Chapter 22
The Global Financial
Environment
of Business
Introductory Question
Stock ownership in America grew in the last half
of the twentieth century. In 1952 only
4% of Americans owned stock. By 2000
over 40% owned stock
What are the full implications of widespread
stock ownership?
The Legal Organization of Firms
 Proprietorships
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
 Proprietorships
– More than 73% of all U.S. firms
– 10 million firms with sales averaging
less than $50,000 per year
– Account for 5 percent of all business revenues
Characteristics of Proprietorships
By Size of Receipts
0.9%
By Type
0.4%
3%
1%
Under $25,000
$25,000 – $49,999
$50,000 – $99,999
$100,000 – $499,999
$500,000 – $999,999
$1,000,000 or more
2%
9%
13%
8%
12%
Agriculture,
forestry, fishing
services
Mining
3%
Construction
5%
Manufacturing
49%
Transportation
Wholesale trade
70%
16%
8%
Retail trade
Finance, insurance,
real estate
Services
Source: Statistical Abstract of the United States
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
 Partnerships
– A business owned 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
Types of Partnerships
1. General
Partnership
–partners share
equally in both
responsibility
and liability.
2. Limited Partnership
– In a limited
partnership, only
one partner is
required to be a
general partner, or
to have unlimited
personal liability for
the firm.
Carnegie-Illinois Steel blast furnaces in Etna, Pennsylvania (194
Limited Partnership Classic Example:
Bloomberg L.P.
(You DO NOT Need to write this)

privately held financial software, news, and data company.

Bloomberg makes up one third of the $16 billion global financial data market with estimated revenue of $6.6 billion.

founded by Michael Bloomberg (current Mayor of New York City)

