Chapter 3

Ownership of Firms

S4____ Name: _________________________ ( )

3.1 Firms
Firms are basic units of production that makes decisions regarding the
• employment of factors of production and production of goods and services

Public enterprises mean firms owned by the government.

Private enterprises mean firms owned by private individuals.

3.2 Public enterprises

• wholly owned by the government
• mainly provide goods and services at low prices to the general public
• do not aim at profit-maximization

Government department
• managed and operated by the government
• staff are civil servants
e.g., Hong Kong Post, Water Supply Department, Hong Kong Police Force

Public corporation
• owned by government but managed by board of directors appointed by the government
• financially independent of the government
• run on commercial principles
e.g., Airport Authority, Hospital Authority, Hong Kong Examinations and Assessment Authority

real-life example - Ocean Park Corporation

real-life example - is Hong Kong Disneyland a public corporation?

“As of the end of fiscal 2017, the Hong Kong Government holds 53 per cent of shares in the company
and The Walt Disney Company holds 47 per cent.”
Extracted from the official website of Disneyland

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Summary
Government department Public corporation
Ownership government government
Management government board of directors
Financially dependent on government independent on government

Features of public enterprises

• Easier to get information and statistical data about the general public from the government for
decision making – make more accurate business decisions

• Can provide stable supply of goods and services at lower prices

- because public enterprises usually do not aim at maximizing profit
e.g., public housing, water supply

• Relatively adequate and stable sources of capital

- for government department, their capital comes from the government
- easier to get loans for public corporations as it is fully owned and supported by the government
(for operation and expansion)
Hong Kong’s troubled Ocean Park saved as lawmakers approve
HK$5.4 billion relief fund Published: 6:08pm, 29 May, 2020

After hours of debate, 32 legislators support lifeline for the home-grown

theme park in Aberdeen due to threats of possible liquidation in June.
Source: South China Morning Post
https://www.scmp.com/news/hong-kong/hong-kong-economy/article/3086730/hong-kongs-troubled-ocean-park-saved-lawmakers
• Higher average production costs
- as public enterprises usually operate on a large scale
- operational problems may arise (e.g., difficulty in management) (diseconomies of scale)

Advantages of operating as public enterprises over private enterprises

• Government will have a better control of the price
- it can decide on the price so that it may reduce the price to relieve the burden of the customers
• It may be easier to get loans as it is fully owned and supported by the government.

Disadvantages of operating as public enterprises over private enterprises

• It may make the management less efficient as
- it would be less sensitive to market (price) signals*
because they may not be responsive to market demand as they do not seek profits from them;
and there is usually no direct competition for the particular goods / services,
or
- decision-making process is complicated
(e.g., considers more area of society / passes through more departments before deciding on certain
policies - more time is required)

*For example, when more people demand for the service, private enterprises would produce more of it in order to obtain a
higher profit. But it may not be the case for public enterprises as they do not aim at profit-maximization
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3.3 Private Enterprises
• Types of private enterprise can mainly be categorized based on whether the firm is a legal entity.

Concept of legal entity

• Imagine if Ruth’s dog bit someone else on street, will she or her dog be sued?
• (Ruth / Ruth’s dog) will be sued. We cannot sue something that is not a legal entity.
• The owner would be the one who bears legal responsibilities.

Legal entity means one is recognised as an individual in terms of laws. (公司是一個個體)

• i.e., the firm / the person has an independent legal status (獨立法律地位)

Not being a legal entity means it is not treated as an individual in terms of laws. (公司不是一個個體)
• i.e., the firm / the person does not have an independent legal status

Legal entity
If the firm is a legal entity,
• the firm acts like a person
• the firm bears legal responsibility on its own
i.e., the firm can be sued, the firm can own a property, the firm can buy other companies

If the firm is not a legal entity …

• the firm and the owner are not separated
• owners have to bear legal responsibility of the company

Liability obligations
If the firm is a legal entity,
• the firm bears the liability (i.e., the firm uses its asset to pay for the liability)
• the owners’ liability is confined to the amount of their initial investments
(as those investments are already regarded as the firm’s asset after they invested)
- no need to use personal properties to pay
ð owners pay (limited / unlimited) liability

If the firm is not a legal entity,

• the owner bears the liability
• the owners’ liability is not confined to the amount of their initial investments
- need to use personal properties to pay if their investments are not enough to pay the liability
ð owners pay (limited / unlimited) liability

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Check your understanding
Suppose a customer suffered from food poisoning after having lunch in Restaurant M. The customer sued the
company and the court imposed a $50,000 fine on Restaurant M.

Mike is one of the owners, who invested $10,000 into the firm.
For simplicity, we assume the restaurant only has the $10,000 contributed by Mike.
[The $10,000 invested to Restaurant M now belongs to Restaurant M.]

