You are on page 1of 19

Introduction to The corporate & Financial Manager

o you know: What finance entails? How financial management functions within the business world? Why you might benefit from studying financial principles? This chapter is the ideal place to get answers to those questions. Finance is largely the study of how to value all sorts of things, such as shares of stock, the payments left on a home mortgage, the purchase of an entire company, and the personal decision to retire early. In this text, were going to focus primarily on one particular area of finance, financial management, which tends to concentrate on valuing things from the perspective of a company. We will discuss the various responsibilities of the corporations financial managers and show you how to tackle many of the problems that these managers are expected to solve. We begin with a discussion of the corporation, the financial decisions it needs to make, and why they are important. To survive and prosper, a company must satisfy its customers. It must also produce and 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 plays a key role in both these decisions.

After studying this material you would be able to: LG 1.1Explain the advantages and disadvantages of the most common forms of business organization and determine which forms are most suitable to different types of businesses. Cite the major business functions & decisions that the firms financial managers are responsible for and understand some of the possible career choices in finance.

LG 1.2-

LG 1.3- Explain why it makes sense for corporations to maximize their market values. LG 1.4- Show why conflicts of interest may arise in large organizations and discuss how corporations can provide incentives for everyone to work toward a common end. LG 1.5- Explain the role of financial markets and institutions.
Chapter 1: The Corporation & The Financial Manager (An Introduction) Page: 1

What is an Organization?
The word is derived from the Greek word organon, itself derived from the better-known word ergon which means "organ" (a compartment for a particular task). An organization is a social entity (A social unit of people) that is structured and managed to meet a need or to pursue collective goals. All organizations have a management structure that determines relationships between the different activities and the members, and subdivides and assigns roles, responsibilities, and authority to carry out different tasks. Organizations are open systems (they affect and are affected by their environment).

corporations are overwhelmingly dominant with respect to business receipts and net profits. Corporations are given primary emphasis in this textbook. An organization is a social entity (A social unit of people) that is structured and managed to meet a need or to pursue collective goals. All organizations have a management structure that determines relationships between the different activities and the members, and subdivides and assigns roles, responsibilities, and authority to carry out different tasks.

Sole Proprietorship:
A sole proprietorship is a business owned by one person who operates it for his or her own profit. About 75 percent of all business firms are sole proprietorships. The typical sole proprietorship is a small business, such as a General store, Book shop, electrocution or plumber. The majority of sole proprietorships are found in the wholesale, retail, service, and construction industries. Typically, the proprietor, along with a few employees, operates the proprietorship. He or she normally raises capital from personal resources or by borrowing and is responsible for all business decisions. The key strengths and weaknesses of sole proprietorships are summarized in Table 1.1

Different types of Organizations:

There are a variety of types of organizations, including: Corporations Public Organizations Private Organizations Hybrid Organizations Governments Organizations Non-Governmental Organizations (NGOs) International Organizations Armed forces Charities Not-for-Profit Corporations Partnerships Cooperatives NOTE: A hybrid organization is a body that operates in both the public sector and the private sector simultaneously, This type of organizations fulfill public duties and develope commercial market activities.

A partnership consists of two or more owners doing business together for profit. Partnerships account for about 10 percent of all businesses, and they are typically larger than sole proprietorships. Finance, insurance, and real estate firms are the most common types of partnership. Public accounting and stock brokerage partnerships often have large numbers of partners. Most partnerships are established by a written contract known as articles of partnership. In a general (or regular) partnership, all partners have unlimited liability, and each partner is legally liable for all of the debts of the partnership. Strengths and weaknesses of partnerships are summarized in Table 1.1.

Forms of Business:
The three most common legal forms of business organization are the sole proprietorship, the partnership, and the corporation. Other specialized forms of business organizations are also exist. Sole proprietorships are the most numerous. However,

Page: 2 Chapter 1: The Corporation & The Financial Manager (An Introduction)

A corporation is an artificial being created by law. This is the most common form of business organization is one which is chartered by a state and given many legal rights as an entity separate from its owners. The process of becoming a corporation, call incorporation, gives the company separate legal standing from its owners and protects those owners from being personally liable in the event that the company is sued. In general; The definition of Corporation is as: A form of business operation that declares the business as a separate, legal entity guided by a group of officers known as the board of directors Although only about 15 percent of all businesses are incorporated, the corporation is the dominant form of business organization in terms of receipts and profits. It accounts for nearly 90 percent of business receipts and 80 percent of net profits. Although corporations are involved in all types of businesses, manufacturing corporations account for the largest portion of corporate business receipts and net profits. The key strengths and weaknesses of large corporations are summarized in Table 1.1.

