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CHLAicPeTnEsRed1 toC:HAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAPTER 1 CHAP
ã Courtesy of Google, Inc.
An Overview of Financial Management
Striking the Right Balance
In1776,AdamSmithdescribedhowan“invisible l A firm’s principal goal should be to maximize
hand”guidescompaniesastheystriveforprofits, the wealth of its stockholders, which means
and that hand leads them to decisions that maximizing the value of its stock.
benefit society. Smith’s insights led him to con-
l Freeenterpriseisstillthebesteconomicsystemfor
cludethatprofitmaximizationistherightgoalfor
thecountryasawhole.Underthefreeenterprise
a business and that the free enterprise system is
framework, companies develop products and
bestforsociety.Buttheworldhaschangedsince
services that people want and that benefit
1776. Firms today are much larger, they operate
society.
globally,theyhavethousandsofemployees,and
l However, some constraints are needed—firms
they are owned by millions of stockholders. This
should not be allowed to pollute the air and
makes us wonder if the “invisible hand” still pro-
water,toengageinunfairemploymentpractices,
videsreliableguidance:Shouldcompaniesstilltry
or to create monopolies that exploit consumers.
tomaximizeprofits,orshouldtheytakeabroader
view and take more balanced actions designed These constraints take a number of different
to benefit customers, employees, suppliers, and forms.Thefirstsetofconstraintsarethecoststhat
society as a whole? are assessed on companies if they take actions
Many academics and finance professionals thatharmsociety.Anothersetofconstraintsarises
todaysubscribetothefollowingmodifiedversion through the political process, where society
ofAdamSmith’stheory: imposes a wide range of regulations that are
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Chapter 1AnOverview ofFinancial Management 3
designedtokeepcompaniesfromengaginginpracticesthat regulators is essential if value is to be maximized. In his
are harmful to society. Properly imposed, these costs fairly words,“ThereasonpeoplecometoworkforGEisthatthey
transfer value to suffering parties and help create incentives wanttobepartofsomethingbiggerthanthemselves.They
thathelppreventsimilareventsfromoccurringinthefuture. want to work hard, win promotions, and be well com-
The recent financial crisis dramatically illustrates these pensated, but they also want to work for a company that
points. We witnessed many Wall Street firms engaging in makesadifference,acompanythat’sdoinggreatthingsin
extremelyriskyactivitiesthatpushedthefinancialsystemto theworld….It’suptoGEtobeagoodcitizen.Notonlyis
thebrinkofcollapsein2007and2008.Savingthefinancial that anicethingtodo,but it’sgoodforbusiness and thus
system required a bailout of the banks and other financial the price of our stock.”
companies, and that bailout imposed huge costs on the GE is not alone. An increasing number of companies
taxpayers, and also helped push the economy into a deep seetheirmissionasmorethanjustmakingmoneyfortheir
recession. Apart from the huge costs imposed on society, shareholders. Google’s well-known corporate motto is
the financial firms also paid a heavy price—a number of “Don’t Be Evil.” Consistent with this mission, the company
leadingfinancialinstitutionssawahugedropintheirstock has its own in-house foundation that has made large
price,somefailedandwentoutofbusiness,andmanyWall investments in a wide range of philanthropic ventures
Street executives lost their jobs. worldwide. There are other instances where corporate
Arguably,thesecostsarenotenoughtopreventanother leaders have donated personal funds.
financialcrisisdowntheroad.Manymaintainthattheevents In 2008, Microsoft Corporation’s Bill Gates gave a
surrounding the financial crisis illustrate that markets don’t speech to the World Economic Forum in which he made
alwaysworkthewaytheyshould,andthatthereisaneedfor thecasefora“creativecapitalism.”Gatesstatedthat,“Such
strongerregulationofthefinancialsector.Forexample,inhis a system would have a twin mission: making profits and
recent book, Nobel Laureate Joseph Stiglitz makes a strong also improving lives for those who don’t fully benefit from
caseforenhancedregulation.Atthesametime,otherswitha market forces.”
different political persuasion continue to express concerns Gates has certainly been true to his word. In 2000, he
about the costs of excessive regulation. and his wife established the Bill & Melinda Gates Founda-
Beyond just the financial crisis, there is a broader tion. Today the fund has assets totaling $34 billion. It
question of whether laws and regulations are enough to received a notable boost in 2006 when famed investor
compel firms to act in society’s interest. For example, GE Warren Buffett announced that he would donate a huge
Chief Executive Officer (CEO) Jeffrey Immelt believes that shareofhisfortunetotheFoundation.Todate,Buffett has
just obeying the law is not enough, and that companies contributed close to $8 billion, and over time he is
should strive to behave ethically and continually operate scheduledtocontributeadditionalstockthatisnowworth
with society’s interests in mind. Immelt further argues that about $40 billion. These efforts show that there is more to
value and reputation go hand in hand, and that having a life than money, but it often takes money to do good
goodreputationwithcustomers,suppliers,employees,and things.
