assign 2 man fin

Learning Objectives

After studying this chapter, you should be able to:

• Describe the relationship between governments, corporations, and markets.

• Express how markets facilitate the process of exchange.

• Explain the different types of financial markets and their functions.

• Illustrate the difference and significance of perfect and imperfect competition in product markets.

• Describe the relationship between market participants and value.

Kike Calvo/National Geographic Stock2

Financial Claims and Markets

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CHAPTER 2Introduction

Introduction

Figure 2.0: Chapter 2 in focus

The Financial Balance Sheet

Investors

FundsGoods and Services

Product Market Financial Market The Government

Supports Infrastructure

Regulates Business Supports Safety

Consumers

In Chapter 2, the economic and regulatory environment within which the firm operates is linked to the value creation goal of the corporation.

Chapter 1 provided an overview of finance and introduced the financial balance sheet. It also discussed the goal of corporate managers—shareholder wealth maximization—and some challenges to achieving that objective. Chapter 1 also described the advantages and disadvantages of the corporate form of organization. Chapter 2 completes the develop- ment of the financial balance sheet by considering the environment in which corporations operate. The long-term viability of any business depends on how well managers under- stand the limits and opportunities that external forces exert on their organization. The key objective (or bottom line, in business parlance) of this chapter is to describe the inter- play between the business and markets. Understanding how this interplay contributes to the success (or failure) of a business, which ultimately determines the company’s value, should be your goal as you read through the material.

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CHAPTER 2Section 2.1 Governments, Corporations, and Markets

Pre-Test

1. The accounting fraud that took place at the turn of this century led to Sarbanes- Oxley legislation.

a. True b. False

2. Price is the least valuable information produced in markets. a. True b. False

3. Highly liquid assets can be easily sold for their approximate value. a. True b. False

4. Wealth is more easily created in perfectly competitive markets than in less com- petitive markets.

a. True b. False

5. Consumption is the behavioral foundation behind the importance of cash flow timing.

a. True b. False

Answers 1. a. True. The answer can be found in Section 2.1. 2. b. False. The answer can be found in Section 2.2. 3. a. True. The answer can be found in Section 2.3. 4. b. False. The answer can be found in Section 2.4. 5. a. True. The answer can be found in Section 2.5.

2.1 Governments, Corporations, and Markets

Before looking at markets, let’s briefly consider some of the effects government has on businesses. Limitations and opportunities for businesses often arise from laws passed by federal, state, and local governments. Many governmental units collect taxes on business income and use tax policy to modify business behavior by applying different tax rates to different types of activities. As an example, local governments com- monly offer property tax reductions to companies that are considering moving into the area, in the expectation that the corporation will provide new jobs for local residents. Government agencies limit or prohibit some activities through administrative regulation in order to protect consumers and the environment. Truth-in-advertising laws, product safety laws, and pollution-control regulations are examples of how the government has limited corporate activities to benefit or protect other constituencies. Governments also pass laws that protect corporations. Examples of laws that help firms prosper from their innovation or protect them from unfair competition include patents, copyrights, and predatory pricing prohibitions.

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CHAPTER 2Section 2.1 Governments, Corporations, and Markets

The government also supports business activity in other, less direct, ways. The regula- tion of capital and commodity markets helps companies obtain investment funds and raw materials at competitive prices. Insurance of bank deposits encourages individuals to save, which provides funds for banks to lend to individuals and businesses. Professional certification of doctors, dentists, lawyers, and pilots provides a tacit assurance of quality. This increases consumer confidence and consumer use of these professional services. A well-developed legal system encourages business activity by penalizing firms that engage in unfair trade practices and assuring that contractual commitments are honored.

Financial crises often lead to new regulations by the government beginning with the Great Depression and the creation of the Securities and Exchange Commission in 1934. Recent history has its own examples of the interplay between financial markets and government regulation. The accounting scandals involving firms like Enron and WorldCom led to the passage of Sarbanes-Oxley (SOX) in 2002, with its tighter reporting standards, strength- ened insider trading rules, and the separation of auditing and consulting services by accounting firms. The “Great Recession” resulted in the Dodd-Frank bill that was signed in 2011. Some of its key provisions included the creation of the Bureau of Consumer Finan- cial Protection and the Financial Stability Oversight Council.

Within the limitations and opportunities provided by this legal framework, corporations compete in markets that operate according to the laws of supply and demand. Corpora- tions sell the goods and services they produce in product markets. Product markets also provide the raw materials and other inputs that firms use in their production process. To create value for their shareholders, corporate managers must pay careful attention to the product markets as they choose the mix of items to produce and decide how best to produce them. Successful managers have a knack for figuring out what consumers want and providing it at an acceptable price. The left-hand side of the financial balance sheet reflects the product market decisions made by managers as they work toward increasing the wealth of shareholders.

Besides product markets, firms also participate in financial markets. A company’s finan- cial market activities appear on the right-hand side of the financial balance sheet under long-term liabilities and equity. Financial markets supply the funds that firms use to purchase productive assets, such as factories, machinery, trucks, computers, and offices. Financial markets also provide a mechanism for valuing a firm’s securities. Investors buy and sell stocks and bonds in these markets. These transactions determine security prices and, thereby, the value investors place on a firm.

Figure 2.1 shows how government, product markets, and financial markets all interact on the financial balance sheet.

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CHAPTER 2Section 2.1 Governments, Corporations, and Markets

Figure 2.1: The financial balance sheet and government

Product Markets

Financial Markets

Taxes paid to government units

Government

Internal and external funds provided to the corporation

Investments made by the corporation

The Financial Balance Sheet

Cash flow from operations

The role of government in the decisions of corporations is complex, impacting both product and financial markets.

One important lesson of modern finance is that corporations are defined in large part by the markets in which they operate. Therefore, in many respects finance is the study of markets. Understanding the markets in which corporations participate is essential to understanding corporations themselves. Corporate assets, such as plant, equipment, and human resources are shown on the left-hand side of the financial balance sheet and reflect the corporation’s activity in product markets. The right-hand side of the financial balance sheet shows how the firm financed those assets; that is, it presents a record of the firm’s activities in the financial markets. The corporation acts as a conduit, linking investment funds from the financial markets to goods and services in the product markets. The cor- poration invests the funds in machinery, factories, raw materials, and skilled personnel, which are organized to produce items that consumers want. See Figure 2.2 for an illustra- tion of this interaction on the financial balance sheet.

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CHAPTER 2Section 2.1 Governments, Corporations, and Markets

Figure 2.2: The financial balance sheet and markets

Internal and external funds provided to the corporation

Funds from the sale of securities

Cash distributions and claims against the corporation

Financial Markets

Competition

Demand

Products

Product Markets

Investments made by the corporation

Use money to purchase

assets

Money from

production profits

ACME Corporation Financial Balance Sheet

The interaction of the product and financial markets is an important aspect of the operation of a corporation.

In both product and financial markets, information avail- ability and ease of entry play important roles in determin- ing whether wealth-increasing opportunities exist. In financial markets, prices typically reflect new information very quickly. For example, if a pharmaceuti- cal company announces it has developed a vaccine for AIDS, within minutes its stock price will reflect investors’ forecasts of the company’s future profits. This market is informationally efficient, producing prices that quickly and accurately reflect the economic impact of corpo- rate news. What informational efficiency implies about mak- ing money in financial markets is one of the important lessons in this chapter.

Farming is one example of a highly competitive market because there are many vendors who sell the same produce at similar prices. Can you think of any other examples?

Bloomberg/Getty Images

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CHAPTER 2Section 2.2 Markets and Exchange

Product markets vary in their competitiveness. Markets that firms can easily enter and exit and in which firms produce very similar goods are called perfectly competitive. Per- fect competition implies that many similar goods are vying for customers and that they offer corporations less potential profits than imperfectly competitive markets do. On the other hand, markets are characterized by imperfect competition when entry is restricted or goods are differentiated. Perfect and imperfect competition are particularly important concepts. In fact, we take a hard look at market imperfections and how corporate manag- ers use them to increase the wealth of the firm’s shareholders.

