Financial Management Challenges

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Chapter 1

A Financial Model of the Corporation

Ge�y Images News/Ge�y Images

Learning Objectives

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

Understand the importance of corporate finance in professional and everyday life. Iden�fy how products, bonds, stock, and people factor into the opera�on of corpora�ons. Describe the financial balance sheet, and understand its significance to corporate ac�vity and decision making. Explain the financial goal of the corpora�on and how it is achieved. Describe how informa�on asymmetry and the agency problem pose challenges to corpora�ons. Compare other forms of business organiza�on with corpora�ons, and describe the benefits and drawback of each.

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Ch. 1 Introduction

Chapter 1 is an overview of corporate finance and provides you with important building blocks for the rest of your study of finance. The first sec�on of the chapter describes why finance is an important part of your business educa�on and why the corpora�on was chosen as the vehicle for studying finance. Next, some important features of corporate products, bonds, and stocks are discussed, along with characteris�cs of the people whose ac�ons affect corpora�ons. A model of the corpora�on, called the financial balance sheet, is presented in the third sec�on of the chapter. This model is the centerpiece of Chapter 1 and is designed to assist you in visualizing the financial concepts and decisions that you will study throughout this book. The fourth sec�on covers the financial goal of the corpora�on—shareholder wealth maximiza�on. Some of the problems encountered by corpora�ons in a�aining this goal and the effec�veness of corpora�ons as a means of crea�ng wealth are also covered in this sec�on of the chapter. The influence of society, markets, and government on corpora�ons' ac�vi�es are introduced in the concluding sec�on of the chapter.

Throughout the book are exercises and features to help the readers understand the key concepts of managerial finance. These include:

In Focus Videos. These short videos are at the start of each chapter and cover some of the main points in each chapter, specifically focusing on the Financial Balance Sheet. Field Trips. Found throughout the book, these feature boxes have web links to give students a chance to visit related sites to help exemplify concepts and ideas. Applying Finance. Found throughout the book, these feature boxes provide exercises for students to prac�ce key skills related to managerial finance. PowerPoint® Slideshows. Found near the end of chapters, these features help students review key topics covered. Pre and Post Tests. These non-graded self-assessment quizzes are to help students review what points they know and what they need more work on. Cri�cal thinking ques�ons that guide readers in their analysis of topics explored in the chapters. Key terms lists that define the key terms discussed in each chapter. Click on any term in the book's Key Terms sec�on to see the defini�on. Web resources that present readers with addi�onal resources that expand on topics discussed in the chapters.

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Financial management involves planning, forecas�ng, analysis and evalua�on, as well as understanding legal and regulatory issues. Throughout this text, we will explore the crucial role financial managers play in achieving a firm's financial success.

Finance plays a pivotal role in many aspects of life. How do you think an educa�on in corporate finance will benefit the choices you make in your personal life?

Radius/SuperStock

1.1 Why Corporate Finance?

Soon you may be deciding whether to rent or buy a home and whether to invest your savings in the stock market or cer�ficates of deposit. You may be choosing what type and amount of life insurance coverage you should purchase to protect your family. At work you may find that making a sale depends on your ability to show that your product is a cost-effec�ve investment for your customer. You may be asked to structure a contract that ensures that all par�es to the agreement are properly compensated and mo�vated. Key elements of all these decisions are financial in nature.

The skills and intui�on you will be developing through your study of finance are cri�cal for making decisions throughout your life. Our aim in this textbook is to enhance your financial reasoning ability.

Much of finance may already be familiar to you. The theories, tools, and concepts covered in this text will simply add a coherent structure to the intui�on you have developed through experience. From your day-to-day ac�vi�es as a consumer, employee, and student, you possess a large part of the intui�on upon which financial theory is based.

Developing financial intui�on by understanding the underlying theory will give you a founda�on for dealing with many problems. The alterna�ve is memorizing specific facts that can become obsolete or will not prepare you for a rapidly changing financial environment. For example, in the 1980s, adjustable rate mortgages and money market accounts were new financial products, and in the 1990s, mortgage-backed securi�es, hedge funds, and exchange traded funds either didn't exist or were brand new. Developing intui�on and understanding the underlying economic theory of finance gives you the flexibility to deal with new, unusual problems as they emerge.

As a vehicle for learning the principles of finance, this text focuses on the corpora�on. Other choices were available. Examples are public finance, which studies how governments raise and disburse funds, and personal finance, which concentrates on individual financial decisions like shopping for life insurance and personal inves�ng. Corporate finance was chosen for several reasons. First, many of you will be, or currently are, working for corpora�ons. Understanding key financial considera�ons in corporate decision making will aid in advancing your career regardless of your posi�on. Second, as an individual, you will be making personal investment decisions. Corporate securi�es, such as stocks and bonds, make up a large propor�on of the investment opportuni�es you will have. And last, the same financial approach to problems used in corporate finance is also properly used to make personal, partnership, or public financial decisions. In effect, you are ge�ng the most "bang for your buck" by studying corporate finance.

Role of Financial Management

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The classic logo of McDonald's is easily recognizable even in a remote region of China. McDonald's reputa�on is so renowned that it is popular throughout the world.

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1.2 Corporations: Products, Bonds, Stocks, and People

This book focuses on corpora�ons. Corpora�ons are associated with the products they produce and the securi�es they issue. For example, we know that Pepsi produces so� drinks and Boeing manufactures airplanes. The stocks and bonds of these firms are discussed on a daily basis in the media and are closely followed by a large segment of the popula�on.

The goods and services produced by corpora�ons are almost endless in their diversity. Each corpora�on a�empts to match its exper�se with consumers' needs in order to produce successful products. Thus, ConAgra Foods processes and sells a variety of agricultural products. General Electric makes and sells refrigerators, radios, and aircra� engines. Yamaha sells motorcycles as well as pianos. Some�mes a corpora�on's primary products are not what they may first appear to be. McDonald's sells hamburgers, but they also sell uniform quality and service. Why has McDonald's been successful? Is it because their hamburgers are superior or because consumers know what to expect when they enter any McDonald's? McDonald's, we could argue, is successful not because they perceived a need for more hamburgers, but because they sa�sfy a need for a fast, affordable, uniform hamburger, consistently delivered in a clean environment.

Good product decisions are rewarding. Consumers benefit as their needs and wants are met. Employees are rewarded with con�nued employment and job security. Communi�es in which the corpora�on is located benefit from a strong economic base. Investors who hold corporate securi�es are also rewarded. Stocks and bonds represent the overwhelming majority of these securi�es. The money made by corpora�ons is distributed to owners of these securi�es, the stockholders and bondholders, providing them with returns on their holdings.

Bonds represent loans made by investors to the corpora�on. Thus, bonds are a form of corporate debt. The firm is obligated to pay its bondholders a fixed series of payments un�l the bonds mature. These payments, generally made semiannually, are called coupon payments. At maturity, the corpora�on must repay the bondholder the face amount, or par value, of the bond, usually $1,000. For example, a bond may have a $1,000 face value and a 6% annual coupon rate, make payments semiannually, and mature in 20 years. This bond represents the corpora�on's promise to pay the bondholder 40 coupon payments (one every 6 months) of $30 each. At the end of the 20-year period, the bond matures and is returned to the issuing corpora�on. The corpora�on then repays the $1,000 face value along with the last $30 coupon. Note that although we are highligh�ng bonds, one should not forget that other forms of borrowing are also available to the corpora�on, such as loans from banks. The ability of the corpora�on to meet these obliga�ons hinges on its success in making and selling

products or services.

Corporate common stock represents an equity or ownership interest in the firm. If a corpora�on has 100 shares of common stock outstanding, then an owner of 1 share owns 1% of that corpora�on, and one holding 10 shares of this stock owns 10% of the corpora�on. Stockholders receive payments from the corpora�on in the form of dividends, usually paid quarterly. Dividends, unlike coupon interest payments on bonds, are not fixed. Dividends may be raised, lowered, or not paid at all at the discre�on of the corpora�on. Amazon is a large and well-known corpora�on that has never paid a dividend. General Motors paid dividends since 1922, but suspended its dividend payment in 2008.

As owners, common stockholders elect a board of directors. Each share of common stock en�tles its holder to vote for directors at the corpora�on's annual shareholders' mee�ng. Because most shareholders of large corpora�ons do not a�end these annual mee�ngs, most vote through the proxy process, similar to the absentee-ballot system used in governmental elec�ons. The board of directors governs the corpora�on on behalf of the shareholders, determining the dividends to be paid that year, hiring and firing top management, approving corporate strategic decisions, and making compensa�on decisions.

Corporate finance is, in large part, the study of the interac�on between products, stocks, bonds, and the people who make decisions affec�ng them. Microso� Corpora�on is an excellent example of this interplay. Microso�'s Windows program is pervasive, and millions of investors own shares of the corpora�on's stock. Bill Gates provided the entrepreneurial vision for the company and is now a face as recognizable as the president's.

Finance, therefore, includes the study of investors, managers, corporate directors, consumers, and corporate employees. One assump�on underlying finance is that people act in their own self-interest. This is considered to be economically ra�onal behavior. It does not pretend to explain the complexity of human behavior, but it does allow us to explain how people are likely to behave when making financial decisions and market transac�ons. They buy stocks and bonds to increase their wealth. People work to make a living; some people desire power and pres�ge. People make product purchases to fulfill needs and desires. Some may boyco�, strike, vote, or pe��on because they perceive injus�ce. In corporate finance, it is important to recognize that the self-interest of individuals mo�vates their ac�ons.

People also are assumed to act ra�onally. Ra�onality means that people will, by and large, make the correct decisions that lead toward fulfilling their self- interest. Departures from ra�onality are eventually corrected by the compe��ve marketplace. Compe��on exists when many individuals are seeking to achieve the same personal goals (in finance, that goal would be increasing wealth). For example, we seldom see money lying on the sidewalk, although it is occasionally dropped. The reason is that many people are interested in increasing their wealth, and the ra�onal thing to do is to pick up the money!Processing math: 0%

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The le�-hand side of the financial balance sheet deals with investments made by the corpora�on, including tangible and intangible assets.

1.3 The Financial Balance Sheet

The authors of this text have a�empted to make it interes�ng and useful to you. We have also tried to make your job easier. Whenever possible, we illustrate key concepts and theories with easily understood examples. Further, these concepts and theories are put into context throughout the text so you be�er understand why the topic is important and where it fits into the discipline of corporate finance. To achieve a coherent structure, we have incorporated a visual financial model of the firm, which we call the financial balance sheet. This tool will be used throughout the text to introduce and link topics as we study corporate finance.

You are already familiar with the balance sheet that accountants use to report the status of a firm in its annual report. The financial balance sheet (FBS) is a conceptual counterpart to the accoun�ng balance sheet. The FBS is a model of the corpora�on that serves several purposes. It is useful for visualizing the financial func�ons of the firm and its objec�ves. Theories and concepts can be introduced using the FBS—thereby maintaining a coherent structure throughout the book. Its use helps answer ques�ons such as, why are we studying this? Also, because it is similar to an accoun�ng balance sheet, accoun�ng and financial decision making can be contrasted and clarified.

