Chapter 1: Corporate Finance and the Financial Manager – Study Notes

Chapter 1: Corporate Finance and the Financial Manager

1.1 Why Study Finance?

Finance is essential for both personal and business decision-making. Understanding finance enables individuals and organizations to make informed choices about investments, savings, and resource allocation.

• Personal Finance Decisions:

  • When to start saving and how much to save for retirement.

  • Choosing between a car loan or lease.

  • Evaluating whether a particular stock is a good investment.

  • Assessing the terms for a home mortgage.

• Business Finance Decisions:

  • Launching new products.

  • Selecting suppliers.

  • Deciding between in-house production or outsourcing.

  • Choosing between issuing new stock or borrowing money.

  • Raising capital for start-up firms.

1.2 The Three Types of Firms

Firms can be organized in several ways, each with distinct characteristics, advantages, and disadvantages.

Sole Proprietorships

• Owned and run by one person; simple to set up.

• Few, if any, employees; no separation between owner and firm.

• Owner has unlimited personal liability for debts.

• Firm's life is limited to the owner's life; difficult to transfer ownership.

Partnerships

• Owned by two or more individuals; income taxed at the personal level.

• General Partnership:

  • All partners have unlimited liability.

  • Partnership ends with death or withdrawal of any partner.

• Limited Partnership:

  • General partners manage and have unlimited liability.

  • Limited partners have liability limited to their investment and no management authority.

• Limited Liability Partnership (LLP):

  • Common in law and accounting firms in Canada.

  • Provides partial limitation of liability for partners regarding negligence of others.

Corporations

• Legally defined, artificial entity separate from its owners.

• Owners (shareholders) are not liable for corporate obligations.

• Formed under provincial or federal acts; more costly to set up than sole proprietorships.

• Ownership divided into shares (stock); no limit on number of owners.

• Shareholders entitled to dividend payments proportional to their holdings.

Key Terms and Definitions

• Stock: Ownership or equity of a corporation divided into shares.

• Equity: Collection of all outstanding shares of a corporation.

• Shareholder (Stockholder/Equity Holder): Owner of a share of stock.

• Dividend Payments: Payments to equity holders at the discretion of the board of directors.

Tax Implications for Corporate Entities

• Corporation profits are taxed separately from owners.

• Double taxation: Corporation pays tax on profits; shareholders pay tax on dividends.

Flow-Through Entities

• Canada Revenue Agency allows some entities (e.g., REITs) to avoid double taxation.

• Types: Business Income Trusts, Energy Trusts, Real Estate Investment Trusts (REITs).

• REITs are not taxed at the business level (as of 2011); other trusts now taxed.

Additional Key Terms

• Flow-through entity: Business where income flows to investors, not retained in the business.

• Income trust: Trust holding income-producing assets or securities.

• Business income trust: Holds all debt/equity of a corporation.

• Energy trust: Holds resource properties or securities of a resource corporation.

• Unit holders: Owners of an income trust.

• REIT: Trust holding real estate properties or securities of a real estate corporation.

Example: Taxation of Corporate Earnings

Suppose a corporation earns $5.00 per share before taxes. Corporate tax rate is 35%, and personal tax rate on dividends is 24% (outside TFSA).

• Corporate tax: $5.00 × 0.35 = $1.75; after-tax earnings = $5.00 - $1.75 = $3.25

• Personal tax on dividend: $3.25 × 0.24 = $0.78; after all taxes, $2.47 remains from $5.00

• Effective tax rate (outside TFSA): $(1.75 + 0.78)/5 = 50.6\%$

• Within TFSA: Only corporate tax applies; $3.25$ remains, effective tax rate $35\%$

Example: Taxation of a REIT

• All earnings flow through to unit holders; no corporate tax.

• Personal tax rate (outside TFSA): 46%

• After-tax earnings: $5.00 × (1 - 0.46) = $2.70$

• Within TFSA: Full $5.00$ remains

1.3 The Financial Manager

The financial manager is responsible for making key decisions that affect the firm's value and operations.

• Investment Decisions: Assessing costs and benefits of projects to determine the best use of stockholders' money.

• Financing Decisions: Deciding whether to raise funds through equity (issuing shares) or debt (borrowing).

• Managing Short-Term Cash Needs: Ensuring the firm can meet its obligations; also known as managing working capital.

• Goal: Maximize the wealth of the stockholders.

1.4 The Financial Manager's Place in the Corporation

Corporations are managed and controlled through a structured hierarchy, with the financial manager playing a central role.

• Corporate Management Team:

  • Shareholders elect a board of directors.

  • Board sets policy, monitors performance, and delegates day-to-day management to executives.

  • Chief Executive Officer (CEO) implements board policies and runs the corporation.

• Ethics and Incentives:

  • Principal-Agent Problem: Managers may act in their own interest rather than shareholders'.

  • Solutions: Tie executive compensation to profits or stock price; consider stakeholder satisfaction and corporate social responsibility (CSR).

• CEO Performance: Poor stock performance may lead to CEO replacement or hostile takeover.

Key Terms

• Board of Directors: Elected group with ultimate decision-making authority.

• Chief Executive Officer (CEO): Runs the corporation by implementing board policies.

1.5 The Stock Market

The stock market is a critical component of the financial system, providing liquidity and valuation for corporate shares.

• Private vs. Public Corporations:

  • Private: Limited owners, no organized market for shares.

  • Public: Many owners, shares traded on organized markets (stock exchanges).

• Primary Market: Where new shares are issued and sold to investors.

• Secondary Market: Where existing shares are traded among investors (e.g., TSX, NYSE, Nasdaq).

• Bid-Ask Spread: Difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller will accept (ask); represents a transaction cost.

• Order Types:

  • Limit Order: Buy/sell at a specified price.

  • Market Order: Buy/sell immediately at the best available price.

• Listing Standards: Requirements for a company to be traded on an exchange (e.g., NYSE standards are more stringent than TSX).

• Other Financial Markets: Bond market, foreign exchange market, commodities market, derivative securities.

1.6 Financial Institutions

Financial institutions play a vital role in the economy by facilitating the flow of funds and managing risk.

• Definition: Entities providing financial services such as deposits, investments, loans, and brokerage.

• The Financial Cycle:

  1. People invest and save money.

  2. Funds flow to companies via loans and stock, enabling growth and profit generation.

  3. Profits and wages flow 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 (combine multiple types)

• Roles:

  • Move funds from savers to borrowers

  • Move funds through time

  • Help spread out risk bearing

Chapter Quiz (Self-Assessment)

1. What are the advantages and disadvantages of organizing a business as a corporation?

2. What are the main types of decisions that a financial manager makes?

3. How do shareholders control a corporation?

4. What is the importance of a stock market to a financial manager?

5. What are the three main roles financial institutions play?