Introduction. Learning Objectives. Chapter 22. Rents, Profits, and the Financial Environment of Business

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Copyright 2011 by Pearson Education, Inc. Chapter 22 Rents, Profits, and the Financial Environment of Business All rights reserved. Introduction They are known as Bowie bonds.

Bowie bonds are just one particular type of bond traded in markets for securities, or legal claims on firms that most of us more commonly refer to as stocks and bonds.

1 Copyright 2011 by Pearson Education, Inc. Chapter 22 Rents, Profits, and the Financial Environment of Business All rights reserved. Introduction They are known as Bowie bonds. The returns on the first Bowie bonds, which were issued in 1997, are based on royalties generated by sales of songs and albums by 1970s rock star David Bowie. Bowie bonds are just one particular type of bond traded in markets for securities, or legal claims on firms that most of us more commonly refer to as stocks and bonds. In this chapter, you will learn about how securities markets function. In addition, you will learn about economic rents, economic profits, and the allocative role of interest 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 22-3

2 Learning Objectives (cont'd) 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 22-4 Chapter Outline Economic Rent Firms and Profits Interest Corporate Financing Methods The Markets for Stocks and Bonds 22-5 Did You Know That... Since 1897, nearly all the increase in the values of ownership shares of companies traded in the U.S. stock markets has occurred when Congress was in recess? The reason for this is that when Congress is in session, representatives and senators propose numerous bills the might reduce firms profits. How do firms measure their profits and what factors determine profits? In this chapter, you will learn the answers to these questions. 22-6

Economic Rent Economic Rent A payment for the use of any resource over and above its opportunity cost Thus, rent has a different meaning in economics.

3 Economic Rent Economic Rent A payment for the use of any resource over and above its opportunity cost Thus, rent has a different meaning in economics Economic Rent (cont'd) Determining land rent Economists originally used the term rent to designate payment for use of land. The concept of economic rent is associated with the British economist David Ricardo Figure 22-1 Economic Rent 22-9

4 Economic Rent (cont'd) Economic rent to labor Professional sports superstars Rock stars Movie stars World-class models Successful inventors and innovators Economic Rent (cont'd) Apply the definition of economic rent to the phenomenal earnings these people make. They would undoubtedly work for considerably less than they earn. Much of their rent occurs because specific resources cannot be replicated exactly. No one can duplicate today s most highly paid entertainment figures Economic Rent (cont'd) Economic rent and the allocation of resources Economic rent allocates resources to their highest valued use

5 Example: Do Entertainment Superstars Make Super Economic Rents? How much of superstars earnings can be called economic rent? A newcomer would almost certainly work for much less than he or she earns, implying that the newcomer is making high economic rent. Seasoned entertainers probably have very high accumulated wealth and also a more jaded outlook about their work. It is therefore not clear how much they would work if they were not offered those huge sums of money. Even if some superstars would work for less, what forces cause them to make so much income anyway? Table 22-1 Superstar Earnings Firms and Profits Firms or businesses, like individuals, seek to earn the highest possible returns. A firm brings together the factors of production labor, physical capital, human capital and entrepreneurial skill to produce a product or service it hopes can be sold at a profit

6 Firm A business organization that employs resources to produce goods or services for profit A firm normally owns and operates at least one plant or facility in order to produce The legal organization of firms Proprietorship Partnership Corporation Table 22-2 Forms of Business Organization 22-18

7 Firms and Profits (cont d) The Legal Organization of Firms Proprietorship 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 Advantages of proprietorships Easy to form and dissolve All decision-making power resides with the sole proprietor Profit is taxed only once 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

8 Partnership 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 Advantages of partnerships Easy to form and dissolve Partners retain decision-making power Permits more effective specialization Profit is taxed only once Disadvantages of partnerships Unlimited liability Decision making more costly Dissolution often occurs when a partner dies or leaves the firm

9 Corporation 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 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 Advantages of corporations Limited liability Continues to exist when owner leaves the business Raising large sums of financial capital 22-27

