An Overview of Corporate Finance and the Financial Environment

AN OVERVIEW OF CORPORATE FINANCE AND THE FINANCIAL ENVIRONMENT

INTRODUCTION

In this introductory chapter to corporate finance, we will discuss thevarious responsibilities of the corporation’s financial managers andshow you how to tackle many of the problems that these managers areexpected to solve. We begin with a discussion of the corporation, the financialdecisions it needs to make, and why they are important.

To survive and prosper, a company must satisfy its customers. It must also produceand sell products and services at a profit. In order to produce, it needs many assets—plant, equipment, offices, computers, technology, and so on. The company has to decide(1) which assets to buy and (2) how to pay for them. The financial manager playsa key role in both these decisions. The investment decision, that is, the decision to investin assets like plant, equipment, and know-how, is in large part a responsibility ofthe financial manager. So is the financing decision, the choice of how to pay for suchinvestments.

We start by explaining how businesses are organized. We then provide a brief introductionto the role of the financial manager and show you why corporate managers needa sophisticated understanding of financial markets. Next we turn to the goals of the firmand ask what makes for a good financial decision. Is the firm’s aim to maximize profits?To avoid bankruptcy?To be a good citizen? We consider some conflicts of interestthat arise in large organizations and review some mechanisms that align the interestsofthe firm’s managers with the interests of its owners.

Corporate Finance /financial Management Definition:

It is a discipline that involvesdecisions about sourcing finance, management and employment of capital so as to attain corporate goals.

It also deals with size of the organisation (level of employment, structure of financing and composition of assets (Employment of capital).

Responsibilities of Corporate Financial Management

The financial manager is tasked with the responsibility of acquiring funds for the business and using those funds in order to maximize the value of the firm.

Specifically, the financial manager has several duties to perform within the firm. These are investment and financing decision making, management of risk, management of value, planning and managing the Statement of Financial Position. We discuss these roles below:

1. Financial Planning. The main responsibility of the financial manager in a large concern is to forecast the needs and sources of finance and ensure the adequate supply cash at proper time for the smooth running of the business. He is to see that cash inflow and outflow must be uninterrupted and continuous. For this purpose, financial planning is necessary, i.e., he must decide the time when he needs money, the sources of supply of money and the investment patterns so that the company may meet its obligations properly and maintains its goodwill in the market. The financial manager is also to see that there is no surplus money in the business which earns nothing.

1. Investment and financing decisions. The financial manager must play a leading role in the investment and financing decisions of the business. He must help to decide the assets that must be acquired and the way in which the assets will be financed. For example, there are several options to be considered with regards to financing. These are debt finance versus equity finance, long-term finance versus short term finance.

1. Management of risk. The financial manager is responsible for the management of risk. The firm's overall risk is determined by the way in which its assets have been financed. For example, the introduction of debt into the business brings with it financial risk. The introduction of fixed assets also brings with it operating risk.
   
2. Raising of Necessary Funds. The second main responsibility of the financial officer is to see the nature of the need, i.e., whether finances are required for long-term or for short-term. He must assess the alternative sources of supply of finance taking into view the cost of raising funds, its effect on various concerned parties, i.e. shareholders, creditors, employees and the society, control and risk in financing and elasticity in capital structure etc.

1. Controlling the Use of Funds and management of value. The financial manager is responsible for the management of value. The financial manager must keep in touch with the financial market that is the money market and capital market. This is because funds must be raised on the financial markets through the issuance of securities (shares and bonds ). These securities are then traded on the financial markets by the investors who have provided funds to the firm. He is also responsible for the proper utilization of funds. Assets must be used effectively so as to earn higher profits; inflow and outflow of cash must be controlled in a manner so as to meet the current as well as future obligations; unnecessary expenditure should be curtailed and there should be left no possibility for misappropriation of money.

1. Disposition of Profits. Appropriation of profits is one of the main responsibilities of the financial manager. He is to advise to the top executive as how much of the profits should be retained in the business as reserves for future expansion; how much to be used in repaying the debts; and how much to be distributed to the shareholders as dividend. On the basis of the advice given by the financial mange, the resolutions regarding depreciations, reserves, general reserves and distribution of dividends are carried out in the meeting of the board of directors of the company.

