Chapter 1: The Corporation

 A key factor in the success of corporations is the ability to easily trade ownership shares.

The Three types of Firms (1.1)

1. Sole proprietorships – a business owned a run by one person. Usually very small with
few employees. Although they are the most common type of business, they are
relatively small in terms of revenues and profits produced and people employed.

Key characteristics include:

 Straightforward to set up. Many businesses use this organizational form.
 The limitation of a sole proprietorship is that there is no separation between the firm
and the owner; the firm can have only one owner and business income is taxed at the
personal level. If there are other investors, they cannot hold an ownership stake in the
firm. This limits the ability of the owner to raise money for a business.
 The owner has unlimited personal liability for any of the firm’s debts. If the firm defaults
on any debt payment, the lender will require the owner to repay the loan from personal
assets. An owner who cannot afford to repay the loan must declare personal
bankruptcy.
 The lift of a sole proprietorship is limited to the life of the owner. It is also difficult to
transfer ownership of a sole proprietorship.

2. Partnerships – similar to a sole proprietorship but it has more than one owner.

Key characteristics include:

 Income is taxed at the personal level. The income is split among partners according to
their ownership in the partnership
 All partners have unlimited personal liability. This applies to the firm’s debt. Similarly,
the unlimited liability applies in a legal judgment against the partnership; each partner is
fully liable. Thus, partners must be chosen carefully, as any single partner’s actions can
affect the exposure of all the partners.
 The partnership ends on the death or withdrawal of any single partner. However,
partners can avoid liquidation if the partnership agreement provides for alternatives
such as a buyout of a deceased or withdrawn partner.

Some old and established businesses remain as partnerships or sole proprietorships. These
firms are in the owner’s personal reputation and are the basis for the business. For example,
law firms and accounting firms are often organized as partnerships. For such firms, the
partner’s personal liability increases the confidence of the firm’s clients that the partners will
strive to maintain their reputation.
 - A limited partnership – is a partnership with two kinds of owners, general partners and
limited partners. There must be at least one general partner.
- General partners have the same rights and privileges as partners in a (general)
partnership they are personally liable for the firm’s debt obligations.
- Limited partners, however, have limited liability. That is, their liability is limited to their
investment. Their private property cannot be seized to pay off the firm’s outstanding
debts. The death or withdrawal does not dissolve the partnership, and a limited
partner’s interest is transferable. A limited partner has no management authority and
cannot legally be involved in the managerial decision making for the business.

In Canada a special type of partnership called a Limited Liability Partnership (LLP) can be used in
the legal and accounting professions. An LLP is a partnership in which a partner’s personal
assets are protected from the negligent actions of other partners. Similar to a general
partnership in that the partners can be active in the management of the firm and they do have
a degree of unlimited liability. The limitation on a partner’s liability takes effect only in cases
relation to actions of negligence of other partners or those supervised by other partners. IN
addition, the assets of the business are potentially at risk of seizure due to the actions of
anyone within the partnership. Thus, while a partner’s personal assets are protected from the
negligent actions of others, the investment into the overall partnership may be lost.

3. Corporations – a legally defined, artificial being, separate from its owners.

Key Features include:

 It has many legal powers that people have such as enter into contracts, acquire assets,
incur obligations, and it receives similar protection against the seizure of its property as
received by an individual
 Solely responsible for its own obligations
 The owners of a corporation (shareholders) have limited liability; they are not liable for
any obligations the corporation enters into. Also, the corporation is not liable for any
personal obligations of its owners.

Formation of a Corporation
- Corporations must be legally formed, which means that the articles of incorporation
must be filed with the relevant registrar of corporations.
- The articles of incorporation are like a corporate constitution that sets out the terms of
the corporation’s ownership and existence.
- Most firms hire lawyers to create the formal articles of incorporation and a set of
bylaws.

Ownership of a Corporation
- No limit on the number of owners a corporation can have. Each owner owns a fraction
of the company.
 - The entire ownership stake of a corporation Is divided into shares known as stock. The
collection of all the outstanding shares of a corporation is known as the equity of the
corporation. An owner of a share of stock in the company is called a shareholder,
stockholder, or equity holder and is entitled to dividend payments.
- Shareholders usually receive voting rights and dividend rights that are proportional to
the amount of stock they own. For example, a shareholder who owns 30% of the firm’s
shares will be entitled to 30% of the votes at an annual meeting and 30% of the total
dividend payment.
- IN Canada a dominant shareholder is around 25% and in the US about less than 5%.
- A unique feature of a corporation is that there is no limitation on who can own its stock
and the owner does not need to have any special expertise or qualification. This allows
free trade in the shares and provides one of the most important advantages of
organizing a firm as a corporation.
- Corporations can raise large amounts of capital because they can sell ownership shares
to anonymous outside investors.

Tax implications for Corporate Entities

- Because a corporation is a separate legal entity, a corporation’s profits are subject to
taxation separate from its owner’s tax obligations. In effect, shareholders of a
corporation pay taxes twice.
- First the corporation pays tax on its profits, and then when the remaining profits are
distributed to the shareholders, the shareholders pay their own personal income tax on
this income.
- This system is referred to as double taxation.

