CHAPTER

8 | Firms, the Stock Market,

and Corporate
Governance

Chapter Summary and Learning Objectives

8.1

Types of Firms (pages 238240)

Categorize the major types of firms in the United States. There are three types 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. A corporation is a
legal form of business that provides the owners with limited liability. An asset is anything of value owned
by a person or a firm. The owners of sole proprietorships and partnerships have unlimited liability, which
means there is no legal distinction between the personal assets of the owners of the business and the assets
of the business. The owners of corporations have limited liability, which means they can never lose more
than their investment in the firm. Although only 18 percent of firms are corporations, they account for the
majority of revenue and profit earned by all firms.
8.2

The Structure of Corporations and the PrincipalAgent Problem (pages 241242)

Describe the typical management structure of corporations and understand the concepts of separation
of ownership from control and the principalagent problem. Corporate governance refers to the way
in which a corporation is structured and the impact a corporations structure has on the firms behavior.
Most corporations have a similar management structure: The shareholders elect a board of directors that
appoints the corporations top managers, such as the chief executive officer (CEO). Because the top
management often does not own a large fraction of the stock in the corporation, large corporations have a
separation of ownership from control. Because top managers have less incentive to increase the
corporations profits than to increase their own salaries and their own enjoyment, corporations can suffer
from the principalagent problem. The principalagent problem exists when the principalsin this
case, the shareholders of the corporationhave difficulty getting the agentthe corporations top
managementto carry out their wishes.
8.3

How Firms Raise Funds (pages 242249)

Explain how firms raise the funds they need to operate and expand. Firms rely on retained earnings
which are profits retained by the firm and not paid out to the firms ownersor on using the savings of
households for the funds they need to operate and expand. With direct finance, the savings of households
flow directly to businesses when investors buy stocks and bonds in financial markets. With indirect
finance, savings flow indirectly to businesses when households deposit money in saving and checking
accounts in banks and the banks lend these funds to businesses. Federal, state, and local governments also
sell bonds in financial markets, and households also borrow funds from banks. When a firm sells a bond,
it is borrowing money from the buyer of the bond. The firm makes a coupon payment to the buyer of the
bond. The interest rate is the cost of borrowing funds, usually expressed as a percentage of the amount
borrowed. When a firm sells stock, it is selling part ownership of the firm to the buyer of the stock.
Dividends are payments by a corporation to its shareholders. The original purchasers of stocks and bonds
may resell them in stock and bond markets, such as the New York Stock Exchange. The performance of

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the U.S. stock market is often measured using stock market indexes. The three most widely followed
stock indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite index.
8.4

Using Financial Statements to Evaluate a Corporation (pages 249251)

Understand the information provided in corporations financial statements. A firms income statement
sums up its revenues, costs, and profit over a period of time. A firms balance sheet sums up its financial
position on a particular day, usually the end of a quarter or year. A balance sheet records a firms assets
and liabilities. A liability is anything owed by a person or a firm. Firms report their accounting profit on
their income statements. Accounting profit does not always include all of a firms opportunity cost.
Explicit cost is a cost that involves spending money. Implicit cost is a nonmonetary opportunity cost.
Because accounting profit excludes some implicit costs, it is larger than economic profit.
8.5

Corporate Governance Policy and the Financial Crisis of 20072009 (pages 251254)

Discuss the role that corporate governance problems may have played in the financial crisis of 2007
2009. Because their compensation often rises with the profitability of the corporation, top managers have
an incentive to overstate the profits reported on their firms income statements. During the early 2000s, it
became clear that the top managers of several large corporations had done this, even though intentionally
falsifying financial statements is illegal. The Sarbanes-Oxley Act of 2002 took several steps intended to
increase the accuracy of financial statements and increase the penalties for falsifying them. The financial
crisis of 20072009 revealed that many financial firms held assets that were far riskier than investors had
realized.
Appendix: Tools to Analyze Firms Financial Information (pages 263269)
Understand the concept of present value and the information contained on a firms income statement
and balance sheet.

Chapter Review
Chapter Opener: How Can You Buy a Piece of Facebook? (page 237)
In 2004, Mark Zuckerberg, a college sophomore at the time, started Facebook. As Facebooks popularity
expanded, the costs of running the business grew as well, and the company looked for sources of funding
to continue operating the business. Facebook remained a private company in 2011 because its stock
shares were held by its founders, employees, and a small number of private investors. Because Facebook
stock was not bought and sold in public financial markets, Facebook was not subject to the federal
regulations that apply to public firms whose shares are available for sale on public markets.

8.1

Types of Firms (pages 238240)

Learning Objective: Categorize the major types of firms in the United States.

In the United States, a firm can assume one of three basic legal structures. A sole proprietorship is a firm
owned by a single individual and not organized as a corporation. A partnership is a firm owned by two
or more persons and not organized as a corporation. Owners of sole proprietorships and partnerships have
control of their day-to-day operations, but they are subject to unlimited liability. There is no legal
distinction between the owners personal assets and those of the firms they own. As a result, employees or
suppliers have a legal right to sue if they are owed money by these firms, even if this requires the owners
to sell their personal assets.

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A corporation is a legal form of business that provides owners with 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 profits of corporations are taxed twice in the United States, and corporations are more difficult
to organize and run than sole proprietorships and partnerships. Despite these disadvantages, limited
liability and the possibility of raising funds by issuing stock make corporations an attractive form of
business.

