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Finance 1 for IBALecture 1 29-01-2019
Chapter 1: The Corporations
The Four Types of Firms
- Sole Proprietorship
o Business is owned and run by one person
o Typically has few, if any, employees
o Advantages: easy to create
o Disadvantages: no separation between the firm and the owner, unlimited personal liability, limited life
- Partnership
o Similar to a sole proprietorship, but with more than one owner
o All partners are personally liable for all of the firm’s debts. A lender can require any partner to repay all
of the firm’s outstanding debts
o The partnership ends with the death or withdrawal of any single partner
o Limited Partnership has two types of owners
▪ General Partners
• Have the same rights and liability as partners in a “regular” partnership
• Typically run the firm on a day-to-day basis
▪ Limited Partners
• Have limited liability and cannot lose more than their initial investment
• Have no management authority and cannot legally be involved in the managerial
discussion making for the business
- Limited Liability Company
o All owners have limited liability, but they can also run the business
o Relatively new business form in the US
- Corporation
o A legal entity separate from its owners
o Has many of the legal powers individuals have such as the ability to enter into contracts, own assets,
and borrow money
o The corporation is solely responsible for its own obligations. Its owners are not liable for any obligation
the corporation enters into
Corporation:
- Ownership
o Represented by shares of stock
o Owner of stock is called
▪ Shareholder
▪ Stockholder
▪ Equity Holder
o Sum of all ownership value is called equity
o There is no limit to the number of shareholders and, thus, the amount of funds a company can raise by
selling stock
o Owner is entitled to dividend payments
- Formation
o Corporations must be legally formed. The corporation files a charter with the state it wishes to
incorporate in. The state then “charters” the corporation, formally giving its consent to the
incorporation
o Due to its attractive legal environment for corporations, Delaware is a popular choice for incorporation
- Tax Implications
o Double Taxation
- “S” Corporations
o Firm’s profits are not subject to corporate income tax, but instead are allocated directly to the
shareholders
Ownership Versus Control of Corporations
, - Corporate Management Team
o In a corporation, ownership and direct control are typically separate
- Board of Directors
o Elected by shareholders
o Have ultimate decision-making authority
- Chief Executive Officer (CEO)
o Board typically delegates day-to-day decision making to CEO
Lecture 2 05-02-2019
Ownership Versus Control of Corporations (cont’d)
- Goal of the Firm
o Shareholders will agree that they are better off if management makes decisions that maximizes the
value of their shares
- The Firm and Society
o Often, a corporation’s decisions that increase the value of the firm’s equity benefit society as a whole (if
the markets well regulated!)
o As long as nobody else is made worse off by a corporation’s decisions, increasing the value of the firm’s
equity is good for society
o It becomes a problem when increasing the value of the firm’s equity comes at the expense of others
- Ethics and Incentives within Corporations
o Agency Problems
▪ Managers may act in their own interest rather than in the best interest of the shareholders
▪ One potential solution is to tie management’s compensation to firm performance
▪ How should performance be measured?
- CEO Performance
o IF a CEO is performing poorly, shareholders can express their dissatisfaction by selling their shares. This
selling pressure will drive the stock price down
o Hostile Takeover
▪ Low stock prices may entice a Corporate Raider to buy enough stock so they have enough
control to replace current management. The stock price will rise after the new management
team “fixes” the company
o Corporate Bankruptcy
▪ Reorganization
▪ Liquidation
The Stock Market
The stock market provides liquidity to shareholders.
Liquidity = The ability to easily sell an asset for close to the price at which you can currently buy it.
