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Lecture 3: Financial Manager Tasks and Business Organization

Five Tasks of Financial Manager​

1. Raise Cash from Investors​

  • Method: Selling financial assets
  • Types: Stocks (equity) or loans (debt/bonds)
  • Stock Terms: Equity, shares, residual claims
  • Why "Residual": Shareholders are last in payment line

2. Invest in Real Assets​

  • Tangible: Equipment, buildings, infrastructure
  • Intangible: R&D, human capital, intellectual property
  • Example - Google: Main investments in R&D and cloud infrastructure
  • Decision: How to allocate money between different assets

3. Generate Cash from Operations​

  • Source: Business activities create cash flow
  • Management: Working capital decisions
  • Example: Google generates cash from advertising operations

4. Reinvest or Pay Out​

  • Options:
    • Reinvest in the firm (growth opportunities)
    • Pay dividends to stockholders (discretionary)
    • Pay debt obligations (mandatory)
  • Decision Framework: Compare internal vs. external investment returns

5. Manage Risk​

  • Capital Structure: Debt vs. equity mix
  • Dividend Policy: Affects firm's risk profile
  • Example: High dividend payout may reduce growth opportunities

Types of Financial Assets​

Stocks (Equity)​

  • Common Stock: Voting rights, residual claims
  • Preferred Stock: Senior to common, usually no voting rights
  • Dual Class Structure: Different voting rights (e.g., Meta)
    • Class A: 1 vote per share
    • Class B: 10 votes per share (held by Zuckerberg)
  • Payment: Discretionary dividends

Bonds (Debt)​

  • Seniority: Higher priority than equity
  • Payment: Mandatory principal and interest
  • Recovery: In bankruptcy, debt holders paid first
  • Risk: Lower risk than equity

Three Types of Financial Decisions​

1. Capital Budgeting​

  • Question: What long-term investment projects should we take?
  • Focus: Investment decisions (activities 2 & 3)

2. Capital Structure​

  • Question: How should we pay for assets? Debt or equity?
  • Focus: Financing decisions (activities 1, 4 & 5)

3. Working Capital Management​

  • Question: How do we manage day-to-day finances?
  • Focus: Short-term vs. long-term finance

Forms of Business Organization​

1. Sole Proprietorship​

  • Characteristics: Single owner, easy to start
  • Advantages:
    • Less regulated
    • Keep all profits
    • Taxed once (personal income)
  • Disadvantages:
    • Limited to owner's life
    • Limited capital (personal wealth only)
    • Unlimited liability: Personal assets at risk
    • Difficult to sell ownership

2. Partnership​

  • Characteristics: Two or more owners
  • Advantages: More capital available, relatively easy to start
  • Disadvantages:
    • Unlimited liability: All partners personally liable
    • Dissolves when partner dies or leaves
    • Difficult to transfer ownership
  • Example: Law firms, dental practices

3. Corporation​

  • Characteristics: Separate legal entity
  • Advantages:
    • Limited liability: Personal assets protected
    • Unlimited life: Continues beyond founders
    • Easy to raise capital (IPO, stock issuance)
    • Easy to transfer ownership (stock trading)
  • Disadvantages:
    • Double taxation: Corporate tax + personal tax on dividends
    • Separation of ownership and management
    • More regulation

Limited Liability Example​

Scenario: Company invests $100M in S&P 500, financed by $80M debt

  • If S&P 500 drops 50%: Assets worth $50M, owe $80M
  • Corporation: Debt holders get $50M, cannot sue shareholders personally
  • Partnership: Debt holders can sue partners personally for remaining $30M

Goal of Financial Management​

Primary Goal: Maximize current value of company's stock

  • Not: Maximize profit, minimize cost, or maximize market share
  • Rationale: Stock price reflects all future cash flows
  • Example: Investing in R&D may reduce current profit but increase future value

Agency Problem​

Definition: Conflict between shareholders (principals) and managers (agents)

Manager Incentives vs. Shareholder Goals​

  • Managers may want:
    • Expensive perks (corporate jets, luxury)
    • Job security (avoid risky projects)
    • Growth and size (more employees, bigger company)
    • Independence from shareholder control
  • Shareholders want: Maximum stock value

Solutions to Agency Problem​

  1. Managerial Incentives (Carrot):

    • Stock options
    • Equity compensation
    • Performance-based pay

  2. Takeover Threat (Stick):

    • Poor management → low stock price
    • Company becomes takeover target
    • New owners replace management

  3. External Pressure:

    • Institutional investors (pension funds)
    • Proxy voting
    • ESG considerations

ESG (Environmental, Social, Governance)​

Definition: Framework for evaluating company's impact beyond financial metrics

Components​

  • Environmental: Climate impact, sustainability
  • Social: Employee treatment, community impact
  • Governance: Corporate ethics, transparency

Examples​

  • Environmental: Carbon footprint, renewable energy
  • Social: Diversity, fair labor practices
  • Governance: Executive compensation, board independence

Ethical Considerations​

Question: Is maximizing shareholder value always ethical?

Examples​

  • Tobacco companies: Legal but harmful products
  • Microsoft: Anti-competitive practices
  • Google: Delayed AI development to protect search business

Balance​

  • Traditional view: Maximize shareholder value
  • Modern view: Consider all stakeholders
  • ESG integration: Value creation with responsibility

Key Takeaways​

  1. Financial manager's role: Bridge between investors and operations
  2. Decision framework: Investment, financing, and working capital
  3. Business forms: Trade-offs between liability, taxation, and flexibility
  4. Agency problem: Align manager and shareholder interests
  5. Modern finance: Balance profit with social responsibility

Review Questions​

  1. Three types of financial decisions: Capital budgeting, capital structure, working capital
  2. Three business forms: Corporation, partnership, sole proprietorship
  3. Goal of financial management: Maximize current stock value
  4. Agency problem: Conflict between managers and shareholders
  5. Primary vs. secondary markets: Issuer vs. investor trading