Corporate Issuers

Study Guide

Organizational Forms, Corporate Issuer Features, and Ownership

An organizational form defines a business's legal structure, impacting liability, taxation, and capital access.

• Sole Proprietorship: Owned by one individual. Simple to create, but owner has unlimited liability and the business has a limited life.
• Partnership: Owned by two or more individuals. Can be a general partnership (unlimited liability) or a limited partnership (limited partners have limited liability).
• Corporation: A separate legal entity owned by shareholders. Key features include:
  • Limited Liability: Shareholders are only liable for their investment.
  • Unlimited Life: The corporation continues to exist beyond the lives of its owners.
  • Ease of Ownership Transfer: Shares can be easily bought and sold.
  • Double Taxation: Profits are taxed at the corporate level and again when distributed as dividends to shareholders.

Corporate Securities

• Common Stock: Represents ownership in a corporation. Holders have voting rights and a residual claim on assets.
• Preferred Stock: A hybrid security with features of both debt and equity. Typically offers a fixed dividend and has priority over common stock in payments, but usually no voting rights.
• Corporate Bonds: Debt instruments issued by a corporation. Bondholders are creditors, not owners. They receive periodic interest (coupon) payments and the principal at maturity.

Investors and Other Stakeholders

A stakeholder is any individual or group that has an interest in or is affected by a company's operations. The primary objective of a firm is generally considered to be the maximization of shareholder wealth.

Stakeholder Management involves balancing the interests of all stakeholders, which can sometimes conflict with the goal of pure shareholder wealth maximization.

Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Corporate Governance is the system of internal controls and procedures by which companies are managed and controlled. It provides the framework for attaining a company's objectives.

Principal-Agent Conflicts This conflict arises when the interests of an agent (e.g., management) do not align with the interests of the principal (e.g., shareholders).

• Shareholder-Manager Conflict: Managers may prioritize personal benefits (e.g., high salary, perquisites) over maximizing shareholder value.
• Director-Shareholder Conflict: The board of directors may be more aligned with management interests than shareholder interests.
• Shareholder-Shareholder Conflict: Controlling shareholders may take actions that benefit them at the expense of minority shareholders.

Governance Mechanisms

• Internal Mechanisms:
  • Board of Directors: The primary governing body. An effective board is independent, has relevant expertise, and has key committees (Audit, Compensation, Nominations).
  • Bylaws & Articles of Incorporation: Define the company's governance structure and rules.
  • Code of Ethics: Guides decision-making and behavior.
• External Mechanisms:
  • Shareholder Activism: Shareholders engaging with the company to influence its decisions.
  • Hostile Takeovers: An outside party attempts to acquire a company against the wishes of its management.
  • Regulations: Laws and listing standards (e.g., Sarbanes-Oxley Act).
  • Media Scrutiny: Public reporting on company activities.

Risks of Poor Governance: Weak control systems, ineffective decision-making, legal and regulatory risks, reputational damage, and a higher cost of capital. Benefits of Good Governance: Improved operational efficiency, better financial performance, lower cost of capital, and increased firm valuation.

Working Capital and Liquidity

Working Capital is a measure of a company's short-term financial health and operational efficiency. $\text{Net Working Capital} = \text{Current Assets} - \text{Current Liabilities}$

Key Liquidity Ratios

• Current Ratio: Measures ability to meet short-term obligations. $\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$
• Quick Ratio (Acid-Test): A more conservative measure that excludes less liquid inventory. $\text{Quick Ratio} = \frac{\text{Cash} + \text{Marketable Securities} + \text{Accounts Receivable}}{\text{Current Liabilities}}$

Operating and Cash Conversion Cycles These cycles measure the time it takes to convert investments in inventory and other resources into cash. A shorter cycle is generally better.

• Operating Cycle: The time from acquiring inventory to collecting cash from its sale. $\text{Operating Cycle} = \text{Days of Inventory on Hand (DOH)} + \text{Days of Sales Outstanding (DSO)}$
• Cash Conversion Cycle (CCC): The time a company's cash is tied up in its operations. $\text{CCC} = \text{DOH} + \text{DSO} - \text{Number of Days of Payables}$

Capital Investments and Capital Allocation

Capital Budgeting is the process of planning and managing a firm's long-term investments. The goal is to select projects that increase firm value.

Investment Decision Criteria

NPV is the theoretically preferred method, as it directly measures the expected increase in firm value. IRR can be misleading for non-conventional cash flows or when comparing mutually exclusive projects.

Capital Structure

Capital Structure refers to the specific mix of debt and equity a company uses to finance its operations and growth. The optimal capital structure is one that minimizes the firm's cost of capital.

Weighted Average Cost of Capital (WACC) WACC represents the blended cost of capital across all sources, including debt, preferred stock, and common equity. $WACC = (w_d)[k_d(1-t)] + (w_{ps})(k_{ps}) + (w_{ce})(k_{ce})$

• $w_d, w_{ps}, w_{ce}$ = weights of debt, preferred stock, and common equity
• $k_d, k_{ps}, k_{ce}$ = costs of debt, preferred stock, and common equity
• $t$ = marginal tax rate

The firm's goal is to find the capital structure (mix of w's) that minimizes WACC, thereby maximizing firm value.

Capital Structure Theories

• Modigliani-Miller (M&M) Theory:
  • Without taxes: Capital structure is irrelevant to firm value.
  • With taxes: The tax deductibility of interest payments makes debt attractive. Firm value is maximized at 100% debt.
  • With taxes and financial distress costs: An optimal capital structure exists that balances the tax benefits of debt against the potential costs of financial distress (e.g., bankruptcy).
• Pecking Order Theory: Firms prefer to finance investments using a hierarchy: first internal funds (retained earnings), then debt, and finally, as a last resort, new equity.

Business Models

A business model describes how an organization creates, delivers, and captures value. It is a conceptual framework that outlines the company's strategy and operations.

Core Components of a Business Model

• Value Proposition: The product or service that creates value for a specific customer segment.
• Customer Segments: The different groups of people or organizations an enterprise aims to reach and serve.
• Channels: How a company communicates with and reaches its customer segments to deliver its value proposition.
• Revenue Streams: The cash a company generates from each customer segment (e.g., asset sales, subscription fees, licensing).
• Cost Structure: The most important costs incurred while operating under a particular business model.

Common Business Model Types

• Low-Cost Provider: Focuses on achieving the lowest costs in the industry to offer products at a lower price than competitors.
• Differentiator: Offers unique products or services that are valued by customers, allowing the firm to charge a premium price.
• Subscription Model: Customers pay a recurring fee for access to a product or service.
• Razor-and-Blade Model: The primary product (the "razor") is sold at a low price or given away to drive sales of a complementary, high-margin consumable product (the "blades").