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Chapter 6

Proprietorship
Unincorporated business owned by one individual
Advantages of Proprietorship
1. Easy and inexpensive to form
2. Subject to few government regulations
3. Taxed like an individual
Disadvantages of Proprietorship
1. Proprietor has unlimited liability for business debts
2. Life of proprietorship is limited to time the creator owns it
3. Transferring ownership can be difficult
4. Difficult for proprietorship to obtain large sums of capital
Partnership
unincorporated business owned by two or more persons
Advantages of Partnership
1. Easy and inexpensive to form
2. Subject to few government regulations
3. Taxed like an individual
(same as proprietorship)
Disadvantages of Partnership
1. Proprietor has unlimited liability for business debts
2. Life of partnership is limited to time the same group of partners owns it
3. Transferring ownership can be difficult
4. Difficult for partnership to obtain large sums of capital (but better than for a proprietorship)
Corporation
legal entity created by a state
Advantages of Corporation
1. Separate and distinct from its owners
2. Unlimited life
3. Easy transferability of ownership
4. Limited liability
5. Easier for corporations than for proprietorships and partnerships to raise money in the financial markets
Disadvantages of Corporation
1. Setting up and filing state and federal reports is complex
-Corporate charter is filed with the state providing information about the company and directors
-Bylaws are for internal management and procedures
2. Earnings are subject to double taxation
Limited Liability Partnership
A partnership form of business that provides for limited liability for some partners.
At least one partner must be a general partner who is fully responsible for the firm’s liabilities.
Limited liability company (LLC)
-Provides for limited liability for owners
-Taxed like a partnership
-Flexible ownership structure
S Corporation
-100 or fewer stockholders
-Only one kind of stock
-Chooses to be taxed like a partnership
Goals of the Corporation
1. Stockholder wealth maximization
2. Managerial incentives to maximize shareholder wealth
3. Social responsibility
4. Stock price maximization and social welfare
According to Sarbanes-Oxley Act (2002), corporations must
1. Have a committee of outside directors to oversee audits
2. Hire an external auditor
3. Provide information about procedures used to construct financial statements
Why would a company want to operate in more than one country?
To seek new markets
To seek raw materials
To seek new technology
To seek production efficiency
To avoid political and regulatory hurdles
Progressive tax
higher tax on higher incomes
Taxable income
gross income minus exemptions and allowable deductions
Marginal tax rate
the tax on the last unit of income
Average tax rate
taxes paid divided by taxable income
What is the role of ethics in successful businesses?
Established codes of conduct help “ethical” firms prosper whereas “unethical” firms do not
Why is it important for a business to have a clear corporate governance policy?
Rules for managers help stakeholders have a clear understanding of how executives run the business
and who is accountable for important decisions
Why is it important to consider taxes when making financial decisions?
Because taxes must be paid in cash, the effects of taxes on cash flows must be considered
Corporate charter
A document filed with the secretary of the state in which a business is incorporated that provides information about the company, including its name, address, directors, and amount of capital stock
Bylaws
A set of rules drawn up by the founders of the corporation that indicate how the company is to be governed; includes procedures for electing directors, the rights of the stockholders, and how to change the bylaws when necessary
Stockholder wealth maximization
The appropriate goal for management decisions; considers the risk and timing associated with expected cash flows to maximize the price of the firm’s common stock.
Profit maximization
Maximization of the firm’s net income each year.