2.2 Markets and Exchange

Before describing the markets in which corporations operate, we want to discuss the role of markets in general. All markets, no matter what their form, have a common purpose: They provide a mechanism for individuals and businesses to exchange goods and services by bringing interested buyers and sellers together. Transactions between willing participants result in both parties being better off. If each trader did not believe that the trade was in his or her interest, they would not make the exchange. There- fore, markets enhance people’s well-being.

Markets are essential to any economic system, and evidence of markets is found in even ancient societies. Markets come in a variety of shapes and sizes. They can be places, such as shopping malls and the floor of the New York Stock Exchange. But exchange no lon- ger requires going to a particular physical location. Modern telecommunications allows markets to be computer networks, like eBay, or television programs. Catalogs are another example of markets without a physical location. The importance and desirability of conve- nient and speedy exchange means that markets undergo constant refinement and change. Immense energy and ingenuity goes into developing ways to facilitate exchange. Every- one benefits as exchange becomes easier and cheaper, and more sellers (with a broader range of goods and services) can meet more buyers (with more money and a broader range of needs and desires).

In ancient markets, goods were bartered, or exchanged, without any money changing hands. Today, money is used as the medium of exchange. When exchange occurs, price is established, even in barter markets. For instance, if a Toyota is exchanged for 30 cases of fine French burgundy, then the price of the Toyota is established as 30 cases of wine, or the price of a case of wine is 1/30th that of a Toyota. Money facilitates exchange because it is commonly accepted as a means of counting and storing value. Using money in transac- tions means that the French are not limited to driving cars manufactured by companies willing to trade for wine and that Japanese car manufacturers can consume something other than burgundy. Exchange without money severely limits the set of goods and ser- vices available to consumers. Many members of the European Union took the ease of exchange a step further when they formed a monetary union, adopting the euro as a single currency for use across much of the continent.

Often our view of markets and exchange extends only to shopping for physical items. However, when we buy or hire services, we exchange money for another person’s time.

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CHAPTER 2Section 2.2 Markets and Exchange

When we work, we exchange our time for money (and the goods and services it can buy). Although exchange often involves the simultaneous payment of money and receipt of a good or service, sometimes one side of the exchange is delayed. This occurs frequently in the field of finance. Investing money today brings no immediate benefits. What is being bought is the expectation of more money in the future. Similarly, a college educa- tion requires paying now (in terms of time and money) for future benefits (a better job and broader view of the world). These examples show that markets need not involve the simultaneous exchange of money for goods.

Markets not only facilitate exchange but also generate and process information. Informa- tion is the lifeblood of markets. Without information, much exchange would not occur, and many markets would not exist. The single most valuable type of information created by markets is price. Prices established by transactions in relatively free and competitive markets are the most fundamental measure of economic value. The market price of an asset, good, or service provides information about equivalent nontraded items. Using cur- rent market prices we can infer the value of many items without having to actually sell them. Prices also help individuals and businesses plan for the future. Prices tell potential buyers and sellers the current value placed on an item. With that information, producers can decide whether to expand or contract their production of particular items, and con- sumers can adjust their spending and savings patterns.

Prices also help allocate raw materials to their highest valued uses and cause talented workers to migrate to employers willing to pay them the highest wage for their skills. As demand for sought-after goods (and services) pushes prices up, the producers of those goods (and services) can afford to pay more for inputs, so they bid skilled labor and raw materials away from other users. By shifting inputs to their most highly valued use, prices help determine the most efficient allocation of scarce resources within an economy. Indeed, prices are the primary piece of information used to coordinate the incredibly varied activi- ties of a modern economy.

There are many types of prices. We place much more trust in market prices than in other types of prices. If you have ever shopped for a car, a computer, a camera, or stereo equip- ment, you know about list or suggested retail prices. Few transactions actually occur at these asking or list prices. In fact, these listed prices, such as automobile sticker prices, are virtually ignored by consumers. Computer magazines display this disregard for list prices by publishing what they call street prices, the price a consumer with a bit of sophistication pays for an item.

We want to stress the importance of prices being set in markets. In socialist countries, where prices were determined by government and not the market, immense economic distortions occurred. For example, in former Soviet Russia, bread once cost less than the grain used in its production! Only with the information provided by prices set in competi- tive markets can an economy approach an efficient allocation of resources.

In the following section, we describe the financial markets in which firms obtain funds. We also discuss the attributes required for these markets to generate prices that quickly and accurately reflect all the available information about a company and its future pros- pects. The information contained in this section is important to students whether or not they plan on becoming financial managers. Anyone who invests in stocks, has a retirement

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CHAPTER 2Section 2.3 Financial Markets

plan, uses credit, or may want to start a business needs to understand something about financial markets.

2.3 Financial Markets

Corporations dominate our economy in part because they have ready access to finan-cial markets. Financial markets provide funds to firms for investment in produc-tive assets. Besides furnishing funds for corporate investment, financial markets also provide investors with opportunities to put their savings to work. By coordinating the savings activities of individuals and the investment needs of corporations, financial markets play a key role in the economic development of our country. In this section, we describe the basic attributes of financial markets and continue our discussion of market efficiency.

Financial Securities, Transferability, and Liquidity As we begin our study of financial markets, we focus on stocks and bonds—the most com- mon financial securities issued by corporations. There are many more types of financial securities than stocks and bonds—every year new financial instruments are introduced. As with physical goods, these securities have value; however, their value derives from the rights attached to their ownership rather than from their physical attributes.

The most important of these rights is the claim a security gives an investor to the cash flows of the issuing corporation. The nature of these financial claims varies with the type of security. Recall from Chapter 1 that some are fixed claims, such as bonds or loans, and others, such as common stock, are residual claims. Bondholders lend money to the cor- poration and in return receive a series of interest payments as well as repayment of the amount originally lent, the principal amount. Interest payments are typically scheduled to be made twice a year for the life of a bond. At the bond’s maturity date, the corporation repays the principal. A bondholder may sell a bond prior to maturity, receiving whatever the market price is for the bond at that time. Once a bond is sold, the new owner receives the remaining interest and principal payments.

Corporations have a legal obligation to make interest and principal payments as sched- uled in the bond indenture contract. The borrowing corporation makes a bond inden- ture contract with a trustee, usually a bank or trust company. The indenture obligates the borrowing company to comply with a set of predetermined conditions that the trustee monitors on behalf of the lenders. The indenture conditions typically include maintaining certain levels of liquidity and limit additional borrowing, the sale of significant assets, and the payment to shareholders of large cash dividends. The objective of these constraints is to help ensure that bondholders will receive their promised interest and principal pay- ments in full and on time. Failure to make the contractual payments can force a company into bankruptcy.

After a company pays bank loans, commercial paper, lines of credit, and all other fixed or contractual obligations, the remaining cash flows belong to shareholders. Since share- holders have a claim to what is leftover, they are referred to as residual claimants. The

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CHAPTER 2Section 2.3 Financial Markets

Timeshare properties typically lose value in the re-sell market, making them susceptible to illiquidity. What are some other examples of illiquid assets?

Sygma/Corbis

corporation can distribute cash to shareholders in the form of dividends. Alternatively, the company may keep some or all of the residual cash flows to invest in new projects or products; money that shareholders have a claim to but that is kept in the firm is called retained earnings. If managers invest these funds wisely, the company’s stock price rises to reflect the higher anticipated future cash flows. Shareholders benefit in two ways from their ownership stake in a corporation: They may receive cash dividends, and/or they may sell the firm’s stock at a price higher than they paid. The sale of a share of stock results in a capital gain (or a capital loss) if the sale price is greater (or less) than the pur- chase price. Both bonds and stocks can create capital gains; however, capital gains are more often associated with common stock. The total return from an investment in com- mon stock includes both the return from dividends and the return from capital gains.

In addition to the claim to cash flows, attributes such as transferability and liquidity can affect a security’s value. With very few exceptions, financial securities are negotiable, meaning that they may be sold or transferred to other investors. A distinguishing feature of corporations, compared to other types of business organizations, is the ease with which ownership can be transferred from one investor to another. Transferability of ownership contributes to the longevity and growth potential of corporations. Although all securi- ties traded in financial markets are negotiable, the ease with which transfer occurs varies depending on a security’s liquidity. Liquidity refers to the ability to sell a security quickly without having to offer a substantial price reduction to attract buyers.

