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7: Firms, investors and capital markets

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    Chapter 7: Firms, investors and capital markets

    In this chapter we will explore:

    7.1

    Business organization

    7.2

    Corporate goals – profit

    7.3

    Risk and the investor

    7.4

    Pooling risks

    7.1 Business organization

    Suppliers of goods and services to the marketplace come in a variety of forms; some are small, some are large. But, whatever their size, suppliers choose an organizational structure that is appropriate for their business: Aircraft, oil rigs, social media and information services are produced by large corporations; dental services and family health are provided by individual professionals or private partnerships.

    The initial material of this chapter addresses organizational forms, their goals and their operation. We then examine why individuals choose to invest in firms, and illustrate that such investment provides individual investors with a means both to earning a return on their savings and to managing the risk associated with investing. Uncertainty regarding the future is a central consideration.

    Understanding the way firms and capital markets function is crucial to understanding our economic history and how different forms of social and economic institutions interact. For example, seventeenth-century Amsterdam had a thriving bourgeoisie, well-developed financial markets, and investors with savings. This environment facilitated the channeling of investors' funds to firms specializing in trade and nautical conquest. This tiny state was then the source of some of the world's leading explorers and traders, and it had colonies stretching to Indonesia. The result was economic growth and prosperity.

    In contrast, for much of the twentieth century, the Soviet Union dominated a huge territory covering much of Asia and Europe. But capital markets were non-existent, independent firms were stifled, and economic decline ultimately ensued. Much of the enormous difference in the respective patterns of economic development can be explained by the fact that one state fostered firms, capital markets, and legal institutions, while the other did not. In terms of our production possibility frontier: One set of institutional arrangements was conducive to expanding the possibilities; the other was not. Sustainable new businesses invariably require investors at an early point in the lifecycle of the business. Accordingly, financial and legal institutions that facilitate the flow of savings and financial investment into new enterprises perform a vital function in the economy.

    Businesses, or firms, have several different forms. At the smallest scale, a business takes the form of a sole proprietor or sole trader who is the exclusive owner. A sole trader gets all of the revenues from the firm and incurs all of the costs. Hence he may make profits or be personally liable for the losses. In the latter case his business or even personal assets may be confiscated to cover debts. Personal bankruptcy may result.

    Sole proprietor is the single owner of a business.

    If a business is to grow, partners may be required. Such partners can inject money in exchange for a share of future profits. Firms where trust is involved, such as legal or accounting firms, typically adopt this structure. A firm is given credibility when customers see that partners invest their own wealth in it.

    Partnership: a business owned jointly by two or more individuals, who share in the profits and are jointly responsible for losses.

    In order to expand and grow, a firm will need cash, perhaps partners, and investors. Providers of family health and dental services rely primarily on human expertise, and therefore they need relatively little physical capital. Hence their cash start-up needs are limited. But firms that produce aircraft, or develop software and organizational systems, need vast amounts of money for capital investment; pharmaceuticals may need a billion dollars worth of research and development to bring a new drug to the marketplace; ride-sharing companies need billions in order to establish their business globally. Such businesses must form corporations – also known as companies. Not all corporations are public; some are privately held, but relatively few large corporations are not publicly traded.

    Large organizations have several inherent advantages over small organizations when a high output level is required. Specialization in particular tasks leads to increased efficiency for production workers. At the same time, non-production workers can perform a multitude of different tasks. If a large corporation decided to contract out every task involved in bringing its product to market, the costs of such agreements would be prohibitively high. In addition, synergies can arise from teamwork. New ideas and better work flow are more likely to materialize when individuals work in close proximity than when working as isolated units, no matter how efficient they may be individually. A key aspect of such large organizations is that they have a legal identity separate from the managers and owners.

    Corporation or company is an organization with a legal identity separate from its owners that produces and trades.

