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Chapter 1: Introduction

Saturday, September 3, 2016

3:34 PM

Corporations were not always private as they are today

Law was passed in 1819 establishing that property of corporation is
private and entitled to protection under constitution
Protection from property seizure by the state or federal government
1.1 Four Types of Firms
Sole proprietorship

Business owned and run by one person
Most common type of firm in the world
Dont generate that much revenue
Key characteristics:
Straightforward to set up

No separation between firm and owner (other investors cannot

hold an ownership stake in the firm)

Owner has unlimited personal liability for any of the firm's debts

Life of sole proprietorship limited to life of owner (diffeicult to

trasnfer ownership)
Disadvantages generally outweigh advantages
If firm reaches point where it can borrow without owner agreeing to be
personally liable, owners typically convert business into a form that limits
owner's liability

Identical to sole proprietorship but more than one owner
Key characteristics:
All partners liable for firm's debt (any partner may be required to

pay debt
Partnership ends on death/withdrawal of any single partner (can

avoid this if partnership provides alternatives such as buyout of a

deceased or withdrawn partner)
Owner's personal reputation is bases of business (law firms, doctors,
accounting firms)
Limited partnership
2 types of owners: general partners and limited partners

General partners liable for firm debt

Limited partners --> limited liability: liability limited to their

investment (ex. Private property cannot be seized to pay debt)

Death or withdrawal of limited partner doesnt dissolve


Interest is transferable

No management authority

Cannot legally be involved in managerial decision making

Limited liability companies (LLC)

Limited partnership without a general partner

All owners have limited liability, but can still run the business
Legally defined, artificial being separate from its owners
Has many legal power that people have
Can enter into contracts, acquire assets, incur obligations

Protected under constituetion against seizure of property

Owners (employees, customers, etc.) not liable for any obligations the
corporation enters into
Corporation not liable for any personal obligations of its owners
Must be legally formed (state gives a charter)

More costly than setting up sole proprietorship

Delaware hot spot for incorporating

No limit on owners

Each owner owns small fraction of corporation

Ownership divided into shares or stock

All shares put together are known as the equity of a corporation

Onwer of a share is a shareholder, stockholder, or equity holder

Entitled to divident payments (payments made at the

discretion of the corporation to its equity holders)
No limitation to who can own stock

Allows free trade of shares

Availability of outside funding enables corporations to dominate


Tax implications for corporate entities

Because corporation is separate legal entity, corporation's profits are subject

to taxation separate from owners' tax obligations

Shareholders pay taxes twice (double taxation)

First, corporation pays tax on profits
Then when remaining proftis distrivuted to shareholders, shareholders
pay their own personal income tox on this income
S corporations

Exempt from double taxation
S corporations are corporations that elect subchapter S tax
Firm's porfits are not subject to corporate taxes, but instead are
allocated directly to shareholders based on their ownership share
Shareholders must include profits as income on individual tax returns
Less than 1/4 of all corporate revenue
C corporations

Majority of corporations
Subject to corporate taxes
1.2 Ownership versus Control of Corporations
Direct control and ownership are separate- too many owners

Board of directors and CEO possess direct control of corporation

Corporate management team
Shareholders elect a board of directors: group of people who have the
ultimate decision making authority in the corporation
Each share of stock gives shareholder one vote in the election of board
of directors
B.o.D. delegates most decision that involve day to day running of
coproration to its management
CEO charged with running corporation by insttituting the rules and
policies set by B.o.D.
The financial manager
In carge of making investment decisions, making financing decisions,
and managing the firm's cash flows
Investment decisions
Weigh cost/benefit of investments and projects and decide which

of them qualify as good uses of money stockholders have invested in

the firm
Shape what firm does and whether it will add value for its

Financing decisions
Decide how to pay for investments

Raise more money from new and existing owners by selling

more shares of stock (equity)

Or borrow money (debt)

Cash management
Must ensure enough cash on hand to meet day to day

obligations (management working captaL0

Company typically burns through significant amount of cash

developing new product before sales generates income

The Goal of the Firm

For corporations with thousands of shareholders, most agree that they are

better off if management makes decisions that increase the value of their
The Firm and Society
Increasing value of equity is good for society (ex. iPhone)

