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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 252–256)
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 256–263)

Explain how firms raise the funds they need to operate and expand.
 Owners of small businesses can obtain funds for expansion by reinvesting profits, taking
on partners, or borrowing from relatives, friends, or a bank.
 Firms can raise external funds by relying on financial intermediaries or through financial
markets.
8.3 Using Financial Statements to Evaluate a Corporation (pages 263–265)

Understand the information corporations include in their financial statements.
 An income statement sums up a firm’s revenues, costs, and profit over a period of time.
A firm’s balance sheet sums up its financial position on a particular day.
8.4 Corporate Governance Policy and the Financial Crisis of 2007–2009

(pages 265–269)
Explain the role that corporate governance problems may have played in the financial
crisis of 2007–2009.
 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 275–283)

Understand the concept of present value and the information contained on a firm’s income
statement and balance sheet.
Copyright © 2017 Pearson Education, Inc.

176 CHAPTER 8 | Firms, the Stock Market, and Corporate Governance
Key Terms
Accounting profit, p. 264. A firm’s net income, Indirect finance, p. 256. A flow of funds
measured as revenue minus operating expenses from savers to borrowers through financial
and taxes paid. intermediaries such as banks. Intermediaries
raise funds from savers to lend to firms
Asset, p. 252. Anything of value owned by a (and other borrowers).
person or a firm.
Interest rate, p. 257. The cost of borrowing
Balance sheet, p. 265. A financial statement funds, usually expressed as a percentage of the
that sums up a firm’s financial position on a amount borrowed.
particular day, usually the end of a quarter or
year. Liability, p. 264. Anything owed by a person or
a firm.
Bond, p. 256. A financial security that
represents a promise to repay a fixed Limited liability, p. 252. The legal provision
amount of funds. that shields owners of a corporation from losing
more than they have invested in the firm.
Corporate governance, p. 255. The way in
which a corporation is structured and the effect Opportunity cost, p. 264. The highest-valued
that structure has on the corporation’s behavior. alternative that must be given up to engage in an
activity.
Corporation, p. 252. A legal form of business
that provides owners with protection from losing Partnership, p. 252. A firm owned jointly by
more than their investment should the business two or more persons and not organized as a
fail. corporation.
Coupon payment, p. 257. An interest payment Principal-agent problem, p. 255. A problem

on a bond. caused by an agent pursuing his own interests
rather than the interests of the principal who
Direct finance, p. 256. A flow of funds from hired him.
savers to firms through financial markets,
such as the New York Stock Exchange. Separation of ownership from control, p. 255.
A situation in a corporation in which the top
Dividends, p. 259. Payments by a corporation to management, rather than the shareholders,
its shareholders. controls day-to-day operations.
Economic profit, p. 265. A firm’s revenues Sole proprietorship, p. 252. A firm owned
minus all of its implicit and explicit costs. by a single individual and not organized as a
corporation.
Explicit cost, p. 264. A cost that involves
spending money. Stock, p. 258. A financial security that
represents partial ownership of a firm.
Implicit cost, p. 264. A nonmonetary
opportunity cost. Wall Street Reform and Consumer Protection
Act (Dodd-Frank Act), p. 267. Legislation
Income statement, p. 264. A financial statement passed during 2010 that was intended to
that shows a firm’s revenues, costs, and profit reform regulation of the financial system.
over a period of time.

