What is country risk? What is exchange rate risk? On what two factors does the return on a foreign investment depend?

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INVESTING OVERSEAS

Investors should consider additional risk factors if they invest overseas. First, there is country risk, which refers to the risk that is attributable to investing in a particular country. This risk depends on the country’s economic, political, and social environment. Some countries provide a safer investment climate, and there-fore less country risk, than others. Examples of country risk include the risk that property will be expropriated without adequate compensation plus risks associated with changes in tax rates, regulations, and currency repatriation. Country risk also includes changes in host-country requirements regarding local production and employment, as well as the danger of damage due to internal strife.

It is especially important to keep in mind when investing overseas that securities are often denominated in a currency other than the dollar, which means that returns on the investment will depend on what happens to exchange rates. This is known as exchange rate risk. For example, if a U.S. investor purchases a Japanese bond, interest will probably be paid in yen, which must then be converted into dollars before the investor can spend his or her money in the United States. If the yen weakens relative to the dollar, then it will buy fewer dollars, hence fewer dollars will be received when funds are repatriated. However, if the yen strengthens, this will increase the effective investment return. It therefore follows that returns on a foreign investment depend on both the performance of the foreign security and on changes in exchange rates.

  • What is country risk?
  • What is exchange rate risk?
  • On what two factors does the return on a foreign investment depend?

What is the price paid to borrow debt capital called? What are the two items whose sum is the cost of equity? What four fundamental factors affect the cost of money?

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THE COST OF MONEY

The four most fundamental factors affecting the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation. To see how these factors operate, visualize an isolated island community where the people live on fish. They have a stock of fishing gear that permits them to survive reasonably well, but they would like to have more fish. Now suppose double his daily catch. However, it would take a year to perfect the design, build the net, and learn to use it efficiently, and Mr. Crusoe would probably starve before he could put his new net into operation. Therefore, he might suggest to Ms. Robinson, Mr. Friday, and several others that if they would give him one fish each day for a year, he would return two fish a day during all of the next year. If someone accepted the offer, then the fish that Ms. Robinson or one of the others gave to Mr. Crusoe would constitute savings; these savings would be invested in the fishnet; and the extra fish the net produced would constitute a return on the investment.

Obviously, the more productive Mr. Crusoe thought the new fishnet would be, the more he could afford to offer potential investors for their savings. In this example, we assume that Mr. Crusoe thought he would be able to pay, and thus he offered, a 100 percent rate of return—he offered to give back two fish for every one he received. He might have tried to attract savings for less—for
example, he might have offered only 1.5 fish per day next year for every one he received this year, which would represent a 50 percent rate of return to Ms. Robinson and the other potential savers.

How attractive Mr. Crusoe’s offer appeared to a potential saver would depend in large part on the saver’s time preference for consumption. For example, Ms. Robinson might be thinking of retirement, and she might be willing to trade fish today for fish in the future on a one-for-one basis. On the other hand, Mr. Friday might have a wife and several young children and need his current fish, so he might be unwilling to “lend” a fish today for anything less than three fish next year. Mr. Friday would be said to have a high time preference for current consumption and Ms. Robinson a low time preference. Note also that if the entire population were living right at the subsistence level, time preferences for current consumption would necessarily be high, aggregate savings would be low, interest rates would be high, and capital formation would be difficult.

The risk inherent in the fishnet project, and thus in Mr. Crusoe’s ability to repay the loan, also affects the return investors require: the higher the perceived risk, the higher the required rate of return. Also, in a more complex society, there are many businesses like Mr. Crusoe’s, many goods other than fish, and many savers like Ms. Robinson and Mr. Friday. Therefore, people use money as a medium of exchange rather than barter with fish. When money is used, its value in the future, which is affected by inflation, comes into play: the higher the expected rate of inflation, the larger the required dollar return. We discuss this point in detail later in the chapter.

Thus, we see that the interest rate paid to savers depends (1) on the rate of return producers expect to earn on invested capital, (2) on savers’ time preferences for current versus future consumption, (3) on the riskiness of the loan, and (4) on the expected future rate of inflation. Producers’ expected returns on their business investments set an upper limit to how much they can pay for savings, while consumers’ time preferences for consumption establish how much consumption they are willing to defer, hence how much they will save at different interest rates.1 Higher risk
and higher inflation also lead to higher interest rates.

