Chapter 1 Flashcards
what’s a key factor in the success of corpoations
ABILITY TO EASILY TRADE OWNERSHIP SHARES
define a sole proprietorship
business owner and run by 1 person
what’s the most common type of business unit in the economy
sole proprietorship
what are some characteristics of sole proprietorship
Sole proprietorships are straightforward to set up. Because of this advantage, many new businesses use this organizational form.
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 and business income is taxed at the personal level. If there are other investors, they cannot hold an ownership stake in the firm; this limits the ability of the owner to raise money for the business.
The owner of a sole proprietorship 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.
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.
what happens when the firms reaches the point at which it can borrow without the owner agreeing to be personally liable?
the owner typically converts the business into a form that limits the owner’s liability
what are the key features of a partnership
Income is taxed at the personal level. The income is split among partners according to their ownership in the partnership.
All partners have unlimited personal liability. This applies to the firm’s debt. That is, a lender can require any partner to repay all the firm’s outstanding debts. Similarly, the unlimited liability applies in a legal judgment against the partnership; each partner is fully liable. Thus, partners must be chosen carefully, as any single partner’s actions can affect the exposure of all the partners.
The partnership ends on the death or withdrawal of any single partner. However, partners can avoid liquidation if the partnership agreement provides for alternatives such as a buyout of a deceased or withdrawn partner.
why will some business remain partnerships/sole proprietorships?
Often these firms are the types of businesses in which the owners’ personal reputations are the basis for the businesses.
For such enterprises, the partners’ personal liability increases the confidence of the firm’s clients that the partners will strive to maintain their reputation.
define a limited partnership
partnership with two kinds of owners, general partners and limited partners. There must be at least one general partner. 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
limited partners’ private property cannot be seized to pay off the firm’s outstanding debts. Furthermore, the death or withdrawal of a limited partner does not dissolve the partnership, and a limited partner’s interest is transferable. However, a limited partner has no management authority and cannot legally be involved in the managerial decision making for the business.
define limited liability
their liability is limited to their investment.
what are examples of industries dominated by limited partnerships
Private equity funds and venture capital funds are two examples of industries dominated by limited partnerships. In these firms, a few general partners contribute some of their own capital and raise additional capital from outside investors who are limited partners. The general partners control how all the capital is invested. Most often, they will actively participate in running the businesses in which they choose to invest. The outside investors play no active role in running the partnership; their concern is with how their investments are performing.
define a limited liability partnership
The LLP is similar to a general partnership in that the partners can be active in the management of the firm, and they do have a degree of unlimited liability. The limitation on a partner’s liability takes effect only in cases related to actions of negligence of other partners or those supervised by other partners. In all other respects, including a particular partner’s own negligence or the negligence of those supervised by the particular partner, that partner has unlimited personal liability. In addition, the assets of the business are potentially at risk of seizure due to the actions of anyone within the partnership. Thus, while a partner’s personal assets are protected from the negligent actions of other partners, the investment into the overall partnership may be lost.
what’s a feature of a corporation
a corporation is that it is a legally defined, artificial being (a judicial person or legal entity), separate from its owners. As such, it has many of the legal powers that people have.
It can enter into contracts, acquire assets, and incur obligations, and it receives similar protection against the seizure of its property as received by an individual. 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 (its shareholders) have limited liability; they are not liable for any obligations the corporation enters into. Similarly, the corporation is not liable for any personal obligations of its owners.
how can corporation be legally formed in Canada
the articles of incorporation must be filed with the relevant registrar of corporations. The articles of incorporation, sometimes referred to as the corporate charter, are like a corporate constitution that sets out the terms of the corporation’s ownership and existence. Setting up a corporation is therefore considerably more costly than setting up a sole proprietorship. Most firms hire lawyers to create the formal articles of incorporation and a set of bylaws.
what are corporations defined under in canada?
provincial Business Corporations Act or the Canada Business Corporations Act.
define a stock
The entire ownership stake of a corporation is divided into shares
define equity
The collection of all the outstanding shares of a corporation
define shareholder, stockholder, or equity holder
An owner of a share of stock in the corporation and is entitled to dividend payments
define dividend payments
payments made at the discretion of the corporation’s board of directors to the equity holders.
