Chapter 7

Topic 1: Types of Firms

1. Sole Proprietorship – firm that is owned and primarily operated by one person. They can be large or small. The thing that distinguishes it is that is owned by one person.

2. Partnership – firm that is owned jointly by two or more persons. These too may be large or small. There are LLP’s or limited liability partnerships that take on the form of a corporation.

3. Corporation – legal form of business that gives the owners limited liability. This is the type of firm that most people think of when we look at the overall economy and stock market.

4. Limited Liability- when a firm fails it only loses what was initially invested. Partnerships and sole proprietorships have unlimited liability. This means that personal assets can be lost if the business turns out to be non-profitable. This comes down to the fact that a sole-proprietorship is not considered a separate legal entity from the owners, while a corporation is.

Here is a table that organizes what the pros and cons of each type of firm

Sole Proprietorship / Partnership / Corporation
Advantages / -Control by owner
-No layers of MGT
-Easy to form / -Ability to share MGT and work duties
-Ability to share risk of loss
-Easy to form / -Limited personal liability
-Greater ability to raise fundsè can petition general public and list on public exchanges
Disadvantages / -Unlimited personal liability
-limited ability to raise fundsè can’t petition general public / -Unlimited personal liability for all partners
-Limited ability to raise funds è can’t petition general public / -Costly to organize
-Possible double tax on incomeè two layers of tax (corporate and personal)

Note: Although sole proprietorships are the most common type of firm in the economy corporation earn the most revenue each year. Corporations are about 20% of firms but earn about 87% of revenue and make about 69% of total reported profit.

Topic 2: Structure of Corporations

The structure of corporations is imperative to their success. Due to the fact that many are large and there are many layers of workers and management involved we will discuss briefly some main topics that arise.

1. Corporate Governance – the way a corporation is structured and the impact it has on the decisions and behaviors of firms.

2. Layers of MGT and Notes

-A corporation is legally owned by all the s/h è they elect a Board of Directors (BOD) who oversee that their legal interests are upheld

-CEO- Chief Executive Officer- runs the day to day operations of the corporation and is appointed by the BOD

-the board may also appoint other members of the top level management such as the chief financial officer (CFO)

-there is a separation of ownership and control of the corporation. This is what makes the corporation different from a sole proprietorship or partnership

-principal agent problem- this is the problem that arises from the fact that the owners of the corporation ( i.e. s/h) don’t directly run the firm, so those that run the corporation have their own interests that may be different from the s/h. In general they don’t maximize profit of the firm which will increase share price. They may do something else to keep their job, such as revenue growth or increase market size which does not mean that profit is maximized.

3. Ways to Raise Funds:

a. Internal Investment – This is when you take profit that is earned through operations and put it back into your firm (i.e. this is taken from retained earnings)

b. Increase the amount of investors by increasing partners in a partnership. They could donate either monetary capital or physical capital in exchange for an interest in the firm.

-for partnerships you cannot go out and publicly solicit people, so this is a very limiting factor

c. Increase the amount of money via friends, family, a bank, or include more personal wealth.

So, as we can see there are very limited fashions that can be obtained, but when you are a corporation you have more options and typically use two main ways to do this by obtaining external funds which you can solicit for:

(1): Indirect Financing – Borrowing from a financial Intermediary (i.e. a bank)

(2): Direct Financing – If you can do this you don’t go through a broker and you directly raise the funds. It can be done through debt financing (issuance of notes payable) or equity financing (issuance of stock or ownership interests in the firm). Equity financing is what people typically think of when they think of the stock market, but note that not all equity is publicly traded and it doesn’t need to be. For a company to list on an exchange there are many rules and regulations that must he adhered. For this reason some firms decided to stay private.

Note: In finance or accounting courses you will cover these topics above again and in more depth, but this will provide us with a good framework about the types of firms, their structure, problems, and how they operate.