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Part

1
Introduction
to
Managerial Finance

Chapter 1
The Role and Environment
of Managerial Finance

Chapter 2
Financial Statements
and Analysis

Chapter 3
Cash Flow
and Financial Planning
Chapter Across the Disciplines


1
Why This Chapter Matters To You
Accounting: You need to understand the
relationships between the firm’s accounting
and finance functions; how the financial state-
ments you prepare will be used for making
investment and financing decisions; ethical

The Role behavior by those responsible for a firm’s
funds; what agency costs are and why the firm
must bear them; and how to calculate the tax

and Environment effects of proposed transactions.

Information systems: You need to under-
stand the organization of the firm; why

of Managerial finance personnel require both historical
and projected data to support investment
and financing decisions; and what data

Finance are necessary for determining the firm’s
tax liability.
Management: You need to understand
the legal forms of business organization;
the tasks that will be performed by finance
LEARNING GOALS personnel; the goal of the firm; the issue of
management compensation; the role of
Define finance, the major areas of ethics in the firm; the agency problem; and
LG1
finance and the opportunities the firm’s relationship to various financial
available in this field, and the legal institutions and markets.
forms of business organization.
Marketing: You need to understand how
Describe the managerial finance the activities you pursue will be affected
LG2
function and its relationship to
by the finance function, such as the firm’s
economics and accounting.
cash and credit management policies; the
Identify the primary activities of the role of ethics in promoting a sound corpo-
LG3
financial manager within the firm. rate image; and the role the financial mar-
kets play in the firm’s ability to raise capi-
Explain why wealth maximization,
LG4
tal for new projects.
rather than profit maximization, is the
firm’s goal and how the agency issue Operations: You need to understand the
is related to it. organization of the firm and of the finance
function in particular; why maximizing
Understand the relationship between
LG5
profit is not the main goal of the firm; the
financial institutions and markets, and
the role and operations of the money role of financial institutions and markets in
and capital markets. providing funds for the firm’s production
capacity; and the agency problem and the
Discuss the fundamentals of business
LG6
role of ethics.
taxation of ordinary income and
capital gains.



2
3
CHAPTER 1 The Role and Environment of Managerial Finance



T he field of finance directly affects the lives of every person and every organi-
zation. Many areas for study and a large number of career opportunities are
available in finance. The purpose of this chapter is to acquaint you with the study
of finance, the managerial finance function, and the goal of the firm. The chapter
also describes financial institutions and markets, and business taxation. Finance
will affect your working life in whatever area of study you choose to concentrate.




Finance and Business
LG1


The field of finance is broad and dynamic. It directly affects the lives of every per-
son and every organization. There are many areas and career opportunities in the
field of finance. Basic principles of finance, such as those you will learn in this
textbook, can be universally applied in business organizations of different types.


What Is Finance?
Finance can be defined as the art and science of managing money. Virtually all indi-
finance
The art and science of managing viduals and organizations earn or raise money and spend or invest money. Finance
money.
is concerned with the process, institutions, markets, and instruments involved in
the transfer of money among individuals, businesses, and governments.


Major Areas and Opportunities in Finance
The major areas of finance can be summarized by reviewing the career opportu-
nities in finance. These opportunities can, for convenience, be divided into two
broad parts: financial services and managerial finance.

Financial Services
Financial services is the area of finance concerned with the design and delivery of
financial services
The part of finance concerned advice and financial products to individuals, business, and government. It
with the design and delivery of
involves a variety of interesting career opportunities within the areas of banking
advice and financial products to
and related institutions, personal financial planning, investments, real estate, and
individuals, business, and
WW insurance. Career opportunities available in each of these areas are described at
government. W
this textbook’s Web site at www.aw.com/gitman.


Managerial Finance
managerial finance
Managerial finance is concerned with the duties of the financial manager in the
Concerns the duties of the finan-
cial manager in the business business firm. Financial managers actively manage the financial affairs of any
firm.
type of businesses—financial and nonfinancial, private and public, large and
small, profit-seeking and not-for-profit. They perform such varied financial tasks
financial manager
Actively manages the financial as planning, extending credit to customers, evaluating proposed large expendi-
affairs of any type of business,
tures, and raising money to fund the firm’s operations. In recent years, the chang-
whether financial or nonfinan-
ing economic and regulatory environments have increased the importance and
cial, private or public, large or
complexity of the financial manager’s duties. As a result, many top executives
small, profit-seeking or not-for-
have come from the finance area.
profit.
4 PART 1 Introduction to Managerial Finance


Another important recent trend has been the globalization of business activ-
ity. U.S. corporations have dramatically increased their sales, purchases, invest-
ments, and fund raising in other countries, and foreign corporations have likewise
increased these activities in the United States. These changes have created a need
for financial managers who can help a firm to manage cash flows in different cur-
rencies and protect against the risks that naturally arise from international trans-
actions. Although these changes make the managerial finance function more com-
plex, they can also lead to a more rewarding and fulfilling career.



Legal Forms of Business Organization
The three most common legal forms of business organization are the sole propri-
etorship, the partnership, and the corporation. Other specialized forms of business
organization also exist. Sole proprietorships are the most numerous. However,
corporations are overwhelmingly dominant with respect to receipts and net prof-
its. Corporations are given primary emphasis in this textbook.


Sole Proprietorships
A sole proprietorship is a business owned by one person who operates it for his
sole proprietorship
A business owned by one person or her own profit. About 75 percent of all business firms are sole proprietorships.
and operated for his or her own
The typical sole proprietorship is a small business, such as a bike shop, personal
profit.
trainer, or plumber. The majority of sole proprietorships are found in the whole-
sale, retail, service, and construction industries.
Typically, the proprietor, along with a few employees, operates the propri-
unlimited liability etorship. He or she normally raises capital from personal resources or by borrow-
The condition of a sole propri-
ing and is responsible for all business decisions. The sole proprietor has unlimited
etorship (or general partnership)
liability; his or her total wealth, not merely the amount originally invested, can be
allowing the owner’s total
taken to satisfy creditors. The key strengths and weaknesses of sole proprietor-
wealth to be taken to satisfy
ships are summarized in Table 1.1.
creditors.


Partnerships
A partnership consists of two or more owners doing business together for profit.
partnership
A business owned by two or Partnerships account for about 10 percent of all businesses, and they are typically
more people and operated for
larger than sole proprietorships. Finance, insurance, and real estate firms are the
profit.
most common types of partnership. Public accounting and stock brokerage part-
nerships often have large numbers of partners.
Most partnerships are established by a written contract known as articles of
articles of partnership
The written contract used to partnership. In a general (or regular) partnership, all partners have unlimited lia-
formally establish a business
bility, and each partner is legally liable for all of the debts of the partnership.
partnership.
Strengths and weaknesses of partnerships are summarized in Table 1.1.


