Buad 195 Chapter 1 Outline Page 1 of 7

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1 Buad 195 Chapter 1 Outline Page 1 of 7 Learning Objectives: To understand 1. the functions of financial management. 2. how businesses are financed. 3. the three forms of business, with emphasis on the corporate form. 4. how a corporation is formed, what its characteristics are, who the owners are and how they benefit from ownership. 5. the types of shares issued by a corporation, and their related dividends. 6. the retained earnings statement. 7. the ultimate goal of financial management within a corporation. Functions of Financial Management Financial management has to do with how a business obtains the funds required to operate, how it uses the funds, and how it uses the income it earns. External forces affect the decisions a business makes. Example 1: What are some recent events or trends that affect the decisions a business must make? Sources of Capital Businesses get their capital from two sources: 1. Owners The owners invest their own capital in the business. The profits made by the business belong to the owners. The two items above constitute equity capital. 2. Creditors The business may borrow from outsiders: this is called debt capital. A very important aspect of finance is the relative importance of debt and equity to the business. More debt means more risk will the company be able to generate enough income as a result of the borrowings to pay the interest on the debt and still be able to provide a return for the owners? Forms of Business Organization There are three forms: 1. Sole proprietorship Owned by a single person, who is personally liable for the debts of the business. Easy and inexpensive to form. The owner makes all of the decisions. 2. Partnership Owned by a more than one person, at least one of whom is personally liable for the debts of the business. Should have a partnership agreement, specifying the responsibilities of each partner, and how decisions will be made.

2 Buad 195 Chapter 1 Outline Page 2 of 7 3. Corporation A corporation is a legal entity that owns its own assets, files a tax return, can enter contracts, can sue and be sued. It is owned by its shareholders. The common shareholders elect a Board of Directors, who hire the management of the company. Advantages of the Corporate Form 1. Limited liability in the event of business failure, the shareholders lose only the amount they invested in the shares of the company. The shareholders other assets are safe from the company s creditors. Note that in practice small corporations usually cannot borrow without a personal guarantee of the shareholder(s), which largely negates this advantage. 2. Continuous existence Corporation keeps going even if only shareholder dies 3. Easily transferred ownership - Can buy and sell shares easily. Incorporation Process Incorporation is a legal process Must apply for a charter, adopt bylaws, and file an annual report This costs money in the form of legal fees. Common Shareholders The common shareholders are the owners can be any number from 1 to? Common shareholders rights: 1. The right to vote. 2. The right to receive dividends. 3. The right to a share of assets, in case of liquidation. 4. The right to sell shares to anyone Dividends A dividend is a distribution of retained earnings to a company s shareholders the corporate equivalent of drawings. For a dividend to be paid, it must first be declared by the Board of Directors of the company. The directors decide whether to declare a dividend, and how much it will be. Each share of a given class gets the same amount. In addition to having retained earnings, a company must have enough cash to pay the dividend.

3 Buad 195 Chapter 1 Outline Page 3 of 7 Preferred Shareholders Shareholders who buy preferred shares get two preferences (benefits) from holding this type of stock: o The annual dividend is fixed and must be paid in full before the common shareholders receive any dividend. o Upon liquidation, the preferred shareholders must receive all of their capital back, before common shareholders receive any capital back. In exchange for these two preferences, the preferred shareholders give up two rights that the common shareholders have: o The right to vote. o The right to participate in earnings growth of the company. They only get their fixed dividend. There are two basic types of preferred shares: o Non-cumulative preferred shareholders get their current year dividends before the common shareholders get any dividends. o Cumulative preferred shareholders get their current and all past unpaid dividends (dividends in arrears) before the common shareholders get any dividends. To the investor, preferred shares offer an investment with less risk and more certainty. Shareholders Equity This has two components: 1. Contributed capital the money invested by owners in the form of shares, both common and preferred. 2. Retained earnings the profits made and retained by a company. See page 37 for the shareholders equity section of a balance sheet for a corporation. Example 2: Write the journal entry to record declaration and payment of a dividend. The retained earnings statement has the same layout and purpose as the Statement of Owner s Equity which a proprietorship would prepare. Sample: XXX Company Ltd. Statement of Retained Earnings Year ended 31 December 20X3 Opening retained earnings $60,000 Plus net income (or minus net loss) 24,000 Less dividends declared 15,000 Closing retained earnings $69,000 The closing retained earnings is the amount that appears on the balance sheet.

4 Buad 195 Chapter 1 Outline Page 4 of 7 Example 3: Given the following trial balance, prepare a statement of retained earnings and the shareholders equity section of the balance sheet for Earnco Ltd. Example 4: Problem 1 (page 21) Example 5: Earnco Ltd. Trial Balance December 31, 20X1 Dr Cr Cash $ 1,000 Accounts receivable 500 Capital Assets 3,500 Accumulated amortization $ 500 Accounts payable 360 Mortgage payable 240 Dividends paid 500 Common stock 1,000 Retained earnings 3,000 Sales 900 Office expense 250 Insurance expense 150 Interest expense 100 Totals $ 6,000 $ 6,000 Bunkles Inc. was organized in 20X1. The incorporation documents permitted the company to issue unlimited numbers of common and preferred shares. In 20X1, 300,000 common shares were sold to the public for $20 a share, and 20,000 preferred shares were sold at $100 each. The preferred shares were entitled to a $10 cumulative dividend each year. During 20X1, 20X2 and 20X3, Bunkles earned a total of $1,400,000. The company did not pay any dividends in 20X1 or 20X2, but paid a dividend of $0.50 per share to the common shareholders in 20X3. Required: Prepare the shareholders' equity section of the balance sheet at the end of 20X3.

