Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the
Dog?
CHAPTER 9
SECURITIES, BUSINESS FINANCE, AND THE
ECONOMY: THE TAIL THAT WAGS THE DOG?
Until now, the firm has been treated as a profit-maximizing black box. Chapter 9 peers inside the
box, to look at the ownership and financial structure of firms in the real world.
CHAPTER OUTLINE
CORPORATIONS AND THEIR UNIQUE CHARACTERISTICS
The largest U.S. firms are corporations, which are treated by law as entities separate from
their owners.
Features:
1. Limited liability
2. Double taxation
Financing Corporate Activity: Stocks and Bonds
When a corporation needs money to add to its plant or equipment, or to finance other types of
real investment, it may:
1. Take out a loan
2. Print and sell new stock certificates or new bonds
Similarities between Stocks and Bonds
Two relevant misconceptions are worth noting:
1. The ownership represented by a few shares of a company’s stock may be more
symbolic than real.
2. Contrary to appearance, bonds actually can be a very risky investment due to
fluctuations in the market price and inflation.
Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the
Dog?
Bond Prices and Interest Rates
Because most bonds carry a fixed nominal return, their current market value fluctuates
inversely with interest rates.
Corporate Choice between Stocks and Bonds
From the point of view of the corporation, bonds are typically (not always) cheaper than
stocks, in terms of expected interest payments versus return to the stockholders, but they are
riskier, because they establish a fixed obligation.
Plowback or Retained Earnings
As well as issuing stocks and bonds, firm can finance their investments through plowback by
What Determines Stock Prices? The Role of Expected Company Earnings
A share of stock will be valuable if the firm earns a good deal of money in the future, and it
STOCK EXCHANGES AND THEIR FUNCTIONS
Stocks are bought and sold on stock exchanges, the largest and most important of which is
the New York Stock Exchange (NYSE), followed by NASDAQ.
Regulation of the Stock Market
Stock exchanges are regulated internally, and also by the Security and Exchange
Commission.
Stock Exchanges and Corporate Capital Needs
A special type of bank called an investment bank usually handles new stock issues.
Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the
Dog?
1. By providing a secondhand market for stocks, they make individual investment in a
company much less risky.
2. The stock market determines the current price of the company’s stocks.
SPECULATION
Speculators receive bad press, but they usually perform important, socially useful tasks. They
protect other people against risk and they help to smooth out price fluctuations by buying
when prices are low and selling when prices are high.
BETTING ON SECURITIES: RISKS TO THE ENTIRE ECONOMY
Investments and Their Risks
Although all investments feature some degree of risk, risk is significantly reduced as
investors diversify their holdings.
Derivatives and Other Complete Security Investments: An Invitation to Gamble?
Derivatives can be used to reduce risk but they can also become a source of risk themselves
Leverage: Raising the Stakes
The process of leveraging or borrowing money to purchase securities increases the potential
return on investment but also increases the risk.
Herd Behavior, the Securities Markets, and the Path to Recession
Irresponsible Lending: Another Booby Trap
During economic expansion, lenders are somewhat less likely to verify a borrower’s ability
to repay, which was the case with many mortgages from 2001 to 2006.
Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the
Dog?
PUZZLE RESOLVED: UNPREDICTABLE STOCK PRICES AS “RANDOM
WALKS”
The evidence is that even skilled analysts cannot accurately predict individual stock prices.
MARGIN DEFINITIONS
Securities: stocks or bonds.
Corporation: a firm that has the legal status of a fictional individual.
Limited Liability: a legal obligation of a firm’s owners to pay back company debts only with
the money they have already invested in the firm.
Common Stock (also called a share): a record that gives the holder of the stock a share of the
ownership of the company.
Plowback (Retained Earnings): the portion of a corporation’s profits that management decides
to keep and invest back into the firm’s operations rather than to pay out directly to stockholders
in the form of dividends.
Takeover: the acquisition by an outside group (the raiders) of a controlling proportion of a
company’s stock.
Speculation: deliberate investment in risky assets in hopes of obtaining profits from future
changes in the prices of these assets.
Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the
Dog?
Mortgage-Backed Security: type of security whose returns to investors come from a large pool
of mortgages and home equity loans.
Mortgage: type of loan used to buy a house or some other physical property.
MAJOR IDEAS
1. The three basic types of firms are corporations, partnerships, and individual
proprietorships. Most U.S. firms are individual proprietorships, but corporations produce
most U.S. manufactured goods.
2. Individual proprietorships and partnerships have tax advantages over corporations. But
corporate investors have greater risk protection because they have limited liability—they
cannot be asked to pay more of the company’s debts than they have invested in the firm.
3. A common stock is a share in a company’s ownership. A bond is an IOU for money lent
to a company by the bondholder.
ON TEACHING THE CHAPTER
The material on corporate finance is likely to be fascinating to the majority of students. No doubt
many of them took economics thinking that this was what the subject was all about—and at last
they have gotten to it! They will be eager to know how to read a stock quotation, what a Dow
Jones average is, and so forth.
Perhaps the most frustrating thing about this chapter to students will be that it does not
unlock the mysteries of corporate finance. Doubtless every economics instructor has been
Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the
Dog?