While the corporate organizational structure is subject to double taxation, Canada Revenue
Agency allowed an exemption from double taxation for certain flow through entities where all
income produced by the business flowed to the investors and virtually no earnings were
retained within the business.

These entities are called income trusts and come in three forms:
1. Business income trust – holds all the debt and equity securities of a corporation (the
underlying business) in trust for the trust’s owners, called the unit holders.
2. Energy trust- either holds resource properties directly or holds all the debt and equity
securities of a resource corporation within the trust.
3. Real estate investment trust – either holds real estate properties directly or holds all the
debt and equity securities of a corporation that owns real estate properties.

Energy trusts got changed to being taxable at the business level in 2011
Ownership Versus Control of Corporations (1.2)
- In a corporation, direct control and ownership are often separate.
- Rather than the owners, the board of directors and CEO possess direct control of the
corporation.

The Corporate Management Team

- Board of directors – a group of people that has the ultimate decision-making authority
in the corporation. Make rules on how the corporation runs and how the top managers
are compensated. They delegate most decisions that involve day-to-day running of the
corporation to its management, headed by the CEO.
- The CEO is in charge of running the company by instituting the rules and policies set by
the board of directors. CEO and board of directors have no distinction and sometimes
CEO is also the chairman of the board of directors.
- CFO is the senior financial manager who usually reports directly to the CEO.

The board of directors, representing the shareholders, controls the corp and hires the CEO, who
is then responsible for running the corp. The CFO oversees the financial operations of the firm,
with the controller managing both tax and accounting functions, and the treasurer being
responsible for the capital budgeting, risk management, and credit management.
The financial Manager
3 main tasks:
- Making investment decisions
- Financial decisions
- Managing the firm’s cash flows

Investment decisions – weigh cost and benefit of each investment and decide which of them
qualify as good uses of the money shareholders have invested in the firm.

Financial decisions – once investments are decided, time to decide how to pay for them. Must
decide whether to raise more money from new and existing owners by selling more shares of a
stock (equity) or to borrow the money instead (debt).

Managing firms cash flow- ensure firm has enough cash on hand to meet obligations from day
to day. Make sure the access to cash does not hinder the firm’s success.

Ownership and control of Corporations

- Shareholder wealth maximization is the goal that generally unites shareholders because
they all benefit from a higher stock price.

Principal – Agent Problem

- As a manger, wouldn’t it be more fun to relax all day? Unfortunately for shareholders,
neglecting the responsibilities of managing and corp or consuming the benefits provided
free of charge to managers does little to benefit them even though the manager can
benefit a lot.
- This is called the principal-agent problem – a problem that arises then employees in
control (agents) act in their own interest rather than in the interest of the owners
(principals).

The CEO’s Performance

- Hostile takeover – an individual or organization can purchase a large fraction of the
stock and in doing so get enough votes to replace the board of directors and the CEO

Shareholders vs Stakeholders
- Stakeholders - any person with an interest in what a corp does, including employees,
customers, suppliers, the government, investors.
- Stakeholder satisfaction – a corp objective that seeks to meet the interest of all
stakeholders of a corp.
- Corporate social responsibility – efforts to asses and be responsible for its activities,
relation to the environment and social impacts, may also include initiatives to promote
positive social and environmental change.
Corporate Bankruptcy
- When the corp fails to repay its debts, the debt holders are entitled to seize the assets
of the corp in compensation for the default.
- To prevent this, the firm may renegotiate with the debt holders or file for bankruptcy
protection.

A useful way to understand corps is to think of there being two sets of investors with claims to
its cash flows: debt holders and equity holders. As long as the corp can satisfy the claims of the
debt holders, ownership remains in the hands of the equity holders.

The Stock Market (1.3)

- Private companies- have a limited set of shareholders ad their shares are not traded
regularly; the value of their shares can be difficult to determine.
- Public companies- shares trade on organized markets called stock markets. These
markets provide liquidity and determine a market price for the company’s shares.
- An investment is said to be liquid (investment that can easily be turned into cash and
sold) if it is possible to sell it quickly and easily for a price very close to the one you
bought it at.

Primary and Secondary Stock Markets

Primary market- market used when a corp itself issues new shares of stock and sells them to
investors.

Secondary Market – Market that shares continue to trade on after the initial transaction
between the corporation and investors.

For example, if you bought 100 shares of Tim Horton’s, you would place an order on a stock
exchange where Tim Horton’s trades under the ticker symbol THI. You would buy the shares
from someone who already held shares of Tim Horton’s, not from Tim Horton’s itself.

The largest stock markets

- New York Stock Exchange (NYSE)in the US and for Canada is the Toronto Stock
Exchange. (TSX)

TSX – electronic exchange.

NYSE – active trading floor to which orders are routed for the trading of shares of stock.
Dark pools – do not make their limit order books visible.

Market maker- people on the trading floor or a stock exchange who math buyers with sellers.

Bid price – the price at which a market maker is willing to buy a security. Highest price being
quoted to buy a stock

Ask price – the lowest price being quoted to sell a stock. The price at which a market maker is
willing to sell a security.

Bid-Ask spread- the amount by which the ask price exceeds the bid price.

Limit order – an order to buy or sell a security at a specified price.

Market order – orders to trade immediately at the best outstanding limit order available.

Thinly traded – low level of trading volume in stocks that attract less investors.