Business Law Question

1. Who is the CFO? Where does this individual fit in the corporate hierarchy? What are his or her responsibilities in an organization? MINIMUM ONE & HALF PAGE REQUIREMENT. Chapter # 1.

2. Why are Financial Markets essential for a Healthy economy and Economic growth? MINIMUM ONE PAGE REQUIREMENT. Chapter # 2.

3. Explore the 10K or 10Q report of any public company of your choice and Write minimum ONE page as to what info you found in this report. You can explore any report of year 2022. Let me know what public company you are choosing by emailing me.

4. Explore the website Marketwatch.com and write TWO pages as to what info you found on the website. Explore different tabs.

REFERENCES ARE MANDATORY.

Below are 2 files chapter 1 and chapter 2 for questions 1 and 2

• APA format, Use the APA template located in the Student Resource Center to complete the assignment.

Introduction
Striking the Right Balance
In 1776, Adam Smith described how an “invisible hand” guides companies as they strive for
profits, and that hand leads them to decisions that benefit society. Smith’s insights led him
to conclude that profit maximization is the right goal for a business and that the free
enterprise system is best for society. But the world has changed since 1776. Firms today are
much larger, they operate globally, they have thousands of employees, and they are owned
by millions of stockholders. This makes us wonder if the “invisible hand” still provides
reliable guidance: Should companies still try to maximize profits, or should they take a
broader view and more balanced actions designed to benefit customers, employees,
suppliers, and society as a whole?
Many academics and finance professionals today subscribe to the following modified version
of Adam Smith’s theory:
A firm’s principal financial goal should be to maximize the wealth of its stockholders, which
means maximizing the value of its stock.
Free enterprise is still the best economic system for society as a whole. Under the free
enterprise framework, companies develop products and services that people want and that
benefit society.
However, some constraints are needed—firms should not be allowed to pollute the air and
water, to engage in unfair employment practices, or to create monopolies that exploit
consumers.
These constraints take a number of different forms. The first set of constraints is the costs
that are assessed on companies if they take actions that harm society. Another set of
constraints arises through the political process, where society imposes a wide range of
regulations that are designed to keep companies from engaging in harmful practices.
Properly imposed, these costs fairly transfer value to suffering parties and help create
incentives that help prevent similar events from occurring in the future.
The financial crisis in 2007 and 2008 dramatically illustrates these points. We witnessed
many Wall Street firms engaging in extremely risky activities that pushed the financial
system to the brink of collapse. Saving the financial system required a bailout of the banks
and other financial companies, and that bailout imposed huge costs on taxpayers and
helped push the economy into a deep recession. Apart from the huge costs imposed on
society, the financial firms also paid a heavy price—a number of leading financial institutions
saw a huge drop in their stock price, some failed and went out of business, and many Wall
Street executives lost their jobs.
Arguably, these costs are not enough to prevent another financial crisis from occurring.
Many maintain that the events surrounding the financial crisis illustrate that markets don’t
always work the way they should and that there is a need for stronger regulation of the
financial sector. For example, in his recent books, Nobel Laureate Joseph Stiglitz makes a
strong case for enhanced regulation. At the same time, others with a different political
persuasion continue to express concerns about the costs of excessive regulation.
Beyond the financial crisis, there is a broader question of whether laws and regulations are
enough to compel firms to act in society’s interest. An increasing number of companies
continue to recognize the need to maximize shareholder value, but they also see their
mission as more than just making money for shareholders. Google’s parent company
Alphabet’s motto is “Do the right thing—follow the law, act honorably, and treat each other
with respect.” Consistent with this mission, the company has its own in-house foundation
that each year makes large investments in a wide range of philanthropic ventures
worldwide.
Microsoft is another good example of a company that has earned a reputation for taking
steps to be socially responsible. The company recently released its 2019 Corporate Social
Responsibility Report. In an accompanying letter to shareholders, Microsoft CEO Satya
Nadella highlighted its broader mission:
Our mission to empower every person and every organization on the planet to achieve more
has never been more important. At a time when many are calling attention to the role
technology plays in society broadly, our mission remains constant. It grounds us in the
enormous opportunity and responsibility we have to ensure that the technology we create
always benefits everyone on the planet, including the planet itself. Our platforms and tools
help make small businesses more productive, multinationals more competitive, nonprofits
more effective, and governments more efficient. They improve healthcare and education
outcomes, amplify human ingenuity, and allow people everywhere to reach higher.
Similarly, the Business Roundtable, a group of leading business executives, made news in
2019 when it put out a statement indicating that companies should explicitly account for the
broader interests of stakeholders, not just focus exclusively on shareholders.
While many companies and individuals have taken very significant steps to demonstrate
their commitments to being socially responsible, corporate managers frequently face a
tough balancing act. Realistically, there will still be cases where companies face conflicts
between their various constituencies—for example, a company may enhance shareholder
value by laying off some workers, or a change in policy may improve the environment but
reduce shareholder value. We also have seen examples where leading tech companies such
as Facebook and Google have come under fire for their handling of their users’ private
information. In each of these instances, managers have to balance these competing interests
and different managers will clearly make different choices. More recently, virtually every
organization has faced considerable pressure trying to manage their various constituencies
in the midst of the massive personal and economic dislocation resulting from the
coronavirus pandemic. At the end of the day, all companies struggle to find the right
balance. Enlightened managers recognize that there is more to life than money, but it often
takes money to do good things.
Sources: “Microsoft 2019 Corporate Social Responsibility Report,” microsoft.com/enus/corporate-responsibility/reports-hub, October 16, 2019; “Microsoft 2019 Annual Report,”
microsoft.com/investor/reports/ar19/index.html, October 16, 2019; “Business Roundtable
Redefines the Purpose of a Corporation to Promote ‘An Economy That Serves All
Americans,’” businessroundtable.org/business-roundtable-redefines-the-purpose-of-acorporation-to-promote-an-economy-that-serves-all-americans, August 19, 2019; Kevin J.
Delaney, “Google: From ‘Don’t Be Evil’ to How to Do Good,” The Wall Street Journal, January
18, 2008, pp. B1–B2; Joseph E. Stiglitz, FreeFall: America, Free Markets, and the Sinking of
the World Economy (New York: W.W. Norton, 2010); and Joseph E. Stiglitz, The Price of
Inequality (New York: W.W. Norton, 2012).
Putting Things in Perspective
This chapter will give you an idea of what financial management is all about. We begin the
chapter by describing how finance is related to the overall business environment, by
pointing out that finance prepares students for jobs in different fields of business, and by
discussing the different forms of business organization. For corporations, management’s goal
should be to maximize shareholder wealth, which means maximizing the value of the stock.
When we say “maximizing the value of the stock,” we mean the “true, long-run value,”
which may be different from the current stock price. In the chapter, we discuss how firms
must provide the right incentives for managers to focus on long-run value maximization.
Good managers understand the importance of ethics, and they recognize that maximizing
long-run value is consistent with being socially responsible.
When you finish this chapter, you should be able to do the following:
Explain the role of finance and the different types of jobs in finance.
Identify the advantages and disadvantages of different forms of business organization.
Explain the links between stock price, intrinsic value, and executive compensation.
Identify the potential conflicts that arise within the firm between stockholders and
managers and between stockholders and bondholders, and discuss the techniques that firms
can use to mitigate these potential conflicts.
Discuss the importance of business ethics and the consequences of unethical behavior.
1-1. What Is Finance?
Finance is defined by Webster’s Dictionary as “the system that includes the circulation of
money, the granting of credit, the making of investments, and the provision of banking
facilities.” Finance has many facets, which makes it difficult to provide one concise definition.
The discussion in this section will give you an idea of what finance professionals do and what
you might do if you enter the finance field after you graduate.
1-1A. Areas of Finance
Finance as taught in universities is generally divided into three areas:
(1)
financial management,
(2)
capital markets, and
(3)
investments.
Financial management, also called corporate finance, focuses on decisions relating to how
much and what types of assets to acquire, how to raise the capital needed to purchase
assets, and how to run the firm so as to maximize its value. The same principles apply to
both for-profit and not-for-profit organizations, and as the title suggests, much of this book
is concerned with financial management.
Capital markets relate to the markets where interest rates, along with stock and bond prices,
are determined. Also studied here are the financial institutions that supply capital to
businesses. Banks, investment banks, stockbrokers, mutual funds, insurance companies, and
the like bring together “savers” who have money to invest and businesses, individuals, and
other entities that need capital for various purposes. Governmental organizations such as
the Federal Reserve System, which regulates banks and controls the supply of money, and
the Securities and Exchange Commission (SEC), which regulates the trading of stocks and
bonds in public markets, are also studied as part of capital markets.
Investments relate to decisions concerning stocks and bonds and include a number of
activities:
(1)
Security analysis deals with finding the proper values of individual securities (i.e., stocks and
bonds).
(2)
Portfolio theory deals with the best way to structure portfolios, or “baskets,” of stocks and
bonds. Rational investors want to hold diversified portfolios in order to limit risks, so
choosing a properly balanced portfolio is an important issue for any investor.
(3)
Market analysis deals with the issue of whether stock and bond markets at any given time
are “too high,” “too low,” or “about right.”
Included in market analysis is behavioral finance, where investor psychology is examined in
an effort to determine whether stock prices have been bid up to unreasonable heights in a
speculative bubble or driven down to unreasonable lows in a fit of irrational pessimism.
Although we separate these three areas, they are closely interconnected. Banking is studied
under capital markets, but a bank lending officer evaluating a business’ loan request must
understand corporate finance to make a sound decision. Similarly, a corporate treasurer
negotiating with a banker must understand banking if the treasurer is to borrow on
“reasonable” terms. Moreover, a security analyst trying to determine a stock’s true value
must understand corporate finance and capital markets to do his or her job. In addition,
financial decisions of all types depend on the level of interest rates; so all people in
corporate finance, investments, and banking must know something about interest rates and
the way they are determined. Because of these interdependencies, we cover all three areas
in this book.
