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Finance 1: summary final exam year 1
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summary finance 1 final exam year 1, UvA
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Summary financeCH1:
Four types of firms:
1. sole proprietorship: business owned and run by one person. Very small with few, if any,
employees. Do not account for many sales revenue, but they are the most common type of
firm in the world.
Key characteristics sole proprietorship:
- straightforward to set up
- principal limitation of it is that there is no separation between firm and owner – firm can
only have one owner. If there are other investors, they cannot hold ownership stake.
- owner has unlimited personal liability for any of firm’s debts. If firm defaults on any debt
payment, lender can (and will) require owner to repay loan from personal assets. Owner
who cannot afford to repay loan must declare personal bankruptcy.
- life of sole proprietorship is limited to life of owner. Also difficult to transfer ownership of
sole proprietorship.
For most businesses, disadvantages outweigh advantages. As soon reach point where can
borrow without being personal liable, owner converts business into form that limits owner
liability.
2. partnerships: identical to sole proprietorship but has more than one owner.
Key characteristics partnerships:
- all partners are liable for the firm’s debt. Lender can require any partner to repay all firm’s
outstanding debts.
- partnerships ends on death or withdrawal of any single partner. Although partners can
avoid liquidation if partnership agreement provides for alternatives such as buyout of
deceased or withdrawn partner.
Some old businesses remain partnerships or sole proprietorships. Often these firms are
types of businesses in which owners’ personal reputations are basis for the business.
Limited partnership: partnership with two kinds of owners; general partners (= have same
rights and privileges as partners in a (general) partnership – they are personally liable for
firm’s debt obligations) and limited partners (= have limited liability – their liability is limited
to their investment. Private property cannot be seized to pay off firm’s outstanding debts,
death/withdrawal limited partner does not dissolve partnership, limited partner’s interest is
transferable, however, limited partner has no management authority and cannot legally be
involved in managerial decision making for business).
Examples of industries dominated by limited partnerships: (in these, few general partners
contribute some of own capital and raise additional capital from outside investors who are
limited partners, general partners control how capital is invested, outside investors play no
active role in partnership other than monitoring how their investments are performing)
→ private equity funds
→ venture capital funds
,3. limited liability companies: is a limited partnership without general partner. All owners
have limited liability, but unlike limited partners, can also run business.
4. corporations (most important): a legally defined, artificial being (judicial person or legal
entity, separate from its owners. Has many of legal powers that people have. Can enter into
contracts, acquire assets, incur obligations, enjoys protection against seizure of its property.
Because corporation legal entity separate and distinct from its owners, its solely responsible
for own obligations. Owners of corporation (or employees, customers) are not liable for any
obligations the corporation enters into. Similarly, corporation not liable for any personal
obligation of its owners.
• Formation of a corporation:
Must be legally formed (chartered). Setting up corporation more costly than sole
proprietorship. For jurisdictional purposes, corporation is citizen of state in which it
is incorporated. Firms hire lawyers to create corporate charter that includes articles
of incorporation and set of bylaws. Charter specifies initial rules that govern how
corporation is run.
• Ownership of a corporation
No limit on number of owners corporation can have. Each owner own small fraction.
Ownership divided into shares (stock). Collection of all outstanding shares of
corporation is known as equity. Owner of share of stock known as shareholder,
stockholder, or equity holder and is entitled to dividend payments (=payments made
at discretion of corporation to equity holders). Unique feature corporation: no
limitation on who can own its stock. You do not need qualification/expertise (most
important advantage of corporation). Corporations can raise substantial amounts of
capital because can sell ownership shares to anonymous outside investors.
Availability of outside funding enabled corporation to dominate economy.
Tax implications for corporate entities:
Important difference between forms is way they tax. Corporation is separate legal entity
thus its profits are subject to taxation separate from owners’ tax obligations. Shareholders
of corporation pay taxes 2x.
1. first, corporation pays tax on its profits
2. when remaing profits distributed to sharheolders, shareholders pay own personal income
tax on this income (double taxation).
S corporations: corporate organizational structure only structure subject to double taxation.
