Chapter 1
Four types of firms: sole proprietorship, partnerships, limited liability companies and corporations.
Sole Proprietorships
= a business owned and run by one person → small with no or few employees.
Key characteristics:
1. Sole proprietorships are straightforward to set up. Many new businesses use this
organizational form.
2. No separation between firm and owner.
3. Owner has unlimited personal liability for any of the firm’s debts.
4. Life of sole proprietorship is limited to the life of the owner.
Partnership
= identical to sole proprietorship except it has more than one owner
Key characteristics:
1. All partners are liable for the firm’s debt
2. The partnership ends on the death or withdrawal of any single partner.
Limited partnership: has two kinds of owners:
1. General partners: are personally liable for the firm’s debt obligations.
2. Limited partners: have limited liability, liability is limited to their investment. Their private
property cannot be seized to pay off the firm’s outstanding debts. + death or withdrawal of a
limited partner does not dissolve the partnership. However, a limited partner has no
management authority and cannot legally be involved in the managerial decision making for
the business.
Limited liability company
= a limited partnership without a general partner. All owners have limited liability, but unlike limited
partners they can also run the business.
Corporation
= a legally defined, artificial being, separate from its owners.
Formation of a corporation
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. A corporation is a citizen of the state
in which it is incorporated.
Ownership of a corporation
The entire ownership stake of a corporation is divided into shares/stock. The collection of all
outstanding shares 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.
,Tax implications for corporate entities
A corporation is a separate legal entity, so its profits are subject to taxation separate from its owners’
tax obligations. Shareholders of a corporation pay taxes twice. 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 in this income.
S Corporations = the only organizational structure subject to double taxation. Exception: subchapter
S tax treatment → firm’s profits (and losses) are not subject to corporate taxes, but instead are
allocated directly to shareholders based on their ownership share.
C corporations: most large corporations → are subject to corporate taxes.
Ownership versus control of corporations
Shareholders 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 policies, and monitors
the performance of the company. Decisions on day-to-day running of the corporation is delegated to
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 Chief Financial Officer (CFO) is the most senior financial manager
Financial managers are responsible for three main tasks
1. 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.
2. Financing decisions. How do we finance the investments made? Selling more shares or
borrow money?
3. Cash management. Make sure that the firm has enough cash on hand to meet its day-to-day
obligations = managing working capital.
The firm and society
Most often decisions that increase the value of the firm’s equity are beneficial 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.
Ethics and incentives within corporations
Agency problem: when managers, despite being hired as the agents of shareholders, put their own
self-interest ahead of the interests of shareholders. This problem is commonly addressed in practice
by minimizing the number of decisions managers must make for which their own self-interest
substantially differs from the interest of the shareholders.
Further potential for conflicts of interest and ethical considerations arise when some stakeholders in
the corporation benefit and others lose from a decision.
The CEOs performance: shareholders can encourage managers to work in their interests by
disciplining them if they don’t. If shareholders are unhappy with a CEOs performance, they could
pressure the board to oust the CEO. This doesn’t happen very often. More common is that unhappy
investors sell their shares.
, Hostile takeover: an individual or organization – sometimes known as corporate raider – can
purchase a large fraction of the stock and acquire enough votes to replace the board of directors and
CEO.
Corporate Bankruptcy: if the corporation fails to repay its debts, the debt holders are entitled to seize
the assets of the corporation in compensation for the default. To prevent this, the firm may attempt
to renegotiate with de debt holders, or file for bankruptcy protection in federal court. Eventually, if
the firm is unable to repay or renegotiate with the debt holders, the control of the corporations
assets will be transferred to them → change of ownership. Importantly, bankruptcy doesn’t need to
result in a liquidation, which involves shutting down the business and selling off its assets.
The stock market
Because 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 stock markets where the value is easy to see. 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.
Primary and secondary stock market
Primary market: when a corporation itself issues new shares of stock and sells them to investors.
Secondary market: trade between investors without the involvement of the corporation.
Traditional trading venues
Bid price: price at which men is willing to buy the stock.
Ask price: price at which men is willing to sell the stock.
NYSE: New York Stock Exchange
NASDAQ: National Association of Security Dealers Automated Quotation.
Market makers (specialists on NYSE) matched buyers and sellers. They set a bid and ask price. When
a costumer came the market maker would honour its posted prices and make the trade. → liquidity
by ensuring that market participants always had somebody to trade with.
On the NASDAQ market all trades were completed over the phone or on a computer network. Here
there are multiple market makers, posting bid and ask prices, and competing with each other.
Market makers make money because ask prices are higher than bid prices. This difference is the bid-
ask spread. Costumers always buy at the ask and sell at the bid. The bid-ask spread is a transaction
cost investors pay in order to trade.
New competition and market changes
Over time the competition of NYSE and NASDAQ increased. Now, most exchange markets are fully
electronic. Because of this 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 all limit orders is known as the limit order
book.
Traders who place market orders - orders that trade immediately at the best outstanding limit order -
are said to be takers of liquidity.
High Frequency Traders (HFTs): 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.
