Firms, the Stock Market, and Corporate Governance: Study Notes

Firms, the Stock Market, and Corporate Governance

Types of Firms

Firms in the United States are legally categorized into three main types, each with distinct characteristics regarding ownership, liability, and organizational structure.

• Sole Proprietorship: Owned by a single individual, not organized as a corporation. The owner has unlimited liability, meaning personal assets can be used to cover business debts.

• Partnership: Owned jointly by two or more persons, not organized as a corporation. Partners share unlimited liability.

• Corporation: A legal entity separate from its owners, providing limited liability. Owners (shareholders) are protected from losing more than their investment.

Limited liability makes corporations attractive for raising funds and investing, but corporations are more expensive to organize and may face double taxation (corporate profits and dividends).

Comparison of Business Organizations

Type	Ownership	Liability	Taxation
Sole Proprietorship	Single owner	Unlimited	Personal income tax
Partnership	Two or more owners	Unlimited	Personal income tax
Corporation	Shareholders	Limited	Corporate tax + dividend tax

Corporate Structure and Governance

Corporations typically feature a separation of ownership from control, where shareholders (owners) elect a board of directors, who appoint top management (e.g., CEO) to run day-to-day operations. This structure can lead to the principal-agent problem, where managers (agents) may pursue their own interests rather than those of shareholders (principals).

• Principal-agent problem: Occurs when agents (managers) act in their own interest, potentially at odds with the goals of principals (owners).

• Solutions include aligning incentives, such as paying managers with stock or stock options, though perfect alignment is rarely achieved.

How Firms Raise Funds

Firms require financial capital to operate and expand. Small business owners typically raise funds through:

• Retained earnings: Reinvesting profits in the firm.

• Recruiting additional owners: Increasing financial capital by adding partners or shareholders.

• Borrowing: Obtaining loans from financial institutions or individuals.

External Funds: Indirect and Direct Finance

• Indirect finance: Funds flow from savers to borrowers via financial intermediaries (e.g., banks).

• Direct finance: Firms raise funds directly from investors through financial markets by issuing bonds (loans) or stocks (ownership shares).

Bonds and Stocks

• Bonds: Promise to repay a fixed amount (principal) at maturity, with periodic coupon payments (interest). Higher default risk requires higher coupon payments.

• Stocks: Represent partial ownership. Shareholders may receive dividends or capital gains. Bonds are less risky than stocks because bondholders are repaid before shareholders.

Mutual Funds and Exchange-Traded Funds (ETFs)

• Mutual funds: Actively managed portfolios; shares can only be sold back to the management company.

• ETFs: Passively managed portfolios; shares can be traded among investors.

Stock and Bond Markets

After issuance, stocks and bonds are traded in secondary markets. These markets provide liquidity and information:

• Stock prices: Reflect expectations about future profits.

• Bond prices: Determined by coupon payments and perceived risk.

Returns and Risk

• Higher returns are generally associated with higher risk.

• Stocks are riskier than bonds; small companies are riskier than large ones.

Using Financial Statements to Evaluate a Corporation

Publicly owned firms must release financial statements using generally accepted accounting principles (GAAP). These statements help investors make informed decisions.

• Income statement: Shows revenues, costs, and profit over a period (usually a fiscal year).

• Balance sheet: Summarizes assets and liabilities at a specific point in time. Net worth is assets minus liabilities.

Accounting Profit vs. Economic Profit

• Accounting profit: Net income calculated as revenue minus explicit costs (actual expenditures).

• Economic profit: Considers both explicit and implicit costs (opportunity costs).

Corporate Governance and Regulation

Accurate financial statements are essential for efficient resource allocation and investor confidence. Government regulations aim to reduce deception and increase transparency:

• Sarbanes-Oxley Act (2002): CEOs must certify financial statements; auditors must disclose conflicts of interest.

• Dodd-Frank Act (2010): Reforms financial system regulation; establishes oversight councils and consumer protection.

Appendix: Using Present Value

The concept of present value is used to determine the value today of funds to be received in the future. This is crucial for pricing financial assets like bonds and stocks.

• Present value formula: $PV = \frac{FV}{(1 + i)^n}$ Where FV is the future value, i is the interest rate, and n is the number of years.

• For a series of payments, sum the present values of each payment.

• Asset prices (bonds, stocks) are calculated as the present value of expected future payments.

Bond Pricing Example

• Suppose a $1,000 bond pays $80 in 2021 and $1,080 in 2022. If the interest rate is 10%, the present value is:$ PV = \frac{80}{(1 + 0.10)^1} + \frac{1080}{(1 + 0.10)^2} $

Stock Pricing Example

• If dividends grow at a constant rate, the price of a stock is: $P = \frac{D}{i - g}$ Where D is the current dividend, i is the interest rate, and g is the growth rate of dividends.

Example: If a firm pays $5.00 per share, i = 10%, and g = 5%, then:$ P = \frac{5}{0.10 - 0.05} = 100 $

Additional info: Academic context was added to clarify formulas, expand definitions, and provide examples for completeness.