Business Finance Project Part #1 COMPANY: B&G Foods (BGS)

profilesunshinelolopop
Chapter1IntroductiontotheFieldofFinancialManagement.pdf

Chapter 1 “Introduction to the Field of Financial Management” from Finance by Boundless is used under the terms of the Creative Commons Attribution-ShareAlike 3.0 Unported license. © 2014, boundless.com. UMGC has modified this work and it is available under the original license.

Chapter 1

Introduction to the Field of Financial Management

https://www.boundless.com/finance/introduction-to-the-field-and- goals-of-financial-management/

Defining Finance

Finance, Economics, and Accounting: Differences and Commonalities

Role of Finance in an Organization

Types of Financial Decisions: Investment and Financing

Functions of Corporate Finance

The Financial Manager: An Overview of the Role

Reasons to Study Finance

Section 1

Introducing Finance

4

https://www.boundless.com/finance/introduction-to-the-field-and-goals-of-financial-management/introducing-finance/

Defining Finance Finance is the study of fund management and asset allocation over time.

KEY POINTS

• The two main drivers of finance are the time value of money and risk.

• Since the value of assets changes over time, finance seeks to ensure the change is beneficial for the organization or individual.

• Financial professionals generally operate in an environment of uncertainty where they must make forecasts about future events.

Overview

Finance is the study of fund management and asset allocation over time. Funds consist of money and other assets. There are many different types of finance, but all are fundamentally concerned with studying how best to allocate assets in different conditions over time.

Importance of Time

The underlying driver behind all of finance is time. There are two reasons why time is so important to finance:

1. Time value of money: For a number of reasons, money today is worth more than the same amount of money in the future. For example, you would rather have $100 today than $100 in 10 years - the money is worth more to you now than it would be in the distant future. We will explore this concept in greater depth later on.

2. Risk: Making an investment does not guarantee a return. When a bank makes a loan, they're not sure the debtor will pay it back. There is a risk that the person will just take the money and run, the debtor will file for bankruptcy, or, for dozens of other reasons, the bank will not get the money they lent back.

The field of finance, however, embraces time. Finance says, "Since I know assets change value over time, how do I use that to cause my assets to change value in the direction I want? How do I manage assets so that they're worth more in the future than they are today?"

5

Challenges in Finance

Figuring out what to do with assets is sometimes easy: all of the variables are known, and there is clearly an option that is better than all the others. Most of the time, this isn't the case. Finance generally operates with a lot of uncertainty. As a result, companies hire entire departments of people to help them figure out which option is best (Figure 1.1).

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/introducing-finance/defining- finance/ CC-BY-SA

Boundless is an openly licensed educational resource

Finance, Economics, and Accounting: Differences and Commonalities Finance, economics, and accounting are business subjects with many similarities and differences; each is a distinct field of study.

KEY POINTS

• Finance is the study of how to optimally allocate assets. Finance is fundamentally a forward looking field, concerned with what an asset will be worth in the future.

• Economics is the social science that analyzes the production, distribution, and consumption of goods and services.

• Accounting is the process of communicating financial information about a business. Accounting is fundamentally a backward-looking field.

Finance, economics, and accounting are business subjects with many similarities and differences. While they influence each other, each is a distinct field of study.

6

Charles Holley, the Chief Financial Officer (CFO) of Wal-Mart, is in charge of making sure all of Wal-Mart's assets are allocated as optimally as possible.

Figure 1.1 Walmart CFO

Finance

Finance is the study of how to optimally allocate assets—how individuals and organizations should invest assets in order to get the highest possible return given changing conditions over time. Finance is fundamentally a forward looking field, concerned with what an asset will be worth in the future.

Economics

Economics is a social science that analyzes the production, distribution, and consumption of goods and services. It focuses on how economic agents (people, businesses, and government) interact and make decisions. Economics is fundamentally the study of cause and effect. It tries to figure out how one variable affects economic agents or the economy as a whole.

Accounting

Accounting focuses on communicating a businesses' financial information. Accounting is fundamentally a backward-looking field, concerned with what has already happened financially and what position that leaves the company in today.

If accounting is called the language of business, then the financial statements that accountants prepare are the words (Figure 1.2). Statements are created under a standardized set of accounting laws,

7

The balance sheet is one of the three main financial statements. The other two are the cash flow statement and the income statement.

Figure 1.2 Balance sheet

which allows one to easily compare and contrast companies. This indicates how financially healthy a company is.

Overlap

Finance, economics, and accounting overlap in a lot of areas. For example, an investor will use accounting to see whether a company has shown past financial success and to predict what the company will look like in the future. Part of that prediction incorporates economics. The investor wants to know what the overall economy will look like in the future and wants to know how the company will interact with its competitors. The investor can use finance to figure out what his or her investment will be worth in the future.

There are few strong delineators between finance, economics and accounting. All three fields intermingle and influence one another. It is almost impossible to have a strong grasp of one without at least a basic understanding of the other two.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/introducing-finance/finance- economics-and-accounting-differences-and-commonalities/ CC-BY-SA

Boundless is an openly licensed educational resourceBoundless is an openly licensed educational resource

Role of Finance in an Organization The primary role of corporate finance is to determine how best to maximize shareholder value.

KEY POINTS

• Maximizing shareholder value can be done over the long- term or the short-term, so the job of the finance department is to determine how best to do both. Sometimes, the goals may appear to contradict each other.

• The finance department is devoted to the task of figuring out how to allocate assets for the overarching goal of maximizing shareholder value. They must ensure that the right assets are in the right place at the right time.

• The finance department must also manage the company's liabilities so that all projects are financed in an optimal way without taking on too much risk.

Corporate finance is the area of finance dealing with monetary decisions that business enterprises make. When finance is talked about in the context of business decisions, it is called corporate finance (technically, corporate finance deals only with corporations, while managerial finance deals with all types of companies, but we will use the terms interchangeably). There are

8

other branches of finance such as personal finance (individuals taking care of their money) and public finance (the finances of the government).

The primary goal of corporate finance is to maximize shareholder value. Maximizing shareholder value can be done over the long- term or the short-term, so the job of the finance department is to determine how best to do both. Sometimes, the goals may appear to be in competition with one another. For example, a company can choose to pay dividends (a small payment to each person who owns a stock of a company), which increases short-term shareholder wealth. However, paying dividends means that the money is not being invested in long-term investments, which may cause the stock price to increase more in the future, and thereby increasing long-term shareholder wealth.

The technique behind maximizing shareholder value is the management of assets. This means that the finance department figures out how to best invest its money.

For example, a company could have two proposals from the R&D department to develop different products, but only enough money to fund one (Figure 1.3). The finance department will project out the future revenues and costs of each product and figure out which one, if either, is worth the money.

Also, the finance department will determine when a company should take on a liability. For example, suppose both projects are absolute home-runs, but the company still only has enough money to fund one. The finance department will figure out if the company should borrow money so that it can fund both.

The role of finance in an organization is to make sure that money is at the right place at the right time. A company wants to have enough money to pay its bills, but also wants to invest so that it can grow in

9

Apple used financial analysis to decide to fund the development of the iPod. The money allocated development could not be used for another project, but the finance department determined the iPod was the best option.

Figure 1.3 iPod Touch

the future. The finance department is devoted to the task of figuring out how to allocate assets to do so, for the overarching goal of maximizing shareholder value.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/introducing-finance/role-of- finance-in-an-organization/ CC-BY-SA

Boundless is an openly licensed educational resource

Types of Financial Decisions: Investment and Financing Investment and financing decisions boil down to how to spend money and how to borrow money.

KEY POINTS

• The primary goal of both investment and financing decisions is to maximize shareholder value.

• Investment decisions revolve around how to best allocate capital to maximize their value.

• Financing decisions revolve around how to pay for investments and expenses. Companies can use existing capital, borrow, or sell equity.

There are two fundamental types of financial decisions that the finance team needs to make in a business: investment and financing. The two decisions boil down to how to spend money and how to borrow money. Recall that the overall goal of financial decisions is to maximize shareholder value, so every decision must be put in that context.

10

Investment

An investment decision revolves around spending capital on assets that will yield the highest return for the company over a desired time period. In other words, the decision is about what to buy so that the company will gain the most value.

To do so, the company needs to find a balance between its short- term and long-term goals. In the very short-term, a company needs money to pay its bills, but keeping all of its cash means that it isn't investing in things that will help it grow in the future. On the other end of the spectrum is a purely long-term view. A company that invests all of its money will maximize its long-term growth prospects, but if it doesn't hold enough cash, it can't pay its bills and will go out of business soon. Companies thus need to find the right mix between long-term and short-term investment.

The investment decision also concerns what specific investments to make. Since there is no guarantee of a return for most investments, the finance department must determine an expected return. This return is not guaranteed, but is the average return on an investment if it were to be made many times.

The investments must meet three main criteria:

1. It must maximize the value of the firm, after considering the amount of risk the company is comfortable with (risk aversion).

2. It must be financed appropriately (we will talk more about this shortly).

3. If there is no investment opportunity that fills (1) and (2), the cash must be returned to shareholder in order to maximize shareholder value.

Financing

All functions of a company need to be paid for one way or another. It is up to the finance department to figure out how to pay for them through the process of financing.

There are two ways to finance an investment: using a company's own money or by raising money from external funders. Each has its advantages and disadvantages.

There are two ways to raise money from external funders: by taking on debt or selling equity. Taking on debt is the same as taking on a loan. The loan has to be paid back with interest, which is the cost of borrowing. Selling equity is essentially selling part of your company (Figure 1.4). When a company goes public, for example,

11

they decide to sell their company to the public instead of to private investors. Going public entails selling stocks which represent owning a small part of the company. The company is selling itself to the public in return for money.

Every investment can be financed through company money or from external funders. It is the financing decision process that determines the optimal way to finance the investment.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/introducing-finance/types-of- financial-decisions-investment-and-financing/ CC-BY-SA

Boundless is an openly licensed educational resource

Functions of Corporate Finance Corporate finance utilizes tools and analysis to make sound financial business decisions.

KEY POINTS

• The finance group is in charge of budgeting. It will look for the optimal allocation of assets across all business functions.

• Corporate finance decides how best to finance projects. The department can either use existing internal funds, borrow money, or sell equity.

• The finance group must balance both short- and long-term company goals, though the overarching goal is to maximize shareholder value.

Corporate finance deals with monetary decisions that business enterprises make and the tools and analysis utilized to make the decisions. Corporate finance is concerned primarily with making investment and financing decisions; that is, making sure that money is being used in the best way.

The corporate finance department of a company is in charge of budgeting. Management must allocate limited resources between

12

If a company chooses to finance an investment by selling equity, they may issue stocks on an exchange like the New York Stock Exchange

Figure 1.4 NYSE

competing opportunities; since a dollar cannot be used for more than one project at once, it is a challenge to determine how much money should be allocated to each part of the business.

In determining how to allocate money, the finance group must also figure out where the money will be best utilized. This requires valuing projects and business functions. A large element of finance is deciding how exactly to value a project. There are a number of variables — inflation, expected revenues, expected costs, length of time required — that are all incorporated into the valuation process. Finding the true value of a project is often wrought with uncertainty, but without an accurate valuation, a company may allocate its resources sub-optimally.

The corporate finance department must also determine how to finance projects. A company can finance a project by using either

internal funds (money the company already has), borrowing, or selling equity. Each option carries a certain cost that can be quantified. It is the job of the finance department to make sure that the overall cost isn't too high and that the company has an optimal mix of all three strategies.

One public job function of corporate finance is determining whether or not the company pays a dividend, and if so, how much. The company has a responsibility to maximize shareholder value, but that can be achieved in multiple ways. Paying a dividend puts cash directly in the hands of shareholders, increasing shareholder value. However, paying a dividend means that money is not being reinvested in the company. If a company doesn't pay a dividend and instead chooses to reinvest the money, the value of the company will presumably increase, in turn increasing shareholder value. The finance department determines which option maximizes shareholder value.

Lastly, the finance department must also ensure that there is a good balance between long- and short-term goals. The company must have enough assets to cover short-term costs, referred to as working capital management, and enough invested to ensure the company has long-term growth (Figure 1.5).

13

Purchasing new machinery requires a valuation of all equipment, an accurate idea of the total cost over time, and a way to finance the purchase while leaving enough cash for other upcoming costs.

Figure 1.5 Factory

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/introducing-finance/functions-of- corporate-finance/ CC-BY-SA

Boundless is an openly licensed educational resource

The Financial Manager: An Overview of the Role The financial manager is responsible for budgeting, projecting cash flows, and determining how to invest and finance projects.

