Showing posts with label Corporation. Show all posts
Showing posts with label Corporation. Show all posts
CORPORATE TAX STRUCTURE BASIC INFORMATION AND SAMPLE PROBLEM TUTORIALS
In order to make sound financial and investment decisions, a corporation’s financial manager must have a general understanding of the corporate tax structure, which includes the following:
1. Corporate tax rate schedule
2. Interest and dividend income
3. Interest and dividends paid by a corporation
4. Operating loss carryback and carry forward
5. Capital gains and losses
6. Alternative ‘‘pass-through’’ entities
Corporate Tax Rate Schedule
Corporations pay federal income tax on their taxable income, which is the corporation’s gross income reduced by the deductions’ permitted under the Internal Revenue Code of 1986. Federal income taxes are imposed at the following tax rates:
15% on the first $50,000
25% on the next $25,000
34% on the next $25,000
39% on the next $235,000
34% on the next $9,665,000
35% on the next $5,000,000
38% on the next $3,333,333
35% on the remaining income
Financial managers often refer to the federal tax rate imposed on the next dollar of income as the ‘‘marginal tax rate’’ of the taxpayer. Because of the fluctuations in the corporate tax rates, financial managers also talk in terms of the ‘‘average tax rate’’ of a corporation.
Average tax rates are computed as follows:
Average Tax Rate ¼ Tax Due=Taxable Income
Taxation Sample Problem and Solution
1. The average tax rate for the corporation in Example 1.5 is 35 percent (7,000,000/20,000,000). The marginal tax rate for the corporation in Example 1.5 is 35 percent.
As suggested, at taxable incomes beyond $18,333,333, corporations pay a tax of 35 percent on all of their taxable income. This fact demonstrates the reasoning behind the patch-quilt of corporate tax rates. The 15 percent–25 percent–34 percent tax brackets demonstrate the intent that there should be a graduated tax rate for small corporate taxpayers.
The effect of the 39 percent tax bracket is to wipe out the early low tax brackets. At $335,000 of corporate income, the cumulative income tax is $113,900, which results in an average tax rate of 34 percent ($113,900/$335,000). The income tax rate increases to 35 percent at taxable incomes of $10,000,000.
The purpose of the 38 percent tax bracket is to wipe out the effect of the 34 percent tax bracket and to raise the average tax rate to 35 percent. This is accomplished at taxable income of $18,333,333. The income tax on $18,333,333 of taxable income is $6,416,667, which results in an average tax rate of 35 percent ($6,416,667/$18,333,333). Thereafter, the tax rate is reduced back to 35 percent.
Corporate Finance Adviser As Strategy Consultant Basic Information and Tutorials
Corporate finance advisers need to be responsive to changes in the wider business environment and help their clients review and adjust their forward business strategies accordingly. Even in the absence of significant changes to the business environment, company owners and managers should be encouraged to step back and revisit the fundamentals of their business thinking.
A good place to start may be the motivations, aims and objectives of the shareholders and/or directors for the future development of the business. If the company is unlisted, perhaps the intention is to build it
up for eventual sale or for a stock market flotation.
If the business is family controlled and managed, perhaps there is a succession problem that can be solved only by introducing and motivating new management. If the company is listed and its share price is languishing, perhaps it should consider going private again.
Alternatively, if a company has particularly high-performing shares it may wish to initiate an acquisition strategy using its shares as currency.
Turning to the business itself, the management and their advisers need to be satisfied that there has been sufficient research to identify the position of the company in its market place. Each element in a thorough SWOT (strengths, weaknesses, opportunities and threats) analysis needs to be examined thoroughly and analysed.
If the evidence is insufficient or inconclusive, additional research should be performed. The following are some of the critical issues on which the management must reach a clear understanding:
• environment analysis – the overall attractiveness of the industry; industry lifecycle; buyer segments; competitor analysis;
• competitive strategy – buyer needs; value chains; positioning the firm;
• organisational implications – achieving differentiation; achieving cost leadership;
• organisation analysis – structure and systems; culture and values; skills and resources;
• corporate and global strategy – restructuring? diversification?