Corporations
A corporation is an artificial being created by law. Often called a “legal entity,” a
corporation
corporation has the powers of an individual in that it can sue and be sued, make
An artificial being created by
law (often called a “legal and be party to contracts, and acquire property in its own name. Although only
entity”).
about 15 percent of all businesses are incorporated, the corporation is the domi-
5
CHAPTER 1 The Role and Environment of Managerial Finance


TABLE 1.1 Strengths and Weaknesses of the Common Legal Forms
of Business Organization

Sole proprietorship Partnership Corporation

Strengths • Owner receives all profits (and • Can raise more funds than sole • Owners have limited liability,
sustains all losses) proprietorships which guarantees that they can-
• Low organizational costs • Borrowing power enhanced not lose more than they invested
• Income included and taxed on by more owners • Can achieve large size via sale
proprietor’s personal tax return • More available brain power and of stock
• Independence managerial skill • Ownership (stock) is readily
• Secrecy • Income included and taxed transferable
• Ease of dissolution on partner’s tax return • Long life of firm
• Can hire professional managers
• Has better access to financing
• Receives certain tax advantages

Weaknesses • Owner has unlimited liability— • Owners have unlimited liability • Taxes generally higher, because
total wealth can be taken to and may have to cover debts of corporate income is taxed, and
satisfy debts other partners dividends paid to owners are also
• Limited fund-raising power tends • Partnership is dissolved when a taxed
to inhibit growth partner dies • More expensive to organize than
• Proprietor must be jack-of-all- • Difficult to liquidate or transfer other business forms
trades partnership • Subject to greater government
• Difficult to give employees long- regulation
run career opportunities • Lacks secrecy, because stock-
• Lacks continuity when proprietor holders must receive financial
dies reports




nant form of business organization in terms of receipts and profits. It accounts
for nearly 90 percent of business receipts and 80 percent of net profits. Although
stockholders corporations are involved in all types of businesses, manufacturing corporations
The owners of a corporation,
account for the largest portion of corporate business receipts and net profits. The
whose ownership, or equity, is
key strengths and weaknesses of large corporations are summarized in Table 1.1.
evidenced by either common
The owners of a corporation are its stockholders, whose ownership, or
stock or preferred stock.
equity, is evidenced by either common stock or preferred stock.1 These forms of
common stock
ownership are defined and discussed in Chapter 7; at this point suffice it to say
The purest and most basic form
that common stock is the purest and most basic form of corporate ownership.
of corporate ownership.
Stockholders expect to earn a return by receiving dividends—periodic distribu-
dividends
tions of earnings—or by realizing gains through increases in share price.
Periodic distributions of earnings
As noted in the upper portion of Figure 1.1, the stockholders vote periodically
to the stockholders of a firm.
to elect the members of the board of directors and to amend the firm’s corporate
board of directors
charter. The board of directors has the ultimate authority in guiding corporate
Group elected by the firm’s
affairs and in making general policy. The directors include key corporate person-
stockholders and having ultimate
nel as well as outside individuals who typically are successful businesspeople and
authority to guide corporate
executives of other major organizations. Outside directors for major corporations
affairs and make general policy.




1. Some corporations do not have stockholders but rather have “members” who often have rights similar to those of
stockholders—that is, they are entitled to vote and receive dividends. Examples include mutual savings banks, credit
unions, mutual insurance companies, and a whole host of charitable organizations.
6 PART 1 Introduction to Managerial Finance


FIGURE 1.1 Corporate Organization
The general organization of a corporation and the finance function (which is shown in yellow)

Stockholders



elect

Board of Directors Owners

hires


President
Managers
(CEO)




Vice President Vice President Vice President
Vice President Vice President
Human Finance Information
Manufacturing Marketing
Resources (CFO) Resources




Treasurer Controller




Capital Foreign Cost
Credit Tax
Expenditure Exchange Accounting
Manager Manager
Manager Manager Manager



Financial
Corporate Financial
Planning and Cash Pension Fund
Accounting Accounting
Fund-Raising Manager Manager
Manager Manager
Manager




are generally paid an annual fee of $10,000 to $20,000 or more. Also, they are
frequently granted options to buy a specified number of shares of the firm’s stock
at a stated—and often attractive—price.
The president or chief executive officer (CEO) is responsible for managing
president or chief
executive officer (CEO) day-to-day operations and carrying out the policies established by the board. The
Corporate official responsible for
CEO is required to report periodically to the firm’s directors.
managing the firm’s day-to-day
It is important to note the division between owners and managers in a large
operations and carrying out the
corporation, as shown by the dashed horizontal line in Figure 1.1. This separa-
policies established by the board
tion and some of the issues surrounding it will be addressed in the discussion of
of directors.
the agency issue later in this chapter.
7
CHAPTER 1 The Role and Environment of Managerial Finance


Other Limited Liability Organizations
A number of other organizational forms provide owners with limited liability. The
most popular are limited partnerships (LPs), S corporations (S corps), limited lia-
bility corporations (LLCs), and limited liability partnerships (LLPs). Each repre-
sents a specialized form or blending of the characteristics of the organizational
forms described before. What they have in common is that their owners enjoy lim-
WW ited liability, and they typically have fewer than 100 owners. Each of these limited
W
liability organizations is described at the book’s Web site at www.aw.com/gitman.


