Introduction to Finance: The Basics

Professor Xi Yang

Module 1: Introduction to Finance

Table of Contents
Module 1: Introduction to Finance .......................................................................................... 1
Lesson 1-1: Module 1 Overview........................................................................................................ 2
Lesson 1-1.1: Module 1 Overview ....................................................................................................................... 2

Lesson 1-2: Three Legal Forms to Organize Firms .............................................................................. 6

Lesson 1-2.1. Introduction of the Three Legal Forms to Organize Firms ............................................................. 6
Lesson 1-2.2. The Sole Proprietorship ................................................................................................................. 7
Lesson 1-2.3. The Partnership............................................................................................................................ 12
Lesson 1-2.4. The Corporation ........................................................................................................................... 17
Lesson 1-2.5. The Hybrid Form .......................................................................................................................... 25

Lesson 1-3: The Goal of Financial Management .............................................................................. 30

Lesson 1-3.1. The Goal of Financial Management ............................................................................................. 30

Lesson 1-4: The Corporate Governance .......................................................................................... 38

Lesson 1-4.1. The Corporate Governance.......................................................................................................... 38

Lesson 1-5: The Agency Problem .................................................................................................... 46

Lesson 1-5.1. The Agency Problem .................................................................................................................... 46

Lesson 1-6: Module 1 Wrap Up....................................................................................................... 55

Lesson 1-6.1. Module 1 Wrap Up ...................................................................................................................... 55

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 Introduction to Finance: The Basics
Professor Xi Yang

Lesson 1-1: Module 1 Overview

Lesson 1-1.1: Module 1 Overview

In this module, let's get introduced to the basics of finance. In order to learn finance, we
first need to know some basics about the structure and the role of firms. Firms are at the
center of finance because they create the wealth in society. Think about your daily life.
In the morning, you may go to your favorite local café or Starbucks to get a cup of
coffee for breakfast. The local café is a small business, and Starbucks is the world's
largest coffee house chain. They have something in common and they also have a lot of
differences.

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You may be curious how they organize their business and why they organize it that
way. If you want to start a new business, what is the best way to set it up?

When you go to work, it's very likely that you work for a company. Corporations provide
a lot of employment opportunities for us. You may wonder, what is the government
structure of the firm? Who are the owners of the corporation?

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Think about the goods and the services we use every day. We buy groceries from either
local stores or big retailers such as Walmart or Target. We shop online at Amazon. Or
computers are made by Apple, Dell, or Hewlett-Packard. We watch movies produced by
Disney, Warner Brothers or Universal. We use streaming services such as Netflix and
Disney Plus. We deposit our money in a local bank or national banks such as Bank of
America, Chase Bank or Citibank. The car we drive to work, maybe Ford, Toyota, or
Volkswagen. When we want to travel to other cities, we may take American Airlines or
Delta Airlines flight. We may stare at a local hotel or Hilton. All of these are examples of
business. It's hard for us to imagine a world without business. Some of the companies
even become American icons. Whenever we want to drink soft drinks, we think about
Coke. McDonald is almost equivalent to hamburger and French fries. Hershey bars are
synonymous for candy bars. When we want to search for something from the Internet,
we just say Google it. The Thanksgiving Day Parade in New York City is named after
the department store chain, Macy's. These companies not only satisfy our basic needs,
but also shape our life and our culture.

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In this module, let me introduce you to three basic legal forms to organize firms and the
advantages and disadvantages of each one. We will cover the goal of financial
management and the structure of corporate governance. On top of that, we will discuss
the agency problem and how companies mitigate agency problems. Now, let's get
started.

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Lesson 1-2: Three Legal Forms to Organize Firms

Lesson 1-2.1. Introduction of the Three Legal Forms to Organize Firms

Hello everyone. Let's talk about starting a business. When you want to start a new
business, one decision you have to make is to decide what form of business to
establish. This is a very important question because the form of business determines
which income tax return you must file, and how much liability protection you can get, in
case of failure. There are three most important forums to organize your business: sole
proprietorship, partnership, and corporation. In the proceeding videos, we will talk about
each form, and also discuss the relationship among them three.