Structure of a Corporation:
In a large corporation, the stockholders and the managers are usually separate groups. The stockholders elect the board of directors, who then select the managers. Management is charged with running the corporations affairs in the stockholders interests. In principle,
Chapter 1: The Corporation & The Financial Manager (An Introduction) Page: 3

stockholders control the corporation because they elect the directors. Following the diagram shows the complete structure of corporations in which Shareholders elect Board of directors that appoints management for operations of firm. All profits that corporation generates goes to shareholders.

Corporation by another name

The corporate form of organization has many variations around the world. The exact laws and regulations differ from country to country, of course, but the essential features of public ownership and limited liability remain. These firms are often called joint stock companies, public limited companies, or limited liability companies, depending on the specific nature of the firm and the country of origin. NOTE: Students are suggests to view the detail on these types of corporation by their self from internet and other online sources.

Why we study Business Finance:

Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another: 1. What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need? 2. Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money? 3. How will you manage your everyday financial activities such as collecting from customers and paying suppliers? These are not the only questions by any means, but they are among the most important. Corporate finance, broadly speaking, is the study of ways to answer these three questions. Accordingly, well be looking at each of them in the chapters ahead. NOTE: Emphasize that business finance is just another name for corporate finance mentioned under the four basic types. Students often get confused by the terminology, especially when different terms are used to refer to the same thing.

Who is the Financial Manager:

A striking feature of large corporations is that the owners (the stockholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation employs managers to represent the owners interests and make decisions on their behalf. In a large corporation, the financial manager would be in charge of answering the three questions we raised in the preceding section (see page 5). The financial management function is usually associated with a top officer of the firm, such as a vice president of finance or some other chief financial officer (CFO). Figure 1.1 is a simplified organizational chart that highlights the finance activity in a large firm.

Page: 4 Chapter 1: The Corporation & The Financial Manager (An Introduction)

As noted in the upper portion of Figure 1.1, control of the corporation is structured as a democracy. The stockholders (owners) vote periodically to elect members of the board of directors and to decide other issues such as amending the corporate charter. The board of directors is typically responsible for developing strategic goals and plans, setting general policy, guiding corporate affairs, approving major expenditures, and hiring/firing, compensating, and monitoring key officers and executives. The president or chief executive officer (CEO) is responsible for managing day-to-day operations and carrying out the policies established by the board of directors. The CEO is required to report periodically to the firms directors. It is important to note the division between owners and managers in a large corporation, as shown by the dashed horizontal line in Figure 1.1. This separation and some of the issues surrounding it will be addressed in the discussion of the agency issue later in this chapter.

Chapter 1: The Corporation & The Financial Manager (An Introduction) Page: 5

The corporation is a wonderful institution. But it contains inherent drawbacks, at the core of which are conflicts of interest. Control over the companys resources is vested in the hands of top managers who may rationally pursue their interests at the expense of all others. Economists call this the principal-agent problem. In the modern economy, where shares are held by fund managers, there is not just one set of principalagent relations but a long chain of them. The principal-agent problem is exacerbated by two others: asymmetric information and obstacles to collective action. Corporate managers know more about what is going on in the business than anybody else and have an interest in keeping at least some of this information to themselves. Equally, dispersed shareholders have a weak incentive to act, because they would share the gains with others but bear much of the cost themselves. The upshot is the chronic vulnerability of the corporation to managerial incompetence, self-seeking, deceit or downright malfeasance. In practice, there are five (interconnected) ways of reducing these risks. The first is market discipline, since failure will ultimately find managers out. The second is internal checks, with independent directors or requirements for voting by institutional shareholders. The third is regulation covering the composition of boards, structure of businesses and reporting requirements. The fourth is transparency, including accounting standards and independent audits. The last is simply values of honest dealing. Economists are very uncomfortable with the notion of morality. Yet it seems to have rather a clear meaning in the business context. It consists of acting honestly even when the opposite may be to ones advantage. Such morality is essential for all trustee relationships. Without it, costs of supervision and control become exorbitant. At the limit, a range of transactions and long-term relationships becomes impossible and society remains impoverished. Corporate managers are trustees. So are fund managers. The more they view themselves (and are viewed) as such, the less they are likely to exploit opportunities created by the conflicts of interest within the business.
Source: Adapted from Martin Wolf, A managers real responsibility, Financial Times (January 30, 2002), p. 13