KEY POINTS

• The finance manager is responsible for knowing how much the product is expected to cost and how much revenue it is expected to earn so that s/he can invest the appropriate amount in the product.

• The finance manager uses a number of tools, such as setting the cost of capital (the cost of money over time, which will be explored in further depth later on) to determine the cost of financing.

• The financial manager must not just be an expert at financial projections; s/he also must have a grasp of the accounting systems in place and the strategy of the business over the coming years.

• The head of the financial department is the chief financial officer (CFO) who is responsible for all financial decisions and reporting done in the company.

14

The Role of the Financial Manager

The role of a financial manager is a complex one, requiring both an understanding of how the business functions as a whole and specialized financial knowledge. The head of the financial operations is called the chief financial officer (CFO).

The structure of the company varies, but a financial manager is responsible for the same general things across the board. The manager is responsible for managing the budget. This involves allocating money to different projects and segments so that the business can continue operating, but the best projects get the necessary funding.

The manager is responsible for figuring out the financial projections for the business. The development of a new product, for example, requires an investment of capital over time. The finance manager is responsible for knowing how much the product is expected to cost and how much revenue it is expected to earn so that s/he can invest the appropriate amount in the product. This is a lot tougher than it sounds because there is no accurate financial data for the future. The finance manager will use data analyses and educated guesses to approximate the value, but it's extremely rare that s/he can be 100% sure of the future cash flows.

Figuring out the value of an operation is one thing, but it is another thing to figure out if it's worth financing. There is a cost to investing money, either the opportunity cost of not investing it elsewhere, the cost of borrowing money, or the cost of selling equity. The finance manager uses a number of tools, such as setting the cost of capital (the cost of money over time, which will be explored in further depth later on) to determine the cost of financing.

At the same time that this is going on, the financial manager must also ensure that the business has enough cash to pay upcoming financial obligations without hoarding assets that could otherwise

15

The finance manager must collaborate across business functions in order to determine how to best allocate and manage assets.

Figure 1.6 Collaboration

be invested. This is a delicate dance between short-term and long- term responsibilities.

The CFO is the head of the financial department and is responsible for all of the same things as his/her subordinates, but is also the person who has to sign off that all of the company's financial statements are accurate. S/he is also responsible for financial planning and record-keeping, as well as financial reporting to higher management.

The financial manager is not just an expert at financial projections, s/he must also have a grasp of the accounting systems in place and the strategy of the business over the coming years (Figure 1.6).

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/introducing-finance/the- financial-manager-an-overview-of-the-role/ CC-BY-SA

Boundless is an openly licensed educational resource

Reasons to Study Finance Finance is relevant to all business functions, the macroeconomy, and personal finances.

KEY POINTS

• Finance plays an involved role in the health of the overall economy, which impacts everyone, regardless of whether or not they have studied finance.

• Like companies, individuals are faced with investment and financing decisions. Having a firm grasp of finance will help individuals make those decisions.

• All businesses functions deal with finance because they need to be able to make the financial argument for the funding of their projects and to manage their budgets.

The study of finance often feels a lot narrower than it really is. There is a lot of talk of issuing bonds or pricing projects which belies how relevant finance is to everyday life, regardless of whether or not you have any desire of working in finance.

Understanding the Economic Environment

Finance plays an involved role in the health of the overall economy, which impacts everyone, regardless of whether or not they have studied finance. The field of finance explains why the 2008

16

recession occurred; it is the reason why people care about how the stock market is doing each day (Figure 1.7); and it articulates why businesses and governments make some of the decisions they do.

Finance plays a role in many of the stories in the news every day, which means that those who understand finance have a better grasp on how the events of the world affect them.

Personal Finances

Each person will also have to manage his or her own personal finances. Like corporations, individuals are faced with investment and financing decisions. In order to invest, individuals must be able to do the same projections and valuations as companies in order to determine the best investment for their needs. Individuals cannot sell equity like corporations, but they can choose to either dip into their savings or take out loans. Many take on debt in the form of student loans, mortgages, or through their credit cards; being able to properly compare options to is just as important for individuals as it is for companies.

Application to Business

Of course, finance is an important field of study for those who have a desire of working in finance or accounting. Finance is heavily used in jobs ranging from investment banker to CFO to venture capitalist.

However, finance is not segmented from the other functions in business. Every job from marketing to engineering has to be able to manage a budget and make a business case that it should get funding for a project.

This is especially true higher up in the organizational hierarchy: managers, directors, and vice presidents need to be able to articulate why their departments should get financial support from the company.

17

Finance helps explain what trends in silver bids mean, but more importantly, why people care about them (even those not trading silver).

Figure 1.7 Silver Bid Chart

Finance is a field of both hard analytical skill and personal judgement. There are set processes and theories for determining which financial option is best, but in the real world, it is rare to have all of the information needed to be absolutely certain about what to do. Finance develops strong analytical skills, but also the degree of finesse required to operate in an environment of uncertainty.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/introducing-finance/reasons-to- study-finance/ CC-BY-SA

Boundless is an openly licensed educational resource

18

Valuation

Maximizing Shareholder and Market Value

Maximizing Value without Harming Stakeholders

Section 2

Goals of Financial Management

19

https://www.boundless.com/finance/introduction-to-the-field-and-goals-of-financial-management/goals-of-financial-management/

Valuation Valuation, a goal of financial management, often relies on fundamental analysis of financial statements.

KEY POINTS

• In finance, valuation is the process of estimating what something is worth. Valuation is used to for a variety of purposes: the purchase or sale of a business, appraisal to resolve disputes, managerial decisions of how to allocate business resources, and many other business and legal purposes.

• Valuation often relies on fundamental financial statement analysis using tools such as discounted cash flow or net present value. As such, an accurate valuation, especially of privately owned companies, largely depends on the reliability of the firm's historic financial information.

• Not only do managers want to keep reliable financial statements so that they can know the value of their own businesses, but they also want to manage finances well to enhance the value of their businesses to potential buyers, creditors, or investors.

Introduction

Financial management focuses on the practical significance of financial numbers. It asks: what do the figures mean? Sound financial management creates value and organizational agility through the allocation of scarce resources among competing business opportunities. It is an aid to the implementation and monitoring of business strategies and helps achieve business objectives. There are several goals of financial management, one of which is valuation (Figure 1.8).

20

Valuation is, for some, one of the goals of financial management.

Figure 1.8 Valuation

Valuation

In finance, valuation is the process of estimating what something is worth. Valuation often relies on fundamental analysis (of financial statements) of the project, business, or firm, using tools such as discounted cash flow or net present value. As such, an accurate valuation, especially of privately owned companies, largely depends on the reliability of the firm's historic financial information. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company).

Valuation is used to determine the price financial market participants are willing to pay or receive to buy or sell a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establishing a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes. Therefore, not only do managers want to keep reliable financial statements so that they can know the value of their own businesses, but they also want to manage finances well

to enhance the value of their businesses to potential buyers, creditors, or investors.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/goals-of-financial-management/ valuation/ CC-BY-SA

Boundless is an openly licensed educational resource

21

Maximizing Shareholder and Market Value A goal of financial management can be to maximize shareholder wealth by paying dividends and/or causing the market value to increase.

KEY POINTS

• One interpretation of proper financial management is that the agents are oriented toward the benefit of the principals, shareholders, and in increasing their wealth by paying dividends and/or causing the stock price or market value to increase.

• The idea of maximizing market value is related to the idea of maximizing shareholder value, as market value is the price at which an asset would trade in a competitive auction setting; for example, returning value to the shareholders if they decide to sell shares or if the firm decides to sell.

• There are many different models of corporate governance around the world. These differ according to the variety of capitalism in which they are embedded. The Anglo- American (US and UK) "model" tends to emphasize the interests of shareholders.

KEY POINTS (cont.)

• The sole concentration on shareholder value has been criticized, for concern that a management decision can maximize shareholder value while lowering the welfare of other stakeholders. Additionally, short-term focus on shareholder value can be detrimental to long-term shareholder value.

Introduction

Financial management is concerned with financial matters for the practical significance of the numbers, asking: what do the figures mean? There are several goals of financial management, one of

which is maximizing shareholder and market value 
 (Figure 1.9).

22

Maximizing shareholder and market value is, for some, one of the goals of financial management.

Figure 1.9 Money to Shareholders

Maximizing Shareholder Value

The idea of maximizing shareholder value comes from interpretations of the role of corporate governance. Corporate governance involves regulatory and market mechanisms and the roles and relationships between a company’s management, its board, its shareholders, other stakeholders, and the goals by which the corporation is governed.

In large firms where there is a separation of ownership and management and no controlling shareholder, the principal–agent issue arises between upper-management (the "agent") and shareholders (the "principals"). The danger arises that, rather than overseeing management on behalf of shareholders, the board of directors may become insulated from shareholders and beholden to management.

Thus, one interpretation of proper financial management is that the agents are oriented toward the benefit of the principals - shareholders - in increasing their wealth by paying dividends and/ or causing the stock price or market value to increase.

Maximizing Market Value

The idea of maximizing market value is related to the idea of maximizing shareholder value, as market value is the price at which an asset would trade in a competitive auction setting; for example,

returning value to the shareholders if they decide to sell shares or if the firm decides to sell.

There are many different models of corporate governance around the world. These differ according to the variety of capitalism in which they are embedded. The Anglo-American (US and UK) "model" tends to emphasize the interests of shareholders.

The sole concentration on shareholder value has been widely criticized, particularly after the late-2000s financial crisis, where attention has risen to the concern that a management decision can maximize shareholder value while lowering the welfare of other stakeholders. Additionally, short-term focus on shareholder value can be detrimental to long-term shareholder value.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/goals-of-financial-management/ maximizing-shareholder-and-market-value/ CC-BY-SA

Boundless is an openly licensed educational resource

23

Maximizing Value without Harming Stakeholders A goal of financial management can be to maximize value without harming stakeholders, the diverse set of parties affected by the business.

KEY POINTS

• Stakeholders are those who are affected by an organization’s activities. The stakeholders can be internal or external to the firm and some will be involved directly in economic transactions with the business, while others will not.

• Owners, employees, customers, suppliers, trade unions, the government, local communities, and the environment can be considered stakeholders. Because of the potential breadth of the term, there are different views on whom to include in stakeholder considerations.

• Debate is ongoing about whether firms should be managed for shareholder value maximization or also with stakeholders in mind. While the Anglo-American "model" tends to emphasize shareholders, some European countries formally recognize other stakeholders in corporate governance decisions.

KEY POINTS (cont.)

• Some proponents of stakeholder considerations argue that attention to other stakeholders is intimately intertwined with market value and can enhance outcomes for all stakeholders. Others argue that value should be maximized without harming stakeholders.

Introduction

Professionals in financial management are concerned with the practical significance of the numbers that appear in financial documents. Given a set of information about certain financial behavior, they ask, what do the figures mean? There are several goals of financial management, one of which is maximizing value without harming shareholders.

The Stakeholder Concept

The stakeholder concept is associated with the concept of corporate governance. Corporate governance involves regulatory and market mechanisms and the relationships that exist between a company’s management, its board, its shareholders, other stakeholders, and the goals for which the corporation is governed. Stakeholders are those who are affected by an organization’s activities. The stakeholders can be internal, like owners or employees. They can also be external, like customers, suppliers, the government, local

24

communities, and the environment (Figure 1.10). Some stakeholders are involved directly in economic transactions with the business. Others are either affected by, or able to affect, an organization's actions without directly engaging in an economic exchange with the business (for example, trade unions, communities, activist groups, etc). Because of the breadth of the term stakeholder, there are different views as to whom should be included in stakeholder considerations.

Stakeholders vs. Shareholders

In the field of corporate governance and corporate responsibility, a major debate is currently occurring about whether a firm or company should make decisions chiefly to maximize value for shareholders, or if a company has obligations to other types of stakeholders. This increased after the financial crisis of the late 2000s, when concerns deepened about the potential of companies to lower the welfare of other stakeholders while maximizing their shareholder value. While the Anglo-American (US and UK) business "model" tends to emphasize the interests of shareholders over other implicated parties, some European countries formally recognize other stakeholders in corporate governance decisions.

Some people who argue that businesses should consider other stakeholders, like the government or the environment, argue that an attention to these types of stakeholders is intimately intwined

with market value. They also argue that a holistic view can enhance general outcomes for all the stakeholders that are involved. Still others argue that stakeholders, even if they are not considered in business decisions, should at the very least not suffer harm, and that businesses should maximize value only if they can do so without generating harm.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/goals-of-financial-management/ maximizing-value-without-harming-stakeholders/ CC-BY-SA

Boundless is an openly licensed educational resource

25

The environment can be seen as a stakeholder. Maximizing value without harming stakeholders is, for some, one of the goals of financial management.

