Topic 7 Capital Markets

Basic Microeconomics
 Agenda
7.1 Business Organizations
7.2 Corporate Goals
7.3 Risk and the Investor
7.4 Pooling Risks
Business Organizations
 Business Organizations

• Sole Proprietor – is the single owner of a business.

• Partnership – a business owned jointly by two or more
individuals, who share in the profits and are jointly
responsible for losses.
• Corporation or company - is an organization with a legal
identity separate from its owners that produces and trades.
 Business Organizations – Corporation

• Shareholders invest in corporations and therefore are the

owners.
• Dividends are payments made from after-tax profits to
company shareholders.
• Capital gains (losses) arise from the ownership of a
corporation when an individual sells a share at a price
higher (lower) than when the share was purchased.
• Real return to corporate stock is the inflation-adjusted
sum of dividends and capital gain (or loss).
 Business Organizations – Corporation

• Shareholders invest in corporations and therefore are the owners.

• Dividends are payments made from after-tax profits to company
shareholders.
• Capital gains (losses) arise from the ownership of a corporation
when an individual sells a share at a price higher (lower) than
when the share was purchased.
• Real return to corporate stock is the inflation-adjusted sum of
dividends and capital gain (or loss).
• Limited liability means that the liability of the company is limited
to the value of the company’s assets.
 Business Organizations – Corporation

• Shareholders invest in corporations and therefore are the owners.

• Dividends are payments made from after-tax profits to company
shareholders.
• Capital gains (losses) arise from the ownership of a corporation when an
individual sells a share at a price higher (lower) than when the share was
purchased.
• Real return to corporate stock is the inflation-adjusted sum of dividends
and capital gain (or loss).
• Limited liability means that the liability of the company is limited to the
value of the company’s assets.
• Retained earnings are the profits retained by a company for reinvestment
and not distributed as dividends.
 Profit

Ownership and Corporate Goals

• Principal or owner: delegates decisions to an agent, or
manager.
• Agent: usually a manager who works in a corporation and is
directed to follow the corporation’s interests.
• Principal-agent problem: arises when the principal cannot
easily monitor the actions of the agent, who therefore may not
act in the best interests of the principal.
• Stock option: an option to buy the stock of the company at a
future date for a fixed, predetermined price.
 Profit

Economic and Accounting Profit

• Accounting profit: is the difference between revenues and
explicit costs.
• Economic profit: is the difference between revenue and
the sum of explicit and implicit costs.
• Explicit costs: are the measured financial costs.
• Implicit costs: represent the opportunity cost of the
resources used in production.
 Risk and the Investor

• Firms need external investment for growth.

• Investors are typically risk-averse but open to risk for
attractive rewards.
• Pooling of risks explains the willingness to invest in risky
firms.
• Diversification in a portfolio of firms helps manage and
spread risk.
• Diversification is an attractive strategy for risk-averse
investors.
 Risk Pooling and Diversification

• Capital market: a set of financial institutions that funnels financing from

investors into bonds and stocks.
• Venture capital: investment in a business venture, where the ultimate
outcome is highly unpredictable.
• Portfolio: a combination of assets that is designed to secure an income from
investing and to reduce risk.
• Risk pooling: Combining individual risks in such a way that the aggregate risk
is reduced.
• Risk measurement: A higher degree of risk is associated with increased
variation in the possible returns around an unchanged mean return.
• Diversification reduces the total risk of a portfolio by pooling risks across
several different assets whose individual returns behave independently.
 Risk Pooling and Diversification – Efficiency and
Allocation
• Individual savers often lack the expertise to research and invest in
ventures with future returns.
• Financial intermediaries, such as banks and financial managers, help
individuals by safeguarding their savings and offering returns on
investments.
• These intermediaries are skilled at assessing risks and returns, making
them better suited for profitable investments.
• Entrusting savings to financial professionals generally yields higher
returns than self-managed investments.
• Professional investors play a crucial role in efficiently allocating savings to
more productive ventures on a macroeconomic level, resulting in higher
economic growth and meeting economic needs and demands.
• Source:Curtis, D. (2017). Principles of Microeconomics.