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?
(3) Should firms behave ethically?
Communication with Investors: Managers must understand how their decisions are viewed by the financial markets. If Ms. DellaTorre's apparel company eventually seeks funding or goes public, all managers must be able to communicate how their actions contribute to the firm's overall profitability and growth.
Organizational Forms: Start-Up to Major Corporation
As Ms. DellaTorre's apparel company grows, it will likely transition through three main legal organizational forms:
Organizational Form
Description
Advantages
Disadvantages
1. Sole Proprietorship
An unincorporated business owned by one individual (e.g., Ms. DellaTorre initially running her design business alone).
Easiest and cheapest to start. Few regulations and taxes (business income taxed as personal income).
Unlimited personal liability (personal assets are at risk). Difficult to raise large amounts of capital. Life of the business is limited to the owner's.
2. Partnership/LLC
A business owned by two or more people (Partnership) or a hybrid (LLC). This is common as a startup takes on investors.
Limited Liability (LLC members/owners only risk the money they invest). Easier to raise capital than a proprietorship.
Partnership features: Unlimited liability for all partners (General Partnership). More complex filing and legal requirements.
3. Corporation (C-Corp)
A legal entity separate and distinct from its owners and managers. Shares of stock are issued to represent ownership.
Limited liability for stockholders (protects personal wealth). Easier to raise capital (by selling stock/bonds). Unlimited life of the business.
Double Taxation (corporate income is taxed, and then dividends paid to shareholders are taxed again). More complex and costly to set up and manage.
Growth, Agency Problems, and Corporate Governance
How Corporations Go Public and Continue to Grow
Going Public (Initial Public Offering - IPO): When a private company like Ms. DellaTorre's decides to sell stock to the general public for the first time, it undergoes an IPO. This primary market transaction raises a large amount of equity capital, transforming the company from private to public.
Continued Growth: After the IPO, a corporation continues to grow by seeking funds in the capital markets (secondary markets) through:
Issuing more equity (stock): This raises capital but dilutes ownership.
Issuing debt (bonds): This provides financing but adds financial obligation and risk.
Using Retained Earnings: Reinvesting profits back into the business (e.g., expanding production, opening new markets).
What are Agency Problems?
An agency relationship arises when a principal (the owner/shareholder) hires an agent (the manager) to act on their behalf.
Agency Problem: This is the potential conflict of interest that arises when the agent (manager) makes decisions that benefit themselves rather than the principal (shareholder). For example, a manager might refuse a risky, high-return project that would increase stock value because they fear they might lose their job if the project fails.
For DellaTorre: Once she hires a professional CEO, the CEO is the agent, and Ms. DellaTorre (as a shareholder) is the principal.
Sample Answer
Welcome to Balik and Kiefer, Inc. It's great to have a client as ambitious as Michelle DellaTorre. Here are the answers to your boss's questions, explained in general terms to help Ms. DellaTorre understand the U.S. financial system and how her business and investments fit in.
Why Corporate Finance is Important to All Managers
Corporate finance is the area of finance that deals with the financial decisions managers make and the tools and analysis used to make those decisions. It's crucial for all managers, regardless of their functional area (e.g., marketing, operations, or HR), for three main reasons:
Resource Allocation: Every manager must make decisions about how to spend the company's money, such as whether to invest in a new marketing campaign (Marketing Manager), upgrade equipment (Operations Manager), or launch a new product line (Product Manager). Corporate finance provides the framework (e.g., Net Present Value, IRR) to evaluate whether these investments will create value for the firm.
Performance Evaluation: Managers are judged on the financial outcomes of their decisions. Understanding financial metrics allows them to interpret budgets, manage costs, and maximize the efficiency of their department's capital.