C H A P T E R An Overview of Finance Chapter Objectives By the end of this chapter you should be able to: T his is a unique finance textbook. Introductory finance texts are usually titled Financial Management or Introduction to Corporate Finance and they focus exclusively on finance applied to business or corporate problem solving and decision making. However, finance is much broader in scope than these texts suggest. Finance also includes 1. Define the major areas of study within the finance discipline 2. Identify the topics and some of the key concepts that will be studied in this course 3. Understand the scope of the financial system and the individual's role in it 4. Discuss the financial manager's role within a corporation 5. Describe the foundation assumptions that underlie the study of finance the study of investments and financial markets. The study of investments includes learning how to convert current dollars into a greater amount of future dollars. The study of financial markets includes learning how the interaction among the various players establishes security prices and facilitates security trading. Finance majors will take separate courses in each of these topic areas, but the course you are taking now provides a foundation in all of them. If this is the only course in finance you take, it will provide a sufficient background to enable you to read and understand popular financial literature. It will also provide a framework for how you should think about financial issues and prepare you for more advanced topics, should you choose to pursue the study of finance further. This chapter briefly discusses the three major areas of study within the finance discipline. It then introduces the financial system and explains how we will approach the study of each element. Finally, the chapter discusses some fundamental assumptions that will be carried throughout the book. This may be the most important course you will take during your college career. You will learn how to manage money on both the corporate CHAPTER 1 An Overview of Finance and personal levels. You will learn to read business periodicals and understand investment advisors. You will learn the correct approach to solving business and personal investment problems. These lessons may have a tremendous impact on your career in business as well as on your personal wealth and security. For example, if you go to work for a firm after graduation, you will probably start your first day in the personnel office. There, you may be asked to choose how your retirement dollars are to be invested. You will learn in this course that one selection may leave you without enough funds to retire when you desire, but another, if history repeats itself, may let you retire early. In this course you will learn how to evaluate retirement options, select among auto and home loans, and analyze business opportunities. You will learn how to evaluate a firm's health and how to project its future. WHAT IS FINANCE? Broadly defined, finance is the study of managing money. At the most basic level this involves determining where to get money and what to do with it. Clearly, finance is central to a wide variety of jobs, disciplines, and activities. Bankers, accountants, financial planners, and many others make their living using financial concepts on a daily basis. Still others use the concepts less directly, but benefit from an understanding of the basics. It is difficult to think of any job that does not require at least some understanding of financial principles. Even an artist must price art fairly and deal with estimating cash flows. Additionally, everyone should take responsibility for his or her own retirement security and plan for it accordingly, which requires an understanding of finance. It will become obvious as you read this book that many of the distinctions between the fields of study in finance are artificial. For example, the study of how interest rates are determined is normally considered part of markets and institutions. However, corporate managers and investors are keenly interested in interest rates and follow them closely. Similarly, both business managers and investors are concerned with how securities are priced. This text points out diverse applications as each topic is presented to help you achieve an integrated picture of the entire field of finance. Markets and Institutions A student majoring in finance will take at least one course in financial markets. The study of financial markets includes the determination of interest rates and how the market prices and distributes securities. To simplify the study of financial markets in Chapter 2, our discussion will be based on the maturity of the securities that trade there. Money markets are for securities that mature in less than 1 year. Capital markets are for securities that mature in more than 1 year. We will also investigate how financial markets facilitate trading and increase the accuracy of security pricing. The study of financial institutions includes learning how banks, thrifts, the Federal Reserve, and finance companies increase the efficiency of financial transactions. Everyone interacts with financial institutions. Business managers deal with investment bankers who help take securities public. Individuals deal with banks for loans and with 3 4 PART I Markets and Institutions other investment institutions to invest for retirement. You will save money and time if you understand which institution specializes in each type of service you need. Additionally by understanding the motives and constraints facing the various institutions, you are more likely to successfully obtain the services you seek. We begin our study of financial institutions in Chapter 3. Another important topic covered in markets