ESCP Business School: Fundamentals of Financial Management, Class Notes (incl. Case studies + Solutions), ISBN: 9781292215075
Recap Fundamentals of Corporate Finance, Global Edition, ISBN: 9781292215075 Public Financ
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Erasmus Universiteit Rotterdam (EUR)
Liberal Arts And Sciences
Corporate Finance
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Chapter 1: The Corporation
Four types of firms
- Sole Proprietorships -> A business owned by one person.
o General characteristics: Few employees, most common form of corporate contract but small
contribution to sales revenue of a country’s economy.
o Advantage: Easy to set up → Many new businesses use this organizational form.
o Disadvantages: (1) No separation between the firm and the owner – the firm can have only
one owner. If there are other investors, they cannot hold an ownership stake in the firm; (2)
the owner has unlimited personal liability for any of the debts. An owner who cannot afford
to repay the loan must declare personal bankruptcy; (3) the life of a sole proprietorship is
limited to the life of the owner. It is also difficult to transfer ownership.
- Partnerships -> A business owned by more than one owner (further similar to sole
proprietorship).
o (Sole) partnership -> (1) All partners are liable for the firm’s debt. That is, a lender can
require any partner to repay all the firm’s debts; (2) The partnership ends on the death or
withdrawal of any single partner, although partners can avoid liquidation if the partnership
agreement provides for alternatives as buyout.
o Limited partnership -> There are two types of partners, the difference is that a limited, in
contrast to general partner, is only liable to the amount of his investment: limited partners
have no management authority and are excluded from their decision making.
o Some old and established businesses remain partnerships or sole proprietorships. Often
these firms are the types of businesses in which the owner’s personal reputations are the
basis for the businesses (e.g. law firms, doctor groups, accounting firms).
- Limited Liability Companies (LLC) -> Limited partnership without a general partner. That is, all
the owners have limited liability, but unlike limited partners, they can also run the business.
- Corporation -> Is legally defined, artificial being, separate from its owners.
o Has many of the legal powers that people have (enter into contracts, acquire assets,
protection); is solely responsible for its own obligations. Consequently, the owners are not
liable for any obligations the corporation enters into. Similarly, the corporation is not liable
for any personal obligations.
o Formation of a corporation: Corporations must be legally formed (consent by state,
incorporation); therefore more costly than setting up a sole proprietorship.
o Ownership of a corporation: No limit on the number of owners. Because most have many
owners, each owner owns only a small fraction of the corporation. The entire ownership
stake of a corporation is divided into shares known as stock. The collection of all the
outstanding shares of a corporation is known as the equity.
▪ Advantage: No limitation on who can own its stock. An owner of a corporation doesn’t
need any special expertise or qualification → free trade in shares → corporations can
raise substantial amounts of capital because they can sell ownership shares to
anonymous outside investors.
Tax implications for corporate entities
- Double taxation: Because a corporation is a separate legal entity, a corporation’s profits are
subject to taxation separate from its owners’ tax obligations. In effect, shareholders of a
corporation pay taxes twice.
, o The corporation pays tax on its profits, and then when the remaining profits are distributed
to the shareholders, the shareholders pay their own personal income tax on this income.
- Corporate organizational structure is the only organizational structure subject to double taxation.
- The U.S. Internal Revenue Code allows an exemption from double taxation for “S’’ Corporations.
Under these tax regulation, the firm’s profits (and losses) are not subject to corporate taxes, but
instead are allocated directly to shareholders based on their ownership share. The shareholders
must include these profits as income on their individual tax returns (even if no money is
distributed to them). However, after the shareholders have paid income taxes on these profits,
no further tax is due.
o The government places strict limitations on the qualifications for subchapter S tax
treatment. In particular, the shareholders of such corporations must be individuals who are
U.S. citizens or residents, and there can be no more than 100 of them. Because most
corporations have no restrictions on who owns their shares or the number of shareholders,
they cannot qualify for subchapter S treatment (less than one quarter).
o So most large corporations are “C” corporations, which are corporations subject to
corporate taxes.
Ownership Vs. Control of Corporations
- In a corporation, direct control and ownership are often separate. Rather than owners, the board
of directors and chief executive officer possess direct control of the corporation.
- Corporate management team
o Shareholders exercise their control by electing a board of directors, who have the ultimate
decision-making authority in the corporation (they make rules, set policies, monitor
performance, etc. It delegates most decisions that involve day-t-day running of the
corporation to its management).
o Chief executive officer (CEO) is charged with running the corporation by instituting the rules
and policies set by the board of directors.
o The most senior financial manager is the chief financial officer (CFO), who often reports
directly to the CEO.
o The financial managers are responsible for three main tasks:
▪ (1) Investment decisions: Financial managers must weigh the costs and benefits of all
investments and projects and decide which of them qualify. These decisions
fundamentally shape what the firm does and whether it will add value for its owners.
▪ (2) Financing decisions: Also decides how to pay for investments; decide whether to
raise more money from new and existing owners by selling more shares of stock
(equity) or to borrow the money (debt).
▪ (3) Cash management: Ensure that the firm has enough cash on hand to meet its day-
to-day obligations.
