In practice, the most common way for a takeover to occur is for one company to purchase the stock of another company, or for the two companies to merge by legal agreement under some new management structure. Stock purchases are more common in what are called hostile takeovers, where the company that is being taken over is fighting to remain independent. Mergers are more common in friendly takeovers, where two companies mutually agree that it makes sense for the companies to combine. In 1996 there were over $556.3 billion worth of mergers and acquisitions in the U.S. economy. Examples of mergers include the purchase of Lotus Development Corporation, a computer software company, by computer manufacturer International Business Machines Corporation
(IBM) and the acquisition of Miramax Films by entertainment and media giant Walt Disney Company.

Takeovers by other firms became commonplace in the closing decades of the
20th century, and some research indicates that these takeovers made firms operate more efficiently and profitably. Those outcomes have been good news for shareholders and for consumers. In the long run, takeovers can help protect a firm’s workers, too, because their jobs will be more secure if the firm is operating efficiently. But initially takeovers often result in job losses, which force many workers to relocate, retrain, or in some cases retire sooner than they had planned. Such workforce reductions happen because if a firm was not operating efficiently, it was probably either operating in markets where it could not compete effectively, or it was using too many workers and other inputs to produce the goods and services it was selling. Sometimes corporate mergers can result in job losses because management combines and streamlines departments within the newly merged companies. Although this streamlining leads to greater efficiency, it often results in fewer jobs. In many cases, some workers are likely to be laid off and face a period of unemployment until they can find work with another firm.

How Corporations Raise Funds for Investment

By investing in new issues of a company’s stock, shareholders provide the funds for a company to begin new or expanded operations. However, most stock sales do not involve new issues of stock. Instead, when someone who owns stock decides to sell some or all of their shares, that stock is typically traded on one of the national stock exchanges, which are specialized markets for buying and selling stocks. In those transactions, the person who sells the stock—not the corporation whose stock is traded—receives the funds from that sale.

An existing corporation that wants to secure funds to expand its operations has three options. It can issue new shares of stock, using the process described earlier. That option will reduce the share of the business that current stockholders own, so a majority of the current stockholders have to approve the issue of new shares of stock. New issues are often approved because if the expansion proves to be profitable, the current stockholders are likely to benefit from higher stock prices and increased dividends. Dividends are corporate profits that some companies periodically pay out to shareholders.

The second way for a corporation to secure funds is by borrowing money from banks, from other financial institutions, or from individuals. To do this the corporation often issues bonds, which are legal obligations to repay the amount of money borrowed, plus interest, at a designated time.
If a corporation goes out of business, it is legally required to pay off any bonds it has issued before any money is returned to stockholders.
That means that stocks are riskier investments than bonds. On the other hand, all a bondholder will ever receive is the amount of money specified in the bond. Stockholders can enjoy much larger returns, if the corporation is profitable.

The final way for a corporation to pay for new investments is by reinvesting some of the profits it has earned. After paying taxes, profits are either paid out to stockholders as dividends or held as retained earnings to use in running and expanding the business. Those retained earnings come from the profits that belong to the stockholders, so reinvesting some of those profits increases the value of what the stockholders own and have risked in the business, which is known as stockholders’ equity. On the other hand, if the corporation incurs losses, the value of what the stockholders own in the business goes down, so stockholders’ equity decreases.

Entrepreneurs and Profits

Entrepreneurs raise money to invest in new enterprises that produce goods and services for consumers to buy—if consumers want these products more than other things they can buy. Entrepreneurs often make decisions on which businesses to pursue based on consumer demands. Making decisions to move resources into more profitable markets, and accepting the risk of losses if they make bad decisions—or fail to produce products that stand the test of competition—is the key role of entrepreneurs in the U.S. economy.

Profits are the financial incentives that lead business owners to risk their resources making goods and services for consumers to buy. But there are no guarantees that consumers will pay prices high enough to cover a firm’s costs of production, so there is an inherent risk that a firm will lose money and not make profits. Even during good years for most businesses, about 70,000 businesses fail in the United States. In years when business conditions are poor, the number approaches 100,000 failures a year. And even among the largest 500 U.S. industrial corporations, a few of these firms lose money in any given year.

Entrepreneurs invest money in firms with the expectation of making a profit. Therefore, if the profits a company earns are not high enough, entrepreneurs will not continue to invest in that firm. Instead, they will invest in other companies that they hope will be more profitable. Or if they want to reduce their risk, they can put their money into savings accounts where banks guarantee a minimum return. They can also invest in other kinds of financial securities (such as government or corporate bonds) that are riskier than savings accounts, but less risky than investments in most businesses. Generally, the riskier the investment, the higher the return investors will require to invest their money.