In terms of the company’s own capability for success, the directors need to make an objective evaluation of the quality, depth and breadth of the company’s management, its structure, business systems and, where relevant, manufacturing systems.
Another key issue is the company’s ability to introduce new products successfully into existing and new markets – a critical factor in any decision to expand regionally or globally from local markets.
These investigations and the self-questioning process will enable the board and its advisers to formulate a strategic plan for, typically, the next five years ahead. The strategic plan becomes the framework within which the company will develop its more detailed business plans and the financing plan with a choice of financial instruments.
Inevitably, the process is reiterative: formulation, implementation, review and feedback. Typically, the planning loop would be of six months’ duration. As the strategic planning routines become implanted in management culture, so the process will become more intensive and self-critical.
The role of the adviser within this process is to maintain an objective external viewpoint, act as a facilitator and source of expertise, and guide the client as required to the realisation of their plans.
THE DIFFERENCE FORMS OF BUSINESS
Sole Proprietorship
Advantages
1. The proprietor is the sole business decision-maker.
2. The proprietor receives all income from business.
3. Income from the business is taxed once, at the individual taxpayer level.
Disadvantages
1. The proprietor is liable for all debts of the business (unlimited liability).
2. The proprietorship has a limited life.
3. There is limited access to additional funds.
General Partnership
Advantages
1. Partners receive income according to terms in partnership agreement.
2. Income from business is taxed once as the partners’ personal income.
3. Decision-making rests with the general partners only.
Disadvantages
1. Each partner is liable for all the debts of the partnership.
2. The partnership’s life is determined by agreement or the life of the partners.
3. There is limited access to additional funds.
Corporation
Advantages
1. The firm has perpetual life.
2. Owners are not liable for the debts of the firm; the most that owners can lose is their initialinvestment.
3. The firm can raise funds by selling additional ownership interest.
4. Income is distributed in proportion to ownership interest.
Disadvantages
1. Income paid to owners is subjected to double taxation.
2. Ownership and management are separated in larger organizations.
One such issue concerns the objective of financial decision-making.
What goal (or goals) do managers have in mind when they choose between financial alternatives—say, between distributing current income among shareholders and investing it to increase future income? There is actually one financial objective: the maximization of the economic wellbeing, or wealth, of the owners. Whenever a decision is to be made, management should choose the alternative that most increases the wealth of the owners of the business.
The Measure of Owner’s Economic Well-Being
The price of a share of stock at any time, or its market value, represents the price that buyers in a free market are willing to pay for it. The market value of shareholders’ equity is the value of all owners’ interest in the corporation. It is calculated as the product of the market value of one share of stock and the number of shares of stock outstanding:
The number of shares of stock outstanding is the total number of shares that are owned by shareholders. For example, at the end of June 2002 there were 2,040 million Walt Disney Company shares outstanding. The price of Disney stock at the end of June 2002 was $18.90 per share.
Therefore, the market value of Disney’s equity at the end of June 2002 was over $38.5 billion.
Investors buy shares of stock in anticipation of future dividends and increases in the market value of the stock. How much are they willing to pay today for this future—and hence uncertain—stream of dividends?
They are willing to pay exactly what they believe it is worth today, an amount that is called the present value, an important financial concept. The present value of a share of stock reflects the following factors:
■ The uncertainty associated with receiving future payments.
■ The timing of these future payments.
■ Compensation for tying up funds in this investment.
The market price of a share is a measure of owners’ economic well-being.
Does this mean that if the share price goes up, management is doing a good job? Not necessarily. Share prices often can be influenced by factors beyond the control of management. These factors include expectations regarding the economy, returns available on alternative investments (such as bonds), and even how investors view the firm and the idea of investing.
These factors influence the price of shares through their effects on expectations regarding future cash flows and investors’ evaluation of those cash flows. Nonetheless, managers can still maximize the value of owners’ equity, given current economic conditions and expectations.
They do so by carefully considering the expected benefits, risk, and timing of the returns on proposed investments.
