Finance 1 Summary from Jonathan B. Berk and Peter DeMarzo's "Corporate Finance, Global Edition" (2019). The summary is 212 pages and includes all the chapters covered in the course 6012B0422Y at UvA, as well as notes from the lectures.
Test Bank for Corporate Finance, 5th Edition by Jonathan Berk, DeMarzo Chapter 1-31 A++
UPDATED Finance 1 for Business Summary
Test Bank For Corporate Finance The Core, 5th Edition by Jonathan Berk, Peter DeMarzo Chapter 1-19
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Universiteit van Amsterdam (UvA)
Business Administration
Finance 1 (6012B0422Y)
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Corporate Finance: Global Edition 4
Chapter 1: The Corporation 2
Chapter 2: Introduction to Financial Statement Analysis 11
Chapter 3: Financial Decision Making and the Law of One Price 27
Lecture 1a 44
Lecture 1b 46
Chapter 4: The Time Value of Money 48
Chapter 5: Interest Rates 62
Chapter 6: Valuing Bonds 71
Lecture 2a 84
Lecture 2b 88
Chapter 7: Investment Decision Rules 90
Chapter 8: Fundamentals of Capital Budgeting 102
Lecture 3a 116
Lecture 3b 118
Chapter 9: Valuing Stocks 121
Chapter 10: Capital Markets and the Pricing of Risk 132
Chapter 11: Optimal Portfolio Choice and Capital Asset Pricing Model 146
Lecture 5a 162
Lecture 5b 166
Chapter 12: Estimating the Cost of Capital 169
Chapter 9: Valuing Stocks 175
Chapter 13: Investor Behaviour and Capital Market Efficiency 178
Lecture 6a 184
Lecture 6b 187
Chapter 26: Working Capital Management 191
Chapter 27: Short-Term Financial Planning 202
,Corporate Finance: Global Edition 4
Chapter 1: The Corporation
The Four Types of Firms
• Sole Proprietorships
o A sole proprietorship is a business owned and run by one person.
o Sole proprietorships are usually very small with few, if any, employees.
o Although they do not account for much sales revenue in the economy, they are the most
common type of firm in the world.
o Sole proprietorships share the following key characteristics:
§ Sole proprietorships are straightforward to set up.
• Consequently, many new businesses use this organizational form.
§ The principal limitation of a sole proprietorship is that there is 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.
§ The owner has unlimited personal liability for any of the firm’s debts.
• That is, if the firm defaults on any debt payment, the lender can (and will)
require the owner to repay the loan from personal assets. An owner who
cannot afford to repay the loan must declare personal bankruptcy.
§ The life of a sole proprietorship is limited to the life of the owner. It is also difficult
to transfer ownership of a sole proprietorship.
o For most businesses, the disadvantages of a sole proprietorship outweigh the advantages.
§ As soon as the firm reaches the point at which it can borrow without the owner
agreeing to be personally liable, the owners typically convert the business into a
form that limits the owner’s liability.
• Partnerships
o A partnership is identical to a sole proprietorship except it has more than one owner.
o The following are key features of a partnership:
§ All partners are liable for the firm’s debt.
• That is, a lender can require any partner to repay all the firm’s outstanding
debts.
§ The partnership ends on the death or withdrawal of any single partner, although
partners can avoid liquidation if the partnership agreement provides for alternatives
such as a buyout of a deceased or withdrawn partner.
o Some old and established businesses remain partnerships or sole proprietorships.
§ Often these firms are the types of businesses in which the owners’ personal
reputations are the basis for the businesses.
• For example, law firms, groups of doctors, and accounting firms are often
organized as partnerships.
§ For such enterprises, the partners’ personal liability increases the confidence of the
firm’s clients that the partners will strive to maintain their reputation.
o A limited partnership is a partnership with two kinds of owners, general partners and limited
partners.
§ General partners have the same rights and privileges as partners in a (general)
partnership—they are personally liable for the firm’s debt obligations.
§ Limited partners, however, have limited liability—that is, their liability is limited to
their investment.
• Their private property cannot be seized to pay off the firm’s outstanding
debts.
• Furthermore, the death or withdrawal of a limited partner does not
dissolve the partnership, and a limited partner’s interest is transferable.
• However, a limited partner has no management authority and cannot
legally be involved in the managerial decision making for the business.
o Private equity funds and venture capital funds are two examples of industries dominated by
limited partnerships.