The Study of Managerial Finance
An understanding of the concepts, techniques, and practices presented through-
out this text will fully acquaint you with the financial manager’s activities and
decisions. Because most business decisions are measured in financial terms, the
financial manager plays a key role in the operation of the firm. People in all areas
of responsibility—accounting, information systems, management, marketing,
operations, and so forth—need a basic understanding of the managerial finance
function.
All managers in the firm, regardless of their job descriptions, work with finan-
cial personnel to justify laborpower requirements, negotiate operating budgets,
deal with financial performance appraisals, and sell proposals at least partly on the
basis of their financial merits. Clearly, those managers who understand the finan-
cial decision-making process will be better able to address financial concerns and
will therefore more often get the resources they need to attain their own goals. The
“Across the Disciplines” element that appears on each chapter-opening page
should help you understand some of the many interactions between managerial
finance and other business careers.
As you study this text, you will learn about the career opportunities in man-
agerial finance, which are briefly described in Table 1.2. Although this text focuses



TABLE 1.2 Career Opportunities in Managerial Finance

Position Description

Financial analyst Primarily prepares the firm’s financial plans and budgets. Other duties include financial fore-
casting, performing financial comparisons, and working closely with accounting.
Capital expenditures manager Evaluates and recommends proposed asset investments. May be involved in the financial
aspects of implementing approved investments.
Project finance manager In large firms, arranges financing for approved asset investments. Coordinates consultants,
investment bankers, and legal counsel.
Cash manager Maintains and controls the firm’s daily cash balances. Frequently manages the firm’s cash col-
lection and disbursement activities and short-term investments; coordinates short-term borrow-
ing and banking relationships.
Credit analyst/manager Administers the firm’s credit policy by evaluating credit applications, extending credit, and
monitoring and collecting accounts receivable.
Pension fund manager In large companies, oversees or manages the assets and liabilities of the employees’ pension
fund.
Foreign exchange manager Manages specific foreign operations and the firm’s exposure to fluctuations in exchange rates.
8 PART 1 Introduction to Managerial Finance


on publicly held profit-seeking firms, the principles presented here are equally
applicable to private and not-for-profit organizations. The decision-making prin-
ciples developed in this text can also be applied to personal financial decisions. I
hope that this first exposure to the exciting field of finance will provide the foun-
dation and initiative for further study and possibly even a future career.


Review Questions

1–1 What is finance? Explain how this field affects the lives of everyone and
every organization.
1–2 What is the financial services area of finance? Describe the field of man-
agerial finance.
1–3 Which legal form of business organization is most common? Which form
is dominant in terms of business receipts and net profits?
1–4 Describe the roles and the basic relationship among the major parties in a
corporation—stockholders, board of directors, and president. How are
corporate owners compensated?
1–5 Briefly name and describe some organizational forms other than corpora-
tions that provide owners with limited liability.
1–6 Why is the study of managerial finance important regardless of the specific
area of responsibility one has within the business firm?



The Managerial Finance Function
LG2 LG3

People in all areas of responsibility within the firm must interact with finance per-
sonnel and procedures to get their jobs done. For financial personnel to make
useful forecasts and decisions, they must be willing and able to talk to individuals
in other areas of the firm. The managerial finance function can be broadly
described by considering its role within the organization, its relationship to eco-
nomics and accounting, and the primary activities of the financial manager.

treasurer
Organization of the Finance Function
The firm’s chief financial man-
ager, who is responsible for the
The size and importance of the managerial finance function depend on the size of
firm’s financial activities, such
the firm. In small firms, the finance function is generally performed by the
as financial planning and fund
accounting department. As a firm grows, the finance function typically evolves
raising, making capital expendi-
into a separate department linked directly to the company president or CEO
ture decisions, and managing
cash, credit, the pension fund, through the chief financial officer (CFO). The lower portion of the organizational
and foreign exchange.
chart in Figure 1.1 (on page 6) shows the structure of the finance function in a
typical medium-to-large-size firm.
controller
The firm’s chief accountant, who Reporting to the CFO are the treasurer and the controller. The treasurer (the
is responsible for the firm’s
chief financial manager) is commonly responsible for handling financial activi-
accounting activities, such as
ties, such as financial planning and fund raising, making capital expenditure deci-
corporate accounting, tax
sions, managing cash, managing credit activities, managing the pension fund, and
management, financial account-
managing foreign exchange. The controller (the chief accountant) typically han-
ing, and cost accounting.
9
CHAPTER 1 The Role and Environment of Managerial Finance


dles the accounting activities, such as corporate accounting, tax management,
financial accounting, and cost accounting. The treasurer’s focus tends to be more
external, the controller’s focus more internal. The activities of the treasurer, or
financial manager, are the primary concern of this text.
If international sales or purchases are important to a firm, it may well employ
one or more finance professionals whose job is to monitor and manage the firm’s
foreign exchange manager exposure to loss from currency fluctuations. A trained financial manager can
The manager responsible for
“hedge,” or protect against such a loss, at reasonable cost by using a variety of
monitoring and managing the
financial instruments. These foreign exchange managers typically report to the
firm’s exposure to loss from
firm’s treasurer.
currency fluctuations.



Relationship to Economics
The field of finance is closely related to economics. Financial managers must
understand the economic framework and be alert to the consequences of varying
levels of economic activity and changes in economic policy. They must also be
able to use economic theories as guidelines for efficient business operation.
Examples include supply-and-demand analysis, profit-maximizing strategies, and
marginal analysis price theory. The primary economic principle used in managerial finance is
Economic principle that states marginal analysis, the principle that financial decisions should be made and
that financial decisions should
actions taken only when the added benefits exceed the added costs. Nearly all
be made and actions taken only
financial decisions ultimately come down to an assessment of their marginal ben-
when the added benefits exceed
efits and marginal costs.
the added costs.

Amy Chen is a financial manager for Strom Department Stores, a large chain of
EXAMPLE
upscale department stores operating primarily in the western United States. She is
currently trying to decide whether to replace one of the firm’s online computers
with a new, more sophisticated one that would both speed processing and handle
a larger volume of transactions. The new computer would require a cash outlay
of $80,000, and the old computer could be sold to net $28,000. The total bene-
fits from the new computer (measured in today’s dollars) would be $100,000.
The benefits over a similar time period from the old computer (measured in
today’s dollars) would be $35,000. Applying marginal analysis, Amy organizes
the data as follows:


Benefits with new computer $100,000
Less: Benefits with old computer 35,000
(1) Marginal (added) benefits $65,000
Cost of new computer $ 80,000
Less: Proceeds from sale of old computer 28,000
(2) Marginal (added) costs 52,000
Net benefit [(1) (2)] $13,000



Because the marginal (added) benefits of $65,000 exceed the marginal (added)
costs of $52,000, Amy recommends that the firm purchase the new computer to
replace the old one. The firm will experience a net benefit of $13,000 as a result
of this action.
10 PART 1 Introduction to Managerial Finance


Relationship to Accounting
The firm’s finance (treasurer) and accounting (controller) activities are closely
related and generally overlap. Indeed, managerial finance and accounting are not
often easily distinguishable. In small firms the controller often carries out the
finance function, and in large firms many accountants are closely involved in var-
ious finance activities. However, there are two basic differences between finance
and accounting; one is related to the emphasis on cash flows and the other to
decision making.

