Chapter 6

Dane decides to give up a job earning ​$80,000 per year as a corporate lawyer and converts the duplex that he owns into a UFO museum.​ (He had been renting out the duplex for ​$18,000 a​ year.) His direct expenses include ​$40,000 per year paid to his assistants and ​$18,000 per year for utilities. Fans flock to the museum to see his collection of extraterrestrial​ paraphernalia, which he easily could sell on eBay for ​$900,000. Over the course of the year the museum brings in revenues of ​$90,000. a. How much is​ Dane's economic profit for the​ year?

-$66,000 - Interest forgone on the $900,000 extraterrestrial gear

You are considering purchasing stock. The stock is expected to pay a dividend of ​$80 per share. The consensus of investors is that these dividends will increase at a rate of 3 percent per year for the indefinite​ future, and the interest rate is 9 percent. The price of the stock should be ​$_________________.(Enter your response rounded to two decimal​ places.)

1,333.33

Present value is the value in​ today's dollars of funds to be paid or received in the future. If the current interest rate is 11​%, then the present value of​ $1,000 to be received in 21 years is ​$___________________. ​(Enter your response rounded to two decimal​ places.)

111.74

Although only _____________ percent of all firms are corporations, corporations account for _____________________ of revenue and profits earned by all firms.

20%; the majority

Sole proprietorship

A firm owned by a single individual and not organized as a corporation.

Partnership

A firm owned jointly by two or more persons and not organized as a corporation.

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.

Corporation

A legal form of business that provides the owners with limited liability.

A column on barrons.com as Lyft was preparing to launch its IPO contained the following​ advice: "The Lyft IPO is sure to create excitement as other tech unicorns prepare to follow it to market. Investors should stand back on the curb until there is a clear road to​ profitability." ​Source: Andrew​ Bary, "Investors Should Steer Clear When Lyft Goes​ Public," barrons.com​, March​ 22, 2019. Part 2 a. What is a​ "tech unicorn"?

A new firm or startup in the tech industry that has a value of more than​ $1 billion.

A​ firm's financial statements are generally assumed to include its income statement and balance sheet. Which of the following piece of information is provided by a​ firm's balance sheet​?

Assets

Accounting profit

A​ firm's net income measured by revenue minus operating expenses and taxes paid.

Economic profit

A​ firm's revenues minus all of its implicit and explicit costs.

Which of the following statements is​ correct? A. Accounting profit equals the​ firm's revenues minus all of its​ costs, implicit and explicit. B. Economic profit equals the​ firm's revenues minus its explicit costs. C. Accounting profit is typically larger than economic profit. D. All of the above.

C. Accounting profit is typically larger than economic profit.

Which of the following is a disadvantage for​ corporations?

Corporations are costly to organize.

c. What does the columnist mean by​ "governance failures"? Who is​ failing? Why might these failures be​ happening?

Governance failure is when a​ firm's top management fails to act in the best interests of its shareholders and instead acts in ways to increase their own salaries and bonuses.

Ronald Dickson and Louis Banks have come up with a new idea to leverage social media for improving business productivity. The​ would-be founders are debating the form of ownership that their company should take. Ronald is in favor of​ partnership, while Louis favors the corporate form of business. Which of the​ following, if​ true, would strengthen the argument in favor of​ partnership?

In order to make the idea work, they would need complete control over operations.

c. What challenges did Lyft face in becoming​ profitable?

Keeping its prices competitive relative to the prices of its rivals. Convincing investors of the continued growth opportunities for​ ride-hailing apps. Dealing with increased government regulatory requirements.

What do we mean by the separation of ownership from control in large​ corporations?

Shareholders own the​ corporation, but it is controlled by managers.

In the United​ States, there are three legal categories of​ firms: sole​ proprietorships, partnerships, and corporations. Which of the following is an advantage for sole proprietorships​?

Sole proprietorships have control by their owner.

Suppose that a firm in which you have invested is making a lot of money. Would you rather own the​ firm's stock or the firm's bonds?

Stock

Stocks are financial securities that represent partial ownership of a firm. Three of the most widely followed stock indexes are the Dow Jones Industrial​ Average, the​ S&P 500, and the NASDAQ. Which of the following does not describe the general movements of these three stock​ indexes?

Stock prices increased after the dot-com crash of 2000.

b. What does the columnist mean by​ "a clear road to​ profitability"?

The ability of a business that is presently losing money to eventually earn a profit.

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

The agents​ (managers) may pursue their own interests rather than the interests of the principals​ (shareholders).

According to an opinion column in the Wall Street Journal​, ​"Directors need to be held more accountable when they fail to set the proper tone at the​ top, and right now there is almost no consequence for most governance​ failures." ​Source: Ronald​ Barusch, "CBS and the Need to Hold Directors​ Accountable," Wall Street Journal​, September​ 16, 2018. a. What is the key principal-agent problem that exists in some​ corporations?

The firm's top management—the agents—may pursue their own interests rather than the interests of its shareholders—the principal.

b. To whom are members of the board of directors​ responsible?

