The Firm and The Financial Manager

The company has to decide which assets to buy and how to pay for them. The
investment decision i.e. the decision to invest in assets like plant, equipment,
and know-how, is in large part a responsibility of the financial manager. So is the
financing decision, the choice of how to pay for such investments.
Organizing a Business
Sole Proprietors have unlimited liability1.
Partnership agreement will set out how management decisions are to be made
and the proportion of the profits to which each partner is entitled. The partners
then pay personal income tax on their share of these profits. Partners, like sole
proprietors, have the disadvantage of unlimited liability. If the business runs into
financial difficulties, each partner has unlimited liability for all the businesss
debts, not just his or her share.
Unlike a proprietorship or partnership, a Corporation is legally distinct from its
owners. It is based on articles of incorporation2 that set out the purpose of the
business, how many shares can be issued, the number of directors to be
appointed, and so on. These articles must conform to the laws of the state in
which the business is incorporated. For many legal purposes, the corporation is
considered a resident of its state. For example, it can borrow or lend money, and
it can sue or be sued. It pays its own taxes (but it cannot vote!). The corporation
is owned by its stockholders and they get to vote on important matters. Unlike
proprietorships or partnerships, corporations have limited liability3, which
means that the stockholders cannot be held personally responsible for the
obligations of the firm. If, say, IBM were to fail, no one could demand that its
shareholders put up more money to pay off the debts. The most a stockholder
can lose is the amount invested in the stock. By organizing as a corporation, a
business may be able to attract a wide variety of investors. The shareholders
may include individuals who hold only a single share worth a few dollars, receive
only a single vote, and are entitled to only a tiny proportion of the profits.
Shareholders may also include giant pension funds and insurance companies
whose investments in the firm may run into the millions of shares and who are
entitled to a correspondingly large number of votes and proportion of the profits.
Because the corporation is a separate legal entity, it is taxed separately. So
corporations pay tax on their profits, and, in addition, shareholders pay tax on
any dividends that they receive from the company. By contrast, income received
by partners and sole proprietors is taxed only once as personal income. The
disadvantage of corporate organization is double taxation4.

1 Snrsz sorumluluk
2 Birleme maddeleri, irket ana szlemesi
3 Snrl sorumluluk
4 ifte vergilendirme
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Business can be set up as limited partnerships. In this case, partners are

classified as general or limited. General partners manage the business and have
unlimited personal liability for the businesss debts. Limited partners, however,
are liable only for the money they contribute to the business. They can lose
everyting they put in, but not more. Limited partners usually have a restricted
role in management. In many states a firm can also be set up as a limited liability
partnership (LLP) or, equivalently, a limited liability company (LLC). These are
partnerships in which all partners have limited liability. This form of business
organization combines the tax advantage of partnership with the limited liability
advantage of incorporation. However, it still does not suit the largest firms, for
which widespread share ownership and separation of ownership and
management are essential.

The Role of the Financial Manager

Many of the real assets5 are tangible, such as machinery, factories and offices;
others are intangible, such as technical expertise, trademarks and patents. All of
them must be paid for. To obtain the necessary money, the company sells
financial assets6, or securities7. These pieces of paper have value because
they are claims on the firms real assets and the cash that those assets will
produce. For example, if the company borrows money from the bank, the bank
has a financial asset. That financial asset gives it a claim to a stream of interest
payments and to repayment of the loan. The companys real assets need to
produce enough cash to satisfy these claims.

