LECTURE 2
•FORMS OF BUSINESS ORGANIZATION
•AGENCY RELATIONSHIPS
Alternative Forms of Business
Organization
Sole proprietorship
An unincorporated business owned by one
individual
Partnership
An unincorporated business owned by two
or more persons
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Sole proprietorships & Partnerships
Advantages
Ease of formation—just start!
Subject to few regulations
No corporate income taxes
Disadvantages
Unlimited liability
Difficult to raise capital
Limited life
Difficult to transfer ownership
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Corporation
A legal entity, separate & distinct from its owners
and managers, having unlimited life, easy
transferability of ownership & limited liability
Advantages
Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Disadvantages
Double taxation
Cost of set-up and report filing
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Value Maximization
If organized as a corporation, the business
value will most likely be maximized
Reasons:
Limited liability means lower risk and therefore,
higher value
Easy access to funds results in growth
opportunities
Easy transfer of ownership means investors are
willing to pay more
Some tax differences are beneficial for
corporations
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Agency relationships
An agency relationship exists whenever
a principal hires an agent to act on their
behalf
Within a corporation, agency
relationships exist between:
Shareholders and managers
Shareholders and creditors
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Shareholders versus Managers
Managers are naturally inclined to act in
their own best interests.
They may want more perks whilst
shareholders want an increase in the
stock price
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How to motivate Managers?
The threat of firing
The threat of takeover
Hostile takeover: instances in which
management does not want the firm to be
taken over
How to prevent takeovers?
Poison pill: an action the firm takes that can
practically kill it and makes it unattractive,
e.g. giving huge retirement bonuses if the
management changed
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Motivating managers…
Greenmail: like blackmail. The target
company offers to buy the stock from the
potential buyer at a price above the market
Managerial compensation plans
Allows managers to purchase stock at
some future time at a given price
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Shareholders versus Creditors
Shareholders (through managers) could take
actions to maximize stock price that are
detrimental to creditors.
E.g., stockholders might push management to take
up a project that has high returns but also high risk
If the venture is successful, all the benefits accrue
to shareholders; creditors just get a fixed return
If things go bad the creditors will have to share the
losses
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Practice Questions: Chapt 1
CHAPTER 2
The Financial Environment: Markets,
Institutions, and Interest Rates and Taxes
Financial markets
Types of financial institutions
Determinants of interest rates
Yield curves
What is a market?
A market is a venue where goods and
services are exchanged.
A financial market is a place where
individuals and organizations wanting to
borrow funds are brought together
with those having a surplus of funds.
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Types of financial markets
Physical assets vs. Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Futures
Mortgage vs. Consumer credit
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Physical assets vs. Financial
assets
Physical assets: wheat, autos, real
estate, machinery
Financial assets: Stocks, bonds
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Money vs. Capital
Money mkt: for debt securities with
maturity of less than 1 year
Capital mkt: for long-term debt AND
common stock
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Primary vs. Secondary
Primary mkts: in which corporations &
governments raise new capital
Secondary mkts: in which existing,
previously issued (already
OUTSTANDING) securities are traded
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Spot vs. Futures
Spot markets: where assets are bought
or sold for “on the spot” delivery
(immediately or within a few days)
Futures markets: where assets are
bought or sold for delivery at a later
date (e.g. six months or a year into the
future)
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Mortgage vs. Consumer credit
Mortgage mkts: loans on commercial,
residential, industrial real estate &
farmland
Consumer credit markets: loans for
autos, appliances, education etc.
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How is capital transferred between savers
and borrowers?
Direct transfers
Investment
banking house
Financial
intermediaries
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Capital formation process
Business sells stocks or bonds to savers
w/o going through any financial institution
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Capital formation process
Intermediary obtains funds from investors,
issuing its own securities
The intermediary might lend to business
Intermediaries create new forms of capital
(e.g. certificates of deposit)
Efficiency of financial mkts increases
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Capital formation process
Investment bank buys & holds securities for
a period of time—so it is taking a chance
Investment bank deals with the issuance of
securities not loans and deposits
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Types of financial intermediaries
Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
Pension funds
Life insurance companies
Mutual funds
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Physical location stock exchanges vs.
Electronic dealer-based markets
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NYSE (New York Stock Exchange)
All trades occur in a physical place, on the
trading floor of the NYSE
An auction market, wherein individuals are
typically buying and selling between one
another and there is an auction occurring
Highest buying (bidding) price will be matched
with the lowest selling (asking) price
Stocks of well established (Blue chip)
companies
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NASDAQ (National Association of
Securities Dealers’ Automated Quotations)
Located on a telecommunications network.
Dealer's market, wherein market
participants are not buying from and selling
to one another but to and from a dealer
He is the market maker
Stocks of firms dealing with the Internet or
electronics.
Stocks are more volatile
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Differences have narrowed
NASDAQ exchange was listed as a publicly-
traded corporation, while the NYSE was
private corporation.
In March 2006 the NYSE went public after
being a not-for-profit exchange for nearly 214
years.
The shares of these exchanges, like those of
any public company, can be bought and sold
by investors on an exchange.
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Organized exchange vs. OTC
market
Organized exchange: Physical place
Over-the-Counter market: Brokers and
Dealers connected over an electronic
network
Give an example…
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Video Clip: Key Takeaways
Primary and Secondary markets
Public financial markets
Where govts borrow money
Corporate financial markets
Where corporations borrow money
Organized security exchanges vs. virtual
networks
Most people think of the stock market
when we talk of financial markets
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