CHAPTER 1: ORGANIZATIONAL FORMS, CORP ISSUER FEATURES & OWNERSHIP

Question 1

Common forms of business structures include:

Answer 1

1. Sole proprietorship
2. General partnership
3. Limited partnership
4. Corporation

Question 2

Business Structures: Key Areas

Answer 2

1. Legal Relationship: Relationship between owners and business.
2. Owner-Operator Relationship: Relationship between owners and operators.
3. Business Liability: Extent of owners’ liability for business actions.
4. Taxation: Tax treatment of business profits.
5. Access to Financing: Ability to raise capital for expansion and risk distribution.

Question 3

General Partnership

Answer 3

Similar to a sole proprietorship but with two or more owners (partners).
Roles and responsibilities outlined in a partnership agreement.
Allows additional resources and shared business risks.

Examples: Law firms, accounting firms, financial advisory firms.

Key Features:

1. Legal Relationship: Defined in partnership agreement.
2. Owner-Operator Relationship: Managed by partners.
3. Business Liability: Shared among partners.
4. Taxation: Profits typically passed through to partners’ personal income.
5. Access to Financing: Greater resources than sole proprietorship; shared capital and risk.

Question 3

Sole Proprietorship (Sole Trader)

Answer 3

Most basic business structure.
Owner funds capital and controls operations.
Owner retains all financial returns and risks.
Example: Family-owned store.

Key Features:

1. Legal Relationship: No separate legal identity; an extension of the owner.
2. Owner-Operator Relationship: Owner-operated; full control retained by the owner.
3. Business Liability: Unlimited liability; owner is financially responsible for all debts.
4. Taxation: Profits taxed as personal income.
5. Access to Financing: Preferred for small-scale businesses; limited by owner’s capital and risk tolerance.

Question 4

General Partnership

Answer 4

No separate legal identity; defined by partnership agreement.
Operated by partners with complementary skills.
Partners share all business risks and liabilities.
Profits taxed as personal income.
Growth limited by partners’ capital and risk tolerance.

Question 5

Limited Partnership

Answer 5

Includes at least one general partner (GP) with unlimited liability.
Limited partners (LPs) have liability limited to their investment.
GP manages the business; LPs have no operational control.
Profits shared among partners, taxed as personal income.
Growth constrained by partners’ financing capabilities and GP’s competence.

Question 5

Privately Owned Corporate Issuers:

Answer 5

Exchange Listing, Liquidity, and Price Transparency:

Not listed on exchanges; valuation and liquidity are challenging.
Ownership transfers through private negotiations, with limited liquidity until acquisition or IPO.

Share Issuance:

Raise smaller capital from fewer investors with longer holding periods.
Limited to accredited investors due to higher risks, requiring specific income or wealth criteria.

Question 6

Corporation (Limited Companies)

Answer 6

Also known as a limited liability company (LLC) or limited company.
Owners enjoy limited liability, facilitating greater access to capital.
Corporations vary between public and private based on shareholder numbers and stock exchange listing.
Public corporations have shares traded on exchanges; private corporations do not.
Examples include national or multinational conglomerates.

Question 7

Public corporations differ from private corporations in terms of:

A the number of shareholders
B listing of the shares on a stock exchange.
C both A) and B).

Answer 7

C is correct.

For-profit corporations can be public or private.

The main difference between the two are the number of shareholders and whether the shares are listed on a stock exchange.

In some countries like the UK, a corporation is categorized as public if the shareholders are greater than 50.

While in many other countries, like the US, a corporation is categorized as public if the company shares are listed on an exchange.

Question 7

Key Features of Corporations:

1. Legal Relationship
2. Owner-Operator Separation
3. Business Liability
4. Access to Financing
5. Double Taxation

Answer 7

1. Legal Relationship:

Separate Legal Entity: Distinct from its owners, allowing it to conduct business, enter contracts, hire employees, and pay taxes independently.

Regulatory Jurisdiction: Subject to regulations where incorporated, conduct business, or list securities.

2. Owner-Operator Separation:
   Board Oversight: Shareholders elect a board of directors to oversee operations.

Management Control: Board hires management (CEO, senior executives) for day-to-day operations.
Governance: Policies prevent conflicts of interest; shareholders can enforce change through voting rights.

