Marty Kimble, who “retired” many years ago after winning a huge lottery jackpot, wants to start a new company that will sell authentic sports memorabilia. He plans to name the company Pro Athlete Remembrances, or PAR for short. Marty is still in the planning stages, so he has a few questions about how PAR should be organized when he starts the business and what he should do if the company becomes very successful in the future. Marty has little knowledge of finance concepts. To answer his questions and learn more about finance in general, Mr. Kimble has hired Sunshine Business Consultants (SBC). Assume that you are a new employee of SBC and your boss has asked you to answer the following questions for Mr. Kimble.

Question

a. What is finance? Why is the finance function important to the success of a business?
b. Why is it important for persons who work in other areas in a business to have an understanding of finance? Do you think it is more important for Marty Kimble to have a basic understanding of all the areas in a business than a person who works for a large national corporation?
c. What are the alternative forms of business organization? What are the advantages and disadvantages of each?
d. What form of business organization do you recommend that Mr. Kimble use when starting PAR? Why?
e. Assume that PAR is organized as a proprietorship when it starts business. If PAR becomes extremely successful and grows substantially, would you recommend that Mr. Kimble change the business organization to either a partnership or a corporation? Explain your answer.
f. What goal should Mr. Kimble pursue when operating PAR?
g. Assume that PAR is organized as a proprietorship when it starts business and that Mr. Kimble plans to convert the business to a corporation at some point in the future. What are some potential problems that Mr. Kimble as one of the owners might face after converting to a corporation? Discuss some solutions to these potential problems.
h. Mr. Kimble would like PAR to grow so that at some point in the future the company can conduct business in other countries. Why do firms “go global”?
i. Discuss any differences and problems that Mr. Kimble should be aware of when conducting business in foreign markets.

Answer 1

a. Finance deals with decisions about money—that is, how money is raised and used by companies and individuals. Because value is based on cash flows, finance is integral to the successful operations of a firm. To be successful, a firm needs to understand how to raise funds, how much it costs to use investors’ money, and how to appropriately invest funds.

b. Everyone deals with financial decisions, both in business and in their personal lives. For this reason, and because there are financial implications in nearly every business-related decision, it is important that everyone has at least a general knowledge of financial concepts so that they can make informed decisions about money. Marty should be especially knowledgeable in finance, because he is a one-person operation—he is the person who makes the financial decisions for his firm.

c. The three main forms of business organization are the proprietorship, the partnership, and the corporation. Although proprietorships and partnerships are easy to start, the major disadvantage to these forms of business is that the owners have unlimited personal liability for the debts of the businesses. On the other hand, a corporation is more difficult to start than the other forms of business, but owners have limited liability. Most business is conducted by corporations because this organizational form maximizes firms’ values.

d. Mr. Kimble probably should organize as a proprietorship, because it is easy to start the business as a proprietorship and it generally is more advantageous from a tax standpoint for a small business to be organized as a proprietorship rather than as a corporation.

e. If the company is so successful that it grows to be a large organization, then Mr. Kimble probably should change from a proprietorship to a corporation. A major reason for changing to a corporation is to protect personal wealth—the owners of a corporation are not personally liable for the debts of the business, whereas the owners of proprietorships and partnerships are personally fully liable for all business debts. When a company becomes very large, most owners believe that the limited liability offered by the corporate form of business is extremely important.

f. Mr. Kimble should operate the business so that his best interests are met. Perhaps he would like to maximize the value of his company, or perhaps he would prefer to maximize his leisure time while making a good living with his business. Whatever goal(s) he chooses, as long as he is sole owner of the company, Mr. Kimble can operate the business as he pleases. However, if he sells a portion of the company to investors, then Mr. Kimble will have to pay more attention to the best interests of the investors—that is, he will have to pursue the goal of maximizing the value of the firm.

g. After converting to a corporation and selling stock to outsiders, PAR will have multiple owners, which means that Mr. Kimble and his management team will have to consider the best interests of the other owners when making decisions about the corporation. Mr. Kimble and his management team are “agents” of the stockholders, and they should operate the business so as to maximize the value of the firm. To ensure that management makes decisions that are in the best interests of the owners, the company can pay incentives that are based on the success of the firm, make management owners of the firms, or use other methods to encourage management to make the “correct” decisions. Such methods will help to lessen the chances of management making decisions in their own best interests rather than the stockholders’ best interests—that is, the chances of agency problems will be mitigated.

h. U.S. and foreign companies “go international” for the following major reasons:
1. To seek new markets. After a company has saturated its home market, growth opportunities often are better in foreign markets.
2. To seek raw materials.
3. To seek new technology. No single nation holds a commanding advantage in all technologies, so companies scour the globe for leading scientific and design ideas.
4. To seek production efficiency. Companies in countries where production costs are high tend to shift production to low-cost countries.
5. To avoid political and regulatory hurdles. For example, companies move production to foreign countries in which they sell products to get around U.S. import quotas.

i. 1. Different currency denominations. Cash flows in various parts of a multinational corporate system often are denominated in different currencies. Hence, an analysis of exchange rates and the effects of fluctuating currency values must be included in all financial analyses.
2. Economic and legal ramifications. Each country in which the firm operates has its own unique political and economic institutions, and institutional differences among countries can cause significant problems when a firm tries to coordinate and control the worldwide operations of its subsidiaries. Such differences can restrict multinational corporations’ flexibility to deploy resources as they wish and can even make procedures illegal in one part of the company that are required in another part. These differences also make it difficult for executives trained in one country to operate effectively in another.
3. Language differences. The ability to communicate is critical in all business transactions.
4. Cultural differences. Even within geographic regions long considered fairly homogeneous, different countries have unique cultural heritages that shape values and influence the role of business in the society. Multinational corporations find that such matters as defining the appropriate goals of the firm, attitudes toward risk taking, dealing with employees, and the ability to curtail unprofitable operations can vary dramatically from one country to the next.
5. Role of governments. Most traditional models in finance assume the existence of a competitive marketplace in which the terms of trade are determined by the participants. However, in foreign countries, in some instances, the terms under which companies compete, the actions that must be taken or avoided, and the terms of trade on various transactions are determined not in the marketplace but by direct negotiation between the host government and the multinational corporation.
6. Political risk. The distinguishing characteristic that differentiates a nation from a multinational corporation is that the nation exercises sovereignty over the people and property in its territory. Hence, a nation is free to place constraints on the transfer of corporate resources and even to expropriate—that is, take for public use—the assets of a firm without compensation.