Finance 1
Source: Berk, J., & Demarzo, P. (2019). Corporate Finance, Global Edition (5th edition). Pearson Education Limited.
WEEK 1
CHAPTER 1: THE CORPORATION AND FINANCIAL MARKETS
In 1819 the Supreme Court ruled that owners of businesses could incorporate and still enjoy the protection of private
property, as well as protection from seizure. This would be the start of modern business corporation. The focus of
this book is on how people in corporations make financial decisions. This chapter introduces the corporation and
explains alternative business organizational forms. A key factor in the success of corporations is the ability to easily
trade ownership shares, and so we will also explain the role of stock markets in facilitating trading among investors
in a corporation and the implications that has for the ownership and control of corporations.
1.1 The Four Types of Firms
Sole Proprietorships
A sole proprietorship is a business owned and run by one person. Although they do not account for much sales
revenue in the economy, they are the most common type of firm in the world.
▪ 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.
▪ The owner has unlimited personal liability for any of the firm’s debts. 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.
When the firm can borrow without the owner agreeing to be personally liable, the firm is typically converted into a
different form.
Partnerships
A partnership is identical to a sole proprietorship except it has more than one owner.
▪ All partners are liable for the firm’s debt.
▪ 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the partnership agreement provides for alternatives such as a buyout of a deceased or withdrawn partner.
Some old and established businesses remain partnerships or sole proprietorships. Often these firms are the types of
businesses in which the owners’ personal reputations are the basis for the businesses.
A limited partnership is a partnership with two kinds of owners, general partners and limited partners.
General partners are personally liable for the firm’s debt obligations. The general partners control how all the
capital is invested.
Limited partners have limited liability: their liability is limited to their investment. The death or withdrawal of a
limited partner does not dissolve the partnership, and a limited partner’s interest is transferable. A limited
partner cannot legally be involved in the managerial decision making for the business.
Limited Liability Companies
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. This is a relatively new phenomenon in
the US, not in Europe.
Corporations
The distinguishing feature of a corporation is that it is a legally defined, artificial being (a judicial person or legal
entity), separate from its owners. The owners of a corporation (or its employees, customers, etc.) are not liable for
any obligations the corporation enters into. Similarly, the corporation is not liable for any personal obligations of its
owners.
Formation of a Corporation: the state in which it is incorporated must formally give its consent to the
incorporation by chartering it → more costly than setting up a sole proprietorship. A corporate charter is created
that specifies the initial rules that govern how the corporation is run
Ownership of a Corporation: 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. There is
free trade in the shares of the corporation which raises substantial amount of capital. This is the reason that
corporations dominate the economy.
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, Tax Implications for Corporate Entities
Because a corporation is a separate legal entity, a corporation’s profits are subject to taxation separate from its
owners’ tax obligations. First, the corporation pays tax on its profits, and then when the remaining profits are
distributed to the shareholders, the shareholders pay their own personal income tax on this income. This system is
sometimes referred to as double taxation
1.2 Ownership Versus Control of Corporations
Rather than the owners, the board of directors and chief executive officer possess direct control of the corporation.
The Corporate Management Team
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. When one or two shareholders own a very large proportion
of the outstanding stock, these shareholders may either be on the board of directors themselves, or they may have
the right to appoint a number of directors. The board of directors makes rules on how the corporation should be run
(including how the top managers in the corporation are
compensated), 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 separation of
powers within corporations between the board of directors
and the CEO is not always distinct. The most senior financial
manager is the chief financial officer (CFO), who often
reports directly to the CEO.
The Financial Manager
Within the corporation, financial managers are responsible
for three main tasks: making investment decisions, making
financing decisions, and managing the firm’s cash flows.
▪ Investment Decisions: The financial manager must weigh the costs and benefits of all investments and projects
and decide which of them qualify as good uses of the money stockholders have invested in the firm.
▪ Financing Decisions: The financial manager must decide whether to raise more money from new and existing
owners by selling more shares of stock (equity) or to borrow the money (debt).
▪ Cash Management (managing working capital): The financial manager must ensure that the firm has enough
cash on hand to meet its day-to-day obligations. Harder than it looks!
The Goal of the Firm
In theory, the goal of a firm should be determined by the firm’s owners. A sole proprietorship has a single owner who
runs the firm, so the goals of a sole proprietorship are the same as the owner’s goals. But in organizational forms
with multiple owners, the appropriate goal of the firm—and thus of its managers—is not as clear. The interests of
shareholders are aligned for many, if not most, important decisions. That is because, regardless of their own
personal financial position and stage in life, all the shareholders will agree that they are better off if management
makes decisions that increase the value of their shares.
The Firm and Society
Most often the decisions that increase the value of the firm’s equity are beneficial for society as a whole, even if it
only makes the shareholders of the corporation better off (as long as nobody else is made worse off). The problem
occurs when increasing the value of equity comes at the expense of others, then these decisions can be costly for
society. When the actions of the corporation impose harm on others in the economy, appropriate public policy and
regulation is required to assure that corporate interests and societal interests remain aligned. Sound public policy
should allow firms to continue to pursue the maximization of shareholder value in a way that benefits society overall.
Ethics and Incentives within Corporations
How can the owners of a corporation ensure that the management team will implement their goals?
▪ Agency Problems: agency problem = when managers, despite being hired as the agents of shareholders, put
their own self-interest ahead of the interests of shareholders (ethical dilemma). Solution: minimizing the
number of decisions managers must make for which their own self-interest substantially differs from the
interests of the shareholders. But by tying compensation too closely to performance, the shareholders might be
asking managers to take on more risk than they are comfortable taking. Further potential for conflicts of interest
and ethical considerations arise when some stakeholders in the corporation benefit and others lose from a
decision. When these concern actions only the corporation can take, it is appropriate for the firm’s managers to
weigh conflicting shareholder preferences in their decision making.
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