can trade already-issued securities among themselves. The financial manager also may raise
funds by borrowing from financial intermediaries like banks or insurance companies. The
financial intermediaries in turn raise funds, often in small amounts, from individual
In small companies there is often only one financial executive. However, the larger
corporation usually has both a treasurer and a controller. The treasurerÔÇ™s job is to obtain
and manage the companyÔÇ™s financing. By contrast, the controllerÔÇ™s job is one of inspecting
to see that the money is used correctly. Large firms may also appoint a chief financial
officer, or CFO.
Why does it make sense for corporations to maximize their market values?
Value maximization is usually taken to be the goal of the firm. Such a strategy maximizes
shareholdersÔÇ™ wealth, thereby enabling shareholders to pursue their personal goals. However,
value maximization does not imply a disregard for ethical decision making, in part because
the firmÔÇ™s reputation as an employer and business partner depends on its past actions.
Why may conflicts of interest arise in large organizations? How can corporations
provide incentives for everyone to work toward a common end?
Agency problems imply that managers may have interests that differ from those of the firm.
These problems are kept in check by compensation plans that link the well-being of
employees to that of the firm, by monitoring of management by the board of directors,
security holders, and creditors, and by the threat of takeover.
FINANCE IN ACTION
Finance through the Ages
still survives and is one of CanadaÔÇ™s largest compa-
Date unknown Compound Growth. Bacteria start to
propagate by subdividing. They thereby demon-
17th century Money. America has been in the fore-
strate the power of compound growth.
front in the development of new types of money.
c. 1800 B.C. Interest Rates. In Babylonia Ham-
Early settlers often used a shell known as wampum.
murabiÔÇ™s Code established maximum interest rates
For example, Peter Stuyvesant raised a loan in
on loans. Borrowers often mortgaged their property
wampum and in Massachusetts it was legal tender.
and sometimes their spouses but in these cases the
Unfortunately, the enterprising settlers found that
lender was obliged to return the spouse in good
with a little dye the relatively common white
condition within 3 years.
wampum shells could be converted profitably into
c. 1000 B.C. Options. One of the earliest recorded
the more valuable black ones, which simply demon-
options is described by Aristotle. The philosopher
strated GreshamÔÇ™s law that bad money drives out
Thales knew by the stars that there would be a great
good. The first issue of paper money in America (and
olive harvest, so, having a little money, he bought
almost in the world) was by the Massachusetts Bay
options for the use of olive presses. When the har-
Colony in 1690, and other colonies soon set their
vest came Thales was able to rent the presses at
printing presses to producing money. In 1862 Con-
great profit. Today financial managers need to be
gress agreed to an issue of paper money which
able to evaluate options to buy or sell a wide variety
would be legal tender. These notes, printed in green
ink, immediately became known as greenbacks.
15th century International Banking. Modern inter-
1720 New Issue Speculation. From time to time in-
national banking has its origins in the great Floren-
vestors have been tempted by speculative new is-
tine banking houses. But the entire European net-
sues. During the South Sea Bubble in England one
work of the Medici empire employed only 57 people
company was launched to develop perpetual mo-
in eight offices. Today Citicorp has 81,000 employ-
tion. Another enterprising individual announced a
ees and 3500 offices in 93 different countries.
company ÔÇťfor carrying on an undertaking of great
1650 Futures. Futures markets allow companies to
advantage but nobody to know what it is.ÔÇŁ Within 5
protect themselves against fluctuations in commod-
hours he had raised ┬ú2000; within 6 hours he was on
ity prices. During the Tokugawa era in Japan feudal
his way out of the country.
lords collected rents in the form of rice but often they
1792 Formation of the New York Stock Exchange.
wished to trade their future rice deliveries. Rice fu-
The New York Stock Exchange (NYSE) was founded
tures therefore came to be traded on what was later
in 1792 when a group of brokers met under a but-
known as the Dojima Rice Market. Rice futures are
tonwood tree and arranged to trade shares with one
still traded but now companies can also trade in fu-
another at agreed rates of commission. Today the
tures on a range of items from pork bellies to stock
NYSE is the largest stock exchange in the world,
trading on average about a billion shares a day.
17th century Joint Stock Corporations. Although
1929 Stock Market Crashes. Common stocks are
investors have for a long time combined together as
risky investments. In September 1929 stock prices in
joint owners of an enterprise, the modern corpora-
the United States reached an all-time high and the
tion with a large number of stockholders originates
economist Irving Fisher forecast that they were at ÔÇťa
with the formation in England of the great trading
permanently high plateau.ÔÇŁ Some 3 years later stock
firms like the East India Company (est. 1599). An-
prices were almost 90 percent lower and it was to be
other early trading firm, HudsonÔÇ™s Bay (est. 1670),
States inflation has been relatively modest, but some
a quarter of a century before the prices of Septem-
countries have suffered from hyperinflation. In Hun-
ber 1929 were seen again. Contrary to popular im-
gary after World War II the government issued bank-
pression, no Wall Street broker jumped out the win-
notes worth 1000 trillion pengoes. In Yugoslavia in
October 1993 prices rose by nearly 2000 percent
1960s Eurodollar Market. In the 1950s the Soviet
and a dollar bought 105 million dinars.
Union transferred its dollar holdings from the United
1780 and 1997 Inflation-Indexed Debt. In 1780,
States to a Russian-owned bank in Paris. This bank
Massachusetts paid Revolutionary War soldiers with
was best known by its telex address, EUROBANK,
interest-bearing notes rather than its rapidly eroding
and consequently dollars held outside the United
currency. Interest and principal payments on the
States came to be known as eurodollars. In the
notes were tied to the rate of subsequent inflation.