what’s the relationships between shareholders and voting rights
Shareholders usually receive voting rights and dividend rights that are proportional to the amount of stock they own
what’s a dominant shareholder? does that occur in canada?
dominant shareholder (controlling in excess of 25% of the equity)
In Canada, many corporations have a dominant shareholder
what’s unique features of a corporation
there is no limitation on who can own its stock. That is, an owner of a corporation need not have any special expertise or qualification. 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 a sole proprietorship or partnership. Corporations can raise substantial amounts of capital because they can sell ownership shares to anonymous outside investors.
how has corporations dominate the economy compared to other enterprises
The availability of outside funding
what are the tax implications for corporate entities
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.
how does canada give relief from double taxation
In Canada, the dividend tax credit gives some relief by effectively giving a lower tax rate on dividend income than on other sources of income.
what’s an exemption under CRA from double taxation
Canada Revenue Agency allowed an exemption from double taxation for certain flow through entities where all income produced by the business flowed to the investors and virtually no earnings were retained within the business. These entities are called income trusts.
however, many of these income trusts have been converting back to the standard corporate form because of the loss of their special non-taxable status.
ONLY REIT has continued to not have tax at the business level beyond 2011
what are the 3 forms of income trusts
A business income trust holds all the debt and equity securities of a corporation (the underlying business) in trust for the trust’s owners, called the unit holders.
An energy trust either holds resource properties directly or holds all the debt and equity securities of a resource corporation within the trust.
A real estate investment trust (REIT) either holds real estate properties directly or holds all the debt and equity securities of a corporation that owns real estate properties.
us direction control vs owner different in coporations?
yes
who has direct control of the corporation
board of directors and chief executive officer
define a board of directors
a group of people that has the ultimate decision-making authority in the corporation.
what are the 1 or 2 shareholders who own a very large proportion of the outstanding stock
these shareholders might be on the board of directors themselves or might have the right to appoint a number of directors.
what’s the role of the board of directors
The board of directors makes rules on how the corporation should be run (including how the top managers in the corporation are compensated), sets policy, and monitors the performance of the company. The board of directors delegates most decisions that involve day-to-day running of the corporation to its management, headed by the chief executive officer (CEO).
define the CEO
The CEO is charged with running the corporation by instituting the rules and policies set by the board of directors.
is the seperation of powers from CEO and BOD distinct
The separation of powers within corporations between the board of directors and CEO is not always distinct. In fact, it is not uncommon for the CEO also to chair the board of directors.
define the CFO
The most senior financial manager is the chief financial officer (CFO), who usually reports directly to the CEO.
what is the financial manager responsible for?
making investment decisions, making financing decisions, and managing the firm’s cash flows.
how does the financial manger make investment decision
The financial manager must weigh the costs and benefits of each investment or project and decide which of them qualify as good uses of the money shareholders have invested in the firm. These investment decisions fundamentally shape what the firm does and whether it will add value for its owners.
how does the financial manager make 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 instead (debt)
how does the financial manager handle cahs management
The financial manager must ensure that the firm has enough cash on hand to meet its obligations from day to day - managing working capital
A company typically burns through a significant amount of cash before the sales of the product generate income. The financial manager’s job is to make sure that access to cash does not hinder the firm’s success.
theoretically how should the goal of a firm be determined by
the firm’s owners
define shareholder wealth maximization
a corporate objective that seeks to maximize the financial benefit to all persons holding stock in the corporation by maximizing the current value of the company stock.
define the principal-agent problem
a problem that arises when employees in control (the agents) act in their own interest rather than n the interest of the owners (the principals)
define the agency problem
occurs when decision makers, despite being the agents of other stakeholders put their self-interest ahead of the interests of the stakeholders
what’s the reason for the downfall of many corporations?
can ultimately be blamed on management acting in their own interests at the expense of shareholders.
how to decrease the principal-agent problem
minimize the number of decisions managers must make for which their own self-interest substantially differs from the interests of the shareholders.
what’s the pro + con of managers’ compensation contracts should be designed to ensure that most decisions in the shareholders’ interest are also in the managers’ interests
shareholders often tie the compensation of top managers to the corporation’s profits or perhaps to its stock price. Thus, if managers shirk or consume too many perquisites, the corporation’s profit and stock price will drop, and managers’ compensation will decline. This encourages managers not to shirk or consume too many perquisites. There are, however, two important limitations to this strategy.
