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Summary finance 1 for IBA
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Summary of the book corporate finance for finance 1 for IBA
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Chapter 1. The corporation and financial markets1.1 the four types of firms
Sole proprietorships
● Sole proprietorship: a business owned and run by 1 person; key characteristics:
○ Straightforward, usually used by new businesses
○ No separation between the firm and the owner
○ The owner has unlimited personal liability for any of the firm’s debts
○ The life of a sole proprietorship is limited to the life of the owner →
difficult to transfer ownership
● Usually, the disadvantages outweigh the advantages
Partnerships
● A partnership: identical to sole proprietorship but >1 owner; key features:
○ All partners are liable for the firm’s debt → any partner can repay all
firm’s debts
○ The partnership ends on the death/withdrawal of any single partner, avoiding
liquidation can be done through a buyout
● Examples: groups of doctors, accounting firms
● A limited partnership is a partnership with 2 kinds of owners:
○ general partners: have same rights & privileges as partners in (general) partnership
○ Limited partners: have limited liability, their liability is limited to their investment
■ Death/withdrawal does not dissolve \partnership +interest = transferable
■ No management authority, cannot legally be involved in managerial
decision-making for the business
■ Examples: private equity funds, venture capital funds
Limited liability companies
● A limited liability company is a limited partnership without a general partner
○ All owners have limited liability, but can also run the business
● Relatively new phenomenon in the US, much older internationally
Corporations
● A corporate is a legally defined, artificial being (a judicial person/legal entity)
separate from its owners → it can enter into contracts, acquire assets, incur
obligations and enoys protection against seizure of its property
● Solely responsible for its own obligations // owners are not liable
● Formation of a corporation: must be legally→ state must formally give consent
(costly)
, ● Ownership of a corporation: no limit on numbers of owners → entire ownership
stake of a corporation is divided into shares known as stock, all outstanding
shares of a corporation is known as equity.
○ An owner is known as shareholder, stockholder, or equity holder, entitled to
dividend payments
○ Free trade in shares
Tax implications for corporate entities
● Important difference between types of organizations → the way they are
taxed
● Corporation is a legal separate entity → profits subject to separate taxation →
shareholders pay tax twice: first on profits, then on profits distributed: double
taxation
● “S” Corporations are an exception from double taxation: profits are not subject to
corporate taxed, but go directly to the shareholders who must include these profits as
incomes on their individual tax returns; Strict limitations
● Most large corporations are “C” corporations, subject to corporate taxes
1.2 Ownership versus control of corporations
The corporate management team
● Shareholders of a corporation exercise their
control by electing a board of directors: a
group of people who have the ultimate decision-
making authority in the corporation
○ Makes rules on how the corporation
should be run, sets policy, monitor
the performance of the company →
delegates most decisions day-to-
day to management
● Chief executive officer (CEO): charged with
running the corporation by instituting rules and
policies set by board of director
● Separation board of directors & CEO not always distinct
● Chief Financial officer (CFO): most senior financial manager
The financial manager
● Financial managers → responsible for 3 tasks
○ Investment decisions
○ Financing decisions → how to pay for investments: raise/borrow
○ Cash management → does the firm have enough cash to meet day-to-
day obligations
,The goal of the firm
● Corporation → lots of shareholders, whose interests and priorities determine
firm’s goal
○ Most important goal shareholder: increase values of their shares
The firm and society
● Are decisions increasing the value of the firm's equity beneficial for society as a whole?
● Problem when raising equity at expense of others (polluting environment can be costly)
○ When harm is caused, appropriate public policy and regulation is required
Ethics and incentives within corporations: agency problem
● How can owners of a corporation ensure management will implement their goals?
● Agency problem occurs when managers out their own self-interest ahead of the
interest of shareholders
○ Minimizing the number of decisions managers must make for which their self-
interest differs from shareholders'.
○ Compensation contract → excessive/too little risk?\
● The CEO’s performance: unhappy with performance → pressure to oust CEO,
by lowering stock price
○ In a hostile replacement, someone can purchase a large fraction of the stock
and acquire enough votes to replace board of directors + CEO
○ Market for corporate control encourages managers + boards of directors to act in
interest of shareholders
● Corporate bankruptcy: When firms are unable to repay debt holders, control will be
transferred to them; debtholders can decide to keep the firm running or liquidation
○ Liquidation of the firm: shutting down the firm & selling its assets
● Two sets of investors: debt holders and equity holders, failing business →
change in ownership rather than failure of the underlying business
1.3 The stock market
● Private companies: limited set of shareholders, shares are not regularly traded, value
of shares can be difficulty determined
● Public companies: shares are traded on organized markets: stock markets/exchange
○ Stock markets provide liquidity: liquid if it is possible to sell it quickly & easy
Primary and secondary stock markets
● Primary market: when corporation issues new shares of stock → sells them to
investors
● Secondary market: trade between investors without involvement of the corporation
, Traditional trading venues
● NYSE: Market makers/specialists matched buyers and sellers posing 2 prices
○ Bid price (buy) and ask price (sell)
○ Liquid because they ensured there always were traders
● Market makers make money because ask price>bid price: the bid-ask price
New competition and market changes
● Now, most transactions occur electronically → anyone can make a market in
a stock by posting a limit order: an order to buy/sell a set amount at a fixed price
○ Limit sell order with lowest price → ask price and vice versa
○ Limit order book: collection of all limit orders
● Traders placing limit order provide liquidity < > traders who place market orders
“take”liquidity: orders that trade immediately at the best outstanding limit ordoer
● High frequency traders (HFT’s) are a class if traders who will place/update/
cancel/execute trades many times per second in response to new info/other orders
Dark pools
● Dark pools: Alternative trading systems that do not make their limit order books visible
○ Offer investors 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
1.4 Fintech: finance and technology
● FinTech: the relation between financial innovation and technical innovation
Telecommunications
● First telegraph to make the same security trading closer → cable → stock
sticker system → CRT technology → microwave technology
Security and verification
● Blockchain technology allows a transaction to be recorded in a pub;icly verifiable way
without the need for a trusted 3rd party to certify the authenticity of the transaction
● Cryptocurrency: a currency whose creation & ownership is determined via a public
blockchain (bitcoin)
Automation of banking services
● Robo-advisors: computer programs that are intended to replace the work of financial
advisors by providing detailed and customized investment recommendations
● ATM, automated customer service, online banking, apps (Tikkie)
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