# Understanding Money and Financial Institutions

## Insuring Bank Deposits

1. How does the Federal Deposit Insurance Corporation (FDIC) protect depositors’ funds?
The U.S. banking system worked fairly well from when the Federal Reserve System was established in 1913 until the stock market crash of 1929 and the Great Depression that followed. Business failures caused by these events resulted in major cash shortages as people rushed to withdraw their money from banks. Many cash-starved banks failed because the Federal Reserve did not, as expected, lend money to them. The government’s efforts to prevent bank failures were ineffective. Over the next two years, 5,000 banks—about 20 percent of the total number—failed.
President Franklin D. Roosevelt made strengthening the banking system his first priority. After taking office in 1933, Roosevelt declared a bank holiday, closing all banks for a week so he could take corrective action. Congress passed the Banking Act of 1933, which empowered the Federal Reserve System to regulate banks and reform the banking system. The act’s most important provision was the creation of the Federal Deposit Insurance Corporation (FDIC) to insure deposits in commercial banks. The 1933 act also gave the Federal Reserve authority to set reserve requirements, ban interest on demand deposits, regulate the interest rates on time deposits, and prohibit banks from investing in specified types of securities. In 1934 the Federal Savings and Loan Insurance Corporation (FSLIC) was formed to insure deposits at S&Ls. When the FSLIC went bankrupt in the 1980s, the FDIC took over responsibility for administering the fund that insures deposits at thrift institutions.
Today, the major deposit insurance funds include the following:
1. The Deposit Insurance Fund (DIF): Administered by the FDIC, this fund provides deposit insurance to commercial banks and thrift institutions.
2. The National Credit Union Share Insurance Fund: Administered by the National Credit Union Administration, this fund provides deposit insurance to credit unions.

### Role of the FDIC

The FDIC is an independent, quasi-public corporation backed by the full faith and credit of the U.S. government. It examines and supervises about 4,000 banks and savings banks, more than half the institutions in the banking system. It insures trillions of dollars of deposits in U.S. banks and thrift institutions against loss if the financial institution fails. The FDIC insures all member banks in the Federal Reserve System. The ceiling on insured deposits is $250,000 per account. Each insured bank pays the insurance premiums, which are a fixed percentage of the bank’s domestic deposits. In 1993, the FDIC switched from a flat rate for deposit insurance to a risk-based premium system because of the large number of bank and thrift failures during the 1980s and early 1990s. Some experts argue that certain banks take too much risk because they view deposit insurance as a safety net for their depositors—a view many believe contributed to earlier bank failures.

### Enforcement by the FDIC

To ensure that banks operate fairly and profitably, the FDIC sets guidelines for banks and then reviews the financial records and management practices of member banks at least once a year. Bank examiners perform these reviews during unannounced visits, rating banks on their compliance with banking regulations—for example, the Equal Credit Opportunity Act, which states that a bank cannot refuse to lend money to people because of their color, religion, or national origin. Examiners also rate a bank’s overall financial condition, focusing on loan quality, management practices, earnings, liquidity, and whether the bank has enough capital (equity) to safely support its activities.
When bank examiners conclude that a bank has serious financial problems, the FDIC can take several actions. It can lend money to the bank, recommend that the bank merge with a stronger bank, require the bank to use new management practices or replace its managers, buy loans from the bank, or provide extra equity capital to the bank. The FDIC may even cover all deposits at a troubled bank, including those over $250,000, to restore the public’s confidence in the financial system.
With the fallout from the financial crisis of 2007–2009 still having an effect on banking and financial markets in this country and abroad, the FDIC works closely with the Federal Reserve to make sure that banks continue to maintain healthy balance sheets by “testing” their solvency on a regular basis. Although the future of Dodd-Frank regulations is open to speculation in 2017, the consequences of thinking that banks and other financial institutions were “too big to fail” has had a positive impact on banking and financial transactions with the hope that such a financial crisis can be avoided in the future.

### Summary of Learning Outcomes

1. How does the Federal Deposit Insurance Corporation (FDIC) protect depositors’ funds?
The Federal Deposit Insurance Corporation insures deposits in commercial banks through the Bank Insurance Fund and deposits in thrift institutions through the Savings Association Insurance Fund. Deposits in credit unions are insured by the National Credit Union Share Insurance Fund, which is administered by the National Credit Union Administration. The FDIC sets banking policies and practices and reviews banks annually to ensure that they operate fairly and profitably.


# Understanding Money and Financial Institutions

## International Banking

1. What roles do U.S. banks play in the international marketplace?
The financial marketplace spans the globe, with money routinely flowing across international borders. U.S. banks play an important role in global business by providing loans to foreign governments and businesses. Multinational corporations need many special banking services, such as foreign-currency exchange and funding for overseas investments. U.S. banks also offer trade-related services, such as global cash management, that help firms manage their cash flows, improve their payment efficiency, and reduce their exposure to operational risks. Sometimes consumers in other nations have a need for banking services that banks in their own countries don’t provide. Therefore, large banks often look beyond their national borders for profitable banking opportunities.
Many U.S. banks have expanded into overseas markets by opening offices in Europe, Latin America, and Asia. They often provide better customer service than local banks and have access to more sources of funding. Citibank, for example, was the first bank to offer banking by phone and 24-hour-a-day ATM service in Japan.
For U.S. banks, expanding internationally can be difficult. Banks in other nations are often subject to fewer regulations than U.S. banks, making it easier for them to undercut American banks on the pricing of loans and services. Some governments also protect their banks against foreign competition. For example, the Chinese government imposes high fees and limits the amount of deposits that foreign banks can accept from customers. It also controls foreign-bank deposit and loan interest rates, limiting the ability of foreign banks to compete with government-owned Chinese banks. Despite the banking restrictions for foreign banks in China, many of the large U.S. banking institutions continue to do business there.
International banks operating within the United States also have a substantial impact on the economy through job creation—they employ thousands of people in the United States, and most workers are U.S. citizens—operating and capital expenditures, taxes, and other contributions. According to March 2017 Federal Reserve data, the combined banking and nonbanking assets of the U.S. operations of foreign banks total more than $24 trillion.
The United States has four banks listed in the top 10 world’s biggest banks, as shown in .
Political and economic uncertainty in other countries can make international banking a high-risk venture. European and Asian banks were not immune to the financial crisis of 2007–2009. In fact, several countries, including Greece, Portugal, Spain, and Ireland, continue to rebound slowly from the near-collapse of their economic and financial systems they experienced a decade ago. Financial bailouts spearheaded by the European Union and the International Monetary Fund have helped stabilize the European and global economy. It is unclear at this writing, however, whether the impending “Brexit” move by the United Kingdom (leaving the European Union) will impact international banking, as many of the world’s top financial institutions seek to move their global operations out of London and shift them to other financial capitals within the eurozone.

### Summary of Learning Outcomes

1. What role do U.S. banks play in the international marketplace?
U.S. banks provide loans and trade-related services to foreign governments and businesses. They also offer specialized services such as cash management and foreign-currency exchange.


# Understanding Money and Financial Institutions

## Trends in Financial Institutions

1. What trends are reshaping financial institutions?
What factors will influence financial institutions in the coming years? The latest reports suggest there will be a continued focus on regulatory and compliance issues (especially after the recent financial crisis), as well as on operational efficiency and technological advances.
Banks will continue to tackle customer engagement and technology initiatives over the next few years. According to a report by Aite Group, a Boston-based firm that forecasts U.S. banking trends, technology continues to empower consumers to control their banking and commerce experiences. Financial institutions have become better at using data and data analytics to help them better understand their customers’ needs and behaviors, which may provide them the competitive advantage they seek in the retail banking industry.
Financial technology (or “fintech” services) will continue to disrupt the banking industry and provide opportunities for banks and other institutions to work closely with fintech companies that can help them innovate and streamline their business practices. According to recent research by Goldman Sachs, fintech startups have the potential to take away billions of dollars in business from traditional investment and lending institutions. Some of the services offered by fintech firms include payment transaction processing, mobile and web payment services for e-commerce firms, peer-to-peer lending, and integrated financial software programs.
Mobile financial apps will continue to be a strategic advantage that separates traditional banking approaches from innovative companies that can offer their clients a connected, digital experience when it comes to their money and investments. Consumers will expect personalization of bank products and services as part of their routine interaction with financial institutions. Otherwise, they will look elsewhere for a competitive platform to meet all of their financial and banking needs.
Although most banks continue to offer local branch offices, the next few years will see branch banking become less prevalent as online and mobile services become more popular. Most banking institutions already offer apps that allow customers to move money between accounts or deposit a check via their smartphones, which happens almost instantaneously, rather than get in a car, drive to the bank, and deposit the check in person. In addition, online payment platforms such as PayPal, Apple Pay, Google Wallet, Shopify, Stripe, and others continue to make personal and business transactions seamless. In this 24/7 world, consumers expect their banking and financial transactions to happen quickly and efficiently.

### Summary of Learning Outcomes

1. What trends are reshaping financial institutions?
There will be a continued focus on regulatory and compliance issues, especially after the recent financial crisis, as well as on operational efficiency and technological advances. Banks will continue to tackle customer engagement and technology initiatives, as consumers will control more than 85 percent of their ongoing relationships with banks and other financial institutions. Fintech services will continue to disrupt the banking industry and will enable some banks to increase innovation and streamline operational efficiencies. Mobile financial apps will continue to provide banks with a strategic advantage, as well as enable them to collect and utilize customer data as part of their overall business strategy. Finally, online payment platforms will play an integral role in the banking and financial sector, as consumers’ expectations continue to drive innovation in the banking industry.