and institutions courses is the determination of interest rates. It is often important to both individuals and business managers to understand the factors that influence interest rates so that they can make educated predictions about future interest rates. For example, in 1992 long-term mortgage interest rates fell from about 10% to less than 8%. Many homeowners were faced with the question of whether they should refinance their home loans immediately or wait for rates to drop further. It turned out that long-term rates increased for two years before falling back to the level achieved in 1992. Homeowners who waited for rates to fall lost several years of lower payments. An understanding of interest rates can lead to better financial decision making. We will investigate how interest rates are determined and the factors that influence them in Chapter 4. We extend our study of interest rates to the Federal Reserve, which is the central bank of the United States. Besides being the government's bank and the bank for banks, it also has tremendous control over the economy and interest rates. Because of the Federal Reserve's critical influence over both investors and businesses, we will study it separately from the other financial institutions in Chapter 5. Investments The second major concentration within finance is investments. The study of investments is the study of how dollars available today can be turned into more dollars in the future. At one time, most individuals had few investment choices. It was difficult to buy stocks with only moderate wealth, and corporate pension plans offered few options to employees. The investment landscape is very different today. As we will discuss later, investors build portfolios of securities. A portfolio is simply a group of different investments. Wise investors hold a variety of securities in their portfolios to reduce their risk, an investment strategy called diversification. Mutual funds enable investors with limited funds to buy a diversified portfolio of securities. Most corporations now give employees a number of investment alternatives. A thorough grounding in investments will help you to understand the implications of these alternatives and to select the best ones for yourself. We begin our study of investments in Chapter 6 by learning how money grows when invested over time and how future dollars are worth less than dollars we have now. You will learn to solve many real-world problems in this chapter. One of the most important topics in finance is the risk-return tradeoff. To get greater returns, you must be willing to incur greater risk. Although this concept seems straightforward, it gets more complex when we try to precisely define risk and to determine exactly how it affects returns. We will study the risk-return relationship in Chapter 7. Anyone buying or investing in securities needs to know how the market arrives at a price. It is easy to find the value of bonds, but we will discover that it is much more CHAPTER 1 An Overview of Finance difficult to accurately price stock. Like risk and return, asset valuation is important both to businesses selling securities and to investors buying them for their portfolios. We address asset valuation and explain how well our valuation theories work in practice as we discuss security pricing in Chapters 8 and 9. The discussion of market efficiency at the end of Chapter 9 ties our study of markets to our study of market pricing. Corporate Finance Corporate finance is finance applied in a business setting. This is the typical focus of introductory finance courses. We will cover most of the topics included in traditional corporate finance texts; however, we will include a personal investment slant whenever possible. Most of you will work for a corporation at some time in your future. You may even run your own firm. For this reason, even if you are never employed as a financial manager, you will benefit from the lessons taught here. Within the study of corporate finance, there are several subareas of study. Evaluation of Long-Term Projects The financial manager is responsible for evaluating whether a firm should pursue a particular investment opportunity. For example, Ford Motor Co. recently decided to make a multi-million dollar investment in engineering and production to produce right-hand drive vehicles for sale in Japan. The financial managers of Ford had to determine whether they could realistically expect to recoup this investment or whether Ford could use its resources better elsewhere. We will examine the most commonly used methods for project evaluation in Chapters 10 and 11. Study of How to Acquire Funds One of the most important yet difficult decisions facing the financial manager is how to fund the firm's investments. Consider the problems faced by many of the new dot com companies, such as Amazon.com. During its early years it focused on gaining market share as opposed to generating profits. Amazon's management decided that its long-run success depended more on building a customer base than on generating revenues. Many Web retailing firms believed this model. It is much like how the focus is on acquiring property at the beginning of a game of Monopoly. The winner will be the one with the most property, not the one with the most cash on hand. The dot com companies had to find ways to support their growth until revenues increased sufficiently to generate profits. There are three options facing the firm: borrow a huge amount of money, sell stock to the public, or sell the entire firm to a larger corporation that has the resources to fund the expansion. The decision managers make will affect the very survival of the firm. We will look at how a decision such as this may be tackled in Chapters 12 and 13. Analyzing