Page: 6 Chapter 1: The Corporation & The Financial Manager (An Introduction)

Financial Manager activities & Descions:

An understanding of the concepts, techniques, and practices presented throughout this text will fully acquaint you with the financial managers activities and decisions. Because most business decisions are measured in financial terms, the financial manager plays a key role in the operation of the firm. People in all areas of responsibility (accounting, information systems, management, marketing, operations, and so forth) need a basic understanding of the managerial finance function. Okay, so youre not planning to major in finance! You still will need to understand the activities of the financial manager to improve your chance of success in your chosen business career. All managers in the firm, regardless of their job descriptions, work with financial personnel to justify labor requirements, negotiate operating budgets, deal with financial performance appraisals, and sell proposals at least partly on the basis of their financial merits. Clearly, those managers who understand the financial decision-making process will be better able to address financial concerns and will therefore more often get the resources they need to attain their own goals. To carry on business, companies need an almost endless variety of real assets. Many of these assets are tangible, such as machinery, factories, and offices; others are intangible, such as technical expertise, trademarks, and patents. All of them must be paid for. To obtain the necessary money, the company sells financial assets, or securities. These pieces of paper have value because they are claims on the firms real assets and the cash that those assets will produce. For example, if the company borrows money from the bank, the bank has a financial asset. That financial asset gives it a claim to a stream of interest payments and to repayment of the loan. The companys real assets need to produce enough cash to satisfy these claims. Financial managers stand between the firms real assets and the financial markets in which the firm raises cash. The financial managers role is shown in Figure 1.2, which traces how money flows from investors to the firm and back to investors again.

The flow starts when: Financial assets are sold to raise cash (arrow 1 in the figure). The cash is employed to purchase the real assets used in the firms operations (arrow 2). Later, if the firm does well, the real assets generate enough cash inflow to more than repay the initial investment (arrow 3). Finally, the cash is either reinvested (arrow 4a) or returned to the investors who contributed the money in the first place (arrow 4b). Of course the choice between arrows 4a and 4b is not a completely free one. For example, if a bank lends the firm money at stage 1, the bank has to be repaid this money plus interest at stage 4b.

The results of the figure 1.2: The flow chart suggests that the financial manager faces two basic problems. First,
how much money should the firm invest, and what specific assets should the firm invest in? This is the firms investment, or capital budgeting decision. Second, how should the cash required for an investment be raised? This is the financing decision.
Chapter 1: The Corporation & The Financial Manager (An Introduction) Page: 7

Primary Activities of the Financial Manager:

In addition to ongoing involvement in financial analysis and planning, the financial managers primary activities are making investment decisions and making financing decisions. Investment decisions determine both the mix and the type of assets held by the firm. Financing decisions determine both the mix and the type of financing used by the firm. These sorts of decisions can be conveniently viewed in terms of the firms balance sheet, However, the decisions are actually made on the basis of their cash flow effects on the overall value of the firm.

Capital Budgeting Decision:

Capital budgeting decisions are central to the companys success or failure. For example, in the late 1980s, the Walt Disney Company committed to construction of a Disneyland Paris theme park at a total cost of well over $2 billion. The park, which opened in 1992, turned out to be a financial bust, and Euro Disney had to reorganize in May 1994. Instead of providing profits on the investment, accumulated losses on the park by that date were more than $200 million. Contrast that with Boeings decision to bet the company by developing the 757 and 767 jets. Boeings investment in these planes was $3 billion, more than double the total value of stockholders investment as shown in the companys accounts at the time. By 1997, estimated cumulative profits from this investment were approaching $8 billion, and the planes were still selling well. Disneys decision to invest in Euro Disney and Boeings decision to invest in a new generation of airliners are both examples of capital budgeting decisions. The success of such decisions is usually judged in terms of value. Good investment projects are worth more than they cost. Adopting such projects increases the value of the firm and therefore the wealth of its shareholders. For example, Boeings investment produced a stream of cash flows that were worth much more than its $3 billion outlay. Not all investments are in physical plant and equipment. like, Gillette spent around $300 million to market its new Mach razor. This represents an investment in a nontangible asset (Brand recognition). Moreover, traditional manufacturing firms are not the only ones that make important capital budgeting decisions Todays investments provide benefits in the future. Thus the financial manager is concerned not solely with the size of the benefits but also with how long the firm must wait for them. The sooner the profits come in, the better. In addition, these benefits are rarely certain; a new project may be a great successbut then again it could be a dismal failure. The financial manager needs a way to place a value on these uncertain future benefits.

