Walter knows the result of the equation “sales-expenses = profits” can be found on the:

I need discussion/talk about chapter 1 no less than 2, discussion/talk for each chapter and no less than 100 words for each discussion/talk will ask to change word count at any time. Discuss/talk about what was interesting about chapter, summary of chapter or any kind of discussion from chapter. Due in 24 hours or less.

Ch1

introduction to

financial management

Do you know: What finance entails? How financial management functions within the business world? Why you might benefit from studying financial principles? This chapter is the ideal place to get answers to those questions. Finance is the study of applying specific valueto things we own, services we use, and decisions we make. Examples are as varied as shares of stock in a company, payments on a home mortgage, the purchase of an entire firm, and the personal decision to retire early. In this text, we focus primarily on one area of finance, financial management, which concentrates on valuing things from the perspective of a company, or firm.

Financial management is critically important to the success of any business organization, and throughout the text we concentrate on describing the key financial concepts in corporate finance. As a bonus, you will find that many tools and techniques for handling the financial management of a firm also apply to broader types of financial problems, such as personal finance decisions.

In finance, cash flow is the term that describes the process of paying and receiving money. It makes sense to start our discussion of finance with an illustration of various financial cash flows. We use simple graphics to help explain the nature of finance and to demonstrate the different subareas of the field of finance.

After we have an overall picture of finance, we will discuss four important variables in the business environment that can and do have significant impact on the firm’s financial decisions. These are (1) the organizational form of the business, (2) the agency relation ship between the managers and owners of a firm, (3) ethical considerations as finance is applied in the real world, and (4) the source and implications of the current financial crisis.

LEARNING GOALS

LG1-1

Define the major areas of finance as they apply to corporate financial management.

LG1-2

Show how finance is at the heart of sound business decisions.

LG1-3

Learn the financial principles that govern your personal decisions.

LG1-4

Examine the three most common forms of business organization in the United States today.

LG1-5

Distinguish among appropriate and inappropriate goals for financial managers.

LG1-6

Identify a firm’s primary agency relationship and discuss the possible conflicts that may arise.

LG1-7

Discuss how ethical decision making is part of the study of financial management.

LG1-8

Describe the complex, necessary relationships among firms, financial institutions, and financial markets.

LG1-9

Explain the fundamental causes of the financial crisis that started in 2006.

viewpoints

business APPLICATION

Caleb has worked very hard to create and expand his juice stand at the mall. He has finally perfected his products and feels that he is offering the right combination of juice and food. As a result, the stand is making a nice profit. Caleb would like to open more stands at malls all over his state and eventually all over the country.

Caleb knows he needs more money to expand. He needs money to buy more equipment, buy more inventory, and hire and train more people. How can Caleb get the capital he needs to expand?

Page 4FINANCE IN BUSINESS AND IN LIFE LG1-1

As you begin this course, what is your first impression of the world of finance? No doubt you’ve experienced the current economic recession firsthand and read, perhaps in detail, about the financial crisis that peaked in the fall of 2008. An understanding of cause, effect, and future impact will be important as we go forward, so please see the nearby Finance at Work reading and the section on the financial crisis at the end of this chapter for brief background information and some analyses to set the stage for more complete explanations to come. But setting aside thoughts of recession and indulging in a quick look at popular culture, you’ll recognize that other influences have been at work for some time. Your opinions already may have been negatively skewed by entertainment. Many movies have portrayed finance professionals as greedy and unethical (see, for example, Wall Street, 1987; Barbarians at the Gate, 1993; Boiler Room, 2000; and Wall Street: Money Never Sleeps, 2010). While colorful characters make for good entertainment, fictional depictions do not reflect reality when it comes to what finance professionals actually do and how they contribute to society. The more you study managerial finance, the more you’ll appreciate this discipline’s broad potential to power the managerial decision making that moves our economy forward.

And what exactly makes up this engine of financial decision making? Successful application of financial theories helps money flow from individuals who want to improve their financial future to businesses that want to expand the scale or scope of their operations. These exchanges lead to a growing economy and more employment opportunities for people at all income levels. So, two important things result from this simple exchange: the economy will be more productive as a result, and individuals’ wealth will grow into the future.

In this first section, we develop a comprehensive description of finance and its subareas, and we look at the specific decisions that professionals in each subarea must make. As you will see, all areas of finance share a common set of ideas and application tools.

What Is Finance?

