1.1: Introducing Finance

1.1.1: Defining Finance

Finance is the study of fund management and asset allocation over time.

Learning Objective

Explain the importance of time to the discipline of finance

Key Points

The two main drivers of finance are the time value of money and risk.
Since the value of assets changes over time, finance seeks to ensure the change is beneficial for the organization or individual.
Financial professionals generally operate in an environment of uncertainty where they must make forecasts about future events.

Key Terms

debtor: A person or firm that owes money, one in debt, or one who owes a debt.
asset: Something or someone of any value; any portion of one’s property or effects so considered.
investment: A placement of capital in expectation of deriving income or profit from its use.

Overview

Finance is the study of fund management and asset allocation over time. Funds consist of money and other assets. There are many different types of finance, but all are fundamentally concerned with studying how best to allocate assets in different conditions over time.

Importance of Time

The underlying driver behind all of finance is time. There are two reasons why time is so important to finance:

Time value of money: For a number of reasons, money today is worth more than the same amount of money in the future. For example, you would rather have $100 today than $100 in 10 years – the money is worth more to you now than it would be in the distant future. We will explore this concept in greater depth later on.
Risk: Making an investment does not guarantee a return. When a bank makes a loan, they’re not sure the debtor will pay it back. There is a risk that the person will just take the money and run, the debtor will file for bankruptcy, or, for dozens of other reasons, the bank will not get the money they lent back.

The field of finance, however, embraces time. Finance says, “Since I know assets change value over time, how do I use that to cause my assets to change value in the direction I want? How do I manage assets so that they’re worth more in the future than they are today? “

Challenges in Finance

Figuring out what to do with assets is sometimes easy: all of the variables are known, and there is clearly an option that is better than all the others. However, most of the time, this is not the case. Finance generally operates with a lot of uncertainty. As a result, companies hire entire departments of people to help them figure out which option is best .

Walmart CFO

Charles Holley, the Chief Financial Officer (CFO) of Wal-Mart, is in charge of making sure all of Wal-Mart’s assets are allocated as optimally as possible.

1.1.2: Comparing the Fields of Finance, Economics, and Accounting

Finance, economics, and accounting are business subjects with many similarities and differences; each is a distinct field of study.

Learning Objective

Recognize how finance, economics and accounting overlap.

Key Points

Finance is the study of how to optimally allocate assets. Finance is fundamentally a forward looking field, concerned with what an asset will be worth in the future.
Economics is the social science that analyzes the production, distribution, and consumption of goods and services.
Accounting is the process of communicating financial information about a business. Accounting is fundamentally a backward-looking field.

Key Term

return: Gain or loss from an investment.

Finance, economics, and accounting are business subjects with many similarities and differences. While they influence each other, each is a distinct field of study.

Finance

Finance is the study of how to optimally allocate assets—how individuals and organizations should invest assets in order to get the highest possible return given changing conditions over time. Finance is fundamentally a forward looking field, concerned with what an asset will be worth in the future.

Economics

Economics is a social science that analyzes the production, distribution, and consumption of goods and services. It focuses on how economic agents (people, businesses, and government) interact and make decisions. Economics is fundamentally the study of cause and effect. It tries to figure out how one variable affects economic agents or the economy as a whole.

Accounting

Accounting focuses on communicating a businesses’ financial information. Accounting is fundamentally a backward-looking field, concerned with what has already happened financially and what position that leaves the company in today.

If accounting is called the language of business, then the financial statements that accountants prepare are the words . Statements are created under a standardized set of accounting laws, which allows one to easily compare and contrast companies. This indicates how financially healthy a company is.

Balance Sheet

The balance sheet is one of the three main financial statements. The other two are the cash flow statement and the income statement.

Overlap

Finance, economics, and accounting overlap in a lot of areas. For example, an investor will use accounting to see whether a company has shown past financial success and to predict what the company will look like in the future. Part of that prediction incorporates economics. The investor wants to know what the overall economy will look like in the future and wants to know how the company will interact with its competitors. The investor can use finance to figure out what his or her investment will be worth in the future.

There are few strong delineators between finance, economics and accounting. All three fields intermingle and influence one another. It is almost impossible to have a strong grasp of one without at least a basic understanding of the other two.

1.1.3: Role of Finance in an Organization

The primary role of corporate finance is to determine how best to maximize shareholder value.

Learning Objective

Define the role of finance in an organization

Key Points

Maximizing shareholder value can be done over the long-term or the short-term, so the job of the finance department is to determine how best to do both. Sometimes, the goals may appear to contradict each other.
The finance department is devoted to the task of figuring out how to allocate assets for the overarching goal of maximizing shareholder value. They must ensure that the right assets are in the right place at the right time.
The finance department must also manage the company’s liabilities so that all projects are financed in an optimal way without taking on too much risk.

Key Terms

liability: An obligation, debt or responsibility owed to someone.
asset: Something or someone of any value; any portion of one’s property or effects so considered.
shareholder: One who owns shares of stock.

Corporate finance is the area of finance dealing with monetary decisions that business enterprises make. When finance is talked about in the context of business decisions, it is called corporate finance (technically, corporate finance deals only with corporations, while managerial finance deals with all types of companies, but we will use the terms interchangeably). There are other branches of finance such as personal finance (individuals taking care of their money) and public finance (the finances of the government).

The primary goal of corporate finance is to maximize shareholder value. Maximizing shareholder value can be done over the long-term or the short-term, so the job of the finance department is to determine how best to do both. Sometimes, the goals may appear to be in competition with one another. For example, a company can choose to pay dividends (a small payment to each person who owns a stock of a company), which increases short-term shareholder wealth. However, paying dividends means that the money is not being invested in long-term investments, which may cause the stock price to increase more in the future, and thereby increasing long-term shareholder wealth.

The technique behind maximizing shareholder value is the management of assets. This means that the finance department figures out how to best invest its money.

For example, a company could have two proposals from the R&D department to develop different products, but only enough money to fund one . The finance department will project out the future revenues and costs of each product and figure out which one, if either, is worth the money.

iPod Touch

Apple used financial analysis to decide to fund the development of the iPod. The money allocated development could not be used for another project, but the finance department determined the iPod was the best option.

Also, the finance department will determine when a company should take on a liability. For example, suppose both projects are absolute home-runs, but the company still only has enough money to fund one. The finance department will figure out if the company should borrow money so that it can fund both.

The role of finance in an organization is to make sure that money is at the right place at the right time. A company wants to have enough money to pay its bills, but also wants to invest so that it can grow in the future. The finance department is devoted to the task of figuring out how to allocate assets to do so, for the overarching goal of maximizing shareholder value.

1.1.4: Types of Financial Decisions: Investment and Financing

Investment and financing decisions boil down to how to spend money and how to borrow money.

Learning Objective

Identify the criteria a corporation must use when making a financial decision

Key Points

The primary goal of both investment and financing decisions is to maximize shareholder value.
Investment decisions revolve around how to best allocate capital to maximize their value.
Financing decisions revolve around how to pay for investments and expenses. Companies can use existing capital, borrow, or sell equity.

Key Terms

equity: Ownership, especially in terms of net monetary value, of a business.
expected return: Considering the magnitude and likelihood of exogenous events, the yield that an investor predicts s/he will earn on average.
financing: A transaction that provides funds for a business.

There are two fundamental types of financial decisions that the finance team needs to make in a business: investment and financing. The two decisions boil down to how to spend money and how to borrow money. Recall that the overall goal of financial decisions is to maximize shareholder value, so every decision must be put in that context.

Investment

An investment decision revolves around spending capital on assets that will yield the highest return for the company over a desired time period. In other words, the decision is about what to buy so that the company will gain the most value.

To do so, the company needs to find a balance between its short-term and long-term goals. In the very short-term, a company needs money to pay its bills, but keeping all of its cash means that it isn’t investing in things that will help it grow in the future. On the other end of the spectrum is a purely long-term view. A company that invests all of its money will maximize its long-term growth prospects, but if it doesn’t hold enough cash, it can’t pay its bills and will go out of business soon. Companies thus need to find the right mix between long-term and short-term investment.

The investment decision also concerns what specific investments to make. Since there is no guarantee of a return for most investments, the finance department must determine an expected return. This return is not guaranteed, but is the average return on an investment if it were to be made many times.

The investments must meet three main criteria:

It must maximize the value of the firm, after considering the amount of risk the company is comfortable with (risk aversion).
It must be financed appropriately (we will talk more about this shortly).
If there is no investment opportunity that fills (1) and (2), the cash must be returned to shareholder in order to maximize shareholder value.

Financing

All functions of a company need to be paid for one way or another. It is up to the finance department to figure out how to pay for them through the process of financing.

There are two ways to finance an investment: using a company’s own money or by raising money from external funders. Each has its advantages and disadvantages.

There are two ways to raise money from external funders: by taking on debt or selling equity. Taking on debt is the same as taking on a loan. The loan has to be paid back with interest, which is the cost of borrowing. Selling equity is essentially selling part of your company . When a company goes public, for example, they decide to sell their company to the public instead of to private investors. Going public entails selling stocks which represent owning a small part of the company. The company is selling itself to the public in return for money.

NYSE

If a company chooses to finance an investment by selling equity, they may issue stocks on an exchange like the New York Stock Exchange

Every investment can be financed through company money or from external funders. It is the financing decision process that determines the optimal way to finance the investment.

1.1.5: Functions of Corporate Finance

Corporate finance utilizes tools and analysis to make sound financial business decisions.

Learning Objective

Describe the role of finance in corporation

Key Points

The finance group is in charge of budgeting. It will look for the optimal allocation of assets across all business functions.
Corporate finance decides how best to finance projects. The department can either use existing internal funds, borrow money, or sell equity.
The finance group must balance both short- and long-term company goals, though the overarching goal is to maximize shareholder value.

Key Terms

investment: A placement of capital in expectation of deriving income or profit from its use.
finance: To provide or obtain funding for a transaction or undertaking; to back; to support.

Corporate finance deals with monetary decisions that business enterprises make and the tools and analysis utilized to make the decisions. Corporate finance is concerned primarily with making investment and financing decisions; that is, making sure that money is being used in the best way.

The corporate finance department of a company is in charge of budgeting. Management must allocate limited resources between competing opportunities; since a dollar cannot be used for more than one project at once, it is a challenge to determine how much money should be allocated to each part of the business.

In determining how to allocate money, the finance group must also figure out where the money will be best utilized. This requires valuing projects and business functions. A large element of finance is deciding how exactly to value a project. There are a number of variables – inflation, expected revenues, expected costs, length of time required – that are all incorporated into the valuation process. Finding the true value of a project is often wrought with uncertainty, but without an accurate valuation, a company may allocate its resources sub-optimally.

The corporate finance department must also determine how to finance projects. A company can finance a project by using either internal funds (money the company already has), borrowing, or selling equity. Each option carries a certain cost that can be quantified. It is the job of the finance department to make sure that the overall cost isn’t too high and that the company has an optimal mix of all three strategies.

One public job function of corporate finance is determining whether or not the company pays a dividend, and if so, how much. The company has a responsibility to maximize shareholder value, but that can be achieved in multiple ways. Paying a dividend puts cash directly in the hands of shareholders, increasing shareholder value. However, paying a dividend means that money is not being reinvested in the company. If a company doesn’t pay a dividend and instead chooses to reinvest the money, the value of the company will presumably increase, in turn increasing shareholder value. The finance department determines which option maximizes shareholder value.

Lastly, the finance department must also ensure that there is a good balance between long- and short-term goals. The company must have enough assets to cover short-term costs, referred to as working capital management, and enough invested to ensure the company has long-term growth .

Factory

Purchasing new machinery requires a valuation of all equipment, an accurate idea of the total cost over time, and a way to finance the purchase while leaving enough cash for other upcoming costs.

1.1.6: Overview of the Role of Financial Manager

The financial manager is responsible for budgeting, projecting cash flows, and determining how to invest and finance projects.

