You are on page 1of 23

Chapter 22

Rents, Profits, and the Financial Environment of Business

Copyright 2010 Pearson Addison-Wesley. 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.

22-2
Copyright 2010 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

22-3
Copyright 2010 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

22-4
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Chapter Outline
Economic Rent Firms and Profits Interest Corporate Financing Methods The Markets for Stocks and Bonds

22-5
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

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
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

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.

22-7
Copyright 2010 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.

22-8
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Figure 22-1 Economic Rent

22-9
Copyright 2010 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

22-10
Copyright 2010 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 todays most highly paid entertainment figures.

22-11
Copyright 2010 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.

22-12
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

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?
22-13
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Table 22-1 Superstar Earnings

22-14
Copyright 2010 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 productionlabor, physical capital, human capital and entrepreneurial skillto produce a product or service it hopes can be sold at a profit.

22-15
Copyright 2010 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.

22-16
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (cont'd)


The legal organization of firms
Proprietorship Partnership Corporation

22-17
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Table 22-2 Forms of Business Organization

22-18
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (contd)


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

22-19
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (cont'd)


Advantages of proprietorships
Easy to form and dissolve All decision-making power resides with the sole proprietor Profit is taxed only once

22-20
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (cont'd)


Disadvantages of proprietorships
Unlimited Liability
The owner of the firm is personally responsible for all of the firms debts.

Limited ability to raise funds Proprietorship normally ends with the death of the proprietor.

22-21
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (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

22-22
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (cont'd)


Advantages of partnerships
Easy to form and dissolve Partners retain decision-making power Permits more effective specialization Profit is taxed only once

22-23
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (cont'd)


Disadvantages of partnerships
Unlimited liability Decision making more costly Dissolution often occurs when a partner dies or leaves the firm.

22-24
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (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 firms profits Enjoy the protection of limited liability

22-25
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (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.

22-26
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (cont'd)


Advantages of corporations
Limited liability Continues to exist when owner leaves the business Raising large sums of financial capital

22-27
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (cont'd)


Disadvantages of corporations
Double taxation
Dividends
Portion of corporations profits paid to its owners (shareholders)

Separation of ownership and control

22-28
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (contd)


The Profits of a Firm Accounting Profit
Total revenue minus total explicit costs

22-29
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (cont'd)


Explicit Costs
Costs that business managers must take account of because they must be paid Examples are wages, taxes and rent

22-30
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (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

22-31
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (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

22-32
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (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.

22-33
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (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.

22-34
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (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.

22-35
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (cont'd)


Economic Profits
Total revenues minus total opportunity costs of all inputs used The total of implicit and explicit costs

22-36
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Figure 22-2 Simplified View of Economic and Accounting Profit

22-37
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (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

22-38
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Firms and Profits (cont'd)


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.

22-39
Copyright 2010 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.

22-40
Copyright 2010 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

22-41
Copyright 2010 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

22-42
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Interest (cont'd)
Nominal Rate of Interest
The market rate of interest expressed in todays dollars

Real Rate of Interest


The nominal rate of interest minus the anticipated rate of inflation

22-43
Copyright 2010 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 in = ir + anticipated inflation rate

22-44
Copyright 2010 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.
22-45
Copyright 2010 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.

22-46
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Interest (cont'd)
Present Value
The value of a future amount expressed in todays dollars The most that someone would pay today to receive a certain sum at some point in the future

22-47
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Interest (cont'd)
PV1 = FV1 / 1 + i
where
PV1 = Present value of a sum one year hence FV1 = Future sum paid or received one year hence i = Market rate of interest

22-48
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Interest (contd)
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

22-49
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Interest (contd)
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?
PV2 x (1.05)2 = $105 PV2 x $105 = $95.24 (105)2

22-50
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Table 22-3 Present Value of a Future Dollar

22-51
Copyright 2010 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

22-52
Copyright 2010 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.

22-53
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Corporate Financing Methods


When it all began1602
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
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Corporate Financing Methods (cont'd)


Share of Stock
A legal claim to a share of a corporations 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

22-55
Copyright 2010 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 bonds maturity date Bonds are issued in return for funds lent to the firm.

22-56
Copyright 2010 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.

22-57
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Corporate Financing Methods (contd)


Stocks
1. Stocks represent ownership. 2. Common stocks do not have a fixed dividend rate.

Bonds
1. Bonds represent debt.

2. Interest on bonds must always be paid, whether or not any profit is earned. 3. Stockholders can elect a board of 3. Bondholders usually have no voice in or directors, which controls the corporation. over management of the corporation. 4. Stocks do not have a maturity date; 4. Bonds have a maturity date on which the corporation does not usually the bondholder is to be repaid the face repay the stockholder. value of the bond. 5. All corporations issue or offer to sell 5. Corporations need not issue bonds. stocks. This is the usual definition of a corporation. 6. Stockholders have a claim against the property and income of a corporation 6. Bondholders have a claim against the after all creditors claims have been met. property and income of a corporation that must be met before the claims of stockholders. 22-58
Copyright 2010 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.

22-59
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

The Markets for Stocks and Bonds (cont'd)


Securities
Stocks and bonds

22-60
Copyright 2010 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

22-61
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

The Markets for Stocks and Bonds (cont'd)


Market Indexes DJIA S&P 500 FTSE 100 CAC 40 Nikkei Hang Seng
22-62
Copyright 2010 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 theory. The best forecast of tomorrows price is todays price plus the effect of any upward drift.

22-63
Copyright 2010 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.

22-64
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

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 firms condition defraud those who buy the firms stock even if they dont 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?
22-65
Copyright 2010 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

22-66
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

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?
22-67
Copyright 2010 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.
22-68
Copyright 2010 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.
22-69
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

You might also like