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Lesson 1-2.2. The Sole Proprietorship

The first form to organize your business is called sole proprietorship. It is a business
owned by a single owner. To start a sole proprietorship, you just need to register your
business with States Business office. In some places, there's no such requirement.
Therefore, this is considered as the best structure for small businesses. Some
examples include bakeries, barbershops, restaurants, bars, bookstores, hair salons and
hardware stores. You can find some common things for these businesses. There's no
need for a larger amount of capital to start with. And you can also handle the business
all by yourself, so you don't need any partners or stockholders. This structure is also
ideal for the business startups. Part-time and home-based businesses. If you have a
great business idea, you want to know whether your business idea will work or not and
also learn more about entrepreneurship, then you can just start your own business as
sole proprietorship.

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Here, I want to share with you some history about Walgreens company. The company
was first established by Charles Walgreen as sole proprietorship in 1901. And this time,
he spent $6,000 to acquire the business from the previous owner. This amount of
money is equivalent to about $182,000 in today's dollars. He ran the business as sole
proprietor for about 15 years before he incorporated the business in 1916. Nowadays,
Walgreens operated as the second largest pharmacy store chains in the United States,
just behind CVS. Walgreens was added as one of the 30 components of the Dow Jones
industrial average in 2018. As the example shown here, a lot of large companies start to
organize their business as sole proprietorships. And later, this structure no longer
sealed the business, and they want to switch to another structure instead. Now, we
want to talk about the advantages and disadvantages of a sole proprietorship.

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The first advantage is that sole proprietorship is easy and inexpensive to form. It is the
simplest and the least expensive way to establish a business structure. You just need to
register your business with state and local government. In some areas, there's no
requirement for a business license. Not a lot of paperwork involved. So, the costs
involved are minimum, with legal costs limited to obtaining the necessary licenses or
permits. Suppose you start a restaurant, and you want to sell alcohol to your customers.
You need to apply for a legal license before you can start your business. These kind of
regulations vary by industry, state, and location. There are a few government
regulations, which means you have the complete control of your business. Because you
are the only owner of the business, you have full control over all decisions. You don't
have to consult with anyone or report to anyone when you need to make a quick
decision or want to make any changes. You have a lot of freedom. You are the boss.
Another advantage is about taxes. You don't have to pay separate taxes for your
business. And so, it's easy to fulfill the tax reporting requirements for a sole
proprietorship. All profits are yours. You just need to file personal income taxes and
nothing else. But this structure also has its downsize.

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The biggest disadvantage is the unlimited personal liability. Since there's no legal
separation between you and your business, you can be held personally liable for the
debts and obligations, such as lawsuits of the business. This risk extends to any
liabilities incurred as a result of employee actions. If the business goes broke, you need
to pay any debt using your personal belongings such as your car and your home. Your
company and personal finances are tangled with each other. Another point is limited life.
The life of the company depends pretty much on the owner. It is limited by the life of the
owner. When the owner quits or sells the business, the business will be disrupted, and
the value of the company won't work the same as before. Customers trust the original
owner, and this kind of trust may not transfer easily to a new owner. Because of the
unlimited liability and the limited life of the business, this kind of business is hard to
raise money. Sole proprietors often face challenges when trying to raise money. You
can't sell stock in the business, which limits investor opportunity. Banks are also
hesitant to lend to a sole proprietorship because of a perceived additional risk when it
comes to repayment if the business fails. As a result, the proprietor has to risk capital by
tapping savings, using credit cards or borrowing from family members. All these pros
and cons are the result of no distinction between the business and the owner. You are
entitled to all profits and are responsible for all your business debts, losses, and
liabilities. You alone are ultimately responsible for the business success and failures.

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Finally, I want to share some statistics with you. Since they are small businesses, the
sole proprietorship dominates all business forms in terms of numbers is more than 70%.
However, it's only a small fraction in terms of profit, just 20% of the total profit of the US
business economy.

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Lesson 1-2.3. The Partnership

Instead of starting a business on your own, you may want to pull money and expertise
with your friends or business associates. In this case, you form a partnership.
Partnerships enable entrepreneurs to pull their talents. One partner maybe good at
design, well, another maybe good at marketing.

In most cases, partners will have a formal partnership agreement in order to outline how

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to make important decisions and how to split profits among partners. This helps to
resolve any disputes that may arise and clear any hurdles in the future. Many big
companies were initially organized as partnerships, such as Morgan Stanley, Merrill
Lynch, Goldman Sachs, and the Microsoft. However, eventually, these companies and
their financing requirements grow too large for them to continue as partnerships.

