Chapter 1

Financial Markets
Environment

0 © Pearson Education 2011

 What is Finance?

Finance can be defined as the art and science of managing

money.
• At the personal level, finance is concerned with individuals’
decisions about how much of their earnings they spend, how
much they save, and how they invest their savings.
• In a business context, finance involves the same types of
decisions: how firms raise money from investors, how firms
invest money in an attempt to earn a profit, and how they
decide whether to reinvest profits in the business or
distribute them back to investors.

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 Legal Forms of Business Organization

One of the most basic decisions that all businesses confront is

how to choose a legal form of organization.
The three most common legal forms of business organization
are:
• Sole proprietorship
• Partnership
• Corporation

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 Legal Forms of Business Organization:
Corporations

• A corporation is an entity created by law. It has the legal

powers of an individual in that it can sue and be sued, make
and be party to contracts, and acquire property.
• Stockholders are the owners of a corporation, whose
ownership, or equity, is evidenced by either common stock
or preferred stock.

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 Legal Forms of Business Organization:
Corporations

Figure 1.1
Corporate
Organization

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 The Managerial Finance Function:
Relationship to Accounting (cont.)

• The Nassima Corporation experienced the following activity

last year:

Sales US$100,000 (1 yacht sold, 100% still uncollected)

Costs US$80,000 (all paid in full under supplier terms)

• Now contrast the differences in performance under the

accounting method versus the cash method.

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 The Managerial Finance Function:
Relationship to Accounting (cont.)

INCOME STATEMENT SUMMARY

ACCRUAL CASH

Sales US$100,000 US$ 0

Less: Costs (80,000) (80,000)

Net Profit/(Loss) US$ 20,000 US$(80,000)

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 The Managerial Finance Function:
Relationship to Accounting (cont.)

• Finance and accounting also differ with respect to

decision-making.
• While accounting is primarily concerned with the
presentation of financial data, the financial manager is
primarily concerned with analyzing and interpreting
this information for decision-making purposes.
• The financial manager uses this data as a vital tool for
making decisions about the financial aspects of the firm.

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 The Managerial Finance Function:
Primary Activities of the Financial Manager
Figure 1.2
Financial Activities

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 Goal of the Firm:
Maximize Shareholder Wealth

Decision rule for managers: only take actions that are expected
to increase the share price.

Figure 1.3
Share Price Maximization

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 Goal of the Firm:
Maximize Shareholder Wealth

• Why?
• Because maximizing shareholder wealth properly
considers cash flows, the timing of these cash flows,
and the risk of these cash flows

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 Goal of the Firm:
Maximize Profit?

Which Investment is Preferred?

• Profit maximization may not lead to the highest possible

share price for at least three reasons:
1. Timing is important—the receipt of funds sooner rather
than later is preferred.
2. Profits do not necessarily result in cash flows available
to stockholders.
3. Profit maximization fails to account for risk.

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 Goal of the Firm:
What About Other Stakeholders?

• Stakeholders are groups such as employees, customers,

suppliers, creditors, owners, and others who have a direct
economic link to the firm.
• A firm with a stakeholder focus consciously avoids actions
that would prove detrimental to stakeholders. The goal is
not to maximize stakeholder well-being but to preserve it.
• Such a view is considered to be "socially responsible."

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 Goal of the Firm:
The Role of Business Ethics

• Business ethics are the standards of conduct or moral

judgment that apply to persons engaged in commerce.
• Violations of these standards in finance involve a variety of
actions: “creative accounting,” earnings management,
misleading financial forecasts, insider trading, fraud,
excessive executive compensation, options backdating,
bribery, and kickbacks.
• Negative publicity often leads to negative impacts on a firm.

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 Goal of the Firm:
Ethics and Share Price

• Ethics programs seek to:

– reduce litigation and judgment costs
– maintain a positive corporate image
– build shareholder confidence
– gain the loyalty and respect of all stakeholders

• The expected result of such programs is to positively affect

the firm’s share price.

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 Governance and Agency:
Corporate Governance

• Corporate governance refers to the rules, processes, and

laws by which companies are operated, controlled, and
regulated.
• It defines the rights and responsibilities of the corporate
participants such as the shareholders, board of directors,
officers and managers, and other stakeholders, as well as
the rules and procedures for making corporate decisions.
• The structure of corporate governance was previously
described in Figure 1.1.

