FINANCE 1
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,Week 1 – Chapters 1,2,3 and Paper Hart and Zingales
Chapter 1: The Corporation
➢ Reproduce the organizational chart of a corporation and the financial functions
➢ Evaluate the objective of shareholder value maximization including limits: principal
agent problem and externalities
➢ Understand the implications and remedies of separation of ownership and control in
corporations: agency problems like excessive risk, partial solutions like executive
compensation.
➢ Understand bankruptcy and ownership claims of debt and equity holders.
➢ Describe how stocks are traded, bid ask spread, role of market makers.
The Four Types of Firms
We begin our study of corporate finance by introducing the four major types of firms:
sole proprietorships, partnerships, limited liability companies, and corporations.
Sole Proprietorships
A sole proprietorship is a business owned and run by one person. Sole proprietorships are
usually very small with few, if any, employees. 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 share the following key characteristics:
1. Sole proprietorships are straightforward to set up. Consequently, many new businesses
use this organizational form.
2. 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.
3. 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.
4. 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.
For most businesses, the
disadvantages of a sole
proprietorship outweigh the
advantages.
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,Partnerships
A partnership is identical to a sole proprietorship except it has more than one owner. The
following are key features of a partnership:
1. 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.
2. 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. Firms with unlimited personal liability include sole proprietorships and
partnerships.
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,
however, have limited liability—that is, their liability is limited to their investment.
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.
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.
Because a corporation is a legal entity separate and distinct from its owners, it is solely
responsible for its own obligations. Consequently, 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.
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. Setting up a corporation is
therefore considerably more costly than setting up a sole proprietorship.
There is no limit on the number of owners a corporation can have. Because most corporations
have many owners, each owner owns only a small fraction of the 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.
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, 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.
Advantages
➢ Clear objective: clearly defined number available in stock market.
➢ Smart price: share price determined in competitive market using a lot of information
and provides a clear trade-off between different moments in time. (as it is all about the
effect on current value)
Disadvantages
➢ A higher share price might no9t be good for all stakeholders. This happens when
contracts are not sufficiently complete and some externalities are not taken into
account when determining market prices. In that case certain actions by the firm can be
wealth decreasing for society (consider environmental pollution, massive layoffs, etc.)
➢ Separation between ownership and control may give managers leeway to deviate from
this objective and act in their own interest (agency costs)
➢ Stock markets may not give a correct representation of value (i.e. bubble)
Tax Implications for Corporate entities
An important difference between the types of organizational forms is the way they are taxed.
Because a corporation is a separate legal entity, a corporation’s profits are subject to taxation
separate from its owners’ tax obligations.
In effect, 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 on this income. This system is sometimes
referred to as double taxation.
The corporate organizational structure is the only organizational structure subject to double
taxation. However, the U.S. Internal Revenue Code allows an exemption from double taxation
for “S” corporations, which are corporations that elect subchapter S tax treatment. They are
exempt from the corporate income tax.
The government places strict limitations on the qualifications for subchapter S tax treatment.
Because most corporations have no restrictions on who owns their shares or the number of
shareholders, they cannot qualify for subchapter S treatment. Thus, most large corporations
are “C” corporations, which are corporations subject to corporate taxes. S corporations
account for less than one quarter of all corporate revenue.
Ownership Versus Control of Corporations
It is often not feasible for the owners of a corporation to have direct control of the firm because
there are sometimes many owners, each of whom can freely trade his or her stock.
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