    The owners of a corporation are known as its shareholders, and their object is usually to make profits. There also exist non-profit corporations whose objective may be philanthropic. Since our focus is upon markets, we will generally assume that profits form the objective of a typical corporation. The profits that accrue to a corporation may be paid to the shareholders in the form of a dividend, or retained in the corporation for future use. When large profits (or losses) accrue the value of the corporation increases (or decreases), and this is reflected in the value of each share of the company. If the value of each share in the company increases (decreases) there is a capital gain (loss) to the owners of the shares – the shareholders. In any given year shareholders may receive a dividend and also obtain a capital gain (or loss). The sum of the dividend and capital gain represents the return to owning corporate stock in that year. When this sum is adjusted for inflation it is termed the real return on corporate stock

    Shareholders invest in corporations and therefore are the owners.

    Dividends are payments made from after-tax profits to company shareholders.

    Capital gains (losses) arise from the ownership of a corporation when an individual sells a share at a price higher (lower) than when the share was purchased.

    Real return to corporate stock is the inflation-adjusted sum of dividends and capital gain (or loss).

    A key difference between a company and a partnership is that a company involves limited liability, whereas a partnership does not. Limited liability means that the liability of the company is limited to the value of the company's assets. Shareholders cannot be further liable for any wrongdoing on the part of the company. Accordingly, partnerships and sole traders normally insure themselves and their operations. For example, all specialist doctors carry malpractice insurance, and engineers insure themselves against error.

    Limited liability means that the liability of the company is limited to the value of the company's assets.

    Corporations use capital, labour, and human expertise to produce a good, to supply a service, or to act as an intermediary. Corporations are required to produce an annual income statement that accurately describes the operation of the firm. An example is given in Table 7.1.

    Table 7.1 The Regal Bank of Toronto, 2025
    Total Revenue $ 32.0b
    Net income post tax $ 4.80b
    Shares outstanding 640m
    Net income/share $ 7.50
    Dividends/share $ 2.50
    Share price $ 72.0
    Market capitalization $ 46.08b

    The data in Table 7.1 define the main financial characteristics of an imaginary bank: the Regal Bank of Toronto in the year 2025. "Net income post-tax" represents after-tax profits. There are 640 million shares outstanding, and thus each share could be attributed a profit of img229.png. Of this amount, $2.50 is distributed to shareholders in the form of dividends per share. The remainder is held by the Corporation in the form of retained earnings - to be used for future investment primarily. Each share traded at a price of $72.00. Given that there were 640 million shares, the total market valuation of the corporation at that time stood at $46.08 billion (img230.png).

    Such information is publicly available for a vast number of corporations at the 'finance' section of major search engines such as Google or Yahoo.

    Retained earnings are the profits retained by a company for reinvestment and not distributed as dividends.

    In Canada, the corporate sector as a whole tends to hold on to more than half of after-tax profits in the form of retained earnings. However there exists considerable variety in the behaviour of corporations, and most firms establish a pattern of how profits are allocated between dividends and retained earnings. In the Table 7.1 example, one third of profits are distributed; yet some corporations have a no-dividend policy. In these latter cases the benefit to investing in a firm must come in the form of capital gain to the owners of the shares.

    7.2 Profit

    Ownership and corporate goals

    As economists, we believe that profit maximization accurately describes a typical firm's objective. However, since large firms are not run by their owners but by their executives or agents, it is frequently hard for the shareholders to know exactly what happens within a company. Even the board of directors—the guiding managerial group—may not be fully aware of the decisions, strategies, and practices of their executives and managers. Occasionally things go wrong, sometimes as a result of managers deciding to follow their own interests rather than the interests of the company. In technical terms, the interests of the corporation and its shareholders might not be aligned with the interests of its managers. For example, managers might have a short horizon and take steps to increase their own income in the short term, knowing that they will move to another job before the long-term effects of their decisions impact the firm.

    At the same time, the marketplace for the ownership of corporations exerts a certain discipline: If firms are not as productive or profitable as possible, they may become subject to takeover by other firms. Fear of such takeover can induce executives and boards to maximize profits.

    The shareholder-manager relationship is sometimes called a principal-agent relationship, and it can give rise to a principal-agent problem. If it is costly or difficult to monitor the behaviour of an agent because the agent has additional information about his own performance, the principal may not know if the agent is working to achieve the firm's goals. This is the principal-agent problem.

    Principal or owner: delegates decisions to an agent, or manager.

    Agent: usually a manager who works in a corporation and is directed to follow the corporation's interests.

