Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 28 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 the owners with limited liability. Types of Firms

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 28 Asset Anything of value owned by a person or a firm. Who Is Liable? Limited and Unlimited Liability Limited liability The legal provision that shields owners of a corporation from losing more than they have invested in the firm. State legislatures have passed general incorporation laws, which allowed firms to be organized as corporations. Unlimited liability means there is no legal distinction between the personal assets of the owners of the firm and the assets of the firm.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 28 Differences among Business Organizations SOLE PROPRIETORSHIPPARTNERSHIPCORPORATION 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 Types of Firms

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 28 Corporations Earn the Majority of Revenue and Profits Figure 8.1 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 18 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. Profit is the difference between revenue and the total cost to a firm of producing the goods and services it offers for sale.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 28 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 that structure has on the corporation’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. Shareholders are the owners of a corporation’s stock whose interests are represented by a board of directors who appoints a chief executive officer (CEO) to run the day-to-day operations of the corporation and sometimes other members of top management, such as the chief financial officer (CFO). Members of the board are referred to as either inside or outside directors, depending on their management role in the firm.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 28 How Firms Raise Funds 1If 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. 2You could obtain funds by taking on one or more partners who invest in the firm, or selling stock in a corporation. These arrangements increase the firm’s financial capital. 3Finally, you could borrow the funds from relatives, friends, or a bank. As the owner of a small business, you can raise the funds for an expansion in three ways:

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 28 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. It is the role of an economy’s financial system to transfer funds from savers to borrowers either directly or indirectly. Direct finance usually takes the form of borrowers selling lenders financial securities, such as stocks and bonds.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 28 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.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 28 Moody’s Investors Service Standard & Poor’s (S&P) Fitch Ratings Meaning of the Ratings Investment-grade bonds AaaAAA Highest credit quality AaAA Very high credit quality AAAHigh credit quality BaaBBB Good credit quality Non-investment- grade bonds BaBB Speculative BBBHighly speculative CaaCCC Substantial default risk CaCC Very high levels of default risk CCC Exceptionally high levels of default risk —DDDefault The Rating Game: Is the U.S. Treasury Likely to Default on Its Bonds? In August 2011, S&P downgraded U.S. Treasury bonds from AAA to AA+, arguing that continuing large deficits increased the chance that someday the Treasury might not make the interest payments on its bonds. Agencies may have an incentive to give higher ratings than might be justified, as occurred with some mortgage-backed bonds issued in the mid-2000s.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 28 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. Investors receive a capital gain when a firm’s share price rises.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 28 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. A lower bond price indicates a higher cost of new external funds. The same applies to stocks and stock prices…… except that stock prices are determined by investors’ expectations about the future profitability of the firm.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 28 Following Abercrombie & Fitch’s Stock Price in the Financial Pages Making the Connection The figure reproduces a small portion of the listings from the Wall Street Journal from August 9, 2011 for stocks listed on the New York Stock Exchange, providing information on the buying and selling of the stock of five firms during the previous day.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 28 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. Accounting profit A firm’s net income, measured as revenue minus operating expenses and taxes paid. In the United States, the Securities and Exchange Commission requires publicly owned firms to report their performance in financial statements, principally income statements and balance sheets, prepared using standard accounting methods, often referred to as generally accepted accounting principles. Using Financial Statements to Evaluate a Corporation Asset Anything of value owned by a person or a firm. 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.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 28 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.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 28 Corporate Governance Policy The landmark Sarbanes-Oxley Act of 2002 requires that corporate directors have a certain level of expertise with financial information and mandates that CEOs personally certify the accuracy of financial statements. Perhaps the most noticeable corporate governance reform under the Sarbanes-Oxley Act is the creation of the Public Company Accounting Oversight Board, a national board that oversees the auditing of public companies’ financial reports. Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was passed during 2010 to reform regulation of the financial system after the financial crisis.

Chapter 7: Firms, the Stock Market, and Corporate Governance © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 28 What Makes a Good Board of Directors? 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?