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Chapter 1-5 Summary Corporate Finance
Detailed notes on the stated chapter including diagrams and relevant equations.
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Corporate Finance Pearson 5th EditionChapter 1: The Corporation
The Four Types of Firms
1. Sole proprietorship
a. A business owned and run by one person
b. They are the most common type of firm in the world although they do not account
for much sales revenue in the economy.
c. Key characteristics:
i. They are straightforward to set up
ii. Limitation → there is no separation between the firm and the owner
- Investors cannot hold an ownership stake in the firm
iii. The owner has unlimited personal liability for any of the firm’s debts
iv. The life of a sole proprietorship is limited to the life of the owner
2. Partnerships
a. It is identical to a sole proprietorship but it has more than one owner.
i. All partners are liable for the firm’s debt
ii. The partnerships end on the death or withdrawal of any single partner
Sole Proprietorship & Partnerships
- These firms are the types of businesses in which the owners’ personal reputations are the
basis for the business
- Law firms, groups of doctors, and accounting firms
- A limited partnership is a partnership with two kinds of owners, general partners, and
limited partners.
,Corporate Finance Pearson 5th Edition
- General partners have the same rights and privileges as partners in the
partnership (liable for debts)
- Limited partners have limited liability, that is their liability is limited to their
investment.
- Their private property cannot be seized off to pay for the firm’s debts.
- Their death does not dissolve the partnership and the interest is
transferable
- A limited partner has no management authority and cannot legally be
involved in the managerial decision-making for the business
- Examples: Private equity funds and venture capital funds
3. Limited liability companies (LLC)
a. A limited partnership without a general partner; all owners have limited liability
and also run the business
4. Corporations
a. A legally defined, artificial being (a judicial persona or legal entity), separate from
its owners
b. It can enter into contracts, acquire assets, incur obligations, and, enjoys protection
under the US Constitution against the seizure of its property.
c. The owners are not liable for any obligations the corporation enters into
- Formation of a Corporation
- Legally formed by means that the state in which it is incorporated must formally
give its consent to the incorporation by chartering it.
- More costly than a sole proprietorship
- A corporate charter set up by the firm’s lawyers specifies the initial rules that
govern how the corporation is run.
- Ownership of a Corporation
,Corporate Finance Pearson 5th Edition
- There is no limit to the number of owners who own a small fraction
- 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, or payments
made at the discretion of the corporation to its equity holders.
- The owner of a corporation need not have any special expertise or qualification to
allow free trade in the shared of the corporation.
- Advantage → Corporations can raise substantial amounts of capital
because they can sell ownership shares to anonymous outside investors.
Tax Implication for Corporate Entities
- A corporation’s profits are subject to taxation separate from its owner’s tax obligations.
- Double taxation → corporation pays tax on its profit and then the shareholders
pay their own personal income tax on the income made by the profits of the
corporation.
- S Corporations
- The U.S. Internal Revenue Code allows an exemption from double taxation for “S”
corporations, which are corporations that elect subchapter S tax treatment.
- The firm’s profits are not subject to corporate taxes but instead are allocated to
shareholders based on their shares.
Ownership Versus Control of Corporations
- In a corporation, direct control and ownership are often separate
- Why? Because there are too many owners that can freely trade their stock.
, Corporate Finance Pearson 5th Edition
- The board of directors and chief executive officers possess direct control of the
corporation
The Corporate Management Team
- A board of directors is a group of people who have the ultimate decision-making
authority in the corporation.
- How is this elected? 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.
- What is their job? The board of directors makes rules on how the corporation should be
run, sets policy, and monitors the performance of the company.
- The chief executive officer (CEO) is charged with running the corporation by instituting
the rules and policies set by the board of directors
- It is not uncommon for the CEO to be the chairman of the board of directors
- The most senior financial officer (CFO) often reports directly to the CEO.
The Financial Manager
- Financial managers are responsible for three tasks: making investment decisions, making
financing decisions, and managing the firm’s cash flow.
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