Berk Chapter 1: The Corporation

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Berk Chapter 1: The Corporation

  1. 1. Chapter 1 The Corporation
  2. 2. Chapter Outline <ul><li>1.1 The Four Types of Firms </li></ul><ul><li>1.2 Ownership Versus Control of Corporations </li></ul><ul><li>1.3 The Stock Market </li></ul>
  3. 3. 1.1 The Four Types of Firms <ul><li>Sole Proprietorship </li></ul><ul><li>Partnership </li></ul><ul><li>Limited Liability Company </li></ul><ul><li>Corporation </li></ul>
  4. 4. Figure 1.1 Types of U.S. Firms Source: www.bizstats.com
  5. 5. 1.1 The Four Types of Firms (cont'd) <ul><li>Sole Proprietorship </li></ul><ul><ul><li>Business is owned and run by one person </li></ul></ul><ul><ul><li>Typically has few, if any, employees </li></ul></ul><ul><ul><li>Advantages </li></ul></ul><ul><ul><ul><li>Easy to create </li></ul></ul></ul><ul><ul><li>Disadvantages </li></ul></ul><ul><ul><ul><li>Unlimited personal liability </li></ul></ul></ul><ul><ul><ul><li>Limited life </li></ul></ul></ul>
  6. 6. 1.1 The Four Types of Firms (cont'd) <ul><li>Partnership </li></ul><ul><ul><li>Similar to a sole proprietorship, but with more than one owner </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>The partnership ends with the death or withdrawal of any single partner. </li></ul></ul>
  7. 7. 1.1 The Four Types of Firms (cont'd) <ul><li>Partnership </li></ul><ul><ul><li>Limited Partnership has two types of owners. </li></ul></ul><ul><ul><ul><li>General Partners </li></ul></ul></ul><ul><ul><ul><ul><li>Have the same rights and liability as partners in a “regular” partnership </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Typically run the firm on a day-to-day basis </li></ul></ul></ul></ul><ul><ul><ul><li>Limited Partners </li></ul></ul></ul><ul><ul><ul><ul><li>Have limited liability and cannot lose more than their initial investment </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Have no management authority and cannot legally be involved in the managerial decision making for the business </li></ul></ul></ul></ul>
  8. 8. 1.1 The Four Types of Firms (cont'd) <ul><li>Limited Liability Company (LLC) </li></ul><ul><ul><li>All owners have limited liability but they can also run the business. </li></ul></ul><ul><ul><li>Relatively new business form in the U.S. </li></ul></ul>
  9. 9. 1.1 The Four Types of Firms (cont'd) <ul><li>Corporation </li></ul><ul><ul><li>A legal entity separate from its owners </li></ul></ul><ul><ul><ul><li>Has many of the legal powers individuals have such as the ability to enter into contracts, own assets, and borrow money </li></ul></ul></ul><ul><ul><ul><li>The corporation is solely responsible for its own obligations. Its owners are not liable for any obligation the corporation enters into. </li></ul></ul></ul>
  10. 10. 1.1 The Four Types of Firms (cont'd) <ul><li>Corporation </li></ul><ul><ul><li>Formation </li></ul></ul><ul><ul><ul><li>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. </li></ul></ul></ul><ul><ul><ul><li>Due to its attractive legal environment for corporations, Delaware is a popular choice for incorporation. </li></ul></ul></ul>
  11. 11. 1.1 The Four Types of Firms (cont'd) <ul><li>Corporation </li></ul><ul><ul><li>Ownership </li></ul></ul><ul><ul><ul><li>Represented by shares of stock </li></ul></ul></ul><ul><ul><ul><li>Owner of stock is called </li></ul></ul></ul><ul><ul><ul><ul><li>Shareholder </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Stockhoder </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Equity Holder </li></ul></ul></ul></ul><ul><ul><ul><li>Sum of all ownership value is called equity. </li></ul></ul></ul><ul><ul><ul><li>There is no limit to the number of shareholders, and thus the amount of funds a company can raise by selling stock. </li></ul></ul></ul><ul><ul><ul><li>Owner is entitled to dividend payments. </li></ul></ul></ul>
  12. 12. 1.1 The Four Types of Firms (cont'd) <ul><li>Corporation </li></ul><ul><ul><li>Tax Implications </li></ul></ul><ul><ul><ul><li>Double Taxation </li></ul></ul></ul><ul><ul><li>“S” Corporations </li></ul></ul><ul><ul><ul><li>Firm’s profits are not subject to corporate income tax, but instead are allocated directly to the shareholders. </li></ul></ul></ul>
