ECON 200 Chapter 8: Firms, the Stock Market, and Corporate Governance

Apply the Concept: Why Are Many People Poor Stock Market Investors?

"Buy low and sell high"—what could be simpler? Stock prices change because of new information about the future profitability of the company. Many Wall Street professionals spend lots of time and money trying to gain and understand this new information. But gathering and properly processing this information is very difficult. Many people over-estimate their ability to do it.

Present and Future Value

= Future valuen/ (1+i)n In this formula, —Future Valuen represents funds that will be received in n years —𝑖 is the interest rate The interest rate to use depends on how the person or firm values future payments compared with present payments: —High if you are very impatient —Low if you are very patient If you are able to borrow and save easily, these should be related to the interest rates at which you can borrow and save.

Bonds

A bond is financial security that is essentially a loan. A firm sells a bond for its face value (without interest) , say $1,000, promising to repay this principal (without interest) at the end of some maturity (when bond will be paid back), say 30 years. (Face value and principal samething) The bond will also include a series of coupon payments: interest paid on the bond. These are intermediate payments that will be made to the bond-holder; say, $40 every year. The interest rate is the cost of borrowing funds, usually expressed as a percentage of the amount borrowed; in this case: 40 (interest) /1000 (principal/face value) = 4% (Coupon payments). The higher the default risk, the higher the coupon payment (hence the interest rate) the firm will have to offer. (The higher the default risk, the more risky/bond might not be paid back)

accounting profit

A firm's income statement reveals the profit that the firm makes. Profit on the income statement is referred to as net income and is calculated as revenue minus operating expenses and taxes paid. Economists refer to this as accounting profit, and call the listed expenses explicit costs, costs that involve actually spending money. Accounting Profit = Revenue − Explicit Costs

8.4 Recent Issues in Corporate Governance

Accurate and truthful financial statements are critical for investors to make investment decisions. Investments help guide resource allocation within the economy. Firms disclose financial statements in periodic filings to the federal government and in annual reports to shareholders. —If these financial statements are inaccurate, the whole economy suffers, as resources are allocated to less productive activities. —This reduces economic growth directly and reduces investor confidence which further erodes growth.

Stock and Bond Markets Provide Capital—and Information

After firms sell their stocks and/or bonds, these financial securities can be traded in stock and bond markets. The existence of these resale markets is beneficial for society, since without them, individuals could not invest in firms without tying up their money for a long time. The price at which a stock trades indicates the degree of confidence in the firm's ability to make future profits, since these profits are what is used to generate a return for investors. The price at which a bond trades is determined by its coupon payment, relative to other coupon payments available. But it also reflects the confidence of investors in the firm's ability to make those payments. If the bond price increases interest rate goes down. If the bond price decreases interest rate goes up. 17)Suppose you buy the bond of a large corporation at a time when the inflation rate is very low. If the inflation rate increases during the time you hold the​ bond, what is likely to happen to the price of the​ bond? The price of the bond decreases because interest rose = bond price decreases if interest falls = bond price increase

Raising Funds as Your Firm Grows: Direct Finance

Alternatively, firms can appeal directly to potential investors for funds. This is direct finance: the flow of funds from savers to firms through financial markets, such as the New York Stock Exchange. Direct finance generally takes the form of one of two financial securities: Bonds: A financial security that represents a promise to repay a fixed amount of funds. Stocks: A financial security that represents partial ownership of a firm. 13) Suppose that a firm in which you have invested is losing a lot of money. Would you rather own the​ firm's stock or the​ firm's bonds​? Bonds or Stocks 14) Suppose you originally invested in a firm when it was large and profitable. Now the firm has downsized and is small and unprofitable. Would you be better off now if you had bought the​ firm's stock... or the​ firm's bonds ? bonds or stocks? You would be better off if you had bought bonds, because a firm that is losing money is unlikely to pay dividend, and if the firm goes bankrupt, the bondholders are paid off before the stockholders.

