+1(978)310-4246 credencewriters@gmail.com


Write research paper computing the financial ratios yourself.

Due Date and Time: 15 days

The Project to be addressed by the Paper:

You have just graduated from UCLA University’s MBA program and have secured a position as a fund manager for a well known investment banking house. You have been given $25 million to manage/invest in a single stock. The fund is a pension/retirement fund so its perspective is long term with moderate risk of loss of capital and a required return of 9% per annum. Your assignment is to determine if the fund you are managing should invest $25 million dollars in the stock of the company you have selected for your first analysis/investment decision. Select a publicly traded US based company. Do not select a bank or financial intermediary (i.e Investment Bank, Insurance Company, Brokerage House etc). Your decision to invest or not invest will be supported by the research paper and a Power Point Presentation.

NOTE:Most of the data needed for this assignment can be found in Yahoo/finance.Go to Yahoo/finance,

select your company, and view the table of contents on the left side of the page.

Your analysis, based on the concepts covered  will address each of the following:

Business Strategy Analysis:Develop an understanding of the business and competitive strategies of the company. Which of the three generic competitive strategies does the company utilize (low cost provider, differentiation, focus)?This should be covered in not more than three paragraphs. Do not spend time writing a history of the company.This is an analysis, not a history lesson.

Accounting Analysis:Do the accounting practices adopted by the company generally reflect an accurate picture of the economic performance of the company? Did your research find any public announcements of restatement of earnings or other financial statements that would indicate that the financial statements may be of dubious value? This can be done by reviewing the company’s 8K filings with the SEC (a mandatory requirement for this paper).These filings can generally be found on the company’s website under Investor Relations – SEC filings.

Financial Analysis: Analyze financial ratios and cash flow measures of the company relative to its historical performance. For purposes of this research paper a 2 year look back is sufficient and required. You must use at least 10 of the ratios noted on page 119 of the text including all four of the profitability ratios.

Prospective Analysis:Develop forecasted performance measures and list the assumptions associated with your forecast.List your assumptions and reasons for your forecast.You may also cite the works of other analysts who have published forecasted earnings for the time frame you are addressing.(Hint:take a look at Yahoo/finance – analysts opinion

Conclusion: Will you or will you not invest $25 million in this particular Company?Support your conclusion?Remember a negative conclusion is just as valid and valuable as a positive conclusion.

Conducting Library Research:

Participate in a research orientation offered by the graduate librarian.

Conduct a search for sources that offer accurate information on your company. A minimum of 6 six  legitimate and valid relevant resources are required. Peer Review Articles.

Note:An excellent place to start is in University’s library LIRN database.

Enter LIRN, go to INFOTRAC, in INFOTRAC enter “Business and Company Resource with PROMT and Newsletters.

Enter the name of your company.Under your company you will find items such as “Historical”, “Investment Reports”, “Financial” and other data. You can find Industry Analysis in Standard & Poor’s.Individual company information may be found in Value Line and Morningstar.Additional information can generally be found on the company’s website under “Investor Relations”.Here you will find SEC 10-K, 10Q, 8K’s and other filings. You may also wish to visit the website of the Securities and Exchange Commission (SEC) for filings by your company.

Avoid general Internet key word searches. Wikipedia and other unauthorized sources are inappropriate for graduate work. Articles noting up to date information is such sources as The Wall Street Journal, Barron’s or Business Week may be useful in addressing the appropriateness of current strategies, resource pricing, etc. given market conditions or the status of competitors.

Writing the Paper:

The following are general guidelines for format and organization.


Minimum of twelve pages (including self prepared exhibits), with numbered pages.

Typed, double spaced.

New Times Roman (i.e. business) font, 12 point.

Margins – 1.25 inches.

Include boldface headings and subheadings.

Note source citations as appropriate under APA guideline.


Cover page – Name of paper, your name, course number and name, date submitted.

Introduction – A brief statement of the purpose of the paper and explanation of its organization. You are welcome to use pseudonyms for the name of the company or individuals addressed in the paper.

Analysis -Address four concepts noted in “The Paper etc” on the preceding page.

Summary – A brief statement combining the finding arising from the analysis.

Conclusion/Recommendations – should you invest or not invest the $25 million and why or why not.

Requirements: 12 pages Will provide examples of previous essays to see am compare . Need to select a big company, like amazon, google, nike, coca cola……..