Here are the list of advantages and disadvantages of partnership. You can see that it
shares a lot in common with sole proprietorship. Partnerships are relatively easy to form
and exempt from most reporting requirements the government imposes on corporations.
They are also taxed favorably. Partners pay personal income taxes on their share of
profits, but their businesses are not taxed.

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Partners, like sole proprietors, have the disadvantage of unlimited liability. If the
business runs into financial difficulties, each partner has unlimited liability for all the
business that's not just his or her own share. A good advice is that you need to know
your partners very well before you start this journey.

One example of partnership I want to show you is the accounting industry. The big four

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accounting companies still use the partnership structure, even if their size is much
larger than a lot of corporations.

On one hand, this provides enough incentives for partners to do their best work,
improve the quality of auditing, and develop a market in the reputational brands for
individual audit partners.

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On the other hand, the partners who directly commit misconduct will take personal
responsibility. There are unlimited liability means there's no place to shield themselves
from liability. Other auditors who are not directly involved will be protected from liability
risks.

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Lesson 1-2.4. The Corporation

A corporation is a legal entity that's separated from its owners.

As a legal person, the corporation enjoys a lot of the legal powers of natural persons
such as make contracts, borrow money, and sue or be sued. One corporation can make
a takeover bid for another and then merge the two businesses together. Corporations
can make a profit, be taxed, and it can be held legally liable.

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When a corporation was initially established, the shares were held by a small group of
people, including the founder, the manager, some employees, and the venture
capitalists. The shares were not traded in public markets.

Eventually, when the firm grows and new shares are issued to raise additional capital,
the shares will be widely treated in stock exchanges. Such corporations are called

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public companies. Most well-known corporations are public companies. The process of
converting a private company to a public company is called initial public offering or IPO.

Corporations have a completely independent life separate from its shareholders. If

shareholders want to leave the company, they just need to sell their shares. The
corporation can continue doing business without any disturbance. Corporations also
offer the strongest protection to its shareholders from personal liability. This gives
corporations an advantage when it comes to raising capital because they can raise
funds through the sale of stock, which can also be a benefit in attracting employees.

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Corporations also have its downsides. Unlike sole proprietorships and partnerships,
corporations pay income taxes on their profits. In fact, corporations' profits are taxed
twice. First, when the company generates a profit, it is taxed at the corporate level.
Then again, when dividends are paid to shareholders, dividends are taxed at personal
level. The cost to form a corporation is higher than other structures. Corporations also
require more extensive bookkeeping, operational process, and reporting. Corporations
are required to hold the shareholders' meetings or take votes on important management
issues. From the characteristics over here, you can see that corporations can be a good
choice for a medium or higher-risk businesses: business that needed to raise money
and businesses that plan to go public or eventually be sold.

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Just like when a new baby is born, there's an official document called birth certificate.
When you establish your company, you also need an official document. This founding
document of corporation is called Articles of Incorporation. It also has other names such
as Articles of Association, Certificate of Incorporation, or Corporate Charter. Now, let's
take a look at an example from Target Corporation, a major retailer in the United States.

The Articles of Incorporation outlines the basic information needed to form a corporation

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such as the name of the corporation, the location, the types and number of authorized
shares, and the shareholder rights.

It also lay out how a corporation should be governed. It specifies the composition and
the role of the board of directors and the limitation of director's liability, actions by
stockholders without a meeting, and the authority to call special meetings of
shareholders. Another key corporate document is the bylaws, which outlines how to run
the corporation. Bylaws work jointly with the Articles of Incorporation to form the legal
backbone of the corporation.

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Here are some examples of large corporations. They are household names in the
United States. These corporations cover all aspects of our lives. Some of them become
our friends. It's hard to imagine a world without them.

Here are some statistics about corporations. There are only 20 percent of business
organized as corporations, but they contribute more than 70 percent of the profits. As

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the corporations are much larger than sole proprietorship and partnerships, they also
hire more employees than other formats of businesses.

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Lesson 1-2.5. The Hybrid Form

A business can also be organized as some hybrids of the basic forms. For example,
some people enjoy vanilla ice cream, and some people enjoy chocolate ice cream.
Then we create a new ice cream flavor which combines vanilla with chocolate so that
we can enjoy the benefits of both.

