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Chapter
1
The Financial
Environment:
Firms, Investors,
and Markets
L EARNING
G OALS
LG1
Define the term finance and explain why finance is relevant to
students
...
LG3
Explain how investors monitor managers to ensure that managerial
decisions are in the best interests of the owners
...
1
2
LG1
What Is Finance?
finance
The processes by which money is transferred among businesses, individuals,
and governments
...
Finance is the processes by which money is transferred (financing
and investing) among businesses, individuals, and governments
...
Every day, financial decisions made within
firms result in financial actions, such as those listed here, which were taken from
the financial news:
• Dell Computer expands its product line
...
• Nike closes a production plant in Asia
...
• Ford Motor Co
...
• Motorola acquires a company in Japan
...
Note that each action reflects a decision on either how to invest funds or how to
obtain funds
...
Financial decisions influence the value of the firm as reflected in its stock price, which affects how much
investors earn on their investments in the firm
...
• Nike’s stock price declines by 5 percent as a result of poor performance
...
• The price of Comp USA stock increases by 30 percent on news that it is
being acquired
...
Some of the more common
types of financial news headlines are related to financial markets:
• The yields offered on bonds decline in response to a decision announced by
the Federal Reserve
...
S
...
• U
...
interest rates rise in response to inflationary fears
...
S
...
The Relevance of Finance
The wide range of events just cited reflects the breadth of finance
...
It also illustrates how financial markets and institutions
CHAPTER 1
The Financial Environment
3
facilitate finance activities of both managers and investors
...
It is also relevant to those who pursue nonfinancial positions but need
to understand how finance is related to their job functions
...
Regardless of how much you have to
invest, finance can help you decide whether to invest your money, what type of
financial instrument to invest in, how much money should be invested, and how
invested funds should be allocated among different investments
...
This
book discusses each of these components in detail and illustrates how they are
integrated
...
Thus this chapter provides an overview of the text
...
financial management
(managerial finance)
The actions taken by financial managers
to make financial decisions for a firm
...
Financial managers are responsible for deciding how to invest a company’s funds
to expand its business and how to obtain funds (financing)
...
Financial managers are expected to make financial decisions that will maximize the firm’s value and therefore maximize the value of the firm’s stock price
...
Some more common career opportunities for financial managers are shown
in Table 1
...
This table summarizes the different types of duties that financial
managers perform
...
However, as the firm grows, financial managers
are hired to specialize in particular managerial finance duties
...
In larger firms, financial managers fit within the firm’s organizational structure as shown in Figure 1
...
The key financial decisions of a firm are commonly
made by or under the supervision of the chief financial officer (CFO), who typically reports directly to the chief executive officer (CEO)
...
1 shows the structure of the finance
4
TABLE 1
...
May
be involved in the financial aspects of implementing
approved investments
...
Coordinates consultants, investment bankers, and
legal counsel
...
Frequently manages the firm’s cash collection and disbursement activities and short-term investments and coordinates
short-term borrowing and banking relationships
...
Pension fund manager
In large companies, oversees or manages the assets and liabilities of the employees’ pension fund
...
Primarily prepares the firm’s financial plans and budgets
...
Capital expenditures manager
treasurer
The officer responsible for the firm’s
financial activities
...
function in a typical medium-size to large firm, where the treasurer and the controller report to the CFO
...
The controller typically handles the accounting activities, such as corporate accounting, tax management, and financial and cost
accounting
...
Rather, the firm’s finance
function is conducted continuously and is integrated with other business functions, as illustrated in Figure 1
...
For larger firms, each function may be handled
separately by a specific department
...
They engage in a marketing function to forecast sales, promote the products, and distribute them
...
The amount of financing and the time period for which financing is needed depends on information drawn from the production and the marketing functions
...
Firms rely on information systems to ensure that information flows between
the finance function and the other business functions
...
1
The Financial Environment
5
Corporate Organization
The general organization of a corporation and the finance function
...