10 Disadvantages of corporations Double taxation Dividends Portion of corporation s profits paid to its owners (shareholders) Separation of ownership and control Firms and Profits (cont d) The Profits of a Firm Accounting Profit Total revenue minus total explicit costs Explicit Costs Costs that business managers must take account of because they must be paid Examples are wages, taxes and rent 22-30

11 Implicit Costs Expenses that managers do not have to pay out of pocket and hence do not normally explicitly calculate Opportunity cost of factors of production that are owned Owner-provided capital and owner-provided labor Normal Rate of Return The amount that must be paid to an investor to induce investment in a business Also known as the opportunity cost of capital Opportunity Cost of Capital The normal rate of return, or the available return on the next-best alternative investment Economists consider this a cost of production, and it is included in our cost examples

12 Opportunity cost of owner-provided land and capital Single-owner proprietorships often exaggerate profit as they understate their opportunity cost of capital. Consider a simple example of a skilled auto mechanic working at his/her own service station, six days a week Accounting profits versus economic profits The term profits in economics means the income entrepreneurs earn. Over and above all costs including their own opportunity cost of time. Plus the opportunity cost of capital they have invested in their business Economic Profits Total revenues minus total opportunity costs of all inputs used The total of implicit and explicit costs 22-36

Figure 22-2 Simplified View of Economic and Accounting Profit 22-37 The goal of the firm: profit maximization Theory of consumer demand: utility (or satisfaction) maximization Theory of the firm:

13 Figure 22-2 Simplified View of Economic and Accounting Profit The goal of the firm: profit maximization Theory of consumer demand: utility (or satisfaction) maximization Theory of the firm: profit maximization is the underlying hypotheses of our predictive theory Firms that can provide relatively higher riskcorrected returns will have an advantage in obtaining financing needed to continue or expand production. We would expect a policy of profit maximization to become a dominant mode of behavior for firms that survive

14 Interest Interest is the price paid from debtors to creditors for the use of loanable funds. Businesses use financial capital in order to invest in physical capital Interest (cont'd) Financial Capital Funds used to purchase physical capital goods, such as buildings and equipment Interest The payment for current rather than future command over resources; the cost of obtaining credit Interest (cont'd) Variations in the rate of annual interest that must be paid for credit depend on 1. Length of loan 2. Risk 3. Handing charges 22-42

15 Interest (cont'd) Nominal Rate of Interest The market rate of interest expressed in today s dollars Real Rate of Interest The nominal rate of interest minus the anticipated rate of inflation Interest (cont'd) We can say that the nominal, or market, rate of interest is approximately equal to the real rate of interest plus anticipated inflation, or i n = i r + anticipated inflation rate Interest (cont'd) Interest is a price that allocates loanable funds (credit) to consumers and businesses. Investment, or capital, projects with rates of return higher than the market rate of interest will be undertaken. The interest rate performs the function of allocating financial capital thus ultimately allocating physical capital

16 Interest (cont'd) Businesses make investments which often incur large costs. They need to compare their investment cost today with a stream of future profits. They must relate present costs to future benefits. Interest rates are used to link the present with the future Interest (cont'd) Present Value The value of a future amount expressed in today s dollars The most that someone would pay today to receive a certain sum at some point in the future Interest (cont'd) PV 1 = FV 1 / 1 + i where PV 1 = Present value of a sum one year hence FV 1 = Future sum paid or received one year hence i = Market rate of interest 22-48

17 Interest (cont d) 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 $ Interest (cont d) How much would have to be put in a savings account today to have $105 two years from now if the account pays 5% per year compounded annually? PV 2 x (1.05) 2 = $105 PV 2 x $105 = $95.24 (105) Table 22-3 Present Value of a Future Dollar 22-51

18 Interest (cont'd) Discounting The method by which the present value of a future sum or a future stream of sums is obtained Rate of Discount The rate of interest used to discount future sums back to present value Interest (cont'd) 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 Corporate Financing Methods 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 22-54

