Money was never a big motivation for me, except as a way to keep score. The real excitement is playing the game.
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You may wonder how a financial manager knows whether he or she is maximizing shareholder value and how ethical (or unethical) behavior may affect the value of the company. This information is provided daily to financial managers through price changes determined in the financial markets. What are the financial markets? Financial markets are the meeting place for people, corporations, and institutions that either need money or have money to lend or invest. In a broad context, the financial markets exist as a vast global network of individuals and institutions that may be lenders, borrowers, or owners of public companies worldwide. Participants in the financial markets also include national, state, and local governments that are primarily borrowers of funds for highways, education, welfare, and other public activities their markets are referred to as public financial markets. Corporations such as Coca-Cola, Nike, and General Motors, on the other hand, raise funds in the corporate financial markets. Structure and Functions of the Financial Markets Financial markets can be broken into many distinct parts. Some divisions such as domestic and international markets, or corporate and government markets, are self explanatory. Others such as money and capital markets need some explanation. Money markets refer to those markets dealing with short-term securities that have a life of one year or less. Securities in these markets can include commercial paper sold by corporations to finance their daily operations, or certificates of deposit with maturities of less than one year sold by banks. Examples of money market securities are presented more fully in future posts. The capital markets are generally defined as those markets where securities have a life of more than one year. While capital markets are long-term markets, as opposed to short-term money markets, it is often common to break down the capital markets into immediate markets (1 to 10 years) and long-term markets (greater than 10 years). The capital markets include securities such as common stock, preferred stock, and corporate and government bonds. Capital markets are fully presented in later posts. Now that you have a very basic understanding of the makeup of the financial markets, you need to understand how these markets affect corporate managers. Allocation of Capital A corporation relies on the financial markets to provide funds for short-term operations and for new plant equipment. A firm may go to the markets and raise financial capital either by borrowing money through a debt offering of corporate bonds or short-term notes, or by selling ownership in the company through an issue of common stock. When a corporation uses the financial markets to raise new funds, the sale of securities is said to be made in the primary market by way of new issue. After the securities are sold to the public (institutions and individuals), they are traded in the secondary market between investors. It is in the secondary market that prices are continually changing as investors buy and sell Securities based on their expectations of a corporation's prospects. It is also in the secondary market that financial managers are given feedback about their firm's performance.  How does the market allocate capital to the thousands of firms that are continually in need of money? Let us assume that you graduate from college as a finance major and are hired to manage money for a wealthy family like the Rockefellers. You are given $250 million to manage and you can choose to invest the money anywhere in the world. For example, you could buy common stock in Microsoft, the American software company, or Nestle, the Swiss food company, or TELMEX, the Mexican telephone company; you could choose to lend money to the U.S. or Japanese government by purchasing its bonds; or you could lend money to ExxonMobil or British Petroleum. Of course these are only some of the endless choices you would have. How do you decide to allocate the $250 million so that you will maximize your return and minimize your risk? Some investors will choose a risk level that meets their objective and maximize return for that given level of risk. By seeking this risk-return objective, you will bid up the prices of securities that seem underpriced and have potential for high returns and you will avoid securities of risk equal risk that, in your judgment, seem overpriced. Since all market participants play the same risk-return game, the financial markets become the playing field, and price movements become the winning or losing score. Let us look at only the corporate sector of the market and 100 companies of equal risk. Those companies with expectations for high return will have higher relative common stock prices than those companies with poor expectations. Since the securities prices in the market reflect the combined judgement of all the players, price movements provide feedback to corporate managers and let them know whether the market thinks they are winning or losing against the competition. Those companies that perform well and are rewarded by the market with high priced securities have an easier time raising new funds in the money and capital markets than their competitors. They are also able to raise funds at a lower cost. Go back to the $250 million dollar you are managing. If ExxonMobil wants to borrow money from you at 9% and Chevron is willing to pay 8% but also is riskier, to which company will you lend money? If you chose ExxonMobil you are on your way to understanding finance. The competition between the two firms for your funds will eventually cause Chevron to offer higher returns than ExxonMobil, or they will have to go without funds. In this way the money and capital markets allocate funds to the highest quality companies at the lowest cost and to the lowest quality companies at the highest cost. In other words, firms pay a penalty for failing to perform competitively.  