A Lecture Presentation

in PowerPoint
to accompany
Exploring Economics
Second Edition
by Robert L. Sexton
Copyright © 2002 Thomson Learning, Inc.
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Printed in the United States of America
ISBN 0030342333

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 Chapter 13
Business Organizations and
Financial Markets

Copyright © 2002 by Thomson Learning, Inc.

 13.1 Different Forms of Business
Organizations
 Literally millions of firms exist in the
United States, from huge corporations
to small family-owned stores.
 Individual proprietorships are simply
business enterprises owned by a single
individual or household.

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 13.1 Different Forms of Business
Organizations
 More than 75 percent of businesses in
the United States are proprietorships,
yet they account for less than 7 percent
of total revenues received by private
businesses.

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 13.1 Different Forms of Business
Organizations
 Proprietorships tend to be small
businesses, although there are
exceptions.
 One reason is that few individuals
control the resources necessary to
finance large-scale production
operations.

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 13.1 Different Forms of Business
Organizations
 In many areas of economic activity,
including much of manufacturing, the
most efficient, lower cost firms are
rather large, often with many millions of
dollars of capital.

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 Forms of Business Enterprise, U.S. 1996

Form of Percent of Percent of

Enterprise Firms Revenues
Proprietorship 73% 5%
Partnerships 7 6
Corporations 20 89

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 13.1 Different Forms of Business
Organizations
 Advantages of a proprietorship
 owners have complete control over the
business
 tend to be fewer legal obligations and
fewer taxes
 Disadvantages of a proprietorship
 unlimited liability for the debts of the
company
 difficulty of raising sufficient funds

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 13.1 Different Forms of Business
Organizations
 One way of overcoming the problem of
inadequate personal resources to
operate a larger business is to form a
partnership.

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 13.1 Different Forms of Business
Organizations
 Partnerships exist when
 two or more persons together own a
business enterprise,
 and there is a formal or informal agreement
between the partners as to
 how the business is to be operated and
 how profits are to be distributed.

 Partnerships account for only about 6

percent of business revenues.

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 13.1 Different Forms of Business
Organizations
 Partnerships have several limitations.
 The partnership agreement must be
changed each time a partner dies or wants
to sell her interest in the firm.
 Limitation of partnership agreement
restricts the ability to amass large sums of
capital.
 Partners are also personally liable for any
losses, so there is a substantial element of
risk in the partnership form of enterprise.

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 13.1 Different Forms of Business
Organizations
 Partnerships usually work best when
the various principals know and trust
each other well.

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 13.1 Different Forms of Business
Organizations
 Advantages of partnerships
 relatively easy to set up
 provide easier access to funds than a
proprietorship
 are not double taxed like corporations
 income is only subject to personal income
taxes and not corporate taxes

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 13.1 Different Forms of Business
Organizations
 Disadvantages of a partnership
 each partner has unlimited liability for the
company’s debt
 often legal complications when any change
in ownership occurs

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 13.1 Different Forms of Business
Organizations
 Corporations
 generally owned by more than one person
 considered to be the equivalent of persons
from a legal perspective.
 a life of its own, independent of that of its
owners.

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 13.1 Different Forms of Business
Organizations
 Corporations are the most dominant
form of business enterprise in the
United States. Fewer than 20 percent of
firms are corporations, but they account
for almost 90 percent of all revenues
generated by private sector businesses.
 Corporations tend to be substantially
larger than either proprietorships or
partnerships.

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 13.1 Different Forms of Business
Organizations
 A corporation that has less than 35
employees and has no foreign or
corporate stockholders is called an S
corporation.
 The unique feature of this type of
corporation is that profits go directly to
the owners like in proprietorships and
partnerships.

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 13.1 Different Forms of Business
Organizations
 This allows the owners to retain the
benefits of limited liability and avoid
double taxation from the earnings on
profits.
 That is, the profits are taxed only once,
as if they were the shareholder’s
personal income.