### Preparing for Tomorrow’s Workplace Skills

1. How much does a checking account cost? Call or visit websites of several local banks and weigh prices and services. Take into consideration how you use your checking account, how many checks a month you write, and the average balances you keep. On the internet, BankRate.com (http://www.bankrate.com) lets you digitally compare bank products, including those banking institutions that are strictly internet-based. Could you pay lower fees elsewhere? Could you earn interest on your checking account at a credit union? Would you be better off paying a monthly fee with unlimited check-writing privileges? Crunch the numbers to find the best deal. (Resources, Information)
2. You are starting a small business selling collectible books over the internet and need to establish a business banking account that will provide the following services: business checking, credit-card processing, a business savings account, and perhaps a line of credit. Call or visit at least three banks, including an internet-based one, to gather information about their business banking services, including data about fees, service options, and other features of interest to entrepreneurs. Write a short summary of each bank’s offerings and benefits and make a recommendation about which bank you would choose for your new business. (Interpersonal, Information)
3. If you watch the news, you’ve undoubtedly heard mention that the Fed is going to raise or lower interest rates. What exactly does this mean? Explain how the Fed’s decision to raise and lower its discount rate might affect (a) a large manufacturer of household appliances, (b) a mid-sized software firm, (c) a small restaurant, (d) a family hoping to purchase their first home, and (e) a college student. (Information)
4. Research the banking system of another country, and write a report on your findings by answering these questions: Is there a central banking system similar to the U.S. Federal Reserve System in place? Which government agency or department controls it, and how does it operate? How stable is the country’s central banking system? How does it compare in structure and operation to the Federal Reserve System? How much control does the government have over banks operating in the country? Are there any barriers to entry specifically facing foreign banks? What would this mean to a foreign business attempting to do business in this country? (Information)
5. Banks use databases to identify profitable and unprofitable customers. Bankers say they lose money on customers who typically keep less than $1,000 in their checking and savings accounts and frequently call or visit the bank. Profitable customers keep several thousand dollars in their accounts and seldom visit a teller or call the bank. To turn unprofitable customers into profitable ones, banks have assessed fees on many of their services, including using a bank teller, although many of the fees are waived for customers who maintain high account balances. Bankers justify the fees by saying they’re in business to earn a profit. Discuss whether banks are justified in treating profitable and unprofitable customers differently. Defend your answers. (Information, Systems)
6. Team Activity During its regular meetings, the Federal Open Market Committee, the Federal Reserve’s monetary policy-making body, considers a number of economic indicators and reports before making decisions. The decisions made by the Fed include whether to sell or purchase Federal treasury bonds, whether to raise or lower bank reserve requirements, and whether to raise or lower the Federal Reserve discount rate. Divide your class into groups (if possible, try to use seven members, the size of the FOMC), and assign each group one of these decisions. As a group, identify the types of information used by the Fed in making their assigned decision and how that information is used. Find the most recent information (sources may include newspapers, business publications, online databases, etc.) and analyze it. Based on this information and your group’s analysis, what should the Fed do now? Present your findings and recommendations to the class. (Interpersonal, Information)

### Ethics Activity

You are a loan officer with a financial company that specializes in auto loans. The senior vice president in charge of your area sets new loan quotas for your group and suggests that courting more subprime borrowers would make the new quotas easier to meet. He reminds you that the company can justifiably charge higher interest rates, loan fees, and servicing costs for these higher-risk loans. He also points out that the loans will earn you and your team larger commissions as well. “Everyone wins,” he tells you. “We help people who might otherwise not be able to get the financing they need, the company makes money, and so do you.”
But you are uneasy about the company’s focus on subprime borrowers, low-income applicants with poor or limited credit histories, many of whom are also minorities. You suspect the company’s tactics could be considered “predatory lending” or “reverse redlining.” You are also convinced that the cost of the company’s subprime loans aren’t tied to the increased risk factor at all, but to how much profit the company can squeeze from a group of unsophisticated borrowers with few other options.
Using a web search tool, locate articles about the topic of subprime auto loans, and then write responses to the following questions. Be sure to support your arguments and cite your sources.
Ethical Dilemma: Should you seek out subprime loans, knowing that you will have to charge borrowers the high fees your company demands, while believing they may not be totally justified?
Sources: Adam Tempkin, “‘Deep’ Subprime Car Loans Hit Crisis-Era Milestone,” Bloomberg Markets, https://www.bloomberg.com, August 15, 2017; Shannara Johnson, “Subprime Auto Loans Up, Car Sales Down: Why This Could Be Good for Gold,” Forbes, https://www.forbes.com, July 13, 2017; Mark Huffman, “Santander Settles Subprime Auto Loan Suit with Massachusetts,” Consumer Affairs, https://www.consumeraffairs.com, March 31, 2017; Michael Corkery and Jessica Silver-Greenberg, “Prosecutors Scrutinize Minority Borrowers’ Auto Loans,” The New York Times, https://www.nytimes.com, March 30, 2015.

### Working the Net

1. Banking on a great career? Go to http://www.careerbank.com to explore what positions are available in banking, finance, and accounting. Make a presentation on the type of job you might choose and its location.
2. Visit the International Money Laundering Network Services Association (http://www.imolin.org) for the latest information on what organizations are doing to ensure international monetary transfers remain out of terrorists’ hands. Summarize your findings.
3. Find out everything you want to know about financial institutions and banking careers from the latest edition of the Bureau of Labor Statistics’ Occupational Outlook Handbook. Visit the OOH’s website at https://www.bls.gov/ooh, and click on the A–Z Index to explore banking and other financial occupations, including the forecast for these careers in the coming decade. Explain why this information should be important to you.
4. Using an internet search engine, research information on digital banking branches used around the country by companies such as Citibank. Make a presentation describing the merits of this trend to your class.
5. The recent Wells Fargo scandal in which bank employees created more than three million fake customer accounts as a result of pressure from their managers to meet sales quotas still has the banking community and consumers up in arms regarding the ethics of fraudulent banking practices, ongoing credit issues, and customer privacy. Using an internet search engine, research what happened at Wells Fargo, what fallout it caused for consumers as well as bank employees, and what the Fed did to intervene. Summarize your findings, and provide recommendations on what banking executives and employees could have done differently.
6. What are your rights to privacy when dealing with financial institutions? Use the internet to research the specific privacy provisions related to banking and financial services, and write a paper on how you can use this information to protect your privacy and financial identity.

### Creative Thinking Case

### Stripe Revolutionizes Digital Payments

Raised in Ireland, Patrick and John Collison were precocious, inquisitive youngsters who taught themselves computer coding at an early age. By the time they were teenagers, the brothers were developing iPhone apps and eventually became college dropouts after a few semesters at MIT (Patrick) and Harvard (John). During this time they started a company called Auctomatic Inc., which created an online marketplace management system for companies such as eBay, and then sold the company for $5 million in 2008.
After selling the business, they continued to work on simplifying the payment process for startup businesses that use the internet to sell goods and services. As the internet entered its second decade and more and more entrepreneurs were using the web to do business, the Collisons recognized that the payment transaction process for online purchases needed an overhaul. In 2011, they opened their new company, Stripe, after testing their service and building relationships with banks, credit card companies, and regulators, so clients could focus their energies on building their businesses—and not building a payment infrastructure from scratch.
Using Stripe, businesses only need to add seven lines of coding to their websites to handle payments—a process that previously could have taken weeks to perfect. Word spread quickly among developers that the Collison brothers’ simple coding architecture could indeed disrupt the payment processing industry. As more and more marketplace companies and other online services needed to divvy up payments between vendors and consumers, Stripe became the go-to company to figure out how to move money online quickly and to get people (and companies) paid. The company’s engineers determined how to separate payments for some of the internet’s startups such as Lyft, which needed consumers to pay for rides and drivers to be compensated quickly. Stripe engineers worked their magic to bypass typical banking protocol and linked payments to Lyft drivers via their debit cards, which allowed them to be paid promptly.
After seven years in business, Stripe is now the financial “back office” for more than 100,000 businesses that take mobile payments—some of them startups and some of them big businesses such as Amazon, Salesforce, and Target. The company charges a 2.9 percent fee on credit card payments in exchange for its services. Although Stripe’s sales data is confidential, analysts estimate Stripe handles more than $50 billion in commerce annually, which translates to nearly $1.5 billion in revenue.
With more than 750 employees, Stripe continues to expand its product offerings in an effort to give customers and potential clients new tools they can use to help grow their business. For example, Radar, Stripe’s fraud detection service, uses artificial intelligence to analyze payments on its extensive network to identify suspicious activity. By looking at such a large data set on its own network, Stripe can spot patterns better than a single company reviewing its own transactions. The company recently rolled out another tool called Atlas, which can help a local or overseas startup incorporate, get a taxpayer ID number and U.S. bank account, and receive legal and tax advice on forming a company—for a fee of $500 and a few simple clicks. Typically this process would take months, many visits to the United States (if a foreign business), and large legal fees.
Stripe continues to disrupt the payment processing industry, and its Irish cofounders believe they have what it takes to continue building a simple internet infrastructure that will allow startups across the globe to do business and handle mobile payments efficiently—giving entrepreneurs more time to focus on growing successful businesses.
2. Do you think Stripe’s strategy of keeping things simple is a sound business plan? Explain your reasoning.
3. What impact do you think the company’s Atlas product offering will have on Stripe’s global expansion?
4. Do you think Stripe’s agility in working with so many different businesses provides the company with a competitive advantage over big banks and credit card companies? Justify your answer.
Sources: “About Us,” https://stripe.com, accessed September 12, 2017; Matt Weinberger, “$9 Billion Stripe Has a Master Plan to Take Over the World—or at Least, Open It Up for Business,” Business Insider, http://www.businessinsider.com, August 10, 2017; Ashlee Vance, “How Two Brothers Turned Seven Lines of Code into a $9.2 Billion Startup,” Bloomberg Businessweek, https://www.businessweek.com, August 1, 2017; “Stripe CEO Patrick Collison on Recode Decode (Podcast transcript),” Recode, https://www.recode.net, June 13, 2017; Marguerite Ward, “Meet the 20-Something Stripe Founders Who Are Now Worth More Than $1 Billion Each,” CNBC, https://www.cnbc.com, March 20, 2017; Rolfe Winkler and Telis Demos, “Stripe’s Valuation Nearly Doubles to $9.2 Billion,” The Wall Street Journal, https://www.wsj.com, November 25, 2016.