1960s U.S. taxes and regulation made it much
After a 217-year hiatus, the United States Treasury
cheaper to borrow and lend dollars in Europe rather
issued 10-year inflation-indexed notes. Many other
than in the United States and a huge market in eu-
countries, including Britain and Israel, had done so
1972 Financial Futures. Financial futures allow com-
1993 Controlling Risk. When a company fails to
panies to protect themselves against fluctuations in
keep close tabs on the risks being taken by its em-
interest rates, exchange rates, and so on. It is said
ployees, it can get into serious trouble. This was the
that they originated from a remark by the economist
fate of Barings, a 220-year-old British bank that
Milton Friedman that he was unable to profit from his
numbered the queen among its clients. In 1993 it
view that sterling was overpriced. The Chicago Mer-
discovered that Nick Leeson, a trader in its Singa-
cantile Exchange founded the first financial futures
pore office, had hidden losses of $1.3 billion (┬ú869
market. Today futures exchanges in the United
million) from unauthorized bets on the Japanese eq-
States trade 200 million contracts a year of financial
uity market. The losses wiped out Barings and
landed Leeson in jail, with a 6-year sentence.
1986 Capital Investment Decisions. The largest in-
1999 The Euro. Large corporations do business in
vestment project undertaken by private companies
many currencies. In 1999 a new currency came into
was the construction of the tunnel under the English
existence, when 11 European countries adopted the
Channel. This started in 1986 and was completed in
euro in place of their separate currencies. This was
1994 at a total cost of $15 billion.
not the first time that different countries have agreed
1988 Mergers. The 1980s saw a wave of takeovers
on a common currency. In 1865 France, Belgium,
culminating in the $25 billion takeover of RJR
Switzerland, and Italy came together in the Latin
Nabisco. Over a period of 6 weeks three groups bat-
Monetary Union, and they were joined by Greece
tled for control of the company. As one of the con-
and Romania the following year. Members of the Eu-
testants put it, ÔÇťWe were charging through the rice
ropean Monetary Union (EMU) hope that the euro
paddies, not stopping for anything and taking no
will be a longer lasting success than earlier experi-
prisoners.ÔÇŁ The takeover was the largest in history
and generated almost $1 billion in fees for the banks
1993 Inflation. Financial managers need to recognize
the effect of inflation on interest rates and on the
profitability of the firmÔÇ™s investments. In the United
28 SECTION ONE
Related Web www.financewise.com/ A search engine for finance-related sites
www.forbes.com/ News about financial management
Links www.wiso.gwdg.de/ifbg/finance.html Links to all kinds of finance sites
www.edgeonline.com/ Information for the small business financial manager
www.corpmon.com/index.htm The corporate monitoring project dedicated to inducing firms to
make good decisions
www.companylink.com/ News, research, and contacts for more than 100,000 companies
http://crcse.business.pitt.edu/pages/biblio.html A bibliography of research on motivating man-
agers through effective incentives
http://pwl.netcom.com/˜jstorres/internalaudit/resources.html Internal control and corporate
sole proprietor capital budgeting decision treasurer
partnership financing decision controller
corporation capital structure chief financial officer (CFO)
limited liability capital markets agency problems
real assets financial intermediary stakeholder
financial assets primary market
financial markets secondary market
Quiz 1. Financial Decisions. Fit each of the following terms into the most appropriate space: fi-
nancing, real, stock, investment, executive airplanes, financial, capital budgeting, brand
Companies usually buy ___ assets. These include both tangible assets such as ___ and
intangible assets such as ___. In order to pay for these assets, they sell ___ assets such as
___. The decision regarding which assets to buy is usually termed the ___ or ___ decision.
The decision regarding how to raise the money is usually termed the ___ decision.
2. Value Maximization. Give an example of an action that might increase profits but at the
same time reduce stock price.
3. Corporate Organization. You may own shares of IBM, but you still canÔÇ™t enter corporate
headquarters whenever you feel like it. In what sense then are you an owner of the firm?
4. Corporate Organization. What are the advantages and disadvantages of organizing a firm
as a proprietorship, partnership, or corporation? In what sense are LLPs or professional cor-
porations hybrid forms of business organization?
5. Corporate Organization. What do we mean when we say that corporate income is subject
to double taxation?
6. Financial Managers. Which of the following statements more accurately describes the
treasurer than the controller?
a. Likely to be the only financial executive in small firms
b. Monitors capital expenditures to make sure that they are not misappropriated
c. Responsible for investing the firmÔÇ™s spare cash
d. Responsible for arranging any issue of common stock
e. Responsible for the companyÔÇ™s tax affairs
The Firm and the Financial Manager 29
Practice 7. Real versus Financial Assets. Which of the following are real assets, and which are
Problems a. A share of stock
b. A personal IOU
c. A trademark
d. A truck
e. Undeveloped land
f. The balance in the firmÔÇ™s checking account
g. An experienced and hardworking sales force
h. A bank loan agreement
8. The Financial Manager. Give two examples of capital budgeting decisions and financing
9. Financial Markets. What is meant by over-the-counter trading? Is this trading mechanism
used for stocks, bonds, or both?
10. Financial Institutions. We gave banks and insurance companies as two examples of finan-
cial institutions. What other types of financial institutions can you identify?
11. Financial Markets. In most years new issues of stock are a tiny fraction of total stock mar-
ket trading. In other words, secondary market volume is much greater than primary market
volume. Does the fact that firms only occasionally sell new shares mean that the stock mar-
ket is largely irrelevant to the financial manager? Hint: How is the price of the firmÔÇ™s stock