Sources:Marc Gunther, “Money and Morals at GE,” Fortune, November 15, 2004, pp. 176–182; Patricia Sellers, “Melinda Gates Goes
Public,” CNNMoney.com, January 7, 2008; Kevin J. Delaney, “Google: From ‘Don’t Be Evil’ to How to Do Good,” The Wall Street
Journal,January18,2008,pp.B1–B2;RobertA.Guth,“BillGatesIssuesCallforKinderCapitalism,”TheWallStreetJournal,January24,
2008, p. A1; and Joseph E. Stiglitz, FreeFall: America, Free Markets, and the Sinking of the World Economy (New York: W.W. Norton &
Company, 2010).
PUTTING THINGS IN PERSPECTIVE
This chapter will give you an idea of what financial management is all about. We
begin the chapter by describing how finance is related to the overall business, by
pointing out that financeprepares students for jobs in different fields of business,
and by discussing the different forms of business organization. For corporations,
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4 Part 1Introduction to FinancialManagement
management’s goal should be to maximize shareholder wealth, which means
maximizing the value of the stock. When we say “maximizing the value of the
stock,” we mean the “true, long-run value,” which may be different from the cur-
rent stock price. Good managers understand the importance of ethics, and they
recognize that maximizing long-run value is consistent with being socially
responsible. We conclude the chapter by discussing how firms must provide
the right incentives for managers to focus on long-run value maximization. When
you finish this chapter, you should be able to:
l Explain the role of finance and the different types of jobs in finance.
l Identify the advantages and disadvantages of different forms of business
organization.
l Explain the links between stock price, intrinsic value, and executive
compensation.
l Discuss the importance of business ethics and the consequences of unethical
behavior.
l Identify the potential conflicts that arise within the firm between stock-
holders and managers and between stockholders and bondholders, and
discuss the techniques that firms can use to mitigate these potential
conflicts.
1-1
WHAT IS FINANCE?
It’s hard to define finance—the term has many facets, which makes it difficult to
provideaclearandconcisedefinition.Thediscussioninthissectionwillgiveyou
anideaofwhatfinancepeopledoandwhatyoumightdoifyouenterthefinance
field after you graduate.
1-1a Finance versus Economics and Accounting
Finance,asweknowittoday,grewoutofeconomicsandaccounting.Economists
developed the notion that an asset’s value is based on the future cash flows
the asset will provide, and accountants provided information regarding the
likely size of those cash flows. People who work in finance need knowledge of
both economics and accounting. As discussed next, in the modern corporation,
the accounting department falls under the control of the chief financial
officer (CFO).
1-1b Finance within an Organization
Most businesses and not-for-profit organizations have an organization chart
similartotheoneshowninFigure1.1.Theboardofdirectorsisthetopgoverning
body,andthechairpersonoftheboardisgenerallythehighest-rankingindividual.
The CEO comes next, but note that the chairperson of the boardoften also serves
astheCEO.BelowtheCEOcomesthechiefoperatingofficer(COO),whoisoften
ThedutiesoftheCFOhave
broadenedovertheyears. also designated as a firm’s president. The COO directs the firm’s operations,
CFOmagazine’sonline whichincludemarketing,manufacturing,sales,andotheroperatingdepartments.
service,cfo.com,isan TheCFO,whoisgenerallyaseniorvicepresidentandthethird-rankingofficer,is
excellentsourceoftimely
in charge of accounting, financing, credit policy, decisions regarding asset
financearticlesintendedto
acquisitions, and investor relations, which involves communications with stock-
helptheCFOmanagethose
newresponsibilities. holders and the press.
