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Business Finance(MGT 232)

Lecture 2

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Business FinanceBusiness FinanceIntroductionIntroduction

Business FinanceBusiness FinanceIntroductionIntroduction

(Role of Financial management (Cont..))(Role of Financial management (Cont..))

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Overview of the Last Lecture

• What is Finance? And interrelated areas• Financial Management • Three Important FM decisions• Goal of a Firm (some alternatives)• Structure of a Modern Corporation• Role of Management• Organization of the Financial Management

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Role of Management

• An agentagent is an individual authorized by another person, called the principalprincipal, to act in the latter’s behalf.

Management acts as an agentagent for the owners (shareholders) of the

firm.

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Agency Theory

• Agency TheoryAgency Theory is a branch of economics relating to the behavior of principals and their agents.

Jensen and Meckling developed a theory of the firm based on agency agency theorytheory.

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• Agency relationship• Agency conflict• Agency cost

Agency Theory

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Agency Theory

• Incentives include stock options, perquisites, stock options, perquisites, and bonuses bonuses.

• Examples

• Principals must provide incentivesincentives so that management acts in the principals’ best interests and then monitormonitor results.

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Social Responsibility

• Corporate Social Responsibility is the integration of business operations and values, whereby the interests of all stakeholders including investors, customers, employees, the community and the environment are reflected in the company's policies and actions.

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Social Responsibility

• Wealth maximization does not preclude the firm from being socially responsiblesocially responsible.

• Assume we view the firm as producing both private and social goods.

• Then shareholdershareholder wealthwealth maximizationmaximization remains the appropriate goal in governing the firm.

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Organization of the Financial Management Function

Board of Directors

President(Chief Executive Officer)

Vice PresidentOperations

Vice PresidentMarketing

VP ofFinance

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TreasurerCapital BudgetingCash ManagementCredit Management

Dividend DisbursementFin Analysis/PlanningPension Management

Insurance/Risk MngmtTax Analysis/Planning

Organization of the Financial Management Function

VP of Finance

ControllerCost Accounting

Cost ManagementData ProcessingGeneral Ledger

Government ReportingInternal Control

Preparing Fin StmtsPreparing BudgetsPreparing Forecasts

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The Business and Financial Environments

• The Business Environment• The Financial Environment

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The Business Environment

• Sole Proprietorships• Partnerships• Corporations• Limited Liability Corporation

There are FOUR basic forms of There are FOUR basic forms of business organization:business organization:

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Sole Proprietorship

AdvantagesAdvantages• Simplicity (single owner)• Low setup cost• Quick setup• Single tax filing on

individual form

DisadvantagesDisadvantages• Unlimited liability• Hard to raise

additional capital• Transfer of

ownership difficulties

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• Unlimited liability means that owners can be held personally accountable for a business's debt

Unlimited Liability

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Partnership

PartnershipPartnership - A business form in which two or more individuals act as owners.

There are two types of partnerships:•General Partnership•Limited partnership

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Types of Partnerships

Limited PartnershipLimited 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.

General PartnershipGeneral Partnership -- All partners have unlimited liability and are liable for all obligations of the partnership.

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Summary for Partnership

AdvantagesAdvantages• Can be simple• Low setup cost, higher

than sole proprietorship• Relatively quick setup• Limited liability for limited

partners

DisadvantagesDisadvantages• Unlimited liability for the

general partner• Difficult to raise

additional capital, but easier than sole proprietorship

• Transfer of ownership difficulties

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The Business Environment

• An artificial entity that can own assets and incur liabilities.

• Business incomeBusiness income is accounted for on the income tax form of the corporationincome tax form of the corporation.

CorporationCorporation - A business form legally separate from its owners.

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Summary for Corporation

AdvantagesAdvantages• Limited liability• Easy transfer of

ownership• Unlimited life• Easier to raise large

quantities of capital

DisadvantagesDisadvantages• Double taxation• More difficult to

establish • More expensive to

set up and maintain

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Limited Liability Company (LLC)

• Limited liability• Centralized management• Unlimited life• In Pakistan LLCs are known as private companies

that end with Pvt. Ltd. They should have at least Rs. 100,000 as their minimum paid up capital.

Generally, LLC will possess only the Generally, LLC will possess only the first two of the following four standard first two of the following four standard

corporation characteristicscorporation characteristics

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Summary for LLC

AdvantagesAdvantages• Limited liability• Eliminates double

taxation• No restriction on

number or type of owners

• Easier to raise additional capital

DisadvantagesDisadvantages• Limited life

(generally)

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Financial Environment• Businesses interact continually with the

financial markets.financial markets.• Financial MarketsFinancial Markets are composed of all

institutions and procedures for bringing buyers and sellers of financial instruments together.

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Summary

• Role of Management • Agency Theory• Social Responsibility• Organization of the Financial Management• Business Environment• Tax Environment• Financial Environment