Points: 100 Criteria 1. In your own words, please identify two different stock exchanges in the United States. Describe the similarities and differences between the two stock exchanges. Identify one stock from each of the two stock exchanges. Weight: 30% 2. Using the two stocks you identified, determine the free cash flow from 2013 and 2014. What inference can you draw from the companies’ free cash flow? Weight: 30% 3. Using the information and formulas from your textbook, please prepare two financial ratios for each stock, using the 2013 and 2014 financial statements, to include: liquidity ratios, asset management ratios, and profitability ratios. You should have a total of six ratios for each stock, per year. What challenges, strengths, or weaknesses do you see? Please be articulate. Weight: 30% 4. Clarity, writing mechanics, and formatting requirements. Weight: 10% Homework Set 1: Chapters 1, 2, and 3 Unacceptable Below 70% F Fair 70-79% C Proficient 80-89% B Exemplary 90-100%A Did not submit or incompletely identified two stock exchanges in the United States. Did not submit or incompletely described the similarities and differences between the two stock exchanges. Did not submit or incompletely identified one stock from each of the two stock exchanges. Partially identified two stock exchanges in the United States. Partially described the similarities and differences between the two stock exchanges. Partially identified one stock from each of the two stock exchanges. Satisfactorily identified two stock exchanges in the United States. Satisfactorily described the similarities and differences between the two stock exchanges. Satisfactorily identified one stock from each of the two stock exchanges. Thoroughly identified two stock exchanges in the United States. Thoroughly described the similarities and differences between the two stock exchanges. Thoroughly identified one stock from each of the two stock exchanges. Did not submit or incompletely determined the free cash flow from 2013 and 2014. Did not submit or incompletely explained the inferences drawn from the companies' free cash flow. Partially determined the free cash flow from 2013 and 2014. Partially explained the inferences drawn from the companies' free cash flow. Satisfactorily determined the free cash flow from 2013 and 2014. Satisfactorily explained the inferences drawn from the companies' free cash flow. Thoroughly determined the free cash flow from 2013 and 2014. Thoroughly explained the inferences drawn from the companies' free cash flow. Did not submit or incompletely prepared two financial ratios for each stock, using the 2013 and 2014 financial statements, to include: liquidity ratios, asset management ratios, and profitability ratios. Did not submit or incompletely explained the challenges, strengths, or weaknesses. Partially prepared two financial ratios for each stock, using the 2013 and 2014 financial statements, to include: liquidity ratios, asset management ratios, and profitability ratios. Partially explained the challenges, strengths, or weaknesses. Satisfactorily prepared two financial ratios for each stock, using the 2013 and 2014 financial statements, to include: liquidity ratios, asset management ratios, and profitability ratios. Satisfactorily explained the challenges, strengths, or weaknesses. Satisfactorily prepared two financial ratios for each stock, using the 2013 and 2014 financial statements, to include: liquidity ratios, asset management ratios, and profitability ratios. Satisfactorily explained the challenges, strengths, or weaknesses. More than 6 errors present 5-6 errors present 3-4 errors present 0-2 errors present PART 1 The Company and Its Environment © EpicStockMedia/Shutterstock.com CHAPTER 1 An Overview of Financial Management and the Financial Environment 3 CHAPTER 2 Financial Statements, Cash Flow, and Taxes 57 CHAPTER 3 Analysis of Financial Statements 101 NOT FOR SALE 1 NOT FOR SALE CHAPTER 1 An Overview of Financial Management and the Financial Environment © Panda3800/Shutterstock.com www See http://fortune.com/ worlds-most-admired -companies for updates on the rankings. In a global beauty contest for companies, the winner is … Apple. Or at least Apple is the most admired company in the world, according to Fortune magazine’s annual survey. The others in the global top ten are Amazon.com, Google, Berkshire Hathaway, Starbucks, Coca-Cola, Walt Disney, FedEx, Southwest Airlines, and General Electric. What do these companies have that separates them from the rest of the pack? Based on a survey of executives, directors, and security analysts, these companies have very high average scores across nine attributes: (1) innovativeness, (2) quality of management, (3) long-term investment value, (4) social responsibility, (5) people management, (6) quality of products and services, (7) financial soundness, (8) use of corporate assets, and (9) effectiveness in doing business globally. After culling weaker companies, the final rankings are then determined by over 3,900 experts from a wide variety of industries. What makes these companies special? In a nutshell, they reduce costs by having innovative production processes, they create value for customers by providing highquality products and services, and they create value for employees by training and fostering an environment that allows employees to utilize all of their skills and talents. As you will see throughout this book, the resulting cash flow and superior return on capital also create value for investors. NOT FOR SALE 3 4 Part 1 The Company and Its Environment resource The textbook’s Web site has tools for teaching, learning, and conducting financial research. This chapter should give you an idea of what financial management is all about, including an overview of the financial markets in which corporations operate. Before going into details, let’s look at the big picture. You’re probably in school because you want an interesting, challenging, and rewarding career. To see where finance fits in, here’s a five-minute MBA. 1-1 The Five-Minute MBA Okay, we realize you can’t get an MBA in five minutes. But just as an artist quickly sketches the outline of a picture before filling in the details, we can sketch the key elements of an MBA education. The primary objective of an MBA program is to provide managers with the knowledge and skills they need to run successful companies, so we start our sketch with some common characteristics of successful companies. First, successful companies have skilled people at all levels inside the company, including leaders, managers, and a capable workforce. Skilled people enable a company to identify, create, and deliver products or services that are highly valued by customers— so highly valued that customers choose to purchase from them rather than from their competitors. Second, successful companies have strong relationships with groups outside the company. For example, successful companies develop win–win relationships with suppliers and excel in customer relationship management. Third, successful companies have enough funding to execute their plans and support their operations. Most companies need cash to purchase land, buildings, equipment, and materials. Companies can reinvest a portion of their earnings, but most growing companies also must raise additional funds externally by some combination of selling stock and/ or borrowing in the financial markets. Therefore, all successful companies sell their products/services at prices that are high enough to cover costs and to compensate owners and creditors for the use of their money and their exposure to risk. To help your company succeed, you must be able to evaluate any proposal or idea, whether it relates to marketing, supply chains, production, strategy, mergers, or any other area. In addition, you must understand the ways that value-adding proposals can be funded. Therefore, we will show you how to evaluate proposals and fund value-adding ideas, essential financial skills that will help you throughout your career. S E L F - T E S T What are three attributes of successful companies? What two essential financial skills must every successful manager have? 1-2 Finance from 40,000 Feet Above Seeing the big picture of finance from a bird’s-eye view will help you keep track of the individual parts. It all starts with some individuals or organizations that have more cash than they presently want to spend. Other individuals or organizations have less cash than they currently want to spend, but they have opportunities to generate cash in the future. Let’s call the two groups providers and users: The providers have extra cash today and the users have opportunities to generate cash in the future. For example, a provider might be an individual who is spending less today in order to save for retirement. Another provider might be a bank with more cash on hand than it needs. In either case, the provider is willing to give up cash today for cash in the future. NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 5 FIGURE 1-1 Providers and Users: Cash Now versus Claims on Risky Future Cash Provider: Person or organization with cash now Cash now User: Person or organization with opportunities to convert cash now into cash later Claim on risky future cash A user might be a student who wants to borrow money for tuition and who plans to pay it back from future earnings after graduating. Another user might be an entrepreneur who has an idea for a new social media application that might generate cash in the future but requires cash today to pay for programmers. Figure 1-1 shows the relationship between providers and users. As Figure 1-1 shows, providers supply cash now to users in exchange for a claim on future cash flows. For example, if you took out a student loan, the bank gave you cash, but you signed a document giving the bank a claim on future cash flows to be paid from you to the bank. This claim is risky, because there is some probability (hopefully small) that you will not be able to repay the loan. Two problems immediately present themselves. First, how do the providers and users identify one another and exchange cash now for claims on risky future cash? Second, how can potential providers evaluate the users’ opportunities? In other words, are the claims on risky future cash flows sufficient to compensate the providers for giving up their cash today? At the risk of oversimplification, financial markets are simply ways of connecting providers with users, and financial analysis is a tool to evaluate risky opportunities. We cover many topics in this book, and it can be easy to miss the forest for the trees. So as you read about a particular topic, think about how the topic is related to the role played by financial markets in connecting providers with users or how the topic explains a tool for evaluating financial claims on risky future cash flows. Later in this chapter we provide an overview of financial markets, but first we address an especially important type of user: companies that are incorporated. S E L F - T E S T What do providers supply? What do providers receive? What do users receive? What do users offer? What two problems are faced by providers and users? 1-3 The Corporate Life Cycle Many major corporations, including Apple and Hewlett-Packard, began life in a garage or basement. How is it possible for such companies to grow into the giants we see today? No two companies develop in exactly the same way, but the following sections describe some typical stages in the corporate life cycle. NOT FOR SALE 6 Part 1 The Company and Its Environment 1-3a Starting Up as a Proprietorship Many companies begin as a proprietorship, which is an unincorporated business owned by one individual. Starting a business as a proprietor is easy—one merely begins business operations after obtaining any required city or state business licenses. The proprietorship has three important advantages: (1) It is easily and inexpensively formed. (2) It is subject to few government regulations. (3) Its income is not subject to corporate taxation but is taxed as part of the proprietor’s personal income. However, the proprietorship also has three important limitations: (1) It may be difficult for a proprietorship to obtain the funding needed for growth. (2) The proprietor has unlimited personal liability for the business’s debts, which can result in losses that exceed the money invested in the company. (Creditors may even be able to seize a proprietor’s house or other personal property!) (3) The life of a proprietorship is limited to the life of its founder. For these three reasons, sole proprietorships are used primarily for small businesses. In fact, proprietorships account for only about 4% of all sales, based on dollar values, even though about 72% of all companies are proprietorships. 