LLC is a relatively new form compared with three traditional forms of organizing a

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business. But it is growing very fast. More and more businesses adopt this hybrid form
because of its benefits. First, LLC enjoys the benefits of limited liability just like of a
corporation. Owners of LLC are protected from personal liability for business debts and
the claims. The maximum amount they can lose is the money invested in the company.
In addition to that, LLC see also enjoys the tax advantages of a partnership. For LLC, its
business income is passed through to its owners who just need to pay personal taxes,
except in some very special situations.

To form an LLC, you need to file Articles of Organization under State law while
corporations founding document is Articles of Corporation. When a business is formed
as LLC, its business name usually has the abbreviation LLC. That is future creditors and
customers realized that they are doing business with a limited liability company instead
of a sole proprietorship or partnership and that they realize all the risks they are facing.
On top of that, LLCs often have an operating agreement. This is an optional document,
but it's very important to have this document in place, especially for an LLC with multiple
owners. The operating agreement specifies the rights and responsibilities of owners,
how to divide the profits and losses, and how to transfer ownership. This document is
comparable to all corporations by laws. The owners of LLCs are called members.
Members may include individuals and entities such as partnerships and corporations.

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While the owners are called shareholders in the corporation setting, an LLC is a better
choice if there are few owners while the corporation is better if there are a lot of
shareholders. The ownership is called the interests while in corporate setting, they are
called shares.

In terms of management, LLCs are either a member-managed, or manager-managed.

Member-managed means all the members are actively involved in running business,

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jointly managed day to day business. This is more common for small LLCs. Sometimes
LLCs, they lack managers to run the business and the manager can either be a member
or a non-member. The management in a corporation is much more complicated. They
have shareholders, directors, and officers. They need to hold shareholder meetings and
board meetings and keep all the minutes. Generally speaking, an LLC is much simpler
to organize and has fewer regulations than a corporation, so it is better for smaller sized
business. But if you have the ambition of growing your business into a large one, a
better choice is to set it up as a corporation rather than an LLC.

I also want to point out some disadvantages of LLCs. An LLC is a business structure
allowed by state statue. For a business that spends several states, this may cause
some trouble because each state has its different standards and the rules.

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LLCs are not able to issue stock. Most of the capital comes from its members or
borrowed from others. It’s not a good choice for a business considering raising large
amount of capital and expanding its business in the future.

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Lesson 1-3: The Goal of Financial Management

Lesson 1-3.1. The Goal of Financial Management

For a public company, the goal of financial management is to maximize the current
share value of the existing stock. If the company does not have stocks traded in public
market, the goal is to maximize shareholder wealth. Shareholders are owners of the
company. If the value of a company increases, its shares also worth more. This goal
provides a very clear direction for financial management. It's also easy to evaluate, you
can check the stock market and get real-time stock price information. Some of you may
wonder why maximizing profit is not the goal of a corporation. It seems like a common
sense that corporations maximize their profits. But when you take a closer look, you will
find out that there are some problems associated with this goal. The first question is that
the profit is an accounting term and there are several ways to manipulate it.

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Another question is which year's profit do you have in mind? If you are thinking about
next year's profit, managers can always maximize it by delaying maintenance and
training. These actions will boost the short-term profit but will harm long-term growth.
There's no consensus as of what the appropriate time horizon of profit maximization is.
This goal is not as clear as maximizing current share price.

Here I want you to think about a question. Do you think there's a conflict between the

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goal of maximizing the current value of the stock and some other goals such as
employee safety, customer satisfaction, and the environmental protection?

The answer to this question is that in general, these goals are not conflict with each
other because the stock market is believed to be largely efficient, although not perfectly
efficient. The information will be reflected in the market even if not immediately. In the
long run, investors will value it.

To dig further into the question, we want to introduce the concept of stakeholders. Who
are the stakeholders of the company? The stakeholders include all the parties related to
the business, including their employees, customers, suppliers, creditors, and the
society. The first group of stakeholders is the company's employees. Nowadays,
companies are more willing to invest in their employees.

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A lot of companies offer benefits to employees such as insurance, paid leave,

retirement plan, and other perks. They improved working conditions and created
opportunities for employees to accumulate their human capital. They motivate their
employees and help them to achieve their professional goals. All these practices seem
costly from appearance, but they will help companies to attract more talents to work for
them, and in return, employees will create more value for the company and the
shareholders. Customers are also important stakeholders of a company.