One, by tying compensation too closely to performance, the shareholders might be asking managers to take on more risk than they are comfortable taking. As a result, managers may not make decisions that the shareholders want them to, or it might be hard to find talented managers willing to accept the job. Two, compensation tied to profits or share price may lead to short-sighted behaviour by managers who can pursue a strategy that may artificially boost short-term results and thus compensation. The market price of the firm may rise on such a strategy if market participants are less informed than management and believe the strategy will provide long-term benefits. When market participants eventually learn the truth, it may be too late as management will have received its compensation and managers may have cashed out of their own shares.
what’s a challenge for boards of directors
design compensation systems for management that discourage short-sighted strategies and promote true wealth creation for shareholders.
what’s another way shareholders can encourage mangers to work in the interests of shareholders - and it’s limitations
discipline them if they don’t - pressure the board to oust the CEO.
However, directors and top executives are very rarely replaced through a grassroots shareholder uprising. Instead, dissatisfied investors often choose to sell their shares
what’s a barometer for corporate leaders that continuously gives them feedback on their shareholders’ opinion of their performance.
Stock Price
why might the BOD be reluctant in firing the CEO
close friends with CEO and lack objectivity
What happens to the stock price in corporations in which the CEO is entrenched and doing a poor job
stock price is lowering
define a hostile takeover and it’s role
an individual or organization—sometimes known as a corporate raider—can purchase a large fraction of the stock and in doing so get enough votes to replace the board of directors and the CEO.
With a new superior management team, the stock is a much more attractive investment, which would likely result in a price rise and a profit for the corporate raider and the other shareholders.
what’s created when a corporation’s shares are publicly traded
a market for corporate control is created that encourages managers + BODS to act in the interest of their shareholders
when might it be impossible for the market for corporate control to work as desired
If there is a dominant shareholder, or a shareholder that owns a class of shares with multiple votes, because not enough shares can be purchased on the market to accumulate enough votes to change control.
define stakeholder
any person with an interest in what a corporation does, employees, customers, suppliers, the community, the government and investors
define stakeholder satisfaction
a corporate objective that seeks to meet the interests of all stakeholders of a corporation
define corporate social responsibility
Corporate initiative to assess and take responsibility for the company’s effects on the environment and impact on social welfare […] The term generally applies to company efforts that go beyond what may be required by regulators or environmental protection groups. Corporate social responsibility may also be referred to as ‘corporate citizenship’ and can involve incurring short-term costs that do not provide an immediate financial benefit to the company, but instead promote positive social and environmental change
why should corporations take care of their stakeholders + adhere to corporate social responsibility
also add true value for their shareholders, so there is a convergence between shareholder wealth maximization, stakeholder satisfaction, and corporate social responsibility.
as there’s long-term benefits instead of short-term benefits with long-term consequences
are the decisions that increase the value of the firm’s equity beneficial for society as a whole?
increasing the value of the equity is good for society as long as nobody is made worse off by its decisions
what’s a problem that offers when increasing the value of equity
when it 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 ensure that corporate interests and societal interests remain aligned. Sound public policy should allow firms to continue to pursue the maximization of shareholder value in a way that benefits society overall.
what does a firms do to prevent a seizure of assets if they default on a loan?
the firm may attempt to renegotiate with the debt holders, or file for bankruptcy protection.
what happens in bankruptcy
management is given the opportunity to reorganize the firm and renegotiate with debt holders. If this process fails, control of the corporation generally passes to the debt holders. In most cases, the original equity holders are left with little or no stake in the firm. Thus, when a firm fails to repay its debts, the end result is often a change in ownership of the firm, with control passing from equity holders to debt holders. Importantly, 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 the firm passes to the debt holders, it is in the debt holders’ interest to run the firm in the most profitable way possible. Doing so often means keeping the business operating.
define liquidation of the firm
closing down a business and selling off all its assets; often the result of the business declaring bankruptcy
Some argue that other stakeholders (e.g., employees, suppliers, customers, government, community) need to be looked after and that this conflicts with shareholder wealth maximization.
