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The Scope of Corporate Finance

Objectives
In U.S. law, a corporation is a separate legal entity with many of the same economic rights and responsibilities as those enjoyed by individuals.

Define the field of finance and various career opportunities. Describe the five basic corporate finance functions. Explain the advantages and disadvantages of the corporation as a business organization, as well as proprietorships and partnerships. Explain the concept of shareholder wealth maximization. Introduce the goal of financial management. Define and discuss agency costs.

Study Notes
There are three major forms of business organizations: sole proprietorship, partnership, and corporation. The latter is the major focus of this course. A corporation is a separate legal entity, and this allows it to enter contracts, own property, sue or be sued, etc. Advantages of the corporate form of organization are the easy access to capital, limited liability, and easy transfer of ownership. The major disadvantages are double taxation and heavy regulation. The financial manager of the firm is the single agent acting in the interest of the shareholders. The financial manager's goal is to maximize the overall value of the firm, which is to maximize the value of the shareholders' stock. Profit maximization is not the objective. Profit maximization is a vague definition and does not directly translate to improve shareholder wealth. Thus, profit maximization does not yield accurate measures for the value of the firm. The corporation form of organization creates separation of ownership and control. Shareholders own the company, and managers control the company. Due to the separation of ownership and control, agency problems exist. Agency problems are conflicts of interests between shareholders and managers. An example would be a CEO who has a taste for expensive office furniture and buys several pieces a year, or buys an expensive company car. These types of purchases benefit the CEO, but they do not make the shareholder better off. Shareholders, however, implement ways of monitoring managers, and the costs of monitoring are called agency costs. Although the corporation operates with the potential of many conflicts, it still remains the efficient form for large organizations. The five basic corporate finance functions are external financing, capital budgeting, financial management, corporate governance, and risk management. Test Yourself: Review the discussion of debt and equity on page 13 of the text and answer the following. Then, click in this area to reveal the answer. Click again if you want to hide the answer.

One decision that financial managers always face is the capital structure decision do we borrow funds to finance assets or do we allow people to buy part of the firm by selling stock? As a business student, you are probably familiar with the concepts of fixed, variable and marginal costs, especially as they relate to costs of production. Keep the concept of fixed, variable and marginal costs in mind as you evaluate the following question regarding financial costs: Assume two companies are investing in roughly identical new product projects. You are the financial manager of Tweedledee Company and you chose to finance the project by selling bonds (bonds are a form of long-term corporate debt). Your buddy Joe Bob is the financial manager of Tweedledumb, Inc., on the other hand, and he chose to sell stock (ownership) and used the proceeds to finance the project. After two years, all experts agree: the new product is a huge success. Ignoring the tax characteristics of debt and equity (which is discussed in Chapter 12), who made the smarter financial decision? How would your answer change if the project had proven to be a bust? Complete the following items in your textbook: Chapter 1: Q1-3, Q1-4, Q1-5, Q1-7 The questions and answers are below. Once you have answered the questions, click on each question area to reveal the answer. Click on the question area again to hide the answer. You can also refer to the Appendix for Homework Solutions for the answers. NOTE: ST=self-test Q=question P=problem There is no assignment to be submitted to your instructor for this lesson.
Q 1-3. What are the advantages and disadvantages of the different legal forms of business organization? Could the limited liability advantage of a corporation also lead to an agency problem? Why? What legal form would an upstart entrepreneur likely prefer?

Q 1-4. Describe the differences between businesses in the United States and those in foreign countries with respect to taxation, financial disclosure, and ownership structure. Is privatization reducing or increasing these differences? Q 1-5. Can there be a difference between profit maximization and shareholder wealth maximization? If so, what could cause this difference? Which of the two should be the goal of the firm and its management? Q 1-7. What is meant by an agency cost or agency problem? Do these interfere with shareholder wealth maximization? Why? What mechanisms minimize these costs/problems? Are executive compensation contracts effective in mitigating these costs/problems?