Economics 7th Edition Hubbard Solutions Manual

Economics 7th Edition Hubbard
Solutions Manual
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CHAPTER 8 | Firms, the Stock Market, and
Corporate Governance
Brief Chapter Summary and Learning Objectives
8.1 Types of Firms (pages 254–258)
Categorize the major types of firms in the United States.
▪ There are three legal categories of firms: sole proprietorships, partnerships, and corporations.
▪ Owners of sole proprietorships and partnerships have unlimited liability. Owners of
corporations have limited liability.
8.2 How Firms Raise Funds (pages 258–266)

Explain how firms raise the funds they need to operate and expand.
▪ Owners of small businesses obtain funds for expansion by reinvesting profits, taking on
partners, or borrowing from relatives, friends, or banks.
▪ Firms raise external funds from financial intermediaries or through financial markets.
8.3 Using Financial Statements to Evaluate a Corporation (pages 266–267)

Describe the information corporations include in their financial statements.
▪ An income statement summarizes a firm’s revenues, costs, and profit over a period of
time. A firm’s balance sheet summarizes its financial position on a particular day.
8.4 Recent Issues in Corporate Governance Policy (pages 268–272)

Discuss the debate over corporate governance policy.
▪ Several scandals in the early 2000s involved top managers who inflated profits and hid
liabilities.
▪ Between 2007 and 2009 a problem in the market for home mortgages led to the worst
financial crisis since the Great Depression. In 2010, Congress overhauled regulation of
the financial system with the passage of the Wall Street Reform and Consumer
Protection Act.
Appendix: Tools to Analyze Firms’ Financial Information (pages 278–287)

Explain the concept of present value and describe the information contained on a firm’s
income statement and balance sheet.
Key Terms
Accounting profit, p. 267. A firm’s net income, Balance sheet, p. 267. A financial statement that
measured as revenue minus operating expenses sums up a firm’s financial position on a particular
and taxes paid. day, usually the end of a quarter or year.
Asset, p. 254. Anything of value owned by a Bond, p. 259. A financial security that represents
person or a firm. a promise to repay a fixed amount of funds.
Copyright © 2019 Pearson Education, Inc.

180 CHAPTER 8 | Firms, the Stock Market, and Corporate Governance
Corporate governance, p. 257. The way in Liability, p. 266. Anything owed by a person or
which a corporation is structured and the effect a firm.
that structure has on the corporation’s behavior.
Limited liability, p. 254. A legal provision that
Corporation, p. 254. A legal form of business shields owners of a corporation from losing
that provides owners with protection from losing more than they have invested in the firm.
more than their investment should the business
fail. Opportunity cost, p. 267. The highest-valued
alternative that must be given up to engage in an
Coupon payment, p. 259. An interest payment activity.
on a bond.
Partnership, p. 254. A firm owned jointly by
Direct finance, p. 259. A flow of funds from
two or more persons and not organized as a
savers to firms through financial markets,
corporation.
such as the New York Stock Exchange.
Dividends, p. 261. Payments by a corporation to Principal–agent problem, p. 258. A problem

its shareholders. caused by an agent pursuing his own interests
rather than the interests of the principal who
Economic profit, p. 267. A firm’s revenues hired him.
minus all of its implicit and explicit costs.
Separation of ownership from control, p. 257.
Explicit cost, p. 267. A cost that involves A situation in a corporation in which the top
spending money. management, rather than the shareholders,
controls day-to-day operations.
Implicit cost, p. 267. A nonmonetary
opportunity cost. Sole proprietorship, p. 254. A firm owned
by a single individual and not organized as a
Income statement, p. 266. A financial statement corporation.
that shows a firm’s revenues, costs, and profit
over a period of time. Stock, p. 261. A financial security that
represents partial ownership of a firm.
Indirect finance, p. 258. A flow of funds
from savers to borrowers through financial
Wall Street Reform and Consumer Protection
intermediaries such as banks. Intermediaries
Act (Dodd-Frank Act), p. 269. Legislation
raise funds from savers to lend to firms
passed during 2010 that was intended to
(and other borrowers).
reform regulation of the financial system.
Interest rate, p. 259. The cost of borrowing
funds, usually expressed as a percentage of the
amount borrowed.
Key Terms—Appendix
Present value, p. 278. The value in today’s Stockholders’ equity, p. 285. The difference
dollars of funds to be paid or received in the between the value of a corporation’s assets and
future. the value of its liabilities; also known as net
worth.

CHAPTER 8 | Firms, the Stock Market, and Corporate Governance 181
Chapter Outline
Is Snapchat the Next Facebook…or the Next Twitter?
When a firm grows large enough to be a public firm and sells stocks and bonds to investors, it has access
to greater financing but faces pressure from investors to earn profits. Twitter became a public company
with an initial public offering (IPO) in 2013. In early 2017, Twitter reported it had suffered losses and
struggled to increase its advertising revenue. During the same period Facebook earned a substantial profit.
Two Stanford undergraduates developed the Snapchat app, which allows photographs to disappear shortly
after being sent. Snapchat’s parent firm, Snap, became a public company with an IPO in 2017. Although
Snapchat is popular with teenagers, popularity is difficult to turn into revenue. Twitter and Snap, unlike
Facebook, have both struggled to convince firms to advertise on their apps.
Types of Firms (pages 254–258)

8.1 Learning Objective: Categorize the major types of firms in the United States.
In the United States, there are three legal categories of firms. A sole proprietorship is a firm owned by a
single individual and not organized as a corporation. A partnership is a firm owned jointly by two or
more persons and not organized as a corporation. Most law and accounting firms are partnerships. Most
large firms are organized as corporations. A corporation is a legal form of business that provides owners
with protection from losing more than their investment should the business fail.
A. Who Is Liable? Limited and Unlimited Liability

The owners of sole proprietorships and partnerships have unlimited liability, which means that there is no
legal distinction between the personal assets of the owners and the assets of the firm. An asset is anything
of value owned by a person or a firm. In the early 1800s, state legislatures in the United States began to
pass general incorporation laws that allowed firms to be more easily organized as corporations. Under the
corporate form of business, the owners have limited liability. Limited liability is a legal provision that
shields owners of a corporation from losing more than they have invested in the firm. The personal assets
of the owners of the firm are not affected if the firm fails. Limited liability makes it possible for
corporations to raise funds by issuing shares of stock to a large number of investors. Corporations have
some disadvantages. Corporate profits are taxed twice—once at the corporate level and again when
investors receive a share of corporate profits. Corporations are generally larger than sole proprietorships
and partnerships and, therefore, more difficult to organize and run.
B. Corporations Earn the Majority of Revenue and Profits

Although only 18 percent of all firms are corporations, corporations account for the majority of revenue
and profits earned by all firms.
C. The Structure of Corporations and the Principal–Agent Problem

Corporate governance is the way in which a corporation is structured and the effect that structure has on
the corporation’s behavior. Unlike the owners of family businesses, the management of a corporation
usually does not own a large share of the firm’s stock. Separation of ownership from control is a
situation in which the top management, rather than the shareholders, controls day-to-day operations. The
conflict between the interests of shareholders and the interests of top management is called the principal–
agent problem: A problem caused by an agent pursuing the agent’s interests rather than the interests of
the principal who hired the agent. To reduce the effects of the principal–agent problem, many boards of
directors in the 1990s began to tie the salaries of top managers to the firm’s profit or to the price of the
firm’s stock.

