Transcript
318Miller•Economics Today, Nineteenth Edition
Chapter 21Rents, Profits, and the Financial Environment of Business317
Answers to Questions for Critical Analysis
Do Government Grants and Subsidies Favor Corporations? (p. 470)
If you were a government official, would you rather have to deal with many small businesses or a few large corporations?
Government officials would rather have to deal with a few large corporations rather than many small businesses.
Why the “Discount rate” That Pension Funds Use to Value Their Liabilities Matters (p. 475)
If administrators of government pension funds for public employees were to discover in a future year that they had used a discount rate was too high, who would end up having to ensure payment of promised pensions?
If administrators of government pension funds were to discover in future year that they had used a discount rate that was too high, taxpayers would end up having to ensure payment of promised pensions.
Does Bounded Rationality Explain Why Some People “Cash Out” Pensions?
(p. 477)
Why do you suppose that some behavioral economists have criticized a recent decision by the United Kingdom’s government to give people more freedom to sell off shares in their pension funds?
Some behavioral economist might view that giving people more freedom to sell off shares in their pension funds would induce people with limited information about the best long-term choices about managing their pension funds to make uninformed choices of selling off their shares of pension funds.
Analyzing Tweets to Predict Stock-Market Swings? (p. 479)
How do you suppose that proponents of the random walk theory for prices of individual shares of stock would respond to the view that the average of stock prices might be predictable? Explain your reasoning.
The random walk theory concerns movements in specific stocks. However, the average or overall level of stock prices might be predictable, especially over a long period of time.
The Federal Reserve Allegedly-and Actually-Has Released Insider Information
(p. 479)
In what respect was one of the releases of confidential Fed policy information discussed above more clearly one involving truly insider information than the other information release?
The internal economic forecasts produced by the Federal Reserve’s staff contain unique information about its potential policy actions.
You Are There
China’s Government Learns That Stock Prices Can Drift Downward (p. 480)
1. Why might state-owned companies that China’s government ordered to buy more shares to help boost returns have been equally likely to have later earned either higher or lower returns? Explain your reasoning.
If share prices of China’s stock market continued to fall, then those shares owned by state-owned companies would generate a negative return. If share prices in fact rose later, then those shares would generate a positive return.
2. What likely caused average stock prices to decline even after China’s government’s efforts to boost the demand for shares of stock? (Hint: Many private individuals and companies continued to seek to sell large amounts of shares of stock.)
As many private individuals and companies continued to sell large amounts of stock shares, the increase in stock shares supplied outweighed the increase in stock shares demanded. As a result, average stock prices would continue to decline.
Issues and Applications
Assessing Three Recent Changes in Stock Exchange Trading (pp. 480–481)
1. Why do you think that people have experienced even more difficulties than usual in predicting the prices of shares of stock issued by individual companies?
Because of the increase in the volatility of stock trading, people have experienced even more difficulties than usual in predicting the prices of individual stocks.
2. Do you suppose that the degree of randomness in the stock prices indicated by the random walk theory has increased or decreased since early 2007? Explain your reasoning.
Because of the increases in both day-to-day variability in share prices as well as their variation within a typical day since early 2007, the degree of randomness in stock prices has increased.
Research Project
1. Take a look at data on daily numbers of NYSE stock transactions, as well as on numbers of and dollar values of shares traded in the Web Links in MyEconLab.
2. To view a measure of volatility of a volatility index for the top 500 firms’ stocks traded on the NYSE, see the Web Links in MyEconLab.
Answers to Problems
21-1. Which of the following individuals would you expect to have a high level of economic rent, and which would you expect to have a low level of economic rent? Explain why for each.
a. Bob has a highly specialized medical skill shared by very few individuals.
b. Sally has never attended school. She is 25 years old and is an internationally known supermodel.
c. Tim is a high school teacher and sells insurance part time.
a. Bob earns a high economic rent. Because he has a specialized skill that is in great demand, his income is likely to be high.
b. Sally earns a high economic rent. Because she is a supermodel, her income is likely to be relatively high.
c. If Tim were to leave teaching, not a relatively high-paying occupation, he could sell insurance full time. Hence, his opportunity cost is high relative to his income, and his economic rent is low.
