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3. 7 CHAPTER Firms,the Stock Market, and Corporate Governance When Mark Zuckerberg started Facebook in 2004, he was still a sophomore in college. Just five years later, Facebook had 150 million users. Prepared by: Fernando Quijano

4. 7 CHAPTER Chapter OutlineandLearning Objectives Firms,the Stock Market, andCorporate Governance

5. 7.1 LEARNING OBJECTIVE Categorize the major types of firms in the United States. Types of Firms • 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.

6. 7.1 LEARNING OBJECTIVE Categorize the major types of firms in the United States. Types of Firms Who Is Liable? Limited and Unlimited Liability • Asset Anything of value owned by a person or a firm. • Limited liability The legal provision that shields owners of a corporation from losing more than they have invested in the firm. Table 7-1 Differences among Business Organizations

7. 7.1 LEARNING OBJECTIVE Categorize the major types of firms in the United States. Types of Firms Corporations Earn the Majority of Revenue and Profits FIGURE 7-1 Business Organizations: Sole Proprietorships, Partnerships, and Corporations The three types of firms in the United States are sole proprietorships, partnerships, and corporations. Panel (a) shows that only 19 percent of all firms are corporations. Yet, as panels (b) and (c) show, corporations account for a large majority of the total revenue and profits earned by all firms.

8. 7.1 LEARNING OBJECTIVE MakingtheConnection • YOUR TURN:Test your understanding by doing related problem 1.6 at the end of this chapter. Categorize the major types of firms in the United States. • How Important Are SmallBusinesses to the U.S. Economy? Entrepreneurs founding small firms have been the source of many of the most important new goods and services available to consumers. In a typical year, 40 percent of new jobs are created by small firms like Yelp.com, which is a community-based review and directory website founded by Jeremy Stoppelman, left, and Russel Simmons.

9. 7.2 LEARNING OBJECTIVE Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principal–agent problem. The Structure of Corporationsand the Principal–Agent Problem Corporate governance The way in which a corporation is structured and the effect a corporation’s structure has on the firm’s behavior. Corporate Structure and Corporate Governance Separation of ownership from controlA situation in a corporation in which the top management, rather than the shareholders, control day-to-day operations. Principal–agent problem A problem caused by an agent pursuing his own interests rather than the interests of the principal who hired him.

10. 7.2 LEARNING OBJECTIVE • YOUR TURN:For more practice, do related problems 2.4 and 2.5 at the end of this chapter. 7-2 Solved Problem Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principal–agent problem. Does the Principal–Agent Problem Apply to the Relationship between Managers and Workers? Briefly explain whether you agree with the following argument: The principal–agent problem applies not just to the relationship between shareholders and top managers. It also applies to the relationship between managers and workers. Just as shareholders have trouble monitoring whether top managers are earning as much profit as possible, managers have trouble monitoring whether workers are working as hard as possible.

11. 7.3 LEARNING OBJECTIVE Explain how firms raise the funds they need to operate and expand. How Firms Raise Funds As the owner of a small business, you can raise the funds for an expansion in three ways: • If you are making a profit, you could reinvest the profits back into your firm. Profits that are reinvested in a firm rather than taken out of a firm and paid to the firm’s owners are retained earnings. • You could raise funds by recruiting additional owners to invest in the firm • Finally, you could borrow the funds from relatives, friends, or a bank.

12. 7.3 LEARNING OBJECTIVE Explain how firms raise the funds they need to operate and expand. How Firms Raise Funds Sources of External Funds 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). Direct finance A flow of funds from savers to firms through financial markets, such as the New York Stock Exchange.

13. 7.3 LEARNING OBJECTIVE Explain how firms raise the funds they need to operate and expand. How Firms Raise Funds Sources of External Funds Bonds Bond A financial security that represents a promise to repay a fixed amount of funds. Coupon payment An interest payment on a bond. Interest rate The cost of borrowing funds, usually expressed as a percentage of the amount borrowed.

