Business Finance

Proprietorship

an unincorporated business owned by one individual

Partnership

a legal arrangement between two or more people who decide to do business together

Corporation

a legal entity created by a state, and it is separate and distinct from its owners and managers

What are the advantages of proprietorship and partnership over corporations?

Advantages

▪ Ease of formation

▪ Subject to few regulations

▪ No corporate income taxes

What are the disadvantages of proprietorship and partnership over corporations?

Disadvantages

▪ Difficult to raise capital

▪ Unlimited liability

▪ Limited life

limited liability company (LLC)

a hybrid between a partnership and a corporation

limited liability partnership (LLP)

similar to an LLC. LLPs are used for professional firms in the fields of accounting, law, and architecture, while LLCs are used by other businesses. Similar to corporations, LLCs and LLPs provide limited liability protection

What are advantages and disadvantages of LLCs and LLPs compared to proprietorship, partnership, and corporation?

Similar to corporations, LLCs and LLPs provide limited liability protection, but they are taxed as partnerships. Further, unlike limited partnerships, where the general partner has full control of the business, the investors in an LLC or LLP have votes in proportion to their ownership interest. LLCs and LLPs have been gaining in popularity in recent years, but large companies still find it advantageous to be C corporations because of the advantages in raising capital to support growth

The main (Financial) Goal of a manager for a corporation is to

maximize stockholder wealth (stock prices of the corporation in the long run)

What are differences between stock prices and intrinsic value?

-In equilibrium, a stock’s price should equal its “true” or intrinsic value.

-Intrinsic value is a long-run concept.

-To the extent that investor perceptions are incorrect, a stock’s price in the short run may deviate from its intrinsic value.

-Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run

What are the conflicts between stockholders and managers of a corporation?

Managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders). In economics, we call this “Agency Problem”. For example, CEO throwing party for his wife. Stockholders wouldn’t like this.

What would be solutions to align managers’ interests with interests of shareholders?

-Managerial compensation packages
-Direct intervention by shareholders
-The threat of firing
-The threat of takeover

Stockholders

provide capital to corporations by buying a corporation’s shares of stock

Bondholders

provide capital to corporations by buying a corporation’s bonds

What will be the conflicts between stockholders and bondholders?

-Stockholders are more likely to prefer riskier projects, because they receive more of the upside (profits) if the project succeeds

-Bondholders receive fixed payments and are more interested in limiting risk

How do bondholders attempt to protect themselves

by including covenants in bond agreements that limit the use of additional debt and constrain managers’ actions

What are the various forms of business organization? What are the advantages and disadvantages of each?

The different forms of business organization are proprietorships, partnerships, corporations, and limited liability corporations and partnerships. The advantages of the first two include the ease and low cost of formation. The advantages of corporations include limited liability, indefinite life, ease of ownership transfer, and access to capital markets. Limited liability companies and partnerships have limited liability like corporations.

The disadvantages of a proprietorship are (1) difficulty in obtaining large sums of capital; (2) unlimited personal liability for business debts; and (3) limited life. The disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) setting up a corporation and filing required state and federal reports, which are complex and time-consuming. Among the disadvantages of limited liability corporations and partnerships are difficulty in raising capital and the complexity of setting them up.

Should stockholder wealth maximization be thought of as a long-term or a short-term goal? For example, if one action increases a firm’s stock price from a current level of $20 to $25 in 6 months and then to $30 in 5 years, but another action keeps the stock at $20 for several years but then increases it to $40 in 5 years, which action would be better? Think of some specific corporate actions that have these general tendencies.

Stockholder wealth maximization is a long-run goal. Companies, and consequently the stockholders, prosper by management making decisions that will produce long-term earnings increases. Actions that are continually shortsighted often “catch up” with a firm and, as a result, it may find itself unable to compete effectively against its competitors. There has been much criticism in recent years that U.S. firms are too short-run profit-oriented. A prime example is the U.S. auto industry, which has been accused of continuing to build large “gas guzzler” automobiles because they had higher profit margins rather than retooling for smaller, more fuel-efficient models.

What is a firm’s intrinsic value? Its current stock price? Is the stock’s “true” long-run value more closely related to its intrinsic value or to its current price?

