Mid-Sem Exam Notes

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FINA 1221
Aug 8, 2023
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Finance Mid-Semester Notes Ch1. The Corporation and Financial Markets The Four Types of Firms Sole Proprietorships A business owned and run by one person with few employees The most common type of firm in the world (72%), but only 4% of the revenue. Corporations are 18% but 82% of revenue Key characteristics o Straightforward and cheap to set up o No separation between firm and owner, can only have one owner. If there are other investors, they cant have an ownership stake in firm o Unlimited personal liability for the firms debts if firm defaults on any debt payments, the lender can (and will) require owner to repay loan from personal assets, and if owner cannot repay loans, must declare personal bankruptcy. o Life of sole proprietorship limited to life of owner and difficult to transfer ownership For must business, disadvnatges often outweigh advantages so when owner can borrow without agreeing to be personally liabile, convert to limited liability business Partnerships Same as sole proprietorship with more than one owner Key features o All partners are liable for firms debt (unlimited liability), lender can require any partner to repay all of firms outstanding debts o Partnership ends on death or withdrawl of a partner, unless partnership agreement provides for alternatives such as buyout of deceased/withdrawn partner Some old and established businesses remain partnerships/sole propreitorships often if the owners' personal reputation is the basis for the business, e.g. law, doctor, accountants o Personal liability increases confidence of clients that partners will maintain rep A limited partnership has two kinds of owners, limited and general partners o General partners same as owners in general (normal) partnership o Limited partners have limited liability, and is limited only to their investment in partnership Their death or withdrawal doesn't cause liquidation and a limited partner's interest is transferable Has no management authority and cant legally be involved in managerial decision making Private equity funds and venture capital funds typically limited partnerhips where general partners control how capital is invested and limited partners provide additional capital Limited Liability Company
A limited liability company is a limited partnership with no general partners, so all partners have limited liability but can also run the business Corporations A legally defined, artificial begin, separate entity from its owners so has legal powers of people Solely responsible for its own obligations thus owners not liable for company and company not liable for owners Formation o Legally formed, thus expensive as must be chartered o Corporate charter includes formal articles of incorporation, set of bylaws and initial rules that govern how corp is run Ownership o No limit on number of owners or who can be owner, each owns a small fraction o Stock is the ownership or equity of a corporation divided into shares o Equity is the collection of all outstanding shares of corp o Dividends are payments made at discretion of corp to stockholders, proportional to stock owned o Since don't have to be qualified as owner, allows free trade of shares and is benefit over sp, partner or llc as can raise substantial capital by selling shares Tax implications for Corporate Entities Corp separate legal entity, so profits subject to tax separate from owners tax obligations, shareholders can pay tax twice, tax on corp profits than individual income tax Corps are only organization structure subject to double taxation S Corp exempt from double taxation, allowed by US internal tax revenue code o Profits not subject to corporate tax, allocated directly to shareholders o Shareholders must include these profits/dividends as income and be taxed o Strict restrictions on who is s corp, shareholders must be us residents/citizens with max 100 o Since most corps have no restrictions on owners, often don't qualify Most countries in the world offer some relief from double taxation Ownership versus Control of Corporations In corp, direct control and ownership separate as many owners as possible who can freely trade stock o Board of directors and CEO possess direct control The Corporate Management Team Shareholders elect board of directors who are group of shareholders with ultimate decision making authority in corp In most corps, one share = 1 vote, so more shares = more influence. When one or two shareholders hold a great proportion, they may be on the board themselves or have right to appoint directors The board of directors o Make rules on how corp is run, including how managers are compensated
o Set policy o Monitor performance of company o Delegate most day-to-day decisions to management CEO runs corp by instituting rules and policies set by board Separation of powers between board and CEO not always distinct as CEO often chairman Most senior financial manager is CFO who reports directly to CEO The Financial Manager Responsible for investment decisions, financing decisions and managing cash flows Investment decisions o Weigh up costs and benefits of all investments and projects and decide which are good o These decisions ultimately shape what firm does and if it will add value for owners Financing decisions o Decide how to pay for investment decisions o Large investments may require extra capital o FM must decide to raise money from new/existing owners by selling more shares or borrow money Cash management (managing working capital) o Ensure enough cash to meet day-to-day obligations o Ensure access to cash doesn't hinder firms success The Goal of the Firm Goal of firm should be decided by owners, but with multiple owners, not clear as each owner likely to have different interests / priorities In general, shareholders want management to increase value of shares The Firm and Society While most decisions that increase value of firms equity also benefit society, problem is when they don't such as polluting the environment and not fixing it or harming environment GFC another example that increased shareholded wealth but hurt society as harmed economy When corp impose harm on others in economy, public policy and regulation required to assure that corp and society interests aligned o Sound public policy allows corp to increase share value while benefiting society Ethics and Incentives within Corporations opport problem is when decision makers (management team) put their own self interest ahead of the interests of shareholders despite being representatives o Ethical dilemma for managers, themselves or shareholders o Addressed by limiting decisions where interests are substantially different o Shareholders often tie compensation of top managers to corps profits or sometimes stock price However, if compensation linked too close to performance, asking managers to take on more risk than they are willing
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