Introduction

The first topic in Business Finance is the “Role of Managers”. Business Finance is just another name for Corporate Finance. In Corporate Finance/Business Finance you will learn about the different decisions that a financial manager makes. In today’s context, the Financial Manager is usually the Chief Financial Officer (CFO) of a company. They are the top financial manager within a firm. Other financial managers include Treasurer and Controller.

Financial manager or CFO: The Financial Manager/CFO answers all finance-related questions associated with the business.

Treasurer: The Treasurer overseas cash management, credit management, capital expenditures and financial planning.

Controller: The Controller oversees taxes, cost accounting, financial accounting and data processing.

In this topic, we will cover the following concepts:

Concept 1: Major types of Business structures

Concept 2: Three important business finance decisions

Concept 3: Financial objective and overall objective

Concept 4: Fundamental concepts in Finance

Concept 1: Major types of Business structures

There are 3 different types of business structures. They are sole traders, partnerships and company forms of business.

Sole Traders

The first type is a sole trader. A sole trader is an individual who runs and owns the business alone. Let’s look at some of the advantages and disadvantages of a sole trader.

Advantages as a sole trader: 

• It is relatively easy to start since the business starts as a small business.
• The sole trader is the least regulated by the Australian Securities and Investments Commission (ASIC). ASIC is an independent Australian Government body. ASIC is Australia’s integrated corporate, markets, financial services and consumer credit regulator. It administers the law effectively in Australian financial markets. It makes information about companies and other bodies available to the public as soon as practicable. It takes whatever action it can, and which is necessary, to enforce and give effect to the law.
• Since the sole trader is a single owner. It gets to keep all the profits from the business.
• Business income and personal income are usually taxed at different rates. Business income can be taxed twice. You will learn about double taxation in Topic 10. Although the sole trader sets up a business, the income from the sole trader is taxed once as personal income.

Disadvantages as a sole trader:

• The business set up by the sole trader is limited to life of the owner unless the business is sold to somebody else.
• Whatever capital is required for the sole trader is limited to owner’s personal wealth. Therefore, there is a limitation to how much the business can grow.
• There is unlimited liability. If the business has debt and incurs a loss, then the sole trader has to pay off the debt from their pocket.
• Difficult to sell ownership interest. Here ownership interest refers to any share an individual/party owns in the sole trader. Since the sole trader is owned by a single individual, only the individual has ownership interest.

Partnership

The second type of business is partnerships. In a partnership, two or more people combine their funds to set up a business. Let’s look at some of the advantages and disadvantages of a partnership form of business.

Advantages to the partnerships form of business:

• There are two or more owners in a partnership. Responsibility to manage the business is shared among the owners. No single owner is responsible for the business.
• There is more knowledge and capital available for the partnerships since there are multiple owners in the business.
• Similar to a sole trader, it is relatively easy to start a partnership.
• Similar to a sole trader, partnership income is taxed once as personal income.

Disadvantages to the partnerships form of business:

• Similar to a sole trader, partnerships have unlimited liability. There are different types of partnerships:
  • General partnership. In this partnership, unlimited liability applies to all partners.
  • Limited partnership. In this partnership, unlimited liability applies to general partners. Some partners have limited liability for the amount they have contributed to the business. Limited partners are passive investors who do not participate in the day-to-day business.
  • Incorporated limited partnerships. Limited liability for partners in the business but there has to be one general partner who has unlimited liability in the business.
• A partnership dissolves when one partner dies or wishes to sell it to others.
• It is rather difficult to transfer ownership in a partnership.

Company

The third form of business structure is a company. According to the 2001 corporations Act, a company is a separate legal entity. This is the first important distinction between a company, sole trader and partnership. A business set up by a sole trader or a partnership is not a legal entity. Let’s look at some of the advantages and disadvantages of a company form of business.

Advantages to the company form of business:

• Company form of business has limited liability. What does limited liability mean? Let’s say you have invested in company A. Let’s say you have bought 20 shares of Company A and each share costs about $20. Now let’s say Company A has a debt of 1 billion dollars and if company A goes bankrupt for some reason, then your loss will be only $400 =$20*20. The lenders are not going to recover any of the company’s debt from your wealth. This is the second point of difference between sole traders and partnerships. Sole traders and partnerships have unlimited liability.
• The company form of business has unlimited life.
• In a company form of business there is a separation of ownership and management. Owners of the business hire manager to run the business.
• In a company form of business transfer of ownership is easy by selling shares.
• It is easier to raise capital by selling shares in the initial public offering.

Disadvantages to the company form of business:

• Dividends are paid from a firm’s after-tax earnings. Dividends are not tax deductible.
• Because of the separation of ownership and management there could be agency issues. Agency issues arise when owners and managers interest are not aligned. Managers could behave opportunistically and maximise their own wealth rather than the shareholders’ wealth. This type of agency issue is not there in sole trader or partnership form of business structures because in those form of business structure owners are managers.

