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Chapter 8

ECO2023 Chapter Notes - Chapter 8: Income Statement, Investment, Balance Sheet


Department
Economics
Course Code
ECO2023
Professor
John Slattery
Chapter
8

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Microeconomics Chapter 8 Firms, the Stock Market, and Corporate Governance
8.1 Types of Firms
o Sole Proprietorship firm owned by a single individual. Most sole proprietorship are
small, some employ many workers and earn large profits
o Partnership A firm owned jointly by two or more persons. Most law and accounting
firms are partnerships
o Corporation legal form of business that provides owners with protection from losing
more than their investment in the firm should the business fail
o Who is Liable? Limited and Unlimited Liability
Key distinction among the three firms is that owners of sole proprietorships and
partnerships have unlimited
No legal distinction between the personal assets of the owners of the
firm and the assets of the firm
o Asset anything of value owned by a person or a firm
o Owners are not legally distinct from the firms they own
Under the corporate form of business, the owners of a firm have limited liability
If the firm fails, the owners can never lose more than the amount they
have invested in the firm.
Personal assets of the owners of the firm are not affected by the failure
of the firm
o Eyes of the law a corporation is a legal person, separate from
their owners
o Possible to raise funds by issuing shares of stock to large
numbers of investors
Corporate profits are taxed twice
One at the corporate level
Whe iestors i the fir reeie a share of the fir’s
profits
Generally are larger than sole proprietorships and partnerships, more
difficult to run
Corporations Earn the Majority of Revenue and Profits
The Structure of Corporation and the Principal-Agent Problem
Large corporations account for a majority of sales and profits in the
economy
o Iportat to ko ho the’re aaged
Corporate governance way a corporation is structured and the effect
that struture has o the orporatio’s ehaior
Corporations are legally owned by their shareholders
o Oers of the orporatio’s stok
Elect a board of directors to represent their interests
Appoints a CEO to run day to day operations
Separation of Ownership from Control top management, rather than
the shareholders, control day-to-day operations
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Principal-agent problem a problem caused by an agent pursuing his
own interest rather than the interest of the principal who hired him
o Tend to happen when top management pursue their own
interests rather than the interests of the principal who hired
them
8.2 How Firms Raise Funds
Firms must raise funds to pay for its operations, including paying its
employees or renting equipment
A central challenge for all firms is to raise funds needed to operate and
expand the business
o If you are making a profit, you could reinvest profits back into
your firm. Profits that are reinvested in a firm rather than taken
out of the fir ad paid to the fir’s oers are alled retained
earnings
o Raise funds by recruiting additional owners to invest in the firm.
This ould irease the fir’s fiaial apital
o You could borrow the funds from relatives, friends, or a bank
Sources of External Funds
o Indirect Finance relies on financial intermediaries such as
banks
Small businesses rely heavily on bank loans as their
primary source of external funds
o Direct Finance flow of funds from savers through firms
through financial markets
New York Stock Exchange
Financial security a document of the borrower selling
the lender that states the terms under which the funds
are passed from the buyer of security to the borrower
bonds and stocks
o Bonds financial securities that represent promises to repay a
fixed amount of funds
Interest on payments on a bond are coupon payments
Interest rate the cost of borrborrowing funds
Divide the coupon b the face value of the bond
Many bonds that corporation issues have terms or
maturities of 30 years
Interest rate that a corporation selling a bond has to
pay depends on how likely bond buyers think that the
corporation is to default or not make the promised
coupon or principal payments
The higher the default risk, the higher the interest rate
Investors can use ratings to decide how much risk they
are willing to accept when buying a bond
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