1-1B. Finance within an Organization
The duties of the CFO have broadened over the years. CFO magazine’s online service,
cfo.com, is an excellent source of timely finance articles intended to help the CFO manage
those new responsibilities.
Most businesses and not-for-profit organizations have an organization chart similar to the
one shown in Figure 1.1. The board of directors is the top governing body, and the
chairperson of the board is generally the highest-ranking individual. The chief executive
officer (CEO) comes next, but note that the chairperson of the board often also serves as the
CEO. Below the CEO comes the chief operating officer (COO), who is often also designated as
a firm’s president. The COO directs the firm’s operations, which include marketing,
manufacturing, sales, and other operating departments. The chief financial officer (CFO),
who is generally a senior vice president and the third-ranking officer, is in charge of
accounting, finance, credit policy, decisions regarding asset acquisitions, and investor
relations, which involves communications with stockholders and the press.
Figure 1.1 Finance within the Organization
Details
If the firm is publicly owned, the CEO and the CFO must both certify to the SEC that reports
released to stockholders, and especially the annual report, are accurate. If inaccuracies later
emerge, the CEO and the CFO could be fined or even jailed. This requirement was instituted
in 2002 as a part of the Sarbanes-Oxley Act. The act was passed by Congress in the wake of a
series of corporate scandals involving now-defunct companies such as Enron and WorldCom,
where investors, workers, and suppliers lost billions of dollars due to false information
released by those companies.
1-1C. Finance versus Economics and Accounting
Finance, as we know it today, grew out of economics and accounting. Economists developed
the notion that an asset’s value is based on the future cash flows the asset will provide, and
accountants provided information regarding the likely size of those cash flows. People who
work in finance need knowledge of both economics and accounting. Figure 1.1 illustrates
that in the modern corporation, the accounting department typically falls under the control
of the CFO. This further illustrates the link among finance, economics, and accounting.
SelfTest
What three areas of finance does this book cover? Are these areas independent of one
another, or are they interrelated in the sense that someone working in one area should
know something about each of the other areas? Explain.
Who is the CFO, and where does this individual fit into the corporate hierarchy? What are
some of his or her responsibilities?
Does it make sense for not-for-profit organizations such as hospitals and universities to have
CFOs? Why or why not?
What is the relationship among economics, finance, and accounting?
1-2. Jobs in Finance
To find information about different finance careers, go to allbusinessschools.com/businesscareers/finance/job-description. This website provides information about different finance
areas.
Finance prepares students for jobs in banking, investments, insurance, corporations, and
government. Accounting students need to know marketing, management, and human
resources; they also need to understand finance, for it affects decisions in all those areas.
For example, marketing people propose advertising programs, but those programs are
examined by finance people to judge the effects of the advertising on the firm’s profitability.
So to be effective in marketing, one needs to have a basic knowledge of finance. The same
holds for management—indeed, most important management decisions are evaluated in
terms of their effects on the firm’s value.
It is also worth noting that finance is important to individuals regardless of their jobs. Some
years ago most employees received pensions from their employers upon retirement, so
managing one’s personal investments was not critically important. That’s no longer true.
Most firms today provide “defined contribution” pension plans, where each year the
company puts a specified amount of money into an account that belongs to the employee.
The employee must decide how those funds are to be invested—how much should be
divided among stocks, bonds, or money funds—and how much risk they’re willing to take
with their stock and bond investments. These decisions have a major effect on people’s lives,
and the concepts covered in this book can improve decision-making skills.
1-3. Forms of Business Organization
efinancialcareers.com provides finance career news and advice including information on
who’s hiring in finance and accounting fields.
The basics of financial management are the same for all businesses, large or small,
regardless of how they are organized. Still, a firm’s legal structure affects its operations and
thus should be recognized. There are four main forms of business organizations:
(1)
proprietorships,
(2)
partnerships,
(3)
corporations, and
(4)
limited liability companies (LLCs) and limited liability partnerships (LLPs).
In terms of numbers, most businesses are proprietorships. However, based on the dollar
value of sales, more than 80% of all business is done by corporations. Because corporations
conduct the most business and because most successful businesses eventually convert to
corporations, we focus on them in this book. Still, it is important to understand the legal
differences between types of firms.
A proprietorship is an unincorporated business owned by one individual. Going into business
as a sole proprietor is easy—a person begins business operations. Proprietorships have three
important advantages:
(1)
They are easy and inexpensive to form,
(2)
they are subject to few government regulations, and
(3)
they are subject to lower income taxes than are corporations.
However, proprietorships also have three important limitations:
(1)
Proprietors have unlimited personal liability for the business’ debts, so they can lose more
than the amount of money they invested in the company. You might invest $10,000 to start a
business but be sued for
$
1
million
if, during company time, one of your employees runs over someone with a car.
(2)
The life of the business is limited to the life of the individual who created it, and to bring in
new equity, investors require a change in the structure of the business.
(3)
Because of the first two points, proprietorships have difficulty obtaining large sums of
capital; hence, proprietorships are used primarily for small businesses.
However, businesses are frequently started as proprietorships and then converted to
corporations when their growth results in the disadvantages outweighing the advantages.
A partnership is a legal arrangement between two or more people who decide to do
business together. Partnerships are similar to proprietorships in that they can be established
relatively easily and inexpensively. Moreover, the firm’s income is allocated on a pro rata
basis to the partners and is taxed on an individual basis. This allows the firm to avoid the
corporate income tax. However, all of the partners are generally subject to unlimited
personal liability, which means that if a partnership goes bankrupt and any partner is unable
to meet his or her pro rata share of the firm’s liabilities, the remaining partners will be
responsible for making good on the unsatisfied claims. Thus, the actions of a Texas partner
can bring ruin to a millionaire New York partner who had nothing to do with the actions that
led to the downfall of the company. Unlimited liability makes it difficult for partnerships to
raise large amounts of capital.
A corporation is a legal entity created by a state, and it is separate and distinct from its
owners and managers. It is this separation that limits stockholders’ losses to the amount
they invested in the firm—the corporation can lose all of its money, but its owners can lose
only the funds that they invested in the company. Corporations also have unlimited lives,
and it is easier to transfer shares of stock in a corporation than one’s interest in an
unincorporated business. These factors make it much easier for corporations to raise the
capital necessary to operate large businesses. Thus, companies such as Hewlett-Packard and
Microsoft generally begin as proprietorships or partnerships, but at some point they find it
advantageous to become a corporation.
A major drawback to corporations is taxes. Most corporations’ earnings are subject to
double taxation—the corporation’s earnings are taxed, and then when its after-tax earnings
are paid out as dividends, those earnings are taxed again as personal income to the
stockholders. However, as an aid to small businesses, Congress created S Corporations,
which are taxed as if they were proprietorships or partnerships; thus, they are exempt from
the corporate income tax. To qualify for S corporation status, a firm can have no more than
100 stockholders, which limits their use to relatively small, privately owned firms. Larger
corporations are known as C corporations. The vast majority of small corporations elect S
status and retain that status until they decide to sell stock to the public, at which time they
become C corporations.
A limited liability company (LLC) is a popular type of organization that is a hybrid between a
partnership and a corporation. A limited liability partnership (LLP) is similar to an LLC. LLPs
are used for professional firms in the fields of accounting, law, and architecture, while LLCs
are used by other businesses. Similar to corporations, LLCs and LLPs provide limited liability
protection, but they are taxed as partnerships. Further, unlike limited partnerships, where
the general partner has full control of the business, the investors in an LLC or LLP have votes
in proportion to their ownership interest. LLCs and LLPs have been gaining in popularity in
recent years, but large companies still find it advantageous to be C corporations because of
the advantages in raising capital to support growth. LLCs/LLPs were dreamed up by lawyers;
they are often structured in very complicated ways, and their legal protections often vary by
state. So it is necessary to hire a good lawyer when establishing one.
When deciding on its form of organization, a firm must trade off the advantages of
incorporation against double taxation. However, for the following reasons, the value of any
business other than a relatively small one will probably be maximized if it is organized as a
corporation:
Limited liability reduces the risks borne by investors, and, other things held constant, the
lower the firm’s risk, the higher its value.
A firm’s value is dependent on its growth opportunities, which are dependent on its ability
to attract capital. Because corporations can attract capital more easily than other types of
businesses, they are better able to take advantage of growth opportunities.
The value of an asset also depends on its liquidity, which means the time and effort it takes
to sell the asset for cash at a fair market value. Because the stock of a corporation is easier
to transfer to a potential buyer than is an interest in a proprietorship or partnership and
because more investors are willing to invest in stocks than in partnerships (with their
potential unlimited liability), a corporate investment is relatively liquid. This too enhances
the value of a corporation.
SelfTest
What are the key differences among proprietorships, partnerships, and corporations?
How are LLCs and LLPs related to the other forms of organization?
What is an S corporation, and what is its advantage over a C corporation? Why don’t firms
such as IBM, GE, and Microsoft choose S corporation status?
What are some reasons why the value of a business other than a small one is generally
maximized when it is organized as a corporation?
1-4. The Main Financial Goal: Creating Value for Investors
In public corporations, managers and employees work on behalf of the shareholders who
own the business, and therefore they have an obligation to pursue policies that promote
stockholder value. While many companies focus on maximizing a broad range of financial
objectives, such as growth, earnings per share, and market share, these goals should not
take precedence over the main financial goal, which is to create value for investors. Keep in
mind that a company’s stockholders are not just an abstract group—they represent
individuals and organizations who have chosen to invest their hard-earned cash into the
company and who are looking for a return on their investment in order to meet their longterm financial goals, which might be saving for retirement, a new home, or a child’s
education. In addition to financial goals, the firm also has nonfinancial goals, which we will
discuss in Section 1-7.