### Hot Links Address Book

1. Tour the American Currency Exhibit to learn the history of our nation’s money at http://www.frbsf.org/currency.
2. The website of the Federal Reserve Bank of St. Louis offers an easy-to-understand explanation of how the Federal Reserve System works, called “In Plain English”: https://www.stlouisfed.org/in-plain-english/landing/home.
3. The FDIC gets so many requests about banks’ insurance status that it added an option to determine “Is my account fully insured?” on its website. Visit http://www.fdic.gov.
4. What goes on at a Federal Open Market Committee meeting? Find out by reading the minutes of the Committee’s latest meeting at http://www.federalreserve.gov/fomc.
5. Find out what other services the Federal Reserve provides to financial institutions at http://www.frbservices.org.
6. How did Abraham Lincoln do his banking? Take a cybertour of American banking history by clicking on the About the OCC tab at https://www.occ.treas.gov.
7. To find out if you’re eligible to join a credit union, visit the National Credit Union Administration’s credit union locator at https://www.ncua.gov.


# Understanding Financial Management and Securities Markets

## Introduction

### Learning Outcomes

After reading this chapter, you should be able to answer these questions:
1. How do finance and the financial manager affect a firm’s overall strategy?
2. What types of short-term and long-term expenditures does a firm make?
3. What are the main sources and costs of unsecured and secured short-term financing?
4. What are the key differences between debt and equity, and what are the major types and features of long-term debt?
5. When and how do firms issue equity, and what are the costs?
6. How do securities markets help firms raise funding, and what securities trade in the capital markets?
7. Where can investors buy and sell securities, and how are securities markets regulated?
8. What are the current developments in financial management and the securities markets?
In today’s fast-paced global economy, managing a firm’s finances is more complex than ever. For financial managers, a thorough command of traditional finance activities—financial planning, investing money, and raising funds—is only part of the job. Financial managers are more than number crunchers. As part of the top management team, chief financial officers (CFOs) need a broad understanding of their firm’s business and industry, as well as leadership ability and creativity. They must never lose sight of the primary goal of the financial manager: to maximize the value of the firm to its owners.
Financial management—spending and raising a firm’s money—is both a science and an art. The science part is analyzing numbers and flows of cash through the firm. The art is answering questions such as these: Is the firm using its financial resources in the best way? Aside from costs, why choose a particular form of financing? How risky is each option? Another important concern for both business managers and investors is understanding the basics of securities markets and the securities traded on them, which affect both corporate plans and investor pocketbooks. About 52 percent of adult Americans now own stocks, compared to just 25 percent in 1981.
This chapter focuses on the financial management of a firm and the securities markets in which firms raise funds. We’ll start with an overview of the role of finance and of the financial manager in the firm’s overall business strategy. Discussions of short- and long-term uses of funds and investment decisions follow. Next, we’ll examine key sources of short- and long-term financing. Then we’ll review the function, operation, and regulation of securities markets. Finally, we’ll look at key trends affecting financial management and securities markets.


# Understanding Financial Management and Securities Markets

## The Role of Finance and the Financial Manager

1. How do finance and the financial manager affect the firm’s overall strategy?
Any company, whether it’s a small-town bakery or General Motors, needs money to operate. To make money, it must first spend money—on inventory and supplies, equipment and facilities, and employee wages and salaries. Therefore, finance is critical to the success of all companies. It may not be as visible as marketing or production, but management of a firm’s finances is just as much a key to the firm’s success.
Financial management—the art and science of managing a firm’s money so that it can meet its goals—is not just the responsibility of the finance department. All business decisions have financial consequences. Managers in all departments must work closely with financial personnel. If you are a sales representative, for example, the company’s credit and collection policies will affect your ability to make sales. The head of the IT department will need to justify any requests for new computer systems or employee laptops.
Revenues from sales of the firm’s products should be the chief source of funding. But money from sales doesn’t always come in when it’s needed to pay the bills. Financial managers must track how money is flowing into and out of the firm (see ). They work with the firm’s other department managers to determine how available funds will be used and how much money is needed. Then they choose the best sources to obtain the required funding.
For example, a financial manager will track day-to-day operational data such as cash collections and disbursements to ensure that the company has enough cash to meet its obligations. Over a longer time horizon, the manager will thoroughly study whether and when the company should open a new manufacturing facility. The manager will also suggest the most appropriate way to finance the project, raise the funds, and then monitor the project’s implementation and operation.
Financial management is closely related to accounting. In most firms, both areas are the responsibility of the vice president of finance or CFO. But the accountant’s main function is to collect and present financial data. Financial managers use financial statements and other information prepared by accountants to make financial decisions. Financial managers focus on cash flows, the inflows and outflows of cash. They plan and monitor the firm’s cash flows to ensure that cash is available when needed.

### The Financial Manager’s Responsibilities and Activities

Financial managers have a complex and challenging job. They analyze financial data prepared by accountants, monitor the firm’s financial status, and prepare and implement financial plans. One day they may be developing a better way to automate cash collections, and the next they may be analyzing a proposed acquisition. The key activities of the financial manager are:
1. Financial planning: Preparing the financial plan, which projects revenues, expenditures, and financing needs over a given period.
2. Investment (spending money): Investing the firm’s funds in projects and securities that provide high returns in relation to their risks.
3. Financing (raising money): Obtaining funding for the firm’s operations and investments and seeking the best balance between debt (borrowed funds) and equity (funds raised through the sale of ownership in the business).

### The Goal of the Financial Manager

How can financial managers make wise planning, investment, and financing decisions? The main goal of the financial manager is to maximize the value of the firm to its owners. The value of a publicly owned corporation is measured by the share price of its stock. A private company’s value is the price at which it could be sold.
To maximize the firm’s value, the financial manager has to consider both short- and long-term consequences of the firm’s actions. Maximizing profits is one approach, but it should not be the only one. Such an approach favors making short-term gains over achieving long-term goals. What if a firm in a highly technical and competitive industry did no research and development? In the short run, profits would be high because research and development is very expensive. But in the long run, the firm might lose its ability to compete because of its lack of new products.
This is true regardless of a company’s size or point in its life cycle. At Corning, a company founded more than 160 years ago, management believes in taking the long-term view and not managing for quarterly earnings to satisfy Wall Street’s expectations. The company, once known to consumers mostly for kitchen products such as Corelle dinnerware and Pyrex heat-resistant glass cookware, is today a technology company that manufactures specialized glass and ceramic products. It is a leading supplier of Gorilla Glass, a special type of glass used for the screens of mobile devices, including the iPhone, the iPad, and devices powered by Google’s Android operating system. The company was also the inventor of optical fiber and cable for the telecommunications industry. These product lines require large investments during their long research and development (R&D) cycles and for plant and equipment once they go into production.
This can be risky in the short term, but staying the course can pay off. In fact, Corning recently announced plans to develop a separate company division for Gorilla Glass, which now has more than 20 percent of the phone market—with over 200 million devices sold. In addition, its fiber-optic cable business is back in vogue and thriving as cable service providers such as Verizon have doubled down on upgrading the fiber-optic network across the United States. As of 2017, Corning’s commitment to repurposing some of its technologies and developing new products has helped the company’s bottom line, increasing revenues in a recent quarter by more than 16 percent.
As the Corning situation demonstrates, financial managers constantly strive for a balance between the opportunity for profit and the potential for loss. In finance, the opportunity for profit is termed return; the potential for loss, or the chance that an investment will not achieve the expected level of return, is risk. A basic principle in finance is that the higher the risk, the greater the return that is required. This widely accepted concept is called the risk-return trade-off. Financial managers consider many risk and return factors when making investment and financing decisions. Among them are changing patterns of market demand, interest rates, general economic conditions, market conditions, and social issues (such as environmental effects and equal employment opportunity policies).

