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. But what are the financial markets? Financial marketsThe place of interaction for people, corporations, and institutions that either need money or have money to lend or invest. 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 financial 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 marketsMarkets in which national, state, and local governments raise money for highways, education, welfare, and other public activities.. Corporations such as Coca-Cola, Nike, and General Motors, on the other hand, raise funds in the corporate financial marketsMarkets in which corporations, in contrast to governmental units, raise funds..
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 marketsCompetitive markets for securities with maturities of one year or less. The best examples of money market instruments would be Treasury bills, commercial paper, and negotiable certificates of deposit. 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 Chapter 7.
The capital marketsCompetitive markets for equity securities or debt securities with maturities of more than one year. The best examples of capital market securities are common stock, bonds, and preferred stock. 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 intermediate 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 Chapter 14. 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 and equipment. A firm may go to the markets and raise financial capital either by borrowing money through a debt offering of corporate bonds or shortterm 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 marketThe market for the raising of new funds as opposed to the trading of securities already in existence. by way of a new issue. After the securities are sold to the public (institutions and individuals), they are traded in the secondary marketThe market for securities that have already been issued. It is a market in which investors trade back and forth with each other. 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 corporations prospects. It is also in the secondary market that financial managers are given feedback about their firms 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 in Nestlé, the Swiss food company, or in Cemex, the Mexican cement 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.
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 that $250 million you are managing. If ExxonMobil wants to borrow money from you at 9 percent and Chevron is willing to pay 8 percent 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 firms shareholder value. As mentioned earlier, 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. RestructuringProcess that can take many forms in a corporation, such as changes in the capital structure (liability and equity on the balance sheet). It can also result in the selling of low-profit-margin divisions with the proceeds reinvested in better investment opportunities. Sometimes restructuring results in the removal of the current management team or large reductions in the workforce. Restructuring has also included mergers and acquisitions. can result in changes in the capital structure (liabilities and equity on the balance sheet). It can 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 technologyor they are simply looking for size to help them compete in an international arena.
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, Nestlé, and Mercedes Benz are known the world over. McDonalds hamburgers are eaten throughout the world, and McDonalds raises funds on most major international money and capital markets. The growth of the global company has led to the growth of global fund raising as companies search for low-priced sources of funds.
In a recent annual report, Coca-Cola stated that it conducted business in 59 different currencies and borrowed money in yen, euros and other international currencies.
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 major stock markets and the merger of brokerage firms with domestic as well as international partners. Advances in computer technology have created electronic communications networks (electronic markets) such as Archipelago and Instinet that have taken market share away from the organized exchanges (such as the New York Stock Exchange and NASDAQ). These electronic markets have speed and cost advantages over the traditional markets and as a result, the New York Stock Exchange is merging with Archipelago, and NASDAQ has bought Instinet from Reuters. The cost pressures and the need for capital have also caused many of the markets to become for-profit publicly traded companies. The most successful has been the Chicago Mercantile Exchange that went public at $35 per share a few years ago and in May of 2006 was trading at $455 per share. Also, the NASDAQ and the New York Stock Exchange are now publicly traded.
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 Salomon 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.
Another change that has squeezed profits for market makers is the change to price quotes in decimals rather than the traditional 1/16, 1/8, 1/4, and 1/2 price quotes. 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 the text.