Foundations of Financial Management: An Analysis (part 1)

Surplus wealth is a sacred trust which its possessor is bound to administer in his lifetime for the good of the community.

Andrew Carnegie

 The Goals and Functions of Financial Management

by

Charles Lamson

 Corporation

In terms of revenue and profits produced, the corporation is by far the most important type of economic unit. While only 5% of business firms are corporations, 62% of revenues can be attributed to the corporate form of organization (Tax Foundation). The corporation 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 incorporation, 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. 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 50 or a hundred partners in most businesses, a corporation may have more than a million shareholders.

The shareholders' interests are ultimately managed by the corporation's board of directors. The directors, who may include key management personnel of the firm as well as outside directors not permanently employed by it, serve in a stewardship capacity and may be liable for the mismanagement of the firm or for the misappropriation of funds. Outside directors of large public corporations may be paid more than $50,000 a year to attend meetings and participate in important decisions (Block & Hirt, 2005, Foundations of Financial Management, 11th ed., p. 9). At the high end you could earn seven figures: former AOL CEO, Jonathan Miller earned more than $1 million in 2015 for sitting on 8 corporate boards (Investopedia), and former Merk & Co. CEO, P. Roy Vagelos, earned more than $20 million, mainly in stock options, as a chairman of a single board in 2014, the Boston Globe reports (Sacha Pfeiffer & Todd Wallack, Dec. 2, 2015, BostonGlobe.com).

Because the corporation is a separate legal entity, it reports and pays taxes on its own income. 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. The tax rate on qualified dividends is 0%, 15%, or 20%, depending on your taxable income and filing status. The tax rate on nonqualified dividends is the same as your tax bracket. In both cases, people in higher tax brackets pay a higher dividend tax rate (Orem, T., July 31, 2020, Dividend Tax Rate 2020, nerdwallet.com).

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 corporation, 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.

While the proprietorship, traditional partnership, and various forms of limited partnerships are all important, the corporation is given primary emphasis in this analysis. 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 analysis are often considered from the corporate viewpoint. 

Corporate Governance

As we learned in the previous section, the corporation is governed by the board of directors, led by the chairman of the board. In most companies the chairman of the board is also the CEO or Chief Executive Officer of the company.

The issues of corporate governance are really agency problems. Agency theory examines the relationship between the owners and the managers of the firm. In privately owned firms, management and owners are usually the same people. Management operates the firm to satisfy its own goals, needs, financial requirements, and the like. However, as a company moves from private to public ownership, management now represents all the owners. This places management in the agency position of making decisions that will be in the best interests of all shareholders. Because of diversified ownership interests, conflicts between managers and shareholders can arise that impact the financial decisions of the firm. When the chairman of the board is also the chief executive of the firm, stockholders recognize that the executive may act in his or her own best interests rather than those of the stockholders of the firm.

Because institutional investors such as pension funds and mutual funds own a large percentage of stock in major U.S. companies, these investors are having more to say about the way publicly-owned corporations are managed. As a group they have the ability to vote large blocks of shares for the election of a board of directors. The threat of their being able to replace poorly-performing boards of directors makes institutional investors quite influential. Since pension funds and mutual funds represent individual workers and investors, they have a responsibility to see that firms are managed in an efficient and ethical way. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 9-11*

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