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The Corporate Structure Outline
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This is an extract of our The Corporate Structure document, which we sell as part of our Corporation Outlines collection written by the top tier of NYU School Of Law students.
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Office hour: mon, wed 11:30am, by appointment mk1@nyu.edu; 11:15-12:35 Thurs class time; TA office hr: Wed 4-5
Basic Terms
Corporation: artificial and separate legal entity (give rise to problems which we will focus on)
Have assets and liabilities, enter into legal obligation through contract, can violate law, can sue/ to be sued
Separate from the stockholders/ shareholders (owners of the corporation/ shares of stocks – equity interest)
Shares/ shares of stock/ stock
We focus on public corporations with a large no. of shareholders
C.f. closely held/ privately held corporation
Creditors: people whom the corporation owe money to
Mostly people who lend money to the corporation
Directors/ managers: people with legal power to run the corporation
Note difference between directors and managers
We will focus on the relationship of powers and conflicts that arise between
Corporation, directors and shareholders;
Corporation, directors and creditors
Corporations
Form by: certificate of incorporation file at the state you want (e.g. Delaware) fee
In the US, 60% public companies are incorporated in Delaware – other states often look to Delaware
Companies need not have domicile in that state
Place of corporation affects internal affairs rules – e.g. subject to Delaware law and Court
Shareholders elect directors directors run the corporation directors owe duties to corporation and shareholders Shareholders approve “major” changes of a corporation
Basic Power Structure: Shareholder Elect Directors
General rule: one year term
Board of directors
Elected during the annual meeting of shareholders
Removal of directors before term expires
A. The Corporate Form
Corporation is the standard form of most large US firms, main features:
Limited liability for investors
Free transferability of investor interests
Legal personality (entity-attributable powers, indefinite life span, and purpose) and
Centralized management
State corporation statutes
establish the separate legal identity (from shareholders and directors)
provide rules governing relationships among shareholders, directors and mangers
Small/ closely-held corporation incorporated for tax/ liability purposes
Corporate law generally better suited to large firms with numerous shareholders (public firms)
Corporate form is designed to raise funds on capital markets
Incorporation process in Delaware
Filing a certificate of incorporation at the Secretary of State + pay fee
Can be done by anyone + for any lawful purpose
Sources of Corporate Law
State Corporation Law (most important)
Corporation Statutes
Corporations are primarily governed by the state corporation statute where it is incorporated
chosen from 50 states, regardless of where they conduct most of their operations
large US corps usually choose Delaware)
Delaware General Corporation Law (DGCL)
Ch 1-3: formation of a corporation
Subchapter 1: formation process, certificate of incorporation, by-laws
Subchapter 2: corporate powers
Subchapter 3: procedure requirements
Subchapter 4: directors and officer
Subchapter 5: stocks and dividends
Subchapter 6: stock transfer restrictions + Delaware anti-takeover provision
Subchapter 7: stockholder/ shareholder’s voting
Subchapter 8: change in certificate of incorporation/ equity capital structure
Subchapter 9: merger
Subchapter 10: major asset sales and dissolution
Subchapter 11: insolvency
Subchapter 12: raising of he dead
Subchapter 13: procedure for suing corporations
Subchapter 14: special provisions for corporations that elect to be ‘close’ corporations’,
Subchapters 15, 26’: non-Delaware corporations that want to do business in/ become domestic in Delaware
Subchapter 17: miscellaneous provisions – sections on taxes and fees
Shareholders/ stockholders
Main source of power: elect directors each year at AGM
Remove of director (other than when term ends on AGM) by:
Special meeting (in between annual meetings) or
Rule in Delaware: only board of director can call special meeting
Written consent (majority signing a form stating they want to remove them)
Directors: legal power to manage the corporation
Decide how to run the business operations, how much salary they receive, how much is distributed to shareholders in dividends, borrowing money, selling some additional stocks
Dividends – distributions to shareholders by the corporation, when and how much are determined by directors, not compulsory for the company to pay dividend [c.f. creditors must be paid principal and interests]
Not bound by shareholders in management
Officers of corporation (CEO/ CFO/ COO/President):
Individuals who help directors to manage day-to-day business operations
Directors can delegate rights to officers, bound by directions given to them by the board
Inside directors/ management (directors that are also officers)
Mostly have 2: CEO and president
Advantages over outside – full time job to run corporation more information + paid a lot more + care more about professional reputation + more influential (since officers are subordinate to directors)
Varies in different companies: some board rubber stamps officers; some don’t
C.f. outside directors
don’t spend much time managing the company
picked by inside directors
receive a relatively small amount of compensation
Law provides that all directors have equal powers, but the real power is often exercised by CEO
Shareholder management power – must approve “major” changes
Directors have general power to manage corporation, but extraordinary decisions require shareholders’ approval:
Dissolution of corporation, liquidation
Sale by corporation of all its assets
Merger of corporation with another corporation (become one corp that holds all assets + owe all liabilities previously held/ owed by either one)
Amendment to certificate of incorporation
Consolidation