1-3b More Than One Owner: A Partnership Some companies start with more than one owner, and some proprietors decide to add a partner as the business grows. A partnership exists whenever two or more persons or entities associate to conduct a noncorporate business for profit. Partnerships may operate under different degrees of formality, ranging from informal, oral understandings to formal agreements filed with the secretary of the state in which the partnership was formed. Partnership agreements define the ways any profits and losses are shared between partners. A partnership’s advantages and disadvantages are generally similar to those of a proprietorship. Regarding liability, the partners potentially can lose all of their personal assets, even assets not invested in the business, because under partnership law, each partner is liable for the business’s debts. Therefore, in the event the partnership goes bankrupt, if any partner is unable to meet his or her pro rata liability then the remaining partners must make good on the unsatisfied claims, drawing on their personal assets to the extent necessary. To avoid this, it is possible to limit the liabilities of some of the partners by establishing a limited partnership, wherein certain partners are designated general partners and others limited partners. In a limited partnership, the limited partners can lose only the amount of their investment in the partnership, while the general partners have unlimited liability. However, the limited partners typically have no control—it rests solely with the general partners—and their returns are likewise limited. Limited partnerships are common in real estate, oil, equipment-leasing ventures, and venture capital. However, they are not widely used in general business situations, because usually no partner is willing to be the general partner and thus accept the majority of the business’s risk, and no partners are willing to be limited partners and give up all control. In both regular and limited partnerships, at least one partner is liable for the debts of the partnership. However, in a limited liability partnership (LLP) and a limited liability company (LLC), all partners (or members) enjoy limited liability with regard to the business’s liabilities, and their potential losses are limited to their investment in the LLP. Of course, this arrangement increases the risk faced by an LLP’s lenders, customers, and suppliers. 1-3c Many Owners: A Corporation Most partnerships have difficulty attracting substantial amounts of capital. This is generally not a problem for a slow-growing business, but if a business’s products or services really catch on, and if it needs to raise large sums of money to capitalize on its opportunities, then NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 7 the difficulty in attracting capital becomes a real drawback. Thus, many growth companies, such as Hewlett-Packard and Microsoft, began life as a proprietorship or partnership, and at some point their founders decided to convert to a corporation. On the other hand, some companies, in anticipation of growth, actually begin as corporations. A corporation is a legal entity created under state laws, and it is separate and distinct from its owners and managers. This separation gives the corporation three major advantages: (1) unlimited life— a corporation can continue after its original owners and managers are deceased; (2) easy transferability of ownership interest—ownership interests are divided into shares of stock, which can be transferred far more easily than can proprietorship or partnership interests; and (3) limited liability—losses are limited to the actual funds invested. To illustrate limited liability, suppose you invested $10,000 in a partnership that then went bankrupt and owed $1 million. Because the owners are liable for the debts of a partnership, you could be assessed for a share of the company’s debt, and you could be held liable for the entire $1 million if your partners could not pay their shares. On the other hand, if you invested $10,000 in the stock of a corporation that went bankrupt, your potential loss on the investment would be limited to your $10,000 investment. Unlimited life, easy transferability of ownership interest, and limited liability make it much easier for corporations than proprietorships or partnerships to raise money in the financial markets and grow into large companies. The corporate form offers significant advantages over proprietorships and partnerships, but it also has two disadvantages: (1) Corporate earnings may be subject to double taxation—the earnings of the corporation are taxed at the corporate level, and then earnings paid out as dividends are taxed again as income to the stockholders. (2) Setting up a corporation involves preparing a charter, writing a set of bylaws, and filing the many required state and federal reports, which is more complex and time-consuming than creating a proprietorship or a partnership. The charter includes the following information: (1) name of the proposed corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of directors, and (5) names and addresses of directors. The charter is filed with the secretary of the state in which the firm will be incorporated, and when it is approved, the corporation is officially in existence.1 After the corporation begins operating, quarterly and annual employment, financial, and tax reports must be filed with state and federal authorities. The bylaws are a set of rules drawn up by the founders of the corporation. Included are such points as: (1) how directors are to be elected (all elected each year or perhaps one-third each year for 3-year terms), (2) whether the existing stockholders will have the first right to buy any new shares the firm issues, and (3) procedures for changing the bylaws themselves, should conditions require it. There are several different types of corporations. Professionals such as doctors, lawyers, and accountants often form a professional corporation (PC) or a professional association (PA). These types of corporations do not relieve the participants of professional (malpractice) liability. Indeed, the primary motivation behind the professional corporation was to provide a way for groups of professionals to incorporate in order to avoid certain types of unlimited liability yet still be held responsible for professional liability. Finally, if certain requirements are met, particularly with regard to size and number of stockholders, owners can establish a corporation but elect to be taxed as if the business were a proprietorship or partnership. Such firms, which differ not in organizational form but only in how their owners are taxed, are called S corporations. 1 More than 60% of major U.S. corporations are chartered in Delaware, which has, over the years, provided a favorable legal environment for corporations. It is not necessary for a firm to be headquartered, or even to conduct operations, in its state of incorporation, or even in its country of incorporation. NOT FOR SALE 8 Part 1 The Company and Its Environment 1-3d Growing a Corporation: Going Public www For updates on IPO activity, see www .renaissancecapital .com/IPOHome/ MarketWatch.aspx. Also, see Professor Jay Ritter’s Web site for additional IPO data and analysis, http://bear .warrington.ufl.edu/ ritter/ipodata.htm. Once a corporation has been established, how does it evolve? When entrepreneurs start a company, they usually provide all the financing from their personal resources, which may include savings, home equity loans, or even credit cards. As the corporation grows, it will need factories, equipment, inventory, and other resources to support its growth. In time, the entrepreneurs usually deplete their own resources and must turn to external financing. Many young companies are too risky for banks, so the founders must sell stock to outsiders, including friends, family, private investors (often called “angels”), or venture capitalists. Any corporation can raise funds by selling shares of its stock, but government regulations restrict the number and type of investors who can buy the stock. Also, the shareholders cannot subsequently sell their stock to the general public. Therefore, a thriving private corporation may decide to seek approval from the Securities and Exchange Commission (SEC), which regulates stock trading, to sell shares in a public stock market.2 In addition to SEC approval, the company applies to be a listed stock on an SEC-registered stock exchange. For example, the company might list on the New York Stock Exchange (NYSE), which is the oldest registered stock exchange in the United States and is the largest exchange when measured by the market value of its listed stocks. Or perhaps the company might list on the NASDAQ Stock Market, which has the most stock listings, especially among smaller, high-tech companies. Going public is called an initial public offering (IPO) because it is the first time the company’s shares are sold to the general public. In most cases, an investment bank, such as Goldman Sachs, helps with the IPO by advising the company. In addition, the investment bank’s company usually has a brokerage firm, which employs brokers who are registered with the SEC to buy and sell stocks on behalf of clients.3 These brokers help the investment banker sell the newly issued stock to investors. Most IPOs raise proceeds in the range of $120 million to $150 million. However, some IPOs are huge, such as the $21.7 billion raised by Alibaba when it went public on the NYSE in 2014. Not only does an IPO raise additional cash to support a company’s growth, but the IPO also makes it possible for the company’s founders and investors to sell some of their own shares, either in the IPO itself or afterward as shares are traded in the stock market. For example, in Facebook’s 2012 IPO, the company raised about $6.4 billion by selling 180 million new shares and the owners received almost $9.2 billion by selling 241 million of their own shares. Most IPOs are underpriced when they are first sold to the public, based on the initial price paid by IPO investors and the closing price at the end of the first day’s trading. For example, in 2014 the average first-day return was over 15%. Even if you are able to identify a “hot” issue, it is often difficult to purchase shares in the initial offering. In strong markets, these deals generally are oversubscribed, which means that the demand for shares at the offering price exceeds the number of shares issued. In such instances, investment bankers favor large institutional investors (who are their best customers), and small investors find it hard, if not impossible, to get in on the ground floor. They can buy the stock in the aftermarket, but evidence suggests that if you do not get in on the ground floor, the average IPO underperforms the overall market over the long run.4 2 The SEC is a government agency created in 1934 to regulate matters related to investors, including the regulation of stock markets. 3 For example, stockbrokers must register with the Financial Industry Regulatory Authority (FINRA), a nongovernment organization that watches over brokerage firms and brokers. FINRA is the biggest, but there are other self-regulatory organizations (SRO). Be aware that not all self-advertised “investment advisors” are actually registered stockbrokers. 