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If a company serves their customers with high-quality products and services, innovate
new products, and remain competitive in the industry, the results will be an increase in
sales and customer loyalty will greatly improve the value of a business. Customers have
become more powerful in recent times because they can easily share a lot of their
experiences, whether good or bad, with their friends and followers on social media,
such as Facebook, Twitter, and Instagram. When we talk about the goal of financial
management, our main focus is the United States. But how about other countries in the
world? Their situations are quite different from the US. They care more about the
stakeholders.

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Based on the research paper done by Massaro Yoshimori, financial managers in the US
and UK think shareholders are more important, while in Japan, Germany, and France,
they care more about the interests of all stakeholders. Other parties are also powerful in
their culture. For example, in Germany, almost a half of the board of directors are
chosen by workers. In this case, maximizing shareholder wealth is not the only goal of
the financial manager.

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Corporations pay more attention to their social responsibilities. In addition to financial

goals, corporations also fulfill social, ethical, and environmental responsibilities.

Here I want to share with you the story of TOMS. TOMS is a shoe company famous for
its one-for-one business model. Based on this charitable donation model, for each pair
of TOMS shoes purchased by its customers, a pair of new shoes is given to a child in
the developing world. The intention of the model is to help children in poverty. But they

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also received some criticism about whether this giving is effective or not. What is the
impact on the local shoe industry and whether this model is sustainable or not?

Later on, the company's model for giving has evolved. If you buy a pair of shoes,
consumers were given a wide variety of choices. Giving shoes is only one option, but
consumers can also choose other causes they want to support, such as clean water,
prescription glasses, medical treatment, and others. Donating part of their profit to
various charities will certainly sacrifice short-term profit. But this will attract more
customers and create loyalty in the long run. But how much social responsibility should
a business take is a question you may want to think about as you run your own
business.

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Lesson 1-4: The Corporate Governance

Lesson 1-4.1. The Corporate Governance

Now, we're going to talk about corporate governance. Corporate governance refers to
the rules, practices, and procedures that direct how the corporation is managed and
controlled. It outlines the distribution of rights and responsibilities among different
groups in the corporation, such as the board of directors, managers, and other
stakeholders. Good corporate governance makes the business run more efficiently and
create value for shareholders.

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If individuals or institutions hold stocks of a company, they are called the company's
shareholders or stockholders. Here, institutions include the companies, mutual funds,
pension funds, hedge funds, endowment funds, and insurance companies. Normally,
when they buy and sell large blocks of stocks, they are more powerful than the small
shareholders for a company.

If a shareholder controls more than 50 percent of a company's outstanding shares, then

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we call him a majority shareholder. In most the cases, majority shareholders are
company's founders or descendants of a company's founders. One example is Mark
Zuckerberg, the founder of Facebook. He controls more than 50 percent of all voting
shares in Facebook. By controlling more than half of a company's voting shares, he has
effective control of the important operational decisions and won't be ousted by the
board. If the stockholding is less than 50 percent of a company's stock, then they are
called the minority shareholders. For most of the outside investors, they are minority
shareholders.

Let's take a look at the rights of shareholders. The rights are mainly two parts. The first
one is the voting rights. As shareholders are owners in a company, they can vote on
important corporate issues, such as electing directors, and merger and acquisition
decisions. Besides voting, they are also entitled to enjoy the benefits of a business
success. The benefits come in the form of dividends. In general, we can summarize the
rights of shareholders as voting rights and cash flow rights.

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The highest governing body of a corporation is the Board of Directors. The directors are
elected by the shareholders, usually once a year at the annual shareholders meeting to
represent the best interests of shareholders. They serve staggered terms, which means
in any certain year, only a fraction of the members will be up for election. The structure
and the powers of a board are determined by organizations, articles of incorporation,
and bylaws. For example, the number of board members and how the board works.

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Insider director refers to the director who has a stake in the corporation. Some
examples include the CEO, COO, CFO, major shareholders, and representatives of
employees. Outside directors are also called independent directors. From the name,
you can tell, they are not stakeholders in a company. Outside directors are required for
big public companies because people believe that they will bring independent voices to
the board. For large corporations, the board members are usually professionals or
leaders in their industry. Outside directors are often leaders of other organizations.
Good corporate governance requires a balance between insider directors and outside
directors. Insiders know the company very well, but their decisions may reflect their
personal interests. Outsiders can provide unbiased perspectives, but they may not have
a deep knowledge about the company.

