Chapter 2 Financial Management. Chapter 2 Outline. 2.1 Forms of Business Organizations. 1. Sole proprietorship 2. P artnership 3. Limited liability company 4. C orporation. Sole Proprietorship. A sole proprietorship is a business owned and operated by one person.
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Chapter 2 Financial Management
1. Sole proprietorship
3. Limited liability company
A sole proprietorship is a business owned and operated by one person.
A partnership is a business owned and operated by two or more people.
General partnership: partners share the management and income of the business
Limited liability partnership (LLP) or simply limited partnership- at least one general partner who manages the business, but there may be any number of limited partners, who are passive investors.
As long as the limited partners are not active in the business, they have the advantage of limited liability; the most they can lose is their initial investment.
The general partner, conversely, has unlimited liability as the operator of the business.
In practice, however, many general partners are corporations (discussed later) and indirectly benefit from limited liability.
A corporation is usually formed by filing articles of incorporation and receiving a certificate of incorporation from the state.
The articles of incorporation indicate the most basic information about the company, such as its mailing address, name, line of business, number of shares issued, names and addresses of the officers of the company, and so on.
The critical feature is that the corporation is a distinct legal entity.
In corporations, the owners are the owners of the ownership interests—that is, the shareholders—who elect members of the board of directors, who in turn hire and monitor the company’s management.
Forsmaller companies, the separation of management and ownership isn’t a problem, but for larger companies, it becomes a serious concern.
This division is the fundamental problem of the governance structure of large companies
A limited liability company (LLC) is a business organized as a separate legal entity in which owners have limited liability, but the income is passed through to the owners for tax purposes.
A subchapter S corporation (Sub S) is a corporation that elects to be taxed as a partnership.
So how does a Sub S compare with an LLC? Let’s consider their basic characteristics:
An LLC can choose to be taxed as a Sub S
Venture capitalists prefer C corporations
Retaining profits? Use a C corp.
LLCs can have more than one class of stock; Sub S’s cannot.
Losses? You can pass through more losses through an LLC than with a Sub S.
Distributing income? Must be by number of shares for a Sub S, but can be disproportionate for an LLC.
Sub S limited to 100 shareholders and all must be US citizens or permanent residents.
Sub S and C corp requires board of directors, annual reports, records of meetings, and other regulatory compliance; with LLC just need an operating agreement (may be informal).
LLC has a limited life; Sub S and C corp are perpetual.
Owners of LLCs must pay SE tax; Sub S and C corp distributions may be dividends, but reasonable compensation is required.
Some states do not recognize Sub S status and some tax double (NY: Sub S profits and s/h share of profits).
Source of data: Internal Revenue Service, Statistics of Income
Initial form of business
The predominant forms of business are the sole proprietorship, the limited liability company, and the Subchapter S corporation.
Source of data: The Kaufman Foundation
Following the companies in their first 6 years
Start-up companies begin their existence as sole proprietorships, limited liability companies, or Sub S corporations.
Partnerships and C Corporations are rare.
Source of data: The Kaufman Foundation
The first 6 years
Start-up companies are largely funded by the owners themselves. As the business generates cash flows, fewer tap outside sources of funds.
Note that venture capital investors and angel investors do not play a large role in most start-ups.
The first 6 years
The percentage of owners who rely on credit card funding – personal and business – is high.
Though a limited source of funding, manufacturing receives more of the venture capital than other industries
A stakeholderof a business is a party that is affected by the decisions and operations of the business entity.
Stakeholders include not only the owners, but also the creditors, the employees, the suppliers, and the customers.
The goal of the company is to maximize the market value of the equity interest or, alternatively, maximizeshareholder value.
The company should take resources and create products that society values more highly than it values the inputs.
The company should operate legally and in compliance with its contractual responsibilities, in the interests of its owners, by creating value for them.
Managers are employees and as such are agents working on behalf of the shareholders.
We refer to this relationship as agency relationship.
Despite the fact that managers have a duty to shareholders, there is always the possibility that managers will act in their own self-interest. This is the classic agency problem associated with the separation of ownership from management.
The costs associated with the agency problem are referred to as agency costs.
The challenge is to design compensation schemes that encourage managers to act in the best interest of shareholders.
The elements that are typically included are salary, bonus, and options.
The compensation committees of the board of directors that design compensation systems were not always completely independent of the CEOs who received the compensation, but this changed with the Sarbanes-Oxley Act of 2002 (SOX Act).
As a result of the SOX Act, publicly-traded companies in the U.S. must now have compensation committees that comprise independent directors.
Financial management is the management of the financial resources of a business or government entity, where financial resources include both the investments of the entity, but also how the entity finances these assets.
Evaluating capital budgets requires analyzing the future incremental cash flows that a project is expected to generate, considering the project’s cost of capital.
In most cases, a capital investment requires a substantial outlay at the beginning, but the investment is expected to generate incremental cash flows for a number of periods into the future.
Long-term investments make up only 16% of total assets, on average, for U.S. business entities.
However, if we break this down by industry, we get a different picture: the investment of companies’ assets varies by industry.
The financing decisions of a company involve the management of short-term obligations, such as bank loans, and long-term financing, which may be debt and/or equity.
The management of short-term obligations requires understanding the needs of the company throughout the year for short-term borrowing and trade credit.
There are many forms of short-term financing, and the financial manager must evaluate the cost of each available type.
An important decision of a company regards its capital structure.
A company’s capitalstructure is the mix of debt and equity that the company uses to finance its business.
Debtcapital consists of interest-bearing debt obligations, which may be notes or bonds, whereas equity capital consists of stock issues and retained earnings and is the ownership interest in a business enterprise.
There are many different ways of organizing businesses, including the sole proprietorship, partnership, corporate, and limited liability company forms of business.
Considerations in evaluating the form of business enterprise include liability, taxation, control, and continuity.
The primary decisions made by corporations involve the financial management of the company’s real and financial assets, as well as the associated corporate financing decisions.