Table of contents
Chapter 1: The Corporation and Financial Markets........................................................................2
Chapter 2: Introduction to Financial Statement Analysis...............................................................6
Chapter 3: Financial Decision Making and the Law of One Price.................................................15
Chapter 4: The Time Value of Money...........................................................................................19
Chapter 5: Interest Rates.............................................................................................................21
Chapter 1: The Corporation and Financial Markets.......................................................................2
Chapter 2: Introduction to Financial Statement Analysis...............................................................6
Chapter 3: Financial Decision Making and the Law of One Price.................................................15
Chapter 4: The Time Value of Money..........................................................................................19
Chapter 5: Interest Rates.............................................................................................................21
1
,Chapter 1: The Corporation and Financial Markets
There are four types of firms:
Sole proprietorships a business owned and run by one person. They are the most
common type of firm and are usually very small, with no to a few employees.
Partnerships identical to a sole proprietorship, but they have more than one owner.
Limited ability companies (LLC) a limited partnership without a general partner. This
means that all the owners have limited ability, but they can also run the business.
Corporations a legal entity, separate and distinct from its owners, with similar legal power
as people have (e.g. enter into contracts, acquire assets, borrow money).
Sole proprietorships
Sole proprietorships have the following key characteristics:
- They are straightforward to set up (and therefore very popular).
- There is no separation between the firm and the owner – the firm can have only one owner.
Other investors cannot hold an ownership stake in the firm.
- The owner has unlimited personal liability for any of the firm’s debts. If the firm defaults on a
debt payment, the lender can require the owner to repay the loan from personal assets.
Failure to repay the loan results in personal bankruptcy.
- The life of a sole proprietorship is limited to the life of the owner, and it is difficult to transfer
ownership of a sole proprietorship.
Partnerships
A partnership has a few key characteristics:
- All partners are liable for the firm’s debt, meaning a lender can require any partner to repay
alle the firm’s outstanding debts.
- 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.
In sole proprietorships and partnerships, such as law firms and accounting firms, the owners’
personal reputations are the basis for the business. The partners’ personal liability increases the
confidence of the firm’s clients that the partners will strive to maintain their reputation.
Limited partnership = a partnership with two kinds of owners:
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 have limited ability = their liability is limited to their investment, and
their private property cannot be seized to pay off the firm’s outstanding debts. The death or
withdrawal of a limited partner does not dissolve the partnership, and a limited partner’s
interest is transferrable. A limited partner has no management authority and cannot legally
be involved in managerial decision-making for the business.
2
,Examples of limited partnerships are private equity funds and venture capital funds. 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 the capital is invested, and
often participate in running the businesses they invest in. Outside investors play no active role in the
partnership other than monitoring how their investments are performing.
Corporations
Corporations have a few key characteristics:
Owners have limited personal liability for the firm’s debts owners are not liable for any
obligations of the corporation and vice versa.
Ownership is divided into shares (or stock) the collection of all the outstanding shares of
a corporation is known as the equity of the corporation.
Usually, separation between ownership and direct control:
o Shareholders (or stock or equity holders) are the owners and elect the board of
directors (who delegate many decisions to the management team).
o The Board of directors and the management team directly control the firm: they take
the decisions and run the firm.
No limitation on who can own its stock allows for free trade in the shares of the
corporation and enables the corporation to raise substantial amounts of capital.
Most owners are anonymous
An important difference between the types of organizational forms is the way they are taxed.
Because a corporation is a separate legal entity, its profits are subject to taxation separate from its
owners’ tax obligations. This means that shareholders pay taxes twice = double taxation:
First the corporation pays tax on its profits. When the remaining profits are distributed to the
shareholders, the shareholders pay their own personal income tax on this income.
The corporate organizational structure is the only one subject to double taxation. An exemption from
double taxation applies to ‘’S’’ corporations = corporations that elect subchapter S tax treatment.
Under these tax regulations, the firm’s profits (and losses) are not subject to corporate taxes, but
instead are allocated directly to shareholder based on their ownership share. The shareholders must
include these profits as income on their individual tax returns.
In order to qualify for subchapter S tax treatment, the shareholders of the corporation must meet
specific criteria. Because most corporations have no restrictions on who owns their shares or the
number of shareholders, they cannot qualify for subchapter S treatment. Thus, most large
corporations are ‘’C’’ corporations who are subject to corporate taxes.
