Chapter 1

The Corporation

Chapter Outline
1.1 The Four Types of Firms

1.2 Ownership Versus Control of Corporations

1.3 The Stock Market

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Learning Objectives
1. List and define the four major types of firms in the U.S.; describe major characteristics of each type, including the means for distributing income to owners. 2. Distinguish between limited and unlimited liability, and list firm types that are subject to each.

3. Describe taxation consequences for C and S corporate forms.

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Learning Objectives (cont'd)

4. Discuss the division of corporate ownership into shares of stock; evaluate the implications of that division for corporate decision making. 5. Explain how corporate bankruptcy can be viewed as a change in firm ownership. 6. Compare and contrast characteristics of shares that are publicly traded and those that are not.

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1.1 The Four Types of Firms

Sole Proprietorship

Partnership
Limited Liability Company

Corporation

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Figure 1.1 Types of U.S. Firms

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1.1 The Four Types of Firms (cont'd)

Sole Proprietorship
Business is owned and run by one person
Typically have few, if any, employees Advantages
Easy to create

Disadvantages
Unlimited personal liability Limited life

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1.1 The Four Types of Firms (cont'd)

Partnership
Similar to a sole proprietorship, but with more than one owner
All partners are personally liable for all of the firms debts. A lender can require any partner to repay all of the firms outstanding debts. The partnership ends with the death or withdrawal of any single partner.

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1.1 The Four Types of Firms (cont'd)

Partnership
Limited Partnership has two types of owners.
General Partners

Have the same rights and liability as partners in a regular partnership Typically run the firm on a day-to-day basis Have limited liability and cannot lose more than their initial investment Have no management authority and cannot legally be involved in the managerial decision making for the business

Limited Partners

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1.1 The Four Types of Firms (cont'd)

Limited Liability Company (LLC)
All owners have limited liability but they can also run the business.
Relatively new business form in the U.S.

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1.1 The Four Types of Firms (cont'd)

Corporation
A legal entity separate from its owners
Has many of the legal powers individuals have such as the ability to enter into contracts, own assets, and borrow money The corporation is solely responsible for its own obligations. Its owners are not liable for any obligation the corporation enters into.

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1.1 The Four Types of Firms (cont'd)

Corporation
Formation
Corporations must be legally formed. The corporation files a charter with the state it wishes to incorporate in. The state then charters the corporation, formally giving its consent to the incorporation. Due to its attractive legal environment for corporations, Delaware is a popular choice for incorporation.

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1.1 The Four Types of Firms (cont'd)

Corporation
Ownership
Represented by shares of stock Owner of stock is called

Shareholder Stockhoder Equity Holder

Sum of all ownership value is called equity. There is no limit to the number of shareholders, and thus the amount of funds a company can raise by selling stock. Owner is entitled to dividend payments.
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1.1 The Four Types of Firms (cont'd)

Corporation
Tax Implications
Double Taxation

S Corporations
Firms profits are not subject to corporate income tax, but instead are allocated directly to the shareholders.

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Example 1.1

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Example 1.1 (cont'd)

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Alternative Example 1.1

Problem
You are a shareholder in a C corporation.
The corporation earns $4 per share before taxes. Once it has paid taxes it will distribute the rest of its earnings to you as a dividend. The corporate tax rate is 34% and the personal tax rate on dividend income is 25%. How much is left for you after all taxes are paid?

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Alternative Example 1.1

Solution
First, the corporation pays taxes. It earned $4 per share, but must pay 0.34 $4 = $1.36 to the government in corporate taxes. That leaves $2.64 to distribute. However, you must pay 0.15 $2.64 = $0.396 in income taxes on this amount, leaving $2.64 $0.396 = $2.244 per share after all taxes are paid. As a shareholder you only end up with $2.244 of the original $4 in earnings. The remaining $1.36 + $0.396 = $1.756 is paid as taxes. Thus, your total effective tax rate is $1.756 $4 = 43.9%.

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Example 1.2

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Example 1.2 (cont'd)

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Alternative Example 1.2

Problem
Rework Alternative Example 1.1 assuming the corporation in that example has elected subchapter S treatment and your tax rate on non-dividend income is 39%.

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Alternative Example 1.2

Solution
In this case, the corporation pays no taxes.
It earned $4 per share. Whether or not the corporation chooses to distribute or retain this cash, you must pay 0.39 $4 = $1.56 in income taxes, which is substantially lower than the $1.756 you paid in Alternative Example 1.1.

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1.2 Ownership versus Control of Corporations

Corporate Management Team
In a corporation, ownership and direct control are typically separate.
Board of Directors
Elected by shareholders Have ultimate decision-making authority

Chief Executive Officer (CEO)

Board typically delegates day-to-day decision making to CEO.

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1.2 Ownership versus Control of Corporations (cont'd)

Ownership and Control
In a corporation, there may be thousands of shareholders, many with different priorities.
Even if all of the shareholders agree on the goals of the firm, the goals must be implemented. This is the job of the management team. How can the shareholders be sure that the management team will implement their goals?

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1.2 Ownership versus Control of Corporations (cont'd)

Principal-Agent Problem
Managers may act in their own interest rather than in the best interest of the shareholders.
One potential solution is to tie managements compensation to firm performance. How should performance be measured?

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1.2 Ownership versus Control of Corporations (cont'd)

CEO Performance
If a CEO is performing poorly, shareholders can express their dissatisfaction by selling their shares. This selling pressure will drive the stock price down. Hostile Takeover
Low stock prices may entice a Corporate Raider to buy enough stock so they have enough control to replace current management. The stock price will rise after the new management team fixes the company.

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1.2 Ownership versus Control of Corporations (cont'd)

Corporate Bankruptcy
Reorganization
Liquidation

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1.3 The Stock Market

The stock market provides liquidity to shareholders.
Liquidity
The ability to easily sell an asset for close to the price you can currently buy it for

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1.3 The Stock Market (cont'd)

Public Company
Stock is traded by the public on a stock exchange.

Private Company
Stock may be traded privately.

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1.3 The Stock Market (cont'd)

Largest Stock Markets
New York Stock Exchange (NYSE)
Market Makers/Specialists

Each stock has only one market maker

NASDAQ
Does not meet in a physical location May have many market makers for a single stock

Bid Price versus Ask Price

Bid-Ask Spread

Transaction cost

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Figure 1.2 Worldwide Stock Markets Ranked by Two Common Measures

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Figure 1.2 Worldwide Stock Markets Ranked by Two Common Measures (cont'd)

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Questions?

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