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The Cost of Capital for Foreign Investment 615
Another Warning 580
Avoiding Fudge Factors 616
22.5 Merger Tactics 582
23.5 Summary 617
Who Gets the Gains? 584
Related Web Links 618
22.6 Leveraged Buyouts 585 Key Terms 618
Barbarians at the Gate? 587 Quiz 618
Practice Problems 619
22.7 Mergers and the Economy 588
Challenge Problem 621
Merger Waves 588
Solutions to Self-Test Questions 621
Do Mergers Generate Net Benefits? 589
Minicase 623
22.8 Summary 590

Glossary 635
Section 1
The Firm and the Financial Manager

The Time Value of Money

Financial Statement Analysis
Who Is the Financial
Organizing a Business
Sole Proprietorships
Careers in Finance
Goals of the Corporation
Hybrid Forms of Business Organization Shareholders Want Managers to Maximize
Market Value
The Role of the Financial
Ethics and Management Objectives
Do Managers Really Maximize Firm
The Capital Budgeting Decision
The Financing Decision
Snippets of History
Financial Institutions and Summary
Financial Institutions
Financial Markets
Other Functions of Financial Markets
and Institutions

A meeting of a corporation™s directors.
Most large businesses are organized as corporations. Corporations are owned by stockholders,
who vote in a board of directors. The directors appoint the corporation™s top executives and
approve major financial decisions.
Comstock, Inc.

his material is an introduction to corporate finance. We will discuss the

T various responsibilities of the corporation™s financial managers and
show you how to tackle many of the problems that these managers are
expected to solve. We begin with a discussion of the corporation, the finan-
cial decisions it needs to make, and why they are important.
To survive and prosper, a company must satisfy its customers. It must also produce
and sell products and services at a profit. In order to produce, it needs many assets”
plant, equipment, offices, computers, technology, and so on. The company has to de-
cide (1) which assets to buy and (2) how to pay for them. The financial manager plays
a key role in both these decisions. The investment decision, that is, the decision to in-
vest in assets like plant, equipment, and know-how, is in large part a responsibility of
the financial manager. So is the financing decision, the choice of how to pay for such
We start by explaining how businesses are organized. We then provide a brief intro-
duction to the role of the financial manager and show you why corporate managers need
a sophisticated understanding of financial markets. Next we turn to the goals of the firm
and ask what makes for a good financial decision. Is the firm™s aim to maximize prof-
its? To avoid bankruptcy? To be a good citizen? We consider some conflicts of interest
that arise in large organizations and review some mechanisms that align the interests of
the firm™s managers with the interests of its owners. Finally, we provide an overview of
what is to come.
After studying this material you should be able to
Explain the advantages and disadvantages of the most common forms of business
organization and determine which forms are most suitable to different types of
Cite the major business functions and decisions that the firm™s financial managers
are responsible for and understand some of the possible career choices in finance.
Explain the role of financial markets and institutions.
Explain why it makes sense for corporations to maximize their market values.
Show why conflicts of interest may arise in large organizations and discuss how cor-
porations can provide incentives for everyone to work toward a common end.

Organizing a Business
In 1901 pharmacist Charles Walgreen bought the drugstore in which he worked on the
South Side of Chicago. Today Walgreen™s is the largest drugstore chain in the United
States. If, like Charles Walgreen, you start on your own, with no partners or stockhold-
ers, you are said to be a sole proprietor. You bear all the costs and keep all the profits
The Firm and the Financial Manager 5

after the Internal Revenue Service has taken its cut. The advantages of a proprietorship
Sole owner of a business are the ease with which it can be established and the lack of regulations governing it.
which has no partners and This makes it well-suited for a small company with an informal business structure.
no shareholders. The As a sole proprietor, you are responsible for all the business™s debts and other liabil-
proprietor is personally liable ities. If the business borrows from the bank and subsequently cannot repay the loan, the
for all the firm™s obligations. bank has a claim against your personal belongings. It could force you into personal
bankruptcy if the business debts are big enough. Thus as sole proprietor you have un-
limited liability.

Instead of starting on your own, you may wish to pool money and expertise with friends
or business associates. If so, a sole proprietorship is obviously inappropriate. Instead,
you can form a partnership. Your partnership agreement will set out how management
decisions are to be made and the proportion of the profits to which each partner is en-
titled. The partners then pay personal income tax on their share of these profits.
Business owned by two or
Partners, like sole proprietors, have the disadvantage of unlimited liability. If the busi-
more persons who are
ness runs into financial difficulties, each partner has unlimited liability for all the busi-
personally responsible for all
ness™s debts, not just his or her share. The moral is clear and simple: “Know thy partner.”
its liabilities.
Many professional businesses are organized as partnerships. They include the large
accounting, legal, and management consulting firms. Most large investment banks such
as Morgan Stanley, Salomon, Smith Barney, Merrill Lynch, and Goldman Sachs started
life as partnerships. So did many well-known companies, such as Microsoft and Apple
Computer. But eventually these companies and their financing requirements grew too
large for them to continue as partnerships.