Teaching Tips
Corporations are often described as “publicly owned.” Be sure your students do not mistakenly believe
this phrase means “government owned.”
Extra Solved Problem 8.1

The Risks of Private Enterprise: The “Names” of Lloyd’s of London
The world famous insurance company Lloyd’s of London got its start in London in the 1600s. Ship
owners would come to Edward Lloyd’s coffeehouse to find someone to insure (or “underwrite”) their
ships and cargo for a fee. Coffeehouse customers—merchants and ship owners themselves—who agreed
to insure ships would make payments from their personal funds if a ship was lost at sea. By the late
1700s, each underwriter would recruit investors known as “Names” and use the funds raised to back
insurance policies sold to a wide variety of clients.
By the 1980s, 34,000 people around the world had invested in Lloyd’s as Names. A series of disasters in
the 1980s and 1990s—such as earthquakes and oil spills—resulted in huge payments made on Lloyd’s
insurance policies. It had become clear that Lloyd’s was not a corporation and the Names did not have the
limited liability that a corporation’s stockholders have. Many Names lost far more than they had invested.
Some of those who invested in Lloyd’s had the financial resources to absorb their losses, but others did
not. Tragically, as many as thirty Names may have committed suicide as a result of their losses. By 2015,
only about 770 Names remained invested in Lloyd’s. New rules allow insurance companies to underwrite
Lloyd’s policies for the first time and Names now provide less than 15 percent of Lloyd’s funds.
a. What characteristic of Lloyd’s of London’s business organization was responsible for the
financial losses suffered by the Names who had invested in Lloyd’s?
b. In the early 2000s, corporations such as Enron and WorldCom suffered severe losses after it was
discovered that executives of the firms had falsified financial statements to deceive investors.
How were the losses suffered by Enron and WorldCom stockholders different from the losses
suffered by Lloyd’s of London’s Names?
Solving the Problem

Step 1: Review the chapter material.
This problem is about firms and corporate governance, so you may want to review the section
“Types of Firms,” which begins on page 254 in the textbook.
Step 2: Answer (a) by explaining what characteristic of Lloyd’s of London’s business

organization was responsible for the financial losses suffered by the Names who
had invested in Lloyd’s.
Lloyd’s of London was a partnership. A disadvantage of partnerships, as well as sole
proprietorships, is the unlimited personal liability of the owners of the firm. The liability
Lloyd’s partners, or Names, incurred went beyond the amount of funds they invested in the
company. Therefore, when the insurance company was hit with a series of financial losses
some of the Names suffered severe financial losses.
Step 3: Answer (b) by explaining how the losses suffered by Enron and WorldCom
stockholders were different from the losses suffered by Lloyd’s of London’s Names.
Enron and WorldCom were corporations, so their stockholders had limited liability. Their
losses were limited to the amount they had invested in these firms.

How Firms Raise Funds (pages 258–266)

8.2 Learning Objective: Explain how firms raise the funds they need to operate and expand.
To earn a profit, a firm must raise funds to pay for its operations. If a small business is successful and the
owner decides to expand, it can obtain funds in three ways. First, the firm can reinvest its profits, called
retained earnings. Second, the owner can take on additional owners to invest in the firm to increase the
firm’s financial capital. Third, the owner can borrow funds from relatives, friends, or a bank.
A. Sources of External Funds

Unless firms rely on retained earnings, they must obtain the external funds they need from others. The
economy’s financial system transfers funds from savers to borrowers—directly through financial
markets or indirectly through financial intermediaries such as banks. Firms raise external funds in two
ways. The first option is called indirect finance. Indirect finance refers to a flow of funds from savers
to borrowers through financial intermediaries such as banks. Intermediaries raise funds from savers
and lend to firms (and other borrowers). The second way to acquire external funds is through financial
markets. Direct finance refers to a flow of funds from savers to firms through financial markets, such
as the New York Stock Exchange. A financial security is a document that states the terms under which
funds have passed from the buyer to the borrower. Bonds and stocks are the two main types
of financial securities. A bond is a financial security that represents a promise to repay a fixed amount
of funds. A coupon payment is an interest payment on a bond. The interest rate is the cost of
borrowing funds, usually expressed as a percentage of the amount borrowed. The interest rate on a
bond, or the coupon rate, is an interest payment on a bond divided by the amount borrowed. For
example, if the annual interest payment on a $1,000 bond is $40, then the interest rate is
$40
= 0.04, or 4%
$1,000
Many bonds that corporations issue have maturities of thirty years. The interest rate that a borrower
selling a bond has to pay depends on how likely bond buyers think that the bond seller is to default. The
higher the default risk on a bond, the higher the interest rate.
A stock is a financial security that represents partial ownership of a firm. When a corporation sells stock,
it is increasing its financial capital by bringing additional owners into the firm. A shareholder is entitled to
a share of the corporation’s profits. Many small investors buy shares of mutual funds rather than buying
stocks issued by individual companies. Mutual funds sell shares to investors and use the funds to invest in
a portfolio of financial assets. Small savers can use mutual funds to diversify, which lowers their
investment risk. Mutual funds can only be bought from or sold back to the firm that issues them.
Exchange-traded funds (ETFs) are similar to mutual funds but can be bought by and sold to other
investors in financial markets.
Corporations generally keep some of their profits as retained earnings. Remaining profits are distributed
to shareholders as dividends. Dividends are payments by a corporation to its shareholders. If investors
expect the firm to earn economic profits on its retained earnings, then the firm’s share price will rise,
providing a capital gain for investors. A corporation must make promised payments to bondholders before
it can make dividend payments to shareholders.
B. Stock and Bond Markets Provide Capital—and Information

Most buying and selling of stocks and bonds involves investors reselling existing stocks and bonds. There is
no single place where stocks and bonds are bought and sold. Some trading takes place in buildings called
exchanges. Computer technology has spread trading to securities dealers outside of exchanges. These
dealers comprise the over-the-counter market. Shares of stock represent claims on the profits of firms that
issue them. Changes in the prices of stocks, bonds, and other securities reflect investors’ future expectations.

Bonds represent claims to receive coupon payments and one final payment of principal. A bond that was
issued in the past may have its price increase or decrease, depending on whether the coupon payments
being offered on newly issued bonds are higher or lower than on existing bonds. If you hold a bond with a
coupon of $30 per year, and newly issued bonds have coupons of $40 per year, the price of your bond will
fall because it is less attractive to buyers. The price of a bond will also be affected by changes in default
risk, or investors’ perceptions of the issuing firm’s ability to make coupon payments.
Changes in the value of stocks and bonds offer information for a firm’s managers as well as investors. An
increase in the stock price means that investors are more optimistic about the firm’s profit prospects, and
the firm might want to expand as a result. A decrease in the firm’s stock price indicates that investors are
less optimistic about the firm’s profit prospects, so management might want to shrink the firm’s
operations. Changes in the value of a firm’s bonds imply changes in the cost of external funds to finance
the firm’s investment in research and development or in new factories.
C. The Fluctuating Stock Market

