Chapter 1: Corporate Finance and the Financial Manager

The Three Types of Firms

Sole Proprietorship

• Owned and run by one person; easy to set up and manage.
• Typically small, with few or no employees.
• No legal distinction between owner and business.
• Limitations:
  • Only one owner allowed.
  • Owner has unlimited personal liability.
  • Business ends with the owner's life.
  • Difficult to transfer ownership.

Partnerships

• Can be general or limited partnerships.
• Income is taxed at the personal level and split by ownership.

General Partnership

• All partners share unlimited liability.
• Any partner can be held responsible for debts.
• Ends when any partner dies or withdraws.
• Shared rights, duties, and risks.

Limited Partnership

• Two roles: general and limited partners.
  • General partners manage and hold full liability.
  • Limited partners have limited liability and no management power.

Limited Liability Partnership (LLP)

• Common in Canada for law and accounting firms.
• Limits liability for negligence of other partners.

Corporations

• Legally separate from its owners.
• Has legal rights similar to a person.
• Owners not liable for corporate obligations.

Formation

• Created under Canadian or provincial Business Corporation Acts.
• Requires articles of incorporation.
• More costly than sole proprietorship.

Ownership

• No limit on number of owners.
• Ownership divided into shares (stock).
• Total shares = equity of the corporation.

Shareholders

• Shareholders (a.k.a. stockholders, equity holders) own shares.
• May receive dividend payments, usually proportional to shareholding.
• No restriction on stock ownership.

Tax Implications for Corporations

• A corporation's profits are taxed separately from its owners.
• Double taxation occurs:
  • The corporation pays taxes on its profits.
  • Shareholders pay personal income tax on the distributed dividends.

Flow-Through Entities (Income Trusts)

• The Canada Revenue Agency allowed some entities to bypass double taxation, known as flow-through entities or income trusts.
  • Under CRA rules, these entities could “flow through” income directly to investors without paying corporate tax—only the investors pay tax on the income they receive. This avoids double taxation.
  • These entities are not taxed at the entity level only if they distribute most (or all) of their income.
• Types:
  • Business Income Trusts
  • Energy Trusts
  • Real Estate Investment Trusts (REITs)
• As of 2011:
  • REITs are still exempt from business-level tax.
  • Other income trusts are now taxed.

The Financial Manager

• 3 main tasks
  • Making investment decisions
  • Make financial decisions
  • Manage short-term cash needs
• The goal: the overriding goal of the firm’s management is to maximize the wealth of the stockholders

The Financial Manager’s Place in the Corporation

• Stockholders of a corporation exercise their control by electing a board of directors.
• Principal-Agent Problem: When managers put their own self-interest ahead of the interests of those shareholders.
  • Shareholders often tie the compensation of top managers to the corporation’s profits or people to its stock price. This strategy also has limitations.

Stock Market

• A private corporation has a limited number of owners and there is no organized market for its shares
• A public corporation has many owners and its shares trade on an organized market, called a stock market
• Primary market: The market where new shares of stock are issued by a corporation and sold to investors.
• Secondary market: Markets, such as the TSX, NYSE, or Nasdaq, where shares of a corporation are traded between investors without the involvement of the corporation.
• Bid-Ask spread:
  • Bid price: the highest price in the market for which someone is willing to purchase a security
    • a security is a financial instrument that holds some type of value and can be bought, sold, or traded.
  • Ask (or offer) price: the lowest price in a market for which someone is willing to sell a security
  • Bid-ask spread is an implicit transaction cost investors have to pay in order to trade quickly
• Limit order: Order to buy at a specified price; until your order matches the ask price (the amount for which someone will sell the stock to you), no trade will take place.
• Market order: Order to buy immediately because it automatically takes the best ask price already posted; customers end up always buying at the ask (the higher price) and selling at the bid (the lower price).

Financial Institutions

• Financial Cycle
  • People invest and save their money.
  • Through loans and stock, that money flows to companies who use it to fund growth through new products, generating profits and wages.
  • The money then flows back to the savers and investors.

Key Terms and Concepts

• Stock: Represents ownership in a corporation, divided into shares.
• Equity: The total value of all outstanding shares in a corporation.
• Shareholder (or stockholder, equity holder): Someone who owns shares in a corporation.
• Dividend payments: Profit distributions to shareholders, determined by the board of directors.
• Flow-through entity: Business where income passes to investors without being retained, avoiding double taxation.
• Income trust: Holds income-generating assets or securities of an operating company.
• Business income trust: Holds securities of a corporation.
• Energy trust: Holds resource properties or securities of a resource company.
• Real estate investment trust (REIT): Holds real estate or related securities.
• Unit holders: Investors who own shares (units) in an income trust.
• Board of directors: Elected group responsible for strategic oversight and decisions in a corporation.
• Chief executive officer (CEO): Executes policies and manages day-to-day operations as directed by the board.