President
(CEO)
Vice President
Human
Resources
Vice President
Manufacturing
Vice President
Finance
(CFO)
Managers
Vice President
Marketing
Treasurer
Capital
Expenditure
Manager
Financial
Planning and
Fund-Raising
Manager
Credit
Manager
Cash
Manager
Vice President
Information
Controller
Foreign
Exchange
Manager
Pension Fund
Manager
Tax
Manager
Corporate
Accounting
Manager
Cost
Accounting
Manager
Financial
Accounting
Manager
ing function that uses information to prepare financial statements on a periodic
(such as quarterly) basis, to prepare and file tax returns, and to provide information and reports to other managers
...
Investment Decisions by Financial Managers
Financial managers assess potential investment opportunities for the firm in
order to determine whether to pursue those opportunities
...
Investment decisions determine the composition of assets found on the left-hand
side of the balance sheet: The financial manager attempts to maintain optimal
levels of each type of current asset, such as cash and inventory
...
These decisions are important because they affect the firm’s success in
achieving its goals
...
2
Integration of Finance
Function with Other
Business Functions
Investors
$ $
$ $
Firm
Obtains
Funds
$
Firm
Invests
Funds
$
Production
Function
Information
Flow
Finance
Function
Information
Flow
Information
Systems
and
Acounting
$
Firm
Invests
Funds
$
Information
Flow
Marketing
Function
The investments made by the firm are intended to generate cash flows that
provide a return on the investments
...
However, these investments are subject to risk, or the uncertainty about the return
...
Financing Decisions by Financial Managers
debt financing
The use of borrowed funds to finance
investments
...
equity financing
The use of funds obtained in exchange
for ownership in the firm to finance
investments
...
When firms obtain funds, their financing can be classified as either debt financing or equity financing
...
For example, firms can obtain loans or can issue debt
securities, which are certificates representing credit provided to the firm by the
security’s purchaser
...
Firms can
obtain equity financing either by retaining some of their earnings or by issuing
equity securities (stocks), which are certificates representing ownership interest in
the issuing firm
...
First, levels of short-term and long-term financing
must be established
...
Many financing decisions
are dictated by necessity, but some require in-depth analysis of the financing
alternatives, their costs, and their long-run implications
...
institutional investors
Financial institutions that provide
investment funds
...
In this book, our focus
regarding investors is on their provision of funds to firms
...
The financial institutions that provide funds are referred to as institutional investors
...
Debt Financing Provided by Investors
principal
The amount borrowed
...
Financial institutions that provide loans employ loan officers,
who evaluate the financial condition of potential borrowers to determine
whether they are creditworthy
...
The debt has a specified maturity date at which the amount borrowed,
which is called the principal, is repaid
...
They
may be compensated by purchasing a debt security at a discount from its principal value, so that the principal they are repaid at maturity exceeds the amount
they paid for the debt security
...
If they desire, investors can sell to other investors
most types of debt securities before their maturity, which transfers the loan to the
other investors (lenders)
...
Because a firm’s ownership is represented by its stock, each investor
who purchases stock becomes an owner of the firm
...
The
sale of stock results in the transfer of ownership
...
Return and Risk from Investing
return
The cash flow that would be received if
an investment were purchased at the
start of a period and sold at the end of
that period; a return is sometimes measured as a percentage of the amount
initially invested
...
In general, the return on any investment is the actual benefit (cash flow) that would be
received if the investment were purchased at the start of a period and sold at
the end of that period
...
For example,
if financial managers use funds received from investors to invest in very profitable projects, the firm earns a high return on its investments
...
shareholders who invested in the firm’s stock earn a high return on their investment in the firm
...
A return is
sometimes measured as a percentage of the amount initially invested
...
They are risk-averse, which implies that they prefer less risk
for a given expected return
...
When
investors provide equity financing, they are exposed to the risk that the return on
their investment will be lower than expected
...
Investor Use of Financial Services
When deciding how they should invest their funds, investors commonly utilize
financial services (such as financial planning and insurance services provided by
financial institutions)
...
Financial Markets
financial markets
Forums that facilitate the flow of funds
among investors, firms, and government units
...
Each financial market is
served by financial institutions that act as intermediaries
...
Some
financial institutions serve as intermediaries by executing transactions between
willing buyers and sellers of stock at agreed-upon prices
...
Some
financial institutions serve as intermediaries by facilitating the exchange of
funds in return for debt securities at an agreed-upon price
...
