Agency Theory Report

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Corporate Finance

Fifth Edition

Chapter 1

The Corporation and Financial Markets

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Chapter Outline

1.1 The Four Types of Firms

1.2 Ownership Versus Control of Corporations

1.3 The Stock Market

1.4 Fintech: Finance and Technology

Learning Objectives (1 of 3)

List and define the four major types of firms in the United States; describe major characteristics of each type, including the means for distributing income to owners.

Distinguish between limited and unlimited liability, and list firm types that are subject to each type of liability.

Describe the taxation consequences for C and S corporate forms.

Learning Objectives (2 of 3)

Discuss the division of corporate ownership into shares of stock; evaluate the implications of that division for corporate decision making.

Explain how corporate bankruptcy can be viewed as a change in firm ownership.

Compare and contrast the characteristics of shares that are publicly traded and those that are not.

Learning Objectives (3 of 3)

Describe the major changes that stock markets have gone through in the last decade.

Differentiate between trading on an exchange and trading in a dark pool.

Describe the impact of various types of Fintech, such as telecommunications, security, automation, and big data on the field of finance.

1.1 The Four Types of Firms

Sole Proprietorship

Partnership

Limited Liability Company

Corporation

Figure 1.1 Types of U.S. Firms

Source:

www.irs.gov

Percentage of businesses:

• Sole proprietorships: 72 percent

• Corporations: 18 percent

• Partnerships: 3 percent

• Limited liability companies: 7 percent

The second pie chart depicts the following:

Percentage of revenue:

• Sole proprietorships: 4 percent

• Corporations: 82 percent

• Partnerships: 6 percent

• Limited liability companies: 8 percent

Sole Proprietorship

Business is owned and run by one person.

Typically has few, if any, employees.

Advantage

Easy to create

Disadvantages

No separation between the firm and the owner

Unlimited personal liability

Limited life

Partnership (1 of 2)

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.

Partnership (2 of 2)

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

Limited Liability Companies (L L C)

All owners have limited liability, but they can also run the business.

Relatively new business form in the United States

Corporation (1 of 3)

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.

Corporation (2 of 3)

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.

Corporation (3 of 3)

Ownership

Represented by shares of stock

Owner of stock is called

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 stock.

Owner is entitled to dividend payments.

Tax Implications for Corporate Entities

Tax Implications

Double Taxation

“S” Corporations

Firm’s profits are not subject to corporate income tax, but instead are allocated directly to the shareholders.

Textbook Example 1.1 (1 of 2)

Taxation of Corporate Earnings

Problem

You are a shareholder in a corporation. The corporation earns $8 per share before taxes. After it has paid taxes, it will distribute the rest of its earnings to you as a dividend. The dividend is income to you, so you will then pay taxes on these earnings. The corporate tax rate is 25% and your tax rate on dividend income is 20%. How much of the earnings remains after all taxes are paid?

Textbook Example 1.1 (2 of 2)

Solution

First, the corporation pays taxes. It earned $8 per share, but

must pay

to the government in corporate

taxes. That leaves $6 to distribute. However, you must pay

in income taxes on this amount, leaving

per share after all taxes are paid. As a

shareholder you only end up with $4.80 of the original $8 in

earnings; the remaining

is paid as taxes.

Thus, your total effective tax rate is

Alternative Example 1.1 (1 of 2)

Problem

You are a shareholder in a C corporation that has income before taxes of $4 million.

Once the firm has paid taxes, it will distribute the rest of its earnings to its shareholders as a dividend.

There are 1 million shares outstanding.

Assume the corporate tax rate is 34%, and the personal tax rate on dividend income is 20%.

As a shareholder with 100 shares, how much will you receive after all taxes are paid?

Alternative Example 1.1 (2 of 2)

Solution

First, the corporation must pay its taxes. It earned $4

million but must pay

million in

corporate taxes.

That leaves $2.64 million to distribute to shareholders.

Collectively, shareholders will have to pay

in taxes on the dividends. This

leaves

after all

taxes are paid.

As the owner of 100 shares, you will have $211.20 after both corporate and personal taxes are paid.

Textbook Example 1.2 (1 of 2)

Taxation of S Corporation Earnings

Problem

Rework Example 1.1 assuming the corporation in that example has elected subchapter S treatment and your tax rate on non-dividend income is 35%.