Securities that trade infre- quently, often called thinly traded, are particularly prone to problems of illiquidity. Some classic examples of illiquid- ity include condominium time shares and precious gems. These are assets with value, but they often sell on the secondary market for substantial price con- cessions. To increase the value of the asset, sellers often offer to create a market for reselling illiq- uid assets. One of the key ben- efits of well-developed financial markets is the increased liquid- ity such markets provide. By bringing together more buyers and sellers, liquidity increases, and the costs of transferring ownership fall.

The lack of liquidity can have large negative impacts on a firms’ value. During the finan- cial crisis of 2008, many large investment banks were following a business model that relied on short-term financing. They routinely paid off and reborrowed billions of dollars of short-term securities on a daily basis. One cause of the crisis was that investors began

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CHAPTER 2Section 2.3 Financial Markets

to question the creditworthiness of these banks because of their exposure to the downturn in the value of home mortgages. With no one willing to buy their short-term debt issues, these banks faced a cash flow crisis and were in danger of being forced into bankruptcy (or entered bankruptcy, as was Lehman Brothers Holdings).

Primary and Secondary Markets Securities trade in financial markets, the best known of which are the stock exchanges in New York, London, and Tokyo. These markets are phenomenally active and competitive. You probably have seen pictures of the trading floor of the New York Stock Exchange, with its frenzied and seemingly chaotic activity. Yet, for all their notoriety, these exchanges do not raise money for corporations; instead, they provide a market for investors to buy and sell existing stocks and bonds. These exchange markets are called secondary mar- kets. In secondary markets like the New York Stock Exchange, investors buy and sell securities among one another. So dominant are these secondary markets that an investor may spend a lifetime trading stocks and bonds and never directly contribute money to a corporation. However, secondary markets are very important because the price discov- ery that occurs in these markets determines the market value of corporations and signals investors’ beliefs about how companies are expected to perform in the future. Secondary market prices provide a report card on the performance of corporate managers and signal the value of the firm’s LHS investments.

Markets that handle the initial issuance of securities—securities that actually raise money for the issuing corporations—are called primary markets. Primary markets bring new security issues to life. Two categories of primary market transactions exist: seasoned and unseasoned. A seasoned offering occurs when a corporation issues additional shares of an existing security. For example, if IBM issues additional shares of its common stock, it is a seasoned issue; the stock being issued already trades in the marketplace, so investors know a great deal about its value from secondary trading in the stock. In fact, secondary market transactions will largely determine the price and other terms of trade for seasoned offerings. If the market price for IBM stock on the New York Stock Exchange is $60, there would be few buyers for a new issue of the same stock priced at $65 or even $61.

An unseasoned offering issues new securities; in other words, the issuing company has no identical security that is currently publicly traded. Unseasoned issues (often called ini- tial public offerings, or IPOs) have no track record, so they require more effort to value than do seasoned issues. This lack of historical market information about a company often results in a systematic underpricing of IPOs. On average, the initial price assigned to a new unseasoned stock issue is about 15% low; that is, the price assigned the stock by the investment bankers organizing the stock offerings is about 15% below the price the stock will trade at immediately after it is issued. Various theories have been suggested for this phenomenon. One theory argues that because so little information is available about the stock, it must be underpriced so that relatively poorly informed investors will buy the shares. A second theory proposed by some knowledgeable investors suggests that under- writers knowingly underprice new issues then allocate the underpriced shares to favored clients, who earn a significant profit by selling the first day of issue. (Thus, these brokers keep their most favored clients happy.) The process of offering an IPO is known as going public.

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CHAPTER 2Section 2.3 Financial Markets

Firms also raise capital through private placements. Using this method of finance, firms will issue and sell securities to a few, select investors rather than to the general public. Private placements are often structured so there is no need to register the issue with the SEC, saving considerable time and money.

Figure 2.3 illustrates the flow of cash and securities through primary and secondary markets.

Figure 2.3: Primary and secondary capital markets

Corporations issue bonds and stock.

Governments issue bonds and bills.

Primary Markets

Investors buy and sell previously issued securities.

Secondary Security Markets

Investors

$ Investment

Newly Issued Securities

Investors play an important role in both the primary and secondary capital markets.

Money and Capital Markets Companies access the financial markets to obtain funds for long-term growth as well as for short-term or seasonal needs. Within finance, short-term has come to mean securities with maturities of one year or less. Short-term securities trade in money markets. Money market instruments include commercial paper and U.S. treasury bills. Commercial paper is a promissory note (with a maturity of 270 days or less) issued by a company. U.S. trea- sury bills (T-bills), which are sold weekly, have maturities of 13, 26, or 52 weeks. By con- vention, long-term refers to securities with a life greater than 1 year from the date of their original sale. Long- term securities include government and corporate bonds as well as stock (which has a conceptually perpetual life). Economists sometimes make a somewhat finer distinction: Intermediate-term securities have maturities of 1 to 10 years. U.S. Treasury

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CHAPTER 2Section 2.3 Financial Markets

notes fall into this category, as do some corporate debt instruments. Intermediate- and long-term securities, such as stocks and bonds, trade in capital markets. Both capital and money markets are broken down into primary and secondary markets. Figure 2.4 sum- marizes the distinctions between money and capital markets, and between primary and secondary markets.

Figure 2.4: Financial market classification

Primary

Money Markets Capital Markets

Secondary

Original issuance of short-term securities

Treasury bills

Commercial paper

Original issuance of long-term securities

Corporate stocks and bonds

Treasury bonds

Trading among investors in short-term securities

Trading among investors in long-term securities

• NYSE • AMEX • NASDAQ

Both capital and money markets take advantage of primary and secondary markets. Consider the implications for investment liquidity.

Money markets process an enormous volume of transactions, a much higher volume than the capital markets. One of the reasons for this activity is that many money market claims are very short lived, some as short as one day. Imagine renewing a borrowing or lending arrangement every day. Many banks do exactly that. These are the markets in which a large portion (about 30%) of all U.S. government debt is financed, and in which the largest national and international banks are particularly active. As interesting as money markets are, we shift our focus to the capital markets. Secondary capital markets occur in two forms: exchanges and over-the-counter markets. The capital market that you are likely most familiar with is the New York Stock Exchange (NYSE). The NYSE is the oldest and larg- est stock exchange in the United States. Purchasing shares of stock listed on the NYSE (or any other stock exchange) typically requires contacting your local stockbroker (sometimes called a commission broker, a registered representative, or an account executive) with your order information. The stockbroker relays your order to the brokerage firm’s head- quarters, which then transmits the order to the floor of the NYSE. Your order may be filled by the specialist in the stock or may be entered in the specialist’s order book (where your buy order is matched with another investor’s sell order) for later execution if the price moves in the right direction. Each stock has an assigned specialist, who maintains a fair and orderly market in his or her particular stock or stocks.

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CHAPTER 2Section 2.3 Financial Markets

Field Trip: Capital Markets

Bloomberg provides extensive information on the activity of capital markets across the globe.

Visit http://www.bloomberg.com/markets/

Look at the performance of the major indexes from around the world. How are those from the United States performing? What about the major indexes in Asia and Europe?

Experiment with different indexes from the United States and other countries, looking at their perfor- mance charts over various time periods. Understanding how to navigate and interpret these charts may one day be invaluable to your professional and personal finances.

The over-the-counter (OTC) market lists the stocks of far more companies than the NYSE. When companies first make an offering of stock to the public, they most often do so by trading over the counter. Most trading in corporate bonds occurs in the over-the-counter market. The term over-the-counter comes from the period in the development of financial markets when banks were the primary dealers in stocks and bonds. Investors completed transactions at banks’ counters, thereby trading over the counter.

Trading in the largest and most active OTC stocks occurs through the National Association of Securities Dealers Automated Quote System (NASDAQ), a nationwide computerized network of dealers. Computer terminals linked to the NASDAQ system give brokerage firms access to all of the current quotations for all stocks on the system (no bonds are traded through the NASDAQ system). Price quotations include the ask price (what the dealer will sell the security for; the price they are asking) and the bid price (what they will pay for the security). The ask price always exceeds the bid price, albeit sometimes by only a few cents. Buying a NASDAQ system stock requires the broker (or a trader at a broker- age company’s headquarters) to find the lowest ask price and contact the dealer offering that price to confirm the transaction.