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 Governance and Agency:
Individual versus Institutional Investors

• Individual investors are investors who own relatively

small quantities of shares so as to meet personal
investment goals.
• Institutional investors are investment professionals, such
as banks, insurance companies, mutual funds, and pension
funds, that are paid to manage and hold large quantities of
securities on behalf of others.
• Unlike individual investors, institutional investors often
monitor and directly influence a firm’s corporate governance
by exerting pressure on management to perform or
communicating their concerns to the firm’s board.

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 Governance and Agency:
Government Regulation

• Government regulation generally shapes the corporate

governance of all firms.
• During the past decade, corporate governance has received
increased attention due to several high-profile corporate
scandals.
• Recent corporate governance codes have been introduced in
many countries internationally, including in the Arab region
in Saudi Arabia, Bahrain, the U.A.E., Oman, and Qatar.

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 The Agency Issue:
The Agency Problem

• Managers can be viewed as agents of the owners who have

hired them.
• Technically, any manager who owns less than 100% of the
firm’s equity is to some degree an agent of other owners.
• In theory, managers would agree with shareholder wealth
maximization. However, managers are also concerned with
their personal interests.
• This potential conflict of owner and personal goals is called the
agency problem.

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 The Agency Issue:
Resolving the Problem

• Market Forces such as major shareholders and the threat

of a hostile takeover act to keep managers in check.
• Agency Costs are the costs borne by stockholders to
maintain a corporate governance structure that minimizes
agency problems and contributes to the maximization of
shareholder wealth.

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 The Agency Issue:
Resolving the Problem (cont.)

• Incentive plans are management compensation plans that

tie management compensation to share price; one example
involves the granting of stock options.
• A stock option is an incentive allowing managers to
purchase stock at the market price set at the time of the
grant.

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 The Agency Issue:
Resolving the Problem (cont.)

• Performance plans tie management compensation to

measures such as EPS growth; performance shares and/or
cash bonuses are used as compensation under these plans.
• Recent studies have failed to find a strong relationship
between CEO compensation and share price.

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 Financial Institutions & Markets

Firms that require funds from external sources can obtain them
in three ways:
• through a bank or other financial institution
• through financial markets
• through private placements

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 Financial Institutions & Markets:
Financial Institutions

• Financial institutions are intermediaries that channel the

savings of individuals, businesses, and governments into
loans or investments.
• The key suppliers and demanders of funds are individuals,
businesses, and governments.
• In general, individuals are net suppliers of funds, while
businesses and governments are net demanders of funds.

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 Financial Institutions & Markets:
Financial Markets

• Financial markets provide a forum in which suppliers of

funds and demanders of funds can transact business
directly.
• The two key financial markets are the money market and
the capital market.
• Transactions in short term marketable securities take place
in the money market, while transactions in long-term
securities take place in the capital market.

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 Financial Institutions & Markets:
Financial Markets (cont.)

• All securities are initially issued through the primary

market.
• The primary market is the only one in which a corporation
or government is directly involved in and receives the
proceeds from the transaction.
• Once issued, securities then trade on the secondary
markets such as the New York Stock Exchange or Tadawul.

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 Financial Institutions & Markets:
Relationship Between Institutions & Markets

Figure 1.4 Flow of Funds

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 The Money Market

• The money market is created by a financial relationship

between suppliers and demanders of short-term funds
(those having a maturity of a year or less).
• Most money market transactions are made in marketable
securities which are short-term debt instruments such as
government Treasury bills and commercial paper.

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 The Capital Market

• Capital markets are the markets for long-term debt and

corporate stocks. The best-known stock market is the New
York Stock Exchange.
• In the Arab world capital markets have grown rapidly in the
past few years, but are relatively small.

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 The Capital Market

• The key capital market securities are bonds (long-term

debt) and both common and preferred stock (equity).
• Bonds are long-term debt instruments used by businesses
and government to raise large sums of money or capital.
• Common stock are units of ownership interest or equity in a
corporation.

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 The Capital Market:
The Role of Capital Markets

• The capital market creates continuous liquid markets in

which firms can obtain needed financing.
• It also creates efficient markets that allocate funds to
their most appropriate uses.
• The price of an individual security is determined by the
demand for and supply of the security.
• Figure 1.5 (next slide) shows the interaction of the forces of
demand and supply for a given security.

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 The Capital Market:
The Role of Capital Markets

Figure 1.5
Supply and
Demand

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