Calculating Profits

The dollar value of profits earned by U.S. businesses—about $700 billion a year in the late 1990s—is a great deal of money. However, it is important to see how profits compare with the money that business owners have risked in the business. Profits are also often compared to the level of sales for individual firms, or for all firms in the U.S. economy.

Accountants calculate profits by starting with the revenue a firm received from selling goods or services. The accountants then subtract the firm’s expenses for all of the material, labor, and other inputs used to produce the product. The resulting number is the dollar level of profits. To evaluate whether that figure is high or low, it must be compared to some measure of the size of the firm. Obviously, $1 million would be an incredibly large amount of profits for a very small firm, and not much profit at all for one of the largest corporations in the country, such as telecommunications giant AT&T Corp. or automobile manufacturer General Motors (GM).

To take into consideration the size of the firm, profits are calculated as a percentage of several different aspects of the business, including the firm’s level of sales, employment, and stockholders’ equity. Various individuals will use one of these different methods to evaluate a company’s performance, depending on what they want to know about how the firm operates. For example, an efficiency expert might examine the firm’s profits as a percentage of employment to determine how much profit is generated by the average worker in that firm. On the other hand, potential investors and a company’s chief executive would be more interested in profit as a percentage of stockholder equity, which allows them to gauge what kind of return to expect on their investments. A sales executive in the same firm might be more interested in learning about the company’s profit as a percentage of sales in order to compare its performance to the performances of competing firms in the same industry.

Using these different accounting methods often results in different profit percent figures for the same company. For example, suppose a firm earned a yearly profit of $1 million, with sales of $20 million. That represents a 5-percent rate of profit as a return on sales. But if stockholders’ equity in the corporation is $10 million, profits as a percent of stockholders’ equity will be 10 percent.

Return on Sales

Year after year, U.S. manufacturing firms average profits of about 5 percent of sales. Many business owners with profits at this level or lower like to say that they earn only about what people can earn on the interest from their savings accounts. That sounds low, especially considering that the federal government insures many savings accounts, so that most people with deposits at a bank run no risk of losing their savings if the bank goes out of business. And in fact, given the risks inherent in almost all businesses, few stockholders would be satisfied with a return on their investment that was this low.

Although it is true that on average, U.S. manufacturing firms only make about a 5-percent return on sales, that figure has little to do with the risks these businesses take. To see why, consider a specific example.

Most grocery stores earn a return on sales of only 1 to 2 percent, while some other kinds of firms typically earn more than the 5-percent average profit on sales. But selling more or less does not really increase what the owners of a grocery store (or most other businesses) are risking.
Each time a grocery store sells $100 worth of canned spinach, it keeps about one or two dollars as profit, and uses the rest of the money to put more cans of spinach on the shelves for consumers to buy. At the end of the year, the grocery store may have sold thousands of dollars worth of canned spinach, but it never really risked those thousands of dollars. At any given time, it only risked what it spent for the cans that were at the store. When some cans were sold, the store bought new cans to put on the shelves, and it turned over its inventory of canned spinach many times during the year.

But the total value of these sales at the end of the year says little or nothing about the actual level of risk that the grocery store owners accepted at any point during the year. And in fact, the grocery industry is a relatively low-risk business, because people buy food in good times and bad. Providing goods or services where production or consumer demand is more variable—such as exploring for oil and uranium, or making movies and high fashion clothing—is far riskier.

Return on Equity

What stockholders risk—the amount they stand to lose if a business incurs losses and shuts down—is the money they have invested in the business, their equity. These are the funds stockholders provide for the firm whenever it offers a new issue of stock, or when the firm keeps some of the profits it earns to use in the business as retained earnings, rather than paying those profits out to stockholders as dividends.

Profits as a return on stockholders’ equity for U.S. corporations usually average from 12 to 16 percent, for larger and smaller corporations alike.
That is more than people can earn on savings accounts, or on long-term government and corporate bonds. That is not surprising, however, because stockholders usually accept more risk by investing in companies than people do when they put money in savings accounts or buy bonds. The higher average yield for corporate profits is required to make up for the fact that there are likely to be some years when returns are lower, or perhaps even some when a company loses money.

At least part of any firm’s profits are required for it to continue to do business. Business owners could put their funds into savings accounts and earn a guaranteed level of return, or put them in government bonds that carry hardly any risk of default. If a business does not earn a rate of return in a particular market at least as high as a savings account or government bonds, its owners will decide to get out of that market and use the resources elsewhere—unless they expect higher levels of profits in the future.

