Tag: finance

• Intrinsic Value

  Maximizing the intrinsic value is the main financial goal of managers at publicly owned companies.

  The intrinsic value and the actual market stock price are determined by several factors, although their underlying foundations are the same.

  Determinants of Intrinsic Value

  The value of any asset, including a share of stock, is fundamentally based on the stream of cash flows that the asset is expected to produce for its owners over time.

  The key determinants of a stock’s intrinsic value are the “true” expected cash flows and the “true” risk associated with those cash flows.

  1. Managerial Actions and Environment: Managerial actions, combined with the economic environment, taxes, and the political climate, influence the level and riskiness of the company’s future cash flows.
  2. Expected Cash Flows: Investors prefer higher expected cash flows.
  3. Perceived Risk: Investors dislike risk, so the lower the perceived risk, the higher the stock’s price.
  4. Long-Run Concept: Intrinsic value is a long-run concept; management’s goal is to maximize the firm’s intrinsic value, which maximizes the average price over the long run.
  5. Estimation: Intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data, as calculated by a competent analyst.

  Determinants of Market Stock Price

  The market price is the actual price at which the stock sells, based on perceived, possibly incorrect, information available to the marginal investor.

  • Perceived Cash Flows and Risk: The market price is based on “perceived” investor cash flows and “perceived” risk, given the limited information investors have.
  • Marginal Investor: It is the views of the marginal investor (the investor currently trading the stock) that determine the actual stock price.
  • Equilibrium: When a stock’s actual market price equals its intrinsic value, the stock is in equilibrium, and there is no pressure for a price change. Market prices can, and do, differ from intrinsic values, but they tend to converge over time as the future unfolds.

  Valuation Models

  Financial analysts use models to estimate a stock’s intrinsic value, including:

  1. Discounted Dividend Model (DDM): Focuses on the present value of expected future dividends.
  2. Corporate Valuation Model: Focuses on the firm’s future free cash flows (FCF), which are discounted using the Weighted Average Cost of Capital (WACC).

  2025.12.04

• Forms of Business Organization

  Understanding the structure of a business is crucial because the legal form affects a firm’s operations and how it is ultimately valued.

  The goal of financial management is to maximize shareholder wealth, which means maximizing the firm’s long-run, true intrinsic value. The form of organization influences how easily a firm can raise capital, which is a major determinant of its ability to grow and maximize value.

  Here is a detailed summary of the main forms of business organization:

  1. Proprietorship

  A proprietorship is an unincorporated business owned by one individual.

  Feature	Description
  Establishment	Easy and inexpensive to form. A person simply begins business operations.
  Taxation	Subject to lower income taxes than corporations.
  Liability	The proprietor has unlimited personal liability for the business’ debts, meaning they can lose more than the amount initially invested.
  Life Span	Limited to the life of the individual who created it. Bringing in new equity requires a change in the structure.
  Capital	Has difficulty obtaining large sums of capital, so it is used primarily for small businesses.
  Conversion	Businesses often start as proprietorships and convert to corporations when growth makes the disadvantages outweigh the advantages.

  2. Partnership

  A partnership is a legal arrangement between two or more people who decide to do business together.

  Feature	Description
  Establishment	Relatively easy and inexpensive to establish.
  Taxation	The firm’s income is allocated to the partners on a pro rata basis and taxed as individual income, avoiding the corporate income tax.
  Liability	Generally, all partners are subject to unlimited personal liability. If one partner is unable to meet their share of liabilities in bankruptcy, the remaining partners are responsible for the unsatisfied claims. Variations exist, such as a limited partnership (which has one general partner with unlimited liability and limited partners whose liability is capped by their investment).
  Capital	Unlimited liability makes it difficult for partnerships to raise large amounts of capital.

  3. Corporation (C Corporation)

  A corporation is a legal entity created by a state that is separate and distinct from its owners (stockholders) and managers.

  Feature	Description
  Establishment	More complicated to form than a proprietorship or partnership.
  Taxation	The major drawback is double taxation. The corporation’s earnings are taxed, and then any after-tax earnings paid out as dividends are taxed again as personal income to the stockholders.
  Liability	Limited liability is a key advantage. Stockholders’ losses are limited to the amount they invested in the firm. This reduces the risks borne by investors, generally leading to a higher firm value.
  Life Span	Corporations have unlimited lives.
  Capital	It is much easier for corporations to transfer shares and raise the large amounts of capital necessary to operate big businesses, which is critical for taking advantage of growth opportunities.
  Dominance	More than 80% of all business (by dollar value of sales) is done by corporations, and this book focuses on them because most successful businesses eventually convert to this form.

  4. Limited Liability Companies (LLCs) and Partnerships (LLPs)

  These forms are popular hybrids combining features of partnerships and corporations.

  Feature	Description
  Structure	LLCs are generally used by other businesses, while LLPs are used for professional firms (accounting, law, architecture).
  Liability	They provide the limited liability protection of a corporation.
  Taxation	They are taxed as partnerships.
  Control	Unlike limited partnerships, investors in an LLC or LLP have votes in proportion to their ownership interest.
  Capital	Large companies still typically find it more advantageous to be C corporations due to the benefits in raising capital to support growth.

  A special type of corporation, the S Corporation, is taxed like a proprietorship or partnership (avoiding corporate income tax) but must meet limits (no more than 100 stockholders). This limits their use to relatively small, privately owned firms.

  The value of any business other than a relatively small one will likely be maximized when organized as a corporation due to its ability to attract capital more easily and the limited liability it offers investors.

  2025.12.04