Macy’s Inc. Analysis of Investment Decision
Student Sample
UCLA University
Dr. H P
Financial Management
October 1, 2018
The retail store industry is a highly competitive market because most of their products are
very similar among the stores, which puts a lot of pressure on businesses to create their image,
setup differentiation, and create loyal customers. Accordingly, it is hard for new companies to
join the industry because the existing firms are strongly positioned in the market. For this
reason, I have selected Macy’s Inc. as my target analysis to evaluate its financial performance in
the retail apparel industry to decide whether to advise investment in this company.
Among the most important departmental stores, Macy’s has established its image as the
store with an extensive collection of unique luxury fashion apparel, shoes, accessories, jewelry,
cosmetics, and gifts that customers at almost all economic levels can afford, which has
positioned the store amongst the largest apparel and home furnishing retailers. Macy’s operates
775 locations in 45 states, the District of Columbia, Puerto Rico, and Guam; additionally, it
serves customers on 100 international destinations through its online store macys.com and
operates blooingdales.com and bluemaercury.com.
For this reason, as Fidelity’s fund manager, I am presenting to the executive committee
the analysis investment decision I have made about Macy’s Inc. for which I have taken into
consideration not only the business strategy and accounting analysis but also the financial
business ratios compared to the average retail sector industry; as well as the prospective points of
view from other analysts about the company’s performance. These considerations have helped
me make and support my final decision about the $25 million our banking house is about to
Macy’s Inc. Analysis of Investment Decision
Business Strategy Analysis
Macy’s, Inc. is one of the most important retailers in The United States, with fiscal sales
of $28.1 billion in 2014. It has almost 900 stores and 172,500 employees. Prior to June 1, 2007,
Macy’s Inc. was known as Federated Department Stores, Inc. Nowadays, its shares are traded
under the symbol “M” on the New York Stock Exchange (Reuters, 2015).
Macy’s occupies an important place in American retailing because it has always been
central to its competitive strategy: differentiation. It offers enormous collections at different
prices that all socio-economic levels can afford to buy. For instance, the store constantly sells
and provides coupons to maintain price-conscious customers coming back to shop. Accordingly,
the store has focused its attention on foreign tourists and audiences born between the 1980s and
2000s looking for name brands (Singer, 2014). Last fall season, Macy’s was the only department
store selling Tommy Hilfiger, and during the holiday season, Macy’s brought the toy business
into the store by hosting more than 250 Fao Schwarz shops. These two were huge opportunities
to differentiate Macy’s brand with unique products and attract more targeted customers
(Lundgren, 2008). As a result, 20% of Macy’s sales in 2014 were private brands, and more than
20% were exclusive (Weishaar, 2015).
Accounting Analysis
In August of 2014, Macy’s published its form 8-K disclosing its financial condition and
operations results to the public. I have confirmed that its accounting practices reflect a truthful
scenario of its economic performance by reviewing it. As it was detailed in the report, Macy’s
uses a non-GAAP financial measure for its accounting. Accordingly, its financial statements are
recorded, making the corresponding adjustments based on the store’s commission by the third
parties operating on certain departments. In other words, the measurements are recorded based
on the percentage of the commissions the store received from the operating leases. Even though
it could be seen as a disadvantage because it possesses flexibility when reporting its expenses,
Macy’s maintains transparency by detailing changes. As a consequence, instead of including
inflated numbers that could give a wrong perspective to investors when evaluating the store’s
capability, this type of reporting is an advantage not only for corporate management that can
evaluate easily the impact of changes affecting the operations of different departments but also
for investors that can have a better picture about the future direction of the business (Reuters,
Additionally, the form 8-K demonstrates that not dubious earnings have been hidden
because in addition to detailing its real estate investments, operating income, and cash flow
amounts. It also records the decrease in its shares value and its sales during the last period.
Moreover, the store has been audited by an independent registered public accounting company
that assures the business meets the standards established by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). Therefore, effective internal control has
been reported on the financial statements’ disclosures, and there is no weakness in the reporting.
As a result, Macy maintains a detailed, accurate, and truthful reflection of its assets transactions
that have been supported with the proper authorization of management and directors of the
company, which assures the prevention of unauthorized acquisition of assets or fraudulent
transactions (Reuters, 2015).
Financial Analysis
Before deciding on investing the 25 million dollars, Macy’s financial ratios analysis will
be done using the 2014 ratios obtained from NASDAQ and Morningstar Financial. Also, the
business strengths and weaknesses concerning the retail apparel industry average obtained from
the CSI market will be identified and how the company will perform in the future.
Liquidity ratios. Because liquidity ratios determine the business’s ability to pay off its
current and long-term liabilities, liquidity ratios demonstrate the cash level the company
possesses and its ability to turn assets into cash (Shaun, 2015).
The quick ratio. Looking at table 1, Macy’s Inc. reported 55% as its quick ratio, which is
not a big difference compared to table 2, which shows a 53% quick ratio for the industry
average. However, it does show an increase from the 51% reported in 2013 and a continuing
increase in 2015, in which 57% has been reported through September (NASDAQ, 2015). This
ratio shows that Macy’s possesses enough liquidity to pay its current liabilities using its quick
assets only. In other words, the store can pay its short-term liabilities, such as its current account
receivables and short-term investments or marketable securities, by using the assets that could be
converted to cash within 90 days (Shaun, 2015).
Assets management ratios. Assets management ratios measure how successfully the
company is using its assets. Therefore, a balance needs to be maintained because if excessive
investment in assets is made, the cash flow is reduced and, consequently, its stock price
(Brigham, 2010).
Total assets turnover ratio. This ratio calculates net sales as a percentage of assets to
show how many sales were generated from each dollar of the assets (Shaun, 2015). In 2014,
Macy’s reported a 1.31% increase in its assets turnover ratio, shown in table 3, while the average
retail sector industry, as listed in table 4, reported 2.25 during the same period. Accordingly,
Macy’s Inc. is located below the industry average, indicating that the company is not generating
enough business compared to its competitors, which might indicate that the assets are not used
properly to generate more sales.
Inventory turnover ratio. By comparing the cost of goods sold with the average
inventory for a period, we can calculate the amount of times the average inventory is sold during
the same period. As a result, 2.72 was reported as the Macy’s turnover ratio (see table 5), versus
7.81 from the average apparel industry (see table 4). This difference between ratios indicates
that the business might be holding big amounts of inventory, which not only indicates holding
obsolete or out of season goods but also could lead to other costs such as storage costs, net
operating working capital (NOWC), and reduces the cash flow making necessary to lower stock
prices (Brigham, 2010).
Debt management ratios. The debt ratios measure business solvency because they
measure its ability to pay off its total liabilities with its total assets. Therefore, companies with a
higher level of liabilities in proportion to their assets are considered risky for lenders, which is
also an important analysis to consider before making the investment decision (Shaun, 2015).
Leverage ratio. This ratio measures the company’s overall debt load and compares it
with its assets or equity, demonstrating how much from the assets belong to the creditors and the
shareholders (Shaun, 2015). According to Morningstar financial, Macy’s Inc. reported 3.46 as
its leverage ratio at the end of 2014 (see table 3). On the other hand, the CSI market reported
2.11 for the average industry (see table 2).
Even though it is noted on Macy’s financial report that the business’ equity value is
capable of facing all its liabilities, based on the leverage ratio comparison, the company is highly
leveraged compared to its competitors making risky its capital structure.
Profitability ratios. By comparing income statement accounts and categories to
demonstrate the company’s ability to produce profits, the profitability ratios arise. These ratios
show the company’s return on investment in inventory and assets showing how great companies
can achieve profits from their operations, so the business return on investment can be measured
based on its resource levels.
Net profit margin. This ratio shows the amount of net income earned with each dollar of
sales by comparing the net income and net sales of the business by showing the percentage of
sales left after all expenses were paid (Shaun, 2015). Accordingly, Macy’s reported 5% as its net
profit margin ratio is 2014 (see table 1), while the average retail apparel industry was 8.38% (see
table 6). Even though Macy’s has constantly been maintaining the same net profit margin ratio
since 2012, it is showed that the competitors are more effectively converting their sales into net
income than Macy’s, which indicates that the store might not be generating enough profits from
its assets.
Basic earning power (BEP) ratio. While Macy’s reported 8% as its basic earning power
ratio (see table 1), the average industry had 13.12% during the same 2014 period (see table 6).
This measurement calculates the business is earning power before being affected by income
