Corporate Finance

1. Forms of Business Organization

2. Sole Proprietorship

• Definition: Business owned by one person; no legal distinction between owner and business.
• Taxation: Income taxed once as personal income.
• Liability: Unlimited; creditors can claim personal assets.
• Transferability: Limited.

3. Partnerships

• General Partnership: Multiple owners with unlimited liability for business and partners' actions.
• Limited Liability Partnership (LLP): Differentiates general and limited partners; limited partners have limited liability but no control.

4. Limited Liability Companies (LLC)

• Combines limited liability of corporations with management flexibility of partnerships.
• All owners have limited liability and can manage the business.

5. Corporations

• Legal Status: Separate legal entity from owners.
• Rights: Can borrow money, enter contracts, own property, sue and be sued.
• Ownership: Shareholders own stock; corporation can own stock in other corporations.

6. Taxation in Corporations

a) Example of Double Taxation (C Corporation)

• Corporation earns $5 per share before tax.
• Corporate tax rate: 40%
• Dividend tax rate: 15%
• After corporate tax: $5 × (1 - 0.40) =$3 per share.
• After dividend tax: $3 × (1 - 0.15) =$2.55 per share.
• Result: $2.55 remains after all taxes.

To remember: Corporations face double taxation—once at the corporate level and again at the shareholder level on dividends.

1. Financial Statements and Balance Sheet

a) Effective Tax Rate on Corporate Earnings

• A corporation earns $5 per share.
• It pays corporate taxes: 0.40 × $5 = **$2**.
• Remaining after corporate tax: $5 -$2 = $3.
• Shareholders pay income tax on dividends: 0.15 × $3 = **$0.45**.
• Net earnings per share after all taxes: $3 -$0.45 = $2.55.
• Total taxes paid: $2 +$0.45 = $2.45.
• Effective total tax rate = $2.45 /$5 = 49%.

b) Tax Treatment under Subchapter S

• Corporation pays no corporate taxes.
• Earnings per share: $5.
• Shareholder pays income tax on all earnings: 0.30 × $5 = **$1.50**.
• This tax burden is lower than the 49% effective tax rate in the previous example.

2. Financial Management and Control of a Firm

3. What is a Firm from a Financial Perspective?

• A pool of resources used to finance and operate assets and investment projects.

4. Example: Mybusiness Corp.

a) Assets Needed to Start Business

b) Financing the Business

5. Balance Sheet of Mybusiness Corp.

6. Purpose of Financial Statements

• Balance Sheet provides a snapshot of:
  • What assets the firm owns to operate the business.
  • How these assets are financed (equity vs. debt).

The balance sheet must always balance: Assets = Liabilities + Equity.

1. Income Statement and Operating Performance

a) Balance Sheet Overview

• Assets: resources owned by the firm (e.g., cash, accounts receivable, inventories, fixed assets like machinery and land, patents, goodwill).
• Liabilities and Equity: sources of financing (equity includes preferred and common stock, retained earnings; liabilities include long-term debt, current debt, accounts payable).
• The balance sheet must balance: $$\text{Total Assets} = \text{Total Liabilities} + \text{Equity}$$

b) Income Statement Essentials

• Records revenues and expenses over a period (quarterly, semi-annual, annual).
• Revenues are recorded when earned, not when cash is received.
• Expenses are recorded when incurred to generate revenues, not when paid.
• Structure of the income statement:

c) Depreciation

• Allocation of an asset’s cost over its useful life.
• Recorded as an expense on the income statement.
• Reduces the net book value of assets on the balance sheet.
• It is a non-cash expense (no actual cash outflow when recorded).

d) Relationship Between Financial Statements

e) Cash Flows in a Firm

• Cash raised from investors (equity or debt issuance).
• Cash invested in projects (capital expenditures).
• Cash generated by operations (core business activities).
• Cash reinvested in the business.
• Cash returned to investors (dividends, debt repayments).

f) Cash Flow Statement Sections

1. Cash flow from operations: cash generated or used by core business activities.
2. Cash flow from investing: cash used for or generated from asset purchases/sales.
3. Cash flow from financing: cash raised from or paid to investors and creditors.

The income statement records economic performance (revenues and expenses) on an accrual basis, while the cash flow statement tracks actual cash movements, essential for understanding liquidity and financial health.

1. Cash Flow Statement

The Cash Flow Statement reports the cash inflows and outflows of a company, categorized into operating, investing, and financing activities. It provides insight into the company’s liquidity and cash management.

2. Methods to Prepare Cash Flow Statement

3. Indirect Method: Operating Activities

Adjust net income by adding or subtracting items that affected net income but did not involve cash:

• Additions to cash:

  • Depreciation (non-cash expense)
  • Decrease in accounts receivable
  • Increase in accounts payable
  • Increase in taxes payable
  • Decrease in inventory

• Subtractions from cash:

  • Increase in accounts receivable
  • Decrease in accounts payable
  • Decrease in taxes payable
  • Increase in inventory

Formula:

Net cash from operations = Net income + Adjustments for non-cash items and working capital changes

4. Cash Flow from Investing and Financing Activities

5. Net Cash Position

Calculated as:

Initial cash position + Net cash from operations + Net cash from investing + Net cash from financing = Net cash position at period end

6. Role of the CFO in Cash Flow Management

The Chief Financial Officer (CFO) manages:

• Cash flows invested in and generated by the firm’s real assets
• Cash flows invested by investors and returned or retained
• Treasury, capital budgeting, financing, cash management
• Dividend policy recommendations
• Insurance and pension plans
• Accounting, financial statement preparation, internal auditing

The CFO aims to maximize firm value through:

1. Investment decisions
2. Financing decisions
3. Dividend decisions

Key point: The cash flow statement reconciles net income with actual cash movements, providing a clear picture of liquidity beyond accounting profits.

1. Role of the Financial Manager

• The financial manager is responsible for maximizing shareholder value by making decisions on investment, financing, and dividends.
• Key tasks include:
  • Investment decisions: selecting projects that add value.
  • Financing decisions: choosing between debt and equity.
  • Dividend decisions: determining profit distribution to shareholders.
• The firm is viewed as a pool of assets used to generate cash flows for investors.

2. Types of Business Ownership

3. Financing a Firm

• Two main ways to finance a firm:
  1. Debt (borrowed funds, must be repaid with interest)
  2. Equity (money raised from shareholders)
• Shareholders own the firm and have residual claims.
• Debtholders are creditors with fixed claims and priority over shareholders.

4. Corporate Governance

• Corporate governance refers to the system of rules, practices, and processes by which a company is directed and controlled.
• It aims to align the interests of managers (agents) with those of shareholders (principals).
• The CEO (Chief Executive Officer) is the top executive responsible for managing the company.
• Effective governance reduces agency problems and improves firm performance.

5. Financial Statements Overview

6. Key Financial Concepts

• Depreciation reduces taxable income but is a non-cash expense.
• Financing investments can be done by:
  • Paying cash (reduces cash on balance sheet)
  • Issuing debt (increases liabilities)
• Changes in financial statements depend on the nature of transactions (cash vs credit, timing of expenses and revenues).

> The financial manager’s primary goal is to maximize shareholder wealth while balancing risk and return through effective corporate governance and financial decision-making.