I don’t think that shareholder wealth maximization is compromised by paying attention to other stakeholders. In the short run you might squeeze out more profits by pressing harder on suppliers or employees. But for the long run, and for a sustainable entity, you need an ecosystem of players who are all benefiting from the activities of the company. That includes customers, suppliers, and particularly employees. If you have a healthy organization, with employees who are happy and engaged in what they are doing, that will help to ensure the long-run success of the company, which then reflects on shareholder value.
in the long-term you need to satisfy all stakeholders to get shareholder wealth maximization
what’s another way to think of corporate bankruptcy in terms of ownership?
a change in ownership of the corporation and not necessarily as a failure of the underlying business
how to understand corporations as 2 sets of investors with claims to its cash flows: debt + equity holders
as long as the corporation can satisfy the claims of the debt holders, ownership remains in the hands of the equity holders.
why do shareholders like the firm’s managers to maximize the value of their investment in the firm?
This is because the value of their investment is determined by the price of a share of the corporation’s stock.
define a stock markets
organize markets in which the shares of many corporations are traded
what’s the benefits of a stock market?
markets provide liquidity and can determine market price for company’s shares unlike the private companies
define liquid
an investment that can be easily be turned into cash bc it can be sold immediately as a competitive market price
when is an investment considered 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.
Why is liquidity attract to outside investors
as it provides flexibility regarding the timing and duration of their investment in the firm.
define the primary market
market used when a corporation itself issues new shares of stock and sells them to investors
define the secondary market
market that continues to trade in after the initial transaction between the corporation and investors
define the bid price
price at which a market maker or specialist is willing to buy a security
highest price being quoted to buy a stock
define an ask price
the price at which a market maker or specialist is willing to sell a security
the lowest price being quoted to sell a stock
define the bid-ask spread
amount by which the ask price exceeds the bid price
define a limit order
an order to buy or sell a security at a specified price
define a limit order book
the collection of all limit orders at a stock exchange,
exchange make their limit order books public so that investors (or their brokers) can see the best bid and ask prices when deciding where to trade
define a market order
order to trade immediately at the best outstanding limit order available
what’s the implicit transaction cost investors have to pay in an market order
the bid-ask spread is an implicit transaction cost investors have to pay in order to trade quickly.
define transaction costs
costs of executing a trade or transaction, normally including broker commissions or other fees
define thinly traded
to describe the low level of trading volume in stocks that attract little investor interest
why is there a range in bid-ask spread
there’s a smaller range for companies with many investors trading
there’s a larger range for companies with less investors trading
define High frequency Traders
are 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 as well as other orders, profiting both by providing liquidity and by taking advantage of stale limit orders.
define trade specialists/market makers
individual on the trading floor of the NYSE who match buyers with sellers; also called market makers
what’s happens to the need/importance of specialists due to technology
The role of floor trading and the importance of specialists has declined dramatically as the need for a specialist to make a market in a company’s stock is replaced by the ability of investors to access an electronic exchange and post their own bid, and ask prices directly.
define dark pools
trading venues in which size and price of orders aren’t disclosed to participants
prices are within the best bid and ask process available in public markets, but traders face the risk their orders may not be filled if an excess of either buy or sell orders is received
Why is trading on dark pool attractive?
Trading on a dark pool is therefore attractive to traders who do not want to reveal their demand and who are willing to sacrifice the guarantee of immediacy for a potentially better price.
what do traders value in an market
value liquid markets, an important area of competition is liquidity
what is an example of exchanges have been experimenting with different rules designed to encourage traders who provide liquidity and discourage traders who take advantage of stale limit orders.
some trading venues pay traders to post limit orders and charge traders who place market orders. Others pay for orders from retail investors and impose additional charges on high frequency trading. The proliferation of exchange venues has generated a wide variety of different compensation schemes.
is there double taxation in a corporation
yes, The shareholders in a corporation effectively must pay tax twice. The corporation pays tax once and then investors must pay personal tax on any funds that are distributed as dividends.