3. Business Liability:

Limited Liability: Owners (shareholders) are liable only up to their investment; not personally responsible for company debts.

Residual Claim: Shareholders participate in company growth through residual assets after liabilities.

4. Access to Financing:

Capital Options: Corporations can raise funds through equity (ownership) and debt (borrowed capital).

Investor Roles: Equity shareholders have ownership stakes and residual claims, while bondholders are lenders without ownership rights.

5. Double Taxation:

Corporate Level: Corporations are taxed on their profits at the corporate tax rate.

Individual Level: Shareholders are taxed on dividends received from the corporation as part of their personal income.

Question 8

Example from the curriculum

The French company Elo (previously known as Auchan Holding) generated operating income of €838 million and paid corporate taxes of €264 million. Investors in France also pay a 30% tax on dividends received. If Elo had distributed all of its after tax income to investors as a dividend, what would have been the effective tax rate on each euro of operating earnings?

Answer 8

To calculate the effective tax rate on each euro of operating earnings for Elo:

1. Calculate After-Tax Income:

Operating Income: €838 million
Corporate Taxes (31.5% of €838 million): €264 million
After-Tax Income: €838 million - €264 million = €574 million

2. Calculate Distributed Dividend:

Distributed Dividend: €574 million
Calculate Investor Dividend Tax:

Investor Dividend Tax Rate: 30%
Tax on Dividend (30% of €574 million): €172.2 million

3. Calculate Total Taxes Paid:

Total Taxes Paid: Corporate Tax + Investor Dividend Tax
€264 million (Corporate Tax) + €172.2 million (Investor Dividend Tax) = €436.2 million

4. Calculate Effective Tax Rate:

Effective Tax Rate = Total Taxes Paid / Operating Income
Effective Tax Rate = €436.2 million / €838 million
Effective Tax Rate ≈ 52.1%

Therefore, the effective tax rate on each euro of operating earnings for Elo, considering both corporate taxes and taxes on distributed dividends, would be approximately 52.1%.

Question 9

L0: Compare the organizational forms of businesses (table)

CORP INCOME= double taxed; corporation income taxed; dividends/distributions taxed as personal income

Answer 9

1. Sole Proprietorship:

Legal Identity: No separate legal identity; business is an extension of the owner.
Owner-Operator Relationship: Solely operated by the owner.
Owner Liability: Owner has unlimited liability; personal assets at risk.
Taxation: Profits taxed as personal income of the owner.
Access to Financing: Limited by the owner’s personal access to capital.

2. General Partnership:

Legal Identity: No separate legal identity; business is an extension of the partners.
Owner-Operator Relationship: Operated by partners with shared responsibilities.
Owner Liability: Partners share unlimited liability; personal assets at risk.
Taxation: Profits taxed as personal income of the partners.
Access to Financing: Limited by the partners’ collective access to capital.

3. Limited Partnership:

Legal Identity: No separate legal identity; business defined by partnership agreement.
Owner-Operator Relationship: General partner(s) manage the business; limited partners have no operational control.
Owner Liability: General partner(s) have unlimited liability; limited partners have liability limited to their investment.
Taxation: Profits taxed as personal income of partners; distributions taxed as personal income.
Access to Financing: Limited by general partner’s ability to manage and raise capital; limited partners have passive investment.

4. Corporation:

Legal Identity: Separate legal entity distinct from its owners (shareholders).
Owner-Operator Relationship: Board of directors and management operate the business on behalf of shareholders.
Owner Liability: Shareholders have limited liability; their liability is limited to their investment.
Taxation: Corporate profits taxed at the corporate level; dividends taxed as personal income for shareholders.
Access to Financing: Access to capital is extensive through equity (ownership) and debt (borrowings).

Question 9

Publicly Owned Corporate Issuers:

Answer 9

Exchange Listing, Liquidity, and Price Transparency:

Listed on exchanges, allowing easy ownership transfer.
Shares traded publicly, providing liquidity and transparent price discovery.
Share prices react to market news and company-specific events.

Share Issuance:

Raise large capital through Initial Public Offerings (IPOs) and subsequent offerings.
Shares traded actively in secondary markets among numerous investors.

Question 9

Which of the following statements is least accurate about limited partnerships (LPs)?