taxes and financial leverage (Explain, 2015). Accordingly, because this ratio compares firms
with different tax situations and different degrees of financial leverage, it is useful when
evaluating companies (Brigham, 2010).
Return on total assets. Even though Macy’s has been increasing its return total assets
ratio year by year, it is significant to identify that its percentage was 6.97% (see table 3), versus
the 14.85% reports as the average industry percentage (see table 7). When a company has a high
return on its assets, it is earning more return on its investments (Shaun, 2015). In this case,
Macy’s return on assets is less than half compared to its competitors, which would be considered
when making the final investment decision.
Return on common equity. This ratio measures the business’s capability to generate
profits with its shareholder’s investments by showing how much profit generates with the
common stockholders’ equity. This measurement shows investors how efficiently their money
will be used to generate net income (Shaun, 2015). In 2014, Macy’s reported a 24.16% return on
common equity ratio (see table 3) while a double number, 46.13%, was found for the average
industry (see table 7). Macy’s return on the common equity ratio has been increasing year by
year, but it is less than from its competitors, a red flag for investors since they might not be
efficiently using the shareholders’ funds.
Market value ratios. Based on NASDAQ’s definition, market value ratios are the ratios
that compare the market price of the company’s common stock to selected financial statement
items (NASDAQ, 2015).
Price/earnings ratio. This ratio calculates the market value concerning its earnings by
comparing the market price per share and the earnings per share. As a result, this ratio shows
how much the market is willing to pay for a stock based on its current earnings, allowing
investors to predict future earnings per share.
Accordingly, companies with higher future
earnings are expected to generate higher dividends and, at the same time, investors’ speculation
and demand also increase the share’s price over time (Shaun, 2015). Being unable to find
Macy’s price/earnings ratio for the 2014 period during this research, the 2015 period was used
for both: Macy’s and the average industry. As a result, the average apparel industry ratio
reported, as shown in table 8, was 28.22, while the Macys ratio, as described in table 9, was
13.15. Moreover, according to NASDAQ, Macy’s is estimated to decrease its ratio in the
following years, reaching 11.69 in 2018 (NASDAQ, 2015).
Price/cash flow ratio. This ratio is considered an investment valuation ratio used to
evaluate how attractive it could be to invest in its shares. With this measurement, only cash
flows are considered. The company’s share market value is divided by the operating cash flow
that the company generates per share to obtain this result. During the 2014 period, Macy’s
reported 12.34 as its price/cash flow ratio (see table 10), while 30.11 was reported by the average
apparel industry (see table 11). Again, the competitors doubled Macy’s numbers, so it will be
one more point to consider when making the decision.
Market/book ratio. The ratio of a stock’s market price to its book value is one indicator
of how investors will consider the business. When a company has a high return on equity, it sells
at higher book value multiples than the business with low returns (Brigham, 2010). The average
apparel industry showed 11.78 as its market/book ratio (see table 11), while Macy’s reported
3.95 (see table 13), establishing one more time an enormous difference compared to its
Prospective Analysis
After analyzing Macy’s Inc.’s financial ratios, I was surprised about the big gaps when
comparing the store with the industry average. Therefore, to enrich my perspective before
making a decision, a review of other analysts’ reports was performed.
Even though I have centralized my ratios analysis on the results from 2014 because I
wanted to use the final results for an entire year, the surprise was even bigger after reviewing the
company’s performance in 2015. According to Zacks’ (2015) equity research, Macy’s shares
have declined about 13%, reporting lower results than expected, which has disappointed
investors and has caused management to lower its sales projection. Although the corporation is
still expecting an improvement before the year ends, unresponsive customer demand and lower
international tourist interest are listed as the main problems the company faces. As a result, the
company now expects to decline 1% in its total sales; instead of the 1% increased, it was
projected (Zacks, 2015).
Macy’s Inc. is the first major retailer Pressured by real estate investors considering
developing a new separate company with its real estate assets as Sears Holdings Corp., and
Darden Restaurants Inc. have recently done. The building Macy’s possesses at New York’s
Herald Square is its prized asset. It is estimated to cost between $3 and $4 billion; therefore,
according to Plever’s (2015) analysis, unloading the building could make much more money for
the store’s shareholders now than could pay off later on. The main idea is to generate the highest
amount of money possible based on the assets taking advantage of the commercial real estate
values, while the retail store is facing big challenges because of the online competitors. On the
other hand, creating a new company to own the real state could saddle the store with rent
payments and force it to lose control of the building and its distinction from other retailers that
own stores in residential neighborhoods (Pleven, 2015).
Bridget Weishaar, a senior equity analyst, has mentioned that Macy’s does not have a
competitive advantage despite its enormous size. Nowadays, e-commerce is selling identical
merchandise due to having wider customer exposure than retailers and wholesalers.
Accordingly, the total department store market share has fallen to 3.6% from 4.8% as a percent
of total retail sales over the last five years, which makes that Macy’s would have to grow its
market share to achieve accelerated growth as well in a shrinking market, which will be difficult
to sustain. Moreover, Weishaar expects Macy’s revenues to decline by 2% in 2015 and keep
losing market share in 2014 when it falls to 3.6% from 4.8% in 2010 (Weishaar, 2015).
After analyzing Macy’s Inc’s ratios, I became somewhat concerned and looked further
into the advantages and disadvantages of investing in this company. For instance, when
analyzing the company’s inventory turnover ratio and comparing it to the average industry, as
shown in tables 4 and 5, appendix A (CSI market, 2015), the difference is enormous. However,
it might be considered an advantage because the stock prices will become lower, making it a
good moment to invest. After all, retail stores’ revenues are based on seasonal sales, and huge
demand will be coming soon during the Black Friday, Cyber Monday, and Christmas shopping.
On the other hand, this ratio demonstrates that the competitors might be offering more
affordable prices for the customers and that the company is not adjusting its strategies to the new
retail environment. For example, Amazon has become a strong competitor. Customers can get
the same brands at lower prices without leaving their houses and not spending on shipping, while
Macy’s still charging for it unless more than $100 is spent. As a result, the store is holding large
amounts of inventory that are leading to other costs.
Consequently, the need for management to increase its sales is fundamental. They have
to restructure their marketing. Macy’s is operating in an area that is losing market share to other
categories. Nowadays, consumers are more disposed to pay for healthier food and technology.
Macy’s is not an exclusive store for famous brands anymore, and consumers are not concerned
about brands as they used to. They care more about quality and economy, which is demonstrated
when seeing that Macy’s sales have fallen from 6% in 2011 to 1% in 2014 (Weishaar, 2015).
Table 14 in appendix A demonstrates that Macy’s is a volatile business because its beta is
larger than 1 with a 1.11773, meaning that its security’s value fluctuates dramatically, which also
makes me concerned. However, the one-year target estimate anticipates $67.76 for the stock
value, increasing 13.85 dollars in 2016 and making me think that I would not lose the money
invested. Moreover, the 52-week range shows that the price had increased to $73.61; therefore,
the store is not predicted to achieve this value (yahoo finance, 2015).
Based on the company’s net profit margin ratio (see Table 1) compared to the average
retail industry (see table 6), it has been demonstrated that the company is not effectively
converting its sales into net income. As a possible investor, Macy’s does not give me the
confidence that its profits will be high enough to distribute dividends. Moreover, when looking
at the analysis estimate table by Yahoo Finances (Table 15), it is demonstrated that Macy’s
revenues are negative and will remain in the same way next year; accordingly, this is another red
flag when thinking about a possible investment.
As a consequence of my research and analysis, I have decided to invest the first 25
million dollars in Macy’s Inc. Now the stock prices are low, and the store will increase its sales
during the holiday season starting on thanksgiving. The store also possesses enough cash to
support the business, but I do consider it still weak; for this reason, I will put the stocks for sale
as soon as the season is over and will stay away from retailers and department stores.
Accordingly, this research has made me see that e-commerce has been increasing rapidly;
therefore, I will start new research on Amazon because it looks to be a solid business due to the
new customer environment.
Brigham, E. F., & Ehrhardt, M. C. (2010). Financial management. (14th ed.). Mason, OH:
South-Western Cengage Learning.
CSI market. (, 2015). The retail sector and Macy’s Inc., Retrieved from
Lundgren, T. (2008). Macy’s differentiation strategy. Leaders Magazine, Inc. Retrieved from
NASDAQ. (, 2015). M company financials. Retrieved from
Morningstar. (, 2015). Financial ratios. Retrieved from
Pleven, L. (2015). What should Macy’s do with its flagship store? The Wall Street Journal.
Retrieved from http://finance.yahoo.com/news/macy-flagship-store164400784.html;_ylt=AwrC0wxYRepViE8A0ECTmYlQ;_ylu=X3oDMTBzdTFzN25o
BGNvbG8DYmYxBHBvcwMxMQR2dGlkAwRzZWMDc2MReuters, T. (2015). Investor relations. Macy’s Inc. Retrieved from
Shaun, CPA. (, 2015). Financial ratios. My Accounting Course. Retrieved from

