Chapter 1: The Corporation & Financial Markets Flashcards
1
Q
what kind of business organizations are the most important
A
corporations
2
Q
why are corporations the most important business organizations
A
because of the amount of:
- products they produce
- revenues and profits they generate
- people they employ
3
Q
what is a key factor in the success of corporations
A
the ability to easily trade ownership shares
4
Q
what is a sole proprietorship
A
- A business owned and run by one person
- Usually small and has few employees
- Most common type of business
- They usually have relatively small revenues, profits, and employees
5
Q
what are key characteristics of a sole proprietorship
A
- Easy to set up
- No separation between the firm and the owner
- Unlimited personal liability for the firm’s debts
- Limited life
6
Q
what is a point about how it is easy to set up for sole proprietorship
A
Many new businesses start off as a sole proprietorship
7
Q
what are some points about how there is no separation between the firm and owner for sole proprietorship
A
- There can only be one owner
- Business income is taxed at a personal level
- Other investors can’t also own the firm
- The ability to raise money is limited
8
Q
what are some points about unlimited liability for sole proprietorship
A
- The firm defaulting on any debt payment = lender will make owner repay the loan with their personal assets
- If they can’t afford, they declare personal bankruptcy
9
Q
what are some points about the limited life for sole proprietorship
A
- Life is limited to the life of the owner
- Difficult to transfer ownership
10
Q
what is the “ratio” of disadvantages and advantages for sole proprietorship
A
- disadvantages > advantages
- The second they can, the owner usually changes the type of firm so they are not personally liable for the business
11
Q
what are partnerships
A
Like a sole proprietorship but has more than one owner
12
Q
what are key features about partnerships
A
- Income taxed at a personal level
- All partners have unlimited personal liability
- Partnership ends with the death or withdrawal of any single partner
13
Q
what is a point about how income is taxed for partnership
A
Income is split among partners based on their ownership in the partnership
14
Q
what are some points about unlimited liability for partnerships
A
- The lender can make ANY partner repay ALL the firm’s debts
- Each partner is fully liable
- Partners have to be chosen carefully, since the action of 1 can affect all
15
Q
what is a point about when partnerships end
A
They can avoid liquidation if their agreement has alternatives like buyout of a deceased or withdrawn partner
16
Q
why wouldn’t some companies not want to switch from a sole proprietor/partnership to something like a corporation
A
- They are the ones where the owner’s personal reputations are the basis for the business
- Ex. law and accounting firms are usually partnerships
- Because they are partnerships, the partner is then personally liable (they want the business to do well)
- Clients are then more confident in the firm if the partners are trying to keep the business up and running (so they don’t go bankrupt)
16
Q
what are examples of types of companies that are mostly limited partnerships
A
- Private equity
- venture capital
- hedge funds
17
Q
what is a limited partnership
A
- A partnership with general and limited partners
- Needs to have at least one general partner
18
Q
what are general partners
A
- They have the same rights and privileges as partners in a (general) partnership; personally liable
- control how the capital is invested, actively participating in running the business
19
Q
what are limited partners like
A
- Limited partners have limited liability; liability limited to their investment and not any other personal assets
- The death/withdrawal of a limited partner doesn’t end the partnership
- Their interest is transferable
- But they have no management authority and can’t legally be involved in making decisions for the company
- Outside investors don’t do anything, they just care about how their investment (the company) is performing
19
Q
A
19
Q
in the common type of companies that are usually limited, how does the partnership work? (between general and limited partner)
A
only a few general partners give their own capital, and the rest is raised from outside investors who are limited partners
19
Q
what is a limited liability partnership (LLP)
A
- A special type of partnership in Canada that can be used in law and accounting firms
- Its like a general partnership since partners can manage the firm and have unlimited liability
- But the liability can be limited if other partners are or supervised negligent
- If the partner themselves performed negligence, they are liable unlimitedly
- Even if a partner’s personal assets safe, based on actions of any partner, the business assets can also be taken
20
Q
what is a corporation
A
- Legally defined entity, separate from its owners
- Has many legal powers people have