PROBLEMS
1. Medical doctors sometimes do business as sole proprietors, they sometimes form
partnerships, and they sometimes form a corporation. What are the advantages and
disadvantages of each business form for doctors?
Solution: Sole proprietorships and partnerships can be established with few complications
and little expense. Individual proprietorships and partnerships have tax advantages over
2. Kim owns all 100 shares of common stock in GBZ Co. She has decided that she needs to
raise $10,000 in new capital this year. She is trying to decide between two alternatives
that are open to her. One is to issue a $10,000 bond, paying 10 percent interest. The other
is to create and sell 100 additional shares, at $100 each. Calculate what her own earnings
will be next year if ABC’s profits, before interest payments, are 0, $1,000, $2,000, $3,000
or $4,000:
a) if she chooses bond financing.
b) if she chooses stock financing.
What should Kim take into account when deciding how to finance the expansion of GBZ
Co?
Solution:
3. In 2006, Sheri invested $1,000 in the stocks of each of three companies, X, Y, and Z.
Over the next four years, as the stock prices changed, the value of her investments
changed as follows:
2006 2007 2008 2009
X $1000 $3000 $500 $1000
Y 1000 1000 2000 2000
Z 1000 500 3000 500
a) Set up a table showing the percentage change in the value of each of Sheri’s stocks
each year over the previous year, and the percentage change in each stock over the
four-year period.
b) What was the percentage change in the value of Sheri’s total investment, each year,
and over four years?
Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the
Dog?
c) If Sheri had been able to predict stock prices accurately, what should her strategy
have been each year? What would the value of her investment have been at the end of
four years?
d) In fact, Sheri was not able to predict stock prices. Discuss the advantages and
disadvantages of the choice she made (to invest equally in three stocks and hold them
for four years) versus other choices she might have made.
Solution:
a)
2006 2007 2008 2009
Overall %
Change
X
$100
0 $3000 $500 $1000
% Change 200.00% −83.33% 100.00% 0.00%
b)
2006 2007 2008 2009
Overall %
Change
X
$100
0 $3000 $500 $1000
c) If Sheri could predict accurately she would have sold at higher rates and reinvested the
same amount in stock with greater appreciation potential.
2006 2007 2008 2009
X$3,000 $9,000
d) Sheri could have booked profits (partial at least) when she got substantial returns, and
4. Max Corporation has $10,000 in retained earnings that it has not distributed to its
stockholders as dividends. It has a choice to invest the funds in a certificate of deposit at a
bank at a guaranteed rate of 7 percent, or to plow back the funds in the expansion of its
own operation.
a) If the expected return on the plowback is 12 percent, l0 percent, 8 percent, or 6
percent, what would be the best choice for the Max Corporation?
b) If the stockholders are risk averse, and on average need a 2 percent compensation for
assuming risk, what choices should the firm make?
Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the
Dog?
Solution:
a) Max Corporation might want to invest in expansion, if the expected returns are 8
percent, 10 percent, or 12 percent. Only 6 percent expected return will deter them,
DISCUSSION QUESTIONS
1. Is there any risk at all for an investor who purchases a bond, expecting to hold it until
maturity?
Suggested Answer: Bondholders may be exposed to losses from inflation. Whether the
$1,000 promised to the bondholder at the 2020 maturity date represents substantial
purchasing power depends on what happens to the general price level in the meantime
(that is, how much price inflation occurs). No one can predict the price level this far in
advance with any accuracy. A firm can issue bonds with little backing; that is, the firm
may own little valuable property that it can use as a guarantee of repayment to the lender
—the bondholder. Related concepts: Junk bonds, default risk.
2. “The financial crisis of 2007–2009 and the so-called Great Recession were a part of the
natural process of economic expansion and contraction. This type of downturn is
unavoidable.” Discuss.
Suggested Answer: Student answers will vary. However, their comments should include
discussion of the additional risk created by derivatives and leverage. The lack of
3. “The public should have no concern about corporate takeovers. They are always
beneficial to the stockholders.” Discuss.
Suggested Answer: This statement is not always true. Takeovers are a useful way to get
rid of incompetent management or to force management to be more efficient. However,
the process is costly and leads to wasteful defensive and offensive activities. Corporate
4. “The stock market is subject every now and again to huge fluctuations. When stocks
crash, people lose fortunes. The stock market is nothing but a huge casino, and we would
be better off without it.” Discuss.
Suggested Answer: The statistical evidence is that, over the long run, stock prices as a
whole have followed a fairly marked upward trend, perhaps reflecting the long-term
Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the
Dog?
5. “Stock prices are obviously not a random walk. If they were, they could not be predicted
and yet we observe people paying financial analysts millions of dollars for investment
advice. People would not be willing to pay those fees if the advice were worthless.”
Discuss.
Suggested Answer: It is not in the overall level of stock prices that the most pertinent
random walk occurs, but in the performance of one company’s stock as compared with
6. Develop an argument in favor of the proposition that interest rates are a random walk.
Suggested Answer: Government policies and other factors that dictate interest rate