The corporate management team consist of a few functions:
Board of directors a group of people who represent the stockholders and have the
ultimate decision-making authority in the corporation. The board of directors delegates most
decisions that involve day-to-day running of the corporation to its management.
Chief executive officer (CEO) charged with running the corporation by instituting rules
and policies set by the board of directors.
Chief financial officer (CFO) the most senior financial manager who oversees the financial
operations of the firm and often reports directly to the CEO.
3
,Corporate finance = managing financial issues within corporate finance. Within the corporation,
financial managers are responsible for three main tasks:
Making investment decisions the financial manager must weigh the costs and benefits of
all investments and projects and decide which of them qualify as good uses of the money
stockholders have invested in the firms.
Making financing decisions the financial manager must decide how to finance these
investments. Large investments may require the corporation to raise additional money. The
financial manager must decide whether to raise more money from new and existing owners
by selling more share of stock (equity) or to borrow the money (debt).
Cash management (managing cashflows/working capital) the financial manager must
ensure that the firm has enough cash on hand to meet its day-to-day obligations.
The goal of a firm should be determined by its owners. A sole proprietorship has a single owner who
runs the firm, so the goals of the firm are the same as the owner’s goals. In organizational forms with
multiple owners, the goal of the firm is not as clear. This is because many corporations have
thousands of owners (shareholders) with different interests and priorities.
Goal of corporate finance: maximize value for the owners of the corporation (make decisions that
increase the value of the shares) as long as other stakeholders are not made worse off.
It becomes a problem when increasing the value of the firm’s equity comes at the expense of
other stakeholders or the environment.
Issues with maximizing shareholder value:
Pollution e.g., carbon dioxide and nitrogen emissions.
Exploiting resources, natural and human e.g., fresh water, forests, cheap labor.
Tax avoidance and evasion for decades, multinational corporations, especially those
based in the U.S., have funneled billions of dollars in profits to tax havens, earning even more
money for their shareholders.
Good public policy and regulation should ensure that when firms take actions that benefit their
shareholders, they are also benefiting society.
Agency problems = potential conflicts between managers and owners due to the separation of
ownership and control (both may have different interests). This may lead managers, hired as agents
of the shareholders, to put their own self-interest ahead of the interests of shareholders.
While the firm’s shareholders would like managers to make decisions that maximize the firm’s share
price, managers often must balance this objective with the desires of other stakeholders, such as
employees and communities, but also themselves.
Corporate governance = the processes, policies, laws, and institutions that direct a company’s actions
in order to control agency problems. There are two types of governance structures:
One-tier governance structure
Two-tier governance structure
4
, GM = general meeting of shareholders
One way in which shareholders can encourage managers to work in the best interests of the
shareholders is by minimizing the number of decisions managers must make for which their own self-
interest substantially differs form the interests of shareholders, for example by tying top managers’
compensation to the corporation’s profits or sometimes its stock price.
Limitation: by tying compensation to closely to performance, shareholders might be asking
managers to take on more risk than they are comfortable taking. As a result, managers may
not make decisions that the shareholders want them to.
Solution: if compensation contracts reduce managers’ risk by rewarding good performance,
but limiting the penalty associated with poor performance, managers may have an incentive
to take excessive risk.
Another way shareholders can encourage managers to work in the interest of shareholders I to
discipline them if they don’t. If shareholders are unhappy with a CEO’s performance, they could
pressure the board to fire the CEO. In practice, dissatisfied shareholders often choose to sell their
shares. To entice investors to buy the shares, they are often offered at a low price.
In contrast, satisfied shareholders will want to purchase shares, which drives the stock price up. Thus,
the stock price of the corporation is a barometer for corporate leaders that continuously gives them
feedback on their shareholder’s opinion of their performance.
When a corporation borrows money, debt holders also become investors in the company. If the firm
is unable to repay or renegotiate with the debt holders, debt holders are entitled to seize the assets
of the corporation in compensation for the default = corporate bankruptcy.
Corporate bankruptcy can be thought of as a change in ownership and control of the
corporation. The equity holders give up their ownership and control to the debt holders.
Bankruptcy does not have to result in liquidation = shutting down the business and selling of its
assets. Even if control of the firm passes to the debt holders, it is in their interest to run the firm in
the most profitable way possible. Doing so often means keeping the business operating.