- Can enter into contracts, acquire assets, incur obligations
- Also has similar protection against the seizure of its property like a person
- Its solely responsible for its own obligations
- The owners have limited liability
- The corporation isn’t liable for any personal obligations the owners
20
how is a corporation formed
- In most provinces, corporations are defined under the provincial Business Corporations Act or the Canada Business Corporations Act
- They must be legally formed
- Need to file the articles of incorporation (corporate charter), which sets out the terms of the corporation’s ownership and existence
- So its much more expensive to set up
- Most firms have lawyers to create the formal articles of incorporation and a set of bylaws
20
how many people can own a corporation
- No limit on the number of owners of a corporation
- So each owner only owns a fraction; stocks/shares
21
what are the total shares sold called/considered
- outstanding shares
- equity of the corporations
22
what are owners of the shares called
shareholder/stockholder/equity holder
23
what can shareholders get
They can get dividends, which are payments made at the discretion of the corporation's BOD
23
what is voting and dividends like
- The voting and dividend rights are usually proportional to the amount of stocks owned
- In Canada, many corporations have a dominant shareholder who control 25% of total shares
- More people hold US companies, so the largest shareholder holds less than 5% of the total
- About 19% of Canadian companies on the TSX have multiple classes of stock
- Some classes have more voting rights than others with the same rights to dividends
24
what is an advantage of corporations
- You don’t need to be an expert or have a qualification to own a stock
- Because of this, there is a free flow in the trade of stocks
- Its an advantage of being a corporation since they can get a lot of capital this way
- This availability of funding makes corporations dominate the economy compared to other enterprises
24
how does shareholders need to pay taxes twice (double taxation)
- The corporation pays tax on its profits
- When remaining profits are distributed to shareholders, they pay their own personal income tax on that income
24
how do you calculate taxation on corporate earnings
- you take the earnings per share before taxes
- calculate how much of it is taxed with the corporate tax rate
- EPS (before tax) - corporate tax
- then from that, calculate how much taxes u need to pay
- EPS (before tax) - corporate tax - personal income tax
- that is how much earnings you have left after tax
24
how do you calculate the total effective tax rate on your actual earnings from being a shareholder
how much you paid in taxes (total) / how much the earnings was b4 taxes
25
what do most countries do to reduce double taxation
- they reduce some of the taxes
- ex. Canada reduces the tax rate on dividend income
- In most provinces in the 2023 tax year, it was about 30% less tax than regular income tax
- Ex. in Ontario, if you were in the top tax bracket, your income tax rate is 53.53%, but your dividends tax was only 39.34% (instead of being the same as your income tax rate)
26
what entities does the CRA not allow double taxation for
income trusts
27
what are income trusts
- Where all income produced by the business flowed to the investors and pretty much no earnings stayed in the business
- there are 3 forms
28
what are the 3 forms of income trust
- business income trust
- energy trust
- real estate investment trust (REIT)
28
what is a business income trust
- Holds all debt and equity securities of a corporation (the underlying business) in trust for the trust owners
- The trust owners = unit holders
28
what is an energy trust
Holds resource properties directly OR holds all the debt and equity securities of a resource corporation within the trust
28
what is a real estate investment trust
Holds real estate properties directly OR holds all the debt and equity securities of a corporation that owns real estate properties
29
which income trusts are taxed at the business level and which don't get taxed
Taxed: business income & energy
not taxed: REITs
30
who are board of directors (BOD)
A group of people that have the ultimate decision-making authority in the corporation
31
how are BOD elected
- Shareholders elect the BOD
- 1 share = 1 vote for each position on the BOD
- More shares = more voting influence
- If 1-2 shareholders have a lot of the stock, they might be on the BOD, or they can have the right to appoint a number of directors
32
what do BOD do
- The BOD determines how the business should be run, how top managers are paid, sets policy, and monitors performance of the company
- The BOD hires the CEO
33
what does management & CEO do
- Most decisions that involve day-to-day operations
- The CEO institutes the rules and policies the BOD sets
34
how large is the management team for each company
depends on the corporation (can vary)
35
what are CEOs sometimes
chairman of the board (COB)
36
who is the chief financial officer (CFO)