Financing Decision:
The financial managers second responsibility is to raise the money to pay for the investment in real assets. This is the financing decision. When a company needs financing, it can invite investors to put up cash in return for a share of profits or it can promise investors a series of fixed payments. In the first case, the investor receives newly issued shares of stock and becomes a shareholder, a part-owner of the firm. In the second, the investor becomes a lender who must one day be repaid. The choice of the long term financing mix is often called the capital structure decision, since capital refers to the firms sources of long-term financing, and the markets for long-term financing are called capital markets. Within the basic distinction (issuing new shares of stock versus borrowing money) there are endless variations. Suppose the company decides to borrow. Should it go to capital markets for long-term debt financing or should it borrow from a bank? Should it borrow in Pakistan, receiving and promising to repay Dollars, or should it borrow dollars in Europe? Should it demand the right to pay off the debt early if future interest rates fall?
Page: 8 Chapter 1: The Corporation & The Financial Manager (An Introduction)

The decision to invest in a new factory or to issue new shares of stock has long-term consequences. But the financial manager is also involved in some important short-term decisions. For example, he needs to make sure that the company has enough cash on hand to pay next weeks bills and that any spare cash is put to work to earn interest. Such short-term financial decisions involve both investment (how to invest spare cash) and financing (how to raise cash to meet a short-term need). Businesses are inherently risky, but the financial manager needs to ensure that risks are managed. For example, the manager will want to be certain that the firm cannot be wiped out by a sudden rise in oil prices or a fall in the value of the dollar. We will look at the techniques that managers use to explore the future and some of the ways that the firm can be protected against nasty surprises.

As noted earlier, the owners of a corporation are normally distinct from its managers. Actions of the financial manager should be taken to achieve the objectives of the firms owners, its stockholders. In most cases, if financial managers are successful in this endeavor, they will also achieve their own financial and professional objectives. Thus financial managers need to know what the objectives of the firms owners are. Assuming that we restrict ourselves to for-profit businesses, the goal of financial management is to make money or add value for the owners. This goal is a little vague, of course, so we examine some different ways of formulating it in order to come up with a more precise definition. Such a definition is important because it leads to an objective basis for making and evaluating financial decisions.

Possible Goals:
If we were to consider possible financial goals, we might come up with some ideas like the following: Survive Avoid financial distress and bankruptcy Beat the competition Maximize sales or market share Minimize costs Maximize profits Maintain steady earnings growth. These are only a few of the goals we could list. Furthermore, each of these possibilities presents problems as a goal for the financial manager. For example, its easy to increase market share or unit sales; all we have to do is lower our prices or relax our credit terms. Similarly, we can always cut costs simply by doing away with things such as research and development. We can avoid bankruptcy by never borrowing any money or never taking any risks, and so on. Its not clear that any of these actions are in the stockholders best interests. Profit maximization would probably be the most commonly cited goal, but even this is not a very precise objective. Do we mean profits this year? If so, then we should note that actions such as deferring maintenance, letting inventories run down, and taking other short-run cost-cutting measures will tend to increase profits now, but these activities arent necessarily desirable. The goal of maximizing profits may refer to some sort of long-run or average profits, but its still unclear exactly what this means. First, do we mean something like accounting net income or earnings per share?
Chapter 1: The Corporation & The Financial Manager (An Introduction) Page: 9

As we will see in more detail in the next chapter, these accounting numbers may have little to do with what is good or bad for the firm. Second, what do we mean by the long run? As a famous economist once remarked, in the long run, were all dead! More to the point, this goal doesnt tell us what the appropriate trade-off is between current and future profits. The goals weve listed here are all different, but they do tend to fall into two classes. The first of these relates to profitability. The goals involving sales, market share, and cost control all relate, at least potentially, to different ways of earning or increasing profits. The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in some way to controlling risk. Unfortunately, these two types of goals are somewhat contradictory. The pursuit of profit normally involves some element of risk, so it isnt really possible to maximize both safety and profit. What we need, therefore, is a goal that encompasses both factors.