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Chapter 1AnOverview ofFinancial Management 5
FIGURE 1.1 Finance within an Organization
Board of Directors
Chief Executive Officer (CEO)
Chief Operating Officer (COO) Chief Financial Officer (CFO)
3
1
0
2
g
n
ni
Lear RMesaorkuertciensg, ,a Pnrdo dOutchteior nO,p Heuramtianng AcLceoguanl,t Cinagp, iTtarel Basuudrgye, Ctirnegd,it,
ge
ga Departments and Investor Relations
n
Ce
©
Ifthefirmispubliclyowned,theCEOandtheCFOmustbothcertifytothe
Securities and Exchange Commission (SEC) that reports released to stock-
holders, and especially the annual report, are accurate. If inaccuracies later
emerge, the CEO and the CFO could be fined or even jailed. This requirement
wasinstitutedin2002asapartoftheSarbanes-OxleyAct.TheActwaspassed Sarbanes-Oxley Act
by Congress in the wake of a series of corporate scandals involving now- Alaw passedbyCongress
defunct companies such as Enron and WorldCom, where investors, workers, thatrequirestheCEOand
CFOtocertifythat their
and suppliers lost billions of dollars due to false information released by those
firm’sfinancialstatements
companies.
areaccurate.
1-1c Corporate Finance, Capital Markets,
and Investments
Financeastaughtinuniversitiesisgenerallydividedintothreeareas:(1)financial
management, (2) capital markets, and (3) investments.
Financial management, also called corporate finance, focuses on decisions
relating to how much and what types of assets to acquire, how to raise the
capitalneededtopurchaseassets,andhowtorunthefirmsoastomaximizeits
value. The same principles apply to both for-profit and not-for-profit orga-
nizations; and as the title suggests, much of this book is concerned with
financial management.
Capitalmarketsrelatetothemarketswhereinterestrates,alongwithstockand
bond prices, are determined. Also studied here are the financial institutions that
supply capital to businesses. Banks, investment banks, stockbrokers, mutual
funds,insurancecompanies,andthelikebringtogether“savers”whohavemoney
to invest and businesses, individuals, and other entities that need capital for
various purposes. Governmental organizations such as the Federal Reserve
System, which regulates banks and controls the supply of money, and the SEC,
whichregulatesthetradingofstocksandbondsinpublicmarkets,arealsostudied
as part of capital markets.
Investments relate to decisions concerning stocks and bonds and include a
number of activities: (1) Security analysisdeals with finding the proper values of
individual securities (i.e., stocks and bonds). (2) Portfolio theory deals with the
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6 Part 1Introduction to FinancialManagement
best way to structure portfolios, or “baskets,” of stocks and bonds. Rational
investorswanttoholddiversifiedportfoliosinordertolimitrisks,sochoosinga
properly balanced portfolio is an important issue for any investor. (3) Market
analysis deals with the issue of whether stock and bond markets at any given
time are “too high,” “too low,” or “about right.” Behavioral finance, where
investor psychology is examined in an effort to determine if stock prices
have been bid up to unreasonable heights in a speculative bubble or driven
down to unreasonable lows in a fit of irrational pessimism, is a part of market
analysis.
Although we separate these three areas, they are closely interconnected.
Bankingisstudiedundercapitalmarkets,butabanklendingofficerevaluatinga
business’ loan request must understand corporate finance to make a sound
decision.Similarly,acorporatetreasurernegotiatingwithabankermustunder-
stand banking if the treasurer is to borrow on “reasonable” terms. Moreover, a
security analyst trying to determine a stock’s true value must understand cor-
porate finance and capital markets to do his or her job. In addition, financial
decisions of all types depend on the level of interest rates; so all people in cor-
porate finance, investments, and banking must know something about interest
rates and the way they are determined. Because of these interdependencies, we
coverallthreeareasinthisbook.
SELF
TEST What is the relationship between economics, finance, and accounting?
Who is the CFO,where doesthis individualfit into the corporatehierarchy,
and what are some of his or her responsibilities?
Does it make sense for not-for-profit organizations such as hospitals and
universities to have CFOs?
What three areas of finance does this book cover? Are these areas inde-
pendentofoneanother,oraretheyinterrelatedinthesensethatsomeone
workinginoneareashouldknowsomethingabouteachoftheotherareas?
Explain.
