BUS 650 Week 1 Responses Needed

Chapter 2

Financial Claims and Markets

Kike Calvo/Na�onal Geographic Stock

Learning Objectives

A�er studying this chapter, you should be able to:

Describe the rela�onship between governments, corpora�ons, and markets. Express how markets facilitate the process of exchange. Explain the different types of financial markets and their func�ons. Illustrate the difference and significance of perfect and imperfect compe��on in product markets. Describe the rela�onship between market par�cipants and value.

Processing math: 0%

Ch. 2 Introduction

Chapter 1 provided an overview of finance and introduced the financial balance sheet. It also discussed the goal of corporate managers—shareholder wealth maximiza�on— and some challenges to achieving that objec�ve. Chapter 1 also described the advantages and disadvantages of the corporate form of organiza�on. Chapter 2 completes the development of the financial balance sheet by considering the environment in which corpora�ons operate. The long-term viability of any business depends on how well managers understand the limits and opportuni�es that external forces exert on their organiza�on. The key objec�ve (or bo�om line, in business parlance) of this chapter is to describe the interplay between the business and markets. Understanding how this interplay contributes to the success (or failure) of a business, which ul�mately determines the company's value, should be your goal as you read through the material.

Processing math: 0%

The role of government in the decisions of corpora�ons is complex, impac�ng both product and financial markets.

2.1 Governments, Corporations, and Markets

Before looking at markets, let's briefly consider some of the effects government has on businesses. Limita�ons and opportuni�es for businesses o�en 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 ac�vi�es. As an example, local governments commonly offer property tax reduc�ons to companies that are considering moving into the area, in the expecta�on that the corpora�on will provide new jobs for local residents. Government agencies limit or prohibit some ac�vi�es through administra�ve regula�on in order to protect consumers and the environment. Truth-in-adver�sing laws, product safety laws, and pollu�on-control regula�ons are examples of how the government has limited corporate ac�vi�es to benefit or protect other cons�tuencies. Governments also pass laws that protect corpora�ons. Examples of laws that help firms prosper from their innova�on or protect them from unfair compe��on include patents, copyrights, and predatory pricing prohibi�ons.

The government also supports business ac�vity in other, less direct, ways. The regula�on of capital and commodity markets helps companies obtain investment funds and raw materials at compe��ve prices. Insurance of bank deposits encourages individuals to save, which provides funds for banks to lend to individuals and businesses. Professional cer�fica�on of doctors, den�sts, 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 ac�vity by penalizing firms that engage in unfair trade prac�ces and assuring that contractual commitments are honored.

Financial crises o�en lead to new regula�ons by the government beginning with the Great Depression and the crea�on of the Securi�es and Exchange Commission in 1934. Recent history has its own examples of the interplay between financial markets and government regula�on. The accoun�ng scandals involving firms like Enron and WorldCom led to the passage of Sarbanes-Oxley (SOX) in 2002, with its �ghter repor�ng standards, strengthened insider trading rules, and the separa�on of audi�ng and consul�ng services by accoun�ng firms. The "Great Recession" resulted in the Dodd-Frank bill that was signed in 2011. Some of its key provisions included the crea�on of the Bureau of Consumer Financial Protec�on and the Financial Stability Oversight Council.

Within the limita�ons and opportuni�es provided by this legal framework, corpora�ons compete in markets that operate according to the laws of supply and demand. Corpora�ons 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 produc�on process. To create value for their shareholders, corporate managers must pay careful a�en�on 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 le�-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 par�cipate in financial markets. A company's financial market ac�vi�es appear on the right-hand side of the financial balance sheet under long-term liabili�es and equity. Financial markets supply the funds that firms use to purchase produc�ve assets, such as factories, machinery, trucks, computers, and offices. Financial markets also provide a mechanism for valuing a firm's securi�es. Investors buy and sell stocks and bonds in these markets. These transac�ons 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.

Figure 2.1: The financial balance sheet and government

One important lesson of modern finance is that corpora�ons 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 corpora�ons par�cipate is essen�al to understanding corpora�ons themselves. Corporate assets, such as plant, equipment, and human resources are shown on the le�-hand side of the financial balance sheet and reflect the corpora�on's ac�vity 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 ac�vi�es in the financial markets. The corpora�on acts as a conduit, linking investment funds from the financial markets to goods and services in the product markets. The corpora�on 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�on of this interac�on on the financial balance sheet.Processing math: 0%

The interac�on of the product and financial markets is an important aspect of the opera�on of a corpora�on.

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

Bloomberg/Ge�y Images

Figure 2.2: The financial balance sheet and markets

In both product and financial markets, informa�on availability and ease of entry play important roles in determining whether wealth-increasing opportuni�es exist. In financial markets, prices typically reflect new informa�on very quickly. For example, if a pharmaceu�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 informa�onally efficient, producing prices that quickly and accurately reflect the economic impact of corporate news. What informa�onal efficiency implies about making money in financial markets is one of the important lessons in this chapter.

Product markets vary in their compe��veness. Markets that firms can easily enter and exit and in which firms produce very similar goods are called perfectly compe��ve. Perfect compe��on implies that many similar goods are vying for customers and that they offer corpora�ons less poten�al profits than imperfectly compe��ve markets do. On the other hand, markets are characterized by imperfect compe��on when entry is restricted or goods are differen�ated. Perfect and imperfect compe��on are par�cularly important concepts. In fact, we take a hard look at market imperfec�ons and how corporate managers use them to increase the wealth of the firm's shareholders.

Processing math: 0%

The study of corporate finance relates to concepts explored in economics, such as perfect and imperfect compe��ve markets. Monopolis�c compe��on, oligopoly, and monopoly are all common forms of imperfect compe��on. How are all types of compe��ve markets significant to financial managers?

2.2 Markets and Exchange

Before describing the markets in which corpora�ons operate, we want to discuss the role of markets in general. All markets, no ma�er 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. Transac�ons between willing par�cipants result in both par�es being be�er off. If each trader did not believe that the trade was in his or her interest, they would not make the exchange. Therefore, markets enhance people's well-being.

Market Structures

Markets are essen�al to any economic system, and evidence of markets is found in even ancient socie�es. 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 longer requires going to a par�cular physical loca�on. Modern telecommunica�ons allows markets to be computer networks, like eBay, or television programs. Catalogs are another example of markets without a physical loca�on. The importance and desirability of convenient and speedy exchange means that markets undergo constant refinement and change. Immense energy and ingenuity goes into developing ways to facilitate exchange. Everyone 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 coun�ng and storing value. Using money in transac�ons 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 services available to consumers. Many members of the European Union took the ease of exchange a step further when they formed a monetary union, adop�ng the euro as a single currency for use across much of the con�nent.

O�en 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 �me.

When we work, we exchange our �me for money (and the goods and services it can buy). Although exchange o�en involves the simultaneous payment of money and receipt of a good or service, some�mes one side of the exchange is delayed. This occurs frequently in the field of finance. Inves�ng money today brings no immediate benefits. What is being bought is the expecta�on of more money in the future. Similarly, a college educa�on requires paying now (in terms of �me and money) for future benefits (a be�er 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 informa�on. Informa�on is the lifeblood of markets. Without informa�on, much exchange would not occur, and many markets would not exist. The single most valuable type of informa�on created by markets is price. Prices established by transac�ons in rela�vely free and compe��ve markets are the most fundamental measure of economic value. The market price of an asset, good, or service provides informa�on about equivalent nontraded items. Using current 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 poten�al buyers and sellers the current value placed on an item. With that informa�on, producers can decide whether to expand or contract their produc�on of par�cular items, and consumers can adjust their spending and savings pa�erns.

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-a�er 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 shi�ing inputs to their most highly valued use, prices help determine the most efficient alloca�on of scarce resources within an economy. Indeed, prices are the primary piece of informa�on used to coordinate the incredibly varied ac�vi�es of a modern economy.

Processing math: 0%

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 equipment, you know about list or suggested retail prices. Few transac�ons actually occur at these asking or list prices. In fact, these listed prices, such as automobile s�cker 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 sophis�ca�on 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 distor�ons occurred. For example, in former Soviet Russia, bread once cost less than the grain used in its produc�on! Only with the informa�on provided by prices set in compe��ve markets can an economy approach an efficient alloca�on of resources.

In the following sec�on, we describe the financial markets in which firms obtain funds. We also discuss the a�ributes required for these markets to generate prices that quickly and accurately reflect all the available informa�on about a company and its future prospects. The informa�on contained in this sec�on is important to students whether or not they plan on becoming financial managers. Anyone who invests in stocks, has a re�rement plan, uses credit, or may want to start a business needs to understand something about financial markets.

Processing math: 0%

Timeshare proper�es typically lose value in the re-sell market, making them suscep�ble to illiquidity. What are some other examples of illiquid assets?

Sygma/Corbis

2.3 Financial Markets

Corpora�ons dominate our economy in part because they have ready access to financial markets. Financial markets provide funds to firms for investment in produc�ve assets. Besides furnishing funds for corporate investment, financial markets also provide investors with opportuni�es to put their savings to work. By coordina�ng the savings ac�vi�es of individuals and the investment needs of corpora�ons, financial markets play a key role in the economic development of our country. In this sec�on, we describe the basic a�ributes of financial markets and con�nue 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 common financial securi�es issued by corpora�ons. There are many more types of financial securi�es than stocks and bonds—every year new financial instruments are introduced. As with physical goods, these securi�es have value; however, their value derives from the rights a�ached to their ownership rather than from their physical a�ributes.

The most important of these rights is the claim a security gives an investor to the cash flows of the issuing corpora�on. 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 corpora�on 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 corpora�on repays the principal. A bondholder may sell a bond prior to maturity, receiving whatever the market price is for the bond at that �me. Once a bond is sold, the new owner receives the remaining interest and principal payments.

Corpora�ons have a legal obliga�on to make interest and principal payments as scheduled in the bond indenture contract. The borrowing corpora�on makes a bond indenture contract with a trustee, usually a bank or trust company. The indenture obligates the borrowing company to comply with a set of predetermined condi�ons that the trustee monitors on behalf of the lenders. The indenture condi�ons typically include maintaining certain levels of liquidity and limit addi�onal borrowing, the sale of significant assets, and the payment to shareholders of large cash dividends. The objec�ve of these constraints is to help ensure that bondholders will receive their promised interest and principal payments in full and on �me. Failure to make the contractual payments can force a company into bankruptcy.

A�er a company pays bank loans, commercial paper, lines of credit, and all other fixed or contractual obliga�ons, the remaining cash flows belong to shareholders. Since shareholders have a claim to what is le�over, they are referred to as residual claimants. The corpora�on can distribute cash to shareholders in the form of dividends. Alterna�vely, 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 an�cipated future cash flows. Shareholders benefit in two ways from their ownership stake in a corpora�on: 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 purchase price. Both bonds and stocks can create capital gains; however, capital gains are more o�en associated with common stock. The total return from an investment in common stock includes both the return from dividends and the return from capital gains.

In addi�on to the claim to cash flows, a�ributes such as transferability and liquidity can affect a security's value. With very few excep�ons, financial securi�es are nego�able, meaning that they may be sold or transferred to other investors. A dis�nguishing feature of corpora�ons, compared to other types of business organiza�ons, is the ease with which ownership can be transferred from one investor to another. Transferability of ownership contributes to the longevity and growth poten�al of corpora�ons. Although all securi�es traded in financial markets are nego�able, 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 substan�al price reduc�on to a�ract buyers.

Securi�es that trade infrequently, o�en called thinly traded, are par�cularly prone to problems of illiquidity. Some classic examples of illiquidity include condominium �me shares and precious gems. These are assets with value, but they o�en sell on the secondary market for substan�al price concessions. To increase the value of the asset, sellers o�en offer to create a market for reselling illiquid assets. One of the key benefits of well- developed financial markets is the increased liquidity 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 nega�ve impacts on a firms' value. During the financial crisis of 2008, many large investment banks were following a business model that relied on short-term financing. They rou�nely paid off and reborrowed billions of dollars of short-term securi�es on a daily basis. One cause of the crisis was that investors began to ques�on 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

Securi�es trade in financial markets, the best known of which are the stock exchanges in New York, London, and Tokyo. These markets are phenomenally ac�ve and compe��ve. You probably have seen pictures of the trading floor of the New York Stock Exchange, with its frenzied and seemingly chao�c ac�vity. Yet, for all their notoriety, these exchanges do not raise money for corpora�ons; instead, they provide a market for investors to buy and sell exis�ng stocks and bonds. These exchange markets are called secondary markets. In secondary markets like the New York Stock Exchange, investors buy and sell securi�es among one another. So dominant are these secondary markets that an investor may spend a life�me trading stocks and bonds and never directly contribute money to a corpora�on. However, secondary markets are very important because the price discovery that occurs in these markets determines the market value of corpora�ons 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.

Processing math: 0%

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

Markets that handle the ini�al issuance of securi�es—securi�es that actually raise money for the issuing corpora�ons—are called primary markets. Primary markets bring new security issues to life. Two categories of primary market transac�ons exist: seasoned and unseasoned. A seasoned offering occurs when a corpora�on issues addi�onal shares of an exis�ng security. For example, if IBM issues addi�onal 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 transac�ons 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 securi�es; in other words, the issuing company has no iden�cal security that is currently publicly traded. Unseasoned issues (o�en called ini�al public offerings, or IPOs) have no track record, so they require more effort to value than do seasoned issues. This lack of historical market informa�on about a company o�en results in a systema�c underpricing of IPOs. On average, the ini�al 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 a�er it is issued. Various theories have been suggested for this phenomenon. One theory argues that because so li�le informa�on is available about the stock, it must be underpriced so that rela�vely poorly informed investors will buy the shares. A second theory proposed by some knowledgeable investors suggests that underwriters 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.

Firms also raise capital through private placements. Using this method of finance, firms will issue and sell securi�es to a few, select investors rather than to the general public. Private placements are o�en structured so there is no need to register the issue with the SEC, saving considerable �me and money. Figure 2.3 illustrates the flow of cash and securi�es through primary and secondary markets.

Figure 2.3: 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 securi�es with maturi�es of one year or less. Short-term securi�es 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. treasury bills (T-bills), which are sold weekly, have maturi�es of 13, 26, or 52 weeks. By conven�on, long-term refers to securi�es with a life greater than 1 year from the date of their original sale. Long- term securi�es include government and corporate bonds as well as stock (which has a conceptually perpetual life). Economists some�mes make a somewhat finer dis�nc�on: Intermediate-term securi�es have maturi�es of 1 to 10 years. U.S. Treasury notes fall into this category, as do some corporate debt instruments. Intermediate- and long-term securi�es, 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 summarizes the dis�nc�ons between money and capital markets, and between primary and secondary markets.

Figure 2.4: Financial market classifica�on

Processing math: 0%

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

Money markets process an enormous volume of transac�ons, a much higher volume than the capital markets. One of the reasons for this ac�vity 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 por�on (about 30%) of all U.S. government debt is financed, and in which the largest na�onal and interna�onal banks are par�cularly ac�ve. As interes�ng as money markets are, we shi� 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 largest stock exchange in the United States. Purchasing shares of stock listed on the NYSE (or any other stock exchange) typically requires contac�ng your local stockbroker (some�mes called a commission broker, a registered representa�ve, or an account execu�ve) with your order informa�on. The stockbroker relays your order to the brokerage firm's headquarters, 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 execu�on if the price moves in the right direc�on. Each stock has an assigned specialist, who maintains a fair and orderly market in his or her par�cular stock or stocks.

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 o�en 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 transac�ons at banks' counters, thereby trading over the counter.

Trading in the largest and most ac�ve OTC stocks occurs through the Na�onal Associa�on of Securi�es Dealers Automated Quote System (NASDAQ), a na�onwide computerized network of dealers. Computer terminals linked to the NASDAQ system give brokerage firms access to all of the current quota�ons for all stocks on the system (no bonds are traded through the NASDAQ system). Price quota�ons 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 some�mes by only a few cents. Buying a NASDAQ system stock requires the broker (or a trader at a brokerage company's headquarters) to find the lowest ask price and contact the dealer offering that price to confirm the transac�on.

Whenever you buy or sell securi�es, whether you trade on the NYSE or NASDAQ system, you pay transac�on 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 Microso� or Intel that trade on high volume, allowing dealers to make a small profit on each transac�on while execu�ng many trades. In contrast, very low-priced, infrequently traded penny stocks o�en 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-effec�ve electronic trading networks, bid-ask spreads are decreasing, and the role of specialists is diminishing. Since 2007, the NYSE has offered the electronic trading pla�orm known as the Hybrid Market for its listed stocks, with a great majority of its trades now being executed electronically.

Field Trip: Capital Markets

Bloomberg provides extensive informa�on on the ac�vity of capital markets across the globe.

Visit h�p://www.bloomberg.com/markets/ (h�p://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 performance charts over various �me periods. Understanding how to navigate and interpret these charts may one day be invaluable to your professional and personal finances.

Processing math: 0%

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 pla�orms?

Ge�y Images News/Ge�y Images

In addi�on to purchasing stocks on the secondary market, investors some�mes carry out transac�ons 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�on. This strategy is especially applicable to situa�ons 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 purchase allows them to return the borrowed stock, and the difference between the high selling price and lower purchase price is their profit (less transac�on costs, of course).

Competition and Information in the Financial Markets

Although there are many complicated ins�tu�onal details associated with financial markets, the basic force driving financial market transac�ons is amazingly simple: People are trying to make money. Companies that issue securi�es 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, rela�ve to other securi�es. Compe�ng investors bid up the price of shares of companies with good prospects and bid down those with declining prospects. In many ways, securi�es are seen as subs�tutes. Investors ac�vely shi� their funds to those securi�es with the brightest prospects. A confirmed Pepsi drinker, who might never consider changing to Coca-Cola or Dr. Pepper, has no compunc�on at all about selling stock in PepsiCo and buying stock in Coca-Cola. Inves�ng is about money and the prospects of companies, and brand loyalty plays li�le 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 ma�er whether the investor personally likes the taste of the product or not. (Note, however, 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 be�er predic�ons 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 compe�ng to predict a security's future cash flows, the relevant informa�on focuses on how companies will fare in the future. This future orienta�on is one of the characteris�cs that dis�nguishes finance from accoun�ng: Finance is almost en�rely about the future, whereas accoun�ng is largely a record of the past.

Investors crave informa�on that helps them make be�er predic�ons (or form more accurate expecta�ons) about a firm's prospects than other investors. In a sense, investors compete with one another for be�er informa�on and be�er methods of processing that informa�on. An immense informa�on industry has evolved to serve the needs of investors. Brokerage houses offer research in exchange for commissions; thousands of professional investors sell advice through newsle�ers; dozens of electronic databases and computer programs are available for investment analysis; and every year dozens of books appear with �ps on how to "beat the market."

Every day thousands of investors digest the latest informa�on and make investment decisions based on this informa�on. Compe��on among investors ensures that security prices accurately reflect the consensus opinion or expecta�on about a security's future cash flows. Thus, security prices are an unbiased assessment of a company's value, given the available informa�on. That securi�es are accurately priced is something like a good-news/bad-news joke. The good news is that securi�es are fairly priced, so investors will not, on average, get tricked and lose lots of money. The bad news is that securi�es 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 compe��on does not imply that no one ever becomes enormously wealthy (or very poor) trading securi�es. It does mean that the majority of investors earn just a normal return—not too big, not too small—from inves�ng in stocks and bonds. Some investors do be�er than others and some do worse, but the average return is just sufficient for investors to con�nue to invest in the market. Expected returns vary across securi�es. We will see later in the text that returns are related to risk; that is, investors expect higher returns for inves�ng in riskier securi�es.

Informational Efficiency in Financial Markets

As we have just discussed, investors compete with one another for informa�on that will give them an edge in assessing the value of financial securi�es. This compe��on means that security prices quickly reflect the informa�on used by investors. Remember that once an investor obtains and analyzes per�nent informa�on, he or she must rush to implement the buy-sell decision before other investors can take advantage of the informa�on. In this race to buy or sell securi�es, prices respond by rising or falling. Therefore, security prices quickly reflect new informa�on (Grossman & S�glitz, 1980).

Financial markets in which prices reflect all relevant informa�on are called informa�onally efficient markets. There are some ques�ons, however, about the type of informa�on that security prices incorporate and how accurately and quickly prices reflect that informa�on (Haugen & Baker, 1996).

Since the buying and selling ac�vi�es of investors drive security price changes, a more precise statement of the issues might be: What type of informa�on do investors use to form expecta�ons about security values, and how accurately and quickly does that informa�on appear in security prices? These ques�ons are of par�cular interest to investors and corporate managers because the answers help determine how profitable financial market ac�vi�es are likely to be. The answers to these ques�ons also provide a method of classifying financial markets according to their degree of efficiency. Financial economists talk about three possible levels of market efficiency: weak-form, semistrong-form, and strong-form efficiency. These classifica�ons differ according to the type of informa�on that is quickly incorporated into security prices.

The weak form of the efficient markets hypothesis assumes that security prices incorporate only historical price and volume data. If markets are weak-form efficient, then investors cannot expect to earn abnormally high profits using trading rules based on historical price and volume pa�erns. Weak-form efficiency challenges char�sts or technical analysts, who claim that they can use technical analysis to iden�fy profitable security investments by examining charts and graphs of historical price and volume data. Compelling evidence exists that securi�es markets are weak-form efficient. That financial markets are at least weakly efficient makes sense. Suppose there was a pa�ern 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 iden�fy such a pa�ern. Smart investors would buy stock on Tuesdays, preparing for the Wednesday rally. Their strategy would be to sell late on Wednesday, a�er security prices rose, and earn supranormal profits. S�ll smarter investors 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 ac�vi�es of the smart investors would drive prices up on

Processing math: 0%

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

Associated Press

Mondays and Tuesdays, reducing, if not completely elimina�ng, the trading profits on Wednesday. Once investors recognize a pricing pa�ern, they will invest in an�cipa�on of that pa�ern, and thereby eliminate it. Therefore, it is highly unlikely that investors can earn abnormal profits using strategies based solely on historical price and volume informa�on.

The semistrong form of the efficient markets hypothesis assumes that security prices fully reflect all publicly available informa�on, including historical price and volume data. If markets are semistrong-form efficient, then investors cannot consistently earn abnormally high returns by trading on publicly available informa�on about the company or its industry, such as that contained in corporate annual and quarterly reports, press releases, ar�cles in the Wall Street Journal or other business publica�ons, or government sta�s�cs. 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 informa�on, but enough must have it so that sufficient trading occurs to cause prices to adjust to new informa�on. 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 informa�on about a company, its products, its compe�tors, its markets, and even its suppliers.

We do not want to leave the impression that semistrong-form efficiency impounds only recent factual or financial informa�on about a company into security prices. Market par�cipants use all available types of informa�on to form expecta�ons about a company's future; that is, they try to an�cipate what a company's value will be or how the company will perform in the future. A few examples might clarify this concept of an�cipatory 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 an�cipa�on to what that implies about the company's future cash flows. When the company announces an actual acquisi�on, the stock price response reflects how investors feel about this specific acquisi�on compared to what they an�cipated. Thus, the announcement of a poten�ally profitable acquisi�on might be met with a reduc�on in share price, if investors had expected an even more profitable acquisi�on. Similarly, each quarter when companies announce their earnings, stock prices will some�mes fall on earnings increases and rise on earnings decreases if the increases were less than an�cipated or the decreases were not as large as an�cipated.

The third category of market efficiency, strong-form efficiency, assumes that security prices fully incorporate all public informa�on plus all nonpublic informa�on, such as informa�on available only to the managers within a corpora�on. Strong-form efficiency exists if even corporate insiders, using their privileged informa�on, cannot earn abnormal 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 discovery, stock prices change drama�cally. Furthermore, we know that corporate insiders were privy to this informa�on prior to its release. This suggests that if insider trading based on the informa�on occurred, it did not occur in sufficient volume for prices to completely reflect the informa�on. Therefore, insiders could make abnormal profits because the market price did not reflect the value of this privileged knowledge. There is a growing interest in the buying and selling of corporate execu�ves. Every Wednesday the Wall Street Journal publishes the "Inside Track" column, which discusses recent trades by corporate insiders.

Doubt about strong-form efficiency also arises from laws prohibi�ng insider trading. These laws a�empt to create a level playing field for outside investors. The problem these laws address is one of asymmetric informa�on, which was discussed in Chapter 1. Asymmetric informa�on means that one person or group has more informa�on than some other person or group. In the case of stock market inves�ng, asymmetric informa�on can create serious problems. If outside investors know that insiders can make stock market trades using their privileged informa�on, they will be hesitant to trade. Outsiders 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 an�cipate. The manager could sell stock before the news is released at a price of $45. A�er 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 informa�on drives other investors away from the market, reducing liquidity and the investment dollars available for corporate growth. Laws prohibi�ng insider trading increase investor trust, and thereby their willingness to invest.

The penal�es 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. Securi�es and Exchange

Commission take insider trading crimes very seriously. More recently, the scandals engulfing Enron in 2001 included the eventual convic�on of CEO Kenneth Lay for fraud, which led to the strict insider trading and disclosure regula�ons 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 assump�ons about the informa�on reflected in security prices. No�ce how the various types of market efficiency relate to the informa�on included in stock prices. You may also think of efficiency in terms of asymmetric informa�on. Markets are efficient in the weak form because there is no asymmetry of informa�on regarding historical price and volume data; that is, everyone has exactly the same informa�on about historical prices and trading volumes. Semistrong-form efficiency holds in many markets, because there are few differences among investors' access to public informa�on. Strong-form efficiency rarely holds because of obvious asymmetries of informa�on. Strong-form efficiency states that stock prices include some private (and therefore unavailable) informa�on, but this requires that insiders trade on that informa�on, which is illegal.

Figure 2.5: Informa�on and price in markets of varying efficiency

Processing math: 0%

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

A balanced discussion of market efficiency must include the fact that there are a number of studies whose results are not consistent with the efficient market hypothesis. For example, there is evidence that stocks some�mes overreact to informa�on, contradic�ng the assump�on that new informa�on is accurately impounded into market prices. Other so-called market anomalies (apparent viola�ons 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 concentra�on of strong stock returns during the first few days of January. The existence of these anomalies led Professor Andrew Lo of MIT to propose the adap�ve markets hypothesis (Lo, 2004, 2005), which a�empts to reconcile anomalies to the idea of efficient markets. Lo's work is based on classical economics but also borrows from evolu�on and neuroscience to suggest that tolerances, regula�ons, and objec�ves shi� over �me resul�ng in market 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 excep�ons that economists are s�ll a�emp�ng to explain.

The lesson of efficient markets is that it is extremely difficult to earn abnormally high returns from inves�ng using publicly available informa�on. 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 �me ac�vely traded financial securi�es 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 corpora�ons is straigh�orward. Corporate managers will rarely enhance the wealth of shareholders (the key decision criterion for managers) through financial market transac�ons in efficient markets. In many ways, this is good news for corporate officers. Efficient markets imply that prices reflect available informa�on, or that prices are fair. When companies issue and sell securi�es, on average, they receive a fair price for those securi�es. 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 prohibi�ons against insider trading, encourage investors to par�cipate 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 rela�vely inexpensive funds.

Processing math: 0%

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

Imaginechina/Associated Press

2.4 Product Markets

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

Perfect Competition

In perfectly compe��ve product markets, no single producer has an advantage in cost, product quality, distribu�on, or any other aspect of the business, and consumers subs�tute items from one producer for those from another, basing their decisions exclusively on price. In markets with a high degree of product subs�tutability and easy entry, compe��on drives selling price to the marginal cost of produc�on, and producers earn only a normal profit. Moreover, to remain compe��ve firms must constantly try to improve their produc�on technology. Therefore, with perfect compe��on, goods are produced as efficiently as possible, and consumers pay the lowest price that allows produc�on to con�nue.

Although perfectly compe��ve markets are rare, highly compe��ve markets are more common than you might imagine. Markets selling products that are considered commodi�es, such as gasoline, coal, steel, sugar, and wheat, are extremely compe��ve, with many consumers using price as the primary purchase criterion. Even memory chips and desktop computers have become commodity-like. Generic products at supermarkets represent products that are very nearly commodi�es and are offered because many shoppers look at price alone when buying these items. Compe��ve markets emerge from two sources. Some products are commodi�es (and therefore perfect subs�tutes), so the markets selling those products become highly compe��ve. For example, one pound of sugar is very similar to any other pound of sugar, assuming minimal standards of product quality, such as cleanliness, are sa�sfied. Highly compe��ve markets also emerge when a market allows easy entry. Such a situa�on 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 a�racted entry into the market. 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 compe�tors to build subs�tutes for IBM and Compaq computers drama�cally increased the compe��veness of the personal computer market.

Can you see any similari�es between perfectly compe��ve product markets and efficient financial markets? In both markets, par�cipants 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 subs�tute 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 iden�fies a promising security, they happily subs�tute that security for others in their por�olio.

Imperfect Competition

In imperfectly compe��ve markets, producers use product differen�a�on and brand loyalty to impede subs�tu�on. Product differen�a�on depends on consumers having fairly complex needs or desires. Product differen�a�on requires iden�fying specific consumer needs and then producing a product or service specially designed to sa�sfy those needs. This process is amply demonstrated with a product as simple as shampoo. To differen�ate 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 dandruff or scalp diseases; or shampoo o�en. Shampoos come with and without condi�oners, with vitamins, with recommenda�ons from celebri�es, with designer names a�ached, and in a variety of fragrances and colors. A number of shampoos are designed specifically for children. The goal of this immense effort in shampoo research and promo�on is to produce a shampoo that fits consumers' needs so well that they have no incen�ve to change brands. Once this brand loyalty is established, consumers will pay a premium price for their preferred product rather than subs�tute a less desirable brand of shampoo. By slowing the urge to subs�tute, producers earn higher than normal profits and thereby enhance shareholder wealth.

The process of differen�a�on goes on con�nuously. Innovators must constantly improve exis�ng 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�a�on concept. Each year new financial instruments debut, with special a�ributes that make them a�rac�ve to a narrow clientele of investors. These instruments may earn their creators a somewhat higher-than-expected return in the short run, but difficul�es in copyrigh�ng financial products means that compe�tors quickly copy good ideas. Entry by imitators reduces the returns to a normal level.

The existence of higher-than-normal profits a�racts these entrants. With more producers vying for a par�cular market segment, price—and thereby profit—typically falls. Above-normal profits from product innova�on can be very short-lived. Therefore, managers must constantly seek new opportuni�es and shi� 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. Compe��on within the United States, as well as from abroad, means that managers must be extremely vigilant in monitoring market condi�ons and be prepared to fight for exis�ng products while con�nuously looking for new products and markets.

Nevertheless, it is possible to make an abnormally high profit from product market investments because of the complex tastes and needs of customers. Iden�fying market segments with unsa�sfied wants and then differen�a�ng a product to sa�sfy 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 compe��ve markets, can earn above-normal profits.

The profits of these minimonopolies draw the a�en�on of compe�tors. Therefore, companies must protect their market segments from new compe��on if they hope to con�nue to earn high rates of return on their investments. Barriers to entry provide such protec�on and may take the form of a patent, a unique loca�on, a highly recognizable brand name, a constantly improving product, or a cost advantage, among other strategies.

Processing math: 0%

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

Associated Press

2.5 Market Participants and Value

In Chapter 1, we described the goal of management as increasing the wealth of shareholders. This is done by developing goods and services whose cost of produc�on 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 par�cipants 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 securi�es' prices) are bid up. On the other hand, if investors expect poor performance, then the value of the claims will fall. Thus, the trick to wealth crea�on is to

Es�mate 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.

Es�ma�ng the cost of product development and produc�on is generally the task of engineers and produc�on managers. Cash flows are es�mated with input from the firm's marke�ng staff. It is in the es�ma�on 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 fi�h value-driver to that list, the op�ons or opportuni�es that are created when a project is pursued.

1. The size of expected cash flows. 2. The �ming of expected cash flows. 3. The riskiness of expected cash flows. 4. The returns available on alterna�ve investments. 5. The op�ons created by the project.

Next, we look at these value determinants in rela�on to human behavior.

Behavioral Foundations of Value

Each of these characteris�cs contributes to the value of a project and is rooted in our understanding of human behavior. A�er all, people are doing the trading in financial markets 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 posi�ve u�lity (or happiness) derived from wealth. In terms of wealth, we assume that people prefer having more rather than less; the greater a person's consump�on 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 ac�vi�es 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 bo�om line is more cash, more value.

2. The �ming of expected cash flows is important because we assume that, all else being the same, people prefer current consump�on over future consump�on. Receiving cash today gives us the opportunity to consume now if we want. Alterna�vely, 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 bo�om 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 aversion also implies the converse of paying to reduce risk; that is, investors must be paid to accept addi�onal risk. Risky investments must offer a higher expected return (a risk premium) to a�ract 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 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 en�ced 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 no�on of risk aversion. There are certainly examples of people accep�ng 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 alterna�ve investments are important because of ra�onal 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 �ming of cash flows, etc.), an investor will assess all the investment alterna�ves available and choose the one that is most a�rac�ve. Thus, investment projects compete with one another. The bo�om line is that, when assessing the value of a project, investors will consider ret urns available on other investments with similar characteris�cs.

5. The op�ons created by an investment are important components of value because of both risk aversion and ra�onal self-interest. Suppose a high school student is considering buying a car. As a senior, she needs a summer job to help pay for college tui�on. She hopes to work as an accoun�ng intern during the summer but has not been formallyProcessing math: 0%

offered the posi�on. 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 op�ons related to her summer employment.

A Simple Value Formula

Now we can express the components of value in a precise mathema�cal form. You may have seen the following formula for the present value (PV) of a single cash flow in an accoun�ng, economics, or business math class.

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

where E(CF) stands for the expected cash flow, r is the interest rate, and t represents the �me un�l the cash is received. Consider this formula in light of the first four characteris�cs of value we just discussed. If investors receive informa�on causing their expecta�ons of 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 infla�on increases. Banks would offer to pay higher rates of interest on cer�ficates of deposit (CDs); in response, other investments would offer higher returns in order to compete with CDs. Thus, the rates of return available on alterna�ve 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 informa�on is reflected in the valua�on is a func�on of the degree of market efficiency. In very efficient markets, valua�on adjustments occur within minutes of news being released.

You might wonder how the fi�h characteris�c, op�ons, is valued. At this point in your financial studies, there is no precise way to do this valua�on. If you pursue finance, you will eventually learn how to value op�ons. For now, you must be sa�sfied with the idea that when you are choosing between alterna�ve projects that are otherwise very similar, you should take the one that creates the most op�ons for the firm.

Processing math: 0%

Ch. 2 Conclusion

This chapter concludes by examining some general traits of human behavior and how they apply to the evalua�on of investments. People want to consume, and, being ra�onal, are concerned with cash flows that can be transformed into consump�on. They are risk averse and must be paid a higher return if an investment involves high risk. Before inves�ng, they examine the alterna�ve investments available to them. Comparable investments must promise comparable benefits or returns. The longer they must delay their consump�on, the higher the future consump�on must be. Finally, people are willing to pay a premium for an investment that provides extra opportuni�es and op�ons.

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 government, 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�ve assessment of the five characteris�cs that contribute to value are revealed by the market price of the business's securi�es. Note that each characteris�c of value, and therefore the market prices of the firm's securi�es, depends on decisions made on the le�-hand side of the financial balance sheet. Cash flows—their size, their �ming, and their riskiness—as well as the op�ons available to the firm are a func�on of the kinds of projects the company pursues and how successfully the company follows those pursuits. Corpora�ons 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 maximiza�on.

Most of the topics introduced in this chapter are covered in greater detail later in the book. Chapter 3 examines the es�ma�on of investment project cash flows. In Chapters 4 and 5, we demonstrate how to treat the �ming of cash flows by using discoun�ng techniques to compute present values. How to es�mate risk premiums and required rates of return are the subjects of Chapter 6. Then we put these pieces together into a single procedure for evalua�ng 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 securi�es to buy and sell and that company managers use when deciding which products to make and which strategies to pursue.

Financial Balance Sheet, Part II

Click here (h�ps://media.thuze.com/MediaService/MediaService.svc/constella�on/book/AUBUS650.13.1/{pdfs}financial_balance_sheet_p2.pdf) to download a pdf of this slideshow.

SLIDE 1 OF 5

Processing math: 0%

Ch. 2 Learning Resources

Key Ideas

Government regula�on of capital and commodity markets helps companies obtain investment funds and raw materials at compe��ve prices. Financial markets supply the funds that firms use to purchase produc�ve assets, such as factories, machinery, trucks, computers, and offices. Financial markets provide a mechanism for valuing a firm's securi�es. Investors buy and sell stocks and bonds in these markets. Securi�es trade in financial markets, the best known of which are the stock exchanges in New York, London, and Tokyo. These markets are phenomenally ac�ve and compe��ve. Investors compete with one another to make be�er predic�ons about the future cash flows associated with financial claims. Financial markets in which prices reflect all relevant informa�on are called informa�onally efficient markets. In perfectly compe��ve product markets, no single producer has an advantage in cost, product quality, distribu�on, or any other aspect of the business, and consumers subs�tute items from one producer for those from another, basing their decisions exclusively on price. Corpora�ons sell the goods and services they produce in product markets and purchase the raw materials and other inputs needed in their produc�on process. In imperfectly compe��ve markets, producers use product differen�a�on and brand loyalty to impede subs�tu�on. The �ming of expected cash flows is important because we assume that, all else being the same, people prefer current consump�on over future consump�on. 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.

Key Equa�ons

Cri�cal Thinking Ques�ons

1. In terms of the characteris�cs of markets such as barriers to entry, similarity of the products, and compe��on, can you explain why LeBron James (the basketball 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 informa�onally efficient, does that mean that you should not expect to earn a posi�ve 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 �me 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 professional future may also want to devote �me to studying in order to complete his or her degree with high grades. In your opinion, which characteris�c of value and which behavioral characteris�c does this decision reflect?

Key Terms

Click on each key term to see the defini�on.

adap�ve markets hypothesis (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A market efficiency hypothesis in which the dynamics of evolu�on, compe��on, muta�on, reproduc�on, and natural selec�on determine the efficiency of markets and the waxing and waning of financial ins�tu�ons, investment products, and, ul�mately, ins�tu�onal and individual fortunes.

ask price (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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 transac�on.

barriers to entry (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Obstacles that make entry into a product market difficult, thus protec�ng the market from compe��on and helping to ensure long-term profitability and wealth-building poten�al. Examples include patents, copyrights, secret formulas, a unique loca�on, and brand name recogni�on.

SLIDE 1 OF 3

Processing math: 0%

bid-ask spread (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The difference between a dealer's bid price and ask price for an asset. It represents the dealer's mark-up and their maximum poten�al profit. Generally the bid price is above the ask price and the bid-ask spread tends to be higher for assets that sell at low volume rather.

bid price (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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 transac�on.

bond indenture contract (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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

capital gain (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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

capital markets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Markets on which financial securi�es that will mature in more than a year are bought and sold. Examples of capital market securi�es include common stock and preferred stock (because they never mature) and long-term bonds.

commercial paper (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A short-term corporate 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 (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Markets in which a firm raises funds, including long-term capital and short-term financing requirements. Financial markets link a firm with its investors, including financial ins�tu�ons, stockholders, and bondholders.

fundamental analysis (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The examina�on of informa�on that, in theory, should affect the price of an asset. For stocks, fundamental analysis would examine such factors as profit margin, growth, risk, expected cash flows. Financial statement analysis and following the news coverage of a firm's new products are examples of ac�vi�es that would be considered part of fundamental analysis.

going public (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Also known as an IPO, occurs when a private, closely held corpora�on sells stock to the general inves�ng public for the first �me. It then becomes a public-held corpora�on with an ac�ve market for buying and selling shares among investors. These firms are o�en new, emerging companies.

imperfect compe��on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Markets characterized by imperfect compe��on may yield wealth-building investment opportuni�es because one firm (or a few firms) has an advantage over others so they may earn profits above those expected in a perfectly compe��ve market. Because of these extraordinary profits, firms try to keep their compe��ve advantage by differen�a�ng their product and establishing barriers to entry.

informa�onal efficiency (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Efficiency based on informa�on being quickly and accurately impounded into asset prices.

ini�al public offering (IPO) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

See going public.

liquidity (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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 gran�ng large price concessions.

market anomalies (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Processing math: 0%

Apparent viola�ons of market efficiency that have been discovered by analysts or researchers. In efficient markets, all relevant informa�on is reflected quickly and accurately in the market price. But there is some evidence of market anomalies sugges�ng that some types of informa�on are not accurately reflected in price, so using that informa�on may enable an investor to earn abnormally high returns, given the risk their risk exposure.

market efficiency (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The characteris�c of a market when the prices quickly and accurately adjust to new informa�on. Prices produced by an efficient market are an unbiased and accurate reflec�on of the underlying value of an asset.

money markets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Markets on which financial securi�es that will mature in less than a year are bought and sold. Examples of money market securi�es include treasury bills (T-bills) and commercial paper.

NASDAQ (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

See over the counter (OTC).

NYSE (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

See secondary markets.

over the counter (OTC) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

When trading of securi�es is done using a computer network of security dealers outside of a physical stock exchange. The best known OTC market is the Na�onal Associa�on of Securi�es Dealers Automated Quote system (NASDAQ).

perfect compe��on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

When there are so many compe�tors and similar products that prices are driven to their minimum level. These prices just cover the cost of produc�on and the least amount of profit that will sustain businesses. Commodity markets are considered to be nearly perfectly compe��ve because there is not differen�a�on between products so consumers make their purchases based solely on who sells for the lowest price.

primary markets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Markets where companies sell securi�es to investors in order to raise funds. IPOs occur on primary markets, for example. However, all trades on the New York Stock Exchange are between investors so the issuing firm is not directly involved; therefore, the NYSE is not a primary market.

private placement (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The sale of securi�es to a rela�vely small number of select investors as a way of raising capital. Investors involved in private placements are usually large banks, mutual funds, insurance companies, and pension funds. Private placement is the opposite of a public issue, in which securi�es are made available for sale on the open market.

product differen�a�on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A strategy of making one's product or service unique compared to it's near-compe�tors. Product differen�a�on is an a�empt to protect the product's ability to create high returns by keeping the market in which it trades from becoming too compe��ve. The unique flavor of, say, Dr. Pepper differen�ates it from most compe�tors.

product market (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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 (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The por�on of net income that is not paid out in the form of dividends and is reinvested in the corpora�on. Each year's retained earnings may be reflected on the firm's income statement or its statement of retained earnings, while the cumula�ve total of all years' retained earnings is reflected on the firm's balance sheet.

seasoned offering (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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

secondary markets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Markets where trading between investors takes place. The New York Stock Exchange (NYSE) is probably the best known of all secondary markets. It is surprising to many to learn that the issuing firm does not receive any financing from trading of its shares in secondary markets. Secondary markets are important to corpora�ons and to investors because they provide liquidity.Processing math: 0%

semistrong-form efficiency (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A type of market where the prices reflect all publicly available informa�on. Any a�empt to forecast price changes using fundamental analysis is useless if the market is semistrong efficient.

strong-form efficiency (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A type of market where the prices reflect all informa�on, both public and private. Any a�empt to forecast price changes using inside informa�on is useless if the market is semistrong efficient. It is generally acknowledged that securi�es markets are not strong-form efficient; therefore ,the existence of insider trading restric�ons are enforced to help ensure the percep�on that markets are fair for the average investor.

technical analysis (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

An approach to trading securi�es based on past prices and trading volumes. Generally, technicians look for pa�erns 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 char�ng.

transac�on costs (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

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

transferability (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The ability of an ownership interest (or other interest) to be transferred from one party to another. Typically shares represen�ng ownership in a corpora�on can be transferred, but o�en partnership interests are non-transferrable without the consent of the other partners.

treasury bills (T-bills) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Short-term securi�es issued by the U.S. government. They are o�en considered nearly riskless securi�es.

unseasoned offering (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

This occurs when a corpora�on sells stock for the first �me.

weak-form efficiency (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

A type of market where the prices reflect all past price and volume informa�on. Returns in such a market are said to follow a random walk, and any a�empt to forecast price changes using technical analysis is useless if the market is weak form efficient.

Web Resources

See which companies have current IPOs here: www.ipocentral.com (h�p://www.ipocentral.com)

Learn more about inves�ng in bonds here: www.bonds-online.com (h�p://www.bonds-online.com)

Learn more about the Department of the Treasury and government bond issues here: h�p://www.treasury.gov (h�p://www.treasury.gov)

Processing math: 0%