1 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance

2 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance

3 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance CHAPTER 7 Firms, the Stock Market, and Corporate Governance Fernando Quijano Prepared by: When Mark Zuckerberg started Facebook in 2004, he was still a sophomore in college. Just five years later, Facebook had 150 million users.

4 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance 7.1Types of Firms Categorize the major types of firms in the United States. 7.2The Structure of Corporations and the Principal–Agent Problem Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principal–agent problem. 7.3How Firms Raise Funds Explain how firms raise the funds they need to operate and expand. 7.4 Using Financial Statements to Evaluate a Corporation Understand the information provided in corporations’ financial statements. 7.5 Corporate Governance Policy Understand the role of government in corporate governance. Appendix: Tools to Analyze Firms’ Financial Information Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. Chapter Outline and Learning Objectives CHAPTER 7 Firms, the Stock Market, and Corporate Governance

5 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Types of Firms Sole proprietorship A firm owned by a single individual and not organized as a corporation. Partnership A firm owned jointly by two or more persons and not organized as a corporation. Corporation A legal form of business that provides owners with protection from losing more than their investment should the business fail. Categorize the major types of firms in the United States. 7.1 LEARNING OBJECTIVE

6 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Asset Anything of value owned by a person or a firm. Limited liability The legal provision that shields owners of a corporation from losing more than they have invested in the firm. SOLE PROPRIETORSHIP PARTNERSHIPCORPORATION ADVANTAGES Control by owner No layers of management Ability to share work Ability to share risks Limited personal liability Greater ability to raise funds DISADVANTAGES Unlimited personal liability Costly to organize Limited ability to raise funds Possible double taxation of income Who Is Liable? Limited and Unlimited Liability Table 7-1 Differences among Business Organizations Categorize the major types of firms in the United States. 7.1 LEARNING OBJECTIVE Types of Firms

7 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Types of Firms Corporations Earn the Majority of Revenue and Profits FIGURE 7-1 Business Organizations: Sole Proprietorships, Partnerships, and Corporations The three types of firms in the United States are sole proprietorships, partnerships, and corporations. Panel (a) shows that only 19 percent of all firms are corporations. Yet, as panels (b) and (c) show, corporations account for a large majority of the total revenue and profits earned by all firms. Categorize the major types of firms in the United States. 7.1 LEARNING OBJECTIVE

8 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance How Important Are Small Businesses to the U.S. Economy? Making the Connection In a typical year, 40 percent of new jobs are created by small firms like Yelp.com, which is a community-based review and directory website founded by Jeremy Stoppelman, left, and Russel Simmons. YOUR TURN: Test your understanding by doing related problem 1.6 at the end of this chapter. Entrepreneurs founding small firms have been the source of many of the most important new goods and services available to consumers. Categorize the major types of firms in the United States. 7.1 LEARNING OBJECTIVE

9 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance The Structure of Corporations and the Principal–Agent Problem Corporate Structure and Corporate Governance Separation of ownership from control A situation in a corporation in which the top management, rather than the shareholders, control day-to-day operations. Corporate governance The way in which a corporation is structured and the effect a corporation’s structure has on the firm’s behavior. Principal–agent problem A problem caused by an agent pursuing his own interests rather than the interests of the principal who hired him. Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principal–agent problem. 7.2 LEARNING OBJECTIVE

10 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Solved Problem 7-2 Does the Principal–Agent Problem Apply to the Relationship between Managers and Workers? Briefly explain whether you agree with the following argument: The principal–agent problem applies not just to the relationship between shareholders and top managers. It also applies to the relationship between managers and workers. Just as shareholders have trouble monitoring whether top managers are earning as much profit as possible, managers have trouble monitoring whether workers are working as hard as possible. YOUR TURN: For more practice, do related problems 2.4 and 2.5 at the end of this chapter. Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principal–agent problem. 7.2 LEARNING OBJECTIVE

11 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance How Firms Raise Funds 1.If you are making a profit, you could reinvest the profits back into your firm. Profits that are reinvested in a firm rather than taken out of a firm and paid to the firm’s owners are retained earnings. 2.You could raise funds by recruiting additional owners to invest in the firm 3.Finally, you could borrow the funds from relatives, friends, or a bank. Explain how firms raise the funds they need to operate and expand. 7.3 LEARNING OBJECTIVE As the owner of a small business, you can raise the funds for an expansion in three ways:

12 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance How Firms Raise Funds Sources of External Funds Indirect finance A flow of funds from savers to borrowers through financial intermediaries such as banks. Intermediaries raise funds from savers to lend to firms (and other borrowers). Direct finance A flow of funds from savers to firms through financial markets, such as the New York Stock Exchange. Explain how firms raise the funds they need to operate and expand. 7.3 LEARNING OBJECTIVE

13 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance How Firms Raise Funds Sources of External Funds Bond A financial security that represents a promise to repay a fixed amount of funds. Bonds Coupon payment An interest payment on a bond. Interest rate The cost of borrowing funds, usually expressed as a percentage of the amount borrowed. Explain how firms raise the funds they need to operate and expand. 7.3 LEARNING OBJECTIVE

14 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance How Firms Raise Funds Sources of External Funds Stock A financial security that represents partial ownership of a firm. Stocks Dividends Payments by a corporation to its shareholders. Explain how firms raise the funds they need to operate and expand. 7.3 LEARNING OBJECTIVE

15 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Don’t Let This Happen to YOU! When Google Shares Change Hands, Google Doesn’t Get the Money Changes in the value of a firm’s stocks and bonds offer important information for a firm’s managers, as well as for investors. How Firms Raise Funds Stock and Bond Markets Provide Capital—and Information A higher bond price indicates a lower cost of new external funds, while a lower bond price indicates a higher cost of new external funds. YOUR TURN: Test your understanding by doing related problem 3.10 at the end of this chapter. Explain how firms raise the funds they need to operate and expand. 7.3 LEARNING OBJECTIVE

16 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance How Firms Raise Funds Why Do Stock Prices Fluctuate So Much? The performance of the U.S. stock market is often measured by market indexes, which are averages of stock prices. The three most important indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ. During the period from 1995 to mid-2009, the three indexes followed similar patterns, rising when the U.S. economy was expanding and falling when the economy was in recession. Explain how firms raise the funds they need to operate and expand. 7.3 LEARNING OBJECTIVE Movements in Stock Market Indexes, 1995–mid-2009

17 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Following Abercrombie & Fitch’s Stock Price in the Financial Pages Making the Connection YOUR TURN: Test your understanding by doing related problem 3.11 at the end of this chapter. Explain how firms raise the funds they need to operate and expand. 7.3 LEARNING OBJECTIVE

18 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Using Financial Statements to Evaluate a Corporation Liability Anything owed by a person or a firm. Income statement A financial statement that sums up a firm’s revenues, costs, and profit over a period of time. The Income Statement Getting to Accounting Profit Accounting profit A firm’s net income, measured by revenue minus operating expenses and taxes paid. Understand the information provided in corporations’ financial statements. 7.4 LEARNING OBJECTIVE

19 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Using Financial Statements to Evaluate a Corporation... And Economic Profit Opportunity cost The highest-valued alternative that must be given up to engage in an activity. The Income Statement Explicit cost A cost that involves spending money. Implicit cost A nonmonetary opportunity cost. Economic profit A firm’s revenues minus all of its implicit and explicit costs. Understand the information provided in corporations’ financial statements. 7.4 LEARNING OBJECTIVE

20 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Using Financial Statements to Evaluate a Corporation Balance sheet A financial statement that sums up a firm’s financial position on a particular day, usually the end of a quarter or year. The Balance Sheet Understand the information provided in corporations’ financial statements. 7.4 LEARNING OBJECTIVE

21 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Corporate Governance Policy The landmark Sarbanes-Oxley Act of 2002 requires that CEOs personally certify the accuracy of financial statements. The Sarbanes-Oxley Act also requires that financial analysts and auditors disclose whether any conflicts of interest might exist that would limit their independence in evaluating a firm’s financial condition. Understand the role of government in corporate governance. 7.5 LEARNING OBJECTIVE The Accounting Scandals of the Early 2000s

22 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance a)What is an “independent outsider” on a board of directors? b)Why is it good for a firm to have a large majority of independent outsiders on the board of directors? c)Why would it be good for a firm to have the auditing and compensation committees composed of outsiders? d)Why would it be good for a firm if its directors own the firm’s stock? Solved Problem 7-5 What Makes a Good Board of Directors? YOUR TURN: For more practice, do related problems 5.3 and 5.4 at the end of this chapter. Understand the role of government in corporate governance. 7.5 LEARNING OBJECTIVE