The Left-Hand Side of the Financial Balance Sheet

Let's begin by describing a simple financial balance sheet and contras�ng it with its accoun�ng counterpart. As Figure 1.1 demonstrates, the le�-hand side (LHS) of the financial balance sheet contains the investments made by the firm (as opposed to assets listed in an accoun�ng balance sheet). It is important to note that LHS accounts are investments—that is, they reflect carefully considered decisions, which, as the term investments implies, should produce some payoff for the corpora�on. As a simple example, consider the cash account. The level of cash does not happen by accident—the cash is there to help produce more cash. A fast-food restaurant that begins each day with only $10 in the cash register has not made an op�mal investment in cash. It will surely lose some customers because the restaurant cannot make proper change. At the other extreme, if each day is begun with $10,000 in the cash register, the restaurant has overinvested in cash. The excess funds could be be�er u�lized by paying off a loan, thus saving interest expense (or worse, the restaurant could be robbed). For the fast-food restaurant, the same logic applies to other investment accounts. Too high an inventory of hamburger buns would result in unused and stale bread; too low an inventory would result in lost sales. Too large an investment in furniture and fixtures is wasted money (i.e., too much sea�ng capacity), whereas too low an investment might lead to lost sales (insufficient sea�ng capacity).

Figure 1.1: Le�-hand side of the financial balance sheet

The le�-hand side of the financial balance sheet includes all the accounts appearing on the accoun�ng statement (cash, inventory, furniture and fixtures, property, plant, etc.) because these are all investments. It is useful, however, to categorize investments into two types: tangible and intangible assets. Tangible assets include those things you can touch—bricks and mortar as the saying goes. Most of the assets associated with the accoun�ng balance sheet are of this type. Intangible assets include patents and copyrights but go well beyond that. This category includes investments that are o�en just as important to the firm as the more obvious investments in factories and inventory.

Assets and Expenditures

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Tangible (fixed) vs. intangible (nonphysical) are two aspects of understanding assets. Three elements of costs involving assets are capital and revenue, expenditures, and deprecia�on. What examples of intangible assets can you think of? Why should a financial manager know how to recognize these different assets?

The right-hand side of the financial balance sheet deals with sources of financing, including fixed and residual claims.

One of the most important intangible assets is human resources. Investment in this asset can produce excellent returns. Recrui�ng and training programs are costly, but the payoffs, in the form of employee produc�vity, loyalty, and the quality service provided to customers, may make such investments worthwhile. Other intangibles that create value for the corpora�on may include establishing the firm's reputa�on for product quality, ethical behavior, community involvement, environmental stewardship, research and development, and establishing brand recogni�on.

Both tangible and intangible investments require an outlay of cash that is expected to produce future cash inflows. If the cash outlay is a good financial decision, the cash flows received should have value greater than the ini�al cost of the investment. Therefore, the corpora�on strives to invest in tangible assets, like factories, and intangible assets, like employee training, whose value to the business is greater than their cost.

The Right-Hand Side of the Financial Balance Sheet

The right-hand side (RHS) of the financial balance sheet reflects the firm's sources of financing. As shown in Figure 1.2, the RHS records the sources of cash that finance the investments reflected on the LHS. The �tle "Sources of Financing" contrasts with the "Liabili�es and Owner's Equity" �tle commonly used on the tradi�onal accoun�ng balance sheet. A second difference between the two statements is that the financial balance sheet accounts are divided into two types of claims: residual claims and fixed claims. Each of these types of accounts has a claim on the cash flows generated by the corpora�on's investments. These cash flows may be generated via the normal cycle of producing and selling products and services. Cash may also be generated through the sale of the en�re firm (as might occur in the case of a liquida�on or a takeover) or through the sale of a division of the corpora�on. When these cash flows are generated, by whatever means, their distribu�on is dependent on the type of claim held by the supplier of financial resources.

Figure 1.2: Right-hand side of the financial balance sheet

Fixed claims receive a contracted or fixed amount of cash. If fixed claimants (e.g., bondholders or employees) receive less than this amount, they have legal recourse to force the firm to meet these fixed obliga�ons. Bank loans and bonds are two examples of fixed claims. Both require contractually specified payments of interest and principal. If these payments are not made in a �mely manner, the bank or bondholder may seek full payment through the legal system. In this case, the corpora�on that has not met its obliga�ons is in default on its payments and may be forced into bankruptcy. Bankruptcy can lead to reorganizing the firm and even liquida�ng (selling off) its assets in order repay its fixed claims.

Suppliers of inventory to the corpora�on may also help finance the firm by not demanding immediate payment for the goods they have delivered. The firm, therefore, has made an investment in inventory that, for a period of �me, the supplier is financing. The claim that reflects this financing is an account

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Cash generated by investments occurs on the le�-hand side of the financial balance sheet, while capital used to pay for those investments occurs on the right-hand side.

Corpora�ons in default must declare bankruptcy and liquidate their inventory in order to pay back the money owed. Are there any other op�ons companies might employ to repay their fixed claims?

ZUMA Press/Corbis

payable. If the account is not fully paid on �me, then the supplier can legally seek repayment. Similarly, workers supply financing to the firm in the form of wages payable. It's no accident, for instance, that some organiza�ons pay their employees on a weekly basis, while other firms pay biweekly or monthly. The employees' labor may be invested in finished goods inventory, while financing for that labor is being supplied by the workers themselves for a period of a week, two weeks, or a month, depending on the firm's payroll policy. In order not to help finance the firm, employees would need to be paid at the end of each day. Again, if employees are not paid on a �mely basis, they may sue the firm for their wages.

Besides legal recourse for payment, a dis�nguishing characteris�c of fixed claims is that, if the firm is extraordinarily profitable in any period, the fixed claimants receive no more than the amount they are owed. For example, when a business has a good year, no bank expects the firm to repay more than the amount of the loan and accrued interest. Fixed claims, therefore, have legal protec�on against losses but do not share in profits. The amount of a fixed claim is limited to the amount of the loan or the value of the resources provided to the firm.

Even with legal protec�on, fixed claimants s�ll are exposed to the risk of loss. There is no guarantee that normal business or even a forced liquida�on of a firm will generate enough cash to sa�sfy all of the fixed claims. Fixed claim investors assess the likelihood of loss when arranging the terms of loans to the corpora�on.

This brings us to residual claims, best represented by common stock. Residual claims, as the name implies, are those that common stockholders have on cash flows that are le� over once fixed claims are paid. If, in any year, a corpora�on generates cash in excess of that required to pay fixed-claim obliga�ons, then that residual cash belongs to the firm's common stockholders—the residual claimholders. These cash flows may be distributed in the form of dividends or retained by the company to help it grow and thereby increase the value of the stockholders' ownership stakes. The poten�al size of these residual cash flows is unlimited.

Unlike bills to suppliers, wages to employees, or other fixed claims, dividends to shareholders are not mandatory or contractual. Every year the board of directors decides whether to issue dividends and how large they should be. This is en�rely a discre�onary decision on the part of the board of directors. Fixed claims, therefore, take priority over residual claims when cash flows are distributed. Residual claims, with their greater upside poten�al returns, must also bear a greater risk of losses because of their lower priority.

Figure 1.3: Interac�on between the right- and le�-hand sides of the financial balance sheet

At this point, we have modeled the corpora�on's basic func�ons. Capital is supplied to the firm, crea�ng claims on the firm's future cash flows. These claims are conceptually recorded on the RHS of the financial balance sheet. The corpora�on uses this capital to make investments that will generate cash flows in the future from the sale of goods and services. These investments are shown on the LHS of the financial balance sheet, and the cash flows they generate will be distributed to claimants who have supplied capital to the corpora�on or may be reinvested in the company. This interac�on between the LHS and RHS of the financial balance sheet is captured in Figure 1.3.

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We must pause to highlight three features of finance that differ from accoun�ng. First, finance focuses on cash flow, while accoun�ng focuses on profit or net income. You should remember that accoun�ng net income includes deduc�ons that involve no outlay of cash— deprecia�on being the classic example. A corpora�on, therefore, may have an accoun�ng loss in a year (nega�ve net income), yet the firm may have generated enough cash flow to meet its fixed claims and, perhaps, even make cash distribu�ons to its residual claimants. Thus, we focus on cash in finance because ul�mately only cash can pay the bills or be invested.

A second dis�nguishing feature is that accountants record the historical cost of assets on the LHS and the historical amount of capital contributed in the RHS accounts. In finance,we are more concerned with the current value of these accounts. An example illustrates why. Consider a firm that invested in undeveloped real estate in downtown Houston in 1950. If the property cost $10,000 in 1950, it would appear on the LHS of 2012's accoun�ng balance sheet at its original cost of $10,000. What is its true value? The current value might be $1,000,000. Which figure is relevant for decision-making purposes? The opposite some�mes holds true as well: A manufacturer may have an inventory of stereos with CD players in which it historically invested $1,000,000, but today stereos with docking sta�ons dominate the market. What is the current value of these CD stereos—more than the original $1,000,000 investment or less? Again, which number is relevant?

The third point we want to make is that an accoun�ng balance sheet is readily available for all to see, whereas the financial balance sheet is a conceptual construct—you won't find it printed in an annual report. Sharp managers and financial analysts, however, have a clear mental picture of the FBS and understand how decisions will affect its accounts. The development of that same mental picture and intui�on is one of the objec�ves of this book.

Table 1.1 summarizes these three differences between accoun�ng and finance.

Table 1.1: Accoun�ng statements versus the financial balance sheet

Accoun�ng statements Financial balance sheet

Records net income, profits, earnings Records cash flows.

Records assets at their historical cost and claims at the historical amount contributed.

Records the current value of LHS investments made by the firm and the current RHS claims.

Reported in audited financial statements. Not observable; its condi�on is determined by analysis. Accoun�ng statements act as clues/evidence of the true financial condi�on of the corpora�on.

Representing Acquisition of Capital on the Financial Balance Sheet

Let us return to the financial balance sheet. The corpora�on's investments, reflected on the LHS of the financial balance sheet, are financed via three methods: trade credit, sale of securi�es (including loans), and retained residual cash flows.

The first method is spontaneously generated loans or trade credit such as payables to suppliers or employees, and taxes payable. The firm has LHS investments, such as inventory, a por�on of whose costs are borne for a period by suppliers who do not demand immediate payment. These types of fixed claims held by suppliers are usually short term. They are spontaneous because the firm does not have to seek approval for such loans formally each �me the credit is granted.

The second method of raising cash is issuing and selling securi�es to individuals and ins�tu�ons. Firms are able to a�ract this capital because LHS investments are expected to yield returns that are equally or more a�rac�ve than alterna�ve investment opportuni�es available to these suppliers of capital. Such securi�es may represent fixed claims on cash flows, such as bonds and bank loans, or common stock that represents a residual claim.

Notes payable are short-term fixed claims, term loans are usually intermediate term, and bonds generally are long term. Common stock is a perpetual claim because it might never be repaid by the corpora�on.

Once issued and sold, the corpora�on's outstanding securi�es, par�cularly its stock and long-term bonds, are ac�vely traded among individual and ins�tu�onal investors. Such trading produces changes in the prices of the firm's outstanding securi�es, reflec�ng either changes in the a�rac�veness of compe�ng investments or changes in investors' expecta�ons of the returns the firm's investments will generate, or a combina�on of both factors. This secondary trading of securi�es produces no addi�onal capital for the firm, but it reflects the traders' refined opinions of the firm's value and so acts as a measure of how investors regard the corpora�on's future prospects.