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For a traditional board, there are at least four basic committees: Executive committee,
Audit committee, Compensation committee, and the Nominating committees. For most
companies they have more committees than that, depending on the needs of the boards
and special considerations. Now, let's talk about the four committees, one by one. The
executive committee is composed of a small group of board of directors. The executive
committee meets more often and set the priorities for the whole board to discuss. The
members of the audit committee are independent outside directors. They oversee the
company's internal control and the financial reporting and disclosures. The
compensation committee determines the pay package for top executives. The
nominating committee is responsible for nominating new board members.

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The major responsibilities of the Board of Directors are listed here. Their main duty is to
select and appoint senior executives and to supervise their performance. They also set
major policies of a company, such as how much dividends to pay shareholders. They
also determine the CEO's compensation and approve annual budgets.

This is a hypothetical organization chart. You can see the board is in the highest order.
The board appoints CEO. The CEO is the most senior executive within the corporation.

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He or she is responsible for managing the corporation and making decisions. He or she
reports to the Board of Directors for the performance of the corporation. In a lot of
cases, CEO is also a member of the Board of Directors. CEO works with other top
executives, such as COO to take care of the daily operations, like production, marketing
and personnel, and CFO who is authority of the financial side of the company. Often the
case, the company will also have other top executives such as Chief Technology
Officer, Chief Security Officer, Chief Marketing Officer, and other, depending on the
industry of the business. For example, you will see the position of Chief Medical Officer,
CMO in a hospital. Here, I want to talk more about the Financial Officers. CFO, Chief
Financial Officer is in charge of the financial planning of the company. The CFO is the
most important financial voice of the corporation. He or she explains earnings results
and forecasts to shareholders and the media. The CFO reports to the CEO and the
board and work closely with other top executives to shape the company's strategies. For
example, the Chief Marketing Officer comes up with some great ideas of digital
marketing campaign, the CFO has to make sure the idea is financially feasible and
there are enough financial resources to devote to marketing campaign. The CFO
supervises the financial unit and the work of treasurer and the controller. A treasurer,
yes mainly responsible for the financial side of a corporation. The duties of treasurer
include managing cash and the liquidity, managing risk, and the setting up budgets. A
controller is responsible for the accounting side of the business. The controller manages
the company's internal accounting systems and prepares financial statements and tax
returns. Having a good corporate governance is just like how you run a country or a
region. If you have a very clear goal and a very clear structure, specify the duties and
responsibilities. Then the goal can be achieved.

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Lesson 1-5: The Agency Problem

Lesson 1-5.1. The Agency Problem

A unique challenge of corporate governance is the agency problem. When a principal

hires an agent to perform part of his duties, conflict of interest may arise. This is called
the agency problem. For sole proprietorship and the partnership, this agency problem is
not a serious issue because their managers are also their owners. Corporations suffer
from this problem because the owners of the corporation and the managers of the
corporation are separated from each other. Managers care more about their job security
rather than maximizing shareholder wealth.

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Agency costs are the expenses incurred by the agency problem. It can be divided into
direct costs and indirect costs.

Direct costs include expenditures that benefit managers but put additional costs to
shareholders. For example, some corporate managers buy luxury corporate jets and
other expenditures that are not so related to their business, and this is considered as
this type of costs. Monitoring costs means the costs associated with monitoring the
activities of managers.

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Professor Xi Yang

The indirect agency costs are those that refer to the expenses incurred due to the last
opportunities. For example, there is a high-risk project that will create value for
shareholders, but the managers may reject the project because they are afraid that they
will lose their jobs if the project fails. Since this expense is very difficult to value
numerically, it is considered as part of the indirect agency costs.

Corporations are also working toward mitigating the agency problem. There are two

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Professor Xi Yang
ways to address this problem. One is through managerial compensation, and another
one is to replace existing management. There is an active market of merger and
acquisition. If the company's management is underperforming, the company will
become a target for other companies. Those companies will take over it and replace its
management to achieve a turnover. Managerial compensation is a widely used way to
align the interests of managers and shareholders.

According to statistics, more than 60% of CEO compensation comes from stock-
options. Here, I want to use a simple example to show you how the stock-option works.