Learning Objective

Describe the role and skills of a financial manager

Key Points

The finance manager is responsible for knowing how much the product is expected to cost and how much revenue it is expected to earn so that s/he can invest the appropriate amount in the product.
The finance manager uses a number of tools, such as setting the cost of capital (the cost of money over time, which will be explored in further depth later on) to determine the cost of financing.
The financial manager must not just be an expert at financial projections; s/he also must have a grasp of the accounting systems in place and the strategy of the business over the coming years.
The head of the financial department is the chief financial officer (CFO) who is responsible for all financial decisions and reporting done in the company.

Key Term

capital: Money and wealth; the means to acquire goods and services, especially in a non-barter system.

The Role of the Financial Manager

The role of a financial manager is a complex one, requiring both an understanding of how the business functions as a whole and specialized financial knowledge. The head of the financial operations is called the chief financial officer (CFO).

The structure of the company varies, but a financial manager is responsible for the same general things across the board. The manager is responsible for managing the budget. This involves allocating money to different projects and segments so that the business can continue operating, but the best projects get the necessary funding.

The manager is responsible for figuring out the financial projections for the business. The development of a new product, for example, requires an investment of capital over time. The finance manager is responsible for knowing how much the product is expected to cost and how much revenue it is expected to earn so that s/he can invest the appropriate amount in the product. This is a lot tougher than it sounds because there is no accurate financial data for the future. The finance manager will use data analyses and educated guesses to approximate the value, but it’s extremely rare that s/he can be 100% sure of the future cash flows.

Figuring out the value of an operation is one thing, but it is another thing to figure out if it’s worth financing. There is a cost to investing money, either the opportunity cost of not investing it elsewhere, the cost of borrowing money, or the cost of selling equity. The finance manager uses a number of tools, such as setting the cost of capital (the cost of money over time, which will be explored in further depth later on) to determine the cost of financing.

At the same time that this is going on, the financial manager must also ensure that the business has enough cash to pay upcoming financial obligations without hoarding assets that could otherwise be invested. This is a delicate dance between short-term and long-term responsibilities.

The CFO is the head of the financial department and is responsible for all of the same things as his/her subordinates, but is also the person who has to sign off that all of the company’s financial statements are accurate. S/he is also responsible for financial planning and record-keeping, as well as financial reporting to higher management.

The financial manager is not just an expert at financial projections, s/he must also have a grasp of the accounting systems in place and the strategy of the business over the coming years .

Collaboration

The finance manager must collaborate across business functions in order to determine how to best allocate and manage assets.

1.1.7: Reasons to Study Finance

Finance is relevant to all business functions, the macroeconomy, and personal finances.

Learning Objective

List the reasons why a person would want to study finance

Key Points

Finance plays an involved role in the health of the overall economy, which impacts everyone, regardless of whether or not they have studied finance.
Like companies, individuals are faced with investment and financing decisions. Having a firm grasp of finance will help individuals make those decisions.
All businesses functions deal with finance because they need to be able to make the financial argument for the funding of their projects and to manage their budgets.

Key Term

leverage: The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return (usually at high risk).

The study of finance often feels a lot narrower than it really is. There is a lot of talk of issuing bonds or pricing projects which belies how relevant finance is to everyday life, regardless of whether or not you have any desire of working in finance.

Understanding the Economic Environment

Finance plays an involved role in the health of the overall economy, which impacts everyone, regardless of whether or not they have studied finance. The field of finance explains why the 2008 recession occurred; it is the reason why people care about how the stock market is doing each day ; and it articulates why businesses and governments make some of the decisions they do.

Random Walk

Stock market cannot be predicted.

Finance plays a role in many of the stories in the news every day, which means that those who understand finance have a better grasp on how the events of the world affect them.

Personal Finances

Each person will also have to manage his or her own personal finances. Like corporations, individuals are faced with investment and financing decisions. In order to invest, individuals must be able to do the same projections and valuations as companies in order to determine the best investment for their needs. Individuals cannot sell equity like corporations, but they can choose to either dip into their savings or take out loans. Many take on debt in the form of student loans, mortgages, or through their credit cards; being able to properly compare options to leverage is just as important for individuals as it is for companies.

Application to Business

Of course, finance is an important field of study for those who have a desire of working in finance or accounting. Finance is heavily used in jobs ranging from investment banker to CFO to venture capitalist.

However, finance is not segmented from the other functions in business. Every job from marketing to engineering has to be able to manage a budget and make a business case that it should get funding for a project.

This is especially true higher up in the organizational hierarchy: managers, directors, and vice presidents need to be able to articulate why their departments should get financial support from the company.

Finance is a field of both hard analytical skill and personal judgement. There are set processes and theories for determining which financial option is best, but in the real world, it is rare to have all of the information needed to be absolutely certain about what to do. Finance develops strong analytical skills, but also the degree of finesse required to operate in an environment of uncertainty.

Silver Bid Chart

Finance helps explain what trends in silver bids mean, but more importantly, why people care about them (even those not trading silver).

1.2: Goals of Financial Management

1.2.1: Valuation

Valuation, a goal of financial management, often relies on fundamental analysis of financial statements.

Learning Objective

Describe the valuation process

Key Points

In finance, valuation is the process of estimating what something is worth. Valuation is used to for a variety of purposes: the purchase or sale of a business, appraisal to resolve disputes, managerial decisions of how to allocate business resources, and many other business and legal purposes.
Valuation often relies on fundamental financial statement analysis using tools such as discounted cash flow or net present value. As such, an accurate valuation, especially of privately owned companies, largely depends on the reliability of the firm’s historic financial information.
Not only do managers want to keep reliable financial statements so that they can know the value of their own businesses, but they also want to manage finances well to enhance the value of their businesses to potential buyers, creditors, or investors.

Key Terms

financial statement: A formal record of all relevant financial information of a business, person, or other entity, presented in a structured and standardized manner to allow easy understanding.
fundamental analysis: An analysis of a business with the goal of financial projections in terms of income statement, financial statements and health, management and competitive advantages, and competitors and markets.
valuation: The process of estimating the market value of a financial asset or liability.

Introduction

Financial management focuses on the practical significance of financial numbers. It asks: what do the figures mean? Sound financial management creates value and organizational agility through the allocation of scarce resources among competing business opportunities. It is an aid to the implementation and monitoring of business strategies and helps achieve business objectives. There are several goals of financial management, one of which is valuation .

Valuation

Valuation is, for some, one of the goals of financial management.

Valuation

In finance, valuation is the process of estimating what something is worth. Valuation often relies on fundamental analysis (of financial statements) of the project, business, or firm, using tools such as discounted cash flow or net present value. As such, an accurate valuation, especially of privately owned companies, largely depends on the reliability of the firm’s historic financial information. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company).

Valuation is used to determine the price financial market participants are willing to pay or receive to buy or sell a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establishing a formula for estimating the value of partners’ ownership interest for buy-sell agreements, and many other business and legal purposes. Therefore, not only do managers want to keep reliable financial statements so that they can know the value of their own businesses, but they also want to manage finances well to enhance the value of their businesses to potential buyers, creditors, or investors.

1.2.2: Maximizing Shareholder and Market Value

A goal of financial management can be to maximize shareholder wealth by paying dividends and/or causing the market value to increase.

Learning Objective

Describe the relationship between shareholder value and market value

Key Points

One interpretation of proper financial management is that the agents are oriented toward the benefit of the principals, shareholders, and in increasing their wealth by paying dividends and/or causing the stock price or market value to increase.
The idea of maximizing market value is related to the idea of maximizing shareholder value, as market value is the price at which an asset would trade in a competitive auction setting; for example, returning value to the shareholders if they decide to sell shares or if the firm decides to sell.
There are many different models of corporate governance around the world. These differ according to the variety of capitalism in which they are embedded. The Anglo-American (US and UK) “model” tends to emphasize the interests of shareholders.
The sole concentration on shareholder value has been criticized, for concern that a management decision can maximize shareholder value while lowering the welfare of other stakeholders. Additionally, short-term focus on shareholder value can be detrimental to long-term shareholder value.

Key Terms

shareholder: One who owns shares of stock.
market value: The total value of the company as traded in the market. Calculated by multiplying the number of shares outstanding by the price per share.
principal: One who directs another (the agent) to act on one′s behalf.

Introduction

Financial management is concerned with financial matters for the practical significance of the numbers, asking: what do the figures mean? There are several goals of financial management, one of which is maximizing shareholder and market value .

Money to Shareholders

Maximizing shareholder and market value is, for some, one of the goals of financial management.

Maximizing Shareholder Value

The idea of maximizing shareholder value comes from interpretations of the role of corporate governance. Corporate governance involves regulatory and market mechanisms and the roles and relationships between a company’s management, its board, its shareholders, other stakeholders, and the goals by which the corporation is governed.

In large firms where there is a separation of ownership and management and no controlling shareholder, the principal–agent issue arises between upper-management (the “agent”) and shareholders (the “principals”). The danger arises that, rather than overseeing management on behalf of shareholders, the board of directors may become insulated from shareholders and beholden to management.

Thus, one interpretation of proper financial management is that the agents are oriented toward the benefit of the principals – shareholders – in increasing their wealth by paying dividends and/or causing the stock price or market value to increase.

Maximizing Market Value

The idea of maximizing market value is related to the idea of maximizing shareholder value, as market value is the price at which an asset would trade in a competitive auction setting; for example, returning value to the shareholders if they decide to sell shares or if the firm decides to sell.

There are many different models of corporate governance around the world. These differ according to the variety of capitalism in which they are embedded. The Anglo-American (US and UK) “model” tends to emphasize the interests of shareholders.

The sole concentration on shareholder value has been widely criticized, particularly after the late-2000s financial crisis, where attention has risen to the concern that a management decision can maximize shareholder value while lowering the welfare of other stakeholders. Additionally, short-term focus on shareholder value can be detrimental to long-term shareholder value.

1.2.3: Maximizing Value Without Harming Stakeholders

A goal of financial management can be to maximize value without harming stakeholders, the diverse set of parties affected by the business.

Learning Objective

Explain how maximizing value for shareholders can harm the business’s other stakeholders

Key Points

Stakeholders are those who are affected by an organization’s activities. The stakeholders can be internal or external to the firm and some will be involved directly in economic transactions with the business, while others will not.
Owners, employees, customers, suppliers, trade unions, the government, local communities, and the environment can be considered stakeholders. Because of the potential breadth of the term, there are different views on whom to include in stakeholder considerations.
Debate is ongoing about whether firms should be managed for shareholder value maximization or also with stakeholders in mind. While the Anglo-American “model” tends to emphasize shareholders, some European countries formally recognize other stakeholders in corporate governance decisions.
Some proponents of stakeholder considerations argue that attention to other stakeholders is intimitely intertwined with market value and can enhance outcomes for all stakeholders. Others argue that value should be maximized without harming stakeholders.

Key Terms

market value: The total value of the company as traded in the market. Calculated by multiplying the number of shares outstanding by the price per share.
stakeholder: A person or organisation with a legitimate interest in a given situation, action or enterprise.

Introduction

Professionals in financial management are concerned with the practical significance of the numbers that appear in financial documents. Given a set of information about certain financial behavior, they ask, what do the figures mean? There are several goals of financial management, one of which is maximizing value without harming shareholders.

The Stakeholder Concept

The stakeholder concept is associated with the concept of corporate governance. Corporate governance involves regulatory and market mechanisms and the relationships that exist between a company’s management, its board, its shareholders, other stakeholders, and the goals for which the corporation is governed. Stakeholders are those who are affected by an organization’s activities. The stakeholders can be internal, like owners or employees. They can also be external, like customers, suppliers, the government, local communities, and the environment . Some stakeholders are involved directly in economic transactions with the business. Others are either affected by, or able to affect, an organization’s actions without directly engaging in an economic exchange with the business (for example, trade unions, communities, activist groups, etc). Because of the breadth of the term stakeholder, there are different views as to whom should be included in stakeholder considerations.

Environment as stakeholder

The environment can be seen as a stakeholder. Maximizing value without harming stakeholders is, for some, one of the goals of financial management.