To get the clearest possible picture of how finance works, let’s begin by grouping all of an economy’s participants along two dimensions. The first dimension is made up of those who may have “extra” money (i.e., money above and beyond their current spending needs) for investment. The second dimension is made up of those who have an ability to develop viable business ideas, a sense of business creativity. Both money and ideas are fuel for the financial engine. In our simple model, these two dimensions result in four groups representing economic roles in society, as shown in Figure 1.1 . Of course, people can move from one group to another over time.

Type 1 people in our model do not lend significant sums of money (capital) or spend much money in a business context, so they play no direct role in financial markets , the mechanisms by which capital is exchanged. Although these people probably play indirect roles by providing labor to economic enterprises or by consuming their products, for simplicity we focus on those who play direct roles. Therefore, type 1 participants will be asked to step aside.

FIGURE 1.1 Participants in Our Hypothetical Economy

Four groups form according to the availability of money and ideas.

Page 5personal APPLICATION

Dagmar is becoming interested in investing some of her money. However, she has heard about several corporations in which the investors lost all of their money. In the past decade, Dagmar has heard that Lehman Brothers (2008), Chrysler (2009), and Six Flags (2009) have all filed for bankruptcy. These firms’ stockholders lost their entire investments in these firms.

Many of the stockholders who lost money were employees of these companies who had invested some of their retirement money in the company stock. Dagmar wonders what guarantee she has as an investor against losing her money.

What is the best way for Dagmar to ensure a happy retirement? Scan the QR code for an extended look. Turn to the back of the book for solutions to these applications.

Type 4 people use financial tools to evaluate their own business concepts and then choose the ideas with the most potential. From there, they create their own enterprises to implement their best ideas efficiently and effectively. Type 4 individuals, however, are self-funded and do not need financial markets. The financial tools they use and the types of decisions they make are narrowly focused or specific to their own purposes. For our discussion, then, type 4 individuals also are asked to move to the sidelines.

Now for our financial role players, the type 2 and type 3 people. Financial markets and financial institutions allow these people to participate in a mutually advantageous exchange. Type 2 people temporarily lend their money to type 3 people, who put that money to use with their good business ideas.

In most developed economies, type 2 participants are usually individual investors . You will likely be an individual investor for most of your life. Each of us separately may not have a lot of extra money at any one time, but by aggregating our available funds, we can provide sizable amounts for investment.

FIGURE 1.2 Capital Flow from Investors to Companies

Investors are people or groups who need ideas to make more money, and companies are groups who need money to develop the ideas they do have.

Type 3 participants, the idea generators, may be individuals, but they are more commonly corporations or other types of companies with research and development (R&D) departments dedicated to developing innovative ideas. It’s easy to see that investors and companies can help one another. If investors lend their “extra” capital to companies, as shown in Figure 1.2 , then companies can use this capital to fund expansion projects. Economically successful projects will eventually be able to repay the money (plus profit) to investors, as Figure 1.3 shows.

Of course, not all of the cash will return to the investors. In reality, sources of friction arise in this system, and the amount of capital returned to investors is reduced. Two primary sources of friction are retained earnings , which are basically funds the firm keeps for its ongoing operations, and taxes, which the government imposes on the company and individuals to help fund public services. Figure 1.4 shows an analysis of cash flows with the associated retained earnings and tax payments. In a very simple way, this figure provides an intuitive overall explanation of finance and of its major subareas. For example, individuals must assess which investment opportunities are right for their needs and risk tolerance; financial institutions and markets must efficiently distribute the capital; and companies must evaluate their potential projects and wisely decide which projects to fund, what kind of capital to use, and how much capital to return to investors. All of these types of decisions deal with the basic cash flows of finance shown in Figure 1.4 , but from different perspectives.

finance The study of applying specific value to things we own, services we use, and decisions we make

financial management The process for and the analysis of making financial decisions in the business context.

financial markets The places and processes that facilitate the trading of financial assets between investors.

investors Those who buy securities or other assets in hopes of earning a return and getting more money back in the future.

retained earnings The portion of company profits that are kept by the company rather than distributed to the stockholders as cash dividends.

FIGURE 1.3 Return of Capital to Investors

In this basic process, the company can expand its business, hire more employees, and create a promising future for its own growth. Meanwhile, the investor can increase wealth for the future.