Study Hint
You may hear a corporation described as a publicly owned company. This phrase means that
corporations are owned by members of the general public, not that they are owned by the government.
Making the Connection How Important Are Small Businesses to the U.S. Economy? explains that
while sole proprietorships and other small businesses together employ a small fraction of the nations
workforce, they are by no means unimportant to the U.S. economy. In a typical year, 40 percent of all
new jobs are created by small firms with fewer than 20 workers. More than 85 percent of all jobs created
by new firms are created by small firms instead of large corporations.

Extra Solved Problem 8.1

The Risks of Private Enterprise: The Names of Lloyds of London

Supports Learning Objective 8.1: Categorize the major types of firms in the United States.
The world famous insurance company Lloyds of London got its start in London in the 1600s. Ship
owners would come to Edward Lloyds coffeehouse to find someone to insure (or underwrite) their
ships and cargo for a fee. Coffeehouse customersmerchants and shipowners themselveswho agreed
to insure ships would make payment 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 Lloyds as Names. A series of disasters in
the 1980s and 1990searthquakes, oil spills, etc.resulted in huge payments made on Lloyds insurance
policies. It had become clear that Lloyds was not a corporation and the Names did not have the limited
liability that a corporations stockholders have. Many Names lost far more than they had invested. Some
of those who invested in Lloyds 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 2008, only
1,100 Names remained invested in Lloyds. New rules allow insurance companies to underwrite Lloyds
policies for the first time, and Names now provide only about 20 percent of Lloyds funds.
a. What characteristic of Lloyds of Londons business organization was responsible for the
financial losses suffered by the Names who had invested in Lloyds?
b. In the early 2000s, firms 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 Lloyds of Londons 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 238 in the textbook.

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CHAPTER 8 | Firms, the Stock Market, and Corporate Governance

Step 2:

Determine what characteristic of Lloyds of Londons business organization was

responsible for the financial losses suffered by the Names who had invested in
Lloyds.
Lloyds 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
Lloyds 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:

Explain how the losses suffered by Enron and WorldCom stockholders were
different from the losses suffered by Lloyds of Londons 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.

8.2

The Structure of Corporations and the PrincipalAgent Problem

(pages 241242)
Learning Objective: Describe the typical management structure of corporations and
understand the concepts of separation of ownership from control and the principal
agent problem.

Corporate governance is the way corporations are structured and the effect that structure has on the
firms behavior. Shareholders in a corporation 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 managers. 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. In corporations,
there is a separation of ownership from control. In most large corporations the top management, rather
than the shareholders, control day-to-day operations. The separation of ownership from control is an
example of a principalagent problema problem caused by an agent pursuing his own interests rather
than the interests of the principal who hired him.

Study Hint
Read Solved Problem 8.2 in the textbook to strengthen your understanding of the principalagent
problem. This Solved Problem explains how the principalagent problem is easily extended to the
relationship between management and workers. Managers would like workers to work as hard as possible,
while workers would sometimes prefer to shirk. It may be difficult for management to determine whether
a worker is working sufficiently hard or not.

8.3

How Firms Raise Funds (pages 242249)

Learning Objective: Explain how firms raise the funds they need to operate and
expand.

To finance expansion, firms can use some of their profits, called retained earnings, rather than pay the
profits to owners as dividends. Firms may obtain external funds in two ways. Indirect finance is the flow
of funds from savers to borrowers through financial intermediaries such as banks. Intermediaries raise
funds from savers to lend to firms and other borrowers. Direct finance is the flow of funds from savers to
firms through financial markets. Direct finance usually takes the form of the borrower selling a financial
security to a lender.

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A financial security is a document that states the terms under which the funds have passed from the buyer
of the security to the borrower. There are two main types of financial securities. A bond is a financial
security that represents a promise to repay a fixed amount of funds. When a firm sells a bond to raise
funds, it promises to pay the purchaser of the bond an interest payment each year for the term of the loan
as well as the final payment (or principal) of the loan. The interest payments on a bond are referred to as
coupon payments. The interest rate is the cost of borrowing funds, usually expressed as a percentage of
the amount borrowed. If the coupon is expressed as a percentage of the face value of the bond, then we
have the coupon rate of the bond.
If the face value of a bond is $1,000 and the annual interest payment on the bond is $60, then the coupon
rate is
$60
= 0.06 or 6 percent.
$1,000
A stock is a financial security that represents partial ownership of a firm. As an owner of the firm, a
shareholder is entitled to a share of the corporations profits. Management decides how much profit to
reinvest in the firm (retained earnings). The remaining profits are paid to stockholders as dividends.
There is a broad market for previously owned stocks and bonds. Changes in the prices of these financial
instruments represent future expectations of the profits likely to be earned by the firms that issued them.
Changes in the prices of bonds issued by a corporation reflect investors perceptions of the firms ability
to make interest payments as well as the prices of newly issued bonds. A previously issued bond with a
coupon payment of $80 and a principal of $1,000 is less attractive than a newly issued bond with a
coupon payment of $100 and a principal of $1,000. The price of the previously issued bond must fall, and
its interest rate must rise, to induce investors to buy it.
Study Hint
The double taxation of corporate profitsonce via the corporate profits tax and again via the income tax
on shareholders dividendsgives corporations an incentive to raise funds more through debt (bonds)
than equity (stocks). Some economists have criticized the corporate profits tax because it gives
corporations an incentive to incur debt solely to reduce taxes. Making the Connection The Rating
Game: Is the U.S. Treasury Likely to Default on Its Bonds? provides a discussion of the major credit
rating agencies bond ratings and the meaning of degrading U.S. Treasury bonds by Standard & Poors in
August 2011. Making the Connection Following Abercrombie & Fitchs Stock Price in the Financial
Pages provides a thorough explanation of how to read the stock pages in the newspaper using
Abercrombie & Fitch as an example.