Figure 1.10 Environment as stakeholder

Current Issues in Finance

Employment in Finance

Section 3

Trends and Issues in Finance

26

https://www.boundless.com/finance/introduction-to-the-field-and-goals-of-financial-management/trends-and-issues-in-finance/

Current Issues in Finance Current issues in finance include the economic and regulatory impacts of the financial crisis and the growth of new types of finance.

KEY POINTS

• The financial crisis of 2007–2008 caused the near-total collapse of many large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world.

• Following the financial crisis, various regulatory reforms were passed in the United States, and European regulators introduced Basel III regulations for banks.

• There are various growing areas of finance, including microfinance, crowdfunding, algorithmic trading, and impact investing.

Financial crisis and regulation

The financial crisis of 2007–2008 caused the near-total collapse of many large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The financial institution crisis hit its peak in late 2008. Several major institutions failed, were acquired under duress, or were subject to government takeover, including Lehman Brothers,

Citigroup, Fannie Mae, and Freddie Mac, among several others.The crisis rapidly developed and spread into global economic shock, resulting in a number of European bank failures, economic crises in Iceland, declines in various stock indexes, and large reductions in the market value of equities and commodities. A currency crisis followed, with investors transferring vast capital resources into stronger currencies. In many areas in the United States, the housing market also suffered, resulting in significant numbers of foreclosures. The crisis played a significant role in the failure of key businesses, declines in consumer wealth, prolonged unemployment, and a downturn in economic activity in the United States. It also led to a global recession and a sovereign debt crisis in Europe.

Critics of the financial crisis have argued that the regulatory framework did not keep pace with rapid innovation in financial markets and have asked for increased regulation and enforcement. Various regulatory reforms have been passed in the United States, and European regulators introduced Basel III regulations for banks.

Growing areas of business

Microfinance is the provision of a wide range of financial services, including savings accounts, to the poor. Microcredit is a part of microfinance and involves the extension of very small loans (microloans) to impoverished borrowers, often with the goal of supporting entrepreneurship and/or alleviating poverty.

27

Peer-to-peer lending over the Internet is another growing development in the financial sector, to which the principles of microcredit have also been applied in attempting to address poverty as well as various non-poverty-related issues. Such efforts include crowdfunding (Figure 1.11), a term describing the collective effort of individuals who network and pool their resources to support charities initiated by other people or organizations. The rules for crowdfunding are still being developed, and the Securities Exchange Commission has yet to set rules in place for equity crowdfunding campaigns involving unaccredited investors for private companies.

Algorithmic trading, now widely used by pension funds, mutual funds, and other institutional traders, is the use of electronic platforms to enter trading orders with an algorithm that calculates aspects such as timing, price, and quantity. Proponents have argued that algorithmic trading substantially improves market liquidity,while critics argue that this type of trading is opaque— a "black box"— and may contribute substantially to market volatility.

The growing field of impact investing refers to investments made based on the practice of assessing not only the financial return on an investment, but also its social and environmental impacts.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/trends-and-issues-in-finance/ current-issues-in-finance/ CC-BY-SA

Boundless is an openly licensed educational resource

28

One of the newer trends in finance is "crowdfunding."

Figure 1.11 Crowds

Employment in Finance The financial sector is a large field offering many different types of employment for a broad range of organizations that manage money.

KEY POINTS

• The financial sector is a large field offering many different types of employment. Financial services encompasses a broad range of organizations that manage money, including banks, credit unions, credit card companies, insurers, stock brokerages, and investment funds.

• Financial analysts may work for government investment funds, mutual fund companies, hedge funds, private equity investors, and investment banks. Similarly, credit analysts work in a variety of institutions to assess the creditworthiness of firms, governments, or individuals for loans.

• In insurance, there are insurance brokers and underwriters as well as actuaries and a host of other positions such as insurance claims investigators and agents. Intermediaries exist not just in the insurance business but also as stockbrokers that assist investors in buying and selling shares.

• Finance professionals may also work in public finance, for local or national governments, or in corporate finance. Growth in microfinance and microcredit has also opened up

KEY POINTS (cont.)

employment opportunities in small-unit finance both in the US and abroad.

• Sophisticated mathematical and technological developments have also advanced the field of quantitative analysis for those who work in investment management, risk management, derivatives pricing, algorithmic trading, and other area that require the application of mathematics in finance.

• Financial employees can come from a variety of backgrounds. Many financial analysis and management positions require some kind of training in finance, accounting, economics, mathematics, engineering, or another quantitative field.

The financial sector is a large field offering many different types of employment. Financial services encompasses a broad range of organizations that manage money, including banks, credit unions, credit card companies, insurers, consumer finance companies, stock brokerages, investment funds, some government sponsored enterprises, and other financial institutions, including peer-to-peer lending platforms.

In banking, employees may serve the range of roles needed to run banks, from tellers to financial planners and underwriters to wealth managers. Workers may be employed in a variety of functions by credit card issuers, such as customer service, foreign

29

exchange service, high-profile trading, and airport currency exchangers. Financial analysts may work for government investment funds, mutual fund companies, hedge funds, private equity investors, and investment banks. Credit analysts work in a variety of institutions to assess the creditworthiness of firms, governments, or individuals for loans. In insurance, there are insurance brokers and underwriters as well as actuaries and a host of other positions such as insurance claims investigators and agents.

Intermediaries exist not just in the insurance business. Stockbrokers, for instance, assist investors in buying and selling shares. There are also investors called venture capitalists and angel investors. Finance professionals may also work in public finance, for local or national governments, or in corporate finance.

Growth in microfinance and microcredit has also opened up employment opportunities in finance both in the US and abroad (Figure 1.12). Sophisticated mathematical and technological developments have also advanced the field of quantitative analysis for those who work in investment management, risk management, derivatives pricing, algorithmic trading, and other areas that require the application of mathematics in finance.

Financial employees can come from a variety of backgrounds. Many financial analysis and management positions require some kind

of training in finance, accounting, economics, mathematics, engineering, or another quantitative field. There are Masters degrees in Finance and Business as well as certifications such as the widely recognized Chartered Financial Analyst certification and accountancy qualifications such as the Certified Public Accountant.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/trends-and-issues-in-finance/ employment-in-finance/ CC-BY-SA

Boundless is an openly licensed educational resource

30

Muhammad Yunus is a banker who grew a field in microcredit and microfinance, opening up new types of financial employment.

Figure 1.12 Muhammad Yunus

Definition of Ethics

Moral Reasoning and Ethics

Culture and Ethics

Personal Values and Ethics

Blurring Ethical Lines

Section 4

Ethics, an Overview

31

https://www.boundless.com/finance/introduction-to-the-field-and-goals-of-financial-management/ethics-an-overview--2/

Definition of Ethics Ethics is a branch of philosophy concerned with the study of what is good and bad.

KEY POINTS

• Ethical behavior is based on written and unwritten codes of principles and values held in society.

• Ethical principles and values serve as a guide to behaviors on a personal level, within professions, and at the collective organizational level.

• Business ethics involves personal, professional, and corporate behaviors.

(Figure 1.13) Ethics is the branch of philosophy concerned with the meaning of all aspects of human behavior. Theoretical ethics, sometimes called normative ethics, is about discovering and delineating right from wrong; it is the consideration of how we develop the rules and principles (or norms) used to judge and guide meaningful decision-making. Theoretical ethics is supremely intellectual in character, and, being a branch of philosophy, is also rational in nature. Theoretical ethics is the rational reflection on what is right, what is wrong, what is just, what is unjust, what is good, and what is bad in terms of human behavior.

Business ethics (also corporate ethics) is a form of applied ethics or professional ethics that examines ethical principles and moral or ethical problems that arise in a business environment. It applies to all aspects of business conduct and is relevant to the conduct of individuals and entire organizations.

32

How do we develop the rules and principles to follow an ethical path?

Figure 1.13 This Way to Ethics

Business ethics can be thought of as written and unwritten codes of principles and values that govern decisions and actions within a company. In the business world, the organization’s culture sets standards for determining the difference between good and bad decision-making and behavior. In the most basic terms, a definition for business ethics boils down to knowing the difference between right and wrong and choosing to do what is right. The phrase 'business ethics' can be used to describe the actions of individuals within an organization or the organization as a whole.

There are three parts to the discipline of business ethics: personal, professional and corporate. All three are intricately related, and it is helpful to distinguish between them because each rests on slightly different assumptions. We are looking at business ethics through a trifocal lens: up close and personal, intermediate and professional, and on the grand scale (utilizing both farsighted and peripheral vision) of the corporation.

First and foremost, business executives are human beings; they seek meaning for their lives through relationships and enterprise, and they want their lives to amount to something. Because ethics is chiefly the discipline of meaning, the business executive (like all other human beings) is engaged in this discipline all the time, whether cognizant of it or not.

EXAMPLE

Corporate Social Responsibility is a form of ethical behavior that requires that organizations understand, identify, and eliminate unethical economic, environmental, and social behaviors.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/trends-and-issues-in-finance/ current-issues-in-finance/ CC-BY-SA

Boundless is an openly licensed educational resource

33

Moral Reasoning and Ethics Moral reasoning allows us to make good decisions even in the absence of good data, experience, or precedent.

KEY POINTS

• There are four components of moral behavior: moral sensitivity, moral judgment, moral motivation, and moral character.

• Moral reasoning is culturally defined.

• Studies have uncovered four skill sets that play a decisive role in the exercise of moral expertise: moral imagination, moral creativity, reasonableness, and perseverance.

(Figure 1.14) Ethical considerations are behind all business decisions. It's simply the nature of decision-making. Consider this idea:

• In most cases, when someone makes an economic decision, they could have chosen an alternate path;

• Whatever decision is made will affect other people;

• These decisions are grounded in a belief system that encompasses some form of basic values.

In an uncertain, complex, and always-changing world, people cannot always count on good data or precedent. Now it is increasingly important to have the ability to make "good" decisions with what information we currently have. Doing so requires the ability to choose what we know to be "good" or "right." Moral reasoning serves just this purpose.

34

I know what is right, but feel no inclination to follow it, I know what is wrong, but cannot desist from it.

Figure 1.14 To be Ethical or not to be...

An Overview of Moral Reasoning

Moral reasoning is a study in psychology that overlaps with philosophy. It is also called moral development. Prominent contributors to theory include Lawrence Kohlberg and Elliot Turiel.

Moral reasoning can be defined as the process in which an individual tries to determine the difference between what is right and what is wrong in a personal situation by using logic. This is an important and often daily process that people use in an attempt to do the right thing. Every day for instance, people are faced with the dilemma of whether to lie in a given situation. People make this decision by reasoning out the morality of this action and weighing that against its consequences.

The Role of Ethics in Moral Reasoning

Although all moral choices can be seen as personal choices, some choices can be seen as an economic choices.

When we talk about moral behavior we generally consider four components:

• Moral sensitivity, which is "the ability to see an ethical dilemma, including how our actions will affect others."

• Moral judgment, which is "the ability to reason correctly about what 'ought' to be done in a specific situation."

• Moral motivation, which is "a personal commitment to moral action, accepting responsibility for the outcome."

• Moral character, which is a "courageous persistence in spite of fatigue or temptations to take the easy way out."

Moral reasoning is concerned with how these issues are perceived by ordinary people, who collectively define it as a culture.

Why Study Moral Reasoning

Our actions stem from our thoughts, and such actions influence the lives of others. Unfortunately, we are not born with a "code of conduct."

The ability to make a choice, and to make a good choice, has powerful consequences. Our lives, and our effect on others, are governed by the decisions we make, and the consequences of our decisions are likely to be governed by the quality of the decisions we make. The ability to make good decisions - however we may end up defining "good" - will impact our lives, how we treat others, and how we are treated in return.

While we will often find ourselves lacking good information, and sometimes lacking in the ability to perceive pertinent facts, the ability to formulate good decisions with whatever information is available can enable us not to merely muddle through, but to intelligently choose the most effective road.

35

Moral Skill Set

Moral expertise is not reducible to knowing what constitutes good conduct and doing your best to bring it about. Realizing good conduct, being an effective moral agent, bringing value into the work, all require skills in addition to "goodwill." Studies have uncovered four skill sets that play a decisive role in the exercise of moral expertise.

• Moral imagination: The ability to project into the standpoint of others and view the situation at hand through their lenses. Moral imagination achieves a balance between becoming lost in the perspectives of others and failing to leave one's own perspective. Adam Smith terms this balance "proportionality" which we can achieve in empathy.