Emphasis on Cash Flows
The accountant’s primary function is to develop and report data for measuring
the performance of the firm, assessing its financial position, and paying taxes.
Using certain standardized and generally accepted principles, the accountant pre-
pares financial statements that recognize revenue at the time of sale (whether pay-
accrual basis
ment has been received or not) and recognize expenses when they are incurred.
In preparation of financial
statements, recognizes revenue This approach is referred to as the accrual basis.
at the time of sale and recognizes
The financial manager, on the other hand, places primary emphasis on cash
expenses when they are
flows, the intake and outgo of cash. He or she maintains the firm’s solvency by plan-
incurred.
ning the cash flows necessary to satisfy its obligations and to acquire assets needed
cash basis to achieve the firm’s goals. The financial manager uses this cash basis to recognize
Recognizes revenues and
the revenues and expenses only with respect to actual inflows and outflows of cash.
expenses only with respect to
Regardless of its profit or loss, a firm must have a sufficient flow of cash to meet its
actual inflows and outflows of
obligations as they come due.
cash.


Thomas Yachts, a small yacht dealer, sold one yacht for $100,000 in the calendar
EXAMPLE
year just ended. The yacht was purchased during the year at a total cost of
$80,000. Although the firm paid in full for the yacht during the year, at year-end
it has yet to collect the $100,000 from the customer. The accounting view and the
financial view of the firm’s performance during the year are given by the follow-
ing income and cash flow statements, respectively.


Accounting View Financial View
(accrual basis) (cash basis)

Thomas Yachts Thomas Yachts
Income Statement Cash Flow Statement
for the Year Ended 12/31 for the Year Ended 12/31

Sales revenue $100,000 Cash inflow $ 0
Less: Costs 80,000 Less: Cash outflow 80,000
Net profit $ 20,000 Net cash flow ($80,000)



In an accounting sense Thomas Yachts is profitable, but in terms of actual
cash flow it is a financial failure. Its lack of cash flow resulted from the uncol-
lected account receivable of $100,000. Without adequate cash inflows to meet its
obligations, the firm will not survive, regardless of its level of profits.
11
CHAPTER 1 The Role and Environment of Managerial Finance


As the example shows, accrual accounting data do not fully describe the cir-
cumstances of a firm. Thus the financial manager must look beyond financial
statements to obtain insight into existing or developing problems. Of course,
accountants are well aware of the importance of cash flows, and financial man-
agers use and understand accrual-based financial statements. Nevertheless, the
financial manager, by concentrating on cash flows, should be able to avoid insol-
vency and achieve the firm’s financial goals.

Decision Making
The second major difference between finance and accounting has to do with deci-
sion making. Accountants devote most of their attention to the collection and
presentation of financial data. Financial managers evaluate the accounting state-
ments, develop additional data, and make decisions on the basis of their assess-
ment of the associated returns and risks. Of course, this does not mean that
accountants never make decisions or that financial managers never gather data.
Rather, the primary focuses of accounting and finance are distinctly different.


Primary Activities of the Financial Manager
In addition to ongoing involvement in financial analysis and planning, the finan-
cial manager’s primary activities are making investment decisions and making
financing decisions. Investment decisions determine both the mix and the type of
assets held by the firm. Financing decisions determine both the mix and the type
of financing used by the firm. These sorts of decisions can be conveniently viewed
in terms of the firm’s balance sheet, as shown in Figure 1.2. However, the deci-
sions are actually made on the basis of their cash flow effects on the overall value
of the firm.


Review Questions

1–7 What financial activities is the treasurer, or financial manager, responsible
for handling in the mature firm?
1–8 What is the primary economic principle used in managerial finance?
1–9 What are the major differences between accounting and finance with
respect to emphasis on cash flows and decision making?



FIGURE 1.2
Balance Sheet
Financial Activities
Current Current
Primary activities of the
Assets Liabilities
Making Making
financial manager
Investment Financing
Fixed Long-Term
Decisions Decisions
Assets Funds
12 PART 1 Introduction to Managerial Finance


1–10 What are the two primary activities of the financial manager that are
related to the firm’s balance sheet?


Goal of the Firm
LG4


As noted earlier, the owners of a corporation are normally distinct from its man-
agers. Actions of the financial manager should be taken to achieve the objectives
of the firm’s owners, its stockholders. In most cases, if financial managers are
successful in this endeavor, they will also achieve their own financial and profes-
sional objectives. Thus financial managers need to know what the objectives of
the firm’s owners are.


Maximize Profit?
Some people believe that the firm’s objective is always to maximize profit. To
achieve this goal, the financial manager would take only those actions that were
expected to make a major contribution to the firm’s overall profits. For each
earnings per share (EPS)
alternative being considered, the financial manager would select the one that is
The amount earned during the
expected to result in the highest monetary return.
period on behalf of each
outstanding share of common Corporations commonly measure profits in terms of earnings per share
stock, calculated by dividing the
(EPS), which represent the amount earned during the period on behalf of each
period’s total earnings available
outstanding share of common stock. EPS are calculated by dividing the period’s
for the firm’s common stockhold-
total earnings available for the firm’s common stockholders by the number of
ers by the number of shares of
shares of common stock outstanding.
common stock outstanding.

Nick Bono, the financial manager of Harpers, Inc., a manufacturer of fishing
EXAMPLE
gear, is choosing between two investments, Rotor and Valve. The following table
shows the EPS that each investment is expected to have over its 3-year life.

Earnings per share (EPS)

Investment Year 1 Year 2 Year 3 Total for years 1, 2, and 3

Rotor $1.40 $1.00 $0.40 $2.80
Valve 0.60 1.00 1.40 3.00


In terms of the profit maximization goal, Valve would be preferred over
Rotor, because it results in higher total earnings per share over the 3-year period
($3.00 EPS compared with $2.80 EPS).

But is profit maximization a reasonable goal? No. It fails for a number of
reasons: It ignores (1) the timing of returns, (2) cash flows available to stockhold-
ers, and (3) risk.

Timing
Because the firm can earn a return on funds it receives, the receipt of funds sooner
rather than later is preferred. In our example, in spite of the fact that the total
earnings from Rotor are smaller than those from Valve, Rotor provides much
13
CHAPTER 1 The Role and Environment of Managerial Finance


greater earnings per share in the first year. The larger returns in year 1 could be
reinvested to provide greater future earnings.

Cash Flows
Profits do not necessarily result in cash flows available to the stockholders. Own-
ers receive cash flow in the form of either cash dividends paid them or the pro-
ceeds from selling their shares for a higher price than initially paid. Greater EPS
do not necessarily mean that a firm’s board of directors will vote to increase divi-
dend payments.
Furthermore, higher EPS do not necessarily translate into a higher stock
price. Firms sometimes experience earnings increases without any correspond-
ingly favorable change in stock price. Only when earnings increases are accompa-
nied by increased future cash flows would a higher stock price be expected.

