Chapter 1: Corporate Finance and the Financial Manager

1.1 Why Study Finance?

  • Individuals make personal finance decisions:
    • Saving for retirement.
    • Car loans vs. leases.
    • Stock investments.
    • Home mortgages.
  • Business career questions:
    • Launching new products.
    • Supplier selection.
    • Production outsourcing.
    • Issuing stock vs. borrowing.
    • Raising startup capital.

1.2 The Three Types of Firms

  • Sole Proprietorships
    • Owned and run by one person.
    • Small, few employees.
    • Easy to set up.
    • No separation between firm and owner.
    • One owner limit.
    • Unlimited personal liability for firm debts.
    • Limited life to owner's life.
    • Difficult to transfer ownership.
  • Partnerships
    • Can be general or limited.
    • Income taxed at the personal level, split among partners.
    • General Partnership
      • All partners have unlimited liability.
      • Lender can require any partner to repay debts.
      • Partnership ends on death/withdrawal of a partner.
      • Personally liable for debts.
      • Unincorporated, owned by more than one owner.
      • Same rights as general partners.
    • Limited Partnership
      • General partners with full rights and liabilities.
      • Limited partners with limited liability up to their investment.
      • Limited partners have no management authority.
  • Limited Liability Partnership (LLP)
    • Used in Canada for law and accounting firms.
    • Partial liability limitation for partner negligence.
  • Corporations
    • Legally defined, artificial being, separate from owners.
    • Legal powers of a person.
    • Solely responsible for obligations.
    • Owners not liable for obligations.
    • Formation
      • Defined under provincial/Canada Business Corporation Act.
      • Articles of incorporation/corporate charter defines constitution.
      • More costly to set up than sole proprietorship.
    • Ownership
      • No limit on owners.
      • Ownership divided into shares (stock).
      • Outstanding shares constitute equity.
      • Shareholder/stockholder/equity holder owns stock.
      • Entitled to dividend payments, proportional to stock owned.
      • No limitation on who can own stock.
    • Key Terms
      • Stock: Ownership/equity divided into shares.
      • Equity: All outstanding shares of a corporation.
      • Shareholder: Stock/equity owner.
      • Dividend payments: Payments to equity holders by board's discretion.
    • Tax Implications
      • Corporate profits taxed separately.
      • Shareholders face double taxation:
        • Corporation pays tax on profits.
        • Shareholders pay income tax on distributed profits.
    • Canada Revenue Agency allowed exemption for double taxation flow-through entities (income trust).
      • Business Income Trusts
      • Energy Trusts
      • Real Estate Investment Trust (REIT)
      • REITs continue to have no tax at the business level beyond 2011 but the other forms of income trusts are now taxed.

Key Terms and Definitions

  • Flow-through entity: Business where income flows to investors, little retained.
  • Income trust: Holds income-producing assets or securities of a corporation.
  • Business income trust: Holds debt/equity of a corporation.
  • Energy trust: Holds resource properties or securities of a resource corporation.
  • Unit holders: Owners of an income trust.
  • Real estate investment trust (REIT): Holds real estate or securities of a real estate corporation.

Example 1.1: Taxation of Corporate Earnings

  • Shareholder with shares in TFSA (tax-free) and taxable accounts.
  • Corporation earns 5.00 per share before taxes.
  • Corporate tax rate: 35\%, dividend income tax rate (outside TFSA): 24\%.
  • Calculate after-tax earnings.
  • Solution
    • Corporate tax: 5 × 0.35 = $1.75, leaving 5 − 1.75 = $3.25 after-tax.
    • Dividend tax: 3.25 × 0.24 = $0.78, leaving 3.25 - 0.78 = $2.47 after all taxes.
    • In TFSA: Keep 3.25, effective tax rate is 35\%.
    • Outside TFSA: Keep 2.47, effective tax rate is (1.75 + 0.78)/5 = 2.53/5 = 50.6\%.

Example 1.2: Taxation of a Real Estate Investment Trust (REIT)

  • REIT flows all earnings to unit holders.
  • Some units in TFSA (tax-free), others taxed at 46\%.
  • Solution
    • TFSA: Keep full 5.00.
    • Taxable: Pay 5.00 × 0.46 = $2.30 in taxes, leaving 2.70.

1.3 The Financial Manager

  • Three main tasks:
    • Make investment decisions.
    • Make financing decisions.
    • Manage short-term cash needs.
  • Making Investment Decisions
    • Weigh costs and benefits of investments.
    • Decide on good uses of stockholder money.
  • Making Financing Decisions
    • Raise money by selling stock (equity) or borrowing (debt).
  • Managing Short-Term Cash Needs
    • Ensure enough cash to meet obligations.
    • Managing working capital.
  • Goal of the Financial Manager
    • Maximize stockholder wealth.

1.4 The Financial Manager’s Place in the Corporation

  • Corporate Management Team
    • Stockholders elect board of directors.
    • Board sets rules, policy, monitors performance, delegates decisions to management.
    • CEO runs corporation, implements board policies.
  • Ethics and Incentives in Corporations
    • Principal-Agent Problem
      • Managers prioritize self-interest over shareholders.
      • Address by tying manager compensation to profit or stock price.
    • Shareholders and managers are stakeholders, including employees, customers, suppliers, communities.
    • Stakeholder satisfaction (Japan/Europe) vs. shareholder wealth maximization.
    • Corporate social responsibility (CSR).
    • Actions benefiting stakeholders/CSR may also benefit shareholders through workforce dedication, publicity, reputation.
  • The CEO’s Performance
    • Poor stock performance:
      • Board replaces CEO.
      • Corporate raider initiates hostile takeover.

Key Terms and Definitions

  • Board of directors: Elected by shareholders, ultimate authority.
  • Chief executive officer (CEO): Runs the corporation, implements board policies.

1.5 The Stock Market

  • Corporations: private or public.
    • Private: limited owners, no organized market.
    • Public: many owners, shares trade on stock market.
  • Primary vs. Secondary Markets
    • Primary market: New shares issued by corporation to investors.
    • Secondary market: Shares traded between investors (e.g., TSX, NYSE, Nasdaq).
    • TSX: electronic exchange, investors post orders.
    • NYSE: active trading floor, specialists/market makers with preferential access.
  • Bid-Ask Spread
    • Bid price: Highest price someone will pay.
    • Ask (offer) price: Lowest price someone will sell.
    • Bid-ask spread: Transaction cost to trade quickly.
  • Limit order: Buy at a specified price, trade occurs when matched.
  • Market order: Buy immediately at best ask price.
  • Listing Standards
    • Requirements to be traded on the exchange.
    • NYSE standards are more stringent than TSX.
  • Other Financial Markets
    • Bond Market
    • Foreign Exchange Market
    • Commodities Market
    • Derivative Securities

1.6 Financial Institutions

  • Entities providing financial services.
  • The Financial Cycle
    1. People invest and save.
    2. Money flows to companies for growth.
    3. Money flows back to savers and investors.
  • Types of Financial Institutions
    • Banks and Credit Unions
    • Insurance Companies
    • Mutual Funds
    • Pension Funds
    • Hedge Funds
    • Venture Capital Funds
    • Private Equity Funds
    • Financial conglomerates/financial services firms combine more than one type of institution
  • Role of Financial Institutions
    • Move funds from savers to borrowers.
    • Move funds through time.
    • Help spread out risk-bearing.