Firm Performance In Chapter 14 we analyze firms using ratios and common-size financial statements. Ratios help the financial manager to identify areas needing attention. Ratio analysis can help the financial manager identify the strengths and weaknesses of a firm. Chapter 15 5 6 PART I Markets and Institutions extends the concepts learned in Chapter 14 by using ratios to forecast a company's future strengths and weaknesses. We conclude our study of corporate finance by reviewing the management of short-term capital, which is how to correctly use current assets and current liabilities, in Chapter 16. Chapters 17 and 18 conclude the text and integrate the various areas of finance by taking a look at how well the ideas and theories advanced earlier in the book can be used to solve real-life problems. In Chapter 17 we extend our discussion to international markets. In Chapter 18 we follow an entrepreneur through her life as she uses the financial lessons taught in this course to solve a variety of different business and personal finance problems. To help link the various topic areas together into a cohesive unit we next introduce the financial system. Self-Test Review Questions* Answers to Self-Test Review Questions appear at the bottom of the page on which the question is located. 1. How is finance defined? 2. What are the three main areas of finance? FINANCIAL SYSTEM The earlier discussion might have led you to conclude, incorrectly, that the field of finance is segregated into distinct areas of study. In fact, all of the topics discussed in the last section fit together in the financial system,which is shown graphically in Figure 1.1. On the far left we see that three groups provide funds: individuals, businesses, and the government. Individuals are the primary investors in the economy. Ultimately, they own every business asset. Individuals invest their savings in the financial system with the expectation of converting them into greater savings for the future. Figure 1.2 shows the typical life-cycle spending by individuals or households. During his or her early years, a person may spend more than is earned. For example, you may be borrowing money to pay for your education. Eventually, you hope to go to work and to earn enough to pay back these loans and begin building up a nest egg (a reserve sufficient to cover emergencies and retirement). You will use this nest egg when you retire and your income falls below your level of spending. The financial system plays a critical role in the individual's financial life cycle. Initially, the markets and intermediaries provide a source of funds when you need to borrow. For instance, you will become acquainted with the mortgage market when you buy your first house. You may have already participated in the money markets if you have borrowed money to buy a car. Undoubtedly you have already dealt with banks, which are financial intermediaries. Later in life, when your income rises, you will begin investing. This may be through an intermediary known as a pension fund, or it may be through banks and stock bro- CHAPTER 1 An Overview of Finance kerage houses. However you choose to invest, the markets, with the aid of intermediaries, will channel your savings to borrower-spenders. Borrower-spenders are listed on the right side of Figure 1.1. They include businesses, the government, and individuals. These borrower-spenders pay for the right to use your money for a period of time. The financial system relies on all of its parts to function. Without you, the individual, there would be no money available for those who need to borrow it. Without the markets and the intermediaries, investors would have difficulty channeling funds to borrowers. Without the borrower-spender, investors would have nowhere to invest. Note from Figure 1.1 that individuals, businesses, and the government are each sometimes lenders and sometimes borrowers. Businesses and the government often have temporary surplus funds to lend. Across the whole economy, however, businesses and the government borrow, which is why they are listed first in the Borrower-Spenders box. Similarly, individuals at times are borrowers. However, in aggregate, individuals are the source of investment funds and so are listed first in the Lender-Savers box. Keep this diagram of the financial system in mind as we move through the text. In Part One we investigate the markets, intermediaries, and interest rates. In Part Two we look at investments, including how cash flows are adjusted for time, how risk and return are related, how assets are valued, and how we may evaluate a firm before making an investment. In Part Three we move our focus to the business. We study how businesses choose between using debt or equity to fund growth and how they choose between investment opportunities, plan for the future, and manage short-term assets. Before we launch into our study of financial markets and institutions in Chapter 2, let us first establish what financial managers are attempting to accomplish. 