Textbook Notes (363,566)
Canada (158,433)
Finance (37)
MGFB10H3 (19)
Chapter 2

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University of Toronto Scarborough
Sultan Ahmed

Chapter 2: Business (Corporate) Finance 2.1 Types of Business Organizations Sole Proprietorships  Business owned and operated by one person  Easy to set up but it is inseparable from the owner and can result in unlimited liability (can lose all assets; not only assets invested into the business)  Owner can borrow money from friends, family, from the bank, through a loan or through a credit card  Net income of sole proprietorships is simply added to any regular salary income and taxed at ordinary tax rates Partnerships  A business owned by 2+ people  Can create a partnership agreement which formalizes how decisions are made, how one partner can buy another partner out if one wants to dissolve the partnership, how income is allocated amongst partners, etc  Traditionally there was unlimited liability for partnerships but now they are creating newer partnership models; 1) limited liability partnerships (LLP) 2) limited and general partnerships o Limited liability partnership each person has limited liability in the event of a lawsuit against the firm but each partner’s income is ordinary liability and filed using an individual tax return o Limited and General Partnership business is made up of limited and general partners. General partner operates the business and has unlimited liability. Limited partners are passive investors; are not active in the operations. Limited partners have limited liability (they only lose their initial investment) Trust  Used to separate ownership from control  Trust: a legal organization in which assets are owned and managed, or controlled by different parties  Use of trusts have recently expanded to income and royalty trusts o Income and royalty trusts: trusts set up to invest in the shares and debt obligations of a company (b/c it’s a trust, all income passes through w/o any tax; don’t have to pay tax)  Unitholder: An investor who owns one or more units in an investment trust  Trusts are inclined to pay out company earnings rather than re-invest in the business Corporations  Tends to have Inc., Ltd., or PLC (Private Limited corporation; used in Europe) at the end of name  Corporations: businesses organized as separate legal entities under corporation law, w/ ownership divided into transferable shares o Limited liability, can separate personal assets from corporation o Corporations have an indefinite life so can borrow by using debt that will be paid off in 40-50yrs o Transferring and selling assets is relatively easy b/c all contracts go w/ the company and the share of ownership is simply transferred o Problem w/ corporations: control and taxation  Ownership of corporation belongs to shareholders and corporation is controlled by management o Board of Directors: manage or supervise the management of the business and affairs of the corporation 2.2 The Goals of the Corporation  Firm’s goal is to enhance owner’s wealth not just maximize profits (wealth is different from profits)  Wealth is made up of today’s profits plus profits in the future  Goal of publically traded firms is to increase its market value or alternatively maximize market shareholder value  Maximize market shareholder value by taking resources and creating products that society values more highly than it values the inputs  Externalities: things that the firm doesn’t pay for or charge for but which affect others o Firm creates value w/o taking into account its impact and may make decisions that are not in the public’s interest  Firms are considered corporations b/c they act I the owners’ interests so the govt has the right to oversee their actions. Consequently, many argue that corporations should act in the “social interest” rather than in the interests of their owners  BOD can ignore stakeholders. Firm is required to follow contractual responsibilities and act in the interest of its owners by creating value for them 2.3 The Role of Management and Agency Issues  Managers run firms and try to ensure that shareholder’s value is being maximized  In small firms, managers are the owners  In corporations, shareholders may be dispersed and CEO can make his/her friends the BOD. o Results in poor governance and few checks on management o Maybe run in management’s interest instead of shareholder’s interests  Agency relationship: managers and employees work on behalf of the shareholders  Agency problems: problems that arise due to potential divergence of interests b/w managers, shareholders and creditors  Agency costs: costs associated w/ agency problems 1. Direct Costs: arise b/c suboptimal decisions are made by managers when they act in a manner that is not in the best interests of their company’s shareholders 2. Indirect Costs: incurred in attempting to avoid direct agency costs (e.g. mgmt compensation schemes that will provide them w/ incentives to act in the shareholders’ best interests)  Interests of managers and shareholders are usually fundamentally different 1. Shareholders tend to have a short-term interest in a firm and hold the shares and other securities of many entities in a large investment portfolio. If shareholders see that managers are acting contrary to what they would like, shareholders will most likely sell their shares and move to a different company  Moral hazard: the fact that an individual’s behavior may change if she or he is not exposed t the full consequences of their actions  Managers of regular corporations tend to be more conservative than justified
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