Chapter 1: Corporate Finance & The Financial Manager
1.1 Why Study Finance?
● The Valuation Principle shows how to make the costs and benefits of a decision
comparable so that we can weigh them properly
● Learning to apply the Valuation Principle will give you the skills to make the types of
comparisons—among loan options, investments, and projects—that will turn you into a
knowledgeable, confident consumer and manager
1.2 Three Types of Firms
Sole Proprietorship
● A sole proprietorship is a business owned and run by one person
● sole proprietorships are relatively small in terms of revenues and profits produced and
people employed
1. Sole proprietorships have the advantage of being straightforward to set up.
Consequently, many new businesses use this organizational form
2. The principal limitation of a sole proprietorship is that
➔ there is no separation between the firm and the owner—the firm can have
only one owner who runs the business.
➔ The business income is taxed as the personal income of the owner.
➔ If there are other investors, they cannot hold an ownership stake in the
firm; this limits the ability of the owner to raise additional money for the
business.
3. The owner has unlimited personal liability for any of the firm’s debts.
➔ if the firm defaults on any debt payment, the lender can (and will) require
the owner to repay the loan from personal assets.
➔ An owner who cannot afford to repay a loan for which he or she is
personally liable must declare personal bankruptcy
4. The life of a sole proprietorship is limited to the life of the owner. It is also difficult
to transfer ownership of a sole proprietorship
● For most growing businesses, the disadvantages of a sole proprietorship outweigh the
advantages.
● As soon as the firm reaches the point at which it can borrow without the owner agreeing
to be personally liable, the owner typically converts the business into another form
Partnership
● Partnerships can be organized/categorized as general partnership or limited
partnerships
● The common feature that all forms of partnerships have is that income from the
partnership is taxed at the personal level
● General partnership: is a partnership owned and run by more than one owner—each
called a general partner
● The Key Features of General Partnership include:
1. All general partners have unlimited liability
➔ a lender can require any partner to repay all the firm’s outstanding debts.
, ➔ Similarly, in a legal judgment against the partnership, each partner is fully
liable; thus, partners must be chosen carefully, as any single partner’s
actions can affect the exposure of all the partners
2. The partnership ends in the event of the death or withdrawal of any single
partner.
➔ Partners can avoid liquidation if the partnership agreement provides for
alternatives, such as a buyout of a deceased or withdrawn partner
● Limited Partnership: is a partnership with two kinds of owners: general partners and
limited partners
● In this case, the general partners have the same rights and privileges as partners in any
general partnership—they are personally liable for the firm’s obligations
● Limited partners, however, have limited liability—that is, their liability is limited to their
investment. Their private property cannot be seized to pay off the firm’s outstanding
debts
● the death or withdrawal of a limited partner does not dissolve the partnership, and a
limited partner’s interest is transferable
● However, a limited partner has no management authority and cannot legally be involved
in the managerial decision making for the business
● Limited Liability Partnership (LLP): A form of Partnership used in Canada for law and
accounting firms that provides partial limitations of a partners liability
● An LLP is similar to a general partnership in that the partners can be active in the
management of the firm, and they do have a degree of unlimited liability
● including a particular partner’s own negligence or the negligence of those supervised by
the particular partner, that partner has unlimited personal liability
● the assets of the business are potentially at risk of seizure due to the actions of anyone
within the partnership
● while a partner’s personal assets are protected from the negligent actions of other
partners, the investment in the overall partnership may be lost
Corporations
● Corporations: is a business form that is a legally defined artificial being (a legal entity)
that is separate from its owners
● Corporations can enter into contracts, acquire assets, incur obligations, and receive
similar protection against the seizure of its property as that received by an individual
● Because a corporation is a legal entity, separate and distinct from its owners, it is solely
responsible for its own obligations.
● the owners of a corporation (its shareholders) are not liable for any obligations the
corporation enters into. the corporation is not liable for any personal obligations of its
owners
Formation of Corporation
● In most provinces, corporations are defined under the provincial Business
Corporations Act or the Canada Business Corporations Act
● Corporations must be legally formed, which means that the articles of
incorporation must be filed with the relevant registrar of corporations.
