Rents, Profits and the Financial Environment of Business

1
Chapter 22

• Rents, Profits and the Financial Environment of
  Business

2
Objectives

• Differentiate between a plant, a firm, and an
  industry
• Define economic rent
• Compare 3 legal forms of business ownership
• Differentiate between economic profit and
  accounting profit
• Define interest and discuss its role in
  allocating resources
• Compute the discounted present value of money
• Distinguish between3 main methods of corporate
  financing

3
Breakdown of a countrys economy

• Economy
• Sector Major division
• Subsector Breakdown of sector
• Industry All firms producing
  same product
• Fim Legal organization that
  purchases inputs and
• converts the inputs
  into output to sell
• Plant, factory, office
  production site, at least one/firm
• Example Economy
• Agriculture sector
• Dairy subsector
• Cheese industry
• Charlies Cheese Company
• LaCrosse, WI factory, 1
  of 8 owned by Charlies

4
Relationships between firms

• Firms producing the same product have a
  horizontal relationship, are rivals in same
  market.
• Firms with buyer-seller relationship have a
  vertical relationship. A firm that conducts more
  than one stage of production process is
  vertically integrated.
• Firms that produce multiple, non-vertically
  related products are called conglomerates or
  diversified firms.

5
Economic Rent

• Payment to a supplier beyond price it would take
  to induce the supplier to provide that quantity
  to the market.
• Typically occurs when facing limit to quantity
  that can be supplied.
• Directs resources toward highest value use.
• Examples High salaries of movie stars and
  sports superstars

6
Economic Rent

• Price S
• 
  D2
• 
  D1
• 
  Quantity

7
3 Types of Firm Ownership

• Proprietorship One owner is responsible for all
  decisions, earns all profits, bears all risk.
• Partnership Two or more owners share
  responsibilities and profits, each bears all
  risk.
• Corporation (Limited) Legal entity that may
  conduct business in own name shareholders own
  shares of ownership and share profits, limited
  liability

8
Sole Proprietorship

• Advantages
• Easy to set up and resolve
• Owner has freedom on management
• Profit only taxed once
• An incentive to do better

• Disadvantages
• Limited Resources such as capital and knowledge
• End with death of the owner
• Unlimited liability brings greater risk

9
Partnership

• Advantages
• Quite easy to set up
• Income only taxed once
• More resources on capital than sole
  proprietorship
• Enjoy some degree of specialization

• Disadvantages
• Limited liability
• Hard to transfer ownership
• Conflict between partners
• Limited capital for a company to grow compared to
  corporation

10
Corporation

• Advantages
• Ability to raise funds easily
• High degree of specialization in management
• Limited liability
• Economics of scale possible
• Easy to transfer ownership

• Disadvantages
• Legal expenses
• Separation of ownership and control,
  principal-agent issues
• Double taxation of profits

11
Implicit vs Explicit Costs

• Total Cost Implicit Cost Explicit Cost
• Implicit Costs Opportunity cost of inputs for
  which a direct payment is not made
• Ex. Normal rate of return on capital
• Explicit Costs Direct payment is made for use
  of an input
• Ex. Wages paid

12
Profit

• Total Revenue Total Cost
• Losses are negative profits
• What counts as revenue and costs?
• Accounting Profit
• Total Revenue Explicit Costs
• Economic Profit
• Total Revenue (Implicit Explicit Costs)
• Total Revenue Total Costs

13
Assumption

• Goal of firm is profit maximization.

14
Interest

• Price paid/received for use of funds
• Borrowers pay interest to use funds they have not
  yet accumulated.
• Lenders receive interest in return for letting
  others use their funds.
• Interest rate on loan impacted by term, risk,
  handling charges.
• Nominal vs real rate of interest
• Nominal i-rate real i-rate expected inflation
  rate

15
Discounted Present Value of Money

• Would you prefer 100 today or in 1 year?
• Present value calculations adjust for differences
  in value of money over time.
• Provides current value of funds to be received in
  the future
• PV FV / ((1 i)t where
• PV present value of funds to be received in
  future
• FV future value, nominal value of funds to be
  received in future
• i interest rate used for discounting
• t number of years into the future when future
  funds to be received

16
Discounted present value of money

• For examples below, use interest rate of 4
• Example 200 to be received in 1 year
• 200 / (1.04)1 200 / 1.04 192.31
• Example 200 to be received in 2 years
• 200 / (1 .04)2 200 / 1.08 185.19

17
3 Methods to finance corporations

• Sell shares of stock
• Shares of ownership
• proportionate claim on future profit
• Proportionate vote electing directors
• Issue bonds
• Method of borrowing, legal debt alternative to
  bank loan
• Reinvest profits
• Alternative is distributing to owners

18
Corporation Finance

• Common Stock owner has certain voting rights
• Preferred Stock get fixed dividend before
  common stock owners
• Bond receives a fixed annual interest plus a
  lump sum payment at maturity date
• Reinvestment profits use to internal expand
  rather than pay out dividend

19
Compare Stock Bond

• Stock
• represents ownership
• Stockholders can elect a board of directors,
  which controls the corporation
• It does not have maturity date
• Stockholders have a claim against the property
  income after all creditors claims have been

• Bond
• Represents debt
• Bondholders have no voice over management
• Have a maturity date

20
Securities Markets

• Stocks and bonds are called securities
• Stock markets
• Initial public offering
• Resale in stock exchanges or OTC (over the
  counter) markets
• Bond markets
• Issue
• Secondary