Summary Chapter 1 Finance:
THE FOUR TYPES OF FIRMS
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.
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 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.
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or withdrawn partner.
Limited partnership is partnership with two kinds of owners, general- and
limited partners.
o General partners have the same rights and privileges as partners in
a (general) partnership—they are personally liable for the firm’s
debt obligations.
o Limited partners have limited liability—their liability is limited to
their investment. Their private property cannot be seized to pay off
firm’s outstanding debts.
Furthermore, death or withdrawal of limited partner does not dissolve the
partnership, and a limited partner’s interest is transferable.
A limited partner has no management authority and 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 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 are not liable for any obligations the corporation
enters into.
Formation of a corporation:
o 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.
Ownership of a corporation:
o There is no limit on number of owners corporation can have. Most
corporations have many owners, each owner owns only small
fraction of corporation.
o 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.
o 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.
o This feature allows free trade in the shares of the corporation and
provides one of the most important advantages of organizing a firm
as a corporation rather than as sole proprietorship, partnership, or
LLC. Corporations can raise substantial amounts of capital because
they can sell ownership shares to anonymous outside investors.
Tax implications for corporate entities:
Because corporation is a separate legal entity, a corporation’s 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 on this income. This system is sometimes referred to
as double taxation.
OWNERHSHIP VERSUS CONTROL OF CORPORATIONS
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.
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.
company.
The most senior financial manager is the chief financial officer (CFO), who
often reports directly to the CEO.
,The financial manager:
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.
Cash management: The financial manager must ensure that the firm
has enough cash on hand to meet its day-to-day obligations.
The goal of the firm:
Many corporations have thousands of shareholders. Each owner is likely to
have different interests and priorities. Whose interests and priorities
determine the goals of the firm?
The firm and society:
But even if the corporation only makes its shareholders better off, as long
as nobody else is made worse off by its decisions, increasing the value of
equity is good for society.
The problem occurs when increasing the value of equity comes at the
expense of others.
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 problems:
o The agency problem is when managers, despite being hired as the
agents of shareholders, put their own self-interest ahead of the
interests of shareholders.
o Managers 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 best interest.
o By tying compensation too closely to performance, the shareholders
might be asking managers to take on more risk than they are
comfortable taking.
o Further potential for conflicts of interest and ethical considerations
arise when some stakeholders in the corporation benefit and others
lose from a decision.
o When these decisions benefit other stakeholders at shareholders’
expense, they represent a form of corporate charity. Indeed, many
corporations explicitly donate to local and global charitable and
political causes.
The CEO’s performance:
o Another way shareholders can encourage managers to work in the
interests of shareholders is to discipline them if they don’t. If
shareholders are unhappy with a CEO’s performance, they could, in
principle, pressure the board to oust the CEO.
, o If enough shareholders are dissatisfied, the only way to entice
investors to buy the shares is to offer them a low price. Similarly,
investors who see a well-managed corporation will want to purchase
shares, which drives the stock price up.
o Thus, stock price of corporation is barometer for corporate leaders
that continuously gives them feedback on their shareholders’
opinion of their performance.
o In hostile takeover individual or organization— corporate raider—
can purchase large fraction of stock and acquire enough votes to
replace board of directors and CEO.
Corporate bankruptcy:
o While the debt holders do not normally exercise control over the
firm, 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.
o Bankruptcy need not result in a liquidation of the firm, which
involves shutting down the business and selling off its assets. Even
if control of firm passes to debt holders, it is in the debt holders’
interest to run the firm in the most profitable way possible.
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 organized
markets called a stock market (or stock exchange).
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 markets:
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 market between investors without
the involvement of the corporation.
Traditional trading venues:
Market makers (known then on the NYSE as specialists) matched buyers
and sellers. They posted two prices for every stock in which they made a
market: the price at which they were willing to buy the stock (the bid
price) and the price at which they were willing to sell the stock (the ask
price).
When a customer arrived and wanted to make a trade at these prices, the
market maker would honour the posted prices (up to a limited number of
shares) and make the trade even when they did not have another
customer willing to take the other side of the trade.
An important difference between the NYSE and Nasdaq was that on the
NYSE, each stock had only one market maker. On the Nasdaq, stocks had
multiple market makers who competed with one another.