Whenever you buy or sell securities, whether you trade on the NYSE or NASDAQ sys- tem, you pay transaction costs. These costs include the commission paid to your broker and the bid-ask spread, the difference between the bid price and the ask price. If you buy a share of stock, you pay an ask price, and when you sell you receive a bid price. For heavily traded stocks the bid-ask spread is small (less than 1% of the share price), but for infrequently or thinly-traded stocks the spread can be significant (in the range of 3% to 6% of the share price). For example, the difference between bid and ask prices is small for stocks like Microsoft or Intel that trade on high volume, allowing dealers to make a small profit on each transaction while executing many trades. In contrast, very low-priced, infrequently traded penny stocks often have bid-ask spreads in excess of 25%, meaning an investor must see the price of the stock increase by 25% just to break even on the investment.

As one might expect, technology is playing an increasing role in security trading. As exchanges embrace faster and cost-effective electronic trading networks, bid-ask spreads are decreasing, and the role of specialists is diminishing. Since 2007, the NYSE has offered the electronic trading platform known as the Hybrid Market for its listed stocks, with a great majority of its trades now being executed electronically.

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CHAPTER 2Section 2.3 Financial Markets

With constantly improving technology, e-trading has become quite common. What would you say might be some of the benefits and drawbacks to electronic trading platforms?

Getty Images News/Getty Images

In addition to purchasing stocks on the secondary market, inves- tors sometimes carry out trans- actions called short sales, in which they sell a stock they don’t own but have borrowed, planning on buying it in the future to even out the transac- tion. This strategy is especially applicable to situations where investors believe that a stock’s price will fall. They sell today at a high price, and buy in the future at a lower price. The pur- chase allows them to return the borrowed stock, and the differ- ence between the high selling price and lower purchase price is their profit (less transaction costs, of course).

Competition and Information in the Financial Markets Although there are many complicated institutional details associated with financial mar- kets, the basic force driving financial market transactions is amazingly simple: People are trying to make money. Companies that issue securities in the primary markets compete with one another for investors’ dollars. Investors trading in secondary markets compete to buy stocks and bonds that appear likely to pay large dividends or interest payments or that may accrue capital gains from an increase in the price of the asset, relative to other securities. Competing investors bid up the price of shares of companies with good pros- pects and bid down those with declining prospects. In many ways, securities are seen as substitutes. Investors actively shift their funds to those securities with the brightest pros- pects. A confirmed Pepsi drinker, who might never consider changing to Coca-Cola or Dr. Pepper, has no compunction at all about selling stock in PepsiCo and buying stock in Coca-Cola. Investing is about money and the prospects of companies, and brand loyalty plays little role. Therefore, one soda pop stock is as good as another, and the best one is the stock that provides the highest expected total return (i.e., dividends and capital gain), no matter whether the investor personally likes the taste of the product or not. (Note, how- ever, that how an investor perceives demand for a product influences his or her opinion of the firm’s future prospects.)

Investors compete with one another to make better predictions about the future cash flows associated with financial claims. If you correctly predict that a company’s prospects have improved before other investors, you can buy shares at a bargain price. Conversely, if you realize that a company’s fortunes have fallen before the crowd does, you can profit by selling shares now and repurchasing them later at a lower price. Because all investors are competing to predict a security’s future cash flows, the relevant information focuses on how companies will fare in the future. This future orientation is one of the characteristics that distinguishes finance from accounting: Finance is almost entirely about the future, whereas accounting is largely a record of the past.

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CHAPTER 2Section 2.3 Financial Markets

Investors crave information that helps them make better predictions (or form more accurate expectations) about a firm’s prospects than other investors. In a sense, inves- tors compete with one another for better information and better methods of processing that information. An immense information industry has evolved to serve the needs of investors. Brokerage houses offer research in exchange for commissions; thousands of professional investors sell advice through newsletters; dozens of electronic databases and computer programs are available for investment analysis; and every year dozens of books appear with tips on how to “beat the market.”

Every day thousands of investors digest the latest information and make investment decisions based on this information. Competition among investors ensures that security prices accurately reflect the consensus opinion or expectation about a security’s future cash flows. Thus, security prices are an unbiased assessment of a company’s value, given the available information. That securities are accurately priced is something like a good- news/bad-news joke. The good news is that securities are fairly priced, so investors will not, on average, get tricked and lose lots of money. The bad news is that securities are priced so investors will not, on average, outsmart the market and make an extraordinary amount of money.

Everyone has heard about someone, an uncle or family friend, who has made a fortune in the stock market. This happens. Sadly, many people have lost their fortunes in the stock market, but you rarely hear about them. Investor competition does not imply that no one ever becomes enormously wealthy (or very poor) trading securities. It does mean that the majority of investors earn just a normal return—not too big, not too small—from invest- ing in stocks and bonds. Some investors do better than others and some do worse, but the average return is just sufficient for investors to continue to invest in the market. Expected returns vary across securities. We will see later in the text that returns are related to risk; that is, investors expect higher returns for investing in riskier securities.

Informational Efficiency in Financial Markets As we have just discussed, investors compete with one another for information that will give them an edge in assessing the value of financial securities. This competition means that security prices quickly reflect the information used by investors. Remember that once an investor obtains and analyzes pertinent information, he or she must rush to implement the buy-sell decision before other investors can take advantage of the information. In this race to buy or sell securities, prices respond by rising or falling. Therefore, security prices quickly reflect new information (Grossman & Stiglitz, 1980).

Financial markets in which prices reflect all relevant information are called informationally efficient markets. There are some questions, however, about the type of information that security prices incorporate and how accurately and quickly prices reflect that information (Haugen & Baker, 1996).

Since the buying and selling activities of investors drive security price changes, a more precise statement of the issues might be: What type of information do investors use to form expectations about security values, and how accurately and quickly does that infor- mation appear in security prices? These questions are of particular interest to investors and corporate managers because the answers help determine how profitable financial market activities are likely to be. The answers to these questions also provide a method

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CHAPTER 2Section 2.3 Financial Markets

of classifying financial markets according to their degree of efficiency. Financial econo- mists talk about three possible levels of market efficiency: weak-form, semistrong-form, and strong-form efficiency. These classifications differ according to the type of information that is quickly incorporated into security prices.

The weak form of the efficient markets hypothesis assumes that security prices incorpo- rate only historical price and volume data. If markets are weak-form efficient, then inves- tors cannot expect to earn abnormally high profits using trading rules based on historical price and volume patterns. Weak-form efficiency challenges chartists or technical analysts, who claim that they can use technical analysis to identify profitable security investments by examining charts and graphs of historical price and volume data. Compelling evi- dence exists that securities markets are weak-form efficient. That financial markets are at least weakly efficient makes sense. Suppose there was a pattern of prices that investors could use to predict future prices. For example, suppose stock prices always increased on Wednesdays. Since investors have nearly costless and immediate access to price and volume data, they can quickly identify such a pattern. Smart investors would buy stock on Tuesdays, preparing for the Wednesday rally. Their strategy would be to sell late on Wednesday, after security prices rose, and earn supranormal profits. Still smarter inves- tors would buy shares on Monday (or the previous Thursday or Friday) to get ready for the Wednesday rally. But in preparing for the Wednesday rally, the buying activities of the smart investors would drive prices up on Mondays and Tuesdays, reducing, if not com- pletely eliminating, the trading profits on Wednesday. Once investors recognize a pricing pattern, they will invest in anticipation of that pattern, and thereby eliminate it. Therefore, it is highly unlikely that investors can earn abnormal profits using strategies based solely on historical price and volume information.