If a manager is to maximize stockholder wealth, he or she must know how that wealth is
determined. Throughout this book, we shall see that the value of any asset is the present
value of the stream of cash flows that the asset provides to its owners over time. We discuss
stock valuation in depth in Chapter 9, where we see that stock prices are based on cash
flows expected in future years, not just in the current year. Thus, stock price maximization
requires us to take a long-run view of operations. At the same time, managerial actions that
affect a company’s value may not immediately be reflected in the company’s stock price.
1-4A. Determinants of Value
Figure 1.2 illustrates the situation. The top box indicates that managerial actions, combined
with the economy, taxes, and political conditions, influence the level and riskiness of the
company’s future cash flows, which ultimately determine the company’s stock price. As you
might expect, investors like higher expected cash flows, but they dislike risk; so the larger the
expected cash flows and the lower the perceived risk, the higher the stock’s price.
Figure 1.2 Determinants of Intrinsic Values and Stock Prices
Details
The second row of boxes differentiates what we call “true” expected cash flows and “true”
risk from “perceived” cash flows and “perceived” risk. By “true,” we mean the cash flows
and risk that investors would expect if they had all of the information that existed about a
company. “Perceived” means what investors expect, given the limited information they have.
To illustrate, in early 2001, investors had information that caused them to think Enron was
highly profitable and would enjoy high and rising future profits. They also thought that
actual results would be close to the expected levels and hence that Enron’s risk was low.
However, true estimates of Enron’s profits, which were known by its executives but not the
investing public, were much lower; Enron’s true situation was extremely risky.
The third row of boxes shows that each stock has an intrinsic value, which is an estimate of
the stock’s “true” value as calculated by a competent analyst who has the best available
data, and a market price, which is the actual market price based on perceived but possibly
incorrect information as seen by the marginal investor. Not all investors agree, so it is the
“marginal” investor who determines the actual price.
When a stock’s actual market price is equal to its intrinsic value, the stock is in equilibrium,
which is shown in the bottom box in Figure 1.2. When equilibrium exists, there is no
pressure for a change in the stock’s price. Market prices can—and do—differ from intrinsic
values; eventually, however, as the future unfolds, the two values tend to converge.
1-4B. Intrinsic Value
Actual stock prices are easy to determine—they can be found on the Internet and are
published in newspapers every day. However, intrinsic values are estimates, and different
analysts with different data and different views about the future form different estimates of
a stock’s intrinsic value. Indeed, estimating intrinsic values is what security analysis is all
about and is what distinguishes successful from unsuccessful investors. Investing would be
easy, profitable, and essentially riskless if we knew all stocks’ intrinsic values—but, of course,
we don’t. We can estimate intrinsic values, but we can’t be sure that we are right. A firm’s
managers have the best information about the firm’s future prospects, so managers’
estimates of intrinsic values are generally better than those of outside investors. However,
even managers can be wrong.
Figure 1.3 graphs a hypothetical company’s actual price and intrinsic value as estimated by
its management over time. The intrinsic value rises because the firm retains and reinvests
earnings each year, which tends to increase profits. The value jumped dramatically in Year
20, when a research and development (R&D) breakthrough raised management’s estimate
of future profits before investors had this information. The actual stock price tended to
move up and down with the estimated intrinsic value, but investor optimism and pessimism,
along with imperfect knowledge about the true intrinsic value, led to deviations between
the actual prices and intrinsic values.
Figure 1.3 Graph of Actual Prices versus Intrinsic Values
Details
Intrinsic value is a long-run concept. Management’s goal should be to take actions designed
to maximize the firm’s intrinsic value, not its current market price. Note, though, that
maximizing the intrinsic value will maximize the average price over the long run but not
necessarily the current price at each point in time. For example, management might make
an investment that lowers profits for the current year but raises expected future profits. If
investors are not aware of the true situation, the stock price will be held down by the low
current profit even though the intrinsic value was actually raised. Management should
provide information that helps investors make better estimates of the firm’s intrinsic value,
which will keep the stock price closer to its equilibrium level. However, there are times when
management cannot divulge the true situation because doing so would provide information
that helps its competitors.
1-4C. Consequences of Having a Short-Run Focus
Ideally, managers adhere to this long-run focus, but there are numerous examples in recent
years where the focus for many companies shifted to the short run. Perhaps most notably,
prior to the recent financial crisis, many Wall Street executives received huge bonuses for
engaging in risky transactions that generated short-term profits. Subsequently, the value of
these transactions collapsed, causing many of these Wall Street firms to seek a massive
government bailout.
Apart from the recent problems on Wall Street, there have been other examples where
managers have focused on short-run profits to the detriment of long-term value. For
example, Wells Fargo implemented incentives to reward employees for signing up customers
to new accounts. Unfortunately, to obtain bonuses some employees created fake accounts
or signed up customers for unauthorized credit cards. This led to the firing of thousands of
employees, as well as its CEO and other senior managers, and millions of dollars in fines for
Wells Fargo. In addition, the Fed has limited Wells Fargo’s growth so total assets are no
greater than the year end 2017 total until the bank repairs its culture and cleans up its act.
On February 21, 2020, Wells Fargo agreed to pay $3 billion to settle claims, including
$
500
million
that will be returned to investors. Wells Fargo has eliminated all product-based sales goals,
restructured its compensation, and strengthened customer consent and oversight systems.
With these types of concerns in mind, many academics and practitioners stress the need for
boards and directors to establish effective procedures for corporate governance. This
involves putting in place a set of rules and practices to ensure that managers act in
shareholders’ interests while also balancing the needs of other key constituencies such as
customers, employees, and affected citizens. Having a strong, independent board of
directors is viewed as an important component of strong governance.
Effective governance requires holding managers accountable for poor performance and
understanding the important role that executive compensation plays in encouraging
managers to focus on the proper objectives. For example, if a manager’s bonus is tied solely
to this year’s earnings, it would not be a surprise to discover that the manager took steps to
pump up current earnings—even if those steps were detrimental to the firm’s long-run
value. With these concerns in mind, a growing number of companies have used stock and
stock options as a key part of executive pay. The intent of structuring compensation in this
way is for managers to think more like stockholders and to continually work to increase
shareholder value.
Despite the best of intentions, stock-based compensation does not always work as planned.
To give managers an incentive to focus on stock prices, stockholders (acting through boards
of directors) awarded executives stock options that could be exercised on a specified future
date. An executive could exercise the option on that date, receive stock, immediately sell it,
and earn a profit. The profit was based on the stock price on the option exercise date, which
led some managers to try to maximize the stock price on that specific date, not over the long
run. That, in turn, led to some horrible abuses. Projects that looked good from a long-run
perspective were turned down because they would penalize profits in the short run and thus
lower the stock price on the option exercise day. Even worse, some managers deliberately
overstated profits, temporarily boosted the stock price, exercised their options, sold the
inflated stock, and left outside stockholders “holding the bag” when the true situation was
revealed.
SelfTest
What’s the difference between a stock’s current market price and its intrinsic value?
Do stocks have known and “provable” intrinsic values, or might different people reach
different conclusions about intrinsic values? Explain.
Should managers estimate intrinsic values or leave that to outside security analysts? Explain.
If a firm could maximize either its current market price or its intrinsic value, what would
stockholders (as a group) want managers to do? Explain.
Should a firm’s managers help investors improve their estimates of the firm’s intrinsic value?
Explain.
1-5. Stockholder–Manager Conflicts
It has long been recognized that managers’ personal goals may compete with shareholder
wealth maximization. In particular, managers might be more interested in maximizing their
own wealth than their stockholders’ wealth; therefore, managers might pay themselves
excessive salaries.
Effective executive compensation plans motivate managers to act in their stockholders’ best
interests. Useful motivational tools include
(1)
reasonable compensation packages,
(2)
firing of managers who don’t perform well, and
(3)
the threat of hostile takeovers.
1-5A. Compensation Packages
Compensation packages should be sufficient to attract and retain able managers, but they
should not go beyond what is needed. Compensation policies need to be consistent over
time. Also, compensation should be structured so that managers are rewarded on the basis
of the stock’s performance over the long run, not the stock’s price on an option exercise
date. This means that options (or direct stock awards) should be phased in over a number of
years so that managers have an incentive to keep the stock price high over time. When the
intrinsic value can be measured in an objective and verifiable manner, performance pay can
be based on changes in intrinsic value. However, because intrinsic value is not observable,
compensation must be based on the stock’s market price—but the price used should be an
average over time rather than on a specific date.
Are CEOs Overpaid?
The Wall Street Journal regularly evaluates the total compensation of large company CEOs.
In a recent report, they found that the median executive in their sample of 143 top CEOs
received total compensation of
$
13
million
in 2019 (up from
$
11.2
million
in 2018). The total compensation for a top CEO typically includes salary, bonuses, and longterm incentives such as stock options. Many of these stock options became quite valuable in
the wake of the stock market’s strong performance in 2019.
Companies have long faced media scrutiny and investor questions about excessive
compensation. Frequently, top executives earn many times more than their firm’s average
employees, which has fueled continued concerns about income inequality. Recognizing
these concerns, the coronavirus pandemic has spurred many companies to restructure their
compensation packages. Nearly 600 companies in the Russell 3000 index have cut their top
executives’ pay, while 102 S&P 500 companies have reduced CEO base salaries. For some,
the pay reductions are for a few months, while for others the reductions are through year
end. How boards change performance measures and goals for 2020 executive compensation
packages remains to be seen; however, these cuts to executive cash salaries represent a shift
from prior economic downturns.
