Corporate Finance - The Corporation and Financial Markets

The Four Types of Firms

  • Sole Proprietorship:
    • Owned and run by one person.
    • Typically has few, if any, employees.
    • Advantage: Easy to create.
    • Disadvantages:
      • No separation between the firm and the owner.
      • Unlimited personal liability.
      • Limited life.
  • Partnership:
    • Similar to a sole proprietorship but with more than one owner.
    • All partners are personally liable for all of the firm’s debts.
    • A lender can require any partner to repay all of the firm’s outstanding debts.
    • The partnership ends with the death or withdrawal of any single partner.
    • Limited Partnership:
      • Two types of owners:
        • General Partners: Have the same rights and liability as partners in a “regular” partnership and typically run the firm on a day-to-day basis.
        • Limited Partners: Have limited liability and cannot lose more than their initial investment; they have no management authority and cannot legally be involved in the managerial decision-making for the business.
  • Limited Liability Companies (LLC):
    • All owners have limited liability, but they can also run the business.
    • Relatively new business form in the United States.
  • Corporation:
    • A legal entity separate from its owners.
    • Has many of the legal powers that individuals have, such as the ability to enter into contracts, own assets, and borrow money.
    • The corporation is solely responsible for its own obligations; its owners are not liable for any obligation the corporation enters into.
    • Formation:
      • Corporations must be legally formed.
      • The corporation files a charter with the state it wishes to incorporate in.
      • The state then “charters” the corporation, formally giving its consent to the incorporation.
      • Delaware is a popular choice for incorporation due to its attractive legal environment for corporations.
    • Ownership:
      • Represented by shares of stock.
      • Owner of stock is called:
        • Shareholder
        • Stockholder
        • Equity Holder
      • The sum of all ownership value is called equity.
      • There is no limit to the number of shareholders and, thus, the amount of funds a company can raise by selling stock.
      • Owner is entitled to dividend payments.

Tax Implications for Corporate Entities

  • Tax Implications:
    • Double Taxation
  • “S” Corporations:
    • Firm’s profits are not subject to corporate income tax but instead are allocated directly to the shareholders.

Taxation of Corporate Earnings

  • C Corporation Example:
    • A corporation earns 8 per share before taxes.
    • Corporate tax rate is 25\%.
    • Dividend income tax rate is 20\%.
    • Calculation:
      • Corporate taxes: 0.25 \times $8 = $2
      • Earnings to distribute: $8 - $2 = $6
      • Income taxes on dividend: 0.20 \times $6 = $1.20
      • Earnings remaining after all taxes: $6 - $1.20 = $4.80
      • Total taxes paid: $2 + $1.20 = $3.20
      • Total effective tax rate: 3.20 / 8 = 40\%.
  • C Corporation Alternative Example:
    • A C corporation has income before taxes of $4 million.
    • Corporate tax rate is 34\%.
    • Personal tax rate on dividend income is 20\%.
    • There are 1 million shares outstanding.
    • Calculation:
      • Corporate taxes: 0.34 \times $4,000,000 = $1,360,000
      • Earnings to distribute: $4,000,000 - $1,360,000 = $2,640,000
      • Taxes on dividends: 0.20 \times $2,640,000 = $528,000
      • Earnings remaining after all taxes: $2,640,000 - $528,000 = $2,112,000
      • Earnings per 100 shares: ($2,112,000 / 1,000,000) \times 100 = $211.20
  • S Corporation Example:
    • Corporation has elected subchapter S treatment.
    • Income before taxes is $8 per share.
    • Tax rate on non-dividend income is 35\%.
    • Calculation:
      • Income taxes: 0.35 \times $8 = $2.80
  • S Corporation Alternative Example:
    • An S corporation has income before taxes of $4 million.
    • Personal tax rate on dividend income is 20\%.
    • There are 1 million shares outstanding.
    • Calculation:
      • Taxes on dividends: 0.20 \times $4,000,000 = $800,000
      • Earnings remaining after all taxes: $4,000,000 - $800,000 = $3,200,000
      • Earnings per 100 shares: ($3,200,000 / 1,000,000) \times 100 = $320.00

