Firms, the Stock Market, and Corporate Governancewpscms.pearsoncmg.com/wps/media/objects/8454/8657870/... · 2009. 12. 7. · Chapter 7: Firms, the Stock Market, and Corporate Governance

1 of 34Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.

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CHAPTER 7

Firms,the Stock Market, and Corporate Governance

Fernando Quijano

Prepared by:

When Mark Zuckerberg started Facebook in 2004, he was still a

sophomore in college. Just five years later,

Facebook had 150 million users.


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7.1 Types of FirmsCategorize the major types of firms in theUnited States.

7.2 The Structure of Corporations and thePrincipal–Agent ProblemDescribe the typical management structure ofcorporations and understand the concepts ofseparation of ownership from control and theprincipal–agent problem.

7.3 How Firms Raise FundsExplain how firms raise the funds they needto operate and expand.

7.4 Using Financial Statements to Evaluate aCorporationUnderstand the information provided incorporations’ financial statements.

7.5 Corporate Governance PolicyUnderstand the role of government incorporate governance.

Appendix: Tools to Analyze Firms’ Financial Information

Understand the concept of present value and theinformation contained on a firm’s income statement and balance sheet.

Chapter Outline andLearning Objectives

CHAPTER 7

Firms,the Stock Market, andCorporate Governance


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Types of Firms

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.

Categorize the major types of firms in the United States.

7.1 LEARNING OBJECTIVE


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Asset Anything of value owned by a person or a firm.

Limited liability The legal provision that shields owners of a corporation from losing more than they have invested in the firm.

SOLE PROPRIETORSHIP PARTNERSHIP CORPORATION

ADVANTAGES • Control by owner• No layers ofmanagement

• Ability to share work• Ability to share risks

• Limited personal liability• Greater ability to raisefunds

DISADVANTAGES • Unlimited personalliability

• Unlimited personal liability • Costly to organize

• Limited ability to raise funds

• Limited ability to raise funds • Possible double taxation of income

Who Is Liable? Limited and Unlimited Liability

Table 7-1Differences among Business Organizations



Types of Firms


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Types of Firms

Corporations Earn the Majority of Revenue and Profits

FIGURE 7-1Business 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 19 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.




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How Important Are SmallBusinesses to the U.S. Economy?

Makingthe

Connection

In a typical year, 40 percent of new jobs are created by small firms like Yelp.com, which is a community-based review and directory website founded by Jeremy Stoppelman, left, and Russel Simmons.

YOUR TURN: Test your understanding by doing related problem 1.6 at the end of this chapter.

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




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The Structure of Corporationsand the Principal–Agent Problem

Corporate Structure and Corporate Governance

Separation of ownership from controlA 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 a corporation’s structure has on the firm’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.

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



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Solved Problem 7-2Does the Principal–Agent Problem Apply to the Relationship between Managers and Workers?

Briefly explain whether you agree with the following argument:

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

YOUR TURN: For more practice, do related problems 2.4 and 2.5 at the end ofthis chapter.

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



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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

3. Finally, you could borrow the funds from relatives, friends, or a bank.

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


As the owner of a small business, you can raise the funds for an expansion in three ways:


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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.




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Bond A financial security that represents a promise to repay a fixed amount of funds.

Bonds

Coupon payment An interest payment on a bond.

Interest rate The cost of borrowing funds, usually expressed as a percentage of the amount borrowed.



6%or ,06.0000,1$60$

=


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Stock A financial security that represents partial ownership of a firm.

Stocks

Dividends Payments by a corporation to its shareholders.




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Don’t Let This Happen to YOU!When Google Shares Change Hands, Google Doesn’t Get the Money

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

A higher bond price indicates a lower cost of new external funds, while a lower bond price indicates a higher cost of new external funds.

YOUR TURN: Test your understanding by doing related problem 3.10 at the endof this chapter.




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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 mid-2009, the three indexes followed similar patterns, rising when the U.S. economywas expanding and falling when the economy was in recession.



Movements in Stock Market Indexes, 1995–mid-2009


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Following Abercrombie & Fitch’sStock Price in the Financial Pages

Makingthe

Connection

YOUR TURN: Test your understanding by doing related problem 3.11 at the endof this chapter.




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Using Financial Statementsto 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.

The Income Statement

Getting to Accounting Profit

Accounting profit A firm’s net income, measured by revenue minus operating expenses and taxes paid.

Understand the information provided in corporations’ financial statements.



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. . . And Economic Profit

Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

The Income Statement

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.