Economic Profit

Because of the difference in purposes, economists think of profit differently from accountants. Economists consider the whole opportunity cost of the firm's activities, including both explicit and implicit costs. Economic profit = Revenue − Explicit Costs − Implicit Costs; Economic profit = (Accounting Profit) − Implicit Costs Opportunity cost: The highest valued alternative that must be given up to engage in some activity Implicit cost: A nonmonetary (without the exchange of cash) opportunity cost. Implicit costs include items like a firm owner's time or the next best use for their invested funds

The Financial Crisis of 2007-2009

Beginning in 2007 and lasting into 2009, the U.S. economy suffered its worst financial crisis since the Great Depression. At its heart were financial instruments based on home mortgage loans: mortgage-backed securities (MBS). —MBS appeared to be much like bonds, and though many of the underlying mortgages were risky (made to "subprime" borrowers), people incorrectly perceived them to be low-risk. —When prices fell in many housing markets, the underlying mortgages went into default, and the value of MBS plunged.

The Structure of Corporations and the Principal-Agent Problem (Corporate governance and Principal-agent problem)

Corporate governance: is the way in which a corporation is structured and the effect that structure has on the corporation's behavior. While the board of directors and top management are, in theory, representing the interests of the firm owners, they may sometimes pursue their own agendas. Example: Managers may procure for themselves a very high salary, or perks such as corporate private jets. The conflict between the interests of shareholders and the interests of top management is a principal-agent problem. Principal-agent problem: A problem caused by an agent pursuing the agent's own interests rather than the interests of the principal who hired the agent.

Figure 8A.2 Twitter's Balance Sheet as of December 31, 2016

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 by tradition as a liability, so the balance sheet must logically balance.

Purposes of Accountants vs. Economists

Economists differ from accountants when calculating profit, because economists and accountants have different intents: Accountants present financial information in order to allow people to make judgments on investments. Economists are interested in decision-making; whether investing in the firm is wise and whether the firm should continue to operate.

Using Present Value to Calculate Asset Prices

Financial assets represent a claim to future funds: Bonds: Coupon payments and repayment of principal Stocks: Dividend payments To calculate what a financial asset is worth today, we consider the value of these future funds: The price of a financial asset should be equal to the present value of the payments to be received from owning that asset.

8.1 Types of Firms (3)

Firms are legally categorized in the U.S. as one of the following: 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. Corporation: A legal form of business that provides owners with protection from losing more than their investment should the business fail.

Apply the Concept: Corporate Governance at Snapchat (1 of 2)

In March 2017, Snap sold stock in an initial public offering (IPO); but investors were only able to purchase Class A shares. Class of Stock Voting Rights Relevance to Snap's IPO Class A No voting rights The IPO consisted only of Class A shares, meaning that investors who bought them would have no votes in electing members of Snap's board of directors Class B 1 vote per share Class B shares were sold to early investors who had provided funds to the firm prior to the IPO. Class C 10 votes per share Evan Spiegel and Bobby Murphy, Snap's cofounders, retained all of the Class C shares. Many investors weren't worried: Snap's IPO raised $3.4 billion. Some worried that if Snap's founders weren't able to make Snap profitable, shareholders would be unable to force them out. But the founders believe they will make better decisions for the company than (short-sighted) shareholders; they believe retaining power is a solution to the principal-agent problem.

