Economics

Chapter 6

Ownership, Expansion and Integration of Firms

Firm

Definition A firm is a unit that makes decisions regarding the

employment of factors of production and the production of goods and services

Types Public enterprise – owned by the government Private enterprise – privately owned

Public enterprise

2 kinds of management Managed by the government

Directly run by the government Department under governmental structure E.g. The Hong Kong Police Force,

The Fire Service Department,The Water Supply Department…

See reference: Organisation Chart of the Gov’t of HKSAR http://www.gov.hk/en/about/govdirectory/govchart/index.htm

Public enterprise

2 kinds of management Managed by the public corporations

Established with government funds Managed by government-appointed directors Operation funds come from service charges E.g. The Airport Authority of Hong Kong,

Hospital Authority,Hong Kong Art Centre,Urban Renewal Authority8 universities…

See reference: Government and Related Organisations http://www.gov.hk/en/about/govdirectory/govwebsite/index.htm#p7

Characteristics of public enterprise

Management Directly by government Managed by the public corporations

Capital Receiving capital from the government Independent account Public corporations are responsible for the success or failure to their own

business. Provision of lowly-priced services and facilities to the public

Might not be aiming at profit maximization Services or facilities provided might be free of charge Provide services or facilities which are necessary to the society but not be

given by private sectors E.g.

Police Force to keep social orderHousing Department to provide lowly-priced public housingWater Supplies Department to provide stable and reliable water supply

Characteristics of public enterprise

Advantages Provision of necessary services to the citizens, more stable living

environment Lower the living cost

Disadvantages Not aiming at profit maximization

no response to market changes lack incentive to modify (lower the cost or improve management)

Mismatch with market demand / price, violate the postulate of maximization

High cost of complaints

Private enterprise

Forms of business ownership Sole proprietorship Partnership Limited company

Main differences

Legal entities Limited liability

Sole proprietorship

Partnership Limited company

Legal entities

An independent entity with rights and obligations like an ordinary individual.

To sole proprietorship and partnership the owner of the firm needs to bear all obligations from any legal

dispute can’t initiate or receive lawsuit

To limited company the company bears the legal obligation owner(s) of the firm need not to be legally responsible Can initiate or receive lawsuit

Liability

Limited liability Owner is liable to the amount of investment he has in the firm. Illustration:

1. An investor invested $100,000 into the Firm A2. The firm applied debt from Bank L3. When time was due, Firm A couldn’t pay for the debt.4. Bank L demanded Firm A liquidation, assets were sold to pay

for the debt.5.The investor needed not to pay for more, his $100,000

investment will be the upper limit of his loss.[ In conclusion: The investor loses $100,000 in maximum.]

Liability Unlimited liability

Owner(s) of sole proprietorship and partnership is/are liable to all debts of the firm.

Illustration:1. An investor invests $50,000 into the Firm B2. The firm applies debt (let say $200,000) from Bank M.3. When time is due, Firm B can’t pay for the debt.4. The investor needs to sell the assets of the firm (let say $100,000).5. If not enough pay for the debt, the investor needs to sell personal assets (let say $50,000).6. If still not enough, the owner goes bankrupt.[ In conclusion: The investor loses more than $50,000.]

Types of ownership Sole proprietorship

Single owner No independent legal entity. Unlimited liability. Advantages:

Simple set-up procedure Registration: Inland Revenue Department

Quick decision making No requirement of information disclosure All profit belongs to the sole owner

Disadvantages: Limited ways of / Difficulties in fund raising Unlimited liabilities Bear all legal obligations Lack of continuity

Death Retirement Ownership transfer Bankruptcy of owner

Types of ownership Partnership

2 or more owners No independent legal entity. Unlimited liability. Advantages:

Simple set-up procedure Registration: Inland Revenue Department

Quick decision making (comparing with limited company) Sharing risk and work, or benefit from division of labour (experience sharing) No requirement of information disclosure

Disadvantages: Slower decision making (comparing with sole proprietorship) Limited ways of / Difficulties in fund raising Unlimited liabilities Bear all legal obligations Lack of continuity, as if one of the partners…

Death Retirement Ownership transfer Bankruptcy of owner

Types of ownership Limited Company (Ltd. Co.)

Private limited company Public limited company

Common features Complicated set-up procedures

To Companies Registry: Memorandum and Articles of Association To Inland Revenue Department: Business registration

Ownership Divided into a number of shares Decision making by voting Shareholders ( w/ > 50% shares, absolute control)

Types of ownership Common features

Structure Ownership ≠ Management General meeting Vote for decision Board of directors Formulates policies, supervises operations & ensures

the resolution of general meeting Legal entity

The company itself is a legal entity Lasting continuity

Death of one owner does not mean end of company Ended unless liquidation

Limited liability Information disclosure

Must be audited by authorized accountants

Types of ownership Private vs. Public limited company

Private company Public / Listed company

No. of shareholders 1 to 50 Unlimited

Transfer -Consent from the BoD-Preference to existing shareholders-Shares not traded on the HKEx

-Free transferal-No need to have consents from the BoD-Exchange through HKEx.

