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Balik and Kiefer Inc
Assume that you recently graduated and have just reported on working as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre.
Why is corporate finance important to all managers? Describe the organizational forms a company might have as it evolves from a start-up to a major corporation. List the advantages and disadvantages of each form. How do corporations go public and continue to grow? What are agency problems? What is corporate governance? What should be the primary objective of managers? (1) Do firms have any responsibilities to society at large?
(2) Is stock price maximization good or bad for society?
Sample Answer
That's a fantastic assignment! As a new investment advisor, I'm happy to help you prepare these answers for Ms. DellaTorre. Here is a breakdown of the U.S. financial system and corporate structure in general terms.
Why is Corporate Finance Important to All Managers?
Corporate finance is essential to all managers, regardless of their specific department (e.g., marketing, operations, human resources), because every business decision has financial implications.
Resource Allocation: Corporate finance provides the tools to determine where the firm’s money should be invested (capital budgeting) and how those investments should be financed (capital structure). For example, the decision by a marketing manager to launch a new advertising campaign requires finance to analyze the projected cash flows and return on investment.
Performance Measurement: It establishes the metrics (like cash flow, profit margins, and return on equity) that managers use to measure their department's performance and ensure it contributes to the overall value of the firm.
Value Creation: Ultimately, the main goal of corporate finance is to maximize the value of the firm. Every manager, therefore, needs to understand how their operational decisions impact the firm's financial health and, consequently, its stock price (if publicly traded).
Organizational Forms of a Company
A company typically evolves through three main organizational forms as it grows.
Form
Description
Advantages (Pros)
Disadvantages (Cons)
Sole Proprietorship
Owned and run by one individual.
Easiest to start (minimal paperwork). Owner keeps all profits. Profits taxed only once (as personal income).
Unlimited personal liability (personal assets at risk). Limited life (ends when owner dies or retires). Hard to raise capital.
Partnership
Similar to a proprietorship, but with two or more owners (partners).
Relatively easy to start. Profits taxed only once (as personal income). More capital can be raised than a proprietorship.
Unlimited personal liability for partners (even for partners' mistakes). Dissolves when one partner leaves or dies. Difficult to transfer ownership.
Corporation (C-Corp)
A legal entity separate and distinct from its owners (shareholders).
Limited liability for owners (personal assets are protected). Unlimited life (can exist forever). Easiest to raise large amounts of capital (selling stock). Easy to transfer ownership.
Double taxation (corporate income is taxed, and shareholders' dividends are taxed again). Most complex and costly to start and maintain.
Corporate Growth, Agency Problems, and Corporate Governance
How Corporations Go Public and Continue to Grow
Going Public (IPO): To raise a massive amount of capital, a private company often transitions into a publicly traded corporation through an Initial Public Offering (IPO). In an IPO, the company sells shares of its stock to the general public for the first time. The proceeds from this sale provide the capital needed for major expansion.
Continued Growth: After the IPO, a corporation continues to raise capital through:
Selling more stock (Seasoned Equity Offerings or SEOs).
Issuing corporate bonds (borrowing money from investors).
Retaining earnings (reinvesting profits back into the business instead of paying dividends).
Agency Problems
An agency problem is the conflict of interest between a company's management (the agents) and its shareholders (the principals/owners).
Example: Shareholders want managers to take calculated risks to maximize the stock price. Managers, whose job security depends on the company's survival, might prefer to avoid risk (or "play it safe") or spend company money on luxury perks (like corporate jets) that do not benefit the shareholders.
Corporate Governance
Corporate governance is the set of rules, practices, and processes by which a company is directed and controlled. It's the mechanism designed to minimize agency problems and ensure managers act in the best interest of shareholders.
Key components of good corporate governance include:
An independent Board of Directors to oversee management.
Executive compensation structures tied to the company’s performance (e.g., stock options).