Discuss the liability obligation of Mike if

Restaurant M Mike
$10,000 $0? $40,000?

a) Restaurant M is a legal entity

• The (firm / owner) will bear the liability.
• The firm will use its asset to pay for the fine.
• If the firm cannot pay the $50,000 fine, it goes bankrupt.
• Mike (has to / does not have to) use his personal properties to pay for the liability.
i.e., the maximum loss of Mike would be the $10,000 (the initial investment) that he has invested.
ð He bears (unlimited / limited) liability.

b) Restaurant M is NOT a legal entity

• The (firm / owner) will bear the liability.
• The owner will use its asset (including the firm) to pay for the fine.
• After using all the money in the restaurant, there is still $40,000 remained.
• Mike (has to / does not have to) use his personal properties to pay for the liability.
i.e., the maximum loss of Mike would exceed the $10,000 (the initial investment) that he has invested.
ð He bears (unlimited / limited) liability.

P.S. “limited / unlimited” refers to whether the liability is limited (confined) to the investment of the owners

Note:
• some professionals are not allowed to bear limited liability, e.g., doctors and lawyers
• if they make a mistake, their clients suffer a huge loss
- in which the firms’ asset may not be enough for compensation
• to encourage professionals to keep up service standard, they must bear unlimited liability

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Overview of private enterprises

Firms that are not legal entities

Sole proprietorship
• only 1 owner
• usually small scale of business
• ownership and management are not separated
• closer relationship with customers and employees due to small scale of operation

Partnership (General partnership)

• 2 owners or above with no upper limit
• Collective responsibility
- all partners are bound by contracts signed by any partners
- all partners are legally bound by the decisions made in the name of the firm, and are responsible
for the consequences of those decisions
- a poor decision made by one partner will affect the whole business

Compared with limited companies, sole proprietorship and partnership …

Advantages J
• require simpler legal set-up procedures
- they can start a business after obtaining a Business Registration Certificate
• pay lower profits tax rate*
• have higher financial confidentiality (only when compared with public limited companies)
- accounting information does not have to be disclosed to the general public

Difference in profits tax rates

Source: Inland Revenue Department

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Disadvantages L
• bears unlimited liability for sole proprietor and partners
i.e., if the business fails, the owners’ loss would not be confined to their initial investment
• lack of lasting continuity
- if the owner(s) die / retire, the firm dissolves at the same time
- a partnership dissolves if a (general) partner withdraws

Both of sole proprietorship and partnership are NOT a legal entity (no independent legal status)

Comparison between sole proprietorship and partnership

Advantages of sole proprietorship over
partnership
• efficient and flexible decision-making
(as the sole proprietor does not need to discuss
with others / require approval from other)
• free and easier transfer of ownership because
the sole proprietor can do it on his own
Disadvantages of partnership over sole
proprietorship
• less flexible and slower decision-making
(as decisions made by a partnership needed to
be agreed by all of the partners)
• transfer of ownership requires consent (同意)
of all partners

Advantages of partnership over sole Disadvantages of sole proprietorship over

proprietorship partnership
• wider source of capital because there are more • narrower source of capital because there is
owners only one owner
• different expertise can be contributed by
different partners to the business • The sources of expertise will be limited to the
(i.e., each partner can contribute specialized owner
knowledge and ability to the business)
• business risk can be shared among partners • business risk is borne by the sole proprietor
=/= lower risk for the business alone

Does wider source of capital mean greater amount of capital?

• 10 beggar and 1 Li Ka Shing / 十個乞衣同一個李嘉誠
Wider source of capital from 乞衣 but lower amount from them

Firms that are legal entities

Limited companies (Ltd.)
• private limited company (1 - 50) and Public limited company (1 - unlimited)
• limited companies are legal entity (with separate legal status)
• separation of ownership and management
- owned by shareholders
- managed by a board of directors

Compared with sole proprietorship and partnership, limited companies …

Advantages J
• (the owners of limited companies) enjoys limited liability
i.e., if the business fails, the shareholders’ liability would be confined to his initial investment

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 • have lasting continuity
- if the owner(s) die / retire, the firm can continue to operate
• enjoy wider source of capital as it can issue shares and bonds

Disadvantages L
• require more complicated and more expensive legal set-up procedures
• pay higher profits tax rate

Comparison between private and public limited companies

Private limited company Public limited company
• cannot issue shares & bonds to the • can issue shares & bonds to the
Source of Capital public (no public subscription) public (public subscription)
ð narrower source of capital ð wider source of capital

Financial • higher (no need to disclose financial • lower (need disclose financial
confidentiality information to the public) information to the public)

• shares cannot be freely transferred • shares can be freely transferred

Transfer of
• requires approval of board of • can be sold freely on stock
ownership
directors before transfer exchange if the company is listed
• higher as shares (ownership) can be
Risk of being • lower as existing shareholders have
transferred without consent of
taken over tighter control over ownership
shareholders

