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Detailed summary of finance
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Chapter 1: the corporation1.1. the four types of firms
A sole proprietorship is a business owned and run by one person. Sole proprietorships
are usually very small with few, if any, employees.
Sole proprietorships share the following key characteristics:
Sole proprietorships are straightforward to set up.
The principal limitation of a sole proprietorship is that there is no separation
between the firm and the owner – the firm can have only one owner. If there are
other investors, they cannot hold an ownership stake in the firm.
The owner has unlimited personal liability for any of the firm’s debts. That is, if
the firm defaults on any debt payment, the lender can (and will) require the
owner to repay the loan from personal assets. An owner who cannot afford to
repay the loan must declare personal bankruptcy.
The life of a sole proprietorship is limited to the life of the owner. It is also difficult
to transfer ownership of a sole proprietorship.
A partnership is identical to a sole proprietorship except it has more than one owner.
The following are key features of a partnership:
All partners are liable for the firm’s debt. That is, a lender can require any partner
to repay all the firm’s outstanding debts.
The partnership ends on the death or withdrawal of any single partner, although
partners can avoid liquidation if the partnership agreement provides for
alternatives such as a buyout of a deceased or withdrawn partner.
A limited partnership is a partnership with two kinds of owners, general partners and
limited partners.
General partners have the same rights and privileges as partners in a (general)
partnership – they are personally liable for the firm’s debt obligations.
Limited partners have limited liability – that is, there liability is limited to their
investment.
A limited liability company (LLC) is a limited partnership without a general partner.
That is, all the owners have limited liability, but unlike limited partners, they can also run
the business.
A feature of a corporation is that it is a legally defined, artificial being (a judicial person
or legal entity), separate from its owners. Corporations must be legally formed, which
means that the state in which it is incorporated must formally give its consent to the
incorporation by chartering it. There is no limit on the number of owners a corporation
can have.
The entire ownership stake of a corporation is divided into shares known as stock. The
collection of all the outstanding shares of a corporation is known as the equity of the
corporation. An owner of a share of stock in the corporation is known as a shareholder,
stockholder, or equity holder and is entitled to dividend payments, that is,
payments made at the discretion of the corporation to its equity holders.
An important difference is the way they are taxed. Shareholders of a corporation pay
taxes twice, double taxation. First, pays the company tax on its profits, and the
shareholders pay their own personal income tax on the dividend income.
The U.S. Internal Revenue Code allows an exemption from double taxation for “S”
corporations, which are corporations that elect subchapter S tax treatment. Under
these tax regulations, the firm’s profits (and losses) are not subject to corporate taxes,
but instead are allocated directly to shareholders based on their ownership share.
Finance summary
,Most large corporations are “C” corporations, where you don’t know who owns their
shares. Which are corporations subject to corporate taxes.
1.2. ownership versus control of corporations
The 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. The board of directors makes rules on how the corporation should be run,
sets policy, and monitors the performance of the company. The board of directors
delegates most decisions that involve day-to-day running of the corporation to its
management. The chief executive officer (CEO) is charged with running the
corporation by instituting the rules and policies set by the board of directors. The most
senior financial manager is the chief financial officer (CFO), who often reports directly
to the CEO.
Within the corporation, financial managers are responsible for three main tasks: making
investment decisions, making financial decisions, and managing the firm’s cash flows.
In theory, the goal of a firm should be determined by the firm’s owners. Even when all
the owners of a corporation agree on the goals of the corporation, these goals must be
implemented.
Agency problem is when managers, despite being hired as the agents of shareholders,
put their own self-interest ahead of the interests of shareholders.
In a hostile takeover, an individual or organization – sometimes known as a corporate
raider – can purchase a large fraction of the stock and acquire enough votes to replace
the board of directors and the CEO.
When a firm fails to repay its debts, the end result is a change in ownership of the firm,
with control passing from equity holders to debt holders. Importantly, bankruptcy need
not result in a liquidation of the firm, which involves shutting down the business and
selling off its assets.
A useful way to understand corporations is to think of there being two sets of investors
with claims to its cash flows – debt holders and equity holders. As long as the
corporation can satisfy the claims of the debt holders, ownership remains in the hands of
the equity holders. If the corporation fails to satisfy debt holders’ claims, debt holders
may take control of the firm. Thus, a corporate bankruptcy is best thought of as a
change in ownership of the corporation, and not necessarily as a failure of the underlying
business.
Finance summary
, 1.3. the stock market
Private companies have a limited set of shareholders, and their shares are not
regularly traded, the value of their shares can be difficult to determine. But many
corporations are public companies, whose shares trade on organized markets called
stock market (or stock exchange).
These markets provide liquidity and determine a market price for the company’s shares.
An investment is said to be liquid if it is possible the sell it quickly and easily for a price
very close to the price at which you could buy it. This liquidity is attractive to outside
investors, as it provides flexibility regarding the timing and duration of their investment
in the firm. In addition, the research and trading of participants in these markets give
rise to share prices that provide constant feedback to managers regarding investors’
view of their decisions.
When a corporation itself issues new shares of stock and sells them to investors, it does
so on the primary market. After this initial transaction between the corporation and
investors, the shares continue to trade in a secondary market between investors
without the involvement of the corporation.
Market makers (or specialists) matched buyers and sellers. They posted two prices
for every stock in which they made a market: the price at which they are willing to buy
the stock (the bid price) and the price at which they are willing to sell the stock (the
ask price). When a customer arrived and wanted to make a trade at these prices, the
market maker would honor the posted prices (up to a limited number of shares) and
make a trade even when they did not have another customer willing to take the other
side of the trade. In this way, market makers provided liquidity by ensuring that market
participants always had somebody to trade with.
Market makers make money because ask prices are higher than bid prices. This
difference is called the bid-ask spread. Customers always buy at the ask (the higher
price) and sell at the bid (the lower price). The bid-ask spread is a transaction cost
investors pay in order to trade.
With a change in market structure, the role of an official market maker has largely
disappeared. Because all transactions occur electronically with computers matching buy
and sell orders, anyone can make a market in a stock by posting a limit order – an
order to buy or sell a set amount at a fixed price.
Traders make the market in stock by posting limit buy and sell orders. The collection of
all limit orders is known as the limit order book. Exchanges make their limit order
books public so that investors (or their brokers) can see the best bid and ask prices
when deciding where to trade.
Traders who post limit orders provide the market with liquidity. On the other hand,
traders who place market orders – orders that trade immediately at the best
outstanding limit order – are said to be “takers” of liquidity.
The high frequency traders (HFTs) are a class of traders who, with the aid of
computers, will place, update, cancel, and execute trades many times per second in
response to new information as well as other orders, profiting both by providing liquidity
and by taking advantage of stale limit orders.
Finance summary
, When trading on an exchange, investors are guaranteed the opportunity to trade
immediately at the current bid or ask price, and transactions are visible to all traders
when they occur. In contrast, alternative trading systems called dark pools do not make
their limit order books visible. Instead, these dark pools offer investors the ability to
trade at a better price, with the tradeoff being that the order might not be filled if an
excess of either buy or sell orders is received. Trading on a dark pool is therefore
attractive to traders who do not want to reveal their demand and who are willing to
sacrifice the guarantee of immediacy for a potentially better price.
Finance summary
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