As your firm grows, you may decide to incorporate. Unlike a proprietorship or part-
nership, a corporation is legally distinct from its owners. It is based on articles of in-
corporation that set out the purpose of the business, how many shares can be issued, the
number of directors to be appointed, and so on. These articles must conform to the laws
Business owned by
of the state in which the business is incorporated. For many legal purposes, the corpo-
stockholders who are not
ration is considered a resident of its state. For example, it can borrow or lend money,
personally liable for the
and it can sue or be sued. It pays its own taxes (but it cannot vote!).
business™s liabilities.
The corporation is owned by its stockholders and they get to vote on important mat-
ters. Unlike proprietorships or partnerships, corporations have limited liability, which
means that the stockholders cannot be held personally responsible for the obligations of
the firm. If, say, IBM were to fail, no one could demand that its shareholders put up
The owners of the
more money to pay off the debts. The most a stockholder can lose is the amount invested
corporation are not
in the stock.
personally responsible for its
While the stockholders of a corporation own the firm, they do not usually manage
it. Instead, they elect a board of directors, which in turn appoints the top managers. The
board is the representative of shareholders and is supposed to ensure that management
is acting in their best interests.
This separation of ownership and management is one distinctive feature of corpora-
tions. In other forms of business organization, such as proprietorships and partnerships,
the owners are the managers.
The separation between management and ownership gives a corporation more flex-
ibility and permanence than a partnership. Even if managers of a corporation quit or are

dismissed and replaced by others, the corporation can survive. Similarly, today™s share-
holders may sell all their shares to new investors without affecting the business. In con-
trast, ownership of a proprietorship cannot be transferred without selling out to another
By organizing as a corporation, a business may be able to attract a wide variety of
investors. The shareholders may include individuals who hold only a single share worth
a few dollars, receive only a single vote, and are entitled to only a tiny proportion of the
profits. Shareholders may also include giant pension funds and insurance companies
whose investment in the firm may run into the millions of shares and who are entitled
to a correspondingly large number of votes and proportion of the profits.
Given these advantages, you might be wondering why all businesses are not organ-
ized as corporations. One reason is the time and cost required to manage a corporation™s
legal machinery. There is also an important tax drawback to corporations in the United
States. Because the corporation is a separate legal entity, it is taxed separately. So cor-
porations pay tax on their profits, and, in addition, shareholders pay tax on any divi-
dends that they receive from the company.1 By contrast, income received by partners
and sole proprietors is taxed only once as personal income.
When you first establish a corporation, the shares may all be held by a small group,
perhaps the company™s managers and a small number of backers who believe the busi-
ness will grow into a profitable investment. Your shares are not publicly traded and your
company is closely held. Eventually, when the firm grows and new shares are issued to
raise additional capital, the shares will be widely traded. Such corporations are known
as public companies. Most well-known corporations are public companies.2

To summarize, the corporation is a distinct, permanent legal entity. Its
advantages are limited liability and the ease with which ownership and
management can be separated. These advantages are especially important for
large firms. The disadvantage of corporate organization is double taxation.

The financial managers of a corporation are responsible, by way of top management
and the board of directors, to the corporation™s shareholders. Financial managers are
supposed to make financial decisions that serve shareholders™ interests. Table 1.1 pre-
sents the distinctive features of the major forms of business organization.

Businesses do not always fit into these neat categories. Some are hybrids of the three
basic types: proprietorships, partnerships, and corporations.
For example, businesses can be set up as limited partnerships. In this case, partners
are classified as general or limited. General partners manage the business and have un-
limited personal liability for the business™s debts. Limited partners, however, are liable
only for the money they contribute to the business. They can lose everything they put
in, but not more. Limited partners usually have a restricted role in management.
In many states a firm can also be set up as a limited liability partnership (LLP) or,
equivalently, a limited liability company (LLC). These are partnerships in which all

1 The United States is unusual in its taxation of corporations. To avoid taxing the same income twice, most
other countries give shareholders at least some credit for the taxes that their company has already paid.
2 For example, when Microsoft was initially established as a corporation, its shares were closely held by a

small number of employees and backers. Microsoft shares were issued to the public in 1986.
The Firm and the Financial Manager 7

Characteristics of
Proprietorship Partnership Corporation
business organizations

Who owns the business? The manager Partners Shareholders

Are managers and owner(s)
No No Usually

What is the owner™s
Unlimited Unlimited Limited

Are the owner and business
No No Yes
taxed separately?

partners have limited liability. This form of business organization combines the tax ad-
vantage of partnership with the limited liability advantage of incorporation. However,
it still does not suit the largest firms, for which widespread share ownership and sepa-
ration of ownership and management are essential.
Another variation on the theme is the professional corporation (PC), which is com-
monly used by doctors, lawyers, and accountants. In this case, the business has limited
liability, but the professionals can still be sued personally for malpractice, even if the
malpractice occurs in their role as employees of the corporation.

Which form of business organization might best suit the following?


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