Maximize shareholders Wealth (Maximize Market Share):

The financial manager in a corporation makes decisions for the stockholders of the firm. Given this, instead of listing possible goals for the financial manager, we really need to answer a more fundamental question: From the stockholders point of view, what is a good financial management decision? If we assume that stockholders buy stock because they seek to gain financially, then the answer is obvious: good decisions increase the value of the stock, and poor decisions decrease the value of the stock. Given our observations, it follows that the financial manager acts in the shareholders best interests by making decisions that increase the value of the stock. The appropriate goal for the financial manager can thus be stated quite easily: The goal of financial management is to maximize the current value per share of the existing stock. The goal of maximizing the value of the stock avoids the problems associated with the different goals we listed earlier. There is no ambiguity in the criterion, and there is no short-run versus long-run issue. We explicitly mean that our goal is to maximize the current stock value. Because the goal of financial management is to maximize the value of the stock, we need to learn how to identify those investments and financing arrangements that favorably impact the value of the stock. This is precisely what we will be studying. In fact, we could have defined corporate finance as the study of the relationship between business decisions and the value of the stock in the business.

A More General Goal:

Given our goal as stated in the preceding section (maximize the value of the stock), an obvious question comes up: What is the appropriate goal when the firm has no traded stock? Corporations are certainly not the only type of business; and the stock in many corporations rarely changes hands, so its difficult to say what the value per share is at any given time. As long as we are dealing with for-profit businesses, only a slight modification is needed. The total value of the stock in a corporation is simply equal to the value of the owners equity. A more general way of stating our goal is as follows: maximize the market value of the existing owners equity. With this in mind, it doesnt matter whether the business is a proprietorship, a partnership, or a corporation. For each of these, good financial decisions increase the market value of the owners equity and poor financial decisions decrease it. In fact, although we choose to focus on corporations in the chapters ahead, the principles we develop apply to all forms of business. Many of them even apply to the not-for-profit sector. Finally, our goal does not imply that the financial manager should take illegal or unethical actions in the hope of increasing the value of the equity in the firm. What we mean is that the financial manager best serves the owners of the business by identifying goods and services that add value to the firm because they are desired and valued in the free marketplace.
Page: 10 Chapter 1: The Corporation & The Financial Manager (An Introduction)

Owner-managers have no conflicts of interest in their management of the business. They work for themselves, reaping the rewards of good work and suffering the penalties of bad work. Their personal well-being is tied to the value of the firm. In most large companies the managers are not the owners and they might be tempted to act in ways that are not in the best interests of the owners. For example, they might buy luxurious corporate jets for their travel, or overindulge in expense-account dinners. They might shy away from attractive but risky projects because they are worried more about the safety of their jobs than the potential for superior profits. Such problems can because the managers of the firm, who are hired as agents of the owners, may have their own axes to grind. They are called agency problems. In theory, most financial managers would agree with the goal of owner wealth maximization. In practice, however, managers are also concerned with their personal wealth, job security, and fringe benefits. Such concerns may make managers reluctant or unwilling to take more than moderate risk if they perceive that taking too much risk might jeopardize their jobs or reduce their personal wealth. The result is a less-than-maximum return and a potential loss of wealth for the owners. This situation is called Agency Problem. The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his/her interests. For example, you might hire someone (an agent) to sell a car that you own while you are away at school. In all such relationships, there is a possibility of conflict of interest between the principal and the agent. Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First, how closely is management goals aligned with stockholder goals? This question relates to the way managers are compensated. Second, can management be replaced if they do not pursue stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of reasons to think that, even in the largest firms, management has a significant incentive to act in the interests of stockholders. A closer look reveals several arrangements that help to ensure that the shareholders and managers are working toward common goals.

