Macro Chapter 6

what is the difference between a firm's balance sheet and its income statment?

A firm's balance sheet is a snapshot of the firm's assets and liabilities on a particular day (such as the end of a quarter). A firm's income statement summarizes its revenues, costs, and profit over a period of time (such as a year).

What are three major types of firms in the US? Briefly discuss the most important characteristics of each type.

A sole proprietorship is owned by a single individual and isn't organized as a corporation. A partnership is owned jointly by two or more persons and isn't organized as a corporation. A corporation is a legal form of business that provides a firm's owners with limited liability. Limited liability is a legal provision that shields owners of a corporation from losing more than they have invested in the firm. The government grants this privilege to corporations because investors are more likely to buy stock in a firm—thereby becoming part owners—if the investors' losses are limited to the amount they invest. Because, unlike with a sole proprietorship or a partnership, most investors will not have a role in managing a corporation, they will be reluctant to become part owners if they face unlimited liability for the corporation's losses. Most economists believe that limited liability laws help increase investment and the rate of economic growth.

What is the difference between a firms assets and its liablities?​ Give an example of an asset and a liability

An asset is anything of value that a firm owns (such as a building). A liability is a debt or obligation owed by a firm (such as an unpaid electric bill).

Distinguish between a firm's explicit and its implicit costs and between a firm's accounting and economic profit.

An explicit cost is a cost that involves spending money; an implicit cost is a nonmonetary opportunity cost. A firm has both explicit costs, such as the rent it pays for a warehouse, and implicit costs, such as the opportunity cost of the services a sole proprietor supplies to her own firm. Accounting profit is a firm's revenue minus its operating expenses and taxes paid (explicit costs); economic profit is a firm's revenue minus all of its implicit and explicit costs

Bond pricing formula

Bond price = Coupon/(i+1)^1 + Coupon/(i+1)^2 + Coupon/(i+1)^3..... Face value/(i+1)^3

If you borrow money from a bank to buy a car, are you using direct ot indirect finance?

Borrowing money from a bank to buy a car is indirect finance, as the bank channels the funds from its depositors to you. Borrowing money from your friend to buy a car would be direct finance.

Why do corporate boards of directors sometimes link top managers' compensation to corporations/ stock prices? Briefly explain how trying compensation too closely to stock prices might create an incentive for corporate fraud.

Corporate boards of directors sometimes link top managers' compensation to the corporations' stock price to lessen the principal-agent problem caused by the separation of ownership from control. Linking compensation to stock prices provides managers with an additional incentive to maximize shareholder profits because they share in those profits when the firms' stock prices increase. But tying compensation too closely to stock prices may cause a firm's management to maximize short-run profits over long-run profits or to commit corporate fraud ("cooking the books") to make the firm appear to be more profitable than it is with the intention of artificially increasing the firm's stock price.

What is the difference between direct finance and indirect finance?

Direct finance occurs when a firm obtains funds directly from savers through the stock or bond market. Indirect finance occurs when firms obtain funds from savers indirectly through an intermediary such as a bank.

Why do financial markets depend on accurate and disclosure practices? Why can misleading accounting and disclosure practices weaken the integrity of financial markets?

Investors in primary and secondary markets make decisions on which firms to invest in, when to invest, how much to invest, and when to sell based on information about firms. If the information is misleading, investors will invest less or, possibly, stop investing. Capital markets depend on accurate information and can function poorly when information is misleading.

General formula

PV = FV/ (i+1)^n

Give the formula for calculating the present value of a bond that will pay a coupon of $100 per year for 10 Years and that has a Face value of $1,000.

PV= $100/(1+i)+$100/(1+i)^2+...$100/(1+i)^10+ $1000/(1+i)^10

Stock pricing formula

Price = Dividen/(i-growth rate)

Suppose that eLake, an online auction site, is paying a dividend of $2 per share. You expect this dividend to grow 2% per year, and the interest rate is 10%. What is the most you would be willing to pay for a share of stock in eLake? IF the interest rate is 5%, what is the most you would be willing to pay? When interest rates in the economy decline, would you expect stock prices in general to rise or fall? Briefly explain.

Stock Price = 2/(.1 - .02) = $25. If the interest rate is 5% = 2/(.05-.02) = $66.67. Following this pattern a lower interest rate means the stock price should rise.

How do the stock and bonds markets provide informationto businesses? Why do stock and bond prices change over time?

Stock and bond markets provide information that helps investors anticipate what will happen to the firm. If they are optimistic and think the firm will earn higher profits, then they will bid up the price of its stock. If they are pessimistic, then the price of the stock will fall. If they are pessimistic and fear that the firm might suffer financial losses and default on its bond payments, then investors will be less willing to buy the firm's bonds, and the prices of the bonds will fall. Optimism about the firm will increase the prices of the firm's bonds. So, the successes and failures of the firm will result in rising or falling prices for the firm's stocks and bonds. Businesses can use these fluctuations in the prices of their stocks and bonds to gauge investors' views of the businesses' prospects. In that way, stock and bond markets provided information to businesses.

What is the Sarbanes-Oxley Act? Why was it passed?

The Sarbanes-Oxley Act of 2002 was intended to strengthen the reliability of corporate financial reports. It was passed in reaction to the accounting fraud at companies like Enron and WorldCom.

How is the separation of ownership from control related to the principal-agent problem?

The principal-agent problem results when an agent pursues his own interests rather than the interests of the principal who hired him. In a corporation, the managers of a firm (the agents) may choose to pursue policies that benefit themselves rather than the firm's stockholders (the principals). Stockholders are interested in higher profits, but managers may be more concerned with paying themselves higher salaries and building luxurious corporate offices, which reduce profits. Because most shareholders are not aware of the daily operations of the firm, they may be unaware of the choices managers make. (to fix this problem bosses give managers stock in company)

Suppose that a firm in which you have invested is losing money. Would you rather own the firm's stocks or bonds? Briefly explain

You would rather own the bonds because a firm losing money is unlikely to pay a dividend, and if the firm goes bankrupt, the bondholders are paid off before the stockholders.

Present value

the value in today's dollars or funds to be paid or received in the future