Over time, high profits in some businesses or industries are a signal to other producers to put more resources into those markets. Low profits, or losses, are a signal to move resources out of a market into something that provides a better return for the level of risk involved. That is a key part of how markets work and respond to changing demand and supply conditions. Markets worked exactly that way in the U.S. economy when people left the blacksmith business to start making automobiles at the beginning of the 20th century. They worked the same way at the end of the century, when many companies stopped making typewriters and started making computers and printers.

CAPITAL, SAVINGS, AND INVESTMENT

In the United States and in other market economies, financial firms and markets channel savings into capital investments. Financial markets, and the economy as a whole, work much better when the value of the dollar is stable, experiencing neither rapid inflation nor deflation. In the United
States, the Federal Reserve System functions as the central banking institution. It has the primary responsibility to keep the right amount of money circulating in the economy.

Investments are one of the most important ways that economies are able to grow over time. Investments allow businesses to purchase factories, machines, and other capital goods, which in turn increase the production of goods and services and thus the standard of living of those who live in the economy. That is especially true when capital goods incorporate recently developed technologies that allow new goods and services to be produced, or existing goods and services to be produced more efficiently with fewer resources.

Investing in capital goods has a cost, however. For investment to take place, some resources that could have been used to produce goods and services for consumption today must be used, instead, to make the capital goods. People must save and reduce their current consumption to allow this investment to take place. In the U.S. economy, these are usually not the same people or organizations that use those funds to buy capital goods. Banks and other financial institutions in the economy play a key role by providing incentives for some people to save, and then lend those funds to firms and other people who are investing in capital goods.

Interest rates are the price someone pays to borrow money. Savings institutions pay interest to people who deposit funds with the institution, and borrowers pay interest on their loans. Like any other price in a market economy, supply and demand determine the interest rate.
The demand for money depends on how much money people and organizations want to have to meet their everyday expenses, how much they want to save to protect themselves against times when their income may fall or their expenses may rise, and how much they want to borrow to invest. The supply of money is largely controlled by a nation’s central bank—which in the
United States is the Federal Reserve System. The Federal Reserve increases or decreases the money supply to try to keep the right amount of money in the economy. Too much money leads to inflation. Too little results in high interest rates that make it more expensive to invest and may lead to a slowdown in the national economy, with rising levels of unemployment.

Providing Funds for Investments in Capital

To take advantage of specialization and economies of scale, firms must build large production facilities that can cost hundreds of millions of dollars. The firms that build these plants raise some funds with new issues of stock, as described above. But firms also borrow huge sums of money every year to undertake these capital investments. When they do that, they compete with government agencies that are borrowing money to finance construction projects and other public spending programs, and with households that are borrowing money to finance the purchase of housing, automobiles, and other goods and services.

Savings play an important role in the lending process. For any of this borrowing to take place, banks and other lenders must have funds to lend out. They obtain these funds from people or organizations that are willing to deposit money in accounts at the bank, including savings accounts. If everyone spent all of the income they earned each year, there would be no funds available for banks to lend out.

Among the three major sectors of the U.S. economy—households, businesses, and government—only households are net savers. In other words, households save more money than they borrow. Conversely, businesses and government are net borrowers. A few businesses may save more than they invest in business ventures. However, overall, businesses in the United States, like businesses in virtually all countries, invest far more than they save. Many companies borrow funds to finance their investments. And while some local and state governments occasionally run budget surpluses, overall the government sector is also a large net borrower in the U.S. economy. The government borrows money by issuing various forms of bonds.
Like corporate bonds, government bonds are contractual obligations to repay what is borrowed, plus some specified rate of interest, at a specified time.

Matching Borrowers and Lenders in Financial Markets

Households save money for several reasons: to provide a cushion against bad times, as when wage earners or others in the household become sick, injured, or disabled; to pay for large expenditures such as houses, cars, and vacations; to set aside money for retirement; or to invest. Banks and other financial institutions compete for households’ savings deposits by paying interest to the savers. Then banks lend those funds out to borrowers at a higher rate of interest than they pay to savers. The difference between the interest rates charged to borrowers and paid to savers is the main way that banks earn profits.

Of course banks must also be careful to lend the money to people and firms that are creditworthy—meaning they will be able to repay the loans.
The creditworthiness of the borrower is one reason why some kinds of loans have higher rates of interest than others do. Short-term loans made to people or businesses with a long history of stable income and employment, and who have assets that can be pledged as collateral that will become the bank’s property if a loan is not repaid, will receive the lowest interest rates. For example, well-established firms such as AT&T often pay what is called the bank’s prime rate—the lowest available rate for business loans—when they borrow money. New, start-up companies pay higher rates because there is a greater risk they will default on the loan or even go out of business.

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