Stakeholders vs. Shareholders

In the field of corporate governance and corporate responsibility, a major debate is currently occurring about whether a firm or company should make decisions chiefly to maximize value for shareholders, or if a company has obligations to other types of stakeholders. This increased after the financial crisis of the late 2000s, when concerns deepened about the potential of companies to lower the welfare of other stakeholders while maximizing their shareholder value. While the Anglo-American (US and UK) business “model” tends to emphasize the interests of shareholders over other implicated parties, some European countries formally recognize other stakeholders in corporate governance decisions.

Some people who argue that businesses should consider other stakeholders, like the government or the environment, argue that an attention to these types of stakeholders is intimately intwined with market value. They also argue that a holistic view can enhance general outcomes for all the stakeholders that are involved. Still others argue that stakeholders, even if they are not considered in business decisions, should at the very least not suffer harm, and that businesses should maximize value only if they can do so without generating harm.

1.3: Trends and Issues in Finance

1.3.1: Current Issues in Finance

Current issues in finance include the economic and regulatory impacts of the financial crisis and the growth of new types of finance.

Learning Objective

Discuss events and trends in finance during the early 21st century

Key Points

The financial crisis of 2007–2008 caused the near-total collapse of many large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world.
Following the financial crisis, various regulatory reforms were passed in the United States, and European regulators introduced Basel III regulations for banks.
There are various growing areas of finance, including microfinance, crowdfunding, algorithmic trading, and impact investing.

Key Terms

bailout: a rescue, especially a financial rescue
crowdfunding: funding by many individuals pooling their money together for a common goal, usually via the Internet

Financial crisis and regulation

The financial crisis of 2007–2008 caused the near-total collapse of many large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The financial institution crisis hit its peak in late 2008. Several major institutions failed, were acquired under duress, or were subject to government takeover, including Lehman Brothers, Citigroup, Fannie Mae, and Freddie Mac, among several others.The crisis rapidly developed and spread into global economic shock, resulting in a number of European bank failures, economic crises in Iceland, declines in various stock indexes, and large reductions in the market value of equities and commodities. A currency crisis followed, with investors transferring vast capital resources into stronger currencies. In many areas in the United States, the housing market also suffered, resulting in significant numbers of foreclosures. The crisis played a significant role in the failure of key businesses, declines in consumer wealth, prolonged unemployment, and a downturn in economic activity in the United States. It also led to a global recession and a sovereign debt crisis in Europe.

Critics of the financial crisis have argued that the regulatory framework did not keep pace with rapid innovation in financial markets and have asked for increased regulation and enforcement. Various regulatory reforms have been passed in the United States, and European regulators introduced Basel III regulations for banks.

Growing areas of business

Microfinance is the provision of a wide range of financial services, including savings accounts, to the poor. Microcredit is a part of microfinance and involves the extension of very small loans (microloans) to impoverished borrowers, often with the goal of supporting entrepreneurship and/or alleviating poverty.

Peer-to-peer lending over the Internet is another growing development in the financial sector, to which the principles of microcredit have also been applied in attempting to address poverty as well as various non-poverty-related issues. Such efforts include crowdfunding , a term describing the collective effort of individuals who network and pool their resources to support charities initiated by other people or organizations. The rules for crowdfunding are still being developed, and the Securities Exchange Commission has yet to set rules in place for equity crowdfunding campaigns involving unaccredited investors for private companies.

Crowds

One of the newer trends in finance is “crowdfunding. “

Algorithmic trading, now widely used by pension funds, mutual funds, and other institutional traders, is the use of electronic platforms to enter trading orders with an algorithm that calculates aspects such as timing, price, and quantity. Proponents have argued that algorithmic trading substantially improves market liquidity,while critics argue that this type of trading is opaque– a “black box”– and may contribute substantially to market volatility.

The growing field of impact investing refers to investments made based on the practice of assessing not only the financial return on an investment, but also its social and environmental impacts.

1.3.2: Employment in Finance

The financial sector is a large field offering many different types of employment for a broad range of organizations that manage money.

Learning Objective

Identify jobs that require a background in finance

Key Points

The financial sector is a large field offering many different types of employment. Financial services encompasses a broad range of organizations that manage money, including banks, credit unions, credit card companies, insurers, stock brokerages, and investment funds.
Financial analysts may work for government investment funds, mutual fund companies, hedge funds, private equity investors, and investment banks. Similarly, credit analysts work in a variety of institutions to assess the creditworthiness of firms, governments, or individuals for loans.
In insurance, there are insurance brokers and underwriters as well as actuaries and a host of other positions such as insurance claims investigators and agents. Intermediaries exist not just in the insurance business but also as stockbrokers that assist investors in buying and selling shares.
Finance professionals may also work in public finance, for local or national governments, or in corporate finance. Growth in microfinance and microcredit has also opened up employment opportunities in small-unit finance both in the US and abroad.
Sophisticated mathematical and technological developments have also advanced the field of quantitative analysis for those who work in investment management, risk management, derivatives pricing, algorithmic trading, and other area that require the application of mathematics in finance.
Financial employees can come from a variety of backgrounds. Many financial analysis and management positions require some kind of training in finance, accounting, economics, mathematics, engineering, or another quantitative field.

Key Terms

credit: A privilege of delayed payment extended to a buyer or borrower on the seller’s or lender’s belief that what is given will be repaid.
underwriter: An entity which markets newly issued securities
bank: An institution where one can place and borrow money and take care of financial affairs.

The financial sector is a large field offering many different types of employment. Financial services encompasses a broad range of organizations that manage money, including banks, credit unions, credit card companies, insurers, consumer finance companies, stock brokerages, investment funds, some government sponsored enterprises, and other financial institutions, including peer-to-peer lending platforms.

In banking, employees may serve the range of roles needed to run banks, from tellers to financial planners and underwriters to wealth managers. Workers may be employed in a variety of functions by credit card issuers, such as customer service, foreign exchange service, high-profile trading, and airport currency exchangers. Financial analysts may work for government investment funds, mutual fund companies, hedge funds, private equity investors, and investment banks. Credit analysts work in a variety of institutions to assess the creditworthiness of firms, governments, or individuals for loans. In insurance, there are insurance brokers and underwriters as well as actuaries and a host of other positions such as insurance claims investigators and agents.

Intermediaries exist not just in the insurance business. Stockbrokers, for instance, assist investors in buying and selling shares. There are also investors called venture capitalists and angel investors. Finance professionals may also work in public finance, for local or national governments, or in corporate finance.

Growth in microfinance and microcredit has also opened up employment opportunities in finance both in the US and abroad . Sophisticated mathematical and technological developments have also advanced the field of quantitative analysis for those who work in investment management, risk management, derivatives pricing, algorithmic trading, and other areas that require the application of mathematics in finance.

Muhammad Yunus

Muhammad Yunus is a banker who grew a field in microcredit and microfinance, opening up new types of financial employment.

Financial employees can come from a variety of backgrounds. Many financial analysis and management positions require some kind of training in finance, accounting, economics, mathematics, engineering, or another quantitative field. There are Masters degrees in Finance and Business as well as certifications such as the widely recognized Chartered Financial Analyst certification and accountancy qualifications such as the Certified Public Accountant.

1.4: Ethics: An Overview

1.4.1: Defining Ethics

Ethics are the set of moral principles that guide a person’s behavior.

Learning Objective

Define ethics and how it applies to organizations

Key Points

Ethical behavior is based on written and unwritten codes of principles and values held in society.
Ethics reflect beliefs about what is right, what is wrong, what is just, what is unjust, what is good, and what is bad in terms of human behavior.
Ethical principles and values serve as a guide to behavior on a personal level, within professions, and at the organizational level.

Key Terms

behavior: The way a living creature acts.
ethics: The study of principles relating to right and wrong conduct.
values: A collection of guiding principles; what one deems to be correct, important, and desirable in life, especially regarding personal conduct.

Ethics are the set of moral principles that guide a person’s behavior. These morals are shaped by social norms, cultural practices, and religious influences. Ethics reflect beliefs about what is right, what is wrong, what is just, what is unjust, what is good, and what is bad in terms of human behavior. They serve as a compass to direct how people should behave toward each other, understand and fulfill their obligations to society, and live their lives.

While ethical beliefs are held by individuals, they can also be reflected in the values, practices, and policies that shape the choices made by decision makers on behalf of their organizations. The phrases business ethics and corporate ethics are often used to describe the application of ethical values to business activities. Ethics applies to all aspects of conduct and is relevant to the actions of individuals, groups, and organizations.

In addition to individual ethics and corporate ethics there are professional ethics. Professionals such as managers, lawyers, and accountants are individuals who exercise specialized knowledge and skills when providing services to customers or to the public. By virtue of their profession, they have obligations to those they serve. For example, lawyers must hold client conversations confidential and accountants must display the highest levels of honest and integrity in their record keeping and financial analysis. Professional organizations, such as the American Medical Association, and licensing authorities, such as state governments, set and enforce ethical standards.

Example

The concept of corporate social responsibility emphasizes ethical behavior in that it requires organizations to understand, identify, and eliminate unethical economic, environmental, and social behaviors.

1.4.2: Ethics Training

Moral reasoning is the process in which an individual tries to determine what is right and what is wrong.

Learning Objective

Explain the role of ethical moral reasoning in the business environment

Key Points

There are four components of moral behavior: moral sensitivity, moral judgment, moral motivation, and moral character.
To make moral assessments, one must first know what an action is intended to accomplish and what its possible consequences will be on others.
Studies have uncovered four skill sets that play a decisive role in the exercise of moral expertise: moral imagination, moral creativity, reasonableness, and perseverance.

Key Terms

goodwill: The ability of an individual or business to exert influence within a community, club, market, or another type of group, without having to resort to the use of an asset (such as money or property).
ethics: The study of principles relating to right and wrong conduct.

Moral reasoning is the process in which an individual tries to determine the difference between what is right and what is wrong in a personal situation by using logic. To make such an assessment, one must first know what an action is intended to accomplish and what its possible consequences will be on others. People use moral reasoning in an attempt to do the right thing. People are frequently faced with moral choices, such as whether to lie to avoid hurting someone’s feelings, or whether to take an action that will benefit some while harming others. Such judgements are made by considering the objective and the likely consequences of an action. Moral reasoning is the consideration of the factors relevant to making these types of assessments.

According to consultant Lynn W. Swaner, moral behavior has four components:

Moral sensitivity, which is “the ability to see an ethical dilemma, including how our actions will affect others.”
Moral judgment, which is “the ability to reason correctly about what ‘ought’ to be done in a specific situation.”
Moral motivation, which is “a personal commitment to moral action, accepting responsibility for the outcome.”
Moral character, which is a “courageous persistence in spite of fatigue or temptations to take the easy way out.”

The ability to think through moral issues and dilemmas, then, requires an awareness of a set of moral and ethical values; the capacity to think objectively and rationally about what may be an emotional issue; the willingness to take a stand for what is right, even in the face of opposition; and the fortitude and resilience to maintain one’s ethical and moral standards.

Realizing good conduct, being an effective moral agent, and bringing values into one’s work, all require skills in addition to a moral inclination. Studies have uncovered four skill sets that play a decisive role in the exercise of moral expertise.

Moral imagination: The ability to see the situation through the eyes of others. Moral imagination achieves a balance between becoming lost in the perspectives of others and failing to leave one’s own perspective. Adam Smith terms this balance “proportionality,” which we can achieve in empathy.
Moral creativity: Moral creativity is closely related to moral imagination, but it centers on the ability to frame a situation in different ways.
Reasonableness: Reasonableness balances openness to the views of others with commitment to moral values and other important goals. That is, a reasonable person is open, but not to the extent where he is willing to believe just anything and/or fails to keep fundamental commitments.
Perseverance: Perseverance is the ability to decide on a moral plan of action and then to adapt to any barriers that arise in order to continue working toward that goal.

Example

William LeMesseur designed the Citicorp Building in New York. When a student identified a critical design flaw in the building during a routine class exercise, LeMesseur responded not by shooting the messenger but by developing an intricate and effective plan for correcting the problem before it resulted in drastic real-world consequences.

1.4.3: Culture and Ethics

Culture reflects the moral values and ethical norms governing how people should behave and interact with others.

