1. R. GLENN HUBBARD Macroeconomics FOURTH EDITION ANTHONY PATRICK O’BRIEN

2. 2 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Firms, the Stock Market, and Corporate Governance CHAPTER 6 Chapter Outline and Learning Objectives 6.1Types of Firms 6.2The Structure of Corporations and the Principal–Agent Problem 6.3How Firms Raise Funds 6.4Using Financial Statements to Evaluate a Corporation 6.5Corporate Governance Policy and the Financial Crisis of 2007–2009 Appendix: Tools to Analyze Firms’ Financial Information

3. 3 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Categorize the major types of firms in the United States. 6.1 LEARNING OBJECTIVE Types of Firms

4. 4 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Sole proprietorship A firm owned by a single individual 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. Partnership A firm owned jointly by two or more persons and not organized as a corporation.

5. 5 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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.

6. 6 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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 Table 6.1 Differences among Business Organizations There are advantages and disadvantages to the different forms of business organization.

7. 7 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Corporations Earn the Majority of Revenue and Profits Figure 6.1 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.

8. 8 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principal–agent problem. 6.2 LEARNING OBJECTIVE The Structure of Corporations and the Principal–Agent Problem

9. 9 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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.

10. 10 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explain how firms raise the funds they need to operate and expand. 6.3 LEARNING OBJECTIVE How Firms Raise Funds

11. 11 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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. This arrangement would increase the firm’s financial capital. 3.Finally, 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: 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. Direct finance usually takes the form of borrowers selling lenders financial securities, such as stocks and bonds. It is the role of an economy’s financial system to transfer funds from savers to borrowers either directly or indirectly.

12. 12 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Bond A financial security that represents a promise to repay a fixed amount of funds. Coupon payment An interest payment on a bond. Interest rate The cost of borrowing funds, usually expressed as a percentage of the amount borrowed. The principal, or face value, of a bond is the final payment of the loan amount at maturity, or the end of its term. The coupon rate is the interest rate on the bond. For instance: The higher the default risk on a bond, the higher the interest rate.

13. 13 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Stock A financial security that represents partial ownership of a firm. Dividends Payments by a corporation to its shareholders. Buyers and sellers of stocks and bonds together make up the stock and bond markets. Some trading of stocks and bonds takes place in buildings known as exchanges. The development of computer technology has spread the trading of stocks and bonds to securities dealers linked by computers comprising the over-the- counter market, the most important of which is the National Association of Securities Dealers Automated Quotations (NASDAQ) system. Changes in the value of a firm’s stocks and bonds offer important information for a firm’s managers, as well as for investors. Stock and Bond Markets Provide Capital—and Information Don’t Let This Happen to You When Google Shares Change Hands, Google Doesn’t Get the Money Google raises funds in a primary market, but shares change hands in a secondary market. Your Turn: Test your understanding by doing related problem 3.12 at the end of this chapter. MyEconLab Investors receive a capital gain when a firm’s share price rises.

14. 14 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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 2011, the three indexes followed similar patterns, rising when the U.S. economy was expanding and falling when the economy was in recession. Figure 6.2 Movements in Stock Market Indexes, January 1995 to September 2011 The value of a stock market index is set equal to 100 in a particular year, called the base year.

15. 15 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Understand the information provided in corporations’ financial statements. 6.4 LEARNING OBJECTIVE Using Financial Statements to Evaluate a Corporation

16. 16 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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. Getting to Accounting Profit 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.

17. 17 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall... 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 nonmonetary opportunity cost. Economic profit A firm’s revenues minus all of its implicit and explicit costs. 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. Economists use the term nominal rate of return to refer to the minimum amount that investors must earn on the funds they invest in a firm, expressed as a percentage of the amount invested. Subtracting the value of a firm’s liabilities from the value of its assets leaves its net worth.

18. 18 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Discuss the role that corporate governance problems may have played in the financial crisis of 2007–2009. 6.5 LEARNING OBJECTIVE Corporate Governance Policy and the Financial Crisis of 2007–2009

19. 19 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall In the early 2000s, the top managers of several large and well-known firms, including Enron, an energy trading firm, and WorldCom, a telecommunications firm, were shown to have falsified their firms’ financial statements in order to mislead investors about how profitable the firms actually were. The federal government regulates how financial statements are prepared, but this regulation cannot by itself guarantee the accuracy of the statements. Public accountants certified to audit their financial statements were even deceived. To guard against future scandals, new federal legislation was enacted in 2002. The landmark Sarbanes-Oxley Act of 2002 requires that CEOs personally certify the accuracy of financial statements and 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. The Accounting Scandals of the Early 2000s Firms disclose financial statements in periodic filings to the federal government and in annual reports to shareholders.