1. Other Responsibilities. Over and above, the responsibilities stated above, there are certain other responsibilities of the financial manager. These are:

a. Responsibility to owners. Shareholders or stock-holders are the real owners of the concern. Financial manager has the prime responsibility to those who have committed funds to the enterprise. He should not only maintain the financial health of the enterprise, but should also help to produce a rate of earning that will reward the owners adequately for the risk capital they provide.
b. Legal Obligations. Financial manager is also under an obligation to consider the enterprise in the light of its legal obligations. A host of laws, taxes and rules and regulations cover nearly every move and policy. Good financial management help to develop a sound legal framework.
c. Responsibilities to Employees. The financial management must try to produce a healthy going concern capable of maintaining regular employment at satisfactory rate of pay under favourable working conditions. The long term financial interests of management, employees and owners are common.
d. Responsibilities to Customers. In order to make the payments of its customers' bill, the effective financial management is necessary. Sound financial management ensures the creditors continued supply of raw material.
e. Wealth Maximization. Prof. Soloman of Stanford University has argued that the main goal of the finance function is wealth maximization. The other goals may be achieved automatically.
In the light of the above discussion, we can conclude that the main responsibility of the financial manager is not only to maintain the financial health of the organisation but also to increase the economic welfare of the shareholders by utilizing funds invested.

Objectives of Corporate Finance

The objectives or goals or corporate financial management are-

(a) Profit maximization,

(b) Return maximization, and

(c) Wealth maximization.

We shall explain these three goals of corporate financial management as under:

1. Goal of Profit maximization.

Maximization of profits is generally regarded as the main objective of a business enterprise. Each company collects its finance by way of issue of shares to the public. Investors in shares purchase these shares in the hope of getting profits from the company as well as dividends. This is possible only when the company's goal is to earn maximum profits out of its available resources. If company fails to distribute higher dividend, investors will not be keen to invest their money in such firm and those who have already invested will like to sell their stocks. On the other hand, higher profits are the barometer of its efficiency on all fronts, i.e., production, sales and management. A few replace the goal of 'maximization of profits' to 'fair profits'. 'Fair Profits' means general rate of profit earned by similar organisation in a particular industry.

1. Goal of Return Maximization.

The second goal of financial management is to safeguard the economic interests of the persons who are directly or indirectly connected with the company, i.e. shareholders, creditors and employees. The all such interested parties must get the maximum return for their contributions. But this is possible only when the company earns higher profits or sufficient profits to discharge its obligations to them. Therefore, the goal of maximization of profits and returns are inter-related.

1. Goal of Wealth Maximization.

Frequently, maximization of profits is regarded as the proper objective of the firm but it is not as inclusive a goal as that of maximising it value to its shareholders. Value is represented by the market price of the ordinary share of the company over the long run, which is certainly a reflection of the performance of the company's investment and financing decisions. It isthe prime goal of the corporate financial management to ensure its shareholders have the value of their shares maximized in the long-run. In fact, the performances of the company can well be evaluated by the value of its share in the long run.

Forms of Business Ownership:

There are three main forms of business organization: (1) sole proprietorships, (2) partnerships, and (3) corporations. In terms of numbers, about 80% of businesses are operated as sole proprietorships, while most of the remainder are divided equally between partnerships and corporations.

Sole Proprietorship

A sole proprietorship is an unincorporated business owned by one individual. Going into business as a sole proprietor is easy—one merely begins business operations. However, even the smallest business normally must be licensed by a governmental unit.

The proprietorship has three important advantages:

1. It is easily and inexpensively formed,
2. it is subject to few government regulations, and
3. The business avoids corporate income taxes.

The proprietorship also has three important limitations:

1. It is difficult for a proprietorship to obtain large sums of capital;
2. The proprietor has unlimited personal liability for the business’s debts, which can result in losses that exceed the money he or she invested in the company; and
3. The life of a business organized as a proprietorship is limited to the life of the individual who created it.

For these three reasons, sole proprietorships are used primarily for small-business operations. However, businesses are frequently started as proprietorships and then converted to corporations when their growth causes the disadvantages of being a proprietorship to outweigh the advantages.

Partnership

A partnership exists whenever two or more up to twenty persons associate to conduct a non-corporate business with a goal of making profit. Partnerships may operate under different degrees of formality, ranging from informal, oral understandings to formal agreements filed in the state in which the partnership was formed. The major advantage of a partnership is its low cost and ease of formation.