Learning Objective

Explain the role of culture in shaping moral and ethical behavior

Key Points

Culture refers to the outlook, attitudes, values, goals, and practices shared by a group, organization, or society.
Interpretation of what is moral is influenced by cultural norms, and different cultures can have different beliefs about what is right and wrong.
According to the theory of cultural relativism, there is no singular truth on which to base ethical or moral behavior, as our interpretations of truths are influenced by our own culture.

Key Terms

norms: Rules or laws that govern a group’s or a society’s behaviors.
moral relativism: Refers to any of several philosophical positions concerned with the differences in moral judgments among different people and across different cultures.
ethnocentric: Of the idea or belief that one’s own culture is more important than, or superior to, other cultures.

Culture describes a collective way of life, or way of doing things. It is the sum of attitudes, values, goals, and practices shared by individuals in a group, organization, or society. Cultures vary over time periods, between countries and geographic regions, and among groups and organizations. Culture reflects the moral and ethical beliefs and standards that speak to how people should behave and interact with others.

Cultural map of the world

This diagram attempts to plot different countries by the importance of different types of values. One axis represents traditional values to secular-rational values, while the other axis accounts for survival values and self-expression values. Different groups of countries can be grouped into certain categories, such as Catholic Europe, English speaking, and Ex-Communist.

Cultural norms are the shared, sanctioned, and integrated systems of beliefs and practices that are passed down through generations and characterize a cultural group. Norms cultivate reliable guidelines for daily living and contribute to the health and well-being of a culture. They act as prescriptions for correct and moral behavior, lend meaning and coherence to life, and provide a means of achieving a sense of integrity, safety, and belonging. These normative beliefs, together with related cultural values and rituals, impose a sense of order and control on aspects of life that might otherwise appear chaotic or unpredictable.

This is where culture intersects with ethics. Since interpretations of what is moral are influenced by cultural norms, the possibility exists that what is ethical to one group will not be considered so by someone living in a different culture. According to cultural relativists this means that there is no singular truth on which to base ethical or moral behavior for all time and geographic space, as our interpretations of truths are influenced by our own culture. This approach is in contrast to universalism, which holds the position that moral values are the same for everyone. Cultural relativists consider this to be an ethnocentric view, as the universal set of values proposed by universalists are based on their set of values. Cultural relativism is also considered more tolerant than universalism because, if there is no basis for making moral judgments between cultures, then cultures have to be tolerant of each other.

Example

The French and Americans have different views on whistle-blowing. Compared to the French, American companies consider it to be a natural part of business. So natural, in fact, that they set up anonymous hotlines. The French, on the other hand, tend to view whistle-blowing as undermining solidarity among coworkers.

1.4.4: The Manager’s Role in Ethical Conduct

Employees can more easily make ethical decisions that promote a company’s values when their personal values match the company’s norms.

Learning Objective

Explain the role of personal values in influencing behavior in organizations

Key Points

Personal values provide an internal reference for what is good, beneficial, important, useful, beautiful, desirable, and constructive.
Personal values take on greater meaning in adulthood as they are meant to influence how we carry out our responsibilities to others.
To make ethical and moral choices, one needs to have a clear understanding of one’s personal values.

Key Terms

value: A standard by which an individual determines what is good or desirable; a measure of relative worth or importance.
norms: According to sociologists, social norms are the laws that govern society’s behaviors.

Personal values provide an internal reference for what is good, beneficial, important, useful, beautiful, desirable, and constructive. Over time, the public expression of personal values has laid the foundations of law, custom, and tradition. Personal values in this way exist in relation to cultural values, either in agreement with or divergent from prevailing norms.

Personal values are developed in many different ways:

The most important influence on our values comes from the families we grow up with. The family is responsible for teaching children what is right and wrong long before there are other influences. It is thus said that a child is a reflection of his or her parents.
Teachers and classmates help shape the values of children during the school years.
Religion (or a lack thereof) also plays a role in teaching children values.

Personal values take on greater meaning in adulthood as they are meant to influence how we carry out our responsibilities to others. This is true in the workplace, especially for managers and leaders, who are charged with overseeing resources for the benefit of others. Because of their authority structures, social norms, and cultures, organizations can have a powerful influence on their employees. Employers do their best to hire individuals who match match well with the organization’s norms and values. In this way they seek to promote their standards of ethical behavior.

Conversely, conflicts can occur between an individual’s moral values and what she perceives to be those of others in their organization. Since moral judgments are based on the analysis of the consequences of behavior, they involve interpretations and assessments. One might be asked to do something that violates a personal belief but is considered appropriate by others. To make ethical and moral choices, one needs to have a clear understanding of one’s personal values. Without that awareness, it can be difficult to justify a decision on ethical or moral grounds in a way that others would find persuasive.

Example

If you value equal rights for all and you go to work for an organization that treats its managers much better than it does its workers, you may form the attitude that the company is an unfair place to work; consequently, you may not produce well or may even leave the company. It is likely that if the company had a more egalitarian policy, your attitude and behaviors would have been more positive.

1.4.5: Blurring Ethical Lines

Ethical decisions involve judgments of facts and situations that are subject to interpretation and other influences.

Learning Objective

Analyze the gray areas of ethical expectations within the context of corporate decision making and ethical business practice

Key Points

Identifying the ethical choice can be difficult, since many situations are ambiguous and facts are subject to interpretation.
In organizations, employees can look to the code of ethics or the statement of values for guidance about how to handle ethical gray areas.
Individual ethical judgement can be clouded by rationalizations to justify one’s actions.

Key Terms

business ethics: The branch of ethics that examines questions of moral right and wrong arising in the context of business practice or theory.
norms: According to sociologists, social norms are the laws that govern society’s behaviors.

Law and ethics are not the same thing. Both exist to influence behavior, but complying with the law is mandatory, while adhering to an ethical code is voluntary. Laws define what is permissible, while ethics speak to what is right, good, and just. Lawyers and judges are responsible for clarifying the meaning of a law when there is ambiguity or when a matter is subject to interpretation. Where ethics are concerned, that responsibility lies with each individual. In organizations, employees can look to the code of ethics or the statement of values for guidance about how to handle ethical gray areas.

Even when an individual has a clear sense of right and wrong, or good and bad, it can be difficult to know what is ethical in a given situation. Ethical choices involve judgment because they involve weighing the potential consequences of one’s actions for other people. One analyzes ethical issues by asking questions such as: What could happen? How likely is it happen? What might the harm be? Who might be hurt? The answers are not always clear cut.

Individual judgments can be influenced, even clouded, by a number of factors. A study by Professor Robert Prentice suggests that self-image can influence an individual’s decision-making process, making him or her feel justified in taking shortcuts or doing things that could be seen as ethically questionable. In addition, there are times when people believe that the ends justify the means. In other words, if the result of an action is good, then it is okay if the action itself is unethical.

There is a saying that a good person is one who does good deeds when no one is looking. The same goes with ethical decisions. People who are ethical follow their beliefs even when they believe no one will find out about what they have done. In many cases of ethical breaches in organizations, those who acted unethically likely believed that they wouldn’t be discovered. Others may have thought that if the issues were discovered, the actions wouldn’t be traced back to them. They had the opportunity to be ethical but chose not to be.

Business Ethics Around the Globe

Social norms aren’t identical in different countries, and ethical standards can vary as well. A business may operate in a country that permits actions that would be considered unethical under that business’s ethical code. How will employees working in that country handle that situation, especially if something that could be considered unethical in one place is actually thought to be important to business success in the other? For instance, in some cultures it is customary for business partners and customers to be invited to weddings, with the expectation that guests will give a cash gift to the bride and groom. A company might consider the gift an unethical bribe in exchange for a customer’s business, yet it may be essential to enter a new market. Adhering to ethical standards in such instances can be difficult.

This way to ethics

Ethical decisions are not always clear-cut.

Example

American companies are often criticized for the treatment of workers who produce their products in China. However, rules concerning the rights of workers are much more relaxed in China than in the United States. Does an American company have the right to order factory owners in China to change their way of doing business? That is one example of an ethical gray area in today’s globalized economy.

1.5: Types of Business Organizations

1.5.1: Overview of Organizational Structure

Business organizations can be structured in various ways, both as legal entities and in terms of internal management processes.

Learning Objective

Select the appropriate organizational structure for a business after reviewing a its key characteristics

Key Points

From a legal structure perspective, many business structures require a form of incorporation to register the business as a legal entity. The business entity’s type, its geographic span of operations, risk profile, and other factors are issues to consider when choosing what entity type to use.
There are various forms of organizational structures from a corporate law perspective, including sole proprietorships, cooperatives, partnerships, limited liability companies, and corporations.
One of the issues dividing the different organizational structures is that of liability. With sole proprietorships and some forms of partnership, owners can be personally liable for business losses, meaning their personal assets are not protected against the claims of creditors.
Internally, organizations can also be structured differently, in terms of the groupings of organizational relationships and the characteristics of management. Some common structures are the functional, divisional, matrix, team, network, and modular structures.
Independent from their legal and internal structures, organizations can also operate differently. For example, hybrid organizations, which may fall under various legal categories, can mix elements, value systems and logics of action from the private, public, and voluntary sectors.

Key Terms

liability: An obligation, debt or responsibility owed to someone.
incorporate: To form into a legal company.
hierarchy: Any group of objects ranked so that every one but the topmost is subordinate to a specified one above it.

Organizational Structure

Business organizations can be structured in various ways, depending on their standing as legal entities, internal structure, and management processes .

Organizational chart

A military organizational chart

Pre-bureaucratic structures

Pre-bureaucratic (entrepreneurial) structures lack standardization of tasks. This structure is most common in smaller organizations and is best used to solve simple tasks. The structure is totally centralized and appears like a hierarchy. The strategic leader makes all key decisions and most communication is done by one-on-one conversations. It is particularly useful for new (entrepreneurial) business as it enables the founder to control growth and development.

Bureaucratic structures

Weber said that the fully developed bureaucratic mechanism compares with other organizations exactly as does the machine compare with the non-mechanical modes of production. Precision, speed, unambiguity…strict subordination, reduction of friction and of material and personal costs are raised to the optimum point in the strictly bureaucratic administration. Bureaucratic structures have a certain degree of standardization. They are better suited for more complex or larger scale organizations, usually adopting a tall structure. The tension between bureaucratic structures and non-bureaucratic is echoed in Burns and Stalker’s distinction between mechanistic and organic structures.

Functional structure

Employees within the functional divisions of an organization tend to perform a specialized set of tasks; for instance, the engineering department is staffed only with software engineers. This leads to operational efficiencies within that group. However, it could also lead to a lack of communication between the functional groups within an organization, making the organization slow and inflexible. As a whole, a functional organization is best suited as a producer of standardized goods and services at large volume and low cost.

Divisional structure

Also called a “product structure,” the divisional structure groups each organizational function into a division. Each division within a divisional structure contains all the necessary resources and functions within it. Divisions can be categorized by different points of view. One might make distinctions on a geographical basis (a US division and an EU division, for example) or on product/service basis (different products for different customers, households, or companies). In another example, an automobile company with a divisional structure might have one division for SUVs, another division for subcompact cars, and another for sedans.

Matrix structure

The matrix structure groups employees by both function and product. This structure can combine the best of both separate structures. A matrix organization frequently uses teams of employees to accomplish work, in order to take advantage of strengths and make up for weaknesses of functional and decentralized forms. An example would be a company that produces two products, “product a” and “product b. ” Using the matrix structure, this company would organize functions within the company as follows: “product a” sales department, “product a” customer service department, “product a” accounting department, “product b” sales department, “product b” customer service department, “product b” accounting department. Matrix structure is amongst the purest of organizational structures – a simple lattice emulating order and regularity demonstrated in nature.

Legal considerations

In the US and elsewhere, many business structures require a form of incorporation to register the business as a legal entity. The owner files articles of incorporation with the secretary of state’s office for the particular jurisdiction. The organization may also hold meetings, select a board of directors, adopt bylaws, and report on a regular basis. The business entity’s type, its geographic span of operations, risk profile, and other factors are issues to consider when choosing what entity type to use, in what jurisdiction to incorporate, how the articles should be drafted, and if a stock form should be used.