Earnings per share (EPS)
Net income divided by the number of shares of common stock outstanding
Agency problem
A potential conflict of interest between outside shareholders (owners) and managers who make decisions about how to operate the firm.
performance shares
A type of incentive plan in which managers are awarded shares of stock on the basis of the firm’s performance over given intervals with respect to earnings per share or other measures.
executive stock options
A type of incentive plan that allows managers to purchase stock at some future time at a given price.
restricted stock grants
Stock is granted to employees based on the firm’s performance, but the stock is restricted in the sense that an employee is not vested—that is, does not have the right to ownership of the stock—until some period in the future.
stakeholders
Those who are associated with a business; stakeholders include managers, employees, customers, suppliers, creditors, stockholders, and other parties with an interest in the firm.
business ethics
A company’s attitude and conduct toward its stakeholders— employees, customers, stockholders, and so forth; ethical behavior requires fair and honest treatment of all parties.
corporate governance
The “set of rules” that a firm follows when conducting business; these rules identify who is accountable for major financial decisions.
proxy votes
Voting power that is assigned to another party, such as another stockholder or institution
industrial groups
Organizations that consist of companies in different industries with common ownership interests, which include firms necessary to manufacture and sell products—a network of manufacturers, suppliers, marketing organizations, distributors, retailers, and creditors
tax loss carryback (carryover)
Losses that can be carried backward (forward) in time to offset taxable income in a given year.
Two key limitations of the proprietorship form of business involve potential difficulty in raising needed capital and the presence of unlimited personal liability for business debts.
True
Four of the disadvantages of a partnership are (1) unlimited liability, (2) limited life of the organization, (3) difficulty of transferring ownership, and (4) difficulty in attracting large amounts of capital.
True
The major advantage of a regular partnership or a corporation as a form of business is the fact that both offer their owners limited liability, whereas proprietorships do not.
False
The proper goal of the financial manager should be to maximize the firm’s expected profit, because this will add the most wealth to each of the individual shareholders (owners) of the firm.
False
If a firm has a single owner, we can say that the proper goal of a financial manager would be to maximize the firm’s earnings per share.
False
By maximizing the earnings of the firm we will ensure that the price per share of common stock is maximized, hence shareholders’ wealth also will be maximized.
False
If a firm’s stock price falls during the year, this indicates that the firm’s managers are not acting in the shareholders’ best interest.
False
An agency problem exists between stockholders and managers. A second agency problem arises between stockholders and creditors.
True
The goal of maximizing stock price is a detriment to society in that few of the actions that result in maximization of stock price also benefit society.
False
Under our current tax laws, when investors pay taxes on their corporate dividend income, they are being subjected to a form of double taxation.
True
The fact that a percentage of the interest income received by one corporation is excluded from taxable income has encouraged firms to use more debt financing relative to equity financing.
False
Interest and dividends paid by a corporation are considered to be deductible operating expenses, hence they decrease the firm’s tax liability.
False
The fact that a proprietorship, as a business, pays no corporate income tax and that it is easily and inexpensively formed are often cited as key advantages to that form of business.
True
Multinational managerial finance requires that financial analyses consider the effects of changing currency values.
True
In order to avoid double taxation and to escape the frequently higher tax rate applied to capital gains, stockholders generally prefer to have corporations pay dividends rather than to retain their earnings and reinvest the money in the business. Thus, earnings should be retained only if the firm needs capital very badly and would have difficulty raising it from external sources.
False
Which of the following is not one of the things that causes a corporation to have a significant advantage over a partnership or a proprietorship?
a. Limited liability.
b. Ease of transfer of ownership interest.
c. Unlimited life.
d. Elimination of double taxation.
e. Ability to retain earnings and thus convert income from personal income to capital gains.
d. Elimination of double taxation.
Which of the following does not need to be considered when assessing the impact of financial decisions?
a. Projected earnings.
b. Financial market conditions.
c. Timing of the earnings flow.
d. Riskiness of the firm.
e. All of the above must be considered.
e. All of the above
Which of the following mechanisms is not used by shareholders to get managers to act in shareholders’ best interests?
a. Threat of firing.
b. Managerial compensation.
c. Performance shares.
d. Threat of takeover.
e. Answers b and c above.
c. Performance shares.
