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Finance 1 Week 1 Summary
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Finance 1 Week 1 Summary including readings
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Week 1:Preparation: Chap 1: The
Corporation
Four types of firms:
- Sole proprietorships: business owned and run by one person. Usually very
small with few or any employee. Most common type of firm in the world
even if doesn’t account for much sales revenue in the eco. (US 72%
businesses but only generate 4% revenue ≠ corporations are <18% and
do 83%). Key characteristics:
o Straightforward set up: attractive for new businesses.
o Principal limitation: no separation between the firm and the owner –
only one owner, other investors cannot hold an ownership stake in
the firm.
o The owner has unlimited personal liability for any of the firm’s debt.
If owner cannot afford to repay a loan: personal bankruptcy.
o The life of a sole proprietorship is limited to the life of the owner.
Ownership is hard to transfer.
As soon as the firm can borrow without the owner agreeing to be
personally liable, the owners convert the business to limit his liability.
- Partnership: identical to a sole proprietorship except it has more than one
owner. Key features:
o All partners are liable for the firm’s debt => A lender can require
any partner to repay all the firm’s outstanding debts.
o The partnership ends on the death or withdrawal of any single
partner, although partners can avoid liquidation if the partnership
agreement provides for alternatives (buyout of a deceased,
withdrawn partner)
Old and established businesses can remain sole proprietorship or
partnership if the business is based on the owners’ personal reputations.
Limited partnership has two types of owners: general partners (personally
liable for the firm’s debt obligations) and limited partners (limited liability
to their investment). Death or withdrawal of a limited partner does not
dissolve the partnership and limited partner’s interest is transferable,
otherwise does not have authority and cannot legally be involved in the
managerial decision making for the business. Mainly present for private
equity funds and venture capital funds industries.
- Limited Liability companies (LLC): limited partnership without a general
partner, so all the owners have limited liability, but they can also run the
business.
- Corporations: it is a legally defined artificial being ( a judicial person or
legal entity) separate from its owner. Has as many of people’s legal power.
It Is solely responsible for its own obligations, so the owners are not liable
for any obligations the corporation enter into, and forth.
o Formation: must be legally formed, i.e. the state where it is formed
must formally give its consent to the incorporation by chartering it
= more costly.
, o Ownership: no limit number of owners, but each one has a small
portion. Its entire ownership stake is divided into shares (stock);
outstanding shares are the equity; an owner of shares is a
shareholder, stockholder or equity holder and is entitled to dividend
payments. Then receive a share of the dividend payments
proportional to the amount of stock they own.
≠ taxations for the ≠ forms.
Corporations are the only organizational structure subject to double taxation.
Exemption for “S” corporations. Under that, firm’s profit and losses are not
subject to corporate taxes but are allocated directly to shareholders based on
their ownership shares. Limitations: shareholders are individuals, U.S citizens or
residents, and for a max of 100 of them. Most large corporations are “C”
corporations, i.e. subject to corporate taxes. S corporations < ¼ corporations.
Sometimes, in corporations, not the owners but the board of directors and chief
executive officer possess direct control of the corporation.
The board of directors has the ultimate decision-making authority. Delegates
most decisions involving day to day running of the corporation to its
management. The CEO is charged with running the corporation by instituting the
rules and policies set by the boards of directors. CEO can be chairman of the
board of directors. Chief Financial Officer (CFO° is the most senior financial
manager, often reporting directly to the CEO.
CFO is in charge of 3 main tasks:
- Investment decisions
- Financing Decisions: how to pay the investments. Can decide to raise
more money from new and existing owners by selling more shares of stock
(equity) or to borrow the money (debt).
- Cash Management: Ensure the cash on hand to ensure the day to day
obligations.
Goal sole proprietorship = owner’s goal.
In the case of shareholders, less easy but shareholders can agree they want an
increase in the value of their shares. But sometimes, decisions increasing
shareholders’ wealth can be costly for society as a whole.
Agency problem: when managers put their own self-interest ahead of the
interest of the shareholders. many people claim that the separation of
ownership and control in a corporation gives managers little incentive to work in
the interests of the shareholders when this means working against their own self-
interest.
The CEO’s performance: if bad, shareholders sell their stock, but people might
not want to buy them back, so CEO can be replaced by the board of directors.
Hostile takeover: when an individual or organization – aka corporate raider – can
purchase a large fraction of the stock and acquire enough votes to replace the
board of directors and the CEO.
Corporate bankruptcy: When a corporation borrows, the holders of the firm’s
debt also become investors in the corporation. => If the firm fails to repay or
renegotiate with the debt holders, the control of the corporation’s assets will be
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