In return, they become part-owners of the firm and share in the future success of the en-
terprise. Anyone who followed the market for Internet IPOs in 1999 knows that these
expectations for future success can be on the optimistic side (to put it mildly).
12 SECTION ONE
An IPO is not the only occasion on which newly issued stock is sold to the public.
Established firms also issue new shares from time to time. For example, suppose Gen-
eral Motors needs to raise funds to renovate an auto plant. It might hire an investment
banking firm to sell $500 million of GM stock to investors. Some of this stock may be
bought by individuals; the remainder will be bought by financial institutions such as
pension funds and insurance companies. In fact, about a quarter of the shares of U.S.
companies are owned by pension funds.
A new issue of securities increases both the amount of cash held by the company and
the amount of stocks or bonds held by the public. Such an issue is known as a primary
issue and it is sold in the primary market. But in addition to helping companies raise
new cash, financial markets also allow investors to trade stocks or bonds between them-
Market for the sale of new
selves. For example, Smith might decide to raise some cash by selling her AT&T stock
securities by corporations.
at the same time that Jones invests his spare cash in AT&T. The result is simply a trans-
fer of ownership from Smith to Jones, which has no effect on the company itself. Such
purchases and sales of existing securities are known as secondary transactions and they
take place in the secondary market.
Some financial assets have no secondary market. For example, when a small com-
Market in which already
pany borrows money from the bank, it gives the bank an IOU promising to repay the
issued securities are traded
money with interest. The bank will keep the IOU and will not sell it to another bank.
Other financial assets are regularly traded. Thus when a large public company raises
cash by selling new shares to investors, it knows that many of these investors will sub-
sequently decide to sell their shares to others.
Most trading in the shares of large United States corporations takes place on stock
exchanges such as the New York Stock Exchange (NYSE). There is also a thriving over-
the-counter (OTC) market in securities. The over-the-counter market is not a centralized
exchange like the NYSE but a network of security dealers who use an electronic sys-
tem known as NASDAQ6 to quote prices at which they will buy and sell shares. While
shares of stock may be traded either on exchanges or over-the-counter, almost all cor-
porate debt is traded over-the-counter, if it is traded at all. United States government
debt is also traded over-the-counter.
Many other things trade in financial markets, including foreign currencies; claims on
commodities such as corn, crude oil, and silver; and options.
Now may be a good point to stress that the financial manager plays on a global stage
and needs to be familiar with markets around the world. For example, the stock of Citi-
corp, one of the largest U.S. banks, is listed in New York, London, Amsterdam, Tokyo,
Zurich, Toronto, and Frankfurt, as well as on several smaller exchanges. Conversely,
British Airways, Deutsche Telecom, Nestl├©, Sony, and nearly 200 other overseas firms
have listed their shares on the New York Stock Exchange.
OTHER FUNCTIONS OF FINANCIAL MARKETS
Financial markets and institutions provide financing for business. They also contribute
in many other ways to our individual well-being and the smooth functioning of the
economy. Here are some examples.7
6 NationalAssociation of Security Dealers Automated Quotation system.
7 Robert Merton gives an excellent overview of these functions in ÔÇťA Functional Perspective of Financial In-
termediation,ÔÇŁ Financial Management 24 (Summer 1995), pp. 23ÔÇ“41.
The Firm and the Financial Manager 13
The Payment Mechanism. Think how inconvenient life would be if you had to pay for
every purchase in cash or if General Motors had to ship truckloads of hundred-dollar bills
round the country to pay its suppliers. Checking accounts, credit cards, and electronic
transfers allow individuals and firms to send and receive payments quickly and safely over
long distances. Banks are the obvious providers of payment services, but they are not
alone. For example, if you buy shares in a money-market mutual fund, your money is
pooled with that of other investors and used to buy safe, short-term securities. You can
then write checks on this mutual fund investment, just as if you had a bank deposit.
Borrowing and Lending. Financial institutions allow individuals to transfer expen-
ditures across time. If you have more money now than you need and you wish to save
for a rainy day, you can (for example) put the money on deposit in a bank. If you wish
to anticipate some of your future income to buy a car, you can borrow money from the
bank. Both the lender and the borrower are happier than if they were forced to spend
cash as it arrived. Of course, individuals are not alone in needing to raise cash from time
to time. Firms with good investment opportunities raise cash by borrowing or selling
new shares. Many governments run at a deficit.