Which of the following statements is correct?
a. A good goal for a corporate manager is maximization of expected EPS.
b. Most business in the U.S. is conducted by corporations; corporations’ popularity results primarily from their favorable tax treatment.
c. A good example of an agency relationship is the one between stockholders and managers.
d. Corporations and partnerships have an advantage over proprietorships because a sole proprietor is subject to unlimited liability, but investors in the other types of businesses are not.
e. Firms in highly competitive industries find it easier to exercise “social responsibility” than do firms in oligopolistic industries.
c. A good example of an agency relationship is the one between stockholders and managers.
Which of the following statements is correct?
a. The major disadvantage of organizing as a corporation is that it does not provide its owners with limited liability.
b. Bond covenants, or restrictions on debt, are an important device to reduce agency conflicts between stockholders and bondholders.
c. The threat of a hostile takeover serves to reduce agency conflicts between stockholders and bondholders.
d. Compensation packages are designed, in part, to reduce agency conflicts between shareholders and managers.
e. Both answers b and d are correct.
e. Both answers b and d are correct.
Current tax laws have which of the following effects?
a. Favor dividends because there are no capital gains taxes on dividends.
b. Do not favor capital gains because the tax must be paid as the value of the stock increases, whether or not the stock is sold.
c. Favor capital gains because the tax does not have to be paid until the stock is sold.
d. Do not favor dividends or capital gains for most people because different people are in different tax brackets.
e. Favor dividends since dividends are tax-deductible for the paying corporation whereas retained earnings, which produce capital gains, are not tax-deductible.
c. Favor capital gains because the tax does not have to be paid until the stock is sold.
Which of the following statements is correct?
a. For the most part, our federal tax rates are progressive, because higher incomes are taxed at higher average rates.
b. Bonds issued by a municipality such as the city of Miami would carry a lower interest rate than bonds with the same risk and maturity issued by a private corporation such as Florida Power & Light.
c. Our federal tax laws tend to encourage corporations to finance with debt rather than with equity securities.
d. Our federal tax laws encourage the managers of corporations with surplus cash to invest it in stocks rather than in bonds. However, other factors may offset tax considerations.
e. All of the above statements are true.
e. All of the above statements are true.
Which of the following is a reason why companies move into international operations?
a. To take advantage of lower production costs in regions of inexpensive labor.
b. To develop new markets for their finished products.
c. To better serve their primary customers.
d. Because important raw materials are located abroad.
e. All of the above.
e. All of the above.
Which of the following actions is consistent with social responsibility but is necessarily inconsistent with stockholder wealth maximization?
a. Investing in a smokestack “scrubber” to reduce the firm’s air pollution as mandated by law.
b. Voluntarily installing expensive machinery to treat effluent discharge which currently is being dumped into a river where it is ruining the drinking water of the community where the plant is located.
c. Investing in a smokestack filter to reduce sulphur-dioxide emissions in order to reduce the current tax being levied on the firm by the state for its pollution.
d. Making a large corporate donation to the local community in order to fund a recreation complex that will be used by the community and the firm’s employees.
e. Each of the above actions is consistent with social responsibility and none is necessarily inconsistent with stockholder wealth maximization.
e. Each of the above actions is consistent with social responsibility and none is necessarily inconsistent with stockholder wealth maximization.
Which of the following statements is correct?
a. A hostile takeover is a primary method of transferring ownership interest in a corporation.
b. The corporation is a legal entity created by the state and is a direct extension of the legal status of its owners and managers, that is, the owners and managers are the corporation.
c. Unlimited liability and limited life are two key advantages of the corporate form over other forms of business organization.
d. In part due to limited liability and ease of ownership transfer, corporations have less trouble raising money in financial markets than other organizational forms.
e. Although stockholders of the corporation are insulated by limited legal liability, the legal status of the corporation does not protect the firm’s managers in the same way.
d. In part due to limited liability and ease of ownership transfer, corporations have less trouble raising money in financial markets than other organizational forms.
