Types of Business Entities cont by liaoqinmei


									    Chapter 17

        Background Topics

    Chapter Goals

       Better apply key economic concepts.
       Determine the contribution and regulation of major
        financial institutions.
       Assess the advantages and disadvantages of
        alternative forms of business entities.
       Recognize important concepts of business law.

    Demand and Supply Analysis

       The amount of output produced for any commodity is
        a function of the demand and supply for that item.
       In the simplest form, demand comes from the
       For example, consider the demand for a particular
        type of personal computer.
       A plot can demonstrate that demand varies with
        price; the lower the price, the greater the quantity
       At higher prices consumers will substitute.

    Demand and Supply Analysis, cont.

       An example of demand and supply curves are as

    Demand and Supply Analysis, cont.

       Supply comes from businesses seeking to make the
        most money possible.
       The amount business will supply is a function of
        price; in this case, the greater the price, the greater
        the amount supplied.
       This is true because more profits are possible, at
        least up to the point at which costs per unit rise and
        ultimately exceed the benefits of higher prices.
       Equilibrium is set where quantity demanded is equal
        to quantity supplied.


       Inflation: The increase in price for a given good or
        service or the growth of overall costs in the economy
        over time.
       Inflation can be caused by any number of factors:
        –   Excess of demand for a good or goods as compared with
            the supply.
        –   Increases in the cost of items needed to produce a good.
        –   Lack of competition arising from few producers for that item
            and barriers to new companies entering the market.
        –   An excess supply of money in the economy.

    Inflation, cont.

       Inflation has been present in our economy from time
        to time since our country was first established.
       It has been omnipresent since World War II, as our
        government has placed more emphasis on limiting
        weak economic periods and maintaining high overall
        employment rates.
       However, the rate of inflation has varied, with high
        rates recorded in the 1950s at the time of the Korean
        War and the 1970s when oil prices moved up
       Inflation, particularly when it is accelerating, is a
7       problem for our economy and for many households.
    Inflation, cont.

       Inflation’s effects include:
        –   Redistribute wealth.
                Owners of large amounts of property and borrowers on fixed
                 interest loans benefit. People on fixed incomes lose.
        –   Change economic behavior and bring about inefficient
            economic activity.
                When inflation is high, consumers may purchase goods today
                 to avoid higher prices tomorrow. Businesses may raise prices
                 in anticipation of higher costs.
        –   Action by the Federal Reserve to stop the inflationary spiral.
                Often the resultant moves by the Fed can bring about a
                 recession, which limits activity relative to the economy’s
                 potential and brings about higher unemployment.
        –   Increased uncertainty about the future, which can reduce
8           the amount of long-term investment.
    Inflation, cont.

        The rate of inflation is measured by:
                                                     Price in Previous
                            Current Price                 Period
        Rate of Inflation                                                100
                                       Price in Previous

        Average inflation by decade:

     Inflation, cont.

        Real items are figures adjusted for inflation, as

        Where n = number of periods

     Inflation, cont.

        For example, the following table details the
         purchasing power of $100,000 at alternative inflation
         rates over time.

     Inflation, cont.

        Disinflation: A period in which inflation is rising but at
         a rate of increase that is declining.
         –   Often a period of disinflation not accompanied by recession
             is positive for many sectors of the economy and for
         –   The period from 1982 to 2002 was a disinflationary period.
        Deflation: A period in which the absolute level of
         prices declines.
         –   In many areas of the economy its effects are the opposite of
             inflation’s impact.
         –   A problem with deflation for our economy can be the
             reluctance of consumers to spend money as they expect
             products to become cheaper in the future.
     The Business Cycle