State Case Law – Directors duties
Duty of care: not to be negligent in managing the corporation – to make informed decisions
Duty of loyalty: manage company for benefit of shareholders, not for own personal benefit [fiduciary duty]
Delaware – most important domicile + influential – has an unique court system
Chancery Court
Expertise: in Delaware (but not in other states), corporate cases are heard by this specialised trial court on corporate law
Their precedents governs many corporate disputes, corporations often domicile in Delaware, and hence binding on them
5 judges: 1 Chancellor + 4 Vice-Chancellors
Jurisdiction over all dispute arising under Delaware corporate law
90% are corporate cases
No juries, judges all have fair degree of subject-matter expertise
Supreme Court
Appeals heard by Delaware Supreme Court
5 judges, normally sits in panels of 3 judges
Chief Justice often a former Chancellor
5 judges in Chancery + 5 judges in supreme court make most of US’ corporate law precedents
Jurisprudence
Federal Law and Regulations
Supplements State law
Securities Exchange Act 1934 (1934 Act/ Exchange Act) – forms complex regulatory scheme (with 1933 Act)
Congress established Securities Exchange Commission (SEC) + empower it to enforce the provision of the Exchange Act + promulgate detailed rules/ regulations
Most important regulation are those on voting, acquisitions of corporations, insider trading
The Certificate of Incorporation
Corporate Contracts drafted by lawyers to lay down rules
| General Rule | XYZ Charter | |
|---|---|---|
| Amend bylaws | Only shareholders [option: board/ shareholders] | Board/ shareholders |
| Director term | 1 year (not in DGCL) | 3 years (after phase in) |
| Removal | No cause if non-staggered; cause if staggered | Only for cause |
| Special meeting | Only board | Only board |
| Written consent | Available | Not available |
| Vote on charter amendment | Majority entitled [50%] | 70% of shares entitle |
Certificate of Incorporation (charter)
Corporation is formed by filing the charter with the Secretary of State
Contains mandatory and optional provisions
Mandatory (listed in DGCL s.102(a))
Name of corporation
Form of corporation: limited liability, domestic/ foreign corporation, partnership (unless waived)
Unless permitted under s.395, cannot contain the word ‘trust’
Cannot contain the word bank
Address of the corporation’s registered office
Nature of business/ purpose to be conducted/ promoted
Engage in any lawful act or activity: will cover anything
Total number of shares authorised (unless nonstock corporation) and par value (if any)
Right after filing Cert of incorporation + paying fees co. owns nth + issued no shares
The max no. of shares which the board of directors are permitted to issue in the future
Name and mailing address of the incorporator(s)
Powers of the incorporator(s), first directors
Example: XYZ Certificate of Incorporation
Name – mandatory s.102(a)(i)
Address/ agent - mandatory s.102(a)(v)
Purpose – mandatory s.102(a)(iii)
Shares – mandatory s.102(a)(iv)
Business managed by the Board of directors, election -
Director not personally liable
ix. Vote, Amendments – optional s.102(b)(4)
Not all mandatory provisions are contained in the charter
Missing s.102(a)(v): name and mailing address of incorporator(s) mandatory
Incorporators are people who filed the certificate of incorporation
To know who are in charge before corporation take its existence, but not relevant in later stages of corporate life
S.245(c) can be omitted in later versions
Missing s.102(a)(vi): if the powers of the incorporator(s) not a required a provision
Optional provision for
Management of the business and conduct of affairs of incorporation;
creating, defining, limiting and regulating powers of corporation, directors and (class of) stockholders
If such provision is not contrary to the laws of this state
For a corporation other than a nonstock corporation
Compromise/arrangement proposed between this corporation and
its creditors or any class of them
stockholders or any class of them
any court of equitable jurisdiction within the State of Delaware may
(on summary application of this corporation/ its creditor/ stockholder/ receiver(s) appointed under s.291 or appointed by trustee in dissolution)
order a meeting of the (class of) creditors, and/or (class of) stockholders to be summoned in such manner as the court directs
if majority in (class of) creditors and/or (class of) stockholders agree to any compromise/ arrangement/ reorganization (if sanctioned by the court) shall be binding on all (class of) creditors, and/or (class of) stockholders, and may also on the corporation
For a nonstock corporation
Whenever a compromise is proposed between the corporation and
(class of) creditors and/or (class of) members
any court of equitable jurisdiction within the State of Delaware may
(on summary application of this corporation/ its creditor/ stockholder/ receiver(s) appointed under s.291 or appointed by trustee in dissolution)
order a meeting of the (class of) creditors, and/or (class of) members to be summoned in such manner as the court directs
if majority in (class of) creditors and/or (class of) stockholders agree to any compromise/ arrangement/ reorganization (if sanctioned by the court) shall be binding on all (class of) creditors, and/or (class of) members, and may also on the corporation
Why are these provision included?
Common theme?
Affect the standard allocation of power between shareholders and current directors
Question 2: P.6 Comparing the charter provisions with DGCL
Fifth B with DGCL §109(a);
S.109(a) “the original or other bylaws of a corporation may be adopted, amended or repealed by initial directors if named in certificate of incorporation/ before corporation received payment for stock, by its board directors”
Fifth B “Board is expressly authorised to adopt, amend or repeal the By-Laws of the Corporation”
Fifth D with DGCL §141(d);
§141(d) director may by COI/ bylaw, be divided into 1-3 classes, term of office of the 1st class will expire at 1st annual meeting; 2nd class expire after 2nd meeting and 3rd class after 3rd meeting.