14. 7.3 LEARNING OBJECTIVE Explain how firms raise the funds they need to operate and expand. How Firms Raise Funds Sources of External Funds Stocks Stock A financial security that represents partial ownership of a firm. Dividends Payments by a corporation to its shareholders.

15. 7.3 LEARNING OBJECTIVE • YOUR TURN:Test your understanding by doing related problem 3.10 at the end of this chapter. Explain how firms raise the funds they need to operate and expand. How Firms Raise Funds Stock and Bond Markets Provide Capital—and Information Changes in the value of a firm’s stocks and bonds offer important information for a firm’s managers, as well as for investors. A higher bond price indicates a lower cost of new external funds, while a lower bond price indicates a higher cost of new external funds. Don’t Let This Happen to YOU!When Google Shares Change Hands, Google Doesn’t Get the Money

16. How Firms Raise Funds 7.3 LEARNING OBJECTIVE Explain how firms raise the funds they need to operate and expand. Why Do Stock Prices Fluctuate So Much? Movements in Stock Market Indexes, 1995–mid-2009 The performance of the U.S. stock market is often measured by market indexes, which are averages of stock prices. The three most important indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ. During the period from 1995 to mid-2009, the three indexes followed similar patterns, rising when the U.S. economywas expanding and falling when the economy was in recession.

17. 7.3 LEARNING OBJECTIVE MakingtheConnection • YOUR TURN:Test your understanding by doing related problem 3.11 at the end of this chapter. Explain how firms raise the funds they need to operate and expand. • Following Abercrombie & Fitch’sStock Price in the Financial Pages

18. 7.4 LEARNING OBJECTIVE Understand the information provided in corporations’ financial statements. Using Financial Statementsto Evaluate a Corporation Liability Anything owed by a person or a firm. The Income Statement Income statement A financial statement that sums up a firm’s revenues, costs, and profit over a period of time. Getting to Accounting Profit Accounting profit A firm’s net income, measured by revenue minus operating expenses and taxes paid.

19. 7.4 LEARNING OBJECTIVE Understand the information provided in corporations’ financial statements. Using Financial Statementsto Evaluate a Corporation The Income Statement . . . And Economic Profit Opportunity cost The highest-valued alternative that must be given up to engage in an activity. Explicit cost A cost that involves spending money. Implicit cost A nonmonetary opportunity cost. Economic profit A firm’s revenues minus all of its implicit and explicit costs.

20. 7.4 LEARNING OBJECTIVE Understand the information provided in corporations’ financial statements. Using Financial Statementsto Evaluate a Corporation The Balance Sheet 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.

21. 7.5 LEARNING OBJECTIVE Understand the role of government in corporate governance. Corporate Governance Policy The Accounting Scandals of the Early 2000s The landmark Sarbanes-Oxley Act of 2002 requires that CEOs personally certify the accuracy of financial statements. The Sarbanes-Oxley Act also requires that financial analysts and auditors disclose whether any conflicts of interest might exist that would limit their independence in evaluating a firm’s financial condition.

22. 7.5 LEARNING OBJECTIVE 7-5 Solved Problem What Makes a Good Board of Directors? • YOUR TURN:For more practice, do related problems 5.3 and 5.4 at the end of this chapter. Understand the role of government in corporate governance. • What is an “independent outsider” on a board of directors? • Why is it good for a firm to have a large majority of independent outsiders on the board of directors? • Why would it be good for a firm to have the auditing and compensation committees composed of outsiders? • Why would it be good for a firm if its directors own the firm’s stock?

23. 7.5 LEARNING OBJECTIVE Corporate Governance Policy Understand the role of government in corporate governance. The Financial Meltdown of the Late 2000s Beginning in 2007 and lasting into 2009, the U.S. economy suffered through the worst financial crisis since the Great Depression of the 1930s. At the heart of the crisis was a problem in the market for home mortgages. Fueled by the ease of obtaining a mortgage, housing prices in the United States soared before beginning a sharp downturn in mid-2006. By 2007, many borrowers—particularly subprime and Alt-A borrowers—began to default on their mortgages. This was bad news for anyone owning mortgage-backed securities because the value of these securities depended on steady payments being made on the underlying mortgages.