21-2. Which of the following individuals would you expect to have a high level of economic rent, and which would you expect to have a low level of economic rent? Explain why for each.
a. Emily quit high school at age 17, and she has since worked for several years as a waitress in fast-food restaurants.
b. Demetrius earned a Ph.D. in financial economics, and he is among a handful of experts who specialize in assessing the values of highly complex securities traded in bond markets.
c. Xin was a child prodigy on the violin, and after years of developing her skills, she is now rated among the most talented performing violinists in the world.
a. Because Emily has little education and experience only in the low-wage fast-food industry, her opportunity cost is high relative to her income, and her economic rent is low.
b. Demetrius earns a high economic rent. Because he has a specialized skill that is in great demand, his income is likely to be high.
c. Xin has a specialized skill, and as one of the top performing violinists, her income is likely to be high while her opportunity cost is relatively low. Hence, she likely earns high economic rent.
21-3. In which of the following situation(s) will owners who supply factors of production be most likely to earn economic rents?
a. Highly elastic supply of the factor; highly elastic demand for the factor
b. Highly elastic supply of the factor; highly inelastic demand for the factor
c. Highly inelastic supply of the factor; highly inelastic demand for the factor
The answer is c only because this is the only case in which the supply of the factor is very inelastic.
21-4. A British pharmaceutical company spent several years and considerable funds on the development of a treatment for HIV patients. Now, with the protection afforded by patent rights, the company has the potential to reap enormous gains. The government, in response, has threatened to tax away any economic rents the company may earn. Is this an advisable policy? Why or why not? (Hint: Contrast the short-run and long-run effects of taxing away the economic rents.)
This may not be a sensible policy. In the short run, of course, the government can boost its tax revenues by taxing away all of this company’s economic rents. Nevertheless, in the long run, taxing away all of the rents the company may earn may serve as a deterrent to other companies undertaking high-risk research. As a result, in future years, society may not benefit from as much research into medicines and cures for diseases as it would otherwise.
21-5. Write a brief explanation of the differences among a sole proprietorship, a partnership, and a corporation. In addition, list one advantage and one disadvantage of a proprietorship, a partnership, and a corporation.
A sole proprietorship is a business entity owned by a single individual, whereas a partnership is a business entity jointly owned by more than one individual. A corporation, in contrast, is a legal entity that is owned by shareholders, who own shares of the profits of the entity. Sole proprietorships and partnerships do not face double taxation, but corporations do. The owners of corporations, however, enjoy limited liability, whereas the sole proprietor or partner does not.
21-6. After graduation, you face a choice. One option is to work for a multinational consulting firm and earn a starting salary (benefits included) of $40,000. The other option is to use $5,000 in savings to start your own consulting firm. You could earn an interest return of 5 percent on your savings. You choose to start your own consulting firm. At the end of the first year, you add up all of your expenses and revenues. Your total includes $12,000 in rent, $1,000 in office supplies, $20,000 for office staff, and $4,000 in telecommunications expenses. What are your total explicit costs and total implicit costs?
Explicit costs are $12,000 in rent, $1,000 in office supplies, $20,000 for office staff, and $4,000 in telephone expenses, for a total of $37,000. Implicit costs are the forgone $40,000 salary and the 5 percent interest on the $5,000 savings ($250), for a total of $40,250.
21-7. Suppose, as in Problem 21-6, that you have now operated your consulting firm for a year. At the end of the first year, your total revenues are $77,250. Based on the information in Problem 21-6, what is the accounting profit, and what is your economic profit?
