Recap

• What is a business?
• Organization engaged in commercial, industrial, or professional activities
• Types of businesses: Sole Proprietorship, Partnership, and Corporation
• Corporations are different: (i) ownership vs. control, (ii) who owns the liabilities, (iii) who pays the taxes?
• What do businesses want to achieve?
• Are there ethical considerations?
• How do they achieve their goals?
• What is financial management?

Supplementary: Other business forms

• We learned about sole proprietorship, partnership, and corporation
• More precisely, “general partnership” and “C-corporation”
• There are also hybrids in between general partnerships and C-corporations that features both limited liability and no double-taxation
• Limited partnerships (LP): Partnerships with general partners + limited partners
• Limited liability partnerships (LLP) and limited liability companies (LLC): Partnerships in which all partners have limited liability
• S-Corp: Must have <= 100 shareholders, all of whom must be U.S. citizens or residents

Supplementary: Taxation on multi-entity structure

• How are firms taxed when a corporation (parent) owns a partnership (subsidiary)?
• Partnership does not pay business income tax
• Income of the partnership (subsidiary) flows to the corporation (parent)
• The corporation pays business income tax on the income it receives from the partnership
• How are firms taxed when a corporation (parent) owns another corporation (subsidiary)?
• The subsidiary corporation pays business income tax
• Income of the subsidiary corporation flows to the parent corporation
• The parent corporation pays business income tax on the income it receives from the subsidiary corporation
• But there are Dividends Received Deduction (DRD)!
• To alleviate triple taxation

Supplementary: How to form/become a corporation?

• File Articles of Incorporation with the Secretary of State
• Adopt bylaws, i.e., internal rules for governance
• Appoint directors & officers to manage the company
• Issue stock to shareholders
• Result: A separate legal entity with limited liability

Supplementary: How to form/become a corporation?

• Corporations which act in more than one state are subject only to the laws of their state of incorporation with regard to the regulation of the internal affairs of the corporation
• Most large U.S. firms incorporate in Delaware due to:
• Business-friendly laws
• E.g., single-person corporation is allowed
• A specialized business court and a more well-developed body of case law than other states => Predictable outcomes of legal disputes

Supplementary: Miscellaneous

• As a U.S. citizen, U.S. taxes your worldwide income no matter where you live. However,
• there is Foreign Earned Income Exclusion (up to ~$120k)
• there is Foreign Tax Credit

What goals should businesses achieve?

• Increase customer satisfaction?
• Have good ESG reputation?
• E: Environmental. S: Social. G: Governance.
• Maximize stakeholder benefits?
• Diversify revenue streams?
• Expand to more countries/Reach more customers?
• Stay ahead of competitors?
• Maximize efficiency/Minimize expenses?
• Maximize cash flow?
• Traditionally, shareholders want to maximize the market value of their shares (equivalently, of the firm)
• This is not the same as maximizing cash flow

Shareholder Theory

• Key Idea of Modern Corporate Finance Theory:
• Primary goal of a corporation is “shareholder value maximization”
• Laws and regulations can protect the interests of other stakeholders
• This is called “Shareholder Theory”
• “The only social responsibility of business is to increase its profits” – Milton Friedman (1970)

Critics of Shareholder Theory

• Is shareholder value maximization ethical?
• Are there cases where laws and regulations fail to protect the interests of other stakeholders?
• Critics – Shareholder theory has harmed society:
• Higher income inequality
• Higher carbon emissions
• Negative externalities on developing countries

Critics of Shareholder Theory

• Is shareholder value maximization ethical?
• Are there cases where laws and regulations fail to protect the interests of other stakeholders?
• Critics – Shareholder theory has harmed society:
• Higher income inequality
• Higher carbon emissions
• Negative externalities on developing countries
• Sometimes, there is no conflict
• Benefitting stakeholders (consumers, employees, etc.) creates a good reputation
• Reputation increases shareholder value in the long run

Ethical considerations

• Sometimes, violations of ethics are obvious
• Clear examples: Bernard Madoff
• Convinced investors to give him $20 billion in return for consistently high returns
• Claimed returns were all fictitious!
• Paid early investors with later investors’ money to give an illusion of high returns!
• “Ponzi Scheme”
• Outcome: Over 20,000 investors lost more than $10 billion. Madoff was sentenced to 150 years in prison.
• Source: Financial Times, dated Apr 16, 2021