A The LPs operate the business and have unlimited liability.
B All partners share profits, which are taxed as personal income.
C Business growth is limited by the financing capabilities and risk appetite of the partners.

Answer 9

A is correct.

The GP operates the business. LPs have no control over the operation of the business. They cannot replace the GP in the event he runs the business poorly or fails to act in the interest of the LPs. The GP has unlimited liability, while LPs have limited liability i.e., they can only lose up to the amount invested in the business.

B and C are correct statements about limited partnerships.

Question 10

Statement 1: Partnerships are taxed at the entity level and not at the individual partner level.

Statement 2: Profits from sole proprietorships are taxed as personal income.

Which of the above statements is correct?

A Statement 1
B Statement 2
C Both Statements 1 and 2

Answer 10

B is correct.

Sole proprietorships are typically pass-through entities, meaning that business income earned by the business is passed through to the owners and is taxed at the personal level. This is also the case with partnerships which are taxed at the individual partner level.

Question 11

Ways a Private Company Can Go Public:

Answer 11

1. Initial Public Offering (IPO):

Meets specific exchange listing requirements.
Underwritten by investment banks. Hard vs Soft.

2. Direct Listing (DL):

No underwriter; no new capital raised.
Existing shareholders sell shares.
Faster and lower-cost compared to IPO.

3. Acquisition:

Acquired by a larger public company or via a Special Purpose Acquisition Company (SPAC).
SPACs raise capital through IPOs and must acquire a private company within a set period.

Question 12

Registration and Disclosure Requirements:

Answer 12

Public Companies:

Must disclose financial reports and significant events (e.g., changes in voting rights, stock transactions by officers).

Information is available to the public, aiding investor and analyst assessments.

Subject to extensive regulatory oversight.

Private Companies:

Not required to disclose as extensively.

Less regulatory oversight compared to public companies.

Question 12

LO. Describe key features of corporate issuers

Answer 12

1. Legal Relationship:

A corporation is a legal entity separate and distinct from its owners.

2. Owner-Operator Relationship:

Separation exists between owners and operators.
Shareholders elect a board of directors to oversee operations.
The board hires the CEO and senior management for day-to-day operations.

3. Access to Capital:

Corporations can raise large amounts of capital through debt and equity.

4. Business Liability:

Owners have limited liability.

5. Taxation:

Corporate profits are taxed twice: once at the corporate level and again at the individual level when profits are distributed as dividends.

Question 13

Going from Public to Private:

Answer 13

Public companies can go private by having an investor acquire all shares and delisting from the exchange.
This often involves paying a premium and using debt to finance the acquisition.
Trends show:
Emerging Economies: Increasing number of public companies due to growth and market transitions.
Developed Economies: Decreasing number due to mergers and acquisitions (M&A), thriving private markets, and companies opting to avoid regulatory burdens.

Question 14

LO. Compare publicly and privately owned corporate issuers

Answer 14

1. Exchange Listing and Ownership Transfer:

Public Companies: Listed on an exchange, allowing ownership to be easily transferred.
Private Companies: Not listed on an exchange; transactions are privately negotiated, making ownership transfer more difficult.

2. Capital Raising:

Public Companies: Raise large amounts of capital from many investors through an IPO and additional issues after listing. Shares are actively traded in the secondary market.
Private Companies: Raise smaller amounts of capital from fewer investors who have longer holding periods.

3. Regulatory and Disclosure Requirements:

Public Companies: Subject to greater regulatory and disclosure requirements, including the disclosure of financial reports and other information affecting stock price.
Private Companies: Generally not required to make such disclosures and are not subject to the same level of regulatory oversight.

Question 14

LO. Compare the organizational forms of businesses

Answer 14

1. Sole Proprietorship:

Legal Identity: No separate legal identity; business is an extension of the owner.
Owner-Operator Relationship: Solely operated by the owner.
Owner Liability: Owner has unlimited liability; personal assets at risk.
Taxation: Profits taxed as personal income of the owner.
Access to Financing: Limited by the owner’s personal access to capital.