In principle, individuals or firms with cash surpluses could take out newspaper
advertisements or surf the Net looking for counterparts with cash shortages. But it is
usually cheaper and more convenient to use financial markets or institutions to link
the borrower and the lender. For example, banks are equipped to check the borrowerÔÇ™s
creditworthiness and to monitor the use of the cash.
Almost all financial institutions are involved in channeling savings toward those who
can best use them.
Pooling Risk. Financial markets and institutions allow individuals and firms to pool
their risks. Insurance companies are an obvious example. Here is another. Suppose that
you have only a small sum to invest. You could buy the stock of a single company, but then
you could be wiped out if that company went belly-up. ItÔÇ™s generally better to buy shares
in a mutual fund that invests in a diversified portfolio of common stocks or other securi-
ties. In this case you are exposed only to the risk that security prices as a whole may fall.8
Do you understand the following distinctions? Briefly explain in each case.
a. Real versus financial assets.
b. Investment versus financing decisions.
c. Capital budgeting versus capital structure decisions.
d. Primary versus secondary markets.
e. Financial intermediation versus direct financing from financial markets.
Who Is the Financial Manager?
We will use the term financial manager to refer to anyone responsible for a significant
corporate investment or financing decision. But except in the smallest firms, no single
8Mutual funds provide other services. For example, they take care of much of the paperwork of holding
shares. Investors also hope that the fundÔÇ™s professional managers will be able to outsmart the market and se-
cure higher returns.
14 SECTION ONE
The financial managers in
large corporations. Chief Financial Officer (CFO)
Responsible for: Responsible for:
Cash management Preparation of financial statements
Raising capital Accounting
Banking relationships Taxes
person is responsible for all the decisions discussed in this book. Responsibility is dis-
persed throughout the firm. Top management is of course constantly involved in finan-
cial decisions. But the engineer who designs a new production facility is also involved:
the design determines the kind of asset the firm will invest in. Likewise the marketing
manager who undertakes a major advertising campaign is making an investment deci-
sion: the campaign is an investment in an intangible asset that will pay off in future sales
Nevertheless, there are managers who specialize in finance, and their functions are
summarized in Figure 1.2. The treasurer is usually the person most directly responsi-
ble for looking after the firmÔÇ™s cash, raising new capital, and maintaining relationships
responsible for financing,
with banks and other investors who hold the firmÔÇ™s securities.
cash management, and
For small firms, the treasurer is likely to be the only financial executive. Larger cor-
relationships with financial
porations usually also have a controller, who prepares the financial statements, man-
markets and institutions.
ages the firmÔÇ™s internal accounting, and looks after its tax affairs. You can see that the
treasurer and controller have different roles: the treasurerÔÇ™s main function is to obtain
and manage the firmÔÇ™s capital, whereas the controller ensures that the money is used ef-
responsible for budgeting,
accounting, and auditing.
The largest firms usually appoint a chief financial officer (CFO) to oversee both
the treasurerÔÇ™s and the controllerÔÇ™s work. The CFO is deeply involved in financial poli-
cymaking and corporate planning. Often he or she will have general responsibilities be-
OFFICER (CFO) Officer
yond strictly financial issues.
who oversees the treasurer
Usually the treasurer, controller, or CFO is responsible for organizing and supervis-
and controller and sets
ing the capital budgeting process. However, major capital investment projects are so
overall financial strategy.
closely tied to plans for product development, production, and marketing that managers
from these other areas are inevitably drawn into planning and analyzing the projects. If
the firm has staff members specializing in corporate planning, they are naturally in-
volved in capital budgeting too.
Because of the importance of many financial issues, ultimate decisions often rest by
law or by custom with the board of directors.9 For example, only the board has the legal
power to declare a dividend or to sanction a public issue of securities. Boards usually
delegate decision-making authority for small- or medium-sized investment outlays, but
the authority to approve large investments is almost never delegated.