• Moral creativity: Moral creativity is closely related to moral imagination. But it centers in the ability to frame a situation in different ways.

• Reasonableness: Reasonableness balances openness to the views of others with commitment to moral values and other important goals. One is open but not to the extent of believing anything and failing to keep fundamental commitments.

• Perseverance: Perseverance is the "ability to plan moral action and continue on that course by responding to circumstances and obstacles while keeping ethical goals intact."

EXAMPLE

William LeMesseur designed the Citicorp Building in New York. When a student identified a critical design flaw in the building during a routine class exercise, LeMesseur responded, not by shooting the messenger, but by developing an intricate and effective plan for correcting the problem before it issued in drastic real world consequences.

Source: https://www.boundless.com/management/ethics-in-business/ ethics-an-overview--5/moral-reasoning-and-ethics--3/ CC-BY-SA

Boundless is an openly licensed educational resource

36

Culture and Ethics Different cultures hold different values, making it tough to make a singular "right" ethical choice.

KEY POINTS

• Culture is the outlook, attitudes, values, goals, and practices shared by a society.

• People can reflect the culture of their country, region, and/or subgroup.

• According to the theory of cultural relativism, there is no singular truth on which to base ethical or moral behavior, as our interpretations of truths are influenced by our own culture.

• Universalists don't agree with cultural relativism; they argue that while behavior may differ from culture to culture, these are surface differences supported by moral principles that are common across cultures.

Culture: An Introduction

Culture describes people's 'way of life,' meaning the way they do things. It is the outlook, attitudes, values, goals, and practices shared by a society. Different groups of people may have different cultures.

Culture is more than just material goods, or the things the culture uses and produces. Culture is also the beliefs and values of the people in that culture. It includes the way people think about and understand the world and their own lives (Figure 1.15).

37

They may differ, but wherever you go, you'll find cultural values.

Figure 1.15 Cultural Map of the World

Culture can also vary within a region, society, or subgroup. A workplace may have a specific culture that sets it apart from similar workplaces. A region of a country may have a different culture than the rest of the country.

Companies or other organizations (groups of people) can have a separate culture. Japanese manufacturing companies often have a different culture than other companies; the workday starts with exercise, and the workers are very loyal to the company. Software and computer companies sometimes allow employees to play games during the workday, or take time off work to relax, because these companies believe that this will help the workers to think better.

Culture's Influence on Ethics in Business

Today's global companies allow people to work with others from different parts of the world, as employees, managers, and colleagues. This is only one way that the variety of cultures might be increased. Employees may bring customs and traditions from home countries and home businesses to the global office.

Cultural norms are the shared, sanctioned, and integrated systems of beliefs and practices that are passed down through generations and characterize a cultural group. Norms cultivate reliable guidelines for daily living and contribute to the health and well- being of a culture. They act as prescriptions for correct and moral behavior, lend meaning and coherence to life, and provide a means

to achieve a sense of integrity, safety, and belonging. These normative beliefs, together with related cultural values and rituals, present a sense of order and control upon aspects of life that might otherwise appear chaotic or unpredictable.

This is where culture intersects ethics. When one has to make an ethical decision, they do so through the lens of their culture. What happens when one culture says a practice is ethical and another says it isn't?

Cultural Relativism

Cultural Relativism focuses on this issue. It states there is no singular truth on which to base ethical or moral behavior, as our interpretations of truths are influenced by our own culture.

Along with moral relativism, it holds the position that there is no absolute or universal set of values or principles that can be used to judge human behavior. It differs from moral relativism in that it situates moral behavior as being relative to (conforming with) a learned set of cultural norms, rather than being relative to the actions of the individual. In this sense it considers moral behavior to be historically and contextually situated.

Cultural relativism is a normative ethical position rather than a prescriptive one. That is, rather than prescribing what ought to be done in a specific situation, it describes the way people behave in that situation.

38

The basis for cultural relativism is the observation that different cultures have different sets of norms and values that govern behavior in their cultural. This is in contrast to universalism, which holds the position that moral values are the same for everyone. Cultural relativists consider this to be an ethnocentric view as the universal set of values proposed by universalists are based on their set of values. Cultural relativism is also considered to be more tolerant than universalism because, if there is no basis for making moral judgments between cultures, then cultures have to be tolerant of each other.

Cultural relativism has been criticized for its focus on behavior. For example, universalists argue that while behavior may differ from culture to culture, these are surface differences supported by moral principles that are common across cultures. Companies that try to create a common code of conduct across all of their locations are in a sense operating under the view that a universal set of values do indeed exist.

EXAMPLE

The French and Americans have different views on whistle- blowing. Compared to the French, American companies consider it to be a natural part of business. So natural, in fact, that they set up anonymous hotlines. The French, on the other hand, view whistle-blowing as undermining solidarity amongst co-workers and deplore such procedures.

Source: https://www.boundless.com/management/ethics-in-business/ ethics-an-overview--5/culture-and-ethics--3/ CC-BY-SA

Boundless is an openly licensed educational resource

39

Personal Values and Ethics Employees can more easily make ethical decisions that promote a company's values and goals when their personal values match the company's norms.

KEY POINTS

• Personal values provide an internal reference for what is good, beneficial, important, useful, beautiful, desirable, and constructive.

• Over time the public expression of personal values lay the foundations of law, custom and tradition.

• Values are obtained from one's family, school, and religion.

An Introduction to Personal Values

Personal values provide an internal reference for what is good, beneficial, important, useful, beautiful, desirable, and constructive.

Values generate behavior and help solve common human problems of survival by comparative rankings of value, the results of which provide answers to questions of why people do what they do.

Wyatt Woodsmall points out that “criteria" are used to refer to "the standards on which an evaluation is based." Values relate then to

what one wants and in what order one wants them. To this point, criteria acts as a comparative standard to evaluate whether goals and values have been met.

Over time the public expression of personal values lay the foundations of law, custom, and tradition. Personal values in this way exist in relation to cultural values, either in agreement with or divergent from prevailing norms.

Without personal values, there would be no cultural reference against which to measure the virtue of individual values. As a consequence, cultural identity would disintegrate.

The Formation of Personal Values

Values are obtained in many different ways:

• The most important place for building values is a person's family. The family is responsible for teaching children what

40

Personal values are learned at an early age.

Figure 1.16 Forming Personal Values

is right and wrong long before there are other influences. It is thus said that a child is a reflection of his or her parents.

• As a child starts school, teachers and classmates help shape the values of children.

• Religion also plays a role in teaching children values (Figure 1.16).

According to Shivam Sharma, values are formed during three significant periods:

1. Imprint period from birth – 7 years.

2. Modelling period from 8 – 13 years.

3. Socialization period from 13 – 21 years.

Personal Values and Ethics in Business

Employers do their best to hire individuals who are a good fit, meaning that they match well with the organization's norms. Still, people are not clones. They come into an organization with the personal values they obtained from their family, school, and religion. A conflict can occur when an employee has to make an ethical decision if their personal values do not match the organization's norms.

The employee may not openly express their divergent view, but their resistance to the norms of the organization can still surface in subtle ways. And like a cancer, their stance can spread throughout the organization, causing negativity and dysfunction.

As in a family where the saying "parents know best" prevails, employees should remember that their decisions need to be based on the organization's norms and not their own personal values if the business is to run successfully.

EXAMPLE

If you value equal rights for all and you go to work for an organization that treats its managers much better than it does its workers, you may form the attitude that the company is an unfair place to work; consequently, you may not produce well or may perhaps leave the company. It is likely that if the company had a more egalitarian policy, your attitude and behaviors would have been more positive.

Source: https://www.boundless.com/management/ethics-in-business/ ethics-an-overview--5/personal-values-and-ethics--3/ CC-BY-SA

Boundless is an openly licensed educational resource

41

Blurring Ethical Lines There is no clear guideline for enforcing ethics within an organization; it is up to a company to establish an ethical code its employees can uphold.

KEY POINTS

• Defining business ethics is hard because unlike laws, which are written down and usually predictable in application, ethics are norms that have evolved from our religious and cultural heritage and are interpreted endlessly.

• It is the duty of a leader to commit to high ethical standards.

• As there are many ethical gray areas, it is often difficult to make ethical decisions in certain situations.

Blurring Ethical Lines

There are many different instances where a business was caught committing acts that were less than ethical. There are times when a business practice is widespread and the government needs to step in and change regulations. The Sarbanes–Oxley Act of 2002 reformed accounting practices after a series of business accounting scandals. The 2000's housing crisis is often blamed on the relaxation of federal regulations that allowed banks to enact questionable business practices.

Large corporations often have the stigma of focusing on profits instead of people. While not every business commits unethical acts, the ones that have been caught can make the general public believe this negative image. This is one reason why understanding business ethics is an important part of the curriculum in many business colleges.

So why is it that some businesses and individuals commit acts that are seemingly unethical? It isn't because they lack a clear idea of right or wrong; rather, it's because ethics itself is full of gray areas and people often have the ability to justify such questionable behavior.

When Ego Takes Control

A study by Professor Robert Prentice suggests that self-image can influence an individual's decision-making process, making him or her feel justified in taking short cuts or doing things that are questionable ethically. In addition, there are times when people believe that the ends justify the means. In other words, if the result of an action is good, then it is okay if the action itself is unethical.

There is a saying that a good person is one who does good deeds when no one is looking. The same goes with ethical decisions. People who are ethical follow their beliefs even when they believe no one will find out about what they have done. As with the case of the accounting practices, those who committed the discrepancies

42

believed that they wouldn't be discovered. Others thought that if the issues were discovered, the actions wouldn't be traced back to them. They had the opportunity to be ethical but chose not to be.

Business Ethics Around the Globe

Social norms aren't identical in different countries. When businesses from the United States and other countries with strong ethics establish operations in less ethical countries, conflicts often arise. There are countries where offering bribes to obtain necessary permits is common practice. If a company has a policy of not bribing political officials, how will employees obtain the necessary documents? In addition, how will employees of these foreign

countries function working for a company with such different policies?

While business ethics is an important issue, there is no clear guideline for creating and enforcing ethics within an organization. It is up to a company and its stakeholders to establish an ethical code its employees can uphold (Figure 1.17).

EXAMPLE

American companies are often criticized for the treatment of workers who produce their products in China. However, rules concerning the rights of workers are much more relaxed in China than in the United States. Does an American company have the right to order a factory in China to change their way of doing business? That is one example of an ethical gray area in today's globalized economy.

Source: https://www.boundless.com/management/ethics-in-business/ ethics-an-overview--5/blurring-ethical-lines--3/ CC-BY-SA

Boundless is an openly licensed educational resource

43

Ethical decisions are not always clear cut.

Figure 1.17 This Way to Ethics

Overview of Organizational Structure

Sole Proprietorship: Pros and Cons

Partnership: Pros and Cons

Corporation: Pros and Cons

Section 5

Business Organization Types

44

https://www.boundless.com/finance/introduction-to-the-field-and-goals-of-financial-management/business-organization-types/

Overview of Organizational Structure Business organizations can be structured in various ways, both as legal entities and in terms of internal management processes.

KEY POINTS

• From a legal structure perspective, many business structures require a form of incorporation to register the business as a legal entity. The business entity’s type, its geographic span of operations, risk profile, and other factors are issues to consider when choosing what entity type to use.

• There are various forms of organizational structures from a corporate law perspective, including sole proprietorships, cooperatives, partnerships, limited liability companies, and corporations.

• One of the issues dividing the different organizational structures is that of liability. With sole proprietorships and some forms of partnership, owners can be personally liable for business losses, meaning their personal assets are not protected against the claims of creditors.

• Internally, organizations can also be structured differently, in terms of the groupings of organizational relationships and the characteristics of management. Some common structures are

KEY POINTS (cont.)

the functional, divisional, matrix, team, network, and modular structures.

• Independent from their legal and internal structures, organizations can also operate differently. For example, hybrid organizations, which may fall under various legal categories, can mix elements, value systems and logics of action from the private, public, and voluntary sectors.

45

Businesses and the military are similar in that they typically rely on some form of hierarchical organization.

Figure 1.18 Military organizational chart

Organizational Structure

Business organizations can be structured in various ways, depending on their standing as legal entities, internal structure, and management processes (Figure 1.18).

Pre-bureaucratic structures

Pre-bureaucratic (entrepreneurial) structures lack standardization of tasks. This structure is most common in smaller organizations and is best used to solve simple tasks. The structure is totally centralized and appears like a hierarchy. The strategic leader makes all key decisions and most communication is done by one-on-one conversations. It is particularly useful for new (entrepreneurial) business as it enables the founder to control growth and development.