    Principal-agent problem: arises when the principal cannot easily monitor the actions of the agent, who therefore may not act in the best interests of the principal.

    In an effort to deal with such a challenge, corporate executives frequently get bonuses or stock options that are related to the overall profitability of their firm. Stock options usually take the form of an executive being allowed to purchase the company's stock in the future – but at a price that is predetermined. If the company's profits do increase, then the price of the company's stock will reflect this and increase likewise. Hence the executive has an incentive to work with the objective of increasing profits because that will enable him to buy the company stock in the future at a lower price than it will be worth.

    Stock option: an option to buy the stock of the company at a future date for a fixed, predetermined price.

    The threat of takeover and the structure of rewards, together, imply that the assumption of profit maximization is a reasonable one.

    Application Box 7.1 The 'Sub-Prime' mortgage crisis: A principal-agent problem

    With a decline in interest and mortgage rates in the early part of the twenty first century, many individuals believed they could afford to buy a house because the borrowing costs were lower than before. Employees and managers of lending companies believed likewise, and they structured loans in such a way as to provide an incentive to low-income individuals to borrow. These mortgage loans frequently enabled purchasers to buy a house with only a 5% down payment, in some cases even less, coupled with a repayment schedule that saw low repayments initially but higher repayments subsequently. The initial interest cost was so low in many of these mortgages that it was even lower than the 'prime' rate – the rate banks charge to their most prized customers.

    The crisis that resulted became known as the 'sub-prime' mortgage crisis. In many cases loan officers got bonuses based on the total value of loans they oversaw, regardless of the quality or risk associated with the loan. The consequence was that they had the incentive to make loans to customers to whom they would not have lent, had these employees and managers been lending their own money, or had they been remunerated differently. The outcomes were disastrous for numerous lending institutions. When interest rates climbed, borrowers could not repay their loans. The construction industry produced a flood of houses that, combined with the sale of houses that buyers could no longer afford, sent housing prices through the floor. This in turn meant that recent house purchasers were left with negative value in their homes – the value of their property was less than what they paid for it. Many such 'owners' simply returned the keys to their bank, declared bankruptcy and walked away. Some lenders went bankrupt; some were bailed out by the government, others bought by surviving firms. This is a perfect example of the principal agent problem – the managers of the lending institutions and their loan officers did not have the incentive to act in the interest of the owners of those institutions.

    The broader consequence of this lending practice was a financial collapse greater than any since the Depression of the nineteen thirties. Assets of the world's commercial and investment banks plummeted in value. Their assets included massive loans and investments both directly and indirectly to the real estate market, and when real estate values fell, so inevitably did the value of the assets based on this sector. Governments around the world had to buy up bad financial assets from financial institutions, or invest massive amounts of taxpayer money in these same institutions. Otherwise the world's financial system might have collapsed, with unknowable consequences.

    Taxpayers and shareholders together bore the burden of this disastrous investment policy. Shareholders in many banks saw their shares drop in value to just a few percent of what they had been worth a year or two prior to the collapse.

    Economic and accounting profit

    Economists and accountants frequently differ in how they measure profits. An accountant stresses the financial flows of corporate activity; the economist is, in addition, concerned with opportunity cost. Imagine that Felicity has just inherited $250,000 and decides to pursue her dream by opening a clothing boutique. She quits her job that pays her $55,000 per annum, invests her inheritance in the purchase of a small retail space on the high street and launches her business. At the end of her first year she records $110,000 in clothing sales, which she purchased from the wholesaler for $50,000. She pays herself a salary of $35,000 and has no other accounting costs because she owns her physical capital – the store. Her accounting profit for the year is given by the margin returned between the buying and selling price of her clothing ($60,000) minus her incurred costs ($35,000) in salary. Her accounting profit is thus $25,000. Should she be content with this sum?