5
Chapter 1: The Corporation and Financial Markets........................................................................2
Chapter 2: Introduction to Financial Statement Analysis...............................................................6
Chapter 3: Financial Decision Making and the Law of One Price.................................................15
Chapter 4: The Time Value of Money...........................................................................................19
Chapter 5: Interest Rates.............................................................................................................21
Chapter 1: The Corporation and Financial Markets.......................................................................2
Chapter 2: Introduction to Financial Statement Analysis...............................................................6
Chapter 3: Financial Decision Making and the Law of One Price.................................................15
Chapter 4: The Time Value of Money..........................................................................................19
Chapter 5: Interest Rates.............................................................................................................21
1
,Chapter 1: The Corporation and Financial Markets
There are four types of firms:
Sole proprietorships a business owned and run by one person. They are the most
common type of firm and are usually very small, with no to a few employees.
Partnerships identical to a sole proprietorship, but they have more than one owner.
Limited ability companies (LLC) a limited partnership without a general partner. This
means that all the owners have limited ability, but they can also run the business.
Corporations a legal entity, separate and distinct from its owners, with similar legal power
as people have (e.g. enter into contracts, acquire assets, borrow money).
Sole proprietorships
Sole proprietorships have the following key characteristics:
- They are straightforward to set up (and therefore very popular).
- There is no separation between the firm and the owner – the firm can have only one owner.
Other investors cannot hold an ownership stake in the firm.
- The owner has unlimited personal liability for any of the firm’s debts. If the firm defaults on a
debt payment, the lender can require the owner to repay the loan from personal assets.
Failure to repay the loan results in personal bankruptcy.
- The life of a sole proprietorship is limited to the life of the owner, and it is difficult to transfer
ownership of a sole proprietorship.
Partnerships
A partnership has a few key characteristics:
- All partners are liable for the firm’s debt, meaning a lender can require any partner to repay
alle the firm’s outstanding debts.
- 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.
In sole proprietorships and partnerships, such as law firms and accounting firms, the owners’
personal reputations are the basis for the business. The partners’ personal liability increases the
confidence of the firm’s clients that the partners will strive to maintain their reputation.
Limited partnership = a partnership with two kinds of owners:
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 have limited ability = their liability is limited to their investment, and
their private property cannot be seized to pay off the firm’s outstanding debts. The death or
withdrawal of a limited partner does not dissolve the partnership, and a limited partner’s
interest is transferrable. A limited partner has no management authority and cannot legally
be involved in managerial decision-making for the business.
2
,Examples of limited partnerships are private equity funds and venture capital funds. 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 the capital is invested, and
often participate in running the businesses they invest in. Outside investors play no active role in the
partnership other than monitoring how their investments are performing.
Corporations
Corporations have a few key characteristics:
Owners have limited personal liability for the firm’s debts owners are not liable for any
obligations of the corporation and vice versa.
Ownership is divided into shares (or stock) the collection of all the outstanding shares of
a corporation is known as the equity of the corporation.
Usually, separation between ownership and direct control:
o Shareholders (or stock or equity holders) are the owners and elect the board of
directors (who delegate many decisions to the management team).
o The Board of directors and the management team directly control the firm: they take
the decisions and run the firm.
No limitation on who can own its stock allows for free trade in the shares of the
corporation and enables the corporation to raise substantial amounts of capital.
Most owners are anonymous
An important difference between the types of organizational forms is the way they are taxed.
Because a corporation is a separate legal entity, its profits are subject to taxation separate from its
owners’ tax obligations. This means that shareholders pay taxes twice = double taxation:
First the corporation pays tax on its profits. When the remaining profits are distributed to the
shareholders, the shareholders pay their own personal income tax on this income.
The corporate organizational structure is the only one subject to double taxation. An exemption from
double taxation applies to ‘’S’’ corporations = corporations that elect subchapter S tax treatment.
Under these tax regulations, the firm’s profits (and losses) are not subject to corporate taxes, but
instead are allocated directly to shareholder based on their ownership share. The shareholders must
include these profits as income on their individual tax returns.
In order to qualify for subchapter S tax treatment, the shareholders of the corporation must meet
specific criteria. Because most corporations have no restrictions on who owns their shares or the
number of shareholders, they cannot qualify for subchapter S treatment. Thus, most large
corporations are ‘’C’’ corporations who are subject to corporate taxes.
