Chapter 21: Rents, Profits, and the Financial Environment of Business

Identify the main sources of corporate funds and differentiate between stocks and bonds.

Which of the following individuals would you expect to have a high level of economic rent, and which would you expect to have a low level of economic rent? Explain why for each.

a. Bob has a highly specialized medical skill shared by very few individuals.

b. Sally has never attended school. She is 25 years old and is an internationally known supermodel.

c. Tim is a high school teacher and sells insurance part-time.

Explain the difference between the dividends of a corporation and the profits of a proprietorship or partnership, particularly in their tax treatment.

The owner of WebCity is trying to decide whether to remain a proprietorship or to incorporate. Suppose that the corporate tax rate on profits is $20$percent and the personal income tax rate is localid="1653216490078" $30$percent. For simplicity, assume that all corporate profits (after corporate taxes are paid) are distributed as dividends in the year they are earned and that such dividends are subject to tax at the personal income tax rate.

a. If the owner of WebCity expects to earn localid="1653216495193" $\backslash (100,000$in before-tax profits this year, regardless of whether the firm is a proprietorship or a corporation, which method of organization should be chosen?

b. What is the dollar value of the after-tax advantage of the form of organization determined in part (a)?

c. Suppose that the corporate form of organization has cost advantages that will raise beforetax profits by localid="1653216505277" $\mathbf{\backslash )}\mathbf{50}\mathbf{,}\mathbf{000}$. Should the owner of WebCity incorporate?

d. Based on parts (a) and (c), by how much will after-tax profits change due to incorporation?

e. Suppose that tax policy is changed to completely exempt from personal taxation the first localid="1653216517393" $\$40,000$per year in dividends. Would this change in policy affect the decision made in part (a)?

f. How can you explain the fact that even though corporate profits are subject to double taxation, most business in the United States is conducted by corporations rather than by proprietorships or partnerships?

Explain how the following events would likely affect the relevant interest rate.

a. A major bond-rating agency has improved the risk rating of a developing nation.

b. The government has passed legislation requiring bank regulators to significantly increase the paperwork required when a bank makes a loan.

Suppose that the interest rate in Japan is only $2$percent, while the comparable rate in the United States is localid="1651988274892" $4$percent. Japan's rate of inflation is $0.5$percent, while the U.S. inflation rate is $3$percent. Which economy has the higher real interest rate?

You expect to receive a payment of $\$104$one year from now.

a. Your rate of discount is $4$percent. What is the present value of the payment to be received?

b. Suppose that your rate of discount rises to $5$percent. What is the present value of the payment to be received?

Outline the differences between common stock and preferred stock.

Explain the basic differences between a share of stock and a bond.

Suppose that one of your classmates informs you that he has developed a method of forecasting stock market returns based on past trends. With a monetary investment from you, he claims that the two of you could profit handsomely from this forecasting method. How should you respond to your classmate?