1-2
JOBS IN FINANCE
Finance prepares students for jobs in banking, investments, insurance, corpo-
rations, and government. Accounting students need to know finance, marketing,
management, and human resources; they also need to understand finance, for it
affects decisions in all those areas. For example, marketing people propose
Tofindinformationabout advertising programs, but those programs are examined by finance people to
differentfinancecareers, judge the effects of the advertising on the firm’s profitability. So to be effective in
gotocareers-in-finance.com.
marketing, one needs to have a basic knowledge of finance. The same holds for
Thiswebsiteprovides
informationaboutdifferent management—indeed, most important management decisions are evaluated in
financeareasand terms of their effects on the firm’s value.
recommendsdifferentbooks It is also worth noting that finance is important to individuals regardless of
aboutjobsinfinance.
theirjobs.Someyearsagomostbusinessesprovidedpensionstotheiremployees,
so managing one’s personal investments was not critically important. That’s no
longer true. Most firms today provide what’s called “defined contribution” pen-
sion plans, where each year the company puts a specified amount of money into
an account that belongs to the employee. The employee must decide how those
funds are to be invested—how much should be divided among stocks, bonds, or
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Chapter 1AnOverview ofFinancial Management 7
moneyfundsandhowmuchriskthey’rewillingtotakewiththeirstockandbond
investments. These decisions have a major effect on people’s lives, and the con-
cepts covered in this book can improve decision-making skills.
1-3
FORMS OF BUSINESS ORGANIZATION
The basics of financial management are the same for all businesses, large or small,
regardlessofhowtheyareorganized.Still,afirm’slegalstructureaffectsitsoperations
andthusshouldberecognized.Therearefourmainformsofbusinessorganizations:
(1) proprietorships, (2) partnerships, (3) corporations, and (4) limited liability com-
panies (LLCs) and limited liability partnerships (LLPs). In terms of numbers, most
businessesareproprietorships.However,basedonthedollarvalueofsales,over80%
of all business is done by corporations.1 Because corporations conduct the most
businessandbecausemostsuccessfulbusinesseseventuallyconverttocorporations,
we concentrate on them in this book. Still, it is important to understand the legal
differencesbetweenfirms.
Aproprietorshipisanunincorporatedbusinessownedbyoneindividual.Going Proprietorship
intobusinessasasoleproprietoriseasy—apersonbeginsbusinessoperations.Pro- Anunincorporated
prietorshipshavethreeimportantadvantages:(1)Theyareeasilyandinexpensively businessownedbyone
individual.
formed,(2)theyaresubjecttofewgovernmentregulations,and(3)theyaresubjectto
lowerincometaxesthanarecorporations.However,proprietorshipsalsohavethree
important limitations: (1) Proprietors have unlimited personal liability for the busi-
ness’ debts, so they can lose more than the amount of money they invested in the
company.Youmightinvest$10,000tostartabusinessbutbesuedfor$1millionif,
duringcompanytime,oneofyouremployeesrunsoversomeonewithacar.(2)The
lifeofthebusinessislimitedtothelifeoftheindividualwhocreatedit;andtobringin
newequity,investorsrequireachangeinthestructureofthebusiness.(3)Becauseof
the first two points, proprietorships have difficulty obtaining large sums of capital;
hence,proprietorshipsareusedprimarilyforsmallbusinesses.However,businesses
are frequently started as proprietorships and then converted to corporations when
theirgrowthresultsinthedisadvantagesoutweighingtheiradvantages.
Apartnershipisalegalarrangementbetweentwoormorepeoplewhodecide Partnership
todobusinesstogether.Partnershipsaresimilartoproprietorshipsinthattheycan Anunincorporated
be established relatively easily and inexpensively. Moreover, the firm’s income is businessownedbytwoor
morepersons.
allocated on a pro rata basis to the partners and is taxed on an individual basis.
This allows the firm to avoid the corporate income tax. However, all of the
partnersaregenerallysubjecttounlimitedpersonalliability,whichmeansthatifa
partnership goes bankrupt and any partner is unable to meet his or her pro rata
shareofthefirm’sliabilities,theremainingpartnerswillberesponsibleformaking
goodontheunsatisfiedclaims.Thus,theactionsofaTexaspartnercanbringruin
toamillionaireNewYorkpartnerwhohadnothingtodowiththeactionsthatled
to the downfall of the company. Unlimited liability makes it difficult for part-
nerships to raise large amounts of capital.2
1RefertoU.S.CensusBureau,StatisticalAbstractoftheUnitedStates:2011(www.census.gov/compendia/statab),
Table743:NumberofTaxReturns,Receipts,andNetIncomebyTypeofBusiness:1990to2007,p.491.
