5th Edition - safe51e19c3b96bf9.jimcontent.com

5th Edition - safe51e19c3b96bf9.jimcontent.com

R. GLENN HUBBARD ANTHONY PATRICK OBRIEN MICROECONOMICS FIFTH EDITION GLOBAL EDITION Pearson Education Limited 2015 CHAPTER CHAPTER 8 Firms, the Stock Market, and Corporate Governance

Chapter 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 Analyze a Corporation

8.5 Corporate Governance Policy and the Financial Crisis of 2007-2009 Appendix: Tools to Analyze Firms Financial Information Pearson Education Limited 2015 2 of 46 Why Firm Structure, Finance, and Governance? In this chapter we will examine how firms are run: How they are organized, How they obtain financing, How they convey information to the public, and Whether they act in the best interest of their owners. Each of these items affect how firms behave, and what their overall

impact on the economy will be. Pearson Education Limited 2015 3 of 46 Types of Firms 8.1 LEARNING OBJECTIVE Categorize the major types of firms in the United States. Pearson Education Limited 2015 4 of 46 The Types of Firms Firms are legally categorized in the U.S. as one of the following: 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 owners with protection from losing more than their investment should the business fail. Pearson Education Limited 2015 5 of 46 Who Is Liable? Limited and Unlimited Liability In sole proprietorships and partnerships, no legal distinction is made between the assets of the firm and the assets of its owner(s). Asset: Anything of value owned by a person or a firm. This is not the case for corporations. The owners of corporations have limited liability, a legal provision shielding owners of the corporation from losing more than they have invested in the firm. Limited liability makes raising funds easier for a firm; it also makes

investing in firms easier for individuals. Pearson Education Limited 2015 6 of 46 Differences among Business Organizations 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 personal liability Limited ability to raise funds Unlimited personal liability Limited ability to raise funds Costly to organize

Table 8.1 Possible double taxation of income Differences among business organizations There is not a unique best business structure. Corporations benefit from limited liability but are expensive to organize. Also, their profits may be taxed twice: once as corporate profits and again when the profits are disbursed to investors. Pearson Education Limited 2015 7 of 46 Proportions of Business Organizations (a) Number of firms

(b) Revenue (c) Profits Figure 8.1 Business organizations: sole proprietorships, partnerships, and corporations Nearly of firms are sole proprietorships, and just one in six is a corporation. But since larger firms tend to be corporations, most economic activity takes place through them. Pearson Education Limited 2015 8 of 46 Making

the Connection The Importance of Small Business Most economists argue that small firms are vital to the health of the economy. In a typical year, new small firms create 3.3 million jobs40% of all new jobs created. Similarly, while large firms may be good at improving existing products, small firms are often better at creating new and innovative

products and services. Also, small firms are less likely to lay off workers during a recession (red bars on the graph). Pearson Education Limited 2015 9 of 46 The Structure of Corporations and the PrincipalAgent Problem 8.2 LEARNING OBJECTIVE Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principalagent problem. Pearson Education Limited 2015 10 of 46

Corporate Structure and Corporate Governance In sole proprietorships and partnerships, the owners of the firm are typically involved in day-to-day decisions at the firm. This is not the case for larger corporations; they usually have separation of ownership from control. Separation of ownership from control: a situation in a corporation in which the top management, rather than the shareholders, controls day-to-day operations. Owners designate a board of directors, who appoint a chief executive officer (CEO) to oversee day-to-day operations, perhaps along with other members of top management. Pearson Education Limited 2015 11 of 46 Corporations and the Principal-Agent Problem The way in which a corporation is structured and the effect that structure has on the corporations behavior is known as corporate governance.

While the board of directors and top management are, in theory, representing the interests of the firm owners, they may sometimes pursue their own agendas. Example: Managers may procure for themselves very high salaries, or perks such as corporate private jets. The conflict between the interests of shareholders and the interests of top management is a principal-agent problem. Principal-agent problem: A problem caused by an agent pursuing his own interests rather than the interests of the principal who hired him. Pearson Education Limited 2015 12 of 46 Can the Principal-Agent Problem Be Resolved? The principal-agent problem derives from economic incentives being improperly aligned. A remedy for the problem must be based on aligning the interests. This is why many top managers are paid a large part of the salary in stock or stock options: their salary becomes tied to the performance

of the firm. However since the CEO owns only a fraction of the firm, incentives can never be 100% aligned. Pearson Education Limited 2015 13 of 46 How Firms Raise Funds 8.3 LEARNING OBJECTIVE Explain how firms raise the funds they need to operate and expand. Pearson Education Limited 2015 14 of 46 Raising Funds as a Small Business Owner Small business owners have three principal methods of raising funds:

Retained earnings Profits reinvested in the firm, instead of paid to firm owners. Recruit additional owners Such an arrangement would increase the firms financial capital. Borrow From financial institutions, or from friends or family. Pearson Education Limited 2015 15 of 46 Raising Funds as Your Firm Grows: Indirect Finance As firms get larger, the need to obtain external funds tends to grow. The economys financial system facilitates the transfer of funds from savers to borrowers. Firms can borrow money from banks. As such, the banks are acting as financial intermediaries, permitting indirect finance of the firm by their savers. 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). Pearson Education Limited 2015 16 of 46 Raising Funds as Your Firm Grows: Direct Finance Alternatively, firms can appeal directly to potential investors for funds. This is direct finance: the flow of funds from savers to firms through financial markets, such as the New York Stock Exchange. Direct finance generally takes the form of one of two financial securities: Bonds A financial security that represents a promise to repay a fixed amount of funds. Stocks A financial security that represents partial ownership of a firm. Pearson Education Limited 2015

17 of 46 Bonds A bond is financial security that is essentially a loan. A firm sells a bond for its face value, say $1000, promising to repay this principal at the end of some term, say 30 years. The bond will also include a series of coupon payments, intermediate payments that will be made to the bond-holder; say, $40 every year. The interest rate, or cost of borrowing, can be expressed as the ratio of the coupon payment to the principal; in this case, $ = . , % $ The higher the default risk, the higher the coupon payment (hence the interest rate) the firm will have to offer. Pearson Education Limited 2015 18 of 46

Stocks Unlike bonds, stocks are financial securities that represent partial ownership of the firm. A corporation that sells a stock acts similarly to a partnership taking on a new partner; though the new shareholder typically owns a tiny fraction of the firm. When the corporation makes profits, these are either reinvested in the firmcausing a capital gain, or increase in value of the stockor paid out to the firms shareholders as dividends. By law, corporations must repay bondholders before shareholders. This helps to ensure that bonds are substantially less risky financial securities to hold than stocks. Pearson Education Limited 2015 19 of 46 Making

the Connection Conflicts of Interest in Credit-Rating Agencies The three main credit-rating agencies (Moodys, Standard and Poors, and Fitch) assign ratings to bonds. This service helps investors to determine which bonds are safe and which at risk of default (non-payment). However, payment for the ratings comes from the firms and governments issuing the bonds, creating the potential for a conflict of interest. Such a conflict of interest may explain why the mortgage-backed bonds issued in the mid-2000s continued to score the highest ratings, even as housing prices began to decline, raising the risk of mortgage default. Pearson Education Limited 2015 20 of 46

Stock and Bond Markets Provide Capitaland Information After firms sell their stocks and/or bonds, these financial securities can be traded in stock and bond markets. The existence of these resale markets is beneficial for society, since without them, individuals could not invest in firms without tying up their money for a long time. The price at which a stock trades indicates the degree of confidence in the firms ability to make future profits, since these profits are what is used to generate a return for investors. The price at which a bond trades is determined by its coupon payment, relative to other coupon payments available. But it also reflects the confidence of investors in the firms ability to make those payments. Pearson Education Limited 2015 21 of 46 Why Do Stock Prices Fluctuate So Much? Since a stock represents a claim to a share of future profits of a firm,

changes in expectations about those profits get reflected in the stocks price. When the overall economy performs well, a rising tide lifts all boats, and the price of a stock rises, reflecting investor confidence. The opposite happens in a recession, of course. Figure 8.2 Pearson Education Limited 2015 Movements in stock market indexes, January 1996-June 2013 22 of 46 Why Do Stock Prices Fluctuate So Much? cont. The values shown are stock market index numbers, created as weighted averages of the underlying stock prices. By convention, the index is set to a value of 100 in some base year; but since the year and initial value are arbitrary, it is changes in the index number that are relevant for determining market performance.

Figure 8.2 Pearson Education Limited 2015 Movements in stock market indexes, January 1996-June 2013 23 of 46 Using Financial Statements to Evaluate a Corporation 8.4 LEARNING OBJECTIVE Understand the information provided in corporations financial statements. Pearson Education Limited 2015 24 of 46 Which Firm(s) Should You Invest In?

Investment decisions are relatively complicated, but can be made more intelligently with information from a firms financial statements. In the U.S., publicly owned firms are required to release regular financial statements prepared using standard accounting methods known as generally accepted accounting principles. Ideally, such statements would present information in an unbiased manner, reducing information costs for investors. Firms specializing in information sell their services in verifying and investigating these reports. Pearson Education Limited 2015 25 of 46 Whats in a Firms Financial Statements? The two principal items in a firms financial statements are: Income Statement: A summary of the firms revenues, costs, and profit over a period of timetypically a 12-month fiscal year, which does not necessarily coincide with the calendar year.

