Chapter 1 The Firm and the

Financial Manager
Organizing a Business The Role of the Financial Manager Who is the Financial Manager? Goals of the Corporation

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Organizing a Business
No two companies will develop in exactly the same way Business fundamental determines the best legal structure Types of business organizations:

Sole Proprietorships Partnerships Corporations Hybrid forms Limited Partnerships: limited liability LLP/LLC: flow-through entities, with taxed on partners, business does not pay income tax PC: taxed as a corporation Income trust: a unique twist
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Starting as a Proprietorship
Sole owner of a business with no partners and no shareholders Advantages:
Ease of formation Subject to fewer regulations No double taxation of corporate earnings

Disadvantages:
Difficult to raise capital to support growth Unlimited liability Limited life span
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Starting as or Growing into a Partnership

Business owned by two or more individuals with various privileges and responsibilities
General (day-to-day management with unlimited liabilities) vs. limited partner (liable only for the money invested) Limited liability partnership

A partnership has roughly the same advantages and disadvantages as a sole proprietorship
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Becoming a Corporation
A corporation is a legal entity separate from its owners and managers File papers and prepare reports federally with Corporation Canada under the Canadian Business Corporate Act
Articles of incorporation Bylaws

Public (with shares listed for trading on an exchange) vs. Private Company (with shares are closely held)
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Becoming a Corporation
Corporations
A business which is legally distinct from its owners, who are called shareholders. One of the key features of a corporation is the separation of ownership and management.
This allows a corporation more flexibility and permanence than other types of business organization.
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Advantages/Disadvantages of a Corporation
Advantages:
Unlimited life Easy transfer of ownership Limited liability Ease of raising capital

Disadvantages:
Double taxation Higher setup cost Endless report filing
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A Unique Twist: Income Trust

Expand 100 times to a market capitalization of $192 billion from 1994 to 2007 Growth ends as government has announced plans in 2006 to tax trusts at the same rate as corporations In the past, cash distributions from income trust are only taxed in the hands of investors, not at the firm level Investors see trusts as tax-efficient and are willing to pay more for a company converted into a trust
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Basic Income Trust Structure

Income Trust Investor
(Unit-holders)
Equity Cash Distributions

INCOME TRUST
Equity/Debt Interest, dividends, return of capital

Operating Company
Copyright 2006 McGraw Hill Ryerson Limited 1-9

Tax Rates and Changes to Income Trust Taxation

Before Investor Income Trust (Income) 46% 0 Large Corp (Dividend) 46% 32% 42% After Income Trust (Income) 45.5% 31.5% 41.5% Large Corp (Dividend) 45.5% 31.5% 41.5%

Taxable Canadian Tax-exempt Canadian

Taxable 15% non-resident

Copyright 2006 McGraw Hill Ryerson Limited

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Organizing a Business: Summary

Sole Partnership Proprietorship
Who owns the business? Are managers and owners separate? What is the owners liability? Are the owner & business taxed separately?
The manager No Partners No

Corporation
Shareholders U sually

U nlimited

U nlimited

Limited

No

No

Yes

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Role of the Financial Manager

(2) (1)

Firm's operations

Financial Manager
(3)

(4a)

Investors
(4b)

Real assets

(1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors
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Role of the Financial Manager

The role of the financial manager is to determine:
What operating assets to invest in?
- Capital budgeting decision, e.g. EnCana has completed a $700m natural gas project offshore Nova Scotia in 2010

How to pay for those assets?

- Financing decision, e.g. TransCanada issued 45.4 million common shares to raise $1.7 billion

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Role of the Financial Manager

Capital Budgeting Decision
The financial manager is concerned with:
1.

The size; The timing; and The risks associated with realizing the future benefits produced by the asset

2.

3.

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Role of the Financial Manager

Financing Decision
The financial manager can use:
Internal financing purchase the assets using the firms own funds. External financing - purchase the assets by raising money from financial institutions or markets. Capital structure mix of debt and equity capital
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Who is the Financial Manager?

Anyone responsible for the capital budgeting and/or the financing decision is known as a financial manager Chief Financial Officer

Treasurer: cash mgmt, raising capital, banking relationship

Controller: preparing financial statements, accounting, taxes

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Determinants of a Firms Value

Goals of the Corporation

The primary goal of any corporation is to maximize shareholder wealth
Increasing market value increases shareholder wealth. Thus, the objective is to maximize the fundamental share price, not just the current price or the profit. .But not at the cost of unethical behavior! Business ethics are a companys attitude and conduct towards its employees, customers, community and shareholders
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Goals of the Corporation

Individuals act in their own self-interest Agency Problems
Conflicts of interest between the firms owners (principals) and its managers (agents) are known as agency problems. Agency relationships result in agency costs, e.g. loss of wealth if agents pursue their own interest, cost of monitoring the agent Agency costs are borne by the principals

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Goals of the Corporation

Agency Problems
Agency problems can be reduced in several ways:
Compensation plans: link the managers salary to the fortunes of the firm
options

Board of Directors Threat of take-over Specialist monitoring: security analysts, bank officers
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