to-day activity that ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities related to the firm's receipt and disbursement of cash. Some questions about working capital that must be answered are the following: (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms will we offer, and to whom will we extend them? (3) How will we obtain any needed short- term financing? Will we purchase on credit, or will we borrow in the short term and pay cash? If we borrow in the short term, how and where should we do it? These are just a small sample of the issues that arise in managing a firm's working capital. Conclusion The three areas of corporate financial management we have described-capital budgeting, capital structure, and working capital management-are very broad categories. **Page 8** --- includes a rich variety of topics, and we have indicated only a few questions that arise in the different areas. The chapters ahead contain greater detail. #### Concept Questions | | | | :---- | :-------------------------------------------------------------------------------------------- | | 1.2a | What is the capital budgeting decision? | | 1.2b | What do you call the specific mixture of long-term debt and equity that a firm chooses to use? | | 1.2c | Into what category of financial management does cash management fall? | --- ## 1.3 Forms of Business Organization Large firms in the United States, such as Ford and Microsoft, are almost all organized as corporations. We examine the three different legal forms of business organization-sole proprietorship, partnership, and corporation-to see why this is so. Each form has distinct advantages and disadvantages for the life of the business, the ability of the business to raise cash, and taxes. A key observation is that as a firm grows, the advantages of the corporate form may come to outweigh the disadvantages. ### SOLE PROPRIETORSHIP A sole proprietorship is a business owned by one person. This is the simplest type of business to start and is the least regulated form of organization. Depending on where you live, you might be able to start a proprietorship by doing little more than getting a business license and opening your doors. For this reason, there are more proprietorships than any other type of business, and many businesses that later become large corporations start out as small proprietorships. The owner of a sole proprietorship keeps all the profits. That's the good news. The bad news is that the owner has unlimited liability for business debts. This means that creditors can look beyond business assets to the proprietor's personal assets for payment. Similarly, there is no distinction between personal and business income, so all business income is taxed as personal income. However, with the passage of the Tax Cuts and Jobs Act of 2017, up to 20 percent of business income may be exempt from taxation (the specific rules are too complex to cover here). **Page 9** The life of a sole proprietorship is limited to the owner's life span, and the amount of equity that can be raised is limited to the amount of the proprietor's personal wealth. This limitation often means that the business is unable to exploit new opportunities because of insufficient capital. Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the sale of the entire business to a new owner. ### PARTNERSHIP A partnership is similar to a proprietorship except that there are two or more owners (partners). In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. The way partnership gains (and losses) are divided is described in the partnership agreement. This agreement can be an informal oral agreement, such as "let's start a lawn mowing business," or a lengthy, formal written document. In a limited partnership, one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business. A limited partner's liability for business debts is limited to the amount that partner contributes to the partnership. This form of organization is common in real estate ventures, for example. The advantages and disadvantages of a partnership are basically the same as those of a proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form. General --- partners have unlimited liability for partnership debts, and the partnership terminates when a general partner wishes to sell out or dies. Ownership of a general partnership is not easily transferred because a transfer requires that a new partnership be formed. A limited partner's interest can be sold without dissolving the partnership, but finding a buyer may be difficult. All income is taxed as personal income to the partners, and the amount of equity that can be raised is limited to the partners' combined wealth. As with sole proprietorships, beginning in 2018, up to 20 percent of a partner's income may be exempt depending on various rules spelled out in the Tax Cuts and Jobs Act of 2017. Because a partner in a general partnership can be held responsible for all partnership debts, having a written agreement is very important. Failure to spell out the rights and duties of the partners frequently leads to misunderstandings later on. Also, if you are a limited partner, you must not become deeply involved in business decisions unless you are willing to assume the obligations of a general partner. The reason is that if things go badly, you may be deemed to be a general partner even though you say you are a limited partner. Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as forms of business organization are (1) unlimited liability for business debts on the part of the owners, (2) limited life of the business, and (3) difficulty of transferring ownership. These three disadvantages add up to a single, central problem: The ability of such businesses to grow can be seriously limited by an inability to raise cash for investment. ### CORPORATION The corporation is the most important form (in terms of size) of business organization in the United States. A corporation is a legal “person,” separate and distinct from its owners, and it has many of the rights, duties, and privileges of an actual person. Corporations can borrow money and own property, sue and be sued, and enter into contracts. A corporation can even be a general partner or a limited partner in a partnership, and a corporation can own stock in another corporation. **Page 6** Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms of business organizations. Forming a corporation involves preparing articles of incorporation (or a charter) and a set of bylaws. The articles of incorporation must contain a number of things, including the corporation's name, its intended life (which can be forever), its business purpose, and the number of shares that can be issued. This information must normally be supplied to the state in which the firm will be incorporated. For most legal purposes, the corporation is a "resident" of that state. The bylaws are rules describing how the corporation regulates its existence. For example, the bylaws describe how directors are elected. These bylaws may be a simple statement of a few rules and procedures, or they may be quite extensive for a large corporation. The bylaws may be amended or extended from time to time by the stockholders. In a large corporation, the stockholders and the managers are usually separate groups. The stockholders elect the board of directors, who then select the managers. Managers are charged with running the corporation's affairs in the stockholders' interests. In principle, stockholders control the corporation because they elect the directors. As a result of the separation of ownership and management, the corporate form has several advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of the --- corporation is therefore not limited. The corporation borrows money in its own name. As a result, the stockholders in a corporation have limited liability for corporate debts. The most they can lose is what they have invested. **Page 10** The relative ease of transferring ownership, the limited liability for business debts, and the unlimited life of the business are why the corporate form is superior for raising cash. If a corporation needs new equity, for example, it can sell new shares of stock and attract new investors. Apple is an example. The company was a pioneer in the personal computer business. As demand for its products exploded, it had to convert to the corporate form of organization to raise the capital needed to fund growth and new product development. The number of owners can be huge; larger corporations have many thousands or even millions of stockholders. For example, in 2020, General Electric Company (better known as GE) had about 440,000 stockholders and about 8.7 billion shares outstanding. In such cases, ownership can change continuously without affecting the continuity of the business. The ability of large corporations to raise cash can be lifesaving. In 2020, the COVID -19 virus decimated the cruise ship industry. Even so, Norwegian Cruise Line, the world's third-largest such company, was able to raise $2.2 billion at the height of the pandemic, enough to keep the company afloat (no pun intended) for well over a year with no ships sailing. The corporate form has a significant disadvantage. Because a corporation is a legal person, it must pay taxes. Moreover, money paid out to stockholders in the form of dividends is taxed again as income to those stockholders. This is double taxation, meaning that corporate profits are taxed twice, first at the corporate level when they are earned and again at the personal level when they are paid out. Today, all 50 states have enacted laws allowing for the creation of a relatively new form of business organization, the limited liability company (LLC). The goal of this entity is to operate and be taxed like a partnership but retain limited liability for owners, so an LLC is essentially a hybrid of partnership and corporation. Although states have differing definitions for LLCs, the more important scorekeeper is the Internal Revenue Service (IRS). The IRS will consider an LLC a corporation, thereby subjecting it to double taxation, unless it meets certain specific criteria. In essence, an LLC cannot be too corporation-like, or it will be treated as one by the IRS. LLCs have become common. For example, Goldman Sachs and Co., one of Wall Street's last remaining partnerships, decided to convert from a private partnership to an LLC (it later “went public," becoming a publicly held corporation). Large accounting firms and law firms by the score have converted to LLCs. **Page 7** As the discussion in this section illustrates, because of their need for outside investors and creditors, the corporate form will generally be the best choice for large firms. We focus on corporations in the chapters ahead because of the importance of the corporate form in the United States and world economies. Also, a few important financial management issues, such as dividend policy, are unique to corporations. However, businesses of all types and sizes need financial management, so the majority of the subjects we discuss bear on any form of business. ### A CORPORATION BY ANOTHER NAME ... The corporate form of organization has many variations around the world. The