Balance Sheet: A financial statement that sums up a firms financial position on a particular day, usually the end of a quarter or year. This summarizes the liabilities (anything owed by a person or firm) and assets of the firm. A firms net worth is calculated as the amount of its assets minus the amount of its liabilities. Pearson Education Limited 2015 26 of 46 Accounting Profit A firms income statement is a financial statement that shows a firms revenues, costs, and profit over a period of time. Profit on the income statement is referred to as net income, and is calculated as revenue minus operating expenses and taxes paid. Economists refer to this as accounting profit, and call the listed expenses explicit costs, costs that involve actually spending money. =

Pearson Education Limited 2015 27 of 46 Economic Profit Economists differ from accountants when calculating profit, because economists and accountants have different intents: Accountants present financial information in order to allow people to make judgments on investments. Economists are interested in decision-making; whether investing in the firm is wise, and whether the firm should continue to operate. So it is important for economists to consider the whole opportunity cost of the firms activities, including both explicit and implicit costs: opportunity costs that do not require an outlay of money; for example, a firm owners time, or the next-best use for their invested funds. Economic profit is a firms revenues minus all of its implicit and explicit costs. Opportunity cost: the highest valued alternative that must be given up to engage in some activity

Pearson Education Limited 2015 28 of 46 Corporate Governance Policy and the Financial Crisis of 20072009 8.5 LEARNING OBJECTIVE Discuss the role that corporate governance problems may have played in the financial crisis of 20072009. Pearson Education Limited 2015 29 of 46 The Importance of Accurate Financial Statements Accurate and truthful financial statements are critical for investors to make investment decisions. Investments help guide resource allocation within the economy.

Firms disclose financial statements in periodic filings to the federal government, and in annual reports to shareholders. If these financial statements are inaccurate, the whole economy suffers, as resources are allocated to less productive activities. This reduces economic growth directly, and reduces investor confidence which further erodes growth. Pearson Education Limited 2015 30 of 46 The Accounting Scandals of the Early 2000s In the early 2000s, top managers at Enron and WorldCom were shown to have falsified their firms financial statements. Some of these managers served jail time, but the damage done to many investors was severe. The government creates regulations to try to minimize the chance of such deception. The accounting scandals prompted the SarbanesOxley Act (2002), requiring that CEOs personally certify financial statements, and requiring disclosure of conflicts of interest from auditors, the accountants charged with checking the accuracy of

financial statements. Pearson Education Limited 2015 31 of 46 The Financial Crisis of 2007-2009 Beginning in 2007 and lasting into 2009, the U.S. economy suffered the worst financial crisis since the Great Depression. At its heart were financial instruments based on home mortgage loans: mortgage-backed securities. These instruments appeared to be much like bonds, and though many of the underlying mortgages were risky (made to subprime borrowers), the securities were incorrectly perceived to be low-risk. When prices fell in many housing markets, the underlying mortgages went into default, and the value of the securities plunged. Pearson Education Limited 2015 32 of 46

The Financial Crisis of 2007-2009continued The mortgage-backed securities had become popular with many investors, including large investment banks and insurance companies. These companies suffered heavy losses, and several were able to remain in business only through federal government aid. The crisis prompted the Wall Street Reform and Consumer Protection Act (2010), an act intended to reform financial regulation. Also known as the Dodd-Frank Act. Created Consumer Financial Protection Bureau, intended to protect consumers in their borrowing and investing activities. Established Financial Stability Oversight Council, intended to identify and act on risks in the financial system. Overall effect on likelihood of future financial crises: unknown. Pearson Education Limited 2015 33 of 46 Principal-Agent Problems and the Financial Crisis

Investment banks (financial institutions that, among other things, aided corporations in stock- and bond-issuance) were traditionally organized as partnerships. By 2000, they had all converted to corporations. The managers now had short-term perspectives, and less incentive to avoid risk: No investment bank owned by its employees would have bought and held $50 billion in [exotic mortgage-backed securities]. or even allow [these securities] to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit. - Michael Lewis, former Wall Street bond salesman Pearson Education Limited 2015 34 of 46 Making the Connection

The Ups and Downs of Investing in Facebook Facebooks Initial Public Offering (IPO) priced shares of Facebook at $38 apiece. A month after the IPO, the price had fallen by 40%. However by September 2013, the stock price was over $47. What explains the swings in Facebooks stock price? Pearson Education Limited 2015

35 of 46 Making the Connection Facebooks Ups and Downscontinued Stock prices are difficult to predict they represent beliefs about future profitability. News can have a strong impact on prices. For Facebook, the drops in price had to do with difficulty

selling advertising; and the sharp rise in July 2013 came after unexpectedly high ad sales on mobile devices. Pearson Education Limited 2015 36 of 46 Common Misconceptions to Avoid Profit in economics tends to refer to economic profit, which takes into account all opportunity costs. This can be substantially different from accounting profit, which only considers explicit costs. When a firm makes shares available, it receives the money from the sale. Subsequent trades of those shares do not result in any profit or loss for the firm, however. The principal-agent problem can occur on various levels: between a firms owners and managers, and between managers and workers.