        Business cycle: The periodic ups and downs in total
         economic activity over time. One traditional pattern:
         –   Acceleration in consumer demand or other factors results in
             production that begins to reach capacity.
         –   Producers strain to put on new units of production and do
             so at an ever-increasing cost, boosting household income
             and spending.
         –   The economy enters into expansion which a period of two-
             quarter or longer increase in real overall economic output of
             a country.
         –   Prices rise to reflect the robust demand and higher costs.
         –   Producer’s profits decline as the marginal cost to produce
             an extra unit accelerates and exceeds the marginal
             revenues from the next unit sold.
         –   Higher inflation brings about a moderation in demand as the
13           purchasing power of consumers is squeezed.
     The Business Cycle, cont.
       –   A peak in economic activity followed by a decline occurs.
       –   Business capital expenditures turn down businesses lay off
           workers, and real household incomes drop, leading to a
           further cutback in demand.
       –   The economy enters a recession (a two-quarter or longer
           decline in real overall output for the nation).
       –   The government attempts to influence the economy through
           outlays and tax cuts. Interest rates decrease as weak
           business conditions result in a decline in demand for funds
           and Federal Reserve actions increase the supply.
       –   The economy reaches a trough and begins to turn up.
       –   Outlays by businesses and consumers enable the economy
           to pick up its pace.
       –   The economy continues to progress and establishes normal
           growth until the next shock to the system.
     The Business Cycle, cont.

        For example:

     Economic Indicators

        Economic indicators: Statistics that represent where
         our economy, or parts of it, has been, is going, or is
         expected to be headed.
        Gross National Product (GNP): Overall U.S.
         economic activity produced by U.S. businesses.
        Gross Domestic Product (GDP): All activity by U.S.
         or foreign businesses produced solely in the U.S.
        Most commonly expressed in real dollars, which is a
         measure of output in units.

     Economic Indicators, cont.

        Average real GDP by decade:

     Economic Indicators, cont.

        One common use of indicators is to attempt to
         forecast where our economy is headed.
        The Index of Leading Indicators measures 11 factors
         such as:
         –   Stock Prices.
         –   Consumer Expectations.
         –   Manufacturers’ New Orders.
         –   Money Supply.
         –   Changes in Selected Prices of Materials.
         –   Initial Unemployment Claims.
        Net progress is announced publicly and can
         influence decisions.
        The Index can give false readings and the lead-time
18       to actual changes in the economy can also vary.
     Fiscal Policy

        Fiscal policy: The role played by government in
         attempting to favorably influence the course of
         economic activity through changes in government
         receipts and disbursements. Two major tools and
         increased spending and tax cuts.
        Increased spending, through:
         –   public works spending.
         –   spending to improve our educational system.
         –   increases in military programs to improve preparedness.
         –   programs to benefit certain age and income brackets .
        With increased spending, the government is
         relatively assured that the money will result in a
         change in economic output. But implementation is
19       often delayed.
     Fiscal Policy, cont.

        Tax cuts: The government can institute temporary or
         permanent declines in tax rates.
        The expectation is that households will spend it.
        Advantage: The relatively brief time it takes to
         implement the cut.
        Disadvantage: Uncertainty as to whether the
         household will actually spend the money.
         –   If the households are pessimistic about the future, they may
             save the money instead.
         –   The tax cut would then have little influence on economic
             weakness at that time.

     Monetary Policy

        Monetary policy: Government actions intended to
         influence the amount of money in circulation in the
         economy. Actions that the Federal Reserve can
         take to influence economic activity include:
         –   Open Market Operations: Purchase government bonds from
             member banks or issue government bonds.
         –   Changes in the Discount Rate: The discount rate is the
             interest rate that member banks pay the Federal Reserve
             for borrowing from it. A change in the discount rate signals
             Federal Reserve intent.
         –   Changes in the Reserve Ratio: The reserve ratio is the
             amount of money the banks have to keep in reserve for
             each dollar they lend.
         –   Moral Suasion: The Federal Reserve can signal the market
             through testimony before Congress, speeches in front of
21           economic groups and well timed interviews.
     Yield Curves

        Yield curve: The connection of individual points on a
         graph representing separate returns for one type of
         bond over all its maturity dates.
         –   Each yield curve represents only one type of bond.
         –   The curve presents all yields based on all maturity dates for
             that type of bond on the same day.
        Interest rates can be thought of as another
         commodity, with yields established by the interaction
         of demand by borrowers of money and supply by
         lenders of capital.
        The Federal Reserve has significant influence
         through tightening or easing the supply of money.

     Yield Curves, cont.

        Yield curve for U.S. Treasury Bonds, October 2004:

     Financial Institutions

        Financial institutions typically serve as middlemen
         between those providing funds and individuals and
         institutions seeking to obtain funds to use for their
         own purposes. Two main types of middlemen:
         –   Middleman that serves as intermediary without use of its
             own capital.
         –   Middleman that uses its own money in their intermediary
             function, thereby placing their own capital at risk.
        Over recent decades the distinctions between
         various types of financial institutions have become
         blurred as individual firms have expanded and offer
         more than one service.