Accounting profit is total revenue, $77,250, minus explicit costs, $37,000, for a total of $40,250. Economic profit is total revenue, $77,250, less explicit costs, $37,000, and implicit costs, $40,250, for a total equal to zero.
21-8. An individual leaves a college faculty, where she was earning $80,000 a year, to begin a new venture. She invests her savings of $20,000, which were earning 10 percent annually. She then spends $40,000 renting office equipment, hires two students at $60,000 a year each, rents office space for $24,000, and has other variable expenses of $80,000. At the end of the year, her revenues are $400,000. What are her accounting profit and her economic profit for the year?
The accounting profit is equal to revenue minus explicit costs. This is $400,000 minus $20,000 (office equipment), $60,000 (student labor), $24,000 (rent), $40,000 (variable expenses), which equals $256,000. Economic profit is derived by subtracting out opportunity costs which equals the foregone salary of $80,000 and the interest she could have earned on her savings, 0.10
(10 percent) times $20,000, or $2,000. Economic profit is $174,000.
21-9. Classify the following items as either financial capital or physical capital.
a. A computer server owned by an information-processing company
b. $100,000 set aside in an account to purchase a computer server
c. Funds raised through a bond offer to expand plant and equipment
d. A warehouse owned by a shipping company
a. Physical capital
b. Financial capital
c Financial capital
d. Physical capital
21-10. Explain the difference between the dividends of a corporation and the profits of a proprietorship or partnership, particularly in their tax treatment.
The dividends of a corporation result from the corporation’s profits, which are subject to corporate income taxation. The dividends that are paid to the shareholders are also taxes as personal income. The profits of a partnership or proprietorship are subject only to individual income tax.
21-11. The owner of WebCity is trying to decide whether to remain a proprietorship or to incorporate. Suppose that the corporate tax rate on profits is 20 percent and the personal income tax rate is 30 percent. For simplicity, assume that all corporate profits (after corporate taxes are paid) are distributed as dividends in the year they are earned and that such dividends are subject to tax at the personal income tax rate.
a. If the owner of WebCity expects to earn $100,000 in before-tax profits this year, regardless of whether the firm is a proprietorship or a corporation, which method of organization should be chosen?
b. What is the dollar value of the after-tax advantage of the form of organization determined in part (a)?
c. Suppose that the corporate form of organization has cost advantages that will raise before-tax profits by $50,000. Should the owner of WebCity incorporate?
d. Based on parts (a) and (c), by how much will after-tax profits change due to incorporation?
e. Suppose that tax policy is changed to completely exempt from personal taxation the first $40,000 per year in dividends. Would this change in policy affect the decision made in part (a)?
f. How can you explain the fact that even though corporate profits are subject to double taxation, most business in the United States is conducted by corporations rather than by proprietorships or partnerships?
a. The owner of WebCity faces both tax rates if the firm is a corporation, but if it is a proprietorship the owner faces only the 30 percent personal income tax rate. Thus, it should choose to be a proprietorship.
b. If WebCity is a corporation, the $100,000 in corporate earnings is taxed at a 20 percent rate, so that after-tax dividends are $80,000, and these are taxed at the personal income tax rate of 30 percent, leaving $56,000 in after-tax income for the owner. Hence, the firm should be organized as a proprietorship, with after-tax earnings $70,000, or a value advantage of $14,000.
c. Yes. In this case, incorporation raises earnings to $150,000, which are taxed at a rate of
20 percent, yielding after-tax dividends of $120,000 that are taxed at the personal rate of
30 percent. This leaves an after-tax income for the owner of $84,000, which is higher than
the after-tax earnings of $70,000 if WebCity is a proprietorship that earns lower pre-tax income taxed at the personal rate.
d. After-tax profits rise from $56,000 to $84,000, or by $28,000.
e. This policy change would only increase the incentive to incorporate.
f. A corporate structure provides limited liability for owners, which can be a major advantage. Furthermore, owners may believe that the corporate structure will yield higher pretax earnings, as in the above example.