Extra Solved Problem 8.3

Googles Stocks

Supports Learning Objective 8.3: Explain how firms raise the funds they need to operate and
expand.
On November 1, 2011, Googles stock closed at a price of $578.65 per share and the trading volume for
the day was 406,925. The trading volume is the number of shares traded on the secondary market for that
day.
a. How much financial capital did the trading of these stocks raise for Google to use for expansion?
b. How could Google raise additional funds for growth?

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Solving the Problem

Step 1:

Review the chapter material.

This problem is about how firms raise funds, so you may want to review the section How
Firms Raise Funds, which begins on page 242 in the textbook.

Step 2:

Discuss the secondary market for stocks and the impact on funds available for
Google to expand.
In the feature Dont Let This Happen to You When Google Shares Change Hands, Google
Doesnt Get the Money, you will find a description of secondary markets. The majority of
stocks that are bought and sold on a daily basis are being traded in the secondary market.
Trading in the secondary market does not raise additional funds for Google.

Step 3:

Consider the options that Google has to raise funds for growth.
There are three main options for a firm to obtain funds for growth. A firm can save some of
its profits, called retained earnings. It can borrow money from a bank. Or it can issue more
stocks or bonds and sell them directly to the public. All of these options are available to
Google.

Source: http://finance.yahoo.com/q?s=goog

8.4

Using Financial Statements to Evaluate a Corporation (pages 249251)

Learning Objective: Understand the information provided in corporations financial
statements.

A firm must accurately disclose its financial condition to enable potential investors to make informed
decisions about the firms stock and bond offerings. The Securities and Exchange Commission (SEC)
requires publicly owned firms to report their performance according to generally accepted accounting
principles.
There are two main types of financial statements. An income statement is a financial statement that sums
up a firms revenues, costs, and profit over a period of time. The income statement is used to compute the
firms accounting profit, which is the firms net income measured by revenue minus operating expenses
and taxes paid. Economic profitmeasured by a firms revenue minus all of its implicit and explicit
costsprovides a better indication than accounting profit of how successful a firm is. Opportunity cost
is the highest-valued alternative that must be given up to engage in an activity. Opportunity costs can
include both explicit costs that involve spending money and implicit costs that are nonmonetary costs.
One significant implicit cost is the cost of investors funds, measured as the value of those funds in their
highest-alternative use. If a firm fails to provide investors with at least a normal rate of return, it will not
be able to retain investors and will not be able to remain in business over the long run.
A balance sheet is a financial statement that sums up a firms financial position on a particular day,
usually the end of a quarter or year. The balance sheet summarizes a firms assets and liabilities. An asset
is anything of value owned by a person or a firm. A liability is anything owed by a person or a firm. The
difference between the value of assets and liabilities is the firms net worth.

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Study Hint
Keep in mind that, while accounting profit is useful in measuring whether a company is earning enough
revenue to pay its bills, economic profit is a more accurate measure of how successful a firm is. Firms
that are earning accounting profits may not be earning economic profits. Even though such a firm may
look healthy financially, if the opportunity costs of producing are greater than revenues, then there are
alternative uses of the companys resources that would be more profitable. Firms that do not earn
economic profits will not remain in business over the long run.

Extra Solved Problem 8.4

Accounting Profit versus Economic Profit

Supports Learning Objective 8.4: Understand the information provided in corporations financial
statements.
Suppose that Sally decides to open a business. Opening Sallys Sassy Salon will cost $130,000 for the
necessary capital equipment. Sally is considering two options for financing her new beauty salon. The
first option she is considering is to borrow $100,000 and take $100,000 from her savings. The second
option is to take $130,000 from her savings to start the business. Suppose that her savings account is
earning 5 percent interest and the loan that her bank offered her also has a 5 percent interest rate.
a. What is the explicit cost of opening Sallys Sassy Salon if she chooses the first option? If she
chooses the second option? What is the implicit cost of opening Sallys Sassy Salon using the
first option? The second option?
b. Which option will give Sally the higher economic profit? The higher accounting profit?

Solving the Problem

Step 1:

Review the chapter material.

This problem is about financial statements, so you may want to review the section Using
Financial Statements to Evaluate a Corporation, which begins on page 249 in the textbook.

Step 2:

Determine the implicit and explicit costs of each option.

The explicit costs would be costs that require an outlay of money, for example, the interest on
the loan, and the implicit costs would be the forgone interest on her savings. The first option
has an explicit cost of 0.05 $100,000 = $5,000 and an implicit cost of 0.05 $100,000 =
$5,000. The second option has no explicit cost and has 0.05 $130,000 = $10,000 in implicit
costs.

Step 3:

Evaluate the economic and accounting profit for Sallys Sassy Salon.
Assuming that her revenue will be unaffected by her choice of how she finances her new
firm, we can see that the explicit cost of the second option is lower than the first option. This
means that the second option would have a higher accounting profit. If we consider all of the
costs, both explicit and implicit, then we are calculating the economic profit. In this case, the
explicit cost plus implicit cost is the same for both options, so the economic profit would be
the same for either option.

