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

Chapter 22

Rents, Profits, and the Financial Environment of Business

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-2

Introduction

To own a seat on the NYSE you may have paid as little as $975,000, or as much as $3 million in 2005.

To understand why, we turn our attention to topics such as the NYSE and discounted present value.


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


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


Chapter Outline

• Economic Rent

• Firms and Profits

• Interest

• Corporate Financing Methods

• The Markets for Stocks and Bonds


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?


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.


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.


Figure 22-1 Economic Rent



• Economic rent to labor

Professional sports superstars

Rock stars

Movie stars

World-class models

Successful inventors and innovators



• 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.



• Economic rent and the allocation of resources

Economic rent allocates resources to their highest valued use.


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?


Table 22-1 Superstar Earnings


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.


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.


Firms and Profits (cont'd)

• The legal organization of firms

Proprietorship

Partnership

Corporation


Table 22-2 Forms of Business Organization


The Legal Organization of Firms

• Proprietorship

A business owned by one individual whoMakes the business decisions

Receives all the profits

Is legally responsible for all the debts of the firm


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



• Disadvantages of proprietorships

Unlimited LiabilityThe 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.



• Partnership

A business owned and managed by two or more co-owners, or partners, whoShare the responsibilities and the profits of

the firm

Are individually liable for all the debts of the partnership



• Advantages of partnerships

Easy to form and dissolve

Partners retain decision-making power

Permits more effective specialization

Profit is taxed only once



• Disadvantages of partnerships

Unlimited liability

Decision making more costly

Dissolution often occurs when a partner dies or leaves the firm.



• Corporation

A legal entity that may conduct business in its own name just as an individual does

The owners of a corporation, called shareholdersOwn shares of the firm’s profits

Enjoy the protection of limited liability



• 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.



• Advantages of corporations

Limited liability

Continues to exist when owner leaves the business

Raising large sums of financial capital



• Disadvantages of corporations

Double taxation Dividends

Portion of corporation’s profits paid to its owners (shareholders)

Separation of ownership and control


The Profits of a Firm

• Accounting Profit

Total revenue minus total explicit costs


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



• Implicit Costs

Expenses that managers do not have to pay out of pocket and hence do not normally explicitly calculateOpportunity cost of factors of production that

are owned

Owner-provided capital and owner-provided labor



• 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



• 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.



• 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.



• 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.



• Economic Profits

Total revenues minus total opportunity costs of all inputs used

The total of implicit and explicit costs


Figure 22-2 Simplified View of Economic and Accounting Profit



• 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



• 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.


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.


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


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


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?


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


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


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.


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.


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


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


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


Table 22-3 Present Value of a Future Dollar


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


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.


Corporate Financing Methods

• When it all began—1602

Dutch East India Company raised financial capital bySelling ownership shares (stock)

Using notes of indebtedness (bonds)

Some profits were retained for reinvestment


Corporate Financing Methods (cont'd)

• Share of Stock

A legal claim to a share of a corporation’s future profitsCommon stock

Incorporates certain voting rights regarding major policy decisions of the corporation

Preferred stock Owners are accorded preferential treatment in the

payment of dividends



• 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.



• 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.


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.

Stocks Bonds


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.


The Markets for Stocks and Bonds (cont'd)

• Securities

Stocks and bonds



• New York Stock Exchange (NYSE)

• Nasdaq

• London Stock Exchange (FTSE)

• Tokyo Stock Exchange

• Bombay Stock Exchange (BSE)

• Shanghai Stock Exchange


Market Indexes

• DJIA

• S&P 500

• FTSE 100

• CAC 40

• Nikkei

• Hang Seng


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.


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?



• 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.



• Random Walk Theory

The theory that there are no predictable trends in securities prices that can be used to “get rich quick.”



• 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


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.


Table 22-4 Reading Stock Quotes


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


Figure 22-3 The Price of a Seat on the New York Stock Exchange Since 1999


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.


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

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

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