The shareholders of the corporation.

State whether the following statement is true or​ false: ​"The total value of the shares of Microsoft stock traded on the NASDAQ last week was​ $895 billion, so the firm actually received much more revenue from stock sales than from selling​ software."

The statement is false because Microsoft does not receive the money investors paid for the stock.

In a study of general incorporation laws in the United​ States, Eric Hilt of Wellesley College​ noted, "Prior to the adoption of a general​ statute, a business could only incorporate if the state passed a special law granting it a corporate​ charter." ​Source: Eric​ Hilt, ​"Corporation Law and the Shift toward Open Access in the Antebellum United​ States," Naomi R. Lamoreaux and John Joseph​ Wallis, eds., ​Organizations, Civil​ Society, and the Roots of Development​, ​Chicago: University of Chicago​ Press, 2017. Part 2 What are the advantages of general incorporation laws over the previous​ system? Are there any disadvantages?

They allow more firms to experience the benefits of incorporation and ultimately allow greater competition in the market. General incorporation laws reduce the​ owners' responsibility for the​ firm's debts. NOTE: One disadvantage of general incorporation laws is that previously firms were exposed to greater scrutiny from the legislature when they tried to incorporate. This scrutiny potentially weeded out some firms that may have intended to sell unsafe or fraudulent goods and services. General incorporation laws also reduce the​ owners' responsibility for the​ firm's debts.

b. Is he earning an accounting profit?

Yes, he is earning an accounting profit.

A corporation is...

a legal form of business that provides the owners with limited liability.

The​ principal-agent problem occurs when...

an agent pursues his own interests rather than the interests of the principal who hired him.

One difference in the formulas for calculating the price of a stock and the price of a bond is that...

bonds have a fixed maturity date while there may be an infinite stream of dividend payments.

Economic profit is equal to a​ firm's revenues minus its​ costs, ________________________. Accounting profit is ______________________ economic profit.

both explicit and implicit; larger than

The formulas for calculating the price of a stock and the price of a bond are similar because...

both represent streams of payments over time.

Profit is the...

difference between revenue and the total cost to a firm of producing the goods and services it offers for sale.

Evaluate the following​ argument: I would like to invest in the stock​ market, but I think that buying shares of stock in a corporation is too risky. Suppose I buy​ $10,000 of Twitter​ stock, and the company ends up going bankrupt. Because as a​ stockholder, I'm part owner of the​ company, I might be responsible for paying hundreds of thousands of dollars of the​ company's debts. This statement is...

false because shareholders are not liable for the debts of a corporation.

A flow of funds from savers to borrowers through financial intermediaries such as banks is ____________________ finance, while a flow of funds from savers to firms through financial markets, such as the New York Stock Exchange is _______________________ finance.

indirect; direct

Limited liability becomes more important for firms trying to raise funds from a large number of​ investors, rather than from a small number of​ investors, because...

investors that make a small investment in a firm may be unwilling to risk all their personal assets if the firm fails.

Changes in the value of a​ firm's stocks and bonds offer important information for a​ firm's managers. If the price is decreasing, investors are​ _______ and are providing information that indicates the​ firm's managers might want to​ _________ the business.

more pessimistic, contract

Subtracting the value of a​ firm's liabilities from the value of its assets leaves its...

net worth.

An example of an asset would be ___________________, while an example of a liability would be ___________________.

plant and equipment; a bond that the company has issued

The shares of stock issued as a result of​ Lyft's Initial Public Offering​ (IPO) were sold in a _____________________ market. The IPO is an example of _______________ finance.

primary; direct

The​ Sarbanes-Oxley Act...

requires that CEOs of corporations certify the accuracy of financial statements.

Limited liability means that...

shareholders in a corporation cannot lose more than their investment in the firm.

An asset is ___________________, and a liability is _______________________.

something that the company owns; anything that the company owes

ExxonMobil is a large corporation. Who owns this​ company? ExxonMobil is owned by...

stockholders.

A balance sheet shows _____________ at some point in time, while an income statement shows _____________ at some point in time.

the firm's overall financial position; the firm's revenues, costs, and profits

Which of the following terms shows a​ firm's revenues,​ costs, and profit over a period of​ time?

the income statement

What term do economists use 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?

the normal rate of return

In a typical year, only one-_______________ of mutual fund managers were able to earn their investors a higher return than a small investor could earn by investing in an index mutual fund that buys only the stocks in the​ S&P 500.

third

The government grants limited liability to the owners of corporations...

to limit shareholder risk and thus encourage investment in corporations.

The​ Sarbanes-Oxley Act was passed...

to promote management accountability in corporations.

The owners of sole proprietorships and partnerships have...

unlimited liability

The landmark legislation that helps guard against inflated profits and hidden liabilities on balance sheets to protect against financial scandals is the...

​Sarbanes-Oxley Act of 2002.

​A(n) ​ _____ is a financial security that represents partial ownership of a​ firm, while a​ _____ is a financial security that represents a promise to repay a fixed amount of funds.

​stock, bond