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8.5

CHAPTER 8 | Firms, the Stock Market, and Corporate Governance

Corporate Governance Policy and the Financial Crisis of 20072009

(pages 251254)

Learning Objective: Discuss the role that corporate governance problems may have
played in the financial crisis of 20072009.

During 2001 and 2002, the importance of providing accurate financial information through financial
statements was illustrated by several major financial scandals. The Sarbanes-Oxley Act of 2002 was
passed in response to these scandals. The act requires corporate directors and chief executive officers to
have greater accountability for the accuracy of their firms financial statements. Beginning in 2007, the
U.S. economy suffered its worst financial crisis since the Great Depression, stemming from problems in
the subprime mortgage industry. Borrowers who were unable to afford their mortgages began to default,
and as housing prices fell, banks and other private financial firms who had securitized these mortgages
began to fail. New regulations were considered to increase oversight over banks and other financial firms
that securitize mortgages. In July 2010, Congress passed the Wall Street Reform and Consumer
Protection Act (Dodd-Frank Act) in an attempt to overhaul regulation of the financial system. The acts
provisions include the creation of the Consumer Financial Protection Bureau that determines rules
intended to protect consumers in their borrowing and investing activities, and the creation of the Financial
Stability Oversight Council that identifies and acts on risks to the financial system.
Study Hint
One result, likely an unintended one, of the Sarbanes-Oxley Act was to increase the demand for newly
hired accountants. For example, the accounting firm Ernst and Young hired 4,500 undergraduate
accounting students in 2005, an increase of 30 percent from the previous year.
Source: Jobs: Accountants are kings among grads, CNNMoney, June 5, 2005. http://money.cnn.com/
2005/06/pf/accountant.jobs.reut/index.htm?ccc=yes

Appendix

Tools to Analyze Firms Financial Information

(pages 263269)
Learning Objective: Understand the concept of present value and the information contained on a
firms income statement and balance sheet.

Using Present Value to Make Investment Decisions

Most people value funds they have today more highly than funds they will receive in the future. Present
value is the value in todays dollars of funds to be paid or received in the future. Someone who lends
money expects to be paid back the amount of the loan and some additional interest. If someone lends
$1,000 for one year at 10 percent interest, the value of money received in the future is:
$1,000 (1 + 0.10) = $1,100.
Dividing this expression by (1 + 0.10) and adjusting terms:
$1,000 =

$1,000
(1.10)

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201

Writing this more generally:

Present Value =

Future Value
(1 + i )

The present value formula for funds received any number of years in the future (n represents the number
of years) is:
Present Value =

Future Valuen
(1 + i ) n

The present value formula can be used to calculate the price of a financial asset. The price of a financial
asset should be equal to the present value of the payments to be received from owning that asset. The
general formula for the price of a bond is:
Bond Price =

Coupon n Face Value

Coupon1 Coupon 2
+
+ ... +
+
2
(1 + i )
(1 + i )
(1 + i )n
(1 + i )n

In this formula,
Coupon1 is the coupon payment, or interest payment, to be received after one year.
Coupon2 is the coupon payment after two years.
Couponn is the coupon payment in 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.
The price of a share of stock should be equal to the present value of the dividends, or the profits paid to
shareholders, that investors expect to receive as a result of owning the stock. The general formula for the
price of a stock is:
Stock Price =

Dividend1 Dividend 2
+
+
(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. Unlike coupon payments, which are written on the bond and cant be changed,
dividend payments are uncertain. If dividends grow at a constant rate, the formula for determining the
price of a stock is:
Stock Price =

Dividend
(i Growth Rate)

Dividend refers to the dividend currently received, and Growth Rate is the rate at which dividends are
expected to grow.

Going Deeper into Financial Statements

Corporations disclose substantial information about their business operations and financial position to
investors. This information is provided for two reasons. First, participants in financial markets demand
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the information. Second, some of this information meets the requirements of the U.S. Securities and
Exchange Commission. The key sources of information about a corporations profitability and financial
position are its income statement and balance sheet. Income statements summarize a firms revenues,
costs, and profit over a time period (for example, one year). These statements list the firms revenues and
its cost of revenue (also called its costs of sales or cost of goods sold). The difference between a firms
revenues and costs is its profit. Operating income is the difference between revenue and operating
expenses. Investment income is income earned on holdings of investments such as government and
corporate bonds. The net income that firms report on income statements is referred to as their after-tax
accounting profit.
A balance sheet summarizes a firms financial position on a particular day. An asset is anything of value
owned by the firm. A liability is a debt or obligation owed by the firm. Stockholders equity is the
difference between the value of a corporations assets and the value of its liabilities, also known as net
worth. Balance sheets list assets on the left side and liabilities and net worth or stockholders equity on
the right side. The value on the left side of the balance sheet must equal the value on the right side.
Current assets are assets the firm could convert into cash quickly. Goodwill represents the difference
between the purchase price of a company and the market value of its assets. Current liabilities are shortterm debts. Long-term liabilities include long-term bank loans and outstanding corporate bonds.

Key Terms
Accounting profit A firms net income,
measured by revenue minus operating expenses
and taxes paid.

Direct finance A flow of funds from savers to

firms through financial markets, such as the
New York Stock Exchange.

Asset Anything of value owned by a person or a

firm.

Dividends Payments by a corporation to its

shareholders.

Balance sheet A financial statement that sums

up a firms financial position on a particular day,
usually the end of a quarter or year.

Economic profit A firms revenues minus all of

its implicit and explicit costs.

