Corporate Finance and Corporations

Overview and Background

Finance functions are critical for an organization. This chapter first discusses various types of organizations and the role of corporate finance in these organizations. This chapter also discusses the different financial managers of an organization and the conflicts of interest of these managers with the owner (shareholder) of the organization.

1.1 Corporate Finance

Corporate Finance is an area in business that deals with the management of money for a firm. As soon as money is involved, the natural question is what is the value? Corporate Finance not only deals with the value of a firm, but also the value of its assets and liabilities. Assets are the possessions of the firm and the liabilities are the obligations of the firms. In other words, assets are what the company owns and liabilities are what the company owes. We will be discussing assets and liabilities in more detail in the next chapter. We can compare corporate finance to personal finance, which deals with management of money for an individual or a household. This can include creation of budget, money management, and borrowing and debt. The level and scope of these two aspects of finance are different, but the fundamentals are the same.

Specifically, corporate finance involves three main decisions related to the firms.

• Should the firm make an investment? If so, in which project? This decision is called investment decision or capital expenditure decision (CapEx for short) or Capital budgeting decision.
• How should firm raise fund to make an investment?  Should the company use retained fund if any, should the firm issue new shares, or should the firm obtain debt? This decision is called financing decision which is related to capital structure decision of the firm.
• How the firm should manage short-term cash flows? Firms operation will involve assets, which can be converted to cash quickly at market price (such as account receivables) and short-term liabilities such as account payables, so firms need to manage these aspects. This decision is called working capital management decision.

1.2 Real Assets, Financial Assets, and Financial Markets and Intermediaries

For now, it is essential to distinguish between real assets and financial assets. Real assets are usually not traded and are mostly related to productive economic activity. Some real assets could be setting up a new plant and machinery, recruiting new workforce members, purchasing space for sales and marketing, etc. In addition to real assets, corporate finance is greatly concerned with financial assets or assets that are used to take money from investors to create real assets. An easy way to distinguish between real and financial assets would be that financial assets are involved with financial markets and intermediaries. Financial markets are places where financial assets are created through agreements on a piece of paper or are traded between two investors. Some examples of financial markets are the New York Stock exchange (https://www.nyse.com/index) and the NASDAQ (https://www.nasdaq.com). Some examples of financial intermediaries are Commercial banks such as Bank of America, insurance companies such as Allstate, and even credit card companies such as Synchrony Financial.

1.3 Corporations, C-Suite, and Finance Manager

As briefed above, from the perspective of corporate finance, firms deal with how to arrange for and create values out of these assets and liabilities for the firm, the participants that help create such arrangement and values (which we will explain more in the paragraph that follows), and the relevance of these processes.

The most important person in a company is the CEO or the chief Executive Officer. The CEO, along with the company’s board of directors, which the shareholders choose, make the most important decisions for their firm. We will discuss more about the board of directors in Chapter 7 when we talk about stock markets. Some notable CEOs in recent times have been Jeff Bezos from Amazon, Bill Gates and now Satya Nadella from Microsoft, Mark Benioff from Salesforce dot com, Steve Jobs and Tim Cook from Apple and Elon Musk from SpaceX and Tesla. However, while a CEO provides strategy, wisdom and direction, there are other officers who need to execute these actions. Some of these are the chief operating officer (COO), the chief financial officer (CFO), the chief technology officer or information officer (CTO or CIO). Together these comprise the so-called C-Suite of officers in corporations.  Depending on the organizational structure, sometimes there is a President of the firm and there are vice presidents. The main officer we are concerned about in this course is the Chief Financial Officer (CFO).The CFO is responsible for carrying out all the functions related to finance, such as raising money for the organization and deciding the most optimal way to do so; putting excess money to work through either short-term or long-term investments. The CFO may or may not be responsible for dealing with lending excess money through financial markets. Therefore, we need to know what interest rates are, what the applications of interest rates are and the different ways of dealing with money and financial instruments. We will provide detail overview of financial markets and instruments in chapter 2.