Staggered board
1st class for 1 year term [phase in period]
2nd class for 2 year term [phase in period]
3rd class for 3 year term [phase in period]
Directors can be chosen on full term afterwards
i.e. each year, ~1/3 of the board will come out of election
if there are only 2 classes only 2 year term, very rare to have 2
General rule: 1 year not provided in Charter, but it is a common practice
Fifth D: Directors are elected for 3 years term, elect new directors in annual meeting
Fifth G with DGCL §141(k)(1);
§141(k)(1): Director(s) may be removed by majority shareholders, with or without cause by vote at an election, except when the Board is classified as under (d) [i.e. staggered], shareholders can effect such removal only for cause, unless provided in certificate of incorporation otherwise [for a staggered board]
General rule: with or without cause
Options: none, but required majority can (probably) be increased – 102(b)(4)
For companies with classified boards
General rule: only for cause
Options: with or without cause
Not staggered can be removed without cause, no reason required
But directors are changed more often in non-staggered board
No option for non-staggered board
Staggered can only be removed for cause
The whole point of a staggered board is to give directors a long term tenor
Gives job security
But this general rule can be modified by providing in the COI, e.g. to remove only with cause
E.g. of cause: not acting in interest of shareholders
Directors of a public co. never removed by cause practically would usually resign/ convicted criminally
Incompetent is not a cause – difficult to decide
Fifth G: notwithstanding Certificate of Incorporation or by-laws, any director/ board may only be removed with cause + by affirmative vote of the holders of a majority shareholders
If there is no longer a staggered board becomes a non-staggered board general rule for non-staggered board = can be removal without cause under DGCL Fifth G requires removal only with cause = would be contradicting §141(k)(1)
If a co. wants to remove without cause, need to amend the charter:
establish staggered board; and
allow removal with or without cause
XYZ can adopt a shareholders resolution to amend Fifth G: “director may be removed with or without cause” [if there is no 5G, need a new provision]
But to amend anything in 5 would need 70% more difficult to change than other articles, which only need regular majority
To make it more difficult to change, co. can include in the charter
Seventh A with DGCL §211(d);
§211(d): special meetings of stockholders may be called by the board/ person authorised by certificate of incorporation/ bylaws
if the charter is silence, general rule would apply
any person can be authorised, person authorised are likely to be individual directors, CEO, secretary, chairman, flexible
Entrenched but diff from 141, which can only be changed in charter
Seventh A: special meetings can only be called by the Board + stockholders have no power to do so for any and all purposes
Charter repeats the general rule, but the majority can amend the article 7 + change in bylaw
To ensure rule is not changed, if charter silent and bylaw allows special meeting to be called by shareholder the charter should be amend to deny shareholders to have such power under the bylaw
The bylaws can be amended by the directors/ shareholders but cannot deny shareholder’s right to amend the charter bylaw contradicts the charter, it will be invalid
Seventh B with DGCL §228(a);
§228(a): unless COI provided, action required to be taken at any annual/special meeting of stockholders may be taken without a meeting/ prior notice and vote, if necessary no. of stockholders signed written consent on the action, delivered to US register office of the co. by hand or registered mail with return receipt
General rule: shareholders can act by written consent, unless charter provides otherwise
Sometimes, written consent requires more votes than at the meeting
Majority entitle: majority of the shares that are entitled to vote
Majority voting: majority who vote
Plurality: general election – person with the most votes wins
If voting standard would have otherwise been majority voting/ plurality the voting standard becomes majority entitled, as you cannot vote no for written consent assumed that anyone who doesn’t consent means they oppose
Seventh B: no written consent
Ninth with DGCL §242(b)(1).
§242(b)(1): amendments shall be made and effect in the following manner
If co. has capital stock, its board shall recommend a charter amendment and then majority of the entitled shareholders to vote
i.e. both the board and the shareholders must be in favour of the amendment
unless required by COI expressly, no meeting/ vote shall be required to adopt an amendment that effects on the corporate name/ delete name of incorporator(s) or provisions necessary to effect a change (a)(1)&(7).
Ninth: affirmative vote of the holders of at least 70% of total voting power of all outstanding shares shall be required to amend, alter, change or repeal any one or more provisions in Articles 5, 6, 9 of this COI, subject to provisions of any class/ series of Preferred Stock [ note:102(b)(4): co. can raise voting standard, but cannot lower it]
Shareholder has all the power DGCL XYZ Board has all the power
All gives the Board more power, and give shareholders less power. Why?
