L1 Refined – Corporate finance: The rise and structure of corporations

The rise of modern corporations emerged due:

To industrialization, which created large-scaled projects e.g. railways and factories that required more capital than any single owner could provide.

To attract investors, two legal and market pillars were established:

-        Limited liability: Which ensures an investor's personal assets (like a house or car) cannot be taken if the firm fails, and-

-        Tradable shares: Which allow investors to buy and exit by selling their ownership at any time.

There are 4 types of firms:

• Sole Proprietorship

• Partnership

• Limited Liability Company

• Corporation

Sole Proprietorship

Owned and run by one person; it is easy to create but suffers from:

o   Unlimited personal liability.

o   Limited life tied to the owner.

o   No legal separation between firm and owner.

Partnership:

•       Owned by multiple people who are personally liable for their debt.

o   Common where the owner reputation is strong

o   Ends with death or withdrawal of any partner except if it’s arranged that they can buyout from the deceased/withdrawn partner.

• Limited Partnerships

Limited Partnerships: Business where there are 2 types of partners:

•   General partners: Manage the business with unlimited personal liability.

• Limited partners: Who invest money but have no management authority (hedge funds), limited partner interest is transferable, and limited liability up to their investment amount.

Limited Liability Company (LLC):

New business form with no general partner, where all owners have limited liability, and can also run the business.

Corporation:

•       A separate legal entity that can enter contracts, own assets and borrow money in its own name.

Corporation traits

o   Owners not liable for company’s obligations.

o   Corporate charter must be approved by the state that they can go big.

o   Ownership stake is divided in shares called stocks.

o   Owners of share of a stock = Shareholders/Stockholders/Equity Holder

o   While they represent only a minority of businesses (18% in the US), they account for most of the revenue (82%)

o   No limit to number of shareholders or value

o   Owners are entitled to dividends and voting rights

o   No limitation on who own its stock.

o   Hence, normal trading in shares is anonymous. For buying/selling big chunks of shares apply transparency rules.

Taxation:

Different types of firms can be taxed differently. A major disadvantage of the corporation is double taxation: profits are taxed at the corporate level, and then dividends are taxed again as personal income for the shareholders.

How are ownership and control seperated in a corporation:

In a corporation, ownership and control are separated. Shareholders own the company and elect a Board of Directors, who then delegate day-to-day operations to the CEO. The ones that own and control are different.

How does the newer paradigm differ from the traditional goal of the firm:

While the traditional goal of the firm was to maximize shareholder wealth via stock prices and dividends, a newer paradigm focuses on maximizing stakeholder utility. This includes considering the needs of workers, lenders, customers, and society (such as avoiding pollution) so that profit is not made at the expense of others.

Agency Problem:

Because managers are not the owners, they may prioritize their own interests e.g. higher salaries, job security (avoid risky projects even if good for shareholders), power ("empire building"), or luxurious perks over the interests of shareholders and wanting short-term results to look good now (even if long-term value suffers).

Various ways of adressing Agency Problems and align managers interest with the company:

•       Incentive Pay: (bonuses, stock, stock options) – Link manager pay to company performance specifically long-term stock and options to ensure managers benefit when the company’s value rises.

•       Board of directors’ oversight: Oversee management and accountability.

•       Monitoring and audits: Internal audits to monitor actions and reduce false information in accounting.

•       Debt discipline: Interest payments (managers spend wastefully) make debt force management to be efficient.

•       Market discipline (threat of takeover or poor stock performance can motivate managers)

•       When company perform and get profit then return interest in debt and cannot misuse it.

The stock market (the whole market):

The stock market provides liquidity to corporations and shareholders, allowing shareholders to buy and sell ownership easily. Private companies can be traded privately.

Trading occurs in two venues:

The primary market, where corporations issue new shares directly to investors, and the secondary market, where investors trade shares among themselves.

Stock exchange: One such marketplace.

Investors use two trading strategies:

•       Buying (Going Long): Buying shares now in hopes the price rises; the maximum loss is the initial investment.

•       Short Selling: Borrowing shares to sell them now, hoping the price drops so they can be bought back cheaper later; the potential loss is unlimited because the stock price can rise indefinitely.

Recent trends include:

market fragmentation and the rise of High-Frequency Traders (HFT), "robot traders" that execute multiple trades in milliseconds to trade on information before others.

New technologies are fundamentally changing how ownership and control work: How shares was traditionally and now modern:

Traditional share ownerships: Share is a legal claim, ownership on a corporation and gives rights to cash flows (dividends), voting and residual value.

Modern: Shares are more digital where ownership is recorded by centralized intermediaries like stock exchanges, clearing house, custodians and brokers.

Blockchain

A distributed, decentralized ledger that records and transfers ownership independently with no traditional intermediaries like banks or clearing houses. Instead, it is the key contribution to corporate finance because of its new infrastructure for recording and transferring ownership. The transactions are grouped into blocks and cryptographically linked.

Tokenization

•       The process of converting real-world assets (like buildings) into many digital tokens, allowing for fractional ownership and lowering entry barriers for small investors.

Tokens

•       Digital representations of economic rights and represent money, ownership claims, voting or cash flow rights.

Key differences between tokenization and tokens:

o   Records are kept on a decentralized ledger.

o   No single central authority controls the ownership register.

Smart Contracts:

Self-executing code on a blockchain that can automatically handle dividends, voting, and ownership transfers, which helps reduce agency problems through automation.

Smart contracts: Economic interpretation

o   Like shares, tokens define who owns what

o   Like incentive contracts, smart contracts can reduce agency problems

o   Enable fractional ownership, lowering entry barriers

-        Why these matters

o   Opens the door to tokenized shares

o   Ownership works like traditional shares, but with fewer intermediaries

AI and Big Data:

Firms now use machine learning to analyze massive data sets, including Twitter feeds, news sentiment, weather, and even satellite images of car parks or oil ships, to make better investment predictions.

Robo-Advisors:

Automated systems that provide investment advice based on mathematical objectives and user preferences.

Cryptocurrencies

Alternative, decentralized and digital currencies • Bitcoin • Blockchain. Currency based on block chain technology, blockchain is just technology that allow to have cryptocurrency.