CHAPTER 8 | Firms, the Stock Market, and Corporate Governance 177
Key Terms—Appendix
Present value, p. 275. The value in today’s Stockholders’ equity, p. 281. 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 Outline
Is Twitter the Next Facebook?
A major decision for a successful media startup company is whether to remain a private firm, to become a
public firm, or to sell itself to a larger company. Firms such as Facebook, Twitter, Snapchat, and
Instagram have all faced this decision. Becoming a public firm provides access to greater financing, but
grants shareholders partial ownership of the firm and a share of its profits. Twitter made the transition to
become a public firm but despite having 300 million active users by 2015 advertisers were not convinced
that advertising on the firm’s site was effective. The ability of firms such as Facebook and Twitter to raise
funds in financial markets is crucial to the health of the economy.
Types of Firms (pages 252–256)

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 the 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

Most large corporations have a similar management structure. Corporate governance is the way in
which a corporation is structured and the effect that structure has on the corporation’s behavior.
Corporations are legally owned by their shareholders, the owners of the corporation’s stock. Shareholders
do not manage the firm directly but elect a board of directors to represent their interests. The board of
directors appoints a chief executive officer (CEO) to run day-to-day operations and may appoint other top
management. Managers may serve on the board of directors; they are referred to as inside directors.
Outside directors are directors who do not have a management role in the firm. The top management of a
large corporation does not generally own a large share of the firm’s stock, so there is a separation of
ownership from control: A situation in a corporation in which the top management, rather than the
shareholders, control day-to-day operations. The separation of ownership from control is an example of a
principal-agent problem: A problem caused by an agent pursuing his own interests rather than the
interests of the principal who hired him.
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 252 in the textbook.
Step 2: Answer part (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 part (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 256–263)

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 one or more partners who invest in the firm. 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 $60, 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 and sold to other investors
can be 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 as 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 an 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 Making
Following Abercrombie & Fitch’s Stock Price in the Financial
the
Pages
Connection
If you read the online stock listings on the Wall Street Journal’s Web site or on another site, 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 263–265)

8.3 Learning Objective: Understand 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 know to decide
whether to buy a firm’s stocks or bonds is contained in the firm’s financial statements.
A. The Income Statement

A firm’s 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, then 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 Making
the A Bull in China’s Financial Shop
Connection
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.
Corporate Governance Policy and the Financial Crisis of 2007–2009

8.4 (pages 265–269)
Learning Objective: Explain the role that corporate governance problems may have
played in the financial crisis of 2007–2009.
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. 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. At first, the securitization process was carried out by the Federal National
Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie
Mac”). Fannie Mae and Freddie Mac would buy mortgages granted to borrowers and bundle them into
securities that were sold to investors. In the 1990s, private financial firms began securitizing mortgages.
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.

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. In the fall of 2008, Fannie Mae and Freddie Mac were
brought under direct control of the government. In July 2010, Congress passed the Wall Street Reform
and Consumer Protection Act (Dodd-Frank Act), legislation 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.
C. 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. To address the risks of investment banking, Congress
passed the Glass-Steagall Act in 1933 to prevent firms from being both commercial banks and investment
banks. Congress repealed the Glass-Steagall Act in 1999. Many of the best-known financial firms, such as
Lehman Brothers and Bear Stearns, remained investment banks. Mortgage-backed securities originated
by investment banks were sold mostly to investors but investment banks retained some of the securities as
investments. When the prices of the securities declined in 2007, the investment banks suffered heavy
losses. Lehman Brothers declared bankruptcy, Merrill Lynch and Bear Stearns were sold to commercial
banks, and Goldman Sachs and Morgan Stanley became bank holding companies.
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:

Spreading the Risks of Stock Ownership
Question: Buying shares of stock would be risky even in the absence of principal-agent problems.
Shareholders enjoy limited liability but, unlike bonds, stock dividends are not always paid, and
shareholders always face the possibility that stock prices can fall below the level the shareholders paid for
them. Aside from buying shares of well-known companies, how can people with limited funds minimize
the risks involved in investing in stocks?
Answer: Many people choose to purchase stocks through mutual funds, which are professionally
managed investments that combine, or pool, the funds of many investors. Mutual fund managers can use
these pooled funds to buy a variety of stocks, rather than just one or two, to minimize the risk that a fall in
the price of one stock results in large losses. Mutual funds are sold through many investment firms, and
there are funds that specialize in different categories of financial instruments; for example, growth stocks
(stocks with high potential for earnings growth, but with a low potential for slow or negative growth),
stocks of firms in a particular industry, and stocks of firms headquartered in foreign countries. There are
also mutual funds that invest in bonds and short-term assets.
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 275–283)
Learning Objective: Understand the concept of present value and 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 Value n
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
8.1 Types of Firms