Page 6finance at work //:markets

The Financial Crisis: Introduction and Overview

At the time of this writing, the world economy has been reeling for over six years from the effects of the worst financial crisis since the Great Depression of the 1930s. By mid-March 2009, the Dow Jones Industrial Average (DJIA) had fallen in value 53.8 percent in less than 1½ years’ time, larger than the decline during the market crash of 1937–1938 when it fell 49 percent. Though the Dow has since recovered much of those losses, the markets continue to be very volatile and unsettled: On May 6, 2010, just after 2:30 pm EST, the Dow plunged by 998.50 points, a loss of 9.2 percent and the biggest one-day fall ever.

The commonly accepted cause of the crisis was the collapse of U.S. home prices in late 2006 and early 2007, but the problem has since spread to affect every part of the economy: The investment banking industry saw the failure or acquisition of all but two of its major firms (Goldman Sachs and Morgan Stanley), and these two firms converted to commercial bank holding companies (i.e., banks much like your neighborhood bank that tend to be safer and less profitable than investment banks). AIG, one of the largest insurance companies in the United States, survived only because of a federal government bailout. Commercial banking giant Citigroup required a massive government guarantee against losses and an injection of cash to prevent failure. The crisis spread internationally, too. Real estate markets fell in many countries across the world. The crisis had a profound impact on the financial health of banks, especially in Europe. In 2010, the unemployment rate had risen to over 10 percent. By 2012, it was still over 8 percent.

The exact mechanisms by which falling home prices led to such dramatic changes in the economic landscape are complicated and have yet to be covered in this book, so we will delay an in-depth discussion of the crisis until later, but we did feel that this is a good place to touch upon the ways that the fallout from the financial crisis are going to affect you, the student, in the years and decades to come.

First, those of you who hoped to fund your education with student loans may be finding it difficult to obtain such loans, especially at favorable rates. If so, thank the financial crisis: Lenders are much more leery about lending money due to the uncertain economic future they (and you, in your hopeful future employment) face. (And we won’t even get into the whole idea of your parents taking out a home equity loan to help you through. . .)

Second, as you’ve no doubt noticed, jobs are scarce, primarily due to companies’ uncertainty about the future. We expect it to stay this way for a while, though the impending retirement of the baby boomers will eventually benefit you.

Third, once you do make it through school and start your career, you may want to hold off on buying a home for a while. Most of the reasons are probably obvious, but compounding the uncertainty about being able to eventually unload any house you buy is the fact that lenders have greatly cut back on the availability of credit, asking for substantial down payments and loan servicing fees when they do lend.

By now, you’re probably starting to wonder if you missed the part about Eeyore (the gloomy donkey in the Winnie-the-Pooh books) being one of the coauthors of this book. Don’t despair: The current financial crisis does have potential silver linings to offer to those who are prepared and educated enough to take advantage of them.

After the extent of the crisis had started to become evident to everyone, one of the authors of this book was asked by a television reporter, “Why would anyone want to study finance now?!?! ” Well, on the one hand, and in the words of the Spanish-born American philosopher and poet George Santayana, “Those who do not learn from history are doomed to repeat it.” You really don’t want to go through this type of thing again, do you?

Another reason to study finance is that some of those silver linings we referred to are beginning to peek through the clouds: For example, in the aftermath of the crisis, more firms in general (and financial institutions in particular) are much more focused on the concepts of measuring and managing risks than ever before, and to effectively do so they need a trained and informed workforce.

Want to know more?

Key Words to Search for Updates: housing bubble, subprime lending, mortgage-backed securities, AIG, Countrywide Financial

Page 7

FIGURE 1.4 The Complete Cash Flows of Finance

All the subareas of the financial system interact, with retained earnings and taxes playing a role in the flows.

Subareas of Finance

Investments is the subarea of finance that involves methods and techniques for making decisions about what kinds of securities to own (e.g., bonds or stocks), which firms’ securities to buy, and how to pay the investor back in the form that the investor wishes (e.g., the timing and certainty of the promised cash flows). Figure 1.5 models cash flows from the investor’s perspective. The concerns of the investments subarea of finance are shown (with the movement of red arrows) from the investor’s viewpoint (seen as the blue box).

FIGURE 1.5 Investments

Investors mark the start and end of the financial process; they put money in and reap the rewards (or take the risk).

