,Chapter 1 | Corporate Finance and the Financial Manager
Valuation Principle: shows how to make the costs and benefits of a decision comparable so that we
can weigh them properly.
The four types of firms:
1. Sole proprietorships: a business owned and run by one person.
Key features:
- Advantage of being straightforward to set up.
- Limitation is that there is no separation between the firm and the owner (the
firm can have only one owner who runs the business).
- The owner has unlimited personal liability for the firm’s debts.
- The life of a sole proprietorship is limited to the life of the owner.
2. Partnerships: a business owned and run by more than one owner.
Key features:
- All partners are liable for the firm’s debt.
- The partnership ends in the event of the death or withdrawal of any single
partner.
- Partners can avoid liquidation if the partnership agreement provides for
alternatives such as a buyout of a deceased or withdrawn partner.
Limited partnership: a partnership with two kinds of owners: general partners (same
rights and privileges as partners) and limited partners (liability is limited to their
investment).
3. Limited liability companies (LLC): a limited partnership without a general partner. All the
owners (members) have limited liability, but unlike limited partners, they can also run the
business (managing members).
4. Corporations: a legally defined, artificial being (a legal entity), separate from its owners.
Formation of a corporation: the state in which a corporation is incorporated must
formally give its consent to the incorporation by chartering it.
Ownership of a corporation: there is no limit to the number of owners a corporation
can have.
- Stock: the ownership or equity of a corporation divided into shares.
- Equity: the collection of all the outstanding shares of a corporation.
- Shareholder/stockholder/equity holder: an owner of a share of stock or equity
in a corporation.
- Dividend payments: payments made at the discretion of the corporation to its
equity holders.
Advantage: an owner of a corporation need not have any special expertise or
qualification. This feature allows free and anonymous trade in the shares of the
corporation.
Biggest percentage of businesses: 71.8% - Sole proprietorships
Biggest percentage of revenue: 84.9% - Corporations
Double taxation: when the corporation first 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.
Types of corporations:
1. S Corporations: those corporations that elect subchapter S tax treatment and are exempted
by the U.S. Internal Revenue Service’s tax code from double taxation.
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, The firm’s profits (and losses) are not subject to corporate taxes, but instead are
allocated directly to shareholders. The shareholders must include these profits as
income on their individual tax returns.
2. C Corporations: corporations that have no restrictions on who owns their shares or the
number of shareholders; they cannot qualify for subchapter S tax treatment and are subject
to direct taxation.
Shareholders, for subchapter S tax treatment, must be individuals who are U.S.
citizens or residents, and there can be no more than 100 of them.
Table – Characteristics of the different types of firms
Number of Liability for Owners Ownership Taxation
owners firm’s debts manage the change
firm dissolves firm
Sole One Yes Yes Yes Personal
Proprietorship
Partnership Unlimited Yes; each Yes Yes Personal
person is
liable for the
entire amount
Limited At least one GP-Yes GP-Yes GP-Yes Personal
Partnership general (GP), LP-No LP-No LP-No
no limit on
limited
partners (LP)
Limited Unlimited No Yes No* Personal
Liability
Company
S Corporation At most 100 No No (but they No Personal
legally may)
C Corporation Unlimited No No (but they No Double
legally may)
*However, most LLCs require the approval of the other members to transfer your ownership.
Tasks of financial manager:
1. Make investment decisions: the financial manager must weigh the costs and benefits of each
investment or project and decide which ones qualify as good uses of the money stockholders
have invested in the firm. These decisions fundamentally shape what the firm does and
whether it will add value for its owners.
2. Make financing decisions: the financial manager must decide whether to raise more money
from new and existing owners by selling more shares of stock (equity) or to borrow the
money instead.
Bond: is a security sold by governments and corporations to raise money form
investors today in exchange for a promised future payment.
3. Manage short-term cash needs: the financial manager’s job is to make sure that limited
access to cash does not hinder the firm’s success.
Managing working capital: the financial manager must ensure that the firm has
enough cash on hand to meet its obligations from day to day.
The Goal of the financial manager is to maximize the wealth of the owners, the stockholders.
3
, The board of directors and the management team headed by the chief executive officer possess
direct control of the corporation.
Board of directors: a group of people elected by shareholders who have the ultimate
decision-making authority in the corporation.
Makes rules on how the corporation should be run, sets policy, and monitors the
performance of the company.
Chief executive officer (CEO): the person charged with running the corporation by instituting
the rules and policies det by the board of directors.
Figure – The financial functions within a corporation
Possibilities to ensure that the management team will implement the goals of the owners:
1. Agency problem: when managers, despite being hired as the agents of shareholders, put
their self-interest ahead of the interests of those shareholders.
Managers face the ethical dilemma of whether to adhere to their responsibility to
put the interests of shareholders first, or to do what is in their personal best
interests.
Solution: minimize the number of decisions managers make that require putting their
self-interest against the interests of the shareholders.
2. The CEO’s performance: another way shareholders can encourage managers to work in the
interests of shareholders is to discipline them if they do not.
Hostile takeover: a situation in which an individual or organization (corporate raider)
purchases a large fraction of a company’s stock and in doing so gets enough votes to
replace the board of directors and its CEO.
The stock market:
- Stock market/stock exchange/bourse: organized market on which the shares of many
corporations are traded.
- Liquid: describes an investment that can be easily turned into cash because it can be sold
immediately at a competitive market price.
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