Micro ch8 ppt

R. GLENN

HUBBARD

MicroeconomicsFOURTH EDITION

ANTHONY PATRICK

O’BRIEN

2 of 37© 2013 Pearson Education, Inc. Publishing as Prentice Hall

Firms, the Stock Market, and Corporate GovernanceC

HA

PT

ER

8Chapter Outline and Learning Objectives

8.1 Types of Firms

8.2 The Structure of Corporations and the Principal–Agent Problem

8.3 How Firms Raise Funds

8.4 Using Financial Statements to Evaluate a Corporation

8.5 Corporate Governance Policy and the Financial Crisis of 2007–2009

Appendix: Tools to Analyze Firms’ Financial Information


How Can You Buy a Piece of Facebook?

• Firms that sell stock that is traded in financial markets such as the New York Stock Exchange are called public firms, whereas firms that do not sell stock are called private firms.

• In late 2011, Facebook remained a private firm offering a small number of its shares for sale on private markets.

• Because the buying and selling of stock in Facebook was not being done on the public financial markets, the firm was not subject to the usual federal regulations that apply to public firms.

• Some economists and policymakers argued that the result was less protection for investors.

• AN INSIDE LOOK on page 256 discusses how two new Internet companies allow qualified investors a chance to buy stock in private companies.


Do Corporate Managers Act in the Best Interests of Shareholders?

Although stockholders legally own corporations, managers often have a great deal of freedom in deciding how corporations are run.

As a result, managers can make decisions that are in their interests but not in the interests of the shareholders.

If managers make decisions that waste money and lower the profits of a firm, the price of the firm’s stock will fall, which hurts the investors who own the stock.

See if you can answer these questions by the end of the chapter:

Suppose you own stock in a corporation. Why is it difficult to get the managers to act in your interests rather than in their own?

Given this problem, should you ever take on the risk of buying stock?

Economics in Your Life


Categorize the major types of firms in the United States.

8.1 LEARNING OBJECTIVE

Types of Firms


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.


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.


Sole Proprietorship Partnership Corporation

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 personalliability

• Unlimited personal liability

• Costly to organize

• Limited ability to raise funds

• Limited ability to raise funds

• Possible double taxation of income

Table 8.1 Differences among Business Organizations

There are advantages and disadvantages to the different forms of businessorganization.


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.


In a typical year, 40 percent of new jobs are created by small firms.

Most economists would argue that small firms are vital to the health of the economy.

Starting a small firm provides an entrepreneur with a vehicle for bringing a new product or process to market.

Entrepreneurs founding small firms have been the source of many of the most important new goods and services available to consumers.

How Important Are Small Businesses to the U.S. Economy?

Makingthe

Connection

Some economists have argued that although spending on research and development by large firms often leads to important improvements in existing products, innovative new products are often introduced by small firms.

Your Turn: Test your understanding by doing related problem 1.8 at the end of this chapter.MyEconLab


Describe the typical management structure of corporations and understandthe concepts of separation of ownership from control and the principal–agent problem.


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 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.


Briefly explain whether you agree with the following argument:

The principal–agent problem applies not just to the relationship between shareholders and top managers, but also 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.

Does the Principal–Agent Problem Apply to the Relationship between Managers and Employees?

Solved Problem 8.2

Solving the Problem

Step 1: Review the chapter material.

Step 2: Evaluate the argument.You should agree with the argument. While a corporation’s shareholders have difficulty monitoring the activities of top managers, managers can have trouble monitoring whether their employees are working hard or goofing off. Employees would often rather not work hard, particularly if they do not see a direct financial reward for doing so.So, the principal–agent problem does apply to the relationship between managers and employees. Managers try to reduce the principal–agent problem by designing compensation policies that give workers an incentive to work harder, just as boards of directors design such policies to give top managers financial incentives to increase profits.

Your Turn: For more practice, do related problems 2.7 and 2.8 at the end of this chapter.MyEconLab


Explain how firms raise the funds they need to operate and expand.


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. 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.


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.

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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.