  • What is the price paid to borrow debt capital called?
  • What are the two items whose sum is the cost of equity?
  • What four fundamental factors affect the cost of money?

Why does an annuity due always have a higher future value than an ordinary annuity? If you calculated the value of an ordinary annuity, how could you find the value of the corresponding annuity due?

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FUTURE VALUE OF AN ANNUITY DUE

Because each payment occurs one period earlier with an annuity due, the payments will all earn interest for one additional year. Therefore, the FV of an annuity due will be greater than that of a similar ordinary annuity. If you went through the step-by-step procedure, you would see that our illustrative annuity due has an FV of $331.01 versus $315.25 for the ordinary annuity.

With the formula approach, we first use Equation 2-3, but since each payment occurs one period earlier, we multiply the Equation 2-3 result by (1 I):

FVA due FVAordinary (1 I) (2-4)
–100053
315.25

Thus, for the annuity due, FVAdue $315.25(1.05) $331.01, which is the same result as found using the period-by-period approach. With a calculator we input the variables just as we did with the ordinary annuity, but now we set the calculator to Begin Mode to get the answer, $331.01.
  • Why does an annuity due always have a higher future value than an ordinary annuity?
  • If you calculated the value of an ordinary annuity, how could you find the value of the corresponding annuity due?
  • Assume that you plan to buy a condo five years from now, and you need to save for a down payment. You plan to save $2,500 per year, with the first payment made immediately, and you will deposit the funds in a bank account that pays 4 percent. How much will you have after five years? How much would you have if you made the deposits at the end of each year? ($14,082.44; $13,540.81)

What’s the difference between an ordinary annuity and an annuity due? Why should you rather receive an annuity due for $10,000 per year for 10 years than an otherwise similar ordinary annuity?

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ANNUITIES

Thus far we have dealt with single payments, or “lump sums.” However, many assets provide a series of cash inflows over time, and many obligations like auto, student, and mortgage loans require a series of payments. If the payments are equal and are made at fixed intervals, then the series is an annuity. For example, $100 paid at the end of each of the next three years is a three-year annuity. If the payments occur at the end of each year, then we have an ordinary (or deferred) annuity. If the payments are made at the beginning of each year, then we have an annuity due. Ordinary annuities are more common in finance, so when we use the term “annuity” in this book, assume that the payments occur at the ends of the periods unless otherwise noted.

Here are the time lines for a $100, three-year, 5 percent, ordinary annuity and for the same annuity on an annuity due basis. With the annuity due, each payment is shifted back to the left by one year. A $100 deposit will be made each year, so we show the payments with minus signs:

 

As we demonstrate in the following sections, we can find an annuity’s future and present values, the interest rate built into annuity contracts, and how long it takes to reach a financial goal using an annuity. Keep in mind that annuities must have constant payments and a fixed number of periods. If these conditions don’t hold, then we don’t have an annuity.

  • What’s the difference between an ordinary annuity and an annuity due?
  • Why should you rather receive an annuity due for $10,000 per year for 10 years than an otherwise similar ordinary annuity?

How long would it take $1,000 to double if it were invested in a bank that pays 6 percent per year? How long would it take if the rate were 10 percent?

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FINDING THE NUMBER OF YEARS

We sometimes need to know how long it will take to accumulate a given sum of money, given our beginning funds and the rate we will earn on those funds. For example, suppose we believe that we could retire comfortably if we had $1 mil- lion, and we want to find how long it will take us to have $1 million, assuming we now have $500,000 invested at 4.5 percent. We cannot use a simple formula— the situation is like that with interest rates. We could set up a formula that uses logarithms, but calculators and spreadsheets can find N very quickly. Here’s the calculator setup:

Enter I/YR 4.5, PV 500000, PMT 0, and FV 1000000. Then, when we press the N key, we get the answer, 15.7473 years. If you plug N 15.7473 into the FV formula, you can prove that this is indeed the correct number of years: FV PV(1 I)N $500,000(1.045)15.7473 $1,000,000 We would also get N 15.7473 with a spreadsheet.

  • How long would it take $1,000 to double if it were invested in a bank that pays 6 percent per year? How long would it take if the rate were 10 percent? (11.9 years; 7.27 years)
  • Microsoft’s 2004 earnings per share were $1.04, and its growth rate during the prior 10 years was 24.1 percent per year. If that growth rate were maintained, how long would it take for Microsoft’s EPS to double? (3.21 years)

Microsoft earned $0.12 per share in 1994. Ten years later, in 2004, it earned $1.04. What was the growth rate in Microsoft’s earnings per share (EPS) over the 10-year period? If EPS in 2004 had been $0.65 rather than $1.04, what would the growth rate have been?