Leaving aside these concessions, average compensation levels are significantly higher than
they were a decade or two ago. The large shifts in CEO compensation over time can often be
attributed to the increased importance of stock options. On the plus side, stock options
provide CEOs with a powerful incentive to raise their companies’ stock prices. Indeed, most
observers believe there is a strong causal relationship between CEO compensation
procedures and stock price performance.
Other critics argue that although performance incentives are entirely appropriate as a
method of compensation, the overall level of CEO compensation is just too high. The critics
ask such questions as these: Would these CEOs have been unwilling to take their jobs if they
had been offered only half as many stock options? Would they have put forth less effort, and
would their firms’ stock prices have not increased as much? It is hard to say. Other critics
lament that the exercise of stock options not only has dramatically increased the
compensation of truly excellent CEOs but has also dramatically increased the compensation
of some pretty average CEOs, who were lucky enough to have had the job during a stock
market boom that raised the stock prices of even poorly performing companies. In addition,
huge CEO salaries are widening the gap between top executives and middle management
salaries, leading to employee discontent and declining employee morale and loyalty.
Stock returns and corporate financial results are only two factors impacting CEO pay. The
correlation between executive compensation and firm performance is not always strong.
Other factors that influence CEO pay are the size of the firm (larger companies pay their
CEOs more) and the type of industry (energy companies pay their CEOs more).
Sources: Inti Pacheco, “Coronavirus Caps Years of Rich Pay for Many CEOs,” The Wall Street
Journal (wsj.com), March 23, 2020; Chip Cutter and Theo Francis, “Coronavirus Crisis Dents
Salaries, Not Stock Awards, for Many CEOs,” The Wall Street Journal (wsj.com), June 3, 2020;
Louis Lavelle, Frederick F. Jespersen, and Michael Arndt, “Executive Pay,” BusinessWeek,
April 15, 2002, pp. 80–86; Jason Zweig, “A Chance to Veto a CEO’s Bonus,” The Wall Street
Journal (wsj.com), January 29, 2011; and Emily Chasan, “Early Say-On-Pay Results Show
Rising Support, Few Failures,” The Wall Street Journal (wsj.com), April 2, 2014.
1-5B. Direct Stockholder Intervention
Years ago most stock was owned by individuals. Today, however, the majority of stock is
owned by institutional investors such as insurance companies, pension funds, hedge funds,
and mutual funds, and private equity groups are ready and able to step in and take over
underperforming firms. These institutional money managers have the clout to exercise
considerable influence over firms’ operations. Given their importance, they have access to
managers and can make suggestions about how the business should be run. In effect,
institutional investors such as CalPERS (California Public Employees’ Retirement System, with
about $330 billion of assets) and TIAA-CREF (Teachers Insurance and Annuity AssociationCollege Retirement Equities Fund, a retirement plan originally set up for professors at private
colleges that now has more than $1,059 billion of assets under management) act as
lobbyists for the body of stockholders. When such large stockholders speak, companies
listen. For example, Coca-Cola Co. revised its compensation package after hearing negative
feedback from its largest stockholder, Warren Buffett.
At the same time, any shareholder who has owned $2,000 of a company’s stock for 1 year
can sponsor a proposal that may be voted on at the annual stockholders’ meeting, even if
management opposes the proposal. Although shareholder-sponsored proposals are
nonbinding, the results of such votes are heard by top management.
There has been an ongoing debate regarding how much influence shareholders should have
through the proxy process. As a result of the passage of the Dodd-Frank Act, the SEC was
given authority to make rules regarding shareholder access to company proxy materials. On
August 25, 2010, the SEC adopted changes to federal proxy rules to give shareholders the
right to nominate directors to a company’s board. Rule 14a-11 under the 1934 SEC Act
requires public companies to permit any shareholder owning at least 3% of a public
company’s voting stock for at least 3 years to include director nominations in the company’s
proxy materials.
Years ago, the probability of a large firm’s management being ousted by its stockholders was
so remote that it posed little threat. Most firms’ shares were so widely distributed and the
CEO had so much control over the voting mechanism that it was virtually impossible for
dissident stockholders to get the votes needed to overthrow a management team. However,
that situation has changed. In recent years, the top executives of WeWork, Under Armour,
EBay, Juul, Uber, Mattel, Citigroup, Coca-Cola, IBM, and Target, to name a few, were forced
out due to poor corporate performance.
Relatedly, a 2015 article in The Wall Street Journal documents the growing importance of
shareholder activists. It points out that in 2014, activists established a record level of
influence when they were granted a board seat in 73% of the proxy fights that occurred that
year. Likewise, a 2015 cover story in The Economist highlights the important role that
activists play in ensuring that managers act in shareholders’ interests—their article labels
these activists as “Capitalism’s Unlikely Heroes.” In another high-profile example, GE became
one of a small group of companies that has voluntarily made it easier for shareholders to
secure a board seat. GE’s new plan allows shareholder groups holding at least 3% of the
company’s stock to directly nominate candidates for its board.
More recently, a 2019 article in The Wall Street Journal highlights activist investors’ growing
tendency to pressure companies to become more socially responsible. The article begins by
pointing to an activist hedge fund, which has pressured a company that it invests in to
reduce its carbon footprint. Other well-publicized examples include the recent steps that
large institutional investors such as BlackRock and Vanguard have taken to leverage their
stock holdings to help accomplish a variety of social goals.
These actions are part of a broader movement to evaluate company performance along a
number of environmental, social, and governance (ESG) measures. Indeed, many individual
investors are looking for ways to invest in socially responsible companies and/or to avoid
companies with low ESG ratings. Not surprisingly, a large number of mutual funds and
exchange-traded funds now focus on companies that are viewed as being more socially
responsible. However, as you can imagine, there is not always a consensus on whether a
company is being responsible. Some investors, for example, may be very concerned about
carbon emissions and climate change, which may lead them to want to avoid investing in
traditional energy companies. But should this restriction also apply to energy companies
that are “greener than average” but still have a substantial carbon footprint? Other investors
may be more concerned about gun manufacturers or companies with less employee
diversity. Relatedly, a 2019 Bloomberg article discusses in detail the large number of
different ESG ratings that are available and how the differences in these ratings often lead to
confusion among investors in socially responsible funds.
1-5C. Managers’ Response
If a firm’s stock is undervalued, corporate raiders will see it as a bargain and will attempt to
capture the firm in a hostile takeover. If the raid is successful, the target’s executives will
almost certainly be fired. This situation gives managers a strong incentive to take actions to
maximize their stock’s price. In the words of one executive, “If you want to keep your job,
never let your stock become a bargain.”
Note that the price managers should be trying to maximize is not the price on a specific day.
Rather, it is the average price over the long run, which will be maximized if management
focuses on the stock’s intrinsic value. However, managers must communicate effectively with
stockholders (without divulging information that would aid their competitors) to keep the
actual price close to the intrinsic value. It’s bad for stockholders and managers when the
intrinsic value is high but the actual price is low. In that situation, a raider may swoop in, buy
the company at a bargain price, and fire the managers. To repeat our earlier message:
Managers should try to maximize their stock’s intrinsic value and then communicate
effectively with stockholders. That will cause the intrinsic value to be high and the actual
stock price to remain close to the intrinsic value over time.
Because the intrinsic value cannot be observed, it is impossible to know whether it is really
being maximized. Still, as we will discuss in Chapter 9, there are procedures for estimating a
stock’s intrinsic value. Managers can use these valuation models to analyze alternative
courses of action and thus see how these actions are likely to impact the firm’s value. This
type of value-based management is not precise, but it is the best way to run a business.
SelfTest
What are three techniques stockholders can use to motivate managers to maximize their
stock’s long-run price?
Should managers focus directly on the stock’s actual market price or its intrinsic value, or are
both important? Explain.
1-6. Stockholder–Debtholder Conflicts
Conflicts can also arise between stockholders and debtholders. Debtholders, which include
the company’s bankers and its bondholders, generally receive fixed payments regardless of
how well the company does, while stockholders do better when the company does better.
This situation leads to conflicts between these two groups, to the extent that stockholders
are typically more willing to take on risky projects.
To illustrate this problem, consider the example in Table 1.1, where a company has raised
$2,000 in capital, $1,000 from bondholders, and $1,000 from stockholders. To keep things
simple, we assume that the bonds have a 1 year maturity and pay an 8% annual interest
rate. The company’s current plan is to invest its $2,000 in Project L, a relatively low-risk
project that is expected to be worth $2,400 one year from now if the market is good and
$2,000 if the market is bad. There is a 50% chance that the market will be good and a 50%
chance the market will be bad. In either case, there will be enough cash to pay the
bondholders their money back plus the 8% annual interest rate that they were promised.
The stockholders will receive whatever is left over after the bondholders have been paid. As
expected, because they are paid last, the stockholders are bearing more risk (their payoff
depends on the market), but they are also earning a higher expected return.
Table 1.1 Stockholder-Debtholder Conflict Example
Details
Now assume that the company discovers another project (Project H) that has considerably
more risk. Project H has the same expected cash flow as Project L, but it will produce cash
flows of $4,400 if the market is good but $0 if the market is bad. Clearly, the bondholders
would not be interested in Project H, because they wouldn’t receive any additional benefits
if the market is good and they would lose everything if the market is bad. Notice, however,
that Project H provides a higher rate of return for stockholders than Project L, because they
capture all of the extra benefits if the market turns out to be good. While Project H is clearly
riskier, in some circumstances managers acting on behalf of the stockholders may decide
that the higher expected return is enough to justify the additional risk, and they would
proceed with Project H despite the strong objections of the bondholders.
Notice, however, that astute bondholders understand that managers and stockholders may
have an incentive to shift to riskier projects. Recognizing this incentive, they will view the
bonds as being riskier and will demand a higher rate of return, and in some cases the
perceived risk may be so great that they will not invest in the company, unless the managers
can credibly convince bondholders that the company will not pursue excessively risky
projects.