Bureaucratic structures

Weber said that the fully developed bureaucratic mechanism compares with other organizations exactly as does the machine compare with the non-mechanical modes of production. Precision, speed, unambiguity…strict subordination, reduction of friction and of material and personal costs are raised to the optimum point in the strictly bureaucratic administration. Bureaucratic structures

have a certain degree of standardization. They are better suited for more complex or larger scale organizations, usually adopting a tall structure. The tension between bureaucratic structures and non- bureaucratic is echoed in Burns and Stalker's distinction between mechanistic and organic structures.

Functional structure

Employees within the functional divisions of an organization tend to perform a specialized set of tasks; for instance, the engineering department is staffed only with software engineers. This leads to operational efficiencies within that group. However, it could also lead to a lack of communication between the functional groups within an organization, making the organization slow and inflexible. As a whole, a functional organization is best suited as a producer of standardized goods and services at large volume and low cost.

Divisional structure

Also called a "product structure," the divisional structure groups each organizational function into a division. Each division within a divisional structure contains all the necessary resources and functions within it. Divisions can be categorized by different points of view. One might make distinctions on a geographical basis (a US division and an EU division, for example) or on product/service

46

basis (different products for different customers, households, or companies). In another example, an automobile company with a divisional structure might have one division for SUVs, another division for subcompact cars, and another for sedans.

Matrix structure

The matrix structure groups employees by both function and product. This structure can combine the best of both separate structures. A matrix organization frequently uses teams of employees to accomplish work, in order to take advantage of strengths and make up for weaknesses of functional and decentralized forms. An example would be a company that produces two products, "product a" and "product b." Using the matrix structure, this company would organize functions within the company as follows: "product a" sales department, "product a" customer service department, "product a" accounting department, "product b" sales department, "product b" customer service department, "product b" accounting department. Matrix structure is amongst the purest of organizational structures – a simple lattice emulating order and regularity demonstrated in nature.

Legal considerations

In the US and elsewhere, many business structures require a form

of incorporation to register the business as a legal entity. The owner files articles of incorporation with the secretary of state’s office for the particular jurisdiction. The organization may also hold meetings, select a board of directors, adopt bylaws, and report on a regular basis. The business entity’s type, its geographic span of operations, risk profile, and other factors are issues to consider when choosing what entity type to use, in what jurisdiction to incorporate, how the articles should be drafted, and if a stock form should be used.

Business perspective

There are various forms of organizational structures from a business perspective, including sole proprietorships, cooperatives, partnerships, limited liability companies, and corporations. All of these structures are for profit, but there are also non-profit corporations and other structures. The differences in structures can depend on the number of entrepreneurs or owners involved, and the different tax treatments. One of the issues dividing forms is that of liability. With sole proprietorships and some forms of partnership, owners can be personally liable for business losses, meaning their personal assets are not protected against the claims of creditors. These organizational structures are also not separate entities from the owners/entrepreneurs, unlike a corporation.

47

Organizational behavior

Internally, organizations can also be structured differently, in terms of the groupings of organizational relationships and the characteristics of management. Some common structures are the functional, divisional, matrix, team, network, and modular structures.

Independent from their legal and internal structures, organizations can also behave differently. For example, hybrid organizations, which may fall under various legal categories, can mix elements, value systems, and logics of action from the private, public, and voluntary sectors.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/business-organization-types/ overview-of-organizational-structure/ CC-BY-SA

Boundless is an openly licensed educational resource

Sole Proprietorship: Pros and Cons The sole proprietorship structure has the benefit of simplicity and control but the drawback of unlimited liability.

KEY POINTS

• The sole proprietorship is a type of business structure open to businesses run and owned by one entrepreneur.

• A large advantage of the sole proprietorship structure is its ease. The sole proprietorship structure does not require filing of articles of incorporation, regular meetings, or election of a board. A sole proprietor also files taxes as personal income.

• The other side of this process is the structure’s main disadvantage: there is no separation between the entrepreneur and the business. This means the sole proprietor is personally liable for business losses. Also, if the proprietor dies, the business ceases to exist.

Overview of Business Structures

Business organizations can be structured in two major ways, namely, in terms of their structures as legal entities and also in

48

terms of the internal structure and management processes. The sole proprietorship is one type of business structure from a legal status perspective. It is a structure open to businesses run and owned by one entrepreneur (Figure 1.19).

Sole Proprietorship: Pros and Cons

A large advantage of the sole proprietorship structure is its ease of filing incorporation and tax documents as well as having uninterrupted control of the business. The sole proprietorship is one type of business structure in the US that does not require formal incorporation, meaning that sole proprietors do not need to formally file articles of incorporation, hold regular meetings, or elect an advising or directing board. This simplicity is also reflected

in tax treatment, as a sole proprietor files taxes as personal income. Sole proprietors also have control over the aspects of their business without the involvement of elected board members.

On the flip side, the sole proprietorship has one main disadvantage: there is no separation between the entrepreneur and the business. With sole proprietorships, like some forms of partnership, owners can be personally liable for business losses, meaning their personal assets are not protected against the claims of creditors. The sole proprietorship is not a separate entity from the owner/ entrepreneur, unlike a corporation. As a result, if the proprietor dies, the business ceases to exist. Because the enterprise rests exclusively on one person, it often has difficulty raising long-term capital.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/business-organization-types/sole- proprietorship-pros-and-cons/ CC-BY-SA

Boundless is an openly licensed educational resource

49

Small businesses (mom and pop shops, in layman's terms) such as this local market are most often structured as a sole proprietorship.

Figure 1.19 Sole Proprietorship

Partnership: Pros and Cons The partnership structure has the benefit of simplicity and control but the drawback of personal liability for the partnership’s activities.

KEY POINTS

• The partnership is a type of business structure open to businesses run and owned by two or more entrepreneurs.

• A large advantage of the partnership structure is its ease, in terms of filing and tax treatment. A general partnership can be started with no special formalities. The partners are taxed individually on their share of the partnership's profits.

• The structure’s main disadvantage is that partnership owners can be personally liable for business losses. The partnership is not a separate entity from the owners/entrepreneurs, unlike a corporation.

• Types of partnership beyond the general partnership have developed to mitigate some of the disadvantages of the structure. Limited partnerships and limited liability partnerships are two examples.

Business Organization Types

Business organizations can be structured in various ways, in terms of their structures as legal entities and also in terms of the internal

structure and management processes. The partnership is one type of business structure. The partnership is the next simplest business structure after the sole proprietorship. Because sole proprietors can only have one owner, the partnership is the simplest structure open to collaborative ownership (Figure 1.20).

Partnership: Pros and Cons

A large advantage of the partnership structure is its ease in filing and tax treatment. With a general partnership, two or more people can start a business as co-owners with no special formalities, directly controlling the partnership and making binding decisions with a simple majority vote. The partners are taxed individually on their share of the partnership's profits. By default, profits are

50

The partnership is the simplest structure open to collaborative ownership.

Figure 1.20 Partnership

shared equally among the partners. However, a partnership agreement will almost invariably expressly provide for the manner in which profits and losses are to be shared.

The structure’s main disadvantage is similar to the sole proprietorship. Owners can be personally liable for business losses in some forms of partnership, meaning their personal assets are not protected against the claims of creditors. The partnership is not a separate entity from the owners/entrepreneurs, unlike a corporation. This means that the partnership structure is only as good as the partnership at the relational level. If the mutual consent to form a partnership breaks down, the partnership breaks down as well; partnerships are considered to be an aggregate of their partners rather than a separate entity.

There has been debate in most states as to whether a partnership should remain aggregate or be allowed to become a business entity with a separate continuing legal personality. Types of partnership beyond the general partnership have developed to mitigate some of the disadvantages of the structure. Limited partnerships allow limited liability for some partners who have no management authority, and in some cases (depending on the jurisdiction) limited liability partnerships provide for limited liability for all partners.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/business-organization-types/ partnership-pros-and-cons/ CC-BY-SA

Boundless is an openly licensed educational resource

51

Corporation: Pros and Cons The corporate structure is less simple to found and maintain but has the advantages of limited liability and perpetual life.

KEY POINTS

• Compared to sole proprietorships and partnerships, the corporation is more complicated to found and maintain, one of its disadvantages. The incorporator must file articles of incorporation as well as hold an organizational meeting to elect a board of directors.

• The structure also generally requires the maintenance of at least annual reporting, including annual financial statements and other data.

• One of the most favorable advantages of the corporate structure is the protection of personal assets of stockholders, directors, and officers. They are limited in liability to the amount they have invested in the corporation.

• Also, because the corporation is an entity separate from its owners, ownership is easily transferable. Similarly, the corporation does not cease to exist with the death of shareholders, directors, or officers of the corporation.

Business organizations can be structured in various ways, in terms of their structures as legal entities and also in terms of the internal structure and management processes. The corporation is one type of business structure. (Figure 1.21)

Corporation: Cons

Compared to other business structures, such as sole proprietorships and partnerships, the corporation is less simple to found and maintain, one of its disadvantages. The incorporator must file articles of incorporation with the secretary of state’s office in the state in which it will be incorporated, as well as hold an organizational meeting to elect a board of directors. The structure also generally requires the maintenance of at least annual reporting. In many jurisdictions corporations, whose shareholders benefit from limited liability, are required to publish annual financial statements and other data, so that creditors who do business with the corporation are able to assess the creditworthiness of the corporation and cannot enforce claims against shareholders. Shareholders, therefore, experience some loss of privacy in return for limited liability.

52

One of the world's largest companies by revenue, it is structured as a corporation.

Figure 1.21 Exxon Mobil Corporation

Corporation: Pros

One of the most favorable advantages of the corporate structure is the protection of personal assets: stockholders, directors, and officers of a corporation are typically not liable for the company's debts and obligations. They are limited in liability to the amount they have invested in the corporation. This limited liability also makes financing more attractive from a risk perspective. Also, because the corporation is an entity separate from its owners, ownership is easily transferable. Similarly, the corporation does not cease to exist with the death of shareholders, directors, or officers of the corporation.

Another benefit of the corporate structure is that, in the United States, corporations are generally taxed at a lower rate than are individuals.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/business-organization-types/ corporation-pros-and-cons/ CC-BY-SA

Boundless is an openly licensed educational resource

53

What is Corporate Governance

Sarbanes-Oxley

Section 6

Corporate Governance

54

https://www.boundless.com/finance/introduction-to-the-field-and-goals-of-financial-management/corporate-governance/

What is Corporate Governance Corporate governance is the system by which companies are directed and controlled.

KEY POINTS

• In contemporary business corporations, the main external stakeholder groups are shareholders, debt holders, trade creditors, suppliers, customers, and communities affected by the corporation's activities. Internal stakeholders are the board of directors, executives, and other employees.

• Ways of mitigating or preventing these conflicts of interests include the processes, customs, policies, laws, and institutions which have impact on the way a company is controlled.

• A related but separate thread of discussion focuses on the impact of a corporate governance system on economic efficiency, with a strong emphasis on shareholders' welfare.

• Principles of corporate governance include rights and equitable treatment of shareholders, interests of other stakeholders, role and responsibilities of the board, integrity and ethical behavior, and disclosure and transparency.

What is Corporate Governance?

Corporate governance is the system by which companies are directed and controlled. It involves regulatory and market mechanisms; the roles and relationships between a company’s management, its board, its shareholders, and other stakeholders; and the goals for which the corporation is governed. In contemporary business corporations, the main external stakeholder groups are shareholders, debt holders, trade creditors, suppliers, customers, and communities affected by the corporation's activities. Internal stakeholders are the board of directors, executives, and other employees (Figure 1.22).

Much of the contemporary interest in corporate governance is concerned with mitigation of the conflicts of interests between

55

Corporate governance deals with the conflicts of interests in a company.

Figure 1.22 Redesigning corporate governance

stakeholders. Ways of mitigating or preventing these conflicts of interests include the processes, customs, policies, laws, and institutions which have impact on the way a company is controlled. An important theme of corporate governance is the nature and extent of accountability of people in the business.

A related but separate thread of discussion focuses on the impact of a corporate governance system on economic efficiency, with a strong emphasis on shareholders' welfare. In large firms where there is a separation of ownership and management and no controlling shareholder, the principal–agent issue arises between upper-management (the "agent") which may have very different interests, and by definition considerably more information, than shareholders (the "principals"). Rather than overseeing management on behalf of shareholders, the board of directors may become insulated from shareholders and beholden to management. This aspect is particularly present in contemporary public debates and developments in regulatory policy.