7 8 PART I Markets and Institutions ROLE OF THE FINANCIAL MANAGER A firm's accountants report the recent history of the firm's earnings (the income statement) and provide a snapshot of the current fiscal condition of the firm (the balance sheet). As important as these functions are, no company succeeds by looking back. The financial manager is responsible for making decisions that affect the future of the firm. The financial manager evaluates future investments, projects, product introductions, and financing. On the basis of this analysis, the firm makes decisions that affect its very survival. It is helpful to have a single goal in mind when making financial decisions. This goal enables us to establish methods to make choices that will ensure profitability. Maximizing Profit Is Not Enough A rational goal to consider would be for managers to maximize the firm's profits. A manager who is maximizing profits makes decisions that result in the highest profits to the firm in every period. Is this really what we want our managers to do? Consider the case of Fresh International, a privately held firm now run by the grandson of the founder. The California-based firm grows vegetables and sells them as salad. In the early 1980s the firm began developing a method to preserve salad in a bag. Initial efforts were a dismal failure (buyers found themselves with a bag of ugly brown mush). Clearly, the early efforts were a cost that the firm could have saved. They took money, time, and energy away from the firm's main business: growing and marketing lettuce. Finally, in 1989 Fresh International's scientists developed a special bag that lets out carbon dioxide without letting in oxygen. The result was bagged salad that would last on retailers' shelves. Total CHAPTER 1 An Overview of Finance sales for Fresh International in 1995 were about $450 million, with about $350 million from the sale of bagged salads. Postponing current period profits for future sales seems to have paid off. This example suggests one problem with the profit maximization goal: Profit maximization can result in short-sighted management decisions. Another problem with the profit maximization goal is that it ignores risk. A manager whose goal is to maximize profits, if faced with two investment options, would choose the one with the highest expected profit, despite its having much higher risk than the alternative. Finally, the timing of the cash flows is important. In general it is better to get cash flows to the company sooner rather than later. Suppose a manager was evaluating two projects. One gave large payments initially and the second gave large payments later. If the total profits of the second were larger, the manager with a profit maximization goal might choose it over the first. This may not be the best decision, as Chapter 6 will show. Shareholder Wealth Maximization Should Be the Goal Rather than profit maximization, we will assume that the manager's goal is to maximize shareholder wealth (which we will see later is equivalent to maximizing the value of the firm). Consider what this implies. Managers should make every decision with the goal of increasing the wealth of the shareholder. How is shareholder wealth increased? By increasing the stock price. So the goal of maximizing shareholder wealth is equivalent to the goal of maximizing stock price. Because investors buy stock for the sole purpose of making money, this goal will please them. Pleased shareholders will reelect directors, who will reward managers with higher salaries. If the goal is to increase shareholder wealth, how can managers achieve this goal? Shareholder wealth is measured as the number of shares held multiplied by the price per share. For example, at the time of this writing William Gates, the CEO and largest shareholder of Microsoft, owns 741,749,300 shares of Microsoft stock. With Microsoft selling at $59,375 per share, Gates's wealth is $44.04 billion. To increase his wealth, Gates must increase the stock price.1 Thus, the wealth maximization goal puts the emphasis on increasing the stock price rather than on profits or earnings per share (EPS). In Chapter 9 we will examine determinants of stock price in more detail, but we can briefly review them here. If a firm's risk falls, investors will pay a higher price for the stock. Similarly, if the projected cash flows increase, the stock price will rise, and it will rise more quickly if investors expect the cash flows sooner rather than later. The wealth maximization goal leads to a very rational directive to managers: Increase the firm's cash flows, get those cash flows to the firm as soon as possible, and do this while minimizing risk. This goal allows us to develop strategies for evaluating projects that provide clear answers to investment questions. 9 10 PART I Markets and Institutions Straying from the Wealth Maximization Goal In practice, managers do not always adhere to the goal of maximizing shareholder wealth. Consider that Business Week2 reported that the cost of operating a private corporate jet averages nearly $10,000 per hour, including depreciation, pilot salaries, and insurance. Despite these high costs, many managers choose to buy a company plane rather than use commercial airlines. In these cases, managers may be looking out for their own welfare and comfort more aggressively than for the welfare of shareholders. This problem arises because managers, rather than owners, run many companies. Managers, as agents of owners, recognize that they will not benefit as much from increasing shareholder wealth as they may by running the company to suit their own agendas. For example, managers could have the company buy expensive luxury cars for their use. This does not increase the wealth of shareholders, but it may make the manager happy. An agency cost is any benefit a manager derives from a company that does not increase shareholder wealth and is not part of the manager's agreed-upon compensation. Agency costs include fancy offices, corporate jets, beachfront condos, and Friday afternoons off for golf. Less obvious costs of the agency relationship, but just as significant, are those associated with reducing agency costs. For example, hiring expensive accounting firms to monitor management decisions and provide accurate accounting and financial information is also an agency cost. It is often difficult for shareholders to control agency costs. One reason is that the shares of stock in most large companies are so widely distributed that no one shareholder has