Business perspective

There are various forms of organizational structures from a business perspective, including sole proprietorships, cooperatives, partnerships, limited liability companies, and corporations. All of these structures are for profit, but there are also non-profit corporations and other structures. The differences in structures can depend on the number of entrepreneurs or owners involved, and the different tax treatments. One of the issues dividing forms is that of liability. With sole proprietorships and some forms of partnership, owners can be personally liable for business losses, meaning their personal assets are not protected against the claims of creditors. These organizational structures are also not separate entities from the owners/entrepreneurs, unlike a corporation.

Organizational behavior

Internally, organizations can also be structured differently, in terms of the groupings of organizational relationships and the characteristics of management. Some common structures are the functional, divisional, matrix, team, network, and modular structures.

Independent from their legal and internal structures, organizations can also behave differently. For example, hybrid organizations, which may fall under various legal categories, can mix elements, value systems, and logics of action from the private, public, and voluntary sectors.

1.5.2: Pros and Cons of Sole Proprietorship

The sole proprietorship structure has the benefit of simplicity and control but the drawback of unlimited liability.

Learning Objective

Describe the key characteristics of a sole proprietorship

Key Points

The sole proprietorship is a type of business structure open to businesses run and owned by one entrepreneur.
A large advantage of the sole proprietorship structure is its ease. The sole proprietorship structure does not require filing of articles of incorporation, regular meetings, or election of a board. A sole proprietor also files taxes as personal income.
The other side of this process is the structure’s main disadvantage: there is no separation between the entrepreneur and the business. This means the sole proprietor is personally liable for business losses. Also, if the proprietor dies, the business ceases to exist.

Key Terms

proprietor: An owner
entrepreneur: A person who organizes and operates a business venture and assumes much of the associated risk.

Overview of Business Structures

Business organizations can be structured in two major ways, namely, in terms of their structures as legal entities and also in terms of the internal structure and management processes. The sole proprietorship is one type of business structure from a legal status perspective. It is a structure open to businesses run and owned by one entrepreneur.

Sole Proprietors

Small businesses are often structured as sole proprietorships.

Sole Proprietorship: Pros and Cons

A large advantage of the sole proprietorship structure is its ease of filing incorporation and tax documents as well as having uninterrupted control of the business. The sole proprietorship is one type of business structure in the US that does not require formal incorporation, meaning that sole proprietors do not need to formally file articles of incorporation, hold regular meetings, or elect an advising or directing board. This simplicity is also reflected in tax treatment, as a sole proprietor files taxes as personal income. Sole proprietors also have control over the aspects of their business without the involvement of elected board members.

On the flip side, the sole proprietorship has one main disadvantage: there is no separation between the entrepreneur and the business. With sole proprietorships, like some forms of partnership, owners can be personally liable for business losses, meaning their personal assets are not protected against the claims of creditors. The sole proprietorship is not a separate entity from the owner/entrepreneur, unlike a corporation. As a result, if the proprietor dies, the business ceases to exist. Because the enterprise rests exclusively on one person, it often has difficulty raising long-term capital.

1.5.3: Pros and Cons of a Partnership

The partnership structure has the benefit of simplicity and control but the drawback of personal liability for the partnership’s activities.

Learning Objective

Describe the legal pros and cons of a partnership

Key Points

The partnership is a type of business structure open to businesses run and owned by two or more entrepreneurs.
A large advantage of the partnership structure is its ease, in terms of filing and tax treatment. A general partnership can be started with no special formalities. The partners are taxed individually on their share of the partnership’s profits.
The structure’s main disadvantage is that partnership owners can be personally liable for business losses. The partnership is not a separate entity from the owners/entrepreneurs, unlike a corporation.
Types of partnership beyond the general partnership have developed to mitigate some of the disadvantages of the structure. Limited partnerships and limited liability partnerships are two examples.

Key Terms

liability: An obligation, debt or responsibility owed to someone.
partnership: An association of two or more people to conduct a business,

Business Organization Types

Business organizations can be structured in various ways, in terms of their structures as legal entities and also in terms of the internal structure and management processes. The partnership is one type of business structure. The partnership is the next simplest business structure after the sole proprietorship. Because sole proprietors can only have one owner, the partnership is the simplest structure open to collaborative ownership .

Partnership

The partnership is the simplest structure open to collaborative ownership.

Partnership: Pros and Cons

A large advantage of the partnership structure is its ease in filing and tax treatment. With a general partnership, two or more people can start a business as co-owners with no special formalities, directly controlling the partnership and making binding decisions with a simple majority vote. The partners are taxed individually on their share of the partnership’s profits. By default, profits are shared equally among the partners. However, a partnership agreement will almost invariably expressly provide for the manner in which profits and losses are to be shared.

The structure’s main disadvantage is similar to the sole proprietorship. Owners can be personally liable for business losses in some forms of partnership, meaning their personal assets are not protected against the claims of creditors. The partnership is not a separate entity from the owners/entrepreneurs, unlike a corporation. This means that the partnership structure is only as good as the partnership at the relational level. If the mutual consent to form a partnership breaks down, the partnership breaks down as well; partnerships are considered to be an aggregate of their partners rather than a separate entity.

There has been debate in most states as to whether a partnership should remain aggregate or be allowed to become a business entity with a separate continuing legal personality. Types of partnership beyond the general partnership have developed to mitigate some of the disadvantages of the structure. Limited partnerships allow limited liability for some partners who have no management authority, and in some cases (depending on the jurisdiction) limited liability partnerships provide for limited liability for all partners.

1.5.4: Pros and Cons of a Corporation

The corporate structure is less simple to found and maintain but has the advantages of limited liability and perpetual life.

Learning Objective

Distinguish the corporate entity from other types of business organizations

Key Points

Compared to sole proprietorships and partnerships, the corporation is more complicated to found and maintain, one of its disadvantages. The incorporator must file articles of incorporation as well as hold an organizational meeting to elect a board of directors.
The structure also generally requires the maintenance of at least annual reporting, including annual financial statements and other data.
One of the most favorable advantages of the corporate structure is the protection of personal assets of stockholders, directors, and officers. They are limited in liability to the amount they have invested in the corporation.
Also, because the corporation is an entity separate from its owners, ownership is easily transferable. Similarly, the corporation does not cease to exist with the death of shareholders, directors, or officers of the corporation.

Key Terms

liability: An obligation, debt or responsibility owed to someone.
incorporate: To form into a legal company.

Exxon Mobil Corporation

One of the world’s largest companies by revenue, it is structured as a corporation.

Corporation: Cons

Compared to other business structures, such as sole proprietorships and partnerships, the corporation is less simple to found and maintain, one of its disadvantages. The incorporator must file articles of incorporation with the secretary of state’s office in the state in which it will be incorporated, as well as hold an organizational meeting to elect a board of directors. The structure also generally requires the maintenance of at least annual reporting. In many jurisdictions corporations, whose shareholders benefit from limited liability, are required to publish annual financial statements and other data, so that creditors who do business with the corporation are able to assess the creditworthiness of the corporation and cannot enforce claims against shareholders. Shareholders, therefore, experience some loss of privacy in return for limited liability. There is also the issue of double taxation, wherein the corporation is taxed on its profits and shareholders are also taxed on their earnings.

Corporation: Pros

One of the most favorable advantages of the corporate structure is the protection of personal assets. Stockholders, directors, and officers of a corporation are typically not liable for the company’s debts and obligations. They are limited in liability to the amount they have invested in the corporation. This limited liability also makes financing more attractive from a risk perspective. Also, because the corporation is an entity separate from its owners, ownership is easily transferable. Similarly, the corporation does not cease to exist with the death of shareholders, directors, or officers of the corporation. Another benefit of the corporate structure is that, in the United States, corporations are generally taxed at a lower rate than are individuals.

Best of Both Worlds: The S Corporation

S corporations are merely corporations that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. S status combines the legal environment of standard corporations with U.S. federal income taxation similar to that of partnerships. As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions are made. Thus, income is taxed at the shareholder level and not at the corporate level. Payments to S shareholders by the corporation are distributed tax-free to the extent that the distributed earnings were previously taxed. Also, certain corporate penalty taxes (e.g., accumulated earnings tax, personal holding company tax) and the alternative minimum tax do not apply to an S corporation.

1.6: Corporate Governance

1.6.1: Defining Corporate Governance

Corporate governance is the system by which companies are directed and controlled.

Learning Objective

Identify the five major categories of financial disclosures

Key Points

In contemporary business corporations, the main external stakeholder groups are shareholders, debtholders, trade creditors, suppliers, customers, and communities affected by the corporation’s activities. Internal stakeholders are the board of directors, executives, and other employees.
Ways of mitigating or preventing these conflicts of interests include the processes, customs, policies, laws, and institutions which have impact on the way a company is controlled.
A related but separate thread of discussion focuses on the impact of a corporate governance system on economic efficiency, with a strong emphasis on shareholders’ welfare.
Principles of corporate governance include rights and equitable treatment of shareholders, interests of other stakeholders, role and responsibilities of the board, integrity and ethical behavior, and disclosure and transparency.

Key Terms

Auditing: The general definition of an audit is an evaluation of a person, organization, system, process, enterprise, project or product. The term most commonly refers to audits in accounting, but similar concepts also exist in project management, quality management, water management, and energy conservation.
stakeholders: A corporate stakeholder is that which can affect or be affected by the actions of the business as a whole.

Example

For example, companies quoted on the London, Toronto, and Australian Stock Exchanges formally need not follow the recommendations of their respective codes. However, they must disclose whether they follow the recommendations in those documents and, where not, they should provide explanations concerning divergent practices. Such disclosure requirements exert a significant pressure on listed companies for compliance.

What is Corporate Governance?

Corporate governance is the system by which companies are directed and controlled. It involves regulatory and market mechanisms; the roles and relationships between a company’s management, its board, its shareholders, and other stakeholders; and the goals for which the corporation is governed. In contemporary business corporations, the main external stakeholder groups are shareholders, debtholders, trade creditors, suppliers, customers, and communities affected by the corporation’s activities. Internal stakeholders are the board of directors, executives, and other employees .

Redisigning corporate governance

Corporate governance deals with the conflicts of interests in a company.

Much of the contemporary interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. Ways of mitigating or preventing these conflicts of interests include the processes, customs, policies, laws, and institutions which have impact on the way a company is controlled. An important theme of corporate governance is the nature and extent of accountability of people in the business.

A related but separate thread of discussion focuses on the impact of a corporate governance system on economic efficiency, with a strong emphasis on shareholders’ welfare. In large firms where there is a separation of ownership and management and no controlling shareholder, the principal–agent issue arises between upper-management (the “agent”) which may have very different interests, and by definition considerably more information, than shareholders (the “principals”). Rather than overseeing management on behalf of shareholders, the board of directors may become insulated from shareholders and beholden to management. This aspect is particularly present in contemporary public debates and developments in regulatory policy.

Principles Of Corporate Governance

Contemporary discussions of corporate governance tend to refer to principles raised in three documents released since 1990: The Cadbury Report (UK, 1992), the Principles of Corporate Governance (OECD, 1998 and 2004), the Sarbanes-Oxley Act of 2002 (US, 2002). The Cadbury and OECD reports present general principals around which businesses are expected to operate to assure proper governance. The Sarbanes-Oxley Act, informally referred to as Sarbox or Sox, is an attempt by the federal government in the United States to legislate several of the principles recommended in the Cadbury and OECD reports.

Rights and Equitable Treatment Of Shareholders

Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by openly and effectively communicating information and by encouraging shareholders to participate in general meetings.

Interests Of Other Stakeholders

Organizations should recognize that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders, such as employees, investors, creditors, suppliers, local communities, customers, and policy makers.

Role and Responsibilities Of the Board

The board needs sufficient relevant skills and understanding to review and challenge management performance. It also needs adequate size and appropriate levels of independence and commitment.

Integrity and Ethical Behavior

Integrity should be a fundamental requirement in choosing corporate officers and board members. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making.

Disclosure and Transparency

Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide stakeholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company’s financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information.

Codes and Guidelines

Corporate governance principles and codes have been developed in different countries and issued from stock exchanges, corporations, institutional investors, or associations (institutes) of directors and managers with the support of governments and international organizations. As a rule, compliance with these governance recommendations is not mandated by law, although the codes linked to stock exchange listing requirements may have a coercive effect.