2Originally,therewerejuststraightforwardpartnerships;butovertheyears,lawyershavecreatedanumberof
variations.Weleavethevariationstocoursesonbusinesslaw,butwenotethatthevariationsaregenerally
designedtolimittheliabilitiesofsomeofthepartners.Forexample,a“limitedpartnership”hasageneralpartner,
whohasunlimitedliability,andoneormorelimitedpartners,whoseliabilityislimitedtotheamountoftheir
investment.Thissoundsgreatfromthestandpointoflimitedliability;butthelimitedpartnersmustcedesole
controltothegeneralpartner,whichmeansthattheyhavealmostnosayinthewaythefirmismanaged.Witha
corporation,theowners(stockholders)havelimitedliability,buttheyalsohavetherighttovoteandthuschange
managementiftheythinkthatachangeisinorder.NotetoothatLLCsandLLPs,discussedlaterinthissection,
areincreasinglyusedinlieuofpartnerships.
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8 Part 1Introduction to FinancialManagement
Corporation Acorporationisalegalentitycreatedbyastate,anditisseparateanddistinct
Alegalentitycreatedbya fromitsownersandmanagers.Itisthisseparationthatlimitsstockholders’losses
state,separate and totheamounttheyinvestedinthefirm—thecorporationcanloseallofitsmoney,
distinctfromitsowners
but its owners can lose only the funds that they invested in the company. Cor-
andmanagers, having
porationsalsohaveunlimitedlives, anditiseasiertotransfersharesofstockina
unlimitedlife, easy
corporationthanone’sinterestinanunincorporatedbusiness.Thesefactorsmake
transferabilityof
it much easier for corporations to raise the capital necessary to operate large
ownership,andlimited
businesses. Thus, companies such as Hewlett-Packard and Microsoft generally
liability.
begin as proprietorships or partnerships, but at some point they find it advanta-
geous to become a corporation.
A major drawback to corporations is taxes. Most corporations’ earnings are
subject to double taxation—the corporation’s earnings are taxed; and then when
its after-tax earnings are paid out as dividends, those earnings are taxed again as
personal income to the stockholders. However, as an aid to small businesses,
SCorporation Congress created S corporations, which are taxed as if they were partnerships;
Aspecialdesignation that thus,theyareexemptfromthecorporateincometax.ToqualifyforScorporation
allowssmallbusinesses status, a firm can have no more than 100 stockholders, which limits their use to
thatmeetqualificationsto
relatively small, privately owned firms. Larger corporations are known as
betaxedasif theywere
Ccorporations.ThevastmajorityofsmallcorporationselectSstatusandretainthat
aproprietorship ora
status until they decide to sell stock to the public, at which time they become
partnershiprather than
C corporations.
acorporation.
A limited liability company (LLC) is a relatively new type of organization
that is a hybrid between a partnership and a corporation. A limited liability
Limited Liability partnership(LLP)issimilartoanLLC;butLLPsareusedforprofessionalfirmsin
Company (LLC) the fields of accounting, law, and architecture, while LLCs are used by other
Arelativelynew typeof businesses. Both LLCs and LLPs have limited liability like corporations but are
organization thatis
taxed like partnerships. Further, unlike limited partnerships, where the general
ahybridbetween a
partnerhasfullcontrolofthebusiness,theinvestorsinanLLCorLLPhavevotes
partnershipand
in proportion to their ownership interest. LLCs and LLPs have been gaining in
acorporation.
popularity in recent years, but large companies still find it advantageous to be C
corporations because of the advantages in raising capital to support growth.
Limited Liability
LLCs/LLPs were dreamed up by lawyers, and it is necessary to hire a good
Partnership (LLP)
SimilartoanLLCbutused lawyer when establishing one.3
forprofessional firmsin When deciding on its form of organization, a firm must trade off the advan-
thefields ofaccounting, tages of incorporation against a possibly higher tax burden. However, for the
law,andarchitecture.It followingreasons,thevalueofanybusinessotherthanarelativelysmallonewill
haslimitedliability like probably be maximized if it is organized as a corporation:
corporations butis taxed
1. Limited liability reduces the risks borne by investors; and other things
likepartnerships. held constant, the lower the firm’s risk, the higher its value.
2. A firm’s value is dependent on its growth opportunities, which are
dependent on its ability to attract capital. Because corporations can attract
capital more easily than other types of businesses, they are better able to
take advantage of growth opportunities.
3. The value of an asset also depends on its liquidity, which means the time
and effort it takes to sell the asset for cash at a fair market value. Because
the stock of a corporation is easier to transfer to a potential buyer than is
an interest in a proprietorship or partnership, and because more investors
are willing to invest in stocks than in partnerships (with their potential
unlimited liability), a corporate investment is relatively liquid. This too
enhances the value of a corporation.
3LLCsandLLPsarerelativelycomplicatedstructures,andwhattheycandoandhowtheymustbesetupvaries
bystate.Moreover,theyarestillevolving.
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