The Corporation Chapter 1

Chapter Outline 1.1 The Types of Firms 1.2 Ownership Versus Control of Corporations 1.3 The Stock Market

Learning Objectives 1. List and define the major types of firms; describe major characteristics of each type, including the means for distributing income to owners. 2. Distinguish between limited and unlimited liability, and list firm types that are subject to each type of liability. 3. Describe the taxation consequences for corporate forms.

Learning Objectives 4. Discuss the division of corporate ownership into shares of stock; evaluate the implications of that division for corporate decision making. 5. Explain how corporate bankruptcy can be viewed as a change in firm ownership. 6. Compare and contrast the characteristics of shares that are publicly traded and the characteristics of those that are not.

1.1 The Types of Firms Sole Proprietorship Partnership Limited Liability Company or Corporation

Figure 1.1 Types of U.S. Firms Source:

1.1 The Types of Firms (cont'd) Sole Proprietorships Business is owned and run by one person Typically has few, if any, employees Advantages Easy to create Disadvantages Unlimited personal liability Limited life

1.1 The Types of Firms (cont'd) Partnerships 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.

1.1 The Types of Firms (cont'd) Partnerships Limited Partnership has two types of owners. General Partners Have the same rights and liability as partners in a (general) partnership Typically run the firm on a day-to-day basis Limited Partners Have limited liability and cannot lose more than their initial investment Have no management authority and cannot legally be involved in the managerial decision making for the business

1.1 The Types of Firms (cont'd) Limited Liability Companies Limits the owners’ liability to their investment. Two types of limited liability company: Private company Public company

1.1 The Types of Firms (cont'd) Corporation (or company) A legal entity separate from its owners Has many of the legal powers 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.

1.1 The Types of Firms (cont'd) Features of Corporations Formation Corporations must be legally formed. A legal document (known as a corporate charter in the United States) is created upon the formation of the company. Setting up a corporation is more costly than setting up a sole proprietorship.

1.1 The Types of Firms (cont'd) Features of Corporations Ownership Represented by shares of stock An owner of share is known as a: Shareholder Stockholder Equity Holder 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 shares. Owner is entitled to dividend payments.

1.1 The Types of Firms (cont'd) Tax Implications for Corporate Entities Tax Implications Double Taxation (or classical system) Imputation system In U.S. for “S” corporations the firm’s profits are not subject to corporate income tax, but instead are allocated directly to the shareholders.

Textbook Example 1.1

Textbook Example 1.1 (cont'd)

Alternative Example 1.1a Problem You are a shareholder in a corporation. The corporation earns $4 per share before taxes. Once it has paid taxes it will distribute the rest of its earnings to you as a dividend. The corporate tax rate is 34% and the personal tax rate on dividend income is 15%. How much is left for you after all taxes are paid?

Alternative Example 1.1a Solution First, the corporation pays taxes. It earned $4 per share, but must pay 0.34 × $4 = $1.36 to the government in corporate taxes. 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. As a shareholder you only end up with $2.244 of the original $4 in earnings. The remaining $ $0.396 = $1.756 is paid as taxes. Thus, your total effective tax rate is $1.756 ÷ $4 = 43.9%.

Alternative Example 1.1b Problem You are a shareholder in a corporation. The corporation earns $7.50 per share before taxes. Once it has paid taxes, it will distribute the rest of its earnings to you as a dividend. The corporate tax rate is 35% and the personal tax rate on dividend income is 20%. How much is left for you after all taxes are paid?

Alternative Example 1.1b Solution First, the corporation pays taxes. It earned $7.50 per share, but must pay 0.35 × $7.50 = $2.625 to the government in corporate taxes. That leaves $4.875 to distribute. However, you must pay 0.20 × $4.875 = $0.975 in income taxes on this amount, leaving $4.875 – $0.975 = $3.90 per share after all taxes are paid. As a shareholder you only end up with $3.90 of the original $7.50 in earnings. The remaining $ $0.975 = $3.60 is paid as taxes. Thus, your total effective tax rate is $3.60 ÷ $7.50 = 48%.

Textbook Example 1.2

Textbook Example 1.2 (cont'd)

Alternative Example 1.2a Problem Rework Alternative Example 1.1a assuming the corporation in that example has elected subchapter S treatment and your tax rate on non-dividend income is 39%.

Alternative Example 1.2a Solution In this case, the corporation pays no taxes. It earned $4 per share. 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.

Alternative Example 1.2b Problem Rework Alternative Example 1.1b assuming the corporation in that example has elected subchapter S treatment and your tax rate on non-dividend income is 36%.

Alternative Example 1.2b Solution In this case, the corporation pays no taxes. It earned $7.50 per share. 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.

1.2 Ownership versus Control of Corporations The 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 CEO.

Figure 1.2 Organizational Chart of a Typical Corporation

1.2 Ownership versus Control of Corporations (cont'd) The Financial Manager Responsible for: Investment Decisions Financing Decisions Cash for Treasury Management

1.2 Ownership versus Control of Corporations (cont'd) The Goal of the Firm Shareholders will agree that they are better off if management makes decisions that maximizes the value of their shares.

1.2 Ownership versus Control of Corporations (cont'd) 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.

1.2 Ownership versus Control of Corporations (cont'd) 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. How should performance be measured?

1.2 Ownership versus Control of Corporations (cont'd) The CEO’s Performance If a CEO is performing poorly, shareholders can express their dissatisfaction by selling their shares. This selling pressure will drive the share price down. Hostile Takeover Low share prices may entice a Corporate Raider to buy enough shares so they have enough control to replace current management. The share price will rise after the new management team “fixes” the company.

1.2 Ownership versus Control of Corporations (cont'd) Corporate Bankruptcy Reorganization Liquidation

1.3 The Stock Market The stock market provides liquidity to shareholders. Liquidity The ability to easily sell an asset for close to the price you can currently buy it for

1.3 The Stock Market (cont'd) Public Company Shares are traded by the public on a stock exchange. Private Company Shares may be traded privately.

1.3 The Stock Market (cont'd) Primary Markets When a corporation itself issues new shares and sells them to investors, they do so on the primary market. Secondary Markets After the initial transaction in the primary market, the shares continue to trade in a secondary market between investors.

1.3 The Stock Market (cont'd) The Largest Stock Markets New York Stock Exchange (NYSE) Market Makers/Specialists Each share has only one market maker NASDAQ (an over-the-counter market) Does not meet in a physical location May have many market makers for a single share Bid Price versus Ask Price Bid-Ask Spread Transaction cost

Figure 1.3 Worldwide Stock Markets Ranked by Two Common Measures Source: