Chapter 7: firms, investors, and capital markets Flashcards
sole proprietor
single owner of business
partership
business owned jointly by town or more individuals
share profits and jointly responsible for losses
company or corporation
organization legally allowed to trade and produce products
shareholders
individual who invest in companies and therefore are the owners
dividends
payments made after tax profits to shareholders
capital gains
income resulting from selling shares at a higher price than original purchase price
limited liability
liability of a company is limited to the value of the company’s assets
retained earnings
profits retained y a company for reinvestment and distributed in dividends
business organizations
goal is to earn profits
use capital, labor and human expertise to produce goods and services
they have to to produce annual income statement that accurately describes the operation of the company
business income statement
total operating revenues
net income post tax
shares outstanding
net income/share
dividends/share
market capitalization
principal-agent relationship
Management (agent) different from ownership (principal)
principal-agent problem
If the principal cannot easily monitor the actions of the agent, the agent may not always act in the best interests of the principal
what is a critical difference between economic profit and accounting profit
treatment of opportunity cost
Opportunity cost must include a wage to a partner or proprietor that reflects her market opportunities
ex: An owner who can earn $80,000 in the market place, but just pays herself $30,000 incurs an opportunity cost of $50,0
Opportunity cost must also include a market return on any private capital invested in the firm
If an owner invests $200,000 in her firm, the opportunity cost of that choice is the return that amount could safely earn in the market
difference between accountant and economist
The accountant focuses upon financial flows
the economist includes opportunity cost in addition
Are profits all distributed as dividends to Canadians?
No
Some are retained by the firm
Some go to foreign owners
diversify risk
avoiding the temptation to put all of their eggs in the one basket
fair gamble
yields zero profit on average
Example 1:
A coin toss game yielding $0 to a participant on ‘heads’ and $10 on ‘tails’ that has a fee for play of $5 is fair.
(0.5 * $0 + 0.5 * $10 = $5)
Example 2:
A fire insurance policy costing $1,000 to insure a $100,000 home is fair if the house may burn down one time in a hundred
(0.01 * 100,000 + 0.99 * $0 = $1,000)
Risk-averse person
Prefers to avoid risk, but may choose to bet or gamble if the odds are sufficiently in their favour
Will avoid a fair game or fair gamble
A risk averse person will pay more than the ‘fair gamble’ insurance premium in order to insure their house
Risk-neutral person
Only interested in whether the odds yield a profit on average, and ignores the dispersion in possible outcomes
rosk pooling
Aggregates independent risks to make the aggregate less uncertain
increases average utility
Individuals pool their risk by investing their savings in several different corporations
risk spreading
reducing the stake of each participant
insurers reduce their risk exposure by spreading the risk to other insurers
Lloyds of London will spread the risk of a supertanker sinking or an oil well blowing out among other insurers
independent risks
risk incurred by each individual was independent of the risk incurred by the other
system risk
macroeconomic conditions may impact individuals in a similar manner
real return
is the nominal return minus the rate of inflation