21-12. Explain how the following events would likely affect the relevant interest rate.
a. A major bond-rating agency has improved the risk rating of a developing nation.
b. The government has passed legislation requiring bank regulators to significantly increase the paperwork required when a bank makes a loan.
a. The debt issued by this country will not appear as risky to individuals. Thus, they will not require as high an interest rate, and the market interest rate will decline.
b. Increases in reporting requirements increase the cost of issuing a loan. The lender will increase rates to compensate for this, as will other lenders. The market interest rate will rise.
21-13. Suppose that the interest rate in Japan is only 2 percent, while the comparable rate in the United States is 4 percent. Japan’s rate of inflation is 0.5 percent, while the U.S. inflation rate is 3 percent. Which economy has the higher real interest rate?
The real rate of interest in Japan is 2% ? 0.5% = 1.5%. The real rate of interest in the United States is 4% ? 3% = 1%. Japan, therefore, has the higher real rate of interest.
21-14. You expect to receive a payment of $104 one year from now.
a. Your rate of discount is 4 percent. What is the present value of the payment to be received?
b. Suppose that your rate of discount rises to 5 percent. What is the present value of the payment to be received?
a. With a 4 percent discount rate, the present value is $104/1.04 = $100.
b. With a 5 percent discount rate, the present value is $104/1.05 = $99.05.
21-15. Outline the differences between common stock and preferred stock.
Ownership of common stock provides voting rights within the firm but also entails immediate loss if assets fall below the value of the firm’s liabilities. Preferred stockholders are repaid prior to owners of common stock, but preferred stockholders do not have voting rights.
21-16. Explain the basic differences between a share of stock and a bond.
A share of stock is a legal claim on the firm and a claim to future profits of the firm. A bond is a loan to the firm and entitles the holder to receive a fixed annual coupon payment and a lump-sum payment of principal at maturity. Bondholders are paid regardless of the profit level of the firm and do not have any claims on future profits.
21-17. Suppose that one of your classmates informs you that he has developed a method of forecasting stock market returns based on past trends. With a monetary investment from you, he claims that the two of you could profit handsomely from this forecasting method. How should you respond to your classmate?
You should point out to your classmate that stock prices tend to drift upward following a random walk. That is, yesterday’s price plus any upward drift is the best guide to today’s price. Therefore, there are no predictable trends that can be used to “beat” the market.
21-18. Suppose that you are trying to decide whether to spend $1,000 on stocks issued by WildWeb or on bonds issued by the same company. There is a 50 percent chance that the value of the stock will rise to $2,200 at the end of the year and a 50 percent chance that the stock will be worthless at the end of the year. The bonds promise an interest rate of 20 percent per year, and it is certain that the bonds and interest will be repaid at the end of the year.
a. Assuming that your time horizon is exactly one year, will you choose the stocks or the bonds?
b. By how much is your expected end-of-year wealth reduced if you make the wrong choice?
c. Suppose the odds of success improve for WildWeb: Now there is a 60 percent chance that the value of the stock will be $2,200 at year’s end and only a 40 percent chance that it will be worthless. Should you now choose the stocks or the bonds?
d. By how much did your expected end-of-year wealth rise as a result of the improved outlook for WildWeb?
a. The average value of stocks at the end of the year is (0.5 × $2,200) + (0.5 × $0) = $1,100,
and the known value of bonds plus accumulated interest is $1,200, so the choice of bonds has a higher average value.
b. . Average wealth would be $100 lower.
c. The average value of stocks rises to $1,320, so the choice of stocks has a higher average value.
d. Average wealth would be $120 higher.
21-19. Take a look at Figure 21-1. Suppose that Q1 = 10 acres and P1 = $2,000 per acre. What is the dollar amount of economic rents received during the current period, and why is this amount classified as economic rents?
The economic rents are equal to the total revenues received by landowners during the current period, which equal 10 acres multiplied by $2,000 per acre, or $20,000. These total revenues constitute economic rents because land’s opportunity cost is equal to zero, so all payments received by landowners are economic rents.