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FINDING THE INTEREST RATE

Thus far we have used Equations 2-1 and 2-2 to find future and present values.
Those equations have four variables, and if we know three of them, we can solve for the fourth. Thus, if we know PV, I, and N, then we can solve 2-1 for FV, while if we know FV, I, and N we can solve 2-2 to find PV. That’s what we did in the preceding two sections.

Now suppose we know PV, FV, and N, and we want to find I. For example, suppose we know that a given bond has a cost of $100 and that it will return $150 after 10 years. Thus, we know PV, FV, and N, and we want to find the rate of return we will earn if we buy the bond. Here’s the situation:

  • FV PV(1 I)N
    $150 $100(1 I)10
    $150/$100 (1 I)10
    1.5 (1 I)10

Unfortunately, we can’t factor I out to produce as simple a formula as we could for FV and PV—we can solve for I, but it requires a bit more algebra.4 However, financial calculators and spreadsheets can find interest rates almost instantly. Here’s the calculator setup: Enter N 10, PV 100, PMT 0 because there are no payments until the security matures, and FV 150. Then, when you press the I/YR key, the calcula- tor gives the answer, 4.14 percent. You would get this same answer with a spreadsheet.

  • The U.S. Treasury offers to sell you a bond for $585.43. No payments will be made until the bond matures 10 years from now, at which time it will be redeemed for $1,000. What interest rate would you earn if you bought this bond for $585.43? What rate would you earn if you could buy the bond for $550? For $600? (5.5%; 6.16%; 5.24%)
  • Microsoft earned $0.12 per share in 1994. Ten years later, in 2004, it earned $1.04. What was the growth rate in Microsoft’s earnings per share (EPS) over the 10-year period? If EPS in 2004 had been $0.65 rather than $1.04, what would the growth rate have been? (24.1%; 18.41%)

Do time lines deal only with years or could other periods be used? Set up a time line to illustrate the following situation: You currently have $2,000 in a three-year certificate of deposit (CD) that pays a guaranteed 4 percent annually

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TIME LINES

The first step in time value analysis is to set up a time line, which will help you visualize what’s happening in a particular problem. To illustrate, consider the following diagram, where PV represents $100 that is on hand today and FV is the value that will be in the account on a future date:

0 21 35%
Periods
Cash PV = $100 FV = ?

The intervals from 0 to 1, 1 to 2, and 2 to 3 are time periods such as years or months. Time 0 is today, and it is the beginning of Period 1; Time 1 is one period from today, and it is both the end of Period 1 and the beginning of Period 2; and so on. Although the periods are often years, periods can also be quarters or months or even days. Note that each tick mark corresponds to both the end of one period and the beginning of the next one. Thus, if the periods are years, the tick mark at Time 2 represents both the end of Year 2 and the beginning of Year 3.

Cash flows are shown directly below the tick marks, and the relevant inter- est rate is shown just above the time line. Unknown cash flows, which you are trying to find, are indicated by question marks. Here the interest rate is 5 per- cent; a single cash outflow, $100, is invested at Time 0; and the Time 3 value is an unknown inflow. In this example, cash flows occur only at Times 0 and 3, with no flows at Times 1 or 2. Note that in our example the interest rate is constant for all three years. That condition is generally true, but if it were not then we would show different interest rates for the different periods.

Time lines are essential when you are first learning time value concepts, but even experts use them to analyze complex finance problems, and we use them throughout the book. We begin each problem by setting up a time line to show what’s happening, after which we provide an equation that must be solved to find the answer, and then we explain how to use a regular calculator, a financial calculator, and a spreadsheet to find the answer.

