ACCOUNTING AND FINANCE

Choirunnisa Arifa

Accounting and Finance

 Sole proprietorship – An unincorporated business
owned by one individual.
 Partnership – An unincorporated business owned by
two or more persons.
 Corporation – a legal entity created by a state,
separate and distinct from its owners and managers,
having unlimited life, easy transferability of
ownership, and limited liability.

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 Sole Proprietorships
Unlimited Liability
Personal tax on profits

Partnerships

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 Advantages
 Ease of formation
 Subject to few regulations
 No corporate income taxes

 Disadvantages
 Difficult to raise capital
 Unlimited liability
 Limited life

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• Corporation -A business organized as a separate
legal entity owned by stockholders.

• Types of Corporations:
• Public Corporations
• Private Corporations
• S Corporations
• Limited liability companies (LLCs)
• Limited liability partnership (LLPs)

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 Limited Liability

Corporations Corporate tax on profits +

Personal tax on dividends

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  Limited liability
 Infinite lifespan
 Ease of raising capital

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• Corporations face the problem of double
taxation

• Improper corporate structures may lead to

“Agency Problems”

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The Investment Decision
 Real Assets

The Financing Decision

 Financial Assets

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 (1)
Firm’s (2)
Investors
Operations Financial
(4a)
Manager
Financial
Real assets Assets
(3) (4b)

1. Cash raised from investors (how?)

2. Cash invested in firm
3. Cash generated by operations

4A. Cash reinvested in the firm

Accounting and Finance 4B. Cash returned to investors 1-10
 Are the following capital budgeting or financing
decisions?

 Apple decides to spend $500 million to develop a new

iPhone.

 GE borrows $400 million from bond investors.

 Microsoft issues 100 million shares to buy a small

technology company.

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 Shareholders want a wealth maximization

 Wealth maximization vs. profit maximization:

 Pitfall: Profits from which period?

 Pitfall: Cutting dividends to increase cash

reserves

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 No, despite a generally high correlation amongst
stock price, EPS, and cash flow.
 Current stock price relies upon current earnings, as
well as future earnings and cash flow.
 Some actions may cause an increase in earnings, yet
cause the stock price to decrease (and vice versa).

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Accounting and Finance
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 CF1 CF2 CFn
Value     
(1  k)1 (1  k) 2 (1  k)n
n
CFt
 t
.
t 1 (1  k)

 To estimate an asset’s value, one estimates the cash flow for

each period t (CFt), the life of the asset (n), and the appropriate
discount rate (k)
 Throughout the course, we discuss how to estimate the inputs
and how financial management is used to improve them and
thus maximize a firm’s value.

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  Projected cash flows
to shareholders
 Timing of the cash
flow stream
 Riskiness of the cash
flows

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 Decisions made by financial managers:
 Investment decisions
 Financing decisions (the relative use of debt
financing)
 Dividend policy decisions
 The external environment

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 Does value maximization justify unethical behavior?

Recent examples:
 Enron
 WorldCom

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• Do managers really maximize value?
Agency Problems
Managers are agents for stockholders, but the
managers may act in their own interests rather
than maximizing value

• Shareholders vs. Stakeholders

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 An agency relationship exists whenever a principal
hires an agent to act on their behalf.
 Within a corporation, agency relationships exist
between:
 Shareholders and managers
 Shareholders and creditors

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 Different Information Different Objectives
 Stock prices vs. returns  Managers vs.
shareholders
 Top managers vs. lower
 Dividend Policy
managers
 Stockholders vs. banks
 Financing Decisions and lenders

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 Managers are naturally inclined to act in their own
best interests.
 But the following factors affect managerial behavior:
 Managerial compensation plans

 Direct intervention by shareholders

 The threat of firing

 The threat of takeover

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 Shareholders (through managers) could take actions
to maximize stock price that are detrimental to
creditors.
 In the long run, such actions will raise the cost of
debt and ultimately lower stock price.

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  Compensation plans

 Board of Directors
 Blockholders

 Takeovers

 Specialist monitoring

 Legal and regulatory requirements

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 Decisions related to assets and capital
 Maximize stock value by:
 Forecasting and planning
 Investment and financing decisions
 Coordination and control
 Transactions in the financial markets
 Managing risk

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