Financial Ratio Analysis

Singer, N. (2014, November 1) For Macy’s a makeover on 34th street. The New York Times.
Retrieved from http://www.nytimes.com/2014/11/02/business/for-macys-a-makeoveron-34th-street.html?_r=0
Xplain. (, 2015). Basic earning power ratio. Retrieved from http://xplaind.com/531544/basicearning-power-ratio
Weishaar, B. (2015). No-moat Macy’s announces store closures for 2016 to right-size in the face
of e-commerce growth. Morningstar. Retrieve from
Yahoo Finance. (, 2015). Macy’s. Inc. Retrieved from http://finance.yahoo.com/q?s=M
Zacks Equity Research. (, 2015). Will Macy’s (M) strategic initiatives help stage a turnaround.
Zacks. Retrieved from http://finance.yahoo.com/news/macys-m-strategic-initiativeshelp183506168.html;_ylt=AwrC0wxYRepViE8AwkCTmYlQ;_ylu=X3oDMTByN2Ruc2
Table 1
Macy’s company financials (NASDAQ, 2015).
Table 2
Retail apparel industry financial strength (CSI market, 2015).
Table 3
Macy’s key ratios (Morningstar, 2015).
Table 4
Retail apparel industry efficiency (CSI market, 2015).
Table 5
Macy’s turnover ratio (CSI market, 2015).
Table 6
Retail apparel industry profitability (CSI market, 2015).
Table 7
Retail apparel industry management effectiveness (CSI market, 2015).
Table 8
Retail apparel industry valuation (CSI market, 2015).
Table 9
Macy’s analysis research (NASDAQ, 2015).
Table 10
Macy’s valuation comparisons (CSI market, 2015).
Table 11
Retail apparel industry valuation (CSI market, 2015).
Table 12
Retail apparel industry valuation (CSI market, 2015).
Table 13
Macy’s valuation comparisons (CSI market, 2015).
Table 14
Macy’s, Inc. (M) summary (Yahoo Finance, 2015).
Table 15
Macy’s, Inc. (M) analysis estimate (Yahoo Finance, 2015).
PepsiCo Research Paper
Sample Paper
UCLA University
Financial Management
Dr. H P
August 1, 2019
Table of Contents
Cover Page……………………………………………………………………………………1
Table of Contents …….………………………………………………………………………2
Business Strategy Analysis…………………………………………………………………………4-5
Accounting Analysis…..………………………………………………………………….…5-7
Financial Analysis …….….…………………………………………………………………7-8
Prospective Analysis………………………………………………………………………..8-11
Appendix A ………………………………………………………………………………16-23
For firms to satisfy clients, investors and maintain success, it must have mature leaders at
every operation level (Brigham & Ehrhardt, 2014). One vital area in a firm is its Corporate
Finance department because it provides the necessary skills to measure all proposals, including
marketing, production, and various strategies within the firm (Brigham & Ehrhardt, 2014). These
areas are important because they add value to a firm, thus gaining an investors’ interest in
whether to invest in the firm. Finance also provides the necessary insight into forecasting in a
firm (Brigham & Ehrhardt, 2014). Forecasting is integral because it provides management on
how to plan and fund projects within the firm (Brigham & Ehrhardt, 2014).
PepsiCo, Inc. is a highly diversified, well-established, combined food and beverage company
(PepsiCo, 2015). Pepsi-Cola is a tested product created in the late 1890s by Caleb Bradham
(PepsiCo, 2015). In 1898, PepsiCo, Inc. was birthed in New York City, and it grew into a wellknown international organization (PepsiCo, 2015). PepsiCo currently stands as the secondlargest food and Beverage Company in the world (PepsiCo, 2015). PepsiCo’s well-known
products include Pepsi, Diet Pepsi, Mountain Dew, Quaker, Lays, Doritos, Tropicana, and
Lipton Green Tea, Starbucks ready-to-go drinks, Aquafina, and Gatorade, to name a few
(PepsiCo, 2015).
PepsiCo is currently headed by Chief Executive Officer (CEO) and Chairman, Indra K.
Nooyi (PepsiCo, 2015). Nooyi follows PepsiCo’s mission and beliefs of guiding performances
with a purpose to respect its customers and investors (PepsiCo, 2015). Nooyi also believes in
PepsiCo’s motto of “businesses and society thriving together” (PepsiCo, 2015). In this research
paper, the reader will gain knowledge about PepsiCo’s business, financial, prospective, and
accounting analysis. Whether to invest in or not in PepsiCo, Inc. will be supported and provided
through this research.
Business Strategy Analysis
For an entity to maintain its competiveness, it must possess a competition strategy that will
center on the competitors’ weaknesses and produce goods and services that are different from its
rivals. A firm needs to focus on the advantage of competition and not the competition process
(Hofer, Cantor, & Dai, 2012). PepsiCo’s rival is Coca-Cola. It has gained a competitive
advantage over Coca-Cola due to its genius strategies such as marketing, products produced, and
PepsiCo’s competitive advantage is its low-cost strategy and differentiation that it portrays
and sells to the market. Even though Coca-Cola has various products, one usually thinks of Coke
or Sprite when Coca-Cola is mentioned. PepsiCo is more diversified, and its products are low in
cost due to the many products. One may not be aware when using PepsiCo’s products due to its
diversification. This allows PepsiCo to reap the benefits of having many products that are
reasonably priced. The products for PepsiCo are performing well in the market and meeting
During the fiscal year 2014, PepsiCo has maintained its competitiveness by driving
growth for its retail clients and becoming the largest contributor in the United States in 2014
regarding retail sales (Yahoo Finance, 2015). PepsiCo has continually risen with investments
from global research and development projects (Yahoo Finance, 2015). PepsiCo’s key focuses
are marketplace execution, building its brand, and finding ways to stay innovative (Yahoo
Finance, 2015). PepsiCo’s initiatives have allowed the company to save $1 billion in productivity
savings and have a 9% Innovation count for its total revenue in 2014 (Yahoo Finance, 2015).
$8.7 billion in the form of dividends and repurchases have been returned to PepsiCo’s
shareholders in 2014 (Yahoo Finance, 2015). Research and development (R&D) and its
competitive strategies have sustained its platform growth in all channels in the fiscal year 2014
with $400 million in retail sales (Yahoo Finance, 2015).
Accounting Analysis
PepsiCo’s accounting practices reflect overall good economic performance (Tables 1-2,
Appendix A). Overall, PepsiCo’s financial statements are aligned with the generally accepted
accounting principles (GAAP) in the accounting policies in which registrants of the Securities
Exchange Commission (SEC) must follow. Financial Accounting Standards Board (FASB)
requires that financial reporting utilize a conceptual framework for GAAP practices (Freka,
2008). The framework’s guidelines include financial reports, qualitative statements describing
the accounting practices, accounting definitions included in the statements, and the evaluations
of principles (Freka, 2008).
Although the GAAP report is in good standing, the net revenue for 2014 declined 6%, which
reflected a 10% point adversely translated with foreign currency (PepsiCo, 2015). The gross
margin still increased to 105 points, and the Earning per Share (EPS) rose 3% to $1.33 (PepsiCo,
2015). Income statements will reflect the costs and expenses, so along with the revenue, it should
all be following the SEC guidelines (SEC, 2014).
A firm needs to comply with SEC policies because the SEC has the authority overpreparing financial statements and determines whether the firm will sell stock publically (Porter
& Norton, 2015). The SEC division aims to act as an advocate for the investors that provides
them with protection, sustain integrity for the market, and help gain capital so that the firm can
grow (SEC, 2015). This protection allows continued expansion for the U.S. economy as well
(SEC, 2015).
Gaining full knowledge of the income statement will require one to start with the total
revenue and make the appropriate deductions in each step until the last step, which would be
referred to as the bottom line (SEC, 2015). Table 1, Appendix A (Yahoo Finance, 2015), the
2014 fiscal year total revenues of $ 66,683,000 million less the cost of revenue $30,884,000
million equaled to the gross profit of $35,799,000 million. The Gross profit $35,799,000 million
less the expenses and operations of $26,218,000 million equal $9,581,000 million in Operating
Income (Yahoo Finance, 2015). Before interest, the Income Earnings are deducted from the
Operating Income to get the total Net Income of $6,513,000 million (Yahoo Finance, 2015).
In Table 1 Appendix A (Yahoo Finance, 2015), PepsiCo’s income statement reveals that
PepsiCo earned a total revenue of $ 66,683,000 million in the 2014 fiscal year compared to
$66,415,000 million in 2013, which was a .4% increase in revenue, but revenue decreased 1.4%
in 2013 compared to 2012 (Yahoo Finance, 2015). The operating income of $9,581,000 was
down 1.3% in 2014 compared to 2013 of $9,705,000 million, but it increased in 2013 6% from
2012 revenue of $9,112,000 million (Yahoo Finance, 2015). The net income for PepsiCo
decreased by 3.5% in 2014 but increased by 8% in 2013 compared to 2012 (Yahoo Finance,
PepsiCo’s balance sheet in Table 2, Appendix A (Yahoo Finance, 2015) reveals that the
combined liabilities and shareholders’ equity totaled $70,509,000 million, which was a 10 %
decrease compared to 2013. Looking at the balance sheet, one will learn about the firms’ assets,
liabilities and shareholders’ equity (SEC, 2015). Utilizing the accounting equation (Assets =
Liabilities + Owner’s Equity) will provide an overall basis for the accounting structure (Porter
and Norton, 2015). The entity’s assets will be located on the left side of the equation and the
individuals who have the right to claim the assets for the firm will be on the right side of the
equation (Porter and Norton, 2015). The key factor in gaining when utilizing the accounting
equation is that one side should always be equivalent to the opposite side (Porter and Norton,
2015). In Table 2 (Yahoo Finance, 2015), in the fiscal year 2014, the total assets of $70,509,000
million are equivalent to the total liabilities and shareholders’ equity combined totaling
$70,509,000 million.
Financial Analysis
The statement of cash flow has been required to be a part of the set of financial
statements for almost 30 years (SEC, 2015). Most financial institutions review income on the
Cash Flow statement in-depth, but the primary aim is to sum up, the cash receipts and payments
(SEC, 2015). The accrual-based income is stabilized on the cash flow statement regarding the
firm’s operating, investing, and financial activities (Porter & Norton, 2015).
Table 3, Appendix A (Yahoo Finance, 2015) the cash flow statement 2014 fiscal year
revealed an 8% increase in the total operating activities of $10,506,000 million, which means
there is enough capital set aside to pay creditors (Yahoo Finance, 2015). There was also a 29%
increase in cash flows from investing activities in the fiscal year 2014 compared to 2013; thus,
funding pensions will not affect the cash flow (Yahoo Finance, 2015).
The net result of a number based on policies and decisions is referred to as Profitability
(Brigham & Ehrhardt, 2014). Profitability ratios provide insight into how a company is
performing and its overall effectiveness in operations (Brigham & Ehrhardt, 2014). A dataset
with 120 stocks that allows trades and quotes to occur is known as the NASDAQ (Carrion,
2013). The data reveals the market capitalization of any publically traded firm, which can be
equally reflected in NASDAQ and NYSE (Carrion, 2013). The symbol PEP is utilized by
PepsiCo, Inc. on the NASDAQ when trading common stocks. In Tables 4-6, Appendix A (Yahoo
Finance, 2015), PepsiCo is gradually approaching its one-year Target Estimate of 105.67 (Yahoo
Finance, 2015). 71% of PepsiCo’s shares are owned by institutional leaders and mutual fund
owners, which are excellent prospects.
It is also noticeable that the valuation methods are all positive, which is good for PepsiCo.
The Market Cap and the stock appear to be inversely proportional when the data is viewed.
Price/Earning (P/E) is defined as the pay per dollar amount of the profit investors are willing to
pay (Brigham & Ehrhardt, 2015). The P/E is relatively high 23.09, which reveals that PepsiCo
has a good growth prospect. The Beta (β) is currently at 0.84, which lets one know that PepsiCo,
Inc. is not volatile. Any time the β is over 1.00, the company is at risk and is volatile.
PepsiCo’s Market Cap is currently at $146.69 Billion, which means that PepsiCo’s stock is
rock solid and can withstand major turmoil within the average market. The valuation
measurements still provide an investor with the knowledge that PepsiCo, Inc.’s overall is in good
standing. Table 7, Appendix A reveals how the stock moves gradually, but there is still evidence
that it will reach its one year Target of 105.67 (Yahoo Finance, 2015). The trends of the past
reveal that PepsiCo was slow to reach the target. For example, in October 2014, it was at its
lowest at 89.82, but in February 2015, the stock was at its highest at 100.76. Looking at the 52Week change for the stock, there has only been an 8.37% difference (Yahoo Finance, 2015). The