,Corporate Finance: Global Edition 4
§ In these firms, a few general partners contribute some of their own capital and raise
additional capital from outside investors who are limited partners.
§ The general partners control how all the capital is invested.
• Most often they will actively participate in running the businesses they
choose to invest in.
§ The outside investors play no active role in the partnership other than monitoring
how their investments are performing.
• Limited Liability Companies
o A limited liability company (LLC) is a limited partnership without a general partner.
§ That is, all the owners have limited liability, but unlike limited partners, they can
also run the business.
o The LLC is a relatively new phenomenon in the United States.
o Internationally, companies with limited liability are much older and established.
• Corporations
o The distinguishing feature of a corporation is that it is a legally defined, artificial being (a
judicial person or legal entity), separate from its owners.
o As such, it has many of the legal powers that people have.
§ It can enter into contracts, acquire assets, incur obligations, and, as we have already
established, it enjoys protection under the U.S. Constitution against the seizure of
its property.
o Because a corporation is a legal entity separate and distinct from its owners, it is solely
responsible for its own obligations.
§ Consequently, the owners of a corporation (or its employees, customers, etc.) are
not liable for any obligations the corporation enters into.
§ Similarly, the corporation is not liable for any personal obligations of its owners.
o Formation of a Corporation.
§ Corporations must be legally formed, which means that the state in which it is
incorporated must formally give its consent to the incorporation by chartering it.
§ Setting up a corporation is therefore considerably more costly than setting up a sole
proprietorship.
§ For jurisdictional purposes, a corporation is a citizen of the state in which it is
incorporated.
§ Most firms hire lawyers to create a corporate charter that includes formal articles of
incorporation and a set of bylaws.
• The corporate charter specifies the initial rules that govern how the
corporation is run.
o Ownership of a Corporation.
§ There is no limit on the number of owners a corporation can have.
§ Because most corporations 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
of the corporation.
§ An owner of a share of stock in the corporation is known as a shareholder,
stockholder, or equity holder and is entitled to dividend payments, that is,
payments made at the discretion of the corporation to its equity holders.
• Shareholders usually receive a share of the dividend payments that is
proportional to the amount of stock they own.
o A unique feature of a corporation is that there is no limitation on who can own its stock.
§ That is, an owner of a corporation need not have any special expertise or
qualification.
§ This feature allows free trade in the shares of the corporation and provides one of
the most important advantages of organizing a firm as a corporation rather than as
sole proprietorship, partnership, or LLC.
, Corporate Finance: Global Edition 4
§ Corporations can raise substantial amounts of capital because they can sell
ownership shares to anonymous outside investors.
o The availability of outside funding has enabled corporations to dominate the economy.
• Tax Implications for Corporate Entities
o An important difference between the types of organizational forms is the way they are
taxed.
o 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.
§ First, 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.
§ This system is sometimes referred to as double taxation.
o S Corporations.
§ The corporate organizational structure is the only organizational structure subject
to double taxation.
§ However, the U.S. Internal Revenue Code allows an exemption from double taxation
for “S” corporations, which are corporations that elect subchapter S tax treatment.
§ Under these tax regulations, 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.
§ Thus most large corporations are “C” corporations, which are corporations subject
to corporate taxes.
§ S corporations account for less than one quarter of all corporate revenue.
Ownership versus Control of Corporations
• It is often not feasible for the owners of a corporation to have direct control of the firm because there
are sometimes many owners, each of whom can freely trade his or her stock.
o That is, in a corporation, direct control and ownership are often separate.
• Rather than the owners, the board of directors and chief executive officer possess direct control of the
corporation.
• The Corporate Management Team
o The shareholders of a corporation exercise their control by electing a board of directors, a
group of people who have the ultimate decision-making authority in the corporation.
o In most corporations, each share of stock gives a shareholder one vote in the election of the
board of directors, so investors with the most shares have the most influence.
§ When one or two shareholders own a very large proportion of the outstanding
stock, these shareholders may either be on the board of directors themselves, or
they may have the right to appoint a number of directors.
o The board of directors makes rules on how the corporation should be run (including how the
top managers in the corporation are compensated), sets policy, and monitors the
performance of the company.
§ The board of directors delegates most decisions that involve day-to-day running of
the corporation to its management.
o The chief executive officer (CEO) is charged with running the corporation by instituting the
rules and policies set by the board of directors.
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