Corporate finance
Book: Jonathan Berk and Peter Demarzo, 2017, Corporate finance. The Core (4th international
edition)
Chapter 1: The Corporations and Financial Markets
1.1 types of firms
• The 4 types of firms
o Sole proprietorship
▪ Business is owned and run by one person
• F.e. open your own shop
▪ Typically has few, if any, employees
▪ most common type of firms in the world, but not account for much sales/
revenue in the economy
▪ Advantages
• Easy to create: straightforward to set up
▪ Disadvantages
• No separate between the firm and the owner
o firm can only have one owner
▪ if any other investors -> cannot hold an ownership
stake in the firm
o Any capital comes from the owner itself
o If external capital: not the firm is liable for the debt but the
person who created the firm
• Unlimited personal liability for any of the firm’s debt
o lender can require the owner to repay the loan from
personal assets
o owner who cannot afford to repay the loan, must declare
personal bankruptcy
• Limited life
o + difficult to transfer ownership
▪ ➔ mostly the disadvantages outweigh the advantages
• as soon as the firm reaches the point at which it can borrow without
the owner agreeing to be personally liable, the owner typically
convert the business into a form that limits owner’s liability
o Partnership
▪ Similar to a sole proprietorship, but with more than one owner: 2 or 3
persons (f.e. doctors, lawyers,..)
▪ 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
▪ If one partner leaves, the firms seizes to exist
• Partnership ends with the death or withdrawal of any single partner
• partners can avoid liquidation if the partnership agreement provides
for alternatives f.e. buyout of a deceased/ withdrawn partner
▪ why stay partnership?
• types of businesses in which the owner’s personal reputation are the
basis for the business f.e. law firms, groups of doctors,… → the
, partner’s personal liability increases the confidence of the firm’s
clients that the partners will strive to maintain their reputation
▪ limited: person who supplies capital but isn’t liable + not actively participate
in decision making
▪ limited partnership have 2 types of owners:
• general partners (‘regular’ partners)
o same rights and privileges as partners
▪ personally liable for the firm’s debt obligations
• limited partners (have no management authority but have limited
liability)
o liability is limited to their investment
o private property cannot be seized to pay of the firm’s
outstanding debts
o the death/ withdrawal of a limited partner doesn’t dissolve
the partnership + transferable
o cannot legally be involved in the managerial decision making
for the business
o f.e. private equity funds, venture capital funds
▪ a few general partners contribute some of their own
capital and raise additional capital from outside
investors who are limited partners
▪ the general partners control how the capital is
invested
▪ outside investors play no active role in the
partnership, other than monitoring their investment
(performance)
o Limited liability company (LLC)
▪ All owners have limited liability, but they can also run the business
▪ Relatively new business form in the USA but a common one in Europe
▪ If it borrow from the bank and fails to repay the debt (default) then the
owners do not have to ship in from their own pockets
▪ The assets can be seized by f.e. the bank
▪ Figure 1.1. types of firms in the US
• Sole proprietorships are very common <-> partnership super rare
(mostly for high professionals like doctors/ lawyers,..)
• Small businesses are almost always sole proprietorships
• <-> revenues: corporations make a lot of money
o <-> revenues of sole proprietorships are very small → they
aren’t that important + very flexible ( a lot open and close,..)