Fear of the shareholders
Shortsighted/short term shareholders are only interested in the value of the stock by the time they sell it; while the Board cares more about the company’s growth, e.g. may want to put money back to allow business grow instead of giving out dividends
Giving too much power to shareholders, would be lure to make mistakes [stupid shareholders] protecting shareholders
Fear of the directors - Agency problem: not acting in the best interest of the shareholders
E.g. the Board can be incompetent; reluctant to take risk; may want to keep their office by amending the charter
Ultra Vires - Corporate actions that are outside of the corporate purpose exceed corporate powers
Company law used to impose significant constraints on corporate activities
Corporation could assert that it was not liable under a contract to a third party since it lacked the power to enter into the contract
Modern statues and charters impose almost no limits on the corporation purpose and powers DGCL 101(a)(3) [Art 3 of XYZ Charter]
If ultra vires is an issue (which is rare), possible consequence [DGCL s.124]
By-laws s.109
s.109 specifies how by-laws are adopted/ changed + what provisions may be contained
s.109(a)
Before corporation receive any payment for stocks [i.e. before shareholders paying the corporation] the corporation has nothing bylaws can be adopted, amended or repealed
After receiving payment for stocks: shareholders can adopt/ amend/ repeal by-law (members of non-stock corporation are entitled to vote – non-stock corporations are rarely dealt with, not relevant)
Corporation can confer directors the power to change the bylaw, in its Certificate of incorporation directors (alone) and shareholders (alone) can change the bylaw
Bylaws are subsidiary documents which contain rules, may not contradict the charter, more limited than the charter
Some governance provisions can be in charter or by-laws DGCL s.126; 141(d)
Note some must be contained in the charter s.141(k)(i)
A company would choose to put provisions into its by-laws rather than into its charter
Used to modify the general rules
Hierarchy: federal laws and regulation > state law > charter > by-laws
Though corporation statutes often contain default/ general rules: rules that can be modified by charter/ by-law provisions
B. Basic Concepts in Valuation and Corporate Finance
Valuation
Time Value of Money
Discounting
Net Present Value
Uncertainty and Risk
Diversification
Efficient Market Hypothesis
Short term/long term distinction
1. Time Value of Money
$1 is more valuable than $1 a year from today
Because if you have $1 today, you have a bundle of rights to do the dollar for a year
E.g. can lend it out to earn interest
Present value: value today of money at some future point
If $1 in 10 years worth $38 cent today: $38 cent = present value of receiving $1 in 10 years
Future value/ (1+ discount rate) = present value
2. Discount rate: tells us how to calculate present values [the difference between $1 today and $1 a year later]
Present value of $10 receivable 1 year from now = $10/1 + 10% (discount rate for next year) = $9.09
In 3 year time = 10/1 + 10%^3 = $7.51
If we compare money in different time, we need to put them on the same scale
Discount rate reflects market price for right to use money
Different/ multiple discount rate for different time period
Higher discount rate = more value $1 today relative to 1 in future
3. Net Present value
Present value analysis determines whether one should invest money into an investment project
General rule: only invest if the “net present value” of a project is positive (gets out more than money paid)
Net present value = (sum of present values of all amount receivable if one invests) – (sum of the present value of the amounts payable if one invests)
Compare what you put in and what you get back
E.g. Investment of $100, return $1200 a year from now, what is the NPV if discount rate is:
10%, NPV = 1200/ (1+0.1)] – 1000 = 91
20%, NPV = 1200/ (1+0.2)] – 1000 = 0
25%, NPV = 1200/ (1+0.25)] – 1000 = -40 [bad investment, should be used in other purposes, other people would earn that 25%]
Usually rather gets profits back quicker, hence prefers short term projects; but if the long term payoffs is better than the short term, long term project can still be better
Aside: discount rate, NPV and rates of return
Discount rate: financial concept, worked out
Aside: discount rate and interest rate
Interest rate – contractually specified way, contractual promise by creditor to lender to pay certain interest [i.e. can be broken]
4. Risk and Return
How uncertainty affects the concepts of discounting and net present value
Returns on investment is uncertain we have to
calculate and discount the expected future cash flows; and
weighted average cash flow = % x expected gain in investment + % x nothing
e.g. bet $10 on a horse race, will get 50 if win/ 0 if lose. If the probability of wining is 15%, expected cash flows on the investment = 15% x $50 + 85% x $0 = $7.5
greater deviations = greater risk
risk commonly measured by variance
adjust the discount rate
Investors prefer less risk, and has to be compensated for risk by expected future cash flows at a higher discount rate “risk-adjusted rate”
Risk-free rate = the rate at which we discount future cash flows that are certain
Risk premium = difference between risk-adjusted rate and risk-free rate
Proper risk premium for a project depends on the amount and type of risk of the project
Multiple discount rates for each time period: 1 risk-free rate + many risk-adjusted rates
Most investment projects will involve risk, but buying government treasury securities involves virtually no risk
Yield earn on buying = risk free discount rate for the corresponding time period
How do we deal with uncertainty (about return) - 2 kinds of adjustment
1) Calculate expected return [weighted return]
Assign probabilities to possible outcomes
Multiply each outcome by the respective probability (weigh)
Sum up the products
Sum of products is equal to expected return
E.g. investment $10k possible actual returns
20% chance of 20k
30% chance of $15k
30% chance of $10k
20$ chance of $0
Expected return = 0.2 x 20k + 0.3 x 15k + 0.3 x 10k + 0.2 x 0
= 4k + 4.5k + 3k
= 11.5k
2) Adjust for Risk
Economic Definition of Risk: Measure of how much the actual outcome on a project can deviate from the expected outcome [Economic definition of risk]
Projects involving no uncertainty (only 1 possible actual return involve no risk)
Risk is not a measure of likelihood of losing money
Project with same expected return can differ greatly in amount of risk
E.g. project with 0 expect return has no risk it is unprofitable
Risk aversion
Discount expected return at higher discount rate
Leads to lower present value given expected future return
Lower present value reflect fact that risk is undesirable
Risk-adjusted discount rate = risk-free discount rate plus risk premium
If project involve risks higher discount rate
Risk-free rate = interest rate in risk free loans
If project involves no risk risk-free discount rate (assuming time stays the same)
E.g. lending to federal gov involves (virtually) no risk – treasury security, with different durations.