How to Minimize Agency Problem:

From this conflict of owner and personal goals arises what has been called the agency problem, the likelihood that managers may place personal goals ahead of corporate goals. Two factors market forces and agency costs serve to prevent or minimize agency problems:

Market forces:
One market force is major shareholders, particularly large institutional investors such as life insurance companies, mutual funds, and pension funds. These holders of large blocks of a firms stock exert pressure on management to perform, by communicating their concerns to the firms board. They often threaten to exercise their voting rights or liquidate their holdings if the board does not respond positively to their concerns. Another market force is the threat of takeover by another firm that believes it can enhance the target firms value by restructuring its management, operations, and financing. The constant threat of a takeover tends to motivate management to act in the best interests of the firms owners. For Example, In recent years, the chief executives of IBM, Eastman Kodak, General Motors, and Apple Computer all were forced out. The nearby box points out that board recently have become more aggressive in their willingness to replace underperforming managers.
Chapter 1: The Corporation & The Financial Manager (An Introduction) Page: 11

Agency Cost:
FTo minimize agency problems and contribute to the maximization of owners wealth, stockholders incur agency costs. These are the costs of maintaining a corporate governance structure that monitors management behavior, ensures against dishonest acts of management, and gives managers the financial incentive to maximize share price. The most popular, powerful, and expensive approach is to structure management compensation to correspond with share price maximization. The objective is to give managers incentives to act in the best interests of the owners. In addition, the resulting compensation packages allow firms to compete for and hire the best managers available. The two key types of compensation plans are incentive plans and performance plans. Incentive plans tend to tie management compensation to share price. The most popular incentive plan is the granting of stock options to management. These options allow managers to purchase stock at the market price set at the time of the grant. If the market price rises, managers will be rewarded by being able to resell the shares at the higher market price. Many firms also offer performance plans, which tie management compensation to measures such as earnings per share (EPS), growth in EPS, and other ratios of return. Performance shares, shares of stock given to management as a result of meeting the stated performance goals, are often used in these plans. Another form of performance-based compensation is cash bonuses, cash payments tied to the achievement of certain performance goals. For example, when Michael Eisner was hired as chief executive officer (CEO) by the Walt Disney Company, his compensation package had three main components: a base annual salary of $750,000; an annual bonus of 2 percent of Disneys net income above a threshold of normal profitability; and a 10-year option that allowed him to purchase 2 million shares of stock for $14 per share, which was about the price of Disney stock at the time. Those options would be worthless if Disneys shares were selling for below $14 but highly valuable if the shares were worth more. This gave Eisner a huge personal stake in the success of the firm.

Weve seen that the primary advantages of the corporate form of organization are that ownership can be transferred more quickly and easily than with other forms and that money can be raised more readily. Both of these advantages are significantly enhanced by the existence of financial markets, and financial markets play an extremely important role in corporate finance.

Cash Flows to and from the Firm:

The interplay between the corporation and the financial markets is illustrated in Figure 1.3. The arrows in Figure 1.3 trace the passage of cash from the financial markets to the firm and from the firm back to the financial markets.

Page: 12 Chapter 1: The Corporation & The Financial Manager (An Introduction)

Suppose we start with the firm selling shares of stock and borrowing money to raise cash. Cash flows to the firm from the financial markets (A). The firm invests the cash in current and fixed assets (B). These assets generate some cash (C), some of which goes to pay corporate taxes (D). After taxes are paid, some of this cash flow is reinvested in the firm (E). The rest goes back to the financial markets as cash paid to creditors and shareholders (F). A financial market, like any market, is just a way of bringing buyers and sellers together. In financial markets, it is debt and equity securities that are bought and sold. Financial markets differ in detail, however. The most important differences concern the types of securities that are traded, how trading is conducted, and who the buyers and sellers are. Some of these differences are discussed next.

Primary Vs. Secondary Markets:

Financial markets function as both primary and secondary markets for debt and equity securities. The term primary market refers to the original sale of securities by governments and corporations. The secondary markets are those in which these securities are bought and sold after the original sale. Equities are, of course, issued solely by corporations. Debt securities are issued by both governments and corporations. In the discussion that follows, we focus on corporate securities only.

Primary Markets:
In a primary market transaction, the corporation is the seller, and the transaction raises money for the corporation. Corporations engage in two types of primary market transactions: public offerings and private placements. A public offering, as the name suggests, involves selling securities to the general public, whereas a private placement is a negotiated sale involving a specific buyer. By law, public offerings of debt and equity must be registered with the Securities and Exchange Commission (SEC). Registration requires the firm to disclose a great deal of information before selling any securities. The accounting, legal, and selling costs of public offerings can be considerable. Partly to avoid the various regulatory requirements and the expense of public offerings, debt and equity are often sold privately to large financial institutions such as life insurance companies or mutual funds. Such private placements do not have to be registered with the SEC & do not require the involvement of underwriters (investment banks that specialize in selling securities to the public).