Indeed, time value analysis is used throughout the book, so it is vital that you understand this chapter before continuing.
You need to understand basic time value concepts, but conceptual knowledge will do you little good if you can’t do the required calculations.
Therefore, this chapter is heavy on calculations. Also, most students studying finance have a financial or scientific calculator, and some also own or have access to a computer. Moreover, one of these tools is necessary to work many finance problems in a “reasonable” length of time. However, when they start on this chapter, many students don’t know how to use the time value functions in their calculator or computer. If you are in that situation, you will find yourself simultaneously studying concepts and trying to learn to use your calculator, and you will need more time to cover this chapter than you might expect. 1

1 Calculator manuals tend to be long and complicated, partly because they cover a number of topics that aren’t required in the basic finance course. Therefore, we provide, on the Thomson NOW Web site, tutorials for the most commonly used calculators. The tutorials are keyed to this chapter, and they show exactly how to do the required calculations. If you don’t know how to use your calculator, go to the ThomsonNOW Web site, get the relevant tutorial, and go through it as you study the chapter.

2 A fifth procedure, using tables that show “interest factors,” was used before financial calculators and computers became available. Now, though, calculators and spreadsheets such as Excel are programmed to calculate the specific factor needed for a given problem and then to use it to find the FV. This is much more efficient than using the tables. Moreover, calculators and spreadsheets can handle fractional periods and fractional interest rates, like the FV of $100 after 3.75 years when the interest rate is 5.375 percent, whereas tables provide numbers only for specific periods and rates. For these reasons, tables are not used in business today; hence we do not discuss them in the text.
  • Do time lines deal only with years or could other periods be used?
  • Set up a time line to illustrate the following situation: You currently have $2,000 in a three-year certificate of deposit (CD) that pays a guaranteed 4 percent annually.

What are three techniques stockholders can use to motivate managers to try to maximize their stock’s long-run price? Should managers focus directly on the actual stock price, on the stock’s intrinsic value, or are both important? Explain.

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CONFLICTS BETWEEN MANAGERS AND STOCKHOLDERS7

It has long been recognized that managers’ personal goals may compete with shareholder wealth maximization. In particular, managers might be more interested in maximizing their own wealth rather than their stockholders’ wealth, hence pay themselves excessive salaries. For example, Disney paid its former president, Michael Ovitz, $140 million as a severance package after just 14 months on the job—$140 million to go away—because he and Disney CEO Michael Eisner were having disagreements. Eisner himself was also handsomely compensated the year Ovitz was fired—a $750,000 base salary, plus a $9.9 million bonus, plus a $565 million profit from stock options, for a total of just over $575 million. As another example of corporate excesses, Tyco CEO Dennis Kozlowski spent more than $2 million of the company’s money on a birthday party for his wife.

Neither the Disney executives’ pay nor Kozlowski’s expenditures seem consistent with shareholder wealth maximization. Still, good executive compensation plans can motivate managers to act in their stockholders’ best interests. Useful motivational tools include (1) reasonable compensation packages; (2) direct intervention by shareholders, including firing managers who don’t perform well; and (3) the threat of a takeover.

The compensation package should be sufficient to attract and retain able managers but not go beyond what is needed. Also, compensation should be structured so that managers are rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so managers will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, because intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a spot date.

Stockholders can intervene directly with managers. Years ago most stock was owned by individuals, but today the majority is owned by institutional investors such as insurance companies, pension funds, and mutual funds. These institutional money managers have the clout to exercise considerable influence over firms’ operations. First, they can talk with managers and make suggestions about how the business should be run. In effect, institutional investors such as Calpers (California Public Employees Retirement System, with $165 billion of assets) and TIAA–CREF (a retirement plan originally set up for professors at private colleges that now has more than $300 billion of assets) act as lobbyists for the body of stockholders. When such large stockholders speak, companies listen. Second, any shareholder who has owned $2,000 of a company’s stock for one year can sponsor a proposal that must be voted on at the annual stockholders’ meeting, even if management opposes the proposal. Although shareholder- sponsored proposals are nonbinding, the results of such votes are clearly heard by top management.

Stockholder intervention can range from making suggestions for improving sales to threatening to fire the management team. Until recently, the probability of a large firm’s management being ousted by its stockholders was so remote that it posed little threat. Most firms’ shares were so widely distributed, and management had so much control over the voting mechanism, that it was virtu- ally impossible for dissident stockholders to get the votes needed to overthrow a management team. However, that situation has changed. In recent years the top executives of AT&T, Coca-Cola, Fannie Mae, General Motors, IBM, and Xerox, to name a few, have been forced out. Also, Tyco’s Kozlowski is gone and Disney’s Eisner is under pressure and will soon be leaving. All of these departures were due to their firm’s poor performance.