Who Is Liable? Limited and Unlimited Liability (asset and limited liability)

In sole proprietorships and partnerships, no legal distinction is made between the assets of the firm and the assets of its owner(s) (Unlimited liability) Definition from google, Unlimited liability: the owners and partners are wholly responsible for their company's debts and all other financial commitments. Asset: Anything of value owned by a person or a firm. This is not the case for corporations. The owners of corporations have limited liability: a legal provision that shields owners of the corporation from losing more than they have invested in the firm. The government grants limited liability to the owners of corporations A.to make market economies more equitable and efficient. B.because the owners do not run the corporation and thus should not be responsible for its debts. C.to limit shareholder risk and thus encourage investment in corporations. D.to allow the corporation to borrow money in the form of bonds. answer is C

Corporate Structure and Corporate Governance

In sole proprietorships and partnerships, the owners of the firm are typically involved in day-to-day decisions at the firm. This is not the case for larger corporations; they usually have separation of ownership from control. Separation of ownership from control: a situation in a corporation in which the top management, rather than the shareholders, controls day-to-day operations. Owners designate a board of directors, who appoint a chief executive officer (CEO) to oversee day-to-day operations, perhaps along with other members of top management.

The Accounting Scandals of the Early 2000s

In the early 2000s, top managers at Enron and WorldCom were shown to have falsified their firms' financial statements. Some of these managers served jail time, but the damage done to many investors was severe. The government creates regulations to try to minimize the chance of such deception. Example: The Sarbanes-Oxley Act (2002), requiring that CEOs personally certify financial statements and requiring disclosure of conflicts of interest from auditors, the accountants charged with checking the accuracy of financial statements.

What's in a Firm's Financial Statements? The two principal items in a firm's financial statements are:

Income statement: A financial statement that shows a firm's revenues, costs, and profit over a period of time. Typically a 12-month fiscal year, which does not necessarily coincide with the calendar year. 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. This summarizes the liabilities (anything owed by a person or firm) and assets of the firm. A firm's net worth is calculated as the amount of its assets minus the amount of its liabilities.

Principal-Agent Problems and the Financial Crisis

Investment banks (financial institutions that, among other things, aided corporations in stock- and bond-issuance) were traditionally organized as partnerships. By 2000, they had all converted to corporations. The managers now had more short-term perspectives and less incentive to avoid risk: "No investment bank owned by its employees would have ... bought and held $50 billion in [exotic MBS]. ... or even allow [these securities] to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit." - Michael Lewis, former Wall Street bond salesman. Apply the Concept: Corporate Governance at Snapchat (1 of 2) In March 2017, Snap sold stock in an initial public offering (IPO); but investors were only able to purchase Class A shares.

8.3 Using Financial Statements to Evaluate a Corporation

Investment decisions are relatively complicated but can be made more intelligently with information from a firm's financial statements: In the U.S., publicly owned firms are required to release regular financial statements prepared using standard accounting methods known as generally accepted accounting principles. -Ideally, such statements would present information in an unbiased manner, reducing information costs for investors. Firms specializing in information sell their services in verifying and investigating these reports.

Government Response to Financial Crisis

MBS had become popular with many investors, including large investment banks and insurance companies. These companies suffered heavy losses, and several were able to remain in business only through federal government aid. The crisis prompted the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) of 2010, legislation intended to reform regulation of the financial system. Created Consumer Financial Protection Bureau, intended to protect consumers in their borrowing and investing activities. Established Financial Stability Oversight Council, intended to identify and act on risks in the financial system. Overall effect on likelihood of future financial crises: unknown.

Apply the Concept: Are Governments Likely to Default on Their Bonds? (1 of 2) The three main credit-rating agencies (Moody's, Standard and Poor's, and Fitch) assign ratings to bonds.

Moody's Investors Services Standard and Poors (S&P) Fitch Ratings Meaning of the Ratings 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 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 (for Moody's: "typically in default" - D D Default

Apply the Concept: Why Are Fewer Young People Starting Businesses? (1 of 2)

Most economists argue that small firms are vital to the health of the economy. In a typical year, small firms create 3.3 million jobs—40 percent of all new jobs created. But recently, there have been fewer small firms—in relative terms (see graph), and in absolute terms (~25 percent fewer new firms). Why have fewer firms been starting up? Fewer young people starting firms Possible slowdown in technological progress Increase in licensing requirements (now nearly 25 percent of people work in jobs requiring licenses)