Bond A financial security that represents a

promise to repay a fixed amount of funds.

Explicit cost A cost that involves spending

money.
Implicit cost A nonmonetary opportunity cost.

Corporate governance The way in which a

corporation is structured and the effect that
structure has on the corporations behavior.
Corporation A legal form of business that
provides owners with protection from losing
more than their investment should the business
fail.
Coupon payment An interest payment on a
bond.

Income statement A financial statement that

sums up a firms revenues, costs, and profit over
a period of time.
Indirect finance A flow of funds from savers to
borrowers through financial intermediaries such
as banks. Intermediaries raise funds from savers
to lend to firms (and other borrowers).
Interest rate The cost of borrowing funds,
usually expressed as a percentage of the amount
borrowed.

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Liability Anything owed by a person or a firm.
Limited liability The legal provision that
shields owners of a corporation from losing
more than they have invested in the firm.
Opportunity cost The highest-valued
alternative that must be given up to engage in an
activity.
Partnership A firm owned jointly by two or
more persons and not organized as a
corporation.
Principalagent problem A problem caused by
an agent pursuing his own interests rather than
the interests of the principal who hired him.

Separation of ownership from control A

situation in a corporation in which the top
management, rather than the shareholders,
control day-to-day operations.
Sole proprietorship A firm owned by a single
individual and not organized as a corporation.
Stock A financial security that represents partial
ownership of a firm.
Wall Street Reform and Consumer Protection
Act (Dodd-Frank Act) Legislation passed
during 2010 that was intended to reform
regulation of the financial system.

Key TermsAppendix
Present value The value in todays dollars of
funds to be paid or received in the future.

Stockholders equity The difference between

the value of a corporations assets and the value
of its liabilities; also known as net worth.

Self-Test
(Answers are provided at the end of the Self-Test.)

Multiple-Choice Questions
1. Which of the following statements is true about firms in the United States?
a. In the United States, most firms are organized as corporations.
b. In the United States, there are more partnerships than sole proprietorships.
c. In the United States, corporations account for the majority of total revenue and profits earned by
all firms.
d. all of the above
2. Which of the following types of firms have limited liability?
a. a corporation
b. a sole proprietorship
c. a partnership
d. all of the above
3. Your friend asks you to join him in the new Internet business he is setting up as a partnership. If you
invest $10,000 in the business, what is the limit to your liability?
a. $10,000
b. $100,000
c. $1,000
d. There is no limit to your liability.
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4. Which of the following is true about liability for a corporation?

a. The owners of a corporation have limited liability.
b. The owners of a corporation have unlimited liability.
c. The owners of a corporation may or may not be subject to unlimited liability.
d. The owners of a corporation do not face any constraints with regard to liability issues.
5. In which of the following cases is there a legal distinction between the personal assets of the owners
of the firm and the assets of the firm?
a. sole proprietorships
b. partnerships
c. corporations
d. in both the case of sole proprietorships and the case of partnerships
6. When a corporation fails, which of the following is true?
a. The owners can always lose more than the amount they have invested in the firm.
b. The owners can never lose more than the amount they have invested in the firm.
c. The owners will always lose less than the amount they have invested in the firm.
d. What the owners lose is unrelated to liability laws.
7. Your friend asks you to join him in the new Internet business he is setting up as a corporation. If you
invest $10,000 in the business, what is the limit to your liability?
a. $10,000
b. $100,000
c. $1,000
d. There is no limit to your liability.
8. In the United States, how are corporate profits taxed?
a. Corporate profits are taxed only when investors of the corporations receive a share of the profits.
b. Corporate profits are taxed only once at the corporate level.
c. Corporate profits are taxed both at the corporate level and at the time when investors of the
corporations receive a share of the profits.
d. Corporate profits are exempt from taxation.
9. Which of the following is one of the advantages of a sole proprietorship as a business organization?
a. The firm can protect itself against debts.
b. Its owner has unlimited personal liability.
c. Profits are taxed only once.
d. Its owner has great ability to raise funds.
10. Which type of firms account for the majority of revenue earned in the United States in 2011?
a. sole proprietorships
b. corporations
c. partnerships
d. none of the above
11. Which type of firms accounts for the majority of business organizations in the United States in 2011?
a. sole proprietorships
b. partnerships
c. corporations
d. none of the above

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12. What is corporate governance?

a. Corporate governance is a structure imposed on all corporations by the Securities and Exchange
Commission.
b. Corporate governance is the way in which corporations are structured and the impact a
corporations structure has on the firms behavior.
c. Corporate governance is the division of business firms among proprietorships, partnerships, and
corporations.
d. Corporate governance is the relationship between corporations and the government officials in the
states in which firms operate.
13. What term do economists use to refer to the conflict between the interests of shareholders and the
interests of top management?
a. corporate governance
b. a principalagent problem
c. gold plating
d. capture theory
14. How can a firm obtain funds for an expansion of its operation?
a. by reinvesting profits
b. by recruiting additional owners to invest in the firm
c. by borrowing funds from relatives, friends, or a bank
d. all of the above
15. Which of the following refers to a flow of funds from savers to firms through financial markets?
a. indirect finance
b. direct finance
c. business finance
d. financial borrowing
16. What is the name given to the interest payments on a bond?
a. coupon payments
b. the cost of borrowing funds
c. the face value of the bond
d. capital gains
17. What are the payments by a corporation to its shareholders?
a. stocks
b. dividends
c. retained earnings
d. interest
18. If Microsoft sells a bond with a face value of $10,000 and agrees to pay $800 of interest per year to
bond purchasers, what is the interest rate paid on the bond?
a. 2%
b. 4%
c. 8%
d. 10%