Textbook Example 1.2 (2 of 2)

Solution

In this case, the corporation pays no taxes. It earned $8 per share. Whether or not the corporation chooses to distribute

or retain this cash, you must pay

income taxes, which is $0.40 lower than the $3.20 paid in Example 1.1.

Alternative Example 1.2 (1 of 2)

Problem

You are a shareholder in an S corporation that has income before taxes of $4 million.

Once the firm has paid taxes, it will distribute the rest of its earnings to its shareholders as a dividend.

There are 1 million shares outstanding.

Assume the corporate tax rate is 34%, and the personal tax rate on dividend income is 20%.

As a shareholder with 100 shares, how much will you receive after all taxes are paid?

Alternative Example 1.2 (2 of 2)

Solution

Because the firm is an S-corp., the corporation pays no taxes.

That leaves $4 million to distribute to shareholders.

Collectively, shareholders will have to pay

in taxes on the dividends. This

leaves

after all

taxes are paid.

As the owner of 100 shares, you will have $320.00 after personal taxes are paid.

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 (C E O)

Board typically delegates day-to-day decision making to C E O.

Figure 1.2 Organizational Chart of a Typical Corporation

• Chief executive officer, or C E O, shaded blue.

C E O leads to the following:

• Chief operating officer, or C O O, shaded blue

• Chief financial officer, or C F O, shaded green

C F O leads to the following:

• Treasurer, shaded green

• Controller, shaded green

Treasurer leads to the following, all shaded green:

• Capital budgeting

• Risk management

• Credit management

Controller leads to the following, all shaded orange:

• Accounting

• Tax department

Financial Manager

Responsible for

Investment Decisions

Financing Decisions

Cash Management

Goal of the Firm

Shareholders will agree that they are better off if management makes decisions that maximize the value of their shares.

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.

Ethics and Incentives Within Corporations (1 of 3)

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?

Ethics and Incentives Within Corporations (2 of 3)

C E O Performance

If a C E O 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.

Ethics and Incentives Within Corporations (3 of 3)

Corporate Bankruptcy

Reorganization

Liquidation

1.3 The Stock Market (1 of 2)

The stock market provides liquidity to shareholders.

Liquidity

The ability to easily sell an asset for close to the price at which you can currently buy it

1.3 The Stock Market (2 of 2)

Public Company

Stock is traded by the public on a stock exchange.

Private Company

Stock may be traded privately.

Primary and Secondary Stock Markets

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.

Traditional Trading Venues

New York Stock Exchange (N Y S E)

Market Makers/Specialists

Each stock has only one market maker.

N A S D A Q

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

New Competition and Market Changes (1 of 2)

In 2005, the N Y S E and N A S D A Q exchanges accounted for over 75% of all trade in U.S. stocks.

Today, due to increased competition from new fully electronic exchanges and alternative trading systems, handle more than 50% of all trades.

Figure 1.3 Worldwide Stock Exchanges Ranked by Two Common Measures

Source:

www.world-exchanges.org

• NYSE: 22.1 dollars

• Nasdaq: 10.0 dollars

• Japan Exchange Group: 6.2 dollars

• Shanghai Stock Exchange: 5.1 dollars

• Euronext: 4.4 dollars

• Shenzhen Stock Exchange: 3.6 dollars

• TMX Group: 2.4 dollars

• National Stock Exchange of India: 2.4 dollars

The second pie chart shows the total volume of different stock exchanges. The data depicted is as follows:

• Nasdaq: 33.4 dollars

• NYSE: 16.1 dollars

• CBOE/BATS Global Markets: 12.3 dollars

• Shenzhen Stock Exchange: 9.2 dollars

• Shanghai Stock Exchange: 7.6 dollars

• CBOE Europe: 7.6 dollars

• Japan Exchange Group: 6.6 dollars

• Euronext: 2.9 dollars

• Hong Kong Exchanges: 2.1 dollars

Figure 1.4 N Y S E and N A S D A Q Market Share

Source: J. Angel, L. Harris, and C. Spatt, “Equity Trading in the 21st Century: An Update,” Quarterly Journal of Finance 5 (2015): 1–39.

• NYSE: The NYSE market share as 80 percent in 2004, which dropped to around 70 percent in 2006, 40 percent in 2008, and 20 percent in 2010. From 2010 to 2012 it has remained almost constant.

