CorporateFinanceFifthEditionChapter1TheCorporationandFinancialMarketsCopyright?2020,2017,2014PearsonEducation,Inc.

AllRightsReservedChapterOutline1.1

TheFourTypesofFirms1.2

OwnershipVersusControlofCorporations

1.3

TheStockMarket1.4

Fintech:FinanceandTechnologyLearningObjectives(1of3)ListanddefinethefourmajortypesoffirmsintheUnitedStates;describemajorcharacteristicsofeachtype,includingthemeansfordistributingincometoowners.Distinguishbetweenlimitedandunlimitedliability,andlistfirmtypesthataresubjecttoeachtypeofliability.DescribethetaxationconsequencesforCandScorporateforms.LearningObjectives(2of3)Discussthedivisionofcorporateownershipintosharesofstock;evaluatetheimplicationsofthatdivisionforcorporatedecisionmaking.Explainhowcorporatebankruptcycanbeviewedasachangeinfirmownership.Compareandcontrastthecharacteristicsofsharesthatarepubliclytradedandthosethatarenot.LearningObjectives(3of3)Describethemajorchangesthatstockmarketshavegonethroughinthelastdecade.Differentiatebetweentradingonanexchangeandtradinginadarkpool.DescribetheimpactofvarioustypesofFintech,suchastelecommunications,security,automation,andbigdataonthefieldoffinance.1.1TheFourTypesofFirmsSoleProprietorshipPartnershipLimitedLiabilityCompanyCorporationFigure1.1TypesofU.S.FirmsSource:SoleProprietorshipBusinessisownedandrunbyoneperson.Typicallyhasfew,ifany,employees.AdvantageEasytocreateDisadvantagesNoseparationbetweenthefirmandtheownerUnlimitedpersonalliabilityLimitedlifePartnership(1of2)Similartoasoleproprietorship,butwithmorethanoneownerAllpartnersarepersonallyliableforallofthefirm’sdebts.Alendercanrequireanypartnertorepayallofthefirm’soutstandingdebts.Thepartnershipendswiththedeathorwithdrawalofanysinglepartner.Partnership(2of2)LimitedPartnershiphastwotypesofowners.GeneralPartnersHavethesamerightsandliabilityaspartnersina

“regular”partnershipTypicallyrunthefirmonaday-to-daybasisLimitedPartnersHavelimitedliabilityandcannotlosemorethantheirinitialinvestmentHavenomanagementauthorityandcannotlegallybeinvolvedinthemanagerialdecisionmakingforthebusinessLimitedLiabilityCompanies(L

