Ugba 10 Module 1 Exam Lecture 1

Front 1

What are the 2 different approaches to business?

Back 1

1. Value Maximization
2. Stakeholder Theory

Front 2

What is the goal of the value maximization approach to business?

Back 2

The goal is to maximize the value (in dollars) of the company.

Front 3

How do companies with the goal of value maximization achieve their goal?

Back 3

They achieve their goal by maximizing the value of financial claimants. This includes shareholders, lenders, and creditors.

Front 4

What do companies with the goal of value maximization focus on?

Back 4

They are more concerned with short-term financial performance so they focus on profits, share price, and earnings per share.

Front 5

What do companies with the stakeholder theory approach to business focus on?

Back 5

They take into account all of the interests in a firm. This includes not only financial claimants, but also employees, customers, communities, governmental offices, etc.

Front 6

What are the 6 different possible ownership structures of a business?

Back 6

1. Sole proprietorships
2. Partnerships
3. Corporations
4. S-Corporations
5. Limited liability corporations (LLCs)
6. Trust companies

Front 7

What is a sole proprietorship?

Back 7

A sole proprietorship is a business owned by one person. Many farms, retail establishments, and small service businesses are sole proprietorships, as are many home-based businesses, such as those operated by caterers, consultants, and freelance writers. If you are paid for performing any kind of service, from babysitting to website design, without being on a company's payroll, you are legally classified as a sole proprietor.

Front 8

What are the advantages of a sole proprietorship?

Back 8

1. Simplicity: About the only legal requirement for establishing a sole proprietorship is obtaining the necessary business licenses and permits required by the city, county, and state.

2. Single layer of taxation: The federal government doesn't recognize the company as a taxable entity; all profit "flows through" to the owner, where it is treated as personal income and taxed accordingly.

3. Privacy: Beyond filing tax returns and certain other government reports that may apply to specific businesses, sole proprietors generally aren't required to report anything to anyone.

4. Flexibility and control: As a sole proprietor, you aren't required to get approval from a business partner, your boss, or a board of directors to change any aspect of your business strategy or tactics. You can keep the business, sell it, give it away, or bequeath it to your children.

5. Fewer limitations on personal income: As a sole proprietor, you keep all the after-tax profits the business generates.

Front 9

What are the disadvantages of a sole proprietorship?

Back 9

1. Financial liability: In a sole proprietorship, the owner and the business are legally insuperable, which gives the proprietor unlimited liability. Any legal damages or debts incurred by the business are the owner's personal responsibility. If you aren't covered by appropriate insurance and run into serious financial or legal difficulty, such as getting sued for an accident that happened on your premises, you could lose not only the business but everything else you own, including your house, your car, and your personal investments.

2. Demands on the owner: In addition to the potential for long hours, you often have the stress of making all the major decisions, solving all the major problems, and being tied so closely to the company that taking time off is sometimes impossible.

3. Limited managerial perspective: Running even a simple business can be a complicated effort that requires expertise in accounting, marketing, information technology, business law, and many other fields.

Hint 9

4. Resource limitations: Because they depend on a single owner, sole proprietorships usually have fewer financial resources and fewer ways to get additional funds from lenders or investors. This lack of capital can hamper a small business in many was, limiting its ability to expect, to hire the best employees, and to survive rough economic periods.

5. No employee benefits for the owner.

6. Finite life span: The owner's death may be the demise of the business.

Front 10

What is a partnership?

Back 10

A partnership is a company that is owned by two or more people but is not a corporation. The partnership structure is appropriate for firms that need more resources and leadership talent than a sole proprietorship but don't need the fundraising capabilities or other advantages of a corporation. Many partnerships are small, with just a handful of owners, although a few are very large; the accounting and consulting firm PwC, for example, has more than 8,000 partners.

Front 11

What are the advantages of a partnership?

Back 11

1. Simplicity: Establishing a partnership is almost as simple as establishing a sole proprietorship. You and your partners just say you're in business together, apply for the necessary business licenses, and get to work.

2. Single layer of taxation: Profit is split between or among the owners based on whatever percentages they have agreed to. Each owner then treats his or her share as personal income.

3. More resources: One of the key reasons to partner up with one or more co-owners is to increase the amount of money you have to launch, operate, and grow the business.

4. Cost sharing: For example, a group of lawyers or doctors can share the cost of facilities and support staff while continuing to work more or less independently.

5. Broader skill and experience base.

6. Longevity: By forming a partnership, you increase the changes that the organization will endure because new partners can be drawn into the business to replace those who die or retire.

Front 12

What are the disadvantages of partnerships?

Back 12

1. Unlimited liability: All owners in a general partnership and the general partners in a limited partnership face the same unlimited liability as sole proprietors.

2. Potential for conflict.

3. Expansion, succession, and termination issues: Partnerships need to consider how they will handle such issues as expanding by bringing in an additional partner, replacing a parter who wants to sell out or retire, and terminating a partner who is unable or unwilling to meet the expectations of his or her role in the organization.

Front 13

What is a corporation?

Back 13

A corporation is a legal entity, distinct from any individual persons, that has the power to own property and conduct business. It is owned by shareholders, investors who purchase shares of stocks.

Front 14

What are the advantages of a corporation?

Back 14

1. Ability to raise capital.

2. Liquidity: The stock of publicly traded companies has a high degree of liquidity, which means that investors can easily and quickly convert their stock into cash by selling it on the open market. In contrast, liquidating (selling) the assets of a sole proprietorship or a partnership can be slow and difficult.

3. Longevity.

4. Limited liability: A corporation itself has unlimited liability, but the various shareholders who own the corporation face only limited liability. Their maximum potential loss is only as great as the amount they've invested in the company.

Front 15

What are the disadvantages of a corporation?

Back 15

1. Cost and complexity: Starting a corporation is more expensive and complicated than starting a sole proprietorship or a partnership, and "taking a company public" can be extremely expensive for a firm and time-sonuming for upper managers.

2. Reporting requirements: Financial reports can eat up a lot of staff and management time, and they can expose strategic information that might benefit competitors or discourage investors unwilling to wait for long-term results.

3. Managerial demands: Top executives must devote considerable time and energy to meeting with shareholders, financial analysts, and the news media.

3. Possible loss of control: Outside investors who acquire enough of a company's stock can gain seats on the board of directors and therefore begin exerting their influence on company management.

Hint 15

4. Double taxation: A corporation must pay federal or state corporate income tax on its profits, and individual shareholders must pay income taxes on their share of the company's profits received as dividends.

5. Short-term orientation of the stock market: Executives feel the pressure to constantly show earnings growth from quarter to quarter so that the stock prices keeps increasing, even if smart, strategic reasons exist for sacrificing earnings in the short term, such as investing in new product development or retaining talented employees instead of laying them off during slow periods.

Front 16

What is an S corporation?

Back 16

An S corporation, or subchapter S corporation, combines the capital-raising options and limited liability of a corporation with the federal taxation advantages of a partnership. Corporations seeking "S" status must meet certain criteria, including a maximum of 100 investors, all of whom must be U.S. residents.

Front 17

What are the 3 ways that a company can finance its business?

Back 17

1. Existing cash balances
2. Debt or borrowing
3. Issuing equity (ownership)

Front 18

What are the 4 factors to consider in financing?

Back 18

1. Form of ownership
2. Desire for control
3. Tolerance for risk
4. State of external financial markets

Front 19

How does debt financing differ from equity financing in regards to maturity?

Back 19

Debt: In most cases, specifies a date by which debt must be repaid.

Equity: Equity funding does not need to be repaid.

Front 20

How does debt financing differ from equity financing in regards to claim on income?

Back 20

Debt: Debt obligation must be repaid, regardless of whether the company is profitable; payments can be regular (e.g., monthly), balloon (repaid all at once), or a combination.

Equity: At management's discretion and if company is profitable, shareholders may receive dividends after creditors have been paid; however, company is not required to pay dividends.

Front 21

How does debt financing differ from equity financing in regards to claim on assets?

Back 21

Debt: Lenders have prior claims on assets.