    Felicity's economist friend, Prudence, informs Felicity that her enterprise is not returning a profit by economic standards. Prudence points out that Felicity could earn $55,000 as an alternative to working in her own store, hence there is an additional implicit cost of $20,000 to be considered, because Felicity only draws a salary of $35,000. Furthermore, Felicity has invested $250,000 in her business to avoid rent. But that sum, invested at the going interest rate of 4%, could earn her $10,000 per annum. That too is a foregone income stream so it is an implicit cost. Altogether, the additional implicit costs, not included in the accounting flows, amount to $30,000, and these implicit costs exceed the 'accounting profits'. Thus no economic profits are being made, because the economist includes implicit costs in her profit calculation. In economic terms Felicity would be better off by returning to her job and investing her inheritance. That strategy would generate an income of $65,000, as opposed to the income of $60,000 that she generates from the boutique – a salary of $35,000 plus an accounting profit of $25,000.

    We can summarize this: Accounting profit is the difference between revenues and explicit costs. Economic profit is the difference between revenue and the sum of explicit and implicit costs. Explicit costs are the measured financial costs; Implicit costs represent the opportunity cost of the resources used in production.

    Accounting profit: is the difference between revenues and explicit costs.

    Economic profit: is the difference between revenue and the sum of explicit and implicit costs.

    Explicit costs: are the measured financial costs.

    Implicit costs: represent the opportunity cost of the resources used in production.

    We will return to these concepts in the following chapters. Opportunity cost, or implicit costs, are critical in determining the long-run structure of certain sectors in the economy.

    7.3 Risk and the investor

    Firms cannot grow without investors. A successful firm's founder always arrives at a point where more investment is required if her enterprise is to expand. Frequently, she will not be able to secure a sufficiently large loan for such growth, and therefore must induce outsiders to buy shares in her firm. She may also realize that expansion carries risk, and she may want others to share in this risk. Risk plays a central role in the life of the firm and the investor. Most investors prefer to avoid risk, but are prepared to assume a limited amount of it if the anticipated rewards are sufficiently attractive.

    An illustration of risk-avoidance is to be seen in the purchase of home insurance. Most home owners who run even a small risk of seeing their house burn down, being flooded, or damaged by a gas leak purchase insurance. By doing so they are avoiding risk. But how much are they willing to pay for such insurance? If the house is worth $500,000 and the probability of its being destroyed is one in one thousand in a given year then, using an averaging perspective, individuals should be willing to pay an insurance premium of $500 per annum. That insurance premium represents what actuaries call a 'fair' gamble: If the probability of disaster is one in one thousand, then the 'fair' premium should be one thousandth the value of the home that is being insured. If the insurance company insures millions of homes, then on average it will have to pay for the replacement of one house for every one thousand houses it insures each year. So by charging homeowners a price that exceeds $500 the insurer will cover not only the replacement cost of homes, but in addition cover her administrative costs and perhaps make a profit. Insurers operate on the basis of what we sometimes call the 'law of large numbers'.

    In fact however, most individuals are willing to pay more than this 'fair' amount, and actually do pay more. If the insurance premium is $750 or $1,000 the home-owner is paying more than is actuarially 'fair', but a person who dislikes risk may be willing to pay such an amount in order to avoid the risk of being uninsured.

    Our challenge now is to explain why individuals who purchase home insurance on terms that are less than actuarially 'fair' in order to avoid risk are simultaneously willing to invest their retirement savings into risky companies. Companies, like homes, are risky; while they may not collapse or implode in any given year, they can have good or bad returns in any given year. Corporate returns are inherently unpredictable and therefore risky. The key to understanding the willingness of risk-averse individuals to invest in risky firms is to be found in the pooling of risks.

    7.4 Risk pooling and diversification

    Silicon Valley: from angel investors to public corporation

    Risky firms frequently succeed in attracting investment through the capital market in the modern economy. A typical start-up firm in the modern economy originates in the form of an idea. The developers of Uber got the idea of simplifying and streamlining the ride sharing business (sometimes called the taxi business). In its simplest form the inventors developed an App that would link users to drivers. The developers of Airbnb got the idea that spare accommodations in individual homes could be used to satisfy the needs of travellers. The founders developed an efficient means of putting potential renters/guests in communication with suppliers of rooms, houses and condominiums. WeWork was founded on the belief that workers and small corporations, particularly those in the technology sector, have immediate and changing space needs. The result is that WeWork provides flexible work space on a 'just in time' basis, frequently on a shared overhead basis. Each of these corporations acts as an intermediary, and sells intermediation services.