stock will reach its target by the end of the fiscal year 2015.
Prospective Analysis
Overall the forecast for PepsiCo, Inc. is promising. Table 8, Appendix A, and the mean
recommendation for buys are strong at 2.2 (Yahoo Finance, 2015). The range for buys are 1.05.0; the closer the number is to 1, it is considered strong, but the closer it is to 5.0, it is time to
sell (Yahoo Finance, 2015). There are 21 brokers for PepsiCo, Inc., and the target summary for
the stock price is as follows: 105.67 for the mean, the median 108.00, the high target is 112.00,
and the low target was 83.00 (Yahoo Finance, 2015).
Currently, the stock is at 99.77, which fluctuates daily in real-time on the NYSE or
NASDAQ listing. The stock is good and approaching its target, but it is wise for brokers to sell
once the stock reaches its target. PepsiCo’s issue is not reaching the target by the end of the fiscal
year, but what happens at the target? The target is where greed can occur because it will fall
once it hits its estimated surplus. It is easy to become deceived in thinking that the stock will
increase, but it always decreases not long after it reaches its target.
Most companies have a stop-loss order limit, which allows the stock to automatically sell
once it reaches its target or sells it below its low target (Plaehn, 2015). PepsiCo’s brokers are
wise, which allows them to deal with many disciplines, which is why PepsiCo has been
successful thus far. Table 8, Appendix A, shows that most investors recommended or purchased
PepsiCo’s stock in three months (Yahoo Finance, 2015). There were no investors that
recommended PepsiCo’s stock to be sold (Yahoo Finance, 2015). Investors are eager to own
some of PepsiCo’s stock this year (Motley, 2015). PepsiCo is known for rewarding its
shareholders (Motley, 2015). The stock is trading at $100 per share, which is considered an alltime high due to the fourth-quarter results in fiscal 2014 (Motley, 2015). In 2015, PepsiCo will
return $8.5- $9 billion in dividends for the shareholders and share buybacks (Motley, 2015). This
is promising for PepsiCo’s institutional and mutual owners since they own 71% of the shares
(Yahoo Finance, 2015).
According to recent quarter results, PepsiCo’s stock is worth owning due to its large and
growing dividends (Motley, 2015). PepsiCo has a history of creating value in shareholders by
paying out and repurchasing (Motley, 2015). In 2014, PepsiCo’s shareholders rewarded a total of
$8.7 billion in repurchases and dividends (Motley, 2015). This year the dividends have been
raised to $2.81 per share at PepsiCo, seen in Table 7, Appendix A (Yahoo Finance, 2015).
Further forecasting reveals that in 2018, PepsiCo plans to buy back approximately $12 billion
of its stock (Low, 2015). This is due to PepsiCo’s aristocratic nature regarding increasing its
dividends for 25 years (Motley, 2015). Since 1952, PepsiCo has dividends every year but
increased its payback for 42 years consecutively (Motley, 2015). The cash flow strength reveals
that PepsiCo will continue to increase the dividend in the future years (Motley, 2015).
CEO Indra Nooyi addressed that PepsiCo’s long-term aim is to deliver consistent results of
the past to meet the anticipated long-term goals (Low, 2015). PepsiCo should continue to thrive
despite the volatile external economic conditions (Low, 2015). One of PepsiCo’s key priorities is
to continue to return cash to its shareholders (Low, 2015). PepsiCo’s PEG 3.68 for fiscal 2014
reveals that Pepsi is the preferred beverage stock to purchase; this can be viewed in Table 4,
Appendix A (Low, 2015). In 2015 PepsiCo planned to save $1 billion in cost-saving as it did in
2014. This will allow room to give back through dividends and repurchases to its shareholders
(Motley, 2015). This will be achieved through cost-cutting and earnings (Motley, 2015). Shares
continue to climb, and there is no looking back for PepsiCo, Inc. (Low, 2015).
PepsiCo, Inc. is a sustainable company and is continuing to thrive. The company has focused
on its customers through low pricing and remained diversified with its products globally. The
stock is approaching its one year target with steadiness. Overall, the financial statements are
aligned with the SEC and FASB guidelines. The operating total in the cash flow statement
discloses that PepsiCo has enough capital to pay its creditors. The dividend and repurchases in
2014 alone are proof that PepsiCo is a mature company with knowledgeable management in
place to guide the company towards its future goals.
Throughout the 2014 financial analysis for PepsiCo, Inc, the company is vibrant and
exceeding most of its targets. As a new graduate from Keiser University’s MBA program, I have
been hired as a fund manager for a well-known investment banking house. I have $300 million
of the banking house’s funds to manage and invest. This is a pension fund and a retirement fund
that possesses moderate risk and capital loss, so its return on investment is 9% annum. I must
make 12 separate investments that consist of $25 million per investment. I have researched
PepsiCo, Inc.’s financial analysis in fiscal 2014 to determine where the first investment of $25
million will be disbursed. This is my first assignment, and I have to make a wise decision for my
After careful evaluation of PepsiCo’s financial analysis, trends, risk, and company growth, I
have decided to make my first investment of $25 million in PepsiCo, Inc. One of the selling
points to invest in was its ability to give back in dividends to its shareholders. Since my firm has
moderate risk associated with capital loss, this will be a wise investment for my firm. The return
on investments from PepsiCo will aid in increasing my firm’s profits in the long-term. PepsiCo’s
market is not volatile due to a low β of 0.84 seen in Table 5, Appendix A (Yahoo Finance, 2015).
PepsiCo will reach its one year target of 105.67 by the end of fiscal 2015 (Yahoo Finance, 2015).
The company did not suffer any major losses in the capital for the fiscal years of 2014, 2013, or
2012, which reinforced my decision to invest.
Table 9, Appendix A (Yahoo Finance, 2015) looked further into PepsiCo’s sales growth for
the current quarter and the two quarters that followed and became somewhat concerned. Table 9,
Appendix A reveals that the current quarter is -5.40%, the next two quarters are -3.20% and 4.60%, respectively (Yahoo Finance, 2015). Compared to the industry growth estimate of
17.10% of this quarter, PepsiCo is still down -5.90% (Yahoo Finance, 2015). The sales growth is
not expected to increase until December 2016 at 3.90%, according to Table 9, Appendix A
(Yahoo Finance, 2015). The company was shorted $9.2 million in fiscal 2014, which raises
further concern about the sales growth because if the company wanted to buy, it would have to
cover (Yahoo Finance, 2015).
Recommendations for PepsiCo would be for management to do more marketing and hire in
sales to increase the sales for PepsiCo before the end of fiscal 2016. It has been seen in the past
that companies which lack in sales suffer in revenue eventually. The sales growth for PepsiCo is
not being met in the industry. When this happens, the company can easily make a 180º downturn,
which can diminish investors’ confidence. Even though PepsiCo is reaching its target stock, it
will decrease again due to the sales decline. This could adversely affect the revenue for PepsiCo.
Looking at Table 9, Appendix A in the quarter that sales are projected to decrease
-5.4%, revenue will take a hit as well. This will affect the market cap, eventually causing it to
decrease, which decreases stock causing investors to immediately sell. The company will then
have to earn its way out of debt. PepsiCo’s first defense will be to layoff, increase sales, and
reduce assets by selling the assets. This can all be avoided if the CEO, Indra Nooyi, is adamant
about keeping investors investing and their trust level. Management will have to drive sales in
order for this to work. Hiring for representatives will need to be expedited. Sales are what drive
revenue. CEO Nooyi should address the sales issues in Table 9, Appendix A, as soon as possible
to avoid potential downfall. The next three quarters appear to be troubling for PepsiCo if the
previous recommendations are not practiced. Once this is improved, investors’ sentiment and
confidence will be restored, and the CEO’s job will be more stable.
Despite these issues, PepsiCo is a thriving organization worth investing in, and I am proud to
make my firm’s first $25 million investment with PepsiCo, Inc.
Brigham, E.F., & Ehrhardt, M.C. (2014). In Brigham, E.F., & Ehrhardt, M.C. Financial
Management (14th ed.). Stamford, CT: South-Western College Publishing Company
Carrion, A. (2013). Very fast money: High-frequency trading on the NASDAQ. Journal of
Financial Markets, 16(4), 680-711.
Freka, T. (2008). Ethical Issues in Financial Reporting: Is Intentional Structuring of Lease
Contracts to Avoid Capitalization Unethical? Journal of Business Ethics, 80, 45-49. DOI
Hofer, C., Cantor, D. E., & Dai, J. (2012). The competitive determinants of a firm’s
environmental management activities: Evidence from US manufacturing
industries. Journal of Operations Management, 30(1), 69-84.
Low, E. February 2015. PepsiCo Gives Investors Dividend, Buyback Sugar Rush. Retrieved from
Investors Business Daily Website: http://news.investors.com/business/021115-738899Pepsico-stock-rises-eps-beat-share-repurchase.htm
Motley. February 2015. Why You Cannot Afford to Ignore PepsiCo Stock in 2015. Retrieved
Motley Fool Website: http://www.fool.com/investing/general/2015/02/15/why-you-cantAfford-to-ignore-PepsiCo-stock-in-201.aspx
PepsiCo Annual Report (n.d.) Retrieved August 2015 from PepsiCo’s website:
Plaehn, T. (2015). How to Buy a Stock and Set It So It Automatically Sells After a Price Drop.
Retrieved from Finance Zacks website: http://finance.zacks.com/buy-stock-setAutomatically-sells-after-price-drop-7144.html
Porter, G. A. & Norton C. L. (2015). In Porter, G.A. & Norton C.L. Financial Accounting: The
Impact on Decision Makers (9th ed.). Stamford, CT: Cengage Learning.
Securities Exchange and Commission (SEC) (n.d.) Retrieved 2015 from the SEC
Website: http://www.sec.gov/about/whatwedo.shtml
Yahoo Finance. (2015). Retrieved August 2015 from Yahoo Finance website:
Table 1. (Yahoo Finance, 2015)
PepsiCo, Inc. Income Statement
Table 2. (Yahoo Finance, 2015)
PepsiCo, Inc. Balance Sheet
Table 3. (Yahoo Finance, 2015)
PepsiCo, Inc. Cash Flow Statement
Table 4. (Yahoo Finance, 2015)
Table 5. (Yahoo Finance, 2015)
PepsiCo, Inc. Ratios
PepsiCo, Inc. NYSE Common Stock
Table 6. (Yahoo Finance, 2015)
PepsiCo, Inc. Major Holders
Table 7. (Yahoo Finance, 2015)
PepsiCo, Inc. Trading History
Table 8. (Yahoo Finance, 2015)
PepsiCo, Inc. Analysts Opinion
Table 9. (Yahoo Finance, 2015)
PepsiCo, Inc. Analyst Estimates
Chapter 1
An Overview of Financial
Management and the
Financial Environment
See http://fortune.com
-companies for updates
on the rankings.
In a global beauty contest for companies, the winner is . . . Apple.
Or at least Apple is the most admired company in the world, according to Fortune
magazine’s annual survey. The others in the global top ten are Amazon.com, Starbucks,
Berkshire Hathaway, Disney, Alphabet (formerly Google), General Electric, Southwest
Airlines, Facebook, and Microsoft. What do these companies have that separates them
from the rest of the pack?
Based on a survey of executives, directors, and security analysts, these companies
have very high average scores across nine attributes: (1) innovativeness, (2) quality
of management, (3) long-term investment value, (4) social responsibility, (5) people
management, (6) quality of products and services, (7) financial soundness, (8) use of
corporate assets, and (9) effectiveness in doing business globally. After culling weaker
companies, the final rankings are then determined by over 3,800 experts from a wide
variety of industries.
What makes these companies special? In a nutshell, they reduce costs by having
innovative production processes, they create value for customers by providing highquality products and services, and they create value for employees by training and
fostering an environment that allows employees to utilize all of their skills and talents.
As you will see throughout this book, the resulting cash flow and superior return on
capital also create value for investors.
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Part 1
The textbook’s Web site
has tools for teaching,
learning, and conducting
financial research.
The Company and Its Environment
This chapter should give you an idea of what financial management is all about, including an overview of the financial markets in which corporations operate. Before going into
details, let’s look at the big picture.
1-1 The Five-Minute MBA
Okay, we realize you can’t get an MBA in five minutes, but we can sketch the key
elements of an MBA education. The primary objective of an MBA program is to provide
managers with the knowledge and skills they need to run successful companies, so we
start there.