For example, Merrill
Lynch (a financial institution) serves as an intermediary in an offering of new
shares by Intel (a firm in need of financing) by selling these shares to investors,
including the California Public Employees Retirement Fund (a financial institution)
...
2
...
CHAPTER 1
TABLE 1
...
Retail bank
managers run bank offices and supervise the programs offered by the bank
...
Personal financial planning
Financial planners advise individuals on all aspects of their personal finances and help
them develop comprehensive financial plans to meet their objectives
...
Appraisers estimate the market values of all types of property
...
Mortgage bankers find and
arrange financing for real estate projects
...
Insurance
Insurance agents/brokers sell insurance policies to meet clients’ needs and assist in claims
processing and settlement
...
Investments
Stockbrokers, or account executives, assist clients in choosing, buying, and selling securities
...
Portfolio managers build and manage portfolios of
securities for firms and individuals
...
Integration of Components in the Financial Environment
real assets
Resources such as buildings, machinery,
and office equipment
...
The integration of components that exist within the financial environment will
be explained throughout the text
...
3 offers a brief overview of that integration
...
For example, the investment decision by Dell Computer to expand
its product line or by The Gap to establish additional stores that require external
financing will result in the firm’s obtaining funds from individual and institutional investors
...
They must decide what to invest in, how much to invest, and the length of the
investment period
...
The investment decisions of financial managers commonly focus on
real assets such as buildings, machinery, and office equipment; the investment
decisions of investors focus on financial assets, which include securities such as
bonds and stocks
...
3 that the investment decisions of financial managers and
investors are related
...
That is, the investment decisions determine the amount of funds that the firm
will obtain from investors
...
10
FIGURE 1
...
Investors’ cash outflows result from purchases of
stocks (and other investment vehicles), so they would like to purchase their
investments at relatively low prices
...
Their cash inflows from owning stock result from dividends and from
the proceeds from selling the stock
...
To make decisions about when to buy and when to sell any
investment, investors need information
...
Their actions
affect the firm’s value, as the following article demonstrates
...
It’s an old investor axiom: Buy on the rumor, sell on the
news
...
”
Amazon
...
The “preannouncement” sent the stock soaring 20%,
adding $6 billion to its market value in a single stroke
...
Whoah: That wasn’t nearly as exciting as the runup
...
2%, closing Tuesday at
$70
...
1875, as investors focused again on the
Internet e-commerce giant’s lack of profits, rather than its
marketing abilities
...
With few Internet companies posting any earnings—and many more not expecting
profits for years—investors have begun using the press
releases—some of scanty substance—as a major tool for
selecting Internet stocks
...
“It’s the best marketed product or service that wins,”
says Jeff Brody, general partner with Redpoint Ventures in
Menlo Park, Calif
...
Take Marimba
...
Though the company shows a mere $8 million
in quarterly revenue and has yet to earn a profit, it has spit
out 27 press releases in the past seven months alone, helping
it to earn a market value in the neighborhood of $900 million
...
24 to
Sept
...
625 on Sept
...
20
...
C1, C2
...
Investors monitor the firms in which they are invested or plan to invest,
so that they can properly “value” these firms to determine whether to buy or sell
the firm’s stock
...
The demand for the firm’s stock at the prevailing price
tends to increase, and the supply of the firm’s stock for sale declines
...
These forces result in a higher equilibrium price (at which the quantity demanded equals the quantity supplied) per
share of the firm’s stock
...
The demand for the firm’s
stock decreases, and the supply of the firm’s stock for sale increases, resulting in
a surplus of stock for sale at the prevailing price
...
A firm’s stock price can change continuously throughout the day, even
though new information about the firm is not disclosed that frequently
...
How Investors Influence a Firm’s Value
The return that investors earn on their equity investment in a firm depends on
how the firm’s value changes during the time they hold the stock
...
Three of the more common methods used by investors
to influence management actions are (1) investor trading, (2) shareholder
activism, and (3) threat of takeover
...
If the future performance is
expected to be weak, investors may sell their shares of the firm’s stock, which
places downward pressure on the firm’s stock price
...
Any managers of the firm whose compensation is tied to the firm’s stock price will be directly penalized if the stock price
declines
...
Conversely, if the future performance of a firm is expected to be strong as a
result of managerial actions, some investors will attempt to buy more shares of
the firm’s stock, which places upward pressure on its price
...