The final method for acquiring capital is through the reten�on of residual cash flows. These cash flows belong to the stockholders, but the firm may choose not to pay out all of this cash as dividends, deciding instead to retain the cash and reinvest it in promising LHS projects.

Figure 1.4 shows the interac�on of the methods of capital acquisi�on in the context of the financial balance sheet.

Figure 1.4: Three methods of capital acquisi�on

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Understanding the interac�on of the three methods of capital acquisi�on is important to financial managers.

It is helpful to view the corpora�on as a conduit that acquires capital from individual and ins�tu�onal investors and invests this capital in promising projects on behalf of these claimants. Subsequent buying and selling of the corpora�on's securi�es produces changes in the prices of these claims.

These price changes produce no capital for the firm; nonetheless, they play an important role in corporate finances. Price changes reflect claimants' ongoing judgment regarding the a�rac�veness of the LHS investments, the value of which underlies the prices of the RHS claims. The prices of the firm's securi�es act as on-going "report cards" on the effec�veness of the corpora�on's decision making and management. Increases in the prices of traded claims provide claimants with increases in wealth. Price apprecia�on, along with payments received directly from the corpora�on (i.e. dividends and interest), provides investors with a return on their investment in corporate securi�es.

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Two types of managerial decisions correspond to the le�-hand side and right-hand side of the financial balance sheet: what investments to make, and how they should be financed.

The details of corporate governance are complex. Understanding the interac�on between management and the board of directors is essen�al.

1.4 The Financial Goal of the Corporation

The financial balance sheet models the corpora�on's financial ac�vi�es. In this sec�on, these ac�vi�es are linked to management's goal. Because managers direct the corpora�on, they must have a clear understanding of the corporate goal. They must understand for whom they work and what their job is if they are to be effec�ve.

Management's Job

Managers make two types of important financial decisions (see Figure 1.5). First, managers choose which investments the firm makes (LHS decisions). Second, managers choose the sources of capital used to finance these investments (RHS decisions). What should managers' objec�ves be as they make these decisions?

Figure 1.5: Managerial decisions and the financial balance sheet

To help us answer this ques�on, recall that a corpora�on's management team operates the company on behalf of its owners, the stockholders. Stockholders invest their money and accept the risk of being a residual claimant because they hope the value of their investment will grow; that is, shareholders invest to increase their wealth. Therefore, as employees of the stockholders, managers must make decisions that they expect will increase shareholder wealth. Figure 1.6 illustrates the basic control mechanisms and rights that fixed and residual claimants have in the corporate structure. This system of control is known as corporate governance. Note that fixed claimants are protected by law. If they are not paid as promised, these claimants can sue the corpora�on for the money that they are owed. Residual claimants have no such rights. The protec�on for residual claimants is their ownership, which enables them to elect the board of directors who may, for example, fire management if such ac�on is judged to be in the shareholders' best interest.

Figure 1.6: Corporate governance

The job of managers, as employees of the stockholders, is to maximize the wealth of these residual claimants. If the cash generated by produc�ve LHS investments is to be large enough to flow to residual claims, there must also be more than enough cash to sa�sfy the fixed claims. Therefore, maximizing shareholder wealth will generally be in the interest of fixed claimants as well.

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Some people interpret maximizing shareholder wealth to mean that corporate managers should use every possible method to shi� wealth from suppliers and lenders and employees to shareholders, but this is not true. The goal of managers of the corpora�on should be the maximiza�on of long-term shareholder wealth or long-term firm value. "Long-term" is important, because corporate managers cannot use decei�ul means over an extended period of �me to take advantage of stakeholders' trust. To do so would ruin those rela�onships. The company (and thereby shareholders) would suffer because the terms of trade or the rela�onships with stakeholders would change, as stakeholders protected themselves from being exploited by corporate managers. The no�on that corporate managers must behave fairly with all stakeholders does not imply that they have to be more generous than is necessary. It implies fair dealing and maintaining honest, open rela�onships with stakeholders.

Creating Wealth

Managers can meet their objec�ve of maximizing shareholder wealth by making investments (on the LHS) whose value is greater than the amount of capital u�lized (from the RHS) to finance these investments. Therefore, managers must have the ability to assess the value of poten�al LHS investments and to make the lowest cost RHS capital-acquisi�on decision.

Let's illustrate wealth crea�on with a very simple example. Consider a firm that has the opportunity to invest in a single project whose value is greater than its cost. At the end of this project, the firm will be liquidated, and all cash will be distributed to the claimants. Management correctly iden�fies the a�rac�ve project and finds sources of capital to finance the cost of the project. The investment is made and almost instantly generates the expected cash flows. Because the value of the investment is greater than its cost, the cash flows more than cover the amount necessary to repay all of both the fixed claims and residual claims used to finance the project. Because the project has more value than cost, there are funds le� over once all claims are repaid. These addi�onal funds accrue to the residual claimants. These le�over or residual cash flows, therefore, increase stockholders' wealth beyond that originally contributed to finance the project.

If this project's payoff was certain, investors had full access to all informa�on regarding the project, and the payoff was almost immediate, then shareholder wealth would increase as soon as the investment in the project was made—even before the cash flows were distributed. Recall that stock, once issued and sold by the corpora�on, is traded among individuals. These investors set the price of the stock based on their beliefs regarding the security's a�rac�veness. If they knew, with certainty, the stock for which they paid $50 a share would soon distribute $54 a share, what would be the value of that stock to the investors? Clearly, the price of the stock would immediately increase to very near $54 per share. Thus, when the company's managers make decisions that maximize the wealth of residual claimants, they also maximize the price of the company's common stock. The A Three-Minute Corpora�on Illustra�ng the Wealth-Building Process feature outlines the progression of wealth-building for this example project.

A Three-Minute Corpora�on Illustra�ng the Wealth-Building Process

Minute 0 A project is iden�fied requiring a $100 investment by the firm.

The project will produce $105 in cash flows 1 minute a�er the firm makes its investment.

Minute 1 Sources of capital are iden�fied:

A 1-minut e loan of $50 bearing an interest rate of $1/minute can be obtained. Stock can be sold for $50.

Minute 2 $100 of capital is raised from the two sources.

The $100 investment in the project is made by the firm.

Minute 3 The project generates the $105 cash flow.

The fixed claim of $51 (the 1-minute loan) is paid in full: $50 principal and $1 interest.

The residual cash flow of $54 is paid to stockholders, increasing their wealth by $4.

The Three-Minute Corpora�on example is greatly simplified, and we will take the rest of the book to fully develop your understanding of wealth crea�on through corporate decision making. You must learn how the value of an investment project depends not only on the size of the cash flows that it is expected to generate (as in our preceding example), but also on the degree of confidence claimants have that those cash flows will be achieved. In other words, value also depends on the risk associated with the investment. Another factor that must be considered when es�ma�ng value is the �ming of the cash flows that an investment generates. Claimants prefer to receive cash flows earlier rather than later. The longer claimants wait for a given payoff, the less valuable that payoff is to them, all else being the same. Last, the value of a par�cular investment also depends on how a�rac�ve that investment is vis- à-vis alterna�ve investments.

Managers must, therefore, consider the size of a project's expected cash flows, their �ming, the riskiness of these cash flows, and the returns available to shareholders on alterna�ve investments as they assess value in pursuit of stockholder wealth maximiza�on. Table 1.2 lists factors that impact an investment's value and their effects.

Table 1.2: Factors determining an investment's value

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Expected level of cash flows The higher the expected cash flows are, the higher the value of the investment will be, all else being the same.

Riskiness of cash flows The more uncertain the expected cash flows are, the lower the value of the investment will be, all else being the same.

Timing of cash flows The longer it takes to receive cash flows, the lower the value of the investment will be, all else being the same.

Returns available on alterna�ve, similar investments

If similar investments offer higher returns, the value of the investment will decrease, all else being the same.

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It is important to understand the differences in informa�on available to corporate insiders and outsiders.

1.5 The Role of Information

Informa�on plays an important role in corporate finance. One of the difficul�es claimants have in assessing how well management is doing in achieving its goal of shareholder wealth maximiza�on is a lack of informa�on. In large corpora�ons, neither the board of directors nor the stockholders can review all of management's decisions. Thus, managers have much more informa�on than those individuals who are not involved in the day-to-day opera�ons of the firm

Information Asymmetry

This rela�onship is characterized as informa�on asymmetry between corporate insiders and outsiders because the two groups do not have equal (or symmetric) informa�on (Dierkens, 1991). Managers, as insiders, have a pre�y clear view of both the RHS and the LHS of the financial balance sheet. Claimants who are not also employees of the corpora�on can observe the RHS sources of capital because most of these claims are represented by ac�vely traded securi�es (bonds and stocks), but LHS investments may only be viewed obscurely. Thus, outsiders have less informa�on to use in drawing conclusions about the value of the ac�vi�es of the corpora�on than do insiders. See Figure 1.7.

Figure 1.7: Informa�on asymmetry

The degree of informa�on asymmetry is largely dependent on the size, complexity, and organiza�onal structure of the corpora�on. Large, widely held corpora�ons with stock held by millions of investors are characterized by a separa�on of ownership (held by the common stockholders) and control (held by managers). Stockholders of such giant companies individually own a very small propor�on of the corpora�on; thus, they have li�le incen�ve to closely scru�nize managerial ac�on. Addi�onally, with such a small stake, individual shareholders have li�le vo�ng power with which to affect a change if they are dissa�sfied with the management and the board. These shareholders tend to simply sell their shares in the corpora�on if they are unhappy. Consequently, widely dispersed ownership can lead to a poten�ally high degree of informa�on asymmetry.

Small, closely held corpora�ons o�en have fewer shareholders, each having a large financial stake in the firm. These claimants have a greater incen�ve to monitor decision making. The closer scru�ny of outsiders reduces the degree of informa�on asymmetry. In the extreme case, insiders may own a very large stake in the corpora�on, and informa�on asymmetry is minimized. Many small businesses are organized as corpora�ons. O�en there is only one residual claimant who holds all of the common stock and also manages the business. In such a case, there is no informa�on asymmetry between management and the residual claimant because they are one and the same. Even here, some asymmetry exists because fixed claimants remain corporate outsiders (e.g., suppliers and bankers) and so have less informa�on about the company than does the owner/manager.

There are costs associated with informa�on asymmetry. Corporate insiders, for example, may trade the firm's outstanding securi�es and reap huge profits based on their superior knowledge of the firm's prospects. The cost associated with insider trading (King, Roell, Kay, & Wyplosz, 1988) would eventually be borne by society. Outsiders would soon lose faith in the fairness of trading the company's securi�es because of their informa�on disadvantage. The ability of the firm to raise capital would be hampered as poten�al capital suppliers became reluctant to commit their funds for fear they were paying too much. Lack of financing would leave promising investment projects untouched, leading to a stagnant economy or one in decline. To protect the integrity and fairness of

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CEOs of large corpora�ons, like GE's Jack Welch, have been scandalized in the news when the public learns the extent of their corporate perquisites. Do you think that corporate managers deserve to receive so many benefits? What can financial managers do to keep excessive perks in check?

