FIN 325 Chapter 1

What are the three types of business organizations? Describe each.

1) Sole proprietorship: A business owned and operated by one person 2) Partnership: A business owned and operated by two or more people. 3) Corporation: A large business not owned by individuals, but that is owned by many stockholders. This type of business must be approved by the government.

What are the advantages and disadvantages of a partnership?

Advantages: Easy to start, easy to manage, lack of special taxes, easily attract capital, larger size makes it run more smoothly, and easier to attract qualified employees. Disadvantages: Partners are responsible for each other, the business must be re-organized if one partner leaves, and the potential for conflict between partners.

What are the advantages and disadvantages of corporations?

Advantages: Easy to raise money, professional managers run the company, stockholders (part owners) are not responsible for losses, unlimited life, and easy to transfer ownership (stock shares) Disadvantages: Difficult and expensive to get government approval to start, stockholders (owners) have no say in how the business is run, double taxation, and more government regulation

Goal of Financial Management [LO2] What goal should always motivate the actions of a firm's financial manager?

To maximize the current market value (share price) of the equity of the firm (whether it's publicly-traded or not).

Primary versus Secondary Markets [LO3] You've probably noticed coverage in the financial press of an initial public offering (IPO) of a company's securities. Is an IPO a primary market transaction or a secondary market transaction?

A primary market transaction.

Agency Problems [LO4] Who owns a corporation? Describe the process whereby the owners control the firm's management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise?

In the corporate form of ownership, the shareholders are In the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm's management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else's best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.

What are the advantages and disadvantages of a sole proprietorship?

Advantages: Easy to start, easy to manage, profits are not shared, do not pay income taxes, and easy to end the business. Disadvantages: The one owner is fully responsible for all losses, difficult to raise capital ($), the owner often has little experience, and difficult to find qualified employees.

Secondary Markets

A secondary market transaction involves one owner or creditor selling to another. Therefore, the secondary markets provide the means for transferring ownership of corporate securities. Although a corporation is directly involved only in a primary market transaction (when it sells securities to raise cash), the secondary markets are still critical to large corporations. The reason is that investors are much more willing to purchase securities in a primary market transaction when they know that those securities can later be resold if desired

1. The Financial Management Decision Process [LO1] What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant.

Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding whether to issue new equity and use the proceeds to retire outstanding debt), and working capital management (modifying the firm's credit collection policy with its customers).

Corporations [LO3] What is the primary disadvantage of the corporate form of organization? Name at least two advantages of corporate organization.

The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life.

Primary Markets

In a primary market transaction, the corporation is the seller, and the transaction raises money for the corporation. Corporations engage in two types of primary market transactions: public offerings and private placements. A public offering, as the name suggests, involves selling securities to the general public, whereas a private placement is a negotiated sale involving a specific buyer. Page 15 To learn more about the SEC, visit www.sec.gov. By law, public offerings of debt and equity must be registered with the Securities and Exchange Commission (SEC). Registration requires the firm to disclose a great deal of information before selling any securities. The accounting, legal, and selling costs of public offerings can be considerable. Partly to avoid the various regulatory requirements and the expense of public offerings, debt and equity are often sold privately to large financial institutions such as life insurance companies or mutual funds. Such private placements do not have to be registered with the SEC and do not require the involvement of underwriters (investment banks that specialize in selling securities to the public).