Stock market indexes are averages of stock prices, with the value of the index set equal to 100 in the base
year. The three most widely followed U.S. stock indexes are the Dow Jones Industrial Average, the
Standard and Poor’s (S&P) 500, and the NASDAQ composite index. All three indexes follow a roughly
similar pattern: Increases in stock prices during expansion and declines in stock prices when the U.S.
economy is in a recession.
Teaching Tips
The double taxation of corporate profits-once from the corporate profits tax and again from the income
tax on shareholders’ dividends-gives corporations the incentive to raise funds more through debt (bonds)
than equity (stocks). Some economists criticize the corporate profit tax for the incentive it gives
corporations to incur debt solely for the tax consequences of doing so.
Extra
Apply the Following Abercrombie & Fitch’s Stock Price in the Financial Pages
Concept
If you read the online stock listings on the Wall Street Journal’s Web site or from another source, you will
notice that the listings pack into a small space a lot of information about what happened to stocks during
the previous day’s trading. The following figure reproduces a small portion of the listings from the Wall
Street Journal on June 8, 2013, for stocks listed on the New York Stock Exchange. The listings provide
information on the buying and selling of stocks of five firms during the previous day. Let’s focus on the
highlighted listing for Abercrombie & Fitch, the clothing store, and examine the information in each
column:
• The first column gives the name of the company.
• The second column gives the firm’s “ticker” symbol (ANF), which you may have seen scrolling
along the bottom of the screen on cable financial news channels.
• The third column (Open) gives the price (in dollars) of the stock at the time when trading began,
which is 9:30 a.m., on the New York Stock Exchange. Abercrombie & Fitch opened for trading at
a price of $51.11.
• The fourth column (High) and the fifth column (Low) give the highest price and the lowest price
the stock sold for during that day.
• The sixth column (Close) gives the price the stock sold for the last time it was traded before the
close of trading (4:00 p.m.), which in this case was $51.70.

• The seventh column (Net Chg) gives the amount by which the closing price changed from the
closing price the day before. In this case, the price of Abercrombie & Fitch’s stock had risen by
$2.10 per share from its closing price the day before. Changes in Abercrombie & Fitch’s stock
price give the firm’s managers a signal that they may want to expand or contract the firm’s
operations.
• The eighth column (%Chg) gives the change in the price in percentage terms rather than in dollar
terms.
• The ninth column (Vol) gives the number of shares of stock traded on the previous day.
• The tenth column (52-Week High) and the eleventh column (52-Week Low) give the highest
price the stock has sold for and the lowest price the stock has sold for during the previous year.
These numbers tell how volatile the stock price is—how much it fluctuates over the course of the
year. In this case, Abercrombie’s stock had been quite volatile, rising as high as $55.23 per share
and falling as low as $28.64 per share. These large fluctuations in price are an indication of how
risky investing in the stock market can be.
• The twelfth column (Div) gives the dividend, expressed in dollars. In this case, 0.80 means that
Abercrombie paid a dividend of $0.80 per share.
• The thirteenth column (Yield) gives the dividend yield, which is calculated by dividing the
dividend by the closing price of the stock—the price at which Abercrombie’s stock last sold
before the close of trading on the previous day.
• The fourteenth column (PE) gives the P–E ratio (or price–earnings ratio), which is calculated by
dividing the price of the firm’s stock by its earnings per share. (Remember that because firms
retain some earnings, earnings per share is not necessarily the same as dividends per share.)
Abercrombie’s P–E ratio was 27, meaning that its price per share was 27 times its earnings per
share. So, you would have to pay $27 to buy $1 of Abercrombie & Fitch’s earnings.
• The final column (Year-to-Date %Chg) gives the percentage change in the price of the stock from
the beginning of the year to the previous day. In this case, the price of Abercrombie’s stock had
increased by 7.8 percent since the beginning of 2013.
Source: “Closing Quote Tables” from Wall Street Journal. Copyright © 2013 by Dow Jones & Company, Inc. Reproduced with
permission of Dow Jones & Company, Inc.

Using Financial Statements to Evaluate a Corporation (pages 266–267)

8.3 Learning Objective: Describe the information corporations include in their financial
statements.
Before a firm can sell new issues of stocks or bonds, it must provide investors with information about its
finances. To borrow money, firms must disclose financial information to the lender. In most high-income
countries, government agencies require firms that want to sell securities to disclose financial information
to the public. In the United States, the Securities and Exchange Commission (SEC) requires publicly
owned firms to report their performance according to generally accepted accounting principles.
Some private companies (for example, Moody’s Investor Service and Standard and Poor’s) collect
information from businesses and sell it to subscribers. Investors and the managers of firms need
information regarding the firm’s revenues and costs, as well as information regarding the value of the
property and other assets the firm owns and the firm’s debts or other liabilities it owes to others. A
liability is anything owed by a person or a firm. The information investors need to decide whether to buy
a firm’s stocks or bonds is contained in the firm’s financial statements.
A. The Income Statement

An income statement is a financial statement that shows a firm’s revenues, costs, and profit over a period
of time. The income statement starts with a firm’s revenue and subtracts its operating expenses and taxes.
Accounting profit is a firm’s net income, measured as revenue minus operating expenses and taxes paid.
Accounting profit neglects some of the firm’s costs. Economic profit is the firm’s revenues minus all of
its implicit and explicit costs. Because economic profit takes into account all costs it provides a better
indication than accounting profit of how successful a firm is. Economists always measure cost as
opportunity cost. Opportunity cost is the highest-valued alternative that must be given up to engage in an
activity. An explicit cost is a cost that involves spending money. An implicit cost is a nonmonetary
opportunity cost. The firm’s most important implicit cost is the opportunity cost to investors of the funds
they have invested in the firm. The minimum amount that investors must earn on the funds they invest,
expressed as a percentage of the funds invested, is called a nominal rate of return. If a firm fails to
provide at least a normal rate of return, it will not remain in business over the long run.
B. The Balance Sheet

A balance sheet is a financial statement that sums up a firm’s financial position on a particular day, usually
the end of a quarter or year. A balance sheet summarizes a firm’s assets and liabilities. Subtracting the value
of a firm’s liabilities from the value of its assets leaves its new worth. Net worth is what the firm’s owners
would be left with if the firm were closed, its assets sold, and its liabilities paid off.
Teaching Tips
Although it is a macroeconomic topic, your students may be interested in the role stock prices play as an
admittedly imperfect leading economic indicator. Changes in stock prices reflect firms’ expected future
performance. A sustained rise or decline in stock prices (as reflected in the Standard and Poor’s average
of 500 stocks or the Dow-Jones Industrial Average of 30 stocks) over several weeks or months can be an
early notice of a turning point in the business cycle from recession to expansion or expansion to recession,
respectively.

Extra
Apply the A Bull in China’s Financial Shop
Concept
Prospects for Sichuan Changhong Electric Co., manufacturer of plasma televisions and liquid crystal
displays, looked excellent in 2008, with rapidly growing output, employment, and profits earned from
trade in the world economy. And Changhong was not alone. In the 2000s, the Chinese economy was
sizzling. China’s output grew by 11.4 percent during 2007, dominated by an astonishing 24 percent
growth in investment in plant and equipment. The Chinese economic juggernaut caught the attention of
the global business community—and charged onto the U.S. political stage, as China’s growth fueled
concerns about job losses in the United States.
Yet at the same time, many economists and financial commentators worried that the Chinese expansion—
which was fueling rising living standards in a rapidly developing economy with 1.3 billion people—
would come to an end. The debate seemed to be over whether China’s boom would have a “soft landing”
(with gradually declining growth) or a “hard landing” (possibly leading to an economic financial crisis).
Why the debate? Although China’s saving rate was estimated to be a very high 40 percent of gross
domestic product (GDP)—double or triple the rate in most other countries—the financial system was
doing a poor job of allocating capital. Excessive expansion in office construction and factories was fueled
less by careful financial analysis than by the directions of national and local government officials trying to
encourage growth. With nonperforming loans—where the borrower cannot make promised payments to
lenders—at unheard-of levels, China’s banks were in financial trouble. Worse still, they continued to lend
to weak, politically connected borrowers.
China’s prospects for long-term economic growth depend importantly on a better developed financial
system to generate information for borrowers and lenders. Many economists have urged Chinese officials
to improve accounting transparency and information disclosure so that stock and bond markets can
flourish. In the absence of well-functioning financial markets, banks are crucial allocators of capital.
Information disclosure and less government direction of lending will help oil the Chinese growth machine
in the long run.
Chinese firms, like Changhong, may well play a major role on the world’s economic stage. But China’s
creaky financial system needs repair if Chinese firms are to grow rapidly enough to raise the standard of
living for Chinese workers over the long run.
Recent Issues in Corporate Governance Policy (pages 268–272)