Institutional Pressure on Public Companies to Restructure Sometimes an additional penalty for poor performance is a forced restructuring by institutional investors seeking to maximize a firm's shareholder value. Institutional investors have begun to flex their combined power, and their influence with corporate boards of directors has become very visible. Nowhere has this power been more evident than in the area of corporate restructuring. Restructuring can result in changes in the capital structure (liabilities and equity on the balance sheet). It could also result in the selling of low-profit-margin divisions with the proceeds of the sale reinvested in better investment opportunities. Sometimes restructuring results in the removal of the current management team or large reductions in the workforce. Restructuring also has included mergers and acquisitions of gigantic proportions unheard of in earlier decades. Rather than seeking risk reduction through diversification, firms are now acquiring greater market shares, brand name products (i.e., British Petroleum acquiring Amoco), hidden assets values, or technology or they are simply looking for size to help them compete in an international arena. The restructuring and management changes in many major multinational corporations is a result of institutional investors affecting change by influencing the boards of directors to exercise control over all facets of the company's activities. Quite a few boards of directors were viewed as rubber stamps for management before this time. Large institutional investors have changed this perception. Without their attempt to maximize the value of their investments, many restructuring deals would not take place. And without the financial markets placing a value on publicly held companies, restructuring would be much more difficult to achieve. Internationalization of the Financial Markets International trade is a growing trend that is likely to continue. Global companies are becoming more common and international brand names like Sony, Coca-Cola, Nestle, and Mercedes-Benz are known the world over. McDonald's hamburgers are eaten throughout the world, and McDonald's raises funds on most major international money and capital markets. The growth of the global company has led to the growth of global fundraising as companies search for low-priced sources of funds. This discussion demonstrates that the allocation of capital and the search for low-cost sources of financing is now an international game for the multinational companies. As an exclamation point consider all the non-U.S. companies who want to raise money in the United States. More and more foreign companies have listed their shares on the New York Stock Exchange.  We live in a world where international events impact economies of all industrial countries and where capital moves from country to country faster than was ever thought possible. Computers interact in a vast international financial network and markets are more vulnerable to the emotions of investors than they have been in the past. The corporate financial manager has an increasing number of external impacts to consider. Future financial managers will need to have the sophistication to understand international capital flows, computerized electronic funds transfer systems, foreign currency hedging strategies, and many other functions. The remaining parts of this analysis should help you learn how corporations are managing these challenges. The Internet and Changes in the Capital Markets Technology has had a significant impact on the capital markets. The biggest impact has been in the area of cost reduction for trading securities. Those firms and exchanges that are at the front of the technology curve are creating tremendous competitive cost pressures on those firms and exchanges that cannot compete on a cost basis. This has caused consolidations among markets and among brokerage firms. Advances in computer technology have helped create electronic markets. These markets enable institutions to trade over the Internet at much lower costs than they would have been able to trade on the New York Stock Exchange. These cost pressures have caused exchanges such as the New York Stock Exchange and NASDAQ to become publicly-traded for-profit companies (Palmer, B., June 21, 2020, Can I Invest in the Nasdaq or NYSE?, Investopedia). This restructuring of the markets will have ramifications on the capital markets for years to come. Another area where the Internet has played its role is in the area of retail stock trading. Firms like Charles Schwab, E-Trade, Ameritrade, and other discount brokerage firms allow customers to trade using the Internet and have created a competitive problem for full-service brokers such as Merrill Lynch and Solomon Smith Barney. These discount firms have forced the full-service retail brokers to offer Internet trading to their customers, even though Internet trading is not as profitable for them as trading through their brokers.  The trend is to a lower-cost environment for the customers and a profit squeeze on markets and brokers. These issues and others will be developed more fully in the capital market section of this analysis. Next Post: "Financial Analysis and Planning: Review of Accounting" *MAIN SOURCE: BLOCK & HIRST, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 13-18* end |
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