2. General Partnership:

Legal Identity: No separate legal identity; business is an extension of the partners.
Owner-Operator Relationship: Operated by partners with shared responsibilities.
Owner Liability: Partners share unlimited liability; personal assets at risk.
Taxation: Profits taxed as personal income of the partners.
Access to Financing: Limited by the partners’ collective access to capital.

3. Limited Partnership:

Legal Identity: No separate legal identity; business defined by partnership agreement.
Owner-Operator Relationship: General partner(s) manage the business; limited partners have no operational control.
Owner Liability: General partner(s) have unlimited liability; limited partners have liability limited to their investment.
Taxation: Profits taxed as personal income of partners; distributions taxed as personal income.
Access to Financing: Limited by general partner’s ability to manage and raise capital; limited partners have passive investment.

4. Corporation:

Legal Identity: Separate legal entity distinct from its owners (shareholders).
Owner-Operator Relationship: Board of directors and management operate the business on behalf of shareholders.
Owner Liability: Shareholders have limited liability; their liability is limited to their investment.
Taxation: Corporate profits taxed at the corporate level; dividends taxed as personal income for shareholders.
Access to Financing: Access to capital is extensive through equity (ownership) and debt (borrowings).

Question 15

The corporate form of business structure is preferred:

A when capital requirements are greater.
B to eliminate conflict of interest between owners and management.
C minimise taxes.

Answer 15

A is correct. The corporate form of business structure is preferred when capital requirements are greater than what could be raised through other business structures.

B is not correct because conflicts of interest can occur in corporations when management places their own interests, or the interests of other stakeholders, above those of the shareholders.

C is not correct because in many jurisdictions, corporate profits are taxed twice (double taxation): once at the corporate level and again at the individual level when profits are distributed as dividends to the owners.

Question 15

Which of the following statements is least accurate about accredited investors?

A They are sophisticated enough to take greater risks.
B They have a higher need for regulatory oversight and protection.
C They have a certain level of income or net worth.

Answer 15

B is correct. Accredited investors are those who are sophisticated enough to take greater risks and to have a reduced need for regulatory oversight and protection.

To be considered accredited, an investor must have a certain level of income or net worth or possess a certain amount of professional experience or knowledge.

Question 16

Underwriters are most likely required in a/an:

A IPO
B Direct Listing
C SPAC

Answer 16

A is correct. An IPO is facilitated by investment banks who underwrite, or guarantee, the offering.

B is not correct because direct listing does not require an underwriter, and no new capital is raised. Instead, the company is simply listed on an exchange and shares are sold by existing shareholders.

C is not correct because a SPAC is a shell company, often called a “blank check” company, because it exists solely for the purpose of acquiring an unspecified private company sometime in the future.

Question 17

Which of the following payments are most likely tax deductible?

A Interest payments only.
B Dividend payments only.
C Both interest and dividend payments only.

Answer 17

A is correct. Interest payments on debt are typically tax-deductible whereas dividend payments on equity are not.

Question 18

Which of the following statements is least accurate?

A Equity does not involve a contractual obligation.
B Debt holders have a residual claim on the company’s net assets.
C Debt has a stated finite term and no voting rights.

Answer 18

B is correct. Equity holders have a residual claim on the company’s net assets after all other stakeholders have been paid.

A is a correct statement. Unlike equity, debt represents a contractual obligation on the part of the issuing company. The company is obligated to make the promised interest and principal payments to debtholders.

B is also a correct statement. In contrast to equity, debt represents a cheaper source of capital with a stated finite term and no voting rights. Equity represents a more permanent source of capital. It has no finite term and includes voting rights.

Question 19

Which of the following statements is most accurate from issuer’s perspective?

A equity is preferred when cash flows are predictable.
B cost of debt is higher.
C debt increases leverage risk.

Answer 19

C is correct. From the company’s perspective, issuing debt is riskier than issuing equity. If a company fails to meet its contractual obligations, it may be forced to declare bankruptcy and liquidate.

A is not correct. A company generating stable, predictable cash flows generally prefers to borrow money rather than issuing additional equity to raise capital. Issuing more equity dilutes the upside return for existing equity owners given that residual value must be shared across more owners. However, early-stage companies or companies with unpredictable cash flows that find it difficult to borrow may prefer to raise capital through equity to avoid the risk of default.

B is not correct because cost of debt is lower than the cost of equity since the returns to debtholders are capped.