8.4 Learning Objective: Discuss the debate over corporate governance policy.
Firms disclose financial statements in periodic filings to the federal government and in annual reports to
shareholders. The management of a firm has two reasons to attract investors and keep the firm’s stock
price high. First, a higher stock price increases the funds the firm can raise when it sells a given amount of
stock. Second, to reduce the principal–agent problem, boards of directors often tie the salaries of top
managers to the firm’s stock price. If managers make good decisions, the firm’s profits will be high and
its assets will be large relative to its liabilities. However, problems that surfaced during the early 2000s
revealed that some managers inflated profits and hid liabilities. At other firms, managers took on more
risk than they disclosed to investors.

A. The Accounting Scandals of the Early 2000s

In the early 2000s, top managers at some firms, such as Enron and WorldCom, falsified their firms’
financial statements to mislead investors about how profitable they were. The federal government
regulates how financial statements are prepared but cannot guarantee the accuracy of the statements. To
guard against future scandals new federal legislation was enacted. The Sarbanes-Oxley Act of 2002
requires that CEOs personally certify the accuracy of financial statements and that financial analysts and
auditors disclose whether conflicts of interest exist that would limit their independence.
Most observers acknowledge that the Sarbanes-Oxley Act increased confidence in the U.S. corporate
governance system, though problems during 2007–2009 at financial firms again raised questions of
whether corporations were adequately disclosing information to investors.
B. Corporate Governance and the Financial Crisis of 2007–2009

Beginning in 2007 and lasting into 2009, the U.S. economy suffered the worst financial crisis since the
Great Depression. At the heart of the crisis was a problem in the mortgage market. Beginning in the
1970s, financial institutions began securitizing mortgage loans. Mortgage-backed securities are similar to
bonds—buyers receive regular interest payments, which in this case come from the payments made on the
original mortgage loans. By the early 2000s, many mortgages were granted to sub-prime borrowers,
borrowers with flawed credit histories, and Alt-A borrowers, who failed to document that their incomes
were high enough to afford their mortgages. Fueled by the ease of obtaining a mortgage, housing prices
soared, but began falling in 2006. By 2007, many borrowers began to default on their mortgages, and
many financial institutions suffered heavy losses.
C. Government Regulation in Response to the Financial Crisis

During the crisis, many investors complained that they weren’t aware of how risky some of the assets on
the balance sheets of financial firms were. Some observers believed that the managers of many financial
firms misled investors about the riskiness of these assets. Congress passed the Wall Street Reform and
Consumer Protection Act (Dodd-Frank Act): Legislation passed during 2010 that was intended to
reform regulation of the financial system. The act created the Consumer Financial Protection Bureau to
write rules to protect consumers in their borrowing and investing activities. The act also established the
Financial Stability Oversight Council, to identify and act on risks to the financial system. In 2017,
President Trump argued that the provisions of the Dodd-Frank Act should be modified.
D. Did Principal–Agent Problems Help Cause the 2007–2009 Financial Crisis?

Beginning in the 1990s, private investment banks began to securitize mortgages. Investment banks had
traditionally concentrated on providing advice to corporations selling stocks and bonds and on
underwriting the issuance of stocks and bonds. Traditionally, Wall Street investment banks had been
organized as partnerships, but by 2000, all had become publicly traded corporations. With a publicly
traded corporation, the principal–agent problem can be severe. Some economists believe that the financial
crisis may not have occurred if investment banks had remained partnerships.

Extra Economics in Your Life & Career:

Are the Benefits of Improved Governance Greater than the Costs?
Question: Commercial and investment banks, mutual funds, and brokerage firms are often called
financial service firms. A review of the effects of the Dodd-Frank Act by an accountant included the
opinion that, “Clearly, the drive for improved governance in financial services will continue for years to
come.” What does the author mean by “improved governance”? Why has improved governance at
financial service firms been a significant policy issue?
Answer: One factor that caused the financial crisis of 2007–2009 was managers of large financial services
firms making risky investments than were not in the best interests of the firms’ shareholders. Some
economists argue that financial service firms should have done a better job of assessing the risks involved
in investing in mortgage-backed securities. Improved governance in this context refers to better aligning
the actions of top managers with the preferences of shareholders and in improving the assessment and
monitoring of investments.
Many economists believe that the Dodd-Frank Act has improved governance at financial service firms,
while other economists believe that the administrative costs the act imposes on firms may be greater than
any benefits from improved governance. Some economists have also criticized other provisions of the act
that restrict the monetary policy actions the Federal Reserve may take in a financial crisis. Only time will
determine whether the costs imposed on financial service firms will be worth the benefits of improved
governance.
Source: David Wright. “Dodd-Frank Four Years Later,” Wall Street Journal, January 28, 2015.
Extra AN INSIDE LOOK News Article to Use in Class

Visit www.myeconlab.com for current An Inside Look news articles.

Appendix
Tools to Analyze Firms’ Financial Information (pages 278–287)
Learning Objective: Explain the concept of present value and describe the information contained
on a firm’s income statement and balance sheet.
Large firms raise funds from outside investors, and outside investors seek information on firms and the
assurance that the firms’ managers will act in the interests of investors.
Using Present Value to Make Investment Decisions

If you own shares of stock or a bond, you will receive payments in the form of dividends or coupons over a
number of years. Most people value funds they already have more highly than funds they will receive in the
future. Present value is the value in today’s dollars of funds to be paid or received in the future. Say that you
are willing to lend $1,000 today if you are paid back $1,100 one year from now. In this case, you are charging
10 percent on the funds you have loaned. Economists would say that $1,000 today is equivalent to the
$1,100 to be received one year in the future. $1,100 can be written as $1,000 (1 + 0.10). Or:
$1,000 × (1 + 0.10) = $1,100
If we divide both sides of this equation by (1 + 0.10), we can rewrite this as
$1,100
$1,000 =
(1+ 0.10)
This formula states that the present value is equal to the future value to be received in one year divided by
one plus the interest rate. Writing the formula more generally:
Future Value1
Present Value =
(1 + i)
The present value of funds to be received in one year—Future Value1—can be calculated by dividing the
amount of those funds to be received by 1 plus the interest rate. The formula can be expanded to calculate
the value of funds to be received more than one year in the future. Suppose you are asked to lend
$1,000 for two years and are promised 10 percent interest per year. After two years, you will be paid back
$1,100 (1 + 0.10) or $1,210. Or:
$1,210 = $1,000 (1 + 0.10)(1 + 0.10),
or
$1,210 = $1,000 (1 + 0.10)2.
This formula can be rewritten as
$1,210
$1,000 =
(1 + 0.10) 2
We can generalize the concept to say that the present value of funds to be received n years in the future
equals the amount of funds to be received divided by the quantity 1 plus the interest rate raised to the nth
power. Or, more generally,
Future Valuen
Present Value =
(1 + i)n
where Future Valuen represents funds that will be received in n years.