Figure 8.1 Business Organizations: Sole Proprietorships, Partnerships, and Corporations

Nearly ¾ of firms are sole proprietorships, and just one in six is a corporation. But since larger firms tend to be corporations, most economic activity takes place through them. From Homework problem 7 Almost​ three-quarters of all firms are sole proprietorships. Only 20 percent of all firms are​ corporations, but corporations account for the majority of 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. There are more than 5 million corporations in the United​ States, but only​ 26,000 have annual revenues of more than​ $50 million. We can think of these​ 26,000 firms as representing​ "big business." These large firms earn almost 85 percent of the total profits of all corporations in the United States.

8.2 How Firms Raise Funds. Small business owners have three principal methods of raising funds:

Retained earnings: Profits reinvested in the firm, instead of paid to firm owners. Recruit additional owners: Such an arrangement would increase the firm's financial capital. Borrow: From financial institutions, or from friends or family.

Figure 8.3 Movements in Stock Market Indices, 1999 to 2017 (1 of 2)

Since a stock represents a claim to a share of future profits of a firm, changes in expectations about those profits get reflected in the stock's price. Recessions and expansions tend to shift many firms' stock prices similarly—"a rising tide lifts all boats". The values shown are stock market index numbers, created as weighted averages of the underlying stock prices. By convention, the index is set to a value of 100 in some base year. Since the year and initial value are arbitrary, it is changes in the index number that are relevant for determining market performance.

Table 8.1 Differences among Business Organizations (advantages and disadvantages)

Sole Proprietorship: Advantages: control by owner and no layers of management Disadvantages: Unlimited personal liability and limited ability to raise funds Partnership: Advantages: Ability to share work and ability to share risks Disadvantages: Unlimited personal liability and limited ability to raise funds Corporation: Advantages: Limited personal liability and greater ability to raise funds Disadvantages: Costly to organize and possible double taxation of income There is not a unique best business structure. Corporations benefit from limited liability but are expensive to organize. Also, their profits may be taxed twice: once as corporate profits, and again when the profits are disbursed to investors.

Using Present Value to Calculate Bond Prices (1 of 2)

Suppose that in 2016, you are considering buying a $1,000 bond with $80 coupon payments (in 2017 and 2018) and a 2018 maturity date. So you will receive $80 in 2017 and $1,080 in 2018. If the appropriate interest rate is i = 10 percent, you value this bond at: PV= $80/((1+0.10))+$80/((1+0.10)^2 )+$1,000/((1+0.10)^2 ) =$72.73+$892.56 =$965.29 More generally, Bond price = Coupon1/(1+i)+ Coupon2/(1+i)1+ L + Couponn/(1+i)n+ Facevaluen/(1+i)n

Can the Principal-Agent Problem Be Resolved?

The principal-agent problem derives from economic incentives being improperly aligned. A remedy for the problem must be based on aligning the interests. — This is why many top managers are paid a large part of the salary in stock or stock options: their salary becomes tied to the performance of the firm. — However since the CEO owns only a fraction of the firm, incentives can never be 100 percent aligned.

Apply the Concept: Are Governments Likely to Default on Their Bonds?

This service helps investors to determine which bonds are safe and which at risk of default (non-payment). In 2011, S&P downgraded U.S. Treasury bonds from AAA to AA+, in response to continuing large deficits. During 2016, S&P reduced ratings on four states' bonds, including reducing Illinois bonds' rating to BBB. But the rate Illinois had to pay on its bonds rose only 1.5 percentage points: investors did not believe there was a substantial risk Illinois would default on its bonds.

Stocks

Unlike bonds, stocks: are financial securities that represent partial ownership of the firm. A corporation that sells a stock acts similarly to a partnership taking on a new partner, though the new shareholder typically owns a tiny fraction of the firm. When the corporation makes profits, these are either reinvested in the firm—causing a capital gain, or increase in value of the stock—or paid out to the firm's shareholders as dividends. By law, corporations must repay bondholders before shareholders. This helps to ensure that bonds are substantially less risky financial securities to hold than stocks.