    Typically the initial funding for new ideas comes from a couple of founding partners who develop a model or prototype of their software or their business. Following trials, the founders may approach potential investors for 'small' amounts that will fund expansion. Such investors are frequently 'angel' investors because they are a source of funding that makes the difference between expansion and death for the venture in question. If the venture shows promise the founders seek 'round A' funding, and this funding may come from venture capitalists who specialize in new ventures. Further evidence of possible success may result in 'round B' funding, and this frequently amounts to hundreds of millions of dollars.

    Venture funds are managed by partners, or capitalists, with reputations for being better able than most to predict which start-ups will ultimately see profitability. These venture capitalists invest both their own funds and the funds of individuals who entrust their accumulated savings to the investing partnership.

    But extremely high risk is associated with most start-ups. Funding frequently takes place in an environment where the venture has no revenue; merely a product in the course of development. Winners in the new economy are recognized and celebrated. Bill Gates' Microsoft, Jeff Bezos' Amazon, Steve Jobs Apple, and Larry Page and Sergey Brin's Google are corporate giants with valuations approach one trillion dollars. But Elizabeth Holmes' Theranos, once with an implicit valuation of several billion dollars has expired. Theranos hired several hundred employees with the aim of developing blood tests for scores of purposes using just a pin-prick of blood. But it was a failure, despite attracting hundreds of millions of dollars in investment. In the year 2019 Canada had dozens of cannabis-based firms listed on the Canadian Securities Exchange. None of these is earning a profit in 2020, some have negligible earnings, yet several have a value in excess of one billion dollars. It is highly improbable that all will survive.

    Capital market: a set of financial institutions that funnels financing from investors into bonds and stocks.

    Venture capital: investment in a business venture, where the ultimate outcome is highly unpredictable.

    How can we reconcile the fact that, while these firms carry extraordinary uncertainty, investors are still willing to part with large sums of money to fund development? And the investors are not only billionaires with a good sense of the marketplace; private individuals who save for their retirement also invest in risky firms on the advice of their financial manager. Let us explore how and why.

    Dealing with risk

    Most (sensible) investors hold a portfolio of investments, which is a combination of different stocks and bonds. By investing in different stocks and bonds rather than concentrating in one single investment or type of investment, an individual diversifies her portfolio, which is to say she engages in risk pooling. Venture capital partnerships act in the same way. They recognize that their investments in start-ups will yield both complete failures and some roaring successes; the variation in their outcomes will exceed the variation in the outcomes of an investor who invests in 'mature' corporations.

    Portfolio: a combination of assets that is designed to secure an income from investing and to reduce risk.

    Risk pooling: Combining individual risks in such a way that the aggregate risk is reduced.

    A rigorous theory underlies this "don't put all of your eggs in the one basket" philosophy. The essentials of diversification or pooling are illustrated in the example given in Table 7.2 below.1 There are two risky stocks here: Natural Gas (NG) and technology (Tech). Each stock is priced at $100, and over time it is observed that each yields a $10 return in good times and $0 in bad times. The investor has $200 to invest, and each sector independently has a 50% probability (p=0.5) of good or bad times. This means that each stock should yield a $5 return on average: half of all outcomes will yield $10 and half will yield zero. The challenge here is to develop an investment strategy that minimizes the risk for the investor.

    At this point we need a specific working definition of risk. We define it in terms of how much variation a stock might experience in its returns from year to year. Each of NG and Tech have returns of either $0 or $10, with equal probability. But what if the Tech returns were either img231.png or img232.png with equal probability; or img233.png or img234.png with equal probability? In each of these alternative scenarios the average outcome remains the same: A positive average return of $5. If the returns profile to NG remains unchanged we would say that Tech is a riskier stock (than NG) if its returns were defined by one of the alternatives here. Note that the average return is unchanged, and we are defining risk in terms of the greater spread in the possible returns around an unchanged average. The key to minimizing risk in the investor's portfolio lies in exploring how the variation in returns can be minimized by pooling risks.