Summary table for comparison

Sole Private limited Public limited
Partnership
proprietorship company company
No. of owners 1 2 or more 1 – 50 1 or more
Owners are called sole proprietor partners shareholders shareholders
Legal entity ✖ ✔
Set up cost / lowest / lower / higher / highest /
procedures simplest simpler more complex most complex
Sources of capital narrowest narrower wider widest
Accounts (disclosure of ✖
✔
financial information) (higher financial confidentiality)
easy
not easy not easy
(shares are freely sold
Transfer of ownership easy (need consent of (need consent of
in stock market if
all partners) board of directors)
listed)
Risk of being taken over / / lower than public higher than private
Continuity no lasting
Liability unlimited limited
Profits tax rate lower than limited companies higher than sole & partnership

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Reminder for MCQ
§ Profits tax rates are same for private and public limited companies
§ never compare profits, amount of capital, riskiness of businesses (unless the question uses
hedging words, e.g., may, maybe)
- e.g., public limited companies earn higher profits than partnerships ✖
- e.g., partnership has a higher amount of capital than sole proprietorship ✖
§ sharing of profits (in partnerships) might NOT be equal

Past Paper Questions

2014 DSE Q8 (74%)
Which of the following statements about partnership and sole proprietorship is correct?

A. Partnership has better continuity than sole proprietorship.

B. Partnership has less flexibility in decision making than sole proprietorship.
C. Partnership has more capital than sole proprietorship.
D. Partnership enjoys more economies of scale than sole proprietorship.

2017 DSE Q5 (88%)

Alan and his partners turned their partnership into a private limited company. After the change, the firm will

A. have more capital for development.

B. have a lower average production cost.
C. enjoy a lower profits tax rate.
D. have a separate legal entity.

2018 DSE Q7 (69%)

Firm X Firm Y
Number of owners 2 10
the consent of other the consent of other
Transfer of ownership
owners required owners NOT required
Disclosure of financial account to public NOT required required

According to the above table, which of the following descriptions of Firm X and Firm Y is correct?
A. Firm Y earns a higher profit than Firm X.
B. Firm Y raises more capital than Firm X.
C. Owners of both firms enjoy limited liability.
D. Firm Y is a legal entity while Firm X may not be.

Examples of long questions

2017 Paper 2 Q10a
MTR Corporation Limited (stock code: 66) provides railway services in Hong Kong.
(a) MTR is a listed company. State TWO differences between such as ownership and a private limited
company. (2 marks)

2018 Paper 2 Q2a

Last year, Peter operated a sole proprietorship. Recently he invited Paul and Mary to form a partnership to
expand the business to other markets.
(a) Suggest TWO reasons why Peter switched his firm’s form of business ownership for expansion. (2 marks)
Ownership of Firms Page 9
3.4 Sources of Capital (for private enterprises)
• sole proprietorship & partnership: owners’ savings, past profits, borrow from friends / bank
• limited companies: the above, plus issuing shares and bonds

Features of shares and bonds

• Shares are certificates of ownership which represent the ownership of shareholders in a limited
company.
• Bonds are certificates of debt issued by a limited company to raise capital.

Shares Bonds

Shareholders Bondholders

Role owners of the company creditors of the company

Voting rights* yes no

• receive a floating rate of dividend
depending on profit • receive a fixed rate of interest
Return
• investors enjoy capital gain when share regardless of profit
prices of listed companies increase
Maturity date no fixed

Liquidation+ the last to get back their capital get back capital before shareholders
* at the Annual General Meeting (AGM) and any other special occasions

+
Liquidation: the company is forced by the court to sell all firms’ assets to repay the debt

Priority of repayment
(1) Liquidation fee to liquidator
(2) Tax to the government
(3) Wages to employees
(4) Bondholders
(5) Shareholders

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Comparison between shares and bonds

Features of shares
Advantages Disadvantages

• unstable return which depends on company’s profits

(floating rate of return)
• higher possible return especially when the firm has profits
(e.g., if the company earns no profits, the company may
To investor (firms may distribute higher rate of dividends)
decide not to distribute dividend)
(buying shares)
• enjoys voting rights (they are owners of the company)
• the last to get back the investor’s capital during
liquidation (get back after bondholders)

• no interest burden
(i.e. the firm has no obligation to pay dividends to
shareholders when they suffer a loss)

To company • no redemption obligation as there is no maturity date for • higher risk of being taken over as shareholders are owners
(issuing shares) shares (i.e., firms do not have to redeem the shares on a of the company
specific date)

• does not increase debt of company - not affect the company

to obtain new loans

To existing shareholders • dilute their voting rights and control

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Features of bonds
Advantages Disadvantages

• enjoy stable return (they receive fixed rate of interest • cannot get extra return even when there is great profit
regardless of profit) because the rate of interest is fixed
To investor
(buying bonds)
• investors get back their capital during liquidation before • do not enjoy voting rights because bondholders are not
shareholders owners of the company

• the firm has interest burden (obligation to pay the fixed

interest even when there is a loss)

To company • lower risk of being taken over as bondholders are not owners • the firm has redemption obligation
(issuing bonds) of the company (i.e., the firm has to redeem the bonds during maturity)

• increase debt of the company, affecting its ability to

obtain new loans

To existing shareholders • voting rights would not be diluted

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