4 See Jay R. Ritter, “The Long-Run Performance of Initial Public Offerings,” Journal of Finance, March 1991, pp. 3–27. NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 9 Before you conclude that it isn’t fair to let only the best customers have the stock in an initial offering, think about what it takes to become a best customer. Best customers are usually investors who have done lots of business in the past with the investment banking firm’s brokerage department. In other words, they have paid large sums as commissions in the past, and they are expected to continue doing so in the future. As is so often true, there is no free lunch—most of the investors who get in on the ground floor of an IPO have, in fact, paid for this privilege. After the IPO, it is easier for a public firm to raise additional funds to support growth than it is for a private company. For example, a public company raises more funds by selling (i.e., issuing) additional shares of stock though a seasoned equity offering, which is much simpler than the original IPO. In addition, publicly traded companies also have better access to the debt markets and can raise additional funds by selling bonds. 1-3e Managing a Corporation’s Value How can managers affect a corporation’s value? To answer this question, we first need to ask, “What determines a corporation’s value?” In a nutshell, it is a company’s ability to generate cash flows now and in the future. In particular, a company’s value is determined by three properties of its cash flows: (1) The size of the expected future cash flows is important—bigger is better. (2) The timing of cash flows counts—cash received sooner is more valuable than cash that comes later. (3) The risk of the cash flows matters—safer cash flows are worth more than uncertain cash flows. Therefore, managers can increase their firm’s value by increasing the size of the expected cash flows, by speeding up their receipt, and by reducing their risk. The relevant cash flows are called free cash flows (FCF), not because they are free, but because they are available (or free) for distribution to all of the company’s investors, including creditors and stockholders. You will learn how to calculate free cash flows in Chapter 2, but for now you should know that free cash flow is: FCF Sales revenues − Operating costs − Operating taxes − Required investments in new operating capital No matter what job you have, your decisions affect free cash flows. For example, brand managers and marketing managers can increase sales (and prices) by truly understanding their customers and then designing goods and services that customers want. Human resource managers can improve productivity through training and employee retention. Production and logistics managers can improve profit margins, reduce inventory, and improve throughput at factories by implementing supply chain management, just-in-time inventory management, and lean manufacturing. All employees, from the CEO down to the night janitor, have an impact on free cash flows. A company’s value depends on its ability to generate free cash flows, but a company must spend money to make money. For example, cash must be spent on R&D, marketing research, land, buildings, equipment, employee training, and many other activities before the subsequent cash flows become positive. Where do companies get this cash? For startups, it comes directly from investors. For mature companies, some of it comes directly from new investors and some comes indirectly from current shareholders when profit is reinvested rather than paid out as dividends. As we stated previously, these cash providers expect a rate of return to compensate them for the timing and risk inherent in their claims on future cash flows. This rate of return from an investor’s perspective is a cost from the company’s point of view. Therefore, the rate of return required by investors is called the weighted average cost of capital (WACC). NOT FOR SALE 10 Part 1 The Company and Its Environment The following equation defines the relationship between a firm’s value, its free cash flows, and its cost of capital: Value FCF1 1 WACC 1 FCF2 1 WACC 2 FCF3 1 WACC 3 FCF∞ 1 WACC ∞ (1-1) We will explain how to use this equation in later chapters, but for now it is enough to understand that a company’s value is determined by the size, timing, and risk of its expected future free cash flows. If the expected future free cash flows and the cost of capital incorporate all relevant information, then the value defined in Equation 1-1 is called the intrinsic value; it is also called the fundamental value. If investors have all the relevant information, the market price, which is the price that we observe in the financial markets, should be equal to the intrinsic value. Whether or not investors have the relevant information depends on the quality and transparency of financial reporting for the company and for the financial markets. This is an important issue that we will address throughout the book. S E L F - T E S T What are the key differences between proprietorships, partnerships, and corporations? Be sure to describe the advantages and disadvantages of each. What are charters and bylaws? Describe some special types of partnerships and corporations, and explain the differences among them. What are some differences between the NYSE and the NASDAQ Stock Market? What does it mean for a company to “go public” and “list” its stock? What roles are played by an investment bank and its brokerage firm during an IPO? What is IPO underpricing? Why is it often difficult for the average investor to take advantage of underpricing? Differentiate between an IPO and a seasoned equity offering. What three properties of future cash flows affect a corporation’s value? How is a firm’s intrinsic (or fundamental) value related to its free cash flows and its cost of capital? Write out the equation and explain what it means. What is required for the market price to equal the fundamental value? 1-4 Governing a Corporation For proprietorships, partnerships, and small corporations, the firm’s owners are also its managers. This is usually not true for a large corporation, which often has many different shareholders who each own a small proportion of the total number of shares. These diffuse shareholders elect directors, who then hire managers to run the corporation on a day-to-day basis. Managers are hired to work on behalf of the shareholders, but what is to prevent managers from acting in their own best interests? This is called an agency problem, because managers are hired as agents to act on behalf of the owners. Agency problems can be addressed by a company’s corporate governance, which is the set of rules that control the company’s behavior toward its directors, managers, employees, shareholders, creditors, customers, competitors, and community. We will have much NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 11 more to say about agency problems and corporate governance throughout the book, especially in Chapters 13, 14, and 15. It is one thing to say that managers should act on behalf of owners, but how can managers put this into practice? 1-4a The Primary Objective of a Corporation: Maximizing Stockholder Wealth Managers are entrusted with shareholders’ property and should be good stewards of this property. Good stewardship implies that managers should seek to increase the entrusted property’s value. In other words, the primary goal of the corporation should be to maximize stockholder wealth unless the company’s charter states differently. This does not mean that managers should break laws or violate ethical considerations. This does not mean that managers should be unmindful of employee welfare or community concerns. But it does mean that managers should seek to maximize stockholder wealth. In fact, maximizing shareholder wealth is a fiduciary duty for most U.S. corporations. If companies fail in this duty, they can be sued by shareholders. For example, suppose several different companies make simultaneous offers to acquire a target company. The target’s board of directors probably will be sued by shareholders if they don’t vote in favor of the highest offer, even if the takeover means that the directors will lose their jobs. Companies can even be sued for maintaining social initiatives (such as purchasing environmentally friendly or locally sourced supplies at higher costs than equivalent imports) if shareholders believe they are too costly to the company. The situation is different for many non-U.S. companies. For example, many European companies’ boards have directors who specifically represent the interests of employees and not just shareholders. Many other international companies have government representatives on their boards or are even completely owned by a government. Such companies obviously represent interests other than shareholders. In a recent development, some U.S. corporations are choosing a new corporate form called a benefit corporation (B-Corp) that expands directors’ fiduciary responsibilities to include interests other than shareholders’ interests (see the box “Be Nice with a B-Corp”). 1-4b Intrinsic Stock Value Maximization and Social Welfare If a firm attempts to maximize its intrinsic stock value, is this good or bad for society? In general, it is good. Aside from such illegal actions as fraudulent accounting, exploiting monopoly power, violating safety codes, and failing to meet environmental standards, the same actions that maximize intrinsic stock values also benefit society. www The Investment Company Institute is a great source of information. For updates on mutual fund ownership, see www .ici.org/research#fact _books. ORDINARY CITIZENS AND THE STOCK MARKET More than 43% of all U.S. households now own mutual funds, as compared with only 4.6% in 1980. When direct stock ownership and indirect ownership through pension funds are also considered, many members of society now have an important stake in the stock market, either directly or indirectly. Therefore, when a manager takes actions to maximize intrinsic value, this improves the quality of life for millions of ordinary citizens. NOT FOR SALE 12 Part 1 The Company and Its Environment Be Nice with a B-Corp In 2010, Maryland became the first state to allow a company, The Big Bad Woof, to be chartered as a benefit corporation (B-Corp). As of early 2015, there were more than 1,000 B-Corps in 27 states, with legislation pending in 14 other states. B-Corps are similar to regular for-profit corporations, but have charters that include mandates to help the environment and society, not just to shareholders. For example, The Big Bad Woof, which sells products for companion pets, seeks to purchase merchandise from small, local, minority-owned businesses even if their prices are a bit higher. B-Corps are required to report their progress in meeting the charters’ objectives. Many self-report, but some choose to be certified by an independent third party, in much the same way that an independent accounting firm certifies a company’s financial statements. Why would a company become a B-Corp? Patagonia founder Yvon Chouinard said, “Benefit corporation legislation creates the legal framework to enable mission-driven companies like Patagonia to stay mission-driven through succession, capital raises, and even changes in ownership, by institutionalizing the values, culture, processes, and high standards put in place by founding entrepreneurs.”a Will being a B-Corp help or hurt a company’s value? Advocates argue that customers will be more loyal and that employees will be prouder, more motivated, and more productive, which will lead to higher free cash flows and greater value. Critics counter that B-Corps will find it difficult to raise cash from additional investors because maximizing shareholder wealth isn’t a B-Corps only objective. There isn’t yet enough data to draw a conclusion, but it will be interesting to see whether B-Corps ultimately produce a kinder, gentler form of capitalism. Notes: a See www.patagonia.com/us/patagonia.go?assetid=68413. CONSUMERS AND COMPETITIVE MARKETS Value maximization requires efficient, low-cost businesses that produce high-quality goods and services at the lowest possible cost. This means that companies must develop products and services that consumers want and need, which leads to new technology and new products. Also, companies that maximize their stock price must generate growth in sales by creating value for customers in the form of efficient and courteous service, adequate stocks of merchandise, and well-located business establishments. Therefore, consumers benefit in competitive markets when companies maximize intrinsic value. EMPLOYEES AT VALUE-MAXIMIZING COMPANIES In some situations a stock price increases when a company announces plans to lay off employees, but viewed over time this is the exception rather than the rule. In general, companies that successfully increase stock prices also grow and add more employees, thus benefiting society. Note, too, that many governments across the world, including U.S. federal and state governments, are privatizing some of their state-owned activities by selling these operations to investors. Perhaps not surprisingly, the sales and cash flows of recently privatized companies generally improve. Moreover, studies show that newly privatized companies tend to grow and thus require more employees when they are managed with the goal of stock price maximization. 