Risk
Profit maximization also disregards risk—the chance that actual outcomes may
risk
The chance that actual outcomes differ from those expected. A basic premise in managerial finance is that a trade-
may differ from those expected. off exists between return (cash flow) and risk. Return and risk are in fact the
key determinants of share price, which represents the wealth of the owners in
the firm.
Cash flow and risk affect share price differently: Higher cash flow is gener-
ally associated with a higher share price. Higher risk tends to result in a lower
share price because the stockholder must be compensated for the greater risk. In
general, stockholders are risk-averse—that is, they want to avoid risk. When risk
risk-averse
Seeking to avoid risk. is involved, stockholders expect to earn higher rates of return on investments of
higher risk and lower rates on lower-risk investments. The key point, which will
be fully developed in Chapter 5, is that differences in risk can significantly affect
the value of an investment.

Because profit maximization does not achieve the objectives of the firm’s
owners, it should not be the goal of the financial manager.


Maximize Shareholder Wealth
The goal of the firm, and therefore of all managers and employees, is to maximize
the wealth of the owners for whom it is being operated. The wealth of corporate
owners is measured by the share price of the stock, which in turn is based on the
timing of returns (cash flows), their magnitude, and their risk. When considering
each financial decision alternative or possible action in terms of its impact on the
share price of the firm’s stock, financial managers should accept only those
actions that are expected to increase share price. Figure 1.3 depicts this process.
Because share price represents the owners’ wealth in the firm, maximizing share
price will maximize owner wealth. Note that return (cash flows) and risk are the
key decision variables in maximizing owner wealth. It is important to recognize
that earnings per share (EPS), because they are viewed as an indicator of the
firm’s future returns (cash flows), often appear to affect share price. Two impor-
tant issues related to maximizing share price are economic value added (EVA®)
and the focus on stakeholders.
14 PART 1 Introduction to Managerial Finance


FIGURE 1.3
Financial
Increase
Financial Decision Return?
Share Price Yes
Share Accept
Manager Alternative Risk?
Maximization Price?
or Action
Financial decisions and share
price
No



Reject




Economic Value Added (EVA®)
Economic value added (EVA®) is a popular measure used by many firms to deter-
economic value added (EVA®)
A popular measure used by many mine whether an investment—proposed or existing—contributes positively to the
firms to determine whether an
owners’ wealth. EVA® is calculated by subtracting the cost of funds used to
investment contributes positively
finance an investment from its after-tax operating profits. Investments with posi-
to the owners’ wealth;
tive EVA®s increase shareholder value and those with negative EVA®s reduce
calculated by subtracting the
shareholder value. Clearly, only those investments with positive EVA®s are desir-
cost of funds used to finance an
able. For example, the EVA® of an investment with after-tax operating profits of
investment from its after-tax
operating profits.
$410,000 and associated financing costs of $375,000 would be $35,000 (i.e.,
$410,000 $375,000). Because this EVA® is positive, the investment is expected
to increase owner wealth and is therefore acceptable. (EVA®-type models are dis-
cussed in greater detail as part of the coverage of stock valuation in Chapter 7.)


What About Stakeholders?
Although maximization of shareholder wealth is the primary goal, many firms
broaden their focus to include the interests of stakeholders as well as shareholders.
Stakeholders are groups such as employees, customers, suppliers, creditors, owners,
stakeholders
Groups such as employees, and others who have a direct economic link to the firm. A firm with a stakeholder
customers, suppliers, creditors,
focus consciously avoids actions that would prove detrimental to stakeholders. The
owners, and others who have a
goal is not to maximize stakeholder well-being but to preserve it.
direct economic link to the firm.
The stakeholder view does not alter the goal of maximizing shareholder
wealth. Such a view is often considered part of the firm’s “social responsibility.”
It is expected to provide long-run benefit to shareholders by maintaining positive
stakeholder relationships. Such relationships should minimize stakeholder
turnover, conflicts, and litigation. Clearly, the firm can better achieve its goal of
shareholder wealth maximization by fostering cooperation with its other stake-
holders, rather than conflict with them.



The Role of Ethics
In recent years, the ethics of actions taken by certain businesses have received major
media attention. Examples include an agreement by American Express Co. in early
2002 to pay $31 million to settle a sex- and age-discrimination lawsuit filed on
15
CHAPTER 1 The Role and Environment of Managerial Finance


behalf of more than 4,000 women who said they were denied equal pay and pro-
motions; Enron Corp.’s key executives indicating to employee-shareholders in mid-
2001 that the firm’s then-depressed stock price would soon recover while, at the
same time, selling their own shares and, not long after, taking the firm into bank-
ruptcy; and Liggett & Meyers’ early 1999 agreement to fund the payment of more
than $1 billion in smoking-related health claims.
Clearly, these and similar actions have raised the question of ethics—standards
ethics
Standards of conduct or moral of conduct or moral judgment. Today, the business community in general and the
judgment. financial community in particular are developing and enforcing ethical standards.
The goal of these ethical standards is to motivate business and market participants
to adhere to both the letter and the spirit of laws and regulations concerned with
business and professional practice. Most business leaders believe businesses actu-
ally strengthen their competitive positions by maintaining high ethical standards.


Considering Ethics
Robert A. Cooke, a noted ethicist, suggests that the following questions be used
to assess the ethical viability of a proposed action.2

1. Is the action arbitrary or capricious? Does it unfairly single out an individual
or group?
2. Does the action violate the moral or legal rights of any individual or group?
3. Does the action conform to accepted moral standards?
4. Are there alternative courses of action that are less likely to cause actual or
potential harm?

Clearly, considering such questions before taking an action can help to ensure its
ethical viability.
Today, more and more firms are directly addressing the issue of ethics by
establishing corporate ethics policies and requiring employee compliance with
them. Frequently, employees are required to sign a formal pledge to uphold the
firm’s ethics policies. Such policies typically apply to employee actions in dealing
with all corporate stakeholders, including the public. Many companies also
require employees to participate in ethics seminars and training programs. To
provide further insight into the ethical dilemmas and issues sometimes facing the
financial manager, a number of the In Practice boxes appearing throughout this
book are labeled to note their focus on ethics.