- Public Company
o Stock is traded by the public on a stock exchange
- Private Company
o Stock may be traded privately
- Primary Markets
o When a corporation itself issues new shares of stock and sells them to investors, they do so on the
primary market
- Secondary Markets
o After the initial transaction in the primary market, the shares continue to trade in a secondary market
between investors
Traditional Trading Venues:
- New York Stock Exchange (NYSE)
o Market Makers/Specialists
▪ Each stock has only one market maker
- NASDAQ
o Does not meet in a physical location
o May have many market makers for a single stock
, - Bid Price versus Ask Price
o Bid-Ask Spread
▪ Transaction cost
New Competition and Market Changes:
In 2005, the NYSE and NASDAQ exchanges accounted for over 75% of all trade in US stocks. Today, due to increased
competition from new fully electronic exchanges and alternative trading systems, handle more than 50% of all trades
- Limit Order
o An order to buy or sell a set amount at a fixed price
- Limit Order Book
o The collection of all limit orders
- Market Orders
o Orders that trade immediately at the best outstanding limit order
- High Frequency Traders (HFTs)
o A class of traders who, with the aid of computers, execute trades many times per second in response to
new information
- Dark Pools
o With exchange trading, the limit book orders are public, allowing investors to trade at the current bid or
ask price, and transactions are visible to all traders when they occur
o Dark pools do not make their limit order books visible
o Instead, they offer investors the ability to trade at a better price with the tradeoff being that their order
might not be filled if an excess of either buy or sell orders is received
Chapter 3: Financial Decision Making and the Law of One Price
Using Market Prices to Determine Cash Values
- Competitive Market
o A market in which goods can be bought and sold at the same price
o If the market is competitive, then the price determines the cash value of the good
Experiment:
Assume that your grandfather suggest to you one of these two options. Which one do you prefer?
A) He will give you $100 now.
B) He will give you $110 next year.
→ Time value of money!!!
𝐹𝑉 = 𝑃𝑉 𝑥 (1 + 𝑟)
𝐹𝑉
𝑃𝑉 =
(1 + 𝑟)
Interest Rate and the Time Value of Money
The rate at which we can exchange money today for money in the future is determined by the current interest rate.
→ Risk-Free Interest Rate (Discount Rate), rf
Never accept a project if you get a negative Future Value.
The Interest Rate: An Exchange Rate Across Time
- The rate at which we can exchange money today for money in the future is determined by the current interest
rate
- Discount Factors and Rate
1
o We can interpret:
1+𝑟
o As the price today of $1 in one year. The amount is called the one-year discount factor. The risk-free
rate is also referred to as the discount rate for a risk-free inveestmnet
- Risk-free Interest Rate (Discount Rate), rf. The interest rate at which money can be borrowed or lent without risk
o Interest rate factor = 1 + rf
o Discount factor = 1 / (1 + rf)
Present versus Future Value:
, When we express the value in terms of dollars today, we call it the present value (PV) of the investment. If we express it in
terms of dollars in the future, we call it the future value of the investment.
Present Value and the NPV Decision Rule
The net present value (NPV) of a project or investment is the difference between the present value of its benefits and the
present value of its costs.
𝑁𝑃𝑉 = 𝑃𝑉(𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠) – 𝑃𝑉(𝐶𝑜𝑠𝑡𝑠)
𝑁𝑃𝑉 = 𝑃𝑉(𝐴𝑙𝑙 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠)
- Accepting or Rejecting a Project
o Accept those projects with positive NPV because accepting them is equivalent to receiving their NPV in
cash today
o Reject those projects with negative NPV because accepting them would reduce the wealth of investors
NPV and Cash Needs
Regardless of our preferences for cash today versus cash in the future, we should always maximize the NPV first. We can
then borrow or lend to shift cash flows through time and find our most preferred pattern of cash flows.
Arbitrage and the Law of One Price
- Arbitrage
o The practice of buying and selling equivalent goods in different markets to take advantage of a price
difference. An arbitrage opportunity occurs when it is possible to make a profit without taking any risk
or making any investment
- Normal Market
o A competitive market in which there are no arbitrage opportunities
- Law of One Price
o If equivalent investment opportunities trade simultaneously in different competitive markets, then they
must trade for the same price in both markets
No-Arbitrage and Security Prices
- Valuing a Security with the Law of One Price
o Assume a security promises a risk-free payment of $1000 in one year. If the risk-free interest rate is 5%,
what is the price of this bond?
Question:
What is a bond? How does it look like?
PV($1000 in one year) = ($1000 in one year) / (1.05 $ in one year / $ today) = $952.38 today
Price(Bond) = $952.38 The same price in all markets!
What if the price of the bond is not $952.38? Assume the price is $940.
Today ($) In One Year ($)
Buy the bond -940.00 +1000.00
Borrow from the bank +952.38 -1000.00
Net cash flow +12.38 0.00
Determining the Interest Rate From Bond Prices
If we know the price of a risk-free bond, we can use
𝑃𝑟𝑖𝑐𝑒(𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦) = 𝑃𝑉(𝐴𝑙𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑝𝑎𝑖𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦)
to determine what the risk-free interest rate must be if there are no arbitrage opportunities.
The NPV of Trading Securities and Firm Decision Making
In a normal market, the NPV of buying or selling a security is zero.
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