The semistrong form of the efficient markets hypothesis assumes that security prices fully reflect all publicly available information, including historical price and volume data. If markets are semistrong-form efficient, then investors cannot consistently earn abnor- mally high returns by trading on publicly available information about the company or its industry, such as that contained in corporate annual and quarterly reports, press releases, articles in the Wall Street Journal or other business publications, or government statistics. Investment professionals refer to analysis of such data as fundamental analysis. Semistrong-form efficiency implies that, on average, fundamental analysis will not result in abnormally high profits. It is not necessary for all investors to have this information, but enough must have it so that sufficient trading occurs to cause prices to adjust to new information. In general, the economic research finds that our major financial markets are semistrong efficient. The research shows that share prices change and respond to new infor- mation about a company, its products, its competitors, its markets, and even its suppliers.

We do not want to leave the impression that semistrong-form efficiency impounds only recent factual or financial information about a company into security prices. Market par- ticipants use all available types of information to form expectations about a company’s future; that is, they try to anticipate what a company’s value will be or how the com- pany will perform in the future. A few examples might clarify this concept of anticipa- tory or forward-looking pricing. Suppose a company announces that its strategy for the next few years is to acquire firms in several business areas. Its stock price reacts in antici- pation to what that implies about the company’s future cash flows. When the company announces an actual acquisition, the stock price response reflects how investors feel about this specific acquisition compared to what they anticipated. Thus, the announcement of a

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CHAPTER 2Section 2.3 Financial Markets

Insider trading crimes are a serious offense as demonstrated by the conviction of the CEO of Enron; new and stricter rules regarding insider trading were a result of this scandal.

Associated Press

potentially profitable acquisition might be met with a reduction in share price, if investors had expected an even more profitable acquisition. Similarly, each quarter when companies announce their earnings, stock prices will sometimes fall on earnings increases and rise on earnings decreases if the increases were less than anticipated or the decreases were not as large as anticipated.

The third category of market efficiency, strong-form efficiency, assumes that security prices fully incorporate all public information plus all nonpublic information, such as information available only to the managers within a corporation. Strong-form efficiency exists if even corporate insiders, using their privileged information, cannot earn abnor- mal profits by trading their company’s stock. Most observers agree that financial markets are not strong form efficient. We know that when significant news items are released to the public, such as the award or loss of a major contract or a new technological discov- ery, stock prices change dramatically. Furthermore, we know that corporate insiders were privy to this information prior to its release. This suggests that if insider trading based on the information occurred, it did not occur in sufficient volume for prices to completely reflect the information. Therefore, insiders could make abnormal profits because the mar- ket price did not reflect the value of this privileged knowledge. There is a growing interest in the buying and selling of corporate executives. Every Wednesday the Wall Street Journal publishes the “Inside Track” column, which discusses recent trades by corporate insiders.

Doubt about strong-form effi- ciency also arises from laws pro- hibiting insider trading. These laws attempt to create a level playing field for outside inves- tors. The problem these laws address is one of asymmetric information, which was dis- cussed in Chapter 1. Asymmet- ric information means that one person or group has more infor- mation than some other person or group. In the case of stock market investing, asymmetric information can create serious problems. If outside investors know that insiders can make stock market trades using their privileged information, they will be hesitant to trade. Outsid- ers know they will undoubtedly

lose money in trades with these insiders. For example, suppose a manager knows that the firm’s quarterly earnings will be much lower than investors anticipate. The manager could sell stock before the news is released at a price of $45. After the news release, the price might fall to $40. The non-inside investors who bought shares from the manager at $45 find themselves owning shares worth only $40. Therefore, allowing insiders to trade on private information drives other investors away from the market, reducing liquidity and the investment dollars available for corporate growth. Laws prohibiting insider trad- ing increase investor trust, and thereby their willingness to invest.

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CHAPTER 2Section 2.3 Financial Markets

The penalties for insider trading are severe. All profits from the illegal trades must be forfeited, and fines and prison sentences may be imposed. Furthermore, stockbrokers, bankers, and lawyers can be banned from future involvement in the security business if convicted of insider trading. As the insider trading cases of Ivan Boesky and Michael Milken in the late 1980s show, federal prosecutors and the U.S. Securities and Exchange Commission take insider trading crimes very seriously. More recently, the scandals engulf- ing Enron in 2001 included the eventual conviction of CEO Kenneth Lay for fraud, which led to the strict insider trading and disclosure regulations included in the Sarbanes-Oxley Act of 2002. In 2011, Raj Rajaratnam, a billionaire who ran one of the world’s largest hedge funds, was sentenced to prison for insider trading.

Figure 2.5 shows how the various levels of market efficiency compare in terms of their assumptions about the information reflected in security prices. Notice how the various types of market efficiency relate to the information included in stock prices. You may also think of efficiency in terms of asymmetric information. Markets are efficient in the weak form because there is no asymmetry of information regarding historical price and volume data; that is, everyone has exactly the same information about historical prices and trading volumes. Semistrong-form efficiency holds in many markets, because there are few differences among investors’ access to public information. Strong-form efficiency rarely holds because of obvious asymmetries of information. Strong-form efficiency states that stock prices include some private (and therefore unavailable) information, but this requires that insiders trade on that information, which is illegal.

Figure 2.5: Information and price in markets of varying efficiency

Weak-form efficient prices reflect price and volume data.

Semistrong-form efficient prices reflect all public information.

Strong-form efficient prices reflect all information.

Market efficiency has a large impact on the information reflected in price. Price reflects less information the further we move from a strong-form-efficient market.

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CHAPTER 2Section 2.4 Product Markets

A balanced discussion of market efficiency must include the fact that there are a num- ber of studies whose results are not consistent with the efficient market hypothesis. For example, there is evidence that stocks sometimes overreact to information, contradicting the assumption that new information is accurately impounded into market prices. Other so-called market anomalies (apparent violations of market efficiency) include the small firm effect, which seems to indicate that small firms’ shares outperform large firms’ shares on a risk-adjusted basis, and the January effect, which is named for the concentration of strong stock returns during the first few days of January. The existence of these anoma- lies led Professor Andrew Lo of MIT to propose the adaptive markets hypothesis (Lo, 2004, 2005), which attempts to reconcile anomalies to the idea of efficient markets. Lo’s work is based on classical economics but also borrows from evolution and neuroscience to suggest that tolerances, regulations, and objectives shift over time resulting in mar- ket behaviors that appear to be inconsistent with market efficiency. This theory is in its infancy, but it reinforces the point that market efficiency is not without its mysteries and well-documented exceptions that economists are still attempting to explain.

The lesson of efficient markets is that it is extremely difficult to earn abnormally high returns from investing using publicly available information. Many students find this result discouraging because it dashes their hopes of making an easy fortune in the stock market. There is, however, encouraging news: At any moment in time actively traded financial securities are likely to be fairly priced, so you may reasonably expect to earn a fair return (fair meaning a return commensurate with the risk you are taking) on your money. In other words, you don’t have to be a genius to do quite well with your savings.

Applying the lesson of efficient markets to corporations is straightforward. Corporate managers will rarely enhance the wealth of shareholders (the key decision criterion for managers) through financial market transactions in efficient markets. In many ways, this is good news for corporate officers. Efficient markets imply that prices reflect available information, or that prices are fair. When companies issue and sell securities, on average, they receive a fair price for those securities. Therefore, managers can concern themselves primarily with how the funds will be used, not with how the funds were obtained. Efficient markets make the job of financial managers simpler. Moreover, fair and efficient financial markets, such as those with prohibitions against insider trading, encourage investors to participate and thereby increase the pool of available funds. A larger supply of investment dollars translates into a lower price for those dollars, so corporate managers benefit in a second way: In efficient markets, they gain access to fairly priced and relatively inexpen- sive funds.

2.4 Product Markets

If corporate managers cannot profit from transactions in efficient financial markets, they must look elsewhere for profitable investment opportunities. The obvious place to seek profits is the product markets. As we will see in this section, if shareholder wealth is to be enhanced, the product markets are the place to do it.

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CHAPTER 2Section 2.4 Product Markets

The personal computer industry became a highly competitive market when lower priced competitors like Dell entered the field. Can you think of any other examples of highly competitive markets?

Imaginechina/Associated Press

Perfect Competition In perfectly competitive product markets, no single producer has an advantage in cost, product quality, distribution, or any other aspect of the business, and consumers substi- tute items from one producer for those from another, basing their decisions exclusively on price. In markets with a high degree of product substitutability and easy entry, com- petition drives selling price to the marginal cost of production, and producers earn only a normal profit. Moreover, to remain competitive firms must constantly try to improve their production technology. Therefore, with perfect competition, goods are produced as efficiently as possible, and consumers pay the lowest price that allows production to continue.

Although perfectly competitive markets are rare, highly compet- itive markets are more common than you might imagine. Mar- kets selling products that are considered commodities, such as gasoline, coal, steel, sugar, and wheat, are extremely com- petitive, with many consumers using price as the primary pur- chase criterion. Even memory chips and desktop computers have become commodity-like. Generic products at supermar- kets represent products that are very nearly commodities and are offered because many shop- pers look at price alone when buying these items. Competi- tive markets emerge from two sources. Some products are commodities (and therefore per- fect substitutes), so the markets selling those products become highly competitive. For example, one pound of sugar is very similar to any other pound of sugar, assuming mini- mal standards of product quality, such as cleanliness, are satisfied. Highly competitive markets also emerge when a market allows easy entry. Such a situation occurred in the personal computer market. Even as late as the mid-1980s, IBM and Compaq were able to charge premium prices for their personal computers. As computer technology became more widespread, the high prices charged by U.S. producers attracted entry into the mar- ket. Low-cost machines from companies such as Dell, HP, and Lenovo quickly cut into IBM’s and Compaq’s market share. They were forced to lower prices and devise new methods to market their machines. Eventually, IBM and Compaq were inclined to leave the PC market. The ability of competitors to build substitutes for IBM and Compaq com- puters dramatically increased the competitiveness of the personal computer market.

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CHAPTER 2Section 2.4 Product Markets

Can you see any similarities between perfectly competitive product markets and efficient financial markets? In both markets, participants should expect to earn only a normal profit. Investors, like consumers of commodity goods, shop based on price. For example, when borrowing money, borrowers will readily substitute doing business with bank A for borrowing at bank B if bank A offers a lower interest rate. Investors also shop around for a good deal. When their analysis identifies a promising security, they happily substitute that security for others in their portfolio.

Imperfect Competition In imperfectly competitive markets, producers use product differentiation and brand loy- alty to impede substitution. Product differentiation depends on consumers having fairly complex needs or desires. Product differentiation requires identifying specific consumer needs and then producing a product or service specially designed to satisfy those needs. This process is amply demonstrated with a product as simple as shampoo. To differentiate their product from generic shampoo, manufacturers produce shampoos for people who dye their hair; have perms; have dry or oily hair; have black, blond, or red hair; have dan- druff or scalp diseases; or shampoo often. Shampoos come with and without conditioners, with vitamins, with recommendations from celebrities, with designer names attached, and in a variety of fragrances and colors. A number of shampoos are designed specifi- cally for children. The goal of this immense effort in shampoo research and promotion is to produce a shampoo that fits consumers’ needs so well that they have no incentive to change brands. Once this brand loyalty is established, consumers will pay a premium price for their preferred product rather than substitute a less desirable brand of shampoo. By slowing the urge to substitute, producers earn higher than normal profits and thereby enhance shareholder wealth.

The process of differentiation goes on continuously. Innovators must constantly improve existing products and develop new ones because imitators quickly copy (or nearly copy) successful items. For example, innovators on Wall Street have begun using the differen- tiation concept. Each year new financial instruments debut, with special attributes that make them attractive to a narrow clientele of investors. These instruments may earn their creators a somewhat higher-than-expected return in the short run, but difficulties in copy- righting financial products means that competitors quickly copy good ideas. Entry by imitators reduces the returns to a normal level.

The existence of higher-than-normal profits attracts these entrants. With more producers vying for a particular market segment, price—and thereby profit—typically falls. Above- normal profits from product innovation can be very short-lived. Therefore, managers must constantly seek new opportunities and shift their product mix into those emerging markets. The days of making a single product and relaxing as the money rolls in, if there ever were days like that, are over. Competition within the United States, as well as from abroad, means that managers must be extremely vigilant in monitoring market conditions and be prepared to fight for existing products while continuously looking for new prod- ucts and markets.

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CHAPTER 2Section 2.5 Market Participants and Value

Nevertheless, it is possible to make an abnormally high profit from product market invest- ments because of the complex tastes and needs of customers. Identifying market segments with unsatisfied wants and then differentiating a product to satisfy those needs can create corporate value if the targeted segment is willing to pay a premium for the product. In a sense, one can create a minimonopoly within a market segment. From basic economics, we know that monopolies, unlike businesses in perfectly competitive markets, can earn above-normal profits.

The profits of these minimonopolies draw the attention of competitors. Therefore, compa- nies must protect their market segments from new competition if they hope to continue to earn high rates of return on their investments. Barriers to entry provide such protection and may take the form of a patent, a unique location, a highly recognizable brand name, a constantly improving product, or a cost advantage, among other strategies.

2.5 Market Participants and Value

In Chapter 1, we described the goal of management as increasing the wealth of share-holders. This is done by developing goods and services whose cost of production is less than their value to consumers. Recall that investors who buy claims on the firm’s future cash flows contribute the funds for developing and producing these goods. The wealth of these investors is increased (or decreased) when financial market participants assess the expected performance of the firm’s goods and services in the product market. If these investors believe the products will be extremely successful, the prices of the claims (i.e., the securities’ prices) are bid up. On the other hand, if investors expect poor perfor- mance, then the value of the claims will fall. Thus, the trick to wealth creation is to

• Estimate the cost of developing and producing a product. • Assess the value of the cash flows that will be generated by the product. • Invest in any project whose products promise to have value greater than their

cost.

Estimating the cost of product development and production is generally the task of engi- neers and production managers. Cash flows are estimated with input from the firm’s mar- keting staff. It is in the estimation of value that finance is most useful; in fact, it is the central theme of this text. Remember the four determinants of value that were introduced in Chapter 1? We now add a fifth value-driver to that list, the options or opportunities that are created when a project is pursued.

1. The size of expected cash flows. 2. The timing of expected cash flows. 3. The riskiness of expected cash flows. 4. The returns available on alternative investments. 5. The options created by the project.

Next, we look at these value determinants in relation to human behavior.

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CHAPTER 2Section 2.5 Market Participants and Value

While some people do enjoy taking risks in frivolous situations like gambling, when it comes to major investments most people are risk averse. Why do you think that is?

Associated Press

Behavioral Foundations of Value Each of these characteristics contributes to the value of a project and is rooted in our understanding of human behavior. After all, people are doing the trading in financial mar- kets where security prices, and therefore value, are determined. Let’s examine the traits of human behavior that are assumed to underlie each of these five components of value.

1. The size of expected cash flows is important because of the positive utility (or hap- piness) derived from wealth. In terms of wealth, we assume that people prefer having more rather than less; the greater a person’s consumption power is, the happier they are. How people choose to spend their wealth—on themselves, their friends and family, their community—is up to them. Even people who devote their lives to charitable activities would prefer to have more, rather than less, to give to their favorite causes. Having more wealth means they can provide more for whomever or whatever purpose they choose. The bottom line is more cash, more value.

2. The timing of expected cash flows is important because we assume that, all else being the same, people prefer current consumption over future consumption. Receiving cash today gives us the opportunity to consume now if we want. Alter- natively, we can invest the cash, earn interest, and consume more at some point in the future. Whether we consume today or not, we like having cash flows as early as possible so we have as many choices as possible. The bottom line is that the sooner the cash comes, the more valuable it is.

3. The riskiness of expected cash flows is important because people are risk averse. Being risk averse means preferring less risk to more risk, and people willingly pay to reduce risk. The insurance industry exists for just this purpose. Risk aver- sion also implies the converse of paying to reduce risk; that is, investors must be paid to accept additional risk. Risky investments must offer a higher expected return (a risk premium) to attract investors. Here is an example that might make the concept clearer.

Ms. Teka Chaunce offers Mr. Rick Averse a chance to make some fast money. They will flip a coin, and Rick can call heads or tails. If he calls it correctly, Teka gives him $1,000. If he is wrong, he pays her a $1,000. No risk-averse person would accept such a bet. The risk of losing $1,000 would cause such a person more anxiety than could be overcome by the

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CHAPTER 2Section 2.5 Market Participants and Value

benefits of winning $1,000. For Rick to make a bet, Teka would have to offer him a higher payoff than just $1,000. He might be enticed to play the game if Teka gave him $1,200 if he won, but he paid only $1,000 if he lost. That extra $200 is a risk premium and raises the value of the gamble to Rick.

Risk aversion is not just an economic theory having to do with uncertain investments. Most people’s behavior suggests they are somewhat risk averse. You may be suspicious of this notion of risk aversion. There are certainly exam- ples of people accepting and even enjoying taking risks. Gamblers know that over the long run the casino will win, but they gamble anyway. Some people enjoy risky sports or hobbies—sky diving, mountain climbing, car racing, and so on—which seems to dispute the claim that people are generally risk averse, but remember that sky divers wear back-up chutes and climbers use ropes. We are quite willing to admit that some people enjoy the thrill of risk taking, but we remain convinced that investors are risk averse.

4. The returns available on alternative investments are important because of ratio- nal self-interest. We assume that people look out for their own welfare and are clever about it. Therefore, when all else is the same (including risk, the timing of cash flows, etc.), an investor will assess all the investment alternatives available and choose the one that is most attractive. Thus, investment projects compete with one another. The bottom line is that, when assessing the value of a proj- ect, investors will consider returns available on other investments with similar characteristics.

5. The options created by an investment are important components of value because of both risk aversion and rational self-interest. Suppose a high school student is considering buying a car. As a senior, she needs a summer job to help pay for col- lege tuition. She hopes to work as an accounting intern during the summer but has not been formally offered the position. If she does not get the internship, she will start a lawn care business to earn money instead. Purchasing a pick-up truck rather than a car creates valuable options related to her summer employment.

A Simple Value Formula Now we can express the components of value in a precise mathematical form. You may have seen the following formula for the present value (PV) of a single cash flow in an accounting, economics, or business math class.

(2.1) PV 5 FV

11 1 r2 t

Suppose the future value (FV) is some expected cash flow. Then the formula would look like:

(2.2) PV 5 E1CF2 11 1 r2 t

where E(CF) stands for the expected cash flow, r is the interest rate, and t represents the time until the cash is received. Consider this formula in light of the first four characteristics of value we just discussed. If investors receive information causing their expectations of

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CHAPTER 2Conclusion

future cash flows to increase, then E(CF) will increase, and the value (PV) will increase as well. Now, suppose that cash flows are expected to arrive sooner than originally thought— then the exponent t in the formula decreases, which will increase PV. The discount rate, r, is adjusted for risk. So, if one thinks a project is riskier than originally thought, then r, increases and value declines. And last, let’s suppose inflation increases. Banks would offer to pay higher rates of interest on certificates of deposit (CDs); in response, other investments would offer higher returns in order to compete with CDs. Thus, the rates of return available on alternative investments have increased, which would cause investors to require a higher return on the project being considered before they would choose to pursue it. The discount rate, r, would increase in order to account for these higher return requirements throughout the economy, and the PV of the investment opportunity would fall. How quickly and accurately the information is reflected in the valuation is a function of the degree of market efficiency. In very efficient markets, valuation adjustments occur within minutes of news being released.

You might wonder how the fifth characteristic, options, is valued. At this point in your financial studies, there is no precise way to do this valuation. If you pursue finance, you will eventually learn how to value options. For now, you must be satisfied with the idea that when you are choosing between alternative projects that are otherwise very similar, you should take the one that creates the most options for the firm.

Conclusion

This chapter concludes by examining some general traits of human behavior and how they apply to the evaluation of investments. People want to consume, and, being rational, are concerned with cash flows that can be transformed into consumption. They are risk averse and must be paid a higher return if an investment involves high risk. Before investing, they examine the alternative investments available to them. Comparable investments must promise comparable benefits or returns. The longer they must delay their consumption, the higher the future consumption must be. Finally, people are willing to pay a premium for an investment that provides extra opportunities and options.

It is in product markets and financial markets that these preferences play their roles in determining value. Within the legal and regulatory environment established by govern- ment, a business strives to provide desirable goods and services that can be profitably sold. The value of the business is determined in capital markets where investors’ collec- tive assessment of the five characteristics that contribute to value are revealed by the mar- ket price of the business’s securities. Note that each characteristic of value, and therefore the market prices of the firm’s securities, depends on decisions made on the left-hand side of the financial balance sheet. Cash flows—their size, their timing, and their riskiness—as well as the options available to the firm are a function of the kinds of projects the company pursues and how successfully the company follows those pursuits. Corporations succeed by making wise investments in imperfect product markets and having those investments valued by efficient financial markets. Recall that increasing the market price of common stock leads to fulfilling the financial goal of shareholder wealth maximization.

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CHAPTER 2Post-Test

Most of the topics introduced in this chapter are covered in greater detail later in the book. Chapter 3 examines the estimation of investment project cash flows. In Chapters 4 and 5, we demonstrate how to treat the timing of cash flows by using discounting techniques to compute present values. How to estimate risk premiums and required rates of return are the subjects of Chapter 6. Then we put these pieces together into a single procedure for evaluating investments. This investment analysis technique—net present value analysis or discounted cash flow analysis—is one of the primary tools that investors use when deciding which securities to buy and sell and that company managers use when deciding which products to make and which strategies to pursue.

Post-Test

1. The accounting fraud that took place at the turn of this century led to Sarbanes- Oxley legislation.

a. True b. False

2. Price is the least valuable information produced in markets. a. True b. False

3. Highly liquid assets can be easily sold for their approximate value. a. True b. False

4. Wealth is more easily created in perfectly competitive markets than in less com- petitive markets.

a. True b. False

5. Consumption is the behavioral foundation behind the importance of cash flow timing.

a. True b. False

6. Informational efficiency in a market means that the market . . . a. produces the most information with the least amount of effort. b. quickly and accurately processes and reflects the economic impact of

information. c. lends itself to fundamental security analysis. d. forecasts future profits.

7. Which of the following is NOT true regarding price? a. Higher prices help pay for better labor. b. There are different kinds of prices. c. Price is always determined by the market. d. Price can help consumers determine a product’s value.

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CHAPTER 2Key Ideas

8. Suppose that the bid price of a stock is $200 a share and the ask price is $205. If you buy 100 shares of stock and immediately sell it, what will be your profit or loss?

a. Zero profit or loss because prices have not changed b. A $500 profit c. A $500 loss d. A $5 loss

9. Barriers to entry include all of the following EXCEPT a. brand name. b. location. c. patents. d. anonymity.

10. The returns available on alternative investment opportunities are one of the fac- tors that must be considered when valuing an investment opportunity. This is attributed to which behavioral assumption given in the text?

a. Risk aversion b. Time preference for consumption c. Rational self-interest d. The positive utility of wealth

Answers 1. a. True. The answer can be found in Section 2.1. 2. b. False. The answer can be found in Section 2.2. 3. a. True. The answer can be found in Section 2.3. 4. b. False. The answer can be found in Section 2.4. 5. a. True. The answer can be found in Section 2.5. 6. b. quickly and accurately processes and reflects the economic impact of information. The answer can be

found in Section 2.1. 7. c. Price is always determined by the market. The answer can be found in Section 2.2. 8. c. A $500 loss. The answer can be found in Section 2.3. 9. d. anonymity. The answer can be found in Section 2.4. 10. c. Rational self-interest. The answer can be found in Section 2.5.

Key Ideas

• Government regulation of capital and commodity markets helps companies obtain investment funds and raw materials at competitive prices.

• Financial markets supply the funds that firms use to purchase productive assets, such as factories, machinery, trucks, computers, and offices.

• Financial markets provide a mechanism for valuing a firm’s securities. Investors buy and sell stocks and bonds in these markets.

• Securities trade in financial markets, the best known of which are the stock exchanges in New York, London, and Tokyo. These markets are phenomenally active and competitive.

• Investors compete with one another to make better predictions about the future cash flows associated with financial claims.

• Financial markets in which prices reflect all relevant information are called infor- mationally efficient markets.

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CHAPTER 2Key Terms

• In perfectly competitive product markets, no single producer has an advantage in cost, product quality, distribution, or any other aspect of the business, and con- sumers substitute items from one producer for those from another, basing their decisions exclusively on price.

• Corporations sell the goods and services they produce in product markets and purchase the raw materials and other inputs needed in their production process.

• In imperfectly competitive markets, producers use product differentiation and brand loyalty to impede substitution.

• The timing of expected cash flows is important because we assume that, all else being the same, people prefer current consumption over future consumption.

• The riskiness of expected cash flows is important because people are risk averse. Being risk averse means preferring less risk to more risk, and people willingly pay to reduce risk.

Critical Thinking Questions

1. In terms of the characteristics of markets such as barriers to entry, similarity of the products, and competition, can you explain why LeBron James (the basket- ball player) is paid millions of dollars each year?

2. EBay is very successful, as is Craigslist. Can you explain their success in terms of markets? What did they provide that did not exist before they were created?

3. If the stock market is informationally efficient, does that mean that you should not expect to earn a positive return if you invest? Why or why not?

4. Describe the steps that a sandwich shop should take as it considers delivering sandwiches at lunch time in the downtown area of a large city. The idea is to invest in two delivery bicycles and a computer system that will allow the shop to take orders and receive payments on-line, as well as schedule delivery and lay out the delivery drivers’ routes.

5. Describe why an all-American college basketball player with a bright profes- sional future may also want to devote time to studying in order to complete his or her degree with high grades. In your opinion, which characteristic of value and which behavioral characteristic does this decision reflect?

Key Terms

adaptive markets hypothesis A market efficiency hypothesis in which the dynam- ics of evolution, competition, mutation, reproduction, and natural selection deter- mine the efficiency of markets and the waxing and waning of financial institu- tions, investment products.

ask price The price at which a dealer offers to purchase an asset. It is generally lower than the bid price, and the bid-ask spread represents the dealer’s mark-up for the transaction.

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CHAPTER 2Key Terms

barriers to entry Obstacles that make entry into a product market difficult, thus protecting the market from competition and helping to ensure long-term profitabil- ity and wealth-building potential. Exam- ples include patents, copyrights, secret formulas, a unique location, and brand name recognition.

bid-ask spread The difference between a dealer’s bid price and ask price for an asset. It represents the dealer’s mark-up and their maximum potential profit.

bid price The price at which a dealer is willing to sell an asset. It is generally higher than the ask price, and the bid-ask spread represents the dealer’s mark-up for the transaction.

bond indenture contract This contract sets out the legal terms under which a bond is issued.

capital gain The increase in the value (or price) of an investment.

capital markets Markets on which finan- cial securities that will mature in more than a year are bought and sold. Examples of capital market securities include com- mon stock and preferred stock (because they never mature) and long-term bonds.

commercial paper A short-term corpo- rate promissory note, issued by large creditworthy businesses, that is traded on money markets. Commercial paper is usually offered in large face amounts and matures in less than a year.

financial markets Markets in which a firm raises funds, including long-term capital and short-term financing require- ments. Financial markets link a firm with its investors, including financial institu- tions, stockholders, and bondholders.

fundamental analysis The examination of information that, in theory, should affect the price of an asset. For stocks, fundamen- tal analysis would examine such factors as profit margin, growth, risk, expected cash flows. Financial statement analysis and fol- lowing the news coverage of a firm’s new products are examples of activities that would be considered part of fundamental analysis.

going public Also known as an IPO, occurs when a private, closely held corpo- ration sells stock to the general investing public for the first time. It then becomes a public-held corporation with an active market for buying and selling shares among investors. These firms are often new, emerging companies.

imperfect competition Characteristic of markets that may yield wealth-building investment opportunities because one firm (or a few firms) has an advantage over oth- ers so they may earn profits above those expected in a perfectly competitive market.

informational efficiency Efficiency based on information being quickly and accu- rately impounded into asset prices.

initial public offering (IPO) See going public.

liquidity The ability to meet cash needs quickly and efficiently. A liquid company can easily pay its upcoming bills, and listed stocks are said to be liquid because they can be quickly bought or sold without paying high commissions or granting large price concessions.

market anomalies Apparent violations of market efficiency that have been discov- ered by analysts or researchers.

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CHAPTER 2Key Terms

market efficiency The characteristic of a market when the prices quickly and accurately adjust to new information. Prices produced by an efficient market are an unbiased and accurate reflection of the underlying value of an asset.

money markets Markets on which finan- cial securities that will mature in less than a year are bought and sold. Examples of money market securities include treasury bills (T-bills) and commercial paper.

NASDAQ See over the counter (OTC).

NYSE See secondary markets.

over the counter (OTC) When trading of securities is done using a computer network of security dealers outside of a physical stock exchange. The best known OTC market is the National Association of Securities Dealers Automated Quote system (NASDAQ).

perfect competition When there are so many competitors and similar products that prices are driven to their minimum level. These prices just cover the cost of production and the least amount of profit that will sustain businesses. Commod- ity markets are considered to be nearly perfectly competitive because there is not differentiation between products so con- sumers make their purchases based solely on who sells for the lowest price.

primary markets Markets where compa- nies sell securities to investors in order to raise funds. IPOs occur on primary mar- kets, for example.

private placement The sale of securities to a relatively small number of select inves- tors as a way of raising capital. Investors involved in private placements are usually large banks, mutual funds, insurance com- panies, and pension funds. Private place- ment is the opposite of a public issue.

product differentiation A strategy of making one’s product or service unique compared to it’s near-competitors. Product differentiation is an attempt to protect the product’s ability to create high returns by keeping the market in which it trades from becoming too competitive. The unique fla- vor of, say, Dr. Pepper differentiates it from most competitors.

product market Markets in which a firm’s goods and services are bought and sold. Product markets are the link between a business and its customers.

retained earnings The portion of net income that is not paid out in the form of dividends and is reinvested in the corpora- tion. Each year’s retained earnings may be reflected on the firm’s income statement or its statement of retained earnings, while the cumulative total of all years’ retained earnings is reflected on the firm’s balance sheet.

seasoned offering Occurs when a publicly traded company (one that has already had an IPO) decides to raise new equity capital by issuing additional shares and selling them to the public.

secondary markets Markets where trad- ing between investors takes place. The New York Stock Exchange (NYSE) is probably the best known of all secondary markets. Secondary markets are important to corporations and to investors because they provide liquidity.

semistrong-form efficient Characteristic of markets where the prices reflect all pub- licly available information. Any attempt to forecast price changes using fundamental analysis is useless if the market is semis- trong efficient.

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CHAPTER 2Web Resources

strong-form efficiency A type of market where the prices reflect all information, both public and private. Any attempt to forecast price changes using inside infor- mation is useless if the market is semis- trong efficient.

technical analysis An approach to trading securities based on past prices and trad- ing volumes. Generally, technicians look for patterns in prices or returns that they believe will help them predict future price movements. Technical analysis will not produce returns superior to a simple buy- and-hold strategy if markets are weak- form efficient. Also known as charting.

transaction costs Costs in addition to the price paid for an item. They may include commissions, fees, legal expenses, search costs, and so on.

transferability The ability of an owner- ship interest (or other interest) to be trans- ferred from one party to another. Typi- cally shares representing ownership in a corporation can be transferred, but often partnership interests are non-transferrable without the consent of the other partners.

treasury bills (T-bills) Short-term secu- rities issued by the U.S. government. They are often considered nearly riskless securities.

unseasoned offering This occurs when a corporation sells stock for the first time.

weak-form efficient Characteristic of mar- kets where the prices reflect all past price and volume information. Returns in such a market are said to follow a random walk, and any attempt to forecast price changes using technical analysis is useless if the market is weak form efficient.

Key Formulas

(2.1) PV 5 FV

11 1 r2 t

(2.2) PV 5 E1CF2 11 1 r2 t

Web Resources

See which companies have current IPOs here: www.ipocentral.com

Learn more about investing in bonds here: www.bonds-online.com

Learn more about the Department of the Treasury and government bond issues here: http://www.treasury.gov

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