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Chapter 2

Chapter 2 Notes

Course Code
Derek Chau

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Chapter 2 Business (Corporate) Finance Notes
2.1 Types of Business Organizations
Sole Proprietorships
sole proprietorship a business owned and operated by one person
the big advantage is that setting one up is easy—non paperwork is involved and the owner needs only to start doing business
unlimited liability the liability not only for what is invested in the business but also for any other assets owned
the sources of finances available for sole proprietorships are the same ones that are available to individuals
if businesses create some revenue, owners can use one of the many government programs designed to stimulate small businesses
there is no continuity in a sole proprietorship, which makes it difficult to sell, and it dies with the owner
because legally a sole proprietorship is inseparable from the individual owner, the owner has to report the income to the Canada
Revenue Agency (CRA) on an annual income tax return
partnership a business owned and operated by two or more people
this partnership can be formalized by having a lawyer create a partnership agreement, which formalizes how decisions are made
there are two types of partnerships: limited liability partnerships (LLP) and limited and general partnerships
LLPs are the new form of organization for professional firms, where each partner has limited liability in the event of a lawsuit
against the firm; however, each partner’s income is still included as ordinary income and filed by using an individual tax return
limited and general partnerships are generally used for tax reasons
in this case, a general partner operates the business and limited partners are passive investors
as long as the limited partners are not active in the business, they have the advantage of limited liability
limited liability the liability for only the initial investment in a limited and general partnership
the general partner, conversely, has unlimited liability as the operator of the business
trust a legal organization in which assets are owned and managed, or controlled by different parties
the use of trusts has recently expanded from personal finance and mutual funds to income and royalty trusts, which have become
very important in the Canadian financial system over the past decade
income and royalty trusts trusts set up to invest in the shares and debt obligations of a company
corporations firms organized as separate legal entities under corporation law, with ownership divided into transferable shares
owners of a corporation have the benefit of limited liability in that the maximum they can lose is their investment—that is, they
cannot be forced to invest more in the firm to make up for any losses the firm incurs
a business that operates as a corporation separates personal assets from any malfeasance or failure at the corporate level
2.2 The Goals of the Corporation
externalities are things that the firm doesn’t pay for or charge for, but which affect others
as a result, firm creates value without taking into account its impact and may make decisions that are not in public’s best interests
2.3 The Role of Management and Agency Issues
agency relationship managers work on behalf of the shareholders
agency problem problems that arise due to potential divergence of interests between managers, shareholders, and creditors
agency costs the costs associated with agency problems
there are two major types of agency costs: (1) direct costs, which arise because suboptimal decisions are made by managers
when they act in a manner that is not in the best interests of their company’s shareholders; and (2) indirect costs, which are
incurred in attempting to avoid direct agency costs
indirect costs include those that arise because of any restrictions that are placed on the actions of management, those that are
associated with monitoring the actions of managers (which includes any compensation paid to BOD), and those costs associated
with management compensation schemes that will provide them with incentives to act in the shareholders’ best interests
moral hazard fact that individual’s behaviour may change if she or he is not exposed to the full consequences of their actions
2.4 Corporate Finance
capital budgeting or capital expenditure analysis the framework for analyzing investment or asset decisions
financial management the process of managing the firm’s investment decisions
corporate financing the sources of money for a company, including using debt or equity, retaining earnings or issuing equity,
going public, using bank debt or bonds, and using the short-term money market or borrowing from a bank
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