the incentive or the power to discipline wayward managers. Many argue that the takeover market is one of the best sources of corporate discipline available. Managers who are looking out for their own interests over the interests of shareholders are likely to be replaced when the firm is taken over by another firm. Boards of directors give many managers stock options and stock incentive plans to help align their interests with those of shareholders. One famous example of this was when Lee Iacocca became CEO of Chrysler. He received a salary of $1 per year plus stock options. At the time, Chrysler was near bankruptcy. By saving the company and increas- CHAPTER 1 An Overview of Finance B o x 1.1 A Question of Ethics: Levi Strauss & Co. and Child Labor In 1992 Levi Strauss was confronted with a difficult problem. Two of its subcontractors in Bangladesh were using child labor. Its first response was to consider ordering the subcontractor to fire the children and replace them with adult workers. On further investigation, Levi learned that if the children lost their jobs, they would probably be driven into prostitution to help support their families. Levi recognized that not only did the managers face an ethical dilemma, but there could be a public relations disaster if the press publicized the fact that they employed children. The dilemma: Lay off the children and force them into prostitution or keep them working at the factories, thereby contributing to child labor and opening the company up to bad publicity The solution Levi arrived at was both unusual and innovative. The children were taken out of the factories and Levi continued to pay their wages as long as they attended school full time. Levi guaranteed the children factory jobs upon reaching age 14, the local age of maturity. This solution benefited Levi in several ways. First, the risk of bad publicity was replaced with a conspicuous display of decency. Second, Levi began preparing a more qualified and better-educated workforce for the future. Finally, because the children had to attend school to get their wages, the families could be counted on to keep them in school—an important issue in a country where education is not strongly supported. Innovative solutions to ethical problems such as these will be required in the future as the shareholder wealth maximization goal conflicts with social consciousness. Let us hope that managers will take the time and trouble to find appropriate solutions. ing the stock price, Iacocca became a very wealthy man. This deal served shareholders very well. At times, firm managers are caught in a position where their own personal ethics and social consciousness are at odds with the wealth maximization goal. For example, should a firm allow child labor in countries where it is legal and is the lowest-cost method of production? Box 1.1 describes how Levi Strauss & Co. dealt with this problem. Managers may need to be creative to find solutions to difficult problems such as this so that shareholders, managers, and the public are satisfied. What About Bondholders? Before we leave our discussion of the financial manager's goal, let us review what this goal means to the firm's bondholders. Bondholders lend money to the firm and are paid interest until the debt matures and they are paid back the principal. If managers are to maximize stockholder wealth, do they care about bondholders' wealth? Bondholders do not elect directors, set managers' salaries, or otherwise directly affect managers' welfare. To the extent that this is true, managers will not work very hard to make the bondholder happy. In fact, the wealth maximization goal suggests that the manager would be willing to take wealth away from the bondholder and give it to the stockholder. Suppose it were possible for managers to set up a new company, sell bonds to the public, immediately distribute the proceeds to shareholders by declaring a dividend, and then file for bankruptcy. Certainly this transaction would please shareholders, but if this happened often, bonds would become impossible to sell. This explains why bondholders demand protection in the form of long, written agreements that constrain managers. 11 12 PART I Markets and Institutions A typical provision prevents the firm from paying a dividend unless the firm meets certain cash flow requirements. Because managers already are looking out for them, shareholders do not need to be protected by these written agreements. Self-Test Review Questions* 1. 2. 3. 4. What is the goal of the financial manager? Give three reasons why profit maximization is not a good goal. Why would managers fail to maximize shareholder wealth? Are managers likely to spend much energy looking out for bondholders? FIVE KEY CONCEPTS OF FINANCE This textbook covers many areas of finance. The lessons may be applied to nearly every aspect of our lives. This may suggest that it contains many unrelated topics, but this is not the case. A few basic concepts reappear throughout the text that help direct our study of the topic at hand. This section summarizes these concepts. We will initially assume that they are true and call them maxims, meaning an established principle or general truth. Later, we will see that there are shades of truth, and that even these fundamental concepts are subject to some controversy. Greater Returns Require Taking Greater Risk Study Tip The distinction between required, expected, and actual returns can be confusing. The required return is what you need to be satisfied. The expected return is what you think you will get. The actual return is what you actually receive. If you expect a security to pay more than you require, you will buy it. This assumption is at the heart of individual behavior. Before giving up consumption