Regula�ons have been established to protect company outsiders from informa�on disadvantage. Martha Stewart was imprisoned for lying about her knowledge of a viola�on of these regula�ons.

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the security markets, society has legislated strict regula�ons on the trading of corporate securi�es by insiders. These laws were at work when Martha Stewart, the famous television personality, was sentenced to prison �me for lying to a grand jury during an inves�ga�on of insider trading.

Other informa�on asymmetry costs are borne by the corpora�on. A good example is audited financial statements. Corpora�ons hire reputable accoun�ng firms to examine and, following well-defined standards, a�est to the accuracy of informa�on reported by insiders (the firm's management). Banks supplying financing to the corpora�on generally require that certain condi�ons be met by the firm throughout the life of the loan. For example, to ensure that these protec�ve covenants are being met, banks may require that the firm regularly provide audited financial statements. Such statements reduce informa�on asymmetry between the firm and these fixed claimants. Restric�ve covenants are also included in bond agreements, while audited financial statements are a repor�ng requirement for virtually all ac�vely traded corporate securi�es.

In the 1980s an interes�ng phenomenon took place with a frequency never before seen. Many large, complex, and widely held corpora�ons' stocks were purchased in their en�rety by rela�vely small groups of individuals or ins�tu�ons in a process known as a leveraged buyout. In essence, widely held firms were transformed into closely held firms. One important ra�onale for these billion-dollar transac�ons was the reduc�on of informa�on asymmetry. How can a reduc�on of this informa�on gap translate into the wealth crea�on that apparently mo�vated these megadeals?

Agency Costs

To answer that ques�on, we must more fully understand the costs that accompany informa�on asymmetry and the separa�on of ownership and control. As we noted earlier, managers control the firm, whereas shareholders own the firm. Managers are ac�ng as the agents of the firm's principals or owners. Managers are hired to act on the owners' behalf, maximizing shareholders' wealth and—in the process—sa�sfying the corpora�on's fixed obliga�ons. However, managers are also concerned with their own welfare and act in their own self-interest. At �mes managers, ac�ng to sa�sfy their own desires, may take ac�ons that are costly to claimants yet produce no wealth for these suppliers of capital. Such ac�ons may be characterized as investments whose value is less than their cost and are, therefore, in direct conflict with the goal of maximizing shareholder wealth. Some corporate expenditures on perquisites may contradict shareholder wealth maximiza�on.

Lavish Golden Parachutes

Perquisites (or perks) are benefits to employees beyond their compensa�on packages and are o�en cost-effec�ve investments. Many execu�ves, for example, are supplied a company-owned car. Shareholders may benefit from such investment—it may be less costly to supply the corporate president with a vehicle than to reimburse her for mileage. The company-owned car also assures stockholders that the corporate reputa�on for being a quality ins�tu�on is enhanced by having clients met in a clean, comfortable mode of transporta�on. On the other hand, what if the president of the firm is supplied with a $200,000 Rolls-Royce rather than a $60,000 Lincoln? Will the decision to supply her with the Rolls produce addi�onal value greater than the cost differen�al of $140,000? The Rolls seems to be a ques�onable investment. This is an example of an excessive perquisite, an expense that benefits an execu�ve while producing no increase in shareholder wealth. On whose judgment does the authoriza�on of such expenses fall? Ordinarily management makes these

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The agency problem creates costs for the business, was�ng corporate resources.

A corpora�on is highly dependent on the trustworthiness of the management it hires. Dennis Kozlowski, former Tyco CEO, shirked his duty by extravagantly spending the company's money.

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decisions. This is an example of an agency cost (Jensen, 2005), a cost that arises because of the separa�on of principals and agents in large corpora�ons (see Figure 1.8).

Figure 1.8: Agency costs

Another source of agency costs is shirking by top management. A corpora�on's top managers are selected and highly compensated because the board feels they have the talent and will expend the effort to seek out value-crea�ng investment projects. But only the managers know precisely how much effort they are direc�ng to their job. Since managerial effort is difficult to monitor, managers can reduce their efforts (i.e., shirk) and thereby generate costs for shareholders with no offse�ng benefits. Such managers may choose to take a three-hour lunch, for which they are richly compensated but which produces no increase in shareholder wealth. Shirking by top management sets a costly example because the behavior may percolate down through the corpora�on. A noteworthy example of the abuse of corporate power at shareholders' expense is the case of Dennis Kozlowski, the CEO of Tyco from 1992 to 2002. The firm paid for Kozlowski's $30 million New York apartment, which featured a shower curtain cos�ng $6,000!

Studies have shown that top execu�ves' pay is posi�vely correlated with the size of the corpora�on. Some incen�ve, therefore, exists for chief execu�ve officers (CEOs) to engage in empire building. A firm may expand in size (add LHS investments) with less regard to the value of these investments than to the impact that a larger firm has on the CEO's pay, power, and pres�ge. Empire-building has been documented as one of the most damaging agency costs in its impact on shareholder wealth.

As part of the 2010 Dodd-Frank legisla�on, shareholders now have the right to cast an advisory vote on execu�ve compensa�on, called say on pay. This can be viewed as an effort to �e compensa�on more closely to performance and help to mi�gate the agency problem between management and owners.

An important characteris�c of these examples of the agency problem is that they would not exist if informa�on asymmetry did not also exist. The megamergers of the 1980s o�en were economically linked to the reduc�on of agency costs. By replacing wasteful management, by increasing the accountability of management to a smaller group of claimants whose stake was high enough to mo�vate close monitoring of the firm, and through dismantling ill-conceived and inefficient empires, wealth gains were achieved as many corpora�ons became closely held through buyouts in the 1980s.

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1.6 Organizational Forms

Even with the problems inherent in the widely held corpora�on—problems such as informa�on asymmetry and agency costs—the modern corpora�on dominates the economic landscape (Helwege, Pirinsky, & Stulz, 2007). The bulk of sales (80%) and net income (60%) are generated by the corpora�on form of business organiza�on. In this sec�on, we look at the different organiza�onal forms in comparison with the corpora�on and explore the corpora�on's role in society.

Sole Proprietorships and Partnerships Versus Corporations

To be sure, sole proprietorships and partnerships are also important—they perhaps best embody the entrepreneurial spirit and o�en are the spawning ground for major corporate en��es. Proprietorships and partnerships also have less significant agency problems than do widely held corpora�ons. These organiza�onal forms are also a�rac�ve because of their rela�vely low organiza�onal costs, and their owners may benefit from lower taxes. Corporate cash flows to residual claimants (dividends) are subject to double taxa�on—once at the corporate level and again at the individual level—while proprietorship and partnership income is taxed only once as part of the owner's personal tax return. Table 1.3 compares the taxa�on of corpora�ons against that of partnerships and proprietorships.

Table 1.3: Tax advantages of partnerships and proprietorships

Taxa�on Partnerships and proprietorships Corpora�ons

Income before business-level taxes $1000 $1000

Corporate Income tax rate 0% 20%

Corporate Income tax payable $0 $200

Income to owners before personal income taxes $1000 $800

Personal income tax rate 25% 25%

Personal income tax payable $250 $200

A�er-tax cash flow to owners $750 $600

Note: Assuming a corporate tax rate of 20% and a personal tax rate of 25%, the corpora�on's owners are at a tax disadvantage because their income is subject to double taxa�on.

But the corpora�on has a�ributes that offset the advantages of proprietorships and partnerships. These a�ributes are par�cularly important for large firms, requiring large amounts of capital. To raise the huge sums necessary to finance large-scale businesses, en��es must accept the difficul�es inherent in the separa�on of ownership and control because few individual investors have sufficient personal wealth, exper�se, and the willingness to both own and manage a corporate giant. Thus, to finance big businesses, it is o�en necessary to have many owners (stockholders) who are willing to relinquish control to hired managers. Now let us consider the characteris�cs of the corporate form of organiza�on that enable it to dominate alterna�ve organiza�onal structures.

First, through the issuance of common stock, a highly transferable security is used as the medium for exchanging ownership interests in the business. The ability of stockholders to sell their shares easily is important if individuals are to be persuaded to take an ownership interest in a firm over which they have limited control. Such claimants, as men�oned earlier, can "vote with their feet," selling their shares when they wish. Moreover, if many stockholders become dissa�sfied, then selling pressure, behaving in accordance with the law of supply and demand, will drive down share prices. The supply of such a corpora�on's stock available for sale on the secondary market will increase while demand for the securi�es decreases. This decline in the price of the corpora�on's securi�es indicates to the board of directors that ac�on needs to be taken. By contrast, partnership and proprietorship ownership interests are less transferable and marketable. For example, partnerships o�en require the approval of remaining partners before a dissident partner can sell his or her interest to a third party. In the end, many partners are stuck with their investment and powerless to change it. Thus, the ease with which stock may be bought and sold (its marketability) is a strong advantage of the corpora�on, aiding its ability to raise capital when compared to alterna�ve business forms.

A second contras�ng characteris�c is the liability of owners. Par�cipants of sole proprietorships and partnerships (with the excep�on of limited partnerships) not only risk their original investments in a business but must stand ready to use their personal resources to meet any shor�all the enterprise experiences in mee�ng its fixed obliga�ons. For example, a large legal judgment against a proprietorship or partnership may lead to the personal bankruptcy of its owners. This is not the case with the corporate form of organiza�on. Stockholders have limited liability, meaning that they can lose no more than the amount they have invested in the stock. In a corpora�on, residual claimants cannot be forced to make up shor�alls in mee�ng fixed claims once corporate assets have been fully liquidated. Again, this corporate a�ribute is especially cri�cal in larger firms with diffuse ownership. Few individuals would be willing to expose their resources to risk, without direct control over how those capital contribu�ons are u�lized, if their liability is unlimited.

The last advantage of the corporate form is its conceptually unlimited life. Partnerships depend on a team ac�ng as both owners and managers. Like any team, the loss of a key player or players can destroy its effec�veness. In proprietorships, this difficulty is exacerbated because the team consists of oneProcessing math: 0%

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Facebook went public on May 18, 2012. Why do you think companies like Facebook eventually decide to go public?

Paul Taggart/Corbis

player, the loss of whom completely changes the character of the en�ty. To replace players in partnerships or proprietorships, an individual must be sought with the wealth, exper�se, and willingness to be both a manager and an owner. If such an individual cannot be located, the business must be liquidated. Corpora�ons, on the other hand, are faced with less cri�cal problems of this nature. Replacing lost owners is rela�vely simple because of marketability of the stock, as already discussed. Loss of key management personnel, although poten�ally difficult, is less of a problem than it is in other organiza�onal forms because the replacement does not necessarily also need to become a major owner, as a proprietorship or partnership requires.

Limited Liability Companies Versus Corporations

A rela�vely recently developed form of organiza�on is the limited liability company, or LLC. LLCs are the business form of choice for many small businesses because they combine corporate-like limited liability with lower costs of organiza�on, flexibility, and ease of regulatory compliance. For example, an LLC may elect to be taxed as a corpora�on or as a partnership, and it can be managed by its owners or by professional managers.

Table 1.4 looks at some of the key characteris�cs of the organiza�onal forms we have discussed.