### Summary of Learning Outcomes

1. How do finance and the financial manager affect the firm’s overall strategy?
Finance involves managing the firm’s money. The financial manager must decide how much money is needed and when, how best to use the available funds, and how to get the required financing. The financial manager’s responsibilities include financial planning, investing (spending money), and financing (raising money). Maximizing the value of the firm is the main goal of the financial manager, whose decisions often have long-term effects.


# Understanding Financial Management and Securities Markets

## How Organizations Use Funds

1. What types of short-term and long-term expenditures does a firm make?
To grow and prosper, a firm must keep investing money in its operations. The financial manager decides how best to use the firm’s money. Short-term expenses support the firm’s day-to-day activities. For instance, athletic-apparel maker Nike regularly spends money to buy such raw materials as leather and fabric and to pay employee salaries. Long-term expenses are typically for fixed assets. For Nike, these would include outlays to build a new factory, buy automated manufacturing equipment, or acquire a small manufacturer of sports apparel.

### Short-Term Expenses

Short-term expenses, often called operating expenses, are outlays used to support current production and selling activities. They typically result in current assets, which include cash and any other assets (accounts receivable and inventory) that can be converted to cash within a year. The financial manager’s goal is to manage current assets so the firm has enough cash to pay its bills and to support its accounts receivable and inventory.

### Cash Management: Assuring Liquidity

Cash is the lifeblood of business. Without it, a firm could not operate. An important duty of the financial manager is cash management, or making sure that enough cash is on hand to pay bills as they come due and to meet unexpected expenses.
Businesses estimate their cash requirements for a specific period. Many companies keep a minimum cash balance to cover unexpected expenses or changes in projected cash flows. The financial manager arranges loans to cover any shortfalls. If the size and timing of cash inflows closely match the size and timing of cash outflows, the company needs to keep only a small amount of cash on hand. A company whose sales and receipts are fairly predictable and regular throughout the year needs less cash than a company with a seasonal pattern of sales and receipts. A toy company, for instance, whose sales are concentrated in the fall, spends a great deal of cash during the spring and summer to build inventory. It has excess cash during the winter and early spring, when it collects on sales from its peak selling season.
Because cash held in checking accounts earns little, if any, interest, the financial manager tries to keep cash balances low and to invest the surplus cash. Surpluses are invested temporarily in marketable securities, short-term investments that are easily converted into cash. The financial manager looks for low-risk investments that offer high returns. Three of the most popular marketable securities are Treasury bills, certificates of deposit, and commercial paper. (Commercial paper is unsecured short-term debt—an IOU—issued by a financially strong corporation.) Today’s financial managers have new tools to help them find the best short-term investments, such as online trading platforms that save time and provide access to more types of investments. These have been especially useful for smaller companies who don’t have large finance staffs.
Companies with overseas operations face even greater cash management challenges. Developing the systems for international cash management may sound simple in theory, but in practice it’s extremely complex. In addition to dealing with multiple foreign currencies, treasurers must understand and follow banking practices and regulatory and tax requirements in each country. Regulations may impede their ability to move funds freely across borders. Also, issuing a standard set of procedures for every office may not work because local business practices differ from country to country. In addition, local managers may resist the shift to a centralized structure because they don’t want to give up control of cash generated by their units. Corporate financial managers must be sensitive to and aware of local customs and adapt the centralization strategy accordingly.
In addition to seeking the right balance between cash and marketable securities, the financial manager tries to shorten the time between the purchase of inventory or services (cash outflows) and the collection of cash from sales (cash inflows). The three key strategies are to collect money owed to the firm (accounts receivable) as quickly as possible, to pay money owed to others (accounts payable) as late as possible without damaging the firm’s credit reputation, and to minimize the funds tied up in inventory.

### Managing Accounts Receivable

Accounts receivable represent sales for which the firm has not yet been paid. Because the product has been sold but cash has not yet been received, an account receivable amounts to a use of funds. For the average manufacturing firm, accounts receivable represent about 15 to 20 percent of total assets.
The financial manager’s goal is to collect money owed to the firm as quickly as possible, while offering customers credit terms attractive enough to increase sales. Accounts receivable management involves setting credit policies, guidelines on offering credit, credit terms, and specific repayment conditions, including how long customers have to pay their bills and whether a cash discount is given for quicker payment. Another aspect of accounts receivable management is deciding on collection policies, the procedures for collecting overdue accounts.
Setting up credit and collection policies is a balancing act for financial managers. On the one hand, easier credit policies or generous credit terms (a longer repayment period or larger cash discount) result in increased sales. On the other hand, the firm has to finance more accounts receivable. The risk of uncollectible accounts receivable also rises. Businesses consider the impact on sales, timing of cash flow, experience with bad debt, customer profiles, and industry standards when developing their credit and collection policies.
Companies that want to speed up collections actively manage their accounts receivable, rather than passively letting customers pay when they want to. According to recent statistics, more than 90 percent of businesses experience late payments from customers, and some companies write off a percentage of their bad debt, which can be expensive.
Technology plays a big role in helping companies improve their credit and collections performance. For example, many companies use some type of automated decision-making, whether that comes in the form of an ERP system or a combination of software programs and supplemental modules that help companies make informed decisions when it comes to credit and collection processes.
Other companies choose to outsource financial and accounting business processes to specialists rather than develop their own systems. The availability of cutting-edge technology and specialized electronic platforms that would be difficult and expensive to develop in-house is winning over firms of all sizes. Giving up control of finance to a third party has not been easy for CFOs. The risks are high when financial and other sensitive corporate data are transferred to an outside computer system: data could be compromised or lost, or rivals could steal corporate data. It’s also harder to monitor an outside provider than your own employees. One outsourcing area that has attracted many clients is international trade, which has regulations that differ from country to country and requires huge amounts of documentation. With specialized IT systems, providers can track not only the physical location of goods, but also all the paperwork associated with shipments. Processing costs for goods purchased overseas are about twice those of domestic goods, so more efficient systems pay off.

### Inventory

Another use of funds is to buy inventory needed by the firm. In a typical manufacturing firm, inventory is nearly 20 percent of total assets. The cost of inventory includes not only its purchase price, but also ordering, handling, storage, interest, and insurance costs.
Production, marketing, and finance managers usually have differing views about inventory. Production managers want lots of raw materials on hand to avoid production delays. Marketing managers want lots of finished goods on hand so customer orders can be filled quickly. But financial managers want the least inventory possible without harming production efficiency or sales. Financial managers must work closely with production and marketing to balance these conflicting goals. Techniques for reducing the investment in inventory are inventory management, the just-in-time system, and materials requirement planning.
For retail firms, inventory management is a critical area for financial managers, who closely monitor inventory turnover ratios. This ratio shows how quickly inventory moves through the firm and is turned into sales. If the inventory number is too high, it will typically affect the amount of working capital a company has on hand, forcing the company to borrow money to cover the excess inventory. If the turnover ratio number is too high, it means the company does not have enough inventory of products on hand to satisfy customer needs, which means they could take their business elsewhere.

### Long-Term Expenditures

A firm also invests funds in physical assets such as land, buildings, machinery, equipment, and information systems. These are called capital expenditures. Unlike operating expenses, which produce benefits within a year, the benefits from capital expenditures extend beyond one year. For instance, a printer’s purchase of a new printing press with a usable life of seven years is a capital expenditure and appears as a fixed asset on the firm’s balance sheet. Paper, ink, and other supplies, however, are expenses. Mergers and acquisitions are also considered capital expenditures.
Firms make capital expenditures for many reasons. The most common are to expand, to replace or renew fixed assets, and to develop new products. Most manufacturing firms have a big investment in long-term assets. Boeing Company, for instance, puts billions of dollars a year into airplane-manufacturing facilities. Because capital expenditures tend to be costly and have a major effect on the firm’s future, the financial manager uses a process called capital budgeting to analyze long-term projects and select those that offer the best returns while maximizing the firm’s value. Decisions involving new products or the acquisition of another business are especially important. Managers look at project costs and forecast the future benefits the project will bring to calculate the firm’s estimated return on the investment.

### Summary of Learning Outcomes

1. What types of short-term and long-term expenditures does a firm make?
A firm incurs short-term expenses—supplies, inventory, and wages—to support current production, marketing, and sales activities. The financial manager manages the firm’s investment in current assets so that the company has enough cash to pay its bills and support accounts receivable and inventory. Long-term expenditures (capital expenditures) are made for fixed assets such as land, buildings, equipment and information systems. Because of the large outlays required for capital expenditures, financial managers carefully analyze proposed projects to determine which offer the best returns.


# Understanding Financial Management and Securities Markets

## Obtaining Short-Term Financing

1. What are the main sources and costs of unsecured and secured short-term financing?
How do firms raise the funding they need? They borrow money (debt), sell ownership shares (equity), and retain earnings (profits). The financial manager must assess all these sources and choose the one most likely to help maximize the firm’s value.
Like expenses, borrowed funds can be divided into short- and long-term loans. A short-term loan comes due within one year; a long-term loan has a maturity greater than one year. Short-term financing is shown as a current liability on the balance sheet and is used to finance current assets and support operations. Short-term loans can be unsecured or secured.

### Unsecured Short-Term Loans

Unsecured loans are made on the basis of the firm’s creditworthiness and the lender’s previous experience with the firm. An unsecured borrower does not have to pledge specific assets as security. The three main types of unsecured short-term loans are trade credit, bank loans, and commercial paper.

