Chapter 1
Four types of firms:
(1) Sole proprietorship: a business owned and run by one person.
Most common in the world.
Key characteristics:
1. Easy to set up.
2. Principal limitation is that there is no separation between firm and owner, other
investors do not hold an ownership.
3. Owner has unlimited personal liability for the firm’s debt.
4. The life of the sole proprietorship is limited to the life of the owner and it is difficult to
transfer ownership.
(2) Partnership: sole proprietorship but more than one owner.
Key features:
1. All partners are liable for the firm’s debt.
2. The partnership ends on the death or withdrawal of any single partner, but liquidation
can be avoided by specifics in the partnership agreement.
- Owner’s reputation is the basis for business.
- Personal liability increases confidence by clients.
- Limited partnership: partnership with two kinds of owners.
- General partners: same rights and privileges as partners in a general
partnership, personally liable for the firm’s debt obligations.
- Limited partners: have limited liability, their private property cannot be
seized to pay off the firm’s outstanding debts, their death does not end the
partnership. But they don’t have management authority.
(3) Limited liability company (LLC): a limited partnership without a general partner.
All owners have limited liability but they can also run the business.
(4) Corporation: a legally defined, artificial being separate from its owners
- Many legal powers like humans have.
- Solely responsible for its own obligations (owners not liable)
Formation:
Must be legally formed, a little costly.
Ownership:
No limited number of owners. Ownership stake is divided into shares stock, collectively
known as the equity.
Owner of a share: shareholder, stockholder, equity holders, is entitled to dividend
payments: payments made at the discretion of the corporation to its equity holders.
Shareholders of a corporation pay taxes twice: first the corporation pays tax on its profits,
then the shareholders pay income tax → double taxation.
Eva Vlieger
,Shareholders elect a board of directors: a group of people who have the ultimate
decision-making authority in the corporation. (One stock = one vote)
- Rules on how the corporation should be run
- Sets policy
- Monitors the performance of the company
- Delegates most daily decisions to its management
- Chief executive officer (CEO) runs the corporation by instituting the rules
and policies set by the board of directors. Not always separation of power.
- Chief financial officer (CFO) is the most senior financial manager and
reports directly to the CEO.
Financial manager:
● Investment decisions: What to invest in?
● Financing decisions: How to pay for the investments? Raise money by selling more
shares of stock, or borrow money?
● Cash management: Does the firm have enough cash on hand to meet its day-to-day
obligations? (Managing working capital)
Goal of the firm: increases the value of shares.
→ only when beneficial or indifferent to society. If negative impact, rules in place.
Agency problems: When managers put their own self-interest ahead of the interests of
shareholders.
● Minimize the amount of decisions managers must make for which their own
self-interest substantially differs from the interests of the shareholders.
○ By tying compensation too closely to performance, managers might be asked
to take on more risk than they are comfortable taking.
○ If there is no ‘punishment’, managers might take on too much risk.
Ethics:
Sometimes some people involved (shareholders/managers/employees) benefit and others
lose from a decision. Sometimes these cases can be solved by giving the shareholders the
decision, like not giving money to a charity from the firm, but letting them give it themselves.
The CEO’s performance:
A way to encourage managers in the interests of shareholders is to discipline them if they
don’t. Dissatisfied investors will often choose to sell their shares. If enough people sell them,
they will be offered at a low price.
The CEO might be replaced but this doesn’t happen often because the board members are
friends with them and lack objectivity.
Hostile takeover: an individual or organization can purchase a large fraction of the stock
and replace the board of directors and CEO.
Corporate bankruptcy:
The holders of a firm’s debt become investors in the corporation. If the corporation fails to
repay the debt, debt holders can seize assets. The firm might try to negotiate with them, or
file for bankruptcy. If they never pay it back, debt holders will gain control of the corporation’s
assets.
Eva Vlieger
,Firm fails to repay debt → transfer in ownership from equity holders to debt holders
Bankruptcy does not mean liquidation.
Private companies: limited set of shareholders, shares not regularly traded.
Public companies: trades shares on organized markets called a stock market (stock
exchange).
Markets provide liquidity and determine a market price for the company’s shares.
1. Primary market: a corporation issues new shares of stock and sells them to
investors.
2. Secondary market: the shares continue to trade between investors without the
involvement of the corporation.
NYSE: Market makers matched buyers and sellers. They posted the bid price (willing to
buy at) and the ask price (willing to sell at). They would accept any trade, so people who
came to them always had someone to trade with.
