1. Signed up for the FinanceProfessor Newsletter
2. Signed up for the Wall Street Journal
3. Posted one message on the class bulletin board introducing yourself
4. Read the first chapter.
5. Investigated variousfinance jobs both generically and  actually posted Finance jobs.
6. Learned about internships in Finance.
7. Decided that this is the most fun class you have EVER had.--It is Right??? 
8. Called home to tell your parents what a great class you have and to tell them you miss them!

	Finance is Fun!
	But Running is more fun! :-)  Check out Running and Fitness links here!

The way that a business is organized influences and is influenced by what it does.  Thus the first thing that we must do is to learn about the ways a business can be organized and the pros and cons of each organizational form. 

Types of Organizational Forms

Just to make sure you actually did read the above link, take a second and be sure you can answer the following:
(The answers are below so you can check your answers.)

Quick Quiz: 
1. What are the main types of organizational forms? 

2. Why are there different forms?

3. Most large firms are _____. 

4. What type of organizational form(s) have an unlimited life and are recognized as legal entities?

Stakeholders

No matter what organizational form a firm chooses, the firm has various stakeholders.  These are groups of people who have a stake in the firm.  For example: employees, managers (in Finance we generally distinguish between managers and employees even though obviously managers are also employees), customers, shareholders, creditors, and just about anyone else you can think of (suppliers, those that live in the area around the business, etc.).  For now this is all you need to know, but if you really want more, you can also check out my lesson of the week from a previous newsletter.

Conflicts of interest

Whenever people get together in any organization there will be disagreements.  This is also true in business.  For example a customer may want to pay very little for the product and the owners of the firm want to sell the product for a high price.  There are conflicts between all of the various stakeholders.  Much of what we do in Finance is to try to lessen these "conflicts" and to make sure everyone is on the same page.  (Gee, a nice sports analogy would fit here...If I weren't such a nice person I would probably say something about the Minnesota Vikings in 2001, but I won't)

Underlying all of the conflicts is the fact that everyone has different incentives and different desires.  To go back to sports for a second, imagine a highly paid wide receiver who wants the ball passed to him every play.  This may not be the best for the team as a whole.  It is the coach's job to make sure the players all work together in spite of their different incentives.  For this reason a good coach can make a big difference.  Similarly, in business a good manager can make a difference.  For this reason we will look at the manager-shareholder conflict first. 

In sports it is easy to identify the overall goal of the team.  It is to win.  In business there is a similar goal: maximize shareholder wealth.  (this is a fancy way of saying that the shareholders are the most important stakeholder). 

Why are shareholders so important? Several reasons: the classic answer is that the shareholders are the owners and have taken the biggest risk however I am not 100% sure if I agree with this.  For example, it is easy to imagine an employee who has much more at risk at a firm than a diversified shareholder. 

A much better reason why shareholders are so important is because they are the residual claimants (this is just a fancy way of saying they get paid last in the event of bankruptcy) and their maximum gain is unlimited, they are in the best position (have best incentives) to monitor the firm. 

Now hopefully some of you are at this point a bit upset--why should shareholders be #1?  Further, since shareholders are paid last, maximizing their returns in a world of efficient markets where everyone has perfect information implies that all the other claims have also being satisfied. Thus the implicit and explicit contracts that make up the "nexus of contracts" have all been satisfied. 

When there is not perfect information, things get murkier.  For example, suppose that to save money you wanted to dump toxic waste in the river (or cheat on your financial statements, fail to maintain your airplanes safely, put inferior meat in your hot dogs, etc.).  You know what you are doing it, but others do not.  Would you do it?  -If you need to stop and think about it for a while. 

BTW The idea that some people have superior information is called an information asymmetry.  You'll see that in the future as well.  :-)

This suggests that acting unethically may be good.  It is not.  Why?  Because sooner or later the information will get out and the market will impose a severe penalty.  THis happens time and time again.  Probably the most famous recent case of this was during late 2001 when some accounting problems effectively destroyed  Enron a firm who was once ne of the world's largest and most successful.  (be sure to read the Cliff Smith reading in the text.)  Your reputation (and this holds for both you as an individual or you as a  firm) is the most valuable asset you have, to act unethically sooner or later will catch up with you. (Can you thank of a college football coach who would agree?)

Of course it is not always quite so easy in practice.  Consider a case where you are dumping toxic wastes but it will take two years for anyone to find out.  In those two years you could make a bunch of money and be in your favorite South American country before it was discovered.  Does that change your thinking?  Hopefully not but it often does.  Because some people do give into the temptation, finance has come up with many ways to lessen this agency problem. 

For starters shareholders (and more importantly their representatives the board of directors), monitor managers.  If managers are not acting in shareholders best interests, the Board of Directors can (and often do) replace the managers.  (If the board does not do this, shareholders may elect a new board of directors to do so, but this is often time consuming and difficult). 

Monitoring is often very hard to do and expensive so it is often cheaper to align mangers incentives by paying them with market based pay (that is they get richer when the shareholders get richer).  The most common form of this pay in the past decade has been stock options.  These sometimes result in astronomically high pay plans ($100 million or more is not uncommon). 

Finally if the board of directors or the compensation plans are not enough to align incentives, then their is always the takeover market.  Poor management is often replaced as the result of a takeover. 

Super Short Summary:
Shareholders are most important, and if mangers don't act accordingly get rid of them.
 

Quick Quiz #2

1. What is the principle-agent problem?

2. Who are stakeholders?

3. What are three ways of controlling the priciple agent problem?
 
 
 

WARNING: Throughout the course we will come back to this idea of conflict quite a bit, so make sure you understand it.  (also in later finance classes you will focus on this idea again, so it probably will save you a lot of work if you get it now.  Don't believe me?  Check out the notes that I use in Finance 401 and Finance 402.) 
 

Answers to Quick Quiz #1.

1. Proprietorship, Partnerships, and Corporations.  Additionally there are many types of hybrid forms such as Limited Partnerships, LLCs, and S-Corporations. 

2.  Limited liability, the amount of financing that is needed, and taxes are the three main reasons for different types of forms

3.  Corporations

4. Corporations
 

Answers to Quick Quiz #2

1. The Principle-agent problem is that the agent (the manager) does not always do what the principle (the owner) want to be done.  This is also called an agency cost.

2. Stakeholders are people with a relationship with the firm.

3. Three ways to control agency costs: monitoring by the Board of directors, replacing the manegment and the board of directors, compensation that aligns management and shareholder incentives. 
 

Assignment:

Online Quiz 1 must be taken and submitted to FinanceProfessor@yahoo.com prior to class on Friday January 25,2002

Any questions?  Email me: JimMahar@FinanceProfessor.com