Learning Objective: Categorize the major types of firms in the United States.
Review Questions
1.1 A sole proprietorship is owned by a single individual and isn’t organized as a corporation. A
partnership is owned jointly by two or more persons and isn’t organized as a corporation. A
corporation is a legal form of business that provides a firm’s owners with limited liability.
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.
1.3 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.
1.4 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. So, although stockholders legally own a corporation, they typically do not
control it.
1.5 The principal-agent problem results when an agent pursues his own interests rather than the
interests of the principal who hired him. 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

1.6 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. The first
firm founded by a young entrepreneur is often a sole proprietorship.

1.7 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.
1.8 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 stock may go
up or down, but the risk is limited to the amount invested.
1.9 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.
1.10 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.
1.11 a. Licensing requirements for some professions, such as medical doctors, help to reassure the
public that competent individuals provide vital human services. However, many critics view
licensing requirements for other professions, such as yoga teachers and hair braiders, as
unnecessary given the non-vital nature of the services provided. Strict, and costly, licensing
requirements can serve as barriers to people entering the licensed professions and reduce the
rate of 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.
1.12 The principal is the person who wants to get something done and hires an agent to do the job.
Seen 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.

1.13 Top managers know more about how the company is run than do the firm’s shareholders. The
principal–agent problem might be overcome if shareholders had all the information about the
company and about the consequences of the actions taken by the firm’s managers that the
managers themselves possess.
1.14 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 the
sales personnel work, the larger their incomes.
1.15 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. Rather than a loan, a share of stock is the purchase of part ownership of a company
itself. The firm isn’t obliged to return the investor’s funds at any particular date; instead, 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, then 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
provided 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 are paid off before the stockholders.
2.5 You would be better off if you had bought the 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 Twitter’s initial public offering (IPO) occurred in the primary market because Twitter sold newly
issued stocks directly to the public. It was an example of direct finance as Twitter acquired
external funds through financial markets, as opposed to going through a financial intermediary.
2.8 a. Moody’s top bond rating is Aaa. Moody’s 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. So, 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 profits 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 profits were lower than expected. The higher expected
profits were already reflected in Google’s stock price, so the lower actual profits 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—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 Buffet 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: Understand 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 Paolo has forgotten to take into account the opportunity cost of keeping the money invested. If he
were to keep the money invested in bonds, he would earn an interest rate of 10 percent per year.
So, the opportunity cost of selling the bonds and using the funds to start a pizza restaurant is 10
percent per year. Therefore, selling the bonds is a more costly way of gaining funds to start his
business than is taking out a bank loan with a 7 percent interest rate.

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 Twitter’s initial public offering (IPO) was in 2013. Corporations must file annual reports with the
SEC. Twitter was not obligated to submit annual reports to the SEC before it became a
corporation in 2013.
3.9 a. By stating that a stock is “overvalued,” a person means that in his 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.
Corporate Governance Policy and the Financial Crisis of 2007–2009