If probability of default is 0 = there is no risk = expected return is the interest rate
Lower expected return because it has less risk – higher discount rate = larger no. in denominator lower discount value for risky project
Discount rate depends on time and risk, derived from market transactions
Discount rate is different from interest rate
5. Diversification
Not all risk is a problem – differentiate between the risk we care about and risk we care less
Distinction between type of risks, but not representable of the reality
Project 1 and 2 involves both risk put together eliminate risk [you do not add risks]
Portfolio – many projects together, which reduces risk [process = diversification]
Some type of risk can be eliminated by diversification diversifiable risk
E.g. a bet is diversifiable – artificially created risk
Other risks are undiversifiable risk (systematic risk) – requires compensation in the risk premium
Risk can be eliminated by betting on both sides
But normally would eliminate risk by spreading investments in multiple projects
e.g. spread the investment into multiple games – instead of $1k in one game; bet $100 in ten games chance of losing 2k would be losing 1 game v losing 10 games
Risk of investment is generated by the economy (not artificial), which is inherently uncertain
E.g. planting crops – high yield of low yield
Many investments’ outcome are correlated, as they are all affected by the economy
Risks that affects economy generates systematic risks
Some investments projects are more sensitive to these events, some less sensitive
E.g., bad economy would more badly affect car co. than soft drink co. car co. more sensitive than soft drink co.
Techniques in finance to derive estimate diversifiable risk
Diversification result from spreading investments among projects that are not (perfectly) correlated.
Portfolio
Expected Return of Portfolio is weighted average return of projects in portfolio
Risk of portfolio is LESS than weighted average risk of projects in portfolio (unless perf. cor.)
Building Portfolios (diversification) thus reduces risk given expected return
Project risk had 2 components: diversifiable risk (unsystematic risk) and undiversifiable risk (systematic risk)
Different project are subjected to different degree of systematic risks
Risks are distributed – to bare less risk than you share, someone else will have to bare greater risk than their share
Finance theory: since investors can get rid of diversifiable risk, discount rate (i.e. risk premium) depends only on undiversifiable risk
Projects involving only diversifiable risk are discounted at risk-free rate
Invest in many different projects to diversify risk
Will a perfectly diversify investor be affected by certain events
Impossible to have a perfectly diversify investor, but easy to diversify substantially by buying a few broad mutual funds
Factors in real economy that will affect the outcome of many different projects
Diversifiable v. Undiversifiable Risk
Diversifiable Risk is risk that is not borne when project is part of “fully diversified portfolio”
Fully diversified portfolio consists of tiny (and proportional) portion of every possible project in the economy
NO ONE has to bear that risk (since everyone can in theory own fully diversified portfolio
Risk is generated by “events”
Hurricane Sandy, Middle East War, recession, changes in interest rate, CEO of JC Penney is replaced, Ben & Jerry’s coming up with new ice cream flavor, weather in Iowa in August, weather in Florida in December
Some “events” affect only a tiny portion of the economy Diversifiable
CEO of JC Penney is replaced, Ben & Jerry’s coming up with new ice cream flavor
Other “events” affect a large segment of the economy in similar way Undiversifiable
recession, changes in interest rate
Example: Phantasia Problem
Loaning money to the government involves no risk since possible actual return is equal to expected return. The other projects involve risk.
The risk of investing in Mets and Yankees stock is diversifiable. An investor holding a fully diversified portfolio will hold the same number of shares of both companies.
Why? Because both companies have the same number of outstanding shares], e.g. 100 of each. The combined value of the shares is $15,000 if the Mets win [$10,000 for 100 Mets shares and $5,000 for 100 Yankee shares] and also if the Yankees win.
The investments in Gov. Loan, Mets stock and Yankees stock should be discounted at risk-free rate. Each share should trade for $75/1.06. Tourism at a higher risk-adjusted rate.
Process of reducing risk by investing in many different projects
By constructing a portfolio of projects, an investor can reduce the risk she bears: risk of the portfolio will be less than the average risk of the investments in the portfolio
Diversification involves different levels, e.g.
