CHAPTER 2:

INTRODUCTION TO
CORPORATIONS

Lecturer: Abdifatah Osman Ali

 What is corporation?

 It is a form of business that is recognized by law as separate legal

entity.
 Corporations can sue or be sued

 Corporations can be:

 Publicly traded company – provides stocks/shares (common/ordinary vs preferred)
 Private owned company

 Corporation should have a some sort of organization/chart of hierarchy.

 Shareholders/BOD/CEO
 Agency theory

 Company has an advantages, as well as disadvantages.

 Adv: Easy to raise capital – IPO Disadv: Expensive and complicated to
start
 Adv: Attract skilled labor Disadv: Require time to manage
 Adv: Limited liability Disadv: Double-taxation
 Adv: Unlimited life Disadv: Many restricted regulations on it.
 Stakeholders

 There are many types of  In the UK (and the USA) the focus is
organisations and many different on the shareholders, on the basis
groups that have a stake in the that it is the shareholders that have
performance of the organisations. a risk and return relationship with
 ๏Shareholders the company.
 ๏ The community at large (in particular,
environmental considerations)
 The aim is to maximise
 ๏ Employees of the company shareholders’ wealth (maximising)
 ๏ Managers / directors of the company while at the same time satisfying
 ๏ Customers the requirements of the other
 ๏ Suppliers stakeholders (satisficing).
 ๏ Finance providers (lenders)
 In many countries of mainland
 ๏ The government
Europe, and Japan, the focus is
 The interests of all more on maximising corporate
wealth which includes technical,
stakeholders need to be human and market resources.
balanced.
 How shareholders’ wealth be maximized

 Shareholders wealth is measured by the Specific allegations include:
market value of their shares  ๏ Excessive remuneration levels

 The main types of decisions that need to  ๏ Empire building

be made (and the main areas for  Chief executives may have the aim of building as
large a group as possible by takeovers – not
consideration) are: always improving the return to shareholders
 ๏ Investment decisions
  ๏ Creative accounting
๏ Sources of finance decisions
  Using creative techniques to improve the
๏ Decisions regarding the level of dividend to be paid
appearance of published accounts and artificially
 ๏ Decisions regarding the hedging of currency or boosting the share price.
interest rate risk
 Off balance sheet finance
 There is a problem here, sometimes the  For example, leasing assets rather than
interests of directors may not directly purchasing them
coincide with the interests of the  Takeover bids
shareholders, even though they are  There have been many instances of directors
working for the shareholders, this is called spending time and money defending their
company against takeover bids
conflict of interest (opp. Goal congruence)
Corporate Reconstruction Vs Corporate Restructuring

 Corporate Restructuring means re-arranging business of a

company for increasing its efficiency and profitability.
 Restructuring a company is corporate surgery to enable a company to
continue in business or to go into liquidation.

 Corporate Reconstruction is a process of the company's

reorganization, concerning legal, operational, ownership and
other structures, by revaluing assets and reassessing the
liabilities.
A. Corporate reconstruction

 Companies can be solvent and insolvent

company.
 For solvent companies, the
reconstruction options are as follows:
 1. conversion of debt to equity
 2. conversion of equity to debt
 3. conversion of equity from one form to another
form
 4. conversion of debt from one form to another
form
Cont…

 1. Conversion of debt to equity:

 The most likely reason is to enhance the equity base of
the company.
 Debt is more riskier than equity
 Debt has restrictive covenants
 It may arise working capital problems

 2. Conversion of equity to debt:

 The interest is tax deductible (tax shield advantage).
 3. Conversion of equity form to another form
of equity:
 It simplifies the capital structure.
 Transferring common stock to preferred stock or vice versa.
Cont…

 4. Conversion of debt form to another form of debt:

 Security reasons – secured vs unsecured loans, convertible loans vs
non-convertible loans.
 Cost reasons – high risk, high required return from creditors.
 The more secure the loan in the eyes of the creditor, the less of required return they
want.
 Flexibility – loans on restrictive covenants vs those who have not

 Therefore, it is important to know the impact of corporate

reconstruction on the stakeholders particularly.
 Ordinary shareholders
 Preference shareholders
 Creditors
Corporate Re-Organizations

 This involves the possible restructuring on corporations.