20. 20 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Beginning in 2007 and lasting into 2009, the U.S. economy suffered the worst financial crisis since the Great Depression of the 1930s, at the heart of which was a problem in the market for home mortgages. In the 1970s, Congress established the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) to begin securitizing some mortgage loans. Mortgage-backed securities are groups of mortgages bundled together and sold to investors who receive regular interest payments from the original loans. The securitization process expanded in the 1990s and by the early 2000s, many mortgages were being granted to “subprime” borrowers, whose credit histories include failures to make payments on bills, and “Alt-A” borrowers, who failed to document that their incomes were high enough to afford their mortgage payments. Fueled by the ease of obtaining a mortgage, housing prices in the United States soared before beginning a sharp downturn in mid-2006 as many borrowers began defaulting on their mortgages. The Financial Crisis of 2007–2009 Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) Legislation passed during 2010 that was intended to reform regulation of the financial system.

21. 21 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Did Principal–Agent Problems Help Bring on the Financial Crisis? Unlike commercial banks, whose main activities are accepting deposits and making loans, investment banks had traditionally concentrated on providing advice to corporations on selling new stocks and bonds and on underwriting their issuance by guaranteeing a price to the firm selling them. Investment banking is considered more risky than commercial banking because investment banks can suffer heavy losses on underwriting. Congress passed the Glass-Steagall Act in 1933 to prevent financial firms from being both commercial and investment banks but after repealing it in 1999, 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. In a partnership, the funds of the relatively small group of owners are put directly at risk, and the principal–agent problem is reduced because there is little separation of ownership from control. With a publicly traded corporation, on the other hand, the principal–agent problem can be severe.

22. 22 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Present value The value in today’s dollars of funds to be paid or received in the future. Tools to Analyze Firms’ Financial Information Appendix 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 Make Investment Decisions where Future value n represents funds that will be received in n years.

23. 23 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Using Present Value to Calculate Bond Prices A Simple Formula for Calculating Stock Prices Using Present Value to Calculate Stock Prices The price of a financial asset should be equal to the present value of the payments to be received from owning that asset. The general formula for the price of a bond is: The general formula for the price of a stock is: It is possible to simplify the formula for determining the price of a stock if we assume that dividends will grow at a constant rate:

24. 24 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Going Deeper into Financial Statements Analyzing Income Statements Figure 6A.1 Google’s Income Statement for 2010 Google’s income statement shows the company’s revenue, costs, and profit for 2010. The difference between its revenue ($29,321 million) and its operating expenses ($18,940 million) is its operating income ($10,381 million). Most corporations also have investments, such as government or corporate bonds, that generate some income for them. In this case, Google earned $415 million, giving the firm an income before taxes of $10,796 million. After paying taxes of $2,291 million, Google was left with a net income, or accounting profit, of $8,505 million for the year.

25. 25 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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 Assets − Liabilities = Stockholders’ Equity or:

26. 26 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 6A.2 Google’s Balance Sheet as of December 31, 2010 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. AssetsLiabilities and Stockholders' Equity Current Assets$41,562Current Liabilities$9,996 Property and Equipment7,759Long-term Liabilities1,614 Investments523Total Liabilities11,610 Goodwill6,256Stockholders' Equity46,241 Other long-term assets1,751 Total Assets57,851Total liabilities and stockholders' equity57,851 Note: All values are in millions of dollars.

27. 27 of 27 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Current assets are assets that the firm could convert into cash quickly, such as the balance in its checking account or its accounts receivable, which is money currently owed to the firm for products that have been delivered but not yet paid for. Goodwill represents the difference between the purchase price of a company and the market value of its assets, from which its ability to earn an economic profit is also represented. Current liabilities are short-term debts such as accounts payable, which is money owed to suppliers for goods received but not yet paid for, or bank loans that will be paid back in less than one year. Long-term bank loans and the value of outstanding corporate bonds are long- term liabilities.