Investor 1: wealth in stock of Exxon (an oil company)
Investor 2: wealth in stock of 10 big oil companies diversified against risk that are specific to Exxon, such as huge liabilities for oil spills, but not against risk affecting the oil industry, e.g. increase in gas taxes/ Mideast War
Investor 3: stocks of 500 US companies in different industries diversified against industry risk, but not against risk affecting American industries (e.g. increase in US corporate taxes)
Investor 4: stock in US companies, gov, municipal bonds, real estate investment more diversified but still concentrated in US
Investor 5: US stocks and bonds, gold, Japanese real estate, foreign currency, stocks of European companies invested in the US, Japan, Europe and gold and foreign currencies
But still subject to some risk, as not every risk is diversifiable, e.g. a nuclear war/ worldwide recession would decline investor 5’s investments’ value
Earthquake in NY would cause substantial direct economic loss + major indirect losses – people would be out of work, operations of companies would be disrupted
To be fully diversifiable, not sufficient that any single investor is not obliged to bear the risk should be: no investor must have to bear the risk
E.g. worldwide recession is not diversifiable – investors who end up bearing the risk must be compensated for bearing the risk (by risk premium)
May be possible for any person to diversify the risk by investing mainly in gold, US gov securities would probably profit from a recession
But not possible for all investor to diversify such risk – not enough gold/ some investor must hold stocks
Problem on Diversification
If a person can only invest in:
Loan money to the Phantasia gov (which borrows $100M per year) at an interest rate of 6% (sure to be repaid next year)
Buy stock of either one/ both of Phantasia’s leading baseball teams, if one win its stock will sell for $100; and if the other loses, it will sell for $50, and vice versa. Each team has 50% chance of winning the championship and that each baseball teams has 3M shares issued and outstanding
Stock of Phantasia Tourism Inc, a local hotel and restaurant operator (4M shares issued and outstanding). If Phantasia has completed the construction of its airport in 1 year, tourism stock will worth $300/share. But if airport is not completed in a year, the stocks will only worth $30. Likelihood that airport will be completed in time is 20%
Which investment involve risk? Which involve risk that is diversifiable; which involve risk that is undiversifiable
Government bonds involve no risk;
Mets and Yankee stock involve diversifiable risk only;
Tourism stock involves undiversifiable risk.
Since Tourism constitutes a significant part of the economy one of four possible investments a fully diversified investor would care whether the airport is completed
What discount rates should be applied to each investments.
Government bonds and Mets or Yankee stock: the risk-free rate of 6%
Tourism stock would have to be discounted at a risk-adjusted rate
We do not know the appropriate risk premium, but know that the risk adjusted rate must exceed 6%
How would answer to Q2 change if the Mets team had 3M shares, with a price of $50 each, issued and outstanding + Yankees team had only 1.5M shares, with price of $50, issued and outstanding?
The risk in Mets stock would no longer be fully diversifiable: since there are not enough Yankee shares so that every person can hold the same number of each (holding the same number of each would make one indifferent as to which team wins the championship).
Rather, a "fully diversified investor" who holds the same percentage of all investments would own twice as any Mets shares than Yankee shares, and thus would care who wins the baseball championship. Thus, you would have to discount Mets stock at a risk-adjusted discount rate.
How would the answer Q2 to 3 change if, instead of stock of Phantasies tourism, you could buy a stok of 4 companies
The more types of investments exist, the more diversifiable becomes the type of risk that affects only one specific investment.
If a Phantasia resident can buy stock in agriculture, oil, drug and movie companies (and the price of these stock does not depend on whether the airport is built), the risk inherent in Phantasia Tourism stock becomes partially diversifiable (i.e., the number of baskets over which you can distribute your eggs has become larger). That is, a fully diversified investor would care less whether the airport is built than in question 2, since a smaller portion of that her wealth is invested in a company (Phantasia Tourism) the value of which hinges on whether the airport is built or not.
Phantasia Agriculture Inc
$300 in a year if it rains a lot in April (20% chance); and $30 if it doesn’t rain a lot (80% chance)
Phantasia Oil Inc
$300 if company finds oil (20% chance); $30 if it doesn’t (80% chance)
Phantasia Drug Inc.
$300 in a year from now if it develops a new drug against phantasaritis (20% chance); and $30 if it doesn’t (80%)
Phantasia Move Inc
$300 in a year from now if the box office hit (20%) and $30 if it is not (80% chance)
The appropriate risk premium and risk-adjusted discount rate depends only on the undiversifiable portion of the risk
Higher the amount of undividable risk, higher the risk premium and risk adjusted discount rate
6. Capital Market Efficiency P.13
Discounting guides valuing tangible and financial assets (e.g. stocks and bonds)
Discounting is a search for comparable investment with an established cost of capital
Value and market price - Project of buy and holding
Value and information
Fundamental/ intrinsic value of a co.’s shares = value/ payoff of buying 100 shares of a co. calculated by going through an analysis
Expected return, discounting term of present value based on info of the co., economy as a whole.
