Chapter 1

The Corporation

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Chapter Outline
1.1 The Four Types of Firms
1.2
Ownership Versus Control of Corporat
ions
1.3 The Stock Market

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1.1 The Four Types of Firms

Sole Proprietorship
Partnership
Limited Liability Company
Corporation

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Figure 1.1 Types of U.S. Firms

Source: www.bizstats.com
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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

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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
firms debts. A lender can require any partner
to repay all of the firms outstanding debts.
The partnership ends with the death or
withdrawal of any single partner.

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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

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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.

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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.

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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.

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

Corporation
Tax Implications
Double Taxation

S Corporations
Firms profits are not subject to corporate income tax,
but instead are allocated directly to the shareholders.

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Textbook Example 1.1

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Textbook Example 1.1 (cont'd)

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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?
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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%.
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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?
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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%.
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Textbook Example 1.2

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Textbook Example 1.2 (cont'd)

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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%.

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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.

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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%.

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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.

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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.

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Figure 1.2 Organizational Chart of a

Typical Corporation

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1.2 Ownership versus Control

of Corporations (cont'd)
Financial Manager
Responsible for:
Investment Decisions
Financing Decisions
Cash Management

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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.

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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 managements
compensation to firm performance.
How should performance be measured?

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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.

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1.2 Ownership versus Control

of Corporations (cont'd)
Corporate Bankruptcy
Reorganization
Liquidation

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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

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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.

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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.

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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

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Figure 1.3 Worldwide Stock Markets

Ranked by Two Common Measures

Source: www.world-exchanges.org
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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?
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