Concept 2: Three important business finance decisions

The role of the financial manager/CFO is to make three important financial management decisions help firms run its operation efficiently. These are investing, financing and dividend decisions.

Investment Decisions/Capital Budgeting

Investment decisions are long-term in nature. What long-term investments or projects the investment should take on? This is the first important decision. The Company decides what type of assets they want to invest in. If you think carefully, the starting point of a business is the investment decision. A business starts because the owner decides to invest to produce a particular product or service. If you think about marketing a product or building strategy around a product it all starts with the decision to invest in a product or service which is the first business finance decision. A business keeps investing in new ideas and products on an ongoing basis. For example, facebook’s decision to buy WhatsApp messenger is an investment decision. Disney planning to invest in a theme park in Rio is an investment decision.

Related to this is the working capital management decision where businesses manage the day-to-day finances of the firm.

Financing Decisions/Capital Structure:

In financing decisions, the company decides what will be the funding source for the investment decisions. What will be the source of capital for the investment decision? There are two broad sources of financing for the investment decisions. They are debt and equity. Should the company use debt, equity or a mix of both to finance the investment decisions. By debt it means taking a loan from the bank or selling bonds to investors. By equity its means selling shares to investors to raise the funds.

Dividend Decisions

Companies invest in products and services to generate profit. What does it do with the profit? Profit could be distributed among the shareholders or retained to be reinvested in the business. Think about the profit Disney will generate if it decides to build a theme park in Rio. Think about the profit Facebook is earning from its WhatsApp business. How much of the profit is reinvested in the business and how much is returned to the owners is the dividend decision.

Concept 3: Financial objective and overall objective

Financial Objective

In the previous concept, you learnt about the three important business decisions that a company makes. What do you think is the purpose/objective of these decisions? Is it to:

• Maximise revenue
• Minimise costs
• Maximise profit
• Maximise share price

Let’s go over these choices one by one. Should the company maximise revenue? Maximising revenue cannot be the firm’s objective because revenue does not take into account costs incurred by the firm.

How about minimising costs? The company can minimise costs by not investing in new investment opportunities such as machines and buildings. This decision may not be good for the business since by not investing, the company can go out of business.

How about maximising profit? When we talk about profit, it is about accounting profit. But there are issues with this objective since changes in accounting rules can have a significant effect on the profit/earnings number. Take the example of facebook (https://www.cfo.com/accounting-tax/2017/02/accounting-change-facebook/). Changing the way the company account for employee stock option boosted Facebook’s earnings by 934 million dollar.

How about maximise share price? The purpose of a company form of business to make money for its owners. Maximising the current share price increases the wealth of the owners of the firm. The share price should incorporate expectations about the future of the company. We will use this idea in Topic 5 Share Valuation. The idea of maximising share price is similar to maximising owners’ equity for firms that are not publicly listed.

Overall objective

Before we settle on this, let’s think about it carefully. Since the days of Milton Friedman, we have learnt that the objective of a company is to maximise share price. However, now it is time for the firms to act responsibly so that there is no further damage to society and the environment. Regulators are now imposing regulations to make sure corporations behave socially responsibly. Do customers/investors care about society and the environment?

Yes, they do. The 2021 global consumer insights pulse survey and another survey by creative research platform visual GPS showed that 55% of customers chose sustainable products that help protect the environment. Customers care if firms are behaving socially responsibly when they are communicating or advertising. Customers also said they are doing everything to minimise their impact on the environment.

Who are these customers? As it turns out, consumers in the Asia pacific region are more eco-friendly. Consumers from the Philippines, Indonesia, Vietnam, Egypt and UAE are more environmentally friendly. These eco-friendly consumers are aged between 23 to 32.

These are United Nations 17 sustainable development goals to transform the world and prepare the world for our future generations. If you think carefully, corporations can contribute to all 17 UN goals. To pick a few, they can contribute to good health and wellbeing, gender equality, responsible consumption, climate action, life below water, life on land and so on.

Image source: un.org

Should we rethink about the objective of firm? The revised overall objective of firms should be to maximise welfare. This overall objective will help firms archive their financial objective which is maximising their share price. Because investors will invest in firms that behave socially responsibly, the outcome of this will be a higher share price for the company in the long run. Academic research by Oliver Hart and Luigi Zingales also shows this (https://promarket.org/where-friedman-was-wrong/).