1-4c Ethics and Intrinsic Stock Value Maximization A firm’s commitment to business ethics can be measured by the tendency of its employees, from the top down, to adhere to laws, regulations, and moral standards relating to product safety and quality, fair employment practices, fair marketing and NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment www For current information from OSHA, see www .osha.gov/index.html and select Data & Statistics. 13 selling practices, the use of confidential information for personal gain, community involvement, and illegal payments to obtain business. How does a lack of commitment to ethical behavior affect stock prices? The intrinsic value of a company ultimately depends on all of its expected future cash flows, and making a substantive change requires hard work to increase sales, cut costs, or reduce capital requirements. There are very few, if any, legal and ethical shortcuts making significant improvements in the stream of future cash flows. Unfortunately, managers at some companies have taken illegal and unethical actions to make estimated future cash flows appear better than truly warranted, which can drive the market stock price up above its intrinsic value. For example, the former CEO and CFO at ArthroCare Corporation were convicted in 2014 for a fraud that involved artificially inflating revenues via undisclosed special deals with their products’ distributors. The misleading financial reports caused ArthroCare’s stock price to be much higher than its fundamental value. By the time the scheme was brought to light, shareholders had lost $750 million. The perpetrators are being punished, but that doesn’t restore shareholders’ lost value or the company’s tarnished reputation. Most illegal or unethical schemes are difficult to completely hide from all other employees. But an employee who believes a company is not adhering to a law or regulation might be hesitant to report it for fear of being fired or otherwise punished by the company. To help address this problem, federal and state governments have created a variety of whistleblower protection programs corresponding to different types of corporate misdeeds. With respect to financial misdeeds, the Sarbanes-Oxley (SOX) Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 strengthened protection for whistleblowers who report financial wrongdoing. Under SOX, employees who report corporate financial wrongdoing and subsequently are penalized by the company can ask the Occupational Safety and Health Administration (OSHA) to investigate the situation. If the employee was improperly penalized, the company can be required to reinstate the person, along with back pay and a sizable penalty award. In addition, SOX made it a criminal act for a CEO or CFO to knowingly falsely certify a company’s financial position. Have these provisions in SOX been successful? The number of SOX-related employee complaints filed each year with OSHA has been falling and is now around 150 per year. Only about one-third of the complaints are deemed worthy of pursuit by OSHA, and the vast majority of these remaining cases are settled out of court. It is hard to determine whether the drop in complaints is due to better corporate behavior or discouraged potential tipsters who have not seen large rewards for whistleblowing. In addition, no executives have been jailed for falsely certifying financial statements, even though a significant number of executives have lost their jobs due to their companies’ financial misreporting. The Dodd-Frank Act’s establishment of the SEC Office of the Whistleblower has led to dozens of announced awards for reporting wrongdoing by financial firms. These awards can be very large because they are based on a percentage of the amount that the SEC fines the wrongdoing corporation. For example, one whistleblower received a $30 million award in 2014. Although not a substitute for high individual moral standards, it appears that large and visible rewards to whistleblowers help ethical employees rein in actions being considered by less ethical employees. This leads to less financial misreporting, which in turn helps keep market prices in line with intrinsic value. NOT FOR SALE 14 Part 1 The Company and Its Environment Taxes and Whistleblowing The Internal Revenue Service (IRS) has a program to reward whistleblowers for information leading to the recovery of unpaid taxes, and sometimes the rewards are huge. The largest reward was $104 million to Bradley C. Birkenfeld, who discovered schemes that UBS, a large Swiss bank, was using to help its clients avoid U.S. taxes. UBS settled with the U.S. Department of Justice in 2009 by paying $780 million in fines and providing account information for over 4,000 U.S. clients to the IRS. This caused thousands of additional U.S. tax payers to fear similar exposure and to enter an IRS amnesty program, leading to over $5 billion in collections of unpaid taxes. Despite the record-setting payout, Birkenfield and the U.S. government do not have an amicable relationship. The government alleged that Birkenfield learned about the UBS tax evasion schemes while using them to shelter one of his own clients from taxes. Birkenfield refused to divulge information about this client during the investigation, so the United States convicted him of fraud. Birkenfield served 30 months in a medium-security federal prison but still received the $104 million reward. How much is freedom worth? About $115,000 per day, based on Birkenfield’s reward and prison time served. S E L F - T E S T What is an agency problem? What is corporate governance? What is the fiduciary duty (i.e., the primary goal) for most U.S. corporations? How does a benefit corporation’s charter differ from that of a typical U.S. corporation? Explain how individuals, customers, and employees can benefit when a company seeks to maximize its intrinsic value. What is a whistleblower? Compare the Sarbanes-Oxley (SOX) Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 with respect to their impact on whistleblowing. 1-5 An Overview of Financial Markets www For current information, see the Federal Reserve Bank of St. Louis’s FRED® Economic Data. Take the total financial assets of households (and nonprofit organizations serving households), found at http://research .stlouisfed.org/fred2/ series/HNOTFAQ027S. Then subtract the financial liabilities, found at http://research .stlouisfed.org/fred2/ series/HNOTOLQ027S. At the risk of oversimplification, we can classify providers and users of cash into four groups: individuals, financial organizations (like banks and insurance companies), nonfinancial organizations (like Apple, Starbucks, and Ford), and governments. Because providers defer spending money today in the hope of spending more money later, we call them savers. Because users receive cash now with plans to repay in the future, we call them borrowers (even though the cash might be in the form of newly issued stock rather than debt). Who are the providers of cash? How does the cash get from providers to users? What are the claims that providers receive from users? We answer these questions in the rest of this section and in following sections. 1-5a The Net Providers and Users of Capital In spite of William Shakespeare’s advice, most individuals and firms are both borrowers and lenders. For example, an individual might borrow money with a car loan or a home mortgage but might also lend money through a bank savings account. In the aggregate, however, individuals are net savers and provide most of the funds ultimately used by nonfinancial corporations. In fact, individuals provide a net amount of about $66 trillion to users. Although most nonfinancial corporations own some financial securities, such as short-term Treasury bills, nonfinancial corporations are net borrowers in the aggregate. NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 15 In the United States, federal, state, and local governments are also net borrowers in the aggregate, although many foreign governments, such as those of China and oil-producing countries, are actually net lenders. Banks and other financial corporations raise money with one hand and invest it with the other. For example, a bank might raise money from individuals in the form of a savings account and then lend most of that money to business customers. In the aggregate, financial corporations are net borrowers by a slight amount. 1-5b Getting Cash from Providers to Users: The Capital Allocation Process Financial corporations evaluate investment opportunities, connect providers to users, and facilitate the actual exchange of cash for claims on future cash. Because this cash is used for investment purposes, it is called “capital.” Transfers of capital from savers to users take place in three different ways. Direct transfers of money and securities, as shown in Panel 1 of Figure 1-2, occur when a business (or government) sells its securities directly to savers. The business delivers its securities to savers, who in turn provide the firm with the money it needs. For example, a privately held company might sell shares of stock directly to a new shareholder, or the U.S. government might sell a Treasury bond directly to an individual investor. As shown in Panel 2, indirect transfers may go through an investment bank, which underwrites the issue. An underwriter serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. Because new securities are involved and the corporation receives the proceeds of the sale, this is a “primary” market transaction. Transfers also can be made through a financial intermediary such as a bank or mutual fund, as shown in Panel 3. Here the intermediary obtains funds from savers in exchange for its own securities. The intermediary then uses this money to purchase and then hold FIGURE 1-2 Diagram of the Capital Allocation Process 1. Direct Transfers Business’s Securities Business Savers Dollars 2. Indirect Transfers through an Investment Bank Business’s Securities Business Dollars Business’s Securities Investment Bank Dollars Savers 3. Indirect Transfers through a Financial Intermediary Intermediary’s Securities Business’s Securities Business Dollars Financial Intermediary Dollars NOT FOR SALE Savers 16 Part 1 The Company and Its Environment businesses’ securities. For example, a saver might give dollars to a bank and receive a certificate of deposit, and then the bank might lend the money to a small business, receiving in exchange a signed loan. Thus, intermediaries literally create new types of securities. There are three important features of the capital allocation process. First, new financial securities are created. Second, different types of financial institutions often act as intermediaries between providers and users. Third, the activities occur in a variety of financial markets. The following sections describe each of these topics, beginning with financial securities. S E L F - T E S T What are the four major groups of providers and users? For each group, state whether it is a net provider or a net user. Identify three ways that capital is transferred between savers and borrowers. Distinguish between the roles played by investment banks and financial intermediaries in exchanging cash now for claims on future cash. 1-6 Claims on Future Cash Flows: Types of Financial Securities Any claim on a future cash flow is called a financial instrument. Providers exchange cash for a financial instrument only if they expect an acceptable rate of return. We begin with an overview of financial instruments and then discuss expected returns. 