One of the most influential guidelines has been the OECD Principles of Corporate Governance—published in 1999 and revised in 2004. The OECD guidelines are often referenced by countries developing local codes or guidelines. Building on the work of the OECD, other international organizations, private sector associations, and more than 20 national corporate governance codes formed the United Nations Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR) to produce their Guidance on Good Practices in Corporate Governance Disclosure. This internationally agreed benchmark consists of more than fifty distinct disclosure items across five broad categories:

Auditing
Board and management structure and process
Corporate responsibility and compliance
Financial transparency and information disclosure
Ownership structure and exercise of control rights

Most codes are largely voluntary. An issue raised in the U.S. since the 2005 Disney decision is the degree to which companies manage their governance responsibilities. In other words, do they merely try to supersede the legal threshold? Or should they create governance guidelines that ascend to the level of best practice?

1.6.2: Sarbanes–Oxley Act of 2002

The Sarbanes–Oxley Act is a US federal law enhancing standards for all US public company boards, management and public accounting firms.

Learning Objective

Describe the new responsibilities imposed on a corporation by Sarbanes-Oxley

Key Points

As a result of SOX, top management must now individually certify the accuracy of financial information.
SOX increased the independence of outside auditors who review the accuracy of corporate financial statements, and increased the oversight role of boards of directors.
SOX was enacted as a reaction to a number of major corporate and accounting scandals.
The Sarbanes–Oxley Act includes Auditor Independence, Corporate Responsibility, Enhanced Financial Disclosures, Analyst Conflicts of Interest, Commission Resources and Authority, Corporate and Criminal Fraud Accountability, Corporate Tax Returns, and Corporate Fraud Accountability. .

Key Terms

conflicts of interest: A conflict of interest (COI) occurs when an individual or organization is involved in multiple interests, one of which could possibly corrupt the motivation for an act in the other.
external auditor: An external auditor is an audit professional who performs an audit in accordance with specific laws or rules on the financial statements of a company, government entity, other legal entity or organization, and who is independent of the entity being audited.

Example

Section 302 requires that the company’s “principal officers” (typically the Chief Executive Officer and Chief Financial Officer) certify and approve the integrity of their company financial reports quarterly.

The Sarbanes–Oxley Act

The Sarbanes–Oxley Act of 2002 is a United States federal law that set new or enhanced standards for all U.S. public company boards, management and public accounting firms. The act is also known as the “Public Company Accounting Reform and Investor Protection Act” (in the Senate) and “Corporate and Auditing Accountability and Responsibility Act” (in the House). It’s more commonly called Sarbanes–Oxley, Sarbox or SOX; it is named after sponsors U.S. Senator Paul Sarbanes (D-MD) and U.S. Representative Michael G. Oxley (R-OH). As a result of SOX, top management must now individually certify the accuracy of financial information. In addition, penalties for fraudulent financial activity are much more severe. Also, SOX increased the oversight role of boards of directors while also increasing the independence of outside auditors who review the accuracy of corporate financial statements.

Sarbanes-Oxley Act

SOX is a United States federal law that set new or enhanced standards for all U.S. public company boards, management and public accounting firms.

The bill was enacted as a reaction to major corporate and accounting scandals affecting Enron, Tyco International and others. These scandals, which cost investors billions of dollars, shook public confidence in the nation’s securities markets.

Debate continues over the perceived benefits and costs of SOX. Opponents of the bill claim it has reduced America’s international competitive edge against foreign financial service providers, saying it introduced an overly complex regulatory environment into U.S. financial markets. Proponents of the measure say that SOX has improved the confidence of fund managers and other investors with regard to the veracity of corporate financial statements.

Public Company Accounting Oversight Board (PCAOB)

Title I consists of nine sections and establishes the Public Company Accounting Oversight Board, providing independent oversight of public accounting firms. It also creates a central oversight board tasked with registering auditors, defining the specific processes for compliance audits, inspecting conduct and quality control, and enforcing compliance.

Auditor Independence

Title II consists of nine sections and establishes standards for external auditor independence. It also addresses new auditor approval requirements, audit partner rotation and auditor reporting requirements. It restricts auditing companies from providing non-audit services (e.g., consulting) for the same clients.

Corporate Responsibility

Title III consists of eight sections mandating that senior executives take individual responsibility for the accuracy and completeness of corporate financial reports. It defines the interaction of external auditors and corporate audit committees, and specifies the responsibility of corporate officers for the accuracy and validity of corporate financial reports.

Enhanced Financial Disclosures

Title IV consists of nine sections. It describes enhanced reporting requirements for financial transactions, including off-balance-sheet transactions, pro-forma figures and stock transactions of corporate officers. It requires internal controls for assuring the accuracy of financial reports and disclosures, and mandates both audits and reports on those controls.

Analyst Conflicts of Interest

Title V consists of only one section, which includes measures designed to help restore investor confidence in reporting of securities analysts. It defines the codes of conduct for securities analysts and requires disclosure of knowable conflicts of interest.

Commission Resources and Authority

Title VI consists of four sections and defines practices to restore investor confidence in securities analysts. It also defines the SEC’s authority to censure securities professionals from practice and defines conditions under which a person can be barred from practicing as a broker, advisor, or dealer.

Studies and Reports

Title VII consists of five sections and requires the Comptroller General and the SEC to perform various studies and report their findings. Studies include the effects of consolidation of public accounting firms and role of credit rating agencies in the operation of securities markets.

Corporate and Criminal Fraud Accountability

Title VIII consists of seven sections and is also referred to as the “Corporate and Criminal Fraud Accountability Act of 2002. ” It describes specific criminal penalties for manipulation, destruction or alteration of financial records, or other interference with investigations, while also providing certain protections for whistleblowers.

White Collar Crime Penalty Enhancement

Title IX consists of six sections. This section increases the criminal penalties associated with white-collar crimes and conspiracies. It recommends stronger sentencing guidelines and specifically adds failure to certify corporate financial reports as a criminal offense.

Corporate Tax Returns

Title X consists of one section. Section 1001 states that the Chief Executive Officer should sign the company tax return.

Corporate Fraud Accountability

Title XI consists of seven sections. Section 1101 recommends a name for this title as “Corporate Fraud Accountability Act of 2002. ” It identifies corporate fraud and records tampering as criminal offenses and joins those offenses to specific penalties. It also revises sentencing guidelines and strengthens their penalties.

1.7: Agency and Conflicts of Interest

1.7.1: Defining Agency Conflicts

Agency conflicts can occur when the incentives of the agent do not align with those of the principal.

Learning Objective

Explain how agency conflicts can influence corporate governance

Key Points

The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders’ interests. Control systems in corporate governance can help align managers’ incentives with those of shareholders and other stakeholders.
The principal–agent problem concerns the difficulties in motivating one party (the “agent”), to act on behalf of another (the “principal”). The two parties have different interests and asymmetric information. Moral hazard and conflict of interest may thus arise.
The deviation from the principal’s interest by the agent is called “agency costs. ” Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control, and the different objectives (rather than shareholder maximization) of the managers.
Much recent interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. These occur when an individual or organization is involved in multiple interests that may lead to conflicts in their ability to act in the best interest of one party.

Key Terms

moral hazard: The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.
agent: One who acts for, or in the place of, another (the principal), by authority from him; one intrusted with the business of another; a substitute; a deputy; a factor.
principal: One who directs another (the agent) to act on one′s behalf.

The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders’ (and other parties’) interests. Partly as a result of this separation, corporate governance mechanisms include a system of controls intended to help align managers’ incentives with those of shareholders and other stakeholders.

The principal–agent problem or agency dilemma, developed in economic theory, concerns the difficulties in motivating one party (the “agent”), to act on behalf of another (the “principal”). The two parties have different interests and asymmetric information (the agent having more information), such that the principal cannot directly ensure that the agents are always acting in its (the principals’) best interests, particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe. Moral hazard and conflict of interest (COI) may thus arise .

Conflict of Interest

Principal-agent problems – which arise when managers act on the behalf of a firm and its investors – include potential conflicts of interest.

The deviation from the principal’s interest by the agent is called “agency costs. ” Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control, and the different objectives (rather than shareholder maximization) of the managers. When a firm has debt, conflicts of interest can also arise between stockholders and bondholders, leading to agency costs on the firm. Examples of agency costs include that borne by shareholders (the principal), when corporate management (the agent) buys other companies to expand its power instead of maximizing the value of the corporation’s worth; or by the constituents of a politician’s district (the principal) when the politician (the agent) passes legislation helpful to large contributors to their campaign rather than helpful to voters.

Much of the contemporary interest in corporate governance is concerned with mitigation of the conflicts of interests between stakeholders. A conflict of interest occurs when an individual or organization is involved in multiple interests that may lead to conflicts in their ability to act in the best interest of one party. In addition to conflicts of interest between managers, shareholders, and bondholders, conflicts of interest can also occur among other stakeholders of a company, such as the board of directors, employees, government, suppliers, and customers. COI is sometimes termed “competition of interest” rather than “conflict”, emphasizing a connotation of natural competition between valid interests rather than violent conflict. At other times, conflicts of interest are confused with cases that might better be termed “corruption”, such as bribe-taking or fraud.

1.7.2: Managers, Shareholders, and Bondholders

Three parties key to the corporation’s functioning are managers, shareholders, and bondholders, each of which can have different interests.

Learning Objective

Describe the reasons why there may be agency costs in an organization

Key Points

Three parties key to the functioning of the corporation are the managers, shareholders, and bondholders. While managers control the corporation and make strategic decisions, shareholders are owners, and bondholders are creditors.
While all three parties have an interest, whether direct or indirect, in the financial performance of the corporation, each of the three parties has different rights and rewards, for example voting rights and forms of financial return.
Shareholders, managers, and bondholders have different objectives. For example, shareholders have an incentive to take riskier projects than bondholders do and may prefer that the company pay more out in dividends. Managers may also be shareholders or prefer risk-averse, empire-building projects.

Key Terms

bond: A documentary obligation to pay a sum or to perform a contract; a debenture.
dividend: A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).
moral hazard: The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders’ and other stakeholders’ interests. Partly as a result of this separation, corporate governance mechanisms include a system of controls intended to help align managers’ incentives with those of shareholders and other stakeholders.

The deviation from the principal’s interest by the agent is called ‘agency costs. ‘ Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control and the different objectives of the managers and other stakeholders. Three parties key to the functioning of the corporation are the managers, shareholders, and bondholders. These three parties have different interests and asymmetric information, such that the principals cannot directly ensure that the agents are always acting in its (the principals’) best interests. Moral hazard and conflict of interest may arise.

Working on Assignments

While managers control the corporation and make strategic decisions, shareholders are owners, and bondholders are creditors. While all three parties have an interest, whether direct or indirect, in the financial performance of the corporation, each of the three parties has different rights and rewards, for example voting rights and forms of financial return. Shareholders, managers, and bondholders have different objectives. For example, stockholders have an incentive to take riskier projects than bondholders do, as bondholders are more interested in strategies that will increase the chances of getting their investment back. Shareholders also prefer that the company pay more out in dividends than bondholders would like. Managers may also be shareholders and reap the profits of more risky strategies or may prefer risk-averse empire-building projects.

1.7.3: Conflicts Between Managers and Shareholders

Agency costs mainly occur when ownership is separated, or when managers have objectives other than shareholder value maximization.

Learning Objective

Discuss different examples of a conflict of interest between managers and shareholders

Key Points

The agency view of the corporation suggests that the decision rights of the corporation should be entrusted to a manager to act in shareholders’ interests. Agency costs mainly occur when ownership is separated, or when managers have objectives other than shareholder value maximization.
Typically, the CEO and other top executives are responsible for making decisions about high-level policy and strategy. Shareholders, on the other hand, are individuals or institutions that legally own shares of corporation stock. Shareholders typically concede control rights to managers.
There are various conflicts of interest that can impact manager’s decisions to act in shareholders’ interests. Management may, for example, buy other companies to expand power. Venturing onto fraud, they may even manipulate financial figures to optimize bonuses and stock-price-related options.
Contemporary discussions of corporate governance argue that corporations should respect the rights of shareholders and help shareholders to exercise those rights. Disclosure and transparency are intimately intertwined with these goals.

