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Investing & Investing Summary Chapter 1-8 (English)
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A summary for the midterm of Investing & Investing. The summary is based on the book (global edition) and the lectures.
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Chapter 1: The corporation1.1: The four types of firms
1. Sole proprietorship
= business owned and run by 1 person
- Straightforward to set up
- Can only be 1 owner. Investors cannot hold an ownership stake in the firm
- Unlimited personal liability for any debts of the firm
- Difficult to transfer ownership. Life of a proprietorship is usually limited to the life of the owner
* Often the form of business starters have. Responsible for very little revenue of the total revenue
2. Partnerships
= identical to sole proprietorship but with multiple owners
- all partners are personally liable for any of the firm’s debts
- partnership ends with the death or withdrawal of any single partner. This can be avoided with
agreements about alternatives such as a buyout
* Often used as a business form if the owner’s reputation is important. Groups of lawyers or doctors.
2.1. Limited partnerships
= partnerships with 2 kinds of owners:
- General partner = all the rights, privileges and debts liabilities
- Limited partner = liability is limited to their investment. Less rights and privileges
3. Limited liability companies
= a limited partnership without a general partner. All the owners have limited liability but can still run
the company
* Relatively new phenomenon. Businesses are usually older and established
4. Corporations
= a legally defined artificial being separate from its owners. A corporation has many legal powers that
people have but no person is responsible for its obligations
- Corporations must be legally formed, which means it is costly, corporation becomes citizen of the
state in which it is incorporated. Corporate charter includes formal articles of incorporation and a set
of bylaws (rules which dictate how the corporation is run)
- No limit on amount of owners. Ownership is divided into fractions which are known as shares.
Shareholders earn a fraction of the dividends comparable to their fraction of the ownership.
- Unique feature of corporation: no limitation on who can own the stock (no expertise or
qualifications required)
Corporation has to pay taxes over its profits. Afterwards shareholders have to pay tax over their
dividend income. This is referred to as double taxation and only happens in corporations.
‘S’ corporations = ‘corporations that elect subchapter S tax treatment. The firm’s profits are hereby
not subject to taxes, so no double taxation’
-> strict limitations. All owners must be U.S. citizens and there can be max. 100 of them
‘C’ corporations = ‘corporations that do not meet requirements for ‘S’ corporations. They have to be
corporate taxes’
1.2: Ownership versus control of corporations
Direct control of a corporation comes to 2 groups:
1. The board of directors
,= chosen by shareholders to represent their interests in the company, 1 share is 1 vote
-> makes rules on how the company is run, sets policy, monitors performance of the company
2. The chief executive officer
= responsible for running the corporation by instituting the rules and policies set by the board of
directors
-> CEO can be chairman of board of directors
Chief financial officer = ‘most senior financial manager who reports directly to CEO’
Financial managers are responsible for three main tasks
1. Managing investments decisions
= most important task. Weighing the costs and benefits of potential investments to grow the firm
2. Managing financial decisions
= figuring out in what way the company should finance the investments
3. Managing the cash flows
= making sure that access to cash does not hinder the firm’s success
Good public policy should allow firms to pursue maximization of shareholder value whilst also
benefiting society overall.
Agency problem = ‘separation of ownership and management creates a problem where managers
have to choose between the interests of the shareholders and their own interests’
-> Solved by tying the manager’s reward to profits or stock price
-> Problems arise when manager’s rewards are tied to closely to performance or to loose
CEO’s performance dictates stock prices. Board of directors can decide because of bad performance
or low stock prices to oust the CEO but that happens rarely. Publicly traded stocks create a market
for corporate control which motivates the CEO to act in the interests of shareholders
Hostile takeover = ‘When a company is performing badly another company might decide to buy a
substantial amount of shares to replace board of directors and CEO. Good management may give rise
to stock prices and a profit for the ‘corporate raider’.’
When a corporation cannot meet the demands of their debt owners. Ownership is transferred from
equity holders to debt holders. This does not have to mean liquidation, where all the assets are sold
and the company seizes to exist. Most often the debt holders continue to operate the business in the
most profitable way.
1.3: The stock market
Private companies have a limited set of shareholders so their stock price is hard to determine
Public companies have unlimited shareholders and their stock price is determined on the stock
market.
An investment is liquid when it can be sold quickly for a good value
Primary market = when you buy shares directly from a company
Secondary market = when you buy shares from another shareholder (most often)
, Traditionally market makers would post 2 prices at which they would buy the stock (bid price) and
sell the stock (ask price). They provided liquidity because buyers and sellers didn’t need to find each
other.
Bid-ask spread = different between buying and selling price. This was profit for the market makers
Limit order = an order to buy or sell a set amount of stocks at a fixed price
-> Provide liquidity to the stock market
Market order = orders that trade immediately to the outstanding market price
-> Takes liquidity from the stock market
High frequency traders = use their computers to place, update, cancel and execute trades many times
per second in response to new information
If they don’t do that, new information can cause limit orders to become outdated and taken
advantage of because for example the price of the stock has risen
Dark pools = alternative trading system with no limit order books visible. Offers investors 1 price
(average of bid-ask) with the trade-off being that their order might not be completed if buyers and
sellers are not in equilibrium.
Chapter 2: Introduction to financial statement analysis
2.1: firms’ disclosure of financial information
Financial statement = ‘accounting reports with past performance information that a firm issues
periodically’
US public companies are required to file 10-Q reports (quarterly) and 10-K reports (annually)
They file these with the Securities and Exchange Commission (SEC) but annual reports must also be
published to shareholders
Financial statements must be prepared in accordance with Generally Accepted Accounting Principles
(GAAP). GAAP provides a common set of rules and a standard format for reports. Reports must also
be checked by a neutral third party, auditors, to make sure they are reliable and prepared according
to GAAP.
Every public company is required to produce four financial statements:
1. The balance sheet
2. The income statement
3. The statement of cash flows
4. The statement of stockholders’ equity
2.2: The balance sheet
= lists the firm’s assets and liabilities, providing a snapshot of the firm’s financial position at a given
point in time (also called: statement of financial position)
Assets (left side) show how the firm uses its capital/investments.
The right side shows the sources of capital, or how the firm raises money.
Current assets = cash or assets that could be converted into cash within one year:
1. Cash and other marketable securities: short-term, low risk and can be easily sold
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