A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data. It can be estimated but not measured precisely. A stock’s current price is its market price—the value based on perceived but possibly incorrect information as seen by the marginal investor. From these definitions, you can see that a stock’s “true” long-run value is more closely related to its intrinsic value rather than its current price.

Is it better for a firm’s actual stock price in the market to be under, over, or equal to its intrinsic value? Would your answer be the same from the standpoints of stockholders in general and a CEO who is about to exercise a million dollars in options and then retire? Explain.

If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium and there is no pressure (buying/selling) to change the stock’s price. So, theoretically, it is better that the two be equal; however, intrinsic value is a long-run concept. Management’s goal should be to maximize the firm’s intrinsic value, not its current price. So, maximizing the intrinsic value will maximize the average price over the long run but not necessarily the current price at each point in time. So, stockholders in general would probably expect the firm’s market price to be under the intrinsic value—realizing that if management is doing its job that current price at any point in time would not necessarily be maximized. However, the CEO would prefer that the market price be high—since it is the current price that he will receive when exercising his stock options. In addition, he will be retiring after exercising those options, so there will be no repercussions to him (with respect to his job) if the market price drops—unless he did something illegal during his tenure as CEO.

What are some actions that stockholders can take to ensure that management’s and stockholders’ interests are aligned?

The board of directors should set CEO compensation dependent on how well the firm performs. The compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, it is easier to measure the growth rate in reported profits than the intrinsic value, although reported profits can be manipulated through aggressive accounting procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a specific date.

The primary goal of the corporate management team is to maximize the shareholders' wealth by _________ .

• Option A

  maximize the company's stock price in the short run

• Option B

  maximize the company's stock price in the long run

  Selected

• Option C

  minimize the company's risk in the long run

• Option D

  maximize the company's profit in the long run

Option B

What would be solutions to align managers’ interests with interests of shareholders?

• Option A

  Reasonable managerial compensation packages

• Option B

  All of the above

• Option C

  Direct intervention, such as threat of firing, by shareholders

• Option D

  The threat of takeover by external investors

Option B

Which of the following statements is CORRECT?

Option A

In general, it is more in bondholders' interests than stockholders' interests for a firm to shift its investment focus away from safe, stable investments and into risky investments, especially those that primarily involve research and development.

Option B

Stockholders in general would be better off if managers never disclosed favorable events and therefore caused the price of the firm's stock to sell at a price below its intrinsic value.

Option C

The efficiency of the U.S. economy would probably be increased if hostile takeovers were absolutely forbidden.

Option D

Hostile takeovers are most likely to occur when a firm's stock is selling below its intrinsic value as a result of poor management.

Option D

Which of the following statements is CORRECT?

Option A

Corporations generally face fewer regulations than proprietorships.

Option B

It is usually easier to transfer ownership in a corporation than in a partnership.

Option C

Corporate shareholders are exposed to unlimited liability.

Option D

Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation.

Option B

Different forms of businesses have different characteristics. Which of the following characteristics would NOT apply to a limited liability company and a limited liability partnership?

Option A

-Owned by a single individual

Option B

-Owners have limited liability and a right to vote

Option C

-Limited financial liability

Option D

-Taxed as a partnership

Option E

-Have corporate ownership structure

Option A

Stock's intrinsic value is determined by _______ and stock's price is determined by ___________.

Option A

true cash flows and true risk; perceived cash flows and perceived risk

Option B

true cash flows and perceived risk; perceived cash flows and true risk

Option C

perceived cash flows and true risk; true cash flows and perceived risk

Option D

perceived cash flows and perceived risk; true cash flows and true risk

Option A

Consider the following scenario and determine whether an agency conflict exists:

Alexander owns Alexander's Tantalizing Tees, a T-shirt shop in a small college town in Georgia. With a staff of three part-time employees, Alexander operates the business in accordance with his personal goals, dreams, and capabilities.

Does Alexander have an agency conflict to deal with?

Option A

No; by having part-time, as opposed to full-time, employees, Alexander is prevented from experiencing an agency conflict.

Option B

No; as both the owner and operator of Alexander's Tantalizing Tees, Alexander has not created the necessary agency relationship through which an agency conflict can exist.