    Risk measurement: A higher degree of risk is associated with increased variation in the possible returns around an unchanged mean return.

    Table 7.2 Investment strategies with risky assets
    Strategy Expected returns with probabilities
    $200 in NG 220 (p=0.5) 200 (p=0.5)
    $200 in Tech 220 (p=0.5) 200 (p=0.5)
    $100 in each 220 (p=0.25) 210 (p=0.5) 200 (p=0.25)

    The outcomes from three different investment strategies are illustrated in Table 7.2. By investing all of her $200 in either NG or Tech, she will obtain $220 half of the time and $200 half of the time, as indicated in the first two outcome rows. But by diversifying through buying one of each stock, as illustrated in the final row, she reduces the variability of her portfolio. To see why note that, since the performance of each stock is independent, there is now only a one chance in four that both stocks do well, and therefore there is a 25 percent probability of earning $220. By the same reasoning, there is a 25 percent probability of earning $200. But there is a 50 percent chance that one stock will perform well and the other poorly. When that happens, she gets a return of $210. In contrast to the outcomes defined in rows 1 and 2, the diversification strategy in row 3 yields fewer extreme potential outcomes and more potential outcomes that lie closer to the mean outcome.

    Diversification reduces the total risk of a portfolio by pooling risks across several different assets whose individual returns behave independently.

    Further diversification could reduce the variation in possible returns even further. To see this, imagine that, rather than having a choice between investing in one or two stocks, we could invest in four different stocks with the same returns profile as the two given in the table above. In such a case, the likelihood of getting extreme returns would be even lower than when investing in two stocks. This is because, if the returns to each stock are independent of the returns on the remaining stocks, it becomes increasingly improbable that all, or almost all, of the stocks will experience favorable (or unfavorable) returns in the same year. Now, imagine that we had 8 stocks, or 16, or 32, or 64, etc. The "magic" of diversification is that the same average return can be attained, yet variability can be reduced. If it can be reduced sufficiently by adding ever more stocks to the portfolio, then even a highly risk-averse individual can build a portfolio that is compatible with buying into risky firms.

    We can conclude from this simple example that there need be no surprise over the fact that risk-averse individuals are willing, at the same time, to pay a high home-insurance premium to avoid risk, and simultaneously invest in risky ventures.

    Application Box 7.2 The value of a financial advisor

    The modern economy has thousands of highly-trained financial advisors. The successful ones earn huge salaries. But there is a puzzle: Why do such advisors exist? Can they predict the behaviour of the market any better than an uninformed advisor? Two insights help us answer the question.

    First, Burton Malkiel wrote a best seller called A Random Walk down Wall Street. He provided ample evidence that a portfolio chosen on the basis of a monkey throwing darts at a list of stocks would do just as well as the average portfolio constructed by your friendly financial advisor.

    Second, there are costs of transacting: An investor who builds a portfolio must devote time to the undertaking, and incur the associated financial trading cost. In recognizing this, investors may choose to invest in what they call mutual funds – a diversified collection of stocks – or may choose to employ a financial advisor who will essentially perform the same task of building a diversified portfolio. But, on average, financial advisors cannot beat the market, even though many individual investors would like to believe otherwise.

    At this point we may reasonably ask why individuals choose to invest any of their funds in a "safe" asset – perhaps cash or Canadian Government bonds. After all, if their return to bonds is lower on average than the return to stocks, and they can diversify away much of the risk associated with stocks, why not get the higher average returns associated with stocks and put little or nothing in the safer asset? The reason is that it is impossible to fully diversify. When a recession hits, for example, the whole stock market may take a dive, because profits fall across the whole economy. On account of this possibility, we cannot ever arrive at a portfolio where the returns to the different stocks are completely independent. As a consequence, the rational investor will decide to put some funds in bonds in order to reduce this systematic risk component that is associated with the whole market. This is not a completely risk-free strategy because such assets can depreciate in value with inflation.