     Financial Institutions, cont.

        Commercial Banks:
         –   The largest depository institutions in the country.
             Commercial banks also make loans to businesses and
         –   Regulated by the Comptroller of the Currency, the Federal
             Reserve, state bank regulators, and the Federal Deposit
             Insurance Company (FDIC).
        Savings Banks and Savings and Loans (S & Ls):
         –   Deposits come from money markets, savings accounts, and
             certificates of deposit. Lending consists principally of
             mortgages, home improvement loans, and, in some cases,
             commercial loans.
         –   Regulated by the FDIC, the Office of Thrift Supervision
             (OTS) for federal and by the state agencies for state.
     Financial Institutions, cont.

        Credit Unions:
         –   Nonprofit organizations in which all members participate in
             the benefits of the operations.
         –   Credit unions can be established by a state or can be
             federally chartered. Federal credit unions are supervised by
             the National Credit Union Administration, which provides
             guarantees for up to $100,000 for insured credit unions.
        Insurance Companies:
         –   Regulated by the states that charter them. For property and
             life insurance companies, supervision and examination
             have been grouped together under the National Association
             of Insurance Commissioners. States attempt to promote
             insurance guarantees so that when one company goes out
             of business others will contribute or even assume the “book
             of business” of a failed company.
     Financial Institutions, cont.

        Brokerage Firms:
         –   Traditionally, a brokerage firm is a middleman offering to
             help match buyers and sellers of an asset or service for a
         –   Full service brokerage companies offer investment
             management, mortgage-loan, check-writing, and insurance
             products. It may be more appropriate to call them securities
             firms rather than brokerage firms.
         –   The Securities and Exchange Commission (SEC) is the
             principal regulator of the brokerage industry. It requires
             registration, adherence to certain practices, and it audits
             individual firms. The New York Stock Exchange (NYSE)
             and the National Association of Securities Dealers (NASD)
             also perform regulatory services.

     Financial Institutions, cont.

        Mutual Funds:
         –   Mutual fund organizations are regulated by the SEC. They
             require a prospectus that, among other things, provides
             disclosures of conflicts of interest and guidelines on how
             performance is to be reported.
        Finance Companies:
         –   Provide capital in the form of loans to individuals and
             businesses. They offer consumer and business loans and
             mortgage loans. Unlike banks, they do not take deposits
             and must therefore borrow monies to finance their loan
             offerings to others.
         –   May moderate their exposure to higher risk loans by
             requiring that the lender provide assets as collateral for the
         –   Not closely regulated, with one exception being limitations
28           on the maximum rate charged.
     Financial Institutions, cont.

        Trust Companies:
         –   Provide trustee services for individuals. As such they act as
             fiduciaries that must place clients’ interests first.
         –   They typically take into their possession funds in
             accordance with state laws on proper actions.
         –    Sometimes the trust services include investment
             management and possibly other activities such as tax
             return, bookkeeping, and bill-paying services.
         –   Trust services may be performed for affluent individuals,
             children, and incapacitated people, among others.
         –    They offer perpetual operations that outlive the services of
             any one advisor.
         –   The services may be provided by a separate company, but
             are often offered by commercial banks.
     Financial Institutions, cont.

     Types of Business Entities

        Individual Proprietorships:
         –   One person runs the operation.
         –   Advantages: Easy to form, less regulated, fewer taxes on
         –   Disadvantages: Lack of continuity, difficulty borrowing large
             sums of money, unlimited liability.
        Partnerships:
         –   Two or more persons join their individual efforts in group
         –   Can offer economic efficiencies.
         –   Advantages: Easy to form, less expensive to operate.
         –   Disadvantages: Lack of continuity, difficulty borrowing large
             sums of money, unlimited liability.
     Types of Business Entities, cont.

        In a limited partnership structure, partners are
         segregated into two groups, general and limited
         –   Limited partners do not have voting rights on decisions and
             are only liable for partnership losses to the extent of their
         –   Advantage: The ability to attract into the partnership
             talented individuals or those with significant resources who
             wish to limit their risk.
        In a family limited partnership, a family maintains
         operating control and passes on financial ownership
         in a family business.
        The limited liability partnership (LLP) combines the
         limited liability feature of a corporation with the lower
32       taxation of a partnership.
     Types of Business Entities, cont.