Secondary Markets:
A secondary market transaction involves one owner or creditor selling to another. It is therefore the secondary markets that provide the means for transferring ownership of corporate securities. Although a corporation is only directly involved in a primary market transaction (when it sells securities to raise cash), the secondary markets are still critical to large corporations. The reason is that investors are much more willing to purchase securities in a primary market transaction when they know that those securities can later be resold if desired. There are two kinds of secondary markets: auction markets and dealer markets. Generally speaking, dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for example, does not normally buy and sell houses.

Chapter 1: The Corporation & The Financial Manager (An Introduction) Page: 13

Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt has no central location; the many dealers are connected electronically. Auction markets differ from dealer markets in two ways. First, an auction market or exchange has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

Major Financial Institutions in Pakistan:

Financial Markets of Pakistan are comprised (Mixture) of both Banking & non-banking sector which is regulated by State bank of Pakistan. The major financial institutions of banking sector are public sector banks, private sector banks & foreign banks. On the other hand non-banking sector includes Investment Banks, Development Banks, Micro Finance Banks, Islamic Banks & Discount Houses. While the other institutions which include Insurance companies, Leasing Institutions: Stock Exchange, Modarba Institutions etc are regulated by Security Exchange Commission of Pakistan (SECP). The purpose of financial markets is to efficiently allocate savings to ultimate users.

Major Participents in Financial Institutions:

Participants that provide funds are called surplus units (investors) e.g., households & the Participants that enter markets to obtain funds are deficit units (issuers) e.g., the government. A major participant in financial markets is the SBP, because it controls the money supply. Follwing Diagram is showing how financial markets works and how how a cycle is done.

Page: 14 Chapter 1: The Corporation & The Financial Manager (An Introduction)

In early 2007, Ali and Adnan formed the ABC Cake Company. The company produced a full line of cakes, and its specialties included chess cake, lemon pound cake, and double-iced, double-chocolate cake. The couple formed the company as an outside interest, and both continued to work at their current jobs. Ali did all the baking, and Adnan handled the marketing and distribution. With good product quality and a sound marketing plan, the company grew rapidly. In early 2012, the company was featured in a widely distributed entrepreneurial magazine. Later that year, the company was featured in Gourmet Desserts, a leading specialty food magazine. After the article appeared in Gourmet Desserts, sales exploded, and the company began receiving orders from all over the world. Because of the increased sales, Ali left his other job, followed shortly by Adnan. The company hired additional workers to meet demand. Unfortunately, the fast growth experienced by the company led to cash flow and capacity problems. The company is currently producing as many cakes as possible with the assets it owns, but demand for its cakes is still growing. Further, the company has been approached by a national supermarket chain with a proposal to put four of its cakes in all of the chains stores, and a national restaurant chain has contacted the company about selling ABC cakes in its restaurants. The restaurant would sell the cakes without a brand name. Ali and Adnan have operated the company as a sole proprietorship. They have approached you to help manage and direct the companys growth. Specifi cally, they have asked you to answer the following questions:
Answer the following questions: Q.1- What are the advantages and disadvantages of changing the company organization from a sole proprietorship to an LLC (Limited Liability Company)? Q.2- What are the advantages and disadvantages of changing the company organization from a sole proprietorship to a corporation? Q.3- Ultimately, what action would you recommend the company undertake? Why?
Chapter 1: The Corporation & The Financial Manager (An Introduction) Page: 15

Amna and Daniyal both work for Sports Products, Inc., a major producer of boating equipment and accessories. Amna works as a clerical assistant in the Accounting Department, and Daniyal works as a packager in the Shipping Department. During their lunch break one day, they began talking about the company. Daniyal complained that he had always worked hard trying not to waste packing materials and efficiently and cost-effectively performing his job. In spite of his efforts and those of his co-workers in the department, the firms stock price had declined nearly Rs. 2 per share over the past 9 months. Amna indicated that she shared Daniyals frustration, particularly because the firms profits had been rising. Neither could understand why the firms stock price was falling as profits rose. Amna indicated that she had seen documents describing the firms profitsharing plan under which all managers were partially compensated on the basis of the firms profits. She suggested that maybe it was profit that was important to management, because it directly affected their pay. Daniyal said, That doesnt make sense, because the stockholders own the firm. Shouldnt management do whats best for stockholders? Somethings wrong! Amna responded, Well, maybe that explains why the company hasnt concerned itself with the stock price. Look, the only profits that stockholders receive are in the form of cash dividends, and this firm has never paid dividends during its 20year history. We as stockholders therefore dont directly benefit from profits. The only way we benefit is for the stock price to rise. Daniyal chimed in, That probably explains why the firm is being sued by state and federal environmental officials for dumping pollutants in the adjacent stream. Why spend money for pollution control? It increases costs, lowers profits, and therefore lowers managements earnings! Aman and Daniyal realized that the lunch break had ended and they must quickly return to work. Before leaving, they decided to meet the next day to continue their discussion.