9 Often the firmÔÇ™s chief financial officer is also a member of its board of directors.
The Firm and the Financial Manager 15
Sal and Sally went to business school together 10 years ago. They have just been hired
by a midsized corporation that wants to bring in new financial managers. Sal studied fi-
nance, with an emphasis on financial markets and institutions. Sally majored in ac-
counting and became a CPA 5 years ago. Who is more suited to be treasurer and who
controller? Briefly explain.
CAREERS IN FINANCE
In the United States well over 1 million people work in financial services, and many oth-
ers work in the finance departments of corporations. We canÔÇ™t tell you what each person
does all day, but we can give you some idea of the variety of careers in finance. The
nearby box summarizes the experience of a small sample of recent (fictitious) graduates.
We explained earlier that corporations face two principal financial decisions: the in-
vestment decision and the financing decision. Therefore, as a newly recruited financial
analyst, you may help to analyze a major new investment project. Or you may instead
help to raise the money to pay for it, perhaps by a new issue of debt or by arranging to
lease the plant and equipment. Other financial analysts work on short-term financial is-
sues, such as collecting and investing the companyÔÇ™s cash or checking whether cus-
tomers are likely to pay their bills. Financial analysts are also involved in monitoring
and controlling risk. For example, they may help to arrange insurance for the firmÔÇ™s
plant and equipment, or they may assist with the purchase and sale of options, futures,
and other exotic tools for managing risk.
Instead of working in the finance department of a corporation, you may join a fi-
nancial institution. The largest employers are the commercial banks. We noted earlier
that banks collect deposits and relend the cash to corporations and individuals. If you
join a bank, at some point you may well work in a branch, where individuals and small
businesses come to deposit cash or to seek a loan. Alternatively, you may be employed
in the head office, helping to analyze a $100 million loan to a large corporation.
Banks do many things in addition to lending money, and they probably provide a
greater variety of jobs than other financial institutions. For example, individuals and
businesses use banks to make payments to each other. So if you work in the cash man-
agement department of a large bank, you may help companies electronically transfer
huge sums of money as wages, taxes, and payments to suppliers. Banks also buy and sell
foreign exchange, so you could find yourself working in front of one of those computer
screens in a foreign exchange dealing room. Another glamorous bank job is in the de-
rivatives group, which helps companies to manage their risk by buying and selling op-
tions, futures, and so on. This is where the mathematicians and the computer buffs thrive.
Investment banks, such as Merrill Lynch or Goldman Sachs, help companies sell
their securities to investors. They also have large corporate finance departments which
assist firms in major reorganizations such as takeovers. When firms issue securities or
try to take over another firm, frequently a lot of money is at stake and the firms may
need to move fast. Thus, working for an investment bank can be a high-pressure activ-
ity with long hours. It can also be very well paid.
The distinction between commercial banks and investment banks is narrowing. For ex-
ample, commercial banks may also be involved in new issues of securities, while invest-
ment banks are major traders in options and futures. Investment banks and commercial
banks may even be owned by the same company; for example, Salomon Smith Barney (an
investment bank) and Citibank (a commercial bank) are both owned by Citigroup.
FINANCE IN ACTION
Working in Finance
builders, operators, suppliers, and so on, were all in
Susan Webb, Research Analyst,
place before we could arrange bank finance for the
Mutual Fund Group
After majoring in biochemistry, I joined the research de-
partment of a large mutual fund group. Because of my
Albert Rodriguez, Emerging Markets Group,
background, I was assigned to work with the senior
Major New York Bank
pharmaceuticals analyst. I start the day by reading the
I joined the bank after majoring in finance. I spent the
Wall Street Journal and reviewing the analyses that
first 6 months in the bankÔÇ™s training program, rotating
come in each day from stockbroking firms. Sometimes
between departments. I was assigned to the Latin
we need to revise our earnings forecasts and meet with
America team just before the 1998 Brazilian crisis when
the portfolio managers to discuss possible trades. The
interest rates jumped to nearly 50 percent and the cur-
remainder of my day is spent mainly in analyzing com-
rency fell by 40 percent. There was a lot of activity, with
panies and developing forecasts of revenues and earn-
everyone trying to figure out what was likely to happen
ings. I meet frequently with pharmaceutical analysts in