Ethics and Share Price
An effective ethics program is believed to enhance corporate value. An ethics pro-
gram can produce a number of positive benefits. It can reduce potential litigation
and judgment costs; maintain a positive corporate image; build shareholder confi-
dence; and gain the loyalty, commitment, and respect of the firm’s stakeholders.
Such actions, by maintaining and enhancing cash flow and reducing perceived



2. Robert A. Cooke, “Business Ethics: A Perspective,” in Arthur Andersen Cases on Business Ethics (Chicago:
Arthur Andersen, September 1991), pp. 2 and 5.
16 PART 1 Introduction to Managerial Finance



In Practice
FOCUS ON ETHICS “Doing Well by Doing Good”
Hewlett-Packard (H-P) was “highest principles of business imizing shareholder wealth is
founded in 1939 by Bill Hewlett and ethics and conduct,” according to somehow the cause of unethical
Dave Packard on the basis of prin- H-P’s 2000 annual report. behavior, ignoring the fact that any
ciples of fair dealing and Maximizing shareholder business goal might be cited as a
respect—long before anyone wealth is what some call a “moral factor pressuring individuals to be
coined the expression “corporate imperative,” in that stockholders unethical.
social responsibility.” H-P credits are owners with property rights, U.S. business professionals
its ongoing commitment to “doing and in that managers as stewards have tended to operate from within
well by doing good” as a major are obliged to look out for owners’ a strong moral framework based
reason why employees, suppliers, interests. Many times, doing what on early-childhood moral develop-
customers, and shareholders seek is right is consistent with maximiz- ment that takes place in families
it out. H-P is clear on its obligation ing the stock price, but what if and religious institutions. This
to increase the market value of its integrity causes a company to lose does not prevent all ethical lapses,
common stock, yet it strives to a contract or causes analysts to obviously. But it is not surprising
maintain the integrity of each reduce the rating of the stock from that chief financial officers declare
employee in every country in “buy” to “sell”? The objective to that the number-1 personal
which it does business. Its maximize shareholder wealth attribute that finance grads need is
“Standards of Business Conduct” holds, but company officers must ethics—which they rank above
include a provision that triggers do so within ethical constraints. interpersonal skills, communica-
immediate dismissal of any Those constraints occasionally tion skills, decision-making ability,
employee who is found to have limit the alternative actions from and computer skills. H-P is aware
told a lie. Its internal auditors are which managers may choose. of this need and has institutional-
expected to adhere to all of these Some critics have mistakenly ized it in the company’s culture
standards, which set forth the assumed that the objective of max- and policies.




risk, can positively affect the firm’s share price. Ethical behavior is therefore
viewed as necessary for achieving the firm’s goal of owner wealth maximization.3


The Agency Issue
We have seen that the goal of the financial manager should be to maximize the
wealth of the firm’s owners. Thus managers can be viewed as agents of the own-
ers who have hired them and given them decision-making authority to manage
the firm. Technically, any manager who owns less than 100 percent of the firm is
to some degree an agent of the other owners. This separation of owners and man-
agers is shown by the dashed horizontal line in Figure 1.1 on page 6.
In theory, most financial managers would agree with the goal of owner
wealth maximization. In practice, however, managers are also concerned with
their personal wealth, job security, and fringe benefits. Such concerns may make
managers reluctant or unwilling to take more than moderate risk if they perceive
that taking too much risk might jeopardize their jobs or reduce their personal



3. For an excellent discussion of this and related issues by a number of finance academics and practitioners who have
given a lot of thought to financial ethics, see James S. Ang, “On Financial Ethics,” Financial Management (Autumn
1993), pp. 32–59.
17
CHAPTER 1 The Role and Environment of Managerial Finance


wealth. The result is a less-than-maximum return and a potential loss of wealth
for the owners.


The Agency Problem
From this conflict of owner and personal goals arises what has been called the
agency problem, the likelihood that managers may place personal goals ahead of
agency problem
The likelihood that managers corporate goals. Two factors—market forces and agency costs—serve to prevent
may place personal goals ahead or minimize agency problems.
of corporate goals.

Market Forces One market force is major shareholders, particularly large
institutional investors such as mutual funds, life insurance companies, and
pension funds. These holders of large blocks of a firm’s stock exert pressure on
management to perform. When necessary, they exercise their voting rights as
agency costs
stockholders to replace underperforming management.
The costs borne by stockholders
to minimize agency problems. Another market force is the threat of takeover by another firm that believes it
can enhance the target firm’s value to restructuring its management, operations,
incentive plans
and financing. The constant threat of a takeover tends to motivate management
Management compensation
plans that tend to tie manage- to act in the best interests of the firm’s owners.
ment compensation to share
price; most popular incentive
Agency Costs To minimize agency problems and contribute to the maxi-
plan involves the grant of stock
mization of owners’ wealth, stockholders incur agency costs. These are the costs
options.
of monitoring management behavior, ensuring against dishonest acts of manage-
stock options
ment, and giving managers the financial incentive to maximize share price.
An incentive allowing managers
The most popular, powerful, and expensive approach is to structure manage-
to purchase stock at the market
ment compensation to correspond with share price maximization. The objective
price set at the time of the grant.
is to give managers incentives to act in the best interests of the owners. In addi-
performance plans
tion, the resulting compensation packages allow firms to compete for and hire the
Plans that tie management
best managers available.
compensation to measures such
The two key types of compensation plans are incentive plans and perfor-
as EPS, growth in EPS, and other
ratios of return. Performance mance plans. Incentive plans tend to tie management compensation to share price.
shares and/or cash bonuses are
The most popular incentive plan is the granting of stock options to management.
used as compensation under
These options allow managers to purchase stock at the market price set at the time
these plans.
of the grant. If the market price rises, managers will be rewarded by being able to
performance shares
resell the shares at the higher market price.
Shares of stock given to manage-
Many firms also offer performance plans, which tie management compensa-
ment for meeting stated perfor-
tion to measures such as earnings per share (EPS), growth in EPS, and other
mance goals.
ratios of return. Performance shares, shares of stock given to management as a
cash bonuses
result of meeting the stated performance goals, are often used in these plans.
Cash paid to management for
Another form of performance-based compensation is cash bonuses, cash pay-
achieving certain performance
ments tied to the achievement of certain performance goals.
goals.


