Macroeconomics ECON 2301 Summer Session 1, 2008 Marilyn Spencer, Ph.D. Professor of Economics June 5, 2008

Chapter 5, Economics: Firms, the Stock Market, and Corporate Governance

Google: From Dorm Room to Wall Street 5 Goggle's offering of stock to outside investors provided the firm with a major inflow of funds for growth.

After studying this chapter, you should be able to: 1.Categorize the major types of business in the United States. 2.Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principal-agent problem. 3.Explain how firms obtain the funds they need to operate and expand. 4.Understand the information provided in firms’ financial statements. 5.Understand the business accounting scandals of 2002, as well as the role of government in corporate governance. LEARNING OBJECTIVES

Types of Firms LEARNING OBJECTIVE 1 4 Sole proprietorship A firm owned by a single individual and not organized as a corporation. 4 Partnership A firm owned jointly by two or more persons and not organized as a corporation. 4 Corporation A legal form of business that provides the owners with limited liability.

Types of Firms Who Is Liable? Limited and Unlimited Liability 4 Asset Anything of value owned by a person or a firm. 4 Limited liability The legal provision that shields owners of a corporation from losing more than they have invested in the firm.

Types of Firms Who Is Liable? Limited and Unlimited Liability 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 Disadvant- ages Unlimited personal liability Limited ability to raise funds Unlimited personal liability Limited ability to raise funds Costly to organize Possible double taxation of income Differences among Business Organizations 5 – 1

Which of the following sets of firms are likely to be partnerships? a.Technology and telecommunications firms. b.Law and accounting firms. c.Public utilities and other natural monopolies. d.All of the above.

Which of the following sets of firms are likely to be partnerships? a.Technology and telecommunications firms. b.Law and accounting firms. c.Public utilities and other natural monopolies. d.All of the above.

What’s in a “Name"? Lloyd’s of London Learns about Unlimited Liability the Hard Way Investors in Lloyd’s of London lost billions of dollars during the 1980s and 1990s.

Types of Firms Corporations Earn the Majority of Revenue and Profits Business Organizations: Sole Proprietorships, Partnerships, and Corporations

When a corporation fails, which of the following is true? a.The owners can always lose more than the amount they invested in the firm. b.The owners can never lose more than the amount they had invested in the firm. c.The owners will always lose less than the amount they had invested in the firm. d.What the owners lose is unrelated to liability laws.

When a corporation fails, which of the following is true? a.The owners can always lose more than the amount they invested in the firm. b.The owners can never lose more than the amount they had invested in the firm. c.The owners will always lose less than the amount they had invested in the firm. d.What the owners lose is unrelated to liability laws.

The Structure of Corporations and the Principal-Agent Problem LEARNING OBJECTIVE 2 4 Corporate governance The way in which a corporation is structured and the impact a corporation’s structure has on the firm’s behavior. Corporate Structure and Corporate Governance 4 Separation of ownership from control In many large corporations the top management, rather than the shareholders, control day-to-day operations. 4 Principal-agent problem A problem caused by an agent pursuing his own interests rather than the interests of the principal who hired him.

5 - 1 LEARNING OBJECTIVE 2 Does the Principal-Agent Problem Also Apply to the Relationship between Managers and Workers?

How Firms Raise Funds LEARNING OBJECTIVE 3 Firms can obtain funds for expansion in three ways:  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.  You could also obtain funds by taking on one or more partners who would invest in the firm. This arrangement would increase the firm’s financial capital.  Finally, you could borrow the funds from relatives, friends, or a bank.

How Firms Raise Funds Sources of External Funds 4 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). 4 Direct finance A flow of funds from savers to firms through financial markets.

How Firms Raise Funds Sources of External Funds 1.BONDS 4 Bond A financial security that represents a promise to repay a fixed amount of funds. 4 Coupon payment Interest payment on a bond. 4 Interest rate The cost of borrowing funds, usually expressed as a percentage of the amount borrowed.