Ownership Versus Control of Corporations

  • Corporate Management Team:
    • In a corporation, ownership and direct control are typically separate.
    • Board of Directors:
      • Elected by shareholders.
      • Have ultimate decision-making authority.
    • Chief Executive Officer (CEO):
      • Board typically delegates day-to-day decision-making to the CEO.
  • Financial Manager:
    • Responsible for:
      • Investment Decisions
      • Financing Decisions
      • Cash Management
  • Goal of the Firm:
    • Shareholders will agree that they are better off if management makes decisions that maximize the value of their shares.
  • The Firm and Society:
    • Often, a corporation’s decisions that increase the value of the firm’s equity benefit society as a whole.
    • As long as nobody else is made worse off by a corporation’s decisions, increasing the value of the firm’s equity is good for society.
    • It becomes a problem when increasing the value of the firm’s equity comes at the expense of others.

Ethics and Incentives Within Corporations

  • Agency Problems:
    • Managers may act in their own interest rather than in the best interest of the shareholders.
    • One potential solution is to tie management’s compensation to firm performance.
  • CEO Performance:
    • If a CEO is performing poorly, shareholders can express their dissatisfaction by selling their shares, which will 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.
      • The stock price will rise after the new management team “fixes” the company.
  • Corporate Bankruptcy:
    • Reorganization
    • Liquidation

The Stock Market

  • The stock market provides liquidity to shareholders.
    • Liquidity: The ability to easily sell an asset for close to the price at which you can currently buy it.
  • Public Company: Stock is traded by the public on a stock exchange.
  • Private Company: Stock may be traded privately.

Primary and Secondary Stock Markets

  • Primary Markets: When a corporation itself issues new shares of stock and sells them to investors.
  • Secondary Markets: After the initial transaction in the primary market, the shares continue to trade between investors.

Traditional Trading Venues

  • New York Stock Exchange (NYSE):
    • Market Makers/Specialists: Each stock has only one market maker.
  • NASDAQ:
    • Does not meet in a physical location.
    • May have many market makers for a single stock.
  • Bid Price Versus Ask Price:
    • Bid-Ask Spread: Transaction cost

New Competition and Market Changes

  • Due to increased competition from new fully electronic exchanges and alternative trading systems, exchanges handle more than 50% of all trades.

New Competition and Market Changes

  • Limit Order: An order to buy or sell a set amount at a fixed price.
  • Limit Order Book: The collection of all limit orders.
  • Market Orders: Orders that trade immediately at the best outstanding limit order.
  • High-Frequency Traders (HFTs): A class of traders who, with the aid of computers, execute trades many times per second in response to new information.

Dark Pools

  • Dark pools do not make their limit order books visible.
  • Offer investors the ability to trade at a better price with the tradeoff being that their order might not be filled if an excess of either buy or sell orders is received.

Fintech: Finance and Technology

  • Fintech refers to the relation between financial innovation and technical innovation.
  • Telecommunications: Finance professionals have always been amongst the first adopters of improved communication technologies.
  • Security and Verification:
    • Blockchain: A technology that allows a transaction to be recorded in a publicly verifiable way without the need for a trusted third party to certify the authenticity of the transaction.
    • Cryptocurrency: A currency whose creation and ownership are determined via a public blockchain.
  • Automation of Banking Services:
    • Robo-Advisors: Computer programs that are intended to replace the work of financial advisors by providing detailed and customized investment recommendations.
  • Big Data and Machine Learning: Availability of data has enabled companies throughout the economy to better target their products to consumers, and financial services companies are no exception.
  • Competition: Technological advances have opened the way for non-finance organizations to provide financial services.