  13. 13. Textbook Example 1.1
  14. 14. Textbook Example 1.1 (cont'd)
  15. 15. Alternative Example 1.1a <ul><li>Problem </li></ul><ul><ul><li>You are a shareholder in a C corporation. </li></ul></ul><ul><ul><li>The corporation earns $4 per share before taxes. </li></ul></ul><ul><ul><li>Once it has paid taxes it will distribute the rest of its earnings to you as a dividend. </li></ul></ul><ul><ul><li>The corporate tax rate is 34% and the personal tax rate on dividend income is 25%. </li></ul></ul><ul><ul><li>How much is left for you after all taxes are paid? </li></ul></ul>
  16. 16. Alternative Example 1.1a <ul><li>Solution </li></ul><ul><ul><li>First, the corporation pays taxes. It earned $4 per share, but must pay 0.34 × $4 = $1.36 to the government in corporate taxes. </li></ul></ul><ul><ul><li>That leaves $2.64 to distribute. However, you must pay 0.15 × $2.64 = $0.396 in income taxes on this amount, leaving $2.64 – $0.396 = $2.244 per share after all taxes are paid. </li></ul></ul><ul><ul><li>As a shareholder you only end up with $2.244 of the original $4 in earnings. The remaining $1.36 + $0.396 = $1.756 is paid as taxes. </li></ul></ul><ul><ul><li>Thus, your total effective tax rate is $1.756 ÷ $4 = 43.9%. </li></ul></ul>
  17. 17. Alternative Example 1.1b <ul><li>Problem </li></ul><ul><ul><li>You are a shareholder in a C corporation. </li></ul></ul><ul><ul><li>The corporation earns $7.50 per share before taxes. </li></ul></ul><ul><ul><li>Once it has paid taxes, it will distribute the rest of its earnings to you as a dividend. </li></ul></ul><ul><ul><li>The corporate tax rate is 35% and the personal tax rate on dividend income is 20%. </li></ul></ul><ul><ul><li>How much is left for you after all taxes are paid? </li></ul></ul>
  18. 18. Alternative Example 1.1b <ul><li>Solution </li></ul><ul><ul><li>First, the corporation pays taxes. It earned $7.50 per share, but must pay 0.35 × $7.50 = $2.70 to the government in corporate taxes. </li></ul></ul><ul><ul><li>That leaves $4.80 to distribute. However, you must pay 0.20 × $4.80 = $0.96 in income taxes on this amount, leaving $4.80 – $0.96 = $3.84 per share after all taxes are paid. </li></ul></ul><ul><ul><li>As a shareholder you only end up with $3.84 of the original $7.50 in earnings. The remaining $2.70 + $0.96 = $3.66 is paid as taxes. </li></ul></ul><ul><ul><li>Thus, your total effective tax rate is $3.66 ÷ $7.50 = 48.8%. </li></ul></ul>
  19. 19. Textbook Example 1.2
  20. 20. Textbook Example 1.2 (cont'd)
  21. 21. Alternative Example 1.2a <ul><li>Problem </li></ul><ul><ul><li>Rework Alternative Example 1.1 assuming the corporation in that example has elected subchapter S treatment and your tax rate on non-dividend income is 39%. </li></ul></ul>
  22. 22. Alternative Example 1.2a <ul><li>Solution </li></ul><ul><ul><li>In this case, the corporation pays no taxes. </li></ul></ul><ul><ul><li>It earned $4 per share. </li></ul></ul><ul><ul><li>Whether or not the corporation chooses to distribute or retain this cash, you must pay 0.39 × $4 = $1.56 in income taxes, which is substantially lower than the $1.756 you paid in Alternative Example 1.1a. </li></ul></ul>
  23. 23. Alternative Example 1.2b <ul><li>Problem </li></ul><ul><ul><li>Rework Alternative Example 1.1 assuming the corporation in that example has elected subchapter S treatment and your tax rate on non-dividend income is 36%. </li></ul></ul>
  24. 24. Alternative Example 1.2b <ul><li>Solution </li></ul><ul><ul><li>In this case, the corporation pays no taxes. </li></ul></ul><ul><ul><li>It earned $7.50 per share. </li></ul></ul><ul><ul><li>Whether or not the corporation chooses to distribute or retain this cash, you must pay 0.36 × $7.50 = $2.70 in income taxes, which is substantially lower than the $3.66 you paid in Alternative Example 1.1b. </li></ul></ul>
