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.