19 Corporate Financing Methods (cont'd) 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 Corporate Financing Methods (cont'd) 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 Bonds are issued in return for funds lent to the firm Corporate Financing Methods (cont'd) Reinvestment Profits (or depreciation reserves) used to purchase new capital equipment Sales of stock are an important source of financing for new firms. Reinvestment and borrowing are the primary means of financing for existing ones

20 Corporate Financing Methods (cont d) Stocks Bonds 1. Stocks represent ownership. 2. Common stocks do not have a fixed dividend rate. 3. Stockholders can elect a board of directors, which controls the corporation. 4. Stocks do not have a maturity date; the corporation does not usually repay the stockholder. 5. All corporations issue or offer to sell stocks. This is the usual definition of a corporation. 6. Stockholders have a claim against the property and income of a corporation after all creditors claims have been met. 1. Bonds represent debt. 2. Interest on bonds must always be paid, whether or not any profit is earned. 3. Bondholders usually have no voice in or over management of the corporation. 4. Bonds have a maturity date on which the bondholder is to be repaid the face value of the bond. 5. Corporations need not issue bonds. 6. Bondholders have a claim against the property and income of a corporation that must be met before the claims of stockholders The Markets for Stocks and Bonds Economists often refer to the market for wheat or the market for labor. These are more conceptual places rather than actual ones. For securities there really are markets physical locations The Markets for Stocks and Bonds (cont'd) Securities Stocks and bonds 22-60

21 The Markets for Stocks and Bonds (cont'd) New York Stock Exchange (NYSE) Nasdaq London Stock Exchange (FTSE) Tokyo Stock Exchange Bombay Stock Exchange (BSE) Shanghai Stock Exchange The Markets for Stocks and Bonds (cont'd) Market Indexes DJIA S&P 500 FTSE 100 CAC 40 Nikkei Hang Seng The Markets for Stocks and Bonds (cont'd) The theory of efficient markets All information entering the market is fully incorporated into stock prices. Consequently, stock prices tend to drift upward following a random walk theory. The best forecast of tomorrow s price is today s price plus the effect of any upward drift

22 The Markets for Stocks and Bonds (cont'd) Random Walk Theory The theory that there are no predictable trends in securities prices that can be used to get rich quick Example: Efficient Markets or Adaptive Markets? In 1988, the U.S. Supreme Court endorsed a legal theory known as fraud on the market, which is based on the efficient markets hypothesis. The Supreme Court decided misleading statements about a firm s condition defraud those who buy the firm s stock even if they don t rely directly on such statements. According to some economists, the Supreme Court may have relied on faulty economics. In place of the efficient markets hypothesis, they propose an adaptive markets hypothesis. Why might proponents of the efficient markets hypothesis contend that even emotion-influenced traders still respond fully to all available market information? The Markets for Stocks and Bonds (cont'd) Inside Information Information that is not available to the general public about what is happening in a corporation One way to beat the market, although it is considered illegal, punishable by substantial fines and imprisonment 22-66

23 Issues and Applications: How Musicians Increasingly Rely on Stocks and Bonds Professional classical musicians increasingly are issuing stocks and bonds to finance activities. Some musicians sell shares to raise funds for expensive instruments. German company SellaBand coordinates start-up funding efforts for more than 250 fledgling rock bands. Fans can buy shares online for $10 apiece. Musicians like David Bowie raise money by issuing securities with returns derived from the stream of revenues from continuing sales of his albums. Why might shares in a cello or a violin be less liquid than shares of stock in a major U.S. Corporation? 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 Summary Discussion of Learning Objectives (cont'd) 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

Rents, Profits, and the Financial Environment of Business

21 Rents, Profits, and the Financial Environment of Business Learning Objectives After you have studied this chapter, you should be able to 1. define economic rent, firm, proprietorship, partnership, corporation,