Equity: Shareholders have claims only after the firm satisfies claims of lenders.

Front 22

How does debt financing differ from equity financing in regards to influence over management?

Back 22

Debt: Lenders usually have no influence over management unless debit vehicles come with conditions or management fails to make payments on time.

Equity: As owners of the company, shareholders can vote on some aspects of corporate operations, although in practice only large shareholders have much influence. Private equity holders (such as venture capitalists) can have considerable influence.

Front 23

How does debt financing differ from equity financing in regards to tax consequences?

Back 23

Debt: Debt payments reduce taxable income, lowering tax obligations.

Equity: Dividend payments are not tax deductible.

Front 24

How does debt financing differ from equity financing in regards to employee benefit potential?

Back 24

Debt: Debt financing does not create any opportunities for compensation alternatives such as stock options.

Equity: Issuing company shares creates the opportunity to use stock options as a motivation or retention tool.

Front 25

What is a company's capital structure?

Back 25

A firm's mix of debt and equity financing.

Front 26

What concepts should you consider when determining a company's capital structure?

Back 26

Look at how these metrics compare to the same company over time, as well as other companies in the same industry:

1. Debt-to-Equity Ratio
2. Leverage
3. Leverage Ratio

Front 27

What is the formula for the debt-to-equity ratio?

Back 27

(Total Debt) / (Total Equity)

Front 28

What does the debt-to-equity ratio indicate about a company?

Back 28

The debt-to-equity ratio indicates the extent to which a business is financed by debt as opposed to invested capital (equity). From a lender's standpoint, the higher this ratio is, the riskier the loan, because the company must devote more of its cash to debt payments. From an investor's standpoint, a higher ratio indicates that the company is spending more of its cash on interest payments than on investing in activities that will help raise the stock price. The typical debt-to-equity ratio varies by industry, ranging from approximately 28% in the technology industry to 65% in the aerospace / defense industry.

Front 29

What is leverage?

Back 29

Leverage is the amount of debt the company holds. It can also be thought of as the ability to use debt to increase rate of return on an investment.

Front 30

What is the leverage ratio?

Back 30

(Total Debt) / (Total Equity + Total Debt)

Front 31

What concepts should you consider when determining a company's Cost of Capital?

Back 31

1. Hurdle Rate
2. Debt (interest rate, tax-affected)
3. Equity (pricing model)
4. Combination

Front 32

What does "cost of capital" refer to?

Back 32

The average rate of interest a firm pays on its combination of debt and equity.

Front 33

What is the idea behind "hurdle rate?"

Back 33

A company's investments must exceed its cost of capital in order for the company to create value.

Front 34

What are the 6 sources of short-term financing?

Back 34

1. Credit cards
2. Trade credit
3. Secured loans
4. Unsecured loans
5. Commercial paper
6. Factoring

Front 35

How do businesses use credit cards for financing?

Back 35

Half of all small companies and start-ups use credit cards to help fund their operations. Credit cards are one of the most expensive forms of financing, but they are sometimes the only form available to business owners.

Front 36

How does trade credit work?

Back 36

Trade credit occurs when suppliers provide goods and services to their customers without requiring immediate payment. Trade credit allows a company to get the goods and services it needs without immediately disrupting cash flow. Trade credit can also lower transaction costs for buyers (as well as sellers) by consolidating multiple purchases into a single payment. In many cases, credit is extended at no interest for a short period (typically 30 days). From the seller's perspective, offering credit terms is often a competitive necessity, and doing so can allow a supplier to sell more to each customer because purchase levels aren't constrained to buyers' immediate cash balances. However, allowing customers to delay payments affects the seller's cash flow and exposes it to the risk that some customers won't be able to pay when their bills come due.

Front 37

What are secured loans?

Back 37

Secured loans are those backed by something of value, known as collateral, that may be seized by the lender in the event that the borrower fails to repay the loan. Common types of collateral include property, equipment, accounts receivable, inventories, and securities.

Front 38

What are unsecured loans?

Back 38

Unsecured loans are ones that require no collateral.

Front 39

What is commercial paper?

Back 39

When businesses need a sizable amount of money for a short period of time, they can issue commercial paper, which is short-term promissory notes, or contractual agreements, to repay a borrowed amount by a specified time with a specified interest rate. Commercial paper is usually sold only by major corporations with strong credit ratings, in denominations of $100,000 or more and with maturities of up to 270 days. Commercial paper is normally issued to secure funds for short-term needs such as buying supplies and paying rent rather than for financing major expansion projects. Because the amounts are generally large, these notes are usually purchased by various investment funds and not by individual investors.

Front 40

What is factoring?

Back 40

Businesses with slow-paying trade credit customers and tight cash flow have the option of selling their accounts receivable, a method known as factoring. First, a factor or factoring agent purchases a company's receivables, paying the company a percentage of the total outstanding amount, typically 70 to 90 percent. Second, the factoring agent collects the amounts owed, freeing the company from the administrative tasks of collection. Third, after a customer pays the factor, the factor makes a second payment to the company, keeping a percentage as a fee for its services. Some factors assume the risk that customers won't ever pay (and their fees are naturally high), while others don't, in which case the company has to refund the initial payment it receive from the factor.

Front 41

What are the 3 sources of long-term financing?

Back 41

1. Long-term loans
2. Leases
3. Corporate bond

Front 42

What are the disadvantages and limitations of long-term loans?

Back 42

Not all companies can qualify for loans and acceptable terms; payments tie up part of cash flow for the duration of the loan; purchases made via loans require substantial down payment

Front 43

What is a lease?

Back 43

Company earns the right to use an asset in exchange for regular payments; arrangement can be directly between lessor and lessee or can involve a third party such as a bank.

Front 44

What is a corporate bond?

Back 44

Company sells bonds to investors, with the promise to pay interest and repay the principle according to a set schedule.

Front 45

What are the advantages of corporate bonds?

Back 45

Can generate more cash with longer repayment terms than are possible with loans

Front 46

What are the limitations of corporate bonds?

Back 46

Available only to large companies with strong credit ratings

Front 47

What are the two main types of investors?

Back 47

1. Private Equity
2. Venture Capital

Front 48

What are Private Equity Funds?

Back 48

Pools of money used to invest in companies

Front 49

What are leveraged buyout funds?

Back 49

PE firm acquires company by using significant levels of debt

-acquire public and private companies
-take them private (change of control private equity transactions)
-hold for 10-12 years
-acquire mature, profitable companies

Front 50

What is the goal of a leveraged buyout?

Back 50

The goal is to make money. They expect a 20% "upside gain" on their investment (when they sell the company).

Front 51

What are Venture Capital Investments (VCs)?

Back 51

VCs are a special type of PE funds. They are focused on new businesses and turnaround situations. They either invest in companies, or offer liquidity to investors who want to "cash out."

Front 52

What do VCs look for in a company?

Back 52

VCs are attracted to growth businesses. They look for an optimistic and adventurous CEO, but a conservative CFO.

Front 53

What do VCs do with the companies they invest in?

Back 53

They shape these businesses into strong IPO candidates or acquisition targets, making them "exit ready." They specifically work on cash management issues, including capital efficiency, research and development, marketing, and other contributors to grown.

Front 54

How do PEs and VCs differ in terms of stake?

Back 54

PE - majority stake

VC - minority stake

Front 55

How do PEs and VCs differ in terms of control?

Back 55

PE - control of board of directors

VC - operational control

Front 56

How do PEs and VCs differ in terms of management?

Back 56

PE - financial or management consulting background; compensated on value creation

VC - successful entrepreneurs; technological expertise

Front 57

How do PEs and VCs differ in terms of goals?

Back 57

PE - concerned with profitability

VC - not concerned with profits

Front 58

How do PEs and VCs differ in terms of technology?

Back 58

PE - not as concerned about technology

VC - risky technological development

Front 59

What is a primary offering?

Back 59

A primary offering occurs when a company sells its unissued securities and receives all the proceeds.

Front 60

What is a secondary offering?

Back 60

A secondary offering occurs when the securities held by the owners of the company are sold and the owners receive the proceeds (not the company).