Dar Al-Hekma University Hekma School of Business and Law Corporate finance

1. Dar Al-Hekma University Hekma School of Business and Law Corporate finance Chapter 1. Corporate Finance and the Financial Manager 1

2. Chapter Outline 1.1 Why Study Finance? 1.2 The Four Types of Firms 1.3 The Financial Manager 1.4 The Financial Manager’s Place in the Corporation

3. Learning Objectives Grasp the importance of financial information in both your personal and business lives Understand the important features of the four main types of firms Explain the goal of the financial manager and the reasoning lying behind that goal Know how a corporation is managed and controlled, the financial manager’s place in it, and some of the ethical issues financial managers face

4. 1. What finance is about? Selected quotations Every day I get up and look through the Forbes list of the richest people in America. If I'm not there, I go to work. Robert Orben In this world, nothing is certain but death and taxes. Benjamin Franklin The highest use of capital is not to make more money, but to make money do more for the betterment of life. Henry Ford I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful. Warren Buffett

5. 1.1 Why Study Finance? Individuals are taking charge of their personal finances with decisions such as: When to start saving and how much to save for retirement Whether a car loan or lease is more advantageous Whether a particular stock is a good investment How to evaluate the terms for a home mortgage

6. 1.1 Why Study Finance? In your business career, you may face such other questions such as: Should your firm launch a new product? Which supplier should your firm choose? Should your firm produce a part or outsource production? Should your firm issue new stock or borrow money instead? How can you raise money for your start-up firm?

7. The basic questions in finance are: • How much should firms save? • Is the risk firms bear rewarded? • How much should firms invest and in which stocks? etc. These questions and many others form a set of interesting questions for our daily life. For example, the saving problem is not only important from an aggregate point of view, but has an impact on individuals since all of us will retire one day, and, hence, one may have an interest in understanding it. Furthermore, aggregate and individual (operating or financial) risks — e.g., operating risk, portfolio risk, state-risk, etc. — form an important issue to financial economists by account of the close relationship it has on our daily life.

8. The savings and risk decisions are also of great importance for the society as a whole. Indeed, aggregate savings determine the prospective production scales of the economy, since aggregate investment depends on savings. Finance theory deals with the capital and risk allocations among economic players, and the determination of assets pricing related to these two types of allocations. Furthermore, it studies the partial and/or total equilibrium brought forth by business activities.

9. Triangle of Finance Time ReturnRisk

10. Scope of finance Three issues constitute the scope of finance :

11. 1.2 The Four Types of Firms Sole Proprietorships Partnerships Limited Liability Companies Corporations

12. 1.2 The Four Types of Firms 1. Sole Proprietorship The firm can have only one owner The owner is responsible for all the business’s debts and other liabilities (Thus as sole proprietor you have unlimited liability). The owner bears all the costs and keeps all the profits

13. 1.2 The Four Types of Firms 1. Sole Proprietorship (advantages) Ease with which it can be established and the lack of regulations governing it. The life of a sole proprietorship is limited to the life of the owner Principal limitation is that there is no separation between the firm and the owner (agency problems are supposed to not exist) Examples: Sole proprietors work as financial planners, offering their services to individuals and small businesses. A landscaper may work alone or hire a small team of employees. Landscapers maintain plants and trees of homeowners and businesses

14. 1.2 The Four Types of Firms 2. Partnership All partners are liable for the firm’s debt A lender can require any partner to repay all the firm’s outstanding debts since all of them are liable. The partnership ends on the death or withdrawal of any single partner. This is not the rule since some partnerships continue after the death of the partner (Procter and Gamble).

15. 1.2 The Four Types of Firms 2. Partnership: Someexamples of partnerhsipsthatworked: • Google, a company founded by Larry Page and Sergey Brin. Page and Brin met at Stanford University while attending graduate school. • Twitter: founded in 2006 by Evan Williams and Biz Stone • Microsoft: founded in 1975 by Bill Gates and Paul Allen Partnershipsworkwell if the partnersshare a commonenthousiasm. For example, Bill Gates and Paul Allen shared obsession with computers and a passion for entrepreneurship Some businesses formed by partnerships survive and continue to be prosperous long after the original partners have died. Proctor and Gamble is a company that makes many popular consumer household brands. Founded in 1837, the company was named after William Proctor and James Gamble.

16. 1.2 The Four Types of Firms 2. Partnership A limited partnership is a partnership with two kinds of owners, general partners and limited partners 2.1 General partners Have the same rights and privileges as partners Are personally liable for the firm’s debt obligations The general partner is the owners of a partnership who have unlimited liability. A general partner is also commonly a managing partner, which means that this person is active in the day-to-day operations of the business. Because any partner in a general partnership can act on behalf of the entire business without the knowledge or permission of the other partners, being a general partner offers poor asset protection.

17. 2. Partnership 2.2 Limited partners • Have limited liability and their ownership interest is transferable • Have no management authority • The death or withdrawal of a limited partner does not dissolve the partnership In the case of a limited partnership, only one of the partners will be the general partner and have unlimited liability. The other partners will have limited liability as long as they do not take an active role in managing the business, so their personal assets will not be at risk.