Answer the following questions:

Q.1- What should the management of Sports Products, Inc., pursue as its overriding goal? Why? Q.2- Does the firm appear to have an effective corporate governance structure? Explain any shortcomings. Q.3- On the basis of the information provided, what specific recommendations would you offer the firm. Q.4- Does the firm appear to have an agency problem? Explain
Page: 16 Chapter 1: The Corporation & The Financial Manager (An Introduction)

What long-term investments should the firm take? Where will the firm get the long-term financing to pay for its investments? In other words, what mixture of debt and equity should we use to fund our operations? How should the firm manage its everyday financial activities?

Chapter 1: The Corporation & The Financial Manager (An Introduction) Page: 17

Q. 1- Recently, some branches of A Inc., have dropped the practice of allowing employees to accept tips. Customers who once said, Keep the change, now have to get used to waiting for their nickels. Management even instituted a policy of requiring that the change be thrown out if a customer drives off without it. As a frequent customer who gets coffee and doughnuts for the office, you notice that the lines are longer and that more mistakes are being made in your order. Explain why tips could be viewed as similar to stock options and why the delays and incorrect orders could represent a case of agency costs. If tips are gone forever, how could A Inc reduce these agency costs? Q. 2- Hamza Ali has invested $25,000 in S&W Development Company. The firm has recently declared bankruptcy and has $60,000 in unpaid debts. Explain the nature of payments, if any, by Hamza in each of the following situations. a. S&W Development Company is a sole proprietorship b. S&W Development Company is a 5050 partnership c. S&W Development Company is a corporation. Q. 3- Explain why each of the following situations is an agency problem and what costs to the firm might result from it. Suggest how the problem might be dealt with short of firing the individual(s) involved. a. The front desk receptionist routinely takes an extra 20 minutes of lunch to run personal errands. b. Division managers are padding cost estimates so as to show short-term efficiency gains when the costs come in lower than the estimates. c. The firms CEO has secret talks with a competitor about the possibility of a merger in which he would become the CEO of the combined firms. d. A branch manager lays off experienced full-time employees and staffs customer service positions with part-time or temporary workers to lower employment costs and raise this years branch profit. The managers bonus is based on profitability. Q. 4- Corporations are now required to make public the amount and form of compensation (e.g., stock options versus salary versus performance bonuses) received by their top executives. Of what use would that information be to a potential investor in the firm?

Q. 5- Which form of business organization might best suit the following? & Why? a. A consulting firm with several senior consultants and support staff. b. A house painting company owned & operated by a college student who hires some friends for occasional help. c. A paper goods company with sales of $100 million and 2,000 employees. Q. 6- Who owns a corporation? Describe the process whereby the owners control the firms management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise? Q. 7- Suppose you were the financial manager of a notfor-profit business (a not-for-profit hospital, perhaps). What kinds of goals do you think would be appropriate? Q. 8- Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits. Q. 9- Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your companys management immediately begins fighting off this hostile bid. Is management acting in the shareholders best interests? Why or why not? Q. 10- Critics have charged that compensation to top managers in the United States is simply too high and should be cut back. For example, focusing on large corporations, Larry Ellison of Oracle has been one of the best-compensated CEOs in the United States, earning about $193 million in 2008 alone and $429 million over the 20042008 period. Are such amounts excessive? In answering, it might be helpful to recognize that superstar athletes such as Tiger Woods, top entertainers such as Tom Hanks and Oprah Winfrey, and many others at the top of their respective fields earn at least as much, if not a great deal more. Q. 11- Define that the Karachi Stock Exchange is an auction market? How are auction markets different from dealer markets?

Page: 18 Chapter 1: The Corporation & The Financial Manager (An Introduction)