Concept 4: Fundamental concepts in Finance

In this topic you will learn five fundamental concepts in finance. They are:

• Time value of money
• Value of firm
• Risk aversion
• Market efficiency and asset pricing
• Agency relationship

Time value of money: This means a dollar is worth more today than tomorrow. This is because a dollar can be invested today to earn a return tomorrow. For example, if you invest $100 in 2022 at 10% interest rate you will get $110 in 2023. If you are getting the money in 2023 then you will be better off getting $110 than $100.

Value of Firm: The second important concept is the value of a firm. This is also called enterprise value. The value of a firm is the sum of the market value of debt and the market value of equity. By market value, from whose perspective do we calculate the value? We calculate the value of debt and equity from the investors who want to invest in the company. You will learn about valuation concepts in Topic 4 and 5. Managers also care about the firm value because higher value of the firm can attract more investors to invest in the company.

Risk aversion: The concept of risk aversion is important in finance. The idea of risk aversion is usually discussed in the context of rational investors. A rational investor always prefers more money to less money. Rational investors do not like to take risk. Given a level of return, the rational investor will choose a less risky investment. To invest in a risky business, the investor would require a higher return. You will learn more about this in the next topic.

Think about these two alternative scenarios. In both cases the average pay off is $100. Which one would you prefer? As rational investors, you would choose alternative 1 because alternative 1 is less risky than alternative 2.

Alternative 1:

	Probability	Probability	Average Payoff
	0.5	0.5
payoff	200	0
	100	0	100

Alternative 2:

	Probability	Probability	Average Payoff
	0.9	0.1
payoff	0	1000
	0	100	100

Market Efficiency: In early January 2019, Apple cuts its revenue outlook in almost two decades due to slowing demand in the Chinese market. As a result of this Apple share fell by 7.8%. if we observe the sequence of events: Apple cuts its revenue outlook, rational investors receive this information and process it and take decisions by selling apple shares as a result apple share fell by 7.8%.

By efficient capital market, we mean that investors, managers and regulators have access to the same information. Investors are rational i.e they take decisions to maximise their benefit. In the previous example, apple stock fail by 7.8% as a result of apple’s announcement. Stock prices reflect all available information in the market.

Asset Pricing: What would determine the return or price of an asset? Note return of an asset depends on its price. The return on an asset will be determined by its riskiness. There are two types of risk. One is the systematic risk which is also called the market risk. These are risks related to macroeconomics such as changes in interest rates, inflation and other macroeconomic factors. The second type of risk is the unsystematic risk specific to the company. For example, if there is a labour strike or suppose a company commits fraud, then this would be a company-specific risk. The idea of asset pricing is that the return on an asset will only be determined by the level of market risk or systematic risk. The market will not price unsystematic risk or company-specific risk.

Agency Relationship: Agency relationship exists when owners hire managers to run the business. This is true in the context of a company form of business because owner (i.e shareholder) hire managers to run the business. It is important to understand the concept of agency conflict or agency issue. Agency issue arises when owners (shareholders) hires managers to run the business. Managers can act opportunistically to maximise their personal benefit rather than maximising shareholders’ benefit. This type of agency issue is not there for sole traders or partnerships because the owners of sole traders and partnerships are in fact the managers.

We have witnessed many infamous examples in corporate world as a result of this agency issue/agency conflicts shown in this slide. The collapse of the Enron, Lehman brothers are all because of agency conflict where managers acted opportunistically to maximise their private benefit. More recently the royal commission into the misconduct in the financial industry in Australia which talks about the bad banking behaviour.

How to fix agency conflict: It is possible if both shareholders and managers interests are aligned. One way to achieve this by mapping manager’s compensation to firm performance. A portion of manager’s compensation is tied to firms’ performance. Another way to have more independent directors on the board of corporate governance. By independent directors we mean directors that have no close family ties with the CEO. Regulation is another way to align the interests of shareholders and managers. The firm can face lawsuits if it fails to comply with the regulation. Another important aspect is corporate culture. Corporate culture is about integrity, ethics, doing the right thing, collaboration, employee safety and so on. Firms with a strong culture will have fewer of these agency issues. The 2017 Royal commission report also talks about how important it is to have a good corporate culture. CASH is King in Finance.

References

• Peirson, G., Brown, R., Easton, S. A., Howard, P., & Pinder, S. (2015). Business finance (Twelfth edition). McGraw-Hill Education.
• Ross, S. A., Trayler, R., Hambusch, G., Koh, C., Glover, K., Westerfield, R., & Jordan, B. (2021). Fundamentals of corporate finance (Eighth edition.). McGraw-Hill Education (Australia) Pty Limited.
• Parrino, R., Au Yong, H. H., Dempsey, M. J., Ekanayake, S., Kidwell, D. S., Kofoed, J., Morkel-Kingsbury, N., & Murray, J. (2014). Fundamentals of corporate finance (Second edition.). John Wiley and Sons Australia, Ltd.