 1) Unbundling companies: process of selling non-core business
to release fund, or reduce gearing or allow management to focus
on the core business. It can be the following forms:
 A) Demergers/Spin-off, existing shareholders are given shares in each of
the two separate businesses – control is maintained. (purpose: to create
higher value company)
 B) sell-offs, at least part of the business will be sold to a third party. -
control of part of the business is lost. (purposes: to raise cash/ prevent
loss-making, concentrate the core areas of business, to protect the
rest of business, dispose the desirable part ).
 asset stripping, means selling the asset of business individually at profit.

 C) Management buyout – management of the business acquires the most

shares and control the company which they managed. (reasons: cash is
required, loss-making part of business (sell instead of liquidation), )
Cont..

 D) Leveraged buyout – investors provides bulk of loan

to acquire the business along with the management.
 E) Employee buyout – all employees are offered a
shares in the new business.
 F) Management buy-in – group of managers from
outside make the acquisition.
 G) Spin-out – buy-out in which the original company
maintain some shares of the business.
 In other way, reconstruction can be divided into:
Financial, Portfolio and organizational restructuring.
 Assessing the Benefits of reorganization

 1. Concentration of growth and maximization of

shareholder value.
 Splitting-off non-core business may rise the visibility and cost of the rest
activities.
 New management may better than the previous management.
 Selling the loss-making business may arise the performance of the rest activities.

 2. Reduction in complexity and improved managerial

efficiency.
 Demergers and sell-offs reduces the complexity of the business
 Diversified businesses are complex to manage
 Improved managerial effectiveness by focusing on only core businesses

 3. Release of financial resources

 Selling loss-making business generates cash to invest the core business

 Capital Restructuring Scheme
Legal framework
 (1) The company must receive the court’s permission to launch a scheme
 (2) Compromises must be agreed by all parties – classes of creditors should meet
separately so that substantial minorities are not voted down. Every class must vote
in favour for the scheme to succeed.
 (3) Under the Insolvency Act a reconstruction can be achieved by transferring
assets of the company to a new company in exchange for shares, these new shared
being distributed to the existing shareholders. Creditors do not lose their rights
in this arrangement.
Why restructuring?
 (1) To write off large debit balances in the profit and loss accounts, so allowing the
company to pay dividends in the future, and therefore encouraging the
injection of new finance.
 (2) To rearrange the capital structure. Ordinary shares may be worth very little
so that small monetary changes in value represent significant relative movements.
Going Private

 All the listed shares of a company are bought by a small group of investors,
and the company is delisted.
 (1) both direct and indirect listing costs are saved
 (2) a hostile takeover bid is impossible
 (3) a small number of shareholders reduces the agency problem
 International Operations
 There are different ways in which a  ๏ joint venture
company can conduct overseas  ‣ access to new markets at comparatively
operations. low cost
 ‣ use of partner’s expertise and local
 ๏ export from the home country knowledge
 ‣ low risk; low capital needs  ‣ easier access to government incentives
 ‣ little local knowledge and local capital markets
 ‣ slow response to market  ‣ but, cultural difference / finding partner
may be difficult
 ๏ set up overseas branch
 ๏ licensing
 ‣ profits of branch treated as profit of parent
company  ‣ rapid penetration of local markets
 ‣ cheap to run  ‣ low investment
 ‣ regular licensing fee income (often
 ๏ set up overseas subsidiary regardless of profitability)
 ‣ may be able to claim local grants / tax
advantages
 ‣ local profile may be better for subsidiary
Ways of remitting income from overseas investments

 The following ways help companies to remit

their income to their parent companies.
 (1) Dividends
 (2) Loan interest
 (3) Royalties
 (4) Management charges
 (5) Transfer prices
 (6) Countertrade
Political Risk

 Political risk is the risk that political action will affect the position
and value of a company.
 Examples of macro (country specific) political risk:
 ๏ outbreak of war / civil unrest
 ๏ confiscation of assets (nationalisation) / restrictions on foreign ownership
 ๏ import quotas / tariffs
 ๏ exchange controls

 Examples of micro (firm specific) political risk

 These are risks that affect only certain firms in certain industries,
rather than all foreign firms.
 ๏ minimum wage legislation
 ๏ pollution controls
 ๏ product legislation
 ๏ health and safety legislation
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