Financial management is the subarea that deals with a firm’s decisions in acquiring and using the cash that is received from investors or from retained earnings. Figure 1.6 depicts the financial management process very simply. As we know, this text focuses primarily on financial management. We’ll see that this critical area of finance involves decisions about:

• How to organize the firm in a manner that will attract capital.

• How to raise capital (e.g., bonds versus stocks).

• Which projects to fund.

• How much capital to retain for ongoing operations and new projects.

• How to minimize taxation.

• How to pay back capital providers.

All of these decisions are quite involved, and we will discuss them throughout later chapters.

Financial institutions and markets make up another major subarea of finance. These two dynamic entities work in different ways to facilitate capital flows between investors and companies. Figure 1.7 illustrates the process in which the firm acquires capital and investors take part in ongoing securities trading to increase that capital. Financial institutions, such as banks and pension administrators, are vital players that contribute to the dynamics of interest rates.

FIGURE 1.6 Financial Management

Financial managers make decisions that should benefit both the company and the investor.

investments The analysis and process of choosing securities and other assets to purchase.

financial institutions and markets The organizations that facilitate the flow of capital between investors and companies.

Page 8

FIGURE 1.7 Financial Institutions and Markets

Financial institutions and markets facilitate the flows of money between investors and companies.

International finance is the final major subarea of finance we will study. As the world has transformed into a global economy, finance has had to become much more innovative and sensitive to changes in other countries. Investors, companies, business operations, and capital markets may all be located in different countries. Adapting to this environment requires understanding of international dynamics, as Figure 1.8 shows. In the past, international financial decisions were considered to be a straightforward application of the other three financial subareas. But experience has shown that the uncertainty about future exchange rates, political risk, and changing business laws across the globe adds enough complexity to these decisions to classify international finance as a subarea of finance in its own right.

Application and Theory for Financial Decisions

Cash flows are neither instantaneous nor guaranteed. We need to keep this in mind as we begin to apply finance theory to real decisions. Future cash flows are uncertain in terms of both timing and size, and we refer to this uncertainty as risk . Investors experience risk about the return of their capital. Companies experience risk in funding and operating their business projects. Most financial decisions involve comparing the rewards of a decision to the risks that decision may generate.

Risk tolerance varies among individuals.

Comparing rewards with risks frequently involves assessing the value today of cash flows that we expect to receive in the future. For example, the price of a financial asset , something worth money, such as a stock or a bond, should depend on the cash flows you expect to receive from that asset in the future. A stock that’s expected to deliver high cash flows in the future will be more valuable today than a stock with low expected future cash flows. Of course, investors would like to buy stocks whose market prices are currently lower than their actual values. They want to get stocks on sale! Similarly, a firm’s goal is to fund projects that will give them more value than their costs.

Most financial decisions involve comparing the rewards of a decision to the risks that decision may generate.

Page 9

FIGURE 1.8 International Finance

Laws, risks, and business relationships are variable across different countries but can interact profitably.

Financial assets are normally grouped into asset classes according to their risk and return characteristics. The most commonly accepted groups of asset classes are stocks, bonds, money market instruments, real estate, and derivative securities, all of which we will discuss in more detail later in the book. As the risk and return profiles of each of these asset classes differ widely between classes, the mathematical models, terminology, and expertise of each class tend to be very specialized and trading tends to happen in distinct, separate financial markets for each asset class.

Despite the large number of stories about investors who’ve struck it rich in the stock market, it’s actually more likely that a firm will find “bargain” projects, projects that may yield profit for a reasonable investment, than investors will find under-priced stocks. Firms can find bargains because business projects involve real assets trading in real markets (markets in tangible assets). In the real environment, some level of monopoly power, special knowledge, and expertise possibly can make such projects worth more than they cost. Investors, however, are trading financial assets in financial markets, where the assets are more likely to be worth, on average, exactly what they cost.

time out!

1-1 What are the main subareas of finance and how do they interact?

The method for relating expected or future cash flows to today’s value, called present value, is known as time value of money (TVM) . Chapters 4 and 5 cover this critical financial concept in detail and apply it to the financial world (as well as daily life). Since the expected cash flows of either a business project or an investment are likely to be uncertain, any TVM analysis must account for both the timing and the risk level of the cash flows.

Finance versus Accounting

In most companies, the financial function is usually closely associated with the accounting function. In a very rough sense, the accountant’s job is to keep track of what happened in the past to the firm’s money, while the finance job uses these historical figures with current information to determine what should happen now and in the future with the firm’s money. The results of financial decisions will eventually appear in accounting statements, so this close association makes sense. Nevertheless, accounting tends to focus on and characterize the past, while finance focuses on the present and future.