Moody’s InvestorsService

Standard &Poor’s (S&P)

FitchRatings

Meaning of theRatings

Investment-gradebonds

Aaa AAA AAA Highest credit quality

Aa AA AA Very high credit quality

A A A High credit quality

Baa BBB BBB Good credit quality

Non-investment-grade bonds

Ba BB BB Speculative

B B B Highly speculative

Caa CCC CCC Substantial default risk

Ca CC CC Very high levels ofdefault risk

C C C Exceptionally highlevels of default risk

— D D Default

The Rating Game: Is the U.S. Treasury Likely to Default on Its Bonds?

Makingthe

Connection


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.


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 YouWhen Google Shares Change Hands, Google Doesn’t Get the MoneyGoogle raises funds in a primary market, but shares change hands in a secondary market.


Investors receive a capital gain when a firm’s share price rises.


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 8.2 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.


Following Abercrombie & Fitch’s Stock Price in the Financial Pages

Makingthe

Connection

Your Turn: Test your understanding by doing related problems 3.13 and 3.14 at the end of this chapter.MyEconLab

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.


Understand the information provided in corporations’ financial statements.


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.

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.


... 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.


Discuss the role that corporate governance problems may have played in the financial crisis of 2007–2009.


Corporate Governance Policy and the Financial Crisis of 2007–2009


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.


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.


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.


Many technology firms turn to venture capital firms for funds, several of which invested in Facebook.

The first issue of stock by a firm is called an initial public offering (IPO).

Facebook CEO Mark Zuckerberg was reluctant to allow an IPO because he wanted to keep the company private rather than bring in many additional investors, which could reduce his control of the firm.

Private placements are the sales of stock firms arrange between buyers and sellers in private firms. The market for shares of private firms is sometimes referred to as the shadow market to distinguish it from the stock markets on which shares of public firms are traded.

It was difficult to tell whether Facebook was worth the amount its stocks sold for per share because the firm did not have to make public its revenue or profits.

Are Buyers of Facebook Stock Getting a Fair Deal?Makingthe

Connection



Do Corporate Managers Act in the Best Interests of Shareholders?

At the beginning of the chapter, we asked you to consider two questions:

Why is it difficult to get the managers of a firm to act in your interests rather than in their own? and Given this problem, should you ever take on the risk of buying stock?

The reason managers may not act in shareholders’ interest is that in large corporations there is separation of ownership from control: The shareholders own the firm, but the top managers actually control it.

This results in the principal–agent problem, which clearly adds to the risk you would face by buying stock rather than doing something safe with your money, such as putting it in the bank.

But the rewards to owning stock can also be substantial, potentially earning you far more over the long run than a bank account.

Economics in Your Life


AN

INSIDE LOOK

Shares of Private Companies Available to Qualified Investors

SecondMarket and SharesPost offer 190 private stocks, which is a small number compared with the number of stock that are publicly traded.


Present value The value in today’s dollars of funds to be paid or received in the future.

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valueFutureluePresent va

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 valuen represents funds that will be received in n years.


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.

How to Receive Your Contest WinningsSolved Problem 8A.1

Solving the ProblemStep 1: Review the chapter material.

Step 2: Explain the basis for choosing the prize. Unless you need cash immediately, you should choose the prize with the highest present value.

Step 3: Calculate the present value of each prize.To calculate present value, we must use an interest rate. Assuming an interest rate of 10 percent, the present value of Prize 1 is:

Your Turn: For more practice, do related problems 8A.6, 8A.7, 8A.8, and 8A.9 at the end of the chapter.MyEconLab

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$208,493$34,150.6737,565.74$41,322.31$45,454.55$50,000

Step 4: State your conclusion. Prize 1 has the greater present value, so you should choose it rather than Prize 2.


Using Present Value to Calculate Bond Prices

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A Simple Formula for Calculating Stock Prices

Using Present Value to Calculate Stock Prices

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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:


Going Deeper into Financial Statements

Analyzing Income Statements

Figure 8A.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.


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:


Figure 8A.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.

Assets Liabilities and Stockholders' Equity

Current Assets $41,562 Current Liabilities $9,996

Property and Equipment 7,759 Long-term Liabilities 1,614

Investments 523 Total Liabilities 11,610

Goodwill 6,256 Stockholders' Equity 46,241

Other long-term assets 1,751

Total Assets 57,851 Total liabilities and stockholders' equity 57,851

Note: All values are in millions of dollars.


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.

Economy & Finance

Micro ch8 ppt