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comm 308: introduction to corporate finance > CHAPTER 2: BUSINESS (CORPORATE) FINANCE PP > Flashcards

CHAPTER 2: BUSINESS (CORPORATE) FINANCE PP Flashcards

1
Q

TYPES OF BUSINESS ORGANIZATIONS

A

Sole proprietorships

Partnerships

Trusts

Corporations

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2
Q

Sole proprietorships

Nature of the Business

A

A business owned and operated by one person

Legally inseparable from the person who owns and operates the business

Reports income, both gross and net, on personal income tax returns

Net business income is taxed at the person’s marginal tax rate

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3
Q

Sole proprietorships

Financing

A

Limited to the resources of the individual owning, operating the business and their personal capacity to borrow

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4
Q

Sole proprietorships

Formality

A

Business records must be maintained for reporting to Canada Revenue Agency like any other business

Owners may wish or be required to register with their provincial government

If employing persons, the owner must obtain an employer number, deduct and remit income taxes as well as make employer contributions to the Canada Pension Plan and Employment Insurance

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5
Q

Sole proprietorships

Advantages

A

Easy to start

Little formality but business records must be maintained

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6
Q

Sole proprietorships

disadvantages

A

Unlimited legal liability

Net income is taxed at the personal marginal tax
rate

Financing is limited to the resources of the owner

The life of the enterprise is limited to the working life of the sole proprietor

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7
Q

Partnerships

Nature of the Business

A

Involves two or more partners

Must have at least one general partner

all other partners are referred to as limited partners

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8
Q

general partner

A

has unlimited legal liability for the activities of the business

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9
Q

limited partner

A

have limited legal liability

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10
Q

Partnerships

Financing

A

A function of the combined resources of the partners

Can attract additional resources through limited partner contributions

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11
Q

Partnerships

Formality

A

Must be registered under provincial partnership legislation

Should be formalized through a partnership agreement outlining partner responsibilities, how partners invest and divest of the business, and the division of net business income

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12
Q

Limited Liability Partnerships

A

A new form of organization for professional firms

commonly used by Canadian legal and accounting firms

limits the liability of partners

The income of partners is included as ordinary income and filed using an individual tax return

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13
Q

Limited and General Partnerships

Used for Tax Purposes

A

Limited partners are often able to use unused non-cash deductions such as depreciation and/or business losses to offset personal tax liabilities

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14
Q

Limited and General Partnerships

The General Partner

A

must be one general partner

is responsible for operating the business and has unlimited legal liability

Often a corporation

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15
Q

Limited and General Partnerships

Limited Partners

A

Passive investors

Contribute money to the business; share in the profits

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16
Q

Partnerships

Advantages

A

Harnesses the combined talents and energies of all the partners

Potential for greater combined financial resources of the partners

Spreads liability across the partners (jointly and severally)

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17
Q

Partnerships

Disadvantages

A

Income is taxed at the individual’s marginal rate

Governed by provincial partnership legislation and often requires a formal partnership agreement

Unlimited legal liability

Non-partnership business arrangements can be deemed partnerships under Canadian law

It can be legally challenging to disassociate oneself from and/or dissolve a partnership arrangement

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18
Q

Trusts

Nature of the Business

A

Trusts are used to separate ownership from control

Controlled by a trustee in accordance with trust documents for the benefit of
the named beneficiary(ies)

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19
Q

Trusts

Examples

A

Inter vivos and testamentary trusts for estate and tax planning purposes

Open-ended mutual funds organized as unit trusts

Many corporations have restructured themselves as income and royalty trusts

20
Q

Trusts

Formality

A

Established through a formal trust agreement naming trustee and beneficiary(ies)

21
Q

Trusts

Nature of the Business

A

Invest in both the debt and shares of one company in order to function as a pass-through entity

Net cash flows from the business operations of the company pass through the trust without taxation

22
Q

Trusts

Purpose of the Structure

A

To minimize the income tax payable on the cash flows generated by the underlying business

we want to make more cash flow than through a traditional common stock investment