If you hold a bond with a coupon of $80 per year and newly issued bonds have coupons of $100 per year, what is likely to happen to the price of the bond you hold? a.The price of your bond will rise. b.The price of your bond will fall. c.The price of your bond will remain the same. d.The price of your bond may raise or fall depending on additional factors.

If you hold a bond with a coupon of $80 per year and newly issued bonds have coupons of $100 per year, what is likely to happen to the price of the bond you hold? a.The price of your bond will rise. b.The price of your bond will fall. c.The price of your bond will remain the same. d.The price of your bond may raise or fall depending on additional factors.

How Firms Raise Funds Sources of External Funds 2.STOCKS 4 Stock A financial security that represents partial ownership of a firm. 4 Dividends Payments by a corporation to its shareholders. Stock and Bond Markets Provide Capital & Info When Google Shares Change Hands, Google Doesn’t Get the Money

In the United States, what market trades the stocks and bonds of the largest corporations? a.The Nasdaq. b.The New York Stock Exchange. c.The AMEX. d.The Chicago Board of Trade.

In the United States, what market trades the stocks and bonds of the largest corporations? a.The Nasdaq. b.The New York Stock Exchange. c.The AMEX. d.The Chicago Board of Trade.

Using Financial Statements to Evaluate a Corporation LEARNING OBJECTIVE 4 4 Liability Anything owed by a person or a firm. The Income Statement 4 Income statement A financial statement that sums up a firm’s revenues, costs, and profit over a period of time.

An income statement starts with the firm’s revenue and subtracts its operating expenses and taxes paid. What is the remainder called? a.Net income, which is the accounting profit of the firm. b.Gross income, which is the economic profit of the firm. c.Implicit cost. d.Explicit cost.

An income statement starts with the firm’s revenue and subtracts its operating expenses and taxes paid. What is the remainder called? a.Net income, which is the accounting profit of the firm. b.Gross income, which is the economic profit of the firm. c.Implicit cost. d.Explicit cost.

A Bull in China’s Financial Shop Will China’s weak financial system derail economic growth?

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. Explicit cost A cost that involves spending money. Implicit cost A non-monetary opportunity cost. Economic profit A firm’s revenues minus all of its costs, implicit and explicit. The Income Statement GETTING TO ACCOUNTING PROFIT Accounting profit A firm’s net income measured by revenue less operating expenses and taxes paid.

Using Financial Statements to Evaluate a Corporation The Balance Sheet 4 Balance sheet A financial statement that sums up a firm’s financial position on a particular day, usually the end of a quarter or a year.

Outcomes of the Business Scandals of In the United States, the landmark Sarbanes-Oxley Act of 2002 requires that corporate directors have a certain level of expertise with financial information and mandates that chief executive officers personally certify the accuracy of financial statements. 4 Outside of the United States, the European Commission released plans in 2003 to tighten corporate governance rules, and Japan has debated such reforms as well. The challenge of ensuring the accurate reporting of firms’ economic profits is a global one.

What Makes a Good Board of Directors? a. What is an “insider” on a board of directors? b. Why might having too many insiders be a problem? c. Why would having outside directors who are CEOs of large firms be a good thing? d. Why would directors not having business ties to the firm be a good thing? 5-2 LEARNING OBJECTIVE 5

Technology Shares Slip, But Google Passes $200

4 Accounting profit 4 Asset 4 Balance sheet 4 Bond 4 Corporate governance 4 Corporation 4 Coupon payment 4 Direct finance 4 Dividends 4 Economic profit 4 Explicit cost 4 Implicit cost 4 Income statement 4 Indirect finance 4 Interest rate 4 Liability 4 Limited liability 4 Opportunity cost 4 Partnership 4 Principal-agent problem 4 Separation of ownership from control 4 Sole proprietorship 4 Stock 4 Present value 4 Stockholders’ equity

Assignment to be completed before class June 10: 4 Read Chapter 7 & also read Review Questions 2-10 on pp , and Problems and Applications 2, 3, 4, 5, 6, 14 & 19 on pp