A Lecture Presentation in Power Point to accompany

A Lecture Presentation in Power. Point to accompany Exploring Economics Second Edition by Robert L. Sexton Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, Second Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0030342333 Copyright © 2002 by Thomson Learning, Inc.

Chapter 13 Business Organizations and Financial Markets Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n n Literally millions of firms exist in the United States, from huge corporations to small family-owned stores. Individual proprietorships are simply business enterprises owned by a single individual or household. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n More than 75 percent of businesses in the United States are proprietorships, yet they account for less than 7 percent of total revenues received by private businesses. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n n Proprietorships tend to be small businesses, although there are exceptions. One reason is that few individuals control the resources necessary to finance large-scale production operations. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n In many areas of economic activity, including much of manufacturing, the most efficient, lower cost firms are rather large, often with many millions of dollars of capital. Copyright © 2002 by Thomson Learning, Inc.

Forms of Business Enterprise, U. S. 1996 Form of Enterprise Proprietorship Partnerships Corporations Copyright © 2002 by Thomson Learning, Inc. Percent of Firms Percent of Revenues 73% 7 20 5% 6 89

13. 1 Different Forms of Business Organizations n Advantages of a proprietorship n n n owners have complete control over the business tend to be fewer legal obligations and fewer taxes Disadvantages of a proprietorship n n unlimited liability for the debts of the company difficulty of raising sufficient funds Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n One way of overcoming the problem of inadequate personal resources to operate a larger business is to form a partnership. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n Partnerships exist when n n two or more persons together own a business enterprise, and there is a formal or informal agreement between the partners as to how the business is to be operated and n how profits are to be distributed. n n Partnerships account for only about 6 percent of business revenues. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n Partnerships have several limitations. n n n The partnership agreement must be changed each time a partner dies or wants to sell her interest in the firm. Limitation of partnership agreement restricts the ability to amass large sums of capital. Partners are also personally liable for any losses, so there is a substantial element of risk in the partnership form of enterprise. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n Partnerships usually work best when the various principals know and trust each other well. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n Advantages of partnerships n n n relatively easy to set up provide easier access to funds than a proprietorship are not double taxed like corporations n income is only subject to personal income taxes and not corporate taxes Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n Disadvantages of a partnership n n each partner has unlimited liability for the company’s debt often legal complications when any change in ownership occurs Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n Corporations n n n generally owned by more than one person considered to be the equivalent of persons from a legal perspective. a life of its own, independent of that of its owners. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n n Corporations are the most dominant form of business enterprise in the United States. Fewer than 20 percent of firms are corporations, but they account for almost 90 percent of all revenues generated by private sector businesses. Corporations tend to be substantially larger than either proprietorships or partnerships. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n n A corporation that has less than 35 employees and has no foreign or corporate stockholders is called an S corporation. The unique feature of this type of corporation is that profits go directly to the owners like in proprietorships and partnerships. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n n This allows the owners to retain the benefits of limited liability and avoid double taxation from the earnings on profits. That is, the profits are taxed only once, as if they were the shareholder’s personal income. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n Advantages to corporations n Limited liability for any financial losses. corporation, as a "person" in its own right, solely responsible for its own debts. n owner’s liability limited to initial investment n n Continue indefinitely n n thousands or even millions of owners, as well as daily changes in ownership, without requiring any changes in the charter. Access to capital necessary for efficient operation Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n Disadvantages of corporations n double taxation first as corporate profits n second as shareholder’s income n n taxes on dividends or taxes on capital gains if the shares of stock increase in value separation of ownership and management. n The typical owner--the stockholder--has little voice in the making of decisions. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n n The typical manager may have interests that diverge more or less from those of the owners. But one should not make too much of this because executives tend to regard their firm's profits as the best measure of their own professional success. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n If managers fail to earn as high a rate of return as informed stockholders believe possible, the stockholders may revolt and seek a new set of executives. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n n Failure to earn a normal rate of return can also endanger the continued existence of a firm, for if it fails for long enough, a firm will be forced into bankruptcy and reorganization. Finally, a satisfactory profit is essential for continued expansion of the firm. Profits provide funds for expansion and make it easier to acquire additional capital. Copyright © 2002 by Thomson Learning, Inc.