Some assets (e.g. stock and oil) has alternative mode of valuation
Assets are bought and sold in a well-functioning market with many traders easy to find a market price
Market price and info - Market price of that co.’s shares
Forms of hypothesis: the fundamental value will equal market price
Efficient Market Hypothesis (EMH)/ Semi-strong EMH: stock’s market price reflect all public info bearing on the expected value of individual stock
Strong EMH: posits that stock prices rapidly reflect both public and non-public information
Intrinsic value based on all info publically available
If not publically available should not affect market value
Market price will reflect their collective assessment of the company
EMH has policy implications on legal disputes
Paramount Communications, Inc. v. Times, Inc
Error to distinguish between long-term and short-term stock value
Nature of market is to discount to a current value, the future financial prospect of the firm, and the market participants seeking info and making judgement do this correctly
In a well-developed stock market, there is no discount for long-term profit maximizing behaviour, except that reflected in the discount for the time value of money
Trading horizon and investment horizon
real conflicts between short term investors and long term investors
some investor plan to sell stocks earlier and some later
long term investors would not care about short term performance of co. shares
what will happen if stock market undervalue projects payoffs in the more distanced future
undervalues long term projects would be lower than efficient market but once project is realised, market value would be reflected
Conflict amongst shareholders for short term and long term holders that can only be true if stock market is not efficient
But if market is efficient, doesn’t matter when you want to sell – net present value would be realised - conflict would disappear
Trading Horizon and Investment Horizon
Provisionally suppose that share prices do reflect rational best estimates, based on public info, about the value of corporate projects:
C. Corporate Securities and Capital Structure
For small businesses, whether to incorporate is an issue of 1) tax planning and 2) Limited Lability Company
If it is to incorporate decide fixing the terms of the deal must be reflected in the design & distribution of corporate securities
Structure of company depends on whether the Corporate raise capital by obtaining equity contributions (i.e. stock) or by borrowing (issuing/ selling securities)
Debt - Creditors must be repaid first
Equity - Stockholders may then receive distributions in form of dividend/ stock repurchases (decided by the Board)
All of the corporation’s equity (and often much of its debt) are raised by issuing (selling) securities
Following examine the common varieties of securities that corporation issue
Division of Cash flows between A, B and C investors
Options to divide capital:
Each get 1/3 only 1 layer
Common stocks for everyone – same no./ proportion of shares for A, B and C
Giving 1 share each may be a problem – if shareholder only want to sell a portion of share, would be difficult to do so – at least beyond 1000
A gets first $1M; B and C get 75% and 25% of rest 2 layers
A may be preferred shareholder or creditor, will get the first $1M
B and C gets the rest = common stockholders
B gets 75,000 and C gets 25,000
A and B gets 2/3 and 1/3 of first $2M; C gets rest 2 layers
A gets first $1M, B gets second $1M, C gets rest 3 layers
A would be bondholder
B would be preferred stockholder
C is common stock holder - if there is only $2M, C will get nothing
A gets first $1M, B gets second $1M, C gets third $1MIssue: If there is more than $1M, what to do with the rest? Doesn’t satisfy the rule
Allocation must be fully specified, regardless of how much $ you can make
C would be residual owner, as he gets the residual
In a corporation, residual owner are the common shareholder
Every corporation need common shareholders (residual owner) to get the residual
Translating Cashflow division into capital structure
Seniority (order in which people get paid) translate into capital structure different types or orders and security
3 types of seniority need 3 types of securities
Types of Securities
Common shares residual owner
Preferred shares paid ahead of the common
Debt securities (bonds) paid ahead of preferred shareholders
Typically common shareholders (residual owners) get to exercise most control of the corporation
Magnitude (who gets what share in what) translate into capital structure diff no. of securities of the same type
How many/ how much of each type of security?
What matters for common stock
Two aspects of order/ seniority
Periodic payment: % interest rate = multiply how much you own (principal amount)
Final/ one-time payment = liquidation preference (sometimes in % x liquidation period; sometimes in an amount)
Common shares and preferred shares can be counted, but bonds cannot be counted (come in different denomination, e.g. some may be 1M, some may be 1K)
Equity Securities
Ownership interest in a business include 2 formal rights:
Claim on firm’s residual earnings (earning remains after production cost/tax)
Right to participate in control of business
These rights reside in 1 or more classes of tradable stocks
Separating ownership rights from identities of individual participant in the firm increases flexibility
Tradability of corporate stock, control over management policies can change hands, owners can turn over without altering legal structure of the firm or renegotiating terms with stockholders
Initial incorporators can structure complex deals by distributing stocks with different control rights and claims on residual earnings
2 types of stocks:
Common stock – voting rights on electing the board + receives dividends after all other participants in the co. have been paid
Stock remained common because they hold residual claims for dividends or other distributions that can only be exercised after other claims against the firms and its earnings are satisfied
Small corporations: often only have one class of stock (common stock)
Large pubic co.: the stock being most commonly traded are common stock
Rights governed by corporate statute, and applicable state and federal law, corporate charter
Multiple classes of common stock might differ in control rights
E.g. Class A shareholders may receive 10 votes per share; Class B shareholders may receive only 1 vote per share
Possible (but rare) for different classes of common stock to differ in distribution rights.
E.g. Class 1 shareholders receive dividend keyed to the performance of the co.’s steel assets; Class 2 shareholders receive dividend keyed to co.’s performance of its oil assets
It is the most common to have only having one class of common stock with identical distribution and voting right
Preferred stock – claim on company’s residual earnings/ assets that comes ahead of common stock
Rights varied, but defined in corporate charter, or more commonly in ‘certificate of designation’ (drafted pursuant to a charter provision, empowering the board to issue preferred stock)
Generally pay fixed dividend
Dividend must be paid before common stock receives any dividend payment
Which pressurize the board to pay preferred dividends
More pressure if these preferred shareholder carries limited control rights
Normally preferred stock does not carry the right to vote for directors, but if no dividends are paid for an extended period (e.g. 6 quarters) + nth said in corporate charter/ certificate of designation presumed that preferred stock carries same voting rights as common stock.