1-6a Type of Claim on Future Cash Flows: Debt, Equity, or Derivatives A financial security is a claim that is standardized and regulated by the government (although the legal definition is a bit longer). The variety of financial securities is limited only by human creativity, ingenuity, and governmental regulations. At the risk of oversimplification, we can classify most financial securities by the type of claim and the time until maturity. DEBT Financial securities are simply pieces of paper with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values. Debt instruments typically have specified payments and a specified maturity. For example, an Alcoa bond might promise to pay 10% interest for 30 years, at which time it promises to make a $1,000 principal payment. If debt matures in more than a year, it is called a capital market security. Thus, the Alcoa bond in this example is a capital market security. If the debt matures in less than a year, it is a money market security. For example, Google might expect to receive $200,000 in 75 days, but it needs cash now. Google might issue commercial paper, which is essentially an IOU. In this example, Google might agree to pay $200,000 in 75 days in exchange for $199,200 today. Thus, commercial paper is a money market security. EQUITY Equity instruments are a claim upon a residual value. For example, Alcoa’s stockholders are entitled to the cash flows generated by Alcoa after its bondholders, creditors, and other claimants have been satisfied. Because stock has no maturity date, it is a capital market security. NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment resource For an overview of derivatives, see Web Extension 1A on the textbook’s Web site. 17 DERIVATIVES Notice that debt and equity represent claims upon the cash flows generated by real assets, such as the cash flows generated by Alcoa’s factories and operations. In contrast, derivatives are securities whose values depend on, or are derived from, the values of some other traded assets. For example, options and futures are two important types of derivatives, and their values depend on the prices of other assets. An option on Alcoa stock or a futures contract to buy wheat are examples of derivatives. We discuss options in Chapter 8 and in Web Extension 1A, which provides a brief overview of options and other derivatives. HYBRIDS Some securities are a mix of debt, equity, and derivatives. For example, preferred stock has some features like debt and some like equity, while convertible debt has both debt-like and option-like features. We discuss these in subsequent chapters. Table 1-1 provides a summary of the major types of financial instrument, including risk and original maturity. 1-6b Type of Claim on Future Cash Flows: Securitized Financial Assets Some securities are created from packages of other financial assets, a process called securitization. The misuse of securitized assets is one of the primary causes of the most recent global financial crisis, so every manager needs to understand the process of securitization. THE PROCESS OF SECURITIZATION The details vary for different financial assets (which are expected to generate future cash flows), but the processes are similar. For example, a bank might loan money to an individual for a car purchase. The individual signs a loan contract, which entitles the contract’s owner to receive future payments from the borrower. The bank can put a large number of these individual contracts into a portfolio (called a pool) and transfer the pool into a trust (a separate legal entity). The trust then creates new financial instruments that pay out a prescribed set of cash flows from the pool. The trust registers these new securities and sells them. The bank receives the proceeds from the sale, and the purchasers receive a new financial security that has a claim on the cash flows generated by the pool of auto loan. Consider the benefits. First, because the bank received cash when it sold the securitized car loans, the bank now has replenished its supply of lendable funds and can make additional loans. Second, the bank no longer bears risk of the borrowers defaulting. Instead, the securities’ purchasers chose to bear that risk in expectation of justifiable returns. Third, the purchaser of a security has greater liquidity than the bank had when it owned the loan contract, because there is an active secondary market for the securities. Almost any class of financial assets can be securitized, including car loans, student loans, credit card debt, and home mortgages. Because securitization began with home mortgages and played such an important role in the recent global financial crisis, we explain it in more detail. MORTGAGE-BACKED SECURITIES At one time, most mortgages were made by savings and loan associations (S&Ls), which took in the vast majority of their deposits from individuals who lived in nearby neighborhoods. The S&Ls pooled these deposits and then lent money to people in the neighborhood NOT FOR SALE 18 Part 1 The Company and Its Environment TABLE 1-1 Summary of Major Financial Instruments Risk Original Maturity Rates of Return on 1/23/2015a Instrument Major Participants U.S. Treasury bills Sold by U.S. Treasury Default-free 91 days to 1 year 0.02% Bankers’ acceptances A firm’s promise to pay, guaranteed by a bank Low if strong bank guarantees Up to 180 days 0.23% Commercial paper Issued by financially secure firms to large investors Low default risk Up to 270 days 0.12% Negotiable certificates of deposit (CDs) Issued by major banks to large investors Depends on strength of issuer Up to 1 year 0.21% Money market mutual funds Invest in short-term debt; held by individuals and businesses Low degree of risk No specific maturity (instant liquidity) 0.08% Eurodollar market time deposits Issued by banks outside the United States Depends on strength of issuer Up to 1 year 0.37% Consumer credit loans Loans by banks/credit unions/finance companies Risk is variable Variable Commercial loans Loans by banks to corporations Depends on borrower Up to 7 years Tied to prime rate (3.25%) or LIBOR (0.35)b U.S. Treasury notes and bonds Issued by U.S. government No default risk, but price falls if interest rates rise 2 to 30 years 1.81% Mortgages Loans secured by property Risk is variable Up to 30 years 3.63% Municipal bonds Issued by state and local governments to individuals and institutions Riskier than U.S. government bonds, but exempt from most taxes Up to 30 years 3.36% Corporate bonds Issued by corporations to individuals and institutions Riskier than U.S. government debt; depends on strength of issuer Up to 40 years (although a few go up to 100 years) 4.41% Leases Similar to debt; firms lease assets rather than borrow and then buy them Risk similar to corporate bonds Generally 3 to 20 years Preferred stocks Issued by corporations to individuals and institutions Riskier than corporate bonds Unlimited 6% to 9% Common stocksc Issued by corporations to individuals and institutions Riskier than preferred stocks Unlimited 9% to 15% Variable Similar to corporate bonds Notes: a Data are from the Federal Reserve Statistical Release (www.federalreserve.gov/releases/H15/update), the Federal Reserve Bank of St. Louis’s FRED® Economic Data web site at https://research.stlouisfed.org/fred2/, or the Market Data Center from The Wall Street Journal (online.wsj.com). b The prime rate is the rate U.S. banks charge to good customers. LIBOR (London Interbank Offered Rate) is the rate that U.K. banks charge one another. c Common stocks are expected to provide a “return” in the form of dividends and capital gains rather than interest. Of course, if you buy a stock, your actual return may be considerably higher or lower than your expected return. in the form of fixed-rate mortgages, which were pieces of paper signed by borrowers promising to make specified payments to the S&L. The new homeowners paid principal and interest to the S&L, which then paid interest to its depositors and reinvested the NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 19 principal repayments in other mortgages. This was clearly better than having individuals lend directly to aspiring homeowners, because a single individual might not have enough money to finance an entire house or the expertise to know if the borrower was creditworthy. Note that S&L assets consisted mainly of long-term, fixed-rate mortgages, but their liabilities were in the form of deposits that could be withdrawn immediately. The combination of long-term assets and short-term liabilities created a problem. If the overall level of interest rates increased, the S&Ls would have to increase the rates they paid on deposits or else savers would take their money elsewhere. However, the S&Ls couldn’t increase the rates on their outstanding mortgages because these mortgages had fixed interest rates, which meant they couldn’t increase the rates they paid on their deposits very much. This problem came to a head in the 1960s, when the Vietnam War led to inflation, which pushed up interest rates. At this point, the “money market fund” industry was born, and it literally sucked money out of the S&Ls, forcing many of them into bankruptcy. This problem of long-term mortgages financed by short-term and unreliable deposits could be resolved if there were some way for the S&Ls and other mortgage lenders like banks to sell the mortgages to investors who wanted a long-term investment and lend out the resulting money again. The outcome was “mortgage securitization,” a process whereby banks, S&Ls, and specialized mortgage-originating firms would originate mortgages and then sell them to investment banks, which would bundle them into packages and then use these packages as collateral for bonds that could be sold to pension funds, insurance companies, and other institutional investors. Thus, individual mortgages were bundled and then used to back a bond—a “security”—that could be traded in the financial markets. Congress facilitated this process by creating two stockholder-owned but governmentsponsored entities, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Fannie Mae and Freddie Mac were financed by issuing a relatively small amount of stock and a huge amount of debt. To illustrate the securitization process, suppose an S&L or bank is paying its depositors 5% but is charging its borrowers 8% on their mortgages. The S&L can take hundreds of these mortgages, put them in a pool, and then sell the pool to Fannie Mae. The borrowers can still make their payments to the original S&L, which will then forward the payments (less a small handling fee) to Fannie Mae. Consider the S&L’s perspective. First, it can use the cash it receives from selling the mortgages to make additional loans to other aspiring homeowners. Second, the S&L is no longer exposed to the risk of owning mortgages. The risk hasn’t disappeared—it has been transferred from the S&L (and its federal deposit insurers) to Fannie Mae. This is clearly a better situation for aspiring homeowners and, perhaps, also for taxpayers. Fannie Mae can take the mortgages it just bought, put them into a very large pool, and sell bonds backed by the pool to investors. The homeowner will pay the S&L, the S&L will forward the payment to Fannie Mae, and Fannie Mae will use the funds to pay interest on the bonds it issued, to pay dividends on its stock, and to buy additional mortgages from S&Ls, which can then make additional loans to aspiring homeowners. Notice that the mortgage risk has been shifted from Fannie Mae to the investors who now own the mortgage-backed bonds. How does the situation look from the perspective of the investors who own the bonds? In theory, they own a share in a large pool of mortgages from all over the country, so a problem in a particular region’s real estate market or job market won’t affect the whole pool. Therefore, their expected rate of return should be very close to the 8% rate paid by the home-owning borrowers. (It will be a little less due to handling fees charged by the S&L and Fannie Mae and to the small amount of expected losses from the homeowners NOT FOR SALE 20 Part 1 The Company and Its Environment who could be expected to default on their mortgages.) These investors could have deposited their money at an S&L and earned a virtually risk-free 5%. Instead, they chose to accept more risk in hopes of the higher 8% return. Note, too, that mortgage-backed bonds are more liquid than individual mortgage loans, so the securitization process increases liquidity, which is desirable. The bottom line is that risk has been reduced by the pooling process and then allocated to those who are willing to accept it in return for a higher rate of return. Thus, in theory it is a win–win–win situation: More money is available for aspiring homeowners, S&Ls (and taxpayers) have less risk, and there are opportunities for investors who are willing to take on more risk to obtain higher potential returns. Mortgage securitization was a win–win situation in theory, but as practiced in the 2000s, it turned into a lose–lose situation. We will have more to say about securitization and the last great recession of 2007 later in this chapter, but first let’s take a look at the cost of money. S E L F - T E S T What is a financial instrument? What is a financial security? What are some differences among the following types of securities: debt, equity, and derivatives? Describe the process of securitization as applied to home mortgages. 