Corporate Finance

and the Financial

Manager
Chapter 1
3rd edition

v.1.1

Types of Firms
1.
2.
a.
b.
3.
4.
a.
b.

Sole Proprietorships
Partnerships
General
Limited Liability
Limited Liability Companies
Corporations
C-Corporations
S-Corporation

Types of Firms
Sole proprietorship
Definition: Business owned by one person
Most businesses in U.S. are sole proprietorships but only produce
small amount of revenue/profits.
Advantages:
Easier to make decisions
Easy to establish
Minimal regulations regarding formation
Minimal organization costs
Owner keeps all profits
Profits taxed at personal rate
Disadvantages:
Unlimited liability
Owner absorbs all losses
Limited capital (borrowing capacity based on owners net
worth
Business terminates at owners death
Transferring ownership can be difficult.

Types of Firms
Partnership
Definition: 2 or more owners, organized through articles of
partnership
Two kinds of owners
General partners: Unlimited liability
All general partners are liable for the firms debt
A lender can require any (general) partner to repay all the
firms outstanding debt.
Limited partners

Types of Firms
General partnership:
Advantages
Minimal organization requirements
Negligible government regulations
Profits taxed at individual rate
Disadvantages
Partners have unlimited liability
Limited capital
Partnership ends with death or withdrawal of partner

Types of Firms
Limited partnership:
Advantages
Limited liability for limited partner
Withdrawal or death of limited partner does not affect
business
Stronger inducement in raising capital
Profits taxed at individual rate
Ownership is transferable
Disadvantages
Must have at least one general partner with has unlimited
liability
More expensive to organize
Cannot manage business

Types of Firms
Limited Liability Companies (LLC)
Definition:
All partners have a form of limited liability.
Partners have the right to manage the business directly, and
(in many areas).
Advantages:
Unlimited number of owners
No general partner
Limited liability
Can manage business
Disadvantages:
Taxed at personal rate

Types of Firms
Corporations
Definition: A corporation is a legally defined, artificial being,
separate from its owners
It has many of the legal powers that people have
It can enter into contracts, acquire assets, incur obligations,
and it enjoys protection under the U.S. Constitution against
the seizure of its property
Solely responsible for its own obligations
Formation of a Corporation
Must be legally formed
Must be 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

Forms of organization
Corporation
Advantages:
Limited liability of owners
Transferability of ownership
Death of owner does not affect business
Able to raise large amounts of capital
Disadvantages:
Difficult and expensive to establish
Control of corporation is not guaranteed by partial ownership
of stock
Double taxation

Types of Firms
S Corporations
Definition:
Form of corporation allowed by IRS.
Not more than 100 shareholders.
Taxed only once (similar to partnership).
Advantages:
Limited liability of owners
No double taxation / Taxed only once at personal rate
Disadvantages:
Limited to 100 owners
Taxation: Profits/losses are allocated directly to shareholders
based on their ownership interest
Shareholders must include these profits as income on
individual tax returns even if no money is distributed to them.

The Financial Manager

The financial manager has three main tasks:
Make investment decisions
Weigh the costs and benefits of each investment or project
Select investments or projects that are good uses of the
stockholders money
Make financing decisions
Whether to raise more money from new and existing owners
Selling more shares of stock
Borrow the money instead
Manage cash flow from operating activities
Ensure firm has enough cash on hand to meet its obligations
at each point in time

Goal of the Firm

Profit maximization?
Why not?
The goal is to maximize shareholder wealth

Profit
Maximization

Allergan Stock Price

Allergan Stock Price

April 7, 1998

Agency Problem
Agents and principals
Agents act on behalf of the principals.
Agency Problem
When managers put their own self-interest ahead of the
interests of those shareholders
Ways to minimize agency problem
Compensation
Bonuses, stock awards, and stock options
Stock option? The executive are given the option of
buying a certain amount of stocks at a certain price
Stock award? The executive are give the share of the
stocks
Job promotion
Job market opportunities
Take over threat

The Stock Market

Primary Versus Secondary Markets
Secondary markets: Between investors
Physical Stock Markets
Auction Market: Share prices set through direct interaction of
buyers and sellers
NYSE
Designated Market Makers
Bid-Ask Spread
Bid price: Price to buy
Ask price: Price to sell
Transaction Cost: Also include broker commissions.
Over-the-Counter Stock Markets
Dealer Markets
NASDAQ

Other Financial Markets

Bond Market
Foreign Exchange Market
Commodities Market
Derivative Securities

Financial Institutions
Financial Institutions
Entities that provide financial services, such as taking deposits,
managing investments, brokering financial transactions, or
making loans
Banks, mutual fund companies, insurance companies, pension
funds, hedge funds, private equity
The Financial Cycle
1. People invest and save their money
2. Money flows to companies who use it to fund growth
3. Money then flows back to the savers and investors
Role of Financial Institutions
Move funds from savers to borrowers
Move funds through time
Help spread out risk-bearing