If a firm’s stock is undervalued, then corporate raiders will see it to be a bar- gain and will attempt to capture the firm in a hostile takeover. If the raid is successful, the target’s executives will almost certainly be fired. This situation gives managers a strong incentive to take actions to maximize their stock’s price. In the words of one executive, “If you want to keep your job, never let your stock sell at a bargain price.”

Again, note that the price managers should be trying to maximize is not the price on a specific day. Rather, it is the average price over the long run, which will be maximized if management focuses on the stock’s intrinsic value. How- ever, managers must communicate effectively with stockholders (without divulging information that would aid their competitors) in order to keep the actual price close to the intrinsic value. It’s bad for both stockholders and managers for the intrinsic value to be high but the actual price low, because then a raider may swoop in, buy the company at a bargain price, and fire the managers. To repeat our earlier message: Managers should try to maximize their stock’s intrinsic value and  then communicate effectively with stockholders. That will cause the intrinsic value to be high and the actual stock price to remain close to the intrinsic value over time.

Because the intrinsic value cannot be observed, it is impossible to know if it is really being maximized. Still, as we will discuss in Chapter 9, there are procedures for estimating a stock’s value. Managers can then use these valuation models to analyze alternative courses of action in terms of how they are likely to affect the estimated value. This type of value-based management is not as precise as we would like, but it is the best way to run a business.

  • What are three techniques stockholders can use to motivate managers to try to maximize their stock’s long-run price?
  • Should managers focus directly on the actual stock price, on the stock’s intrinsic value, or are both important? Explain.

What do investors expect to receive when they buy a share of stock? Do investors know for sure what they will receive? Explain. Based just on the name, which company would you regard as being riskier, General Foods or South Seas Oil Exploration Company? Explain.

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STOCK PRICES AND SHAREHOLDER VALUE

At the outset, it is important to understand the chief goals of a business. As we will see, the goals of a sole proprietor may be different than the goals of a corporation. Consider first Larry Jackson, a sole proprietor who operates a sporting goods store on Main Street. Jackson is in business to make money, but he also likes to take time off to play golf on Fridays. Jackson also has a few employees who are no longer very productive, but he keeps them on the payroll out of friendship and loyalty. Jackson is clearly running the business in a way that is consistent with his own personal goals—which is perfectly reasonable given that he is a sole proprietor. Jackson knows that he would make more money if he didn’t play golf or if he replaced some of his employees, but he is comfortable with the choices he has made, and since it is his business, he is free to make those choices.

By contrast, Linda Smith is CEO of a large corporation. Smith manages the company on a day-to-day basis, but she isn’t the sole owner of the company. The company is owned primarily by shareholders who purchased its stock because they were looking for a financial return that would help them retire, send their kids to college, or pay for a long-anticipated trip. The shareholders elected a board of directors, who then selected Smith to run the company. Smith and the firm’s other managers are working on behalf of the shareholders, and they were hired to pursue policies that enhance shareholder value. Throughout this book we focus primarily on publicly owned companies, hence we operate on the assumption that management’s primary goal is stockholder wealth maximization, which translates into maximizing the price of the firm’s common stock.

If managers are to maximize shareholder wealth, they must know how that wealth is determined. Essentially, a company’s shareholder wealth is simply the number of shares outstanding times the market price per share. If you own 100 shares of GE’s stock and the price is $35 per share, then your wealth in GE is $3,500. The wealth of all its stockholders can be summed, and that is the value of GE, the item that management is supposed to maximize. The number of shares outstanding is for all intents and purposes a given, so what really determines shareholder wealth is the price of the stock. Therefore, a central issue is this: What determines the stock’s price?

Throughout this book, we will see that the value of any asset is simply the present value of the cash flows it provides to its owners over time. We discuss stock valuation in depth in Chapter 9, where we will see that a stock’s price at any given time depends on the cash flows an “average” investor expects to receive in the future if he or she bought the stock. To illustrate, suppose investors are aware that GE earned $1.58 per share in 2004 and paid out 51 per- cent of that amount, or $0.80 per share, in dividends. Suppose further that most investors expect earnings, dividends, and the stock price to all increase by about 6 percent per year. Management might run the company so that these expectations are met. However, management might make some wonderful decisions that cause profits to rise at a 12 percent rate, causing the dividends and stock price to increase at that same rate. Of course, management might make some big mistakes, profits might suffer, and the stock price might decline sharply rather than grow. Thus, investors are exposed to more risk if they buy GE stock than if they buy a new U.S. Treasury bond, which offers a guaranteed interest payment every six months plus repayment of the purchase price when the bond matures.