Principles Of Corporate Governance

Contemporary discussions of corporate governance tend to refer to principles raised in three documents released since 1990: The Cadbury Report (UK, 1992), the Principles of Corporate Governance (OECD, 1998 and 2004), the Sarbanes-Oxley Act of 2002 (US, 2002). The Cadbury and OECD reports present general principals

around which businesses are expected to operate to assure proper governance. The Sarbanes-Oxley Act, informally referred to as Sarbox or Sox, is an attempt by the federal government in the United States to legislate several of the principles recommended in the Cadbury and OECD reports.

Rights and Equitable Treatment Of Shareholders

Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by openly and effectively communicating information and by encouraging shareholders to participate in general meetings.

Interests Of Other Stakeholders

Organizations should recognize that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders, such as employees, investors, creditors, suppliers, local communities, customers, and policy makers.

Role and Responsibilities Of the Board

The board needs sufficient relevant skills and understanding to review and challenge management performance. It also needs adequate size and appropriate levels of independence and commitment.

56

Integrity and Ethical Behavior

Integrity should be a fundamental requirement in choosing corporate officers and board members. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making.

Disclosure and Transparency

Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide stakeholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company's financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information.

Codes and Guidelines

Corporate governance principles and codes have been developed in different countries and issued from stock exchanges, corporations, institutional investors, or associations (institutes) of directors and managers with the support of governments and international organizations. As a rule, compliance with these governance recommendations is not mandated by law, although the codes linked to stock exchange listing requirements may have a coercive effect.

One of the most influential guidelines has been the OECD Principles of Corporate Governance—published in 1999 and revised in 2004. The OECD guidelines are often referenced by countries developing local codes or guidelines. Building on the work of the OECD, other international organizations, private sector associations, and more than 20 national corporate governance codes formed the United Nations Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR) to produce their Guidance on Good Practices in Corporate Governance Disclosure. This internationally agreed benchmark consists of more than fifty distinct disclosure items across five broad categories:

1. Auditing

2. Board and management structure and process

3. Corporate responsibility and compliance

4. Financial transparency and information disclosure

5. Ownership structure and exercise of control rights

Most codes are largely voluntary. An issue raised in the U.S. since the 2005 Disney decision is the degree to which companies manage their governance responsibilities. In other words, do they merely try

57

to supersede the legal threshold? Or should they create governance guidelines that ascend to the level of best practice?

EXAMPLE

For example, companies quoted on the London, Toronto, and Australian Stock Exchanges formally need not follow the recommendations of their respective codes. However, they must disclose whether they follow the recommendations in those documents and, where not, they should provide explanations concerning divergent practices. Such disclosure requirements exert a significant pressure on listed companies for compliance.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/corporate-governance/what-is- corporate-governance/ CC-BY-SA

Boundless is an openly licensed educational resource

Sarbanes-Oxley The Sarbanes–Oxley Act is a US federal law enhancing standards for all US public company boards, management and public accounting firms.

KEY POINTS

• As a result of SOX, top management must now individually certify the accuracy of financial information.

• SOX increased the independence of outside auditors who review the accuracy of corporate financial statements, and increased the oversight role of boards of directors.

• SOX was enacted as a reaction to a number of major corporate and accounting scandals.

• The Sarbanes–Oxley Act includes Auditor Independence, Corporate Responsibility, Enhanced Financial Disclosures, Analyst Conflicts of Interest, Commission Resources and Authority, Corporate and Criminal Fraud Accountability, Corporate Tax Returns, and Corporate Fraud Accountability.

The Sarbanes–Oxley Act

The Sarbanes–Oxley Act of 2002 is a United States federal law that set new or enhanced standards for all U.S. public company boards, management and public accounting firms. The act is also known as the "Public Company Accounting Reform and Investor Protection

58

Act" (in the Senate) and "Corporate and Auditing Accountability and Responsibility Act" (in the House). It's more commonly called Sarbanes–Oxley, Sarbox or SOX; it is named after sponsors U.S. Senator Paul Sarbanes (D-MD) and U.S. Representative Michael G. Oxley (R-OH). As a result of SOX, top management must now individually certify the accuracy of financial information. In addition, penalties for fraudulent financial activity are much more severe. Also, SOX increased the oversight role of boards of directors while also increasing the independence of outside auditors who review the accuracy of corporate financial statements. (Figure 1.23)

The bill was enacted as a reaction to major corporate and accounting scandals affecting Enron, Tyco International and others.

These scandals, which cost investors billions of dollars, shook public confidence in the nation's securities markets.

Debate continues over the perceived benefits and costs of SOX. Opponents of the bill claim it has reduced America's international competitive edge against foreign financial service providers, saying it introduced an overly complex regulatory environment into U.S. financial markets. Proponents of the measure say that SOX has improved the confidence of fund managers and other investors with regard to the veracity of corporate financial statements.

Public Company Accounting Oversight Board (PCAOB)

Title I consists of nine sections and establishes the Public Company Accounting Oversight Board, providing independent oversight of public accounting firms. It also creates a central oversight board tasked with registering auditors, defining the specific processes for compliance audits, inspecting conduct and quality control, and enforcing compliance.

Auditor Independence

Title II consists of nine sections and establishes standards for external auditor independence. It also addresses new auditor approval requirements, audit partner rotation and auditor

59

SOX is a United States federal law that set new or enhanced standards for all U.S. public company boards, management and public accounting firms.

Figure 1.23 Sarbanes- Oxley Act

reporting requirements. It restricts auditing companies from providing non-audit services (e.g., consulting) for the same clients.

Corporate Responsibility

Title III consists of eight sections mandating that senior executives take individual responsibility for the accuracy and completeness of corporate financial reports. It defines the interaction of external auditors and corporate audit committees, and specifies the responsibility of corporate officers for the accuracy and validity of corporate financial reports.

Enhanced Financial Disclosures

Title IV consists of nine sections. It describes enhanced reporting requirements for financial transactions, including off-balance- sheet transactions, pro-forma figures and stock transactions of corporate officers. It requires internal controls for assuring the accuracy of financial reports and disclosures, and mandates both audits and reports on those controls.

Analyst Conflicts of Interest

Title V consists of only one section, which includes measures designed to help restore investor confidence in reporting of

securities analysts. It defines the codes of conduct for securities analysts and requires disclosure of knowable conflicts of interest.

Commission Resources and Authority

Title VI consists of four sections and defines practices to restore investor confidence in securities analysts. It also defines the SEC's authority to censure securities professionals from practice and defines conditions under which a person can be barred from practicing as a broker, advisor, or dealer.

Studies and Reports

Title VII consists of five sections and requires the Comptroller General and the SEC to perform various studies and report their findings. Studies include the effects of consolidation of public accounting firms and role of credit rating agencies in the operation of securities markets.

Corporate and Criminal Fraud Accountability

Title VIII consists of seven sections and is also referred to as the "Corporate and Criminal Fraud Accountability Act of 2002." It describes specific criminal penalties for manipulation, destruction or alteration of financial records, or other interference with

60

investigations, while also providing certain protections for whistleblowers.

White Collar Crime Penalty Enhancement

Title IX consists of six sections. This section increases the criminal penalties associated with white-collar crimes and conspiracies. It recommends stronger sentencing guidelines and specifically adds failure to certify corporate financial reports as a criminal offense.

Corporate Tax Returns

Title X consists of one section. Section 1001 states that the Chief Executive Officer should sign the company tax return.

Corporate Fraud Accountability

Title XI consists of seven sections. Section 1101 recommends a name for this title as "Corporate Fraud Accountability Act of 2002." It identifies corporate fraud and records tampering as criminal offenses and joins those offenses to specific penalties. It also revises sentencing guidelines and strengthens their penalties.

EXAMPLE

Section 302 requires that the company's "principal officers" (typically the Chief Executive Officer and Chief Financial Officer) certify and approve the integrity of their company financial reports quarterly.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/corporate-governance/sarbanes- oxley/ CC-BY-SA

Boundless is an openly licensed educational resource

61

Defining Agency Conflicts

Managers, Shareholders, and Bondholders

Managers Conflicts with Shareholders

Shareholders Conflicts with Bondholders

Section 7

Agency and Conflicts of Interest

62

https://www.boundless.com/finance/introduction-to-the-field-and-goals-of-financial-management/agency-and-conflicts-of-interest/

Defining Agency Conflicts Agency conflicts can occur when the incentives of the agent do not align with those of the principal.

KEY POINTS

• The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders’ interests. Control systems in corporate governance can help align managers' incentives with those of shareholders and other stakeholders.

• The principal–agent problem concerns the difficulties in motivating one party (the "agent"), to act on behalf of another (the "principal"). The two parties have different interests and asymmetric information. Moral hazard and conflict of interest may thus arise.

• The deviation from the principal's interest by the agent is called "agency costs." Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control, and the different objectives (rather than shareholder maximization) of the managers.

The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders’ (and other parties’) interests. Partly as a result of this separation, corporate governance mechanisms include a system of

controls intended to help align managers' incentives with those of shareholders and other stakeholders.

The principal–agent problem or agency dilemma, developed in economic theory, concerns the difficulties in motivating one party (the "agent"), to act on behalf of another (the "principal"). The two parties have different interests and asymmetric information (the agent having more information), such that the principal cannot directly ensure that the agents are always acting in its (the principals') best interests, particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe. Moral hazard and conflict of interest (COI) may thus arise (Figure 1. 24).

63

Principal-agent problems - which arise when managers act on the behalf of a firm and its investors - include potential conflicts of interest.

Figure 1.24 Conflict of Interest

The deviation from the principal's interest by the agent is called "agency costs." Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control, and the different objectives (rather than shareholder maximization) of the managers. When a firm has debt, conflicts of interest can also arise between stockholders and bondholders, leading to agency costs on the firm. Examples of agency costs include that borne by shareholders (the principal), when corporate management (the agent) buys other companies to expand its power instead of maximizing the value of the corporation's worth; or by the constituents of a politician's district (the principal) when the politician (the agent) passes legislation helpful to large contributors to their campaign rather than helpful to voters.

Much of the contemporary interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. A conflict of interest occurs when an individual or organization is involved in multiple interests that may lead to conflicts in their ability to act in the best interest of one party. In addition to conflicts of interest between managers, shareholders, and bondholders, conflicts of interest can also occur among other stakeholders of a company, such as the board of directors, employees, government, suppliers, and customers. COI is sometimes termed "competition of interest" rather than "conflict", emphasizing a connotation of natural competition between valid

interests rather than violent conflict. At other times, conflicts of interest are confused with cases that might better be termed "corruption", such as bribe-taking or fraud.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/agency-and-conflicts-of-interest/ defining-agency-conflicts/ CC-BY-SA

Boundless is an openly licensed educational resource

64

Managers, Shareholders, and Bondholders Three parties key to the corporation's functioning are managers, shareholders, and bondholders, each of which can have different interests.

KEY POINTS

• Three parties key to the functioning of the corporation are the managers, shareholders, and bondholders. While managers control the corporation and make strategic decisions, shareholders are owners, and bondholders are creditors.

• While all three parties have an interest, whether direct or indirect, in the financial performance of the corporation, each of the three parties has different rights and rewards, for example voting rights and forms of financial return.

• Shareholders, managers, and bondholders have different objectives. For example, shareholders have an incentive to take riskier projects than bondholders do and may prefer that the company pay more out in dividends. Managers may also be shareholders or prefer risk-averse, empire-building projects.

The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in

shareholders’ and other stakeholders’ interests. Partly as a result of this separation, corporate governance mechanisms include a system of controls intended to help align managers' incentives with those of shareholders and other stakeholders.

The deviation from the principal's interest by the agent is called 'agency costs.' Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control and the different objectives of the managers and other stakeholders. Three parties key to the functioning of the corporation are the managers, shareholders, and bondholders (Figure 1.25). These three parties have different interests and asymmetric information, such that the principals cannot directly ensure that the agents are always acting in its (the principals') best interests. Moral hazard and conflict of interest may arise.

65

Business involves a complex network of interests of managers, shareholders, and bondholders.

Figure 1.25 Three Businessmen Discussing a Document

While managers control the corporation and make strategic decisions, shareholders are owners, and bondholders are creditors. While all three parties have an interest, whether direct or indirect, in the financial performance of the corporation, each of the three parties has different rights and rewards, for example voting rights and forms of financial return. Shareholders, managers, and bondholders have different objectives. For example, stockholders have an incentive to take riskier projects than bondholders do, as bondholders are more interested in strategies that will increase the chances of getting their investment back. Shareholders also prefer that the company pay more out in dividends than bondholders would like. Managers may also be shareholders and reap the profits of more risky strategies or may prefer risk-averse empire-building projects.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/agency-and-conflicts-of-interest/ managers-shareholders-and-bondholders/ CC-BY-SA

Boundless is an openly licensed educational resource

Managers Conflicts with Shareholders Agency costs mainly occur when ownership is separated, or when managers have objectives other than shareholder value maximization.