Table 1.4: Key characteris�cs of the forms of business organiza�on

Business characteris�c Corpora�ons Partnerships Proprietorships Limited liability corpora�on

Taxa�on Twice—once at the business level and once at the individual level

Once at the individual level

Once at the individual level

Flexible—corporate or partnership

Liability Limited to amount invested

Unlimited Unlimited Limited to amount invested

Ownership and control Separated—majority of stockholders are not usually management

Partners own and control enterprise

Ownership and control are in the hands of a single individual

Flexible—partners own enterprise, and may control enterprise or hire professional managers

Transferability of ownership

Rela�vely easy through sale of stock

Poten�ally difficult Poten�ally difficult Rela�vely easy

Access to capital Best Moderate Most restric�ve Moderate

Informa�on asymmetry and agency costs

Poten�ally high Rela�vely low if all partners are equal and ac�ve

Very li�le, as there is not separa�on of ownership and control

Flexible—depends on ownership structure. Professional management leads to high informa�on asymmetry. Partner management leads to low informa�on asymmetry.

In terms of numbers, most businesses are small and closely held. These businesses are o�en ini�ally financed by the owners' own out-of-pocket equity. For these companies, borrowing takes the form of loans rather than bonds because the legal expenses and regulatory issues associated with bonds make their issuance generally too costly for small enterprises. Both equity and debt may be raised by appealing to family and friends, called FF financing, and individual independent investors, called angel investors. There are also organiza�ons that pool funds to help small, new enterprises with their funding needs. These kinds of investments are referred to as venture capital. If successful, many small entrepreneurial firms eventually adopt the corporate form of organiza�on and sell stock and bonds in the broader securi�es market a�er they "go public" with an ini�al public offering (IPO) of their shares. For example, in 2012, Facebook went public. Its IPO spread some of its ownership from a small group of founders and other owners to the general inves�ng public.

Venture capital, angel inves�ng, and the financial par�cipa�on of friends and family are extremely risky but can reap big rewards. Cau�on is advised, par�cularly with FF financing because many �mes these investments may jeopardize personal rela�onships, a risk well beyond tradi�onal financial risk.

Over the past century, advances in technology, more cost-effec�ve means of transporta�on and distribu�on, communica�ons advances, a rising standard of living, and the globaliza�on of markets have provided many investment opportuni�es for corpora�ons, requiring large amounts of capital to finance their growth. Organiza�ons have sought the most efficient means of mee�ng these needs. Many would argue that the advantages of corporate organiza�onal forms outweigh the disadvantages as firms become large.

Corporations and Society

The rela�ve efficiency of the corporate form of organiza�on has led to its being the structure of choice for firms foreseeing a�rac�ve growth opportuni�es. The efficiency of corpora�ons

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Corpora�ons and society are o�en at odds due to the outcomes of corporate externali�es such as pollu�on caused by factories. Do you think corpora�on cri�cs are jus�fied in their accusa�ons?

Sam Ki�ner/Na�onal Geographic Stock

has led to cri�cism as well. Corpora�ons are o�en portrayed as cold-hearted in their pursuit of economic gains. They have been charged with ignoring the communi�es in which they operate, lacking concern for the welfare of their customers, and even ignoring the planet in their relentless pursuit of profits.

Some cri�cs of corpora�ons charge that the goal of shareholder wealth maximiza�on is too narrow for the good of society. These cri�cs contend that corpora�ons should act in a socially responsible manner. Although social responsibility has different meanings to different people, circumstances exist when the good of society is at odds with the welfare of corporate shareholders. For example, in its manufacturing endeavors a firm may produce externali�es, such as air pollu�on, while the cost of cleaning up this dirty air may be borne not by the corpora�on but by society. Thus, shareholders receive higher returns as society bears some of the costs of producing the product.

These charges are o�en true on a case-by-case basis and must be taken seriously by all corpora�ons, even non-offenders, because corpora�ons as legal en��es exist at the pleasure of society. Should society see pervasive abuses, it will surely restrict the freedom of corpora�ons to act.

Businesses, and corpora�ons in par�cular, are remarkably resilient. Abuses of labor, unethical securi�es prac�ces, and consumer fraud have led to major legisla�ve ini�a�ves that restrict the freedom of firms. Yet the compe��ve drive toward shareholder wealth maximiza�on has allowed corpora�ons to meet society's legal mandates and con�nue to thrive.

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Ch. 1 Conclusion

In this chapter, several key concepts that underlie finance were introduced. These are the blocks on which the bulk of this book is built. The chapter began by introducing the financial balance sheet as a model of how financial managers view the corpora�on. The financial balance sheet will be used throughout the text to illustrate how topics fit into the "financial picture" introduced in this chapter.

This chapter also presented shareholder wealth maximiza�on as the overarching goal of business and then discussed factors (such as cash flows and risk) that must be considered as firms strive to create value for their owners. You learned that the choice of organiza�onal form can have a drama�c effect on risk and the a�er-tax cash flows that a business produces. Finally, the agency problem and the challenges presented by informa�on asymmetry were introduced.

In Chapter 2, we will focus on extending these fundamental concepts to the economic environment in which a firm operates.

Financial Balance Sheet, Part I

Click here (h�ps://media.thuze.com/MediaService/MediaService.svc/constella�on/book/AUBUS650.13.1/{pdfs}financial_balance_sheet_p1.pdf) to download a pdf of this slideshow.

SLIDE 1 OF 8

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Ch. 1 Learning Resources

Key Ideas

The financial balance sheet illustrates the firm's capital acquisi�on and investment ac�vi�es. Residual and fixed claims' characteris�cs include the priority of claims, default and legal recourse, and vo�ng rights. Shareholder wealth maximiza�on is the financial goal of the corpora�on. Wealth crea�on is achieved by corporate investment in a project whose value is greater than its cost. A project's value is dependent on the size of expected cash flows, the riskiness of those cash flows, their �ming, and the returns available on alterna�ve investments of similar risk. Agency costs and informa�on asymmetry are impediments to maximizing shareholder wealth. Compe�ng forms of business organiza�on were compared to the corporate form. These include sole proprietorships, partnerships, and limited liability companies. Corpora�ons exist at society's pleasure and must be sensi�ve to social concerns.

Cri�cal Thinking Ques�ons

1. Economists who favor strictly free markets may oppose insider trading laws because these laws do not allow prices to fully reflect all informa�on that is available (namely, prices won't reflect that informa�on that is held exclusively by the firm's insiders). They could argue that prices can best allocate capital to its best use if all informa�on is reflected in the price and therefore the laws prohibi�ng trading by insiders who use their special knowledge should be repealed. Other economists disagree. They believe that the economy is be�er off with these insider trading prohibi�ons. Supply their side of this argument.

2. Why do residual claimants have the right to elect the board of directors? Why don't fixed claimants have the same right? 3. In theory, the maximiza�on of shareholder wealth also contributes to the well-being of other stakeholders. Explain this asser�on. 4. Which do you think is the biggest agency cost: excessive perquisites, shirking, or empire building? Explain your reasoning. 5. Some observers could argue that without limited liability we would not have large corpora�ons like Bri�sh Petroleum. Explain what you think is the ra�onale

behind this asser�on.

Key Terms

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

agency cost (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

A cost that occurs when control of corporate assets is held by management and is separated from the ownership of those assets. The cost is considered a waste of investors' money because it is being used to benefit the management but not to create wealth for shareholders. An example could be excessive managerial perquisites like luxury condominiums supplied to CEOs at the firm's expense. Sole proprietorships have no agency costs because the owner of the business has direct control of the business assets, and by defini�on, you can do what you like with your own money.

angel investors (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Anyone who invests his or her money in an entrepreneurial company (unlike ins�tu�onal venture capitalists who invest other people's money).

bankruptcy (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

The quality or state of being insolvent.

bonds (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

The security that represents the issuer's promise to pay a predetermined amount of interest over a fixed term and to repay the principal on the security's maturity date.

board of directors (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

A panel of individuals, elected by the stockholders, who act as their (the owners') representa�ves. The board's du�es include direc�ng the strategic ac�vi�es of the corpora�on, including the hiring and firing and compensa�on of top management, and ra�fying major corporate decisions such as the payment of dividends.

cash flow (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

The amount of money that passes through a corpora�on. Residual cash flow, for example, refers to the amount of money that stockholders have a claim on a�er all other claims have been paid.

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closely held corpora�ons (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Corpora�ons whose stock is not publicly traded and is held by only a few shareholders. Because each shareholder owns a substan�al part of the company, they have a greater incen�ve to pay a�en�on to corporate ac�vity resul�ng in low informa�on asymmetry and lower agency costs. One problem for the closely held corpora�on is that there is no ac�ve market for its stock so it becomes difficult to raise addi�onal equity capital.

common stock (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

A security that represents a residual claim on the firm's earnings and an ownership share of the company.

corporate governance (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

A general term used to describe the decision making within a corpora�on, par�cularly at the top levels of management and the board of directors.

corpora�on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

The form of business organiza�on where ownership is held by the common stockholders who own a propor�onal share of the business depending on the percentage of outstanding shares they own. They exercise control of the company through their elected representa�ves, the board of directors.

coupon payments (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

A stream of regular (usually semiannual) interest payments from a bond issuer to the bondholders. Each payment is determined by taking the product of the coupon rate �mes the bond's par value (and then divided by two if payments are made semi-annually).

default (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Missing a scheduled payment to a fixed claimant, such as a coupon payment on a bond, or a loan payment on an equipment loan. This can lead to bankruptcy.

dividends (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Payments made to stockholders by the corpora�ons. Regular cash dividends are typically paid quarterly. An increase in the regular cash dividend is generally considered a signal of the company's improving profitability. Stock dividends are addi�onal shares of stock issued to current shareholders on a propor�onal basis.

externali�es (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Nega�ve externali�es are unwanted byproducts of produc�on, the costs of which are not borne by the business but by other par�es. For example, a factory burning fossil fuels may be crea�ng health problems for people living downwind from the factory who must pay for their added medical costs and the indirect costs of irritated eyes and lungs. There are posi�ve externali�es in some cases as well, where a third party benefits from another's ac�vity but does not pay for the benefit, as in the case of when an unsightly building is torn down across the street from your house causing your property value to increase.