Key Term

shareholder: One who owns shares of stock.

The “agency view” of corporations argues that the decisions rights (or control) of a corporation should be entrusted to a manager, so that the manager can act in the interest of shareholders . Partly as a result of this, mechanisms of corporate governance include a system of controls that are intended to align the incentives of managers with those of shareholders.

Two Businessmen Having a Discussion

These two businessmen could represent a manager and shareholder discussing the operation of the business.

The term “agency costs” refers to instances when an agent’s behavior has deviated from a principal’s interest. In this case, the principal would be the shareholder. These types of costs mainly arise because of contracting costs, or because individual managers might only possess partial control of corporation behavior. They also arise when managers have personal objectives that are different from the goal of maximizing shareholder profit.

Typically, the CEO and other top executives are responsible for making decisions about high-level policy and strategy. Shareholders, on the other hand, are individuals or institutions that legally own shares of stock in a corporation. Typically, these people have the right to sell those shares, to vote on directors nominated by various boards, and many other privileges. This being said, shareholders usually concede most of their control rights to managers.

While attempting to benefit shareholders, managers often encounter conflicts of interest. For example, a manager might engage in self-dealing, entering into transactions that benefit themselves over shareholders. Managers might also purchase other companies to expand individual power, or spend money on wasteful pet projects, instead of working to maximize the value of corporation stock. Venturing onto fraud, they may even manipulate financial figures to optimize bonuses and stock-price-related benefits.

The chief goal of current corporate governance is to eliminate instances when shareholders have conflicts of interest with one another. Another important goal is to evaluate whether a corporate governance system hampers or improves the efficiency of an organization. Research of this type is particularly focused on how corporate governance impacts the welfare of shareholders. After the high-profile collapse of a number of large corporations in the past two decades, several of which involved accounting fraud, there has been a renewed public interest in how modern corporations practice governance, particularly regarding accounting.

Advocates of governance typically encourage corporations to respect shareholder rights, and to help shareholders learn how and where to exercise those rights. Disclosure and transparency are intertwined with these goals.

1.7.4: Conflicts of Interest Between Shareholders and Bondholders

The shareholders and bondholders have different rights and returns, leading to potential conflicts of interest.

Learning Objective

Describe the conflict of interest between a company’s shareholders and its bondholders

Key Points

The shareholders are individuals or institutions that legally own shares of stock in the corporation, while the bondholders are the firm’s creditors. The two parties have different relationships to the company, accompanied by different rights and financial returns.
Stockholders have an incentive to take riskier projects than bondholders do. Other conflicts of interest can stem from the fact that bonds often have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely but can also be sold at any point.
Bondholders may put contracts in place prohibiting management from taking on very risky projects or may raise the interest rate demanded, increasing the cost of capital for the company. Conversely, shareholder preferences–for example for riskier growth strategies–can adversely impact bondholders.

Key Terms

shareholder: One who owns shares of stock.
bond: A documentary obligation to pay a sum or to perform a contract; a debenture.
maturity: Date when payment is due.

The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager (the agent) to act in the principals’ interests.

The deviation from the principals’ interests by the agent is called ‘agency costs’, which are often described as existing between managers and shareholders; but conflicts of interest can also exist between shareholders and bondholders.

The shareholders are individuals or institutions that legally own shares of stock in the corporation, while the bondholders are the firm’s creditors. The two parties have different relationships to the company, accompanied by different rights and financial returns. For example, stockholders have an incentive to take riskier projects than bondholders do , as bondholders are more interested in strategies that will increase the chances of getting their investment back. Shareholders also prefer that the company pay more out in dividends than bondholders would like. Shareholders have voting rights at general meetings, while bondholders do not. If there is no profit, the shareholder does not receive a dividend, while interest is paid to debenture-holders regardless of whether or not a profit has been made. Other conflicts of interest can stem from the fact that bonds often have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely but can also be sold at any point.

Wall Street bull

The bull on Wall Street is an iconic image of the New York Stock Exchange.

Because bondholders know this, they may create ex-ante contracts prohibiting the management from taking on very risky projects that might arise, or they may raise the interest rate demanded, increasing the cost of capital for the company. For example, loan covenants can be put in place to control the risk profile of a loan, requiring the borrower to fulfill certain conditions or forbidding the borrower from undertaking certain actions as a condition of the loan. This can negatively impact the shareholders. Conversely, shareholder preferences–as for example riskier strategies for growth–can adversely impact bondholders.

1.8: Asset Classes

1.8.1: Cash

Cash, the most liquid asset, refers to physical currency such as banknotes and coins.

Learning Objective

Distinguish cash and cash equivalents from other types of assets

Key Points

Cash refers to physical currency such as banknotes and coins.
Cash has now become a very small part of the money supply.
A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand.
Cash and cash equivalents are the most liquid assets found within the asset portion of a company’s balance sheet.

Key Terms

socio-economic: Social economics refers broadly to the use of economics in the study of society.
money supply: In economics, the money supply or money stock is the total amount of monetary assets available in an economy at a specific time.

Cash

In common language, cash refers to physical currency such as banknotes and coins.

In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately (as in the case of money market accounts). Cash is viewed either as a reserve for payments, in case of a structural or incidental negative cash flow, or as a way to avoid a downturn in financial markets.

Cash

Cash has now become a very small part of the money supply. Its remaining role is to provide a form of currency storage and payment for those who do not wish to take part in other systems, and prefer to make small payments conveniently and promptly. This latter method, however, is being replaced more and more frequently by electronic payment systems.

A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods and they acquire buildings and equipment. In other words, because businesses have assets, they cannot immediately turn them into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. This means that businesses also have liabilities. Cash and cash equivalents can be used to pay the short-term debt of a company.

Cash and cash equivalents

Cash and cash equivalents are the most liquid assets found within the asset portion of a company’s balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or treasury bills, marketable securities, and commercial paper. Cash equivalents are distinguished from other investments through their short-term existence; they mature within 3 months, whereas short-term investments take 12 months or less and long-term investments take longer than 12 months. Cash equivalent investments should also have an insignificant risk of change in value: for example, common stock cannot be considered a cash equivalent, but preferred stock acquired shortly before its redemption date can.

Money

Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country. The main functions of money can be defined as follows: a medium of exchange; a unit of account; a store of value; and occasionally, in the past, a standard of deferred payment. Any kind of object or secure verifiable record that fulfills these functions can serve as money.

Banknote

A banknote (often known as a bill, paper money, or simply a note) is a type of negotiable instrument known as a promissory note, made by a bank, payable to the bearer on demand. When banknotes were first introduced, they were, in effect, a promise to pay the bearer in coins, but gradually became a substitute for the coins and a form of money in their own right.

1.8.2: Debt

A debt is an obligation owed by one party (the debtor) to a second party (the creditor).

Learning Objective

Classify different types of debt based on its characteristics

Key Points

A debt is created when a creditor agrees to lend a sum of assets to a debtor. Debt is usually granted with expected repayment.
The various types of debt can generally be categorized into: 1) secured and unsecured debt, 2) private and public debt, 3) syndicated and bilateral debt, and 4) other types of debt that display one or more of the characteristics noted above.
Debt allows people and organizations to do things that they would otherwise not be able, or allowed, to do.

Key Term

TIPS: Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index (CPI), the commonly used measure of inflation. When the CPI rises, the principal adjusts upward. If the index falls, the principal adjusts downwards.

Debt

A debt is an obligation owed by one party (the debtor) to a second party (the creditor). Debt usually refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.

A debt is created when a creditor agrees to lend a sum of assets to a debtor. Debt is usually granted with expected repayment. In modern society, this typically includes repayment of the original sum, plus interest.

In finance, debt is a means of using anticipated future purchasing power in the present before it has actually been earned. Some companies and corporations use debt as a part of their overall corporate finance strategy.

Debt allows people and organizations to do things that they would otherwise not be able, or allowed, to do. People in industrialized nations commonly use it to purchase houses, cars, and many other things too expensive to buy with cash on hand. Companies also use debt in many ways to leverage the investment made in their assets, by “leveraging” the return on their equity. This leverage, the proportion of debt to equity, is considered important in determining the riskiness of an investment–the more debt per equity, the riskier. For both companies and individuals, this increased risk can lead to poor results, as the cost of servicing the debt can grow beyond the ability to pay due to either external events (income loss) or internal difficulties (poor management of resources).

Types of debt

A company uses various kinds of debt to finance its operations. The various types of debt can generally be categorized into:

1) secured and unsecured debt

A debt obligation is considered secured if creditors have recourse to the assets of the company on a proprietary basis or otherwise ahead of general claims against the company. Unsecured debt comprises financial obligations, where creditors do not have recourse to the assets of the borrower to satisfy their claims.

2) private and public debt

Private debt involves bank-loan type obligations, whether senior or mezzanine. Public debt is a general definition covering all the financial instruments that are freely tradeable on a public exchange or over the counter, with few if any restrictions.

3) syndicated and bilateral debt

A syndicated loan is a loan that is granted to companies that wish to borrow more money than any single lender is prepared to risk in a single loan, an amount usually in the many millions of dollars. In such a case, a syndicate of banks can each agree to put forward a portion of the principal sum. Loan syndication is a risk management tool that allows the lead banks underwriting the debt to reduce their risk and free up lending capacity.

4) other types of debt

A bond is a debt security issued by certain institutions such as companies and governments. A bond entitles the holder to repayment of the principal sum, plus interest. Bonds are issued to investors in a marketplace when an institution wishes to borrow money. Bonds have a fixed lifetime, usually a number of years. Some long-term bonds, can last over 30 years, though they are less common. At the end of the bond’s life the money should be repaid in full. Interest may be added to the end payment or can be paid in regular installments (known as coupons) during the life of the bond. Bonds may be traded in the bond markets and are widely used as relatively safe investments in comparison to equity.

Borrowing and repayment arrangements linked to inflation-indexed units of account are possible and are used in some countries. For example, the US government issues two types of inflation-indexed bonds, Treasury Inflation-Protected Securities (TIPS) and I-bonds. Inflation-indexed debt is one of the safest forms of investment available, since the only major source of risk – that of inflation – is eliminated. A number of other governments issue similar bonds, with some doing so for many years before the US government. In countries with consistently high inflation, ordinary borrowings at banks may also be inflation indexed.

Treasury Bills

Treasury bills are one kind of debt issued by the U.S. Treasury.

1.8.3: Stocks

The capital stock (or stock) of a business entity represents the original capital paid into or invested in the business by its founders.

Learning Objective

Distinguish between preferred and common shares of stock

Key Points

The capital stock (or stock) of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors.
Stock typically takes the form of shares of either common stock or preferred stock.
As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions; Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders.
In general, the shares of a company may be transferred from shareholders to other parties by sale or other mechanisms, unless prohibited.

Key Term

Initial public offering: An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are sold to the general public, on a securities exchange, for the first time.

Example

Preferred stock usually comes with a letter designation at the end of the security; for example, Berkshire-Hathaway Class “B” shares sell under stock ticker BRK.B whereas Class “A” shares of ORION DHC, Inc will sell under ticker OODHA until the company drops the “A” creating ticker OODH for its “Common” shares only designation.

Stock

The capital stock (or stock) of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is different from the property and the assets of a business which may fluctuate in quantity and value.

The stock of a business is divided into multiple shares, the total of which must be stated at the time of business formation. Given the total amount of money invested in the business, a share has a certain declared face value, commonly known as the par value of a share. The par value is the de minimis (minimum) amount of money that a business may issue and sell shares for in many jurisdictions and it is the value represented as capital in the accounting of the business. In other jurisdictions, however, shares may not have an associated par value at all. Such stock is often called non-par stock. Shares represent a fraction of ownership in a business. A business may declare different types (classes) of shares, each having distinctive ownership rules, privileges, or share values.

Types of stock

Stock typically takes the form of shares of either common stock or preferred stock.

As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions.
Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders.
Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually any time after a predetermined date. Shares of such stock are called “convertible preferred shares”.

