1-1 What Is Finance?

1-1 What Is Finance?
Finance is defined by Webster’s Dictionary as “the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities.” Finance has many facets, which makes it difficult to provide one concise definition. The discussion in this section will give you an idea of what finance professionals do and what you might do if you enter the finance field after you graduate.
1-1AAreas of Finance
Finance as taught in universities is generally divided into three areas: (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 capital needed to purchase assets, and how to run the firm so as to maximize its value. The same principles apply to both for-profit and not-for-profit organizations; and as the title suggests, much of this book is concerned with financial management.
Capital markets relate to the markets where interest rates, along with stock and bond prices, are determined. Also studied here are the financial institutions that supply capital to businesses. Banks, investment banks, stockbrokers, mutual funds, insurance companies, and the like bring together “savers” who have money 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 Securities and Exchange Commission (SEC), which regulates the trading of stocks and bonds in public markets, are also studied as part of capital markets.
Investments relate to decisions concerning stocks and bonds and include a number of activities: (1) Security analysis deals with finding the proper values of individual securities (i.e., stocks and bonds). (2) Portfolio theory deals with the best way to structure portfolios, or “baskets,” of stocks and bonds. Rational investors want to hold diversified portfolios in order to limit risks, so choosing a 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.” Included in market analysis is behavioral finance, where investor psychology is examined in an effort to determine whether 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.
Although we separate these three areas, they are closely interconnected. Banking is studied under capital markets, but a bank lending officer evaluating a business’ loan request must understand corporate finance to make a sound decision. Similarly, a corporate treasurer negotiating with a banker must understand banking if the treasurer is to borrow on “reasonable” terms. Moreover, a security analyst trying to determine a stock’s true value must understand corporate 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 corporate finance, investments, and banking must know something about interest rates and the way they are determined. Because of these interdependencies, we cover all three areas in this book.
1-1c Finance versus Economics and Accounting
Finance, as we know it today, grew out of economics and accounting. 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. Figure 1.1 illustrates that in the modern corporation, the accountingdepartment typically falls under the control of the CFO. This further illustrates the link among finance, economics, and accounting.
1-2 Jobs in Finance
To find information about different finance careers, go toallbusinessschools.com/business-careers/finance/job-description. This website provides information about different finance areas.
Finance prepares students for jobs in banking, investments, insurance, corporations, and government. Accounting students need to know marketing, management, and human resources; they also need to understand finance, for it affects decisions in all those areas. For example, marketing people propose advertising programs, but those programs are examined by finance people to judge the effects of the advertising on the firm’s profitability. So to be effective in marketing, one needs to have a basic knowledge of finance. The same holds for management—indeed, most important management decisions are evaluated in terms of their effects on the firm’s value.
It is also worth noting that finance is important to individuals regardless of their jobs. Some years ago most employees received pensions from their employers upon retirement, so managing one’s personal investments was not critically important. That’s no longer true. Most firms today provide “defined contribution” pension 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 money funds—and how much risk they’re willing to take with their stock and bond investments. These decisions have a major effect on people’s lives, and the concepts covered in this book can improve decision-making skills.
1-3Forms of Business Organization
efinancialcareers.com provides finance career news and advice including information on who’s hiring in finance and accounting fields.
The basics of financial management are the same for all businesses, large or small, regardless of how they are organized. Still, a firm’s legal structure affects its operations and thus should be recognized. There are four main forms of business organizations: (1) proprietorships, (2) partnerships, (3) corporations, and (4) limited liability companies (LLCs) and limited liability partnerships (LLPs). In terms of numbers, most businesses are proprietorships. However, based on the dollar value of sales, more than 80% of all business is done by corporations. Because corporations conduct the most business and because most successful businesses eventually convert to corporations, we focus on them in this book. Still, it is important to understand the legal differences between types of firms.
A proprietorship is an unincorporated business owned by one individual. Going into business as a sole proprietor is easy—a person begins business operations. Proprietorships have three important advantages: (1) They are easy and inexpensive to form. (2) They are subject to few government regulations. (3) They are subject to lower income taxes than are corporations. However, proprietorships also have three important limitations: (1) Proprietors have unlimited personal liability for the business’ debts, so they can lose more than the amount of money they invested in the company. You might invest $10,000 to start a business but be sued for $1 million if, during company time, one of your employees runs over someone with a car. (2) The life of the business is limited to the life of the individual who created it; and to bring in new equity, investors require a change in the structure of the business. (3) Because of the first two points, proprietorships have difficulty obtaining large sums of capital; hence, proprietorships are used primarily for small businesses. However, businesses are frequently started as proprietorships and then converted to corporations when their growth results in the disadvantages outweighing the advantages.
A partnership is a legal arrangement between two or more people who decide to do business together. Partnerships are similar to proprietorships in that they can be established relatively easily and inexpensively. Moreover, the firm’s income is 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 partners are generally subject to unlimited personal liability, which means that if a partnership goes bankrupt and any partner is unable to meet his or her pro rata share of the firm’s liabilities, the remaining partners will be responsible for making good on the unsatisfied claims. Thus, the actions of a Texas partner can bring ruin to a millionaire New York partner who had nothing to do with the actions that led to the downfall of the company. Unlimited liability makes it difficult for partnerships to raise large amounts of capital.
A corporation is a legal entity created by a state, and it is separate and distinct from its owners and managers. It is this separation that limits stockholders’ losses to the amount they invested in the firm—the corporation can lose all of its money, but its owners can lose only the funds that they invested in the company. Corporations also have unlimited lives, and it is easier to transfer shares of stock in a corporation than one’s interest in an unincorporated business. These factors make it much easier for corporations to raise the capital necessary to operate large businesses. Thus, companies such as Hewlett-Packard and Microsoft generally begin as proprietorships or partnerships, but at some point they find it advantageous 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, Congress created S corporations, which are taxed as if they were proprietorships or partnerships; thus, they are exempt from the corporate income tax. To qualify for S corporation status, a firm can have no more than 100 stockholders, which limits their use to relatively small, privately owned firms. Larger corporations are known as C corporations. The vast majority of small corporations elect S status and retain that status until they decide to sell stock to the public, at which time they become C corporations.
A limited liability company (LLC) is a popular type of organization that is a hybrid between a partnership and a corporation. A limited liability partnership (LLP) is similar to an LLC. LLPs are used for professional firms in the fields of accounting, law, and architecture, while LLCs are used by other businesses. Similar to corporations, LLCs and LLPs provide limited liability protection, but they are taxed as partnerships. Further, unlike limited partnerships, where the general partner has full control of the business, the investors in an LLC or LLP have votes in proportion to their ownership interest. LLCs and LLPs have been gaining in 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. LLCs/LLPs were dreamed up by lawyers; they are often structured in very complicated ways, and their legal protections often vary by state. So, it is necessary to hire a good lawyer when establishing one.
When deciding on its form of organization, a firm must trade off the advantages of incorporation against a possibly higher tax burden. However, for the following reasons, the value of any business other than a relatively small one will probably be maximized if it is organized as a corporation:
1. Limited liability reduces the risks borne by investors; and other things 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.