, ● The articles of incorporation, sometimes referred to as the corporate charter, are
like a corporate constitution that sets out the terms of the corporation’s ownership
and existence
Ownership of a Corporations
● Because most corporations have many owners, each owner owns only a fraction
of the corporation. The entire ownership stake of a corporation is divided into
shares known as stock
● The collection of all the outstanding shares of a corporation is known as the
equity of the corporation
● An owner of a share of stock in the corporation is known as a shareholder (or
stockholder or equity holder).
● Shareholders are entitled to dividend payments; that is, payments made at the
discretion of the corporation’s board of directors to the equity holders
➔ E.g., An owner of a share of stock in the corporation is known as a
shareholder (or stockholder or equity holder). Shareholders are
entitled to dividend payments; that is, payments made at the discretion
of the corporation’s board of directors to the equity holders
● In Canada, many corporations have a dominant shareholder ; in the United
States, more corporations are considered widely held (equal distribution) ○
● Some corporations can have multiple classes of stock such that some classes
may have more voting rights than others even though they have the same rights
to dividends
● A unique feature of a corporation is that there is no limitation on who can own its
stock
➢ That is, an owner of a corporation need not have any special expertise or
qualification This feature allows free trade in the shares of the corporation
and provides one of the most important advantages of organizing a firm
as a corporation rather than as a sole proprietorship or partnership
➢ Corporations can raise substantial amounts of capital because they can
sell ownership shares to anonymous outside investors
● The availability of outside funding has enabled corporations to dominate the
economy compared to unincorporated businesses
● Let’s take the world’s largest corporation ranked by total revenue in the 2017
Fortune Global 500 survey, Walmart
➢ For the fiscal year ended January 31, 2017, Walmart’s annual report
indicated revenue was about $486 billion and profit was about $14 billion
➢ Walmart’s market capitalization (or market cap—the wealth in the
company the owners collectively owned or the total value of all shares
outstanding) was over $203 billion
Tax Implications for Corporate Entities
● An important difference between the types of corporate organizational forms is the way
they are taxed.
● Because a corporation is a separate legal entity, a corporation’s profits are subject to
taxation separate from its owners’ tax obligations.
, ● In effect, shareholders of a corporation pay taxes twice.
➔ First, the corporation pays tax on its profits, and then,
➔ When the remaining profits are distributed to the shareholders as dividends, the
shareholders pay their own personal income tax on this income.
● This system is sometimes referred to as double taxation
● While the corporate organizational structure is subject to double taxation, Canada
Revenue Agency allowed an exemption from double taxation for certain flow-through
entities where all income produced by the business flows to the investors and virtually no
earnings are retained within the business
● Flow-Through Entities: Businesses in which all income produced flows to the investors
and virtually no earrings are retained within the business
● business income trust: holds all the debt and equity securities of a corporation (the
underlying business) in trust for the trust’s owners, called the unit holders - owners of
an income trust
● An energy trust: either holds resource properties directly or holds all the debt and
equity securities of a resource corporation within the trust
● A real estate investment trust (REIT): either holds real estate properties directly or
holds all the debt and equity securities of a corporation that owns real estate properties
➔ For income trusts formed before November 2006, there was no tax at the
business level until 2011.
➔ REITs continue to have no tax at the business level beyond 2011, but the other
forms of income trusts are now taxed
Table 1.2: Characteristics of Different Types of Firms
Number of Liability For Owners Ownership Change Taxation
Owners Firm’s Debt Manage the Dissolves the Firm
Firm
Sole Proprietorship One Yes Yes Yes Personal
General Unlimited Yes Yes Yes Personal
Partnership
Limited Partnership At least one General General General Partners: Personal
general Partners: Yes Partners: Yes Yes
partner, no limit Limited Limited Limited Partners:
on number of Partners: No Partners: No No
limited partners
Corporation Unlimited No No (but they No Business and
may legally Personal
REIT Unlimited No No No Personal
1.1 Why Study Finance?
● The Valuation Principle shows how to make the costs and benefits of a decision
comparable so that we can weigh them properly
● Learning to apply the Valuation Principle will give you the skills to make the types of
comparisons—among loan options, investments, and projects—that will turn you into a
knowledgeable, confident consumer and manager
1.2 Three Types of Firms
Sole Proprietorship
● A sole proprietorship is a business owned and run by one person
● sole proprietorships are relatively small in terms of revenues and profits produced and
people employed
1. Sole proprietorships have the advantage of being straightforward to set up.
Consequently, many new businesses use this organizational form
2. The principal limitation of a sole proprietorship is that
➔ there is no separation between the firm and the owner—the firm can have
only one owner who runs the business.
➔ The business income is taxed as the personal income of the owner.
➔ If there are other investors, they cannot hold an ownership stake in the
firm; this limits the ability of the owner to raise additional money for the
business.
3. The owner has unlimited personal liability for any of the firm’s debts.
➔ if the firm defaults on any debt payment, the lender can (and will) require
the owner to repay the loan from personal assets.
➔ An owner who cannot afford to repay a loan for which he or she is
personally liable must declare personal bankruptcy
4. The life of a sole proprietorship is limited to the life of the owner. It is also difficult
to transfer ownership of a sole proprietorship
● For most growing businesses, the disadvantages of a sole proprietorship outweigh the
advantages.
● As soon as the firm reaches the point at which it can borrow without the owner agreeing
to be personally liable, the owner typically converts the business into another form
Partnership
● Partnerships can be organized/categorized as general partnership or limited
partnerships
● The common feature that all forms of partnerships have is that income from the
partnership is taxed at the personal level
● General partnership: is a partnership owned and run by more than one owner—each
called a general partner
● The Key Features of General Partnership include:
1. All general partners have unlimited liability
➔ a lender can require any partner to repay all the firm’s outstanding debts.
, ➔ Similarly, in a legal judgment against the partnership, each partner is fully
liable; thus, partners must be chosen carefully, as any single partner’s
actions can affect the exposure of all the partners
2. The partnership ends in the event of the death or withdrawal of any single
partner.
➔ Partners can avoid liquidation if the partnership agreement provides for
alternatives, such as a buyout of a deceased or withdrawn partner
● Limited Partnership: is a partnership with two kinds of owners: general partners and
limited partners
● In this case, the general partners have the same rights and privileges as partners in any
general partnership—they are personally liable for the firm’s obligations
● Limited partners, however, have limited liability—that is, their liability is limited to their
investment. Their private property cannot be seized to pay off the firm’s outstanding
debts
● the death or withdrawal of a limited partner does not dissolve the partnership, and a
limited partner’s interest is transferable
● However, a limited partner has no management authority and cannot legally be involved
in the managerial decision making for the business
● Limited Liability Partnership (LLP): A form of Partnership used in Canada for law and
accounting firms that provides partial limitations of a partners liability
● An LLP is similar to a general partnership in that the partners can be active in the
management of the firm, and they do have a degree of unlimited liability
● including a particular partner’s own negligence or the negligence of those supervised by
the particular partner, that partner has unlimited personal liability
● the assets of the business are potentially at risk of seizure due to the actions of anyone
within the partnership
● while a partner’s personal assets are protected from the negligent actions of other
partners, the investment in the overall partnership may be lost
Corporations
● Corporations: is a business form that is a legally defined artificial being (a legal entity)
that is separate from its owners
● Corporations can enter into contracts, acquire assets, incur obligations, and receive
similar protection against the seizure of its property as that received by an individual
● Because a corporation is a legal entity, separate and distinct from its owners, it is solely
responsible for its own obligations.
● the owners of a corporation (its shareholders) are not liable for any obligations the
corporation enters into. the corporation is not liable for any personal obligations of its
owners
Formation of Corporation
● In most provinces, corporations are defined under the provincial Business
Corporations Act or the Canada Business Corporations Act
● Corporations must be legally formed, which means that the articles of
incorporation must be filed with the relevant registrar of corporations.