Another type of stockholder–debtholder conflict arises over the use of additional debt. As
we see later in this book, the more debt a firm uses to finance a given amount of assets, the
riskier the firm becomes. For example, if a firm has
$
100
million
of assets and finances them with
$
5
million
of bonds and
$
95
million
of common stock, things have to go terribly badly before the bondholders suffer a loss. On
the other hand, if the firm uses
$
95
million
of bonds and
$
5
million
of stock, the bondholders suffer a loss even if the value of the assets declines only slightly.
Bondholders attempt to protect themselves by including covenants in the bond agreements
that limit firms’ use of additional debt and constrain managers’ actions in other ways. We
address these issues later in this book, but they are quite important and everyone should be
aware of them.
SelfTest
Why might conflicts arise between stockholders and debtholders?
How might astute bondholders react if stockholders take on risky projects?
How can bondholders protect themselves from managers’ actions that negatively impact
bondholders?
1-7. Balancing Shareholder Interests and the Interests of Society
Throughout this book, we focus primarily on publicly owned companies; hence, we operate
on the assumption that management’s primary financial goal is shareholder wealth
maximization. At the same time, the managers know that this does not mean maximize
shareholder value “at all costs.” Managers have an obligation to behave ethically, and they
must follow the laws and other society-imposed constraints that we discussed in the
opening vignette to this chapter.
Investing in Socially Responsible Funds
The same societal pressures that have encouraged consumers to buy products of companies
that they believe to be socially responsible have also led some investors to search for ways
to limit their investments to firms they deem to be socially responsible. Indeed, today there
are a large number of mutual funds that only invest in companies that meet specified social
goals. Each of these socially responsible funds applies different criteria, but typically they
consider a company’s environmental record, its commitment to social causes, and its
employee relations. Many of these funds also avoid investments in companies that are
involved with alcohol, tobacco, gambling, and nuclear power. Investment performance varies
among funds from year to year. The accompanying chart compares the past performance of
a representative socially responsible fund, the Domini Impact Equity Investor Fund, with that
of the S&P 500 during the past 20+ years. Although the general shape of each is similar, in
the last 18 years or so the S&P 500 has outperformed this fund.
A 2015 article in The Wall Street Journal cites a study that suggests that investors may be
able to profit by buying stocks that other investors choose to avoid. The study by professors
Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School found that over
the past century, U.S. tobacco stocks have dramatically outperformed the overall market. As
a possible explanation, the article provides a quote from one of the authors:
“It appears that when the people who abhor such stocks have shunned them, they have
depressed the share prices but haven’t managed to destroy the industries,” Prof. Marsh says.
“So investors who don’t have the same scruples have been able to pick up [these stocks] at a
cheaper price.”
Recent Performance of Domini Impact Equity Investor Fund versus S&P 500
Details
Source: finance.yahoo.com, March 25, 2020.
To understand how corporate managers balance the interests of society and shareholders, it
is helpful to first look at those issues from the perspective of a sole proprietor. Consider
Larry Jackson, the owner of a local sporting goods store. Jackson is in business to make
money, but he likes to take time off to play golf on Fridays. He also has a few employees who
are no longer very productive, but he keeps them on the payroll out of friendship and
loyalty. Jackson is running the business in a way that is consistent with his own personal
goals. He knows that he could make more money if he didn’t play golf or if he replaced some
of his employees. But he is comfortable with his choices—and because it is his business, he
is free to make those choices.
By contrast, Linda Smith is CEO of a large corporation. Smith manages the company;
however, most of the stock is owned by shareholders who purchased it because they were
looking for an investment that would help them retire, send their children to college, pay for
a long-anticipated trip, and so forth. The shareholders elected a board of directors, which
then selected Smith to run the company. Smith and the firm’s other managers are working
on behalf of the shareholders, and they were hired to pursue policies that enhance
shareholder value.
Most managers understand that maximizing shareholder value does not mean that they are
free to ignore the larger interests of society. Consider, for example, what would happen if
Linda Smith narrowly focused on creating shareholder value, but in the process her company
was unresponsive to its employees and customers, hostile to its local community, and
indifferent to the effects its actions had on the environment. In all likelihood, society would
impose a wide range of costs on the company. It may find it hard to attract top-notch
employees, its products may be boycotted, it may face additional lawsuits and regulations,
and it may be confronted with negative publicity. These costs would ultimately lead to a
reduction in shareholder value. So clearly, when taking steps to maximize shareholder value,
enlightened managers need to also keep in mind these society-imposed constraints.
From a broader perspective, firms have a number of different departments, including
marketing, accounting, production, human resources, and finance. The finance department’s
principal task is to evaluate proposed decisions and judge how they will affect the stock price
and thus shareholder wealth. For example, suppose the production manager wants to
replace some old equipment with new automated machinery that will reduce labor costs.
The finance staff will evaluate that proposal and determine whether the savings seem to be
worth the cost. Similarly, if marketing wants to spend
$
10
million
of advertising during the Super Bowl, the financial staff will evaluate the proposal, look at
the probable increase in sales, and reach a conclusion as to whether the money spent will
lead to a higher stock price. Most significant decisions are evaluated in terms of their
financial consequences, but astute managers recognize that they also need to take into
account how these decisions affect society at large.
Interestingly, some companies have taken more explicit steps to recognize the broader
needs of society. A fairly small but rapidly growing number of companies have become
certified as “B” or “benefit” corporations. While these companies are still focused on making
a profit, they are committed to putting other stakeholders such as employees, customers,
and their communities on an equal footing with shareholders. To qualify as a B corporation,
the company must subject itself to an annual audit in which its practices regarding social
responsibility, corporate governance, and transparency are reviewed. A 2015 Time magazine
article points out that 26 states now provide a legal framework for companies to be certified
as a B corporation. The article also estimates that roughly 1,200 companies (mostly small)
have qualified as B corporations.
As you might imagine, there is a very wide range of opinions regarding the appropriate
balance between the interests of shareholders and other societal stakeholders. For example,
a mutual fund manager attracted a lot of attention when he characterized shareholder
wealth maximization as the “world’s dumbest idea.” Later on, a high-profile columnist for
The Wall Street Journal offered a strong criticism of this viewpoint and laid out his argument
for why maximizing shareholder value is the appropriate goal. Likewise, there has been
considerable debate regarding the Business Roundtable’s 2019 statement urging companies
to focus more on stakeholder interests. While these arguments will no doubt continue, there
is a broader consensus emphasizing that maximizing shareholder value doesn’t mean that
corporate managers should ignore other societal interests. Indeed, our discussion in this
chapter is meant to illustrate that companies striving to increase shareholder value have to
be ever mindful of these broader interests.
SelfTest
Is maximizing shareholder value inconsistent with being socially responsible? Explain.
When Boeing decides to invest $5 billion in a new jet airliner, are its managers certain of the
project’s effects on Boeing’s future profits and stock price? Explain.
1-8. Business Ethics
As a result of the financial scandals occurring during the past decade, there has been a
strong push to improve business ethics. This is occurring on many fronts—actions begun by
former New York Attorney General and former Governor Elliot Spitzer and others who sued
companies for improper acts; Congress’s passing of the Sarbanes-Oxley Act of 2002 to
impose sanctions on executives who sign financial statements later found to be false;
Congress’s passing of the Dodd-Frank Act to implement an aggressive overhaul of the U.S.
financial regulatory system aimed at preventing reckless actions that would cause another
financial crisis; and business schools trying to inform students about proper versus improper
business actions.
As noted earlier, companies benefit from having good reputations and are penalized by
having bad ones; the same is true for individuals. Reputations reflect the extent to which
firms and people are ethical. Ethics is defined in Webster’s Dictionary as “standards of
conduct or moral behavior.” Business ethics can be thought of as a company’s attitude and
conduct toward its employees, customers, community, and stockholders. A firm’s
commitment to business ethics can be measured by the tendency of its employees, from the
top down, to adhere to laws, regulations, and moral standards relating to product safety and
quality, fair employment practices, fair marketing and selling practices, the use of
confidential information for personal gain, community involvement, and the use of illegal
payments to obtain business.
For the past 14 years, Ethisphere, an organization based out of Scottsdale, Arizona, has
focused on evaluating ethical business practices and has published a list of “The World’s
Most Ethical Companies.” It honors companies that promote ethical business standards and
practices internally, enable managers and employees to make good choices, and shape
industry standards by introducing best practices. Those companies that have made the list in
every year are Aflac, Ecolab, Fluor Corporation, International Paper, Kao Corporation,
Milliken & Company, and Pepsico.
1-8A. What Companies are Doing
Most firms today have strong written codes of ethical behavior; companies also conduct
training programs to ensure that employees understand proper behavior in different
situations. When conflicts arise involving profits and ethics, ethical considerations
sometimes are so obviously important that they dominate. In other cases, however, the right
choice is not clear. For example, suppose that Norfolk Southern’s managers know that its
coal trains are polluting the air, but the amount of pollution is within legal limits and further
that reduction would be costly. Are the managers ethically bound to reduce pollution?
Similarly, several years ago Merck’s research indicated that its Vioxx pain medicine might be
causing heart attacks. However, the evidence was not overly strong, and the product was
clearly helping some patients. Over time, additional tests produced stronger evidence that
Vioxx did pose a health risk. What should Merck have done, and when should Merck have
done it? If the company released negative but perhaps incorrect information, this
announcement would have hurt sales and possibly prevented some patients benefitting
from the product. If the company delayed the release of this additional information, more
patients might have suffered irreversible harm. At what point should Merck have made the
potential problem known to the public? There are no obvious answers to questions such as
these, but companies must deal with them, and a failure to handle them properly can lead
to severe consequences.