The disadvantages are similar to those associated with proprietorships:

1. Unlimited liability,

2. limited life of the organization,

3. difficulty transferring ownership, and

4. Difficulty raising largeamounts of capital.

Regarding liability, the partners can potentially lose all of their personal assets,even assets not invested in the business, because under partnership law, each partner isliable for the business’s debts. Therefore, if any partner is unable to meet his or herpro rata liability in the event the partnership goes bankrupt, the remaining partnersmust make good on the unsatisfied claims, drawing on their personal assets to the extentnecessary.

The first three disadvantages—unlimited liability, impermanence of the organization,and difficulty of transferring ownership—lead to the fourth, the difficulty partnershipshave in attracting substantial amounts of capital. This is generally not a problemfor a slow-growing business, but if a business’s products or services really catch on, andif it needs to raise large sums of money to capitalize on its opportunities, the difficulty inattracting capital becomes a real drawback. Thus, growth companies such as Hewlett-Packard and Microsoft generally begin life as a proprietorship or partnership, but atsome point their founders find it necessary to convert to a corporation.

Corporation

A corporation is a legal entity created by the state in terms of the Company’s Act in Zimbabwe, and it is separate and distinct fromits owners and managers. This separateness gives the corporation three major advantages:

1. Unlimited life. A corporation can continue after its original owners and managers are deceased.
2. Easy transferability of ownership interest. Ownership interests can be divided into shares, which, in turn, can be transferred far more easily thancan proprietorship or partnership interests.
3. Limited liability. Losses are limited tothe actual funds invested.

To illustrate limited liability, suppose you invested $10,000in a partnership that then went bankrupt owing $1 million. Because the ownersareliable for the debts of a partnership, you could be assessed for a share of the company’sdebt, and you could be held liable for the entire $1 million if your partners could notpay their shares. Thus, an investor in a partnership is exposed to unlimited liability.

On the other hand, if you invested $10,000 in the stock of a corporation that thenwent bankrupt, your potential loss on the investment would be limited to your$10,000 investment. These three factors—unlimited life, easy transferability of ownershipinterest, and limited liability—make it much easier for corporations than forproprietorships or partnerships to raise money in the capital markets.

The corporate form offers significant advantages over proprietorships and partnerships,but it also has two disadvantages:

1. Corporate earnings may be subject todouble taxation—the earnings of the corporation are taxed at the corporate level, andthen any earnings paid out as dividends are taxed again as income to the shareholders.
2. Setting up a corporation ismore complex and time-consuming than for a proprietorship or a partnership.A proprietorship or a partnership can commence operations without much paperwork,but setting up a corporation requires that the incorporators prepare an Articles of Association and Memorandum of Association.

The Memorandumincludes the following information:

1. Nameof the proposed corporation,

2. Types of activities it will pursue,

3. Amount of capital stock,

4. Number of directors,

5. Names and addresses of directors.

The memo is filed with the Registrar of Companies, and when it is approved, the corporationis officially in existence.Then,after the corporation is in operation, quarterlyandannualemployment, financial, and tax reports must be filed with state authorities.

The Articlesare a set of rules drawn up by the founders of the corporation. Included re such points as

1. how directors are to be elected (all elected each year, orperhaps one-third each year for three-year terms);
2. whether the existing shareholderswill have the first right to buy any new shares the firm issues; and
3. Procedures for changing the articles themselves, should conditions require it.

The principal objective of a Corporation (company)

Shareholders are the owners of a corporation, and they purchase shares because they want to earn a good return on their investment without undue risk exposure. In most cases, shareholders elect directors, who then hire managers to run the corporation on a day-to-day basis. Because managers are supposed to be working on behalf of shareholders, it follows that they should pursue policies that enhance shareholder value.

Consequently, throughout this module we operate on the assumption that management’s primary objective is stockholder wealth maximization, which translates into maximizing the price of the firm’s common stock/shares. Firms do, of course, have other objectives— in particular, the managers who make the actual decisions are interested in their own personal satisfaction, in their employees’ welfare, and in the good of the community and of society at large. Still, stock price maximization is the most important objective for most corporations.

Agency theory

NB.TO DO AS ASSIGNMENT IN GROUPS OF TEN TO BE SUBMITTED 5 April.