Finance
Chapter 1 - The Corporation
1.1 The Four Types of Firms
- There are four major types of firms: sole proprietorships, partnerships, limited liability
companies, and corporations.
- Sole Proprietorship: a business owned and run by one person.
- The characteristics of a sole proprietorship:
1. Straightforward to set up - many new businesses use this organisational form.
2. No separation between the firm and the owner - it can only have one owner.
3. The owner has unlimited personal liability for any of the firm's debts.
4. The life is limited to the life of the owner.
- Partnership: identical to a sole proprietorship, but has more than one owner.
- The characteristics of a partnership:
1. All parents are liable for the firms debts.
2. The partnership ends on the death or withdrawal of any single 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.
However, limited partners have Limited Liability, that is their liability is limited to their
investment.
- Limited Liability Company (LLC): a limited partnership without a general partner.
That is, all the owners have limited liability, but unlike limited partners, can also run the
business.
- Corporation: a legally defined, artificial being, separate from its owners. As such, it
has many of the legal powers that people have.
- The characteristics of a corporation:
1. They must be legally formed - the state in which it is incorporated must give
consent.
2. No limit on the number of owners a corporation can have.
3. No limitation on who can own its stock.
- A S Corporation are corporations that have exemption from double taxation. Here,
the firm's profits are not subject to corporate taxes, but instead are allocated directly to
shareholders based on their ownership stake.
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- Most large corporations are C Corporations, which are corporations that are subject
to corporate taxes. These have no restriction on who owns their shares or the number
of shareholders, and they cannot qualify for subchapter S treatment.
1.2 Ownership Versus Control or Corporations
- The ownership of a corporation is divided into shares of stock collectively known as
Equity. Investors in the shares are known as Shareholders, Stockholders, or
Equity Holders.
- 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 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 managers is the Chief Financial Officer
(CFO) that reports directly to the CEO.
- The financial managers has three main tasks:
1. Making investment decisions
2. Make financing decisions - which investments to make and how to pay for them
3. Managing the firm's cash flows - ensure enough cash for day-to-day obligations
- Agency Problem: when managers, despite being hired as the agents of
shareholders, put their own self-interest ahead of the interests of the shareholders.
They face the ethical dilemma of whether to adhere to their responsibility to put the
interests of shareholders first, or to do what is in their own personal best interest.
- Hostile Takeover: where an individual or organisation can purchase a large fraction
of the stock and acquire enough votes to replace the board of directors and the CEO.
- Liquidation: involves shutting down the business and selling off its assets.
- 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.
1.3 The Stock Market
- Shareholders would like the firm's managers to maximise the value of their investment
in the firm. The value of their investment is determined by the price of a share of the
corporation's stock.
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- 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.
- Public Companies: organisations whose shares trade of organised markets called a
stock market.
- Stock markets provide Liquidity and determine a market price for the company's
shares. An investment is said to be Liquid if it is possible to sell it quickly and easily
for a price very close to the price at which you could contemporaneously buy it.
- 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 Markets between
investors without the involvement of the corporation.
- Traditional trading venues → Market Makers match buyers and sellers - post 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 were willing to sell the
stock (the Ask Price).
- Market makers make money because they ask prices higher than the bid prices. This
difference is known as the Bid-Ask Spread. The bid-ask spread is a Transaction
Cost investors pay in order to trade.
- New competition and market changes → The role of an official market maker has
disappeared. All transactions occur electronically with computers matching buy and
sell orders, so anyone can make a market in stock by posting a Limit Order - an
order to buy or sell a set amount at a fixed price. The collection of limit orders is
known as the Limit Order Book. Traders who post limit order provide the market with
liquidity.
- High Frequency Traders (HFTs): class of traders, that with the aid of computers, will
place, update, cancel, and execute trades many times per second in response to new
information as well as others, profiting both by providing liquidity and by taking
advantage of stale limit orders.
- When trading on an exchange, investors are guaranteed the opportunity to trade
immediately at the current bid or ask price, and tractions are visible to all traders when
they occur. In contrast, alternative trading systems, known as Dark Pools, do not
make their limit order books visible, but 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.
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