Chapter 1

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Corporate Finance and the Financial Manager
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1

Four types of firms

1. Sole proprietorship

2. Partnerships

3. Limited Liability Companies

4. Corporations

2

Sole Proprietorship

-owned and run by 1 person

-represent 71% of all businesses in the US

-account for ~5% of total business revenues in the US

3

Sole Proprietorship (Advanatages)

easy formation (because of it many new businesses use this organizational form

4

Sole Proprietorship (Disadvantages)

-principal limitation (there is no seperation between the firm and the owner)

-unlimited personal liability

-difficulty raising funds

-permanence of the business (life of a sole proprietorship is limited to the life of the owner) (it is difficult to transfer ownership of a sole proprietorship)

5

Partnership

- ~4% of US businesses

-less than 5% of the business revenues in US

-owned and run by more than one owner (partners)

-all partners liable for firms debt

-partnership ends on the death or withdrawal of any single partner (can avoid liquidation if the partnership agreement provides for alternatives such a buyout of a deceased or withdrawn partner

6

Limited Partnership

partnership with two kinds of owners general partners and limited partners

7

General Partners

-have same rights and privileges as partners in any general partnership

-personally liable for the firms debt obligations

8

Limited Partners

-limited liability and their ownership interest is transferable

-have no management authority

9

Limites Liability Companies (LLC)

-As a limited partnership but with no general partner

-all owners have limited liability, but can also run business

10

Corporations

-is a legal entity separate and distinct from its owners

-can enter into contracts, acquire assets, incur obligations, and it enjoys protection under the US Constitution against the seizure of its property

-solely responsible for its own obligations

-owners of a corporation are not liable for any obligations the corporation enters into

-not liable for any personal obligations of its owners

-about 19% of US business

-84% of business revenues

-private (closely-held) or public companies

11

Stockholders

owners of a corporation aka shareholders

12

Formation of a corporation

must be:

  • legally formed
  • chartered in the state in which it is incorporated
  • corporate charter specifies the initial rules that govern how the corporation is run
  • more costly than setting up a sole proprietorship
13

Ownership of a corporation

-no limit on the number of owners

-entire ownership stake of a corporation is divided into shares known as stock

collection of all outstanding shares of a corporation is known as the equity of the corporation

-known as a shareholder/stockholder

-no limitation on who can own stock

-shareholders entitled to dividend payments

14

Corporation Advantages

-limited liability of shareholders

-permanency

-flexibility

-higher ability to raise capital due to the limited liability and easy marketability of corporation shares

15

Corporation Disadvantages

-high cost and longer process to establish

-double "taxation"

-agency problems due to the separation of ownership and management

16

Tax implications for corporate entities

-corporations profits subject to taxation seperate from its owners tax obligations

-shareholders of a corporation pay taxes twice

-corporation pays taxes on its profits

-when remaining profits are distributed to the shareholders they pay their own personal income tax on this income

17

Tax implications for corporate entities

-Two types of corporations

  • C corporations
  • S corporations
18

C Corporations

-most corporations are C

-no restrictions on number of shares or owners

-must pay corporate taxes on its profits

19

S corporation

-100 or less shareholders

-must be US Citizens or residents

-paying taxes similarly to partnerships but preserving benefits of a corporation (limited liability)

- firms profit/losses are not subject to corporate tax instead are allocated directly to shareholders based on their ownership share

20

Financial manager 3 main tasks

1. make investment decisions

2. make financing decisions

3. manage cash flow from operating activities

21

Making investment decisions

-financial manager must:

  • weigh the cost and benefits of each investment project
  • decide which investments or projects qualify as good uses of the stockholders money
  • decide whether to raise more money from new and existing owners by selling more shares of stock or to borrow the money instead
22

Managing short-term cash needs

financial manager must ensure that the firm has enough cash on hand to meet its obligations at each point in time

-aka managing working capital

23

Goal of the financial manager

-primary goal is to maximize the wealth of the stockholders

24

shareholder wealth

present value of the expected future returns to the shareholders of the firm

25

how to measure shareholder wealth

by the market value of the firm or more precisely:

number of shares outstanding X market price per share

26

Essential role of financial manager

1. cash raised from investors

2. cash invested in firm

3. cash generated by operations

4. cash reinvested

5. cash returned to investors

27

Corporate management team

-Board of directors

-Chief executive officer

28

Board of Directors

-group of people elected by shareholders

-typically each stock gives a shareholder 1 vote in board election

-elect the officers/management team, delegating most daily operating decisions to them

29

Chief executive officer (CEO)

-person charged with running the corporation by instituting the rules and policies set by the board of directors

30

agency problems

when managers hired as agents of shareholders put their own self-interest ahead of the interest of the shareholders

31

Managerial compensation

-designed to align shareholder-management conflicts

-compensation plan tied to the performance of the firm as managers will not do will unless the stock market value increases

32

CEO's performance

when stock performs poorly:

  • board of directors might react by replacing CEO
  • another corporation might initiate a hostile takeover
33

Accounting Scandals

-manipulation of financial data

-ex: enron

34

Analyst scandals

overly optimistic reports, favorable analysis traded for future i-banking business

35

Private corporation

limited number of owners and there is no organized market for shares

36

public corporation

many owners and its shares trade on an organized market called a stock market