1-8B. Consequences of Unethical Behavior
Over the past few years, ethical lapses have led to a number of bankruptcies. The collapses
of Enron and WorldCom as well as the accounting firm Arthur Andersen dramatically
illustrate how unethical behavior can lead to a firm’s rapid decline. In all three cases, top
executives came under fire because of misleading accounting practices that led to overstated
profits. Enron and WorldCom executives were busily selling their stock at the same time they
were recommending the stock to employees and outside investors. These executives reaped
millions before the stock declined, while lower-level employees and outside investors were
left “holding the bag.” Some of these executives are now in jail, and Enron’s CEO had a fatal
heart attack while awaiting sentencing after being found guilty of conspiracy and fraud.
Moreover, Merrill Lynch and Citigroup, which were accused of facilitating these frauds, were
fined hundreds of millions of dollars.
In other cases, companies avoid bankruptcy but face a damaging blow to their reputation.
Safety concerns tarnished Toyota’s once sterling reputation for reliability. Ethical questions
were raised regarding when the company’s senior management became aware of the
problems and whether they were forthcoming in sharing these concerns with the public.
Similarly, GM agreed to pay a
$
900
million
settlement for its delay in addressing defective ignition switches, which have been
connected to 57 deaths and the recall of 2.6 million vehicles.
Likewise, in April 2010, the SEC brought forth a civil fraud suit against Goldman Sachs. The
SEC contended that Goldman Sachs misled its investors when it created and marketed
securities that were backed by subprime mortgages. In July 2010, Goldman Sachs ultimately
reached a settlement where it agreed to pay
$
550
million
. While just one example, many believe that too many Wall Street executives in recent years
have been willing to compromise their ethics. In May 2011, Raj Rajaratnam, the founder of
the hedge fund Galleon Group LLC, was convicted of securities fraud and conspiracy in one
of the government’s largest insider trading cases. Mr. Rajaratnam traded on information
(worth approximately
$
63.8
million
) from insiders at technology companies and others in the hedge fund industry. On October
13, 2011, he was sentenced to 11 years in prison. On March 14, 2014, the Federal Deposit
Insurance Corporation (FDIC) sued 16 big banks (including Bank of America, Citigroup, and
JPMorgan Chase) for actively manipulating the London Interbank Offered Rate (the LIBOR
rate) to make additional profits on their trades. This is particularly important because the
LIBOR rate is used to set the terms in many financial contracts. The banks are accused of
rigging LIBOR from August 2007 to mid-2011. Five of the banks, Barclays, RBS, UBS,
Deutsche Bank, and Rabobank of the Netherlands, together have paid $5 billion to settle the
charges and avoid criminal prosecution if they meet certain conditions. It is worth noting
that in the wake of these scandals, regulators have pushed banks to de-emphasize LIBOR
and to begin developing alternative benchmark rates by 2021.
More recently, Mylan, a pharmaceutical company, agreed to pay the U.S. Department of
Justice a
$
465
million
settlement for overcharging Medicaid for its allergy shot EPIPen. In early 2018, Theranos
founder Elizabeth Holmes agreed to a settlement with the SEC after being charged with
fraud. The settlement included a financial penalty, eliminated her voting control of the
company, and barred her for 10 years from serving as an officer or director of a public
company. In another high-profile case, Wells Fargo fired its CEO, other senior managers, and
5,000 employees, and paid
$
185
million
in government fines and customer refunds because employees created fake accounts and
signed up customers for unauthorized credit cards to reach sales quotas for bonuses. In
February 2020, the company agreed to pay an additional $3 billion to settle claims. The Fed
has placed an additional penalty on Wells Fargo by limiting its growth. These recent
problems are not unique to U.S. companies. Volkswagen (VW) recently admitted to selling
cars that were installed with software to cheat emissions tests. Approximately 11 million cars
worldwide, including 8 million in Europe, have the software installed in them. VW has set
aside 6.7 billion euros (roughly $7.6 billion) to cover the cost of recalling millions of cars,
which resulted in its first quarterly loss (third quarter, 2015) in 15 years. Its CEO resigned and
several of its top executives were fired because of this scandal. In another recent scandal,
Canadian drug maker Valeant has been accused of improper accounting and predatory price
hikes to boost its growth. In addition, it appears that Philidor (an undisclosed affiliate of
Valeant) may have changed patients’ prescriptions to push Valeant’s high-priced drugs. Near
the end of 2016, two Philidor executives (one of whom had been an executive with Valeant)
had been arrested and charged with a multimillion-dollar fraud and kickback scheme.
A firm’s CEO is the face of the corporation. When a CEO is accused of illegal activity, the
Board of Directors conducts an independent investigation, and if the allegation is verified, it
takes corrective action. In most cases, the CEO is terminated. It’s much less obvious what the
board should do when the CEO is accused of questionable but not illegal behavior. When a
CEO is accused of misconduct, the board must investigate the situation, take proactive steps
to ensure that the situation is properly dealt with, and, most importantly, ensure that the
corporate reputation, culture, and long-term performance are not damaged.
The perception of widespread improper actions has caused many investors to lose faith in
American business and to turn away from the stock market, which makes it difficult for firms
to raise the capital they need to grow, create jobs, and stimulate the economy. So unethical
actions can have adverse consequences far beyond the companies that perpetrate them.
All this raises a question: Are companies unethical, or is it just a few of their employees?
That was a central issue that came up in the case of Arthur Andersen, the accounting firm
that audited Enron, WorldCom, and several other companies that committed accounting
fraud. Evidence showed that relatively few of Andersen’s accountants helped perpetrate the
frauds. Its top managers argued that while a few rogue employees did bad things, most of
the firm’s 85,000 employees, and the firm itself, were innocent. The U.S. Justice Department
disagreed, concluding that the firm was guilty because it fostered a climate where unethical
behavior was permitted and that Andersen used an incentive system that made such
behavior profitable to both the perpetrators and the firm. As a result, Andersen was put out
of business, its partners lost millions of dollars, and its 85,000 employees lost their jobs. In
most other cases, individuals, rather than firms, were tried, and though the firms survived,
they suffered damage to their reputations, which greatly lowered their future profit
potential and value.
1-8C. How should Employees Deal with Unethical Behavior?
Far too often the desire for stock options, bonuses, and promotions drives managers to take
unethical actions such as fudging the books to make profits in the manager’s division look
good, holding back information about bad products that would depress sales, and failing to
take costly but needed measures to protect the environment. Generally, these acts don’t rise
to the level of an Enron or a WorldCom, but they are still bad. If questionable things are
going on, who should take action and what should that action be? Obviously, in situations
such as Enron and WorldCom, where fraud was being perpetrated at or close to the top,
senior managers knew about the illegal activities. In other cases, the problem is caused by a
mid-level manager trying to boost his or her unit’s profits and thus his or her bonus. In all
cases, though, at least some lower-level employees are aware of what’s happening; they
may even be ordered to take fraudulent actions. Should the lower-level employees obey
their boss’s orders, refuse to obey those orders, or report the situation to a higher authority,
such as the company’s board of directors, the company’s auditors, or a federal prosecutor?
As you might imagine, these issues are often tricky, and judgment comes into play when
deciding on what action to take and when to take it. If a lower-level employee thinks that a
product should be pulled, but the boss disagrees, what should the employee do? If an
employee decides to report the problem, trouble may ensue regardless of the merits of the
case. If the alarm is false, the company will have been harmed, and nothing will have been
gained. In that case, the employee will probably be fired. Even if the employee is right, his or
her career may still be ruined because many companies (or at least bosses) don’t like
“disloyal, troublemaking” employees.
Such situations arise fairly often, ranging from accounting fraud to product liability, sexual
harassment, and environmental cases. Employees jeopardize their jobs if they come forward
over their bosses’ objections. However, if they don’t speak up, they may suffer emotional
problems and contribute to the downfall of their companies and the accompanying loss of
jobs and savings. Moreover, if employees obey orders regarding actions they know are
illegal, they may end up going to jail. Indeed, in most of the scandals that have gone to trial,
the lower-level people who physically entered the bad data received longer jail sentences
than the bosses who presumably gave the directives. So employees can be “stuck between a
rock and a hard place,” that is, doing what they should do and possibly losing their jobs
versus going along with the boss and possibly ending up in jail. This discussion shows why
ethics is such an important consideration in business and in business schools—and why we
are concerned with it in this book.
SelfTest
How would you define business ethics?
Can a firm’s executive compensation plan lead to unethical behavior? Explain.
Unethical acts are generally committed by unethical people. What are some things
companies can do to help ensure that their employees act ethically?
Tying it All Together
This chapter provides a broad overview of financial management. Management’s primary
goal should be to maximize the long-run value of the stock, which means the intrinsic value
as measured by the stock’s price over time. To maximize value, firms must develop products
that consumers want, produce the products efficiently, sell them at competitive prices, and
observe laws relating to corporate behavior. If firms are successful at maximizing the stock’s
value, they will also be contributing to social welfare and citizens’ well-being.
Businesses can be organized as proprietorships, partnerships, corporations, limited liability
companies (LLCs), or limited liability partnerships (LLPs). The vast majority of all business is
done by corporations, and the most successful firms become corporations, which explains
the focus on corporations in this book.
The primary tasks of the CFO are
(1)
to make sure the accounting system provides “good” numbers for internal decision making
and for investors,
(2)
to ensure that the firm is financed in the proper manner,
(3)
to evaluate the operating units to make sure they are performing in an optimal manner, and
(4)
to evaluate all proposed capital expenditures to make sure they will increase the firm’s
value.
In the remainder of this book, we discuss exactly how financial managers carry out these
tasks.
Chapter 2
Introduction
The Economy Depends on a Strong Financial System
History shows that a strong financial system is a necessary ingredient for a growing and
prosperous economy. Companies raising capital to finance capital expenditures and investors
saving to accumulate funds for future use require well-functioning financial markets and
institutions.