today, an investor will demand greater consumption in the future. Economists call the additional amount of consumption demanded the real rate of interest. It is independent of inflation. If I offer you the option of receiving a new pair of shoes today or next year, you are most likely to choose to receive them today. Wanting things now is part of human nature. I will have to offer you more in the future to induce you to delay consumption. For example, if I offer you the choice between a pair of shoes now or a pair of shoes plus a pair of socks next year and the socks are the minimum required to induce you to wait, then they represent your real rate of return. Real rates are expressed as percentages rather than as clothing accessories. This real rate is the minimum acceptable return, and it is based purely on human nature. We simply like to have things now rather than later. However, if investors want something more than the real rate of return, they must incur more risk. Figure f .3 shows the relationship between risk and return. They-intercept is at the risk-free rate (the rate you can earn without incurring any chance of loss). As the level of risk increases, the required return increases. The required return is the CHAPTER 1 An Overview of Finance minimum return needed to make the investor feel properly compensated for taking on additional risk. Why does the risk-return line slope upward? Suppose an investor wants to save for the future. It is natural that this investor will choose the least risky investment available. However, there are securities for sale that have various amounts of risk. The only way that sellers of risky securities can entice an investor to buy these securities is to offer a higher interest rate. The seller will raise the return to the investor until the securities sell. Investors demand more return to compensate for the greater risk. If the return on assets did not fluctuate with risk, no one would be willing to buy riskier securities. As a result, not all of the securities in the market would sell. Do higher-risk investments always provide higher returns? Absolutely not! If we knew what the return was going to be, the investment would not really be risky. When an investor buys a risky security, the required return is high. The actual return may indeed be equal to the expected return, or it may be even more. It also may be much less. Investments are always made based on expected returns. The expected return is what investors think the future return will be. If they expect more than they require, they will buy the stock. Investment analysts make their living attempting to project future stock returns. We will pursue this topic further in Chapter 7. The risk-return assumption can be summarized as follows: Finance Maxim 1: Investors will not delay consumption unless they expect to get something extra in return, nor will they incur risk without being compensated for that risk. Good Deals Disappear Fast Suppose a new employee at Nordstrom's Department Store misunderstands the manager and, rather than putting last year's unsold merchandise out for sale, drastically reduces the price on a new shipment of Tommy Hilfiger shirts. Shoppers would quickly buy the 13 14 PART I Markets and Institutions shirts. Who would be able to take advantage of this good deal? Only shoppers who knew what the true price of the shirts should be and who happened to spot the bargain. Every shopper is looking for the same thing—good deals—but which shoppers are most likely to find them? The good deals go to those who know prices well enough to recognize a deal when it surfaces and to those who find it first. The same situation exists in the securities markets. Every investor is looking for the same thing: a good deal. Good deals may occasionally surface. Who will be able to take advantage of them? The answer to this question leads to our next finance maxim. Finance Maxim 2: Good deals go to the investor who is able to recognize them and reacts first. For example, big investment fund companies employ a number of specialists who spend all of their time studying a few stocks or industries. When news about one of these stocks or industries is released, the mutual fund specialists can quickly buy or sell the affected security. Because the investment company controls large amounts of money the price of the security will move quickly, and the opportunity for big returns disappears. Consider this simplified example. In October 1995 China's leading car maker picked General Motors Corp. over Ford Motor Co. for a project valued at more than $1 billion to build sedans in China. General Motors stock was then selling at $44.50 per share and earnings per share (EPS) were $7.43. If GM distributed all of the earnings to the shareholders, the return would have been If analysts projected that earnings per share would increase to $7.75 because of the deal with China, the projected return would increase to 17.42%: If a return of 16.70%, as it was before the announcement, was adequate given the risk of this stock, then General Motors stock represented a good deal at $44.50, and analysts would have issued buy orders. The demand for millions of shares of the stock would cause its price to rise. Theoretically, investors would continue to buy shares until the price rose to the point where the return was again 16.70%. This happens when the stock price is $46.42: As new information becomes available to investors, security prices will adjust so that the return to investors is fair. Millions of investors are looking for mispriced securities every day. Many of these investors control large amounts of money that they can direct into good deals. As these securities are bought or sold, the prices move up or down until the good deal is gone. Exactly