First, successful companies have skilled people at all levels inside the company, including leaders, managers, and a capable workforce. Skilled people enable a company to
identify, create, and deliver products or services that are highly valued by customers—so
highly valued that customers choose to purchase from them rather than from their
Second, successful companies have strong relationships with groups outside the company. For example, successful companies develop win–win relationships with suppliers
and excel in customer relationship management.
Third, successful companies have enough funding to execute their plans and support
their growing operations. Companies can reinvest a portion of their earnings, but most
growing companies also must raise additional funds externally by some combination of
selling stock and/or borrowing in the financial markets. To do this, a company must provide investors with high enough returns to compensate them for the use of their money
and their exposure to risk.
To help your company succeed, you must have the skills necessary to evaluate any
proposal or idea, whether it relates to marketing, supply chains, production, strategy,
mergers, or any other area. In a nutshell, that is what we will do in this book.
S e l f -T e s t
What are three attributes of successful companies?
What financial skills must every successful manager have?
1-2 Finance from 40,000 Feet Above
A bird’s-eye view showing the big picture of finance will help you keep track of its individual components. It all starts with individuals or organizations that have more cash
than they presently want to spend (i.e., providers of cash now) and others with opportunities to generate cash in the future (i.e., users of cash now). For example, providers of cash
include individuals who are saving for retirement, banks willing to make loans, and many
other types of investors. Users of cash include: (1) students wishing to borrow money for
tuition and planning to repay it with future earnings after graduating, (2) entrepreneurs
with ideas, and (3) corporations with growth plans.
Figure 1-1 shows the relationship between providers and users.
Two problems immediately present themselves. First, how do the providers and users
identify one another and exchange cash now for claims on risky future cash? Second,
how can potential providers evaluate the users’ opportunities? In other words, are the
claims on risky future cash flows sufficient to compensate the providers for giving up
their cash today? At the risk of oversimplification, financial markets are simply ways
of connecting providers with users, and financial analysis is a tool to evaluate risky
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Chapter 1
An Overview of Financial Management and the Financial Environment
Figure 1-1
Providers and Users: Cash Now versus Claims on Risky Future Cash
Person or organization
with cash now
Cash now
Person or organization
with opportunities to
convert cash now into
cash later
Claim on risky future cash
We cover many topics in this book, and it can be easy to miss the forest for the
trees. As you read about a particular topic, think about how the topic is related to
the role played by financial markets or the tools used to evaluate claims on future
cash flows.
We begin with an especially important type of user: companies that are incorporated.
S e l f -T e s t
What do providers supply? What do providers receive?
What do users receive? What do users offer?
What two problems are faced by providers and users?
1-3 The Corporate Life Cycle
Apple began life in a garage, and Facebook started in a dorm room. How is it possible
for such companies to grow into the giants we see today? The following sections describe
some typical stages in the corporate life cycle.
1-3a Starting Up as a Proprietorship
Many companies begin as a proprietorship, which is an unincorporated business owned
by one individual. Starting a business as a proprietor is easy—obtain any required city or
state business licenses and begin business operations. The proprietorship has three important advantages: (1) It is easy and inexpensive to start. (2) Relatively few government regulations affect it. (3) It pays no corporate income tax on profits—instead, they are included
in the proprietor’s personal taxable income.
However, the proprietorship also has three important limitations: (1) It may be difficult for a proprietorship to obtain the funding needed for growth. (2) The proprietor has
unlimited personal liability for the business’s debts, which can result in losses that exceed
the money invested in the company. (Creditors may even be able to seize a proprietor’s
house or other personal property!) (3) The life of a proprietorship is limited to the life of
its founder. Therefore, usually only small businesses operate as sole proprietorships. In
fact, about 73% of all companies are proprietorships, accounting for less than 5% of all
sales revenue.
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Part 1
The Company and Its Environment
1-3b More Than One Owner: A Partnership
Some companies start with more than one owner, and some proprietors decide to add
a partner as the business grows. A partnership exists whenever two or more persons
or entities associate to conduct a noncorporate business for profit. Partnerships may
operate under different degrees of formality, ranging from informal, oral understandings to formal agreements filed with the secretary of the state in which the partnership
was formed. Partnership agreements define the ways any profits and losses are shared
between partners. A partnership’s advantages and disadvantages are similar to those of
a proprietorship.
Regarding liability, partners potentially can lose all of their personal assets in the
event of bankruptcy because each partner is liable for the business’s debts. To avoid this,
the liabilities of some of the partners can be limited by establishing a limited partnership.
Limited partners can lose only the amount of their investment in the partnership, but the
general partners have unlimited liability. However, the limited partners typically have no
control—which rests solely with the general partners—and their returns are likewise limited. Limited partnerships are common in real estate, oil, equipment-leasing ventures, and
venture capital. However, they are not widely used in other businesses because usually no
partner is willing to be the general partner due to the risk, and no partners are willing to
be limited partners with no control.
In regular and limited partnerships, at least one partner is liable for the partnership’s
debts. However, in a limited liability partnership (LLP) and a limited liability company
(LLC), all partners’ (or members’) potential losses are limited to their investment in the
LLP. Of course, this arrangement increases the risk faced by an LLP’s lenders, customers,
and suppliers.
1-3c Many Owners: A Corporation
Most partnerships have difficulty attracting substantial amounts of capital to support
growth. Thus, many growth companies begin as a proprietorship or partnership but subsequently convert to a corporation. Other companies, in anticipation of growth, actually
begin as corporations.
A corporation is a legal entity created under state laws, and it is separate and
distinct from its owners and managers. This separation gives the corporation three
major advantages: (1) unlimited life—a corporation can continue after its original owners and managers are deceased; (2) easy transfers of ownership interests—ownership is
divided into shares of stock, which can be transferred far more easily than ownership in
a proprietorship or partnership; and (3) limited liability—losses are limited to the actual
funds invested.
To illustrate limited liability, suppose you invested $10,000 in a partnership that
then went bankrupt and owed $1 million. Because partners are liable, you could be held
liable for the entire $1 million if your partners could not pay their shares. However, if you
invested $10,000 in a corporation’s stock, your potential loss in a bankruptcy would be
limited to your $10,000 investment.
Unlimited life, easy transfers of ownership, and limited liability make it much easier
for corporations to raise money in the financial markets and grow into large companies.
Although the corporate form offers significant advantages relative to proprietorships and
partnerships, it has two disadvantages: (1) Corporate earnings may be subject to double
taxation—the earnings of the corporation are taxed at the corporate level, and then earnings paid out as dividends are taxed again as income to the stockholders. (2) Setting up
a corporation involves preparing a charter, writing a set of bylaws, and filing the many
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Chapter 1
An Overview of Financial Management and the Financial Environment
required state and federal reports, which is more complex and time-consuming than
creating a proprietorship or a partnership.
The charter includes the following information: (1) name of the proposed corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of
directors, and (5) names and addresses of directors. The charter is filed with the secretary of the state in which the firm will be incorporated, and when it is approved, the
corporation is officially in existence.1 After the corporation begins operating, quarterly
and annual employment, financial, and tax reports must be filed with state and federal
The bylaws are a set of rules drawn up by the founders of the corporation. Bylaws
specify: (1) how directors are to be elected (all elected each year or perhaps one-third each
year for 3-year terms), (2) whether the existing stockholders will have the first right to buy
any new shares the firm issues, and (3) procedures for changing the bylaws themselves,
should conditions require it.
There are several different types of corporations. Professionals such as doctors,
lawyers, and accountants often form a professional corporation (PC) or a professional
association (PA). These types of corporations do not relieve the participants of professional (malpractice) liability. Indeed, the primary motivation behind the professional
corporation was to provide a way for groups of professionals to avoid certain types of
unlimited liability yet still be held responsible for professional liability.
Finally, some corporations can elect to be taxed as if the business were a proprietorship
or partnership if the corporation meets certain requirements regarding size and number
of stockholders. Such firms are called S corporations.
1-3d Growing a Corporation: Going Public
For updates on IPO
activity, see www
.com/IPO-Center. Also,
see Professor Jay Ritter’s
Web site for additional IPO
data and analysis, https://
After a company incorporates, how does it evolve? When entrepreneurs start a company, they usually provide all the financing from their personal resources, which may
include savings, home equity loans, or even credit cards. A fast-growing business
must continue to invest in buildings, equipment, technology, and employees. Such
investments usually deplete the founders’ resources, so they turn to external financing. Many young companies are too risky for banks, so the founders must sell stock
to outsiders, including friends, family, private investors (often called “angels”), or
venture capitalists.
Any corporation can raise funds by selling shares of its stock, but government
regulations restrict the number and type of investors who can buy the stock. Also, the
shareholders cannot subsequently sell their stock to the general public. Due to these
limitations, the shares are called closely held stock and the company is a closely held
As it continues to grow, a thriving private corporation may decide to seek approval from the Securities and Exchange Commission (SEC), which regulates stock
trading, to sell shares in a public stock market. 2 It does so by filing a prospectus with
the SEC, which provides relevant information about the company to investors and
regulators. In addition to SEC approval, the company applies to be a listed stock on
About 64% of major U.S. corporations are chartered in Delaware, which has, over the years, provided a favorable legal environment for corporations. It is not necessary for a firm to be headquartered or even to conduct
operations in its state of incorporation or even in its country of incorporation.
The SEC is a government agency created in 1934 to regulate matters related to investors, including the regulation of stock markets.
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an SEC-registered stock exchange. For example, the company might list on the New
York Stock Exchange (NYSE), which is the oldest registered stock exchange in the
United States and is the largest exchange in the world when measured by the market value of its listed stocks. Or perhaps the company might list on the NASDAQ
Stock Market, which has the most stock listings, especially among smaller, high-tech
Going public is called an initial public offering (IPO) because it is the first time the
