Introduction to Corporate Finance

1: The Scope of Corporate Finance

Companies may issue two forms of shares, ordinary and preferred, each with slightly different rights

and privileges. Shareholders of ordinary and preferred stock or shares, as owners of the company’s

equity securities, are often called equity claimants. Shareholders of preferred shares typically have

higher-priority access to the company’s earnings and bear less risk than shareholders of ordinary

shares. In exchange for this privileged risk position, the preferred shareholders may not have the right

to vote. Therefore, we refer to ordinary shareholders as the company’s ultimate owners. Ordinary

shareholders vote periodically to elect the members of the board of directors and, occasionally, to

amend the company’s constitution.

It is important to note the division between owners and managers in a large company. The managing

director or chief executive officer (CEO) is responsible for managing day-to-day operations and carrying

out policies established by the board. The board expects regular reports from the CEO regarding the

company’s current status and future direction. However, the CEO and the board serve at the will of the

shareholders. The separation between owners and managers leads to agency costs, the costs that arise

from conflicts of interest between shareholders (owners) and managers. These costs – and the agency

problems that cause them – are discussed in greater depth in Section 1-4b.

Although companies dominate economic life around the world, this form has some competitive

disadvantages. Many governments tax corporate income at both company and personal levels. In

Australia, however, this is generally not an issue: because of the implementation of the dividend

imputation tax regime, the personal investor in a company is taxed at his or her own rate of taxation, with

compensation being provided for any corporate tax that has already been paid on dividends received. This

tax arrangement is discussed in more detail in our later chapter on dividends and payout policy.

1-3b FORMS OF BUSINESS ORGANISATION USEd BY

COMPANIES OUTSIdE AUSTRALIA

Here, we briefly review the most important organisational forms used by companies in the US and some

other countries outside Australia. Companies operating in current or former British Commonwealth

countries – such as India, Singapore, Hong Kong, New Zealand and Canada – tend to share very similar

laws relating to corporations, and hence have similar organisational forms. In countries with different

legal structures, such as Germany or France, which have codified laws, the organisational forms may

differ.

Almost all capitalist economies allow some form of limited liability business organisation, with

ownership shares that are freely traded on national share markets. These companies tend to dominate

economic life in the countries where these organisations exist.

Limited Liability Companies

The limited liability company (LLC) combines the tax advantages of a partnership with the limited liability

protection of a company. These forms were developed in the US, where they are easy to set up. The

US Internal Revenue Service, or IRS (the American federal tax office), allows an LLC’s owners to

elect taxation as either a partnership or as a company, and many states allow one-person LLCs and

a choice between a finite or infinite company life. Even though LLCs can be taxed as partnerships,

their owners face no personal liability for other partners’ malpractice, making this type of company

especially attractive for professional service companies. Given the limited liability feature and the

flexibility of LLCs, it is likely that they will continue to gain significant organisational market share in

years to come.

equity claimants

Owners of a company’s equity

securities

managing director or

chief executive officer

(CEO)

The top company manager

with overall responsibility and

authority for managing daily

company affairs and carrying

out policies established by

the board

agency costs

Costs that arise from

conflicts of interest between

shareholders and managers

LO1.3 limited liability company
(LLC)
A form of business
organisation that combines
the tax advantages of a
partnership with the limited
liability protection of a
company

What are the pros and cons

of organising a business as

a company rather than as a

partnership?

thinking cap

question