The three types of firms:
-​ Sole proprietorships. Owned and run by one person, usually very small, and are the
most common business unit in the economy (despite contributing in terms of revenue)
-​ Easy to set up.
-​ No separation between the firm and the owner. Business is taxed at the personal
level of the owner.
-​ Unlimited personal liabilities for debts.
-​ Life of the business is limited to the life of the owner.
-​ Partnerships. Similar to sole proprietorship but has more than one owner.
-​ Income taxed at the personal level but split amongst partners in relation to their
ownership stake.
-​ All partners must have unlimited personal liability, and can be held accountable
for the whole firm’s debt.
-​ The partnership ends on the death or withdrawal of any single partner.
-​ Corporations.
Charters - articles of incorporation written by lawyers.
Limited partnership - a structure with a general partner and limited partners, wherein the general
partner has unlimited liability but the limited partner does not. Additionally, the death or
withdrawal of a limited partner does not end the partnership. However, they also have no
management authority in the firm.
Limited liability - where your liability is limited to your investment in the firm.
Limited liability partnership (LLP) - used in the legal and accounting professions. Partners can
be active in management and still have a limited amount of protection, where they are typically
only liable for negligence.
Corporation - a legally defined entity separate from its owners. The corporation is solely
responsible for its obligation and its shareholders do not take on any liability.
Articles of incorporation - a legal charter that defines a corporation.
Stock - the shares of a corporation.
Equity - all outstanding shares of a corporation.
*Corporations make up the largest share of income generated in Canada.
Double taxation - a system under which corporations are taxed, such that the corporation first
pays tax on its earnings and then the shareholders must pay tax on the payouts they receive.
Flow through entities - where basically all of the income generated is distributed as dividends
and virtually nothing is retained in the company. These entities often receive relief from double
taxation.
Income trusts - entities under the flow through principle. There are three types:
-​ Business income trust. Holds all the debt and equity of a company in trust for the trust’s
owners, called unit holders.
-​ Energy trust. Holds resource properties directly or all the debt and equity of a resources
corporation within the trust.
-​ Real estate investment trust (REIT) - either holds real estate properties directly or holds
all the debt and equity securities of a corporation that owns real estate.
*REIT’s continue to have no taxation at the business level, but other forms of income trusts are
now taxed.
Board of directors - a group of people who have ultimate decision-making authority within an
organization, elected by the shareholders. The board sets rules on how a corporation should be
run, sets policy, and monitors the company’s performance. The board delegates day-to-day
running of the corporation to the Chief Executive Officer (CEO).
Chief financial officer (CFO) - the most senior financial manager, who usually reports to the
CEO.
Financial manager - responsible for making investment decisions, making financial
decisions, and managing the firm’s cash flows.
Shareholder wealth maximization - the one goal that generally unites all shareholders
because they all benefit from a higher stock price.
Principal-agent problem (or agency problem) - when managers, despite being hired as
agents of the corporation, put their own self-interests above those of the shareholders.
Hostile takeover - when an individual or organization sometimes called a corporate
raider purchases enough of the stock to replace the board and the CEO. Even just this
threat pressures managers and the board to perform well.
Stakeholders - people that retain interest in how the corporation operates like
employees, shareholders, managers, and debtholders.
Corporate social responsibility - corporate initiatives to assess and take responsibility for
the company’s effects on the environment and the impact on social welfare.
Environmental Social Governance investing (ESG) criteria - used to produce scores on
how well companies are stewards of the environment, benefit society, and maintain
good corporate governance practices. These are often used by companies to maximize
shareholder value.
Bankruptcy - often results in a restructuring rather than liquidation, as it is in everyone's
best interest to keep the company going.
*It's useful to think of an organization as being owned by its debt-holders and
equity-holders. As long as a company can satisfy the claims of its debt-holders, the
equity-holders remain in ownership. A bankruptcy is often a change in ownership of the
organization rather than a total liquidation.
Liquid - if an investment is possible to sell quickly and easily at a price very close to the
price at which you could buy it.
Primary market - where a corporation itself issues new shares of a stock and sells it to
investors.
Secondary market - where the shares continue to be traded without the involvement of
the company.
Bid price - the highest price being quoted to buy a stock.
Ask price - the lowest price being quoted to sell a stock.
*When the bid and ask prices are the same, the trade gets completed.
The bid-ask spread - the difference between the bid and the ask, as the bid is lower
than the ask.
Limit order - an order to buy at a specified price (until your bid matches the ask).
Limit order book - the collection of all limit orders. These are public so that investors can
see their best bid and asking prices when making a trade.
Market order - a purchase that will transact immediately at the best ask price already
quoted.
*Bid and ask spreads are often tighter for more attractive companies as their stocks are
traded frequently.
*Traders who post limit orders provide markets with liquidity, while those that post
market orders take liquidity.
High-frequency traders (HFT) - traders who with the aid of computers place, update,
and cancel orders many times per second in response to new information and other
orders.
Specialists or Market Makers - people on the trading floor who are given preferential
access to orders but must also stand ready to buy and sell and their own posted bid/ask
prices, thus creating liquidity for investors.
Dark pools - alternative trading systems that do not publish their order books and allow
investors to trade at better prices (like the average of the bid-ask spread). The downside
is that the order may not be filled.
Competitive market - a market in which goods can be bought and sold at the same
price.
Valuation principle - the value of an asset to the firm or its investors is determined by its
competitive market price. The benefits and costs of a decision should be evaluated
using these market prices, and when the value of the benefits exceeds the value of the
costs, the decision will increase the market value of the firm. This is used as the basis of
decision making.
Time value of money - the difference in the value between money today and money in
the future.
*An interest rate is like an exchange rate across time.
Risk-free interest rate (rf) - the interest rate at which money can be borrowed or lent
without risk over that period. Also called the discount rate.
Interest rate factor - (1 + rf) for risk-free cash flows. This defines the exchange rate
across time.
Present value (PV) - the value in terms of dollars today.
Future value - the value in terms of dollars in the future.
One year discount factor - the discount at which we can purchase money in the future
defined as 1 / (1 + r).
Net present value (NPV) - the difference between the present value of a project’s
benefits and the present value of its costs. NPV = PV (benefits) - PV (costs). If thought
in terms of net cash flows, NPV = PV (all project cash flows). As long as NPV is
positive, the decisions increase the value of the firm and is a good decision regardless
of current cash needs or preferences.
NPV Decision Rule - when making an investment decision, take the alternative with the
highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today.
Separation of the Individual's Consumption Preferences From the Optimal Investment
Decision - regardless of our consumption preferences that dictate whether we prefer
cash today versus cash in the future, we should always maximize NPV first. We can
then borrow or lend to shift cash flows through time so as to match our most preferred
consumption spending patterns through time. In effect, our preferences regarding
consumption spending throughout time are separate from our optimal investment
decision.