A. Using Present Value to Calculate Bond Prices

The price of a financial asset, such as a bond, should be equal to the present value of the payments to be
received from owning the asset. The relevant interest rate used by investors in the bond market to
calculate the present value and, therefore, the price of an existing bond is usually the coupon rate on
comparable newly issued bonds. The general formula for the price of a bond is
Coupon1 Coupon 2 Coupon n Face Value
Bond Price = + + ... + +
(1 + i) (1 + i) 2
(1 + i) n
(1 + i)n
where Coupon1 is the coupon payment to be received after one year, Coupon2 is the coupon payment to be
received after two years, up to Couponn, which is the coupon received in the year the bond matures. The
ellipsis takes the place of the coupon payments received between the second year and the year the bond
matures. Face Value is the face value of the bond to be received when the bond matures. The interest rate
on comparable newly issued bonds is i.
B. Using Present Value to Calculate Stock Prices

The price of a share of stock should be equal to the present value of the dividends investors expect to
receive as a result of owning the stock.
The general formula for the price of a stock is

Dividend1 Dividend 2
Stock Price = + +…
(1+ i) (1+ i)2
Unlike a bond, a stock has no maturity date so the stock price is the present value of an infinite number of
dividend payments. Another difference between the stock formula and the bond price formula is that you
don’t know for sure what the dividend payments from owning stock will be.
C. A Simple Formula for Calculating Stock Prices

It is possible to simplify the formula for determining the price of a stock if we assume that dividends
grow at a constant rate:
Dividend
Stock Price =
(i − Growth Rate)
Dividend is the dividend investors expect to receive one year from now, and Growth Rate is the rate at
which dividends are expected to grow.
Going Deeper into Financial Statements

Key sources of information about a corporation’s profitability and financial position are its principal
financial statements—the income statement and the balance sheet.
A. Analyzing Income Statements

A firm’s income statement summarizes its revenues, costs, and profit over a period of time. Listed first
are the revenues the firm earned. Listed next are operating expenses, including the cost of revenue, which
is commonly known as cost of sales or cost of goods sold. The difference between a firm’s revenues and
its costs is its profit. A firm’s operating income is the difference between its revenue and its operating
expenses. Most corporations have interest expenses and income from investments, such as government
and corporate bonds. The federal government taxes the profits of corporations. The net income that firms
report on their income statements is referred to as their after-tax accounting profit.

B. Analyzing Balance Sheets

A firm’s balance sheet summarizes its financial position on a particular day, usually the end of a quarter
or year. Subtracting the value of a firm’s liabilities from the value of its assets leaves its net worth.
Because a corporation’s stockholders are its owners, net worth is often listed as stockholders’ equity.
Stockholders’ equity is the difference between the value of a corporation’s assets and the value of its
liabilities, which is also known as net worth. The value of a firm’s assets must equal the value of its
liabilities plus the value of stockholders’ equity. An important accounting convention holds that balance
sheets should list assets on the left side and liabilities and net worth, or stockholders’ equity, on the right
side. This means that the value of the left side of the balance sheet must always equal the value on the
right side. Included on the asset side of the balance sheet are current assets, which are assets that the firm
can convert into cash quickly, and goodwill, which represents the difference between the purchase price
of a company and the market value of its assets. Current liabilities are short-term debts such as accounts
payable, which is money owned to suppliers for goods received but not yet paid for, or bank loans that
will be paid back in less than one year. Long-term bank loans and the value of outstanding corporate
bonds are long-term liabilities.
Teaching Tips
Although the principal–agent problem is a serious one, managers who pursue their own goals at the
expense of the firm’s best interests invite the scrutiny of institutional investors such as mutual funds and
pension funds. Unlike many shareholders who have modest stock holdings, institutional investors often
hold a significant percentage of a firm’s outstanding shares. These large investors can demand that a
board of directors make strategic and personnel changes if a firm’s performance is unsatisfactory and they
can cause a drop in share prices by selling some or all of their stock holdings.

Solutions to End-of-Chapter Exercises
Types of Firms
8.1 Learning Objective: Categorize the major types of firms in the United States.
Review Questions
1.1 The three major types of firms in the United States are sole proprietorships, partnerships, and
corporations. A sole proprietorship is owned by a single individual who controls the firm with no
layers of management. A partnership is owned jointly by two or more persons who share the
work and share the risks. Both a sole proprietorship and a partnership have unlimited personal
liability and limited ability to raise funds. A corporation is a legal form of business that provides a
firm’s owners with limited liability and a greater ability to raise funds. A corporation has more
layers of management and is costly to organize.
1.2 Limited liability is a legal provision that shields owners of a corporation from losing more than they
have invested in the firm. The government grants this privilege to corporations because investors
are more likely to buy stock in a firm—thereby becoming part owners—if the investors’ losses are
limited to the amount they invest. Because, unlike with a sole proprietorship or a partnership, most
investors will not have a role in managing a corporation, they will be reluctant to become part
owners if they face unlimited liability for the corporation’s losses. Most economists believe that
limited liability laws help increase investment and the rate of economic growth. Because the
stockholders of a corporation can never lose more than the amount they invested in the firm, a firm
can raise more funds from a large number of investors if it is organized as a corporation.
1.3 Shares of stock represent partial ownership in large corporations, so that those who own stock
own the corporation and share in the company’s profits. Control of the corporation is possessed
by members of its board of directors who select managers responsible for the day-to-day
operations of the firm. Although stockholders legally own a corporation, they typically do not
control it. The principal–agent problem results when an agent pursues his or her own interests
rather than the interests of the principal who hired him or her. In a corporation, the managers of a
firm (the agents) may choose to pursue policies that benefit themselves rather than the firm’s
stockholders (the principals). Stockholders are interested in higher profits, but managers may be
more concerned with paying themselves higher salaries and building luxurious corporate offices,
which reduce profits. Because most shareholders are not aware of the daily operations of the firm,
they may be unaware of the choices managers make.
Problems and Applications

1.4 It depends on the type of business you are entering. Incorporation has the advantage of limited
liability but the disadvantage of additional taxes. If you choose not to form a corporation, then your
choice between a sole proprietorship and a partnership will depend on whether you will gain enough
by bringing in a partner or partners and sharing control and profits with them. A young entrepreneur
who starts a firm for the first time often chooses to organize the firm as a sole proprietorship.
1.5 Before the incorporation law was passed, owners of all businesses established in Connecticut had
unlimited liability. If a firm failed, the personal assets of firm owners were at risk. Under the
corporate form of business, if a firm fails owners will not lose more than the amount they invest in
the firm.

