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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Introduction To own a seat on the NYSE you may have paid as little as $975,000, or as much as $3 million in To understand why, we turn our attention to topics such as the NYSE and discounted present value.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Chapter Outline Economic Rent Firms and Profits Interest Corporate Financing Methods The Markets for Stocks and Bonds

Copyright © 2008 Pearson Addison Wesley. All rights reserved Did You Know That... There are almost 800,000 nonprofit organizations in the United States? There are nearly 28 million profit-seeking businesses in the United States? These businesses are financed and organized very differently?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Economic Rent  A payment for the use of any resource over and above its opportunity cost  Thus, rent has a different meaning in economics.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 22-1 Economic Rent

Copyright © 2008 Pearson Addison Wesley. All rights reserved Economic Rent (cont'd) Economic rent to labor  Professional sports superstars  Rock stars  Movie stars  World-class models  Successful inventors and innovators

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Economic Rent (cont'd) Economic rent and the allocation of resources  Economic rent allocates resources to their highest valued use.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Example: Do Entertainment Superstars Make Super Economic Rents? Superstars certainly do well financially. Forbes magazine has ranked them. How much of these earnings can be called economic rent?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 22-1 Superstar Earnings

Copyright © 2008 Pearson Addison Wesley. All rights reserved Firms and Profits Firms or businesses, like individuals, seek to earn the highest possible returns. A firm brings together the factors of production to produce a product or service it hopes can be sold at a profit.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Firms and Profits (cont'd) 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Firms and Profits (cont'd) The legal organization of firms  Proprietorship  Partnership  Corporation

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 22-2 Forms of Business Organization

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Legal Organization of Firms (cont'd) Advantages of proprietorships  Easy to form and dissolve  All decision-making power resides with the sole proprietor  Profit is taxed only once

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Legal Organization of Firms (cont'd) 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Legal Organization of Firms (cont'd) 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Legal Organization of Firms (cont'd) Advantages of partnerships  Easy to form and dissolve  Partners retain decision-making power  Permits more effective specialization  Profit is taxed only once

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Legal Organization of Firms (cont'd) Disadvantages of partnerships  Unlimited liability  Decision making more costly  Dissolution often occurs when a partner dies or leaves the firm.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Legal Organization of Firms (cont'd) 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Legal Organization of Firms (cont'd) 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Legal Organization of Firms (cont'd) Advantages of corporations  Limited liability  Continues to exist when owner leaves the business  Raising large sums of financial capital

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Legal Organization of Firms (cont'd) Disadvantages of corporations  Double taxation  Dividends  Portion of corporation’s profits paid to its owners (shareholders)  Separation of ownership and control

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Profits of a Firm Accounting Profit  Total revenue minus total explicit costs

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Profits of a Firm (cont'd) Explicit Costs  Costs that business managers must take account of because they must be paid  Examples are wages, taxes and rent

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Profits of a Firm (cont'd) 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Profits of a Firm (cont'd) 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Profits of a Firm (cont'd) 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Profits of a Firm (cont'd) 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Profits of a Firm (cont'd) 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Profits of a Firm (cont'd) Economic Profits  Total revenues minus total opportunity costs of all inputs used  The total of implicit and explicit costs

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 22-2 Simplified View of Economic and Accounting Profit

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Profits of a Firm (cont'd) 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Profits of a Firm (cont'd) Firms that can provide relatively higher risk-corrected 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Example: No Interest for the Life of the Loan, but with Strings Attached Why did Chase and Discover offer the zero-interest commitment? Why didn’t they offer “zero-interest for life” to all their customers? What strings were attached to the “zero-interest” offer?

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 22-3 Present Value of a Future Dollar

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Difference Between Stocks and 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. StocksBonds

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Markets for Stocks and Bonds (cont'd) Securities  Stocks and bonds

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Market Indexes DJIA S&P 500 FTSE 100 CAC 40 Nikkei Hang Seng

Copyright © 2008 Pearson Addison Wesley. All rights reserved International Example: Aiming to Duplicate Nasdaq’s Successes in China Publicly traded stocks of the largest companies in China are exchanged on the Shanghai Stock exchange. Smaller firms, including start-up companies, have traditionally relied on bank loans to finance their operations. In hopes of broadening the sources of funds available to smaller firms, China’s State Council recently approved a plan by the Shenzhen Stock Exchange to emulate the Nasdaq.

Copyright © 2008 Pearson Addison Wesley. All rights reserved International Example: Aiming to Duplicate Nasdaq’s Successes in China (cont'd) Their objective is to offer a Nasdaq-style electronic trading network through which traders will be able to exchange shares of future new Chinese versions of Microsoft or Intel. How might the fact that average stock prices on both the Shanghai and Shenzhen exchanges have fallen by more than 30% since 2000 have contributed to the financing problems faced by smaller Chinese firms?

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.  The best forecast of tomorrow’s price is today’s price plus the effect of any upward drift.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.”

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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

Copyright © 2008 Pearson Addison Wesley. All rights reserved Example: How to Read the Financial Press: Stock Prices The Wall Street Journal contains information on stocks. Review the columns of information regarding four stocks. See if you can calculate the yield on these stocks.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 22-4 Reading Stock Quotes

Copyright © 2008 Pearson Addison Wesley. All rights reserved Issues and Applications: Downs and Ups in Seats on the NYSE The key determinant of a seat’s price Explaining variations in an NYSE seat’s price in the 2000s The actual price of a seat on the NYSE

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 22-3 The Price of a Seat on the New York Stock Exchange Since 1999

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

Copyright © 2008 Pearson Addison Wesley. All rights reserved 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.

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