Over the past few decades, changing technology and improving communications have
increased cross-border transactions and expanded the scope and efficiency of the global
financial system. Companies routinely raise funds throughout the world to finance projects
all around the globe. Likewise, with the click of a mouse an individual investor in Pittsburgh
can deposit funds in a European bank or purchase a mutual fund that invests in Chinese
securities.
These innovations helped spur global economic growth by providing capital to an increasing
number of individuals and businesses throughout the world. Along the way, the financial
industry attracted a lot of talented people who created, marketed, and traded a large
number of new financial products. Despite their benefits many of these same factors led to
excesses that culminated in the financial crisis of 2007 and 2008. This crisis also reaffirmed
how changes in the value of financial assets can quickly spill over and affect other parts of
the economy. For example, a 2014 article in The Wall Street Journal described how a
dramatic drop in many of the leading hot tech stocks (Facebook, King Digital Entertainment,
Netflix, Yelp, and Twitter) suddenly made it more difficult for new start-ups to raise money in
the initial public offering (IPO) market.
In the years since, new technologies have spawned many businesses with exciting products
and services, but these same forces have also led to increased volatility and disruption. For
example, in 2019 many high-profile companies such as Uber, Lyft, Slack, and Beyond Meat
went public but struggled to maintain their high-flying valuations following their IPOs. And in
September 2019, we witnessed the dramatic fall of WeWork and the withdrawal of its
planned IPO.
While these recent events have attracted a lot of attention, it is important to understand
that almost all companies have been affected by changing technology and globalization.
More generally, managers and investors don’t operate in a vacuum—they make decisions
within a large and complex financial environment. This environment includes financial
markets and institutions, tax and regulatory policies, and the state of the economy. We also
saw in 2020 how shocks to oil prices and the coronavirus outbreak dramatically transformed
the economy and financial markets. In short, the environment both determines the available
financial alternatives and affects the outcome of various decisions. Thus, it is crucial that
investors and financial managers have a good understanding of the environment in which
they operate.
Sources: Dan Gallagher, “Tech IPOs Will Face a Much Higher Bar,” The Wall Street Journal
(wsj.com), January 6, 2020; Mike Isaac and Michael J. De La Merced, “Uber Closes $1.6
Billion in Financing,” The New York Times (dealbook.nytimes.com), January 21, 2015; Scott
Austin, Chris Canipe, and Sarah Slobin, “The Billion Dollar Startup Club,” The Wall Street
Journal (graphics.wsj.com/billion-dollar-club/), February 18, 2015; and Rolfe Winkler, Matt
Jarzemsky, and Evelyn Rusli, “Drop in Tech Stocks Hits Startup Funding,” The Wall Street
Journal (wsj.com), April 16, 2014.
Putting Things in Perspective
In Chapter 1, we saw that a firm’s primary financial goal is to maximize long-run shareholder
value. Shareholder value is ultimately determined in the financial markets; so if financial
managers are to make good decisions, they must understand how these markets operate. In
addition, individuals make personal investment decisions; so they too need to know
something about financial markets and the institutions that operate in those markets.
Therefore, in this chapter, we describe the markets where capital is raised, securities are
traded, and stock prices are established, as well as the institutions that operate in these
markets. We will also discuss the concept of market efficiency and demonstrate how
efficient markets help promote the effective allocation of capital.
For additional information regarding the financial crisis, students can refer to
stlouisfed.org/Financial-Crisis. Another good source can be found at fcic.law.stanford.edu,
which focuses on the Financial Crisis Inquiry Commission.
In recent years, the dramatic price swings in the financial markets that have become
increasingly common have led many to question whether markets are always efficient. In
response, there has been increased interest in behavioral finance theory. This theory focuses
on how psychological factors influence individual decisions (sometimes in perverse ways),
and the resulting impact these decisions have on financial markets.
When you finish this chapter, you should be able to do the following:
Identify the different types of financial markets and financial institutions, and explain how
these markets and institutions enhance capital allocation.
Explain how the stock market operates, and list the distinctions between the different types
of stock markets.
Explain how the stock market has performed in recent years.
Discuss the importance of market efficiency, and explain why some markets are more
efficient than others.
Develop a simple understanding of behavioral finance.
2-1. The Capital Allocation Process
Businesses, individuals, and governments often need to raise capital. For example, Carolina
Power & Light Energy (CP&L) forecasts an increase in the demand for electricity in North and
South Carolina, so it will build a new power plant to meet those needs. Because CP&L’s bank
account does not contain the $1 billion necessary to pay for the plant, the company must
raise this capital in the financial markets. Similarly, the proprietor of a San Francisco
hardware store wants to expand into appliances. Where will he get the money to buy the
initial inventory of TV sets, washers, and freezers? Or suppose the Johnson family wants to
buy a home that costs $200,000, but they have only $50,000 in savings. Where will they
obtain the additional $150,000? The city of New York needs $200 million to build a new
sewer plant. Where can it obtain this money? Finally, the federal government needs more
money than it receives from taxes. Where will the extra money come from?
On the other hand, some individuals and firms have incomes that exceed their current
expenditures, in which case they have funds available to invest. For example, Carol Hawk has
an income of $36,000, but her expenses are only $30,000. That leaves her with $6,000 to
invest. Similarly, Microsoft has accumulated roughly $134.253 billion of cash and marketable
securities. What can Microsoft do with this money until it is needed in the business?
People and organizations with surplus funds are saving today in order to accumulate funds
for some future use. Members of a household might save to pay for their children’s
education and the parents’ retirement, while a business might save to fund future
investments. Those with surplus funds expect to earn a return on their investments, while
people and organizations that need capital understand that they must pay interest to those
who provide that capital.
In a well-functioning economy, capital flows efficiently from those with surplus capital to
those who need it. This transfer can take place in the three ways described in Figure 2.1.
Direct transfers of money and securities, as shown in the top section, occur when a business
sells its stocks or bonds directly to savers, without going through any type of financial
institution. The business delivers its securities to savers, who, in turn, give the firm the
money it needs. This procedure is used mainly by small firms, and relatively little capital is
raised by direct transfers.
As shown in the middle section, transfers may also go through an investment bank (IB) such
as Morgan Stanley, which underwrites the issue. An underwriter facilitates the issuance of
securities. The company sells its stocks or bonds to the investment bank, which then sells
these same securities to savers. The businesses’ securities and the savers’ money merely
“pass through” the investment bank. However, because the investment bank buys and holds
the securities for a period of time, it is taking a risk—it may not be able to resell the
securities to savers for as much as it paid. Because new securities are involved and the
corporation receives the sale proceeds, this transaction is called a primary market
transaction.
Transfers can also be made through a financial intermediary such as a bank, an insurance
company, or a mutual fund. Here the intermediary obtains funds from savers in exchange for
its securities. The intermediary uses this money to buy and hold businesses’ securities, and
the savers hold the intermediary’s securities. For example, a saver deposits dollars in a bank,
receiving a certificate of deposit; then the bank lends the money to a business in the form of
a mortgage loan. Thus, intermediaries literally create new forms of capital—in this case,
certificates of deposit, which are safer and more liquid than mortgages and thus better for
most savers to hold. The existence of intermediaries greatly increases the efficiency of
money and capital markets.
Figure 2.1 Diagram of the Capital Formation Process for Business
Details
Often the entity needing capital is a business (and specifically a corporation), but it is easy to
visualize the demander of capital being a home purchaser, a small business, or a government
unit. For example, if your uncle lends you money to fund a new business, a direct transfer of
funds will occur. Alternatively, if you borrow money to purchase a home, you will probably
raise the funds through a financial intermediary such as your local commercial bank or
mortgage banker. That banker could sell your mortgage to an investment bank, which then
might use it as collateral for a bond that is purchased by a pension fund.
In a global context, economic development is highly correlated with the level and efficiency
of financial markets and institutions. It is difficult, if not impossible, for an economy to reach
its full potential if it doesn’t have access to a well-functioning financial system. In a welldeveloped economy like that of the United States, an extensive set of markets and
institutions has evolved over time to facilitate the efficient allocation of capital. To raise
capital efficiently, managers must understand how these markets and institutions work, and
individuals need to know how the markets and institutions work to earn high rates of returns
on their savings.
SelfTest
Name three ways capital is transferred between savers and borrowers.
Why are efficient capital markets necessary for economic growth?
2-2. Financial Markets
People and organizations wanting to borrow money are brought together with those who
have surplus funds in the financial markets. Note that markets is plural; there are many
different financial markets in a developed economy such as that of the United States. We
describe some of these markets and some trends in their development.
2-2A. Types of Markets
Different financial markets serve different types of customers or different parts of the
country. Financial markets also vary depending on the maturity of the securities being
traded and the types of assets used to back the securities. For these reasons, it is useful to
classify markets along the following dimensions:
Physical asset markets versus financial asset markets. Physical asset markets (also called
“tangible” or “real” asset markets) are for products such as wheat, autos, real estate,
computers, and machinery. Financial asset markets, on the other hand, deal with stocks,
bonds, notes, and mortgages. Financial markets also deal with derivative securities whose
values are derived from changes in the prices of other assets. A share of Ford stock is a “pure
financial asset,” while an option to buy Ford shares is a derivative security whose value
depends on the price of Ford stock.
Spot markets versus futures markets. Spot markets are markets in which assets are bought
or sold for “on-the-spot” delivery (literally, within a few days). Futures markets are markets
in which participants agree today to buy or sell an asset at some future date. For example, a
farmer may enter into a futures contract in which he agrees today to sell 5,000 bushels of
soybeans 6 months from now at a price of $8.7925 a bushel. To continue that example, a
food processor that needs soybeans in the future may enter into a futures contract in which
it agrees to buy soybeans 6 months from now. Such a transaction can reduce, or hedge, the
risks faced by both the farmer and the food processor.