18. 1.2 The Four Types of Firms 3. Limited Liability Companies (LLC) Is like a limited partnership but without a general partner. No general partner All the owners have limited liability, but they can also run the business

19. 1.2 The Four Types of Firms 4. Corporations A corporationis a legally defined, artificial being, separate from its owners. It has many of the legal powers that people have. E.g., it can enter into contracts, acquire assets, incur obligations…etc

20. 1.2 The Four Types of Firms 4. Corporations A corporation is solely responsible for its own obligations The owners of a corporation are not liable for any obligations the corporation enters into The corporation is not liable for any personal obligations of its owners

21. 1.2 The Four Types of Firms Formation of a Corporation Must be legally formed Must be chartered in the state in which it is incorporated Corporate charter specifies the initial rules that govern how the corporation is run. The corporate charter defines: The corporation's name and address The corporation's purpose Whether the corporation is nonprofit or for-profit entity (e.g. Melinda-Bill Gates Fnd) The number of shares authorized The classes and par values of these authorized shares The directors of the new corporation) More costly than setting up a sole proprietorship

22. 1.2 The Four Types of Firms Ownership of a Corporation No limit on the number of owners, but there is a limit to the minimum number The entire ownership stake of a corporation is divided into shares known as stocks (ordinary vs preferred) The collection of all the outstanding shares of a corporation is known as the equity of the corporation

23. 1.2 The Four Types of Firms Ownership of a Corporation An owner of a share of stock in the corporation is known as a shareholder, stockholder, or equity holder Shareholders are entitled to dividend payments Usually receive a share of the dividend payments that is proportional to the amount of stock they own No limitation on who can own its stocks

24. 1.2 The Four Types of Firms

25. 1.2 The Four Types of Firms Tax Implications for Corporate Entities Corporation’s profits are subject to taxation separate from its owners’ tax obligations (double taxation). Shareholders of a corporation pay taxes twice The corporation pays tax on its profits When the remaining profits are distributed to the shareholders, the shareholders pay their own personal income tax on this income

26. Example 1.1 Taxation of Corporate Earnings Problem: You are a shareholder in a corporation. The corporation earns $5 per share before taxes. After it has paid taxes, it will distribute the rest of its earnings to you as a dividend. The dividend is income to you, so you will then pay taxes on these earnings. The corporate tax rate is 40% and your tax rate on dividend income is 15%. How much of the earnings remains after all taxes are paid?

27. Example 1.1 Taxation of Corporate Earnings Solution: Plan Earnings before taxes: $5 Tax Rate: 40% Personal Dividend Tax Rate: 15% We need to first calculate the corporation’s earnings after taxes by subtracting the taxes paid from the pre-tax earnings of $5. The taxes paid will be 40% (the corporate tax rate) of $5. Since all of the after-tax earnings will be paid to you as a dividend, you will pay taxes of 15% on that amount. The amount leftover is what remains after all taxes are paid.

28. Example 1.1 Taxation of Corporate Earnings Execute: $5 per share  0.40 = $2 in taxes at the corporate level, leaving $5 - $2 = $3 in after-tax earnings per share to distribute. You will pay $3  0.15 = $0.45 in taxes on that dividend, leaving you with $2.55 from the original $5 after all taxes.

29. Example 1.1 Taxation of Corporate Earnings Evaluate: As a shareholder you keep $2.55 of the original $5 in earnings; the remaining $2 + $0.45 = $2.45 is paid as taxes. Thus, your total effective tax rate is 2.45/5 = 49% (it is neither 40% nor 15%),

30. Table 1.1 Characteristics of the Different Types of Firms

31. 1.3 The Financial Manager The financial manager has three main tasks: Make investment decisions Make financing decisions Manage cash flow from operating activities

32. Corporate social responsibility (CSR) • Obligation toward society assumed by business.

33. Corporate Social Responsibility • Economic responsibilities • Produce goods and services that society wants at a price that perpetuates the business and satisfies its obligations to investors. • Legal responsibilities • Obey local, state, federal, and relevant international laws

34. Corporate Social Responsibility • Ethical responsibilities • Meeting other social expectations, not written as law. • Philanthropic responsibilities • Additional behaviors and activities that society finds desirable and that the values of the business support.

35. Contrasting Views First - holds that managers act as agents for shareholders and, as such, are obligated to maximize the present value of the firm Second - managers should be motivated by principled moral reasoning

36. 1.4 The Financial Manager’s Place in the Corporation A corporation is run by a management team, separate from its owners. Ethics and Incentives in Corporations  Agency Problems When managers put their own self-interest ahead of the interests of those shareholders For example, managers’ compensation contracts or keeping a loss-generating factory open because it is the main provider of jobs in a small town.

37. 1.4 The Financial Manager’s Place in the Corporation • The CEO’s Performance • When the stock performs poorly: • The board of directors might react by replacing the CEO • A corporate raider may initiate a hostile takeover where an individual or organization—sometimes known as a corporate raider—can purchase a large fraction of the company’s stock

38. 1.5 The Stock Market Corporations can be private or public A private corporation has a limited number of owners and there is no organized market for its shares A public corporation has many owners and its shares trade on an organized market, called a stock market The value of the owners’ investments in the corporation is determined by the price of a share of the corporation’s stock.

39. 1.6 Financial Institutions The Financial Cycle In the financial cycle: People invest and save their money Through loans and stock, that money flows to companies who use it to fund growth through new products, generating profits and wages The money then flows back to the savers and investors

40. Figure 1.3 The Financial Cycle

41. 1.6 Financial Institutions Types of Financial Institutions Banks Insurance Companies Pension Funds Hedge Funds Venture Capital Funds Private Equity Funds

42. 1.6 Financial Institutions Types of Financial Institutions: financial services firms combine more than one type of institution

43. 1.6 Financial Institutions Role of Financial Institutions Financial institutions: Move funds from savers to borrowers Move funds through time (intertemporal allocation of funds) Help spread out risk-bearing

44. Chapter Quiz What are the advantages and disadvantages of organizing a business as a corporation? Give real life examples of the main types of decisions that a financial manager makes? Discuss the three main roles financial institutions play?