23
Q

Trusts

Advantages

A

Funds flowing through the trust are not subject to income tax

Separates ownership and control

24
Q

Trusts

Disadvantages

A

Governance structure may only be appropriate for well established firms with little further needs for capital investment

25
Corporations Nature of the Business
A separate legal entity (person) under the law that be incorporated under provincial or federal legislation Governed by a Board of Directors (BOD) elected by shareholders managed by professional managers owned by shareholders
26
Corporations Financing
Highly flexible and long-term issuing stocks, bonds and other hybrid securities to raise capital
27
Corporations Formality
Articles of Incorporation, and corporate bylaws and practices are governed by corporate and securities law
28
Corporations Advantages
No limit to how long an enterprise can operate --> it can issue securities with very long terms to maturity Potential to attract large amount of financing by expanding its base of shareholders Potential to attract well qualified people to its BOD and to use their expertise to advance the firm’s interests Has the potential to hire professional managers to build value
29
Corporations Disadvantages
Formality and structure may slow the speed of organizational response Canadian tax law double-taxes dividends
30
dividend double taxation
dividends paid to shareholders are taxed first as income of the corporation and then again as personal income of shareholders
31
Corporations' shareholders
owners of the corporation have residual claims to profits and assets have voting rights vote to: (1) elect the Board of Directors (2) adopt financial statements, and (3) approve the auditors for the coming year
32
Corporations' board of directors and management
responsible for the day-to-day operation of the corporation all in accordance with standards set out in the Canada Business Corporations Act
33
Corporations' Director and Officer Responsibilities
Act honestly and in good faith with a view to the best interests of the corporation Exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances
34
what are the disadvantages of the separation of ownership and management in corporations?
It is possible for agents (management) to pursue their own goals at the expense of the principal (shareholders) owners (shareholders) have limited access to information about the company they own managers and the board of directors hold superior information creates further potential for conflict potential for principal-agent conflict
35
principal-agent conflict
managers having more info than shareholders will act in management greedy interest instead of enriching the owners
36
how does corporate law reduce the risk of the principal-agent conflict arising?
imposes responsibilities and reporting controls on management
37
Information Asymmetry
Management has more information about the company than shareholders
38
how to reduce the potential for conflict arising out of information asymmetry?
corporate and securities law requires regular release of information about corporate performance the right to require approval from shareholders for major changes in the corporation ex: – Annual shareholder meetings with proper notice – Audited financial statements – Shareholder approval of auditors for the coming year – Shareholder approval for changes to bylaws and articles of incorporation
39
why is profit maximization an inadequate goal to guide officers and directors of the corporation?
It fails to consider the risks undertaken by the firm to pursue profit It focuses on accounting profit Its focus on one year’s accounting profit can potentially be at the expense of the long-term interests of the shareholders
40
why is shareholder wealth maximization considered the most appropriate goal to guide the corporation’s directors and officers?
Its focus is on genuine economic profit It reflects the value of all economic profits of the corporation now and into the future It takes into account the timing, magnitude and riskiness of all prospective (future) cash flows the corporation’s capital investment is expected to generate
41
the two main appropriate goals of management in a corporation?
Operate legally and in compliance with contractual responsibilities Act in the interests of the principals (shareholders) by creating value for them
42
agency relationship in corporations
Managers work on behalf of shareholder
43
Moral Hazard (agency problem) in corporations
can arise due to the potential divergence of interest between managers, shareholders and creditors
44
Direct agency costs
result from management making decisions that do not maximize shareholder value ex: Managers avoiding high-risk projects to avoid looking bad or losing their jobs if the project fails managers spending corporate resources on perks for themselves such as executive aircraft
45
Indirect agency costs
incurred by the firm in the attempt to avoid agency costs ex: Compensation schemes that attempt to align the interests of managers and shareholders (e.g., stock options) reporting requirements placed on management shareholder approval requirements for changes to corporate bylaws, articles of incorporation
46
why tie compensation to performance measures in corporations?
to align management and shareholder interests
47
main cons of performance-based compensation schemes?
not always effective in achieving the goal of aligning interests have lead to concerns about excessive management compensation

comm 308: introduction to corporate finance (13 decks)

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