Chapter 22

1. Chapter 22 Rents, Profits, and the Financial Environment of Business

2. The real return you receive on your investments depends in part on the rate of inflation that prevails. To protect themselves from variable inflation rates, some investors hold Treasury Inflation-Protection Securities. Introduction

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. Learning Objectives • 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. Chapter Outline • Economic Rent • The Legal Organization of Firms • Interest • Methods of Corporate Finance • The Markets for Stocks and Bonds

6. Did You Know That . . . • Even in colonial America, securities were issued with inflation-adjusted returns? • Today, some investment houses offer such securities in the form of inflation-indexed bonds?

7. Economic Rent • Economic rent is payment to the owner of a resource in excess of its opportunity cost. • Some individuals earn economic rent in the labor force.

8. Economic Rent • Who earns economic rent for labor services? • Movie Stars • Top Athletes • Successful innovators

9. Economic Rent • Superstars who earn economic rent are paid more than the minimum they would have to earn in order to continue in their work. • But the rent serves an economic function of allocating their labor to the best use. • The amount of rent they can earn will be determined by the demand for services only they can offer.

10. The Legal Organization of Firms • Proprietorships • 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

11. The Legal Organization of Firms • Proprietorships • About 70 percent of all U.S. firms • 10 million firms with sales averaging not much more than $50,000 per year • Account for 5 percent of all business revenues

12. The Legal Organization of Firms • Advantages of proprietorships • Easy to form and dissolve • All decision-making power resides with the sole proprietor • Profit is taxed only once

13. The Legal Organization of Firms • 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

14. The Legal Organization of Firms • Partnerships • 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

15. The Legal Organization of Firms • Advantages of partnerships • Easy to form and dissolve • Partners retain decision-making power • Permits more effective specialization • Profit is taxed only once

16. The Legal Organization of Firms • Disadvantages of partnerships • Unlimited liability • Decision making more costly • Dissolution generally necessary when a partner dies or leaves the firm

17. The Legal Organization of Firms • Corporations • 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

18. The Legal Organization of Firms • 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

19. The Legal Organization of Firms • Advantages of corporations • Limited liability • Continues to exist when owner leaves the business • Raising large sums of financial capital

20. The Legal Organization of Firms • Disadvantages of corporations • Double taxation • Separation of ownership and control

21. International Policy Example:One-Yen Business Success • In order to encourage the formation of new businesses, Japan instituted a policy that allowed companies to begin operating with as little as one yen (the equivalent of less than a penny) on hand. • But this has not served as much of a stimulus, because the other legal and financial requirements applying to new businesses are more of an impediment.

22. Profits • Accounting profit equals total revenue minus explicit costs. • If a business earns an accounting profit that is equal to the normal rate of return, then it is earning enough to cover the opportunity cost of capital.

23. Profits • Economic profit equalstotal revenue minus the total opportunity cost of all inputs used. • This is equivalent to saying that economic profit is what remains of total revenue once all explicit and implicit costs have been covered.

24. Profits • Economic theory assumes that the goal of any firm is to maximize profit. • An enterprise cannot obtain capital financing unless it generates the profits necessary to reward investors.

25. Interest • Interest is the price paid by debtors to creditors for the use of financial capital. • Interest is the market return earned by capital as a factor of production.

26. Interest and Credit • The interest rate paid depends on • Length of the loan • Risk • Handling charges

27. Real versus Nominal Interest Rates • The nominal interest rate rises along with increases in expected inflation

28. The Allocative Role of Interest • Interest is a price that allocates loanable funds to consumers and businesses. • Like any price set by the free market, it can serve to bring about an efficient allocation of a scarce good. • In this case, the scarce good is financial capital.

29. Interest Rates and Present Value • The present value of a given amount to be received in the future is the most that someone would pay today in order to be entitled to receive that amount in the future.

30. Interest Rates and Present Value • 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

31. Interest Rates and Present Value • Discounting • The process of determining the present value of a sum to be received some time in the future.

32. Interest Rates and Present Value • 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.

33. Methods of Corporate Financing • 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

34. Methods of Corporate Financing • 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

35. Methods of Corporate Financing • 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 • Issued in return for funds lent to the firm

36. The Difference Between Stocks and Bonds Stocks Bonds 1. Stocks represent ownership. 1. Bonds represent debt. 2. Common stocks do not have a fixed 2. Interest on bonds must always be dividend rate. paid, whether or not any profit is earned. 3. Stockholders can elect a board of 3. Bondholders usually have no voice in directors, which controls the or over management of the corporation. corporation. 4. Stocks do not have a maturity date; 4. Bonds have a maturity date on whichthe corporation does not usually the bondholder is to be repaid the face repay the stockholder. value of the bond. 5. All corporations issue or offer to sell 5. Corporations need not issue bonds. stocks. This is the usual definition of a corporation. 6. Stockholders have a claim against the 6. Bondholders have a claim against the property and income of a corporation after property and income of a corporationall creditors’ claims have been met. that must be met before the claims of stockholders.

37. The Markets for Stocks and Bonds • New York Stock Exchange (NYSE) • More than 2,500 stocks are traded on the NYSE • About 600 brokerage firms pay up to $2,000,000 per seat to trade on the NYSE

38. International Example:A Pan-African Stock Exchange • There are a few small stock exchanges spread throughout the African continent. • Because the number of trades in each exchange is small, there may not be any buyers for a share offered for sale on a given day.

39. International Example:A Pan-African Stock Exchange • In order to create a more continuous spectrum of buyers and sellers, attempts have been made to combine all the African exchanges into one market for the entire continent. • If the telecommunications network can bring this about, it would allow for a market in which shares would be offered when demanded, and purchased when supplied.

40. The Markets for Stocks and Bonds • The theory of efficient markets • Can you predict the future price of a stock? • If all available information about the performance of a company is incorporated in the price of its stock, then the best predictor of tomorrow’s price is today’s price.

41. The Markets for Stocks and Bonds • The theory of efficient markets • If some people are trading based on inside Information, then they have an opportunity to profit from their transactions before the market price adjusts to the information.

42. Issues and Applications:TIPS From the U.S. Treasury • Treasury Inflation-Protection Securities have nominal rates of return that are adjusted to changes in the Consumer Price Index. • They guarantee a specified real rate of return. • Since 2003, the demand for these securities has been increasing, which may suggest increasing uncertainty about future inflation.

43. 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 • Accounting profit is the excess of total revenue over explicit costs. To arrive at economic profit, we must subtract implicit costs as well.

44. Summary Discussion of Learning Objectives • Interest is a payment for the ability to use resources today instead of in the future. • 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.

45. End of Chapter 22 Rents, Profits, and the Financial Environment of Business