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Chapter 22
Rents, Profits,
and the Financial
Environment
of Business
Introduction
The real return you receive on your
investments depends in part on the rate
of inflation that prevails.
To protect themselves from variable
inflation rates, some investors hold
Treasury Inflation-Protection Securities.
Slide 22-2
Learning Objectives
 Understand the concept of economic rent
 Distinguish among the main organizational
forms of business and explain the chief
advantages and disadvantages of each
 Explain the difference between accounting
profits and economic profits
Slide 22-3
Learning Objectives
 Discuss how the interest rate plays a key
role in allocating resources
 Calculate the present discounted value of a
payment to be received at a future date
 Identify the three main sources of corporate
funds and differentiate between stocks and
bonds
Slide 22-4
Chapter Outline
 Economic Rent
 The Legal Organization of Firms
 Interest
 Methods of Corporate Finance
 The Markets for Stocks and Bonds
Slide 22-5
Did You Know That . . .
 Even in colonial America, securities
were issued with inflation-adjusted
returns?
 Today, some investment houses offer
such securities in the form of inflationindexed bonds?
Slide 22-6
Economic Rent
 Economic rent is payment to the owner
of a resource in excess of its
opportunity cost.
 Some individuals earn economic rent
in the labor force.
Slide 22-7
Economic Rent
 Who earns economic rent for labor
services?
– Movie Stars
– Top Athletes
– Successful innovators
Slide 22-8
Economic Rent
 Superstars who earn economic rent are paid
more than the minimum they would have to
earn in order to continue in their work.
 But the rent serves an economic function of
allocating their labor to the best use.
 The amount of rent they can earn will be
determined by the demand for services only
they can offer.
Slide 22-9
The Legal Organization of Firms
 Proprietorships
– A business owned by one individual who:
• Makes the business decisions
• Receives all the profits
• Is legally responsible for all the debts of the
firm
Slide 22-10
The Legal Organization of Firms
 Proprietorships
– About 70 percent of all U.S. firms
– 10 million firms with sales averaging not
much more than $50,000 per year
– Account for 5 percent of all business
revenues
Slide 22-11
The Legal Organization of Firms
 Advantages of proprietorships
– Easy to form and dissolve
– All decision-making power resides with
the sole proprietor
– Profit is taxed only once
Slide 22-12
The Legal Organization of Firms
 Disadvantages of proprietorships
– Unlimited liability
• The owner of the firm is personally
responsible for all of the firm’s debts
– Limited ability to raise funds
– Proprietorship normally ends with the
death of the proprietor
Slide 22-13
The Legal Organization of Firms
 Partnerships
– A business owned and managed by two
or more co-owners, or partners, who
• Share the responsibilities and the profits of the
firm
• Are individually liable for all the debts of the
partnership
Slide 22-14
The Legal Organization of Firms
 Advantages of partnerships
– Easy to form and dissolve
– Partners retain decision-making power
– Permits more effective specialization
– Profit is taxed only once
Slide 22-15
The Legal Organization of Firms
 Disadvantages of partnerships
– Unlimited liability
– Decision making more costly
– Dissolution generally necessary when a
partner dies or leaves the firm
Slide 22-16
The Legal Organization of Firms
 Corporations
– A legal entity that may conduct business
in its own name just as an individual does
– The owners of a corporation, called
shareholders:
• Own shares of the firm’s profits
• Enjoy the protection of limited liability
Slide 22-17
The Legal Organization of Firms
 Limited Liability
– A legal concept whereby the responsibility,
or liability, of the owners of a corporation is
limited to the value of the shares in the firm
that they own
Slide 22-18
The Legal Organization of Firms
 Advantages of corporations
– Limited liability
– Continues to exist when owner leaves
the business
– Raising large sums of financial capital
Slide 22-19
The Legal Organization of Firms
 Disadvantages of corporations
– Double taxation
– Separation of ownership and control
Slide 22-20
International Policy Example:
One-Yen Business Success
 In order to encourage the formation of new
businesses, Japan instituted a policy that
allowed companies to begin operating with
as little as one yen (the equivalent of less
than a penny) on hand.
 But this has not served as much of a
stimulus, because the other legal and
financial requirements applying to new
businesses are more of an impediment.
Slide 22-21
Profits
 Accounting profit equals
total revenue minus explicit costs.
 If a business earns an accounting profit
that is equal to the normal rate of
return, then it is earning enough to
cover the opportunity cost of capital.
Slide 22-22
Profits
 Economic profit equals
total revenue minus the total
opportunity cost of all inputs used.
 This is equivalent to saying that
economic profit is what remains of total
revenue once all explicit and implicit
costs have been covered.
Slide 22-23
Profits
 Economic theory assumes that the
goal of any firm is to maximize profit.
 An enterprise cannot obtain capital
financing unless it generates the profits
necessary to reward investors.
Slide 22-24
Interest
 Interest is the price paid by debtors to
creditors for the use of financial capital.
 Interest is the market return earned by
capital as a factor of production.