Those managers of the firm whose compensation is tied to the firm’s stock price will be directly rewarded if the stock price
increases
...
Alternatively, shareholders may attempt to influence the decisions of the firms in
which they are invested, in order to align the firm’s actions more closely with
their financial interests
...
In particular, when institutional investors hold large blocks of the
firm’s outstanding shares, they can try to use their voting power to influence,
and often change, the firm’s management and/or board of directors
...
In 1955, institutional investors held only about 10 percent of the total stocks
(in terms of value) in the United States
...
Thus institutional investors now have much more
power to ensure that managers act in the interests of shareholders
...
CHAPTER 1
Example
The Financial Environment
13
Wilmington Inc
...
The portfolio managers of Wilmington Inc
...
had much potential when they purchased the stock 3 years ago, but Lexo has
performed poorly over this period
...
Lexo’s board of directors responded by pressuring the executives of Lexo to
implement changes that increased the firm’s efficiency
...
Because
Wilmington holds 2 million shares, it gained $6 million as a result of exerting its
influence on Lexo Co
...
had held a much smaller number of
shares (as most individual investors do), it would not have been able to influence
Lexo’s board of directors
...
They then may restructure the firm in order to better achieve the shareholders’
goal to maximize the share price
...
Example
Oregon Co
...
Some institutional investors believed that the firm had excellent potential and that they could improve the firm if they could acquire enough shares to
take control
...
They then restructured the firm by
firing the inefficient managers and replacing them
...
In many takeovers, some of the managers of the firm serve as the investors
who take control of the firm
...
In
other cases, managers may not be able to purchase underperforming firms,
because the amount of funds needed to gain control of the firm is too large
...
Regardless of whether a firm might be acquired by some of its managers or
by another firm, the threat of a takeover should give the firm’s managers an
incentive to perform well, because a takeover may result in the elimination of
their jobs
...
Example
Investors monitor firms by reviewing the financial statements that firms must
provide to their shareholders on a periodic basis
...
They also may
periodically meet with managers, and therefore have more detailed information
about firms than other investors
...
A firm
may experience problems that cannot be discerned in its published financial
statements
...
Because a
firm’s stock price responds to new information, investors prefer that any asymmetric information be eliminated or reduced so that they can better monitor
firms over time and make more informed investment decisions
...
Thus the
degree of asymmetric information varies among firms
...
and Limited-Info Co
...
Assume that Full-Info Co
...
Conversely, Limited-Info Co
...
Limited-Info Co
...
Consequently, investors who monitor
Limited-Info Co
...
In general, the higher degree of asymmetric information results in
greater uncertainty about the value of Limited-Info Co
...
Some institutional investors subscribe to proprietary services that provide
assessments of firms, whereas other institutional investors have an in-house service
...
For this
reason, some individual investors prefer to allow specific institutional investors
(such as full-service brokers) to make their investment decisions for them
...
In essence, individual investors who pay for advice (in the
form of higher commissions on transactions or in other ways) must ensure that
their advisors are serving their best interests
...
importing
Purchasing products from firms in other
countries
...
In response to a lowering of various international barriers, financial managers
and investors commonly pursue investment opportunities in foreign countries
...
They also engage in
importing, in which they purchase supplies or materials from firms in other
countries
...
Such direct
foreign investment is especially common in countries with low labor costs
...
S
...
Risks of International Business
exchange rate risk
The risk that cash flows will be adversely affected by movements in the price
of one currency in relation to another
...
appreciation
The strengthening of one currency relative to another
...
International businesses can be exposed to exchange rate risk, which
represents the risk that their cash flows will be tracking adversely affected by
movements in the price of one currency in relation to another (the exchange
rate)
...
S
...
S
...
In addition, if the firm must make payment in a foreign currency that
appreciates (strengthens) against the U
...
dollar by the time payment is due, it
will be forced to increase its dollar cash outflows
...
International Finance by Investors
Just as U
...
firms can attempt to capitalize on foreign business opportunities by
engaging in international business, U
...
investors can invest in securities issued
by foreign firms
...
Some foreign securities are desirable because they may possibly offer a
higher return to U
...
investors than any U
...
stocks, but they can cause exposure
to exchange rate risk
...
