What is a corporation?
A legally defined entity, separate from its owners
What two things are required when registering a company?
- Memorandum of association
- articles of association
What is a memorandum of association?
- a legal statement signed by all initial shareholders or guarantors agreeing to the formation of the company
What is the article of association?
- written rules about running the company agreed by the shareholders/guarantors, directors and the company secretary
Since a corporation is a legal entity what can it do/have done?
- can create contracts, sue, and be sued completely independent of its owners
What is the difference between a private corporation and public corporation?
Private corporation: shares are not publicly traded
Publicly traded: shares are publicly traded
- anyone can own % of the company
- Separation of control and ownership
What is the benefit of a public corporation?
Since there can be an infinite number of shareholders the company can go on forever
Shareholders of a corporation have limited liability, what is limited liability?
- limited liability means that the shareholders cannot be held responsible for the company’s debts
- the only thing the shareholders lose should the company end up in financial difficulty is their investment
- limited liability is a benefit of a corporation
What is double taxation?
- a corporation pays its own taxes in the profits it earns (profits-taxes) = net profit. Since the shareholders are seen as the owners this is seen as the first taxation
- from the net profit shareholders can receive dividends
- shareholders are then required to pay personal income taxes on these dividends (double taxation)
- seen as a disadvantage of a corporation
What are investment decisions?
- decisions to purchase assets/invest in projects which will generate revenue
- the cash flow generated is then used as spending money for the corporation
- also known CAPEX decisions
- also includes managing current assets and the risk associated with them
How are investment decisions financed?
- through the selling of financial assets/securities
- financing decisions
- these decisions relate to raising money
What types of financing decisions are available?
Debt financing- through loans
Equity financing through the issuing of new shares of the reinvestment of cash flow
Describe the role of the financial manager
- Financial manager raises money from financial markets (e.g selling securities/assets, etc.)
- The cash flow generated from stage 1 is used to fund company’s operations/projects
- These operations/investments generate cash flow
- This cash flow can either be reinvested back into the business or they can return the cash flow to financial markets/investors
What is the main financial goal of a corporation?
- maximise shareholder (current) wealth
Describe the 3 things the shareholder wants and the role of the financial manager
- Maximise current wealth
- To transform wealth into the most desirable time pattern of consumption
- To manage risk characteristics of chosen consumption plan
The first want is not possible without the help of the financial manager
- to increase the value of the company good financial investment decisions are required
The second and third wants can be achieved without the help of the financial manager
- but shareholders require free access to competitive and well functioning markets
Wealth maximisation is not equivalent to profit maximisation, describe why profit maximisation is not the main goal
Profit maximisation is not a well defined financial objective
- short term vs long term - company may increase future profits by cutting years dividend and investing freed up cash which isn’t in the shareholders interest if the opportunity cost of capital > project rate of return
Describe how agency problem arises between financial managers and shareholders
- financial managers are rarely shareholders, therefore they may be less interested in the success of the company than the shareholders would like
- therefore incentives are not aligned
- furthermore principals (shareholders) cannot monitor financial managers (agents) actions effectively (IMPERFECT MONITORING)
- leading to agency problem
Agency problem leads to agency costs, what are they?
- Value lost from non-maximising decisions
- I.e revenue lost from non-beneficial investment decisions as a result of financial manager lack of effort - Mitigating /intervening costs
- since principals are aware of the agency problem they wish to mitigate these costs through better monitoring, training, improving operations, etc. all of which are costly
What are the 5 main agency problems?
- Reduced effort
- Private benefits
- Over-investment
- Risk Taking
- Short termism
Describe the agency problem reduced effort
- occurs when financial managers do not act in the best interest of the corporation and shirk from their expected duties
Two forms:
Errors of commission- taking bad actions
Errors of omission - failing to take good actions
Describe the agency problem private benefit
- when financial managers use the company’s resources for their own benefit
E.g. private events, expensive company car
Describe the agency problem over-investment
Three forms:
1. Compensation
- investing in projects which are not profitable in order to look busy and to achieve greater compensation (higher salary/bonus)
- Prestige
- investing a lot in order to make the company (appear) bigger/more active
- bigger is not always better
Makes the CFO look better - Entrenching investment
- investing in projects which makes the financial manager look good even when the overall project is not beneficial and may even decrease the company’s value
Describe the agency problem risk taking
Two forms:
1. Taking too much risk ( “gambling to resurrection”)
- e.g if company is doing badly financial managers may take excessive risk as they see it as they have nothing to lose
- Taking too little risk
- not being risky enough to grow the company and generate revenue as it isn’t in their best interest
Describe the agency problem short termism
- only thinking of the short term benefit, even if LT the decision is bad for the company
- in other words the financial manager is short-sighted
