Lecture 2 - Firms Sole Propiertorships, Partnerships and Corporations

Question 1

What are the six purposes of contract law?

Answer 1

1. Convert non-cooperative games into a cooperative game
2. Encourage efficient information disclosure
3. Secure optimal performance
4. Secure optimal reliance
5. Minimize transaction costs of negotiating contracts by supplying efficient default terms and regulations
6. Foster long term relationships (reducing reliance on the courts to enforce contracts)

Question 2

What will an owner do if they manage a wholly owned firm? (Proprietorships)

Answer 2

They will make operating decisions which maximize their utility

Question 3

Transaction costs of contracts that partners face:

Answer 3

1. Studies
2. Experts
3. Hiring lawyers
4. Going to court

Question 4

What happens to the intersections of the IC (Indifference Curve) in relation to the production function in Partnerships?

Answer 4

Incomplete contracts causes in a downward shift in the IC curve (decrease in utility due to reasons such as free riding) resulting in a lower intersection point between the production function an the IC curve.

Question 5

What is a Complete Contract and Incomplete Contract?

Answer 5

A contract in which everything is considered.

An Incomplete contract is where some conditions of the contract are not always met (free-riding may occur).

Question 6

How does corporations avoid pressure from the market?

Answer 6

Corporations avoid pressure because no one can buy or sell it.

Question 7

Who makes the most profit from corporations?

Answer 7

No one person can make the most profit from corporations because there are no markets to move or control these organizations.

Question 8

Examples of INALIENABLE ORGANIZATIONS:

Answer 8

• Families
• Club
• Church
• Co-op
• Trust
• Charity
• County

Question 9

Examples of ALIENABLE ORGANIZATIONS:

Answer 9

Corporations

Question 10

Why do owned organization adjust their structure?

Answer 10

1. To improve performance or change goals
2. To respond from pressure from markets

Question 11

Who is Canada’s oldest corporation?

Answer 11

Hudson Bay Company (Formed May 2, 1670) - Bought a license to trade fur from the British government.

Question 12

Are owners of the historic corporations were liable for the corporation’s debt, give an example.

Answer 12

Yes, for example when Hudson Bay had gone bankrupt in the 18th century, creditors obtained repayment by seizing the wealth of its stockholders.

Question 13

What is the price of limited liability in relation to corporations?

Answer 13

By common law, shareholders could not sue directors for harm done to the corporation.

Therefore owners of modern corporations are not liable for the corporation’s debts.

As a result, people who invest in stock run the risk of losing their investment and nothing more.

Question 14

What does limited liability allow for in corporations?

Answer 14

Limited liability allows people to invest in a company without monitoring or controlling the company’s policies.

Question 15

What is the principal-agent problem?

Answer 15

A contract that gives the agent incentives to manage the assets in the best way for the principal (owners).

This occurs when owners (principal) place their assets under the control of someone else (agent).

Question 16

Benefits of limited liability?

Answer 16

Increases the efficiency of capital markets by reducing transaction costs of individual transactions.

Thus, the choice of liability rule is neutral on economic outcomes (Theorem of Coase).

Question 17

Why did firms maintained unlimited liability after the British Parliament restored limited liability in 1856?

Answer 17

Investors would have still lost the value of their shares under limited liability

Question 18

What is separation of ownership from control?

Answer 18

A situation created from limited liability where many stockholders in large companies sold on public stock exchange had little to no monitoring / control over it.

Question 19

What is the role of management in a corporation?

Answer 19

Owners do not exercise control over the corporation and rely on management to do so.

However, managers may not always try to maximize the profits of the organization due to their own goals.

Question 20

How can the goals of management change for a corporation?

Answer 20

When the possibility of a hostile takeover occurs, management will not depart from the goal of maximizing the company’s profits.

On the other hand, thin markets (few buyers and sellers) for corporations makes hostile takeovers unlikely, resulting in managers pursuing other goals than profit.

Question 21

Problems created by the separation of ownership from control:

Answer 21

Managers employ various contractual devices to reduce the possibility that someone will buy the company and bring in new managers

Question 22

What happens when managers own a small faction of the outstanding shares in a firm?

Answer 22

1. They will be more interested than outside shareholders in long term growth
2. They will be focused on promotion games and enhancing their own perks
3. They will want more independence from the outside shareholders

Question 23

Regulation of Insider Trading:

Answer 23

• Corporations rarely prohibited insider trading
• Common law did not prohibit insider trading
• Canada and the U.S. did not prevent insider trading, rather they simply required trades to be reported

Question 24

What did the Stock Market allow for?

Answer 24

Property right to be exchangeable or transferable

Question 25

What is the issue with “separation of ownership and control” in modern corporations?

Answer 25

Modern corporations are associated with the general problem of agency in contracts.

Smaller organizations can avoid the moral hazard or limited liability (partnerships)

Question 26

What two conflicting interests does capital structure affect?

Answer 26

Managers vs. Equity Owners

Question 27

The Linear Contract model in relation to capital structure…

Answer 27

Points to the moral hazard in controlling costs and maximizing value

Question 28

The prisoners dilemma model in relation to capital models:

Answer 28

Points to the conflict among creditors

Question 29

How has shareholder conflict concentred towards share ownership?

Answer 29

The presence of a dominant shareholder can increase pay for performance, and impose other discipline measure to improve management practices

Question 30

What might invoke a hostile takeover?

Answer 30

When the managers fail to maximize the company’s profits and the expected future earning of the company fall and its stock price declines

Question 31

What occurs during a successful hostile takeover?

Answer 31

An outsider may attempt to buy the company and replace its management and try to raise the stock price of the firm.

Question 32

What are Poison Pills in management?

Answer 32

Provisions put in place that are designed to make hostile takeovers too expensive (first adopted by INCO in 1989).

Deters potential acquirers from purchasing 20% or more of the target’s shares

Question 33

How do Poison Pills work in management?

Answer 33

The pill makes the acquisition expensive and is attractive for the board and management who may believe that a bid is not in the best interest of the corporation

Question 34

Poison Pill and Other Takeover Defences

Answer 34

• insider resist takeovers that can enhance share value by issuing poison pills or policies that reduce firm value
• Golden parachutes “overpay” exiting executives
• Greenmail rewards corporate raiders who abandon the takeover