Option C

Yes; there is always an inherent conflict of interest between owners and operators (managers).

Option D

Yes; as both the owner and operators of Alexander's Tantalizing Tees, Alexander has created the necessary agency relationship through which an agency conflict can exist.

Option B

The following statement describes a business. Using the description of the business, classify it as a sole proprietorship, partnership, corporation, or a limited liability company/limited liability partnership.

Brandon started a business, based in a different state, with his uncle. Due to the business's underperformance, they had to close the business. Brandon, however, ended up losing his house due to a litigation claim.

Option A

LLC/LLP

Option B

Sole proprietorship

Option C

Partnership

Option D

Corporation

Option C

Which of the following statements is CORRECT?

Option A

One drawback of forming a corporation is that it is more difficult for the firm's investors to transfer their ownership interests.

Option B

One drawback of forming a corporation is that it generally subjects the firm to additional regulations.

Option C

One drawback of forming a corporation is that it subjects the firm's investors to increased personal liabilities.

Option D

One drawback of forming a corporation is that it makes it more difficult for the firm to raise capital.

Option B

The following statement describes a business. Using the description of the business, classify it as a sole proprietorship, partnership, corporation, or a limited liability company/limited liability partnership.

Chris, the CEO of a beverage company, is required to certify the accuracy of information provided in the company's quarterly reports.

Option A

Sole propreitorship

Option B

Partnership

Option C

Corporation

Option D

LLC/LLP

Option C

Krit Corp. is a U.S. manufacturing company based in the Midwest. As an investor, Wilson bought 225 shares of stock in Krit Corp. The stock price of Krit Corp. is currently trading at $45.00 per share.

Wilson's total wealth in Krit Corp. is:

Option A

$500.00

Option B

$32,250.00

Option C

$225.00

Option D

$10,125.00

Option D

Which of the following could explain why a business might choose to operate as a corporation rather than as a proprietorship or a partnership?

Option A

Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation.

Option B

Corporations generally face fewer regulations.

Option C

Corporate investors are exposed to unlimited liability.

Option D

Corporations generally find it easier to raise large amounts of capital.

Option D

The following statement describes a business. Using the description of the business, classify it as a sole proprietorship, partnership, corporation, or a limited liability company/limited liability partnership.

Selena and Mario run a law firm in Chicago. The firm has debt of $100,000, but Selena and Mario will not be held personally liable for the law firm's debt.

Option A

LLC/LLP

Option B

Partnership

Option C

Sole proprietorship

Option D

Corporation

Option A

An analyst with a leading investment bank tracks the stock of Mandalays Inc. According to her estimations, the value of Mandalays Inc. stock should be $11.52 per share, but Mandalay's Inc. stock is trading at $19.57 per share on the New York Stock Exchange (NYSE). Considering the analyst's expectations, the stock is currently:

Option A

Not enough information

Option B

In equilibrium

Option C

Undervalued

Option D

Overvalued

Option D

Which of the following actions would be likely to encourage a firm's managers to make decisions that are in the best interests of shareholders?

Option A

The percentage of executive compensation that comes in the form of cash is increased and the percentage coming from long-term stock options is reduced.

Option B

The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds rather than by small individual investors rises from 10% to 80%.

Option C

The firm's founder, who is also president and chairman of the board, sells 90% of her shares.

Option D

The state legislature passes a law that makes it more difficult to successfully complete a hostile takeover.

Option B

The owners of a corporation are the _________.

Option A

shareholders of the company

Option B

creditors of the company

Option C

bondholders of the company

Option D

suppliers of the company

Option A

Which of the following statements is CORRECT?

Option A

One advantage to forming a corporation is that the owners of the firm have limited liability.

Option B

Because of their simplified organization, it is easier for proprietors and partnerships to raise large amounts of outside capital than it is for corporations.

Option C

Bond covenants are an effective way to resolve conflicts between shareholders and managers.

Option D

Managers who face the threat of hostile takeovers are less likely to pursue policies that maximize shareholder value compared to managers who do not face the threat of hostile takeovers.

Option A

The CFO is not responsible for the following departments except ______

Option A

Human resources

Option B

Marketing

Option C

Accounting

Option D

Production

Option C