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19. If Motorola sells a bond with a face value of $5,000 and an interest rate of 5 percent, what is the
coupon payment on the bond?
a. $250
b. $500
c. $1,000
d. $1,500
20. An increase in a firms stock price most likely reflects which of the following?
a. concern that the firm will soon go out of business
b. optimism about the firms profit prospects
c. a higher cost of new external funds
d. All of the above would increase the price of a firms stock.
21. What are markets called in which an issuer sells new claims to buyers?
a. primary markets
b. secondary markets
c. tertiary markets
d. initial public offerings
22. Investors resell existing stocks to each other in what type of market?
a. a primary market
b. a secondary market
c. a bond market
d. a dividend market
23. If Mark Zuckerberg, the owner and founder of Facebook, decides to open up ownership of his
company to the public, the initial public offering of stock in Facebook will take place in what type of
market?
a. a primary market
b. a secondary market
c. a bond market
d. a coupon market
24. Which of the following is the most important of the over-the-counter markets?
a. the New York Stock Exchange
b. the American Stock Exchange
c. the NASDAQ
d. the S&P 500
25. In the United States, the Securities and Exchange Commission requires publicly owned firms to
report their performance in financial statements using standard methods. What are these methods
called?
a. Standard and Poors Accounting Standards
b. generally accepted accounting principles
c. Moodys Investors Service Standards
d. U.S. Standard Financial Practices

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26. If investors become more optimistic about a firms profit prospects, and the firms managers want to
expand the firms operations as a result, what will happen to the price of the companys stock?
a. It will rise.
b. It will fall.
c. It will remain constant.
d. It may rise for a while, but then fall.
27. To answer the three basic questions: what to produce, how to produce it, and what price to charge,
what does a firms management need to know?
a. the firms revenues and costs
b. the value of the property and other assets the firm owns
c. the firms debts, or other liabilities, that it owes to another person or business
d. all of the above
28. Which of the following sums up a firms revenues, costs, and profit over a period of time?
a. the balance sheet
b. the income statement
c. the firms accounting profit
d. the firms economic profit
29. An income statement starts with the firms revenue and subtracts its operating expenses and taxes
paid. What is the remainder called?
a. net income
b. gross income
c. economic profit
d. explicit cost
30. Which of the following is considered an explicit cost?
a. the cost of labor
b. the cost of materials
c. the cost of electricity
d. All of the above are explicit costs.
31. What term do economists use to refer to the minimum amount that investors must earn on the funds
they invest in a firm, expressed as a percentage of the amount invested?
a. opportunity cost
b. the normal rate of return
c. explicit cost
d. economic profit
32. Accounting profit is equal to which of the following?
(i) Total revenue explicit costs
(ii) Total revenue opportunity costs
(iii) Economic profit + implicit costs
a. (i) only
b. (ii) only
c. (iii) only
d. (i) and (iii) only

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33. In which of the following industries do investors require a higher rate of return?
a. in more risky industries
b. in less risky industries
c. in more established industries, such as electric utilities
d. in any industry (Investors always need to receive high rates of return regardless of the type of
investment or the risk involved.)
34. Which of the following statements is correct?
a. Economic profit equals the firms revenues minus its explicit costs.
b. Accounting profit equals the firms revenues minus all of its costs, implicit and explicit.
c. Accounting profit is larger than economic profit.
d. all of the above
35. What is a balance sheet?
a. a summary of a firms financial position on a particular day
b. a summary of revenues, costs, and profit over a particular period of time
c. a firms net income measured by revenue less operating expenses and taxes paid
d. a list of anything owed by a person or business
36. What do you obtain by subtracting the value of a firms liabilities from the value of its assets?
a. income
b. net worth
c. economic profit
d. accounting profit
37. Which set of incentives does the top management of a corporation have?
a. an incentive to attract investors and to keep the firms stock price high
b. an incentive to attract investors and to keep the firms stock price low
c. an incentive to discourage investors and to keep the firms stock price high
d. an incentive to discourage investors and to keep the firms stock price low
38. Which of the following is true? Top managers who are determined to cheat and hide the true financial
condition of their firms can
a. deceive investors but never outside auditors.
b. deceive outside auditors but never investors.
c. deceive investors and sometimes also deceive outside auditors.
d. deceive other managers but never the companys investors or its outside auditors.
39. The landmark Sarbanes-Oxley Act of 2002 mandated that
a. chief executive officers personally certify the accuracy of financial statements.
b. financial analysts and auditors shall disclose whether any conflicts of interest might exist that
could limit their independence in evaluating a firms financial condition.
c. managers shall be held accountable and face stiff penalties (including long jail sentences) for not
meeting their responsibilities.
d. all of the above be satisfied.