- the most senior financial manager
- usually report directly to the CEO
37
what are financial managers responsible for
- making investment decisions
- making financing decisions
- managing the firm's cash flow
38
what are financing decisions financial managers need to do
- After deciding what investments to make, they need to decide how to pay for it
- Large investments may require to raise additional money
- They have to decide to either raise money from selling more shares of stock (equity) or to borrow (debt)
38
what are investment decisions financial managers need to do
- Most important job for the financial manager
- They need to weight the costs and benefits of each investment/project and decide which ones would be good investments
- The investment decisions shape what the company does and if it will add value for its owners
39
who determines the goal of a firm
- the owner's
- In sole proprietorship, the goal of the company = goal of the owner
- In companies with multiple owners, the proper goal of the firm aka the goal of the managers isn’t clear
40
what are cash management things financial managers need to do
- The financial manager also needs to manage working capital (making sure there's enough cash for day-to-day operations)
- For young growing companies, the management can result in success and failure of the companies
- Even companies with great products require significant amounts of money to develop and sell them
- The company usually uses a lot of cash before they start making money from the sales
- The financial manager’s job is to make sure that access to cash doesn’t affect the firm’s success
40
what is the big goal of shareholders for corporations & why
- that management makes decisions that increase the value of shares (shareholder wealth maximization)
- This is because they want the stock price to be higher
41
what is one way to address the principal-agent problem
- minimize the number of decisions managers need to make where their own self-interest is very different from the interests of shareholders
- Ex. can design their compensation contracts so that the compensation of the top managers is based on the profit/stock price of the company
42
what is an issue with the compensation contract solutions
- managers might not make the decisions that shareholders want them too, and it would also be hard to find talented managers that would want to work like this
- Managers could also perform short-sighted behaviour where they artificially increase the results of the company for a short term
- Then the outsiders who don’t really know whats happening inside the company will think the company is doing really well, and will continue to do well in the long-term will buy the stock for the company
- Then the stock price of the company and the compensation for managers would go up
- But once the new shareholders learn about the truth, the managers would have already sold their shares
42
what is the principal-agent problem
- Managers are hired to be agents for the owners of the company
- They are in charge of making decisions that are geared towards the shareholder’s goals
- With power to make decisions for the company, the managers can make decisions that fit their own interests instead of the interests of the shareholders
- They may shirk (neglect the responsibilities of managing the company) or consume perquisites (benefits that are free to managers) instead
- Corporations can end badly if the management is acting in their own interests at the expense of shareholders
42
how does changing managers' compensation contracts address the principal agent problem
This way they wouldn’t shirk or consume too many perquisites because then it would drop the profit/stock price, which would then drop their compensation
43
when does the BOD not remove the CEO when they should and what is the consequence
- But sometimes because those on the board are close friends with the CEO, they don’t remove the CEO
- If the CEO isn’t being removed by the BOD even if they aren’t doing good, the expectation of continued poor performance will decrease the stock price
- Low stock price can result to a profit opportunity
43
what do owners of firms make sure the firms goal is
- In a sole proprietorship, the owner can make sure the firm’s goal = their own
- In a corporation, the management team needs to make sure the firm’s goal = the owner’s goals
43
what do corporate leaders do to determine what shareholders think about their performance
- use the stock price
- If a stock performs badly, the BOD might replace the CEO
44
how can shareholders also make managers work in the shareholders' interests by disciplining them
- Ex. if they are unhappy with a CEO’s performance, they can pressure the BOD to get rid of the CEO
- But directors and top executives rarely get removed this way
44
what doe investors usually do if they're dissatisfied
- sell their shares
- But when they sell their shares, someone else needs to buy it from them
