What are 3 key elements of corporate finance?
What is capital structure?
Financial arrangements determine how the value of the firm is sliced up. Institutions that buy debt from the firm are called creditors, bondholders or debtholders. Holders of equity shares are called shareholders.
Value of a firm = value of bonds + value of shares
What is a finance manager responsible for? What is the goal of financial management?
investment decisions / financing decisions / short term financial planning / etc.
The goal of financial management is to maximize the share price of the company.
What are financial markets?
Financial markets = money markets (debt securities that will pay off in the short term; less than 1 year) and the capital markets (long-term debt and equity shares)
When firms require cash to invest in projects, they have to choose the most efficient and cost-effective financing option. Generally, there are two ways of financing investments: borrow money (bonds/debt) or give up a fraction of ownership (shares/equity).
Debt: When borrowing, the firm can go to a bank for a loan or it can issue debt securities in the financial markets. Debt Securities are contractual obligations to repay corporate borrowing.
Equity: The public sale of ownership is undertaken through the marketing and sale of equity securities. Equity securities are shares that represent non-contractual claims on the residual cash flow of the firm.
Difference between primary and secondary markets:
- Securities are sold to investors
- Money that is raised goes to issuing firm
- First share issue is called an Initial Public Offering (IPO)
- Second share issue is called a seasoned offering
- Investors trade securities with one another
- Money that is raised goes to seller of securities
- Share prices
Different Types of Firms (where a firm is a way of organizing the economic activity of many individuals):
1. Sole Proprietorship
A business owned and managed by one person
Very easy to form, since it can be set up without any formal charter, articles or memoranda of association
Pays no corporate income taxes (all profits are taxed as individual income)
Unlimited liability for business debts and obligations, and its life is limited by the life of the sole proprietor
The equity money that can be raised by the sole proprietor is limited to the proprietor’s personal wealth
2. The Partnership: general partnerships and limited partnerships
Partnerships are formed by several people and requires a partnership agreement
In a general partnership all partners agree to provide some fraction of the work and cash, and share the profits and losses (each partner is liable for all of the debts of the partnership)
Limited partnerships permit the liability of some of the partners to be limited to the amount of cash each has contributed to the partnership
The partnership is terminated when a partner dies or leaves the firm
The profits of the partnership are taxed as personal income
3. The Corporation:
A distinct legal entity and by far the most important form of business enterprise
The incorporators must prepare articles of incorporation and a memorandum of association
The shares of a corporation can be exchanged without termination of the corporation, i.e. the life of the corporation is hypothetically unlimited and ownership can be easily transferred
The shareholders are not personally liable for obligations of the corporation (limited liability)
Corporations may have double taxation: corporate income is taxable and dividends to shareholders are also taxable
The senior executives of a corporation make up the board of directors
In corporations with single-tier (or unitary) board structures, the shareholders control the corporation’s direction, policies and activities
In corporations with two-tier board structures, the management is elected by and reports to a supervisory board
Agency relationships are those between management and shareholders OR large shareholders and minority shareholders OR shareholders and debtholders. Agency problems arise when an agent (i.e., manager) is hired by a principal to do a job for them (i.e., shareholders).
How can one incentivize managers to act in the interest of shareholders?
Pay is linked to market performance
Better performers tend to get promoted or better jobs elsewhere
If managers perform poorly they can lose their job
Two Tier Systems
Trade Unions and other groups can make managers act in the interests of stakeholders as well as shareholders