### Trade Credit: Accounts Payable

When Goodyear sells tires to General Motors, GM does not have to pay cash on delivery. Instead, Goodyear regularly bills GM for its tire purchases, and GM pays at a later date. This is an example of trade credit: the seller extends credit to the buyer between the time the buyer receives the goods or services and when it pays for them. Trade credit is a major source of short-term business financing. The buyer enters the credit on its books as an account payable. In effect, the credit is a short-term loan from the seller to the buyer of the goods and services. Until GM pays Goodyear, Goodyear has an account receivable from GM, and GM has an account payable to Goodyear.

### Bank Loans

Unsecured bank loans are another source of short-term business financing. Companies often use these loans to finance seasonal (cyclical) businesses. Unsecured bank loans include lines of credit and revolving credit agreements. A line of credit specifies the maximum amount of unsecured short-term borrowing the bank will allow the firm over a given period, typically one year. The firm either pays a fee or keeps a certain percentage of the loan amount (generally 10 to 20 percent) in a checking account at the bank. Another bank loan, the revolving credit agreement, is basically a guaranteed line of credit that carries an extra fee in addition to interest. Revolving credit agreements are often arranged for a period of two to five years.

### Commercial Paper

As noted earlier, commercial paper is an unsecured short-term debt—an IOU—issued by a financially strong corporation. Thus, it is both a short-term investment and a financing option for major corporations. Corporations issue commercial paper in multiples of $100,000 for periods ranging from 3 to 270 days. Many big companies use commercial paper instead of short-term bank loans because the interest rate on commercial paper is usually 1 to 3 percent below bank rates.

### Secured Short-Term Loans

Secured loans require the borrower to pledge specific assets as collateral, or security. The secured lender can legally take the collateral if the borrower doesn’t repay the loan. Commercial banks and commercial finance companies are the main sources of secured short-term loans to business. Borrowers whose credit is not strong enough to qualify for unsecured loans use these loans. Typically, the collateral for secured short-term loans is accounts receivable or inventory. Because accounts receivable are normally quite liquid (easily converted to cash), they are an attractive form of collateral. The appeal of inventory—raw materials or finished goods—as collateral depends on how easily it can be sold at a fair price.
Another form of short-term financing using accounts receivable is factoring. A firm sells its accounts receivable outright to a factor, a financial institution (often a commercial bank or commercial finance company) that buys accounts receivable at a discount. Factoring is widely used in the clothing, furniture, and appliance industries. Factoring is more expensive than a bank loan, however, because the factor buys the receivables at a discount from their actual value.

### Summary of Learning Outcomes

1. What are the main sources and costs of unsecured and secured short-term financing?
Short-term financing comes due within one year. The main sources of unsecured short-term financing are trade credit, bank loans, and commercial paper. Secured loans require a pledge of certain assets, such as accounts receivable or inventory, as security for the loan. Factoring, or selling accounts receivable outright at a discount, is another form of short-term financing.


# Understanding Financial Management and Securities Markets

## Raising Long-Term Financing

1. What are the key differences between debt and equity, and what are the major types and features of long-term debt?
A basic principle of finance is to match the term of the financing to the period over which benefits are expected to be received from the associated outlay. Short-term items should be financed with short-term funds, and long-term items should be financed with long-term funds. Long-term financing sources include both debt (borrowing) and equity (ownership). Equity financing comes either from selling new ownership interests or from retaining earnings. Financial managers try to select the mix of long-term debt and equity that results in the best balance between cost and risk.

### Debt versus Equity Financing

Say that the Boeing Company plans to spend $2 billion over the next four years to build and equip new factories to make jet aircraft. Boeing’s top management will assess the pros and cons of both debt and equity and then consider several possible sources of the desired form of long-term financing.
The major advantage of debt financing is the deductibility of interest expense for income tax purposes, which lowers its overall cost. In addition, there is no loss of ownership. The major drawback is financial risk: the chance that the firm will be unable to make scheduled interest and principal payments. The lender can force a borrower that fails to make scheduled debt payments into bankruptcy. Most loan agreements have restrictions to ensure that the borrower operates efficiently.
Equity, on the other hand, is a form of permanent financing that places few restrictions on the firm. The firm is not required to pay dividends or repay the investment. However, equity financing gives common stockholders voting rights that provide them with a voice in management. Equity is more costly than debt. Unlike the interest on debt, dividends to owners are not tax-deductible expenses.  summarizes the major differences between debt and equity financing.

### Debt Financing

Long-term debt is used to finance long-term (capital) expenditures. The initial maturities of long-term debt typically range between 5 and 20 years. Three important forms of long-term debt are term loans, bonds, and mortgage loans.
A term loan is a business loan with a maturity of more than one year. Term loans generally have maturities of 5 to 12 years and can be unsecured or secured. They are available from commercial banks, insurance companies, pension funds, commercial finance companies, and manufacturers’ financing subsidiaries. A contract between the borrower and the lender spells out the amount and maturity of the loan, the interest rate, payment dates, the purpose of the loan, and other provisions such as operating and financial restrictions on the borrower to control the risk of default. The payments include both interest and principal, so the loan balance declines over time. Borrowers try to arrange a repayment schedule that matches the forecast cash flow from the project being financed.
Bonds are long-term debt obligations (liabilities) of corporations and governments. A bond certificate is issued as proof of the obligation. The issuer of a bond must pay the buyer a fixed amount of money—called interest, stated as the coupon rate—on a regular schedule, typically every six months. The issuer must also pay the bondholder the amount borrowed—called the principal, or par value—at the bond’s maturity date (due date). Bonds are usually issued in units of $1,000—for instance, $1,000, $5,000, or $10,000—and have initial maturities of 10 to 30 years. They may be secured or unsecured, include special provisions for early retirement, or be convertible to common stock.
A mortgage loan is a long-term loan made against real estate as collateral. The lender takes a mortgage on the property, which lets the lender seize the property, sell it, and use the proceeds to pay off the loan if the borrower fails to make the scheduled payments. Long-term mortgage loans are often used to finance office buildings, factories, and warehouses. Life insurance companies are an important source of these loans. They make billions of dollars’ worth of mortgage loans to businesses each year.

### Summary of Learning Outcomes

1. What are the key differences between debt and equity, and what are the major types and features of long-term debt?
Financial managers must choose the best mix of debt and equity for their firm. The main advantage of debt financing is the tax-deductibility of interest. But debt involves financial risk because it requires the payment of interest and principal on specified dates. Equity—common and preferred stock—is considered a permanent form of financing on which the firm may or may not pay dividends. Dividends are not tax-deductible.
The main types of long-term debt are term loans, bonds, and mortgage loans. Term loans can be unsecured or secured and generally have maturities of 5 to 12 years. Bonds usually have initial maturities of 10 to 30 years. Mortgage loans are secured by real estate. Long-term debt usually costs more than short-term financing because of the greater uncertainty that the borrower will be able to make the scheduled loan payments.


# Understanding Financial Management and Securities Markets

## Equity Financing

1. When and how do firms issue equity, and what are the costs?
Equity refers to the owners’ investment in the business. In corporations, the preferred and common stockholders are the owners. A firm obtains equity financing by selling new ownership shares (external financing), by retaining earnings (internal financing), or for small and growing, typically high-tech, companies, through venture capital (external financing).

### Selling New Issues of Common Stock

Common stock is a security that represents an ownership interest in a corporation. A company’s first sale of stock to the public is called an initial public offering (IPO). An IPO often enables existing stockholders, usually employees, family, and friends who bought the stock privately, to earn big profits on their investment. (Companies that are already public can issue and sell additional shares of common stock to raise equity funds.)
But going public has some drawbacks. For one thing, there is no guarantee an IPO will sell. It is also expensive. Big fees must be paid to investment bankers, brokers, attorneys, accountants, and printers. Once the company is public, it is closely watched by regulators, stockholders, and securities analysts. The firm must reveal such information as operating and financial data, product details, financing plans, and operating strategies. Providing this information is often costly.
Going public is the dream of many small company founders and early investors, who hope to recoup their investments and become instant millionaires. Google, which went public in 2004 at $85 a share and soared to $475 in early 2006 before settling back to trade in the high-300 range in August 2006. More than a decade later, in October 2017, Google continues to be a successful IPO, trading at more than $990 per share.
In recent years, the number of IPOs has dropped sharply, as start-ups think long and hard about going public, despite the promise of millions of dollars for investors and entrepreneurs. For example, in 2017, Blue Apron, a meal-kit delivery service, went public with an opening stock price of $10 per share. Several months later, the share price dropped more than 40 percent. Some analysts believe that Amazon’s possible entry into the meal-kit delivery sector has hurt Blue Apron’s value, as well as the company’s high marketing costs to attract and retain monthly subscribers.
Some companies choose to remain private. Cargill, SC Johnson, Mars, Publix Super Markets, and Bloomberg are among the largest U.S. private companies.

