Chapter 1: Company Structures

Question 1

Sole Proprietorship

Answer 1

Business owned and run by one person

Question 2

Advantages of Sole Proprietorship

Answer 2

• Easy to establish
• Strong sense of ownership (perfect goal alignment)

Question 3

Disadvantages of Sole Proprietorship

Answer 3

• Difficult to transfer ownership
  
  • No separation of owner and firm
  • Limited to life of the owner
• Unlimited Personal Liability

Question 4

Partnership

Answer 4

Identical to sole proprietorship except that there are multiple owners

Question 5

Advantages of Partnership

Answer 5

• Relatively easy to establish
• More than one owner (possible increase in liquidity)
• Strong sense of ownership (goal alignment)

Question 6

Disadvantages of Partnership

Answer 6

• Disagreements Among Partners (goal alignment issue)
• Unlimited Personal Liability
• Difficulties transferring ownership

Question 7

Limited Liability Company (LLC)

Answer 7

Limited partnership without a general partner. All of the owners have limited liability over the company but can all run the business unlike limited partners

Question 8

Advantages of LLC

Answer 8

• Relatively easy to establish
• More than one owner (possible increase in liquidity)
• Strong sense of ownership (goal alignment)

Question 9

Disadvantages of LLC

Answer 9

• Disagreements Among Partners (goal alignment issue)
• Difficulties transferring ownership

Question 10

Corporation

Answer 10

Legally defined, artificial being (legal entity) separate from its owners. Can enter into contacts, acquire assets, and incur obligations

Question 11

Advantages of Corporation

Answer 11

• Owners have limited liability (amount invested)
• Easier to access capital markets
• Allows free trade in the shares of C corporations
• No limit on the numbers of owners of a C corporation
• No restriction on who can be the owners of C corporation

Question 12

Disadvantages of Corporation

Answer 12

• More difficult and expensive to establish and operate
• Double taxation (except “S” corporations) - dividends are subject to tax
• Separation of ownership and control created principle-agent problems (goal alignment issue)

Question 13

What are the three main tasks of financial managers?

Answer 13

• Investment Decisions: What projects to put money in
• Financing Decisions: How to fund projects (debt or equity combination) or when and how to return money to shareholders.
• Managing the firm’s cash flows: When and how to return the money to lenders and shareholders

Question 14

As measured by the total number of firms, what is the most common type of business structure in the U.S.?

Answer 14

Sole Proprietorship

Question 15

In a limited partnership, what are the two main differences that distinguish limited partners from general partners?

Answer 15

General Partners have all the management authority-they make the decisions. But general partners have unlimited personal liability. Limited partners have limited liability (limited to the amount they invested in the firm), but limited partners do not have a vote in management decisions.

Question 16

Most large businesses are organized under what type of business structure?

Answer 16

Corporations

Question 17

In a corporation, what is the principal-agent problem? What are some ways this problem may be mitigated?

Answer 17

The principals (owners) are wide spread and do not control nor manage the corporation. The agents are the managers who control and manage the corporation. If the interests of these groups are not aligned, then the agents (managers) may not be working in the best interests of the owners. Many people believe that one way this can be mitigated is by variable pay (also known as pay-for-performance) compensation plans that reward the managers when the firm does well, for example by exceeding earnings targets. Similarly, you can reward managers with stock compensation- often restricted (deferred) stock making them owners of the corporation.

Question 18

Who has the ultimate decision making authority in a corporation?

Answer 18

The Board of Directors

Question 19

Who carries out the day-to-day management of a corporation?

Answer 19

Management, lead by the CEO

Question 20

What are the primary goals of financial managers?

Answer 20

To maximize the wealth of the corporation within the risk tolerances set by the Board of Directors