o Corporations are super important: make the most revenues
o 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
▪ legal entity separate and distinct from its owners
▪ The corporation is solely responsible its own obligations -> owners aren’t
liable for any obligation the corporation enters into
, • the owners aren’t liable for any obligation the corporation enters
into
• the corporation isn’t liable for any personal obligations of its owners
• <-> LLC: corporation responsible for its own debts → here the
separation level goes further
▪ Corporations must be legally formed -> some regions/ countries offer more
attractive legal environment for corporations
• the state in which it is incorporated must formally give its consent to
the incorporation by chartering it
• more costly than setting up a sole proprietorship
• citizen of the state in which it is incorporated
• most firms hire lawyers to create a corporate charter that includes
formal articles of incorporation an a set of bylaws + specifies the
initial rules that govern how the corporation is run
• figure 1.1: Types of firms in the US
o
1.2 separation of ownership control in a corporation
• Ownership in a corporation
o Represented by shares of stock
▪ If you own some fraction of shares, then you are owner of the corporation
• no limit on the number of owners a corporation can have
• each owner owns a small fraction of the corporation
• the entire ownership stake of a corporation is divided into shares (=
stock)
o Owner of stock is called:
▪ Shareholder
▪ Stockholder
▪ Equity holder
o Sum of all ownership value is called equity
▪ = collection of all the outstanding shares of a corporation
▪ Corporation can have as many shares as it wants: value will be the total
equity divided by the number of shares
o There is no limit to the number of shareholders and, thus, the amount of funds a
company can raise by selling stock
o Owner is entitled to dividend payments
, ▪ = payments made at the discretion of the corporation to its equity holders
• proportional to the amount of stock they own
▪ If the corporation does well, you get some for yourself for as long as you
hold the share (cashflows in the form of units)
▪ If corporation makes a lot of profits
• Leave it inside the firms
• Spend it in investments (f.e. repayment inside the firm)
• Pay dividend (take the profit outside the firm) → equally among the
shares
o The more shares, the more dividends
▪ Dividend <-> loan
• Loan: repayment + interest
• Corporation decides whether to pay or not: discretionary power (no
obligation)
• At some point there has to be the expectation that dividend will get
paid: if investors know that they won’t pay dividend, the shares of
the company will have value of 0
▪ no limitation on who can own its stock → owner of a corporation need not
have any special expertise or qualification
• allows free trade in the shares of the corporation + provides one of
the most important advantages of organizing a firms as a corporation
rather than as a sole proprietorship, partnership, LLC corporation →
raise substantial amounts of capital, sell ownership shares to
anonymous outside investors
o Tax implications for corporate entities
▪ corporation: separate legal entity → corporation’s profit are subject to
taxation separate from its owners’ tax obligations
• so, shareholders of a corporation pay taxes 2x
o 1: corporation pays tax on its profit
o 2: remaining profits are distributed to the shareholders, the
shareholders pay their own personal income tax on this
income
o = double taxation
▪ exception for S corporations = corporations that
elect subchapter S tax treatment
▪ the firm’s profits (and losses) are not subject to
corporate taxes, but instead are allocated directly to
shareholders based on their ownership share
▪ shareholders must include these profits as income
on their individual tax returns (even if no money is
distributed to them)
▪ → after the shareholders have paid income taxes on
these profits, no further tax is due
• Control in a corporation
o often not feasible for owners to have direct control of the firm: sometimes many
owners, each of whom can freely trade his stock
o ‘who makes decisions?’
Book: Jonathan Berk and Peter Demarzo, 2017, Corporate finance. The Core (4th international
edition)
Chapter 1: The Corporations and Financial Markets
1.1 types of firms
• The 4 types of firms
o Sole proprietorship
▪ Business is owned and run by one person
• F.e. open your own shop
▪ Typically has few, if any, employees
▪ most common type of firms in the world, but not account for much sales/
revenue in the economy
▪ Advantages
• Easy to create: straightforward to set up
▪ Disadvantages
• No separate between the firm and the owner
o firm can only have one owner
▪ if any other investors -> cannot hold an ownership
stake in the firm
o Any capital comes from the owner itself
o If external capital: not the firm is liable for the debt but the
person who created the firm
• Unlimited personal liability for any of the firm’s debt
o lender can require the owner to repay the loan from
personal assets
o owner who cannot afford to repay the loan, must declare
personal bankruptcy
• Limited life
o + difficult to transfer ownership
▪ ➔ mostly the disadvantages outweigh the advantages
• as soon as the firm reaches the point at which it can borrow without
the owner agreeing to be personally liable, the owner typically
convert the business into a form that limits owner’s liability
o Partnership
▪ Similar to a sole proprietorship, but with more than one owner: 2 or 3
persons (f.e. doctors, lawyers,..)
▪ 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
▪ If one partner leaves, the firms seizes to exist
• Partnership ends with the death or withdrawal of any single partner
• partners can avoid liquidation if the partnership agreement provides
for alternatives f.e. buyout of a deceased/ withdrawn partner
▪ why stay partnership?