1-7 Claims on Future Cash Flows: The Required Rate of Return (The Cost of Money) Providers of cash expect more cash back in the future than they originally supply to users. In other words, providers expect a positive rate of return on their investment. We call this a required rate of return because a prospect of more money in the future is required to induce an investor to give up money today. Keep in mind that a rate of return from an investor’s viewpoint is a cost from that of a user. For debt, we call this cost the interest rate. For equity, we call it the cost of equity, which consists of the dividends and capital gains stockholders expect. Therefore, the required rate of return is also called the cost of money or the price of money. Notice in Table 1-1 that a financial instrument’s rate of return generally increases as its maturity and risk increase. We will have much more to say about the relationships among an individual security’s features, risk, and required rate of return later in the book, but first we will examine some fundamental factors and economic conditions that affect all financial instruments. 1-7a Fundamental Factors That Affect the Required Rate of Return (The Cost of Money) The four most fundamental factors affecting the supply and demand of capital and the resulting cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation. PRODUCTION OPPORTUNITIES Production opportunities are activities that require cash now but have the potential to generate cash in the future. For example, a company might sell stock to build a new factory or a student might borrow to attend college. In both cases, there are prospects of NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 21 future cash flows: The company might increase sales and the new graduate might get a high-paying job. Notice that the size and likelihood of the future cash flows put an upper limit on the amount that can be repaid. All else held equal, improvements in production opportunities will increase this upper limit and create more demand for cash now, which will lead to higher interest rates and required returns. TIME PREFERENCE FOR CONSUMPTION Providers can use their current funds for consumption or saving. By saving, they choose not to consume now, expecting to consume more in the future. If providers strongly prefer consumption now, then it takes high interest rates to induce them to trade current consumption for future consumption. Therefore, the time preference for consumption has a major impact on the cost of money. Notice that the time preference for consumption varies for different individuals, for different age groups, and for different cultures. For example, people in Japan have a lower time preference for consumption than those in the United States, which partially explains why Japanese families tend to save more than U.S. families even though interest rates are lower in Japan. RISK If an opportunity’s future cash flows are very uncertain and might be much lower than expected, providers require a higher expected return to induce them to take the extra risk. EXPECTED INFLATION Expected inflation also leads to a higher interest rates and required returns. For example, suppose you earned 10% one year on your investment but inflation caused prices to increase by 20%. This means you can’t consume as much at the end of the year as when you originally invested your money. Obviously, if you had expected 20% inflation, you would have required a much higher rate of return. 1-7b Economic Conditions and Policies That Affect the Required Rate of Return (The Cost of Money) www The home page for the Board of Governors of the Federal Reserve System can be found at www.federalreserve .gov. You can access general information about the Federal Reserve, including press releases, speeches, and monetary policy. Economic conditions and policies also affect the required rates of return. These include: (1) Federal Reserve policy, (2) the federal budget deficit or surplus, (3) the level of business activity, and (4) international factors. FEDERAL RESERVE POLICY If the Federal Reserve Board wants to stimulate the economy, it most often uses open market operations to purchase Treasury securities held by banks. Because banks are selling some of their securities, the banks will have more cash, which increases their supply of loanable funds, which in turn makes banks willing to lend more money at lower interest rates. In addition, the Fed’s purchases represent an increase in the demand for Treasury securities. As with anything for sale, increased demand causes Treasury securities’ prices to go up and interest rates to go down. The net result is a reduction in interest rates, which stimulates the economy by making it less costly for companies to borrow for new projects or for individuals to borrow for major purchases or other expenditures. Unfortunately, there is a downside to stimulation from the Fed. When banks sell their holdings of Treasury securities to the Fed, the banks’ reserves go up, which increases the money supply. A larger money supply ultimately leads to an increase in expected inflation, NOT FOR SALE 22 Part 1 The Company and Its Environment which eventually pushes interest rates up. Thus, the Fed can stimulate the economy in the short term by driving down interest rates and increasing the money supply, but this creates longer-term inflationary pressures. This was exactly the dilemma facing the Fed in early 2015. On the other hand, if the Fed wishes to slow down the economy and reduce inflation, the Fed reverses the process. Instead of purchasing Treasury securities, the Fed sells Treasury securities to banks, which reduces banking reserves and causes an increase in short-term interest rates but a decrease in long-term inflationary pressures. FEDERAL BUDGET DEFICITS OR SURPLUSES If the federal government spends more than it takes in from tax revenues, then it runs a deficit, and that deficit must be covered either by borrowing or by printing money (increasing the money supply). The government borrows by issuing new Treasury securities. All else held equal, this creates a greater supply of Treasury securities, which leads to lower security prices and higher interest rates. Federal government actions that increase the money supply also increase expectations for future inflation, which drives up interest rates. Thus, the larger the federal deficit, other things held constant, the higher the level of interest rates. As shown in Figure 1-3, the federal government has run deficits in 18 of the past 22 years. Annual deficits in the mid-1990s were in the $250 billion range, but they ballooned to well over a trillion dollars in the past recession and are now about $500 billion. These huge deficits have contributed to the cumulative federal debt, which in early 2015 stood at more than $18 trillion. FIGURE 1-3 Federal Budget Surplus/Deficits and Trade Balances (Billions of Dollars) Surplus or Deficit 400 200 0 –200 –400 –600 Trade Balance –800 –1,000 –1,200 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2003 2002 2001 2000 1999 1998 1997 1996 1995 –1,600 2004 Federal Budget Surplus/Deficit –1,400 1994 For today’s cumulative total federal debt (the total public debt), check out the Current Daily Treasury Statement at www.fms.treas.gov/ dts/index.html. 1993 www Sources: The raw data are from the Federal Reserve Bank of St. Louis’s FRED® Economic Data: http://research.stlouisfed .org/fred2/series/FYFSD and http://research.stlouisfed.org/fred2/series/BOPGSTB?cid=125. NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 23 LEVEL OF BUSINESS ACTIVITY Figure 1-4 shows interest rates, inflation, and recessions. First, notice that interest rates and inflation are presently (early 2015) very low relative to the past 40 years. However, you should never assume that the future always will be like the recent past! Second, notice that interest rates and inflation typically rise prior to a recession and fall afterward. There are several reasons for this pattern. Consumer demand slows during a recession, keeping companies from increasing prices, which reduces price inflation. Companies also cut back on hiring, which reduces wage inflation. Less disposable income causes consumers to reduce their purchases of homes and automobiles, reducing consumer demand for loans. Companies reduce investments in new operations, which reduces their demand for funds. The cumulative effect is downward pressure on inflation and interest rates. The Federal Reserve is also active during recessions, trying to stimulate the economy by driving down interest rates. FOREIGN TRADE BALANCE: DEFICITS OR SURPLUSES Businesses and individuals in the United States buy from and sell to people and firms in other countries. The foreign trade balance describes the level of imports relative to exports. If we buy more than we sell (that is, if we import more than we export), we are said to be running a foreign trade deficit. When trade deficits occur, they must be FIGURE 1-4 Business Activity, Interest Rates, and Inflation Interest Rate (%) 16 Recession 14 Interest Rates 12 10 8 Inflation 6 4 2 2015 2013 2011 2009 2007 2005 2003 2001 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977 1975 –2 1973 0 Notes: 1. Tick marks represent January 1 of the year. 2. The shaded areas designate business recessions as defined by the National Bureau of Economic Research; see www.nber.org/cycles. 3. Interest rates are for AAA corporate bonds; see the Federal Reserve Bank of St. Louis’s FRED® Economic Data at http://research.stlouisfed .org/fred. These rates reflect the average rate during the month ending on the date shown. 