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*IS10095*//integrafs1/cengage/3-Pagination/Cengage_US/Business_and_Economics/FFM13e/3B2/brigham_fm_cont.3d,11/18/11,21:4,page:26 Licensed to: *IS10095*//integrafs1/cengage/3-Pagination/Cengage_US/Business_and_Economics/FFM13e/3B2/brigham_fm_cont.3d,11/18/11,21:4,page:26 Licensed to: This is an electronic version of the print textbook. Due to electronic rights restrictions, some third party content may be suppressed. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it. For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. 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All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. *IS657*//integrafs1/cengage/3-Pagination/Cengage_US/Business_and_Economics/FFM13e/3B2/brigham_ch01.3d,11/14/11,21:38,page:2 CHLAicPeTnEsRed1 toC:HAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAP ã Courtesy of Google, Inc. An Overview of Financial Management Striking the Right Balance In1776,AdamSmithdescribedhowan“invisible l A firm’s principal goal should be to maximize hand”guidescompaniesastheystriveforprofits, the wealth of its stockholders, which means and that hand leads them to decisions that maximizing the value of its stock. benefit society. Smith’s insights led him to con- l Freeenterpriseisstillthebesteconomicsystemfor cludethatprofitmaximizationistherightgoalfor thecountryasawhole.Underthefreeenterprise a business and that the free enterprise system is framework, companies develop products and bestforsociety.Buttheworldhaschangedsince services that people want and that benefit 1776. Firms today are much larger, they operate society. globally,theyhavethousandsofemployees,and l However, some constraints are needed—firms they are owned by millions of stockholders. This should not be allowed to pollute the air and makes us wonder if the “invisible hand” still pro- water,toengageinunfairemploymentpractices, videsreliableguidance:Shouldcompaniesstilltry or to create monopolies that exploit consumers. tomaximizeprofits,orshouldtheytakeabroader view and take more balanced actions designed These constraints take a number of different to benefit customers, employees, suppliers, and forms.Thefirstsetofconstraintsarethecoststhat society as a whole? are assessed on companies if they take actions Many academics and finance professionals thatharmsociety.Anothersetofconstraintsarises todaysubscribetothefollowingmodifiedversion through the political process, where society ofAdamSmith’stheory: imposes a wide range of regulations that are Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. *IS657*//integrafs1/cengage/3-Pagination/Cengage_US/Business_and_Economics/FFM13e/3B2/brigham_ch01.3d,11/14/11,21:38,page:3 Licensed to: Chapter 1AnOverview ofFinancial Management 3 designedtokeepcompaniesfromengaginginpracticesthat regulators is essential if value is to be maximized. In his are harmful to society. Properly imposed, these costs fairly words,“ThereasonpeoplecometoworkforGEisthatthey transfer value to suffering parties and help create incentives wanttobepartofsomethingbiggerthanthemselves.They thathelppreventsimilareventsfromoccurringinthefuture. want to work hard, win promotions, and be well com- The recent financial crisis dramatically illustrates these pensated, but they also want to work for a company that points. We witnessed many Wall Street firms engaging in makesadifference,acompanythat’sdoinggreatthingsin extremelyriskyactivitiesthatpushedthefinancialsystemto theworld….It’suptoGEtobeagoodcitizen.Notonlyis thebrinkofcollapsein2007and2008.Savingthefinancial that anicethingtodo,but it’sgoodforbusiness and thus system required a bailout of the banks and other financial the price of our stock.” companies, and that bailout imposed huge costs on the GE is not alone. An increasing number of companies taxpayers, and also helped push the economy into a deep seetheirmissionasmorethanjustmakingmoneyfortheir recession. Apart from the huge costs imposed on society, shareholders. Google’s well-known corporate motto is the financial firms also paid a heavy price—a number of “Don’t Be Evil.” Consistent with this mission, the company leadingfinancialinstitutionssawahugedropintheirstock has its own in-house foundation that