1.6 The person making this argument does not understand that stockholders in a corporation have
limited liability. Limited liability is the legal provision that shields owners of a corporation from
losing more than they have invested in the firm. Therefore, this person will not be responsible for
any other losses the firm may have. Holding stocks is risky because the value of the stocks may
go up or down, but the risk is limited to the amount invested.
1.7 Early in the nineteenth century, state legislatures in the United States began passing general
incorporation laws, allowing firms to be organized as corporations. These laws gave owners of
incorporated firms limited liability, making it possible for firms to raise funds by issuing shares of
stock to large numbers of investors. As a result, firms were able to raise enough funds to operate
railroads and other large-scale businesses.
1.8 a. Many large, existing firms are focused on improving existing goods and services because
they have established markets and the firms have expertise in producing these products. New
firms have incentives to establish markets with new “disruptive” innovations that have a high
risk of failure but, if successful, high profits.
b. Most economists recognize that new, innovative firms are vital to the future health of the U.S.
economy. Although 95 percent of new firms employ fewer than 20 workers, in recent years
they have created over 3 million jobs annually, over 80 percent of all new jobs. However, in
recent years there has been a decrease in the number of new business startups, a trend that
concerns economists who believe this could be one reason the U.S. economy is experiencing
a slowdown in technological progress.
1.9 a. The proposal would have (i) reduced the costs of forming a new business and (ii) compensated
states and localities that streamline licensing programs that discourage new business formation.
b. Some state and local government officials pass licensing requirements for occupations that do
not provide vital services because of lobbying efforts by existing firms that provide the same,
or similar, services. By restricting the entry of new firms existing firms face less competition
and earn higher profits.
1.10 The principal is the person who wants to get something done and hires an agent to do the job.
Seen in this way, the students are the principals, along with a state’s taxpayers, at least at public
universities. In effect, students hire the instructor to do a job that they can’t easily do by
themselves—to teach them about a subject such as economics. The principal–agent problem
arises if the instructor has her own best interests in mind, rather than those of the students or the
taxpayers. For example, the instructor might give exams and assignments that are too easy or too
hard from the point of view of the students, or spend time playing video games rather than
preparing for class.
1.11 Sales personnel have an incentive to receive the highest income possible for the least amount of
effort. The owner of the business would like his or her employees to make as many sales as
possible for the lowest possible pay. Paying sales personnel by commission better aligns the
objectives of the employees, whose activities are often difficult to monitor, with the objectives of
the owner than does paying a straight hourly wage. When paid by commission, the harder sales
personnel work, the larger their incomes.
1.12 Private equity firms do reduce problems of corporate governance by helping to establish a market
for corporate control, which can reduce principal–agent problems by providing a means to
remove top management that is failing to carry out the wishes of shareholders.

How Firms Raise Funds

8.2 Learning Objective: Explain how firms raise the funds they need to operate and expand.
Review Questions
2.1 Direct finance occurs when a firm obtains funds directly from savers through the stock or bond
market. Indirect finance occurs when firms obtain funds from savers indirectly through an
intermediary such as a bank. Borrowing money from a bank to buy a car is indirect finance, as the
bank channels the funds from its depositors to you. Borrowing money from your friend to buy a
car would be direct finance.
2.2 A bond is a loan because the firm promises to pay back the principal and interest to the
bondholder. A share of stock is not a loan but is instead the purchase of partial ownership of a
company itself. Unlike with a loan, the firm isn’t obliged to return the funds of an investor who
purchases the firm’s stock. The investor owns a share of the firm’s assets and has a claim on the
firm’s profits. Corporations must issue some shares, because someone must be the owner. When a
corporation wishes to raise more money, it will issue bonds if it believes it will be cheaper to
borrow the money than to promise a share of the future profits to an expanded set of owners.
2.3 Stock and bond markets provide information that helps investors anticipate what will happen to
the firm. If they are optimistic and think the firm will earn higher profits, they will bid up the
price of its stock. If they are pessimistic, then the price of the stock will fall. If they are
pessimistic and fear that the firm might suffer financial losses and default on its bond payments,
then investors will be less willing to buy the firm’s bonds, and the prices of the bonds will fall.
Optimism about the firm will increase the prices of the firm’s bonds. So, the successes and
failures of the firm will result in rising or falling prices for the firm’s stocks and bonds. Changes
in investor expectations about the firm’s likely future profitability will also affect the prices of the
firm’s stocks and bonds. Businesses can use these fluctuations in the prices of their stocks and
bonds to gauge investors’ views of the businesses’ prospects. In that way, stock and bond markets
provide information to businesses.

2.4 You would rather own the bonds because a firm losing money is unlikely to pay a dividend, and
if the firm goes bankrupt, the bondholders would be paid off before the stockholders.
2.5 You would be better off if you had bought stock because it will have increased in value, while the
interest the firm pays on the bonds will have remained the same.
2.6 Finding someone to borrow your money may be difficult. You would then need to check that
person’s credit, write a loan agreement, and repossess the car if the borrower fails to pay back the
loan. Banks specialize in these activities, so they can do them more efficiently than you can.
2.7 Snap’s initial public offering (IPO) occurred in the primary market because Snap sold newly
issued stocks directly to the public. It was an example of direct finance as Snap acquired external
funds through financial markets, as opposed to going through a financial intermediary.

2.8 a. Fitch’s top bond rating is AAA. Fitch Ratings must have had concerns about McDonald’s
ability to repay its debt. Such concerns could have been influenced by slow sales growth and
changes in top management at McDonald’s.
b. A lower debt rating would reflect a higher risk that McDonald’s might not repay its debt,
which would raise the interest rate investors would be willing to accept when buying the
company’s bonds. The higher interest rate would be required to compensate investors for the
higher risk of default.
2.9 Selling their services to investors would create a “free rider” problem. An investor who bought
the ratings services of S&P for the ABC Corporation would be free to share this information with
other investors. The ratings services would be unlikely to sell their ratings to enough investors to
be able to cover their costs.
2.10 a. Google’s stock price will fall because its expected future revenues and profits will have
fallen.
b. Google’s stock price will rise because Google’s after-tax profit will rise.
c. Google’s stock price will fall because expected future profits will fall. In these circumstances,
the board of directors is not likely to provide independent supervision of top management,
which will make the principal–agent problem worse.
d. Google’s stock price will rise because expected revenues and profits will rise.
e. Google’s stock price will fall because its profit was lower than expected. The higher expected
profit was already reflected in Google’s stock price, so the lower actual profit will cause
Google’s stock price to fall.
2.11 The statement is false. These shares were traded in the secondary market (the NASDAQ), so the
money went from the investors who had owned these shares to the investors who bought the
shares in the market. The money didn’t go to Microsoft.
2.12 Attempting to forecast stock prices is inherently difficult for anyone because stock prices are
based on expected future profitability. Forecasting stocks whose prices will rise in the future is
similar to forecasting the winner of the next year’s Super Bowl or World Series. Average
investors are at an even greater disadvantage because professional investors are forecasting future
stock prices as well. When these professional investors believe the price of a company’s stock
will change in the future they will react quickly by buying or selling the stock, which causes its
price to rise or fall. It’s important for investors to remember that all information currently
available about a firm is already reflected in the firm’s stock price. Only new information—
information that was not expected—will cause the price of the firm’s stock price to change, and
it’s difficult to expect things that are unexpected!
2.13 Warren Buffett advises individual (non-professional) investors to concentrate on buying shares of
mutual funds that charge relatively low fees. Mutual funds allow individuals to diversify their
investments so that a decline in the price of a single stock or bond can be offset by price increases
in other stocks or bonds. Another advantage of mutual funds is professional management. Fund
managers are well informed about the companies whose securities they trade and have an
incentive to earn high returns for their customers. By buying mutual funds—particularly index
mutual funds that hold a large portfolio of stocks or bonds—individuals can earn long-run
investment gains from investing in financial markets without having to acquire specialized
knowledge about firms or markets.