company’s shares are sold to the general public. In most cases, an investment bank, such
as Goldman Sachs, helps with the IPO by advising the company. In addition, the investment bank’s company usually has a brokerage firm, which employs brokers who are registered with the SEC to buy and sell stocks on behalf of clients.3 These brokers help the
investment banker sell the newly issued stock to investors.
Most IPOs raise proceeds in the range of $90 million to $140 million. However, some
IPOs are huge, such as the $21.7 billion raised by Alibaba when it went public on the NYSE
in 2014. Not only does an IPO raise additional cash to support a company’s growth, but
the IPO also makes it possible for the company’s founders and investors to sell some of
their own shares, either in the IPO itself or afterward as shares are traded in the stock
market. For example, in Facebook’s 2012 IPO, the company raised about $6.4 billion by
selling 180 million new shares, and the owners received almost $9.2 billion by selling
241 million of their own shares.
Most IPOs are underpriced when they are first sold to the public, based on the initial
price paid by IPO investors and the closing price at the end of the first day’s trading. For
example, in 2017 the average first-day return was around 15%.
Even if you are able to identify a “hot” issue, it is often difficult to purchase shares in
the initial offering. In strong markets, these deals generally are oversubscribed, which
means that the demand for shares at the offering price exceeds the number of shares
issued. In such instances, investment bankers favor large institutional investors (who are
their best customers), and small investors find it hard, if not impossible, to get in on the
ground floor. They can buy the stock in the aftermarket, but evidence suggests that if you
do not get in on the ground floor, the average IPO underperforms the overall market over
the long run.4
Before you conclude that it isn’t fair to let only the best customers have the stock in an
initial offering, think about what it takes to become a best customer. Best customers are
usually investors who have done lots of business in the past with the investment banking
firm’s brokerage department. In other words, they have paid large sums as commissions in
the past, and they are expected to continue doing so in the future. As is so often true, there
is no free lunch—most of the investors who get in on the ground floor of an IPO have, in
fact, paid for this privilege.
After the IPO, it is easier for a public firm to raise additional funds to support
growth than it is for a private company. For example, a public company raises more
funds by selling (i.e., issuing) additional shares of stock through a seasoned equity
offering, which is much simpler than the original IPO. In addition, publicly traded
companies also have better access to the debt markets and can raise additional funds
by selling bonds.
For example, stockbrokers must register with the Financial Industry Regulatory Authority (FINRA), a
nongovernment organization that watches over brokerage firms and brokers. FINRA is the biggest, but there
are other self-regulatory organizations (SROs). Be aware that not all self-advertised “investment advisors” are
actually registered stockbrokers.
See Jay R. Ritter, “The Long-Run Performance of Initial Public Offerings,” Journal of Finance, March 1991,
pp. 3–27.
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Chapter 1
An Overview of Financial Management and the Financial Environment
1-3e Managing a Corporation’s Value
How can managers affect a corporation’s value? To answer this question, we first need
to ask, “What determines a corporation’s value?” In a nutshell, it is a company’s ability to
generate cash flows now and in the future.
In particular, a company’s value is determined by three properties of its cash flows:
(1) The size of the expected future cash flows is important—bigger is better. (2) The
timing of cash flows counts—cash received sooner is more valuable than cash that
comes later. (3) The risk of the cash flows matters—safer cash flows are worth more than
uncertain cash flows. Therefore, managers can increase their firm’s value by increasing the size of the expected cash flows, by speeding up their receipt, and by reducing
their risk.
The relevant cash flow is called free cash flow (FCF), not because it is free, but because
it is available (or free) for distribution to a company’s investors, including creditors and
stockholders. You will learn how to calculate free cash flows in Chapter 2, but for now you
should know that free cash flow is:
Required investments
in new operating capital
A company’s value depends on its ability to generate free cash flows, but a company
must spend money to make money. For example, cash must be spent on R&D, marketing
research, land, buildings, equipment, employee training, and many other activities before
the subsequent cash flows become positive. Where do companies get this cash? For startups, it comes directly from investors. For mature companies, some of it comes directly
from new investors, and some comes indirectly from current shareholders when profit
is reinvested rather than paid out as dividends. As stated previously, these cash providers
expect a rate of return to compensate them for the timing and risk inherent in their claims
on future cash flows. This rate of return from an investor’s perspective is a cost from the
company’s point of view. Therefore, the rate of return required by investors is called the
weighted average cost of capital (WACC).
The following equation defines the relationship between a firm’s value, its free cash
flows, and its cost of capital:
Value 5
(1 1 WACC)
(1 1 WACC)
(1 1 WACC)
1 Á 1
(1 1 WACC)`
We will explain how to use this equation in later chapters, but for now it is enough to
understand that a company’s value is determined by the size, timing, and risk of its expected future free cash flows.
If the expected future free cash flows and the cost of capital incorporate all relevant
information, then the value defined in Equation 1-1 is called the intrinsic value; it is
also called the fundamental value. If investors have all the relevant information, the
market price, which is the price that we observe in the financial markets, should be
equal to the intrinsic value. Whether or not investors have the relevant information
depends on the quality and transparency of financial reporting for the company and
for the financial markets. This is an important issue that we will address throughout
the book.
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Part 1
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S e l f -T e s t
What are the key differences between proprietorships, partnerships, and corporations? Be sure to
describe the advantages and disadvantages of each.
What are charters and bylaws?
Describe some special types of partnerships and corporations, and explain the differences among
What does it mean for a company to “go public” and “list” its stock?
What are some differences between the NYSE and the NASDAQ stock market?
What roles are played by an investment bank and its brokerage firm during an IPO?
What is IPO underpricing? Why is it often difficult for the average investor to take advantage of
Differentiate between an IPO and a seasoned equity offering.
What three properties of future cash flows affect a corporation’s value?
How is a firm’s intrinsic (or fundamental) value related to its free cash flows and its cost of capital?
Write out the free cash flow equation and explain what it means.
What is required for the market price to equal the fundamental value?
1-4 Governing a Corporation
For proprietorships, partnerships, and small corporations, the firm’s owners determine
strategy and manage day-to-day operations. This is usually not true for a large corporation, which often has many different shareholders who each own a small proportion of the
total number of shares. These diffuse shareholders elect directors, who then hire senior
executives, who then hire other managers to run the corporation on a day-to-day basis.
These insiders are elected or hired to work on behalf of the shareholders, but what is to
prevent them from acting in their own best interests? This is called an agency problem
because managers are hired as agents to act on behalf of the owners. Agency problems
can be addressed by a company’s corporate governance, which is the set of rules that
control the company’s behavior toward its directors, managers, employees, shareholders,
creditors, customers, competitors, and community. We will have much more to say about
agency problems and corporate governance throughout the book, especially in Chapters 13,
14, and 15.
It is one thing to say that managers should act on behalf of owners, but how can
managers put this into practice?
1-4a The Primary Objective of a Corporation:
Maximizing Stockholder Wealth
A company’s decisions matter to many different stakeholders, such as shareholders,
employees, local communities, and others who are affected by the company’s environmental impact. How should managers address and prioritize stakeholders’ different
First, managers are entrusted with shareholders’ property and should be good stewards
of this property. Second, good stewardship implies that managers should seek to increase
the entrusted property’s value. In other words, the primary goal of the corporation should
be to maximize stockholder wealth unless the company’s charter states differently. This does
not mean that managers should break laws or violate ethical considerations. This does not
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Chapter 1
An Overview of Financial Management and the Financial Environment
mean that managers should be unmindful of employee welfare or community concerns.
But it does mean that managers should seek to maximize stockholder wealth.
In fact, maximizing shareholder wealth is a fiduciary duty for most U.S. corporations.
If companies fail in this duty, they can be sued by shareholders. For example, suppose
several different companies make simultaneous offers to acquire a target company. The
target’s board of directors probably will be sued by shareholders if they don’t vote in
favor of the highest offer, even if the takeover means that the directors will lose their jobs.
Companies can even be sued for maintaining social initiatives (such as purchasing environmentally friendly or locally sourced supplies at higher costs than equivalent imports)
if shareholders believe they are too costly to the company.
The situation is different for many non-U.S. companies. For example, many European
companies’ boards have directors who specifically represent the interests of employees
and not just shareholders. Many other international companies have government representatives on their boards or are even completely owned by a government. Such companies
obviously represent interests other than shareholders.
In a recent development, some U.S. corporations are choosing a new corporate form
called a benefit corporation (B-corp), which expands directors’ fiduciary responsibilities
to include interests other than shareholders’ interests (see the box “Be Nice with a B-Corp”).
1-4b I ntrinsic Stock Value Maximization
and Social Welfare
If a firm attempts to maximize its intrinsic stock value, is this good or bad for society?
In general, it is good. Aside from illegal actions such as making or taking bribes, fraudulent accounting, exploiting monopoly power, violating safety codes, or failing to
meet environmental standards, the same actions that maximize intrinsic stock values
usually benefit society.
Be Nice with a B-Corp
In 2010, Maryland became the first state to allow a company,
The Big Bad Woof, to be chartered as a benefit corporation
(B-corp). As of early 2015, there were more than 1,000 B-corps in
27 states, with legislation pending in 14 other states. B-corps
are similar to regular for-profit corporations but have charters
that include mandates to benefit the environment and society
even if this might not maximize shareholder wealth. For example, The Big Bad Woof, which sells products for companion
pets, seeks to purchase merchandise from small, local, minorityowned businesses even if their prices are a bit higher.
B-corps are required to report their progress in meeting
the charters’ objectives. Many self-report, but some choose
to be certified by an independent third party, in much the
same way that an independent accounting firm certifies a
company’s financial statements.
Why would a company become a B-corp? Patagonia
founder Yvon Chouinard said, “Benefit corporation legislation
creates the legal framework to enable mission-driven companies like Patagonia to stay mission-driven through succession, capital raises, and even changes in ownership, by
institutionalizing the values, culture, processes, and high
standards put in place by founding entrepreneurs.”a
Does being a B-corp help or hurt a company’s value?
Advocates argue that customers will be more loyal and that
employees will be prouder, more motivated, and more productive, which will lead to higher free cash flows and greater