THE FINANCIAL FUNCTION LG1-2

As we said previously, this text focuses primarily on financial management, so we will discuss the particular functions and responsibilities of the firm’s financial manager. We will also explain how the financial function fits in and interacts with the other areas of the firm. Finally, to make this study as interesting and as relevant as possible, we will make the connections that allow you to see how the concepts covered in this book are important in your own personal finances.

international finance The use of finance theory in a global business environment.

risk A potential future negative impact to value and/or cash flows. It is often discussed in terms of the probability of loss and the expected magnitude of the loss.

financial asset A general term for securities like stocks, bonds, and other assets that represent ownership in a cash flow.

asset classes A group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations.

real assets Physical property like gold, machinery, equipment, or real estate.

real markets The places and processes that facilitate the trading of real assets.

time value of money (TVM) The theory and application of valuing cash flows at various points in time.

The Financial Manager

The firm’s highest-level financial manager is usually the chief financial officer, or CFO. Both the company treasurer and the Page 10controller report to the CFO. The treasurer is typically responsible for:

• Managing cash and credit.

• Issuing and repurchasing financial securities such as stocks and bonds.

• Deciding how and when to spend capital for new and existing projects.

• Hedging (reducing the firm’s potential risk) against changes in foreign exchange and interest rates.

In larger corporations, the treasurer may also oversee other areas, such as purchasing insurance or managing the firm’s pension fund investments. The controller oversees the accounting function, usually managing the tax, cost accounting, financial accounting, and data processing functions.

Finance in Other Business Functions

Although the CFO and treasurer positions tend to be the firm’s most visible finance-related positions, finance affects the firm in many ways and throughout all levels of a company’s organizational chart. Finance permeates the entire business organization, providing guidance for both strategic and day-to-day decisions of the firm and collecting information for control and feedback about the firm’s financial decisions. Operational managers use finance daily to determine how much overtime labor to use, or to perform cost/benefit analysis when they consider new production lines or methods. Marketing managers use finance to assess the cost effectiveness of doing follow-up marketing surveys. Human resource managers use finance to evaluate the company’s cost for various employee benefit packages. No matter where you work in business, finance can help you do your job better.

Finance in Your Personal Life LG1-3

Finance can help you make good financial decisions in your personal life. Consider these common activities you will probably face in your life:

• Borrowing money to buy a new car.

• Refinancing your home mortgage at a lower rate.

• Making credit card or student loan payments.

• Saving for retirement.

You will be able to perform all of these tasks better after learning about finance. Recent changes throughout our economy and the U.S. business environment make knowledge of finance even more valuable to you than before. For example, most companies have switched from providing defined benefit retirement plans to employees to offering defined contribution plans (such as 401k plans) and self-funded plans like Individual Retirement Accounts (IRAs) . Tax changes in the early 1980s made this switch more or less inevitable. It appears that each of us will have to ensure adequate funds for our own retirement—much more so than previous generations.

defined benefit plan A retirement plan in which the employer funds a pension generally based on each employee’s years of service and salary.

defined contribution plan A retirement plan in which the employee contributes money and directs its investment. The amount of retirement benefits are directly related to the amount of money contributed and the success of its investment.

401k plan A defined contribution plan that is sponsored by corporate employers.

Individual Retirement Account (IRA) A self-sponsored retirement program.

sole proprietorship A business entity that is not legally separate from its owner

EXAMPLE 1-1

Finance Applications LG1-3

Scan the code or log in to Connect for access to the interactive guided examples

Chloe realizes how important finance will be for her future business career. However, some of the ways that she will see financial applications seem way off in the future. She is curious about how the theory applies to her personal life, both in the near term and in the long term.

SOLUTION:

Chloe will quickly find that her financial health now and in the future will depend upon many decisions she makes as she goes through life—starting now! For example, she will learn that the same tools that she applies to a business loan analysis can be applied to her own personal debt. After this course, Chloe will be able to evaluate credit card offers and select one that could save her hundreds of dollars per year. When she buys a new car and the dealership offers her a low-interest-rate loan or a higher-rate loan with cash back, she will be able to pick the option that will truly cost her the least. Also, when Chloe gets her first professional job, she will know how to direct her retirement account so that she can earn millions of dollars for her future. (Of course, inflation between now and when she retires will imply that Chloe’s millions won’t be worth as much as they would today.)