    To see how the whole market can change dramatically students can go to any publicly accessible financial data site – such as Yahoo Finance and attempt to plot the TSX for the period 2005 – present, or the NASDAQ index from the mid-nineties to the present. The year 2020 is a particularly appropriate year to examine. In that year the coronavirus pandemic struck with disastrous impacts on stock markets worldwide. Initially almost all stocks declined in value. But within a matter of days investors realized that some firms would perform better in this particular downturn: those specializing in home delivery and those specializing in home exercise equipment for example. The stock valuations of firms such as Shopify, Amazon and Peloton shot up, while the valuations of traditional auto makers languished.

    Efficiency and Allocation

    We have now come full circle. We started this chapter by describing the key role in economic development and growth played by firms and capital markets. Capital markets channel the funds of individual investors to risk-taking firms. Such firms—whether they are Dutch spice importers in the seventeenth century, the Hudson's Bay Company in nineteenth-century Canada, communications corporations such as Airbnb or Expedia, or some high tech start-ups in Silicon Valley—are engines of growth and play a pivotal role in an economy's development. Capital markets are what make it possible for these firms to attract the savings of risk-averse individuals. By enabling individuals to diversify their portfolios, capital markets form the link between individuals and firms.

    But capital markets fulfill another function, or at least they frequently do. They are a means of funnelling financial capital into ventures that appear to have a future return. It is not possible for each individual saver to perform the research necessary on a series of existing or new corporations, or 'ventures', in order to be able to invest in a knowledgeable manner. That is one reason we have financial intermediaries. When individuals deposit their savings with a bank, or with a financial manager, these individuals are anticipating that their savings will be protected and that a return will be forthcoming. A bank may promise a return of a fixed percent if an individual deposits her money in a guaranteed investment certificate. Alternatively, if the individual saver wishes to take on some risk she can place her savings with her financial manager, an equity fund, or even a venture capitalist. These intermediaries are better at assessing risks and returns than most private individuals. This in turn means that the return to the individual from entrusting their savings to one of them should on average exceed the returns that the individual would earn herself by following some investment strategy.

    If the professional investor indeed invests in more profitable ventures than an amateur investor, then that intermediary is performing an efficiency function for the whole economy: He does better at directing the economy's savings to where it is more productive on a macro level. This in turn means that the economy should have a higher growth rate than if savings are allocated towards ventures that are less likely to grow and satisfy a need or a demand in the economy.

    Consider the example of Airbnb that we cited earlier. The original intent of this corporation was to provide the owners of unused (home) space the opportunity to earn a return on that space. Airbnb was thus a transformative mechanism, in that it enabled unused resources to be more fully utilized - by linking potential buyers who were willing to pay for the product, with potential sellers who were willing to supply at a price buyers were willing to pay. Unused resources became utilized, created a surplus and contributed to growth in the macro economy.

    While financial intermediaries perform a valuable service to both individual savers, and the economy at large, we should not expect that intermediaries always make optimal decisions. However, these analysts have research resources available, and thus they have a comparative advantage over individuals for whom investing is a part-time activity. By being more efficient than individuals, financial intermediaries perform their broader economic allocation function, even if that is an unintended by-product of their professional activity.

    At times professional investors suffer from what has been called 'irrational exuberance'. Crowd psychology creeps into the investment world from time to time, sometimes with devastating consequences. In the late 1990s tech stocks were all the rage and the stock market that specialized in trading such stocks saw the capital value of these stocks rise to stratospheric heights. The NASDAQ index stood at about 5,000 in March 2,000 but crashed to 1,300 by January of 2003. The run-up in NASDAQ valuations in the late nineties turned out to be a bubble.

    Conclusion

    We next turn to examine decision making within the firm. Firms must make the right decisions if they are to grow and provide investors with a satisfactory return. Firms that survive the growth process and ultimately bring a product to market are the survivors of the uncertainty surrounding product development.

    Key Terms

    Sole proprietor is the single owner of a business and is responsible for all profits and losses.

    Partnership: a business owned jointly by two or more individuals, who share in the profits and are jointly responsible for losses.

    Corporation or company is an organization with a legal identity separate from its owners that produces and trades.

    Shareholders invest in corporations and therefore are the owners. They have limited liability personally if the firm incurs losses.

    Dividends are payments made from after-tax profits to company shareholders.

    Capital gains (losses) arise from the ownership of a corporation when an individual sells a share at a price higher (lower) than when the share was purchased.