4. Inflation is measured by the annual rate of change for the Consumer Price Index (CPI) for the preceding 12 months; see http://research .stlouisfed.org/fred. NOT FOR SALE 24 Part 1 The Company and Its Environment financed, and the main source of financing is debt. In other words, if we import $200 billion of goods but export only $90 billion, we run a trade deficit of $110 billion, and we will probably borrow the $110 billion.5 Therefore, the larger our trade deficit, the more we must borrow, and the increased borrowing drives up interest rates. Also, international investors are only willing to hold U.S. debt if the risk-adjusted rate paid on this debt is competitive with interest rates in other countries. Therefore, if the Federal Reserve attempts to lower interest rates in the United States, causing our rates to fall below rates abroad (after adjustments for expected changes in the exchange rate), then international investors will sell U.S. bonds, which will depress bond prices and result in higher U.S. rates. Thus, if the trade deficit is large relative to the size of the overall economy, it will hinder the Fed’s ability to reduce interest rates and combat a recession. The United States has been running annual trade deficits since the mid-1970s; see Figure 1-3 for recent years. The cumulative effect of trade deficits and budget deficits is that the United States has become the largest debtor nation of all time. As noted earlier, this federal debt exceeds $18 trillion! As a result, our interest rates are influenced by interest rates in other countries around the world. International risk factors may increase the cost of money that is invested abroad. These include international changes in tax rates, regulations, currency conversion laws, and currency exchange rates. Foreign investments also include the risk that property will be expropriated by the host government. We discuss these issues in Chapter 17. Recall that financial markets connect providers and users: Providers supply cash now in exchange for claims on risky future cash. Our discussion has focused on the claims and their required returns, but now we turn our attention to the different ways in which cash is exchanged for claims, beginning with the roles played by financial institutions. S E L F - T E S T What is a “required rate of return”? Why is it called the “cost of money” or the “price of money”? What is debt’s cost of money called? What two components make up the cost of money for equity? What four fundamental factors affect required rates of return (i.e., the cost of money)? How does Federal Reserve policy affect interest rates now and in the future? What is a federal budget deficit or surplus? How does this affect interest rates? What is a foreign trade deficit or surplus? How does this affect interest rates? 1-8 The Functions of Financial Institutions Direct transfers of funds from individuals to businesses are relatively uncommon in developed economies. Instead, businesses usually find it more efficient to enlist the services of one or more financial institutions to raise capital. Most financial institutions don’t compete in a single line of business but instead provide a wide variety of services and products, both domestically and globally. The following sections describe the major types of financial institutions and services, but keep in mind that the dividing lines among them are often blurred. 5 The deficit could also be financed by selling assets, including gold, corporate stocks, entire companies, and real estate. The United States has financed its massive trade deficits through all of these means in recent years, but the primary method has been by borrowing from foreigners. NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 25 1-8a Investment Banks and Brokerage Activities Investment banks help companies raise capital. Such organizations underwrite security offerings, which means they (1) advise corporations regarding the design and pricing of new securities, (2) buy these securities from the issuing corporation, and (3) resell them to investors. Although the securities are sold twice, this process is really one primary market transaction, with the investment banker acting as a facilitator to help transfer capital from savers to businesses. An investment bank often is a division or subsidiary of a larger company. For example, JPMorgan Chase & Co. is a very large financial services firm, with over $2.4 trillion in managed assets. One of its holdings is J.P. Morgan, an investment bank. In addition to security offerings, investment banks also provide consulting and advisory services, such as merger and acquisition (M&A) analysis and investment management for wealthy individuals. Most investment banks also provide brokerage services for institutions and individuals (called “retail” customers). For example, Merrill Lynch (acquired in 2008 by Bank of America) has a large retail brokerage operation that provides advice and executes trades for its individual clients. Similarly, J.P. Morgan helps execute trades for institutional customers, such as pension funds. At one time, most investment banks were partnerships, with income generated primarily by fees from their underwriting, M&A consulting, asset management, and brokering activities. When business was good, investment banks generated high fees and paid big bonuses to their partners. When times were tough, investment banks paid no bonuses and often fired employees. In the 1990s, however, most large investment banks were reorganized into publicly traded corporations (or were acquired and then operated as subsidiaries of public companies). For example, in 1994 Lehman Brothers sold some of its own shares of stock to the public via an IPO. Like most corporations, Lehman Brothers was financed by a combination of equity and debt. A relaxation of regulations in the 2000s allowed investment banks to undertake much riskier activities than at any time since the Great Depression. The new regulations allowed investment banks to use an unprecedented amount of debt to finance their activities— Lehman used roughly $30 of debt for every dollar of equity. In addition to their feegenerating activities, most investment banks also began trading securities for their own accounts. In other words, they took the borrowed money and invested it in financial securities. If you are earning 12% on your investments while paying 8% on your borrowings, then the more money you borrow, the more profit you make. But if you are leveraged 30 to 1 and your investments decline in value by even 3.33%, your business will fail. This is exactly what happened to Bear Stearns, Lehman Brothers, and Merrill Lynch in the fall of 2008. In short, they borrowed money, used it to make risky investments, and then failed when the investments turned out to be worth less than the amount they owed. Note that it was not their traditional investment banking activities that caused the failure, but the fact that they borrowed so much and used those funds to speculate in the market. 1-8b Deposit-Taking Financial Intermediaries Some financial institutions take deposits from savers and then lend most of the deposited money to borrowers. Following is a brief description of such intermediaries. SAVINGS AND LOAN ASSOCIATIONS (S&LS) As we explained previously, S&Ls originally accepted deposits from many small savers and then loaned this money to home buyers and consumers. Later, they were allowed to NOT FOR SALE 26 Part 1 The Company and Its Environment make riskier investments, such as investing in real estate development. Mutual savings banks (MSBs) are similar to S&Ls, but they operate primarily in the northeastern states. Today, most S&Ls and MSBs have been acquired by banks. CREDIT UNIONS Credit unions are cooperative associations whose members have a common bond, such as being employees of the same firm or living in the same geographic area. Members’ savings are loaned only to other members, generally for auto purchases, home-improvement loans, and home mortgages. Credit unions are often the cheapest source of funds available to individual borrowers. COMMERCIAL BANKS Commercial banks raise funds from depositors and by issuing stock and bonds to investors. For example, someone might deposit money in a checking account. In return, that person can write checks, use a debit card, and even receive interest on the deposits. Those who buy the banks’ stocks and bonds expect to receive dividends and interest payments. Unlike nonfinancial corporations, most commercial banks are highly leveraged in the sense that they owe much more to their depositors and creditors than they raised from stockholders. For example, a typical bank has about $90 of debt for every $10 of stockholders’ equity. If the bank’s assets are worth $100, we can calculate its equity capital by subtracting the $90 of liabilities from the $100 of assets: Equity capital $100 − $90 $10. But if the assets drop in value by 5% to $95, the equity drops to $5 $95 − $90, a 50% decline. Banks are vitally important for a well-functioning economy, and their highly leveraged positions make them risky. As a result, banks are more highly regulated than nonfinancial firms. Given the high risk, banks might have a hard time attracting and retaining deposits unless the deposits were insured, so the Federal Deposit Insurance Corporation (FDIC), which is backed by the U.S. government, insures up to $250,000 per depositor. As a result of the great recession of 2007, this insured amount was increased from $100,000 in 2008 to reassure depositors. Without such insurance, if depositors believed that a bank was in trouble, they would rush to withdraw funds. This is called a “bank run,” which is exactly what happened in the United States during the Great Depression, causing many bank failures and leading to the creation of the FDIC in an effort to prevent future bank runs. Not all countries have their own versions of the FDIC, so international bank runs are still possible. In fact, a bank run occurred in September 2008 at the U.K. bank Northern Rock, leading to its nationalization by the government. Most banks are small and locally owned, but the largest banks are parts of giant financial services firms. For example, JPMorgan Chase Bank, commonly called Chase Bank, is owned by JPMorgan Chase & Co., and Citibank is owned by Citicorp. 1-8c Investment Funds At some financial institutions, savers have an ownership interest in a pool of funds rather than owning a deposit account. Examples include mutual funds, hedge funds, and private equity funds. MUTUAL FUNDS Mutual funds are corporations that accept money from savers and then use these funds to buy financial instruments. These organizations pool funds, which allows them to reduce risks by diversification and achieve economies of scale in analyzing securities, managing portfolios, and buying/selling securities. Different funds are designed to meet the NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 27 objectives of different types of savers. Hence, there are bond funds for those who desire safety and stock funds for savers who are willing to accept risks in the hope of higher returns. There are literally thousands of different mutual funds with dozens of different goals and purposes. Some funds are actively managed, with their managers trying to find undervalued securities, while other funds are passively managed and simply try to minimize expenses by matching the returns on a particular market index. Money market funds invest in short-term, low-risk securities, such as Treasury bills and commercial paper. Many of these funds offer interest-bearing checking accounts with rates that are greater than those offered by banks, so many people invest in money market funds as an alternative to depositing money in a bank. Note, though, that money market funds are not required to be insured and so are riskier than bank deposits.6 Most traditional mutual funds allow investors to redeem their share of the fund only at the close of business. A special type of mutual fund, the exchange-traded fund (ETF), allows investors to sell their share at any time during normal trading hours. ETFs usually have very low management expenses and are rapidly gaining in popularity. HEDGE FUNDS Hedge funds raise money from investors and engage in a variety of investment activities. Unlike typical mutual funds, which can have thousands of investors, hedge funds are limited to institutional investors and a relatively small number of high–net-worth individuals. Because these investors are supposed to be sophisticated, hedge funds are much less regulated than mutual funds. The first hedge funds literally tried to hedge their bets by forming portfolios of conventional securities and derivatives in such a way as to limit their potential losses without sacrificing too much of their potential gains. Many hedge funds had spectacular rates of return during the 1990s. This success attracted more investors, and thousands of new hedge funds were created. Much of the low-hanging fruit had already been picked, however, so the hedge funds began pursuing much riskier (and unhedged) strategies, including the use of high leverage in unhedged positions. Perhaps not surprisingly (at least in retrospect), some funds have produced spectacular losses. For example, many hedge fund investors suffered huge losses in 2007 and 2008 when large numbers of sub-prime mortgages defaulted. PRIVATE EQUITY FUNDS Private equity funds are similar to hedge funds in that they are limited to a relatively small number of large investors. They differ in that they own stock (equity) in other companies and often control those companies, whereas hedge funds usually own many different types of securities. In contrast to a mutual fund, which might own a small percentage of a publicly traded company’s stock, a private equity fund typically owns virtually all of a company’s stock. Because the company’s stock is not traded in the public markets, it is called “private equity.” In fact, private equity funds often take a public company (or subsidiary) and turn it private, such as the 2007 privatization of Chrysler by Cerberus. (Fiat is now the majority owner.) The general partners who manage private equity funds usually sit on the companies’ boards and guide their strategies with the goal of later selling the companies for a profit. For example, The Carlyle Group, Clayton Dubilier & Rice, and Merrill Lynch Global Private Equity bought Hertz from Ford on December 22, 2005, and then sold shares of Hertz in an IPO less than a year later. 