### Dividends and Retained Earnings

Dividends are payments to stockholders from a corporation’s profits. Dividends can be paid in cash or in stock. Stock dividends are payments in the form of more stock. Stock dividends may replace or supplement cash dividends. After a stock dividend has been paid, more shares have a claim on the same company, so the value of each share often declines. A company does not have to pay dividends to stockholders. But if investors buy the stock expecting to get dividends and the firm does not pay them, the investors may sell their stocks.
At their quarterly meetings, the company’s board of directors (typically with the advice of its CFO) decides how much of the profits to distribute as dividends and how much to reinvest. A firm’s basic approach to paying dividends can greatly affect its share price. A stable history of dividend payments indicates good financial health. For example, cable giant Comcast has increased its dividend more than 20 percent over the past five years, giving shareholders a healthy return on their investment.
If a firm that has been making regular dividend payments cuts or skips a dividend, investors start thinking it has serious financial problems. The increased uncertainty often results in lower stock prices. Thus, most firms set dividends at a level they can keep paying. They start with a relatively low dividend payout ratio so that they can maintain a steady or slightly increasing dividend over time.
Retained earnings, profits that have been reinvested in the firm, have a big advantage over other sources of equity capital: They do not incur underwriting costs. Financial managers strive to balance dividends and retained earnings to maximize the value of the firm. Often the balance reflects the nature of the firm and its industry. Well-established and stable firms and those that expect only modest growth, such as public utilities, financial services companies, and large industrial corporations, typically pay out much of their earnings in dividends. For example, in the 2016 fiscal year, ExxonMobil paid dividends of $3.08 per share, Altria Group paid $2.64 per share, Apple paid $2.23 per share, and Costco paid $2.00 per share.
Most high-growth companies, such as those in technology-related fields, finance much of their growth through retained earnings and pay little or no dividends to stockholders. As they mature, many decide to begin paying dividends, as Apple decided to do in 2012, after 17 years of paying no annual dividends to shareholders.

### Preferred Stock

Another form of equity is preferred stock. Unlike common stock, preferred stock usually has a dividend amount that is set at the time the stock is issued. These dividends must be paid before the company can pay any dividends to common stockholders. Also, if the firm goes bankrupt and sells its assets, preferred stockholders get their money back before common stockholders do.
Like debt, preferred stock increases the firm’s financial risk because it obligates the firm to make a fixed payment. But preferred stock is more flexible. The firm can miss a dividend payment without suffering the serious results of failing to pay back a debt.
Preferred stock is more expensive than debt financing, however, because preferred dividends are not tax-deductible. Also, because the claims of preferred stockholders on income and assets are second to those of debtholders, preferred stockholders require higher returns to compensate for the greater risk.

### Venture Capital

Venture capital is another source of equity capital. It is most often used by small and growing firms that aren’t big enough to sell securities to the public. This type of financing is especially popular among high-tech companies that need large sums of money.
Venture capitalists invest in new businesses in return for part of the ownership, sometimes as much as 60 percent. They look for new businesses with high growth potential, and they expect a high investment return within 5 to 10 years. By getting in on the ground floor, venture capitalists buy stock at a very low price. They earn profits by selling the stock at a much higher price when the company goes public. Venture capitalists generally get a voice in management through seats on the board of directors. Getting venture capital is difficult, even though there are hundreds of private venture-capital firms in this country. Most venture capitalists finance only about 1 to 5 percent of the companies that apply. Venture-capital investors, many of whom experienced losses during recent years from their investments in failed dot-coms, are currently less willing to take risks on very early-stage companies with unproven technology. As a result, other sources of venture capital, including private foundations, states, and wealthy individuals (called angel investors), are helping start-up firms find equity capital. These private investors are motivated by the potential to earn a high return on their investment.

### Summary of Learning Outcomes

1. When and how do firms issue equity, and what are the costs?
The chief sources of equity financing are common stock, retained earnings, and preferred stock. The cost of selling stock includes issuing costs and potential dividend payments. Retained earnings are profits reinvested in the firm. For the issuing firm, preferred stock is more expensive than debt because its dividends are not tax-deductible and its claims are secondary to those of debtholders but less expensive than common stock. Venture capital is often a source of equity financing for young companies.


# Understanding Financial Management and Securities Markets

## Securities Markets

1. How do securities markets help firms raise funding, and what securities trade in the capital markets?
Stocks, bonds, and other securities trade in securities markets. These markets streamline the purchase and sales activities of investors by allowing transactions to be made quickly and at a fair price. Securities are investment certificates that represent either equity (ownership in the issuing organization) or debt (a loan to the issuer). Corporations and governments raise capital to finance operations and expansion by selling securities to investors, who in turn take on a certain amount of risk with the hope of receiving a profit from their investment.
Securities markets are busy places. On an average day, individual and institutional investors trade billions of shares of stock in more than 10,000 companies through securities markets. Individual investors invest their own money to achieve their personal financial goals. Institutional investors are investment professionals who are paid to manage other people’s money. Most of these professional money managers work for financial institutions, such as banks, mutual funds, insurance companies, and pension funds. Institutional investors control very large sums of money, often buying stock in 10,000-share blocks. They aim to meet the investment goals of their clients. Institutional investors are a major force in the securities markets, accounting for about half of the dollar volume of equities traded.

### Types of Markets

Securities markets can be divided into primary and secondary markets. The primary market is where new securities are sold to the public, usually with the help of investment bankers. In the primary market, the issuer of the security gets the proceeds from the transaction. A security is sold in the primary market just once—when the corporation or government first issues it. The Blue Apron IPO is an example of a primary market offering.
Later transactions take place in the secondary market, where old (already issued) securities are bought and sold, or traded, among investors. The issuers generally are not involved in these transactions. The vast majority of securities transactions take place in secondary markets, which include broker markets, dealer markets, the over-the-counter market, and the commodities exchanges. You’ll see tombstones, announcements of both primary and secondary stock and bond offerings, in the Wall Street Journal and other newspapers.

### The Role of Investment Bankers and Stockbrokers

Two types of investment specialists play key roles in the functioning of the securities markets. Investment bankers help companies raise long-term financing. These firms act as intermediaries, buying securities from corporations and governments and reselling them to the public. This process, called underwriting, is the main activity of the investment banker, which acquires the security for an agreed-upon price and hopes to be able to resell it at a higher price to make a profit. Investment bankers advise clients on the pricing and structure of new securities offerings, as well as on mergers, acquisitions, and other types of financing. Well-known investment banking firms include Goldman Sachs, Morgan Stanley, JP Morgan, Bank of America Merrill Lynch, and Citigroup.
A stockbroker is a person who is licensed to buy and sell securities on behalf of clients. Also called account executives, these investment professionals work for brokerage firms and execute the orders customers place for stocks, bonds, mutual funds, and other securities. Investors are wise to seek a broker who understands their investment goals and can help them pursue their objectives.
Brokerage firms are paid commissions for executing clients’ transactions. Although brokers can charge whatever they want, most firms have fixed commission schedules for small transactions. These commissions usually depend on the value of the transaction and the number of shares involved.

### Online Investing

Improvements in internet technology have made it possible for investors to research, analyze, and trade securities online. Today almost all brokerage firms offer online trading capabilities. Online brokerages are popular with “do-it-yourself” investors who choose their own stocks and don’t want to pay a full-service broker for these services. Lower transaction costs are a major benefit. Fees at online brokerages range from about $4.95 to $8.00, depending on the number of trades a client makes and the size of a client’s account. Although there are many online brokerage firms, the four largest—Charles Schwab, Fidelity, TD Ameritrade, and E*Trade—account for more than 80 percent of all trading volume and trillions in assets in customer accounts. The internet also offers investors access to a wealth of investment information.

### Investing in Bonds

When many people think of financial markets, they picture the equity markets. However, the bond markets are huge—the Securities Industry and Financial Markets Association (SIFMA) estimates that the global bond market is nearly $88 trillion. In the United States, companies and government entities sold about $2 billion in new bond issues in 2016. Average daily trading volume exceeded $760 billion, with U.S. Treasury securities accounting for more than 60 percent of the total.
Bonds can be bought and sold in the securities markets. However, the price of a bond changes over its life as market interest rates fluctuate. When the market interest rate drops below the fixed interest rate on a bond, it becomes more valuable, and the price rises. If interest rates rise, the bond’s price will fall. Corporate bonds, as the name implies, are issued by corporations. They usually have a par value of $1,000. They may be secured or unsecured (called debentures), include special provisions for early retirement, or be convertible to common stock. Corporations can also issue mortgage bonds, bonds secured by property such as land, buildings, or equipment. Approximately $1.5 trillion in new corporate bonds were issued in 2016.
In addition to regular corporate debt issues, investors can buy high-yield, or junk, bonds—high-risk, high-return bonds often used by companies whose credit characteristics would not otherwise allow them access to the debt markets. They generally earn 3 percent or more above the returns on high-quality corporate bonds. Corporate bonds may also be issued with an option for the bondholder to convert them into common stock. These convertible bonds generally allow the bondholder to exchange each bond for a specified number of shares of common stock.