, ● The articles of incorporation, sometimes referred to as the corporate charter, are
like a corporate constitution that sets out the terms of the corporation’s ownership
and existence
Ownership of a Corporations
● Because most corporations have many owners, each owner owns only a fraction
of the corporation. The entire ownership stake of a corporation is divided into
shares known as stock
● The collection of all the outstanding shares of a corporation is known as the
equity of the corporation
● An owner of a share of stock in the corporation is known as a shareholder (or
stockholder or equity holder).
● Shareholders are entitled to dividend payments; that is, payments made at the
discretion of the corporation’s board of directors to the equity holders
➔ E.g., An owner of a share of stock in the corporation is known as a
shareholder (or stockholder or equity holder). Shareholders are
entitled to dividend payments; that is, payments made at the discretion
of the corporation’s board of directors to the equity holders
● In Canada, many corporations have a dominant shareholder ; in the United
States, more corporations are considered widely held (equal distribution) ○
● Some corporations can have multiple classes of stock such that some classes
may have more voting rights than others even though they have the same rights
to dividends
● A unique feature of a corporation is that there is no limitation on who can own its
stock
➢ That is, an owner of a corporation need not have any special expertise or
qualification This feature allows free trade in the shares of the corporation
and provides one of the most important advantages of organizing a firm
as a corporation rather than as a sole proprietorship or partnership
➢ Corporations can raise substantial amounts of capital because they can
sell ownership shares to anonymous outside investors
● The availability of outside funding has enabled corporations to dominate the
economy compared to unincorporated businesses
● Let’s take the world’s largest corporation ranked by total revenue in the 2017
Fortune Global 500 survey, Walmart
➢ For the fiscal year ended January 31, 2017, Walmart’s annual report
indicated revenue was about $486 billion and profit was about $14 billion
➢ Walmart’s market capitalization (or market cap—the wealth in the
company the owners collectively owned or the total value of all shares
outstanding) was over $203 billion
Tax Implications for Corporate Entities
● An important difference between the types of corporate organizational forms is the way
they are taxed.
● Because a corporation is a separate legal entity, a corporation’s profits are subject to
taxation separate from its owners’ tax obligations.
, ● In effect, shareholders of a corporation pay taxes twice.
➔ First, the corporation pays tax on its profits, and then,
➔ When the remaining profits are distributed to the shareholders as dividends, the
shareholders pay their own personal income tax on this income.
● This system is sometimes referred to as double taxation
● While the corporate organizational structure is subject to double taxation, Canada
Revenue Agency allowed an exemption from double taxation for certain flow-through
entities where all income produced by the business flows to the investors and virtually no
earnings are retained within the business
● Flow-Through Entities: Businesses in which all income produced flows to the investors
and virtually no earrings are retained within the business
● business income trust: holds all the debt and equity securities of a corporation (the
underlying business) in trust for the trust’s owners, called the unit holders - owners of
an income trust
● An energy trust: either holds resource properties directly or holds all the debt and
equity securities of a resource corporation within the trust
● A real estate investment trust (REIT): either holds real estate properties directly or
holds all the debt and equity securities of a corporation that owns real estate properties
➔ For income trusts formed before November 2006, there was no tax at the
business level until 2011.
➔ REITs continue to have no tax at the business level beyond 2011, but the other
forms of income trusts are now taxed
Table 1.2: Characteristics of Different Types of Firms
Number of Liability For Owners Ownership Change Taxation
Owners Firm’s Debt Manage the Dissolves the Firm
Firm
Sole Proprietorship One Yes Yes Yes Personal
General Unlimited Yes Yes Yes Personal
Partnership
Limited Partnership At least one General General General Partners: Personal
general Partners: Yes Partners: Yes Yes
partner, no limit Limited Limited Limited Partners:
on number of Partners: No Partners: No No
limited partners
Corporation Unlimited No No (but they No Business and
may legally Personal
REIT Unlimited No No No Personal