8.4 Learning Objective: Explain the role that corporate governance problems may have
played in the financial crisis of 2007-2009.
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 like 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 Corporate governance is the way in which a corporation is structured and the effect a
corporation’s structure has on the firm’s behavior. Stronger corporate governance laws may
reduce the principal–agent problem and increase a corporation’s profitability and, therefore, its
value for shareholders.
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 lower 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 There are benefits and drawbacks to being a private firm rather than a public firm. One benefit to
being a private firm is that top managers can take a longer-term view and make decisions that
might reduce short-term profits but help the firm to succeed in the long run. Sometimes in public
firms, pressure from shareholders to earn higher profits in the short run makes it difficult for
managers to take a long-run view. Mr. Dell claimed that before the firm reverted to private
ownership the interests of shareholders were interfering with the interests of customers. He
believed that shareholders’ desire for short-term profits was limiting his ability to invest in new
technologies that would reduce profits in the short run but increase profits in the long run.
4.6 a. Investors in primary and secondary markets make decisions on which firms to invest in, when
to invest, how much to invest, and when to sell based on information about firms. If the
information is misleading, investors will invest less or, possibly, stop investing. Capital
markets depend on accurate information and can function poorly when information is
misleading.
b. Corporate boards of directors sometimes link top managers’ compensation to the
corporations’ stock price to lessen the principal-agent problem caused by the separation of
ownership from control. Linking compensation to stock prices provides managers with an
additional incentive to maximize shareholder profits because they share in those profits when
the firms’ stock prices increase. But tying compensation too closely to stock prices may cause
a firm’s management to maximize short-run profits over long-run profits or to commit
corporate fraud (“cooking the books”) to make the firm appear to be more profitable than it is
with the intention of artificially increasing the firm’s stock price.
Solutions to Real-Time Data Exercises

D8.1 The following data are from September 4, 2015.
(a) $88.26
(b) $2,386,416,245
(c) 27,038,480
(d) 2.27 billion (2,270,000,000)
(e) 0.012 (1.19%)

D8.2 The following graph shows performance of prices of stocks on the NASDAQ Index from
February 1971 to September 2015. The NASDAQ Composite Stock Index tracks stock prices for
over 2,500 companies. The table below the graphs describes how stock prices moved just before,
during, and just after recessions from 1957 to the present. Stock prices have typically declined
before recessions. Immediately following the ends of recessions, stock prices have typically risen,
although there are several exceptions. The movement of stock prices during recessions has been
quite varied.
Stock Prices
Stock Prices Stock Prices During After
Date of Recession Before Recession Recession Recession
August 1957 – April 1958 Declined Declined, then rose Rose
April 1960 – February 1961 Declined Rose and Declined, but Declined
generally rose
December 1969 – November 1970 Declined Declined, then rose Rose
November 1973 – March 1975 Stable Declined, then rose Rose
January 1980 – July 1980 Declined Rose, Declined, then rose Rose
July 1981 – November 1982 Stable Very volatile, but Declined
generally rose, declined
and then rose
July 1990 – March 1991 Declined Declined, then rose Rose
March 2001 – November 2001 Declined Declined, rose, declined, Rose
then rose
December 2007 – June 2009 Declined Declined Declined

D8.3 The following data are from September 2015:

a. Microsoft: $0.31
b. Apple: $0.52
c. Coca-Cola: $0.25
d. Facebook: none
A firm might not pay a dividend if it is not profitable, if it is earning only a very small profit, or if
it chooses to retain the profits to reinvest in itself. Investors might buy the stock of a firm that
does not pay a dividend if they believe the company has a good potential for future growth and
profits that will allow the firm to eventually pay a dividend.
D8.4
19-Jun-15
Company Morgan Stanley Citigroup Inc. PNC
Stock Symbol MS C PNC
Closing Price $ 39.37 $ 56.23 $ 97.13

latest dividend $ 0.15 $ 0.05 $ 0.51
number of shares 100 100 100
Value of shares $ 3,937.00 $ 5,623.00 $ 9,713.00
Total dividend $ 15.00 $ 5.00 $ 51.00
Stock price increase 5 percent 5 percent 5 percent
New Stock Price $ 41.34 $ 59.04 $ 101.99
Value of shares $ 4,133.85 $ 5,904.15 $ 10,198.65
Capital Gain $ 196.85 $ 281.15 $ 485.65
Dividend payments will not change as stock prices change. Shareholders will receive the per
share dividend times the number of shares they hold (100 shares in this example).
Solutions to Chapter 8 Appendix

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 enjoyment 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 goes down.

