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1 Ownership & Governance of Firms

1 Ownership & Governance of Firms

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7.1 Ownership & Governance of
Firms
• Ownership of For-Profit Firms: Sole Proprietorships
– Firms owned and controlled by a single individual

• Ownership of For-Profit Firms: Partnerships
– Businesses jointly owned and controlled by two or more people operating
under a partnership agreement.

• Ownership of For-Profit Firms: Corporations
– Firms owned by shareholders, who own the firm’s shares or stocks.
– Each share is a unit of ownership in the firm. Therefore, shareholders own
the firm in proportion to the number of shares they hold.
– Shareholders elect a board of directors to represent them. In turn, the
board of directors usually hires managers who manage the firm’s
operations.
– The legal name of a corporation often includes the term Incorporated (Inc.)
or Limited (Ltd) to indicate its corporate status.

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7.1 Ownership & Governance of
Firms
• Publicly Traded Corporation



Corporations whose shares can be readily bought and sold by the general public
Stocks may be available at the New York Stock Exchange, the NASDAQ, the Tokyo
Stock Exchange, the Toronto Stock Exchange, or the London Stock Exchange.

• Closely Held Corporation



Shares not available for purchase or sale on an organized exchange.
Typically its stock is owned by a small group of individuals (private equity).

• From Publicly Traded to Closely Held Corporation





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To make the transition the closely held firm makes an initial public offering (IPO) of
its shares on an organized stock exchange.
One major advantage of going public is to raise money. However, a major
disadvantage is that ownership of the firm becomes broadly distributed, possibly
causing the original owners to lose control of the firm.
It is also possible for a publicly traded firm to go private and convert to closely held
status. Examples are Toys-R-Us and Burger King

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7.1 Ownership & Governance of
Firms
• Liability and Ownership
– Owners of a corporation are not personally liable for the firm’s debts; they
have limited liability: The personal assets of the corporate owners cannot
be taken to pay a corporation’s debts even if it goes into bankruptcy.
– Traditionally, the owners of sole proprietorships and partnerships were
fully liable, individually and collectively, for any debts of the firm. Now
they can be a limited liability company (LLC). The precise regulations that
apply to LLCs vary from country to country and from state to state within
the United States.

• Firm Size and Ownership
– Most large firms are corporations. According to the U.S. Statistical Abstract
2012, U.S. corporations are only 18% of all nonfarm firms but make 81% of
sales revenue and 58% of net income. Nonfarm sole proprietorships are
72% of firms but make only 4% of the sales revenue and earn 15% of net
income.
– Corporations that earn over $50 million are less than 1% of all
corporations, but they make 77% of revenue.

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7.1 Ownership & Governance of
Firms
• Firm Governance: Small Firms
– In a small private sector firm with a single owner-manager,
the governance of the firm is straightforward: the ownermanager makes the important decisions for the firm.
• Firm Governance: Publicly Traded Corporation
– The shareholders own the corporation. However, most of
them play no meaningful role in day-to-day decisionmaking or even in long range planning.
– Shareholders elect a board of directors and delegate many
of their ownership rights to them.
– The board of a large publicly traded corporation normally
includes outside directors and inside directors, such as the
chief executive officer (CEO) of the corporation and other
senior executives.
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7.2 Profit Maximization

• Revenue (R) is price times quantity.
• Cost(C), the correct measure is the opportunity cost: the value of the best alternative
use of any input the firm employs. The full opportunity cost of inputs used might
exceed the explicit or out-of-pocket costs recorded in financial accounting
statements.
• Profit (π) is Revenue minus Cost. If π < 0, the firm makes a loss.
• To add profits over time calculate the present value, in which future profits are
discounted using the interest rate.

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7.2 Profit Maximization
• Two Steps to Maximize Profit: π (q) = R (q) – C (q)
– Profit varies with the level of output because both revenue
and cost vary with output.
– There are two key decisions to maximize profit.

• First Step: Output Decision
– What is the output level, q, that maximizes profit or
minimizes loss?

• Second Step: Shutdown Decision
– Is it more profitable to produce q or to shut down and
produce no output?

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7.2 Profit Maximization
• Rule 1: Set output where profit is maximized
– If the firm knows its entire profit curve (Figure 7.1), it sets output at q*to
get π*.

• Rule 2: Set output where Mπ = 0
– Marginal profit , ∆p/∆q, where ∆q = 1, is the slope of the profit curve. The
maximum profit occurs where the slope is zero.

• Rule 3: Set output where MR(q)=MC(q)
– Marginal Profit = MR - MC. The extra income raises profit but the extra cost
reduces profit. Maximum profit occurs at MR(q) = MC(q).
– Using calculus: dπ (q)/dq = dR (q)/dq – dC (q)/dq = 0; MR(q)=MC(q)

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7.2 Profit Maximization
Figure 7.1 Maximizing Profit

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7.2 Profit Maximization
• Shutdown Rules
– Should the firm shut down if its profit is negative? It
depends
• Shutdown Rule 1: Shut down only if loss is reduced
– This rule applies to the short run and long run alike.
• Shutdown Rule 2: Shut down only if revenue < avoidable cost
– In the short run, variable costs are avoidable but fixed
costs are unavoidable (sunk costs).
– As long as revenue covers variable costs and some fixed
costs, no shut down occurs.
– In the long run all costs are avoidable; shutting down
eliminates all costs.

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7.2 Profit Maximization
• Profit Over Time
– Firms maximize profit not only for the current period. They are
normally interested in maximizing profit over many periods.
– The difference between maximizing the current period’s profit and
long-run profit is important in some situations.
• Present Value: PV = FV / (1+i)t
– Compound Interest Rate: $100 today (PV) at a 10% interest rate
has a future value (FV) of $110 in one year, and $121 in two
years. In general FV = PV (1+i)t, where t is the number of years.
– Money in the future is worth less than money today: $100 in one
year is less than $100 today. In general, PV = FV / (1+i)t
– Shareholders of a firm may value a stream of profits over time by
calculating the present value, in which future profits are
discounted using the interest rate (see Appendix 7 for more
detail).

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7.3 Owners’ vs. Managers’
Objectives
• Consistent Objectives: Principal-Agent Problem
– Owners (principal) delegate tasks to managers and other workers
(agent) in most firms.
– If the principal wants to maximize profit and agents want to
maximize their own incomes or perks the resulting profit is not
the maximum (agency cost).

• Consistent Objectives: Contingent Rewards
– To make the owner and manager objectives more closely aligned,
many firms use contingent rewards: higher pay if the firm does
well.
– A year-end bonus based on the performance of the firm or a group
of workers within the firm
– A stock option or the right to buy a certain number of the firm’s
shares at a pre-specified exercise price within a specified time

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