Using Financial Statements to Evaluate a Corporation

8.3 Learning Objective: Describe the information corporations include in their financial
statements.
Review Questions
3.1 An asset is anything of value that a firm owns (such as a building). A liability is a debt or
obligation owed by a firm (such as an unpaid electric bill).
3.2. A firm’s balance sheet is a snapshot of the firm’s assets and liabilities on a particular day (such as
the end of a quarter). A firm’s income statement summarizes its revenues, costs, and profit over a
period of time (such as a year).
3.3 An explicit cost is a cost that involves spending money; an implicit cost is a nonmonetary
opportunity cost. A firm has both explicit costs, such as the rent it pays for a warehouse, and
implicit costs, such as the opportunity cost of the services a sole proprietor supplies to her own
firm. Accounting profit is a firm’s revenue minus its operating expenses and taxes paid (explicit
costs); economic profit is a firm’s revenue minus all of its implicit and explicit costs.
3.4 Regardless of its accounting profit, a firm making a negative economic profit is not likely to
survive in the long run because it is not covering all of its implicit costs, such as the minimum
amount that investors must earn on the funds they have invested in the firm.

3.5 If he were to keep the money invested in bonds, Paolo would earn an interest rate of 4 percent per
year, which would be the opportunity cost of using the funds from selling his bonds to start his
restaurant. Paolo is correct in stating that this would be a less costly option than taking out a loan
that has a 6 percent interest rate. But it is not true that he doesn’t have to “pay anything” (that is,
incur any cost) to use the funds he receives from the sale of his bonds.
3.6 Their costs are the same. Even though Alfredo receives the pizza ovens for free, as the owner of
the restaurant he incurs an opportunity cost by using the ovens in his own business. There is an
opportunity cost because he is giving up the funds he could receive by leasing the ovens or by
selling them to some other pizza restaurant owner. Paolo’s costs of using the ovens are the same
as Alfredo’s. Once Paolo has purchased the ovens, his decision as the restaurant owner to use the
ovens in his own business means he incurs an opportunity cost equal to the funds he gives up by
not leasing or selling the ovens. As an individual, Alfredo is better off than Paolo because he was
given the ovens rather than having to buy them. But as a restaurant owner, Alfredo’s costs are no
lower than Paolo’s.
3.7 a. Accounting profit = revenues – explicit costs. Explicit costs are those that involve spending
money, which include $75,000 paid to assistants and $10,000 for utilities. Accounting profit
= $200,000 – $85,000 = $115,000.
b. Economic profit = revenue – opportunity cost (explicit cost + implicit cost). Implicit cost for
Dane includes $200,000 in forgone wages, $20,000 in forgone rent on his duplex, and interest
forgone by not selling his $1,000,000 in extraterrestrial gear and investing the funds. His
economic profits are negative because his opportunity costs exceed his revenues.

3.8 Snap’s initial public offering (IPO) was in 2017. Corporations must file annual reports with the SEC.
Snap was not obligated to submit annual reports to the SEC before it became a corporation in 2017.
3.9 a. By stating that a stock is “overvalued,” a person means that in his or her opinion the stock
price is higher than the firm’s expected future profitability would justify.
b. A firm’s stock might be overvalued despite the firm having “solid growth prospects” if
investors are too optimistic about the future profitability of the firm; for example, expecting
exceptional growth instead of solid growth.
Recent Issues in Corporate Governance Policy

8.4 Recent Issues in Corporate Governance Policy Learning Objective: Discuss the debate
over corporate governance policy.
Review Questions
4.1 The Sarbanes-Oxley Act of 2002 was intended to strengthen the reliability of corporate financial
reports. It was passed in reaction to the accounting fraud at companies such as Enron and
WorldCom.
4.2 The primary source of the problems was that financial firms began securitizing home mortgages
from “subprime” borrowers, who are borrowers with flawed credit histories, and “Alt-A”
borrowers, who did not document their incomes when applying for mortgages. When housing
prices began falling in 2006, many of these borrowers began to default on their mortgages,
causing some financial institutions to suffer heavy losses as securitized mortgage bonds
plummeted in value.

4.3 a. Corporate governance is the way in which a corporation is structured and the effect a
corporation’s structure has on the firm’s behavior. Corporations should be governed in the
interest of the corporation’s owners: its stockholders.
b. It is difficult to determine whether limiting the percentage of a firm’s stock that one person
can own is either “good” or “bad” governance. Allowing an individual to hold a large
percentage of stock could reduce the principal–agent problem because the individual would
have an incentive to encourage the corporation’s managers to pursue profit-maximizing
policies that would benefit all shareholders. On the other hand, an individual—or
individuals—who owns a large percentage of a firm’s stock could encourage managers to
pursue policies that are riskier than other shareholders believe is prudent. There is no
consensus among economists or business analysts as to the optimal maximum percentage of
shares a person should own that would minimize a corporation’s principal–agent problem.
4.4 Having members of the boards of director serve for longer periods could be bad news for
corporate governance if it means that stockholders now exert less influence on the board and the
functioning of the firm. Members of the board of directors may be less attentive to stockholder
desires if there is low turnover of board members. Having members of the board of directors
serve for longer periods could be good news for corporate governance if it is the result of
stockholders being pleased with the oversight of management by the current board. In addition,
long-serving board members may be more familiar with the firm and better able to judge whether
top managers are acting in the best interests of the stockholders.

4.5 a. The columnist refers to corporate governance: the way in which a corporation is structured
and the effect that structure has on the corporation’s behavior.
b. The columnist considered Snap’s governance to be “shareholder unfriendly” because Snap
issued only nonvoting shares in its initial public officering (IPO) in March 2017. This means
that people who bought shares of Snap stock would have no opportunity to participate in the
governance of the company. Shareholders who bought Snap’s stock expected that, despite its
governance structure, Snap would be a profitable firm. The investors anticipated the price of
the stock would increase over time.
4.6 a. Shareholders can “bail out” by selling some or all of the shares of stock they own.
b. Long-term shareholders are more willing to allow a corporation to invest in new products and
technology that yield little or no profit in the short run, but contribute to the firm’s long-term
profitability. Snap attempted to achieve its goal of maximizing its long-term profitability by
limiting Class C shares to its two cofounders and Class B shares to investors who had
provided funds to Snap prior to its IPO. Class B and Class C are the only shares that have
voting rights.
c. It could be argued that giving long-time shareholders greater influence in corporate
governance limits the ability of other investors to discipline corporate managers who fail to
pursue profit-maximizing strategies.
Suggestions for Critical Thinking Exercises

CT8.1 It is likely that at least some students have little familiarity with the details of stocks, bonds, and
corporations.
CT8.2 Any reasonable answer will probably suffice for this question. Non-business students will likely
have a difficult time with assets and liabilities so many will find this a challenging question.
CT8.3 The answer to this question will clearly depend upon the article that the student selects.

Solutions to Chapter 8 Appendix Exercises

Review Questions
8A.1 Money received at some future date is worth less than money received today because if you have
the money today, you can use it today to buy goods and services and receive benefits from them.
In addition, prices are likely to rise, so money received later will have less purchasing power.
Finally, there is some risk that you will not receive the money in the future. Present value =
Future value/(1 + interest rate). So, if the interest rate rises, the present value decreases.
Coupon1 Coupon 2 Coupon n Face Value

8A.2 Present Value = + + ... + +
(1 + i) (1 + i) 2
(1 + i)n (1 + i)n
$100 $100 $100 $1000
= + + ... + +
(1 + i) (1 + i) 2
(1 + i)10
(1 + i)10
8A.3 The present value of bond payments is generally much more certain. The coupon payments and
the face value are part of the bond contract, but the future dividends of the firm are not known
with certainty. In addition, bond payments are spread out over a specific number of years, but
stock dividends extend out toward infinity (or the life of the firm). The main similarity is that
both sets of future payments are discounted by dividing by (1 + interest rate) raised to the number
of years in the future that the payment will be received.
8A.4 Operating income = revenue – operating expenses. Operating income differs from net income
because it excludes both investment income (or loss) and income taxes. Net income and after-tax
accounting profit are equivalent terms.
8A.5 An income statement reflects the revenues, costs, and profits of a firm during one year (or some
other period of time). A balance sheet reflects the assets, liabilities, and equity of a firm at one
moment in time. Assets are listed on the left side of a balance sheet; liabilities and stockholders’
equity are listed on the right side.

