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How Stocks Promote Growth
Mr. Way, Economics, 4-26-12
12.2.9 Describe the functions of the
financial markets.
12.1.4 Evaluate the role of private
property as an incentive in conserving
and improving scarce resources, including
renewable and nonrenewable natural
How Stocks Promote Growth
• Increase the availability of funds for
growing firms
• Lower interest rates
• Improve management
Why don’t firms always grow?
• Companies need cash to expand.
– Buy/rent capital
– Pay workers
– Buy materials
– Bureaucratic/Legal issues
– Advertising
• Even when a company finds all the money
to pay for these, it has no guarantee of
success; the expansion may not be
profitable after all.
Where do they get the money?
• For a privately owned firm, they have two
options, each with its downside.
• Profits from previous years/Personal savings
– Takes a long time to accumulate the money
– If they had more money right away, they could
expand immediately and increase profits!
• Take out a loan
– Requires interest payments, lowering profit
– If the expanded firm isn’t profitable, the owner will
have debts they cannot repay -- “ruined”
– The risk to the owner discourages growth.
Where do they get the money? (2)
• For a publicly traded firm, it’s easy:
• Sell partial ownership of the company
– Instant cash to pay for expansion of business!
– Cost of failure falls on investors, decreasing
the risk of loss for the original owner, making
them more likely to take the chance.
– However, shareholders will also take a cut of
the profits – often more than interest on a loan
would be.
Lower Interest Rates
• If some companies get their funds from
investors, they don’t need to take out
loans from banks.
• This means less demand for bank loans.
Since the price of a loan is the interest
rate, the interest rate will fall.
• If the interest rate is low, this lowers the
risk to anyone taking out a loan,
encouraging companies to expand more.
Better Management
• Most shareholders demand the highest
possible profit on their investments –
they’re the ones taking the risk, after all.
• To achieve this, they use their power as
owners to hire the best CEO available to
run the firm.
• New managers find ways to cut costs,
increasing productivity, profits, and
therefore future growth.
Summary Questions:
• How does the stock market increase the
availability of funds for companies?
– (directly and indirectly)
• How else does the stock market promote
growth in the economy?