6 The U.S. Treasury sold deposit insurance to eligible money market funds between September 2008 and September 2009 to help stabilize the markets during the height of the financial crisis. NOT FOR SALE 28 Part 1 The Company and Its Environment Many private equity funds experienced high rates of return in the last decade, and those returns attracted enormous sums from investors. A few funds, most notably The Blackstone Group, actually went public themselves through an IPO. Just as with hedge funds, the performance of many private equity funds faltered during the great recession. For example, shortly after its IPO in June 2007, Blackstone’s stock price was over $31 per share. By early 2009, however, it had fallen to about $4 and it’s now (early 2015) up around $34. 1-8d Life Insurance Companies and Pension Funds Life insurance companies take premiums, invest these funds in stocks, bonds, real estate, and mortgages, and then make payments to beneficiaries. Life insurance companies also offer a variety of tax-deferred savings plans designed to provide retirement benefits. Traditional pension funds are retirement plans funded by corporations or government agencies. Pension funds invest primarily in bonds, stocks, mortgages, hedge funds, private equity, and real estate. Most companies now offer self-directed retirement plans, such as 401(k) plans, as an addition to or substitute for traditional pension plans. In traditional plans, the plan administrators determine how to invest the funds; in selfdirected plans, all individual participants must decide how to invest their own funds. Many companies are switching from traditional plans to self-directed plans, partly because this shifts the risk from the company to the employee. 1-8e Regulation of Financial Institutions www For current bank rankings, go to Global Finance Magazine’s Web site,www.gfmag.com, and use the search for “biggest global banks.” In 1933, the Glass-Steagall Act was passed with the intent of preventing another great depression. In addition to creating the FDIC to insure bank deposits, the law imposed constraints on banking activities and separated investment banking from commercial banking. The regulatory environment of the post-Depression era included a prohibition on nationwide branch banking, restrictions on the types of assets the institutions could buy, ceilings on the interest rates they could pay, and limitations on the types of services they could provide. Arguing that these regulations impeded the free flow of capital and hurt the efficiency of our capital markets, policymakers took several steps from the 1970s to the 1990s to deregulate financial services companies, culminating with the Gramm– Leach–Bliley Act of 1999, which “repealed” Glass-Steagall’s separation of commercial and investment banking. One result of deregulation was the creation of huge financial services corporations, which own commercial banks, S&Ls, mortgage companies, investment-banking houses, insurance companies, pension plan operations, and mutual funds. Many are now global banks with branches and operations across the country and around the world. For example, Citigroup combined one of the world’s largest commercial banks (Citibank), a huge insurance company (Travelers), and a major investment bank (Smith Barney), along with numerous other subsidiaries that operate throughout the world. Bank of America also made numerous acquisitions of many different financial companies, including Merrill Lynch, with its large brokerage and investment banking operations, and mortgage giant Countrywide Financial. These conglomerate structures are similar to those of major institutions in China, Europe, Japan, and elsewhere around the globe. Though U.S. banks grew dramatically as a result of recent mergers, they are still relatively small by global standards. The world’s largest bank is the Industrial and Commercial Bank of China. Among the world’s ten largest world banks, based upon total assets, only one (JPMorgan Chase) is headquartered in the United States. NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 29 The financial crisis of 2008–2009 and the continuing global economic weakness are causing regulators and financial institutions to rethink the wisdom of deregulating conglomerate financial services corporations. To address some of these concerns, the DoddFrank Wall Street Reform and Consumer Protection Act was passed in 2010. We discuss Dodd-Frank and other regulatory changes in Section 1-11, where we explain the events leading up to the great recession of 2007. S E L F - T E S T What were the traditional roles of investment banks prior to the 1990s? What types of activities did investment banks add after that? Describe the different types of deposit-taking institutions. What are some similarities and differences among mutual funds, hedge funds, and private equity funds? Describe a life insurance company’s basic activities. What are traditional pension funds? What are 401(k) plans? 1-9 Financial Markets Financial markets serve to connect providers of funds with users for the purpose of exchanging cash now for claims on future cash (e.g., securities such as stocks or bonds). In addition, they provide a means for trading securities after they have been issued. We describe different types of markets and trading procedures in the following sections. 1-9a Types of Financial Markets There are many different ways to classify financial markets, depending upon the types of instruments, customer, or geographic locations. You should recognize the big differences among types of markets, but keep in mind that the distinctions are often blurred. PHYSICAL ASSETS VERSUS FINANCIAL ASSETS Physical asset markets (also called “tangible” or “real” asset markets) are those for such products as wheat, autos, real estate, computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds, notes, mortgages, derivatives, and other financial instruments. TIME OF DELIVERY: SPOT VERSUS FUTURE Spot markets are markets where assets are being bought or sold for “on-the-spot” delivery (literally, within a few days). Futures markets are for assets whose delivery is at some future date, such as 6 months or a year into the future. MATURITY OF FINANCIAL ASSET: SHORT VERSUS LONG Money markets are the markets for short-term, highly liquid debt securities, while capital markets are the markets for corporate stocks and debt maturing more than a year in the future. The New York Stock Exchange is an example of a capital market. When describing debt markets, “short term” generally means less than 1 year, “intermediate term” means 1 to 5 years, and “long term” means more than 5 years. NOT FOR SALE 30 Part 1 The Company and Its Environment PURPOSE OF LOANS TO INDIVIDUALS: LONG-TERM ASSET PURCHASES VERSUS SHORTER-TERM SPENDING Mortgage markets deal with loans on residential, agricultural, commercial, and industrial real estate, while consumer credit markets involve loans for autos, appliances, education, vacations, and so on. PRIVATE VERSUS PUBLIC Private markets are where transactions are worked out directly between two parties. For example, bank loans and private placements of debt with insurance companies are examples of private market transactions. Because these transactions are private, they may be structured in any manner that appeals to the two parties. Public markets are where standardized contracts are traded on organized exchanges. Because securities that are traded in public markets (for example, common stock and futures contracts) are ultimately held by a large number of individuals, they must have fairly standardized contractual features. Private market securities are more tailor-made but less liquid, whereas public market securities are more liquid but subject to greater standardization. GEOGRAPHIC EXTENT World, national, regional, and local markets also exist. Thus, depending on an organization’s size and scope of operations, it may be able to borrow or lend all around the world, or it may be confined to a strictly local, even neighborhood, market. PRIMARY MARKETS VERSUS SECONDARY MARKETS Primary markets are the markets in which corporations raise new capital. For example, if a private company has an IPO or if a public company sells a new issue of common stock to raise capital, this would be a primary market transaction. The corporation selling the newly created stock receives the proceeds from such a transaction. Secondary markets are markets in which existing, already-outstanding securities are traded among investors. Thus, if you decided to buy 1,000 shares of Starbucks stock, the purchase would occur in the secondary market. Secondary markets exist for many financial securities, including stock and bonds. It is important to remember that the company whose securities are being traded is not involved in a secondary market transaction and, thus, does not receive any funds from such a sale. However, secondary markets are vital for a well-functioning economy because they provide liquidity and foster entrepreneurship. 1-9b Why Are Secondary Markets Important? Secondary markets provide liquidity for investors who need cash or who wish to reallocate their investments to potentially more productive opportunities. For example, a parent who owns stock might wish to help pay for a child’s college education. Or consider an investor who owns stock in a coal-mining company but who wishes to invest in a manufacturer of solar panels. Without active secondary markets, investors would be stuck with the securities they purchase. Secondary markets also foster entrepreneurship. For example, it might take a very long time before an entrepreneur can use a start-up company’s cash flow for personal spending because the cash flow is needed to support the company’s growth. In other words, the company might be successful, but the entrepreneur feels “cash poor.” However, if the company goes public, its stock can be traded in the secondary market. The NOT FOR SALE Chapter 1 An Overview of Financial Management and the Financial Environment 31 entrepreneur then can sell some personal shares of stock and begin to enjoy the financial rewards of having started a successful company. Without this prospect, entrepreneurs have diminished incentives to start companies. Secondary markets also provide a measure of value as perceived by buyers and sellers, making it easy to quickly compare different investments. 1-9c Trading Procedures in the Secondary Markets A trading venue is a site (geographical or electronic) where secondary market trading o...
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