  25. 25. 1.2 Ownership versus Control of Corporations <ul><li>Corporate Management Team </li></ul><ul><ul><li>In a corporation, ownership and direct control are typically separate. </li></ul></ul><ul><ul><li>Board of Directors </li></ul></ul><ul><ul><ul><li>Elected by shareholders </li></ul></ul></ul><ul><ul><ul><li>Have ultimate decision-making authority </li></ul></ul></ul><ul><ul><li>Chief Executive Officer (CEO) </li></ul></ul><ul><ul><ul><li>Board typically delegates day-to-day decision making to CEO. </li></ul></ul></ul>
  26. 26. Figure 1.2 Organizational Chart of a Typical Corporation
  27. 27. 1.2 Ownership versus Control of Corporations (cont'd) <ul><li>Financial Manager </li></ul><ul><ul><li>Responsible for: </li></ul></ul><ul><ul><ul><li>Investment Decisions </li></ul></ul></ul><ul><ul><ul><li>Financing Decisions </li></ul></ul></ul><ul><ul><ul><li>Cash Management </li></ul></ul></ul>
  28. 28. 1.2 Ownership versus Control of Corporations (cont'd) <ul><li>Goal of the Firm </li></ul><ul><ul><li>Shareholders will agree that they are better off if management makes decisions that maximizes the value of their shares. </li></ul></ul>
  29. 29. 1.2 Ownership versus Control of Corporations (cont'd) <ul><li>Ethics and Incentives within Corporations </li></ul><ul><ul><li>Agency Problems </li></ul></ul><ul><ul><ul><li>Managers may act in their own interest rather than in the best interest of the shareholders. </li></ul></ul></ul><ul><ul><ul><li>One potential solution is to tie management’s compensation to firm performance. </li></ul></ul></ul><ul><ul><ul><li>How should performance be measured? </li></ul></ul></ul>
  30. 30. 1.2 Ownership versus Control of Corporations (cont'd) <ul><li>CEO Performance </li></ul><ul><ul><li>If a CEO is performing poorly, shareholders can express their dissatisfaction by selling their shares. This selling pressure will drive the stock price down. </li></ul></ul><ul><ul><li>Hostile Takeover </li></ul></ul><ul><ul><ul><li>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. </li></ul></ul></ul>
  31. 31. 1.2 Ownership versus Control of Corporations (cont'd) <ul><li>Corporate Bankruptcy </li></ul><ul><ul><li>Reorganization </li></ul></ul><ul><ul><li>Liquidation </li></ul></ul>
  32. 32. 1.3 The Stock Market <ul><li>The stock market provides liquidity to shareholders. </li></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><ul><li>The ability to easily sell an asset for close to the price you can currently buy it for </li></ul></ul></ul>
  33. 33. 1.3 The Stock Market (cont'd) <ul><li>Public Company </li></ul><ul><ul><li>Stock is traded by the public on a stock exchange. </li></ul></ul><ul><li>Private Company </li></ul><ul><ul><li>Stock may be traded privately. </li></ul></ul>
  34. 34. 1.3 The Stock Market (cont'd) <ul><li>Primary Markets </li></ul><ul><ul><li>When a corporation itself issues new shares of stock and sells them to investors, they do so on the primary market. </li></ul></ul><ul><li>Secondary Markets </li></ul><ul><ul><li>After the initial transaction in the primary market, the shares continue to trade in a secondary market between investors. </li></ul></ul>
  35. 35. 1.3 The Stock Market (cont'd) <ul><li>Largest Stock Markets </li></ul><ul><ul><li>New York Stock Exchange (NYSE) </li></ul></ul><ul><ul><ul><li>Market Makers/Specialists </li></ul></ul></ul><ul><ul><ul><ul><li>Each stock has only one market maker </li></ul></ul></ul></ul><ul><ul><li>NASDAQ </li></ul></ul><ul><ul><ul><li>Does not meet in a physical location </li></ul></ul></ul><ul><ul><ul><li>May have many market makers for a single stock </li></ul></ul></ul><ul><ul><li>Bid Price versus Ask Price </li></ul></ul><ul><ul><ul><li>Bid-Ask Spread </li></ul></ul></ul><ul><ul><ul><ul><li>Transaction cost </li></ul></ul></ul></ul>
  36. 36. Figure 1.3 Worldwide Stock Markets Ranked by Two Common Measures <ul><li>Source: www.world-exchanges.org </li></ul>
  37. 37. Chapter Quiz <ul><li>What are the advantages and disadvantages of organizing a business as a “S” corporation? </li></ul><ul><li>How does a limited partnership differ from a limited liability company? </li></ul><ul><li>What is the principal-agent problem that may exist in a corporation? </li></ul><ul><li>What is the NASDAQ? </li></ul><ul><li>What advantage does a stock market provide to investors of corporations? </li></ul>

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