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C)Allownershavelimitedliability,buttheycanalsorunthebusiness.RelativelynewbusinessformintheUnitedStatesCorporation(1of3)AlegalentityseparatefromitsownersHasmanyofthelegalpowersindividualshavesuchastheabilitytoenterintocontracts,ownassets,andborrowmoney.Thecorporationissolelyresponsibleforitsownobligations.Itsownersarenotliableforanyobligationthecorporationentersinto.Corporation(2of3)FormationCorporationsmustbelegallyformed.Thecorporationfilesacharterwiththestateitwishestoincorporatein.Thestatethen“charters”thecorporation,formallygivingitsconsenttotheincorporation.Duetoitsattractivelegalenvironmentforcorporations,Delawareisapopularchoiceforincorporation.Corporation(3of3)OwnershipRepresentedbysharesofstockOwnerofstockiscalledShareholderStockholderEquityHolderSumofallownershipvalueiscalledequity.Thereisnolimittothenumberofshareholdersand,thus,theamountoffundsacompanycanraisebysellingstock.Ownerisentitledtodividendpayments.TaxImplicationsforCorporateEntitiesTaxImplicationsDoubleTaxation“S”CorporationsFirm’sprofitsarenotsubjecttocorporateincometax,butinsteadareallocateddirectlytotheshareholders.TextbookExample1.1(1of2)TaxationofCorporateEarningsProblemYouareashareholderinacorporation.Thecorporationearns$8persharebeforetaxes.Afterithaspaidtaxes,itwilldistributetherestofitsearningstoyouasadividend.Thedividendisincometoyou,soyouwillthenpaytaxesontheseearnings.Thecorporatetaxrateis25%andyourtaxrateondividendincomeis20%.Howmuchoftheearningsremainsafteralltaxesarepaid?TextbookExample1.1(2of2)SolutionFirst,thecorporationpaystaxes.Itearned$8pershare,butmustpaytothegovernmentincorporatetaxes.Thatleaves$6todistribute.However,youmustpayinincometaxesonthisamount,leavingpershareafteralltaxesarepaid.Asashareholderyouonlyendupwith$4.80oftheoriginal$8inearnings;theremainingispaidastaxes.Thus,yourtotaleffectivetaxrateisAlternativeExample1.1(1of2)ProblemYouareashareholderinaCcorporationthathasincomebeforetaxesof$4million.Oncethefirmhaspaidtaxes,itwilldistributetherestofitsearningstoitsshareholdersasadividend.Thereare1millionsharesoutstanding.Assumethecorporatetaxrateis34%,andthepersonaltaxrateondividendincomeis20%.Asashareholderwith100shares,howmuchwillyoureceiveafteralltaxesarepaid?AlternativeExample1.1(2of2)SolutionFirst,thecorporationmustpayitstaxes.Itearned$4millionbutmustpaymillionincorporatetaxes.Thatleaves$2.64milliontodistributetoshareholders.Collectively,shareholderswillhavetopayintaxesonthedividends.Thisleavesafteralltaxesarepaid.Astheownerof100shares,youwillhave$211.20afterbothcorporateandpersonaltaxesarepaid.TextbookExample1.2(1of2)TaxationofSCorporationEarningsProblemReworkExample1.1assumingthecorporationinthatexamplehaselectedsubchapterStreatmentandyourtaxrateonnon-dividendincomeis35%.TextbookExample1.2(2of2)SolutionInthiscase,thecorporationpaysnotaxes.Itearned$8pershare.Whetherornotthecorporationchoosestodistributeorretainthiscash,youmustpayincometaxes,whichis$0.40lowerthanthe$3.20paidinExample1.1.AlternativeExample1.2(1of2)ProblemYouareashareholderinanScorporationthathasincomebeforetaxesof$4million.Oncethefirmhaspaidtaxes,itwilldistributetherestofitsearningstoitsshareholdersasadividend.Thereare1millionsharesoutstanding.Assumethecorporatetaxrateis34%,andthepersonaltaxrateondividendincomeis20%.Asashareholderwith100shares,howmuchwillyoureceiveafteralltaxesarepaid?AlternativeExample1.2(2of2)SolutionBecausethefirmisanS-corp.,thecorporationpaysnotaxes.Thatleaves$4milliontodistributetoshareholders.Collectively,shareholderswillhavetopayintaxesonthedividends.Thisleavesafteralltaxesarepaid.Astheownerof100shares,youwillhave$320.00afterpersonaltaxesarepaid.1.2OwnershipVersusControlofCorporationsCorporateManagementTeamInacorporation,ownershipanddirectcontrolaretypicallyseparate.BoardofDirectorsElectedbyshareholdersHaveultimatedecision-makingauthorityChiefExecutiveOfficer(C

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O)Boardtypicallydelegatesday-to-daydecisionmakingtoC

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O.Figure1.2OrganizationalChartofaTypicalCorporationFinancialManagerResponsibleforInvestmentDecisionsFinancingDecisionsCashManagementGoaloftheFirmShareholderswillagreethattheyarebetteroffifmanagementmakesdecisionsthatmaximizethevalueoftheirshares.TheFirmandSocietyOften,acorporation’sdecisionsthatincreasethevalueofthefirm’sequitybenefitsocietyasawhole.Aslongasnobodyelseismadeworseoffbyacorporation’sdecisions,increasingthevalueofthefirm’sequityisgoodforsociety.Itbecomesaproblemwhenincreasingthevalueofthefirm’sequitycomesattheexpenseofothers.EthicsandIncentivesWithinCorporations(1of3)AgencyProblemsManagersmayactintheirowninterestratherthaninthebestinterestoftheshareholders.Onepotentialsolutionistotiemanagement’scompensationtofirmperformance.Howshouldperformancebemeasured?EthicsandIncentivesWithinCorporations(2of3)C