Which of the following statements is correct?
a. In a partnership, liability for other partners’ misdeeds includes but is limited to the amount a particular partner has invested in the business.
b. Partnerships must be formed according to specific rules which include the filing of a formal written agreement with state authorities where the partnership does business.
c. A fast growth company would be more likely to set up a partnership for its business organization than would a slow-growth company.
d. Partnerships have difficulties attracting capital in part because of the other disadvantages of the partnership form of business, including impermanence of the organization.
e. A major disadvantage of a partnership as a form of business organization is the high cost and practical difficulties of its formation
d. Partnerships have difficulties attracting capital in part because of the other disadvantages of the partnership form of business, including impermanence of the organization.
Which of the following statements is correct?
a. Other things held constant, it generally is safer to invest money in a proprietorship than in a partnership or a corporation.
b. According to the text, law firms and accounting firms must be organized as proprietorships or partnerships; these businesses do not have the option of incorporating.
c. If you are planning to start a business, which you will run as the sole employee, and if you expect the business to earn $1,000,000 per year before taxes, you can minimize federal income taxes by setting up the business as a corporation.
d. According to the text, “agency problems” tend to increase as the percentage of a corporation’s stock owned by its managers increases.
e. Maximizing the income statement item “net income” is not the best goal for a corporation whose managers are interested in maximizing the economic welfare of the firm’s stockholders.
e. Maximizing the income statement item “net income” is not the best goal for a corporation whose managers are interested in maximizing the economic welfare of the firm’s stockholders.
Which of the following statements is correct?
a. A major disadvantage of a regular partnership or a corporation as a form of business is the fact that they do not offer their owners limited liability, whereas proprietorships do.
b. An advantage of the corporate form for many businesses is the fact that the corporate tax rate always exceeds the personal tax rate, which is the rate at which proprietorships and partnerships are taxed.
c. There are more partnerships and sole proprietorships than corporations in the U.S., but corporations produce more goods and services than do other forms of business.
d. Because corporations enjoy the benefits of limited liability, easy transferability of ownership interest, unlimited life, and favorable tax status relative to the situation for partnerships and proprietorships, most large businesses choose to incorporate.
e. Because lawyers have the incorporation process so automated (e.g., word processors for drawing up the necessary papers), it is less expensive to form a corporation than to form a proprietorship or partnership.
c. There are more partnerships and sole proprietorships than corporations in the U.S., but corporations produce more goods and services than do other forms of business.
Jane Doe, who has substantial personal wealth and income, is considering the possibility of opening a new business in the chemical waste management field. She will be the sole owner. The business will have a relatively high degree of risk, and it is expected that the firm will incur losses for the first few years. However, the prospects for growth and positive future income look good, and Jane expects to realize substantial cash flows from dividends the firm will eventually pay out. Which of the legal forms of business organization would probably best suit her needs?
a. Proprietorship, because of ease of entry.
b. Regular corporation, because of the limited liability.
c. Partnership, if she needs additional capital.
d. S corporation, to enjoy tax advantages and gain limited liability.
e. In this situation, the various forms of organization seem equally desirable.
d. S corporation, to enjoy tax advantages and gain limited liability.
Your corporation has the following cash flows:
Operating income $250,000
Interest received 10,000
Interest paid 45,000
Dividends received 20,000
Dividends paid 50,000
If the applicable income tax rate is 40 percent, and if 70 percent of dividends received are exempt from taxes, what is the corporation’s tax liability?
a. $74,000
b. $88,400
c. $91,600
d. $100,000
e. $106,500
b. $88,400
In 2014, Ibis International had a taxable income of $2.5 million from operations. During that year, the company paid $600,000 interest on its outstanding debt, which included bank loans and bonds, and it paid its common stockholders $220,000 in dividends. Ibis received $180,000 in interest from its investments in the debts of other companies, and it also received $80,000 in dividends from its investments in other companies’ common stock. What is the company’s taxable income?
2,104,000
Interest and Dividends Paid by a Corporation
Interest paid to creditors is a tax-deductible expense, whereas dividends paid to stockholders are not tax deductible.

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