Micro ch8 ppt

R. GLENN
HUBBARD
Microeconomics
FOURTH EDITION
ANTHONY PATRICK
O’BRIEN

2 of 37© 2013 Pearson Education, Inc. Publishing as Prentice Hall
Firms, the Stock Market, and
Corporate Governance
CHAPTER
8
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
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 personal
liability
• 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 business
organization.

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?
Making
the
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 understand
the 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.
6%or,06.0
000,1$
60$

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 Investors
Service
Standard &
Poor’s (S&P)
Fitch
Ratings
Meaning of the
Ratings
Investment-grade
bonds
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 of
default risk
C C C Exceptionally high
levels of default risk
— D D Default
The Rating Game: Is the U.S. Treasury Likely to
Default on Its Bonds?
Making
the
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 You
When Google Shares Change Hands, Google Doesn’t Get the Money
Google 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
Making
the
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?Making
the
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.
n
n
i)1(
valueFuture
luePresent 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: $175,000 to be received right away
Explain which prize you would choose and the basis for your decision.
How to Receive Your Contest Winnings
Solved Problem 8A.1
Solving the Problem
Step 1: Review the chapter material.
Step 2: Explain the basis for choosing the prize.
Unless you need cash immediately, you should choose the prize with the highest
present value.
Step 3: Calculate the present value of each prize.
To calculate present value, we must use an interest rate.
Assuming an interest rate of 10 percent, the present value of Prize 1 is:
Your Turn: For more practice, do related problems 8A.6, 8A.7, 8A.8, and 8A.9 at the end of the chapter.MyEconLab








 432
)10.01(
000,50$
)10.01(
000,50$
)10.01(
000,50$
)10.01(
000,50$
000,50$
$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
nn
n
iiii )1(
valueFace
)1(
Coupon
...
)1(
Coupon
)1(
Coupon
priceBond 2
21








A Simple Formula for Calculating Stock Prices
Using Present Value to Calculate Stock Prices
...
)1(
Dividend
)1(
Dividend
priceStock 2
21





ii
)rateGrowth(
Dividend
priceStock


i
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.

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