has made large price,somefailedandwentoutofbusiness,andmanyWall investments in a wide range of philanthropic ventures Street executives lost their jobs. worldwide. There are other instances where corporate Arguably,thesecostsarenotenoughtopreventanother leaders have donated personal funds. financialcrisisdowntheroad.Manymaintainthattheevents In 2008, Microsoft Corporation’s Bill Gates gave a surrounding the financial crisis illustrate that markets don’t speech to the World Economic Forum in which he made alwaysworkthewaytheyshould,andthatthereisaneedfor thecasefora“creativecapitalism.”Gatesstatedthat,“Such strongerregulationofthefinancialsector.Forexample,inhis a system would have a twin mission: making profits and recent book, Nobel Laureate Joseph Stiglitz makes a strong also improving lives for those who don’t fully benefit from caseforenhancedregulation.Atthesametime,otherswitha market forces.” different political persuasion continue to express concerns Gates has certainly been true to his word. In 2000, he about the costs of excessive regulation. and his wife established the Bill & Melinda Gates Founda- Beyond just the financial crisis, there is a broader tion. Today the fund has assets totaling $34 billion. It question of whether laws and regulations are enough to received a notable boost in 2006 when famed investor compel firms to act in society’s interest. For example, GE Warren Buffett announced that he would donate a huge Chief Executive Officer (CEO) Jeffrey Immelt believes that shareofhisfortunetotheFoundation.Todate,Buffett has just obeying the law is not enough, and that companies contributed close to $8 billion, and over time he is should strive to behave ethically and continually operate scheduledtocontributeadditionalstockthatisnowworth with society’s interests in mind. Immelt further argues that about $40 billion. These efforts show that there is more to value and reputation go hand in hand, and that having a life than money, but it often takes money to do good goodreputationwithcustomers,suppliers,employees,and things. Sources:Marc Gunther, “Money and Morals at GE,” Fortune, November 15, 2004, pp. 176–182; Patricia Sellers, “Melinda Gates Goes Public,” CNNMoney.com, January 7, 2008; Kevin J. Delaney, “Google: From ‘Don’t Be Evil’ to How to Do Good,” The Wall Street Journal,January18,2008,pp.B1–B2;RobertA.Guth,“BillGatesIssuesCallforKinderCapitalism,”TheWallStreetJournal,January24, 2008, p. A1; and Joseph E. Stiglitz, FreeFall: America, Free Markets, and the Sinking of the World Economy (New York: W.W. Norton & Company, 2010). PUTTING THINGS IN PERSPECTIVE This chapter will give you an idea of what financial management is all about. We begin the chapter by describing how finance is related to the overall business, by pointing out that financeprepares students for jobs in different fields of business, and by discussing the different forms of business organization. For corporations, Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. *IS657*//integrafs1/cengage/3-Pagination/Cengage_US/Business_and_Economics/FFM13e/3B2/brigham_ch01.3d,11/14/11,21:38,page:4 Licensed to: 4 Part 1Introduction to FinancialManagement management’s goal should be to maximize shareholder wealth, which means maximizing the value of the stock. When we say “maximizing the value of the stock,” we mean the “true, long-run value,” which may be different from the cur- rent stock price. Good managers understand the importance of ethics, and they recognize that maximizing long-run value is consistent with being socially responsible. We conclude the chapter by discussing how firms must provide the right incentives for managers to focus on long-run value maximization. When you finish this chapter, you should be able to: l Explain the role of finance and the different types of jobs in finance. l Identify the advantages and disadvantages of different forms of business organization. l Explain the links between stock price, intrinsic value, and executive compensation. l Discuss the importance of business ethics and the consequences of unethical behavior. l Identify the potential conflicts that arise within the firm between stock- holders and managers and between stockholders and bondholders, and discuss the techniques that firms can use to mitigate these potential conflicts. 