Sometimes, violations of ethics are obvious

• Clear examples: Bernard Madoff
• Convinced investors to give him $20 billion in return for consistently high returns
• Claimed returns were all fictitious!
• Paid early investors with later investors’ money to give an illusion of high returns!
• “Ponzi Scheme”
• Outcome: Over 20,000 investors lost more than $10 billion. Madoff was sentenced to 150 years in prison.
• Unclear territory: Private equity
• Private equity firms often acquire businesses to transform them
• They layoff a lot of people who lose their jobs
• We should be mindful of these ethical considerations
• Source: Financial Times, dated Oct 6, 2019
• Ethical considerations

What do businesses want to achieve?

• In cases like Bernard Madoff's Ponzi scheme, who is most to blame for the losses?
• The perpetrator (Madoff himself).
• The investors, for not doing enough due diligence.
• Regulators, for failing to catch the fraud earlier.
• A combination of all the above.
• Follow-Up: How to prevent such major ethical violations?

What do businesses want to achieve?

• When private equity firms acquire a company and lay off workers to make it more profitable, do you agree with this practice?
• Yes, it’s necessary to improve efficiency and maximize shareholder value.
• No, it prioritizes profits over people.
• It depends on how the layoffs are managed and whether the business becomes sustainable in the long term.
• I'm unsure or have mixed feelings.
• Follow-Up: Should the government regulate private equity to minimize these layoffs? Why or why not?

What is financial management?

• The next question is: How do businesses achieve the goal of shareholder value maximization?
• Whether a business is small, like a local coffee shop, or large, like Tesla, achieving its goals requires sound financial management – making good decisions involving money
• Businesses make many such decisions
• Should I hire more workers?
• Should I launch new products?
• Should I use cash or sell shares or take a loan for the new machine?
• …

What is financial management?

• Financial management is two things:

Investment Decision

• Decision to buy or sell real assets

Investment Decision

• Decision to buy or sell real assets
• What are real assets?
• Costly assets that pay real returns in future
• Tangible Assets
• Physical assets that you can touch
• E.g., Equipment, factory, land, etc.

Investment Decision

• Decision to buy or sell real assets
• What are real assets?
• Costly assets that pay real returns in future
• Tangible Assets
• Physical assets that you can touch
• E.g., Equipment, factory, land, etc.
• Intangible Assets
• Assets that are not physical (but still valuable!)
• E.g., Expertise, brand recognition, patents, etc.
• E.g., ChatGPT’s algorithm and database

Financing Decision

• Decision on how to raise money from investors and repay them
• Suppose the business wants to buy a real asset:
• Use own money:
• Cash savings, retained earnings
• Raise money from others:
• Sell shares or borrow (bank/investors)

Financing Decision

• A financial asset is a non-physical asset that gets its value from a contractual right or ownership claim. E.g.,
• A stock is a claim on the firm’s real assets and on the income that those assets will produce
• A bank loan gives the bank the contractual right to get its money back plus interest
• A business finances its investment in real assets by issuing financial assets to investors
• “Finance” means gathering money
• Business
• Investors
• Money
• Financial Assets

Example

• In 2017, Delta decided to expand its fleet
• It orders 100 Airbus 321 airliners
• This is an example of Investment Decision
• Or “Capital budgeting decision”
• Or “Capital expenditure (CAPEX) decision”
• (these terms are synonyms!)
• Doing this requires money, so Delta must decide how to pay for this investment
• It issued (sold) $1 billion 5-year bonds
• Investors gave money to Delta
• Received a paper promising that the money will be returned with interest
• This is an example of Financing Decision

How do maximize shareholder value?

• Key: Financial Management!
• Make good investment and financing decisions
• Investment Decision
• Choose investments whose returns are higher than any other alternative use of cash
• Financing Decision
• Choose the cheapest source of funding

What we covered so far…

• What is a business?
• Organization engaged in commercial, industrial, or professional activities
• Types of businesses: Sole Proprietorship, Partnership, and Corporation
• Corporations are different: (i) ownership vs. control, (ii) who owns the liabilities, (iii) who pays the taxes?
• What do businesses want to achieve?
• Maximize shareholder value
• Are there ethical considerations?
• Yes
• How do they achieve their goals?
• What is financial management?
• Investment Decision -- Picking projects that return more than the best alternative
• Financing Decision -- Choose the cheapest source of funding