13. 1 Different Forms of Business Organizations n Growth of the company not only increases managers' incomes but also enhances their prestige and power. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n n The owners of corporations own shares of stock in the company and are called stockholders. Each stockholder's ownership of the corporation and voting rights in the selection of corporate management is proportionate to the number of shares owned. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n n Shares of stock are bought and sold by individuals and institutions in the stock market, usually on one of the organized stock exchanges. The price that shares sell for will fluctuate (often many times a day) with changes in demand and/or supply. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n n Corporations sometimes use proceeds from new sales of stock to finance expansion of their activities. Two primary types of stock n n preferred stock common stock Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n Preferred stock n n Owners receive a fixed regular dividend payment; the payment remains the same regardless of the profits of the corporation. No dividends can generally be paid to holders of common stock until the preferred stockholders receive a specified fixed amount per share of stock, assuming that funds are available after the debts of the corporation are paid. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n Common stock n Owners are residual claimants. Share in profits after expenses are paid, including interest payments to debt obligations and dividend payments to preferred stock. n If corporation is sold or liquidated, receive assets after all debts are paid and preferred stockholders are paid a fixed amount per share. n n Dividends frequently vary with profits. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n Owners of common stock assume greater risks than preferred stockholders, doing so because the potential rewards are then greater if the company is in fact successful. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n n Individuals as well as institutions such as insurance companies, pension funds, mutual funds, trust departments of banks, and university and foundation endowment funds, all hold corporate stocks. General Motors, IBM, and Microsoft have millions of individual stockholders. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n Indirectly, millions more are involved in stocks through their interest in mutual funds, ownership of life insurance, vested rights in private pension funds, and so on. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n n Corporations obtain some of their initial financial capital (dollars used to buy capital goods) by selling stock. Growth in the financial resources n n n reinvesting profits that are earned in the business selling new shares of stock borrowing money Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n n While corporate borrowing takes different forms, corporations primarily borrow by issuing bonds. The holder of a bond is not a part owner of a corporation; rather, he is a creditor to whom the corporation has a debt obligation. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n The obligation to bondholders is of higher legal priority than that of stockholders. n n Before any dividends can be paid, even to owners of preferred stock, the interest obligations to bondholders must be met. If a company is liquidated, bondholders must be paid in full the face value of their bond holding before any disbursements can be made to stockholders. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n n Bondholders have greater financial security than stockholders, but receive a fixed annual interest payment, with no possibility to receive increased payments as the company prospers. The possibility of the value of a bond increasing greatly—a capital gain—is limited compared to that of stocks. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n n A company can get finances through plowbacks or reinvestment. Instead of using their profits to pay out dividends, a firm might take some of its profits and plow it back into the company for new capital equipment. Copyright © 2002 by Thomson Learning, Inc.

13. 2 Corporate Financing n n Refinancing is by far the most important source of funding—almost 65 percent of a firm’s finances come from reinvestment. Attractive to firms as a source of funds because issuing new stocks and bonds can be an expensive and lengthy process. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n n The two most important financial markets where savers can provide funds to borrowers are the stock market and the bond market. The values of securities (stocks and bonds) sold in financial markets change with expectations of benefits and costs. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n Expected corporate earnings, business conditions, the economic policies of the government, business conditions in foreign countries, and concern over inflation all influence the price of stocks (and, to a lesser extent, bonds). Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n During periods of rising securities markets, optimism is generally great, and businesses are more likely to invest in new capital equipment, perhaps financing it by selling new shares of stock at current high prices. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n n During periods of pessimism, stock prices fall, and businesses reduce expenditures on new capital equipment, partly because financing such equipment by stock sales is more costly. More shares have to be sold to get a given amount of cash, seriously diluting the ownership interest of existing stockholders. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n Economists consider the stock market a random walk. n Without illegal inside information or a lot of luck, it is very difficult to consistently pick winners in the stock market. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n n n Hot tips are only hot if you are one of only a few to know if a company's stock is going to rise. Once that news hits the street, it will cease to be a source of profit. In sum, if markets are operating efficiently, the current stock prices will reflect all available information, and consistent, extraordinary profit opportunities will not exist. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n Many financial analysts think that the best stock market strategy is to diversify, buying several different stocks, and holding them for long periods. n n You don't have to continue to pay commissions on additional trades. The stock market has historically outperformed other financial assets. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n n Most newspapers (and many Web sites) have a financial section that covers the prices of stocks so investors can have some of the information that they need to make their decisions to buy and sell stocks. Some investors watch this data by the second as they are trading in and out of stocks a number of times during the day. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n At the other extreme, some investors pick a good company and hold the stock for a long time hoping that it will give them a better return than other assets, like saving accounts. Copyright © 2002 by Thomson Learning, Inc.

Wall Street Journal Stock Table Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n Wall Street Journal’s stock tables explained: n n First column shows the stock’s highest price over the last 52 weeks. Second column shows the stock’s lowest price over the last 52 weeks. Third column shows the name of the stock. Fourth column shows the symbol for the stock. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n (continued) n Fifth column shows the dividend n n n annual amount the company has paid over the preceding year on each share of stock. Sixth column shows the yield, the dividend divided by the price of the stock. Seventh column shows the price-earnings (PE) ratio n price of the stock divided by the amount the company earned per share over the past year. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n (continued) n n Eighth column shows the previous trading day’s high for the stock. Ninth column shows the previous trading day’s low for the stock. Tenth column shows the previous trading day’s closing price for the stock. Eleventh column shows the net change in the stock price during the previous trading day. Copyright © 2002 by Thomson Learning, Inc.

13. 3 The Stock Market n Price earnings ratio n n Measure of how highly a stock is valued. Typical price earnings ratio is around 15. n If higher, the stock is relatively expensive in terms of its recent earnings. n n n The stock might be overvalued or investors are expecting share prices to rise in the future. If lower, the stock is either undervalued or investors may expect future earnings to fall. Copyright © 2002 by Thomson Learning, Inc.