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40. What does the term insiders refer to in the realm of corporate management?
a. Insiders are auditors who have access to the corporations financial statements.
b. Insiders are members of top management who also serve on a firms board of directors.
c. Insiders are managers who have connections with people on independent auditing boards.
d. An insider is anyone who is not part of a public corporation but who knows something that the
public at large does not know.
41. In 2010, Congress attempted to overhaul regulation of the U.S. financial system with the passage of
a. the Dodd-Frank Act.
b. the Gramm-Leach-Bliley Act.
c. the Glass-Steagall Act.
d. the Sarbanes-Oxley Act.
42. One of the causes of the 20072009 financial crisis was a dramatic decrease in the value of mortgagebacked securities when housing prices began to fall. What does it mean to securitize a mortgage?
a. To securitize a mortgage is to bundle mortgages together and sell them to investors.
b. To securitize a mortgage is to buy insurance that guarantees your mortgage will be paid even if
you lose your job.
c. To securitize a mortgage is to offer a mortgage to a borrower whose credit is below average.
d. To securitize a mortgage is to purchase a mortgage from Fannie Mae or Freddie Mac.

Short Answer Questions

1. Owners of successful sole proprietorships may choose to change their firms to corporations to
raise money to finance expansion and limit the owners liability. But this will also subject the
firm to the principalagent problem. Why dont sole proprietorships face the principalagent
problem?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. For corporations, the owners personal assets are not affected by the failure of the firms. Why is
this legal provision important for firms trying to raising large amounts of financial capital?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

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3. In addition to salary and benefits, the compensation of the top managers of many corporations
includes shares of company stock or options to buy the stock at a favorable price. Why?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
4. Explain why a firm that reports a profit on its income statement may actually suffer an economic
loss.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
__________________________________________________________________________
5. Publicly owned firms in the United States are required to report their performance in financial
statements using generally accepted accounting principles. These statements are examined closely
by private firms and investors. Why did the public disclosure of the statements of Enron and
WorldCom fail to provide investors with advance warning of serious financial problems that
resulted in billions of dollars of shareholders losses?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

True/False Questions
T F 1.
T F 2.
T F 3.
T F 4.
T F 5.
T F 6.

In the United States, Standard and Poors requires publicly owned firms to report their
performance in financial statements.
If investors expect a firm to earn economic profits, the firms share price will rise, providing
a dividend for shareholders.
Indirect finance refers to raising funds through financial intermediaries such as banks.
A disadvantage of organizing a firm as a sole proprietorship or a partnership is that owners
have limited liability.
A disadvantage of organizing a firm as a corporation is that the firm is subject to the
principalagent problem.
Economic profit is equal to a firms revenue minus its operating expenses and taxes paid for
a given time period.

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T F 7.
T F 8.
T F 9.
T F 10.
T F 11.
T F 12.
T F 13.
T F 14.
T F 15.

When a firm incurs an opportunity cost without spending money, its accounting profit is
larger than its economic profit.
The larger a firms profits are, the higher its stock price.
The price of a bond is equal to the present value of dividends, or the profits paid out by the
firm that issues the bond.
The unexpected rise in the price of Google stock in 2004 led to the passage of the SarbanesOxley Act.
Over 70 percent of firms in the United States are sole proprietorships.
The day-to-day operations of a corporation are run by the firms board of directors.
An advantage of organizing a firm as a partnership is that the partners share the risks of
owning the firm.
The legal and financial problems incurred by Enron, WorldCom, and other well-known
firms were due to the unlimited liability of the firms owners.
The Glass-Steagall Act of 1933 that reduced competition between investment banks and
commercial banks was a major cause for the financial crisis of 20072009.

Answers to the Self-Test

Multiple-Choice Questions
Question

Answer

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

Comment
Based on data for 2009, corporations accounted for 83 percent of revenue and 70
percent of the profits earned by all firms in the United States. See Figure 8.1 on
page 239 in the textbook.
The owners of corporations have limited liability, while sole proprietorships and
partnerships have unlimited liability.
Partnerships are firms owned jointly by two or more people, and there is no limit
to liability.
Most large firms are organized as corporations. A corporation is a legal form of
business that provides the owners with limited liability.
Unlimited liability means there is no legal distinction between the personal assets
of the owners of the firm and the assets of the firm. In sole proprietorships and
partnerships, the owners are not legally distinct from the firms they own.
Limited liability is the legal provision that shields owners of a corporation from
losing more than they have invested in the firm.
Liability for owners of a corporation is limited to the amount invested in the
firm.
Corporate profits are taxed twiceonce at the corporate level and again when
investors receive a share of corporate profits (revenues less expenses).
The profit of a sole proprietorship is taxed only once, without possible double
taxation of income as for corporations.
Although only 18 percent of all firms are corporations, corporations account for
the majority of revenue and profits earned by all firms. See textbook Figure 8.1
for the distribution of revenues and profits by business type.

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Question

Answer

11.

12.

13.

14.

15.

16.

17.
18.

b
c

19.

20.

21.

22.
23.
24.

b
a
c

25.

26.

27.

28.