Money markets versus capital markets. Money markets are the markets for short-term,
highly liquid debt securities. The New York, London, and Tokyo money markets are among
the world’s largest. Capital markets are the markets for intermediate- or long-term debt and
corporate stocks. The New York Stock Exchange, where the stocks of the largest U.S.
corporations are traded, is a prime example of a capital market. There is no hard-and-fast
rule, but in a description of debt markets, short-term generally means less than 1 year,
intermediate-term means 1 to 10 years, and long-term means more than 10 years.
Primary markets versus secondary markets. Primary markets are the markets in which
corporations raise new capital. If GE were to sell a new issue of common stock to raise
capital, a primary market transaction would take place. The corporation selling the newly
created stock, GE, receives the proceeds from the sale in a primary market transaction.
Secondary markets are markets in which existing, already outstanding securities are traded
among investors. Thus, if Jane Doe decided to buy 1,000 shares of GE stock, the purchase
would occur in the secondary market. The New York Stock Exchange (NSYE) is a secondary
market because it deals in outstanding, as opposed to newly issued, stocks and bonds.
Secondary markets also exist for mortgages, other types of loans, and other financial assets.
The corporation whose securities are being traded is not involved in a secondary market
transaction and thus does not receive funds from such a sale.
Private markets versus public markets. Private markets, where transactions are negotiated
directly between two or more parties, are differentiated from public markets, where
standardized contracts are traded on organized exchanges. Bank loans and private debt
placements with insurance companies are examples of private market transactions. Because
these transactions are private, they may be structured in any manner to which the relevant
parties agree. By contrast, securities that are traded in public markets (e.g., common stock
and corporate bonds) are held by a large number of individuals. These securities must have
fairly standardized contractual features because public investors do not generally have the
time and expertise to negotiate unique, nonstandardized contracts. Broad ownership and
standardization result in publicly traded securities being more liquid than tailor-made,
uniquely negotiated securities.
Other classifications could be made, but this breakdown shows that there are many types of
financial markets. Also note that the distinctions among markets are often blurred and
unimportant except as a general point of reference. For example, it makes little difference if
a firm borrows for 11, 12, or 13 months, that is, whether the transaction is a “money” or
“capital” market transaction. You should be aware of the important differences among types
of markets, but don’t be overly concerned about trying to distinguish them at the
boundaries.
A healthy economy is dependent on efficient funds transfers from people who are net savers
to firms and individuals who need capital. Without efficient transfers, the economy could
not function: Carolina Power & Light Energy could not raise capital, so Raleigh’s citizens
would have no electricity; the Johnson family would not have adequate housing; Carol Hawk
would have no place to invest her savings; and so forth. Obviously, the level of employment
and productivity (i.e., the standard of living) would be much lower. Therefore, it is essential
that financial markets function efficiently—not only quickly, but also inexpensively.
Table 2.1 is a listing of the most important instruments traded in the various financial
markets. The instruments are arranged in ascending order of typical length of maturity. As
we go through this book, we will look in more detail at many of the instruments listed in
Table 2.1. For example, we will see that there are many varieties of corporate bonds, ranging
from “plain vanilla” bonds to bonds that can be converted to common stocks to bonds
whose interest payments vary depending on the inflation rate. Still, the table provides an
overview of the characteristics and costs of the instruments traded in the major financial
markets.
Table 2.1 Summary of Major Market Instruments, Market Participants, and Security
Characteristics
Security Characteristics
Instrument
Market
Major Participants
Riskiness
Original Maturity
Interest Rate on 3/24/20
(1)
(2)
(3)
(4)
(5)
(6)
U.S. Treasury bills
Money
Sold by U.S. Treasury to finance federal expenditures
Default-free, close to riskless
91 days to 1 year
0.01%
Commercial paper
Money
Issued by financially secure firms to large investors
Low default risk
Up to 270 days
2.35%
Negotiable certificates of deposit (CDs)
Money
Issued by major money-center commercial banks to large investors
Default risk depends on the strength of the issuing bank
Up to 1 year
0.15%
Money market mutual funds
Money
Invest in Treasury bills, CDs, and commercial paper; held by individuals and businesses
Low degree of risk
No specific maturity (instant liquidity)
0.36%
Consumer credit, including credit card debt
Money
Issued by banks, credit unions, and finance companies to individuals
Risk is variable
Variable
Variable, but average APR is 12.90% to 25.49%
U.S. Treasury notes and bonds
Capital
Issued by the U.S. government
No default risk, but price will decline if interest rates rise; hence, there is some risk
2 to 30 years
0.336% on 2-year to 1.446% on 30-year bonds
Mortgages
Capital
Loans to individuals and businesses secured by real estate; bought by banks and other
institutions
Risk is variable; risk is high in the case of subprime loans
Up to 30 years
3.55% adjustable 5-year rate, 3.89% 30-year fixed rate
State and local government bonds
Capital
Issued by state and local governments; held by individuals and institutional investors
Riskier than U.S. government securities but exempt from most taxes
Up to 30 years
2.977% to 4.431% on 20-year AAA-rated to A-rated bonds
Corporate bonds
Capital
Issued by corporations; held by individuals and institutional investors
Riskier than U.S. government securities but less risky than preferred and common stocks;
varying degree of risk within bonds depends on strength of issuer
Up to 40 years
3.111% on 20-year AAA bonds, 4.937% on 20-year A bonds
Leases
Capital
Similar to debt in that firms can lease assets rather than borrow and then buy the assets
Risk similar to corporate bonds
Generally 3 to 20 years
Similar to bond yields
Preferred stocks
Capital
Issued by corporations to individuals and institutional investors
Generally riskier than corporate bonds but less risky than common stock
Unlimited
5.75% to 9.5%
Common stocks
Capital
Issued by corporations to individuals and institutional investors
Riskier than bonds and preferred stock; risk varies from company to company
Unlimited
NA
2-2B. Recent Trends
Financial markets have experienced many changes in recent years. Technological advances in
computers and telecommunications, along with the globalization of banking and commerce,
have led to deregulation, which has increased competition throughout the world. As a
result, there are more efficient, internationally linked markets, which are far more complex
than what existed a few years ago. While these developments have been largely positive,
they have also created problems for policymakers. With these concerns in mind, Congress
and regulators have moved to reregulate parts of the financial sector. The box “Changing
Technology Has Transformed Financial Markets” illustrates some dramatic examples of how
changing technology has transformed financial markets in recent years.
Globalization has exposed the need for greater cooperation among regulators at the
international level, but the task is not easy. Factors that complicate coordination include
(1)
the different structures in nations’ banking and securities industries,
(2)
the trend toward financial services conglomerates, which obscures developments in various
market segments, and
(3)
the reluctance of individual countries to give up control over their national monetary
policies.
Still, regulators are unanimous about the need to close the gaps in the supervision of
worldwide markets.
Changing Technology has Transformed Financial markets
In recent years, changing technology has created numerous innovations and has dramatically
transformed the operation of financial markets. Here are just a few interesting examples:
Changing technology has created a whole class of firms that use computer algorithms to buy
and sell securities, often at speeds of less than a second. The trades conducted by these
high-frequency trading (HFT) firms now represent a very significant fraction of the total
trading volume in a given day. Proponents argue that these HFT firms generate liquidity,
which helps reduce transactions costs and makes it easier for other investors to get in and
out of the market. Critics argue that these activities can create market instability and that
HFT firms often engage in trades that are self-serving to their own interests, to the
detriment of other investors. A recent best-selling book by Michael Lewis, titled Flash Boys,
attracted a lot of attention for its highly critical depiction of HFT firms.
Changing technology has allowed some individuals and firms to bypass intermediaries and
directly raise money from investors to help fund various projects. This activity is referred to
as crowdfunding. Two leading examples of these platforms include Kickstarter and
Indiegogo.
Many financial firms have created “robo-advisors” that utilize algorithmic technology to
create relatively low-cost optimal investment portfolios for investors based on important
factors such as their investment horizon and their tolerance for risk. These products have
begun to have a disruptive effect on many human advisors, who are often more expensive.
At the same time, astute financial advisors continue to find ways to add value and to
incorporate technology in ways that benefit both them and their clients.
Changing technology has changed the way that many people pay for transactions. Many of
us rarely use cash anymore and instead often rely on debit and credit cards for payment.
Others often use electronic commerce services such as PayPal to make online payments.
Likewise, tech companies such as Facebook and Google have long been thought to have an
interest in becoming more involved in banking and payment-related activities. More
recently, there has been a growing interest in Bitcoin and other cryptocurrencies that involve
no intermediary and have no fees. The following chart from The Wall Street Journal
illustrates the recent dramatic swings in Bitcoin’s value. In March 2017, Bitcoin was trading
at just over $1,000. The price surged to a high of $19,783 by mid-December 2017. In the
subsequent 2 years, the currency has fallen in value and was trading just over $6,500 near
the end of March 2020. Although intriguing, many are concerned that the lack of regulation
makes Bitcoin and other cryptocurrencies an attractive vehicle for illegal transactions.
While many debate the true value of Bitcoin, even many of its skeptics believe that its
underlying blockchain technology has the potential to be transformative. A 2015 article in
The Economist provides an excellent early summary of the promise of this technology. Here’s
a relevant quote from that article:
But most unfair of all is that bitcoin’s shady image causes people to overlook the
extraordinary potential of the “blockchain”, the technology that underpins it. This innovation
carries a significance stretching far beyond cryptocurrency. The blockchain lets people who
have no particular confidence in each other collaborate without having to go through a
neutral central authority. Simply put, it is a machine for creating trust.
Details
Professor David Yermack of NYU, a leading academic expert on block…