Risk and Return, Business Structures

By R. S. Miolla

Risk and Return

• Return– Cash inflows– Profits (net income)– Satisfaction

• Risk – How wide a range of outcomes– Standard deviation– Only relevant if good and bad outcomes

Risk and Return - Example

• A) $10,000 to invest– At the bank in a cd paying 5%– In the stock market: will pay between -50% and

+50 %. Mean of all possibilities is +5%.

Which investment would you choose? Why?

Risk and Return - Example

• Still $10,000 to invest.– Still a bank cd paying 5%.– Invest in the stock market: return will be between

-50% and +75%. The mean of the outcomes (expected value) is +25%.

• Which investment would you invest in? Why?

Finance Terms

• Financial Capital: Cash or “money”• Real Capital: Long term plant and equipment• Capital Structure: The mix (%) of debt and

equity used to finance the business. What your sources of capital are.

• Inflation: Increase of prices over time.• The goal of finance is to maximize shareholder

wealth.

The Flow of Business

• 1) obtain financing• 2) receive cash• 3) buy real assets• 4) produce net income in the period• 5) collect cash flows• 6) reinvest (retained earnings) or pay

dividends

Forms of Ownership

• 1) Sole Proprietorship: – Single owner– Unlimited liability– Taxed as owner’s income

• 2) Partnership:– Two or more owners, Unlimited liability– Articles of partnership: profits, withdrawal terms,

ownership %– Limited Liability Partnership (LLP): General partner and

limited partners

Forms of Ownership, con’t

• 3) Limited Liability Company (LLC):– Low reporting costs, taxed as partnership or Corp.,

limits liability• 4) Corporation:– A legal entity, limited liability– Many owners (shareholders)– Board of Directors– Profits taxed twice: corporate and dividends– Subchapter S Corp. – Income taxed once to

shareholders, maximum of 75 shareholders