Understanding Business Structures and Financial Management
Chapter 1: Key Financial Terms and Business Structures
Investment vs. Financing Decisions
Investment (Capital Budgeting) Decisions: These decisions involve choosing which tangible or intangible assets to acquire and how much to invest. Factors considered include the impact on future cash flows, timing, risk, and overall value.
Financing Decisions: These decisions determine how to fund investments, including the mix of debt and equity, maturity dates, and types of securities issued. This impacts the firm’s capital structure.
Keywords for Identifying Investment Decisions:
- Research and development spending
- Completed testing and development
- Plans to open new facilities
- Acquisition costs
- Announced investments
- Capital expenditures
- Modernization investments
Keywords for Identifying Financing Decisions:
- Reinvestment of cash flow from sales
- Borrowing to bolster cash position
- Repayment of long-term debt, share buybacks, and dividends
- Issuance of debt to shareholders
- Lease financing
- Debt payoff
- Issuance of bonds and raising foreign currency
- Issuance of debt with specific maturity dates
- Arranging credit lines for borrowers
Business Structures
Sole Proprietorship:
A business owned by one person. Advantages: Easy to start, minimal regulations, owner keeps all profits, taxed once as personal income. Disadvantages: Limited lifespan, limited capital, unlimited liability, difficult to transfer ownership.
Partnership:
A business with multiple owners who are not incorporated. Can be general or limited partnerships. Advantages: Relatively easy to start, income taxed once as personal income. Disadvantages: Unlimited liability for general partners, partnership dissolves upon partner’s death or withdrawal, difficult to transfer ownership.
Corporation:
A separate legal entity owned by shareholders. Advantages: Limited liability, unlimited lifespan, easy transfer of ownership, easier to raise capital. Disadvantages: Agency problems, double taxation.
Agency Problem and Solutions
The conflict of interest between shareholders and managers. Solutions include:
- Compensation plans: Aligning management incentives with shareholder interests.
- Board of Directors: Elected by shareholders to oversee management.
- Proxy fights: Dissatisfied shareholders can attempt to replace the board.
- Takeovers: Poorly performing companies may be acquired by new investors.
- Specialist monitoring: Analysts and regulators scrutinize management actions.
Goal of the Corporation
To maximize shareholder value. Ethical behavior and long-term value creation are crucial for achieving this goal. The Sarbanes-Oxley Act (2002) aims to protect investors and prevent corporate scandals.
Practice Questions
1. Which is a capital budgeting decision? Deciding whether or not to open a new store.
2. What describes sole proprietorships? They are limited to the business owner’s life.
3. What is the primary advantage of being a limited partner? Liability for firm debts is limited to the capital invested.
4. What is true about limited partnerships? They generally permit limited partners to sell their ownership interest without the partnership terminating.
5. Which business type is best for raising large amounts of capital? Corporation.
6. What is the primary goal of financial management? To maximize the current value per share of the existing stock.
7. What refers to a conflict of interest between stockholders and managers? Agency problem.
8. What helps convince managers to work in the best interest of stockholders? I. Compensation based on stock value, II. Stock option plans, III. Threat of a proxy fight.
9. What is a proxy fight? A group solicits votes to replace the board of directors.