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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.

The Balance Sheet




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Corporate Governance Policy

The landmark Sarbanes-Oxley Act of 2002 requires that CEOs personally certify the accuracy of financial statements. The Sarbanes-Oxley Act also requires 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.

Understand the role of government in corporate governance.


The Accounting Scandals of the Early 2000s


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a) What is an “independent outsider” on a board of directors?

b) Why is it good for a firm to have a large majority of independent outsiders on the board of directors?

c) Why would it be good for a firm to have the auditing and compensation committees composed of outsiders?

d) Why would it be good for a firm if its directors own the firm’s stock?

Solved Problem 7-5What Makes a Good Board of Directors?

YOUR TURN: For more practice, do related problems 5.3 and 5.4 at the end ofthis chapter.




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Corporate Governance Policy

Beginning in 2007 and lasting into 2009, the U.S. economy suffered through the worst financial crisis since the Great Depression of the 1930s. At the heart of the crisis was a problem in the market for home mortgages.

Fueled by the ease of obtaining a mortgage, housing prices in the United States soared before beginning a sharp downturn in mid-2006. By 2007, many borrowers—particularly subprime and Alt-A borrowers—began to default on their mortgages. This was bad news for anyone owning mortgage-backed securities because the value of these securities depended on steady payments being made on the underlying mortgages.

The Financial Meltdown of the Late 2000s




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Was the Principal–Agent Problemat the Heart of the Financial Crisis?

Makingthe

Connection

Did principal–agent problems lay low this Wall Street bull?

YOUR TURN: Test your understanding by doing related problem 5.8 at the end of this chapter.

Congress repealed the Glass-Steagall Act in 1999, after which 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. With a publicly traded corporation, the principal–agent problem can be severe.




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Facebook Founder Puts Idealism Before Profits

The Principal–Agent Problem at Facebook

>>AN INSIDE LOOK

The Growth of Facebook.


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Accounting profitAssetBalance sheetBondCorporate governanceCorporationCoupon paymentDirect financeDividendsEconomic profitExplicit costImplicit cost

Income statementIndirect financeInterest rateLiabilityLimited liabilityOpportunity costPartnershipPrincipal–agent problemSeparation of ownership from controlSole proprietorshipStock

KEY TERMS


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Tools to Analyze Firms’ Financial Information

Appendix

Using Present Value to Make Investment Decisions

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

Understand the concept of present value and the information contained on a firm’s income statement and balance sheet.

LEARNING OBJECTIVE

nn

i)1(Value FutureValuePresent +

=


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Solved Problem 7A-1How to Receive Your Contest Winnings

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.

Appendix

YOUR TURN: For more practice, do related problems 7A-6, 7A-8, 7A-9 and 7A-10 at the end of this chapter.


LEARNING OBJECTIVE


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Appendix



LEARNING OBJECTIVE

Using Present Value to Calculate Bond Prices

nnn

iiii )1(Value Face

)1(Coupon...

)1(Coupon

)1(Coupon Price Bond 2

21

++

+++

++

+=


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Appendix


A Simple Formula for Calculating Stock Prices


LEARNING OBJECTIVE

Using Present Value to Calculate Stock Prices

...)1(

Dividend)1(

Dividend PriceStock 221 +

++

+=

ii

)RateGrowth 1(Dividend PriceStock

−=


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Going Deeper into Financial Statements

Appendix

Analyzing Income StatementsFIGURE 7A-1Google’s Income Statement for 2008

Google’s income statement shows the company’s revenue, costs, and profit for 2008. The difference between its revenue ($21,796 million) and its operating expenses ($16,258 million) is its operating income ($5,538 million). Most corporations also have investments, such as government or corporate bonds, that generate some income for them. In this case, Google earned $316 million, giving the firm an income before taxes of $5,854 million. After paying taxes of $1,627 million, Google was left with a net income, or accounting profit, of $4,227 million for the year.


LEARNING OBJECTIVE



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Appendix

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


LEARNING OBJECTIVE



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Appendix

Analyzing Balance SheetsFIGURE 7A-2Google’s Balance Sheet as of December 31, 2008

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.

Note: All values are in millions of dollars.


LEARNING OBJECTIVE



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Present valueStockholders’ equity

KEY TERMS

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Firms, the Stock Market, and Corporate Governancewpscms.pearsoncmg.com/wps/media/objects/8454/8657870/... · 2009. 12. 7. · Chapter 7: Firms, the Stock Market, and Corporate Governance