When you studied economics, you saw that the objective of the firm is to maximize profit. In finance, however, the objective is to maximize owners’ wealth. Is this a contradiction? No. We have simply used different terminology to express the same goal. The difference arises from the distinction between accounting profit and economic profit.
Economic profit is the difference between revenues and costs, where costs include both the actual business costs (the explicit costs) and the implicit costs. The implicit costs are the payments that are necessary to secure the needed resources, the cost of capital. With any business enterprise, someone supplies funds, or capital, that the business then invests. The supplier of these funds may be the business owner, an entrepreneur, or banks, bondholders, and shareholders. The cost of capital depends on both the time value of money—what could have been earned on a risk-free investment—and the uncertainty associated with the investment. The greater the uncertainty associated with an investment, the greater the cost of capital.
Consider the case of the typical corporation. Shareholders invest in the shares of a corporation with the expectation that they will receive future dividends. But shareholders could have invested their funds in any other investment, as well. So what keeps them interested in keeping their money in the particular corporation? Getting a return on their investment that is better than they could get elsewhere, considering the amount of uncertainty of receiving the future dividends. If the corporation cannot generate economic profits, the shareholders will move their funds elsewhere.
Accounting profit, however, is the difference between revenues and costs, recorded according to accounting principles, where costs are primarily the actual costs of doing business. The implicit costs—opportunity cost and normal profit—which reflect the uncertainty and timing of future cash flows, are not taken into consideration in accounting profit.
Moreover accounting procedures, and hence the computation of accounting profit, can vary from firm to firm. For both these reasons, accounting profit is not a reasonable gauge of shareholders’ return on their investment, and the maximization of accounting profit is not equivalent to the maximization of shareholder wealth.
Many U. S. corporations, including Coca −Cola, Briggs & Stratton, and Boise Cascade, are embracing a relatively new method of evaluating and rewarding management performance that is based on the idea of compensating management for economic profit, rather than for accounting profit. The most prominent of recently developed techniques to evaluate a firm’s performance are economic value−added and market value-added.
Advantages
1. The proprietor is the sole business decision-maker.
2. The proprietor receives all income from business.
3. Income from the business is taxed once, at the individual taxpayer level.
Disadvantages
1. The proprietor is liable for all debts of the business (unlimited liability).
2. The proprietorship has a limited life.
3. There is limited access to additional funds.
General Partnership
Advantages
1. Partners receive income according to terms in partnership agreement.
2. Income from business is taxed once as the partners’ personal income.
3. Decision-making rests with the general partners only.
Disadvantages
1. Each partner is liable for all the debts of the partnership.
2. The partnership’s life is determined by agreement or the life of the partners.
3. There is limited access to additional funds.
Corporation
Advantages
1. The firm has perpetual life.
2. Owners are not liable for the debts of the firm; the most that owners can lose is their initialinvestment.
3. The firm can raise funds by selling additional ownership interest.
4. Income is distributed in proportion to ownership interest.
Disadvantages
1. Income paid to owners is subjected to double taxation.
2. Ownership and management are separated in larger organizations.
One such issue concerns the objective of financial decision-making.
What goal (or goals) do managers have in mind when they choose between financial alternatives—say, between distributing current income among shareholders and investing it to increase future income? There is actually one financial objective: the maximization of the economic wellbeing, or wealth, of the owners. Whenever a decision is to be made, management should choose the alternative that most increases the wealth of the owners of the business.
The Measure of Owner’s Economic Well-Being
The price of a share of stock at any time, or its market value, represents the price that buyers in a free market are willing to pay for it. The market value of shareholders’ equity is the value of all owners’ interest in the corporation. It is calculated as the product of the market value of one share of stock and the number of shares of stock outstanding:
Market value of shareholders’ equity = Market value of a share of stock × Number of shares of stock outstanding
The number of shares of stock outstanding is the total number of shares that are owned by shareholders. For example, at the end of June 2002 there were 2,040 million Walt Disney Company shares outstanding. The price of Disney stock at the end of June 2002 was $18.90 per share.