- If there are enough unsatisfied shareholders, other investors would only buy the shares from them if they are cheap
- If investors see a corporation as well-managed, they would want to buy the shares, making the stock price go up
44
who do stakeholders include and what are they interested in
- Shareholders
- Employees; interested in their jobs in the corporation
- Customers; interested in the quality of the corporation’s products
- Suppliers; interested in being paid for the supplies and making a profit on what they sell to the corporations
- Community; interested in the environmental impact of the corporation
- Government; interested in collecting the tax dollars
- Others: managers & debt holders
45
what is a hostile takeover
An individual or organization (sometimes known as a corporate raider) can purchase a large amount of the stock to get enough votes to replace the board of directors and the CEO
45
what is created when a corporation's shares are publicly traded
- market for corporate control
- Means that if the stock price becomes low enough, anyone can gain control of the company, so it encourages managers and BOD to act in the interests of their shareholders
45
how do politicians and the media make corporations look bad
- they think that major controversies were caused because the corporations focused more on shareholder wealth maximization at the expense of stakeholders
- But most times its actually not because of that, but because of the principal-agent problem, and managers are maximizing their personal benefits at the expense of others
- but this can happen anywhere where leadership can exploit or manipulate things to benefit themselves properly
- This problem can be reduced if there is proper government policies in place
45
what happens in hostile takeovers
- When a hostile takeover happens, more investors would want to buy the stock since there is a new superior management team
- More investors buying = stock price rises = more profit for the corporate raider & shareholders
45
when would market for corporate control not work
- if there is a dominant shareholder/shareholder that has a class of shares that has multiple votes, it would be impossible for the market for corporate control to work
- This is because if there’s someone who already owns majority of the shares or has more votes than what can be acquired currently in the market, other investors can’t try to gain control of the company
- A lot of Canadian companies has this, so investors may not want to invest in these types of firms
45
why are hostile takeovers and corporate raiders important for shareholders
Just with the threat of a hostile takeover alone is enough to discipline bad managers and motivate BOD to make difficult decisions (like firing their friends)
45
what are stakeholders
Those that have an interest (or stake) in how a corporation operates
45
what is the corporate goal in japan and some european countries
stakeholder satisfaction (relates to CSR)
45
what is the corporate goal in Cda, us, uk
shareholder wealth maximization
45
what should be done to make sure corporate interests = societal interests
- public policy and regulation
- They should allow firms to still try to maximize shareholder value, but in a way that benefits society overall
- ESG investing criteria is used to promote the good things corporations are doing and to reduce the risk an investment in a corporation’s stock will be impacted by negative reputational factors or the government imposing policies or regulations that would harm the firm’s value
45
what is corporate social responsibility (CSR)
Corporate initiative to assess and take responsibility for the company’s effects on the environment and impact on social welfare
45
why is it an issue of making proper government policies towards reducing the principal-agent problem
- But at the same time, politicians are the ones that are making these policies, and they can also be corrupt
- Even though they are supposed to do what is best for all the citizens and the country as a whole, there are a lot of times when they acted for their own interests at the expense of the citizens or country
- Like wanting to enjoy the benefits of power by taking control of resources or activities that would be more efficiently managed by others, redistributing resources within a country to regions that are more likely to elect their own political party, or engaging in corruption
- Citizens can also just vote these politicians out of power
45
what kind of decisions should be made to increase the value of the firm's equity be beneficial for society as a whole
- Even if a company only makes their shareholders better off, as long as nobody else is made worse off by its decisions, increasing the value of equity is good for society
- Its not good when decisions are made to increase the value of equity at the expense of others
- Ex. a corporation pollutes the environment and doesn’t pay the costs to clean it up
- Ex. the corporation doesn’t pollute, but using their products can harm the environment
- In those cases, increasing shareholder wealth doesn’t benefit society