The corporate management team consist of a few functions:
Board of directors a group of people who represent the stockholders and have the
ultimate decision-making authority in the corporation. The board of directors delegates most
decisions that involve day-to-day running of the corporation to its management.
Chief executive officer (CEO) charged with running the corporation by instituting rules
and policies set by the board of directors.
Chief financial officer (CFO) the most senior financial manager who oversees the financial
operations of the firm and often reports directly to the CEO.
3
,Corporate finance = managing financial issues within corporate finance. Within the corporation,
financial managers are responsible for three main tasks:
Making investment decisions the financial manager must weigh the costs and benefits of
all investments and projects and decide which of them qualify as good uses of the money
stockholders have invested in the firms.
Making financing decisions the financial manager must decide how to finance these
investments. Large investments may require the corporation to raise additional money. The
financial manager must decide whether to raise more money from new and existing owners
by selling more share of stock (equity) or to borrow the money (debt).
Cash management (managing cashflows/working capital) the financial manager must
ensure that the firm has enough cash on hand to meet its day-to-day obligations.
The goal of a firm should be determined by its owners. A sole proprietorship has a single owner who
runs the firm, so the goals of the firm are the same as the owner’s goals. In organizational forms with
multiple owners, the goal of the firm is not as clear. This is because many corporations have
thousands of owners (shareholders) with different interests and priorities.
Goal of corporate finance: maximize value for the owners of the corporation (make decisions that
increase the value of the shares) as long as other stakeholders are not made worse off.
It becomes a problem when increasing the value of the firm’s equity comes at the expense of
other stakeholders or the environment.
Issues with maximizing shareholder value:
Pollution e.g., carbon dioxide and nitrogen emissions.
Exploiting resources, natural and human e.g., fresh water, forests, cheap labor.
Tax avoidance and evasion for decades, multinational corporations, especially those
based in the U.S., have funneled billions of dollars in profits to tax havens, earning even more
money for their shareholders.
Good public policy and regulation should ensure that when firms take actions that benefit their
shareholders, they are also benefiting society.
Agency problems = potential conflicts between managers and owners due to the separation of
ownership and control (both may have different interests). This may lead managers, hired as agents
of the shareholders, to put their own self-interest ahead of the interests of shareholders.
While the firm’s shareholders would like managers to make decisions that maximize the firm’s share
price, managers often must balance this objective with the desires of other stakeholders, such as
employees and communities, but also themselves.
Corporate governance = the processes, policies, laws, and institutions that direct a company’s actions
in order to control agency problems. There are two types of governance structures:
One-tier governance structure
Two-tier governance structure
4
, GM = general meeting of shareholders
One way in which shareholders can encourage managers to work in the best interests of the
shareholders is by minimizing the number of decisions managers must make for which their own self-
interest substantially differs form the interests of shareholders, for example by tying top managers’
compensation to the corporation’s profits or sometimes its stock price.
Limitation: by tying compensation to closely to performance, shareholders might be asking
managers to take on more risk than they are comfortable taking. As a result, managers may
not make decisions that the shareholders want them to.
Solution: if compensation contracts reduce managers’ risk by rewarding good performance,
but limiting the penalty associated with poor performance, managers may have an incentive
to take excessive risk.
Another way shareholders can encourage managers to work in the interest of shareholders I to
discipline them if they don’t. If shareholders are unhappy with a CEO’s performance, they could
pressure the board to fire the CEO. In practice, dissatisfied shareholders often choose to sell their
shares. To entice investors to buy the shares, they are often offered at a low price.
In contrast, satisfied shareholders will want to purchase shares, which drives the stock price up. Thus,
the stock price of the corporation is a barometer for corporate leaders that continuously gives them
feedback on their shareholder’s opinion of their performance.
When a corporation borrows money, debt holders also become investors in the company. If the firm
is unable to repay or renegotiate with the debt holders, debt holders are entitled to seize the assets
of the corporation in compensation for the default = corporate bankruptcy.
Corporate bankruptcy can be thought of as a change in ownership and control of the
corporation. The equity holders give up their ownership and control to the debt holders.
Bankruptcy does not have to result in liquidation = shutting down the business and selling of its
assets. Even if control of the firm passes to the debt holders, it is in their interest to run the firm in
the most profitable way possible. Doing so often means keeping the business operating.
5