Preferred stock may be redeemable by the corporation for a price/ convertible by its holder into shares of common stock at a pre-set ratio
Note the board has the discretion to withhold dividends from holders of preferred stock
Aspects of stocks
Voting rights – unlimited options – different types of shares different classes, but someone must have voting right
90% publicly traded co. in US 1 share 1 vote for common shares; most publicly traded co. in US do not have preferred shares
10% publicly traded co. in US: varied
Par value
Mostly insignificant
As an ID mark (like color), the no. put in is irrelevant, don’t want it to be 0 nor very high
Conversion: generally refers to an exchange of security for a different security
Empirical matter to find convertible securities usually referred to common; bonds to common
Redemption: generally refers to the exchange of security for cash
Whose option? Condition? Rate? Specified in actual contract/ quasi contract
Certificate of incorporation authorised but doesn’t describe the preferred stock
Description would be drawn by board in certificate of designation, which would have similar status to certificate of incorporation
Questions on Certificate of Designation for Preferred Stock P.17
Co. has 3M common stock issued and outstanding – has 1M preferred stock (held by T) and 2M common stock
Is Tamara entitled to receive any dividends on her preferred stock? If not, when does Tamara receive dividends? If no dividends are paid on the Preferred Stock, may Integrated pay any dividends on its common stock?
Tamara receives dividends only "when, as and if declared by the Board of Directors." If dividend on the preferred stock are not paid, Integrated may not pay dividends on the common stock (with some exceptions).
Co. is not obligated to pay - s.2: not entitled, only if declared by the Board
“only when, as and if declared by the Board of Directors”
S.5 as long as shares of Preferred Stock is outstanding, no dividends shall be paid or declared on the Common Stock
If dividends are paid, what amount will Tamara receive on June 1 of each year?
$3.07 a year in quarterly installments comes to $0.7675 per quarter.
S.2 Dividend rate on preferred stocks is $3.07 per annum (year) x 1M
On March, June, Sep, Dec 1: will get $3.07M/4 = 767,500 per quarter
Cumulative dividend [incorp Ppt]
Any dividend payable to preferred stockholder which are not paid shall be cumulative
Cannot skip the preferred shareholders + if a dividend is ever skipped, need to make up all the prescribed dividend that need to be paid before paying to common
If dividend is skipped amount you are paid would not go up later, which would lose time value of money (not as valuable as money paid now)
If skip dividend too much, preferred shareholder gets to elect director to the board (to be represented)
Preferred shareholder cannot sue, no legal entitlement, no cause of action
Skipped dividends increase amount payable upon redemption
Skipped dividends increase preference amount in liquidation
Section 5 Priority: dividends to common until all skipped dividends paid
Section 7 Voting Rights: Two directors if 6 dividends skipped
Assume that Integrated has paid all dividends on its preferred stock except those for March 1 and June 1, 1982. If Integrated wanted to redeem Preferred Stock on Aug 1, 1982, what is the price per share that Integrated would have to pay to Tamara?
$28 plus accrued and unpaid interest from 12/1/81 to 8/1/82 (2 and 2/3 installments) comes to $30.05.
Redemption price + accrued and unpaid dividends
During the 12-month period beginning Nov 26 of the year indicated
March and June 1 1982 1981 = $28
A period to pay the accrued and unpaid dividend
Accrual calculations
From Dec 1, 1981 [when last dividend was paid]
Until date of redemption: August 1, 1982
How long/ how much?
8 months
March 1 to June - covered
June 1 and Aug 1 – dividend not paid
Period between June 1 and Aug 1 2 months of the next instalments of the preferred dividend
Price per share = 3.07 x 2/3 = $2.0467
Accrued payment = Periodic payment paid once a month/ quarter/ year that compensate the whole period it covers
If a preferred stock dividend is skilled cannot pay common stockholders dividends
Assume that Integrated will be liquidated next week and that its net assets (i.e., its assets less its liabilities) may take any of the following values: (i) $10 million, (ii) 25 million, (iii) $50 million, (iv) $100 million, (v) $150 million or (vi) $200million. There are no accrued and unpaid dividends.
If Tamara holds on to the Preferred Stock, she will receive $25 million (unless the net asset value is less than $25 million, in which case she will receive the net asset value).
If she converts, she will receive 1/4 of the net asset value (after she converts, 4 million shares of Common Stock will be outstanding, and she will hold 1 million shares).
In either case, the (other) common shareholders will receive whatever is left.
How much will Tamara receive, in each of these cases, if (x) she holds on to the Preferred Stock or (y) she converts her Preferred Stock into Common Stock under s.6(A)? How much will the holders of the 3M shares of Common Stock receive?
(x) Preferred Stock
$25 per outstanding share x Tamara holds 1M Shares = $25M
Preferred stockholders are not entitled to any further payment
S.4: preferred shock shareholders shall be entitled to paid before any payment is made upon any Common Stock.
(i) $10 million $10M...
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