23 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Corporate Governance Policy Beginning in 2007 and lasting into 2009, the U.S. economy suffered through the worst financial crisis since the Great Depression of the 1930s. At the heart of the crisis was a problem in the market for home mortgages. Fueled by the ease of obtaining a mortgage, housing prices in the United States soared before beginning a sharp downturn in mid By 2007, many borrowers— particularly subprime and Alt-A borrowers—began to default on their mortgages. This was bad news for anyone owning mortgage-backed securities because the value of these securities depended on steady payments being made on the underlying mortgages. The Financial Meltdown of the Late 2000s Understand the role of government in corporate governance. 7.5 LEARNING OBJECTIVE

24 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Was the Principal–Agent Problem at the Heart of the Financial Crisis? Making the Connection Did principal–agent problems lay low this Wall Street bull? YOUR TURN: Test your understanding by doing related problem 5.8 at the end of this chapter. Congress repealed the Glass- Steagall Act in 1999, after which some commercial banks began engaging in investment banking. Traditionally, Wall Street investment banks had been organized as partnerships, but by 2000 they had all converted to being publicly traded corporations. With a publicly traded corporation, the principal–agent problem can be severe. Understand the role of government in corporate governance. 7.5 LEARNING OBJECTIVE

25 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Facebook Founder Puts Idealism Before Profits The Principal–Agent Problem at Facebook >> AN INSIDE LOOK The Growth of Facebook.

26 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Accounting profit Asset Balance sheet Bond Corporate governance Corporation Coupon payment Direct finance Dividends Economic profit Explicit cost Implicit cost Income statement Indirect finance Interest rate Liability Limited liability Opportunity cost Partnership Principal–agent problem Separation of ownership from control Sole proprietorship Stock KEY TERMS

27 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Tools to Analyze Firms’ Financial Information Appendix Using Present Value to Make Investment Decisions Present value The value in today’s dollars of funds to be paid or received in the future. Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. LEARNING OBJECTIVE

28 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Solved Problem 7A-1 How to Receive Your Contest Winnings Suppose you win a contest and are given the choice of the following prizes: Prize 1: $50,000 to be received right away, with four additional payments of $50,000 to be received each year for the next four years Prize 2: $175,000 to be received right away Explain which prize you would choose and the basis for your decision. Appendix YOUR TURN: For more practice, do related problems 7A-6, 7A-8, 7A-9 and 7A-10 at the end of this chapter. Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. LEARNING OBJECTIVE

29 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Tools to Analyze Firms’ Financial Information Appendix Using Present Value to Make Investment Decisions Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. LEARNING OBJECTIVE Using Present Value to Calculate Bond Prices

30 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Tools to Analyze Firms’ Financial Information Appendix Using Present Value to Make Investment Decisions A Simple Formula for Calculating Stock Prices Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. LEARNING OBJECTIVE Using Present Value to Calculate Stock Prices

31 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Going Deeper into Financial Statements Appendix Analyzing Income Statements FIGURE 7A-1 Google’s Income Statement for 2008 Google’s income statement shows the company’s revenue, costs, and profit for The difference between its revenue ($21,796 million) and its operating expenses ($16,258 million) is its operating income ($5,538 million). Most corporations also have investments, such as government or corporate bonds, that generate some income for them. In this case, Google earned $316 million, giving the firm an income before taxes of $5,854 million. After paying taxes of $1,627 million, Google was left with a net income, or accounting profit, of $4,227 million for the year. Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. LEARNING OBJECTIVE Tools to Analyze Firms’ Financial Information

32 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Going Deeper into Financial Statements Appendix Analyzing Balance Sheets Stockholders’ equity The difference between the value of a corporation’s assets and the value of its liabilities; also known as net worth. Assets = Liabilities + Stockholders’ Equity Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. LEARNING OBJECTIVE Tools to Analyze Firms’ Financial Information

33 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Going Deeper into Financial Statements Appendix Analyzing Balance Sheets FIGURE 7A-2 Google’s Balance Sheet as of December 31, 2008 Corporations list their assets on the left of their balance sheets and their liabilities on the right. The difference between the value of the firm’s assets and the value of its liabilities equals the net worth of the firm, or stockholders’ equity. Stockholders’ equity is listed on the right side of the balance sheet. Therefore, the value of the left side of the balance sheet must always equal the value of the right side. Note: All values are in millions of dollars. Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. LEARNING OBJECTIVE Tools to Analyze Firms’ Financial Information

34 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: Firms, the Stock Market, and Corporate Governance Present value Stockholders’ equity KEY TERMS