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LLM Law Outlines > Corporation Outlines

The Corporate Structure Outline

Updates Available

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.

The following is a more accessble plain text extract of the PDF sample above, taken from our Corporation Outlines. Due to the challenges of extracting text from PDFs, it will have odd formatting:

Office hour: mon, wed 11:30am, by appointment; 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


  • 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:

    1. Limited liability for investors

    2. Free transferability of investor interests

    3. Legal personality (entity-attributable powers, indefinite life span, and purpose) and

    4. 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

  1. State Corporation Law (most important)

    1. 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:

          1. Special meeting (in between annual meetings) or

            • Rule in Delaware: only board of director can call special meeting

          2. 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:

          1. Dissolution of corporation, liquidation

          2. Sale by corporation of all its assets

          3. Merger of corporation with another corporation (become one corp that holds all assets + owe all liabilities previously held/ owed by either one)

          4. Amendment to certificate of incorporation

          5. Consolidation

    2. State Case Law – Directors duties

      1. Duty of care: not to be negligent in managing the corporation – to make informed decisions

      2. 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

        1. 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

        2. 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

  2. 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

  1. 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
  1. Certificate of Incorporation (charter)

    • Corporation is formed by filing the charter with the Secretary of State

    • Contains mandatory and optional provisions

    1. Mandatory (listed in DGCL s.102(a))

    1. Name of corporation

      1. Form of corporation: limited liability, domestic/ foreign corporation, partnership (unless waived)

      2. Unless permitted under s.395, cannot contain the word ‘trust’

      3. Cannot contain the word bank

    2. Address of the corporation’s registered office

    3. Nature of business/ purpose to be conducted/ promoted

      1. Engage in any lawful act or activity: will cover anything

    4. Total number of shares authorised (unless nonstock corporation) and par value (if any)

      1. Right after filing Cert of incorporation + paying fees co. owns nth + issued no shares

      2. The max no. of shares which the board of directors are permitted to issue in the future

    5. Name and mailing address of the incorporator(s)

    6. Powers of the incorporator(s), first directors

      • Example: XYZ Certificate of Incorporation

  1. Name – mandatory s.102(a)(i)

  2. Address/ agent - mandatory s.102(a)(v)

  3. Purpose – mandatory s.102(a)(iii)

  4. Shares – mandatory s.102(a)(iv)

  5. Business managed by the Board of directors, election -

  6. 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

  1. 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

  1. 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

  2. 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.

      1. Staggered board

        1. 1st class for 1 year term [phase in period]

        2. 2nd class for 2 year term [phase in period]

        3. 3rd class for 3 year term [phase in period]

        4. Directors can be chosen on full term afterwards

        5. i.e. each year, ~1/3 of the board will come out of election

        6. if there are only 2 classes only 2 year term, very rare to have 2

      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

  3. 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]

      1. General rule: with or without cause

      2. Options: none, but required majority can (probably) be increased – 102(b)(4)

      3. For companies with classified boards

        1. General rule: only for cause

        2. Options: with or without cause

      4. 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

      5. 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

      6. 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

      1. 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)

      2. If a co. wants to remove without cause, need to amend the charter:

        1. establish staggered board; and

        2. allow removal with or without cause

      3. 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]

        1. But to amend anything in 5 would need 70% more difficult to change than other articles, which only need regular majority

        2. To make it more difficult to change, co. can include in the charter

  4. 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

      1. if the charter is silence, general rule would apply

      2. any person can be authorised, person authorised are likely to be individual directors, CEO, secretary, chairman, flexible

      3. 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

      1. Charter repeats the general rule, but the majority can amend the article 7 + change in bylaw

      2. 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

      3. 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

  5. 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

      1. General rule: shareholders can act by written consent, unless charter provides otherwise

      2. Sometimes, written consent requires more votes than at the meeting

        1. Majority entitle: majority of the shares that are entitled to vote

        2. Majority voting: majority who vote

        3. 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

  1. Ninth with DGCL §242(b)(1).

    • §242(b)(1): amendments shall be made and effect in the following manner

      1. If co. has capital stock, its board shall recommend a charter amendment and then majority of the entitled shareholders to vote

        1. i.e. both the board and the shareholders must be in favour of the amendment

        2. 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]

    1. 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


  1. Time Value of Money

  2. Discounting

  3. Net Present Value

  4. Uncertainty and Risk

  5. Diversification

  6. 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:

    1. Loan money to the Phantasia gov (which borrows $100M per year) at an interest rate of 6% (sure to be repaid next year)

    2. 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

    3. 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%

  1. 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

  2. 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%

  3. 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.

  4. 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

    1. Efficient Market Hypothesis (EMH)/ Semi-strong EMH: stock’s market price reflect all public info bearing on the expected value of individual stock

    2. 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:

  1. 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

  2. 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

  3. A and B gets 2/3 and 1/3 of first $2M; C gets rest 2 layers

  4. 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

  5. A gets first $1M, B gets second $1M, C gets third $1M

    • Issue: 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

      1. Common shares residual owner

      2. Preferred shares paid ahead of the common

      3. 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:

    1. Claim on firm’s residual earnings (earning remains after production cost/tax)

    2. 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:

  1. 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

  2. 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

  1. 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

  2. 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

  3. 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.

    1. 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

    2. 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

  1. 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.

    1. 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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