ba - basic concepts

8/7/2019 BA - basic concepts

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Residual/Equity Interests v. Fixed Interests

y Residual claim/interest holder gets whatever is leftover after the fixed claim/interestholder recovers its fixed interest

y Equity / residual interest what the owner (who is the borrower) haso Owner has a residual claim in cash flow generatedo Owner has control over business, limited by agreements with creditors, investors, etc.o Idea-type owner = full residual claim and full control (in reality, is on a spectrum)

y Fixed interest what an salaried employee or creditor (the lender) haso ideal-type employee = a fixed claim, to a salary, and is obligated to follow all the

owners directions (in reality, is on a spectrum)

y Common mixture: Employees compensation package = baseline salary (fixed claim)+bonus based on profits (residual claim)

o such an employee may bargain for some degree of control (ex. discretion to hire/fireunderlings)

note: Even if owner contracts this control to employee, in practice, the lawwill not grant specific performance relating to control. (24)

y Note:o In corporations: equity investors = shareholders; collectively own the residual/equity

interest in the corporation

4 Fundamental Bargain Elements (or deal points):

1) Risk ofLoss allocation among participants of losses from the investment in or operation ofthe business

a. CORP: shareholders have collective residual claim; they bear risk of loss only up tothe amount of their investment2) Return salaries, interest, and other fixed claims; and shares of the residual (profit)

a. Division of the residual has many possibilities:i. May grant lender an option to convert its fixed claim into some share of

the residual

3) Allocation ofControl determines who has the right to make the carious decisions affectingthe business

a. General goes with the residual claimb. CORP: management authority is vested in BOD, not in the shareholdersi. Shareholders elect a BOD, who then select the officers who run the business

4) Durationa. how long the relationships will lastb. which relationships can be terminatedc. terms on which a claim may be transferredd. ASK: What happens if an owner wants to withdraw?


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) Note:a. Greater risk of loss = greater controlb. Allocations of return and loss are major incentivesc. The attributes: risk, control, returns associated with ownership

Constraints on Business Arrangements (3):

1) Conflict ofInteresta. Self-serving behavior may be hard to detect or controlb. Devices that may help control:

i. structure of compensation packageii. protective rules (ex. limitations on certain transactions between corporations

and their officers and directors)2) Government Regulation

a. May limit freedom of participants to adopt rules they would otherwise have choseni. Ex) bankruptcy laws limit ability of a borrower to agree to an expeditious

foreclosure in the event of default on a loan3) Level of specificity

a. Complete specificity is not possible or even worth the costb. Vague general rules leave room for potential litigation

3 Basic sets of Legal rules, doctrines, and devicesused in creating business arrangements:

1) Employment relationships2) Partnerships3) Corporations

CONCEPTUAL:

y Legal rules and devices are tools by which people entering business relationships seek toresolve issues re: bargaining elements (allocation of loss, returns, and control; duration)

y Derivative suit(205)o If a corporate official violates any duties owed to the corporation + BOD fails to take

appropriate action shareholder has a right to sue in the corporations behalfo The shareholder derives the right to sue from the corporation (hence: derivative suit)o Parties:

Plaintiff = shareholder(s) Defendant = nominally, the corporation; actually, the individuals who

wronged the corporations officers and/or directorso Damages:

Recovery accrues to the corporation


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In a successful derivative suit: the corporation must pay for the shareholders legal expenses

y Solves the free rider problem this in effect taxes all shareholders(including the wrongdoer) and thus equitably apportions the costs ofmonitoring s conduct

Derivative suit

TYPES OF SECURITIES: BONDS, DEBENTURES, AND NOTES (248)

y Basic elementso Terms usedo relationships between investors with different claims in the firm (between lenders and

equity investors)

y Focus on: traditional obligations o Fixed claims to interest and principal; ando Fixed duration

General:

y Short-termo Notes shorter-term obligations

y Long-term (5+ years, seldom more than 30-40 years):o Bonds long-term obligation secured by a mortgage on some property of the issuero Debenture long-term unsecured obligationo NOTE: Bonds and debentures tend to be referred to interchangeably as bondso Essentially:

Commitments of funds to a firm for a relatively long, but limited period Maturity date a fixed date at which the firm must pay the principal sum

y A corporation selling or issuing bonds to the public means that:o The corporation is borrowing money from peopleo Those people/lenders may receive a fancy certificate as tangible evidence of the

corporations obligation to: Pay interest Repay the principal Abide by certain terms and conditions

y Bond holders can sell the bond to anyone for any priceBond calculations:

y Bonds/debentures are usually issued in denominations of $1,000o Price quotes in financial pages:

Price per $100 face value Price of bond is 98 denomination is $1,000 and price is $985

y Denomination = face value = par value of a bond


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o the amount that must be paid on maturity (at the end of the term of the loan)y A bond manifests the borrower/corporations obligation to pay:

o A fixed amount of interest at regular intervals (usually 6 mos.) Expressed as the nominal interest rate or coupon rate

o Face amount at maturityy Nominal interest rate = coupon rate:

o The total annual interest payment expressed asa % of the face valueo Reveals the annual $ amount that the borrower is required to payo (AOT the true interest rate or yield which is different if bond is not bought and sold

at par)o Example:

If a bond obligates a company to pay $85/year and $1,000 at maturity coupon rate is at 8.5%

o Note:

Original sale price and current market price NO effect on coupon rate

y Yield/true interest rate considers:o Coupon rate,o current price of bond, ando length of time to maturity

ba - basic concepts

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