Therefore, the market value of Disney’s equity at the end of June 2002 was over $38.5 billion.
Investors buy shares of stock in anticipation of future dividends and increases in the market value of the stock. How much are they willing to pay today for this future—and hence uncertain—stream of dividends?
They are willing to pay exactly what they believe it is worth today, an amount that is called the present value, an important financial concept. The present value of a share of stock reflects the following factors:
■ The uncertainty associated with receiving future payments.
■ The timing of these future payments.
■ Compensation for tying up funds in this investment.
The market price of a share is a measure of owners’ economic well-being.
Does this mean that if the share price goes up, management is doing a good job? Not necessarily. Share prices often can be influenced by factors beyond the control of management. These factors include expectations regarding the economy, returns available on alternative investments (such as bonds), and even how investors view the firm and the idea of investing.
These factors influence the price of shares through their effects on expectations regarding future cash flows and investors’ evaluation of those cash flows. Nonetheless, managers can still maximize the value of owners’ equity, given current economic conditions and expectations.
They do so by carefully considering the expected benefits, risk, and timing of the returns on proposed investments.
Economic Profit versus Accounting Profit: Share Price versus Earnings Per Share
When you studied economics, you saw that the objective of the firm is to maximize profit. In finance, however, the objective is to maximize owners’ wealth. Is this a contradiction? No. We have simply used different terminology to express the same goal. The difference arises from the distinction between accounting profit and economic profit.
Economic profit is the difference between revenues and costs, where costs include both the actual business costs (the explicit costs) and the implicit costs. The implicit costs are the payments that are necessary to secure the needed resources, the cost of capital. With any business enterprise, someone supplies funds, or capital, that the business then invests. The supplier of these funds may be the business owner, an entrepreneur, or banks, bondholders, and shareholders. The cost of capital depends on both the time value of money—what could have been earned on a risk-free investment—and the uncertainty associated with the investment. The greater the uncertainty associated with an investment, the greater the cost of capital.
Consider the case of the typical corporation. Shareholders invest in the shares of a corporation with the expectation that they will receive future dividends. But shareholders could have invested their funds in any other investment, as well. So what keeps them interested in keeping their money in the particular corporation? Getting a return on their investment that is better than they could get elsewhere, considering the amount of uncertainty of receiving the future dividends. If the corporation cannot generate economic profits, the shareholders will move their funds elsewhere.
Accounting profit, however, is the difference between revenues and costs, recorded according to accounting principles, where costs are primarily the actual costs of doing business. The implicit costs—opportunity cost and normal profit—which reflect the uncertainty and timing of future cash flows, are not taken into consideration in accounting profit.
Moreover accounting procedures, and hence the computation of accounting profit, can vary from firm to firm. For both these reasons, accounting profit is not a reasonable gauge of shareholders’ return on their investment, and the maximization of accounting profit is not equivalent to the maximization of shareholder wealth.
Many U. S. corporations, including Coca −Cola, Briggs & Stratton, and Boise Cascade, are embracing a relatively new method of evaluating and rewarding management performance that is based on the idea of compensating management for economic profit, rather than for accounting profit. The most prominent of recently developed techniques to evaluate a firm’s performance are economic value−added and market value-added.
CORPORATE FINANCE DEFINITION AND BASICS
WHAT IS CORPORATE FINANCE?
Corporate finance describes the financial decisions of corporations. Its main objective is to maximize corporate value while reducing financial risk. The financial manager has responsibility for corporate finance decisions.
In order to understand what corporate finance is, we need to understand who the financial manager is and what his or her responsibilities are.
The financial manager is responsible for financing the firm and acts as an intermediary between the financial system’s institutions and markets, on the one hand, and the enterprise, on the other. He or she has two main roles:
1. To ensure the company has enough funds to finance its expansion and meet its obligations. In order to do this, the company issues securities (equity and debt) which the financial manager sells to financial investors at the highest possible price.
In today’s capital market economy, the role of the financial manager is less a buyer of funds, with an objective to minimize cost, but more a seller of financial securities. By emphasizing the financial security, we focus on its value, which combines the notions of return and risk.