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PerformanceIfaC

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isperformingpoorly,shareholderscanexpresstheirdissatisfactionbysellingtheirshares.Thissellingpressurewilldrivethestockpricedown.HostileTakeoverLowstockpricesmayenticeaCorporateRaidertobuyenoughstocksotheyhaveenoughcontroltoreplacecurrentmanagement.Thestockpricewillriseafterthenewmanagementteam“fixes”thecompany.EthicsandIncentivesWithinCorporations(3of3)CorporateBankruptcyReorganizationLiquidation1.3TheStockMarket(1of2)Thestockmarketprovidesliquiditytoshareholders.LiquidityTheabilitytoeasilysellanassetforclosetothepriceatwhichyoucancurrentlybuyit1.3TheStockMarket(2of2)PublicCompanyStockistradedbythepubliconastockexchange.PrivateCompanyStockmaybetradedprivately.PrimaryandSecondaryStockMarketsPrimaryMarketsWhenacorporationitselfissuesnewsharesofstockandsellsthemtoinvestors,theydosoontheprimarymarket.SecondaryMarketsAftertheinitialtransactionintheprimarymarket,thesharescontinuetotradeinasecondarymarketbetweeninvestors.TraditionalTradingVenuesNewYorkStockExchange(N

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E)MarketMakers/SpecialistsEachstockhasonlyonemarketmaker.N

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QDoesnotmeetinaphysicallocationMayhavemanymarketmakersforasinglestockBidPriceVersusAskPriceBid-AskSpreadTransactioncostNewCompetitionandMarketChanges(1of2)In2005,theN

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EandN

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Qexchangesaccountedforover75%ofalltradeinU.S.stocks.Today,duetoincreasedcompetitionfromnewfullyelectronicexchangesandalternativetradingsystems,handlemorethan50%ofalltrades.Figure1.3WorldwideStockExchangesRankedbyTwoCommonMeasuresSource:Figure1.4N

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QMarketShareSource:J.Angel,L.Harris,andC.Spatt,“EquityTradinginthe21stCentury:AnUpdate,”QuarterlyJournalofFinance5(2015):1–39.NewCompetitionandMarketChanges(2of2)NewCompetitionandMarketChangesLimitOrderAnordertobuyorsellasetamountatafixedpriceLimitOrderBookThecollectionofalllimitordersMarketOrdersOrdersthattradeimmediatelyatthebestoutstandinglimitorderHighFrequencyTraders(H

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Ts)Aclassoftraderswho,withtheaidofcomputers,executetradesmanytimespersecondinresponsetonewinformationDarkPoolsWithexchangetrading,thelimitbookordersarepublic,allowinginvestorstotradeatthecurrentbidoraskprice,andtransactionsarevisibletoalltraderswhentheyoccur.Darkpoolsdonotmaketheirlimitorderbooksvisible.Instead,theyofferinvestorstheabilitytotradeatabetterpricewiththetradeoffbeingthattheirordermightnotbefilledifanexcessofeitherbuyorsellordersisreceived.1.4Fintech:FinanceandTechnologyFintechreferstotherelationbetweenfinancialinnovationandtechnicalinnovation.TelecommunicationsBecausethesamefinancialsecuritiesareoftentradedonmarketsthatarephysicallyfarapart,financeprofessionalshavealwaysbeenamongstthefirstadoptersofimprovedcommunicationtechnologies.SecurityandVerificationBlockchainAtechnologythatallowsatransactiontoberecordedinapubliclyverifiablewaywithouttheneedforatrustedthirdpartytocertifytheauthenticityofthetransactionCryptocurrencyAcurrencywhosecreationandownershipisdeterminedviaapublicblockchainAutomationofBankingServicesRobo-AdvisorsComputerprogramsthatareintendedtoreplacetheworkoffinancialadvisorsbyprovidingdetailedandcustomizedinvestmentrecommendationsBigDataandMachineLearningFinancialorganizationshavelongrecog