KEY POINTS

• The agency view of the corporation suggests that the decision rights of the corporation should be entrusted to a manager to act in shareholders’ interests. Agency costs mainly occur when ownership is separated, or when managers have objectives other than shareholder value maximization.

• Typically, the CEO and other top executives are responsible for making decisions about high-level policy and strategy. Shareholders, on the other hand, are individuals or institutions that legally own shares of corporation stock. Shareholders typically concede control rights to managers.

• There are various conflicts of interest that can impact manager’s decisions to act in shareholders’ interests. Management may, for example, buy other companies to expand power. Venturing onto fraud, they may even manipulate financial figures to optimize bonuses and stock- price-related options.

66

KEY POINTS (cont.)

• Contemporary discussions of corporate governance argue that corporations should respect the rights of shareholders and help shareholders to exercise those rights. Disclosure and transparency are intimately intertwined with these goals.

The "agency view" of corporations argues that the decisions rights (or control) of a corporation should be entrusted to a manager, so that the manager can act in the interest of shareholders (Figure 1.26). Partly as a result of this, mechanisms of corporate governance include a system of controls that are intended to align the incentives of managers with those of shareholders.

The term "agency costs" refers to instances when an agent's behavior has deviated

from a principal's interest. In this case, the principal would be the shareholder. These types of costs mainly arise because of contracting costs, or because individual managers might only possess partial control of corporation behavior. They also arise when managers have personal objectives that are different from the goal of maximizing shareholder profit.

Typically, the CEO and other top executives are responsible for making decisions about high-level policy and strategy. Shareholders, on the other hand, are individuals or institutions that legally own shares of stock in a corporation. Typically, these people have the right to sell those shares, to vote on directors nominated by various boards, and many other privileges. This being said, shareholders usually concede most of their control rights to managers.

While attempting to benefit shareholders, managers often encounter conflicts of interest. For example, a manager might engage in self-dealing, entering into transactions that benefit themselves over shareholders. Managers might also purchase other companies to expand individual power, or spend money on wasteful pet projects, instead of working to maximize the value of corporation stock. Venturing onto fraud, they may even manipulate financial figures to optimize bonuses and stock-price-related benefits.

67

These two businessmen could represent a manager and shareholder discussing the operation of the business.

Figure 1.26 Two Businessmen Having a Discussion

The chief goal of current corporate governance is to eliminate instances when shareholders have conflicts of interest with one another. Another important goal is to evaluate whether a corporate governance system hampers or improves the efficiency of an organization. Research of this type is particularly focused on how corporate governance impacts the welfare of shareholders. After the high-profile collapse of a number of large corporations in the past two decades, several of which involved accounting fraud, there has been a renewed public interest in how modern corporations practice governance, particularly regarding accounting.

Advocates of governance typically encourage corporations to respect shareholder rights, and to help shareholders learn how and where to exercise those rights. Disclosure and transparency are intertwined with these goals.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/agency-and-conflicts-of-interest/ managers-conflicts-with-shareholders/ CC-BY-SA

Boundless is an openly licensed educational resource

Shareholders Conflicts with Bondholders The shareholders and bondholders have different rights and returns, leading to potential conflicts of interest.

KEY POINTS

• The shareholders are individuals or institutions that legally own shares of stock in the corporation, while the bondholders are the firm’s creditors. The two parties have different relationships to the company, accompanied by different rights and financial returns.

• Stockholders have an incentive to take riskier projects than bondholders do. Other conflicts of interest can stem from the fact that bonds often have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely but can also be sold at any point.

• Bondholders may put contracts in place prohibiting management from taking on very risky projects or may raise the interest rate demanded, increasing the cost of capital for the company. Conversely, shareholder preferences—for example for riskier growth strategies—can adversely impact bondholders.

68

The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager (the agent) to act in the principals’ interests.

The deviation from the principals’ interests by the agent is called 'agency costs', which are often described as existing between managers and shareholders; but conflicts of interest can also exist between shareholders and bondholders.

The shareholders are individuals or institutions that legally own shares of stock in the corporation, while the bondholders are the firm’s creditors. The two parties have different relationships to the company, accompanied by different rights and financial returns. For example, stockholders have an incentive to take riskier projects than bondholders do (Figure 1.27), as bondholders are more interested in strategies that will increase the chances of getting their investment back. Shareholders also prefer that the company pay more out in dividends than bondholders would like. Shareholders have voting rights at general meetings, while bondholders do not. If there is no profit, the shareholder does not receive a dividend, while interest is paid to debenture-holders regardless of whether or not a profit has been made. Other conflicts of interest can stem from the fact that bonds often have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely but can also be sold at any point.

Because bondholders know this, they may create ex-ante contracts prohibiting the management from taking on very risky projects that might arise, or they may raise the interest rate demanded, increasing the cost of capital for the company. For example, loan covenants can be put in place to control the risk profile of a loan, requiring the borrower to fulfill certain conditions or forbidding the borrower from undertaking certain actions as a condition of the loan. This can negatively impact the shareholders. Conversely,

69

The bull on Wall Street is an iconic image of the New York Stock Exchange.

Figure 1.27 Wall Street bull

shareholder preferences—as for example riskier strategies for growth—can adversely impact bondholders.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/agency-and-conflicts-of-interest/ shareholders-conflicts-with-bondholders/ CC-BY-SA

Boundless is an openly licensed educational resource

70

Cash

Debt

Stocks

Section 8

Asset Classes

71

https://www.boundless.com/finance/introduction-to-the-field-and-goals-of-financial-management/asset-classes/

Cash Cash, the most liquid asset, refers to physical currency such as banknotes and coins.

KEY POINTS

• Cash refers to physical currency such as banknotes and coins.

• Cash has now become a very small part of the money supply.

• A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand.

• Cash and cash equivalents are the most liquid assets found within the asset portion of a company's balance sheet.

Cash

In common language, cash refers to physical currency such as banknotes and coins. (Figure 1.28)

In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately (as in the case of money market accounts). Cash is viewed either as a reserve for payments, in case of a structural or incidental negative cash flow, or as a way to avoid a downturn in financial markets.

Cash has now become a very small part of the money supply. Its remaining role is to provide a form of currency storage and payment for those who do not wish to take part in other systems, and prefer to make small payments conveniently and promptly. This latter method, however, is being replaced more and more frequently by electronic payment systems.

A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods and they acquire buildings and equipment. In other words, because businesses have assets, they cannot immediately turn them into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. This means that businesses also have liabilities. Cash and cash equivalents can be used to pay the short-term debt of a company.

72

Cash is the most liquid asset within a business.

Figure 1.28 Cash

Cash and cash equivalents

Cash and cash equivalents are the most liquid assets found within the asset portion of a company's balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or treasury bills, marketable securities, and commercial paper. Cash equivalents are distinguished from other investments through their short-term existence; they mature within 3 months, whereas short-term investments take 12 months or less and long-term investments take longer than 12 months. Cash equivalent investments should also have an insignificant risk of change in value: for example, common stock cannot be considered a cash equivalent, but preferred stock acquired shortly before its redemption date can.

Money

Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socioeconomic context or country. The main functions of money can be defined as follows: a medium of exchange; a unit of account; a store of value; and occasionally, in the past, a standard of deferred payment. Any kind of object or secure verifiable record that fulfills these functions can serve as money.

Banknote

A banknote (often known as a bill, paper money, or simply a note) is a type of negotiable instrument known as a promissory note, made by a bank, payable to the bearer on demand. When banknotes were first introduced, they were, in effect, a promise to pay the bearer in coins, but gradually became a substitute for the coins and a form of money in their own right.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/asset-classes/cash/ CC-BY-SA

Boundless is an openly licensed educational resource

73

Debt A debt is an obligation owed by one party (the debtor) to a second party (the creditor).

KEY POINTS

• A debt is created when a creditor agrees to lend a sum of assets to a debtor. Debt is usually granted with expected repayment.

• The various types of debt can generally be categorized into: 1) secured and unsecured debt, 2) private and public debt, 3) syndicated and bilateral debt, and 4) other types of debt that display one or more of the characteristics noted above.

• Debt allows people and organizations to do things that they would otherwise not be able, or allowed, to do.

Debt

A debt is an obligation owed by one party (the debtor) to a second party (the creditor). Debt usually refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.

A debt is created when a creditor agrees to lend a sum of assets to a debtor. Debt is usually granted with expected repayment. In

modern society, this typically includes repayment of the original sum, plus interest.

In finance, debt is a means of using anticipated future purchasing power in the present before it has actually been earned. Some companies and corporations use debt as a part of their overall corporate finance strategy.

Debt allows people and organizations to do things that they would otherwise not be able, or allowed, to do. People in industrialized nations commonly use it to purchase houses, cars, and many other things too expensive to buy with cash on hand. Companies also use debt in many ways to leverage the investment made in their assets, by "leveraging" the return on their equity. This leverage, the proportion of debt to equity, is considered important in determining the riskiness of an investment—the more debt per equity, the riskier. For both companies and individuals, this increased risk can lead to poor results, as the cost of servicing the debt can grow beyond the ability to pay due to either external events (income loss) or internal difficulties (poor management of resources).

Types of debt

A company uses various kinds of debt to finance its operations. The various types of debt can generally be categorized into:

74

1) secured and unsecured debt

A debt obligation is considered secured if creditors have recourse to the assets of the company on a proprietary basis or otherwise ahead of general claims against the company. Unsecured debt comprises financial obligations, where creditors do not have recourse to the assets of the borrower to satisfy their claims.

2) private and public debt

Private debt involves bank-loan type obligations, whether senior or mezzanine. Public debt is a general definition covering all the financial instruments that are freely tradeable on a public exchange or over the counter, with few if any restrictions.

3) syndicated and bilateral debt

A syndicated loan is a loan that is granted to companies that wish to borrow more money than any single lender is prepared to risk in a single loan, an amount usually in the many millions of dollars. In such a case, a syndicate of banks can each agree to put forward a portion of the principal sum. Loan syndication is a risk management tool that allows the lead banks underwriting the debt to reduce their risk and free up lending capacity.

4) other types of debt

A bond is a debt security issued by certain institutions such as companies and governments. A bond entitles the holder to repayment of the principal sum, plus interest. Bonds are issued to investors in a marketplace when an institution wishes to borrow money. Bonds have a fixed lifetime, usually a number of years. Some long-term bonds, can last over 30 years, though they are less common. At the end of the bond's life the money should be repaid in full. Interest may be added to the end payment or can be paid in regular installments (known as coupons) during the life of the bond.

75

Treasury bills are one of the debts issued by governments.

Figure 1.29 T-bill

Bonds may be traded in the bond markets and are widely used as relatively safe investments in comparison to equity.

Borrowing and repayment arrangements linked to inflation-indexed units of account are possible and are used in some countries. For example, the US government issues two types of inflation-indexed bonds, Treasury Inflation-Protected Securities (TIPS) and I-bonds. Inflation-indexed debt is one of the safest forms of investment available, since the only major source of risk – that of inflation – is eliminated. A number of other governments issue similar bonds, with some doing so for many years before the US government. In countries with consistently high inflation, ordinary borrowings at banks may also be inflation indexed. (Figure 1.29)

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/asset-classes/debt/ CC-BY-SA

Boundless is an openly licensed educational resource

Stocks The capital stock (or stock) of a business entity represents the original capital paid into or invested in the business by its founders.

KEY POINTS

• The capital stock (or stock) of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors.

• Stock typically takes the form of shares of either common stock or preferred stock.

• As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions; Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders.

• In general, the shares of a company may be transferred from shareholders to other parties by sale or other mechanisms, unless prohibited.

76

Stock

The capital stock (or stock) of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is different from the property and the assets of a business which may fluctuate in quantity and value.

The stock of a business is divided into multiple shares, the total of which must be stated at the time of business formation. Given the total amount of money invested in the business, a share has a certain declared face value, commonly known as the par value of a share. The par value is the de minimis (minimum) amount of money that a business may issue and sell shares for in many jurisdictions and it is the value represented as capital in the accounting of the business. In other jurisdictions, however, shares may not have an associated par value at all. Such stock is often called non-par stock. Shares represent a fraction of ownership in a business. A business may declare different types (classes) of shares, each having distinctive ownership rules, privileges, or share values.