We see, then, that if GE’s management makes good decisions, the stock price should increase, while if it makes enough bad decisions, the stock price will decrease. Management’s goal is to make the set of decisions that leads to the maximum stock price, as that will maximize its shareholders’ wealth. Note, though, that factors beyond management’s control also affect stock prices. Thus, after the 9/11 terrorist attacks on the World Trade Center and Pentagon, the prices of virtually all stocks fell, no matter how effective their management was.

Firms have a number of different departments, including marketing, accounting, production, human resources, and finance. The finance department’s principal task is to evaluate proposed decisions and judge how they will affect the stock price and therefore shareholder wealth. For example, suppose the production manager wants to replace some old equipment with new, automated machinery that will enable the firm to reduce labor costs. The finance staff will evaluate that proposal and determine if the savings are worth the cost. Similarly, if marketing wants to sign a contract with Tiger Woods that will cost $10 million per year for five years, the financial staff will evaluate the proposal, looking at the probable increased sales and other related factors, and reach a conclusion as to whether signing Tiger will lead to a higher stock price. Most significant decisions will be evaluated similarly.

Note too that stock prices change over time as conditions change and as investors obtain new information about companies’ prospects. For example, Apple Computer’s stock ranged from a low of $21.18 to $69.57 per share during 2004, rising and falling as good and bad news was released. GE, which is older, more diversified, and consequently more stable, had a narrower price range, from $28.88 to $37.75. Investors can predict future results for GE more accurately than for Apple, hence GE is less risky. Note too that the investment decisions firms make determine their future profits and investors’ cash flows. Some corporate projects are relatively straightforward and easy to evaluate, hence not very risky. For example, if Walmart were considering opening a new store, the expected revenues, costs, and profits for this project would be easier to estimate than an Apple Computer project for a new voice-activated computer. The success or lack of success of projects such as these will determine the future stock prices of Walt-Mart, Apple, and other companies.

Managers must estimate the probable effects of projects on profitability and thus on the stock price. Stockholders must forecast how successful companies will be, and current stock prices reflect investors’ judgments as to that future success.

What is management’s primary goal?
What do investors expect to receive when they buy a share of stock?
Do investors know for sure what they will receive? Explain.
Based just on the name, which company would you regard as being riskier, General Foods or South Seas Oil Exploration Company? Explain.
When a company like Boeing decides to invest $5 billion in a new jet airliner, are its managers positive about the project’s effect on Boeing’s future profits and stock price? Explain.
Would Boeing’s managers or its stockholders be better able to judge the effect of a new airliner on profits and the stock price? Explain.
Would all Boeing stockholders expect the same outcome from an airliner project, and how would these expectations affect the stock price? Explain.

What are the key differences between sole proprietorships, partnerships, and corporations? How do some firms get to enjoy the benefits of the corporate form of organization yet avoid corporate income taxes? Why don’t all firms—for example, IBM or GE—do this?

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1.1 FORMS OF BUSINESS ORGANIZATION

The key aspects of financial management are the same for all businesses, large or small, regardless of how they are organized. Still, its legal structure does affect some aspects of a firm’s operations and thus must be recognized. There are three main forms of business organization: (1) sole proprietorships, (2) partnerships, and (3) corporations. In terms of numbers, about 80 percent of businesses are operated as sole proprietorships, while most of the remainder are divided equally between partnerships and corporations. However, based on the dollar value of sales, about 80 percent of all business is done by corporations, about 13 percent by sole proprietorships, and about 7 percent by partnerships. Because corporations conduct the most business, and because most successful proprietor- them in this book. Still, it is important to understand the differences among the three types of firms.
A proprietorship is an unincorporated business owned by one individual. Going into business as a sole proprietor is easy—merely begin business operations. Proprietorships have three important advantages: (1) They are easily and inexpensively formed, (2) they are subject to few government regulations, and (3) they are subject to lower income taxes than corporations. However, proprietorships also have three important limitations: (1) Proprietors have unlimited personal liability for the business’s debts, which can result in losses that exceed the money they have invested in the company; (2) it is difficult for proprietorships to obtain large sums of capital; and (3) the life of a business organized as a proprietorship is limited to the life of the individual who created it. For these reasons, sole proprietorships are used primarily for small businesses. However, businesses are frequently started as proprietorships and then converted to corporations when their growth causes the disadvantages of being a proprietorship to outweigh the advantages. A partnership is a legal arrangement between two or more people who decide to do business together. Partnerships are similar to proprietorships in that they can be established easily and inexpensively, and they are not subject to the corporate income tax. They also have the disadvantages associated with proprietorships: unlimited personal liability, difficulty raising capital, and limited lives. The liability issue is especially important, because under partnership law, each partner is liable for the business’s debts. Therefore, if any partner is unable to meet his or her pro rata liability and the partnership goes bankrupt, then the remaining partners are personally responsible for making good on the unsatisfied claims. The partners of a national accounting firm, Laventhol and Horvath, a huge partnership that went bankrupt as a result of suits filed by investors who
relied on faulty audit statements, learned all about the perils of doing business as a partnership. Another major accounting firm, Arthur Andersen, suffered a similar fate because the partners who worked with Enron, WorldCom, and a few other clients broke the law and led to the firm’s demise. Thus, a Texas partner who audits a business that goes under can bring ruin to a millionaire New York partner who never even went near the client company.3