• types of businesses in which the owner’s personal reputation are the
basis for the business f.e. law firms, groups of doctors,… → the
, partner’s personal liability increases the confidence of the firm’s
clients that the partners will strive to maintain their reputation
▪ limited: person who supplies capital but isn’t liable + not actively participate
in decision making
▪ limited partnership have 2 types of owners:
• general partners (‘regular’ partners)
o same rights and privileges as partners
▪ personally liable for the firm’s debt obligations
• limited partners (have no management authority but have limited
liability)
o liability is limited to their investment
o private property cannot be seized to pay of the firm’s
outstanding debts
o the death/ withdrawal of a limited partner doesn’t dissolve
the partnership + transferable
o cannot legally be involved in the managerial decision making
for the business
o f.e. private equity funds, venture capital funds
▪ a few general partners contribute some of their own
capital and raise additional capital from outside
investors who are limited partners
▪ the general partners control how the capital is
invested
▪ outside investors play no active role in the
partnership, other than monitoring their investment
(performance)
o Limited liability company (LLC)
▪ All owners have limited liability, but they can also run the business
▪ Relatively new business form in the USA but a common one in Europe
▪ If it borrow from the bank and fails to repay the debt (default) then the
owners do not have to ship in from their own pockets
▪ The assets can be seized by f.e. the bank
▪ Figure 1.1. types of firms in the US
• Sole proprietorships are very common <-> partnership super rare
(mostly for high professionals like doctors/ lawyers,..)
• Small businesses are almost always sole proprietorships
• <-> revenues: corporations make a lot of money
o <-> revenues of sole proprietorships are very small → they
aren’t that important + very flexible ( a lot open and close,..)
o Corporations are super important: make the most revenues
o 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
▪ legal entity separate and distinct from its owners
▪ The corporation is solely responsible its own obligations -> owners aren’t
liable for any obligation the corporation enters into
, • the owners aren’t liable for any obligation the corporation enters
into
• the corporation isn’t liable for any personal obligations of its owners
• <-> LLC: corporation responsible for its own debts → here the
separation level goes further
▪ Corporations must be legally formed -> some regions/ countries offer more
attractive legal environment for corporations
• the state in which it is incorporated must formally give its consent to
the incorporation by chartering it
• more costly than setting up a sole proprietorship
• citizen of the state in which it is incorporated
• most firms hire lawyers to create a corporate charter that includes
formal articles of incorporation an a set of bylaws + specifies the
initial rules that govern how the corporation is run
• figure 1.1: Types of firms in the US
o
1.2 separation of ownership control in a corporation
• Ownership in a corporation
o Represented by shares of stock
▪ If you own some fraction of shares, then you are owner of the corporation
• no limit on the number of owners a corporation can have
• each owner owns a small fraction of the corporation
• the entire ownership stake of a corporation is divided into shares (=
stock)
o Owner of stock is called:
▪ Shareholder
▪ Stockholder
▪ Equity holder
o Sum of all ownership value is called equity
▪ = collection of all the outstanding shares of a corporation
▪ Corporation can have as many shares as it wants: value will be the total
equity divided by the number of shares
o There is no limit to the number of shareholders and, thus, the amount of funds a
company can raise by selling stock
o Owner is entitled to dividend payments
, ▪ = payments made at the discretion of the corporation to its equity holders
• proportional to the amount of stock they own
▪ If the corporation does well, you get some for yourself for as long as you
hold the share (cashflows in the form of units)
▪ If corporation makes a lot of profits
• Leave it inside the firms
• Spend it in investments (f.e. repayment inside the firm)
• Pay dividend (take the profit outside the firm) → equally among the
shares
o The more shares, the more dividends
▪ Dividend <-> loan
• Loan: repayment + interest
• Corporation decides whether to pay or not: discretionary power (no
obligation)
• At some point there has to be the expectation that dividend will get
paid: if investors know that they won’t pay dividend, the shares of
the company will have value of 0
▪ no limitation on who can own its stock → owner of a corporation need not
have any special expertise or qualification
• allows free trade in the shares of the corporation + provides one of
the most important advantages of organizing a firms as a corporation
rather than as a sole proprietorship, partnership, LLC corporation →
raise substantial amounts of capital, sell ownership shares to
anonymous outside investors
o Tax implications for corporate entities
▪ corporation: separate legal entity → corporation’s profit are subject to
taxation separate from its owners’ tax obligations
• so, shareholders of a corporation pay taxes 2x
o 1: corporation pays tax on its profit
o 2: remaining profits are distributed to the shareholders, the
shareholders pay their own personal income tax on this
income
o = double taxation
▪ exception for S corporations = corporations that
elect subchapter S tax treatment
▪ the firm’s profits (and losses) are not subject to
corporate taxes, but instead are allocated directly to
shareholders based on their ownership share
▪ shareholders must include these profits as income
on their individual tax returns (even if no money is
distributed to them)
▪ → after the shareholders have paid income taxes on
these profits, no further tax is due
• Control in a corporation
o often not feasible for owners to have direct control of the firm: sometimes many
owners, each of whom can freely trade his stock
o ‘who makes decisions?’
