The Firm Flashcards
4 types of firms
sole proprietorship
partnership
limited liability company
corporation
sole proprietorship
owned and run by one person
typically has few, if any employees
ads: - easy & cheap to create
disads: - no separation between the firm and the owner
- unlimited personal liability
- limited life
limited liability
where a person’s financial liability is limited to a fixed sum, most commonly the value of a person’s investment in a company or partnership
- a shareholders in a limited company is not personally liable for any debts of the company, other than for the amount already invested in the company
most a person can lose is their investment in the company
investors have limited liability
unlimited liability
upon losing investment, will have to pay the value pf the debt from your own pocket
Partnership
similar to sole proprietorship but with more than one owner
no separation between the firm and owner
all partners are personally liable for all of the firm’s debt
a lender can acquire any partner to repay all of the firms outstanding debts
partnership ends with death/withdrawal of any partner
ad: easy to set up
disad: - no separation, unlimited liability, difficult to transfer ownership
Limited partnership
two types of owners
General partners:
- have same rights and liability as partners in a regular partnership, typically run firm on day-to-day basis
Limited partners:
- limited liability
- have no management authority and can’t legally be involved in the managerial decisions
limited liability company
LLC
all owners have limited liability but they can also run the business
disad: - may have to be dissolved if one member dies or is bankrupted (difficult to transfer ownership)
- difficult to raise capital
Corporation
a legal entity separate from its owners
can enter into contracts, own assets and borrow money
solely responsible for its own obligations. It’s owners aren’t liable for any obligation the corporation enters into
limited liability
- must be legally formed (files a charter with the state it wishes to incorporate into)
the state then charters the coporation - more costly to set up
ads: easy to raise capital, limited liability, easy to transfer ownership
disad: double taxation unless “S” corporation
Ownership
represented by shares of stock
sum of all ownership value is called equity (value of stocks)
no limit to the number of shareholders so no limit on funds company can raise by selling stock
owner of stocks is entitled to dividend payments (up to firm if they are to issue them)
Double taxation
corporation has to pay corporate tax for its profit
after tax profit is used for:
- paying dividends to shareholders
- retain earnings for reinvestment
for the dividends a shareholder receives they have to pay income tax
“S” corporations
profits not subject to corporate income tax
profits directly allocated to shareholders
Board of directors
elected by shareholders
if you have more shares, you probably have more say
have ultimate-decision making authority
board typically elects a CEO who carries out the day-today decision making
Financial managers
responsible for:
- investment decisions
- financing decisions: how investments financed
eg through using internal funds, raising money by selling stocks, borrow money
- cash management (managing working capital)
ensure firm has enough cash to meet day-to-day obligations
goal of firm is to maximise value of the shares
The firm & society
often a corporations decisions that increases the firms equity value benefit society as a whole
as long as no one else is worse off
becomes a problem when increasing equity value comes at others expense (pollution)
Agency problems in a firm
managers may act in their own interests rather than in best interest of the shareholders
e.g over-use of private jets, corruption
could tie management’s compensation to firms performance
performance could be measured through stock price
if a CEO is performing badly then shareholders can sell their shares and 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
stock price may rise under new management
hard for hostile takeover to succeed but pressure will incentivise CEO to do better
Corporate bankruptcy
when a firm is unable to pay its debt
transfer of ownership from equity owners to lenders
can be reorganised if some part of the business is still running
could be liquidated when business shut down and assets sold
Total assets= equity + total liability
so equity= total assets - total liabilities so equity owners are the residual claimer
if total assets are smaller than total liabilities, ownership transferred from equity owners to lenders
The stock market & liquidity
stock market provides liquidity to share holders
liquidity is the ability to easily sell an asset for close to the price at which you currently buy it
if you can’t sell it easily without substantial loss of value, then its an illiquid asset
public companies have their stock traded on a stock exchange
private companies have their stocks traded privately
primary markets
when a corporation itself issues new shares of stock and sells them to investors, done on primary market
secondary market
after the initial transaction in the primary market, the shares continue to trade in a secondary market between investors
Bid price versus ask price
the bid-ask spread is the transaction cost for the investors
bid price is the price the market maker is willing to purchase stocks (price you get if you sell)
ask price is the price the market maker is selling stocks
IPO
a private company offering stocks to the public in a new stock issuance
stocks then traded on a stock exchange
Market maker
- individuals/entities who both buy and sell financial securities (e.g stocks) from their own account in a financial market
main goal is to profit from the bid-ask spread
provides liquidity to the stock exchange
