Chapter 22 – Rents, Profits and
the Financial Environment of
Business
 Distinguish among the main organizational forms
of business and explain the chief advantages and
disadvantages of each
 Explain the difference between accounting profits
and economic profits
Chapter 22 – Rents, Profits and
the Financial Environment of
Business
Discuss how the interest rate plays a key
role in allocating resources
Calculate the present discounted value of a
payment to be received at a future date
Identify the three main sources of corporate
funds and differentiate between stocks
and bonds
Did You Know That . . .
There are almost 800,000 nonprofit
organizations in the United States?
There are nearly 28 million
profit-seeking businesses in the
United States?
These businesses are financed and
organized very differently?
Firms and Profits
Firms or businesses, like individuals, seek
to earn the highest possible returns.
A firm brings together the factors of
production to produce a product or service it
hopes can be sold at a profit.
Firms and Profits
Firm
– A business organization that employs resources
to produce goods or services
for profit
– A firm normally owns and operates at least one
“plant” or facility in order to produce.
Firms and Profits
The legal organization of firms
– Proprietorship
– Partnership
– Corporation
Forms of Business
Organization
The Legal Organization of
Firms
Proprietorship
– A business owned by one individual who
• Makes the business decisions
• Receives all the profits
• Is legally responsible for all the debts of
the firm
The Legal Organization
of Firms
Advantages of proprietorships
– Easy to form and dissolve
– All decision-making power resides with the
sole proprietor
– Profit is taxed only once
The Legal Organization
of Firms
Disadvantages of proprietorships
– Unlimited Liability
• The owner of the firm is personally responsible for
all of the firm’s debts.
– Limited ability to raise funds
– Proprietorship normally ends with the death of
the proprietor.
The Legal Organization
of Firms
Partnership
– A business owned and managed by two or more
co-owners, or partners, who
• Share the responsibilities and the profits of
the firm
• Are individually liable for all the debts of
the partnership
The Legal Organization
of Firms
Advantages of partnerships
– Easy to form and dissolve
– Partners retain decision-making power
– Permits more effective specialization
– Profit is taxed only once
The Legal Organization
of Firms
Disadvantages of partnerships
– Unlimited liability
– Decision making more costly
– Dissolution often occurs when a partner dies or
leaves the firm.
The Legal Organization
of Firms
Corporation
– A legal entity that may conduct business in its
own name just as an individual does
– The owners of a corporation, called
shareholders
• Own shares of the firm’s profits
• Enjoy the protection of limited liability
The Legal Organization
of Firms
Limited Liability
– A legal concept whereby the responsibility, or
liability, of the owners of a corporation is
limited to the value of the shares in the firm that
they own.
The Legal Organization
of Firms
Advantages of corporations
– Limited liability
– Continues to exist when owner leaves
the business
– Raising large sums of financial capital
The Legal Organization
of Firms
Disadvantages of corporations
– Double taxation
• Dividends
 Portion of corporation’s profits paid to its
owners (shareholders)
– Separation of ownership and control
The Profits of a Firm
Accounting Profit
– Total revenue minus total explicit costs
The Profits of a Firm
Explicit Costs
– Costs that business managers must take account
of because they must be paid
– Examples are wages, taxes and rent
The Profits of a Firm
Implicit Costs
– Expenses that managers do not have to pay out
of pocket and hence do not normally explicitly
calculate
• Opportunity cost of factors of production that are
owned
• Owner-provided capital and owner-provided labor
The Profits of a Firm
Accounting profits versus economic profits
– The term profits in economics means
the income entrepreneurs earn.
• Over and above all costs including their own
opportunity cost of time.
• Plus the opportunity cost of capital they have
invested in their business.
The Profits of a Firm
Economic Profits
– Total revenues minus total opportunity costs of
all inputs used
– The total of implicit and explicit costs
Simplified View of Economic
and Accounting Profit
The Profits of a Firm
The goal of the firm: profit maximization
– Theory of consumer demand: utility (or
satisfaction) maximization
– Theory of the firm: profit maximization
is the underlying hypotheses of our predictive
theory
Interest
Interest is the price paid from debtors to
creditors for the use of loanable funds.
Businesses use financial capital in order to
invest in physical capital.
Interest
Financial Capital
– Funds used to purchase physical capital goods,
such as buildings and equipment
Interest
– The payment for current rather than future
command over resources; the cost of obtaining
credit
Interest
Variations in the rate of annual interest that
must be paid for credit depend on
1. Length of loan
2. Risk
Interest
 Interest is a price that allocates loanable funds
(credit) to consumers and businesses.
 Investment, or capital, projects with rates of return
higher than the market rate of interest will be
undertaken.
 The interest rate performs the function of
allocating financial capital thus ultimately
allocating physical capital.
Interest
 Businesses make investments which often incur
large costs.
 They need to compare their investment cost today
with a stream of future profits.
 They must relate present costs to future benefits.
 Interest rates are used to link the present with the
future.
Interest
Present Value
– The value of a future amount expressed in
today’s dollars
– The most that someone would pay today to
receive a certain sum at some point in the future
Interest
Discounting
– The method by which the present value
of a future sum or a future stream of sums is
obtained
Corporate Financing Methods
Share of Stock
– A legal claim to a share of a corporation’s
future profits
Corporate Financing Methods
Bond
– A legal claim against a firm
– Usually entitling the owner of the bond to
receive a fixed annual coupon payment, plus a
lump-sum payment at the bond’s maturity date
– Bonds are issued in return for funds lent to the
firm.
Corporate Financing Methods
Reinvestment
– Profits (or depreciation reserves) used to
purchase new capital equipment
– Sales of stock are an important source of
financing for new firms.
– Reinvestment and borrowing are
the primary means of financing for
existing ones.
The Difference Between
Stocks and Bonds
Stocks
Bonds
1. Stocks represent ownership.
1. Bonds represent debt.
2. Common stocks do not have a fixed
dividend rate.
2. Interest on bonds must always be paid,
whether or not any profit is earned.
3. Stockholders can elect a board of directors,
which controls the corporation.
3. Bondholders usually have no voice in or
over management of the corporation.
4. Stocks do not have a maturity date;
the corporation does not usually
repay the stockholder.
4. Bonds have a maturity date on which the
bondholder is to be repaid the face value of
the bond.
5. All corporations issue or offer to sell stocks.
This is the usual definition of
a corporation.
5. Corporations need not issue bonds.
6. Stockholders have a claim against the
property and income of a corporation after
all creditors’ claims have been met.
6. Bondholders have a claim against the
property and income of a corporation that
must be met before the claims
of stockholders.
The Markets for Stocks and
Bonds
Securities
– Stocks and bonds
The Markets for Stocks and
Bonds
Inside Information
– Information that is not available to the general
public about what is happening
in a corporation
– One way to “beat the market,” although it is
considered illegal, punishable by substantial
fines and imprisonment
Reading Stock Quotes
Summary Discussion
of Learning Objectives
 The main types of business organization
– Proprietorship
– Partnership
– Corporation
 Accounting profit is the excess of total revenue over
explicit costs.
– To arrive at economic profit, we must subtract implicit
costs as well.
Summary Discussion
of Learning Objectives
Interest is a payment for the ability to use
resources today instead of in the future.
The present value of a sum to be
received in the future can be calculated
through discounting.
Sources of corporate funds are stocks,
bonds, and reinvestment of profits.