The

The Business,
Business, Tax,
Tax, and
and
Financial
Financial Environments
Environments
After studying, you should
be able to:
1.Describe the three basic forms of business organisation –
and the advantages and disadvantages of each.
2.Understand why acquiring assets through the use of debt
financing offers a tax advantage over both common and
preferred stock financing.
3.Describe the purpose and make up of financial markets.
4.Demonstrate an understanding of how letter ratings of
the major rating agencies help you to judge a security’s
default risk.
5.Understand what is meant by the term “term structure
of interest rates” and relate it to a “yield curve.”
Summary
• Business environment
• Types of business
• Strengths and weaknesses
• Financial environment
• Financial institutions borrow and lend
• Financial markets – new issues to the public, and
secondary market
• Private placement
• Interest rates
• Yield curve
• What effects the interest rate
 The Business, Tax, and
Financial Environments

• The Business Environment

• The Tax Environment
• The Financial Environment
 The Business Environment
There are three basic forms of business
organization:
• Sole Proprietorships: A business owned by one person and
operated for his or her own profit
• Partnerships: A business operated by two or more people
together for a profit. (general and limited)
• Corporations: An intangible business entity created by law
and is a separate ‘entity’ to its owners.
• There are other forms of business organisation, but we are
not looking at them here.
 The Business Environment
• Strengths of the basic legal forms of business organisation
 The Business Environment

• Weaknesses of the basic legal forms of business organisation

 The Business
Environment

Sole Proprietorship – A business form for

which there is one owner. This single
owner has unlimited liability for all
debts of the firm.
• Oldest form of business organization.
• Business income is accounted for on your personal
income tax form.
 Summary for
Sole Proprietorship
Advantages Disadvantages
• Simplicity • Unlimited liability
• Hard to raise additional
• Low setup cost capital
• Quick setup • Business entity limited
to life of owner
• Least regulated
• Can have limited access
• Owner keeps all profits to outside funding for
the business
 The Business
Environment
Partnership – A business form in which
two or more individuals act as owners.

• Business income is accounted for on each

partner’s personal income tax form.
 Types of Partnerships

General Partnership – all partners have unlimited

liability and are liable for all obligations of the
partnership.
Limited Partnership – limited partners have
liability limited to their capital contribution
(investors only). At least one general partner is
required and all general partners have unlimited
liability.
 Summary for Partnership
Advantages Disadvantages
• Can be simple • Unlimited liability for the
• Low setup cost, higher than general partner
sole proprietorship • Difficult to raise additional
• Relatively quick setup capital, but easier than
sole proprietorship
• Limited liability for limited
partners • Transfer of ownership
difficulties
 The Business
Environment
Corporation – A business form legally
separate from its owners.

• An artificial entity that can own assets and incur

liabilities.
• Business income is accounted for on the income
tax form of the corporation.
 Summary for Corporation
Advantages Disadvantages
• Business is legal, separate • Double taxation of
entity from owners company profits
• Limited liability • More difficult to
• Easy transfer of ownership establish
• Unlimited life • More expensive to set
• Easier to raise large up and maintain
quantities of capital
 Financial Environment
• External funds can be sourced three ways:
• Financial institutions
• Financial markets
• Private placement
 Financial Environment
• Businesses interact continually with the
financial markets.
• Financial Markets are composed of all
institutions and procedures for bringing buyers
and sellers of financial instruments together.
• The purpose of financial markets is to
efficiently allocate savings to ultimate users.
 Financial Environment
• Financial Institutions:
• Organisations that take the savings of individuals,
businesses and governments and turn them into loans
or investments with other organisations.
• Many different types:
• Banks, building societies, credit unions
• Life insurance and finance companies
• Superannuation and pension funds
• Merchant banks
• Specialised government funding agencies etc
 Allocation of Funds
• Funds will flow to economic units that are willing
to provide the greatest expected return (holding
risk constant).
• In a rational world, the highest expected returns
will be offered only by those economic units with
the most promising investment opportunities.
• Result: Savings tend to be allocated to the most
efficient uses.
 Term Structure of Interest
Rates
Upward Sloping Yield Curve
0 2 4 6 8 10

(Usual)
YIELD (%)

Downward Sloping Yield Curve

(Unusual)
0 5 10 15 20 25 30
YEARS TO MATURITY

A yield curve is a graph of the relationship between yields and

term to maturity for particular securities.
 Risk-Expected Return
Profile
Speculative Common Stocks
EXPECTED RETURN (%)

Conservative Common Stocks

Preferred Stocks
Medium-grade Corporate Bonds
Investment-grade Corporate Bonds
Long-term Government Bonds
Prime-grade Commercial Paper
US Treasury Bills (risk-free securities)

RISK
 What Influences Security
Expected Returns?
• Default Risk is the failure to meet the terms
of a contract.
• Marketability is the ability to sell a
significant volume of securities in a short
period of time in the secondary market
without significant price concession.
 What Influences Expected
Security Returns?
• Maturity is concerned with the life of the
security; the amount of time before the
principal amount of a security becomes due.

• Taxability considers the expected tax

consequences of the security.
 What Influences Expected
Security Returns?
• Embedded Options provide the opportunity to
change specific attributes of the security.

