Having examined the field of finance and some of its more recent developments, let us turn our attention to the functions financial managers must perform. It is the responsibility of financial management to allocate funds to current and fixed assets, to obtain the best mix of financing alternatives, and to develop an appropriate dividend policy within the context of the firm’s objectives. These functions are performed on a day-to-day basis as well as through infrequent use of the capital markets to acquire new funds. The daily activities of financial management include credit management, inventory control, and the receipt and disbursement of funds. Less routine functions encompass the sale of stocks and bonds and the establishment of capital budgeting and dividend plans.

As indicated in Figure 1–1, all these functions are carried out while balancing the profitability and risk components of the firm.

Figure 1-1   Functions of the financial manager

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The appropriate risk-return trade-off must be determined to maximize the market value of the firm for its shareholders. The risk-return decision will influence not only the operational side of the business (capital versus labor or Product A versus Product B) but also the financing mix (stocks versus bonds versus retained earnings).

Forms of Organization

The finance function may be carried out within a number of different forms of organizations. Of primary interest are the sole proprietorship, the partnership, and the corporation.

Sole Proprietorship   The sole proprietorshipA form of organization that represents single-person ownership and offers the advantages of simplicity of decision making and low organizational and operating costs. form of organization represents single-person ownership and offers the advantages of simplicity of decision making and low organizational and operating costs. Most small businesses with 1 to 10 employees are sole proprietorships. The major drawback of the sole proprietorship is that there is unlimited liability to the owner. In settlement of the firm’s debts, the owner can lose not only the capital that has been invested in the business, but also personal assets. This drawback can be serious, and the student should realize that few lenders are willing to advance funds to a small business without a personal liability commitment.

The profits or losses of a sole proprietorship are taxed as though they belong to the individual owner. Thus if a sole proprietorship makes $25,000, the owner will claim the profits on his or her tax return. (In the corporate form of organization, the corporation first pays a tax on profits, and then the owners of the corporation pay a tax on any distributed profits.) Approximately 71 percent of the 25 million business firms in this country are organized as sole proprietorships, and these produce approximately 5 percent of the total revenue and 20 percent of the total profits of the U.S. economy.

Partnership   The second form of organization is the partnershipA form of ownership in which two or more partners are involved. Like the sole proprietorship, a partnership arrangement carries unlimited liability for the owners. However, there is only single taxation for the partners, an advantage over the corporate form of ownership., which is similar to a sole proprietorship except there are two or more owners. Multiple ownership makes it possible to raise more capital and to share ownership responsibilities. Most partnerships are formed through an agreement between the participants, known as the articles of partnershipAn agreement between the partners in a business that specifies the ownership interest of each, the methods of distributing profits, and the means for withdrawing from the partnership., which specifies the ownership interest, the methods for distributing profits, and the means for withdrawing from the partnership. For taxing purposes, partnership profits or losses are allocated directly to the partners, and there is no double taxation as there is in the corporate form.

Like the sole proprietorship, the partnership arrangement carries unlimited liability for the owners. While the partnership offers the advantage of sharing possible losses, it presents the problem of owners with unequal wealth having to absorb losses. If three people form a partnership with a $10,000 contribution each and the business loses $100,000, one wealthy partner may have to bear a disproportionate share of the losses if the other two partners do not have sufficient personal assets.

To circumvent this shared unlimited liability feature, a special form of partnership, called a limited partnershipA special form of partnership to limit liability for most of the partners. Under this arrangement, one or more partners are designated as general partners and have unlimited liability for the debts of the firm, while the other partners are designated as limited partners and are only liable for their initial contribution., can be utilized. Under this arrangement, one or more partners are designated general partners and have unlimited liability for the debts of the firm; other partners are designated limited partners and are liable only for their initial contribution. The limited partners are normally prohibited from being active in the management of the firm. You may have heard of limited partnerships in real estate syndications in which a number of limited partners are doctors, lawyers, and CPAs and there is one general partner who is a real estate professional. Not all financial institutions will extend funds to a limited partnership.

Corporation   In terms of revenue and profits produced, the corporation is by far the most important type of economic unit. While only 20 percent of U.S. business firms are corporations, over 85 percent of sales and over 60 percent of profits can be attributed to the corporate form of organization. The corporationA form of ownership in which a separate legal entity is created. A corporation may sue or be sued, engage in contracts, and acquire property. It has a continual life and is not dependent on any one stockholder for maintaining its legal existence. A corporation is owned by stockholders who enjoy the privilege of limited liability. There is, however, the potential for double taxation in the corporate form of organization: the first time at the corporate level in the form of profits, and again at the stockholder level in the form of dividends. is unique—it is a legal entity unto itself. Thus the corporation may sue or be sued, engage in contracts, and acquire property. A corporation is formed through articles of incorporationA document that establishes a corporation and specifies the rights and limitations of the business entity., which specify the rights and limitations of the entity.

A corporation is owned by shareholders who enjoy the privilege of limited liability, meaning their liability exposure is generally no greater than their initial investment.² A corporation also has a continual life and is not dependent on any one shareholder for maintaining its legal existence.

A key feature of the corporation is the easy divisibility of the ownership interest by issuing shares of stock. While it would be nearly impossible to have more than 10,000 or 20,000 partners in most businesses, a corporation may have several hundred thousand shareholders. For example, General Electric has 10.6 billion shares of common stock outstanding and 660,000 shareholders, and Microsoft with 10.7 billion shares outstanding has 142,000 shareholders. Both corporations have close to 60 percent of their shares held by institutional investors, but GE has many more small investors than Microsoft, which accounts for the large difference in number of shareholders.

The shareholders’ interests are ultimately managed by the corporation’s board of directors. The directors may include key management personnel of the firm as well as directors from outside the firm. Directors serve in a fiduciary capacity for the shareholders and may be liable for the mismanagement of the firm. After the collapse of corporations such as Enron and WorldCom due to fraud, the role of outside directors became much more important and corporations were motivated to comply with more stringent corporate governance laws mandated by Congress. Outside directors may make from $5,000 per year for serving on the board of small companies to $75,000 to $150,000 per year for serving on the board of large companies such as General Electric. GE pays additional fees for outside directors who chair or are on the audit, the management development, and compensation committees.

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Because the corporation is a separate legal entity, it reports and pays taxes on its own income. As previously mentioned, any remaining income that is paid to the shareholders in the form of dividends will require the payment of a second tax by the shareholders. One of the key disadvantages to the corporate form of organization is this potential double taxation of earnings. In 2003, Congress diminished part of this impact by lowering the maximum tax rate on dividends from 38.6 percent to 15 percent.

There is, however, one way to completely circumvent the double taxation of a normal corporation and that is through formation of a Subchapter S corporation. With a Subchapter S corporationA special corporate form of ownership, in which profit is taxed as direct income to the stockholders and thus is only taxed once, as would be true of a partnership. The stockholders still receive all the organizational benefits of a corporation, including limited liability. The Subchapter S designation can apply only to corporations with up to 75 stockholders., the income is taxed as direct income to the stockholders and thus is taxed only once as normal income, similar to a partnership. Nevertheless, the shareholders receive all the organizational benefits of a corporation, including limited liability. The Subchapter S designation can apply to corporations with up to 75 stockholders.³

While the proprietorship, traditional partnership, and various forms of limited partnerships are all important, the corporation is given primary emphasis in this text. Because of the all-pervasive impact of the corporation on our economy, and because most growing businesses eventually become corporations, the effects of most decisions in this text are often considered from the corporate viewpoint.

³If there are more than 75 investors, a master limited partnership can be formed in which there is limited liability and single taxation of owners.