S
...
S
...
If the value of the Canadian dollar depreciates against the U
...
dollar over the investment horizon, the return to U
...
investors will be reduced
...
S
...
16
?
Review Questions
|
1–9 Why do firms engage in direct foreign investment?
1–10 How is a firm’s cash flow exposed to exchange rate risk?
Using This Textbook
In this textbook we will focus on three key components of finance: financial
managers, financial markets, and investors
...
Financial managers: Obtain funds for their firms (arrange financing) and
invest the firm’s funds
...
Investors: Provide debt financing and equity financing to firms in pursuit of
their own personal financial goals
...
As you study this book, you will observe that each chapter is organized and
developed around a group of learning goals
...
At
periodic intervals in each chapter (usually before major section headings) review
questions test your understanding of the material just presented
...
Think about what you’ve just read
...
) If
you’re able to answer the review questions, you’ll be well on your way toward
mastering the chapter’s learning goals
...
CHAPTER 1
The Financial Environment
17
TYING IT ALL TOGETHER
This chapter introduced financial managers, financial markets, and investors as
the key components of the financial environment and explained how these components are related
...
INTEGRATIVE TABLE
Participating in the Financial Environment
Role of
Role of
Role of
Financial Managers
Financial Markets
Investors
Financial managers determine
how to invest a firm’s funds to
capitalize on potential opportunities
...
Financial markets facilitate the
flow of funds from the suppliers
of funds to firms or governments
who need funds
...
Investors commonly finance the
investments made by firms by
purchasing debt securities or
equity securities issued by those
firms
...
Finance is the
processes by which money is transferred
among businesses, individuals, and governments
...
An understanding of finance can prepare students for careers in managerial finance or in other
areas of business, including work in financial institutions or in financial markets
...
best interests of the owners
...
If the managers
make poor decisions inconsistent with maximizing
the value of the stock, the investors will sell the
stock, placing downward pressure on its price
...
In
addition, investors can initiate various forms of
shareholder activism
...
Identify the components of the financial environment
...
Describe how the financial environment has
become internationalized
...
However, the international environment can also cause future cash flows to be subject
to more uncertainty because of currency exchange
rate risk and other factors specific to foreign
countries
...
EXERCISES
LG1
1–1
LG2
1–2
Why is knowledge of finance important even to students in other business disciplines?
Explain the role of the financial manager in the firm
...
LG2
1–4
LG3
1–5
How are investment decisions of financial managers different from those of individual investors?
What factors can influence the equilibrium price of a firm’s stock?
LG3
1–6
How does favorable (or unfavorable) information relating to a firm’s future
cash flows affect the equilibrium price of its stock?
LG3
1–7
LG3
1–8
LG3
1–9
Explain why investors would want to monitor the activities of managers in a
corporation
...
a
...
b
...
, a maker of security lights, is owned by Dan Druther, who
has members of his own family in key positions in the company
...
Dan is involved in the day-to-day operations of the company and
makes all important decisions, although he solicits input from trusted
employees in the company
...
Corporations in some developing countries are required to disclose only
scant information on their operations and earnings once a year
...
Members
of the board are appointed by the company’s chief executive officer
...
Companies in Pandemonia are owned by thousands of shareholders all of
whom own the same number of shares as a result of government policies to
CHAPTER 1
LG3
1–10
LG3
1–11
LG4
1–12
LG4
1–13
The Financial Environment
19
“spread the wealth around
...
What is asymmetric information and how does it affect investors’ ability to
monitor the firm? Does the situation change in the presence of institutional
investors?
Should managers in firms disclose all information to the investing public? Can
you suggest a situation in which it is prudent for a manager to withhold some
information from the public?
What is the primary source of risks for firms operating abroad? Can you identify
other sources of risks?
Identify the benefits to an individual investor in a foreign country
...
monster
...
From the monster
...
On the Search Jobs screen, you can select the job location
you want and then select the job category Finance/Economics
...
You can also post your résumé; research companies; tap into a career resource that offers help
with interviewing, networking, and writing résumés; and chat online to share questions and
concerns
...
careermosaic
...
occ
...
gov/
www
...
com/
For additional practice with concepts from this chapter, visit
http://www
...
com/gitman_madura