We thereby reduce the importance of minimizing the cost of financial resources, because this approach ignores the risk factor. Casting the financial manager in the role of salesman also underlines the marketing aspect of the job.
Financial managers have customers (investors) whom they must persuade to buy the securities of their company. The better financial managers understand their needs, the more successful they will be.
2. To ensure that, over the long term, the company uses the resources provided by investors to generate a rate of return at least equal to the rate of return the investors require. If it does, the company creates value. If it does not, it destroys value.
If it continues to destroy value, investors will turn their backs on the company and the
value of its securities will decline.
The company’s real assets are transformed into financial assets in the financial manager’s first role. The financial manager must maximize the value of these financial assets, while selling them to the various categories of investors.
The second role is a thankless one. The financial manager must be a ‘party-pooper’, a ‘Mr. No’ who examines every proposed investment project under the microscope of expected returns and advises on whether to reject those that fall below the cost of funds available to the company.
CORPORATE GOVERNANCE BASICS AND TUTORIALS
WHAT IS CORPORATE GOVERNANCE?
Corporate governance refers to the rules, processes, and laws by which companies are operated, controlled, and regulated. It defines the rights and responsibilities of the corporate participants such as the shareholders, board of directors, officers and managers, and other stakeholders, as well as the rules and procedures for making corporate decisions.
A well-defined corporate governance structure is intended to benefit all corporate stakeholders by ensuring that the firm is run in a lawful and ethical fashion, in accordance with best practices, and subject to all corporate regulations.
A firm’s corporate governance is influenced by both internal factors such as the shareholders, board of directors, and officers as well as external forces such as clients, creditors, suppliers, competitors, and government regulations. In particular, the stockholders elect a board of directors, who in turn hire officers or managers to operate the firm in a manner consistent with the goals, plans, and policies established and monitored by the board on behalf of the shareholders.
Individual versus Institutional Investors
To better understand the role that shareholders play in shaping a firm’s corporate governance, it is helpful to differentiate between the two broad classes of owners—individuals and institutions. Generally, individual investors own relatively small quantities of shares and as a result do not typically have sufficient means to directly influence a firm’s corporate governance.
In order to influence the firm, individual investors often find it necessary to act as a group by voting collectively on corporate matters. The most important corporate matter individual investors vote on is the election of the firm’s board of directors.
The corporate board’s first responsibility is to the shareholders. The board not only sets policies that specify ethical practices and provide for the protection of stakeholder interests, but it also monitors managerial decision making on behalf of investors.
Although they also benefit from the presence of the board of directors, institutional investors have advantages over individual investors when it comes to influencing the corporate governance of a firm. Institutional investors are investment professionals that are paid to manage and hold large quantities of securities on behalf of individuals, businesses, and governments.
Institutional investors include banks, insurance companies, mutual funds, and pension funds. Unlike individual investors, institutional investors often monitor and directly influence a firm’s corporate governance by exerting pressure on management to perform or communicating their concerns to the firm’s board.
These large investors can also threaten to exercise their voting rights or liquidate their holdings if the board does not respond positively to their concerns. Because individual and institutional investors share the same goal, individual investors benefit from the shareholder activism of institutional investors.
Government Regulation
Unlike the impact that clients, creditors, suppliers, or competitors can have on a particular firm’s corporate governance, government regulation generally shapes the corporate governance of all firms. During the past decade, corporate governance has received increased attention due to several high-profile corporate scandals involving abuse of corporate power and, in some cases, alleged criminal activity by corporate officers.
The misdeeds derived from two main types of issues: (1) false disclosures in financial reporting and other material information releases and (2) undisclosed conflicts of interest between corporations and their analysts, auditors, and attorneys and between corporate directors, officers, and shareholders.
Asserting that an integral part of an effective corporate governance regime is provisions for civil or criminal prosecution of individuals who conduct unethical or illegal acts in the name of the firm, in July 2002 the U.S. Congress passed the Sarbanes-Oxley Act of 2002 (commonly called SOX). Sarbanes-Oxley is intended to eliminate many of the disclosure and conflict of interest problems that can arise when corporate managers are not held personally accountable for their firm’s financial decisions and disclosures.
