1. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 21 Rents, Profits, and the Financial Environment of Business

2. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-2 Introduction Between late 2007 and early 2009, average U.S. stock prices dropped by about 57 percent, an eerie parallel to the aftermath of the Great Crash of 1929. Was the meltdown in stock prices after October 2007 as substantial as the decline over the same period after the 1929 crash? To answer this question, you must first learn about interest rates and discount present value, which are key topics of this chapter.

3. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-3 Learning Objectives Understand the concept of economic rent Distinguish among the main organizational forms of business and explain the chief advantages and disadvantages of each Explain the difference between accounting profits and economic profits

4. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-4 Learning Objectives (cont'd) Discuss how the interest rate plays a key role in allocating resources Calculate the present discounted value of a payment to be received at a future date Identify the three main sources of corporate funds and differentiate between stocks and bonds

5. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-5 Chapter Outline Economic Rent Firms and Profits Interest Corporate Financing Methods The Markets for Stocks and Bonds

6. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-6 Did You Know That... During 2008, there were 42 days when average prices of shares of stock in U.S. companies gained or lost more than 3 percent of their value? There was greater volatility in U.S. stock prices in 2008 than in any other year since 1933. How do markets for shares of stock function? What are shares of stock? In this chapter, you will learn the answers to these questions.

7. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-7 Economic Rent –A payment for the use of any resource over and above its opportunity cost –Thus, rent has a different meaning in economics.

8. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-8 Economic Rent (cont'd) Determining land rent –Economists originally used the term rent to designate payment for use of land –The concept of economic rent is associated with the British economist David Ricardo

9. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-9 Figure 21-1 Economic Rent

10. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-10 Economic Rent (cont'd) Economic rent to labor –Professional sports superstars –Rock stars –Movie stars –World-class models –Successful inventors and innovators

11. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-11 Economic Rent (cont'd) Apply the definition of economic rent to the phenomenal earnings these people make. They would undoubtedly work for considerably less than they earn. Much of their rent occurs because specific resources cannot be replicated exactly. No one can duplicate today’s most highly paid entertainment figures.

12. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-12 Economic Rent (cont'd) Economic rent and the allocation of resources –Economic rent allocates resources to their highest valued use

13. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-13 Example: Do Entertainment Superstars Make Super Economic Rents? How much of superstars’ earnings can be called economic rent? A newcomer would almost certainly work for much less than he or she earns, implying that the newcomer is making high economic rent. Seasoned entertainers probably have very high accumulated wealth and also a more jaded outlook about their work. It is therefore not clear how much they would work if they were not offered those huge sums of money. Even if some superstars would work for less, what forces cause them to make so much income anyway?

14. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-14 Table 21-1 Superstar Earnings

15. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-15 Firms and Profits Firms or businesses, like individuals, seek to earn the highest possible returns A firm brings together the factors of production—labor, physical capital, human capital and entrepreneurial skill—to produce a product or service it hopes can be sold at a profit

16. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-16 Firms and Profits (cont'd) Firm –A business organization that employs resources to produce goods or services for profit –A firm normally owns and operates at least one “plant” or facility in order to produce

17. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-17 Firms and Profits (cont'd) The legal organization of firms –Proprietorship –Partnership –Corporation

18. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-18 Table 21-2 Forms of Business Organization

19. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-19 Firms and Profits (cont’d) Proprietorship –A business owned by one individual who Makes the business decisions Receives all the profits Is legally responsible for all the debts of the firm

20. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-20 Firms and Profits (cont'd) Advantages of proprietorships –Easy to form and dissolve –All decision-making power resides with the sole proprietor –Profit is taxed only once

21. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-21 Firms and Profits (cont'd) Disadvantages of proprietorships –Unlimited Liability The owner of the firm is personally responsible for all of the firm’s debts. –Limited ability to raise funds –Proprietorship normally ends with the death of the proprietor

22. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-22 Firms and Profits (cont'd) Partnership –A business owned and managed by two or more co-owners, or partners, who Share the responsibilities and the profits of the firm Are individually liable for all the debts of the partnership

23. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-23 Firms and Profits (cont'd) Advantages of partnerships –Easy to form and dissolve –Partners retain decision-making power –Permits more effective specialization –Profit is taxed only once

24. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-24 Firms and Profits (cont'd) Disadvantages of partnerships –Unlimited liability –Decision making more costly –Dissolution often occurs when a partner dies or leaves the firm.

25. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-25 Firms and Profits (cont'd) Corporation –A legal entity that may conduct business in its own name just as an individual does –The owners of a corporation, called shareholders Own shares of the firm’s profits Enjoy the protection of limited liability

26. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-26 Firms and Profits (cont'd) Limited Liability –A legal concept whereby the responsibility, or liability, of the owners of a corporation is limited to the value of the shares in the firm that they own

27. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-27 Firms and Profits (cont'd) Advantages of corporations –Limited liability –Continues to exist when owner leaves the business –Raising large sums of financial capital

28. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-28 Firms and Profits (cont'd) Disadvantages of corporations –Double taxation Dividends –Portion of corporation’s profits paid to its owners (shareholders) –Separation of ownership and control

29. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-29 International Example: British Law Firms Adopt Corporate Structures In 2011, law firms in the United Kingdom were authorized to restructure themselves as corporations instead of remaining private partnerships. This restructuring allows those firms to raise more financial capital, to have limited liability, and to continue as a business concern following the death of a top attorney.

30. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-30 Firms and Profits (cont’d) Accounting Profit –Total revenue minus total explicit costs Explicit costs –Expenses that business managers must take account of because they must be paid –Examples are wages, taxes and rent

31. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-31 Firms and Profits (cont'd) Implicit Costs –Expenses that managers do not have to pay out of pocket and hence do not normally explicitly calculate Opportunity cost of factors of production that are owned Owner-provided capital and owner-provided labor

32. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-32 Firms and Profits (cont'd) Normal Rate of Return –The amount that must be paid to an investor to induce investment in a business –Also known as the opportunity cost of capital

33. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-33 Firms and Profits (cont'd) Opportunity Cost of Capital –The normal rate of return, or the available return on the next-best alternative investment –Economists consider this a cost of production, and it is included in our cost examples

34. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-34 Firms and Profits (cont'd) Opportunity cost of owner-provided land and capital –Single-owner proprietorships often exaggerate profit as they understate their opportunity cost of capital –Consider a simple example of a skilled auto mechanic working at his/her own service station, six days a week

35. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-35 Firms and Profits (cont'd) Accounting profits versus economic profits –The term profits in economics means the income entrepreneurs earn Over and above all costs including their own opportunity cost of time Plus the opportunity cost of capital they have invested in their business

36. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-36 Firms and Profits (cont'd) Economic Profits –Total revenues minus total opportunity costs of all inputs used –The total of implicit and explicit costs

37. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-37 Figure 21-2 Simplified View of Economic and Accounting Profit

38. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-38 Firms and Profits (cont'd) The goal of the firm: profit maximization –Theory of consumer demand: utility (or satisfaction) maximization –Theory of the firm: profit maximization is the underlying hypotheses of our predictive theory

39. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-39 Firms and Profits (cont'd) Firms that can provide relatively higher risk-corrected returns will have an advantage in obtaining financing needed to continue or expand production We would expect a policy of profit maximization to become a dominant mode of behavior for firms that survive

40. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-40 Interest Interest is the price paid from debtors to creditors for the use of loanable funds. Businesses use financial capital in order to invest in physical capital.

41. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-41 Interest (cont'd) Financial Capital –Funds used to purchase physical capital goods, such as buildings and equipment Interest –The payment for current rather than future command over resources; the cost of obtaining credit

42. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-42 Interest (cont'd) Variations in the rate of annual interest that must be paid for credit depend on 1.Length of loan 2.Risk 3.Handing charges

43. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-43 Interest (cont'd) Nominal Rate of Interest –The market rate of interest expressed in today’s dollars Real Rate of Interest –The nominal rate of interest minus the anticipated rate of inflation

44. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-44 Interest (cont'd) We can say that the nominal, or market, rate of interest is approximately equal to the real rate of interest plus anticipated inflation, or i n = i r + anticipated inflation rate

45. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-45 Interest (cont'd) Interest is a price that allocates loanable funds (credit) to consumers and businesses Investment, or capital, projects with rates of return higher than the market rate of interest will be undertaken The interest rate performs the function of allocating financial capital thus ultimately allocating physical capital

46. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-46 Interest (cont'd) Businesses make investments which often incur large costs They need to compare their investment cost today with a stream of future profits They must relate present costs to future benefits. Interest rates are used to link the present with the future

47. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-47 Interest (cont'd) Present Value –The value of a future amount expressed in today’s dollars –The most that someone would pay today to receive a certain sum at some point in the future

48. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-48 Interest (cont'd) where PV 1 = Present value of a sum one year hence FV 1 = Future sum paid or received one year hence i = Market rate of interest PV 1 = FV 1 1 + i

49. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-49 Interest (cont’d) Present value of $105 to be received one year from now, if the interest rate is 5%: –PV = 105/(1.05) = $100 –The present value is $100

50. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-50 Interest (cont’d) How much would have to be put in a savings account today to have $105 two years from now if the account pays 5% per year compounded annually? PV 2 x (1.05) 2 = $105 PV 2 x $105 = $95.24 (105) 2

51. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-51 Table 21-3 Present Value of a Future Dollar

52. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-52 Interest (cont'd) Discounting –The method by which the present value of a future sum or a future stream of sums is obtained Rate of Discount –The rate of interest used to discount future sums back to present value

53. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-53 Interest (cont'd) Your own personal discount rate will determine how willing you are to save and to borrow. The market interest rate lies between the upper and lower ranges of personal rates of discount.

54. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-54 Example: Higher Future Taxes Reduce the Discounted Present Value of Profits One of the provisions of the health care legislation that President Obama signed into law in March 2010 was to reduce the amount that companies can deduct from their federal taxes for providing prescription drug benefits for their retired employees. In effect, this health care program has reduced U.S. companies’ discounted present value of anticipated after-tax profits by about $14 billion.

55. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-55 Corporate Financing Methods When it all began—1602 –Dutch East India Company raised financial capital by Selling ownership shares (stock) Using notes of indebtedness (bonds) Some profits were retained for reinvestment

56. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-56 Corporate Financing Methods (cont'd) Share of Stock –A legal claim to a share of a corporation’s future profits Common stock –Incorporates certain voting rights regarding major policy decisions of the corporation Preferred stock –Owners are accorded preferential treatment in the payment of dividends

57. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-57 Corporate Financing Methods (cont'd) Bond –A legal claim against a firm –Usually entitling the owner of the bond to receive a fixed annual coupon payment, plus a lump-sum payment at the bond’s maturity date –Bonds are issued in return for funds lent to the firm.

58. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-58 Corporate Financing Methods (cont'd) Reinvestment –Profits (or depreciation reserves) used to purchase new capital equipment –Sales of stock are an important source of financing for new firms –Reinvestment and borrowing are the primary means of financing for existing ones

59. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-59 The Markets for Stocks and Bonds Economists often refer to the “market for wheat” or the “market for labor” These are more conceptual places rather than actual ones For securities there really are markets— physical locations

60. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-60 The Markets for Stocks and Bonds (cont'd) Securities –Stocks and bonds

61. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-61 The Markets for Stocks and Bonds (cont'd) New York Stock Exchange (NYSE) Nasdaq London Stock Exchange (FTSE) Tokyo Stock Exchange Bombay Stock Exchange (BSE) Shanghai Stock Exchange

62. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-62 The Markets for Stocks and Bonds (cont'd) The theory of efficient markets –All information entering the market is fully incorporated into stock prices –Consequently, stock prices tend to drift upward following a random walk theory –The best forecast of tomorrow’s price is today’s price plus the effect of any upward drift

63. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-63 The Markets for Stocks and Bonds (cont'd) Random Walk Theory –The theory that there are no predictable trends in securities prices that can be used to “get rich quick”

64. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-64 Why Not … compare average stock prices today with average stock prices in years past? Comparing average stock prices over time fails to account for inflation. Once all past and current stock prices are adjusted to incorporate the effects of inflation, today’s average stock prices are about the same as the average stock prices that prevailed in the 1920s.

65. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-65 The Markets for Stocks and Bonds (cont'd) Inside Information –Information that is not available to the general public about what is happening in a corporation –One way to “beat the market,” although it is considered illegal, punishable by substantial fines and imprisonment

66. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-66 Policy Example: The Insider-Trading Regulator’s Insiders Require Regulating The Securities and Exchange Commission (SEC) is the U.S. government agency charged with enforcing insider-trading laws. SEC officials recently discovered that members of the commission’s own staff had failed to report all their stock trades, and those individuals could have profited from insider trading.

67. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-67 You Are There: Why New York City Provides the Homeless with One-Way Tickets The government of New York City will pay each homeless person a one-way plane ticket to anywhere in the world. Why? This is lower-cost alternative to the higher discounted present value of anticipated future expenses to shelter and feed a typical homeless person year after year.

68. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-68 Issues & Applications: The Recent Stock Market Meltdown versus Past Meltdowns The percentage decline 17 months after October 2007 was very close to the overall percentage decrease 17 months after stock prices began dropping in September 1929—the onset of the Great Crash. During the spring of 2009, however, average share prices began to level off and then recover— a pattern that looked more like that observed during the 1973–1974 and 2000–2002 periods instead.

69. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-69 Figure 21-3 Comparing Four U.S. Downturns in Stock Prices

70. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-70 Summary Discussion of Learning Objectives Economic rent serves an efficient allocative function for resources that are fixed in supply The main types of business organization –Proprietorship –Partnership –Corporation

71. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-71 Summary Discussion of Learning Objectives Accounting profit is the excess of total revenue over explicit costs –To arrive at economic profit, we must subtract implicit costs as well Interest is a payment for the ability to use resources today instead of in the future.

72. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 21-72 Summary Discussion of Learning Objectives (cont'd) The present value of a sum to be received in the future can be calculated through discounting The three main sources of corporate funds are stocks, bonds, and reinvestment of profits