THE CORPORATIONThe Financial CycleThe Four Legal Forms of Firms1. Sole Proprietorships2. Partnerships and Limited Partnerships3. Limited Liability Companies4. Corporations• Main differences along two dimensions:– Liability– Taxation of profitsTypes of U.S. FirmsSource: www.bizstats.comForming a Corporation• A corporation is a legally defined, artificial being, separate from its owners– Must be legally formed – “incorporated” (many in Delaware)– Corporate charter specifies the initial rules that govern how the corporation is run• A corporation is solely responsible for its own obligations Limited liability for ownersOwnership of a Corporation• The entire ownership stake of a corporation is divided into shares – forms the “equity” of the corporation• Shareholders are entitled to dividend payments • Shareholders have voting rights• Larger ownership (usually) means larger share of dividends and more votesTax Implications for Corporations• A corporation’s profits are subject to taxation separate from its owners’ tax obligations.• Shareholders of a corporation pay taxes twice (“double taxation”)– The corporation pays tax on its profits– When remaining profits are distributed to the shareholders, the shareholders pay personal taxes on these dividends• Exception: “S” CorporationsExample• You are a shareholder in a corporation that earns $4 per share before taxes. • Once it has paid taxes it distributes the rest of its earnings to you as a dividend. • The corporate tax rate is 34% and the personal tax rate on dividend income is 15%. • How much is left for you after all taxes are paid?Solution• The earned $4 per share, but must pay 0.34 × $4 = $1.36 to the government in corporate taxes. That leaves $2.64 to distribute. • Next, you must pay 0.25 × $2.64 = $0.396 in income taxes, which leaves leaving $2.64 – $0.396 = $2.244 per share• Thus, your total effective tax rate is $1.756 ÷ $4 = 43.9%.Private or Public• Corporations can be private or public– A private corporation has a limited number of owners and there is no organized market for its shares– A public corporation has many owners and its shares trade on an organized market (e.g. NYSE, NASDAQ)Ownership versus Control• In a corporation, ownership and direct control are typically separate• Shareholders have no direct control• Board of Directors– Elected by shareholders– Have ultimate decision-making authority– Among main tasks: hiring (and firing) CEO• Chief Executive Officer (CEO)– Board typically delegates day-to-day decision making to the CEOOrganizational Chart of a Typical CorporationOwnership versus Control (cont.)• Goal of owners/shareholders– Shareholders want management to make decisions that maximizes the value of their shares• “Agency Problems”– Managers may act in their own interest rather than in the best interest of the shareholders– How can the interests be better