8A.6 To find the present value of the bond, you must find the present value of each payment and then
add the payments. At an interest rate of 10 percent, the present value of the bond is:
$85 $1, 085
= $85 / (1.10 ) + $1, 085 / (1.10 ) = $77.27 + $896.69 = $973.96
2
+ 2
1.10 (1.10)
8A.7 a. Pierre-Paul’s contract was not worth $62 million in present-value terms because most of the
money will be received in future years and is therefore worth less in present-value terms. This
statement would be correct only if the interest rate equaled zero.
To find the present value of the contract, you must find the present value of each year’s
payment and then add the payments. At an interest rate of 10 percent, the present value of the
contract is:
$2,500,000 $17,500,000 $19,500,000 $17,500,000
$5,000,000 + + + + =
1.10 (1.10)2 (1.10)3 (1.10)4
$5,000,000 + $2,272,727 + $14,462,810 + 14,650,639 + $11,952,735 = $48,338,911

At an interest rate of 5 percent, the present value of the contract is:

$5,000,000 + $2,380,952 + $15,873,016 + $16,844,833 +$14,397,293 = $54,496,095
8A.8 a. If the winner had opted for the 25 annual payments, she would have received:
25 × $1,440,000 = $36,000,000.
b. At an interest rate of 10 percent the present value of the 25 payments would be calculated as
the sum of the present value of each of the 25 payments:
$1,440,000 $1,440,000 $1,440,000 $1,440,000 $1,440,000
+ + + + ... + = $13,070,938.
1 + 0.10 (1 + 0.10) 2
(1 + 0.10)3
(1 + 0.10) 4
(1 + 0.10)25
In this case, the lump sum payment of $18,000,000 has a greater present value than the
25 annual payments.
c. At an interest rate of 5 percent the present value of the 25 payments would be calculated as
the sum of the present value of each of the 25 payments:
$1,440,000 $1,440,000 $1,440,000 $1,440,000 $1,440,000
+ + + + ... + = $20,295,280.
1 + 0.05 (1 + 0.05) 2
(1 + 0.05) 3
(1 + 0.05) 4
(1 + 0.05)25
In this case, the 25 annual payments have a greater present value than the lump sum payment
of $18,000,000.
d. 6.24% gives a present value of almost exactly $18 million.
8A.9 The decision of which is more valuable depends on the rate of interest used in calculating the
present value. At a 10 percent interest rate, the present value in 2011 of the 25 one-year payments
of $1,193,248.20 would equal:
$1,193, 248.20 $1,193, 248.20 $1,193, 248.20 $ 1,193, 248.20
+ + + +
(1 + .10 ) (1 + .10 )
2
(1 + .10 )
3
(1 + .10 )
25
= $10,831,162.
The present value in 2000 of this $10,831,162 in 2011 would equal:
$10,831,162
= $3,786,256.
(1 + 0.10)11
So, at a 10 percent interest rate, Bonilla would have been wise to take the $5.9 million lump sum
in 2000.
At a 5 percent interest rate, the present value in 2011 of the 25 one-year payments of $1,193,248.20
would equal $16,817,573.98. The present value in 2000 of this $16,817,573.98 in 2011 would equal
$9,832,887. At a 5 percent interest rate, Bonilla would have been wise to take the 25 one-year
payments.
Dividend $2.00
8A.10 Stock price = = = $2/0.08 = $25. If the interest rate is 5 percent,
(i − Growth Rate) (0.10 − 0.02)
then the maximum price you would pay is $2/(0.05− 0.02) = $2/0.03 = $66.67. Stock prices will
rise when interest rates drop because the present value of the dividends investors receive will
increase.

8A.11 Interest rates on newly issued bonds are likely to rise as a result of inflation. This will cause the
price of your bond to fall.
8A.12 Values are in millions of dollars.
Revenue $24,622
Revenue from company restaurants 15,295
Revenue from franchised restaurants 9,327
Operating expenses $16,877
Cost of operating company-owned restaurants 12,699
General and administrative cost 2,460
Cost of restaurant leases 1,718
Operating income $7,745
Interest expense 885
Income before income taxes 7,372
Income taxes 2,180
Net income (accounting profit) $4,682
8A.13 Values are in millions of dollars.
Assets Liabilities
Current assets $4,761 Current liabilities $4,547
Property and equipment 4,534 Long-term liabilities 3,892
Goodwill 1,720 Total liabilities 8,439
Other assets 3,316 Stockholder’s equity 5,892
Total assets $14,331 Total liabilities and
stockholder’s equity $14,331
8A.14 Twitter’s current ratio (values are in millions of dollars) =

$4,747 million
= 8.1
$584 million
Firms with a low current ratio may have difficulty raising cash quickly if they need to pay off
their current liabilities.

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Economics 7th Edition Hubbard

8.2 How Firms Raise Funds (pages 258–266)

8.3 Using Financial Statements to Evaluate a Corporation (pages 266–267)

8.4 Recent Issues in Corporate Governance Policy (pages 268–272)

Appendix: Tools to Analyze Firms’ Financial Information (pages 278–287)

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Dividends, p. 261. Payments by a corporation to Principal–agent problem, p. 258. A problem

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Types of Firms (pages 254–258)

A. Who Is Liable? Limited and Unlimited Liability

B. Corporations Earn the Majority of Revenue and Profits

C. The Structure of Corporations and the Principal–Agent Problem

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Extra Solved Problem 8.1

Solving the Problem

Step 2: Answer (a) by explaining what characteristic of Lloyd’s of London’s business

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How Firms Raise Funds (pages 258–266)

A. Sources of External Funds

B. Stock and Bond Markets Provide Capital—and Information

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C. The Fluctuating Stock Market

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Using Financial Statements to Evaluate a Corporation (pages 266–267)

A. The Income Statement

B. The Balance Sheet

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Recent Issues in Corporate Governance Policy (pages 268–272)

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A. The Accounting Scandals of the Early 2000s

B. Corporate Governance and the Financial Crisis of 2007–2009

C. Government Regulation in Response to the Financial Crisis

D. Did Principal–Agent Problems Help Cause the 2007–2009 Financial Crisis?

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Extra Economics in Your Life & Career:

Extra AN INSIDE LOOK News Article to Use in Class

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Using Present Value to Make Investment Decisions

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A. Using Present Value to Calculate Bond Prices

B. Using Present Value to Calculate Stock Prices

The general formula for the price of a stock is

C. A Simple Formula for Calculating Stock Prices

Going Deeper into Financial Statements

A. Analyzing Income Statements

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B. Analyzing Balance Sheets

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Solutions to End-of-Chapter Exercises

Problems and Applications

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How Firms Raise Funds

Problems and Applications

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Using Financial Statements to Evaluate a Corporation

Problems and Applications

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Recent Issues in Corporate Governance Policy

Problems and Applications

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Suggestions for Critical Thinking Exercises