5 Buad 195 Chapter 1 Outline Page 5 of 7 Example 6: The shareholders' equity section of Toulouse Corporation appears below: $4.50 cumulative preferred shares, unlimited shares authorized, 40,000 issued and outstanding $2,000,000 Common shares, unlimited shares authorized, no par value, 400,000 shares issued and outstanding 3,000,000 Contributed capital 5,000,000 Retained earnings 2,500,000 Total shareholders' equity $7,500,000 a. What is the average issue price of the preferred shares? b. What is the average issue price of the common shares? c. What is the total amount of the annual dividends paid to preferred shareholders? d. If the company paid a total dividend of $500,000, how much would go to the common shareholders? e. What is the market price of each common share? f. Why would an investor buy preferred shares of this company? g. Why would an investor buy common shares of this company? h. This company has more contributed capital than retained earnings. Is this situation desirable? Discuss. The Goal of Financial Management Not simply maximizing profits, as a focus on short-term profits may mean long-term failure. Growth in profits requires growth in assets of the company, which may mean more financing, which increases risk. Many companies have failed because they grew at a rate they could not handle. The ultimate measure of performance is not what is earned, but how the owners (shareholders) value these earnings. It is the share value MAXIMIZATION OF SHAREHOLDER WEALTH that counts. If a decision increases the firm s value, and hence the wealth of the shareholders, it is likely acceptable. Decisions must be tempered by social responsibility and ethical standards in order for them to be in the best long-term interests of the business. Example 7 In 1996, an American television newsmagazine reported that clothing bearing the Kathie Lee Gifford label and sold in Wal-Mart Stores was produced by sweatshops in Honduras using child labour. Discuss how this labour policy would relate to the financial management objective of maximizing shareholder wealth. Required Reading Pages Maximizing Shareholder Wealth 6, 7 Management and Shareholder Wealth 8,9 Social Responsibility and Ethical Behaviour 9 12 Forms of Organization 13, 14 The Role of the Financial Markets 14, 15 only

6 Buad 195 Chapter 1 Outline Page 6 of 7 Assignment: 1. Johnson Inc began operations in 20X1. In that year, the company earned net income of $145,000 and paid dividends of $1.25 per share on each of its 30,000 outstanding common shares. Calculate retained earnings at the end of 20X1. 2. Continue with Johnson Inc. from #1. In the following year, Johnson incurred a loss of $127,000 and paid no dividends. Calculate retained earnings or deficit at the end of 20X2. 3. Blaine Corporation had $200,000 in retained earnings at the end of 20X2. It started the year with $100,000 of retained earnings. During 20X2, the company paid dividends of $20,000. Calculate the net income for the year. 4. Princess Company has the following shareholders' equity on its balance sheet: Shareholders' Equity Preferred shares, $9 cumulative, 4,000 issued and outstanding $400,000 Common shares, 50,000 issued and outstanding 2,600,000 Retained earnings 460,000 Total shareholders' equity $3,460,000 a. Calculate the total annual preferred dividend entitlement. b. Calculate the total amount of contributed capital. c. If the company paid total dividends of $120,000 in the year, and there were no preferred dividends owing from past years, how much did the common shareholders receive per share? d. Calculate the market price of the common shares. e. Which shareholders have the right to vote for the Board of Directors? 5. Suppose that Company X reported earnings of $100,000 and paid dividends of $40,000 in 20X1. What happened to the remainder? 6. Do Problem 2 (page 21) 7. Complete the True or False questions on the next page

7 Buad 195 Chapter 1 Outline Page 7 of 7 8. True or False? Corporations 1 The owner of a corporation is called a director The payment of business profits to the owners of a corporate business is known as drawings. A dividend is a distribution of retained earnings. The shareholders provide all of the financing for a corporation One of the advantages of investing in preferred shares is that you will always be paid your dividend. The members of the Board of Directors are elected by the owners of the corporation: that is, by the common and preferred shareholders. Both interest to the creditors and dividends to the preferred shareholders must be paid each year. A corporation is discontinued if the only shareholder dies. The market price of common shares is shown on the balance sheet. 10 If a corporation goes bankrupt, the common shareholders are required to pay the creditors from their own resources. 11 In a year of huge profits, the preferred shareholders can expect higher than normal dividends. 12 The balance in retained earnings represents the cumulative earnings of a company since its inception, less the total dividends paid out. 13 The main goal of a responsible financial manager is high profits. 14 Shareholders equity for a corporation consists of contributed capital and retained earnings.