SOX accomplished the following: established an oversight board to monitor the accounting industry; tightened audit regulations and controls; toughened penalties against executives who commit corporate fraud; strengthened accounting disclosure requirements and ethical guidelines for corporate officers; established corporate board structure and membership guidelines; established guidelines with regard to analyst conflicts of interest; mandated instant disclosure of stock sales by corporate executives; and increased securities regulation authority and budgets for auditors and investigators.
Corporate governance refers to the rules, processes, and laws by which companies are operated, controlled, and regulated. It defines the rights and responsibilities of the corporate participants such as the shareholders, board of directors, officers and managers, and other stakeholders, as well as the rules and procedures for making corporate decisions.
A well-defined corporate governance structure is intended to benefit all corporate stakeholders by ensuring that the firm is run in a lawful and ethical fashion, in accordance with best practices, and subject to all corporate regulations.
A firm’s corporate governance is influenced by both internal factors such as the shareholders, board of directors, and officers as well as external forces such as clients, creditors, suppliers, competitors, and government regulations. In particular, the stockholders elect a board of directors, who in turn hire officers or managers to operate the firm in a manner consistent with the goals, plans, and policies established and monitored by the board on behalf of the shareholders.
Individual versus Institutional Investors
To better understand the role that shareholders play in shaping a firm’s corporate governance, it is helpful to differentiate between the two broad classes of owners—individuals and institutions. Generally, individual investors own relatively small quantities of shares and as a result do not typically have sufficient means to directly influence a firm’s corporate governance.
In order to influence the firm, individual investors often find it necessary to act as a group by voting collectively on corporate matters. The most important corporate matter individual investors vote on is the election of the firm’s board of directors.
The corporate board’s first responsibility is to the shareholders. The board not only sets policies that specify ethical practices and provide for the protection of stakeholder interests, but it also monitors managerial decision making on behalf of investors.
Although they also benefit from the presence of the board of directors, institutional investors have advantages over individual investors when it comes to influencing the corporate governance of a firm. Institutional investors are investment professionals that are paid to manage and hold large quantities of securities on behalf of individuals, businesses, and governments.
Institutional investors include banks, insurance companies, mutual funds, and pension funds. Unlike individual investors, institutional investors often monitor and directly influence a firm’s corporate governance by exerting pressure on management to perform or communicating their concerns to the firm’s board.
These large investors can also threaten to exercise their voting rights or liquidate their holdings if the board does not respond positively to their concerns. Because individual and institutional investors share the same goal, individual investors benefit from the shareholder activism of institutional investors.
Government Regulation
Unlike the impact that clients, creditors, suppliers, or competitors can have on a particular firm’s corporate governance, government regulation generally shapes the corporate governance of all firms. During the past decade, corporate governance has received increased attention due to several high-profile corporate scandals involving abuse of corporate power and, in some cases, alleged criminal activity by corporate officers.
The misdeeds derived from two main types of issues: (1) false disclosures in financial reporting and other material information releases and (2) undisclosed conflicts of interest between corporations and their analysts, auditors, and attorneys and between corporate directors, officers, and shareholders.
Asserting that an integral part of an effective corporate governance regime is provisions for civil or criminal prosecution of individuals who conduct unethical or illegal acts in the name of the firm, in July 2002 the U.S. Congress passed the Sarbanes-Oxley Act of 2002 (commonly called SOX). Sarbanes-Oxley is intended to eliminate many of the disclosure and conflict of interest problems that can arise when corporate managers are not held personally accountable for their firm’s financial decisions and disclosures.
SOX accomplished the following: established an oversight board to monitor the accounting industry; tightened audit regulations and controls; toughened penalties against executives who commit corporate fraud; strengthened accounting disclosure requirements and ethical guidelines for corporate officers; established corporate board structure and membership guidelines; established guidelines with regard to analyst conflicts of interest; mandated instant disclosure of stock sales by corporate executives; and increased securities regulation authority and budgets for auditors and investigators.