Types of stock

Stock typically takes the form of shares of either common stock or preferred stock.

• As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions.

• Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders.

• Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually any time after a predetermined date. Shares of such stock are called "convertible preferred shares".

New equity issues may have specific legal clauses attached that differentiate them from previous issues of the issuer. Some shares of common stock may be issued without the typical voting rights, for instance, or some shares may have special rights unique to them and issued only to certain parties. Often, new issues that have not been registered with a securities governing body may be restricted from resale for certain periods of time.

Preferred stock may be hybrid by having the qualities of bonds of fixed returns and common stock voting rights. They also have preference in the payment of dividends over common stock and also have been given preference at the time of liquidation over common stock. They have other features of accumulation in

77

dividend. In addition, preferred stock usually comes with a letter designation at the end of the security. This extra letter does not mean that any exclusive rights exist for the shareholders but it does let investors know that the shares are considered for such, however, these rights or privileges may change based on the decisions made by the underlying company.

Application

The owners of a private company may want additional capital to invest in new projects within the company. They may also simply wish to reduce their holding, freeing up capital for their own private use. They can achieve these goals by selling shares in the company to the general public, through a sale on a stock exchange. This process is called an initial public offering, or IPO.

By selling shares they can sell part or all of the company to many part-owners. The purchase of one share entitles the owner of that share to literally share in the ownership of the company, a fraction of the decision-making power, and potentially a fraction of the profits, which the company may issue as dividends.

Trading

In general, the shares of a company may be transferred from shareholders to other parties by sale or other mechanisms, unless prohibited. Most jurisdictions have established laws and regulations

governing such transfers, particularly if the issuer is a publicly traded entity.

The desire of stockholders to trade their shares has led to the establishment of stock exchanges, organizations which provide marketplaces for trading shares and other derivatives and financial products. Today, stock traders are usually

represented by a stockbroker who buys and sells shares of a wide range of companies on such exchanges. A company may list its shares on an exchange by meeting and maintaining the listing requirements of a particular stock exchange. In the United States, through the intermarket trading system, stocks listed on one exchange can often also be traded on other participating exchanges, including electronic communication networks (ECNs), such as Archipelago or Instinet (Figure 1.30).

78

The price of a stock fluctuates fundamentally due to the theory of supply and demand.

Figure 1.30 Stock price

EXAMPLE

Preferred stock usually comes with a letter designation at the end of the security; for example, Berkshire-Hathaway Class "B" shares sell under stock ticker BRK.B whereas Class "A" shares of ORION DHC, Inc will sell under ticker OODHA until the company drops the "A" creating ticker OODH for its "Common" shares only designation.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/asset-classes/stocks/ CC-BY-SA

Boundless is an openly licensed educational resource

79

Types of Financial Markets

Role in Capital Allocation

Role in Providing Feedback to Management

Trends in Markets

Section 9

Financial Markets

80

https://www.boundless.com/finance/introduction-to-the-field-and-goals-of-financial-management/financial-markets/

Types of Financial Markets Financial markets are of many types, including general and specialized; capital and money; and primary and secondary.

KEY POINTS

• A financial market is an aggregate of possible buyers and sellers of financial securities, commodities, and other fungible items, as well as the transactions between them.

• The term "financial markets" is often used to refer solely to the markets that are used to raise finance: for long-term finance, capital markets are used; for short-term finance (maturity up to one year), money markets are used.

• Stock markets and bond markets are two types of capital markets that provide financing through the issuing of shares of stock or the issuing of bonds, respectively. A key division within the capital markets is between the primary markets and secondary markets.

• While capital markets and money markets constitute the narrower definition of financial markets, other markets, such as derivatives and currency markets, are often included in the more general sense of the word.

A financial market is an aggregate of possible buyers and sellers of financial securities, commodities, and other fungible items, as well

as the transactions between them. Examples of financial markets include capital markets, derivative markets, money markets, and currency markets. There are many different ways to divide and classify financial markets: for example, into general markets and specialized markets, capital markets and money markets, and primary and secondary markets.

Within the financial sector, the term "financial markets" is often used to refer solely to the markets that are used to raise finance:

• for long-term finance, capital markets are used

• for short-term finance (maturity up to one year), money markets are used.

Stock markets (Figure 1.31) and bond markets are two types of capital markets that provide financing through the issuing of shares of stock and the issuing of bonds, respectively. A key division within the capital markets is between the primary markets and secondary

81

The New York Stock Exchange (NYSE) is an exchange enabling a financial market.

Figure 1.31 The New York Stock Exchange

markets. Newly formed (issued) securities are bought or sold in primary markets, such as during initial public offerings. Secondary markets are for the secondary trade of securities, providing a continuous and regular market for the buying and selling of securities.

While capital markets and money markets constitute the narrower definition of financial markets, other markets are often included in the more general sense of the word. The derivatives market is the financial market for derivatives— financial instruments like futures contracts or options— which are derived from other forms of assets. Currency markets, enabled by foreign exchange (or forex) markets enable currency conversion and determine the relative value of world currencies.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/financial-markets/types-of- financial-markets/ CC-BY-SA

Boundless is an openly licensed educational resource

Role in Capital Allocation One of the main functions of financial markets is to allocate capital, matching those who have capital to those who need it.

KEY POINTS

• One of the main functions of financial markets is to allocate capital. Capital markets especially facilitate the raising of capital while money markets facilitate the transfer of liquidity, in both cases matching those who have capital to those who need it.

• Financial markets attract funds from investors and channel them to enterprises that use that capital to finance their operations and achieve growth, from startup phases to expansion—even much later in the firm’s life.

• Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Bank deposits are a simple way in which capital is allocated from a pool of savers to businesses that want to deploy it.

• More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing instruments can be resold. One example being a stock exchange.

82

Introduction

A financial market is an aggregate of possible buyers and sellers of financial securities, commodities, and other fungible items and the transactions between them (Figure 1.32). Within the financial sector, the term "financial markets" is often used to refer just to the markets that are used to raise finance: the capital markets for long- term finance and the money markets for short-term finance (maturity up to one year).

Allocating Capital

One of the main functions of financial markets is to allocate capital. Capital markets especially facilitate the raising of capital while money markets facilitate the transfer of liquidity, matching those who have capital to those who need it. Financial markets attract

funds from investors and channel them to enterprises that use that capital to finance their operations and achieve growth, from start- up phases to expansion—even much later in the firm’s life. Money markets allow firms to borrow funds on a short-term basis, while capital markets allow corporations to gain long-term funding to support expansion.

Funds borrowed from the money markets are typically used for general operating expenses, to cover brief periods of illiquidity. When a company borrows from the primary capital markets, often the purpose is to invest in additional physical capital goods, which will be used to help increase its income. Financial capital is money used by entrepreneurs and businesses to buy what they need to make their products or provide their services. It can take many months or years before the investment generates sufficient return to pay back its cost, and hence the finance is long-term. Long-term capital can come in the form of shared capital, mortgage loans, and venture capital, among other types.

Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Banks take deposits from those who have money to save. Many individuals are not aware that they are lenders providing capital, but many do lend money at least indirectly, for example when they put money in a savings account or contribute to a

83

The Frankfurt Bond Market is an example of a financial market that allocates capital.

Figure 1.32 Frankfurt Bond Market

pension. Intermediaries like banks can then lend money from this pool of deposited money in the form of loans to those who seek to borrow. More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. One example is the stock exchange, where a company can raise money by selling ownership shares to investors and its existing shares can be bought or sold.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/financial-markets/role-in- capital-allocation/ CC-BY-SA

Boundless is an openly licensed educational resource

Role in Providing Feedback to Management Financial markets can provide feedback to management by showing signals of the demand to supply funds to that enterprise.

KEY POINTS

• Financial markets function through the interaction of buyers and sellers that determine the price of traded assets. Financial markets provide a sign for the allocation of funds in the economy based on the demand and supply through the mechanism called the price discovery process.

• Management often has imperfect information about its own business. One way in which managers try to gain feedback on their business is by conducting market research. Financial markets can also provide feedback.

• These various audiences can provide feedback to management, such as when the stock price rises or declines. However, given that the stock market is prone to oscillation, this feedback can vary in its usefulness for managers making decisions.

84

Market Role in Providing Feedback to Management

Management often has imperfect information about its own business, especially its business’ value in the outside world (Figure 1.33). One way in which managers try to gain feedback on their business is by conducting market research to discover what people want, need, or believe. Once that research is completed, it can be used to determine how to market various products.

Financial markets can also provide feedback, demonstrating how potential shareholders view the financial value of one company as compared to its competitors. For example, investors who hold shares in multiple firms in a sector may have more information about the prospects in that sector than the manager of one firm in

that sector. In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other, creating an imbalance of power. Financial economists have applied information asymmetry in studies of differentially informed financial market participants (insiders, stock analysts, investors, among others).

These various audiences can provide feedback to management, such as when the stock price rises or declines. That said, the stock market is an example of a system prone to oscillation. It is governed by positive and negative feedback resulting from the cognitive and emotional factors among market participants. This may be the result of data-based fundamental analysis or more sentiment- based analysis, meaning that the feedback from the stock market can vary in its usefulness for mangers making short-term and long- term decisions.

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/financial-markets/role-in- providing-feedback-to-management/ CC-BY-SA

Boundless is an openly licensed educational resource

85

Here a group may be providing feedback to management. This can be done at a much larger scale today.

Figure 1.33 Feedback to Management

Trends in Markets A market trend is a putative tendency of a financial market to move in a particular direction over time.

KEY POINTS

• The terms bull market and bear market describe upward and downward market trends, respectively, and can be used to describe either the market as a whole or specific sectors and securities.

• A secular market trend is a long-term trend that lasts 5 to 25 years and consists of a series of primary trends.

• A primary trend has broad support throughout the entire market and lasts for a year or more.

Trends in Markets

A market trend is a putative tendency of a financial market to move in a particular direction over time. These trends are classified as secular for long-term frames, primary for medium-term frames, and secondary for short-term frames. Traders identify market trends using technical analysis, a framework which characterizes market trends as predictable price tendencies when price reaches support and resistance levels, varying over time.

The terms bull market and bear market describe upward and downward market trends, respectively, and can be used to describe either the market as a whole or specific sectors and securities (Figure 1.34).

Secular Market Trend

A secular market trend is a long-term trend that lasts 5 to 25 years and consists of a series of primary trends. A secular bear market consists of smaller bull markets and larger bear markets, while a secular bull market consists of larger bull markets and smaller bear markets.

In a secular bull market, the prevailing trend is "bullish" or upward- moving. The United States stock market was described as being in a

86

The bull and bear represent the two major forms of market trend.

Figure 1.34 Bull and Bear.

secular bull market from about 1983 to 2000, with brief upsets including the crash of 1987 and the dot-com bust of 2000 to 2002.

In a secular bear market, the prevailing trend is "bearish" or downward-moving. An example of a secular bear market was seen in gold during the period between January 1980 to June 1999, culminating with the Brown Bottom. During this period, the nominal gold price fell from a high of $850/oz ($30/g) to a low of $253/oz ($9/g), and became part of the Great Commodities Depression.

Primary Market Trend

A primary trend has broad support throughout the entire market and lasts for a year or more.

Bull Market

A bull market is associated with increasing investor confidence, and increased investing in anticipation of future price increases. A bullish trend in the stock market often begins before the general economy shows clear signs of recovery.

Bear Market

A bear market is a general decline in the stock market over a period of time. It is a transition from high investor optimism to widespread investor fear and pessimism. According to The Vanguard Group,

"While there’s no agreed-upon definition of a bear market, one generally accepted measure is a price decline of 20% or more over at least a two-month period."

Market Top

A market top (or market high) is usually not a dramatic event. The market has simply reached the highest point that it will for some time. A decline then follows, usually gradually at first and later with more rapidity. William J. O'Neil and company reported that since the 1950s, a market top is characterized by three to five distribution days in a major market index occurring within a relatively short period of time. Distribution is a decline in price with higher volume than the preceding session.

Market Bottom

A market bottom is a trend reversal, the end of a market downturn, and precedes the beginning of an upward moving trend (bull market).

It is very difficult to identify a bottom while it is occurring. The upturn following a decline is often short-lived and prices might resume their decline. This would bring a loss for the investor who purchased stock during a misperceived or "false" market bottom.

87

Source: https://www.boundless.com/finance/introduction-to-the-field- and-goals-of-financial-management/financial-markets/trends-in- markets/ CC-BY-SA

Boundless is an openly licensed educational resource

88