Problem occurs when increasing value of equity comes at the expences of

others (ex. Pollution)

Ethics and Incentives within Corporations
Agency problems

Managers, despite being hired as agents of shareholders, put their own
self interest ahead of interest of shareholders
Solution is to minize number of decisions managers must make for
Ex. Manager compensation contracts (top manager salaries are usually
tied to corporation's porfits or stock price)

Another potential conflict: some stakeholders in the corporation benefit

and other lose from a decision (ex. keep a factory generating loss to
provide jobs in a small town; or Walmart donates millions to charitydecreases value of shares but may reflect values of some, but not all,
CEO's performance
CEOs can be forced to resign
In a hostile takeover, an idividual or organiation can purchase a

large fraction of the stock and acquire enough votes to replace the
board of directors and CEO
Usually threat of being removed is often enough to discipline

bad manager
When a corporation is doing well, more people want to buy their stock,
which drives stock price up- this gives opinion to corporate leaders of their
Corporate bankruptcy
When corporation is in debt, holders of the firm's debt also

become investors in the corporation

If corp cannot repay debt, debt holders can seize assets of the

corp for compensation

To prevent seiaure, fium can renegotiate with debt holders, or

file for bandruptcy protection in federal court

Thus when firm fails to repay debts, end result is change in

ownership of the firm with control passing from equity holders to debt
Bankruptcy doesnt need to result in liquidation of the firm

1.3 The Stock Market

Private companies have a limited set of shareholders and their share sare not

regularly traded- value of sare can be diffciult to determine

Many corps are public companies whose shares trade on organized markets

called stock market

These markets provide liquidity

Determine a market price for company's shares
Investment is liquid if it is possible to sell quickly and easily for a price
close to what you bought it for
Liquidity attractive to outside investors because it provides flexibility
regarding timing and duration of investment in the firm
Research and trading of participatns in these markets gives rise to share

Primary market: when a corp issues new shares of stock and sells them to

Secondary market: where stock is traded after initial transaction

Ex. When you buy SBUX shares, you buy from someone who already
held shares not Starbucks itself
Traditional Trading Venues
Firm chooses one stock exchange on which to list its stock

Most common are NYSE and NASDAQ

Before 2005, all trade on NYSE took place on trading floor (physical location)
Market makers (specialists) matched buyers to sellers
Post 2 prices

Bid price: price at which they were willing to buy

Ask price: price at which they were willing to sell

If buyer couldnt be matched with seller, market maker would pay the
price which maintains liquidity of market
NASDAQ all trades were completed over phone or computer network
Multiple market makers compete with one another unlike NYSE
Each market maker posted bid and ask prices that were viewed by all
Market makers make money because ask prices are higher than bid prices
Difference is called bid-ask spread
Customers buy at the ask (the higher price) and sell at the bid

(the lower price)

Bid ask spread is a transaction cost investors pay in order to trade

New Competition and Market Changes

Now more than 50% of all trades are electronic

Thus role of official market maker has largely disappeared

Because computers now math buy and sell orders, anyone can make a

market in a stock by posting a limit order (an order to buy or sell a set amount
at a fixed price)
Bid ask spread determined by outstanding limit orders

Limit sell order with lowest price is ask price
Limit buy order with the highest price is the bid price
Limit order book: collection of all limit orders

Exchanges make limit order books public so investors can see best bid and

ask prices
Traders who post limit orders provide market with liquidity

Traders who place market orders (order that trade immediately at the best

outstand limit order) are takers of liquidity

High frequency traders (HFTs) place, update, cancel, and execute trades

many times per second in response to new information and other orders,
profiting both from providing liquidy and taking advantage of stale limit orders

Alternative trading system
Don't make their limit order books visible
Offer investors ability to trade at better price
Tradeoff is the order might not be filled if an excess of either buy or sell
orders is received
Liquidity is the key factor
Markets experimenting with how to promote liquidity
Encourage traders who provide liquidity
Discourage traders who take advantage of stale limit orders