LEGAL FORMS OF BUSINESS ORGANIZATION TUTORIALS
What Are The Legal Forms Of Business Organization?
One of the most basic decisions that all businesses confront is how to choose a legal form of organization. This decision has very important financial implications because how a business is organized legally influences the risks that the firm’s owners must bear, how the firm can raise money, and how the firm’s profits will be taxed.
The three most common legal forms of business organization are the sole proprietorship, the partnership, and the corporation. More businesses are organized as sole proprietorships than any other legal form. However, the largest businesses are almost always organized as corporations. Even so, each type of organization has its advantages and disadvantages.
Sole Proprietorships
A sole proprietorship is a business owned by one person who operates it for his or her own profit. About 73 percent of all businesses are sole proprietorships. The typical sole proprietorship is small, such as a bike shop, personal trainer, or plumber. The majority of sole proprietorships operate in the wholesale, retail, service, and construction industries.
Typically, the owner (proprietor), along with a few employees, operates the proprietorship. The proprietor raises capital from personal resources or by borrowing, and he or she is responsible for all business decisions. As a result, this form of organization appeals to entrepreneurs who enjoy working independently.
A major drawback to the sole proprietorship is unlimited liability, which means that liabilities of the business are the entrepreneur’s responsibility, and creditors can make claims against the entrepreneur’s personal assets if the business fails to pay its debts.
Partnerships
A partnership consists of two or more owners doing business together for profit. Partnerships account for about 7 percent of all businesses, and they are typically larger than sole proprietorships. Partnerships are common in the finance, insurance, and real estate industries. Public accounting and law partnerships often have large numbers of partners.
Most partnerships are established by a written contract known as articles of partnership. In a general (or regular) partnership, all partners have unlimited liability, and each partner is legally liable for all of the debts of the partnership.
Corporations
A corporation is an entity created by law. A corporation has the legal powers of an individual in that it can sue and be sued, make and be party to contracts, and acquire property in its own name. Although only about 20 percent of all U.S. businesses are incorporated, the largest businesses nearly always are; corporations account for nearly 90 percent of total business revenues.
Although corporations engage in all types of businesses, manufacturing firms account for the
largest portion of corporate business receipts and net profits.
The owners of a corporation are its stockholders, whose ownership, or equity, takes the form of either common stock or preferred stock. Unlike the owners of sole proprietorships or partnerships, stockholders of a corporation enjoy limited liability, meaning that they are not personally liable for the firm’s debts.
Their losses are limited to the amount they invested in the firm when they purchased shares of stock. Stockholders expect to earn a return by receiving dividends—periodic distributions of cash—or by realizing gains through increases in share price.
Because the money to pay dividends generally comes from the profits that a firm earns, stockholders are sometimes referred to as residual claimants, meaning that stockholders are paid last—after employees, suppliers, tax authorities, and lenders receive what they are owed. If the firm does not generate enough cash to pay everyone else, there is nothing available for stockholders.
The stockholders (owners) vote periodically to elect members of the board of directors and to decide other issues such as amending the corporate charter. The board of directors is typically responsible for approving strategic goals and plans, setting general policy, guiding corporate affairs, and approving major expenditures.
Most importantly, the board decides when to hire or fire top managers and establishes compensation packages for the most senior executives. The board consists of “inside” directors, such as key corporate executives, and “outside” or “independent” directors, such as executives from other companies, major shareholders, and national or community leaders.
Outside directors for major corporations receive compensation in the form of cash, stock, and stock options. This compensation often totals $100,000 per year or more.
The president or chief executive officer (CEO) is responsible for managing day-to-day operations and carrying out the policies established by the board of directors. The CEO reports periodically to the firm’s directors.
Other Limited Liability Organizations
A number of other organizational forms provide owners with limited liability. The most popular are limited partnership (LP), S corporation (S corp), limited liability company (LLC), and limited liability partnership (LLP).
