Question

1. The corporate structure – ownership rights and limited liability – Profitability and the markets

What is the difference between a sole proprietorship, a partnership, and a corporation?

Answer:

What is Capital Budgeting and what does the Capital Structure of a company refer to?

What is the “cost of capital” for a company?

What is CAPM?

What is the book value of a company as opposed to its market value?

Answer 1

What is the difference between a sole proprietorship, a partnership, and a corporation?

Answer:

Sole Proprietorship: It is a business form where only one person has the ownership of the business as well as operates the business. In the sole proprietorship, the owner has all the liability of the firm as his personal liability. The advantage of the sole proprietorship is that it’s easy to incorporate, it has few regulatory requirement and low setup cost of business operation. The disadvantage of the sole proprietorship is that it has unlimited liability and business is solely dependent on the owner of the company. This form should be preferred for the new startup business with low capital for investment.

Partnership: It is a business form where two or more persons agree to carry a common business and share profits and losses of the business at mutually agreed term and condition. In the partnership form also, all the liability of the firm belongs to the partners of the firm. The advantage of the partnership is similar to sole proprietorship like it’s easy to incorporate, few regulatory requirement and low setup cost and also they have more fund for investment as many partners can combine their fund to make it bigger. The disadvantage of the partnership firm is that it has unlimited liability to its partners and conflict and differences between partners can destroy all the business of the firm. The partnership is good for the small businesses where number of owners is more than one.

Corporation: A corporation or company is a legal entity which is separate from its members or shareholders. In a company each shareholder has limited liability of the firm up to their contribution to the firm. Ownership rights of a company can change easily by transferring the shares of the firm. The advantage of the company is that its shareholders has limited liability, separate legal entity, ownership is transferable and mostly professionally managed organization. The disadvantage of the company is that it has higher set-up cost and more rules and regulations to follow. If the business view is long term and company is planning to become publically listed company.

What is Capital Budgeting and what does the Capital Structure of a company refer to?

Answer:

Capital budgeting is the process of identifying, evaluating and taking decisions on the long term investments plan of the company. During this process company evaluate various alternatives of investment in different projects and select one of the best alternative based on its cost, rate of return, NPV, time required and risk associated with it etc.

The capital structure of a firm is based on the arrangement of different sources of funds which are used to finance the operations of the firm. It is generally consists of debt, preferred stock and common equity.

What is the “cost of capital” for a company?

Answer:

The company’s cost of capital depends on its riskiness. It is an important factor to make capital budgeting decisions and analyze that its worth to go for new projects or not. There are various methods which are used for evaluation; one is net present value method; where if the present value of expected returns from investment minus cost of investment is more than zero, then project can be considered otherwise not. The present value of expected return is calculated by discounting the expected cash inflows at effective cost of capital of the company or weighted average cost of capital (WACC).

What is CAPM?

Answer:

The capital asset pricing model (CAPM) model states that a project’s total risk contains both diversifiable and non-diversifiable components in it. But the investors should think only about the systematic part of project risk which makes it less risky when it is well-diversified while performing a Discounted Cash Flow analysis. The CAPM calculates the required rate of return or cost of capital for any risky asset based on the security’s beta and explains that why capital assets are priced the way they are and uses single factor beta as sensitivity to market price changes in following manner-

Expected return of stock = risk free rate + Beta of stock *market risk premium

What is the book value of a company as opposed to its market value?

Answer:

The book value of company is difference between its total assets and total liabilities.

While the market value of a company is equal to the current stock price * number of outstanding shares