The Current View of Management Compensation
The execution of many compensation plans has been closely scrutinized in recent
years. Both individuals and institutional stockholders, as well as the Securities
and Exchange Commission (SEC), have publicly questioned the appropriateness
of the multimillion-dollar compensation packages that many corporate executives
receive. For example, the three highest-paid CEOs in 2001 were (1) Lawrence
Ellison, of Oracle, who earned $706.1 million; (2) Jozef Straus, of JDS Uniphase,
18 PART 1 Introduction to Managerial Finance


who earned $150.8 million; and (3) Howard Solomon, of Forest Laboratories,
who earned $148.5 million. Tenth on the same list was Timothy Koogle, of
Yahoo!, who earned $64.6 million. During 2001, the compensation of the average
CEO of a major U.S. corporation declined by about 16 percent from 2000. CEOs
of 365 of the largest U.S. companies surveyed by Business Week, using data from
Standard & Poor’s EXECUCOMP, earned an average of $11 million in total com-
pensation; the average for the 20 highest paid CEOs was $112.5 million.
Recent studies have failed to find a strong relationship between CEO com-
pensation and share price. Publicity surrounding these large compensation pack-
ages (without corresponding share price performance) is expected to drive down
executive compensation in the future. Contributing to this publicity is the SEC
requirement that publicly traded companies disclose to shareholders and others
both the amount of compensation to their highest paid executives and the
method used to determine it. At the same time, new compensation plans that bet-
ter link managers’ performance with regard to shareholder wealth to their com-
pensation are expected to be developed and implemented.
Unconstrained, managers may have other goals in addition to share price
maximization, but much of the evidence suggests that share price maximiza-
tion—the focus of this book—is the primary goal of most firms.


Review Questions

1–11 For what three basic reasons is profit maximization inconsistent with
wealth maximization?
1–12 What is risk? Why must risk as well as return be considered by the finan-
cial manager who is evaluating a decision alternative or action?
1–13 What is the goal of the firm and therefore of all managers and employees?
Discuss how one measures achievement of this goal.
1–14 What is economic value added (EVA®)? How is it used?
1–15 Describe the role of corporate ethics policies and guidelines, and discuss
the relationship that is believed to exist between ethics and share price.
1–16 How do market forces, both shareholder activism and the threat of
takeover, act to prevent or minimize the agency problem?
1–17 Define agency costs, and explain why firms incur them. How can manage-
ment structure management compensation to minimize agency problems?
What is the current view with regard to the execution of many compensa-
tion plans?



Financial Institutions and Markets
LG5


Most successful firms have ongoing needs for funds. They can obtain funds from
external sources in three ways. One is through a financial institution that accepts
savings and transfers them to those that need funds. Another is through financial
markets, organized forums in which the suppliers and demanders of various types
of funds can make transactions. A third is through private placement. Because of
the unstructured nature of private placements, here we focus primarily on finan-
cial institutions and financial markets.
19
CHAPTER 1 The Role and Environment of Managerial Finance


Financial Institutions
Financial institutions serve as intermediaries by channeling the savings of individ-
financial institution
An intermediary that channels uals, businesses, and governments into loans or investments. Many financial
the savings of individuals, institutions directly or indirectly pay savers interest on deposited funds; others
businesses, and governments
provide services for a fee (for example, checking accounts for which customers
into loans or investments.
pay service charges). Some financial institutions accept customers’ savings
deposits and lend this money to other customers or to firms; others invest
customers’ savings in earning assets such as real estate or stocks and bonds; and
some do both. Financial institutions are required by the government to operate
within established regulatory guidelines.

Key Customers of Financial Institutions
The key suppliers of funds to financial institutions and the key demanders of
funds from financial institutions are individuals, businesses, and governments.
The savings that individual consumers place in financial institutions provide
these institutions with a large portion of their funds. Individuals not only supply
funds to financial institutions but also demand funds from them in the form of
loans. However, individuals as a group are the net suppliers for financial institu-
tions: They save more money than they borrow.
Business firms also deposit some of their funds in financial institutions, pri-
marily in checking accounts with various commercial banks. Like individuals,
firms also borrow funds from these institutions, but firms are net demanders of
funds. They borrow more money than they save.
Governments maintain deposits of temporarily idle funds, certain tax pay-
ments, and Social Security payments in commercial banks. They do not borrow
funds directly from financial institutions, although by selling their debt securities
to various institutions, governments indirectly borrow from them. The govern-
ment, like business firms, is typically a net demander of funds. It typically bor-
rows more than it saves. We’ve all heard about the federal budget deficit.

Major Financial Institutions
The major financial institutions in the U.S. economy are commercial banks, sav-
ings and loans, credit unions, savings banks, insurance companies, pension funds,
and mutual funds. These institutions attract funds from individuals, businesses,
and governments, combine them, and make loans available to individuals and
WW businesses. Descriptions of the major financial institutions are found at the text-
W
book’s Web site at www.aw.com/gitman.


Financial Markets
Financial markets are forums in which suppliers of funds and demanders of funds
financial markets
Forums in which suppliers of can transact business directly. Whereas the loans and investments of institutions
funds and demanders of funds
are made without the direct knowledge of the suppliers of funds (savers), suppliers
can transact business directly.
in the financial markets know where their funds are being lent or invested. The two
key financial markets are the money market and the capital market. Transactions
in short-term debt instruments, or marketable securities, take place in the money
market. Long-term securities—bonds and stocks—are traded in the capital market.
20 PART 1 Introduction to Managerial Finance


To raise money, firms can use either private placements or public offerings.
Private placement involves the sale of a new security issue, typically bonds or pre-
private placement
The sale of a new security issue, ferred stock, directly to an investor or group of investors, such as an insurance
typically bonds or preferred company or pension fund. Most firms, however, raise money through a public
stock, directly to an investor or
offering of securities, which is the nonexclusive sale of either bonds or stocks to
group of investors.
the general public.
public offering All securities are initially issued in the primary market. This is the only mar-
The nonexclusive sale of either
ket in which the corporate or government issuer is directly involved in the trans-
bonds or stocks to the general
action and receives direct benefit from the issue. That is, the company actually
public.
receives the proceeds from the sale of securities. Once the securities begin to trade
primary market
between savers and investors, they become part of the secondary market. The pri-
Financial market in which
mary market is the one in which “new” securities are sold. The secondary market
securities are initially issued; the
can be viewed as a “preowned” securities market.
only market in which the issuer
is directly involved in the
transaction.
The Relationship Between Institutions and Markets
secondary market
Financial market in which
Financial institutions actively participate in the financial markets as both suppliers
preowned securities (those that
and demanders of funds. Figure 1.4 depicts the general flow of funds through and
are not new issues) are traded.
between financial institutions and financial markets; private placement transac-
tions are also shown. The individuals, businesses, and governments that supply
and demand funds may be domestic or foreign. We next briefly discuss the money
market, including its international equivalent—the Eurocurrency market. We then
end this section with a discussion of the capital market, which is of key importance
to the firm.