### U.S. Government Securities and Municipal Bonds

Both the federal government and local government agencies also issue bonds. The U.S. Treasury sells three major types of federal debt securities: Treasury bills, Treasury notes, and Treasury bonds. All three are viewed as default-risk-free because they are backed by the U.S. government. Treasury bills mature in less than a year and are issued with a minimum par value of $1,000. Treasury notes have maturities of 10 years or less, and Treasury bonds have maturities as long as 25 years or more. Both notes and bonds are sold in denominations of $1,000 and $5,000. The interest earned on government securities is subject to federal income tax but is free from state and local income taxes. According to SIFMA, a total of $1.7 trillion U.S. treasuries were issued in 2016, down 20 percent from 2015.
Municipal bonds are issued by states, cities, counties, and other state and local government agencies. Almost $445.8 billion in municipal bonds were issued in 2016. These bonds typically have a par value of $5,000 and are either general obligation or revenue bonds. General obligation bonds are backed by the full faith and credit (and taxing power) of the issuing government. Revenue bonds, on the other hand, are repaid only from income generated by the specific project being financed. Examples of revenue bond projects include toll highways and bridges, power plants, and parking structures. Because the issuer of revenue bonds has no legal obligation to back the bonds if the project’s revenues are inadequate, they are considered more risky and therefore have higher interest rates than general obligation bonds.
Municipal bonds are attractive to investors because interest earned on them is exempt from federal income tax. For the same reason, the coupon interest rate for a municipal bond is lower than for a similar-quality corporate bond. In addition, interest earned on municipal bonds issued by governments within the taxpayer’s home state is exempt from state income tax as well. In contrast, all interest earned on corporate bonds is fully taxable.

### Bond Ratings

Bonds vary in quality, depending on the financial strength of the issuer. Because the claims of bondholders come before those of stockholders, bonds are generally considered less risky than stocks. However, some bonds are in fact quite risky. Companies can default—fail to make scheduled interest or principal payments—on their bonds. Investors can use bond ratings, letter grades assigned to bond issues to indicate their quality or level of risk. Ratings for corporate bonds are easy to find. The two largest and best-known rating agencies are Moody’s and Standard & Poor’s (S&P), whose publications are in most libraries and in stock brokerages.  lists the letter grades assigned by Moody’s and S&P. A bond’s rating may change if a company’s financial condition changes.

### Other Popular Securities

In addition to stocks and bonds, investors can buy mutual funds, a very popular investment category, or exchange-traded funds (ETFs). Futures contracts and options are more complex investments for experienced investors.

### Mutual Funds

Suppose that you have $1,000 to invest but don’t know which stocks or bonds to buy, when to buy them, or when to sell them. By investing in a mutual fund, you can buy shares in a large, professionally managed portfolio, or group, of stocks and bonds. A mutual fund is a financial-service company that pools its investors’ funds to buy a selection of securities—marketable securities, stocks, bonds, or a combination of securities—that meet its stated investment goals. Each mutual fund focuses on one of a wide variety of possible investment goals, such as growth or income. Many large financial-service companies, such as Fidelity and Vanguard, sell a wide variety of mutual funds, each with a different investment goal. Investors can pick and choose funds that match their particular interests. Some specialized funds invest in a particular type of company or asset: in one industry such as health care or technology, in a geographical region such as Asia, or in an asset such as precious metals.
Mutual funds are one of the most popular investments for individuals today: they can choose from about 9,500 different funds. Investments in mutual funds are more than $40 trillion worldwide, of which U.S. mutual funds hold more than $19 trillion. About 94 million individuals, representing 55 percent of all U.S. households, own mutual funds. Mutual funds appeal to investors for three main reasons:
1. They are a good way to hold a diversified, and thus less risky, portfolio. Investors with only $500 or $1,000 to invest cannot diversify much on their own. Buying shares in a mutual fund lets them own part of a portfolio that may contain 100 or more securities.
2. Mutual funds are professionally managed.
3. Mutual funds may offer higher returns than individual investors could achieve on their own.

### Exchange-Traded Funds

Another type of investment, the exchange-traded fund (ETF), has become very popular with investors. ETFs are similar to mutual funds because they hold a broad basket of stocks with a common theme, giving investors instant diversification. ETFs trade on stock exchanges (most trade on the American Stock Exchange, AMEX), so their prices change throughout the day, whereas mutual fund share prices, called net asset values (NAVs), are calculated once a day, at the end of trading. Worldwide, ETF assets in 2016 were more than $3.5 trillion, with the U.S. ETF market accounting for 73 percent of the global market.
Investors can choose from more than 1,700 ETFs that track almost any market sector, from a broad market index such as the S&P 500 (described later in this chapter), industry sectors such as health care or energy, and geographical areas such as a particular country (Japan) or region (Latin America). ETFs have very low expense ratios. However, because they trade as stocks, investors pay commissions to buy and sell these shares.

### Futures Contracts and Options

Futures contracts are legally binding obligations to buy or sell specified quantities of commodities (agricultural or mining products) or financial instruments (securities or currencies) at an agreed-on price at a future date. An investor can buy commodity futures contracts in cattle, pork bellies (large slabs of bacon), eggs, coffee, flour, gasoline, fuel oil, lumber, wheat, gold, and silver. Financial futures include Treasury securities and foreign currencies, such as the British pound or Japanese yen. Futures contracts do not pay interest or dividends. The return depends solely on favorable price changes. These are very risky investments because the prices can vary a great deal.
Options are contracts that entitle holders to buy or sell specified quantities of common stocks or other financial instruments at a set price during a specified time. As with futures contracts, investors must correctly guess future price movements in the underlying financial instrument to earn a positive return. Unlike futures contracts, options do not legally obligate the holder to buy or sell, and the price paid for an option is the maximum amount that can be lost. However, options have very short maturities, so it is easy to quickly lose a lot of money with them.

### Summary of Learning Outcomes

1. How do securities markets help firms raise funding, and what securities trade in the capital markets?
Securities markets allow stocks, bonds, and other securities to be bought and sold quickly and at a fair price. New issues are sold in the primary market. After that, securities are traded in the secondary market. Investment bankers specialize in issuing and selling new security issues. Stockbrokers are licensed professionals who buy and sell securities on behalf of their clients.
In addition to corporate securities, investors can trade U.S. government Treasury securities and municipal bonds, mutual funds, futures, and options. Mutual funds are managed by financial-service companies that pool the funds of many investors to buy a diversified portfolio of securities. Investors choose mutual funds because they offer a convenient way to diversify and are professionally managed. Exchange-traded funds (ETFs) are similar to mutual funds but trade on stock exchanges similar to common stock. Futures contracts are legally binding obligations to buy or sell specified quantities of commodities or financial instruments at an agreed-on price at a future date. They are very risky investments because the price of the commodity or financial instrument may change drastically. Options are contracts that entitle the holder the right to buy or sell specified quantities of common stock or other financial instruments at a set price during a specified time. They, too, are high-risk investments.


# Understanding Financial Management and Securities Markets

## Buying and Selling at Securities Exchanges

1. Where can investors buy and sell securities, and how are securities markets regulated?
When we think of stock markets, we are typically referring to secondary markets, which handle most of the securities trading activity. The two segments of the secondary markets are broker markets and dealer markets, as  shows. The primary difference between broker and dealer markets is the way each executes securities trades. Securities trades can also take place in alternative market systems and on non-U.S. securities exchanges.
The securities markets both in the United States and around the world are in flux and undergoing tremendous changes. We present the basics of securities exchanges in this section and discuss the latest trends in the global securities markets later in the chapter.

### Broker Markets

The broker market consists of national and regional securities exchanges that bring buyers and sellers together through brokers on a centralized trading floor. In the broker market, the buyer purchases the securities directly from the seller through the broker. Broker markets account for about 60 percent of the total dollar volume of all shares traded in the U.S. securities markets.

### New York Stock Exchange

The oldest and most prestigious broker market is the New York Stock Exchange (NYSE), which has existed since 1792. Often called the Big Board, it is located on Wall Street in downtown New York City. The NYSE, which lists the shares of some 2,400 corporations, had a total market capitalization (domestic and foreign companies) of $25.8 trillion at year-end 2016. On a typical day, more than 3 billion shares of stock are traded on the NYSE. It represents 90 percent of the trading volume in the U.S. broker marketplace. Major companies such as IBM, Coca-Cola, AT&T, Procter & Gamble, Ford Motor Co., and Chevron list their shares on the NYSE. Companies that list on the NYSE must meet stringent listing requirements and annual maintenance requirements, which give them creditability.
The NYSE is also popular with non-U.S. companies. More than 490 foreign companies with a global market capitalization of almost $63 trillion now list their securities on the NYSE.
Until recently, all NYSE transactions occurred on the vast NYSE trading floor. Each of the companies traded at the NYSE is assigned to a trading post on the floor. When an exchange member receives an order to buy or sell a particular stock, the order is transmitted to a floor broker at the company’s trading post. The floor brokers then compete with other brokers on the trading floor to get the best price for their customers.
In response to competitive pressures from electronic exchanges, the NYSE created a hybrid market that combines features of the floor auction market and automated trading. Its customers now have a choice of how they execute trades. In the trends section, we’ll discuss other changes the NYSE is making to maintain a leadership position among securities exchanges.
Another national stock exchange, the American Stock Exchange (AMEX), lists the securities of more than 700 corporations but handles only 4 percent of the annual share volume of shares traded on U.S. securities exchanges. Because the AMEX’s rules are less strict than those of the NYSE, most AMEX firms are smaller and less well known than NYSE-listed corporations. Some firms move up to the NYSE once they qualify for listing there. Other companies choose to remain on the AMEX. Companies cannot be listed on both exchanges at the same time. The AMEX has become a major market, however, for exchange-traded funds and in options trading.