<h31.3.1 Functions of the Finance Managers

Although, CFO is overall responsible for functions related to finance, obviously, the CFO does not work alone. There are two types of finance managers working for the CFO. These are the Treasury Manager, who is responsible for an organization’s short-term and day-to-day liquidity, and the Accounting Manager, who is responsible for maintaining books of accounts. A simplistic way to look at two branches of financial management is that the treasury department carries out the business transactions of money. In contrast, the accounting department ensures that these transactions are recorded correctly for reporting the numbers to all interested parties inside and outside a firm.

The importance of treasury and accounting departments cannot be underscored enough. Without financial transactions, large profits can be made or lost. Without a proper recording of transactions, the firm would not realize how to acknowledge these profits or losses. Some of these financial transactions need to be reported to regulators, who are government representatives. The regulators’ function is to ensure that all transactions are carried out legally, smoothly, and correctly in a country’s and its people’s broad interests. Regulators include institutions such as the Securities and Exchange Commission (SEC, 2017), which ensures that companies’ size and profits are correctly reported to everyone for investment purposes; the Federal Reserve Board (FRB), which takes care of the supply of money, liquidity, credit conditions, and so on (Federal Reserve, 2019).

1.4 Types of Corporations

Depending on size, scope, nature of business and operations, there are different organizational set ups of the firms. Such differences in organizational structure may have implications on taxation during their life and on distribution of assets in case the company has to liquidate.  We discuss the various types of corporations and their main features.

A Proprietorship is usually smaller in scope and, by definition, is individual/family-owned. The owner(s) pay taxes for the company as their taxes.

In a partnership, the consideration is similar to a proprietary organization, except two or more separate individuals own the company in some ratio. Owners still pay taxes as their own, and any company is the owners’ liability.  However, there are instances when the liability of some owners is not the responsibility of all owners.

There is another type of partnership form of business in which partners are only limitedly liable (owners are not typically responsible for the liability of the business or liability of other owners) and enjoy pass-through taxation (businesses do not pay taxes, the income passes to the owners of the business, and they pay personal income taxes for their portion of the business). Limited liability firms incorporate the tax benefits of a partnership and the limited liability protection of a corporation. Such businesses include Limited Liability Corporations (LLC), Limited Liability Partnerships (LLP), and Professional Corporations (PC). Some examples are a doctor’s office, a lawyer’s office, etc.

When there is a need for the formation of a separate entity from the owners and the need for a larger scope of operations (so beyond the examples listed above), then corporations are created. Another purpose of creation of corporations is when the owners of proprietary firms or partnerships want to sell some stake in their company for creating and diversifying their personal wealth. Thus, shares of the company are created by issuance to general public (this is called “going public” and also called a primary market transaction). One attractive part of owning shares is that shares can be easily bought and sold (also known as “traded”) on stock exchanges. This is also called a secondary market transaction because the primary issuer (or the corporation itself is not involved in the transaction).  The assets that can be easily traded at market price are called liquid assets. Therefore, shares of a company are liquid assets.

Corporations are usually complex entities with several departments that handle their respective functions, such as sales, product development, manufacturing, and accounting. The size and structure of these are determined by the size and scope of the operations of the corporations. The system also depends on the sector of operation. For example, a company such as Oracle or Microsoft (MSFT) or Google (GOOGL), or Apple (AAPL) are called “old school” technology companies1. Companies such as Dow chemicals (DOW), Cummins (CMI), and Honeywell (HON) belong to the manufacturing sector. Then there are the banking and financial sectors, metals, retail and consumer discretionary sectors, the agricultural sector, and so on.

Airlines belong to the transportation sector. As corporations, airlines also have a unique structure. In the U.S., Delta (DAL), American Airlines (AAL), United (UAL), and Southwest Airlines (LUV) are the top four airlines by market share, which together control almost 80% of the market share. We consider here the structure of Delta Airlines as an example.

