Corporate Finance For Dummies. Michael Taillard

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Visiting the Main Attractions in Finance Land

Finance Land is filled with a surprisingly large and diverse number of organizations, each one specializing in a different area of financial goods or services and many of them being quite narrow in their focus. Regardless of how limited or unlimited in offerings any particular organization may be, they’re all interconnected, and each one plays a very important role in the greater economy. All the organizations in Finance Land influence each other and the individuals working for them in several important ways that vary depending on which type of organization you’re talking about.

      The following sections introduce you to some of the more common financial institutions and related organizations and explain how each one plays a role in the world of corporate finance.

      Corporations

      In case the name of this book didn’t give it away already, corporations are the primary focus, so I start your finance tour with them. Corporations are a special type of organization wherein the people who have ownership can transfer their shares of ownership to other individuals without having to legally reorganize the company. This transferring of shares is possible because the corporation is considered a separate legal entity from its owners, which isn’t the case for other forms of companies. This characteristic has a few significant implications that influence the financial operations and status of corporations compared to other forms of organizations:

       Professional managers typically run corporations rather than the owners given the wide distribution of ownership by non-owners. This leads to questions about moral hazard — the conflict of interest that occurs when managers make decisions that benefit themselves rather than the owners of the organization they’re managing, called the agency problem. Often, an individual who holds a very large proportion of a corporation’s stock will also be a manager or a director, but generally speaking, corporations have the resources to hire highly experienced professionals.

       The corporation is taxed on its earnings separately from the owners. In most organizations, the profits are considered the owners’ income and they’re only taxed as such. In corporations, however, the company itself is taxed on any earnings it makes and the owners are taxed on any income they generate by possessing stock ownership (called capital gains). This double taxation of income is one of the pitfalls associated with a corporate structure.

       Corporations have limited liability, meaning the owners can’t be sued for the actions of the company. Oddly enough, this characteristic also frequently protects managers, though to a lesser extent since the establishment of the Sarbanes-Oxley laws, which hold managers more accountable.

       Corporations are required to disclose all their financial information in a regulated, systematic, and standardized manner. These records are public not only to the government and the shareholders but also to the public. Shareholders can also request specialized financial information.

The primary goal of corporations is to provide goods or services in exchange for money; their underlying goal is to generate a profit, as the law requires them to operate using the Shareholder Wealth Maximization model wherein corporate management is legally obligated to operate in a manner that increases profitability and corporate value and, as a result, increase the value of the shares of stock held by the shareholders as the owners of the corporation. In most cases, profits are the income of a corporation. The one exception is the nonprofit corporation, which includes such organizations as The American Red Cross, many public universities, and other organizations that operate within the parameters of a tax-exempt status. Although nonprofits can still be profitable, their profits are capped (meaning they can’t make more than a specific percentage in profit), so they use their resources to provide goods or services below cost. Many nonprofits choose not to generate any revenues, relying instead on donations. (Due to the unique considerations that you must give nonprofit organizations when assessing them, I don’t discuss them further in this book.)

      Depository institutions

      Anytime you give your money to someone with the expectation that the person will hold it for you and give it back when you request it, you’re either dealing with a depository institution or acting very foolishly. Depository institutions come in several different types, but they all function in the same basic manner:

       They accept your money and typically pay interest over time, though some accounts will provide other services to attract depositors in lieu of interest payments.

       While holding your money, they lend it out to other people or organizations in the form of mortgages or other loans and generate more interest than they pay you.

       When you want your money back, they have to give it back. Fortunately, they usually have enough deposits that they can give you back what you want. That’s not always true, as everyone saw during the Great Depression, but it’s almost always the case. Plus, safeguards are now in place to protect against another Great Depression in the future (at least one that occurs because banks lend out more money than they keep on hand to pay back to their lenders).

      The three main types of depository institutions are commercial banks, savings institutions, and credit unions.

      Commercial banks

      Commercial banks are easily the largest type of depository institution. They’re for-profit corporations that are usually owned by private investors. They often offer a wide range of services to consumers and corporations around the world. Often the size of the bank determines the exact scope of the services it offers. For example, smaller community or regional banks typically limit their services to consumer banking and small-business lending, which includes simple deposits, mortgage and consumer loans (such as car, home equity, and so on), small-business banking, small-business loans, and other services with a limited range of markets. Larger national or global banks often also perform services such as money management, foreign exchange services, investing, and investment banking, for large corporations and even other banks like overnight interbank loans. Large commercial banks have the most diverse set of services of all the depository institutions.

      Savings institutions

      Have you ever passed by a savings bank or savings association? Those are both forms of savings institutions, which have a primary focus on consumer mortgage lending. Sometimes savings institutions are designed as corporations; other times they’re set up as mutual cooperatives, wherein depositing cash into an account buys you a share of ownership in the institution. Corporations don’t use these institutions frequently, however, so I don’t cover them throughout the rest of the book.

      Credit unions

      Credit unions are mutual cooperatives, wherein making deposits into a particular credit union is similar to buying stock in that credit union. The earnings of that credit union are distributed to everyone who has an account in the form of dividends (in other words, depositors are partial owners). Credit unions are highly focused on consumer services, so I don’t discuss them extensively here or elsewhere in this book. However, their design is important to understand because this same format is very popular among the commercial banks in Muslim nations, where sharia law forbids charging or paying traditional forms of interest. As a result, the structure of a credit union in the U. S. is adopted by commercial banks in other parts of the world, so a basic awareness of this structure can be useful for international corporate banking.

      Insurance companies

Insurance companies are a special type of financial