how quickly and accurately security prices reflect CHAPTER 1 An Overview of Finance news is the subject of a tremendous amount of research and debate. We say that markets that do a good job of pricing securities are efficient. Few argue the logic behind efficient markets, but many disagree as to exactly how efficient the markets actually are. What are the implications of efficient markets? If the markets were really able to assign the true intrinsic price to every security and investment offered for sale, every investment would be fair. It would not matter how the investor selected assets for a portfolio. A monkey throwing darts at the Wall Street Journal could pick stocks as well as the most learned professional. Obviously, the learned professional is not going to accept this idea easily. Chapter 9 discusses market efficiency in greater depth. The concept of market efficiency can be summarized as follows: If financial markets are efficient, the price of a security is an accurate estimate by the market of its true alue. The Value of Money Depends on When It Is Received Which would you rather have: $ 100 right now or $ 100 in 1 year? This is an easy choice. Even if you do not need the $100 now, you could invest it so that more would be available in a year. People pay more for things they prefer, so if investors prefer cash flows now rather than later, current cash flows are more valuable. The longer it will be before a cash flow arrives, the less valuable it becomes. Much of the math we do in this course revolves around adjusting the value of cash flows to compensate for when they arrive. The value of assets depends on when the cash flows generated by the assets arrive. Investment opportunities depend on whether the values of future cash flows are greater than the initial investment. To make these calculations, we must recognize that the interest rate the initial investment could have earned is an opportunity cost. The higher the risk of the future cash flows, the greater the required return (remember the risk-return assumption) and the higher the interest rate. Another way of looking at why we must adjust for when cash flows arrive is to consider what happens when we make an investment. Investors spend money today hoping that they will receive funds in the future. To decide whether the investment should be made, the investor compares what is being spent with what will be received. How can investors make this comparison if they receive the dollars at different points in time? Because the dollars have different values depending on when they are received, comparing dollars without adjusting for time is like comparing dollars with pesos without adjusting for the exchange rate. We can summarize our third finance maxim, the time value of money concept, as follows: Finance Maxim 3: A dollar received today is worth more than a dollar received in the future. Cash Is King In finance, cash flows are what matter, not accounting earnings or profits. This is because cash flows are what investors can invest and firms can use to pay dividends. 15 16 PART I Markets and Institutions Accountants report earnings when they are earned, not when they are received. Because accounting profits cannot be invested or used to pay dividends, we must deal with cash. Another reason we deal with cash flows rather than accounting profits is that financial calculations always consider the exact timing of the cash flows and adjust for the time value of money. Accounting profits often have little to do with when funds will actually be received or spent. The major difference between cash flows and accounting profits is how asset purchases are treated. Accountants depreciate an asset over its useful life. The financial analyst deducts the entire cost of an asset during the period when the firm buys it because that is when the cash expenditure takes place. Unfortunately, one problem with this adjustment is that firms pay taxes according to the accountant's way of recording asset purchase expenses. This requires that we compute taxes one way and report cash flows another. We will learn how this is done in Chapter 11. Our fourth finance maxim, the concept that cash is king, can be stated as follows: Finance Maxim 4: Cash flows determine value. Not Everyone Knows the Same Things In a business context, asymmetric information refers to the fact that not everyone knows everything. Investors may not know what the firm's insiders know. A bank may not know what a borrower plans to do with a loan. An insurance agent may not know how well an insured person will act to protect against loss. Each of these examples represents an opportunity for one party to gain at the expense of the other. Consider Gina Day, owner of Rockies Brewing Co., a microbrewery located in Boulder, Colorado. During the first several years, she tried to convince investors that her firm was doing well and would provide excellent returns. Unfortunately, firm managers have no credibility with the public because they have an incentive to stretch the truth. Rockies Brewing Co. has survived and has grown by 1,000% since 1990. Too bad investors did not believe her! The asymmetric information problem explains many events in finance. When a firm announces that it is going to borrow, the stock price usually rises. This is because investors believe that if management issues debt it is signaling the firm's ability to meet the required cash flows far into the future. Similarly, when it sells new stock, management is signaling that the stock is overpriced, so stock prices, on average, drop. Asymmetric information can explain many different financial events, such as why there are protective covenants and why firms may pay a dividend while simultaneously borrowing money. We will point out these