Comment
Sole proprietorships account for 72 percent of all firms in the United States. See
Figure 8.1 for the distribution of firms by business type.
The way in which corporations are structured and the impact a corporations
structure has on the firms behavior is referred to as corporate governance.
The fact that top managers do not own the entire firm means they may have an
incentive to decrease the firms profits by spending money to purchase private
jets or schedule management meetings at luxurious resorts. This problem occurs
when agentsin this case, a firms top managementpursue their own interests
rather than the interests of the principal who hired themin this case, the
shareholders of the corporation.
All of these are ways in which firms raise the funds they need to expand their
operations.
A flow of funds from savers to firms through financial markets is known as
direct finance. Direct finance usually takes the form of firms selling savers
financial securities.
A coupon payment is the interest payment on a bond, usually expressed as a
percentage of the amount borrowed.
Dividends are payments by a corporation to its shareholders.
The interest rate on a bond is calculated as the ratio of the coupon payment to the
face value of the bond.
The annual coupon payment will be the face value of the bond multiplied by the
interest rate.
Higher stock prices mean that investors are more optimistic about the firms
profit prospects.
Primary markets are those in which newly issued claims are sold to initial buyers
by the issuer.
When stocks and bonds are resold, they are traded in secondary markets.
New issues of stocks and bonds are sold in primary markets.
The stocks of many computer and other high-technology firmsincluding
Microsoft and Appleare traded on the NASDAQ.
In most high-income countries, government agencies establish standard
requirements for information that is disclosed in order for publicly owned firms
to sell stocks and bonds. In the United States, this government agency is the
Securities and Exchange Commission. To maintain consistency, all firms are
required to use generally accepted accounting principles.
Changes in the value of a firms stocks and bonds offer important information for
a firms managers, as well as for investors. An increase in the stock price means
that investors are more optimistic about the firms profit prospects, and the firms
managers may wish to expand the firms operations as a result.
To answer these questions, a firms management needs the following
information: The firms revenues and costs, the value of the property and other
assets the firm owns, and the firms liabilities.
A firms income statement sums up the firms revenues, costs, and profits over a
period of time.

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Question

Answer

29.

30.

31.

32.

33.

34.

35.

36.

37.

38.

39.
40.

d
b

41.

42.

Comment
A firms net income is revenue less expenses and taxes paid in a given time
period.
Firms pay explicit labor costs to employees. They have many other explicit costs
as well, such as the cost of the electricity used to light their office buildings.
Economists refer to the minimum amount that investors must earn on the funds
they invest in a firm, expressed as a percentage of the amount invested, as a
normal rate of return.
Accounting profit equals a firms revenue minus its explicit costs. This is
equivalent to adding a firms economic profit and implicit costs.
The necessary rate of return that investors must receive to continue investing in a
firm varies from firm to firm. If the investment is risky, then investors will
require a high rate of return to compensate them for the risk.
Because accounting profit excludes some implicit costs, it will be larger than
economic profit.
A firms balance sheet sums up its financial position on a particular day, usually
the end of a quarter or a year.
We can think of the net worth as what the firms owners would be left with if the
firm closed, its assets sold, and its liabilities paid off. Investors can determine a
firms net worth by inspecting its balance sheet.
The top management of a firm has at least two reasons to attract investors and
keep the firms 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
principalagent problem, boards of directors will often tie the salaries of top
managers to the firms stock price or to the profitability of the firm.
This is what the textbook argues in Corporate Governance Policy and the
Financial Crisis of 20072009, beginning on page 251 in the textbook.
Each of the responses is a provision of the Sarbanes-Oxley Act.
Insiders are members of top management of a firm who also serve on the
firms board of directors.
In 2010, Congress passed the Wall Street Reform and Consumer Protect Act, also
referred to as the Dodd-Frank Act.
When groups of mortgages are bundled together and sold to investors, they are
securitized.

Short Answer Responses

1. The principalagent problem is used to describe the consequence of separating ownership and
management. There is no such division with a sole proprietorship and no principalagent problem
because the principal is also the agent.
2. The legal provision of limited liability is important for corporations that try to raise large amounts of
funds because the incentive for investors to buy stocks will be greater if they know that their total
liability is limited to the investment they make in buying the shares of stock.

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3. Tying the compensation of managers to the stock price of the firms they manage provides a greater
incentive to pursue strategies that enhance profitability. Members of corporate boards of directors
choose this form of compensation, in part, in response to the principalagent problem.
4. An income statement reports a firms accounting profit, which is net income measured by revenue
minus explicit costsoperating expenses and taxes paidover a period of time. Because the income
statement does not account for the implicit costs incurred by the firm, accounting profit will be
greater than economic profit. Economic profit is computed by subtracting both explicit and implicit
costs from total revenue.
5. Ultimately the accuracy of a firms statements depends on the integrity of corporate officials and the
accountants who audit these statements. If some corporate officials deliberately choose to provide
incomplete and misleading information in their financial statements, then analysts may be persuaded
that their firms are more profitable than they actually are.

True/False Answers
Question

Answer

1.
2.
3.
4.
5.

F
F
T
F
T

6.
7.

F
T

8.

9.

10.

11.
12.

T
F

13.
14.

T
F

15.

Comment
This is the responsibility of the Securities and Exchange Commission.
An increase in the share price results in a capital gain.
This is the definition of indirect finance.
These firms have unlimited liability.
The managers of a corporation are typically not the owners, so the principal
agent problem may arise.
This is the definition of accounting profit.
Because the opportunity cost is included its calculation, economic profit is
smaller than accounting profit.
Stock ownership represents a claim on the firms profits, so the larger the firms
profits are, the higher will be its stock price.
This statement confuses stocks with bonds. The price of stock is equal to the
present value of dividends.
The Sarbanes-Oxley Act came about to prevent future accounting scandals like
those of Enron and WorldCom in 2001.
See Figure 8.1 in the textbook for the distribution of firms.
The chief executive officer of a corporation is appointed by the board of
directors to conduct the firms day-to-day operations.
A partnership allows owners to share risk.
The legal problems resulted from the stock incentive system associated with top
managements pay. The capital gains and dividends that these managers received
from their own shares of stock were higher due to their manipulation of the
financial statements.
The Glass-Steagall Act of 1933 was repealed by Congress in 1999, after which
some commercial banks engaged in investment banking while investment banks
took on too much risk.

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