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 13.1 Different Forms of Business
Organizations
 Advantages to corporations
 Limited liability for any financial losses.
 corporation, as a "person" in its own right,
solely responsible for its own debts.
 owner’s liability limited to initial investment

 Continue indefinitely
 thousands or even millions of owners, as well
as daily changes in ownership, without
requiring any changes in the charter.
 Access to capital necessary for efficient
operation
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 13.1 Different Forms of Business
Organizations
 Disadvantages of corporations
 double taxation
 first as corporate profits
 second as shareholder’s income
 taxes on dividends
 or taxes on capital gains if the shares of stock
increase in value
 separation of ownership and management.
 The typical owner--the stockholder--has little
voice in the making of decisions.

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 13.1 Different Forms of Business
Organizations
 The typical manager may have interests
that diverge more or less from those of
the owners.
 But one should not make too much of
this because executives tend to regard
their firm's profits as the best measure
of their own professional success.

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 13.1 Different Forms of Business
Organizations
 If managers fail to earn as high a rate of
return as informed stockholders believe
possible, the stockholders may revolt
and seek a new set of executives.

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 13.1 Different Forms of Business
Organizations
 Failure to earn a normal rate of return
can also endanger the continued
existence of a firm, for if it fails for long
enough, a firm will be forced into
bankruptcy and reorganization.
 Finally, a satisfactory profit is essential
for continued expansion of the firm.
Profits provide funds for expansion and
make it easier to acquire additional
capital.
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 13.1 Different Forms of Business
Organizations
 Growth of the company not only
increases managers' incomes but also
enhances their prestige and power.

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 13.2 Corporate Financing
 The owners of corporations own shares
of stock in the company and are called
stockholders.
 Each stockholder's ownership of the
corporation and voting rights in the
selection of corporate management is
proportionate to the number of shares
owned.

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 13.2 Corporate Financing
 Shares of stock are bought and sold by
individuals and institutions in the stock
market, usually on one of the organized
stock exchanges.
 The price that shares sell for will
fluctuate (often many times a day) with
changes in demand and/or supply.

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 13.2 Corporate Financing
 Corporations sometimes use proceeds
from new sales of stock to finance
expansion of their activities.
 Two primary types of stock
 preferred stock
 common stock

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 13.2 Corporate Financing
 Preferred stock
 Owners receive a fixed regular dividend
payment; the payment remains the same
regardless of the profits of the corporation.
 No dividends can generally be paid to
holders of common stock until the
preferred stockholders receive a specified
fixed amount per share of stock, assuming
that funds are available after the debts of
the corporation are paid.

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 13.2 Corporate Financing
 Common stock
 Owners are residual claimants.
 Share in profits after expenses are paid,
including interest payments to debt obligations
and dividend payments to preferred stock.
 If corporation is sold or liquidated, receive

assets after all debts are paid and preferred

stockholders are paid a fixed amount per share.
 Dividends frequently vary with profits.

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 13.2 Corporate Financing
 Owners of common stock assume
greater risks than preferred
stockholders, doing so because the
potential rewards are then greater if the
company is in fact successful.

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 13.2 Corporate Financing
 Individuals as well as institutions such
as insurance companies, pension funds,
mutual funds, trust departments of
banks, and university and foundation
endowment funds, all hold corporate
stocks.
 General Motors, IBM, and Microsoft
have millions of individual stockholders.

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 13.2 Corporate Financing
 Indirectly, millions more are involved in
stocks through their interest in mutual
funds, ownership of life insurance,
vested rights in private pension funds,
and so on.

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 13.2 Corporate Financing
 Corporations obtain some of their initial
financial capital (dollars used to buy
capital goods) by selling stock.
 Growth in the financial resources
 reinvesting profits that are earned in the
business
 selling new shares of stock
 borrowing money

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 13.2 Corporate Financing
 While corporate borrowing takes
different forms, corporations primarily
borrow by issuing bonds.
 The holder of a bond is not a part owner
of a corporation; rather, he is a creditor
to whom the corporation has a debt
obligation.

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 13.2 Corporate Financing
 The obligation to bondholders is of
higher legal priority than that of
stockholders.
 Before any dividends can be paid, even to
owners of preferred stock, the interest
obligations to bondholders must be met.
 If a company is liquidated, bondholders
must be paid in full the face value of their
bond holding before any disbursements
can be made to stockholders.