issues as they arise later in the text. In summary, our fifth finance maxim is as follows: Finance Maxim 5: Asymmetric information is the difference in the information set held by different participants in the financial marketplace; these differences must be handled by business participants. CHAPTER 1 An Overview of Finance 17 CHAPTER SUMMARY Finance is the study of managing money. Because everyone must deal with money in one context or another, the study of finance is universally important. Finance can be distinguished from accounting by noting that the accounting function reports what has already happened, whereas finance involves making decisions that affect the future. There are three main areas of study in finance. Markets and institutions deal with the financial intermediaries, who can be either suppliers or users of funds. The institutions that participate in the financial markets bring the suppliers and the users of funds together. The financial markets establish security prices so that all of the funds supplied are used and the markets clear. Investments is the study of how money is converted into more money over time. It includes how investment portfolios are created and how securities are selected. Corporate finance deals with financial problems and issues that face a firm. These include evaluating whether projects should be taken and how projects should be financed, and evaluating the financial health of the firm. The goal of the financial manager is to maximize shareholder wealth. Maximizing profits fails to consider the timing and riskiness of the firm and may be short-sighted. Wealth maximization requires the financial manager to maximize the price of the firm's stock. This requires taking a long-term view of cash flows because the stock price is determined by the current value of all future cash flows. The following five assumptions touch on much that will be discussed later in the text: 1. Greater returns require taking greater risk. 2. Good deals disappear fast. 3. The value of money depends on when it is received. 4. Cash is king. 5. Not everyone knows the same things. Chapter 2 begins our study of the financial markets and institutions. KEY WORDS agency cost 10 asymmetric information 16 capital markets 3 corporate finance 5 diversification 4 efficient markets 15 finance 3 financial institutions 3 financial markets 3 financial system 6 investments 4 money markets 3 opportunity cost 15 portfolio 4 real rate of interest 12 risk-return tradeoff 4 DISCUSSION OUESTIONS 1. Why is profit maximization not an appropriate goal for firm managers? 2. Wealth maximization is the goal of financial managers. What, specifically, can the financial manager do to improve shareholder wealth? Discuss this issue in terms of the firm attributes that actually influence shareholder wealth. 3. Discuss the following in terms of agency costs. a. Why are financial managers not as concerned about bondholder wealth as they are about stockholder wealth? b. What do bondholders do to protect themselves? c. Why should financial managers be concerned with keeping bondholders satisfied? 4. Discuss the following in terms of the risk-return tradeoff. a. Distinguish between actual returns and expected returns. b. Distinguish between expected returns and required returns. c. Which must rise with increasing risk? d. If the expected return is less than the required return, will the investor buy the security? e. Will the actual return always be greater for higher-risk securities? 5. In an efficient market, if the required return is 10%, what is the expected return? Explain your answer. 18 PART I Markets and Institutions 6. Why are financial managers so concerned with comput­ ing cash flows when accounting earnings and income data are more readily available? 7. An investor was reviewing a company with the intent of purchasing shares of stock. In the annual report the pres­ ident is quoted as saying that the firm's primary goal is to increase the value of shareholders' equity. However, after additional reading the investor learned of possibly con­ tradictory actions by the firm. Discuss each of the follow­ ing with respect to how the firm's stock price may react. a. The company contributed $5 million to the local hospital development fund. The firm is the major employer in a small town and the hospital is in danger of closing. b. The company is spending $500 million to open a new plant in Korea. The new plant will not be operational for 5 years, so the firm's net income will fall during this period. с The firm is increasing its use of debt financing. The risk of the firm is not significantly increased by the additional debt. d. The firm is embarking on a plan to upgrade its production process using new, untried technol­ ogy. If the new systems work, substantial savings could result. If the systems fail, orders will be delayed or unfilled and many customers can be expected to go elsewhere. e. The firm will decrease its dividend payout ratio. The firm proposes no new investment opportu­ nities. PROBLEMS 1. Expected earnings per share of a company's stock is $5.00. The current price of the stock is $50. a. What is the current expected return? b. If the stock price rises to $60 because of increased demand, what will the expected return be? с If the stock price falls to $45 because a news release states that the firm is now more risky, what will the expected return be? d. Which maxim discussed in this chapter best explains the change in return computed in part c? 2. Expected earnings per share of a firm's stock are $1.50. This stock is selling for $35. a. What is the current expected return? b. If the stock price increases to $40, what will the expected return be? с If the stock price falls to $30, what will the expected return be?