24. 7.5 LEARNING OBJECTIVE MakingtheConnection • YOUR TURN:Test your understanding by doing related problem 5.8 at the end of this chapter. Understand the role of government in corporate governance. • Was the Principal–Agent Problem • at the Heart of the Financial Crisis? Congress repealed the Glass-Steagall Act in 1999, after which some commercial banks began engaging in investment banking. Traditionally, Wall Street investment banks had been organized as partnerships, but by 2000 they had all converted to being publicly traded corporations. With a publicly traded corporation, the principal–agent problem can be severe. Did principal–agent problems lay low this Wall Street bull?

25. AN INSIDE LOOK The Principal–Agent Problem at Facebook >> Facebook Founder Puts Idealism Before Profits The Growth of Facebook.

26. KEY TERMS Income statement Indirect finance Interest rate Liability Limited liability Opportunity cost Partnership Principal–agent problem Separation of ownership from control Sole proprietorship Stock Accounting profit Asset Balance sheet Bond Corporate governance Corporation Coupon payment Direct finance Dividends Economic profit Explicit cost Implicit cost

27. LEARNING OBJECTIVE Appendix Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. Using Present Value to Make Investment Decisions • Tools to Analyze Firms’ Financial Information Present value The value in today’s dollars of funds to be paid or received in the future.

28. LEARNING OBJECTIVE Appendix 7A-1 Solved Problem How to Receive Your Contest Winnings • YOUR TURN:For more practice, do related problems 7A-6, 7A-8, 7A-9 and 7A-10 at the end of this chapter. Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. Suppose you win a contest and are given the choice of the following prizes: Prize 1: $50,000 to be received right away, with four additional payments of $50,000 to be received each year for the next four years Prize 2: $175,000 to be received right away Explain which prize you would choose and the basis for your decision.

29. LEARNING OBJECTIVE Appendix Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. Using Present Value to Make Investment Decisions • Tools to Analyze Firms’ Financial Information Using Present Value to Calculate Bond Prices

30. LEARNING OBJECTIVE Appendix Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. Using Present Value to Make Investment Decisions • Tools to Analyze Firms’ Financial Information Using Present Value to Calculate Stock Prices A Simple Formula for Calculating Stock Prices

31. LEARNING OBJECTIVE Appendix Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. Tools to Analyze Firms’ Financial Information • Going Deeper into Financial Statements Analyzing Income Statements FIGURE 7A-1 Google’s Income Statement for 2008 Google’s income statement shows the company’s revenue, costs, and profit for 2008. The difference between its revenue ($21,796 million) and its operating expenses ($16,258 million) is its operating income ($5,538 million). Most corporations also have investments, such as government or corporate bonds, that generate some income for them. In this case, Google earned $316 million, giving the firm an income before taxes of $5,854 million. After paying taxes of $1,627 million, Google was left with a net income, or accounting profit, of $4,227 million for the year.

32. LEARNING OBJECTIVE Appendix Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. Tools to Analyze Firms’ Financial Information • Going Deeper into Financial Statements Analyzing Balance Sheets Stockholders’ equity The difference between the value of a corporation’s assets and the value of its liabilities; also known as net worth. Assets = Liabilities + Stockholders’ Equity

33. LEARNING OBJECTIVE Appendix Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. Tools to Analyze Firms’ Financial Information • Going Deeper into Financial Statements Analyzing Balance Sheets FIGURE 7A-2 Google’s Balance Sheet as of December 31, 2008 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 on the right side of the balance sheet. Therefore, the value of the left side of the balance sheet must always equal the value of the right side. Note: All values are in millions of dollars.

34. KEY TERMS Present value Stockholders’ equity