### Regional Exchanges

The remaining 6 percent of annual share volume takes place on several regional exchanges in the United States. These exchanges list about 100 to 500 securities of firms located in their area. Regional exchange membership rules are much less strict than for the NYSE. The top regional exchanges are the Boston, Chicago, Philadelphia, and National (formerly the Cincinnati) exchanges. An electronic network linking the NYSE and many of the regional exchanges allows brokers to make securities transactions at the best prices.
The regional exchanges, which have struggled to compete, benefited from the passage of the Securities and Exchange Commission’s (SEC’s) Regulation NMS (National Market System), which became fully effective in 2007. Regulation NMS makes price the most important factor in making securities trades, and all orders must go to the trading venue with the best price.

### Dealer Markets

Unlike broker markets, dealer markets do not operate on centralized trading floors but instead use sophisticated telecommunications networks that link dealers throughout the United States. Buyers and sellers do not trade securities directly, as they do in broker markets. They work through securities dealers called market makers, who make markets in one or more securities and offer to buy or sell securities at stated prices. A security transaction in the dealer market has two parts: the selling investor sells his or her securities to one dealer, and the buyer purchases the securities from another dealer (or in some cases, the same dealer).

### NASDAQ

The largest dealer market is the National Association of Securities Dealers Automated Quotation system, commonly referred to as NASDAQ. The first electronic-based stock market, the NASDAQ is a sophisticated telecommunications network that links dealers throughout the United States. Founded in 1971 with origins in the over-the-counter (OTC) market, today NASDAQ is a separate securities exchange that is no longer part of the OTC market. The NASDAQ lists more companies than the NYSE, but the NYSE still leads in total market capitalization. An average of 1.6 billion shares were exchanged daily in 2016 through NASDAQ, which is now the largest electronic stock market. It provides up-to-date bid and ask prices on about 3,700 of the most active OTC securities. Its sophisticated electronic communication system provides faster transaction speeds than traditional floor markets and is the main reason for the popularity and growth of the OTC market.
In January 2006, the SEC approved NASDAQ’s application to operate as a national securities exchange. As a result, the NASDAQ Stock Market LLC began operating independently in August 2006. The securities of many well-known companies, some of which could be listed on the organized exchanges, trade on the NASDAQ. Examples include Amazon, Apple, Costco, Comcast, JetBlue, Microsoft, Qualcomm, and Starbucks. The stocks of most commercial banks and insurance companies also trade in this market, as do most government and corporate bonds. More than 400 foreign companies also trade on the NASDAQ.
More than a decade ago, the NASDAQ changed its structure to a three-tier market:
1. The NASDAQ Global Select Market, a new tier with “financial and liquidity requirements that are higher than those of any other market,” according to NASDAQ. More than 1,000 NASDAQ companies qualify for this group.
2. The NASDAQ Global Market (formerly the NASDAQ National Market), which will list about 1,650 companies.
3. The NASDAQ Capital Market will replace the NASDAQ Small Cap Market and list about 550 companies.
All three market tiers adhere to NASDAQ’s rigorous listing and corporate governance standards.

### The Over-the-Counter Market

The over-the-counter (OTC) markets refer to those other than the organized exchanges described above. There are two OTC markets: the Over-the-Counter Bulletin Board (OTCBB) and the Pink Sheets. These markets generally list small companies and have no listing or maintenance standards, making them attractive to young companies looking for funding. OTC companies do not have to file with the SEC or follow the costly provisions of Sarbanes-Oxley. Investing in OTC companies is therefore highly risky and should be for experienced investors only.

### Alternative Trading Systems

In addition to broker and dealer markets, alternative trading systems such as electronic communications networks (ECNs) make securities transactions. ECNs are private trading networks that allow institutional traders and some individuals to make direct transactions in what is called the fourth market. ECNs bypass brokers and dealers to automatically match electronic buy and sell orders. They are most effective for high-volume, actively traded stocks. Money managers and institutions such as pension funds and mutual funds with large amounts of money to invest like ECNs because they cost far less than other trading venues.

### Global Trading and Foreign Exchanges

Improved communications and the elimination of many legal barriers are helping the securities markets go global. The number of securities listed on exchanges in more than one country is growing. Foreign securities are now traded in the United States. Likewise, foreign investors can easily buy U.S. securities.
Stock markets also exist in foreign countries: more than 60 countries operate their own securities exchanges. NASDAQ ranks second to the NYSE, followed by the London Stock Exchange (LSE) and the Tokyo Stock Exchange. Other important foreign stock exchanges include Euronext (which merged with the NYSE but operates separately) and those in Toronto, Frankfurt, Hong Kong, Zurich, Australia, Paris, and Taiwan. The number of big U.S. corporations with listings on foreign exchanges is growing steadily, especially in Europe. For example, significant activity in NYSE-listed stocks also occurs on the LSE. The LSE also is getting a growing share of the world’s IPOs. Emerging markets such as India, whose economy has been growing 6 percent or more a year, continue to attract investor attention. The Sensex, the benchmark index of the Bombay Stock Exchange, increased close to 40 percent between 2013 and 2017 as foreign investors continue to pump billions into Indian stocks.
Why should U.S. investors pay attention to international stock markets? Because the world’s economies are increasingly interdependent, businesses must look beyond their own national borders to find materials to make their goods and markets for foreign goods and services. The same is true for investors, who may find that they can earn higher returns in international markets.

### Regulation of Securities Markets

Both state and federal governments regulate the securities markets. The states were the first to pass laws aimed at preventing securities fraud. But most securities transactions occur across state lines, so federal securities laws are more effective. In addition to legislation, the industry has self-regulatory groups and measures.

### Securities Legislation

Congress passed the Securities Act of 1933 in response to the 1929 stock market crash and subsequent problems during the Great Depression. It protects investors by requiring full disclosure of information about new securities issues. The issuer must file a registration statement with the SEC, which must be approved by the SEC before the security can be sold.
The Securities Exchange Act of 1934 formally gave the SEC power to regulate securities exchanges. The act was amended in 1964 to give the SEC authority over the dealer markets as well. The amendment included rules for operating the stock exchanges and granted the SEC control over all participants (exchange members, brokers, dealers) and the securities traded in these markets.
The 1934 act also banned insider trading, the use of information that is not available to the general public to make profits on securities transactions. Because of lax enforcement, however, several big insider trading scandals occurred during the late 1980s. The Insider Trading and Fraud Act of 1988 greatly increased the penalties for illegal insider trading and gave the SEC more power to investigate and prosecute claims of illegal actions. The meaning of insider was expanded beyond a company’s directors, employees, and their relatives to include anyone who gets private information about a company.
Other important legislation includes the Investment Company Act of 1940, which gives the SEC the right to regulate the practices of investment companies (such as mutual funds managed by financial institutions), and the Investment Advisers Act of 1940, which requires investment advisers to disclose information about their background. The Securities Investor Protection Corporation (SIPC) was established in 1970 to protect customers if a brokerage firm fails, by insuring each customer’s account for up to $500,000.
In response to corporate scandals that hurt thousands of investors, the SEC passed new regulations designed to restore public trust in the securities industry. It issued Regulation FD (for “fair disclosure”) in October 2000. Regulation FD requires public companies to share information with all investors at the same time, leveling the information playing field. The Sarbanes-Oxley Act of 2002 has given the SEC more power when it comes to regulating how securities are offered, sold, and marketed.

### Self-Regulation

The investment community also regulates itself, developing and enforcing ethical standards to reduce the potential for abuses in the financial marketplace. The Financial Industry Regulatory Authority (FINRA) oversees the nation’s more than 3,700 brokerage firms and more 600,000 registered brokers. It develops rules and regulations, provides a dispute resolution forum, and conducts regulatory reviews of member activities for the protection and benefit of investors.
In response to “Black Monday”—October 19, 1987, when the Dow Jones Industrial Average plunged 508 points and the trading activity severely overloaded the exchange’s computers—the securities markets instituted corrective measures to prevent a repeat of the crisis. Now, under certain conditions, circuit breakers stop trading for a 15-minute cooling-off period to limit the amount the market can drop in one day. Under revised rules approved in 2012 by the SEC, market-wide circuit breakers kick in when the S&P 500 Index drops 7 percent (level 1), 13 percent (level 2), and 20 percent (level 3) from the prior day’s closing numbers.

### Summary of Learning Outcomes

1. Where can investors buy and sell securities, and how are securities markets regulated?
Securities are resold in secondary markets, which include both broker markets and dealer markets. The broker market consists of national and regional securities exchanges, such as the New York Stock Exchange, that bring buyers and sellers together through brokers on a centralized trading floor. Dealer markets use sophisticated telecommunications networks that link dealers throughout the United States. The NASDAQ and over-the-counter markets are examples of dealer markets. In addition to broker and dealer markets, electronic communications networks (ECNs) can be used to make securities transactions. In addition to the U.S. markets, more than 60 countries have securities exchanges. The largest non-U.S. exchanges are the London, Tokyo, Toronto, Frankfurt, Hong Kong, and Taiwan exchanges.
The Securities Act of 1933 requires disclosure of important information regarding new securities issues. The Securities Exchange Act of 1934 and its 1964 amendment formally empowered the Securities and Exchange Commission and granted it broad powers to regulate the securities exchanges and the dealer markets. The Investment Company Act of 1940 places investment companies such as companies that issue mutual funds under SEC control. The securities markets also have self-regulatory groups such as the Financial Industry Regulatory Authority (FINRA) and measures such as “circuit breakers” to halt trading if the S&P 500 Index drops rapidly.