1-1 WHAT IS FINANCE? It’s hard to define finance—the term has many facets, which makes it difficult to provideaclearandconcisedefinition.Thediscussioninthissectionwillgiveyou anideaofwhatfinancepeopledoandwhatyoumightdoifyouenterthefinance field after you graduate. 1-1a Finance versus Economics and Accounting Finance,asweknowittoday,grewoutofeconomicsandaccounting.Economists developed the notion that an asset’s value is based on the future cash flows the asset will provide, and accountants provided information regarding the likely size of those cash flows. People who work in finance need knowledge of both economics and accounting. As discussed next, in the modern corporation, the accounting department falls under the control of the chief financial officer (CFO). 1-1b Finance within an Organization Most businesses and not-for-profit organizations have an organization chart similartotheoneshowninFigure1.1.Theboardofdirectorsisthetopgoverning body,andthechairpersonoftheboardisgenerallythehighest-rankingindividual. The CEO comes next, but note that the chairperson of the boardoften also serves astheCEO.BelowtheCEOcomesthechiefoperatingofficer(COO),whoisoften ThedutiesoftheCFOhave broadenedovertheyears. also designated as a firm’s president. The COO directs the firm’s operations, CFOmagazine’sonline whichincludemarketing,manufacturing,sales,andotheroperatingdepartments. service,cfo.com,isan TheCFO,whoisgenerallyaseniorvicepresidentandthethird-rankingofficer,is excellentsourceoftimely in charge of accounting, financing, credit policy, decisions regarding asset financearticlesintendedto acquisitions, and investor relations, which involves communications with stock- helptheCFOmanagethose newresponsibilities. holders and the press. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. *IS657*//integrafs1/cengage/3-Pagination/Cengage_US/Business_and_Economics/FFM13e/3B2/brigham_ch01.3d,11/14/11,21:38,page:5 Licensed to: Chapter 1AnOverview ofFinancial Management 5 FIGURE 1.1 Finance within an Organization Board of Directors Chief Executive Officer (CEO) Chief Operating Officer (COO) Chief Financial Officer (CFO) 3 1 0 2 g n ni Lear RMesaorkuertciensg, ,a Pnrdo dOutchteior nO,p Heuramtianng AcLceoguanl,t Cinagp, iTtarel Basuudrgye, Ctirnegd,it, ge ga Departments and Investor Relations n Ce © Ifthefirmispubliclyowned,theCEOandtheCFOmustbothcertifytothe Securities and Exchange Commission (SEC) that reports released to stock- holders, and especially the annual report, are accurate. If inaccuracies later emerge, the CEO and the CFO could be fined or even jailed. This requirement wasinstitutedin2002asapartoftheSarbanes-OxleyAct.TheActwaspassed Sarbanes-Oxley Act by Congress in the wake of a series of corporate scandals involving now- Alaw passedbyCongress defunct companies such as Enron and WorldCom, where investors, workers, thatrequirestheCEOand CFOtocertifythat their and suppliers lost billions of dollars due to false information released by those firm’sfinancialstatements companies. areaccurate. 1-1c Corporate Finance, Capital Markets, and Investments Financeastaughtinuniversitiesisgenerallydividedintothreeareas:(1)financial management, (2) capital markets, and (3) investments. Financial management, also called corporate finance, focuses on decisions relating to how much and what types of assets to acquire, how to raise the capitalneededtopurchaseassets,andhowtorunthefirmsoastomaximizeits value. The same principles apply to both for-profit and not-for-profit orga- nizations; and as the title suggests, much of this book is concerned with financial management. Capitalmarketsrelatetothemarketswhereinterestrates,alongwithstockand bond prices, are determined. Also studied here are the financial institutions that supply capital to businesses. Banks, investment banks, stockbrokers, mutual funds,insurancecompanies,andthelikebringtogether“savers”whohavemoney to invest and businesses, individuals, and other entities that need capital for various purposes. Governmental organizations such as the Federal Reserve System, which regulates banks and controls the supply of money, and the SEC, whichregulatesthetradingofstocksandbondsinpublicmarkets,arealsostudied as part