21-20. Reconsider Figure 21-1 and the data provided in Problem 21-19, and suppose that
P2 = $2,800 per acre. By how much do economic rents change when the rental rate
on land rises from P1 to P2 in the figure?
The rise in the rental rate from $2,000 per acre to $2,800 per acre is an increase in the rental rate on land relative to land’s zero opportunity cost, so during the current period economic rents rise by $800 per acre multiplied by 10 acres, or by $8,000.
21-21. Consider Figure 21-2. Explain why the figure indicates that if the normal rate of return on investment were to remain unchanged while accounting profit increased, economic profit also would increase?
The green-shaded amount of accounting profit equals the sum of the yellow-shaded economic profit and the blue-shaded opportunity cost of capital plus any other implicit costs. Consequently, if the green-shaded amount of accounting profit were to increase while the blue-shaded opportunity cost of capital plus any other implicit costs remained unchanged, the yellow-shaded economic profit would have to rise.
21-22. Take a look at Figure 21-2. Explain why the figure implies that if the amount of accounting profit were to shrink to zero while the normal rate of return on investment remained unchanged, economic profit necessarily would become negative?
The green-shaded amount of economic profit equals the sum of the orange-shaded economic profit and the blue-shaded opportunity cost of capital plus any other implicit costs. The latter, blue-shaded quantity is a positive amount of incurred costs that have not changed as the amount of accounting profit has shrunk to zero. Hence, the difference, economic profits, would have to become a negative amount.
21-23. Take a look at Table 21-1. Suppose that you are planning your retirement. The appropriate interest rate for computing the present values of future dollars to be received is 8 percent, and you plan to “cash in” all of what you save for retirement this year in exactly 30 years. How many dollars would you have to save this year to ensure being able to have a total of $50,000 accumulated 30 years from now?
Today’s present value at a 30-year horizon for each dollar saved at an interest rate of 8 percent
is $0.0994. Thus, you would have to save $0.0994 today per future dollar you wanted to have available 30 years from now, or $0.0994 today per future dollar times 50,000 future dollars, or $4,970. Thus, you would have to save $4,970 just this year to assure have $50,000 available
30 years from now.
21-24. Reconsider Table 21-1, and assume that as in Problem 21-23, you wish to save enough this year to have $50,000 available for your planned retirement 30 years into the future. How many dollars would you have to save this year to ensure that a total amount of $50,000 would be accumulated 30 years into the future if the interest rate appropriate for discounting decreases to 3 percent?
Today’s present value at a 30-year horizon of each dollar saved an interest rate of 3 percent rises to $0.412. Thus, you would have to save $0.412 today per future dollar you wanted to have available 30 years from now, or $0.412 today per future dollar times 50,000 future dollars, or $20,600. Thus, you now would have to save $20,600 today to assure accumulating $50,000 to have available 30 years from now.
Selected References
Berle, Adolf A., Power Without Property, New York: Harcourt, Brace, and World, 1959.
Cootner Paul H., ed., The Random Character of Stock Market Price, Cambridge, MA: MIT Press, 1964.
Eitman, David K. and Arthur I. Stone, Multinational Business Finance, 5th ed., New York: Addison Wesley, 1989.
Fortier, Diana L., “Hostile Takeovers and the Market for Corporate Control,” Economic Perspectives, Federal Reserve Bank of Chicago, January/February 1989, pp. 2–16.
Geisst, Charles R., A Guide to the Financial Markets, New York: St. Martin’s Press, 1989.
Gitman, Lawrence J. and Carl McDaniel, The World of Business, Cincinnati, OH: South-Western Publishing Company, 1992.
Malkeil, Burton C., A Random Walk Down Wall Street, 4th ed., New York: W.W. Norton, 1985.
Nickles, William G., Understanding Business, Homewood, IL: Irwin.