    Real return on corporate stock: the sum of dividend plus capital gain, adjusted for inflation.

    Real return: the nominal return minus the rate of inflation.

    Limited liability means that the liability of the company is limited to the value of the company's assets.

    Retained earnings are the profits retained by a company for reinvestment and not distributed as dividends.

    Principal or owner: delegates decisions to an agent, or manager.

    Agent: usually a manager who works in a corporation and is directed to follow the corporation's interests.

    Principal-agent problem: arises when the principal cannot easily monitor the actions of the agent, who therefore may not act in the best interests of the principal.

    Stock option: an option to buy the stock of the company at a future date for a fixed, predetermined price.

    Accounting profit: is the difference between revenues and explicit costs.

    Economic profit: is the difference between revenue and the sum of explicit and implicit costs.

    Explicit costs: are the measured financial costs.

    Implicit costs: represent the opportunity cost of the resources used in production.

    Capital market: a set of financial institutions that funnels financing from investors into bonds and stocks.

    Portfolio: a combination of assets that is designed to secure an income from investing and to reduce risk.

    Risk pooling: a means of reducing risk and increasing utility by aggregating or pooling multiple independent risks.

    Risk: the risk associated with an investment can be measured by the dispersion in possible outcomes. A greater dispersion in outcomes implies more risk.

    Diversification reduces the total risk of a portfolio by pooling risks across several different assets whose individual returns behave independently.

    Exercises for Chapter 7

    EXERCISE 7.1

    Henry is contemplating opening a microbrewery and investing his savings of $100,000 in it. He will quit his current job as a quality controller at Megaweiser where he is paid an annual salary of $50,000. He plans on paying himself a salary of $40,000 at the microbrewery. He also anticipates that his beer sales minus all costs other than his salary will yield him a surplus of $55,000 per annum. The rate of return on savings is 7%.

    1. Calculate the accounting profits envisaged by Henry.

    2. Calculate the economic profits.

    3. Should Henry open the microbrewery?

    4. If all values except the return on savings remain the same, what rate of return would leave him indifferent between opening the brewery and not?

    EXERCISE 7.2

    You see an advertisement for life insurance for everyone 55 years of age and older. The advertisement says that no medical examination is required prior to purchasing insurance. If you are a very healthy 57-year old, do you think you will get a good deal from purchasing this insurance?

    EXERCISE 7.3

    In which of the following are risks being pooled, and in which would risks likely be spread by insurance companies?

    1. Insurance against Alberta's Bow River Valley flooding.

    2. Life insurance.

    3. Insurance for the voice of Avril Lavigne or Celine Dion.

    4. Insuring the voices of the lead vocalists in Metallica, Black Eyed Peas, Incubus, Evanescence, Green Day, and Jurassic Five.

    EXERCISE 7.4

    Your house has a one in five hundred probability chance of burning down in any given year. It is valued at $350,000.

    1. What insurance premium would be actuarially fair for this situation?

    2. If the owner is willing to pay a premium of $900, does she dislike risk or is she indifferent to risk?

    EXERCISE 7.5

    If individuals experience diminishing marginal utility from income it means that their utility function will resemble the total utility functions developed graphically in Section 6.2. Let us imagine specifically that if Y is income and U is utility, the individual gets utility from income according to the relation img238.png.

    1. In a spreadsheet or using a calculator, calculate the amount of utility the individual gets for all income values running from $1 to $25.

    2. Graph the result with utility on the vertical axis and income on the horizontal axis, and verify from its shape that the marginal utility of income is declining.

    3. Using your calculations, how much utility will the individual get from $4, $9 and $16?

    4. Suppose now that income results from a lottery and half of the time the individual gets $4 and half of the time he gets $16. How much utility will he get on average?

    5. Now suppose he gets $10 each time with certainty. How much utility will he get from this?

    6. Since $10 is exactly an average of $4 and $16, can you explain why $10 with certainty gives him more utility than getting $4 and $16 each half of the time?

    EXERCISE 7.6

    In Question 7.5, suppose that the individual gets utility according to the relation img242.png Repeat the calculations for each part of the question and see if you can understand why the answers are different.


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