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Finance 1 for Business, Summary Endterm. Grade: 10
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Full summary for Finance 1 for Business. Bachelor Business Administration at the UvA, second year.
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Summary Finance 1Chapter 1
Sole proprietorship=business owned and run by one person. Easy to set up. No separation between
firm and owner -> other investors cannot hold ownership. Unlimited personal liability. Life of the firm
is limited to the life of the owner, difficult to transfer ownership.
Partnership=identical to sole proprietorship but with multiple owners. All partners are liable for the
firm’s debt. The partnership ends on the death or withdrawal of a partner, although the agreement
can provide alternatives such as buyouts. Remain partnership if personal reputation is the basis of
the business. Personal liability increases confidence.
Limited partnership has 2 kinds of owners: general and limited partners. For limited partners
the liability is limited to initial investment. Has no management authority. Death or withdrawal does
not dissolve the partnership.
Limited liability company (LLC)=limited partnership without general partner. Owners have
limited liability but can also run the business.
Corporation=legally defined, artificial being, separate from its owners. Has many of the legal powers
that people have. Corporation is solely responsible for its own obligations -> owners are not liable.
Must be legally formed (state gives its consent) -> costly. Create a corporate charter with rules.
Ownership is divided into shares=stock. Equity=collection of all outstanding shares. A corporation’s
profits are subject to taxation separate from its owners’ tax obligations -> shareholders pay taxes
twice. “S” corporations: elect subchapter S tax treatment -> the firm’s profits are not subject to
corporate taxes, but instead are allocated directly to shareholders based on their ownership share.
Shareholders must include these profits as income, even if no money is distributed to them.
In a corporation, direct control and ownership are often separate; rather than owners, the board of
directors and chief executive officer possess direct control.
Shareholders exercise their control by electing a board of directors, a group of people who have the
ultimate decision-making authority. Day-to-day decisions are delegated to its management.
3 responsibilities of financial managers:
1. Investment decisions.
2. Financing decisions.
3. Cash (flow) management – to develop new products.
The goal of the firm should be determined by its owners. Difficult if there are many owners ->
increase value of shares.
Agency problem=when managers, despite being hired as the agents of shareholders, put their own
self-interest ahead of the interests of shareholders. Due to separation of ownership and control in a
corporation. Minimize the number of decisions managers must make for which their own self-
interest substantially differs from the interests of shareholders: compensation contracts. Tying
compensation too closely to performance might let the manager take on more risk. Discipline CEOs if
they don’t act in the interests of shareholders, pressure board to oust them. Or sell shares -> price
lowers -> hostile takeover: an individual/organization (sometimes known as corporate raider) can
purchase a large fraction of the stock and acquire enough votes to replace the board and CEO. Price
rises thanks to new management. This threat leads to a market for corporate control.
, If a firm is unable to repay or renegotiate with the debt holders, the control of the corporation’s
assets will be transferred to them. Bankruptcy need not result in a liquidation which involves
shutting down the business and selling off its assets.
Stock markets provide liquidity. 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.
When a corporation itself issues new shares of stock and sells them to investors, it does so on the
primary market. Afterwards shares continue to trade in a secondary market between investors
without the involvement of the corporation.
Market makers (specialist) match buyers and sellers. They posted 2 prices for every stock: the price
at which they are willing to buy (bid price) and the price at which they are willing to sell (ask price).
Provide liquidity by ensuring that market participants always had somebody to trade with. They
make money because ask prices are higher than bid prices: bid-ask spread. This is a transaction cost
investors pay in order to trade.
With changes in market structure, the role of an official market maker has largely disappeared.
Anyone can make a market in a stock by posting a limit order: an order to buy/sell a set amount at a
fixed price. Limit order book=collection of all limit orders.
Market orders trade immediately at the best outstanding limit order. Those people are said to be
“takers” of liquidity.
Dark pools do not make their limit order books visible. Offer investors the ability to trade at a better
price (e.g. the average of the bid and ask, saving the bid-ask spread), with the tradeoff being that the
order might not be filled if an excess of either buy or sell orders is received.
Chapter 2
Financial statements are accounting reports with past performance information that a firm issues
periodically. Quarterly: 10-Q. yearly: 10-K. Must send annual report to shareholders.
Auditor=neutral third party that checks the annual financial statements to ensure that they are
reliable and prepared according to Generally Accepted Accounting Principles.
Stockholders’ equity=difference between assets and liabilities, an accounting measure of the firm’s
net worth. Book value of equity.
Current assets=assets that could be converted into cash within one year. Marketable securities:
short-term, low-risk investments that can be easily sold. Accounts receivable. Inventories. Prepaid
expenses.
Long-term assets: first category: net property, plant, and equipment. Amortization/impairment
change: depreciation of intangible assets.
Current liabilities: accounts payable, short-term debt/notes payable and current maturities of long-
term debt, salary/taxes owed and deferred/unearned revenue (received but not delivered).
Net working capital=current assets – current liabilities.
Long-term liabilities: long-term debt, capital leases, deferred taxes.
Market value of equity/market capitalization=shares outstanding x market price per share.
Market-to-book ratio/price-to-book [P/B] ratio=market value of equity/book value of equity.
Value-stocks=low market-to-book ratio, growth stocks=high market-to-book ratio.
Enterprise value=market value of equity + debt – cash. The cost to take over the business.
Gross profit=total sales – cost of sales (COGS).
Operating income=gross profit – operating expenses (includes depreciation).
Earnings before interest and taxes (EBIT)=operating income + other income.
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