Nasdaq: trades computers over the phone or online, every stock had multiple market
makers.
Market makers make money because the ask prices are higher than bid prices, the bid-ask
spread, a transaction cost investors pay in order to trade.
Eva Vlieger
, Chapter 2
Financial statements: accounting reports with past performance information that a firm
issues periodically. They are important tools through which investors, financial analysts, and
other interested outside parties obtain information about a corporation.
There are rules created by GAAP which make comparing different firms easier and the
statements more accurate.
A neutral third party, an auditor, checks the statements for reliability.
Four financial statements:
(1) Balance sheet
A list of the firm’s assets (cash, inventory, property, plant, equipment, investments) on the
left and liabilities (obligations to creditors) on the right along with stockholders’ equity (the
difference between the firm’s assets and liabilities, a measure of the firm’s net worth).
Balance Sheet Identity: Assets = Liabilities + Stockholders’ Equity
Current assets: cash or assets that can be converted into cash within one year.
1. Cash and other marketable securities: short term low-risk investment easily
converted to cash.
2. Accounts receivable: amounts owed to the firm by customers.
3. Inventories: raw materials as well as work-in-progress and finished goods.
4. Other current assets (like prepaid expenses).
Long-term assets:
1. Net property, plant, and equipment (produce tangible benefits for more than one
year).
- Equipment wears out, so the value is reduced yearly by deducting a
depreciation expense.
- Accumulated depreciation: total amount deducted over an asset’s life.
- Book value (value in statements) = cost price - accumulated depreciation
2. When a company buys another company, they pay more than just for the tangible
assets. This difference is recorded as goodwill and intangible assets.
- If the value of intangible assets declines over time, the amount listed on the
balance sheet will be reduced by an amortization or impairment charge.
3. Other long term assets (start up costs, unused property, etc).
Current liabilities: liabilities satisfied within one year.
1. Account payable: amounts owed to suppliers for products or services purchased
with credit.
2. Short-term debt or notes payable, and current maturities of long term debt:
repayments of debt that will occur within the next year.
3. Items such as salary or taxes that are owed but not yet paid, and deferred or
unearned revenue: revenue received for products that have not yet been delivered.
Current Assets - Current Liabilities = Net Working Capital (short term available capital)
Eva Vlieger
Four types of firms:
(1) Sole proprietorship: a business owned and run by one person.
Most common in the world.
Key characteristics:
1. Easy to set up.
2. Principal limitation is that there is no separation between firm and owner, other
investors do not hold an ownership.
3. Owner has unlimited personal liability for the firm’s debt.
4. The life of the sole proprietorship is limited to the life of the owner and it is difficult to
transfer ownership.
(2) Partnership: sole proprietorship but more than one owner.
Key features:
1. All partners are liable for the firm’s debt.
2. The partnership ends on the death or withdrawal of any single partner, but liquidation
can be avoided by specifics in the partnership agreement.
- Owner’s reputation is the basis for business.
- Personal liability increases confidence by clients.
- Limited partnership: partnership with two kinds of owners.
- General partners: same rights and privileges as partners in a general
partnership, personally liable for the firm’s debt obligations.
- Limited partners: have limited liability, their private property cannot be
seized to pay off the firm’s outstanding debts, their death does not end the
partnership. But they don’t have management authority.
(3) Limited liability company (LLC): a limited partnership without a general partner.
All owners have limited liability but they can also run the business.
(4) Corporation: a legally defined, artificial being separate from its owners
- Many legal powers like humans have.
- Solely responsible for its own obligations (owners not liable)
Formation:
Must be legally formed, a little costly.
Ownership:
No limited number of owners. Ownership stake is divided into shares stock, collectively
known as the equity.
Owner of a share: shareholder, stockholder, equity holders, is entitled to dividend
payments: payments made at the discretion of the corporation to its equity holders.
Shareholders of a corporation pay taxes twice: first the corporation pays tax on its profits,
then the shareholders pay income tax → double taxation.
Eva Vlieger
,Shareholders elect a board of directors: a group of people who have the ultimate
decision-making authority in the corporation. (One stock = one vote)
- Rules on how the corporation should be run
- Sets policy
- Monitors the performance of the company
- Delegates most daily decisions to its management
- Chief executive officer (CEO) runs the corporation by instituting the rules
and policies set by the board of directors. Not always separation of power.
- Chief financial officer (CFO) is the most senior financial manager and
reports directly to the CEO.
Financial manager:
● Investment decisions: What to invest in?