The Money Market
money market
The money market is created by a financial relationship between suppliers and
A financial relationship created
demanders of short-term funds (funds with maturities of one year or less). The
between suppliers and
money market exists because some individuals, businesses, governments, and
demanders of short-term funds.




FIGURE 1.4 Funds Funds
Financial
Flow of Funds
Institutions
Deposits/Shares Loans
Flow of funds for financial
Funds




institutions and markets


Funds
Suppliers Private Demanders
of Funds Placement of Funds
Securities
Securities




Funds Funds
Financial
Markets
Securities Securities
21
CHAPTER 1 The Role and Environment of Managerial Finance


financial institutions have temporarily idle funds that they wish to put to some
interest-earning use. At the same time, other individuals, businesses, govern-
ments, and financial institutions find themselves in need of seasonal or temporary
marketable securities
financing. The money market brings together these suppliers and demanders of
Short-term debt instruments,
such as U.S. Treasury bills, short-term funds.
commercial paper, and
Most money market transactions are made in marketable securities—short-
negotiable certificates of deposit
term debt instruments, such as U.S. Treasury bills, commercial paper, and
issued by government, business,
negotiable certificates of deposit issued by government, business, and financial
and financial institutions,
institutions, respectively. (Marketable securities are described in Chapter 13.)
respectively.


The Operation of the Money Market
The money market is not an actual organization housed in some central location.
How, then, are suppliers and demanders of short-term funds brought together?
Typically, they are matched through the facilities of large New York banks and
through government securities dealers. A number of stock brokerage firms pur-
chase money market instruments for resale to customers. Also, financial institu-
tions purchase money market instruments for their portfolios in order to provide
attractive returns on their customers’ deposits and share purchases. Additionally,
the Federal Reserve banks become involved in loans from one commercial bank
to another; these loans are referred to as transactions in federal funds.
federal funds
Loan transactions between In the money market, businesses and governments demand short-term funds
commercial banks in which the (borrow) by issuing a money market instrument. Parties who supply short-term
Federal Reserve banks become
funds (invest) purchase the money market instruments. To issue or purchase a
involved.
money market instrument, one party must go directly to another party or use an
intermediary, such as a bank or brokerage firm, to make the transaction. The sec-
ondary (resale) market for marketable securities is no different from the primary
(initial issue) market with respect to the basic transactions that are made. Individ-
uals also participate in the money market as purchasers and sellers of money mar-
ket instruments. Although individuals do not issue marketable securities, they
may sell them in the money market to liquidate them prior to maturity.


The Eurocurrency Market
The international equivalent of the domestic money market is called the
Eurocurrency market. This is a market for short-term bank deposits denomi-
Eurocurrency market
International equivalent of the nated in U.S. dollars or other easily convertible currencies. Historically, the
domestic money market. Eurocurrency market has been centered in London, but it has evolved into a
truly global market.
Eurocurrency deposits arise when a corporation or individual makes a bank
deposit in a currency other than the local currency of the country where the bank
is located. If, for example, a multinational corporation were to deposit U.S. dol-
lars in a London bank, this would create a Eurodollar deposit (a dollar deposit at
a bank in Europe). Nearly all Eurodollar deposits are time deposits. This means
that the bank would promise to repay the deposit, with interest, at a fixed date in
the future—say, in 6 months. During the interim, the bank is free to lend this
London Interbank Offered Rate
dollar deposit to creditworthy corporate or government borrowers. If the bank
(LIBOR)
cannot find a borrower on its own, it may lend the deposit to another interna-
The base rate that is used to
tional bank. The rate charged on these “interbank loans” is called the London
price all Eurocurrency loans.
22 PART 1 Introduction to Managerial Finance


Interbank Offered Rate (LIBOR), and this is the base rate that is used to price all
Eurocurrency loans.
The Eurocurrency market has grown rapidly, primarily because it is an
unregulated, wholesale, and global market that fills the needs of both borrowers
and lenders. Investors with excess cash to lend are able to make large, short-term,
and safe deposits at attractive interest rates. Likewise, borrowers are able to
arrange large loans, quickly and confidentially, also at attractive interest rates.



The Capital Market
The capital market is a market that enables suppliers and demanders of long-term
capital market
A market that enables suppliers funds to make transactions. Included are securities issues of business and govern-
and demanders of long-term
ment. The backbone of the capital market is formed by the various securities
funds to make transactions.
exchanges that provide a forum for bond and stock transactions.


Key Securities Traded: Bonds and Stocks
The key capital market securities are bonds (long-term debt) and both common
and preferred stock (equity, or ownership). Bonds are long-term debt instruments
bond
Long-term debt instrument used used by business and government to raise large sums of money, generally from a
by business and government to
diverse group of lenders. Corporate bonds typically pay interest semiannually
raise large sums of money,
(every 6 months) at a stated coupon interest rate. They have an initial maturity of
generally from a diverse group of
from 10 to 30 years, and a par, or face, value of $l,000 that must be repaid at
lenders.
maturity. Bonds are described in detail in Chapter 6.

Lakeview Industries, a major microprocessor manufacturer, has issued a 9 per-
EXAMPLE
cent coupon interest rate, 20-year bond with a $1,000 par value that pays interest
semiannually. Investors who buy this bond receive the contractual right to $90
annual interest (9% coupon interest rate $1,000 par value) distributed as $45
at the end of each 6 months (1/2 $90) for 20 years, plus the $1,000 par value at
the end of year 20.

As noted earlier, shares of common stock are units of ownership, or equity, in
a corporation. Common stockholders earn a return by receiving dividends—peri-
odic distributions of earnings—or by realizing increases in share price. Preferred
preferred stock
A special form of ownership stock is a special form of ownership that has features of both a bond and common
having a fixed periodic dividend
stock. Preferred stockholders are promised a fixed periodic dividend that must be
that must be paid prior to
paid prior to payment of any dividends to common stockholders. In other words,
payment of any common stock
preferred stock has “preference” over common stock. Preferred and common
dividends.
stock are described in detail in Chapter 7.


Major Securities Exchanges
securities exchanges
Organizations that provide the
Securities exchanges provide the marketplace in which firms can raise funds
marketplace in which firms can
through the sale of new securities and purchasers of securities can easily resell
raise funds through the sale of
them when necessary. Many people call securities exchanges “stock markets,”
new securities and purchasers
but this label is misleading because bonds, common stock, preferred stock, and a
can resell securities.
23
CHAPTER 1 The Role and Environment of Managerial Finance


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