Page 11

time out!

1-2 How might the application of finance improve your professional and personal decisions?

BUSINESS ORGANIZATION LG1-4

In the United States, people can structure businesses in any of several ways; the number of owners is the key to how business structures are classified. Traditionally, single owners, partners, and corporations operate businesses. We can express the advantages and disadvantages of each organizational form through several dimensions:

• Who controls the firm.

• Who owns the firm.

• What are the owners’ risks.

• What access to capital exists.

• What are the tax ramifications.

Recently, small businesses have adopted hybrid structures that capture the benefits from multiple organizational forms, and we’ll discuss those hybrid structures after we cover the more common, traditional types of business organizations.

“The owner, or sole proprietor, of the business has complete control of the firm’s activities. The owner also receives all of the firm’s profits and is solely responsible for all losses.”

Venture capital helped Starbucks become a success story.

Sole Proprietorships

The sole proprietorship represents, by far, the most common type of business in the United States. 1 A sole proprietorship is defined as any unincorporated business owned by a single individual. 2 Perhaps these businesses are so popular because they are relatively easy to start, and they’re subject to a much lighter regulatory and paperwork burden than other business forms. The owner, or sole proprietor, of the business has complete control of the firm’s activities. The owner also receives all of the firm’s profits and is solely responsible for all losses.

The biggest disad vantage that sole proprietor-ships carry relative to other organizational forms is that they have unlimited liability for their companies’ debts and actions. The owner’s personal assets may be confiscated if the business fails. The law recognizes no distinction between the owner’s business assets and personal assets. The income of the business is also added to the owner’s personal income and taxed by the government at the appropriate personal tax rate. Finally, sole proprietors have a difficult time obtaining capital to expand their business operations. Banks and other lenders are not typically interested in lending much money to sole proprietors because small firms have only one person liable for paying back the debt. A sole proprietor could raise capital by issuing equity to another investor. Angel investors and venture capitalists exchange capital for ownership in a business. But this requires re-forming the business as a partnership and the sole proprietor must give up some of the ownership (and thus control) of the firm. Table 1.1 summarizes sole proprietorships’ characteristics, along with those of the three other business organizations we will study.

unlimited liability A situation in which a person’s personal assets are at risk from a business liability.

equity An ownership interest in a business enterprise.

angel investors Individuals who provide small amounts of capital and expert business advice to small firms in exchange for an ownership stake in the firm.

venture capitalists Similar to angel investors except that they are organized as groups of investors and can provide larger amounts of capital.

Page 12Partnerships

A general partnership , or as it is more commonly known, a partnership, is an organizational form that features multiple individual owners. Each partner can own a different percentage of the firm. Firm control is typically determined by the size of partners’ ownership stakes. Business profits are split among the partners according to a prearranged agreement, usually by the percentage of firm ownership. Received profits are added to each partner’s personal income and taxed at personal income tax rates.

The partners jointly share unlimited personal liability for the debts of the firm and all are obligated for contracts agreed to by any one of the partners. Banks are more willing to lend to partnerships than to sole proprietorships, because all partners are liable for repaying the debt. Partners would have to give up some ownership and control in the firm to raise more equity capital. In order to raise enough capital for substantial growth, a partnership often changes into a public corporation.

Corporations

A public corporation is a legally independent entity entirely separate from its owners. This independence dramatically alters the firm’s characteristics. Corporations hold many rights and obligations of individual persons, such as the ability to own property, sign binding contracts, and pay taxes. Federal and state governments tax corporate income once at the corporate level. Then shareholders pay taxes again at the personal level when corporate profits are paid out as dividends. This practice is generally known as double taxation .

Corporate owners are stockholders, also called shareholders. Public corporations typically have thousands of stockholders. The firm must hire managers to direct the firm, since thousands of individual shareholders could not direct day-to-day operations under any sort of consensus. As a result, managers control the company. Strong possibilities of conflicts of interests arise when one group of people owns the business, but another group controls it. We’ll discuss conflicts of interest and their resolution later in the chapter.

As individual legal entities, corporations assume liability for their own debts, so the shareholders have only limited liability . That is, corporate shareholders cannot lose more money than they originally paid for their shares of stock. This limited liability is one reason that many people feel comfortable owning stock. Corporations are thus able to raise incredible