Chapter 1

Goals &
Governance
of the Firm

Prepared by
© 2020 McGraw-Hill Education Limited
Humayun Qadri
MacEwan University
Learning Objectives
After studying this chapter, you should be able
to:
 LO1 Give examples of the investment and financing
decisions that financial managers make.
 LO2 Distinguish between real and financial assets.
 LO3 Cite some of the advantages and disadvantages

of organizing a business as a corporation.

 LO4 Describe the responsibilities of the CFO, the

treasurer, and the controller.

 LO5 Explain why maximizing market value is the

logical financial goal of the corporation.

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Learning Objectives
 LO6 Explain why value maximization is usually
consistent with ethical behaviour.
 LO7 Explain how corporations mitigate conflicts and

encourage cooperative behaviour.

 LO8 Give examples of career paths in Finance.

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1.1 Investment and Financing Decisions

Two major decisions are made by finance managers:

 A decision about which real assets the firm should

acquire and how much to invest in these assets.
 This decision is called the capital budgeting or the investment
decision.

 A decision about how to raise the money the firm needs

for its investments and operations.
 This decision is called the financing decision.

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The Investment Decision
 The financial manager needs to place a value on the
uncertain future cash inflows (benefits) generated by
capital investment projects. In order to achieve this,
he/she needs to account for the:

amounts of the future cash flows,

timing of the future cash flows, and

the risk of the future cash flows.

 Ifthe project’s value is greater than its required

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investment, the project is attractive financially. 5
The Financing Decision
 In
order to raise money for the investments and
operations of the firm, the financial manager can
use:
internally generated funds
or
external financing sources
 Two broad categories of external financing:
Debt financing
Equity financing
 The choice between debt and equity financing is
called the Capital Structure Decision.
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 The Financing Decision (Figure 1.1)
Flow of cash between investors and the firm’s operations.
Key: (1) cash raised by selling financial assets to investors; (2) cash invested in the
firm’s operations; (3) cash generated by the firm’s operations; (4a) cash reinvested;
(4b) cash returned to investors.

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The Financing Decision
 Real
Assets
Assets used to produce goods and services.
e.g. machinery, factories, trademarks, and patents.

 Financial Assets
Financial claims to the income generated by the
firm’s real assets.
e.g. a share of stock, a bank loan.

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1.2 What is a Corporation?
A business (separate legal entity) owned by
shareholders who are not personally liable for the
business’s liabilities (limited liability).

 Shareholders
are owners, but the corporations are
run by employees led by the CEO.

 Although the separation of ownership and control

adds flexibility to the operation and gives
permanence to the corporation, it also creates
agency problems.

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What is a Corporation?
 Shareholders can sell shares (ownership).

 Has a Boards of Directors elected by the

shareholders.

 Must abide by the rules of stock exchanges,

accounting standards and securities laws.

 Taxed twice – on the company profits and also in the

hands of shareholders (dividends and/or capital
gains).

 Must share information with the public.

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1.3 Other Forms of Business Organization

 Soleproprietorship - a business owned and operated

by one individual who is personally liable for all the
firm’s obligations.

 Partnership- business owned by 2 or more people

who are personally responsible for all of its liabilities.
Many professional businesses are organized as
partnerships.

 Hybridforms – (LLP, LLC, PC) have characteristics of

corporations and partnerships.
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 Different Forms of Business Organizations
Attributes Sole Proprietorship Partnership Corporation

Who owns the One individual Partners Shareholders

business?

Are managers and No No Usually, yes

owners separate?

What is the owners’ Unlimited General – unlimited Limited

liability? Limited - limited

Owners and No No Yes

business taxed
separately?

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1.4 Who is the Financial Manager?
 Anyoneresponsible for a significant corporate
investment or financing decision.

 Underthe Chief Financial Officer, there are usually

two broad categories of job descriptions:

Treasurer - responsible for cash management, raising new

capital and maintaining relationship with banks and other
investors.

Controller - responsible for preparing financial statements,

managing internal accounting and taxes.
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1.5 Goals of the Corporation
 Shareholders want managers to maximize market
value of the corporation.

 Increasing market value increases shareholders

wealth.

 Maximizing profit does not necessarily increase

overall market value.

 The
objective should be to maximize the current
market value.

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Agency Problems?
 In
most large public companies, the managers are
not the owners and they may not always act in the
best interests of the owners.

 Managers are hired as the agents of the owners.

 When the personal goals of these agents create

conflict in their roles in the corporation, they create
Agency Problems.

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Agency Problems?
 Agency problems – Conflict of interest between the
firm’s owners and its managers.
Managers may over indulge in unnecessary
expenses.
They may shy away from attractive but risky
projects.
They may engage in empire building.

 Managers must consider the interests of all

stakeholders.
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Agency Problems, Executive compensation
and Corporate Governance
Agency problems can be reduced in several ways:

 Executive Compensation

 Corporate Governance

 Threat of takeovers

 Specialist monitoring

 Shareholder Pressure
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Ethics and Management Objectives
 Using unethical means to increase share price will
only lead to failure.

 Crime does not pay

WorldCom, Enron, Goldman Sachs

 The Ethics of Maximizing Value

Unwritten rules of behaviour
Reputation

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1.6 Careers in Finance
Over half a million people work in financial services,
and many others as financial managers. Job
opportunities are available in:

 Commercial banking

 Corporate finance

 Investment banking

 Insurance industry
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Summary
 Investment Decisions – How much to invest and what assets to
acquire.
 Financing Decisions – How to raise the necessary cash.
 Real assets – All assets used in the production or sale of the firms

products or services.
 Financial Assets – Securities sold by the firm to raise money.
 What is a corporation?

 Characteristics – separate legal entity.

 Advantages and Disadvantages – limited liability; double taxation.
 Other forms of Business Organization

 Sole proprietorships
 Partnerships
 Hybrids
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Summary
 Who are the major Financial Managers?
 CFO – oversees Treasurer and Controller.
 Treasurer – raises capital and maintains relationships with banks and
investors.
 Controller – prepares financial statements, taxes.
 Goals of the Corporation

 Maximize market value – maximizing value maximizes the wealth of the

firm’s owners, its shareholders.
 Ethics and Management Objectives

 Maximum value starts with products and services that satisfy customers.
 Conflicts of interest, called Agency Problems, may arise in large firms
between the owners, stakeholders and managers.
 Executive compensation plans, good corporate governance, monitoring,
and threats of takeovers can help reduce the problem
 Careers in Finance

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