45
what is environmental, social, governance (ESG)
(The investing criteria) is used to produce scores on how well firms are stewards of the environment, benefit society, and maintain good corporate governance practices
46
lets say a company does bad things (bad for stakeholder satisfaction) but is able to get higher profits (good for shareholder wealth maximization) what happens
- higher profits is only in the short term
- actually bad in the long term
- the stakeholders act out against what they "should be" doing, resulting in the fall of the reputation and profits in the long term
- when stockholders find out about this, stock prices will go down
46
what is CSR usually for
- company efforts that are more than what is required by regulators (law) or environmental protection groups
- Also referred to as “corporate citizenship”
- Involves incurring short-term costs that don’t provide immediate financial benefit to the company, but promote positive social and environmental change
46
how can decisions that are made to increase the value of the firm's equity be beneficial for society as a whole (example)
Ex. Apple
- In the beginning of 2023, the shares were worth over x590 they were in 2001 when the first iPod came out
- All investors who had bought Apple shares benefited (since their stocks rose) from the divisions of Apple’s managers
- Customers also are better off since they got the products that Apple made (they made value for their customers)
- They also created jobs that attract good employees
47
what do the environmental factors of ESG include
- Contribution to greenhouse gas emissions
- If they sustainably use natural resources
- How much they pollute or produce dangerous waste products
48
what do the societal factors (stakeholder satisfaction) of ESG include
- Positive relations with customers, suppliers, employees
- Aspects related to human rights
- Recognizing the importance of diversity, equity, and inclusion (DEI)
49
what do the governance factors of ESG include
- If the principal-agent problem is being addressed adequately
- If there are safeguards and processes to ensure tax, legal, and regulatory compliance
50
what are other investors in a corporation
debt holders
51
when do debt holders become investors
- when the corporation borrows money
- They don’t have control over the company like shareholders, but if the corporation can’t pay back its debts, the debt holders can seize the assets of the corporation
52
what can firms do to prevent their assets from being seized
- could reorganize and attempt to renegotiate with debt holders or file for bankruptcy protection
- If management failed in renegotiation, the debt holders then get control of the corporation and become the new owners
- The original equity holders usually have little to no stake in the firm
- When the debt holders have ownership, they don’t need to liquidate (sell everything) the company, but instead they need to run the firm in the most profitable way
- Usually this means keeping the business running
53
what are the 2 sets of investors that can get the cash flows of a company
- debt holders and equity holders
- If a company goes bankrupt, as long as they can satisfy the claims of the debt holders, the ownership is still in the hands of the equity holders
- But if they can’t satisfy the claims of the debt holders, then the debt holders gets control/ownership of the firm
54
what is corporate bankruptcy
a change in ownership instead of a failure of the business
55
what do shareholders want to do with their investment
- maximize the value of their investment
- The value of their investment depends on the price of the corporation’s stock
- Private companies are not traded regularly and have a limited set of shareholders so the value of the shares are hard to determine
- Public companies trade on stock markets/stock exchanges , which provide liquidity and determine a market price of the shares
56
what does liquid investment mean
if you can sell it quickly and easily for a price very close to the price you can buy it for (at the same time)
57
why would outside investors want liquidity
it gives flexibility for the timing and duration of their investment in the firm
58
what is the primary market
When a corporation issues new shares of stock and sells them to investors
59
what is the secondary market
- When shares continue to trade between investors after the initial trade between the corporation and the investors without the involvement of the company
- Secondary markets is when you're trading with other investors who own the stock
- The trades don’t go to the corporation of the trade (ex. Apple doesn’t get profit when you’re trading Apple stocks)
60
what is the best known and largest stock market in the world
New York Stock Exchange (NYSE)
61
what is the largest stock exchange in canada
- Toronto Stock Exchange (TSX)
- TSX is part of TMX Group
- TMX Group is the merge of TSX and Montreal Exchange
- Montreal Exchange is a market for trading derivatives