Going Deeper into Financial Statements

Using the income statements and balance sheets of a firm, we can learn a lot about the firm's profitability and financial positions. Recall that an income statement gives a record of the firm's revenues and costs over a period of time, while a balance sheet gives a "snapshot" of the firm's financial position at a particular point in time. Figure 8A.1 Twitter's Income Statement for 2016 The difference between revenue ($2,530 million) and operating expenses ($2,897 million) is operating income (−$367 million). Most corporations also have investments, such as government or corporate bonds, that generate some income for them. The sum of these incomes is the firm's (before-tax) accounting profit (or loss, in Twitter's case).

Using Present Value to Calculate Stock Prices (1 of 2)

Valuing a stock is a little trickier, since there is no end date on a stock—you own a share of the firm forever. The value of a stock derives from the expected dividend payments of the stock: Stock price = Dividend1 + Dividend2 + L (1+i) (1+i)2 Note that this has no maturity date, so we calculate the present value of an infinite stream of payments. Because the present value of those payments decreases in value quickly, the value of the underlying stock is not infinite. Also note that these are expected or estimated dividends. Using Present Value to Calculate Stock Prices (2 of 2) We can obtain a simple formula for determining the price of a stock if we assume the dividends will grow at a constant rate: Stock price = Dividend/ (i-growth rate) If a firm currently pays $5.00 per share as a dividend, the interest rate is i =10 percent, and dividends are projected to grow at 5 percent per year, then the stock price is: $5.00/ (0.10-0.05) = $100.000

Present Value of a Series of Payments

When calculating the present value of a series of payments, we add the present values of each individual payment. For example, suppose you will receive $50,000 immediately, and $50,000 each year for four additional years. The present value of this series of payments, assuming a 10 percent interest rate, is: $50,000+$50,000/((1+0.10))+$50,000/((1+0.10)^2 )+$50,000/((1+0.10)^3 )+$50,000/((1+0.10)^4 ) =$50,000+$45,454.55+$41,322.31+$37,565.74+$34,150.67 =$208,493

Appendix: Tools to Analyze Firms' Financial Information

When people lend money, they expect to receive back more than they lend. $1,000 today is worth more than $1,000 a year from now, and that in turn is worth less than $1,000 two years from now. How much are funds in the future worth to you? Economists refer to this amount as the present value of those funds: the value in today's dollars of funds to be paid or received in the future. The general formula is: Present value= Future valuen/ (1+i)n

Figure 8.2 The Structure of a Typical Corporation

While outside directors are intended to represent the interests of shareholders—the owners of the firm—they may not always be willing or able to do so. Combined with the independent decision-making power that top managers have, it is difficult to overcome the principal-agent problem. Shareholders elect> board of directors, inside and outside directors> appoint top mangers (CEO, CFO, Other C-Suites Executives, can be on inside board of directors) Which of the following is true of the management structure of corporations in the United​ States? A.Members of management who are inside directors serve on the board of directors. B.Large corporations are legally owned by shareholders who do usually not directly manage the firm. C.Large corporations are legally owned by a board of directors that directly manages the firm. D.The chief executive officer runs the​ day-to-day operations of the corporation but does not sit on the board of directors. E.Both a and b. answer a and b

Raising Funds as Your Firm Grows: Indirect Finance. As firms get larger...

the need to obtain external funds tends to grow. The economy's financial system facilitates the transfer of funds from savers to borrowers. Firms can borrow money from banks. As such, the banks are acting as financial intermediaries, permitting indirect finance of the firm by their savers. Definition from Google, saver: a person, company or institution who sets aside a proportion of current income by forgoing immediate spending on consumption. 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).