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 13.2 Corporate Financing
 Bondholders have greater financial
security than stockholders, but receive
a fixed annual interest payment, with no
possibility to receive increased
payments as the company prospers.
 The possibility of the value of a bond
increasing greatly—a capital gain—is
limited compared to that of stocks.

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 13.2 Corporate Financing
 A company can get finances through
plowbacks or reinvestment.
 Instead of using their profits to pay out
dividends, a firm might take some of its
profits and plow it back into the
company for new capital equipment.

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 13.2 Corporate Financing
 Refinancing is by far the most important
source of funding—almost 65 percent of
a firm’s finances come from
reinvestment.
 Attractive to firms as a source of funds
because issuing new stocks and bonds
can be an expensive and lengthy
process.

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 13.3 The Stock Market
 The two most important financial
markets where savers can provide
funds to borrowers are the stock market
and the bond market.
 The values of securities (stocks and
bonds) sold in financial markets change
with expectations of benefits and costs.

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 13.3 The Stock Market
 Expected corporate earnings, business
conditions, the economic policies of the
government, business conditions in
foreign countries, and concern over
inflation all influence the price of stocks
(and, to a lesser extent, bonds).

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 13.3 The Stock Market
 During periods of rising securities
markets, optimism is generally great,
and businesses are more likely to invest
in new capital equipment, perhaps
financing it by selling new shares of
stock at current high prices.

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 13.3 The Stock Market
 During periods of pessimism, stock
prices fall, and businesses reduce
expenditures on new capital equipment,
partly because financing such
equipment by stock sales is more
costly.
 More shares have to be sold to get a
given amount of cash, seriously diluting
the ownership interest of existing
stockholders.
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 13.3 The Stock Market
 Economists consider the stock market a
random walk.
 Without illegal inside information or a lot of
luck, it is very difficult to consistently pick
winners in the stock market.

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 13.3 The Stock Market
 Hot tips are only hot if you are one of
only a few to know if a company's stock
is going to rise.
 Once that news hits the street, it will
cease to be a source of profit.
 In sum, if markets are operating
efficiently, the current stock prices will
reflect all available information, and
consistent, extraordinary profit
opportunities will not exist.
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 13.3 The Stock Market
 Many financial analysts think that the
best stock market strategy is to
diversify, buying several different
stocks, and holding them for long
periods.
 You don't have to continue to pay
commissions on additional trades.
 The stock market has historically
outperformed other financial assets.

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 13.3 The Stock Market
 Most newspapers (and many Web sites)
have a financial section that covers the
prices of stocks so investors can have
some of the information that they need
to make their decisions to buy and sell
stocks.
 Some investors watch this data by the
second as they are trading in and out of
stocks a number of times during the
day.
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 13.3 The Stock Market
 At the other extreme, some investors
pick a good company and hold the stock
for a long time hoping that it will give
them a better return than other assets,
like saving accounts.

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 Wall Street Journal Stock Table

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 13.3 The Stock Market
 Wall Street Journal’s stock tables
explained:
 First column shows the stock’s highest
price over the last 52 weeks.
 Second column shows the stock’s lowest
price over the last 52 weeks.
 Third column shows the name of the stock.
 Fourth column shows the symbol for the
stock.

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 13.3 The Stock Market
 (continued)
 Fifth column shows the dividend
 annual amount the company has paid over the
preceding year on each share of stock.
 Sixth column shows the yield, the dividend
divided by the price of the stock.
 Seventh column shows the price-earnings
(PE) ratio
 price of the stock divided by the amount the
company earned per share over the past year.

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 13.3 The Stock Market
 (continued)
 Eighth column shows the previous trading
day’s high for the stock.
 Ninth column shows the previous trading
day’s low for the stock.
 Tenth column shows the previous trading
day’s closing price for the stock.
 Eleventh column shows the net change in
the stock price during the previous trading
day.

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 13.3 The Stock Market
 Price earnings ratio
 Measure of how highly a stock is valued.
 Typical price earnings ratio is around 15.
 If higher, the stock is relatively expensive in
terms of its recent earnings.
 The stock might be overvalued or
 investors are expecting share prices to rise in the
future.
 If lower, the stock is either undervalued or
investors may expect future earnings to fall.

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