4 Part 1 Introduction to Financial Management

Proprietorship
An unincorporated business owned by one individual.

3 There are actually a number of types of partnerships, but we focus on “plain vanilla partnerships” and leave the variations to courses on business law. We note, though, that the variations are generally designed to limit the liabilities of some of the partners. For example, a “limited partnership” has a general partner, who has unlimited liability, and limited partners, whose liability is limited to their investment. This sounds great from the standpoint of the limited partners, but they have to cede sole and absolute authority to the general partner, which means that they have no say in the way the firm conducts its business. With a corporation, the owners (stockholders) have limited liability, but they also have the right to vote and thus influence management.

Partnership
An unincorporated business owned by two or more persons.

A corporation is a legal entity created by a state, and it is separate and distinct from its owners and managers. Corporations have unlimited lives, their owners are not subject to losses beyond the amount they have invested in the business, and it is easier to transfer one’s ownership interest (stock) in a corpora- tion than one’s interest in a non incorporated business. These three factors make it much easier for corporations to raise the capital necessary to operate large businesses. Thus, growth companies such as Hewlett-Packard and Microsoft generally begin life as proprietorships or partnerships, but at some point find it advantageous to convert to the corporate form. The biggest drawback to incorporation is taxes: Corporate earnings are generally subject to double taxation the earnings of the corporation are taxed at the corporate level, and then, when after-tax earnings are paid out as dividends, those earnings are taxed again as personal income to the stockholders. However, as an aid to small businesses Congress created S corporations and allowed them to be taxed as if they were proprietorships or partnerships and thus exempt from the corporate income tax. The S designation is based on the section of the Tax Code that deals with S corporations, though it could stand for “small.” Larger corporations are known as C corporations. S corporations can have no more than 75 stockholders, which limits their use to relatively small, privately owned firms. The vast majority of small firms elect S status and retain that status until they decide to sell stock to the public and thus expand their ownership beyond 75 stockholders.

In deciding on a form of organization, firms must trade off the advantages of incorporation against a possibly higher tax burden. However, the value of any business other than a very small one will probably be maximized if it is organized as a corporation for the following three reasons:
1. Limited liability reduces the risks borne by investors, and, other things held constant, the lower the firm’s risk, the higher its value.
2. A firm’s value is dependent on its growth opportunities, which, in turn, are dependent on its ability to attract capital. Because corporations can attract capital more easily than can unincorporated businesses, they are better able to take advantage of growth opportunities.
3. The value of an asset also depends on its liquidity, which means the ease of selling the asset and converting it to cash at a “fair market value.” Because an investment in the stock of a corporation is much easier to transfer to another investor than are proprietorship or partnership interests, a corporate investment is more liquid than a similar investment in a proprietorship or partnership, and this too enhances the value of a corporation.

As we just discussed, most firms are managed with value maximization in mind, and that, in turn, has caused most large businesses to be organized as corporations.
What are the key differences between sole proprietorships, partnerships, and corporations?
How do some firms get to enjoy the benefits of the corporate form of organization yet avoid corporate income taxes? Why don’t all firms—for example, IBM or GE—do this?
Why is the value of a business other than a small one generally maximized if it is organized as a corporation?