Pearson Education Limited 2015 37 of 46 Appendix: Tools to Analyze Firms Financial Information LEARNING OBJECTIVE Understand the concept of present value and the information contained on a firms income statement and balance sheet. Pearson Education Limited 2015 38 of 46 Present Value When people lend money, they expect to receive back more than they lend. $1000 today is worth more than $1000 a year from now; and that in

turn is worth less than $1000 two years from now. How much are funds in the future worth to you? Economists refer to this amount as the present value of those funds: the value in todays dollars of funds to be paid or received in the future. The general formula is: Present va lue Future value n (1 i) n where Future valuen represents funds that will be received in n years, and i is the rate of interest. Pearson Education Limited 2015 39 of 46 Present Value of a Series of Payments When calculating the present value of a series of payments, we add the present values of each individual payment.

For example, suppose you will receive $50,000 immediately, and $50,000 each year for four additional years. The present value of this series of payments, assuming a 10% interest rate, is: $50,000 $50,000 $50,000 $50,000 $50,000 (1 0.10) (1 0.10) 2 (1 0.10)3 (1 0.10) 4 $50,000 $45,454.55 $41,322.31 37,565.74 $34,150.67 $208,493 Pearson Education Limited 2015 40 of 46

What Interest Rate Should We Use? The interest rate to use depends on how each person values future payments compared with present payments: If you are very impatient, a high interest rate describes your time preferences for funds. If you are very patient, a low interest rate is appropriate. As people become able to borrow and save for themselves, their personal interest rates become related to the rates at which they can borrow or save. Pearson Education Limited 2015 41 of 46 Using Present Value to Calculate Bond Prices Suppose that in 2014, you are considering buying a $1000 bond with $80 coupon payments (in 2015 and 2016) and a 2016 maturity date. So you will receive $80 in 2015 and $1080 in 2016. If your personal interest

rate is 10%, you value this bond at: $80 $1080 (1 0.10) (1 0.10) 2 However if your personal interest rate is 5%, you value this bond at: $80 $1080 (1 0.05) (1 0.05) 2 $72.73 $892.56 $76.19 $979.59 $965.29

$1055.78 Bond price Pearson Education Limited 2015 Coupon1 Coupon 2 Coupon n Face value ... 2 n (1 i ) (1 i ) (1 i ) (1 i ) n

42 of 46 Using Present Value to Calculate Stock Prices Valuing a stock is a little trickier, since there is no end-date on a stock you own a share of the firm forever. The value of a stock derives from the expected dividend payments of the stock. Stock price Dividend1 Dividend 2 ... 2 (1 i ) (1 i ) Suppose you expect a stock to pay a $5 dividend this year, and the dividend will grow at a rate of 5% per year. There is a nice shortcut to finding the value of the stock:

Dividend (i Growth rate ) $5 (0.10 0.05) Stock price $100.00 (assuming you have a 10% personal interest rate). Pearson Education Limited 2015 43 of 46 Going Deeper into Financial Statements Using the income statements and balance sheets of a firm, we can learn a lot about the firms profitability and financial positions. Recall that an income statement gives a record of the firms revenues and costs over a period of time, while a balance sheet gives a

snapshot of the firms financial position at a particular point in time. On the next slides, we will see Facebooks income statement from 2012, and its balance sheet as of December 31, 2012. Pearson Education Limited 2015 44 of 46 Analyzing Income Statements Figure 8A.1 Facebooks income statement for 2012 The difference between revenue ($5,089 million) and operating expenses ($4,551 million) is operating income ($538 million). Most corporations also have investments, such as government or corporate bonds, that generate some income for them. The sum of these incomes is the firms (before-tax) accounting

profit. Pearson Education Limited 2015 45 of 46 Analyzing Balance Sheets Assets Current assets Liabilities and Stockholders' Equity $11,267 Current liabilities $1,052 Property and equipment 2,391

Long-term liabilities 2,296 Goodwill 1,388 Total liabilities 3,348 Other long-term assets Total assets 57 $15,103 Note: All values are in millions of dollars.

Stockholders equity Total liabilities and stockholders' equity Figure 8A.2 11,755 $15,103 Facebooks balance sheet as of December 31, 2012 Corporations list their assets on the left of their balance sheets and their liabilities on the right. The difference between the value of the firms assets and the value of its liabilities equals the net worth of the firm, or stockholders equity. Stockholders equity is listed by tradition as a liability, so the balance sheet must logically balance. Pearson Education Limited 2015 46 of 46

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