Slide 22-25
Interest and Credit
 The interest rate paid depends on
– Length of the loan
– Risk
– Handling charges
Slide 22-26
Real versus Nominal Interest Rates
 The nominal interest rate rises along
with increases in expected inflation
Slide 22-27
The Allocative Role of Interest
 Interest is a price that allocates loanable
funds to consumers and businesses.
 Like any price set by the free market, it can
serve to bring about an efficient allocation of
a scarce good.
 In this case, the scarce good is financial
capital.
Slide 22-28
Interest Rates and Present Value
 The present value of a given amount to
be received in the future is the most
that someone would pay today in order
to be entitled to receive that amount in
the future.
Slide 22-29
Interest Rates and Present Value
 Present value of $105 to be received
one year from now, if the interest rate
is 5%:
–
PV = 105/(1.05) = 100
–
The present value is $100
Slide 22-30
Interest Rates and Present Value
 Discounting
– The process of determining the present
value of a sum to be received some time
in the future.
Slide 22-31
Interest Rates and Present Value
 Your own personal discount rate will
determine how willing you are to save
and to borrow.
 The market interest rate lies between
the upper and lower ranges of personal
rates of discount.
Slide 22-32
Methods of Corporate Financing
 When it all began—1602
– Dutch East India Company raised
financial capital by:
• Selling ownership shares (stock)
• Using notes of indebtedness (bonds)
• Some profits were retained for reinvestment
Slide 22-33
Methods of Corporate Financing
 Share of Stock
– A legal claim to a share of a corporation’s
future profits
• Common stock
– Incorporates certain voting rights regarding
major policy decisions of the corporation
• Preferred stock
– Owners are accorded preferential treatment
in the payment of dividends
Slide 22-34
Methods of Corporate Financing
 Bond
– A legal claim against a firm, usually
entitling the owner of the bond to receive
a fixed annual coupon payment, plus a
lump-sum payment at the bond’s maturity
date
– Issued in return for funds lent to the firm
Slide 22-35
The Difference Between
Stocks and Bonds
Stocks
Bonds
1. Stocks represent ownership.
1. Bonds represent debt.
2. Common stocks do not have a fixed
dividend rate.
2. Interest on bonds must always be
paid, whether or not any profit is earned.
3. Stockholders can elect a board of
directors, which controls the
corporation.
3. Bondholders usually have no voice in
or over management of the corporation.
4. Stocks do not have a maturity date;
the corporation does not usually
repay the stockholder.
4. Bonds have a maturity date on which
the bondholder is to be repaid the face
value of the bond.
5. All corporations issue or offer to sell
stocks. This is the usual definition
of a corporation.
5. Corporations need not issue bonds.
6. Stockholders have a claim against the
property and income of a corporation after
all creditors’ claims have been met.
6. Bondholders have a claim against the
property and income of a corporation
that must be met before the claims of
stockholders.
Slide 22-36
The Markets for Stocks and Bonds
 New York Stock Exchange (NYSE)
– More than 2,500 stocks are traded on the
NYSE
– About 600 brokerage firms pay up to
$2,000,000 per seat to trade on the NYSE
Slide 22-37
International Example:
A Pan-African Stock Exchange
 There are a few small stock exchanges
spread throughout the African
continent.
 Because the number of trades in each
exchange is small, there may not be
any buyers for a share offered for sale
on a given day.
Slide 22-38
International Example:
A Pan-African Stock Exchange
 In order to create a more continuous
spectrum of buyers and sellers, attempts
have been made to combine all the African
exchanges into one market for the entire
continent.
 If the telecommunications network can bring
this about, it would allow for a market in
which shares would be offered when
demanded, and purchased when supplied.
Slide 22-39
The Markets for Stocks and Bonds
 The theory of efficient markets
– Can you predict the future price of a
stock?
– If all available information about the
performance of a company is incorporated
in the price of its stock, then the best
predictor of tomorrow’s price is today’s
price.
Slide 22-40
The Markets for Stocks and Bonds
 The theory of efficient markets
• If some people are trading based on inside
Information, then they have an opportunity to
profit from their transactions before the market
price adjusts to the information.
Slide 22-41
Issues and Applications:
TIPS From the U.S. Treasury
 Treasury Inflation-Protection Securities have
nominal rates of return that are adjusted to
changes in the Consumer Price Index.
 They guarantee a specified real rate of
return.
 Since 2003, the demand for these securities
has been increasing, which may suggest
increasing uncertainty about future inflation.
Slide 22-42
Summary Discussion
of Learning Objectives
 Economic rent serves an efficient allocative function
for resources that are fixed in supply
 The main types of business organization
– Proprietorship
– Partnership
– Corporation
 Accounting profit is the excess of total revenue over
explicit costs. To arrive at economic profit, we must
subtract implicit costs as well.
Slide 22-43
Summary Discussion
of Learning Objectives
 Interest is a payment for the ability to use
resources today instead of in the future.
 The present value of a sum to be received in
the future can be calculated through
discounting.
 The three main sources of corporate funds
are stocks, bonds, and reinvestment of
profits.
Slide 22-44
End of
Chapter 22
Rents, Profits,
and the Financial
Environment
of Business