FF financing (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Capital investments made by friends and family of a business owner.

financial balance sheet (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

A conceptual tool used in this text to illustrate financial thinking and decision making and contrasted to the familiar accoun�ng balance sheet. For example, the financial balance sheet lists Investments Made by the Firm on its le�-hand side in contrast to Assets listed on an accoun�ng statement. In finance, these accounts are valued at their market values rather than the book values or historical costs used in accoun�ng.

fixed claims (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Securi�es like bonds, bank loans, and wages payable, which are en�tled to a fixed payment and receive their payments prior to any payments to the owners of the business.

informa�on asymmetry (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

The difference between the knowledge of the corpora�on held by insiders and known by outsiders. For example, the average stockholder in Microso� knows much less about the company and its opera�ons and performance than Bill Gates knows so there is significant informa�on asymmetry in that case.Processing math: 0%

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insiders (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Typically refers to corporate management and other employees who have greater knowledge about the opera�ons and performance of the company than the firm's outsiders do (outsiders are those without that knowledge).

insider trading (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Trading by insiders who have an informa�on advantage over the typical investor. Insider trading is restricted by law and trading by insiders who u�lize their privileged informa�on to profit (or to avoid losses) is illegal.

intangible assets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Assets recorded on the le�-hand side of the financial balance sheet that include brand name recogni�on, human resources, and the firm's reputa�on.

limited liability (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

A characteris�c of the corporate, limited partnership, and LLC forms of business organiza�on, which limits the maximum loss one can take in a business to the amount one contributes.

limited liability company (LLC) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

an organiza�onal form that can combine the features of limited liability and professional management but avoid the double taxa�on of income that plagues the corporate form of organiza�on.

limited partnership (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

A partnership with a general partner who manages the business and a group of general partners whose liability is limited to the amount that they invest but who must remain uninvolved in the day-to-day management of the business.

outsiders (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

See insiders.

partnerships (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

When two or more individuals join to pursue a business venture.

par value (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Value of a bond equal to the amount that will be paid to the bondholder on the bond's maturity date. Corporate bonds o�en have a par value equal to $1,000. Also known as the face amount or maturity value of a bond.

perquisites (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Benefits of employment beyond direct monetary compensa�on. These commonly include health insurance, vaca�on, company cars, and day care. Excessive perquisites are those which do not contribute to corporate value by mo�va�ng employees or other means. Also known as perks.

protec�ve covenants (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Por�ons of the loan agreement that limit certain ac�ons a company may take during the term of the loan to protect the lender's interests.

proxy (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

A mechanism for shareholders to vote at the corpora�on's annual mee�ng when they cannot a�end in person. A proxy statement is sent to all shareholders prior to the mee�ng and lists the individuals who are running for elec�on to the board of directors as well as other issues being voted on like amendments to the corporate charter. Signing and returning the proxy designates someone to vote in the shareholder's place at the annual mee�ng.

residual claims (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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Securi�es, like common stock, that receive the cash le� over a�er fixed claims have been paid. Because of their lower priority for payment, residual claims are riskier than fixed claims.

say on pay (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

The ability of shareholders in a corpora�on to ac�vely vote on execu�ve compensa�on. Corporate laws provide this power to shareholders.

secondary trading (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

The buying and selling of publicly owned securi�es in secondary markets.

securi�es (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Documents represen�ng claims on the firm's cash flows and assets. Stocks and bonds are both securi�es.

sole proprietorship (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

The form of business organiza�on where the owner is also the manager. Characterized by low informa�on asymmetry, no agency problem between owners and managers (since they are the same), but a limited organiza�onal life and a difficult �me raising funding from outside sources.

tangible assets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Assets recorded on the le�-hand side of the financial balance sheet that include land, cash, inventory, factory, and equipment investments.

trade credit (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Credit extended by one firm to another in the normal course of buying/selling inventory.

venture capital (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Funds provided by investors to startup firms and small businesses with perceived long-term growth poten�al. Due to the lack of access to capital markets, venture capital is a very important source of funding for startups. Venture capital investments are characterized as high risk for the investor but have the poten�al for above-average returns.

widely held corpora�ons (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Corpora�ons whose stock is owned by a large and diverse group of shareholders and is generally publicly traded. Characterized by a liquid secondary market for the company's stock but plagued by problems of informa�on asymmetry and large poten�al agency costs.

Web Resources

Learn more about the NYSE by visi�ng its website. www.nyse.com (h�p://www.nyse.com)

Learn more about the NASDAQ by visi�ng its website. www.nasdaq.com (h�p://www.nasdaq.com)

Learn more about bankruptcy by visi�ng the American Bankruptcy Ins�tute (ABI) website. The ABI is the largest mul�disciplinary, nonpar�san organiza�on dedicated to research and educa�on on ma�ers related to insolvency. www.abiworld.org (h�p://www.abiworld.org)

Learn more about corporate social responsibility here: www.csrhub.com (h�p://www.csrhub.com)

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Chapter 2

Financial Claims and Markets

Kike Calvo/Na�onal Geographic Stock

Learning Objectives

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

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

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Ch. 2 Introduction

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

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

2.1 Governments, Corporations, and Markets

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

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

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

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

Besides product markets, firms also par�cipate in financial markets. A company's financial market ac�vi�es appear on the right-hand side of the financial balance sheet under long-term liabili�es and equity. Financial markets supply the funds that firms use to purchase produc�ve assets, such as factories, machinery, trucks, computers, and offices. Financial markets also provide a mechanism for valuing a firm's securi�es. Investors buy and sell stocks and bonds in these markets. These transac�ons determine security prices and, thereby, the value investors place on a firm.

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

Figure 2.1: The financial balance sheet and government

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

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

Bloomberg/Ge�y Images

One important lesson of modern finance is that corpora�ons are defined in large part by the markets in which they operate. Therefore, in many respects finance is the study of markets. Understanding the markets in which corpora�ons par�cipate is essen�al to understanding corpora�ons themselves. Corporate assets, such as plant, equipment, and human resources are shown on the le�-hand side of the financial balance sheet and reflect the corpora�on's ac�vity in product markets. The right-hand side of the financial balance sheet shows how the firm financed those assets; that is, it presents a record of the firm's ac�vi�es in the financial markets. The corpora�on acts as a conduit, linking investment funds from the financial markets to goods and services in the product markets. The corpora�on invests the funds in machinery, factories, raw materials, and skilled personnel, which are organized to produce items that consumers want. See Figure 2.2 for an illustra�on of this interac�on on the financial balance sheet.

Figure 2.2: The financial balance sheet and markets

In both product and financial markets, informa�on availability and ease of entry play important roles in determining whether wealth-increasing opportuni�es exist. In financial markets, prices typically reflect new informa�on very quickly. For example, if a pharmaceu�cal company announces it has developed a vaccine for AIDS, within minutes its stock price will reflect investors' forecasts of the company's future profits. This market is informa�onally efficient, producing prices that quickly and accurately reflect the economic impact of corporate news. What informa�onal efficiency implies about making money in financial markets is one of the important lessons in this chapter.

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

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

2.2 Markets and Exchange

Before describing the markets in which corpora�ons operate, we want to discuss the role of markets in general. All markets, no ma�er what their form, have a common purpose: They provide a mechanism for individuals and businesses to exchange goods and services by bringing interested buyers and sellers together. Transac�ons between willing par�cipants result in both par�es being be�er off. If each trader did not believe that the trade was in his or her interest, they would not make the exchange. Therefore, markets enhance people's well-being.

Market Structures

Markets are essen�al to any economic system, and evidence of markets is found in even ancient socie�es. Markets come in a variety of shapes and sizes. They can be places, such as shopping malls and the floor of the New York Stock Exchange. But exchange no longer requires going to a par�cular physical loca�on. Modern telecommunica�ons allows markets to be computer networks, like eBay, or television programs. Catalogs are another example of markets without a physical loca�on. The importance and desirability of convenient and speedy exchange means that markets undergo constant refinement and change. Immense energy and ingenuity goes into developing ways to facilitate exchange. Everyone benefits as exchange becomes easier and cheaper, and more sellers (with a broader range of goods and services) can meet more buyers (with more money and a broader range of needs and desires).

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

O�en our view of markets and exchange extends only to shopping for physical items. However, when we buy or hire services, we exchange money for another person's �me.

When we work, we exchange our �me for money (and the goods and services it can buy). Although exchange o�en involves the simultaneous payment of money and receipt of a good or service, some�mes one side of the exchange is delayed. This occurs frequently in the field of finance. Inves�ng money today brings no immediate benefits. What is being bought is the expecta�on of more money in the future. Similarly, a college educa�on requires paying now (in terms of �me and money) for future benefits (a be�er job and broader view of the world). These examples show that markets need not involve the simultaneous exchange of money for goods.

Markets not only facilitate exchange but also generate and process informa�on. Informa�on is the lifeblood of markets. Without informa�on, much exchange would not occur, and many markets would not exist. The single most valuable type of informa�on created by markets is price. Prices established by transac�ons in rela�vely free and compe��ve markets are the most fundamental measure of economic value. The market price of an asset, good, or

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service provides informa�on about equivalent nontraded items. Using current market prices we can infer the value of many items without having to actually sell them. Prices also help individuals and businesses plan for the future. Prices tell poten�al buyers and sellers the current value placed on an item. With that informa�on, producers can decide whether to expand or contract their produc�on of par�cular items, and consumers can adjust their spending and savings pa�erns.

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

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

We want to stress the importance of prices being set in markets. In socialist countries, where prices were determined by government and not the market, immense economic distor�ons occurred. For example, in former Soviet Russia, bread once cost less than the grain used in its produc�on! Only with the informa�on provided by prices set in compe��ve markets can an economy approach an efficient alloca�on of resources.

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

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

Sygma/Corbis

2.3 Financial Markets

Corpora�ons dominate our economy in part because they have ready access to financial markets. Financial markets provide funds to firms for investment in produc�ve assets. Besides furnishing funds for corporate investment, financial markets also provide investors with opportuni�es to put their savings to work. By coordina�ng the savings ac�vi�es of individuals and the investment needs of corpora�ons, financial markets play a key role in the economic development of our country. In this sec�on, we describe the basic a�ributes of financial markets and con�nue our discussion of market efficiency.

Financial Securities, Transferability, and Liquidity

As we begin our study of financial markets, we focus on stocks and bonds—the most common financial securi�es issued by corpora�ons. There are many more types of financial securi�es than stocks and bonds—every year new financial instruments are introduced. As with physical goods, these securi�es have value; however, their value derives from the rights a�ached to their ownership rather than from their physical a�ributes.

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

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

A�er a company pays bank loans, commercial paper, lines of credit, and all other fixed or contractual obliga�ons, the remaining cash flows belong to shareholders. Since shareholders have a claim to what is le�over, they are referred to as residual claimants. The corpora�on can distribute cash to shareholders in the form of dividends. Alterna�vely, the company may keep some or all of the residual cash flows to invest in new projects or products; money that shareholders have a claim to but that is kept in the firm is called retained earnings. If managers invest these funds wisely, the company's stock price rises to reflect the higher an�cipated future cash flows. Shareholders benefit in two ways from their ownership stake in a corpora�on: They may receive cash dividends, and/or they may sell the firm's stock at a price higher than they paid. The sale of a share of stock results in a capital gain (or a capital loss) if the sale price is greater (or less) than the purchase price. Both bonds and stocks can create capital gains; however, capital gains are more o�en associated with common stock. The total return from an investment in common stock includes both the return from dividends and the return from capital gains.

In addi�on to the claim to cash flows, a�ributes such as transferability and liquidity can affect a security's value. With very few excep�ons, financial securi�es are nego�able, meaning that they may be sold or transferred to other investors. A dis�nguishing feature of corpora�ons, compared to other types of business organiza�ons, is the ease with which ownership can be transferred from one investor to another. Transferability of ownership contributes to the longevity and growth poten�al of corpora�ons. Although all securi�es traded in financial markets are nego�able, the ease with which transfer occurs varies depending on a security's liquidity. Liquidity refers to the ability to sell a security quickly without having to offer a substan�al price reduc�on to a�ract buyers.

Securi�es that trade infrequently, o�en called thinly traded, are par�cularly prone to problems of illiquidity. Some classic examples of illiquidity include condominium �me shares and precious gems. These are assets with value, but they o�en sell on the secondary market for substan�al price concessions. To increase the value of the asset, sellers o�en offer to create a market for reselling illiquid assets. One of the key benefits of well-developed financial markets is the increased liquidity such markets provide. By bringing together more buyers and sellers, liquidity increases, and the costs of transferring ownership fall.