exact laws and regulations differ from country to country, of course, but the essential features of public ownership and --- limited liability remain. These firms are often called joint stock companies, public limited companies, or limited liability companies, depending on the specific nature of the firm and the country of origin. Table 1.1 gives the names of a few well-known international corporations, their countries of origin, and a translation of the abbreviation that follows the company name. ### BENEFIT CORPORATION As of early 2020, 36 states have enacted laws for a new type of company called a benefit corporation. A benefit corporation is for profit, but it has three additional legal attributes: accountability, transparency, and purpose. *Accountability* refers to the fact that a benefit corporation must consider how an action will affect shareholders, employees, customers, the community, and the environment. *Transparency* means that, in addition to standard corporate reports, a benefit corporation must provide an annual report detailing how the company pursued a public benefit during the year, or any factors that inhibited the pursuit of this goal. Finally, *purpose* refers to the idea that a benefit corporation must provide a public benefit, either to society as a whole or the environment. #### TABLE 1.1 International Corporations **Page 11** | Company | Country of Origin | In Original language | | :-------------------------------------------- | :---------------- | :---------------------------- | | Bayerische Motoren Werke (BMW) AG | Germany | Aktiengesellschaft | | Lindauer Dornier GmbH | Germany | Gesellschaft mit beschränkter Haftung | | Rolls-Royce PLC | United Kingdom | Public limited company | | Shell UK Ltd. | United Kingdom | Limited | | Unilever NV | Netherlands | Naamloze Vennootschap | | Assicurazioni Generali SpA | Italy | Societa per Azioni | | Volvo AB | Sweden | Aktiebolag | | Peugeot SA | France | Société Anonyme | --- For more about benefit corporations, check out benefitcorp.net. #### Concept Questions | | | | :---- | :------------------------------------------------------------------------------------------------ | | 1.3a | What are the three forms of business organization? | | 1.3b | What are the primary advantages and disadvantages of sole proprietorships and partnerships? | | 1.3c | What is the difference between a general and a limited partnership? | | 1.3d | Why is the corporate form superior when it comes to raising cash? | --- ## 1.4 The Goal of Financial Managemen Assuming that we restrict ourselves to for-profit businesses, the goal of financial management is to make money or add value for the owners. This goal is a little vague, of course, so we examine some different ways of formulating it to come up with a more precise definition. Such a definition is important because it leads to an objective basis for making and evaluating financial decisions. #### POSSIBLE GOALS **Page 012** If we were to consider possible financial goals, we might come up with some ideas like the following: - Survive. - Avoid financial distress and bankruptcy. - Beat the competition. - Maximize sales or market share. - Minimize costs. - Maximize profits. - Maintain steady earnings growth. These are only a few of the goals we could list. Furthermore, each of these possibilities presents problems as a goal for the financial manager. For example, it's easy to increase market share or unit sales: All we have to do is lower our prices or relax our credit terms. Similarly, we can always cut costs by doing away with things such as research and development. We can avoid bankruptcy by never borrowing any money or never taking any risks, and so on. However, it's not clear that any of these actions are in the stockholders' best interests. Profit maximization would probably be the most commonly cited goal, but even this is not a precise objective. Do we mean profits this year? If so, we should note that actions such as deferring maintenance, letting inventories run down, and taking other short-run cost-cutting measures will tend to increase profits now, but these activities aren't necessarily desirable. The goal of maximizing profits may refer to some sort of "long-run" or "average" profits, but it's still unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? As we will see in more detail in the next chapter, these accounting numbers may have little to do with what is good or bad for the firm. Second, what do we mean by the long run? As a famous economist once remarked, in the long run, we're all dead! More to the point, this goal doesn't tell us what the appropriate trade-off is between current and future profits. The goals we've listed here are all different, but they tend to fall into two classes. The first of these relates to profitability. The goals involving sales, market share, and cost control all relate, at least potentially, to different ways of earning or increasing profits. The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in some way to controlling risk. Unfortunately, these two types of goals are somewhat contradictory. The pursuit of profit normally involves some element --- of risk, so it isn't really possible to maximize both safety and profit. What we need, therefore, is a goal that encompasses both factors. #### THE GOAL OF FINANCIAL MANAGEMENT The financial manager in a corporation makes decisions for the stockholders of the firm. Given this, instead of listing possible goals for the financial manager, we really need to answer a more fundamental question: From the stockholders' point of view, what is a good financial