Ways to raise Capital -Can’t invite public to buy shares and bonds

-Rely on debts

-Shares and bonds to public-Equity and debt funding

Disclosure of financial info.

-To shareholders only-Can keep secret to the public

- Disclose to public

Ways for Ltd. Co. to raise capital Debts from financial institutes

Bank loan Loan from financial companies Payment: Interest

Issuing shares (both Private and Public Ltd. Co.) Selling of ownership Investors buy the shares of the companies Share companies’ profit Payment: Dividends

Issuing bonds (only Public Ltd. Co.) Bonds to creditors as certificates A bond is a statement of debt info.: Amount / interest rate / due date Payment: Interest

Borrower = Bond issuer Lender (Creditor) = Bondholder

Bond

Bond

Shares BondsNature Proof of ownership Certificates of debt

Return -Different in price (exchange market)-Dividends

-Different in price (bond market)-Interest

Priority for obtaining returns

Priority to get back the capital if liquidation

Voting right

Shares vs. Bonds

Issuing shares Issuing bondsAdvantages -Capital kept forever

-No need to repay-Dividends are not mandatory.

-Ownership and control not to be weaken.-Signal of rapid growth

Disadvantages -Risk of price drop, decrease in asset value-Spread of ownership and controlling power-Slow economic growth

-Risk of liability-Interest payment-Payback of loan on due date

Pros and Cons

Return and Risk

Once you want to invest: Expected rate of returns

Shares > Bonds > Bank Deposit > Cash Risks

Shares > Bonds > Bank Deposit > Cash

∴Risk ReturnRisk Return

Expansion

Expansion Enlarge the scale of production Aim at achieving economies of scales

Ways of expansion New branches New products New business

Integration

Integration Take over or merge with other companies Aim at achieving economies of scales

Types of integration Horizontal Vertical Lateral Conglomerate

Integration Horizontal Integration

Merge with another firm producing the same type of products Reasons:

Defeat competitor, more market share Same product Lower cost of production New market

Example: A mobile service company takes over another mobile service company

Cases: Cathay Pacific took over Dragonair (2006) Sony & Ericsson (2005) HP took over Compaq (2002) IBM took over Lotus (1995) Panasonic and Rasonic (1994)

Integration Vertical Integration

Merge with another firm in different stage of production

Backward integration Another firm in the preceding/earlier stage of production Reason:

Ensure the supply of resources or services Lower the cost of supply of resources

Example: A clothing company takes over a button company Cases:

Dairy Farm and Nestle Reliance Industries (Garment producer): from textiles into polyester fibres

and further into petrochemicals. Esso+Exxon+Mobil: SeaRiver Maritime, a petroleum shipping company.

Integration Vertical Integration

Merge with another firm in different stage of production

Forward integration Another firm in the next stage of production Reason:

Ensure the channel of product and service sales Lower the cost of information from market

Example: A clothing company takes over a retailer

Cases: Cathey Pacific & Hong Kong Air Cargo Terminals Limited Vodafone Airtouch PLC took over Mannesmann (Germany)

Integration Lateral Integration

Merge with another firm producing related nut not directly competing products

Reason: Risk diversification Lower the cost of sales of products and services (market economi

es, R&D economies) Example:

A garment company takes over a shoe factory A mp3 player factory takes over a headphone factory

Cases: Citigroup & Travelers Group (1998) China Strategic Holdings(中策集團 ) & Primus Financial Holdings

Limited (博智金融控股 ) suggested acquisition over AIG Nan Shan Life Insurance Company, Ltd. (南山人壽 ) (2009)

Integration Conglomerate Integration

Merge with another firm with different business Reason:

Risk diversification Lower the cost of sales of products and services (market economies, R&D economies)

Example: A garment company takes over a toy factory

Cases:

Hutchison Whampoa Ltd. owns:

Hong Kong International Terminals

Hutchison Whampoa Property

A.S. Watsons Group

Cheung Kong Infrastructure Holding Ltd.

Hutchison Telecommunications International Limited

CITIC Group owns:

CITIC Ka Wah Bank Limited

CITIC Pacific

CITIC Resources Holdings Ltd.

中信文化傳媒集團Asia Satellite Telecommunications Co. Ltd.

CITIC Travel Co.

China CITIC Press

Western Harbour Tunnel Co. Ltd.

The motives of expansion

General motives Economies of scale

scale of production Lower the production market share profit

Simplify structure Reorganizing business Efficiency in management Flexible allocation of resources Cut down over-abundant expenditure

Acquisition of technology New technology R & D

Acquisition of brands Takeover the brand from other firms Save time and cost to develop new brand

The motives of expansion

Specific motives

Types Motives

Horizontal -Defeat competitors-Market share-Influence on the market

Vertical Backward-Ensure supply of resources

Forward-Stable sales outlets-First-hand market information

Lateral -Risk diversification-Extension of brands, save costConglomerate