● Financing decisions: How to pay for the investments? Raise money by selling more
shares of stock, or borrow money?
● Cash management: Does the firm have enough cash on hand to meet its day-to-day
obligations? (Managing working capital)
Goal of the firm: increases the value of shares.
→ only when beneficial or indifferent to society. If negative impact, rules in place.
Agency problems: When managers put their own self-interest ahead of the interests of
shareholders.
● Minimize the amount of decisions managers must make for which their own
self-interest substantially differs from the interests of the shareholders.
○ By tying compensation too closely to performance, managers might be asked
to take on more risk than they are comfortable taking.
○ If there is no ‘punishment’, managers might take on too much risk.
Ethics:
Sometimes some people involved (shareholders/managers/employees) benefit and others
lose from a decision. Sometimes these cases can be solved by giving the shareholders the
decision, like not giving money to a charity from the firm, but letting them give it themselves.
The CEO’s performance:
A way to encourage managers in the interests of shareholders is to discipline them if they
don’t. Dissatisfied investors will often choose to sell their shares. If enough people sell them,
they will be offered at a low price.
The CEO might be replaced but this doesn’t happen often because the board members are
friends with them and lack objectivity.
Hostile takeover: an individual or organization can purchase a large fraction of the stock
and replace the board of directors and CEO.
Corporate bankruptcy:
The holders of a firm’s debt become investors in the corporation. If the corporation fails to
repay the debt, debt holders can seize assets. The firm might try to negotiate with them, or
file for bankruptcy. If they never pay it back, debt holders will gain control of the corporation’s
assets.
Eva Vlieger
,Firm fails to repay debt → transfer in ownership from equity holders to debt holders
Bankruptcy does not mean liquidation.
Private companies: limited set of shareholders, shares not regularly traded.
Public companies: trades shares on organized markets called a stock market (stock
exchange).
Markets provide liquidity and determine a market price for the company’s shares.
1. Primary market: a corporation issues new shares of stock and sells them to
investors.
2. Secondary market: the shares continue to trade between investors without the
involvement of the corporation.
NYSE: Market makers matched buyers and sellers. They posted the bid price (willing to
buy at) and the ask price (willing to sell at). They would accept any trade, so people who
came to them always had someone to trade with.
Nasdaq: trades computers over the phone or online, every stock had multiple market
makers.
Market makers make money because the ask prices are higher than bid prices, the bid-ask
spread, a transaction cost investors pay in order to trade.
Eva Vlieger
, Chapter 2
Financial statements: accounting reports with past performance information that a firm
issues periodically. They are important tools through which investors, financial analysts, and
other interested outside parties obtain information about a corporation.
There are rules created by GAAP which make comparing different firms easier and the
statements more accurate.
A neutral third party, an auditor, checks the statements for reliability.
Four financial statements:
(1) Balance sheet
A list of the firm’s assets (cash, inventory, property, plant, equipment, investments) on the
left and liabilities (obligations to creditors) on the right along with stockholders’ equity (the
difference between the firm’s assets and liabilities, a measure of the firm’s net worth).
Balance Sheet Identity: Assets = Liabilities + Stockholders’ Equity
Current assets: cash or assets that can be converted into cash within one year.
1. Cash and other marketable securities: short term low-risk investment easily
converted to cash.
2. Accounts receivable: amounts owed to the firm by customers.
3. Inventories: raw materials as well as work-in-progress and finished goods.
4. Other current assets (like prepaid expenses).
Long-term assets:
1. Net property, plant, and equipment (produce tangible benefits for more than one
year).
- Equipment wears out, so the value is reduced yearly by deducting a
depreciation expense.
- Accumulated depreciation: total amount deducted over an asset’s life.
- Book value (value in statements) = cost price - accumulated depreciation
2. When a company buys another company, they pay more than just for the tangible
assets. This difference is recorded as goodwill and intangible assets.
- If the value of intangible assets declines over time, the amount listed on the
balance sheet will be reduced by an amortization or impairment charge.
3. Other long term assets (start up costs, unused property, etc).
Current liabilities: liabilities satisfied within one year.
1. Account payable: amounts owed to suppliers for products or services purchased
with credit.
2. Short-term debt or notes payable, and current maturities of long term debt:
repayments of debt that will occur within the next year.
3. Items such as salary or taxes that are owed but not yet paid, and deferred or
unearned revenue: revenue received for products that have not yet been delivered.
Current Assets - Current Liabilities = Net Working Capital (short term available capital)
Eva Vlieger