As one of the most successful airlines in North America and the world, Delta, operates under a classic “machine bureaucracy” structure, with a top-down tiered administrative structure. Information and decisions flow primarily from the top management team to the front-line staff. The management team includes Chief Executive Officer (CEO), president, Executive Vice President (EVP), Chief Operating Officer (COO), Chief Legal Officer (CLO), Chief Financial Officer (CFO), Chief Information Officer (CIO), and Chief Health Officer. The company operates through departments such as business development and financial planning, corporate strategy, global sales, supply chain, fleet management, crew resources, network planning, alliances, and corporate real estate. The company develops many standard operating procedures (SOP) for various functions and roles of employees. One idiosyncrasy of Delta airlines is that, being a legacy carrier, there is a “partly-unionized structure” for pilots and dispatchers. However, a majority of the workforce, including flight attendants and ground crew, are not unionized.

CEO compensation continues to remain very high. For example, Elon Musk, the CEO of SpaceX and Tesla and the wealthiest man in 2022, has a take-home compensation of $23 billion. Musk is an extreme illustration of wealth inequity within these companies showing vastly different compensation levels for C-suite executives, managers, and the larger workforce. On the other hand, the median annual wage for CEOs ranges from $146,374 to $202,637, depending on the company size and its revenue size (BDO Study, 2021).

1.5 Goal of Corporations, Conflict of Interest and CEO Compensation

Managers may not always act in the best interest of the firm. The firms’ goal, that is, the main objective of the shareholders is to maximize the value of the company. However, the managers who are the agents of the shareholders may have some other interests. For example, a senior manager may want to acquire a line of business of her expertise to keep her job intact even if the new business does not add value to the company. Thus, there might be a conflict of interest between the principal (the owners), and the agents (the managers). This conflict of interest is called an agency problem.There are various mechanisms such as takeover threat (threat that another company will acquire and fire op management), monitoring by board, monitoring by debtholders, and so on in place to mitigate the agency problem.  Among them, one of the ways of reducing agency problem is the design of managers’ compensation. Typically, managers’ packages consist of a base salary, bonus, stock award, and option award. Stock and option awards increase their value if the value of the company increases. Thus, this design of compensation aligns with the interest of the managers and shareholders.

As an illustration, please see Delta Airline CEO Ed Bastian’s compensation in 2021 below.

1.6 Summary

To determine how an organization functions, it is critical to determine the goals of a corporation. The Board of Directors, the Chairman, the Chief Executive Officer of a Corporation, all have a say in this decision. For different organizations, it could be partners or the owners who decide this.

This chapter focuses on the financial aspects of the organization – such as why finances are critical for an organization, who are the managers that organize and manage the financial aspects of an organization and how the roles of these managers tie in with the overall objectives of the organization.

In the next chapter, we will discuss various markets and instruments which a financial manager needs use to interact with others, in order to achieve the financial goals of the organization.

References

BLS. (2021). Chief Executives. (2021). Bls.gov. https://www.bls.gov/oes/current/oes111011.htm
SEC. (2017, February 5). SEC.gov | HOME. Sec.gov. https://www.sec.gov/
Federal Reserve. (2019). Federal Reserve Board – Home. Federalreserve.gov. https://www.federalreserve.gov/
Compensation Survey. (2021). | Level of pay & Company Size. Www.familybusinessmagazine.com. Retrieved November 7, 2022, from https://www.familybusinessmagazine.com/2021-compensation-survey#:~:text=Median%20chief%20executive%20officer%20total
BDO Study. (2021). Mid-Market CEOs, CFOs See Double-Digit Pay Increase. Www.businesswire.com. https://www.businesswire.com/news/home/20211102005805/en/Mid-Market-CEOs-CFOs-See-Double-Digit-Pay-Increase-