5 Assets used to produce goods and services

6 Financial assets claims to the income generated by real assets. Also called
securities.
7 Tahviller ya da menkul deerler. Securities refers to financial assets that are
widely held, like the shares of IBM.
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Financial manager faces two basic problems. First, how much money should the
firm invest, and what specific assets should the firm invest in? This is the firms
investment or capital budgeting decision. Second, how should the cash
required for an investment be raised? This is the financing decision.
Todays investments provide benefits in the future. Thus the financial manager is
concerned not solely with the size of the benefits but also with how long the firm
must wait for them. The sooner the profits come in, the better. In addition, these
benefits are rarely certain; a new project may be a great success but then again
it could be a dismal failure. The financial manager needs a way to place a value
on these uncertain future benefits.
The financial managers second responsibility is to raise the money to pay for the
investment in real assets. This is the financing decision. When a company needs
financing, it can invite investors to put up cash in return for a share of profits or it
can promise investors a series of fixed payments. In the first case, the investor
receives newly issued shares of stock and becomes a shareholder, a part-owner
of the firm. In the second, the investor becomes a lender who must one day be
repaid. The choice of the longterm financing mix is often called the capital
structure decision, since capital refers to the firms sources of long-term
financing, and the markets for long-term financing are called capital markets. A
successful investment is one that increases firm value.
Financial Markets
The first time the firm sells shares to the general public is called the initial public
offering8, or IPO. A new issue of securities9 increases both the amount of cash
held by the company and the amount of stocks or bonds held by the public. Such
an issue is known as a primary issue and it is sold in the primary market10.
But in addition to helping companies raise new cash, financial markets also allow
investors to trade stocks or bonds between themselves. For example, Smith
might decide to raise some cash by selling her AT&T stock at the same time that
Jones invests his spare cash in AT&T. The result is simply a transfer of ownership
from Smith to Jones, which has no effect on the company itself. Such purchases
and sales of existing securities are known as secondary transactions and they
take place in the secondary market11.
------------------------------------------------------------------------------------------------------------------------------------The distinction between commercial banks and investment banks is narrowing.
For example, commercial banks may also be involved in new issues of securities,
while investment banks are major traders in options and futures. Invenstment
banks and commercial banks may even be owned by the same company; for
8 lk halka arz
9 Menkul kymetler ihrac
10 Market for the sale of new securities by corporations.
11 Market in which already issued securities are traded among investors.
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example, Salomon Smith Barney (an investment bank) and Citibank (a

commercial bank) are both owned by Citigroup.
Future Values and Compound Interest12
You have $100 invested in a bank account. Suppose banks are currently paying
an interest rate of 6 percent per year on deposits. So after a year, your account
will earn interest of $6:
Interest = interest rate x initial investment13 = .06 x $100 = $6
You start the year with $100 and you earn interest of $6, so the value of your
investment will grow to $106 by the end of the year.
Notice that the $100 invested grows by the factor (1 +.06) = 1.06. In general, for
any interest rate r, the value of the investment at the end of 1 year is (1 + r)
times the initial investment: Value after 1 year = initial investment x (1 + r) =
$100 x (1.06) = $106
What if you leave this money in the bank for a second year? Your balance, now
$106, will continue to earn interest of 6 percent. So Interest in Year 2 = .06 x
$106 = $6.36 $106 + $6.36 = $112.36
Value of account after 2 years = $100 x 1.06 x 1.06 = $100 x (1.06) 2 = $112.36
If you keep your money invested for a third year, your investment multiplies by
1.06 each year for 3 years. By the end of the third year it will total $100 x (1.06) 3
= $119.10
Clearly for an investment horizon of t year, the original $100 investment will grow
to $100 x (1.06)t. For an interest rate of r and a horizon of t years, the future
value of your investment will be:
Future value of $100 = $100 x (1 + r)t

Present Value
We have seen that $100 invested for 1 year at 6 percent will grow to a future
value of 100 x 1.06 = $106. Lets turn this around: How much do we need to
invest now in order to produce $106 at the end of the year? Financial managers
refer to this as the present value (PV) of the $106 payoff.
Future value is calculated by multiplying the present investment by 1 plus the
interest rate, 0.06, or 1.06. To calculate present value, we simply reverse the
process and divide the future value by 1.06:
Present Value = Future Value 1.06
= 106 1.06
= 100
In general, for a future value or payment t periods away, present value is:
12 Bileik faiz
13 lk yatrm, balangtaki yatrm
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Present Value = Future Value after t periods (1 +r)t

In this context the interest rate r is known as the discount rate and the present
value is often called the discounted value of the future payment. To calculate
present value, we discounted the future value at the interest r.
Suppose you need $3000 next year to buy a new computer. The interest rate is 8
percent per year. How much money should you set aside now in order to pay for
the purchase? Just calculate the present value at an 8 percent interest rate of a
$3000 payment at the end of one year. This value is:
3000 (1 + 0.08) = 2778
The longer the time before you must make a payment, the less you need to
invest today. For example, suppose that you can postpone buying that computer
until the end of 2 years. In this case we calculate the present value of the future
payment by dividing $3000 by (1.08)2 = 2572
------------------------------------------------------------------------------------------------------------------------------------You should never compare cash flows occurring at different times without first
discounting them to a common date. By calculating present values, we see how
much cash must be set aside today to pay future bills.
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