US I.R.V allows exemption from DT for S corporations, which are corps that elect subchapter
S treatment. Under these tax rules, firm’s profits (and losses) are not subject to corporate
taxes, but are allocated directly to shareholders. Shareholders must include these profits as
,income on their individual tax returns (even if no money distributed to them). After
shareholders have paid income taxes on these profits, no further tax is due. Gov places
limitations on qualifications for subchapter S tax treatment. In particular, shareholders of
such corps must be indiv. Who are US citizens/residents, and can be no more than 100 of
them. Most do not qualify so they are C corporations, which are corps subject to corporate
taxes.
1.2 ownership vs control of corporations
- not feasible for owners corp to have direct control of firm because many owners. Direct
control and ownership separate.
- board of directions and chief executive officer possess direct control of corporation.
Corporate management team
Board of directors: group of people who have ultimate decision-making authority in
corporation. Each share of stock gives shareholder one vote in election of board of
directions, so investors with most shares have most influence. When 1 or 2 shareholders
own very large proportion of outstanding stock, thus may be on board or may have right to
appoint number of directors. Board makes rules in how corporation should be run. (incl.
how topmanagers in corp are compensated), sets policy, monitors performance of company
Board deligates decisions that involde day-to-day running to its management.
Chief executive officer (CEO): charged with running corp by instituting rules/policy set by
board of directors. Size of rest of management team varies. Separation of powers within
corporation between board of directors and CEO not always distinct. Not uncommon for
CEO to also be chairman of board.
Chief financial officer (CFO): most senior financial manager, who reports directly to CEO.
The financial manager
Responsible for three main tasks:
1. investment decisions:
Most important job to make investment decisions. Must weigh costs and benefits of all
investments and projects and decide which of them qualify as good uses of the money
, stockholders have invested in the firm. These decisions shape what firm does and if will add
value for its owners.
2. financing decisions:
Once decided which investments to make, he/she decides how to pay for them. Large
investments require corporation to raise additional money. Manager must decide whether
to raise more money from new and existing owners by selling more shares of stock (equity)
or to borrow money (debt).
3. cash management:
Manager must ensure firm has enough cash on hand to meet day-to-day obligations. This
job, also known as managing working capital, can mean in young/growing company
difference between success and failure. A company burns through significant amount of
cash developing a new product before its sales generate income. Manager job to make sure
access to cash does not hinder firm’s success.
The goal of the firm
- in theory determined by firm’s owners. Sole proprietorship goals same as owner goals (one
owner). In organizational form with multiple owners, appropriate goal of firm not clear.
- corporations have thousands of owners (shareholders). Each owner different
interest/priorities.
- all shareholders will agree that they are better off if management makes decisions that
increase value of their shares.
The firm and the society
- even if corporation only makes shareholders better off, as long as nobody else is made
worse off by its decisions, increasing value of equity is good for society.
- problem occurs when increasing value of equity comes at expense of others. Consider corp
that pollutes environment and does not pay cost to clean up pollution. Alternatively,
corporation may not itself pollute, but use of its products may harm environment, thus
decisions that increase shareholder wealth can be costly for society as a whole.
- when actions of corporation impose harm on others in economy, appropriate public policy
and regulation is required to assure that corporate interests and societal interests remain
aligned. Sound public policy should allow firms to continue to pursue maximization of
shareholder value in way that benefits society overall.
Ethics and incentives within corporations
- goals must be implemented, in simple organization form as SPS, owner can ensure firm’s
goal match his/her own. Corporation run by management team, separate from its owners,
giving rise to conflicts of interest.
- agency problems: people claim that because of separation ownership and control in
corporation, managers have little incentive to work in interests of shareholders when means
working against own self-interest. Agency problem is when managers, despite being hired as
agents of shareholders, put own self-interest ahead of interests of shareholders. Managers
face ethical dilemma of whether to adhere to their responsib. To put intrest of shareholders
first, or to do what is in own personal best interest.
- problem commonly addressed In practice by minimizing number of decisions managers
must make from which own self-interest differs from shareholder’s interest.
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