- its 10th largest in the world based on total market capitalization
62
what kind of exchange is the TSX
- an electronic exchange
- Investors can post their orders onto the TSX trading system from anywhere
63
what is the bid price
The highest price being quoted to buy a stock
64
what is the ask price (offer)
The lowest price being quoted to sell a stock
65
what is a bid-ask spread
- The difference between the posted ask price and bid price (since ask prices > bid prices)
- a transaction cost investors need to pay to trade quickly
65
when is a trade done
- When bid price = ask price, the trade is done
- Then the next highest bid & next lowest ask = the next quoted bid and ask prices
65
what is a limit order
An order placed to buy at a specified price, that won’t happen until the order price = ask price (the amount someone will sell the stock to you for = the amount you are willing to buy for)
65
what is a limit order book
- The collection of all limit orders
- They’re public on exchanges so investors or their brokers can see the best bid and ask prices when deciding to trade
66
what is a market order
- An order that automatically takes the best ask price already posted, so it will buy the stock immediately
- With market orders, customers always end up buying at the ask (higher price) and selling at the bid (the lower price)
66
what does the TSX venture exchange exchange stocks for
relatively small companies
67
where is there lower bid-ask spreads
Stocks that trade on the TSX have lower bid-ask spreads than those on the TSX Venture Exchange
67
when is the bid-ask spread small
- Companies that are frequently traded get a lot of orders to buy and sell the stock
- This causes the bid-ask spread to be pretty small, since there are more people, there are more that are willing to sell at lower prices or buy at higher prices
67
when is the bid-ask spread big
- Companies that don’t get frequently traded are thinly traded
- Since not much people trade these stocks, the bid-ask spread is larger
68
what are limit order traders considered as
- liquidity providers
- They buy or sell stocks at specific prices that other people need to accept
- Because they set these prices, they provide liquidity to the market, giving options to trade
- Limit order traders make money from the bid-ask spread
68
what are the risks for limit order traders
- If something important happens, like new information about a stock, the price of it may change quickly
- Because it happens so fast, limit order traders may not be able to update their orders fast enough and end up selling or buying at outdated prices
- They could end up loosing money if they are trading at old prices if the stock is now worth more or less
- So they would need to constantly look at the market and cancel old orders and post new ones when appropriate
68
what do market order traders do
- just buy or sell immediately at the best price available
- Since those prices would be the prices liquidity providers give, they are taking liquidity from the market
68
who are high frequency traders (HTFs)
A class of traders who use computers to help them 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
68
what is NYSE
- One of the last major stock exchanges to have an active trading floor where orders are routed for the trading of shares of stock
- It also has specialists/market makers
69
what is active trading floor where orders are routed for the trading of shares of stock
- Where stock is traded in person
- The trading floor is where you go to make the request to make a trade
- Its then “routed” to the stock exchange, where its matched with another order (find someone who is willing to sell at the price you want to buy for)
69
who are specialists/market makers
Those who are given preferential access to orders but must also stand ready to buy or sell shares at their own posted bid and ask prices and thus provide liquidity for investors
69
what do specialists do
- help facilitate the trades of investors
- They also will buy and sell stocks themselves to keep the market liquid
- Ex. Someone wants to sell stocks at a certain price, but no one at that moment is willing to buy it
- The specialists will buy the stocks from that person, and just sell it at a later date
70
what normally happens when you trade on an exchange
you are guaranteed to trade immediately at the current bid or ask price and everyone can see the transactions
70
how many different places to trade stocks
estimated 50 that compete order volume
70
what do traders want that affect what exchanges want
Since traders want liquid markets, the exchanges want to have deep limit order books; those that have a lot of orders
70
what do exchanges do to get deeper limit order books
- experiment with different rules to try to get more traders that provide liquidity, and less traders that take advantage of stale limit orders
- Ex. some trading venues pay traders to post limit orders and charge traders who place market orders
- Ex. some pay for orders from retail investors and impose additional charges on high frequency trading