1-4The Main Financial Goal: Creating Value for Investors
In public corporations, managers and employees work on behalf of the shareholders who own the business, and therefore they have an obligation to pursue policies that promote stockholder value. While many companies focus on maximizing a broad range of financial objectives, such as growth, earnings per share, and market share, these goals should not take precedence over the main financial goal, which is to create value for investors. Keep in mind that a company’s stockholders are not just an abstract group—they represent individuals and organizations who have chosen to invest their hard-earned cash into the company and who are looking for a return on their investment in order to meet their long-term financial goals, which might be saving for retirement, a new home, or a child’s education.
If a manager is to maximize stockholder wealth, he or she must know how that wealth is determined. Throughout this book, we shall see that the value of any asset is the present value of the stream of cash flows that the asset provides to its owners over time. We discuss stock valuation in depth in Chapter 9, where we see that stock prices are based on cash flows expected in future years, not just in the current year. Thus, stock price maximization requires us to take a long-run view of operations. At the same time, managerial actions that affect a company’s value may not immediately be reflected in the company’s stock price.
1-5Stockholder–Manager Conflicts
It has long been recognized that managers’ personal goals may compete with shareholder wealth maximization. In particular, managers might be more interested in maximizing their own wealth than their stockholders’ wealth; therefore, managers might pay themselves excessive salaries.
Effective executive compensation plans motivate managers to act in their stockholders’ best interests. Useful motivational tools include (1) reasonable compensation packages, (2) firing of managers who don’t perform well, and (3) the threat of hostile takeovers.

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1-6Stockholder–Debtholder Conflicts
Conflicts can also arise between stockholders and debtholders. Debtholders, which include the company’s bankers and its bondholders, generally receive fixed payments regardless of how well the company does, while stockholders do better when the company does better. This situation leads to conflicts between these two groups, to the extent that stockholders are typically more willing to take on risky projects.
To illustrate this problem, consider the example in Table 1.1, where a company has raised $2,000 in capital, $1,000 from bondholders and $1,000 from stockholders. To keep things simple, we assume that the bonds have a 1-year maturity and pay an 8% annual interest rate. The company’s current plan is to invest its $2,000 in Project L, a relatively low-risk project that is expected to be worth $2,400 one year from now if the market is good and $2,000 if the market is bad. There is a 50% chance that the market will be good and a 50% chance the market will be bad. In either case, there will be enough cash to pay the bondholders their money back plus the 8% annual interest rate that they were promised. The stockholders will receive whatever is left over after the bondholders have been paid. As expected, because they are paid last, the stockholders are bearing more risk (their payoff depends on the market), but they are also earning a higher expected return.
Now assume that the company discovers another project (Project H) that has considerably more risk. Project H has the same expected cash flow as Project L, but it will produce cash flows of $4,400 if the market is good but $0 if the market is bad. Clearly, the bondholders would not be interested in Project H, because they wouldn’t receive any additional benefits if the market is good and they would lose everything if the market is bad. Notice, however, that Project H provides a higher rate of return for stockholders than Project L, because they capture all of the extra benefits if the market turns out to be good. While Project H is clearly riskier, in some circumstances managers acting on behalf of the stockholders may decide that the higher expected return is enough to justify the additional risk, and they would proceed with Project H despite the strong objections of the bondholders.
Notice, however, that astute bondholders understand that managers and stockholders may have an incentive to shift to riskier projects. Recognizing this incentive, they will view the bonds as being riskier and will demand a higher rate of return, and in some cases the perceived risk may be so great that they will not invest in the company, unless the managers can credibly convince bondholders that the company will not pursue excessively risky projects.
Another type of stockholder–debtholder conflict arises over the use of additional debt. As we see later in this book, the more debt a firm uses to finance a given amount of assets, the riskier the firm becomes. For example, if a firm has $100 million of assets and finances them with $5 million of bonds and $95 million of common stock, things have to go terribly badly before the bondholders suffer a loss. On the other hand, if the firm uses $95 million of bonds and $5 million of stock, the bondholders suffer a loss even if the value of the assets declines only slightly.
Bondholders attempt to protect themselves by including covenants in the bond agreements that limit firms’ use of additional debt and constrain managers’ actions in other ways. We address these issues later in this book, but they are quite important and everyone should be aware of them.

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