Chapter 7: firms, investors, and capital markets

Question 1

sole proprietor

Answer 1

single owner of business

Question 2

partership

Answer 2

business owned jointly by town or more individuals

share profits and jointly responsible for losses

Question 3

company or corporation

Answer 3

organization legally allowed to trade and produce products

Question 4

shareholders

Answer 4

individual who invest in companies and therefore are the owners

Question 5

dividends

Answer 5

payments made after tax profits to shareholders

Question 6

capital gains

Answer 6

income resulting from selling shares at a higher price than original purchase price

Question 7

limited liability

Answer 7

liability of a company is limited to the value of the company’s assets

Question 8

retained earnings

Answer 8

profits retained y a company for reinvestment and distributed in dividends

Question 9

business organizations

Answer 9

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

Question 10

business income statement

Answer 10

total operating revenues

net income post tax

shares outstanding

net income/share

dividends/share

market capitalization

Question 11

principal-agent relationship

Answer 11

Management (agent) different from ownership (principal)

Question 12

principal-agent problem

Answer 12

If the principal cannot easily monitor the actions of the agent, the agent may not always act in the best interests of the principal

Question 13

what is a critical difference between economic profit and accounting profit

Answer 13

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

Question 14

difference between accountant and economist

Answer 14

The accountant focuses upon financial flows

the economist includes opportunity cost in addition

Question 15

Are profits all distributed as dividends to Canadians?

Answer 15

No

Some are retained by the firm

Some go to foreign owners

Question 16

diversify risk

Answer 16

avoiding the temptation to put all of their eggs in the one basket

Question 17

fair gamble

Answer 17

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)

Question 18

Risk-averse person

Answer 18

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

Question 19

Risk-neutral person

Answer 19

Only interested in whether the odds yield a profit on average, and ignores the dispersion in possible outcomes

Question 20

rosk pooling

Answer 20

Aggregates independent risks to make the aggregate less uncertain

increases average utility

Individuals pool their risk by investing their savings in several different corporations

Question 21

risk spreading

Answer 21

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

Question 22

independent risks

Answer 22

risk incurred by each individual was independent of the risk incurred by the other

Question 23

system risk

Answer 23

macroeconomic conditions may impact individuals in a similar manner

Question 24

real return

Answer 24

is the nominal return minus the rate of inflation

Question 25

Real return to investing in a company share/stock

Answer 25

is the sum of the dividend and the capital gain or loss, adjusted for the rate of inflation

Question 26

portfolio

Answer 26

combination of assets that is designed to secure an income from investing and to reduce risk

Question 27

capital market

Answer 27

set of financial institutions that funnels financing from investors into bonds and stocks

Question 28

diversification, what does it do?

Answer 28

reduces the total risk of a portfolio by pooling risks across several different assets

Total degree of risk can be measured by the variance

Question 29

extreme stock price variation

Answer 29

the more companies you invest in, the lower to variation

the lower chances you have of making extra profits or extremel losses