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Mizzou ECONOM 1051 - Exam 2 Study Guide
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ECON 1051 1nd EditionExam # 2 Study Guide Lectures: 21 - 41Chapter 8 – Firms, Stock Market and Corporate Governance The Three Types of Firms: 1. Sole Proprietorship a. Characteristics: i. A firm owned by a single individual and not organized as a corporation ii. Unlimited liability: no legal distinction between the personal assets of the owners of the firm and the assets of the firm b. Advantages: i. Control by the owner ii. No layers of management 2. Partnership a. Characteristics: i. A firm owned jointly by two or more persons not organized as a corporation ii. Unlimited liability b. Advantages: i. Ability to share work and risks 3. Corporation a. Characteristics:i. A legal form of business that provides owners with protection from losing more than their investment if the businesses fails ii. Corporations are treated as individuals in the eyes of the government iii. Limited liability - This means owners are protected from losing more than they invested b. Advantages: i. Greater ability to raise funds ii. Limited liability c. Disadvantages: i. Costly ii. Double taxation Firms can either be public or private:- Public Firms sell stock that is traded in financial markets - Private Firms do not sell stock publically How Corporations Are Set Up: - Corporate Governance describes the way in which a corporation is structured o Shareholders are the owners of a corporations stock o A board of directors represent the interests of the stockholders  Can either be inside or outside directors o A CEO is appointed by the board to run the day-to-day operations- A separation of ownership from control can occur when the top management, rather than shareholders, control day-to-day operations - Principal-Agent Problem occurs when an agent pursues his own interests rather than the interests of the principal who hired him A firm can raise funds using internal finance in three ways: 1. Reinvest the profits back into the firm- Retained Earnings:o Profits that are reinvested in a firm rather than taken out of a firm andpaid to the firms owner2. Recruit additional owners to invest in the firm - Increases the firm’s financial capital 3. Borrow money - Known as leveraging or selling debt - Can also be done by selling bonds or taking out a loan o Bonds: the principal or face value of a bond is the final payment of theloan amount at maturity, or the end of its term  Coupon payment is an interest payment on a bond and the interest rate is the cost of borrowing funds, expressed as a percentage of the amount borrowed  Therefore, a $1000 face value at a 6% coupon rate that matures at 10 years would have a coupon payment or interest payment of $60 every year Indirect vs. Direct Finance: - Indirect Finance is a flow of funds from savers to borrowers through financial intermediaries such as banks, credit unions, mutual funds or pension funds- Direct Finance is a flow of funds from savers to firms through financial markets such as the New York Stock Exchange. Usually takes the form of borrowers sellinglenders financial securities such as stocks and bondsThe Stock Market:- Secondary Markets trade financial securities that are already pre-issued, what people are referring to when they say “the stock market)o New York Stock Exchange and NASDAQ- Primary Markets are where companies raise money and securities are created o IPO (initial public offering) occurs when companies sell stocks to the public for the first time - Dividends are payments by a corporation to its shareholders - Capital Loss occurs when the price of stock goes down - Stock Market Index is set to equal 100 in a particular yearFirms must follow generally accepted accounting principals:- Income Statement is required by the SEC to report a firm’s performance. The income statement sums up a firm’s revenue and profit over a period of timeo Balance Sheet Statement outlines the firms assets and liabilities o Net Worth is the difference between what the firm owns and what they owe- Disclosures are a firms financial statements in periodic fillings to the federal government and in annual reports to shareholersThe Accounting Scandal of the Early 2000s:- Enron and WorldCom falsified these statements in order to mislead investors about how profitable their firms actually wereThe Financial Crisis of 2007-2009 - Overview: o They expected the housing market to continue to rise, so the banks originated mortgage loans but instead of keeping them they resold them to investors. Because the banks no longer owned those mortgage loans, they had little incentives to check the creditworthiness of borrowers.o Caused a series of defaults on mortgage loans, which affected everyone who held those loans as assets.  These loans were originally rated AAA but quickly fell to junk status- They were rated AAA because the same companies who they were supposed to rate were paying the credit rating agencies. This caused a conflict of interest. Because of these, the credit rating industry was reluctant to give bad ratings to these securities - Height of the Crisis:o Sept. 15 when Lehman Brothers filed for bankruptcy and AIG had to be bailed out by the FED and Treasury - Glass-Steagall Act of 1993 o This act prevented financial firms from being both commercial and investment banks. They repealed this act in 1999 and some commercial banks engaged in investment banking. Chapter 11 – Technology, Production and Costs Technology and Technological Changes: - Technology is processes in a firm used to turn inputs into outputs of goods and services- Technological Change is a change in the ability of a firm to produce a given level of output with a given quantity of inputsShort Run vs. Long Run: - Short Run is the period of time during which at least one of a firm’s inputs is fixedo Can’t change the way something is produced - Long Run is the period of time in which a firm can vary all its inputs, adopt new technology and increase or decrease the size of its physical plant o Can change the way something is produced  Long Run Average Cost Curve: A curve that shows that lowest cost at which a firm is able to produce a given quantity of output in the long run, when no inputs are fixed Economies of Scale is the situation when a firms long-run average cost falls as it increases the quantity of output it produces  Constant returns to the scale is when a firm’s long-run average costs remain unchanged as it


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Mizzou ECONOM 1051 - Exam 2 Study Guide

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