with the help of Thomas Secunda and other partners (Bloomberg's former coworkers from Salomon Brothers) in 1981 and a
30% ownership investment by Merrill Lynch.
3. Limited Liability Partnership
– A newer type of partnership is the limited liability
partnership. In this form, all partners are limited partners.
Dentists
Attorneys
Accountants
The Legal Organization of Firms
 Advantages of partnerships
– Easy to form and dissolve
– Permits more effective specialization
– Profit is taxed only once
The Legal Organization of Firms
 Disadvantages of partnerships
– Unlimited liability
– Decision making more costly
– Dissolution generally necessary
when a partner dies or leaves the firm
 Corporations
– 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
 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
Types of Corporations
1) Closely Held Corporation
2) Publicly Held Corporation
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
– Separation of ownership and control
The Legal Organization of Firms
Type
of Firm
Proprietorship
Percentage
of U.S. Firms
Average Size
(annual sales
in dollars)
Percentage
of Total
Business Revenues
73.1
49,999
5.1
Partnership
7.0
540,000
5.5
Corporation
19.9
3,122,000
89.4
Methods of Corporate Financing
 Share of Stock
– A legal claim to a share of a corporation’s future
profits
• Common stock
– Incorporates certain voting rights regarding major
policy decisions of the corporation
• Preferred stock
– Owners are accorded preferential treatment in the
payment of dividends
Methods of Corporate Financing
 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 bonds’
maturity date
– Issued in return for funds lent to the firm
Video: The Ascent of Money
Episode 2: Human Bondage
Methods of Corporate Financing
 When it all began—1602
– Dutch East India Company
raised financial capital by:
• Selling ownership shares (stock)
• Using notes of indebtedness (bonds)
• Some profits were retained for reinvestment
Methods of Corporate Financing
 Reinvestment
– Profits used to purchase new capital
equipment
Methods of Corporate Financing
 Reinvestment
– Accounts for 75% of new financial capital
– A tradeoff exists between consumption
(dividends) and capital
The Difference Between
Stocks and Bonds
Stocks
Bonds
1. Stocks represent ownership.
1. Bonds represent debt.
2. Common stocks do not have a fixed
2. Interest on bonds must always be
dividend rate.
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
all creditors’ claims have been.
6. Bondholders have a claim against the
property and income of a corporation after
that must be met before the claims of met
stockholders.
The Markets for Stocks and Bonds
 New York Stock Exchange (NYSE)
– More than 2,500 stocks are traded
on the NYSE
– About 600 brokerage firms pay
up to $2,000,000 per seat to trade
on the NYSE
The Markets for Stocks and Bonds
 The theory of efficient markets
– Can you predict the future price
of a stock?
– Two approaches
• Random Walk Theory
– The theory that there are no predictable
trends in security prices that can be used
to “get rich quick.”
The Markets for Stocks and Bonds
 The theory of efficient markets
– Can you predict the future price
of a stock?
– Two approaches
• Inside Information
– Information that is not available
to the general public about what
is happening in a corporation
Reading Stock Quotes
52 Weeks
Hi
Lo
Stock
Sym
Div
Yld%
PE
69 9/16
40 3/16
Eastman Chm
EMN
1.76
3.4
21
88 15/16 60 13/16
Ekodak
EK
1.76
2.4
18
92 7/16
57
Eaton
ETN
1.76
2.1
19
29 5/8
17 5/8
Eaton/Vance
EV
.30
1.0
N/A
Reading Stock Quotes
52 Weeks
Stock
Eastman Chm
EKodak
Eaton
Eaton/Vance
Vol 100s
Hi
Lo
Close
Net Chg
2838
52
51
51
+ 3/4
17286
74
72 1/8
73
-2 9/16
4198
89 1/8
84
85
-4 9/16
710
52 5/8
29 1/16
30
- 7/16
Global Capital Markets
 Financial institutions in the U.S. are tied to the
rest of the world via their lending capacities.
 As legal barriers have come down, distinctions
between financial institutions and between
financial and nonfinancial institutions have
blurred.
 Multinational corporations offering a wide
array of financial services are becoming
dominant.
Globalizing Financial Markets
 The world market for U.S. government
securities
– “World’s fastest-growing 24-hour market”
•
•
•
•
Communications and computer technology
Deregulation
1984 tax legislation
Large U.S. federal deficits in the 1980s
Globalizing Financial Markets
 Other globalized markets
– Foreign exchange
– Commodities and other futures
Electronics Securities Trading
 Online trading of shares of corporate stock
is transforming the market for these securities
 Benefits of on-line trading
– Low brokerage fees
– Faster trading speed
– By 2000 there were over 2 million
on-line trading accounts
– By 2003 the number of on-line trading accounts
is expected to be between 8 and 11 million
Electronic Securities Trading
 Trading speed matters
 Since a trade takes no more
than a few minutes, the opportunity
cost of trading is reduced
Electronic Securities Trading
 Can brokerage firms keep up
with on-line trading?
– In 1996 many traders were unable
to access their on-line accounts
after a drop in U.S. stock prices
– Today Internet brokers are better able
to handle huge trading volumes
Electronic Securities Trading
 A lower return to “day trading”
– Evidence shows that persons who spend
significant portions of their day buying
and selling stocks on-line earn lower
return to their portfolios.
• Some day traders may be more inclined
to act on impulse.
• People who trade less often are more careful
about the trades they make.
Electronic Securities Trading
 Policy issues of on-line trading
– Which country’s securities
regulations apply?
– Should each country enforce
all other countries’ securities laws?
Problems
in Corporate Governance
 Separation of Ownership and Control
– The situation that exists in corporations
in which the owners (shareholders)
are not the people who control the
operation of the corporation (managers)
– The goals of these two groups
are often different
Problems
in Corporate Governance
 Asymmetric information
– Information possessed by one side
of a transaction but not the other
– The side with more information
will be at an advantage
Problems
in Corporate Governance
 Adverse selection
– The circumstance that arises in financial
markets when borrowers who are the
worst credit risks are the ones most likely
to seek loans
Problems
in Corporate Governance
 Moral hazard
– A problem that occurs because
of asymmetric information after
a transaction occurs
– In financial markets, a person to whom
money has been lent may indulge
in more risky behavior, thereby
increasing the probability of default
on the debt
Problems
in Corporate Governance
 Principle-Agent Problem
– The conflict of interest that occurs when
agents—managers of firms—pursue their
own objectives to the detriment of the
goals of the firms principals, or owners
Problems
in Corporate Governance
 What do you think?
– How would you solve the principle-agent
and moral hazard problems?
Problems
in Corporate Governance
 Two solutions
– Collateral
• An asset pledged to guarantee
the repayment of a loan
– Incentive-Compatible Contract
• A loan contract under which a significant
amount of the borrower’s assets are at risk,
providing for the borrower to look after the
lender’s interests
Issues and Applications:
The Spread of Corporate Stock Ownership
 The percent of Americans owning stock has
increased from 4 percent just after World
War II to almost 50 percent by the year 2000.
 Factors accounting for this trend
– Loss of memory of the Great Depression
– Advent of the IRA
– Growth of online trading
Web Links
 The following Web links appear in the
margin of this chapter in the textbook:
– http://www.sec.gov
– http://www.theonlineinvestor.com
Summary Discussion
of Learning Objectives
 Consequences of widespread
stock ownership
– Economic
• Changing stock prices have a larger effect
on consumer spending
– Political
• Desire for lower capital gains taxes
• Expanded support for IRAs
• Support for personal Social Security accounts
under the control of the individual rather
than the government
Summary Discussion
of Learning Objectives
 The main organizational forms of business
– Proprietorship
– Partnership
– Corporation
 The differences between the three main
sources of corporate funds
– Stocks: ownership claims
– Bonds: debt
– Reinvestment of profits
Summary Discussion
of Learning Objectives
 The difference between stocks and bonds
– Stocks represent ownership in a corporation
– Bonds represent the debt of a corporation
 The economic impact of on-line trading
of stocks and bonds
– On-line trading helps make stock and bond
markets more efficient
• Fewer resources needed per trade
• Lower costs of on-line trading make more trades
possible
Summary Discussion
of Learning Objectives
 The global nature of capital markets
– Deregulation in foreign countries allows more
international securities trading
 Problems of corporate control
– Asymmetric information
– Principal-agent problem
– Moral hazard
End of Chapter
Chapter 21
The Global Financial Environment
of Business