• Inflation is a rise in the average level of prices

of goods and services. The greater inflation
expectations, then the greater the expected
return.
The
The Role
Role of
of Financial
Financial
Management
Management
After studying, you should
be able to:
1. Explain why the role of the financial manager today is so important.
2. Describe "financial management" in terms of the three major decision
areas that confront the financial manager.
3. Identify the goal of the firm and understand why shareholders' wealth
maximization is preferred over other goals.
4. Understand the potential problems arising when management of the
corporation and ownership are separated (i.e., agency problems).
5. Demonstrate an understanding of corporate governance.
6. Discuss the issues underlying social responsibility of the firm.
7. Understand the basic responsibilities of financial managers and the
differences between a "treasurer" and a "controller."
 Why should I care about
Financial Management ?
• Prepare for the workplace of tomorrow.
• Broadening expectations of financial knowledge
and skills.
• Use and understand financial terminology and
concepts in team communication.
• Developing cross-functional capabilities.
• Critical thinking.
 The Role of
Financial Management
• What is Financial Management?
• The Goal of the Firm
• Corporate Governance
• Organization of the Financial Management
Function
 What is Financial
Management?

Concerns the acquisition,

financing, and management of
assets with some overall goal
in mind.
 Investment Decisions
Most important of the three
decisions.
• What is the optimal firm size?
• What specific assets should be acquired?
• What assets (if any) should be reduced or
eliminated?
Financing Decisions
Determine how the assets (LHS of
balance sheet) will be financed (RHS of
balance sheet).
• What is the best type of financing?
• What is the best financing mix?
• What is the best dividend policy (e.g.,
dividend-payout ratio)?
• How will the funds be physically acquired?
 Asset Management
Decisions
• How do we manage existing assets efficiently?
• Financial Manager has varying degrees of
operating responsibility over assets.
• Greater emphasis on current asset
management than fixed asset management.
What is the Goal of
the Firm?

Maximization of
Shareholder Wealth!
Value creation occurs when we maximize
the share price for current shareholders.
Corporate Social Responsibility
Discussion
Class Discussion: What role should CSR and/or
sustainability have on living the “goal of the firm”?

Corporate Social Responsibility (CSR): A business

outlook that acknowledges a firm’s responsibilities to
its stakeholders and the natural environment.
Sustainability: Meeting the needs of the present without
compromising the ability of future generations to meet
their own needs.
 What Goals do some
Firms have?
• “Creating superior shareholder value is our top priority.” Associated
Banc-Corp 2006 Annual Report.
• “The desire to increase shareholder value is what drives our actions.”
Phillips 2006 Annual Report.
• “FedEx’s main responsibility is to create shareholder value.” FedEx
Corporation, SEC Form Def 14A for the period ending 9/25/2006.
• “… the Board of Directors plays a central role in the Company’s
corporate governance system; it has the power (and the duty) to direct
Company business, pursuing and fulfilling its primary and ultimate
objective of creating shareholder value.” Pirelli & C. S.p.A. Milan
Annual Report 2006.
 Shortcomings of
Alternative Perspectives
Profit Maximization
• Maximizing a firm’s earnings after taxes.
Problems
• Could increase current profits while harming firm
(e.g., defer maintenance, issue common stock to
buy T-bills, etc.).
• Ignores changes in the risk level of the firm.
 Shortcomings of
Alternative Perspectives
Earnings per Share Maximization
• Maximizing earnings after taxes divided
by shares outstanding.
Problems
• Does not specify timing or duration of expected
returns.
• Ignores changes in the risk level of the firm.
• Calls for a zero payout dividend policy.
Strengths of Shareholder
Wealth Maximization

• Takes account of: current and future profits and EPS; the
timing, duration, and risk of profits and EPS; dividend
policy; and all other relevant factors.
• Thus, share price serves as a barometer for business
performance.
The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between owners and

managers.
Role of Management

Management acts as an agent for

the owners (shareholders) of the
firm.
• An agent is an individual authorized by another
person, called the principal, to act in the
latter’s behalf.
Agency Theory

• Jensen and Meckling developed

a theory of the firm based on
agency theory.
• Agency Theory is a branch of economics relating to
the behavior of principals and their agents.
Agency Theory

• Principals must provide incentives

so that management acts in the
principals’ best interests and then
monitor results.
• Incentives include, stock options, perquisites, and
bonuses.
 Corporate
Social Responsibility
• Wealth maximization does not preclude the
firm from being socially responsible at the
corporate level.
• Assume we view the firm as producing both
private and social goods.
• Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.
 Corporate Governance
• Corporate governance: represents the system
by which corporations are managed and
controlled.
• Includes shareholders, board of directors,
and senior management.
• Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.
 Board of Directors
• Typical responsibilities:
• Set company-wide policy;
• Advise the CEO and other senior executives;
• Hire, fire, and set the compensation of the CEO;
• Review and approve strategy, significant investments, and
acquisitions; and
• Oversee operating plans, capital budgets, and financial
reports to common shareholders.
• CEO/Chairman roles commonly same person in US, but
separate in Britain (US moving in this direction).
 Sarbanes-Oxley Act of 2002
• Sarbanes-Oxley Act of 2002 (SOX): addresses corporate
governance, auditing and accounting, executive compensation,
and enhanced and timely disclosure of corporate information.
• Imposes new penalties for violations of securities laws.
• Established the Public Company Accounting Oversight
Board (PCAOB) to adopt auditing, quality control, ethics,
disclosure standards for public companies and their
auditors, and policing authority.
• Generally increasing the standards for corporate
governance.
 Organization of the Financial
Management Function

Board of Directors

President
(Chief Executive Officer)

Executive Vice Executive Vice Executive Vice

President President President
(Operations) (Finance - CFO) (Marketing)
 Organization of the Financial
Management Function
EVP of Finance
Vice President (Treasurer) Controller
• Capital Investment • Cost Accounting
• Cash Management • Cost Management
• Commercial/investment • Data Processing
banking relationships • General Ledger
• Credit Management • Government Reporting
• Dividend Disbursement • Internal Control
• Financial Analysis/Planning • Preparing Financial
• Investor Relations Statements
• Mergers and Acquisitions • Preparing Budgets
• Pension Management • Preparing Forecasts
• Insurance/Risk Management
• Tax Analysis/Planning