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Suppose the CEO of a company is awarded with 50,000 stock-options. The option gives
him the right but not the obligation to buy shares at $50 per share. The stock is trading
at $50 per share at the stock market, but he cannot exercise the option right now.

He signed a contract of five years with the company, so he has to wait for five years
until he can exercise the option.

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Professor Xi Yang

If the company stock rises about $50 per share five years later, let's say $70 per share
at that time, the CEO will earn $20 per share or $1 million in total from the stock-
options. If the share price drops below $50 then he earns nothing. From this example,
you can tell the CEO's personal benefit is tied up with the shareholder's interest, so that
executives will work in the best interest of shareholders.

One extreme example of the agency problem is Enron. Enron was one of the largest
companies in the United States.

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When the company was losing money from investment and accumulating debt, their
management used accounting methods such as off-balance sheet, special purpose
vehicles, to hide the debt and financial losses from its investors and creditors.

The accounting scandal started to unfold in 2001, when SEC started investigating
Enron. Its share price dropped from over $90 to almost 0. The company ended up
fighting for bankruptcy on December 2, 2001.

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Several senior managers of Enron, such as its Chairman, CEO and CFO, were charged
with insider trading and securities fraud. As Enron's directors, they had a legal obligation
to protect interests of shareholders, but they failed to carry out their responsibilities.
Enron's collapse led to new regulations and the legislation to promote the accuracy of
financial reporting.

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One example is the Sarbanes-Oxley Act. Sarbanes-Oxley created the public companies
accounting oversight board to establish new audit guidelines, and ethical standards.
The new ethical standards are significantly higher than ever before. It also promotes the
independence of auditors. It prohibits auditing companies from providing non-audit
services such as consulting service for the same client. This regulation is based on
Enron's lesson. Enron's auditor firm, Arthur Andersen, was one of the five largest
accounting firms in the United States at that time. But it didn't perform its duty because it
charged hefty fees for its consulting service, and it didn't want to lose a customer. It
requires public companies auditing committee of corporate boards to include only
independent outside directors to oversee the annual audits. It also defines the
interaction of the external auditors and the corporate audit committees. It mandates that
officers take personal responsibility for the accuracy and completeness of corporate
financial reports. If there are any false statements or anything missing from the annual
reports, they are responsible for it. So, when we reflect this scandal, we realized that
whenever after a scandal, there are new regulations and new legislation. So, it helps us
to reflect what is missing in the regulation, and it also helps us to fill out the loopholes.

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Lesson 1-6: Module 1 Wrap Up

Lesson 1-6.1. Module 1 Wrap Up

In this module, we covered the basics of finance. We got introduced to three legal forms
to organize a business; of which sole proprietorship is the simplest way to start a
business. The owners can keep all the profits to themselves and there's no need to pay
corporate taxes. But this comes at a cost. They have unlimited liabilities for business
debts and obligations. For small businesses, this is a good choice.

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The second form to organize a business is through a partnership. It refers to a business

organized by several owners. The advantages and disadvantages of partnerships are
very similar to the sole proprietorship.

The last form is corporation. Corporations are complicated and expensive to form. The
big downside of the corporation is double taxation. But the good news is that
shareholders of corporations have limited liability, meaning they are not personally

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responsible for the debts and obligations of the corporation. Most of large businesses
are organized as corporations. Besides these three basic structures, businesses can
also be organized using hybrid forms, such as a limited liability company, LLC.

An LLC combines a lot of benefits of three basic forms. An LLC offers personal liability
protection to its owners, and it doesn't need to pay corporate taxes. Therefore, the
number of limited liability companies are growing faster than three basic structures.
Then we focused our attention on corporations. We discussed the goal of financial
management.

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For public companies, the goal is to maximize the current value per share of the existing
stock. We also discussed whether this goal conflict with other goals such as employee
safety, customer satisfaction, and social responsibility.

Another topic is corporate governance. We discussed the role of shareholders, the

board of directors, and managers. Good corporate governance will pave the way for
future development.

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A unique question for corporations is the agency problem. It refers to the conflict of
interest between a company's management and shareholders. Corporations come up
with multiple ways to mitigate this problem, and the regulators also tighten regulations to
protect shareholders. This module is just a start of a journey. Let's work together to
explore more about finance in the following modules.

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