Business Finance

• Business Organizational Forms

  Sole Proprietorships<|>Partnerships<|>Corporations
• Sole Proprietorship

  • Business owned by a single individual
  • Entitled to all of the firm's profits
  • Responsible for all of the firm's debt
  • Typically raise money by investing their own funds and by borrowing from a bank
• Sole Proprietorship - Advantages

  • Easy to form
  • No need to consult others while making decisions
  • Profits are taxed at the owner's tax rate
• Sole Proprietorship - Disadvantages

  • Personally liable for the business debts
  • The business ceases on the death of the proprietor
  • Limited access to external sources of financing
• General Partnership


  • Association of two or more persons who come together as co-owners for the purpose of operating a business for profit
• General Partnership - Advantages

  • Relatively easy to start
  • Taxed at the personal tax rate
  • Access to funds from multiple partners
• General Partnership - Disadvantages

  • Partners jointly share unlimited liability
  • It is not always easy to transfer ownership
• Limited Partnership

  • Limited partner is liable only up to the amount the limited partner invested
  • Provide capital but cannot make managerial decisions and are not responsible for any debts beyond their initial investment
  • The life of the partnership is tied to the life of the general partner, but the limited partner's shares can be transferred to another owner without the need to dissolve the partnership
• Corporation


  • Legally functions separately and apart from its owners (the shareholders)
  • Can individually sue and be sued and can purchase, sell, or own property
  • Legally owned by its current set of stockholders, or owners
  • The Board of directors are elected by the shareholder, and the board appoints the senior management of the firm
• Corporation - Advantages

  • Liability of owners is limited to invested funds
  • Life of corporation is not tied to the status of the investors
  • Easier to raise Capital
• Corporation - Disadvantages

  • Greater regulation
  • Double taxation of dividends
• If very large sums of money are needed to build a business, then the typical organizational form chosen is the corporation
• Figure 1.1 How the Finance Area Fits into a Corporation
• LLC vs. partnership (GP, LP, and LLP): Which business structure is the best choice for multiple business owners?
• Common stock

  Common stockholders are the owners of the firm. They elect the firm's board of directors who in turn appoint the firm's top management team. The firm's management team then carries out the day-to-day management of the firm.
• Characteristics of common stock

  • It does not have a maturity date but exists as long as the firm does
  • It does not have an upper or lower limit on its dividend payments
  • In the event of bankruptcy, the common stockholders – as owners of corporation – have the most junior claim
• Claim on income

  Common stockholders have the right to the firm's income that remains after bondholders and preferred stockholders have been paid<|>The common stockholders will either receive cash payments in the form of dividends or, any increase in value that results from the reinvested earnings
• Claim on assets

  Common stock has a residual claim on assets in case of liquidation<|>When bankruptcy does occur, the claims of the common stockholders generally go unsatisfied
• Voting rights

  The common stockholders elect the board of directors and are in general the only security holders given a vote<|>Common stockholders also must approve any changes in the corporate charter
• Discounted dividend model


  The value of a common stock is equal to the present value of all future cash flows that the stockholder expects to receive from owning the share of stock
• Constant dividend growth rate model

  1. Dividend in Year 1

  2. Stockholder's Required Dividend Rate of Return

  3. Dividend Growth Rate
• Valuing common stock

  Dividend in Year 0<|>Dividend Growth Rate<|>Stockholder's Required Dividend Rate of Return
• Valuing common stock

  • Dividend of $6 last year, expected to grow at 5% per year, investor's required rate of return is 12%
  • Dividend of $1.20 last year, expected to grow at 6% per year, investor's required rate of return is 14%
  • Dividend of $5.50 last year, expected to grow at 8% per year, investor's required rate of return is 15%
• Preferred stock


  Dividend is fixed, either stated as a dollar amount or as a percentage of the preferred stock's par value<|>A company can issue more than one class of preferred stock, each with different characteristics<|>Claims of preferred stockholders have priority over common stockholders for payment of dividends and in settlement of claims at bankruptcy, but lower priority than debt holders<|>Preferred stock is a hybrid security - like common stock it has no fixed maturity date, but like debt it has a fixed dividend amount
• Valuing preferred stock


  1. Annual preferred stock dividend

  2. Market's required yield on preferred stock
• Valuing preferred stock

  • Preferred stock pays $12 annual dividend, market's yield is 8%
  • Preferred stock pays $3.60 annual dividend, selling for $33, investor's required rate of return is 10%