        Corporations: A separate organization that is
         established by the state and is legally separate from
         the individuals who form it.
         –   Advantages include limited liability, ease in transferring
             ownership, the potential for unlimited life, and economic
         –   Perceived by outside investors as more stable, which can
             make it easier to raise material sums of both debt and
             equity capital.
         –   If publicly traded, it has the advantage of a current
             independently established market value and the ability for
             its owners to increase or decrease their ownership through
             transactions in the open market.
         –   Disadvantages: More complexity when establishing, more
             detailed recordkeeping, the possibility of more government
33           taxation.
     Types of Business Entities, cont.

        The corporations described above are called C
         Corporations by the IRS, referring to the way they
         are taxed.
        By Subchapter S Corporation, limited liability, but
         profits are taxed as if the corporation were a
         partnership or an individual proprietorship.
         –   Advantage: The ability to deduct operating losses
             immediately on each individual’s income tax return and to
             reinvest in the business without double taxation.
        The Limited Liability Corporation (LLC):
         –   Combines the limited liability feature of a corporation with
             being taxed as a partnership or an individual proprietorship.
             It can also be taxed as a corporation.
         –   It can be somewhat more flexible than a regular corporation
34           and may have less paperwork to do than one.
     Types of Business Entities, cont.

        PCs are professional service corporations whose
         benefit is to allow professionals to incorporate and
         take advantage of its limited liability feature. Can be
         sued personally for professional malpractice.
        An association is a grouping of individuals or
         businesses that share a common interest or goal
         and that generally finance an organization. It is
         taxed as a separate entity unless the government
         deems it a nonprofit association, which would then
         provide it with an exemption from taxes.

     Types of Business Entities, cont.

     Business Law

        There are three parts to a valid contract:
         –   An Offer: Must be communicated to the other parties.
         –   An Acceptance: Must be clear and unqualified.
         –   Consideration: Must be lawful and engaged in by competent
             parties adhering to the form required by law.
        A tort : An act of wrongdoing against a person or a
         business or their property for which compensation is
        Negligence: Behavior that could result in loss. Arises
         from insufficient care. Four parts to a claim:
         –   A duty was placed upon a person.
         –   The duty was violated.
         –   The violation caused the loss.
37       –   The loss resulted in damages.
     Business Law, cont.

        A negotiable instrument must be written, signed by
         the maker, an unconditional promise to pay an exact
         amount of money, payable on demand or as agreed
         upon, and paid to a specific person or to anyone
         presenting the paper.
        Professional Liability: A person who is deemed to be
         a professional has a standard of care that must be
         upheld with clients.
        Fiduciary Liability: A fiduciary is a trusted party who
         acts as an agent for another person.
         –   The agent must act with sufficient capability, comply with
             the terms of duties given, steer clear of conflicts of interest,
             refrain from revealing personal information, disclose
             relevant data to the principal, and account for work done
38           and its cost.
     Business Law, cont.

        Arbitration is the act of transferring decision making
         from two or more people who are in conflict to a third
         party. That third-party decision is generally binding
         and is very difficult to appeal unless the arbitrator
         does not follow appropriate procedures.
        Mediation is a method of handling disputes in which
         the mediator attempts to facilitate a resolution; unlike
         an arbitrator, a mediator acts as an advisor and does
         not have the power to render a final binding decision.
        Arbitration and mediation are two increasingly
         popular ways of resolving disputes because they are
         less costly than litigation.

     Chapter Summary

        Macroeconomics detailed the centrality of demand and supply
         for establishing prices. New equilibrium prices are an outgrowth
         of changes in supply and/or demand.
        Fiscal and monetary policy are government’s attempts to
         maintain strong stable economic conditions.
        Financial institutions are intermediaries that serve as
         middlemen between those providing funds and individuals and
         institutions seeking to obtain funds for their own use.
        The way a business is established, whether in individual
         proprietorship or a form of partnership or corporation, has
         important effects on economic, taxation, legal, and life-cycle
        Understanding and complying with business legal matters such
         as contract terms, negligence issues, general and fiduciary
         liability are key factors in handling household and business
40       matters.

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