THE FOUR TYPES OF FIRMS
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.
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 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.
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.
Limited partnership is partnership with two kinds of owners, general- and
limited partners.
o General partners have the same rights and privileges as partners in
a (general) partnership—they are personally liable for the firm’s
debt obligations.
o Limited partners have limited liability—their liability is limited to
their investment. Their private property cannot be seized to pay off
firm’s outstanding debts.
Furthermore, death or withdrawal of limited partner does not dissolve the
partnership, and a limited partner’s interest is transferable.
A limited partner has no management authority and 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 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 are not liable for any obligations the corporation
enters into.
Formation of a corporation:
o 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.
Ownership of a corporation:
o There is no limit on number of owners corporation can have. Most
corporations have many owners, each owner owns only small
fraction of corporation.
o 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.
o 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.
o This feature allows free trade in the shares of the corporation and
provides one of the most important advantages of organizing a firm
as a corporation rather than as sole proprietorship, partnership, or
LLC. Corporations can raise substantial amounts of capital because
they can sell ownership shares to anonymous outside investors.
Tax implications for corporate entities:
Because corporation is a separate legal entity, a corporation’s 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 on this income. This system is sometimes referred to
as double taxation.
OWNERHSHIP VERSUS CONTROL OF CORPORATIONS
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.
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.
company.
The most senior financial manager is the chief financial officer (CFO), who
often reports directly to the CEO.
,The financial manager:
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.
Cash management: The financial manager must ensure that the firm
has enough cash on hand to meet its day-to-day obligations.
The goal of the firm:
Many corporations have thousands of shareholders. Each owner is likely to
have different interests and priorities. Whose interests and priorities
determine the goals of the firm?
The firm and society:
But even if the corporation only makes its shareholders better off, as long
as nobody else is made worse off by its decisions, increasing the value of
equity is good for society.
The problem occurs when increasing the value of equity comes at the
expense of others.
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 problems:
o The agency problem is when managers, despite being hired as the
agents of shareholders, put their own self-interest ahead of the
interests of shareholders.
o Managers 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 best interest.
o By tying compensation too closely to performance, the shareholders
might be asking managers to take on more risk than they are
comfortable taking.
o Further potential for conflicts of interest and ethical considerations
arise when some stakeholders in the corporation benefit and others
lose from a decision.
o When these decisions benefit other stakeholders at shareholders’
expense, they represent a form of corporate charity. Indeed, many
corporations explicitly donate to local and global charitable and
political causes.
The CEO’s performance:
o Another way shareholders can encourage managers to work in the
interests of shareholders is to discipline them if they don’t. If
shareholders are unhappy with a CEO’s performance, they could, in
principle, pressure the board to oust the CEO.
, o If enough shareholders are dissatisfied, the only way to entice
investors to buy the shares is to offer them a low price. Similarly,
investors who see a well-managed corporation will want to purchase
shares, which drives the stock price up.
o Thus, stock price of corporation is barometer for corporate leaders
that continuously gives them feedback on their shareholders’
opinion of their performance.
o In hostile takeover individual or organization— corporate raider—
can purchase large fraction of stock and acquire enough votes to
replace board of directors and CEO.
Corporate bankruptcy:
o While the debt holders do not normally exercise control over the
firm, 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.
o Bankruptcy need not result in a liquidation of the firm, which
involves shutting down the business and selling off its assets. Even
if control of firm passes to debt holders, it is in the debt holders’
interest to run the firm in the most profitable way possible.
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 organized
markets called a stock market (or stock exchange).
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 markets:
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 market between investors without
the involvement of the corporation.
Traditional trading venues:
Market makers (known then on the NYSE as specialists) matched buyers
and sellers. They posted two prices for every stock in which they made a
market: the price at which they were willing to buy the stock (the bid
price) and the price at which they were willing to sell the stock (the ask
price).
When a customer arrived and wanted to make a trade at these prices, the
market maker would honour the posted prices (up to a limited number of
shares) and make the trade even when they did not have another
customer willing to take the other side of the trade.
An important difference between the NYSE and Nasdaq was that on the
NYSE, each stock had only one market maker. On the Nasdaq, stocks had
multiple market makers who competed with one another.