Each represents a specialized form or blending of the characteristics of the organizational forms described previously. What they have in common is that their owners enjoy limited liability, and they typically have fewer than 100 owners.
One of the most basic decisions that all businesses confront is how to choose a legal form of organization. This decision has very important financial implications because how a business is organized legally influences the risks that the firm’s owners must bear, how the firm can raise money, and how the firm’s profits will be taxed.
The three most common legal forms of business organization are the sole proprietorship, the partnership, and the corporation. More businesses are organized as sole proprietorships than any other legal form. However, the largest businesses are almost always organized as corporations. Even so, each type of organization has its advantages and disadvantages.
Sole Proprietorships
A sole proprietorship is a business owned by one person who operates it for his or her own profit. About 73 percent of all businesses are sole proprietorships. The typical sole proprietorship is small, such as a bike shop, personal trainer, or plumber. The majority of sole proprietorships operate in the wholesale, retail, service, and construction industries.
Typically, the owner (proprietor), along with a few employees, operates the proprietorship. The proprietor raises capital from personal resources or by borrowing, and he or she is responsible for all business decisions. As a result, this form of organization appeals to entrepreneurs who enjoy working independently.
A major drawback to the sole proprietorship is unlimited liability, which means that liabilities of the business are the entrepreneur’s responsibility, and creditors can make claims against the entrepreneur’s personal assets if the business fails to pay its debts.
Partnerships
A partnership consists of two or more owners doing business together for profit. Partnerships account for about 7 percent of all businesses, and they are typically larger than sole proprietorships. Partnerships are common in the finance, insurance, and real estate industries. Public accounting and law partnerships often have large numbers of partners.
Most partnerships are established by a written contract known as articles of partnership. In a general (or regular) partnership, all partners have unlimited liability, and each partner is legally liable for all of the debts of the partnership.
Corporations
A corporation is an entity created by law. A corporation has the legal powers of an individual in that it can sue and be sued, make and be party to contracts, and acquire property in its own name. Although only about 20 percent of all U.S. businesses are incorporated, the largest businesses nearly always are; corporations account for nearly 90 percent of total business revenues.
Although corporations engage in all types of businesses, manufacturing firms account for the
largest portion of corporate business receipts and net profits.
The owners of a corporation are its stockholders, whose ownership, or equity, takes the form of either common stock or preferred stock. Unlike the owners of sole proprietorships or partnerships, stockholders of a corporation enjoy limited liability, meaning that they are not personally liable for the firm’s debts.
Their losses are limited to the amount they invested in the firm when they purchased shares of stock. Stockholders expect to earn a return by receiving dividends—periodic distributions of cash—or by realizing gains through increases in share price.
Because the money to pay dividends generally comes from the profits that a firm earns, stockholders are sometimes referred to as residual claimants, meaning that stockholders are paid last—after employees, suppliers, tax authorities, and lenders receive what they are owed. If the firm does not generate enough cash to pay everyone else, there is nothing available for stockholders.
The stockholders (owners) vote periodically to elect members of the board of directors and to decide other issues such as amending the corporate charter. The board of directors is typically responsible for approving strategic goals and plans, setting general policy, guiding corporate affairs, and approving major expenditures.
Most importantly, the board decides when to hire or fire top managers and establishes compensation packages for the most senior executives. The board consists of “inside” directors, such as key corporate executives, and “outside” or “independent” directors, such as executives from other companies, major shareholders, and national or community leaders.
Outside directors for major corporations receive compensation in the form of cash, stock, and stock options. This compensation often totals $100,000 per year or more.
The president or chief executive officer (CEO) is responsible for managing day-to-day operations and carrying out the policies established by the board of directors. The CEO reports periodically to the firm’s directors.
Other Limited Liability Organizations
A number of other organizational forms provide owners with limited liability. The most popular are limited partnership (LP), S corporation (S corp), limited liability company (LLC), and limited liability partnership (LLP).
Each represents a specialized form or blending of the characteristics of the organizational forms described previously. What they have in common is that their owners enjoy limited liability, and they typically have fewer than 100 owners.
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