1. Copyright © 2011 Pearson Prentice Hall. All rights reserved. Chapter 1 The Corporation

2. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-2 Chapter Outline 1.1 The Four Types of Firms 1.2 Ownership Versus Control of Corporations 1.3 The Stock Market

3. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-3 1.1 The Four Types of Firms Sole Proprietorship Partnership Limited Liability Company Corporation

4. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-4 Figure 1.1 Types of U.S. Firms Source: www.bizstats.com

5. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-5 1.1 The Four Types of Firms (cont'd) Sole Proprietorship –Business is owned and run by one person –Typically has few, if any, employees –Advantages Easy to create –Disadvantages Unlimited personal liability Limited life

6. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-6 1.1 The Four Types of Firms (cont'd) 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.

7. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-7 1.1 The Four Types of Firms (cont'd) Partnership –Limited Partnership has two types of owners. General Partners –Have the same rights and liability as partners in a “regular” 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

8. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-8 1.1 The Four Types of Firms (cont'd) Limited Liability Company (LLC) –All owners have limited liability but they can also run the business. –Relatively new business form in the U.S.

9. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-9 1.1 The Four Types of Firms (cont'd) Corporation –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.

10. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-10 1.1 The Four Types of Firms (cont'd) Corporation –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. Due to its attractive legal environment for corporations, Delaware is a popular choice for incorporation.

11. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-11 1.1 The Four Types of Firms (cont'd) Corporation –Ownership Represented by shares of stock Owner of stock is called –Shareholder –Stockhoder –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 stock. Owner is entitled to dividend payments.

12. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-12 1.1 The Four Types of Firms (cont'd) Corporation –Tax Implications Double Taxation –“S” Corporations Firm’s profits are not subject to corporate income tax, but instead are allocated directly to the shareholders.

13. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-13 Textbook Example 1.1

14. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-14 Textbook Example 1.1 (cont'd)

15. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-15 Alternative Example 1.1a Problem –You are a shareholder in a C 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 25%. –How much is left for you after all taxes are paid?

16. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-16 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 $1.36 + $0.396 = $1.756 is paid as taxes. –Thus, your total effective tax rate is $1.756 ÷ $4 = 43.9%.

17. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-17 Alternative Example 1.1b Problem –You are a shareholder in a C 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?

18. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-18 Alternative Example 1.1b Solution –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. –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. –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. –Thus, your total effective tax rate is $3.66 ÷ $7.50 = 48.8%.

19. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-19 Textbook Example 1.2

20. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-20 Textbook Example 1.2 (cont'd)

21. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-21 Alternative Example 1.2a Problem –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%.

22. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-22 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.

23. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-23 Alternative Example 1.2b Problem –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%.

24. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-24 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.

25. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-25 1.2 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 CEO.

26. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-26 Figure 1.2 Organizational Chart of a Typical Corporation

27. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-27 1.2 Ownership versus Control of Corporations (cont'd) Financial Manager –Responsible for: Investment Decisions Financing Decisions Cash Management

28. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-28 1.2 Ownership versus Control of Corporations (cont'd) Goal of the Firm –Shareholders will agree that they are better off if management makes decisions that maximizes the value of their shares.

29. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-29 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?

30. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-30 1.2 Ownership versus Control of Corporations (cont'd) CEO Performance –If a CEO is performing poorly, shareholders can express their dissatisfaction by selling their shares. This selling pressure 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.

31. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-31 1.2 Ownership versus Control of Corporations (cont'd) Corporate Bankruptcy –Reorganization –Liquidation

32. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-32 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

33. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-33 1.3 The Stock Market (cont'd) Public Company –Stock is traded by the public on a stock exchange. Private Company –Stock may be traded privately.

34. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-34 1.3 The Stock Market (cont'd) Primary Markets –When a corporation itself issues new shares of stock 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.

35. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-35 1.3 The Stock Market (cont'd) Largest Stock Markets –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

36. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-36 Figure 1.3 Worldwide Stock Markets Ranked by Two Common Measures Source: www.world-exchanges.org

37. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1-37 Chapter Quiz 1.What are the advantages and disadvantages of organizing a business as a “S” corporation? 2.How does a limited partnership differ from a limited liability company? 3.What is the principal-agent problem that may exist in a corporation? 4.What is the NASDAQ? 5.What advantage does a stock market provide to investors of corporations?