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, the bond payments are spread out over a specific number of years, but
the 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 add
them together. 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

1.10 (1.10) 2
8A.7 a. Hamilton’s contract was not worth $125 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. (Note: Hamilton was traded
to the Texas Rangers during the 2015 season.)
b. To find the present value of the contract, you must find the present value of each year’s
payment and add the payments. At an interest rate of 10 percent, the present value of the
contract is:
$15,000,000 $15,000,000 $23,000,000 $30,000,000 $30,000,000

$10,000,000     
1  .10  1  .10 
2
1  .10 
3
1  .10 
4
1  .10 
5
 $10,000,000  $13,636,364  $12,396,694  $17, 280, 240  $20, 490, 404  $18,627,640
 $92, 431,342

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

$15,000,000 $15,000,000 $23,000,000 $30,000,000 $30,000,000
$10,000,000     
1  .05 1  .05
2
1  .05
3
1  .05
4
1  .05
5
 $10,000,000  $14, 285,714  $13,605, 442  $19,868, 265  $24,681,074  $23,505,785

 $105,946, 280
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 $2/0.03 = $66.67. Following this pattern, a lower
interest rate means that stock prices should rise.
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 $27,441
Revenue from company restaurants 18,169
Revenue from franchised restaurants 9,272
Operating expenses $19,492
Cost of operating company-owned restaurants 15,288
General and administrative cost 2,507
Cost of restaurant leases 1,697
Total operating expenses $19,492
Operating income $7,949
Interest expense 577
Income before income taxes 7,372
Income taxes 2,614
Net income (accounting profit) $4,758
8A.13 Values are in millions of dollars.
Assets Liabilities
Current assets $4,169 Current liabilities $3,039
Property and equipment 3,519 Long-term liabilities 2,441
Goodwill 856 Total liabilities 5,480
Other assets 2,209 Stockholder’s equity 5,273
Total assets $10,753 Total liabilities and
stockholder’s equity $10,753
8A.14 Twitter’s current ratio (values are in millions of dollars) =
$4,256 billion
 10.8
$394 billion
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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8.2 How Firms Raise Funds (pages 256–263)

8.3 Using Financial Statements to Evaluate a Corporation (pages 263–265)

8.4 Corporate Governance Policy and the Financial Crisis of 2007–2009

Appendix: Tools to Analyze Firms’ Financial Information (pages 275–283)

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Coupon payment, p. 257. An interest payment Principal-agent problem, p. 255. A problem

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Types of Firms (pages 252–256)

A. Who Is Liable? Limited and Unlimited Liability

B. Corporations Earn the Majority of Revenue and Profits

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

Extra Solved Problem 8.1

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Solving the Problem

How Firms Raise Funds (pages 256–263)

A. Sources of External Funds

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B. Stock and Bond Markets Provide Capital—and Information

C. The Fluctuating Stock Market

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Copyright © 2017 Pearson Education, Inc.

Using Financial Statements to Evaluate a Corporation (pages 263–265)

A. The Income Statement

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B. The Balance Sheet

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Corporate Governance Policy and the Financial Crisis of 2007–2009

A. The Accounting Scandals of the Early 2000s

B. The Financial Crisis of 2007–2009

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

Extra Economics in Your Life:

Extra AN INSIDE LOOK News Article to Use in Class

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Using Present Value to Make Investment Decisions

$1,000 × (1 + 0.10) = $1,100

$1,210 = $1,000 (1 + 0.10)(1 + 0.10),

$1,210 = $1,000 (1 + 0.10)2.

This formula can be rewritten as:

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where Future Valuen represents funds that will be received in n years.

A. Using Present Value to Calculate Bond Prices

Coupon1 Coupon 2 Coupon n Face Value

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

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Going Deeper into Financial Statements