of capital markets. Investments relate to decisions concerning stocks and bonds and include a number of activities: (1) Security analysisdeals with finding the proper values of individual securities (i.e., stocks and bonds). (2) Portfolio theory deals with the Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. *IS657*//integrafs1/cengage/3-Pagination/Cengage_US/Business_and_Economics/FFM13e/3B2/brigham_ch01.3d,11/14/11,21:38,page:6 Licensed to: 6 Part 1Introduction to FinancialManagement best way to structure portfolios, or “baskets,” of stocks and bonds. Rational investorswanttoholddiversifiedportfoliosinordertolimitrisks,sochoosinga properly balanced portfolio is an important issue for any investor. (3) Market analysis deals with the issue of whether stock and bond markets at any given time are “too high,” “too low,” or “about right.” Behavioral finance, where investor psychology is examined in an effort to determine if stock prices have been bid up to unreasonable heights in a speculative bubble or driven down to unreasonable lows in a fit of irrational pessimism, is a part of market analysis. Although we separate these three areas, they are closely interconnected. Bankingisstudiedundercapitalmarkets,butabanklendingofficerevaluatinga business’ loan request must understand corporate finance to make a sound decision.Similarly,acorporatetreasurernegotiatingwithabankermustunder- stand banking if the treasurer is to borrow on “reasonable” terms. Moreover, a security analyst trying to determine a stock’s true value must understand cor- porate finance and capital markets to do his or her job. In addition, financial decisions of all types depend on the level of interest rates; so all people in cor- porate finance, investments, and banking must know something about interest rates and the way they are determined. Because of these interdependencies, we coverallthreeareasinthisbook. SELF TEST What is the relationship between economics, finance, and accounting? Who is the CFO,where doesthis individualfit into the corporatehierarchy, and what are some of his or her responsibilities? Does it make sense for not-for-profit organizations such as hospitals and universities to have CFOs? What three areas of finance does this book cover? Are these areas inde- pendentofoneanother,oraretheyinterrelatedinthesensethatsomeone workinginoneareashouldknowsomethingabouteachoftheotherareas? Explain. 1-2 JOBS IN FINANCE Finance prepares students for jobs in banking, investments, insurance, corpo- rations, and government. Accounting students need to know finance, marketing, management, and human resources; they also need to understand finance, for it affects decisions in all those areas. For example, marketing people propose Tofindinformationabout advertising programs, but those programs are examined by finance people to differentfinancecareers, judge the effects of the advertising on the firm’s profitability. So to be effective in gotocareers-in-finance.com. marketing, one needs to have a basic knowledge of finance. The same holds for Thiswebsiteprovides informationaboutdifferent management—indeed, most important management decisions are evaluated in financeareasand terms of their effects on the firm’s value. recommendsdifferentbooks It is also worth noting that finance is important to individuals regardless of aboutjobsinfinance. theirjobs.Someyearsagomostbusinessesprovidedpensionstotheiremployees, so managing one’s personal investments was not critically important. That’s no longer true. Most firms today provide what’s called “defined contribution” pen- sion plans, where each year the company puts a specified amount of money into an account that belongs to the employee. The employee must decide how those funds are to be invested—how much should be divided among stocks, bonds, or Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. *IS657*//integrafs1/cengage/3-Pagination/Cengage_US/Business_and_Economics/FFM13e/3B2/brigham_ch01.3d,11/14/11,21:38,page:7 Licensed to: Chapter 1AnOverview ofFinancial Management 7 moneyfundsandhowmuchriskthey’rewillingtotakewiththeirstockandbond investments. These decisions have a major effect on people’s lives, and the con- cepts covered in this book can improve decision-making skills. 