Chapter 1 - Principles of finance

Three types of business

organizations
The legal forms of business organization fall
into three categories:
The sole proprietorship
The partnership
The corporation

The sole proprietorship

Owned by a single individual
who is entitled to all the firms profits and
who is also responsible for all the firms debt
(unlimited)
Forming a sole proprietorship is very easy
Limited access to outside sources of financing
Personal taxes

Partnership
General partnership
Owned by two or more persons
who are entitled to all the firms profits and who
are also responsible for all the firms debt
(unlimited)
Limited access to outside sources of financing
Personal taxes

Partnership (cont.)
Limited partnerships
There are two classes of partners: general and limited
The general partner actually runs the business and
faces unlimited liability for the firms debts, while the
limited partner is only liable up to the amount the
limited partner invested.
It is difficult to transfer ownership of the general
partners interest in the business; However, the
limited partners shares can be transferred to another
owner

Corporation
There are too many onwers
The owners liability is confined to the amount
of their investment in the company (limited)
The life of the business is not tied to the status
of the investors
The ease of raising capital and they can easily
sell their stock
Double taxation

A Comparison
Corporation

Partnership

Liquidity

Shares can be easily

exchanged

Subject to substantial
restrictions

Voting Rights

Usually each share gets one

vote

General Partner is in charge;

limited partners may have
some voting rights

Taxation

Double

Reinvestment and
dividend payout

Broad latitude

Partners pay taxes on

distributions
All net cash flow is
distributed to partners

Liability

Limited liability

Continuity

Perpetual life

General partners may have

unlimited liability; limited
partners enjoy limited
liability
Limited life

The goal of the financial manager

A firm has several goals: revenue, profit,
market-share, etc
Because the shareholders are their true
owners, companies commonly have a
principle goal described as maximizing
shareholder wealth, which is achieved by
maximizing the stock price.

Agency problem
Managers often face situations where their own
personal interests differ from the interests of
shareholders
The conflict of interest between the stockholders
and the managers of a firm as an agency problem
When the managers have little or no ownership
in the firm, they are less likely to work
energetically for the companys shareholders

Agency problem (cont.)

The managers will have an incentive to enrich
themselves: luxury corporate jets, expensive
corporate apartments, or resort vacations.
To turn down projects that have an element of
risk in order to avoid jeopardizing their jobs
Debt may be the cheapest source of financing,
but managers might want to avoid debt
financing

Agency problem (cont.)

Compensation plans can be put in place that
reward managers when they act to maximize
shareholder wealth (shareholder)
The board of directors can actively monitor
the actions of managers
Auditors, bankers, and credit agencies monitor
the firms performance

Factors impact on the cost of money

(the interest rate or the cost of equity)
Production opportunity (user side)
The higher production opportunity, the higher the
cost of money the user pays.

Time preference for consumption (supplier

side)
The supplier prefers consumption rather then
saving, they ask higher cost of money

Risk (supplier side)

Inflation (supplier side)