Concepts of finance_analysis

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Today, the corporate structure is ubiquitous all over the world, and yet continues to evolve in the face of

new forces. In 2008 the financial crisis once again transformed the financial landscape, bringing down giants

like Bear Stearns, Lehman Brothers, and AIG and reshaping investment banks like Goldman Sachs into

government-guaranteed commercial banks. These changes have as profound an effect on the future of

corporate finance. Government bailouts have provoked challenging questions regarding the role of the

federal government in the control and management of private corporations. In the wake of the crisis,

significant reforms of the regulation and oversight of financial markets were passed into law. Understanding

the principles of corporate finance has never been more important to the practice of business than it is

now, during this time of great change. The focus of this lecture is on how people in corporations make

financial decisions. This lecture introduces the corporation and explains alternative business organizational

forms. A key factor in the success of corporations is the ability to easily trade ownership shares, and so I will

also explain the role of stock markets in facilitating trading among investors in a corporation and the

implications that has for the ownership and control of corporations.

The Four Types of Firms

We begin our study of corporate finance by introducing the four major types of firms: sole proprietorships,

partnerships, limited liability companies, and corporations. I will explain each organizational form in turn,

but our primary focus is on the most important form—the corporation. In addition to describing what a

corporation is, we also provide an overview of why corporations are so successful.

Proprietorship

A sole proprietorship is a business owned and run by one person. Sole proprietorships are usually very small

with few, if any, employees. Although they do not account for much sales revenue in the economy, they are

the most common type of firm in the world, as shown in Figure 1.1. Statistics indicate that 71% of

businesses in the United States are sole proprietorships, although they generate only 5% of the revenue.2

Contrast this with corporations, which make up only 19% of firms but are responsible for 84% of U.S.

revenue. Sole proprietorships share the following key characteristics:

1. Sole proprietorships are 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. If there are other investors, they cannot hold an ownership

stake in the firm.

3. The owner has unlimited personal liability for any of the firm’s debts. That is, 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 the loan 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 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

owners typically convert the business into a form that limits the owner’s liability.

Partnerships

A partnership is identical to a sole proprietorship except it has more than one owner. The following are key

features of a partnership:

1. All partners are liable for the firm’s debt. That is, a lender can require any partner to repay all the firm’s

outstanding debts.

2. The partnership ends on the death or withdrawal of any single partner, although partners can avoid

liquidation if the partnership agreement provides for alternatives such as a buyout of a deceased or

withdrawn partner.

Some old and established businesses remain partnerships or sole proprietorships. Often these firms are the

types of businesses in which the owners’ personal reputations are the basis for the businesses. For example,

law firms, groups of doctors, and accounting firms are often organized as partnerships. For such enterprises,

the partners’ personal liability increases the confidence of the firm’s clients that the partners will strive to

maintain their reputation.

A limited partnership is a partnership with two kinds of owners, general partners and limited partners.

General partners have the same rights and privileges as partners in a (general) partnership—they are

personally liable for the firm’s debt 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. Furthermore, 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.

Private equity funds and venture capital funds are two examples of industries dominated by limited

partnerships. In these firms, a few general partners contribute some of their own capital and raise

additional capital from outside investors who are limited partners. The general partners control how all the

capital is invested. Most often they will actively participate in running the businesses they choose to invest

in. The outside investors play no active role in the partnership other than monitoring how their investments

are performing.

Limited Liability Companies

A limited liability company (LLC) is a limited partnership without a general partner. That is, all the owners

have limited liability, but unlike limited partners, they can also run the business.

The LLC is a relatively new phenomenon in the United States. The first state to pass a statute allowing the

creation of an LLC was Wyoming in 1977; the last was Hawaii in 1997. Internationally, companies with

limited liability are much older and established. LLCs rose to prominence first in Germany over 100 years

ago as a Gesellschaft mit beschränkter Haftung (GmbH) and then in other European and Latin American

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Today, the corporate structure is ubiquitous all over the world, and yet continues to evolve in the face of new forces. In 2008 the financial crisis once again transformed the financial landscape, bringing down giants like Bear Stearns, Lehman Brothers, and AIG and reshaping investment banks like Goldman Sachs into government-guaranteed commercial banks. These changes have as profound an effect on the future of corporate finance. Government bailouts have provoked challenging questions regarding the role of the federal government in the control and management of private corporations. In the wake of the crisis, significant reforms of the regulation and oversight of financial markets were passed into law. Understanding the principles of corporate finance has never been more important to the practice of business than it is now, during this time of great change. The focus of this lecture is on how people in corporations make financial decisions. This lecture introduces the corporation and explains alternative business organizational forms. A key factor in the success of corporations is the ability to easily trade ownership shares, and so I will also explain the role of stock markets in facilitating trading among investors in a corporation and the implications that has for the ownership and control of corporations. The Four Types of Firms We begin our study of corporate finance by introducing the four major types of firms: sole proprietorships, partnerships, limited liability co ...
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