The lack of liquidity can have large nega�ve impacts on a firms' value. During the financial crisis of 2008, many large investment banks were following a business model that relied on short-term financing. They rou�nely paid off and reborrowed billions of dollars of short-term securi�es on a daily basis. One cause of the crisis was that investors began to ques�on the creditworthiness of these banks because of their exposure to the downturn in the value of home mortgages. With no one willing to buy their short-term debt issues, these banks faced a cash flow crisis and were in danger of being forced into bankruptcy (or entered bankruptcy, as was Lehman Brothers Holdings).

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

Primary and Secondary Markets

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

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

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

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

Figure 2.3: Primary and secondary capital markets

Money and Capital Markets

Companies access the financial markets to obtain funds for long-term growth as well as for short-term or seasonal needs. Within finance, short-term has come to mean securi�es with maturi�es of one year or less. Short-term securi�es trade in money markets. Money market instruments include commercial paper and U.S. treasury bills. Commercial paper is a promissory note (with a maturity of 270 days or less) issued by a company. U.S. treasury bills (T-bills),Processing math: 0%

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

which are sold weekly, have maturi�es of 13, 26, or 52 weeks. By conven�on, long-term refers to securi�es with a life greater than 1 year from the date of their original sale. Long- term securi�es include government and corporate bonds as well as stock (which has a conceptually perpetual life). Economists some�mes make a somewhat finer dis�nc�on: Intermediate-term securi�es have maturi�es of 1 to 10 years. U.S. Treasury notes fall into this category, as do some corporate debt instruments. Intermediate- and long-term securi�es, such as stocks and bonds, trade in capital markets. Both capital and money markets are broken down into primary and secondary markets. Figure 2.4 summarizes the dis�nc�ons between money and capital markets, and between primary and secondary markets.

Figure 2.4: Financial market classifica�on

Money markets process an enormous volume of transac�ons, a much higher volume than the capital markets. One of the reasons for this ac�vity is that many money market claims are very short lived, some as short as one day. Imagine renewing a borrowing or lending arrangement every day. Many banks do exactly that. These are the markets in which a large por�on (about 30%) of all U.S. government debt is financed, and in which the largest na�onal and interna�onal banks are par�cularly ac�ve. As interes�ng as money markets are, we shi� our focus to the capital markets. Secondary capital markets occur in two forms: exchanges and over-the-counter markets. The capital market that you are likely most familiar with is the New York Stock Exchange (NYSE). The NYSE is the oldest and largest stock exchange in the United States. Purchasing shares of stock listed on the NYSE (or any other stock exchange) typically requires contac�ng your local stockbroker (some�mes called a commission broker, a registered representa�ve, or an account execu�ve) with your order informa�on. The stockbroker relays your order to the brokerage firm's headquarters, which then transmits the order to the floor of the NYSE. Your order may be filled by the specialist in the stock or may be entered in the specialist's order book (where your buy order is matched with another investor's sell order) for later execu�on if the price moves in the right direc�on. Each stock has an assigned specialist, who maintains a fair and orderly market in his or her par�cular stock or stocks.

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

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

Whenever you buy or sell securi�es, whether you trade on the NYSE or NASDAQ system, you pay transac�on costs. These costs include the commission paid to your broker and the bid-ask spread, the difference between the bid price and the ask price. If you buy a share of stock, you pay an ask price, and when you sell you receive a bid price. For heavily traded stocks the bid-ask spread is small (less than 1% of the share price), but for infrequently or thinly-traded stocks the spread can be significant (in the range of 3% to 6% of the share price). For example, the difference between bid and ask prices is small for stocks like Microso� or Intel that trade on high volume, allowing dealers to make a small profit on each transac�on while execu�ng many trades. In contrast, very low-priced, infrequently traded penny stocks o�en have bid-ask spreads in excess of 25%, meaning an investor must see the price of the stock increase by 25% just to break even on the investment.Processing math: 0%

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

Ge�y Images News/Ge�y Images

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

Field Trip: Capital Markets

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

Visit h�p://www.bloomberg.com/markets/ (h�p://www.bloomberg.com/markets/)

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

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

In addi�on to purchasing stocks on the secondary market, investors some�mes carry out transac�ons called short sales, in which they sell a stock they don't own but have borrowed, planning on buying it in the future to even out the transac�on. This strategy is especially applicable to situa�ons where investors believe that a stock's price will fall. They sell today at a high price, and buy in the future at a lower price. The purchase allows them to return the borrowed stock, and the difference between the high selling price and lower purchase price is their profit (less transac�on costs, of course).

Competition and Information in the Financial Markets

Although there are many complicated ins�tu�onal details associated with financial markets, the basic force driving financial market transac�ons is amazingly simple: People are trying to make money. Companies that issue securi�es in the primary markets compete with one another for investors' dollars. Investors trading in secondary markets compete to buy stocks and bonds that appear likely to pay large dividends or interest payments or that may accrue capital gains from an increase in the price of the asset, rela�ve to other securi�es. Compe�ng investors bid up the price of shares of companies with good prospects and bid down those with declining prospects. In many ways, securi�es are seen as subs�tutes. Investors ac�vely shi� their funds to those securi�es with the brightest prospects. A confirmed Pepsi drinker, who might never consider changing to Coca-Cola or Dr. Pepper, has no compunc�on at all about selling stock in PepsiCo and buying stock in Coca-Cola. Inves�ng is about money and the prospects of companies, and brand loyalty plays li�le role. Therefore, one soda pop stock is as good as another, and the best one is the stock that provides the highest expected total return (i.e., dividends and capital gain), no ma�er whether the investor personally likes the taste of the product or not. (Note, however, that how an investor perceives demand for a product influences his or her opinion of the firm's future prospects.)

Investors compete with one another to make be�er predic�ons about the future cash flows associated with financial claims. If you correctly predict that a company's prospects have improved before other investors, you can buy shares at a bargain price. Conversely, if you realize that a company's fortunes have fallen before the crowd does, you can profit by selling shares now and repurchasing them later at a lower price. Because all investors are compe�ng to predict a security's future cash flows, the relevant informa�on focuses on how companies will fare in the future. This future orienta�on is one of the characteris�cs that dis�nguishes finance from accoun�ng: Finance is almost en�rely about the future, whereas accoun�ng is largely a record of the past.

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

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

Everyone has heard about someone, an uncle or family friend, who has made a fortune in the stock market. This happens. Sadly, many people have lost their fortunes in the stock market, but you rarely hear about them. Investor compe��on does not imply that no one ever becomes enormously wealthy (or very poor) trading securi�es. It does mean that the majority of investors earn just a normal return—not too big, not too small—from inves�ng in stocks and bonds. Some investors do be�er than others and some do worse, but the average return is just sufficient for investors to con�nue to invest in the market.

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Expected returns vary across securi�es. We will see later in the text that returns are related to risk; that is, investors expect higher returns for inves�ng in riskier securi�es.

Informational Efficiency in Financial Markets

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

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

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

The weak form of the efficient markets hypothesis assumes that security prices incorporate only historical price and volume data. If markets are weak-form efficient, then investors cannot expect to earn abnormally high profits using trading rules based on historical price and volume pa�erns. Weak-form efficiency challenges char�sts or technical analysts, who claim that they can use technical analysis to iden�fy profitable security investments by examining charts and graphs of historical price and volume data. Compelling evidence exists that securi�es markets are weak-form efficient. That financial markets are at least weakly efficient makes sense. Suppose there was a pa�ern of prices that investors could use to predict future prices. For example, suppose stock prices always increased on Wednesdays. Since investors have nearly costless and immediate access to price and volume data, they can quickly iden�fy such a pa�ern. Smart investors would buy stock on Tuesdays, preparing for the Wednesday rally. Their strategy would be to sell late on Wednesday, a�er security prices rose, and earn supranormal profits. S�ll smarter investors would buy shares on Monday (or the previous Thursday or Friday) to get ready for the Wednesday rally. But in preparing for the Wednesday rally, the buying ac�vi�es of the smart investors would drive prices up on Mondays and Tuesdays, reducing, if not completely elimina�ng, the trading profits on Wednesday. Once investors recognize a pricing pa�ern, they will invest in an�cipa�on of that pa�ern, and thereby eliminate it. Therefore, it is highly unlikely that investors can earn abnormal profits using strategies based solely on historical price and volume informa�on.

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

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

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

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

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

Associated Press

Doubt about strong-form efficiency also arises from laws prohibi�ng insider trading. These laws a�empt to create a level playing field for outside investors. The problem these laws address is one of asymmetric informa�on, which was discussed in Chapter 1. Asymmetric informa�on means that one person or group has more informa�on than some other person or group. In the case of stock market inves�ng, asymmetric informa�on can create serious problems. If outside investors know that insiders can make stock market trades using their privileged informa�on, they will be hesitant to trade. Outsiders know they will undoubtedly lose money in trades with these insiders. For example, suppose a manager knows that the firm's quarterly earnings will be much lower than investors an�cipate. The manager could sell stock before the news is released at a price of $45. A�er the news release, the price might fall to $40. The non-inside investors who bought shares from the manager at $45 find themselves owning shares worth only $40. Therefore, allowing insiders to trade on private informa�on drives other investors away from the market, reducing liquidity and the investment dollars available for corporate growth. Laws prohibi�ng insider trading increase investor trust, and thereby their willingness to invest.

The penal�es for insider trading are severe. All profits from the illegal trades must be forfeited, and fines and prison sentences may be imposed. Furthermore, stockbrokers, bankers, and lawyers can be banned from future involvement in the security business if

convicted of insider trading. As the insider trading cases of Ivan Boesky and Michael Milken in the late 1980s show, federal prosecutors and the U.S. Securi�es and Exchange Commission take insider trading crimes very seriously. More recently, the scandals engulfing Enron in 2001 included the eventual convic�on of CEO Kenneth Lay for fraud, which led to the strict insider trading and disclosure regula�ons included in the Sarbanes-Oxley Act of 2002. In 2011, Raj Rajaratnam, a billionaire who ran one of the world's largest hedge funds, was sentenced to prison for insider trading.

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

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

A balanced discussion of market efficiency must include the fact that there are a number of studies whose results are not consistent with the efficient market hypothesis. For example, there is evidence that stocks some�mes overreact to informa�on, contradic�ng the assump�on that new informa�on isProcessing math: 0%

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accurately impounded into market prices. Other so-called market anomalies (apparent viola�ons of market efficiency) include the small firm effect, which seems to indicate that small firms' shares outperform large firms' shares on a risk-adjusted basis, and the January effect, which is named for the concentra�on of strong stock returns during the first few days of January. The existence of these anomalies led Professor Andrew Lo of MIT to propose the adap�ve markets hypothesis (Lo, 2004, 2005), which a�empts to reconcile anomalies to the idea of efficient markets. Lo's work is based on classical economics but also borrows from evolu�on and neuroscience to suggest that tolerances, regula�ons, and objec�ves shi� over �me resul�ng in market behaviors that appear to be inconsistent with market efficiency. This theory is in its infancy, but it reinforces the point that market efficiency is not without its mysteries and well-documented excep�ons that economists are s�ll a�emp�ng to explain.