• NYSE Arca: The NYSE arca market share was 0 percent in 2004 which increased slightly to around 4 percent in 2006. It increased to around 12 percent in 2008 and then decreased to 10 percent in 2010. From 2010 to 2012 it has remained almost constant.

• Nasdaq: The Nasdaq market share was almost 0 percent in 2004. It increased to 10 percent in 2006 and 20 percent in 2008. It then decreased to around 12 percent in 2010. From 2010 to 2012 it has remained almost constant with marginal ups and downs.

• BATS: The BATS market share was 0 percent in 2007 and increased to 5 percent in 2008. It further increased to around 8 percent in 2010 and 10 percent in 2012.

• Direct Edge: The Direct Edge market share was around 2 percent in 2008. It increased to around 10 percent in 2010 and remained almost constant till 2012.

• Other Venues: The market share of other venues was around 1 percent in 2004. It decreased to around 11 percent in 2006. It then increased to around 18 percent in 2008 and 30 percent in 2010. It increased a bit in 2011 but again dropped to 30 percent in 2012.

Second graph: Nasdaq-listed market shares

• Nasdaq: The Nasdaq market share was around 50 percent from 2004 to 2006 after which it started decreasing. The share decreased to around 40 percent in 2008, 30 percent in 2010, and 25 percent in 2012.

• NYSE Arca: The NYSE Arca market share was around 20 percent from 2004 to 2006. It then decreased to around 16 percent in 2008, 12 percent in 2010, and 10 percent in 2012.

• BATS: The BATS market share 0 percent in 2006. It increased to around 10 percent in 2008 and remained almost constant till 2010. It slightly increased to around 12 percent in 2012.

• Direct Edge: The Direct Edge market share was 0 percent from 2004 to 2007. It started increasing before 2008 and was around 5 percent in 2008. It increased to 11 percent in 201o and remained almost constant till 2012. In 2012, it was 10 percent.

• Other Venues: The market share of other venues was around 31 percent in 2004 and remained almost the same till 2006 with a share of 30 percent in 2006. It remained almost constant till 2007. It decreased to around 21 percent in 2008. It then started increasing and reached around 33 percent in 2010 and 40 percent in 2012.

New Competition and Market Changes (2 of 2)

New Competition and Market Changes

Limit Order

An order to buy or sell a set amount at a fixed price

Limit Order Book

The collection of all limit orders

Market Orders

Orders that trade immediately at the best outstanding limit order

High Frequency Traders (H F Ts)

A class of traders who, with the aid of computers, execute trades many times per second in response to new information

Dark Pools

With exchange trading, the limit book orders are public, allowing investors to trade at the current bid or ask price, and transactions are visible to all traders when they occur.

Dark pools do not make their limit order books visible.

Instead, they offer investors the ability to trade at a better price with the tradeoff being that their order might not be filled if an excess of either buy or sell orders is received.

1.4 Fintech: Finance and Technology

Fintech refers to the relation between financial innovation and technical innovation.

Telecommunications

Because the same financial securities are often traded on markets that are physically far apart, finance professionals have always been amongst the first adopters of improved communication technologies.

Security and Verification

Blockchain

A technology that allows a transaction to be recorded in a publicly verifiable way without the need for a trusted third party to certify the authenticity of the transaction

Cryptocurrency

A currency whose creation and ownership is determined via a public blockchain

Automation of Banking Services

Robo-Advisors

Computer programs that are intended to replace the work of financial advisors by providing detailed and customized investment recommendations

Big Data and Machine Learning

Financial organizations have long recognized the importance of collecting data and using it in decision making.

The availability of data has enabled companies throughout the economy to better target their products to consumers, and financial services companies are no exception.

Competition

Technological advances have opened the way for non-finance organizations to provide financial services.

Chapter Quiz

What are the advantages and disadvantages of organizing a business as a “S” corporation?

What is the principal-agent problem that may exist in a corporation?

What advantage does a stock market provide to investors of corporations?

What are dark pools?

How have changes in technology impacted financial innovation?

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0.25$8$2

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0.20$6$1.20

$6$1.20 = $4.80

$2$1.20$3.20

3.20/840%.

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34%$4 million$1.36

20%$2.64

million$528,000

$2.64 million$528,000$2,112,000

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0.35$8$2.80 in

20%$4

million = $800,000

$4 million$800,000$3,200,000

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