New equity issues may have specific legal clauses attached that differentiate them from previous issues of the issuer. Some shares of common stock may be issued without the typical voting rights, for instance, or some shares may have special rights unique to them and issued only to certain parties. Often, new issues that have not been registered with a securities governing body may be restricted from resale for certain periods of time.

Preferred stock may be hybrid by having the qualities of bonds of fixed returns and common stock voting rights. They also have preference in the payment of dividends over common stock and also have been given preference at the time of liquidation over common stock. They have other features of accumulation in dividend. In addition, preferred stock usually comes with a letter designation at the end of the security. This extra letter does not mean that any exclusive rights exist for the shareholders but it does let investors know that the shares are considered for such, however, these rights or privileges may change based on the decisions made by the underlying company.

Application

The owners of a private company may want additional capital to invest in new projects within the company. They may also simply wish to reduce their holding, freeing up capital for their own private use. They can achieve these goals by selling shares in the company to the general public, through a sale on a stock exchange. This process is called an initial public offering, or IPO.

By selling shares they can sell part or all of the company to many part-owners. The purchase of one share entitles the owner of that share to literally share in the ownership of the company, a fraction of the decision-making power, and potentially a fraction of the profits, which the company may issue as dividends.

Trading

In general, the shares of a company may be transferred from shareholders to other parties by sale or other mechanisms, unless prohibited. Most jurisdictions have established laws and regulations governing such transfers, particularly if the issuer is a publicly traded entity.

The desire of stockholders to trade their shares has led to the establishment of stock exchanges, organizations which provide marketplaces for trading shares and other derivatives and financial products. Today, stock traders are usually represented by a stockbroker who buys and sells shares of a wide range of companies on such exchanges. A company may list its shares on an exchange by meeting and maintaining the listing requirements of a particular stock exchange. In the United States, through the intermarket trading system, stocks listed on one exchange can often also be traded on other participating exchanges, including electronic communication networks (ECNs), such as Archipelago or Instinet.

Stock Market Prices

Stock prices vary according to supply and demand for the stocks in question.

1.9: Financial Markets

1.9.1: Types of Financial Markets

Financial markets are of many types, including general and specialized; capital and money; and primary and secondary.

Learning Objective

Describe different types of financial markets

Key Points

A financial market is an aggregate of possible buyers and sellers of financial securities, commodities, and other fungible items, as well as the transactions between them.
The term “financial markets” is often used to refer solely to the markets that are used to raise finance: for long-term finance, capital markets are used; for short-term finance (maturity up to one year), money markets are used.
Stock markets and bond markets are two types of capital markets that provide financing through the issuing of shares of stock or the issuing of bonds, respectively. A key division within the capital markets is between the primary markets and secondary markets.
While capital markets and money markets constitute the narrower definition of financial markets, other markets, such as derivatives and currency markets, are often included in the more general sense of the word.

Key Terms

derivative: A financial instrument whose value depends on the valuation of an underlying asset; such as a warrant, an option, etc.
maturity: Date when payment is due.
capital: Money and wealth; the means to acquire goods and services, especially in a non-barter system.
fungible: Able to be substituted for something of equal value or utility; interchangeable, exchangeable, replaceable

A financial market is an aggregate of possible buyers and sellers of financial securities, commodities, and other fungible items, as well as the transactions between them. Examples of financial markets include capital markets, derivative markets, money markets, and currency markets. There are many different ways to divide and classify financial markets: for example, into general markets and specialized markets, capital markets and money markets, and primary and secondary markets.

Within the financial sector, the term “financial markets” is often used to refer solely to the markets that are used to raise finance:

for long-term finance, capital markets are used
for short-term finance (maturity up to one year), money markets are used.

Stock markets and bond markets are two types of capital markets that provide financing through the issuing of shares of stock and the issuing of bonds, respectively. A key division within the capital markets is between the primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets, such as during initial public offerings. Secondary markets are for the secondary trade of securities, providing a continuous and regular market for the buying and selling of securities.

The New York Stock Exchange

The New York Stock Exchange (NYSE) is an exchange enabling a financial market.

While capital markets and money markets constitute the narrower definition of financial markets, other markets are often included in the more general sense of the word. The derivatives market is the financial market for derivatives– financial instruments like futures contracts or options– which are derived from other forms of assets. Currency markets, enabled by foreign exchange (or forex) markets enable currency conversion and determine the relative value of world currencies.

1.9.2: Role of Financial Markets in Capital Allocation

One of the main functions of financial markets is to allocate capital, matching those who have capital to those who need it.

Learning Objective

Explain how financial markets allocates capital

Key Points

One of the main functions of financial markets is to allocate capital. Capital markets especially facilitate the raising of capital while money markets facilitate the transfer of liquidity, in both cases matching those who have capital to those who need it.
Financial markets attract funds from investors and channel them to enterprises that use that capital to finance their operations and achieve growth, from startup phases to expansion–even much later in the firm’s life.
Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Bank deposits are a simple way in which capital is allocated from a pool of savers to businesses that want to deploy it.
More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing instruments can be resold. One example being a stock exchange.

Key Terms

exchange: A place for conducting trading.
capital: Money and wealth; the means to acquire goods and services, especially in a non-barter system.
liquidity: Availability of cash over short term: ability to service short-term debt.

Introduction

A financial market is an aggregate of possible buyers and sellers of financial securities, commodities, and other fungible items and the transactions between them . Within the financial sector, the term “financial markets” is often used to refer just to the markets that are used to raise finance: the capital markets for long-term finance and the money markets for short-term finance (maturity up to one year).

Frankfurt Bond Market

The Frankfurt Bond Market is an example of a financial market that allocates capital.

Allocating Capital

One of the main functions of financial markets is to allocate capital. Capital markets especially facilitate the raising of capital while money markets facilitate the transfer of liquidity, matching those who have capital to those who need it. Financial markets attract funds from investors and channel them to enterprises that use that capital to finance their operations and achieve growth, from start-up phases to expansion–even much later in the firm’s life. Money markets allow firms to borrow funds on a short-term basis, while capital markets allow corporations to gain long-term funding to support expansion.

Funds borrowed from the money markets are typically used for general operating expenses, to cover brief periods of illiquidity. When a company borrows from the primary capital markets, often the purpose is to invest in additional physical capital goods, which will be used to help increase its income. Financial capital is money used by entrepreneurs and businesses to buy what they need to make their products or provide their services. It can take many months or years before the investment generates sufficient return to pay back its cost, and hence the finance is long-term. Long-term capital can come in the form of shared capital, mortgage loans, and venture capital, among other types.

Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Banks take deposits from those who have money to save. Many individuals are not aware that they are lenders providing capital, but many do lend money at least indirectly, for example when they put money in a savings account or contribute to a pension. Intermediaries like banks can then lend money from this pool of deposited money in the form of loans to those who seek to borrow. More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. One example is the stock exchange, where a company can raise money by selling ownership shares to investors and its existing shares can be bought or sold.

1.9.3: Role of Financial Markets in Providing Feedback to Management

Financial markets can provide feedback to management by showing signals of the demand to supply funds to that enterprise.

Learning Objective

Describe how financial markets can provide feedback to a company’s management

Key Points

Financial markets function through the interaction of buyers and sellers that determine the price of traded assets. Financial markets provide a sign for the allocation of funds in the economy based on the demand and supply through the mechanism called the price discovery process.
Management often has imperfect information about its own business. One way in which managers try to gain feedback on their business is by conducting market research. Financial markets can also provide feedback.
These various audiences can provide feedback to management, such as when the stock price rises or declines. However, given that the stock market is prone to oscillation, this feedback can vary in its usefulness for managers making decisions.
More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing instruments can be resold, an example being a stock exchange.

Key Term

feedback: Critical assessment on information produced

Market Role in Providing Feedback to Management

Management often has imperfect information about its own business, especially its business’ value in the outside world . One way in which managers try to gain feedback on their business is by conducting market research to discover what people want, need, or believe. Once that research is completed, it can be used to determine how to market various products.

Feedback to Management

Here a group may be providing feedback to management. This can be done at a much larger scale today.

Financial markets can also provide feedback, demonstrating how potential shareholders view the financial value of one company as compared to its competitors. For example, investors who hold shares in multiple firms in a sector may have more information about the prospects in that sector than the manager of one firm in that sector. In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other, creating an imbalance of power. Financial economists have applied information asymmetry in studies of differentially informed financial market participants (insiders, stock analysts, investors, among others).

These various audiences can provide feedback to management, such as when the stock price rises or declines. That said, the stock market is an example of a system prone to oscillation. It is governed by positive and negative feedback resulting from the cognitive and emotional factors among market participants. This may be the result of data-based fundamental analysis or more sentiment-based analysis, meaning that the feedback from the stock market can vary in its usefulness for mangers making short-term and long-term decisions.

1.9.4: Trends in Markets

A market trend is a putative tendency of a financial market to move in a particular direction over time.

Learning Objective

Define different types of market trends

Key Points

The terms bull market and bear market describe upward and downward market trends, respectively, and can be used to describe either the market as a whole or specific sectors and securities.
A secular market trend is a long-term trend that lasts 5 to 25 years and consists of a series of primary trends.
A primary trend has broad support throughout the entire market and lasts for a year or more.
There are also trends in new ways of transacting in financial markets, for example electronic trading innovations. Algorithmic trading allows trading orders to be entered with an algorithm deciding on aspects of the order. Stock market data systems have also changed drastically over the years.
Additionally, new markets are emerging, such as private secondary markets allowing trading of unregistered and private company securities.

Key Term

putative: Commonly believed or deemed to be the case; accepted by supposition rather than as a result of proof.

Trends in Markets

A market trend is a putative tendency of a financial market to move in a particular direction over time. These trends are classified as secular for long-term frames, primary for medium-term frames, and secondary for short-term frames. Traders identify market trends using technical analysis, a framework which characterizes market trends as predictable price tendencies when price reaches support and resistance levels, varying over time.

The terms bull market and bear market describe upward and downward market trends, respectively, and can be used to describe either the market as a whole or specific sectors and securities .

Bull and Bear.

The bull and bear represent the two major forms of market trend.

Secular Market Trend

A secular market trend is a long-term trend that lasts 5 to 25 years and consists of a series of primary trends. A secular bear market consists of smaller bull markets and larger bear markets, while a secular bull market consists of larger bull markets and smaller bear markets.

In a secular bull market, the prevailing trend is “bullish” or upward-moving. The United States stock market was described as being in a secular bull market from about 1983 to 2000, with brief upsets including the crash of 1987 and the dot-com bust of 2000 to 2002.

In a secular bear market, the prevailing trend is “bearish” or downward-moving. An example of a secular bear market was seen in gold during the period between January 1980 to June 1999, culminating with the Brown Bottom. During this period, the nominal gold price fell from a high of $850/oz ($30/g) to a low of $253/oz ($9/g), and became part of the Great Commodities Depression.

Primary Market Trend

A primary trend has broad support throughout the entire market and lasts for a year or more.

Bull Market

A bull market is associated with increasing investor confidence, and increased investing in anticipation of future price increases. A bullish trend in the stock market often begins before the general economy shows clear signs of recovery.

Bear Market

A bear market is a general decline in the stock market over a period of time. It is a transition from high investor optimism to widespread investor fear and pessimism. According to The Vanguard Group, “While there’s no agreed-upon definition of a bear market, one generally accepted measure is a price decline of 20% or more over at least a two-month period. “

Market Top

A market top (or market high) is usually not a dramatic event. The market has simply reached the highest point that it will for some time. A decline then follows, usually gradually at first and later with more rapidity. William J. O’Neil and company reported that since the 1950s, a market top is characterized by three to five distribution days in a major market index occurring within a relatively short period of time. Distribution is a decline in price with higher volume than the preceding session.

Market Bottom

A market bottom is a trend reversal, the end of a market downturn, and precedes the beginning of an upward moving trend (bull market).

It is very difficult to identify a bottom while it is occurring. The upturn following a decline is often short-lived and prices might resume their decline. This would bring a loss for the investor who purchased stock during a misperceived or “false” market bottom.