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

Applying the lesson of efficient markets to corpora�ons is straigh�orward. Corporate managers will rarely enhance the wealth of shareholders (the key decision criterion for managers) through financial market transac�ons in efficient markets. In many ways, this is good news for corporate officers. Efficient markets imply that prices reflect available informa�on, or that prices are fair. When companies issue and sell securi�es, on average, they receive a fair price for those securi�es. Therefore, managers can concern themselves primarily with how the funds will be used, not with how the funds were obtained. Efficient markets make the job of financial managers simpler. Moreover, fair and efficient financial markets, such as those with prohibi�ons against insider trading, encourage investors to par�cipate and thereby increase the pool of available funds. A larger supply of investment dollars translates into a lower price for those dollars, so corporate managers benefit in a second way: In efficient markets, they gain access to fairly priced and rela�vely inexpensive funds.

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

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2.4 Product Markets

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

Perfect Competition

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

Although perfectly compe��ve markets are rare, highly compe��ve markets are more common than you might imagine. Markets selling products that are considered commodi�es, such as gasoline, coal, steel, sugar, and wheat, are extremely compe��ve, with many consumers using price as the primary purchase criterion. Even memory chips and desktop computers have become commodity-like. Generic products at supermarkets represent products that are very nearly commodi�es and are offered because many shoppers look at price alone when buying these items. Compe��ve markets emerge from two sources. Some products are commodi�es (and therefore perfect subs�tutes), so the markets selling those products become highly compe��ve. For example, one pound of sugar is very similar to any other pound of sugar, assuming minimal standards of product quality, such as cleanliness, are sa�sfied. Highly compe��ve markets also emerge when a market allows easy entry. Such a situa�on occurred in the personal computer market. Even as late as the mid-1980s, IBM and Compaq were able to charge premium prices for their personal computers. As computer technology became more widespread, the high prices charged by U.S. producers a�racted entry into the market. Low-cost machines from companies such as Dell, HP, and Lenovo quickly cut into IBM's and Compaq's market share. They were forced to lower prices and devise new methods to market their machines. Eventually, IBM and Compaq were inclined to leave the PC market. The ability of compe�tors to build subs�tutes for IBM and Compaq computers drama�cally increased the compe��veness of the personal computer market.

Can you see any similari�es between perfectly compe��ve product markets and efficient financial markets? In both markets, par�cipants should expect to earn only a normal profit. Investors, like consumers of commodity goods, shop based on price. For example, when borrowing money, borrowers will readily subs�tute doing business with bank A for borrowing at bank B if bank A offers a lower interest rate. Investors also shop around for a good deal. When their analysis iden�fies a promising security, they happily subs�tute that security for others in their por�olio.

Imperfect Competition

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

The process of differen�a�on goes on con�nuously. Innovators must constantly improve exis�ng products and develop new ones because imitators quickly copy (or nearly copy) successful items. For example, innovators on Wall Street have begun using the differen�a�on concept. Each year new financial instruments debut, with special a�ributes that make them a�rac�ve to a narrow clientele of investors. These instruments may earn their creators a somewhat higher-than-expected return in the short run, but difficul�es in copyrigh�ng financial products means that compe�tors quickly copy good ideas. Entry by imitators reduces the returns to a normal level.

The existence of higher-than-normal profits a�racts these entrants. With more producers vying for a par�cular market segment, price—and thereby profit— typically falls. Above-normal profits from product innova�on can be very short-lived. Therefore, managers must constantly seek new opportuni�es and shi� their product mix into those emerging markets. The days of making a single product and relaxing as the money rolls in, if there ever were days like that, areProcessing math: 0%

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over. Compe��on within the United States, as well as from abroad, means that managers must be extremely vigilant in monitoring market condi�ons and be prepared to fight for exis�ng products while con�nuously looking for new products and markets.

Nevertheless, it is possible to make an abnormally high profit from product market investments because of the complex tastes and needs of customers. Iden�fying market segments with unsa�sfied wants and then differen�a�ng a product to sa�sfy those needs can create corporate value if the targeted segment is willing to pay a premium for the product. In a sense, one can create a minimonopoly within a market segment. From basic economics, we know that monopolies, unlike businesses in perfectly compe��ve markets, can earn above-normal profits.

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

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

Associated Press

2.5 Market Participants and Value

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

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

Es�ma�ng the cost of product development and produc�on is generally the task of engineers and produc�on managers. Cash flows are es�mated with input from the firm's marke�ng staff. It is in the es�ma�on of value that finance is most useful; in fact, it is the central theme of this text. Remember the four determinants of value that were introduced in Chapter 1? We now add a fi�h value-driver to that list, the op�ons or opportuni�es that are created when a project is pursued.

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

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

Behavioral Foundations of Value

Each of these characteris�cs contributes to the value of a project and is rooted in our understanding of human behavior. A�er all, people are doing the trading in financial markets where security prices, and therefore value, are determined. Let's examine the traits of human behavior that are assumed to underlie each of these five components of value.

1. The size of expected cash flows is important because of the posi�ve u�lity (or happiness) derived from wealth. In terms of wealth, we assume that people prefer having more rather than less; the greater a person's consump�on power is, the happier they are. How people choose to spend their wealth—on themselves, their friends and family, their community—is up to them. Even people who devote their lives to charitable ac�vi�es would prefer to have more, rather than less, to give to their favorite causes. Having more wealth means they can provide more for whomever or whatever purpose they choose. The bo�om line is more cash, more value.

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

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

Ms. Teka Chaunce offers Mr. Rick Averse a chance to make some fast money. They will flip a coin, and Rick can call heads or tails. If he calls it correctly, Teka gives him $1,000. If he is wrong, he pays her a $1,000. No risk-averse person would accept such a bet. The risk of losing $1,000 would cause such a person more anxiety than could be overcome by the benefits of winning $1,000. For Rick to make a bet, Teka would have to offer him a higher payoff than just $1,000. He might be en�ced to play the game if Teka gave him $1,200 if he won, but he paid only $1,000 if he lost. That extra $200 is a risk premium and raises the value of the gamble to Rick.

Risk aversion is not just an economic theory having to do with uncertain investments. Most people's behavior suggests they are somewhat risk averse. You may be suspicious of this no�on of risk aversion. There are certainly examples of people accep�ng and even enjoying taking risks. Gamblers know that over the long run the casino will win, but they gamble anyway. Some people enjoy risky sports orProcessing math: 0%

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hobbies—sky diving, mountain climbing, car racing, and so on—which seems to dispute the claim that people are generally risk averse, but remember that sky divers wear back-up chutes and climbers use ropes. We are quite willing to admit that some people enjoy the thrill of risk taking, but we remain convinced that investors are risk averse.

4. The returns available on alterna�ve investments are important because of ra�onal self-interest. We assume that people look out for their own welfare and are clever about it. Therefore, when all else is the same (including risk, the �ming of cash flows, etc.), an investor will assess all the investment alterna�ves available and choose the one that is most a�rac�ve. Thus, investment projects compete with one another. The bo�om line is that, when assessing the value of a project, investors will consider ret urns available on other investments with similar characteris�cs.

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

A Simple Value Formula

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

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

where E(CF) stands for the expected cash flow, r is the interest rate, and t represents the �me un�l the cash is received. Consider this formula in light of the first four characteris�cs of value we just discussed. If investors receive informa�on causing their expecta�ons of future cash flows to increase, then E(CF) will increase, and the value (PV) will increase as well. Now, suppose that cash flows are expected to arrive sooner than originally thought—then the exponent t in the formula decreases, which will increase PV. The discount rate, r, is adjusted for risk. So, if one thinks a project is riskier than originally thought, then r, increases and value declines. And last, let's suppose infla�on increases. Banks would offer to pay higher rates of interest on cer�ficates of deposit (CDs); in response, other investments would offer higher returns in order to compete with CDs. Thus, the rates of return available on alterna�ve investments have increased, which would cause investors to require a higher return on the project being considered before they would choose to pursue it. The discount rate, r, would increase in order to account for these higher return requirements throughout the economy, and the PV of the investment opportunity would fall. How quickly and accurately the informa�on is reflected in the valua�on is a func�on of the degree of market efficiency. In very efficient markets, valua�on adjustments occur within minutes of news being released.

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

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Ch. 2 Conclusion

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

It is in product markets and financial markets that these preferences play their roles in determining value. Within the legal and regulatory environment established by government, a business strives to provide desirable goods and services that can be profitably sold. The value of the business is determined in capital markets where investors' collec�ve assessment of the five characteris�cs that contribute to value are revealed by the market price of the business's securi�es. Note that each characteris�c of value, and therefore the market prices of the firm's securi�es, depends on decisions made on the le�-hand side of the financial balance sheet. Cash flows—their size, their �ming, and their riskiness—as well as the op�ons available to the firm are a func�on of the kinds of projects the company pursues and how successfully the company follows those pursuits. Corpora�ons succeed by making wise investments in imperfect product markets and having those investments valued by efficient financial markets. Recall that increasing the market price of common stock leads to fulfilling the financial goal of shareholder wealth maximiza�on.

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

Financial Balance Sheet, Part II

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

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Ch. 2 Learning Resources

Key Ideas

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

Key Equa�ons

Cri�cal Thinking Ques�ons

1. In terms of the characteris�cs of markets such as barriers to entry, similarity of the products, and compe��on, can you explain why LeBron James (the basketball player) is paid millions of dollars each year?

2. EBay is very successful, as is Craigslist. Can you explain their success in terms of markets? What did they provide that did not exist before they were created? 3. If the stock market is informa�onally efficient, does that mean that you should not expect to earn a posi�ve return if you invest? Why or why not? 4. Describe the steps that a sandwich shop should take as it considers delivering sandwiches at lunch �me in the downtown area of a large city. The idea is to

invest in two delivery bicycles and a computer system that will allow the shop to take orders and receive payments on-line, as well as schedule delivery and lay out the delivery drivers' routes.

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

Key Terms

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

adap�ve markets hypothesis (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

ask price (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

barriers to entry (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

bid-ask spread (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

bid price (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

bond indenture contract (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

capital gain (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

capital markets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

commercial paper (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

financial markets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

fundamental analysis (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

going public (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

imperfect compe��on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

informa�onal efficiency (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

Efficiency based on informa�on being quickly and accurately impounded into asset prices.Processing math: 0%

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ini�al public offering (IPO) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

See going public.

liquidity (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

market anomalies (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

market efficiency (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

money markets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

NASDAQ (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

See over the counter (OTC).

NYSE (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

See secondary markets.

over the counter (OTC) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

perfect compe��on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

primary markets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

private placement (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

product differen�a�on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

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product market (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

retained earnings (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

seasoned offering (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

secondary markets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

semistrong-form efficiency (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

strong-form efficiency (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

technical analysis (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

An approach to trading securi�es based on past prices and trading volumes. Generally, technicians look for pa�erns in prices or returns that they believe will help them predict future price movements. Technical analysis will not produce returns superior to a simple buy-and-hold strategy if markets are weak-form efficient. Also known as char�ng.

transac�on costs (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

transferability (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

treasury bills (T-bills) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

unseasoned offering (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

weak-form efficiency (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65

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

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

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

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

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