- Ethics and incentives within corporations:
o Agency problem – when managers, despite being hired as the agents of shareholders, put
their own self-interest ahead of the interests of shareholders.
o The CEO’s performance
▪ In a hostile takeover, an individual or organization (corporate raider) can purchase a
large fraction of the stock and acquire enough votes to replace the board of directors
and the CEO.
o Corporate bankruptcy need not to result in liquidation of the firm, which involves shutting
down the business and selling off its assets.
- Two sets of investors with claims to its cash flows: debt holders and equity holders.
, o As long as the corporation can satisfy the claims of the debt holders, ownership remains in
the hands of the equity holders. If the corporation fails to satisfy debt holders’ claims, debt
holders may take control of the firm. Thus, a corporate bankruptcy is best thought of as a
change in ownership of the corporation, and not necessarily as a failure of the business.
The stock market
- The value of shareholders’ investment is determined by the price of a share.
o Because private companies have a limited set of shareholders and their shares are not
regularly traded, the value of their shares can be difficult to determine.
o But many corporations are public companies, whose shares trade on organized markets
called a stock market (or stock exchange).
- These markets provide liquidity and determine a market price for the company’s shares. An
investment is said to be liquid if it is possible to sell it quickly and easily for a price very close to
the price at which you could contemporaneously buy it.
o This is attractive to outside investors, as it provides flexibility regarding the timing and
duration of their investment in the firm.
- When a corporation itself issues new shares of stock and sells them to investors, it does so on the
primary market. After this initial transaction between the corporation and investors, the shares
continue to trade in a secondary market between investors without the involvement of the
corporation.
- Market makers (specialists) matched buyers and sellers. They posted the price at which they
were willing to buy the stock (the bid price) and the price at which they were willing to sell the
stock (the ask price).
o When a customer arrived and wanted to make a trade at these prices, the market maker
would honor the posted prices (up to a limited amount) and make the trade even when they
did not have another customer willing to take the other side of the trade. In this way, they
provided liquidity by ensuring that market participants always had somebody to trade with.
o The profit/difference is called the bid-ask spread -> this is a transaction cost investors pay in
order to trade.
- Anyone can make a market in a stock by posting a limit order – an order to buy or sell a set
amount at a fixed price.
o The limit sell order with the lowest price is the ask price. The limit buy order with the
highest price is the bid price.
o Traders make the market in the stock by posting these orders. The collection of all limit
orders is known as the limit order book.
- Alternative trading systems called dark pools do not make their limit order books visible.
Chapter 2: Introduction to financial statement analysis
, Firms’ disclosure of financial information
- Financial statements are accounting reports with past performance information that a firm
issues periodically (usually quarterly (10-Q) and annually (10-K)).
- They must also send an annual report with their financial statements to their shareholders.
- Private companies often prepare financial statements as well, but they usually do not have to
disclose these reports to the public.
- Generally Accepted Accounting Principles (GAAP) provide a common set of rules and a standard
format for public companies to use when they prepare their reports.
o Corporations are required to hire a neutral third party, known as an auditor to check the
annual financial statements, to ensure that they are reliable and prepared according to
GAAP.
- Every public company is required to produce four financial statements: (1) the balance sheet, (2)
the income statement, (3) the statement of cash flows, and (4) the statement of stockholders’
equity.
The Balance Sheet
- The balance sheet (statement of financial position) lists the firm’s assets and liabilities, providing
a snapshot of the firm’s financial position at a given point in time.
- Assets on the left side, liabilities on the right.
- The assets list the cash, inventory, property, plant, and equipment, and other investments the
company has made.
o Current assets are either cash or assets that could be converted into cash within one year.
▪ Cash and other marketable securities, which are short-term. Low-risk investments that
can easily be sold and converted to cash (money market investments maturing in year).
▪ Accounts receivable, which are amounts owed to the firm, by customers who have
purchased goods or services on credit.
▪ Inventories, which are composed of raw materials as well as work-in-progress and
finished goods.
▪ Other current assets, which is a catch-all category that includes items such as pre-paid
expenses (rent or insurance paid in advance).
o Long-term assets: Net property, plant, and equipment. Assets such as real estate or
machinery that produce tangible benefits for more than one year.
▪ You might have to reduce the value recorded for equipment each year by deducting a
depreciation expense: an asset’s accumulated depreciation is the total amount
deducted over its life.
▪ The Book value of an assets, which is shown on the financial statements, is equal to its
acquisition costs less accumulated depreciation. Net property, plant, and equipment.
▪ Goodwill/Intangible assets: Difference between the price paid for the company and
the book value assigned to its tangible assets.
• Captures the value of other “intangibles” that the firm acquired through the
acquisition (e.g. brand names, trademarks, patents, customer relationships,
employees). If the firm assesses that the value of these intangible assets declined
over time, it will reduce the amount listed on the balance sheet by an amortization
or impairment charge that captures the change in value of the acquired assets.
• Like depreciation, amortization is not an actual cash expense.
- The liabilities show the firm’s obligations to creditors and include the stockholders’ equity, the
difference between the firm’s assets and liabilities (accounting measure of the firm’s net worth).
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