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Lecture 1 - Overview of Corporations

This lesson introduces the three business forms and then focuses on corporations. The advantages and disadvantages of the corporate form are discussed and how the corporation is managed. Several explanations are given why corporations tend to have complex structures.

Introduction to Finance

1. Finance - the study of how people allocate scarce resources over time

  • Characteristics
    • Costs and benefits are distributed over time
    • The cash flows from costs and benefits are not known with certainty
    • This course teaches you how to calculate these cash flows
    • When implementing decisions, people make use of the financial system to exchange assets and risks
    • Financial system - the set of markets and other institutions used to exchange of assets and risks
  • Financial theory
    • Business Organizations - produce goods and services
    • Help organize how to allocate resources over time
    • Use quantitative models help evaluate alternatives, make decisions, and implement them
    • Apply concepts and models to all levels and scales of decision making
    • Basic tenet of finance - economic organizations (e.g. firms and governments) facilitate the satisfaction of people's consumption preferences

2. Definitions

  1. Assets - anything that has value
    • Cash
    • Bank account
    • House
    • Car
    • Stock - a share of a corporation
    • Patent - right to produce an invention for 17 years in the United States
  2. Asset allocation - people and corporations invest their assets into a variety of commodities or financial instruments (stocks and bonds)
  3. Liabilities - debt or obligations
    • Bank loan
    • Bond - a debt from a corporation or government
    • Credit card balance
    • Taxes
    • Note - many assets and liabilities are complements
    • Savings at a bank; an asset to the saver, but a liability to a bank
    • Taxes; a liability to the taxpayer, but an asset to the government agency
  4. Net worth = total assets - total liabilities
    • Also called equity or net assets
    • Creditors want net worth to be positive, so if the business fails, the creditor goes after the assets

3. Forms of Business Organization

  1. Sole Proprietorship - a firm owned by an individual or family
    • Owner owns the assets and is liable for its liabilities
    • Business is dissolved when owner dies
    • Unlimited liability - if business fails, creditors can go after any of the owner's assets
    • Low administrative costs
    • Most numerous business in the U.S.
    • Restaurants, hotels, grocery stores, etc.
  2. Partnership - a firm owned by two or more owners
    • Agreement - who makes decisions and how profit and losses are split
    • General Partners - unlimited liability
      • If business fails, then creditors can go after any of the partners' liabilities
      • One partner can bind the company to a contract; other partners responsible
      • All partners are liable if one partner steals from the company
    • Limited Liability Partners - liability is limited
      • If business fails, then creditors can go after some of the partners' liabilities
    • If a partner dies, then firm is dissolved and a new firm is formed
    • Accounting and law firms
  3. Corporations - discussed in detail
    • Dominate businesses activity
4. Goals of Financial Management
  • Alfred P. Sloan - "General Motors is not In the business of making automobiles. General Motors Is In the business of making money."
  • All businesses - earn profits
  • Corporations can also add:
    • Maximize shareholder wealth
    • Maximize share price
    • Maximize firm value


Advantages of a Corporation

  1. Separate, independent legal entity
    • Law treats it as a person
    • May own property, borrow, sue, be sued, and enter into legal contracts
  2. Limited Liability
    • Stockholders are not liable for corporate debt
    • If corporation fails, stockholders lose value of investment (stock)
  3. Ownership is easily transferred
    • Stockholders can easily sell stock to other people
    • Corporation can raise substantial amount of capital
  4. Corporations have continuity of life
    • Theoretically could live forever
  5. Stockholders cannot bind corporation to contracts

Disadvantages of a Corporation

  1. Corporations are heavily regulated
    • Corporations can branch into many areas, activities, and legal jurisdictions
    • File many reports with government
    • Corporations may encourage this!
    • Makes it more difficult for a new company to enter a market
  2. Corporations are taxed twice
    • Corporations pay taxes on income
    • Dividends - stockholders receive profit from corporation
    • Stockholder’s income subject to income taxes
  3. Principal-Agent Problem - a corporation separates the owners (shareholders) and management
    • Shareholders want dividends and the value of their stocks to increase
    • Management has its own self-interest different from shareholders
      • Luxurious offices
      • Private planes and limousines
    • During 2008 Financial Crisis, GM management dissolved its outstanding shares, leaving shareholders with nothing but useless paper

Corporate Management

1. Charter – document from a U.S. state that creates the corporation
  • Stockholders own the corporation
  • Board of Directors sets policy
  • Executive Officers run the corporation 

2. Corporations could issue different securities

  1. Stocks – own a piece of corporation 
    • Common stock
      • Can vote at stockholder meetings
      • Receive dividends last
    • Preferred stock
      • Sell for a higher price
      • Dividends are paid first
      • Cannot vote at stockholder meetings
      • Why issue preferred stock?
        • Corporation wants to expand a factory
        • If it issues new common stock, then current stockholders have to share control with new stockholders
  2. Bonds is a loan to the corporation
    • Bonds pay interest
    • Bonds are standardized; every bond from the same corporation is identical
  3. If a corporation bankrupts
    • The corporation's debts and legal obligations are paid first
      • Taxes, bank loans, bondholders, etc.
    • Preferred stockholders are second
    • Common shareholders are last

3. Stockholders’ Meeting

  • Stockholders meet usually once a year
  • Vote for Board of Directors
  • One share = One vote
  • Board of Directors selects president
  • Majority shareholder dominates
    • Majority shareholder votes himself/herself onto board of directors
    • Majority shareholder could be another corporation
    • One corporation can take over another corporation by becoming majority shareholder

4. Two Forms of Management

Corporate Structure

Corporate Structure

Corporate Structure

1. Corporations have complex structures

  • A parent corporation can have many subsidiaries
  • Corporations are international and operate in many countries
  • The subsidiaries are not fully integrated into the parent corporation
    • Lawsuits
      • Lawsuits are “crazy” in the U.S.
        • Judge sued a dry cleaners for $65 million, because the dry cleaners lost his pants. They found his pants a week later!
        • A women was fired from Bank of America. She sued because she claimed she was too pretty
      • If a successful lawsuit bankrupts a corporation (subsidiary), only that subsidiary is impacted
    • Taxes
      • Form subsidiaries
      • Parent corporation is located in Bahamas, Cayman Islands, etc.
      • Parent corporation in the United States has to pay taxes on all profits from around the world
        • These countries are tax havens
        • Low taxes, low regulations, strong confidentiality
        • Shift assets and liabilities among subsidiaries to decrease tax burden
    • Regulations

2. Tax Terminology

  1. Tax evasion
    • Corporation owes government for taxes
    • Some activity created the liability
    • It is illegal!
    • Fines, prison, etc.
  2. Tax Avoidance
    • Careful planning, corporation avoids a tax liability from being created
    • Perfectly legal

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