1-3 FORMS OF BUSINESS ORGANIZATION The basics of financial management are the same for all businesses, large or small, regardlessofhowtheyareorganized.Still,afirm’slegalstructureaffectsitsoperations andthusshouldberecognized.Therearefourmainformsofbusinessorganizations: (1) proprietorships, (2) partnerships, (3) corporations, and (4) limited liability com- panies (LLCs) and limited liability partnerships (LLPs). In terms of numbers, most businessesareproprietorships.However,basedonthedollarvalueofsales,over80% of all business is done by corporations.1 Because corporations conduct the most businessandbecausemostsuccessfulbusinesseseventuallyconverttocorporations, we concentrate on them in this book. Still, it is important to understand the legal differencesbetweenfirms. Aproprietorshipisanunincorporatedbusinessownedbyoneindividual.Going Proprietorship intobusinessasasoleproprietoriseasy—apersonbeginsbusinessoperations.Pro- Anunincorporated prietorshipshavethreeimportantadvantages:(1)Theyareeasilyandinexpensively businessownedbyone individual. formed,(2)theyaresubjecttofewgovernmentregulations,and(3)theyaresubjectto lowerincometaxesthanarecorporations.However,proprietorshipsalsohavethree important limitations: (1) Proprietors have unlimited personal liability for the busi- ness’ debts, so they can lose more than the amount of money they invested in the company.Youmightinvest$10,000tostartabusinessbutbesuedfor$1millionif, duringcompanytime,oneofyouremployeesrunsoversomeonewithacar.(2)The lifeofthebusinessislimitedtothelifeoftheindividualwhocreatedit;andtobringin newequity,investorsrequireachangeinthestructureofthebusiness.(3)Becauseof the first two points, proprietorships have difficulty obtaining large sums of capital; hence,proprietorshipsareusedprimarilyforsmallbusinesses.However,businesses are frequently started as proprietorships and then converted to corporations when theirgrowthresultsinthedisadvantagesoutweighingtheiradvantages. Apartnershipisalegalarrangementbetweentwoormorepeoplewhodecide Partnership todobusinesstogether.Partnershipsaresimilartoproprietorshipsinthattheycan Anunincorporated be established relatively easily and inexpensively. Moreover, the firm’s income is businessownedbytwoor morepersons. allocated on a pro rata basis to the partners and is taxed on an individual basis. This allows the firm to avoid the corporate income tax. However, all of the partnersaregenerallysubjecttounlimitedpersonalliability,whichmeansthatifa partnership goes bankrupt and any partner is unable to meet his or her pro rata shareofthefirm’sliabilities,theremainingpartnerswillberesponsibleformaking goodontheunsatisfiedclaims.Thus,theactionsofaTexaspartnercanbringruin toamillionaireNewYorkpartnerwhohadnothingtodowiththeactionsthatled to the downfall of the company. Unlimited liability makes it difficult for part- nerships to raise large amounts of capital.2 1RefertoU.S.CensusBureau,StatisticalAbstractoftheUnitedStates:2011(www.census.gov/compendia/statab), Table743:NumberofTaxReturns,Receipts,andNetIncomebyTypeofBusiness:1990to2007,p.491. 2Originally,therewerejuststraightforwardpartnerships;butovertheyears,lawyershavecreatedanumberof variations.Weleavethevariationstocoursesonbusinesslaw,butwenotethatthevariationsaregenerally designedtolimittheliabilitiesofsomeofthepartners.Forexample,a“limitedpartnership”hasageneralpartner, whohasunlimitedliability,andoneormorelimitedpartners,whoseliabilityislimitedtotheamountoftheir investment.Thissoundsgreatfromthestandpointoflimitedliability;butthelimitedpartnersmustcedesole controltothegeneralpartner,whichmeansthattheyhavealmostnosayinthewaythefirmismanaged.Witha corporation,theowners(stockholders)havelimitedliability,buttheyalsohavetherighttovoteandthuschange managementiftheythinkthatachangeisinorder.NotetoothatLLCsandLLPs,discussedlaterinthissection, areincreasinglyusedinlieuofpartnerships. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. *IS657*//integrafs1/cengage/3-Pagination/Cengage_US/Business_and_Economics/FFM13e/3B2/brigham_ch01.3d,11/14/11,21:38,page:8 Licensed to: 8 Part 1Introduction to FinancialManagement Corporation Acorporationisalegalentitycreatedbyastate,anditisseparateanddistinct Alegalentitycreatedbya fromitsownersandmanagers.Itisthisseparationthatlimitsstockholders’losses state,separate and totheamounttheyinvestedinthefirm—thecorporationcanloseallofitsmoney, distinctfromitsowners but its owners can lose only the funds that they invested in the company. Cor- andmanagers, having porationsalsohaveunlimitedlives, anditiseasiertotransfersharesofstockina unlimitedlife, easy corporationthanone’sinterestinanunincorporatedbusiness.Thesefactorsmake transferabilityof it much easier for corporations to raise the capital necessary to operate large ownership,andlimited businesses. Thus, companies such as Hewlett-Packard and Microsoft generally liability. begin as proprietorships or partnerships, but at some point they find it advanta- geous to become a corporation. A major drawback to corporations is taxes. Most corporations’ earnings are subject to double taxation—the corporation’s earnings are taxed; and then when its after-tax earnings are paid out as dividends, those earnings are taxed again as personal income to the stockholders. However, as an aid to small businesses, SCorporation Congress created S corporations, which are taxed as if they were partnerships; Aspecialdesignation that thus,theyareexemptfromthecorporateincometax.ToqualifyforScorporation allowssmallbusinesses status, a firm can have no more than 100 stockholders, which limits their use to thatmeetqualificationsto relatively small, privately owned firms. Larger corporations are known as betaxedasif theywere Ccorporations.ThevastmajorityofsmallcorporationselectSstatusandretainthat aproprietorship ora status until they decide to sell stock to the public, at which time they become partnershiprather than C corporations. acorporation. A limited liability company (LLC) is a relatively new type of organization that is a hybrid between a partnership and a corporation. A limited liability Limited Liability partnership(LLP)issimilartoanLLC;butLLPsareusedforprofessionalfirmsin Company (LLC) the fields of accounting, law, and architecture, while LLCs are used by other Arelativelynew typeof businesses. Both LLCs and LLPs have limited liability like corporations but are organization thatis taxed like partnerships. Further, unlike limited partnerships, where the general ahybridbetween a partnerhasfullcontrolofthebusiness,theinvestorsinanLLCorLLPhavevotes partnershipand in proportion to their ownership interest. LLCs and LLPs have been gaining in acorporation. popularity in recent years, but large companies still find it advantageous to be C corporations because of the advantages in raising capital to support growth. Limited Liability LLCs/LLPs were dreamed up by lawyers, and it is necessary to hire a good Partnership (LLP) SimilartoanLLCbutused lawyer when establishing one.3 forprofessional firmsin When deciding on its form of organization, a firm must trade off the advan- thefields ofaccounting, tages of incorporation against a possibly higher tax burden. However, for the law,andarchitecture.It followingreasons,thevalueofanybusinessotherthanarelativelysmallonewill haslimitedliability like probably be maximized if it is organized as a corporation: corporations butis taxed 1. Limited liability reduces the risks borne by investors; and other things likepartnerships. held constant, the lower the firm’s risk, the higher its value. 2. A firm’s value is dependent on its growth opportunities, which are dependent on its ability to attract capital. Because corporations can attract capital more easily than other types of businesses, they are better able to take advantage of growth opportunities. 3. The value of an asset also depends on its liquidity, which means the time and effort it takes to sell the asset for cash at a fair market value. Because the stock of a corporation is easier to transfer to a potential buyer than is an interest in a proprietorship or partnership, and because more investors are willing to invest in stocks than in partnerships (with their potential unlimited liability), a corporate investment is relatively liquid. This too enhances the value of a corporation. 3LLCsandLLPsarerelativelycomplicatedstructures,andwhattheycandoandhowtheymustbesetupvaries bystate.Moreover,theyarestillevolving. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

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