value. Critics counter that a B-corp will find it difficult to raise
cash from additional investors because maximizing shareholder wealth isn’t its only objective.
There isn’t yet enough data to draw a conclusion, but it
will be interesting to see whether B-corps ultimately produce
a kinder, gentler form of capitalism.
Note: aSee www.patagonia.com/us/patagonia.go?assetid=68413.
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Part 1
The Company and Its Environment
Ordinary Citizens and the Stock Market
The Federal Reserve
Board conducts surveys of
consumer finances every
three years. For updates,
go to https://www
About 52% of U.S. households own stock, either directly or indirectly through mutual
funds or retirement plans. Therefore, when a manager takes actions to maximize intrinsic
value, this increases wealth and quality of life for millions of citizens.
Note that about 48% of households don’t directly benefit from higher stock prices. Even
for the stock-owning households, most of the wealth accrues to the rich: (1) 1% of stockowning households own about 39% of the wealth, (2) the next 9% own about 38%, and
(3) the bottom 90% own about 23% (a substantial decrease from the bottom group’s 33%
share in 1989). If you ask someone whether wealth and income inequality are good or bad
for our country, the answer probably depends on the person’s political views.
Employees at Value-Maximizing Companies
Sometimes a company’s stock price increases when it announces plans to lay off employees, but viewed over time, this is the exception rather than the rule. In general, companies
that successfully increase stock prices also grow and add more employees, thus benefiting
society. Note, too, that many governments across the world, including U.S. federal and
state governments, are privatizing some of their state-owned activities by selling these
operations to investors. Perhaps not surprisingly, the sales and cash flows of recently
privatized companies generally improve. Moreover, studies show that newly privatized
companies tend to grow and thus require more employees when they are managed with
the goal of stock price maximization.
Consumers and Competitive Markets
Value maximization requires efficient, low-cost businesses that produce high-quality
goods and services at the lowest possible cost. This means that companies must develop
products and services that consumers want and need, which leads to new technology and
new products. Also, companies that maximize their stock price must generate growth
in sales by creating value for customers in the form of efficient and courteous service,
adequate stocks of merchandise, and well-located business establishments. Therefore,
consumers benefit in competitive markets when companies maximize intrinsic value.
1-4c Ethics and Intrinsic Stock Value Maximization
A firm’s commitment to business ethics can be measured by the tendency of its employees,
from the top down, to adhere to laws and regulations. But ethical behavior also includes a
commitment to (1) appropriate use of confidential information (i.e., not for personal gain),
(3) attention to product safety and quality, (3) fair employment practices, (4) fair marketing and selling practices, and (5) community involvement.
The intrinsic value of a company ultimately depends on all of its expected future cash
flows, and making a substantive change requires hard work to increase sales, cut costs,
or reduce capital requirements. There are very few, if any, legal and ethical shortcuts to
making significant improvements in the stream of future cash flows, as illustrated by the
following examples.
Illegal Actions
Unfortunately, managers at some companies have taken illegal actions to make intrinsic
values seem much higher than warranted. For example, ForceField Energy Inc. claimed
to be a wholesale distributor of efficient LED lighting products. However, its Chairman
of the Board, Richard St. Julien, was arrested in 2015 on charges of security fraud.
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Chapter 1
An Overview of Financial Management and the Financial Environment
Nine others, including brokers and fund managers, were charged in 2016 for taking kickbacks from ForceField in exchange for encouraging investors to purchase the stock even
though they knew that the company was in dire financial straits. St. Julien pled guilty and
cooperated with investigators in exchange for the possibility of a sentence of less than
40 years. As of mid-2018, five of the others have been sentenced to prison and four have
pled guilty. The perpetrators are being punished, but that doesn’t restore the $130 million
lost by shareholders.
Alleged Unethical Actions
Other companies have been accused of unethical actions. For example, Mylan N.V. purchased exclusive rights in 2007 to sell EpiPens, which deliver a dose of epinephrine to
reduce the impact of a sudden dangerous allergic reaction. Mylan subsequently increased
the price 17 times from $100 per pair to $600 by May 2016. In late August 2016, Mylan
was selling about $1 billion in EpiPens and its stock was trading close to $50 per share.
However, the steep price increases had touched off outrage from parents and the news
media. By fall of 2017, Mylan’s stock price had fallen to about $32, a 36% decline. Part of
that decline was due to (1) reputational damage, (2) lower revenues because Mylan introduced a generic version of the EpiPen (at $300 per pair), (3) a $467 million settlement with
the Justice Department to resolve claims that Mylan had misclassified the EpiPen to avoid
paying rebates to Medicaid, and (4) a still unresolved (as of early 2018) class action lawsuit
alleging racketeering. As this example shows, even alleged unethical behavior can significantly reduce a company’s value.
Whistleblower Protections
For current information
from OSHA, see www
.osha.gov/index.html and
search for “whistleblower
investigation data.”
Most illegal or unethical schemes are difficult to hide completely from all other
employees. But an employee who believes a company is not adhering to a law or regulation might be hesitant to report it for fear of being fired or otherwise punished by
the company. To help address this problem, federal and state governments have created
a variety of whistleblower protection programs corresponding to different types of
corporate misdeeds.
With respect to financial misdeeds, the Sarbanes-Oxley (SOX) Act of 2002 and the
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 strengthened
protection for whistleblowers who report financial wrongdoing. Under SOX, employees
who report corporate financial wrongdoing and subsequently are penalized by the company can ask the Occupational Safety and Health Administration (OSHA) to investigate
the situation. If the employee was improperly penalized, the company can be required
to reinstate the person, along with back pay and a sizable penalty award. In addition,
SOX made it a criminal act for a CEO or CFO to knowingly falsely certify a company’s
financial position.
Have these provisions in SOX been successful? There were 202 SOX-related employee
complaints in 2017. Only 23% were settled in the employee’s favor—the others were withdrawn, dismissed, or kicked out by OSHA. No executives have been jailed for falsely certifying financial statements, even though a significant number of executives have lost their
jobs due to their companies’ financial misreporting.
The Dodd-Frank Act’s establishment of the SEC Office of the Whistleblower has led
to dozens of announced awards for reporting wrongdoing by financial firms. In 2017,
13 whistleblowers received a total of $43 million, with one of them receiving $20 million.
The awards can be very large because they are based on a percentage of the amount
that the SEC fines the wrongdoing corporation. The largest award to an individual was
$33 million in 2018.
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Taxes and Whistleblowing
The Internal Revenue Service (IRS) has a program to reward
whistleblowers for information leading to the recovery of unpaid taxes, and sometimes the rewards are huge. The largest
reward was $104 million to Bradley C. Birkenfeld, who discovered schemes that UBS, a large Swiss bank, was using to help
its clients avoid U.S. taxes. UBS settled with the U.S. Department of Justice in 2009 by paying $780 million in fines and
providing account information for over 4,000 U.S. clients to
the IRS. This caused thousands of additional U.S. taxpayers to
fear similar exposure and to enter an IRS amnesty program,
leading to over $5 billion in collections of unpaid taxes.
Despite the record-setting payout, Birkenfeld and the
U.S. government do not have an amicable relationship. The
government alleged that Birkenfeld learned about the UBS
tax evasion schemes while using them to shelter one of his
own clients from taxes. Birkenfeld refused to divulge information about this client during the investigation, so the United
States convicted him of fraud. Birkenfeld served 30 months
in a medium-security federal prison but still received the
$104 million reward.
How much is freedom worth? About $115,000 per day,
based on Birkenfeld’s reward and prison time served.
Although not a substitute for high individual moral standards, it appears that large
and visible rewards to whistleblowers help ethical employees rein in actions being considered by less ethical employees. This leads to less financial misreporting, which in turn
helps keep market prices in line with intrinsic value.
S e l f -T e s t
What is an agency problem? What is corporate governance?
What is the fiduciary duty (i.e., the primary goal) for most U.S. corporations?
How does a benefit corporation’s charter differ from that of a typical U.S. corporation?
Explain how individuals, customers, and employees can benefit when a company seeks to
maximize its intrinsic value.
What is a whistleblower?
Compare the Sarbanes-Oxley (SOX) Act of 2002 and the Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010 with respect to their impact on whistleblowing.
1-5 An Overview of Financial Markets
At the risk of oversimplification, we can classify providers and users of cash into four
groups: individuals, financial organizations (like banks and insurance companies), nonfinancial organizations (like Apple, Starbucks, and Ford), and governments. The following sections explain how these groups interact to allocate capital from providers to users.
For current information,
see the Federal Reserve
Bank of St. Louis’s FRED®
Economic Data. Take the
total financial assets of
households (and nonprofit
organizations serving
households), found at
Then subtract the
financial liabilities,
found at https://fred
1-5a The Net Providers and Users of Capital
In spite of William Shakespeare’s advice, most individuals and firms are both borrowers and lenders. For example, an individual might borrow money by having a car loan
but might also lend money by having a bank savings account. In the aggregate, however,
individuals are net providers (i.e., savers) of most funds ultimately used by nonfinancial
corporations. In fact, individuals provide a net amount of about $62 trillion to users.
Although most nonfinancial corporations own some financial securities, such as shortterm Treasury bills, nonfinancial corporations are net users (i.e., borrowers) in the aggregate.
In the United States, federal, state, and local governments are also net users (i.e.,
borrowers) in the aggregate, although many foreign governments, such as those of China
and oil-producing countries, are actually net providers.
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Banks and other financial corporations raise money with one hand and invest it with
the other. For example, a bank might raise money from individuals in the form of savings accounts and then lend most of that money to business customers. In the aggregate,
financial corporations are net users (i.e., borrowers) by a slight amount.
1-5b G
etting Cash from Providers to Users:
The Capital Allocation Process
Because users invest the cash received from providers, it is called “capital.” Transfers of
capital from providers to users take place in three different ways. Direct transfers of money
and securities, as shown in Panel A of Figure 1-2, occur when a business (or government)
sells its securities directly to providers. Providers purchase the securities with cash and
the business delivers the securities to the providers. For example, a privately held company
might sell shares of stock directly to a new shareholder, or the U.S. government might sell
a Treasury bond directly to an individual investor.
As shown in Panel B, indirect transfers may go through an investment bank, which
underwrites the issue. An underwriter serves as a middleman and facilitates the issuance
of securities. The company sells its stocks or bonds to the investment bank, which in turn
sells these same securities to savers. Because new securities are involved and the corporation receives the proceeds of the sale, this is a “primary” market transaction.
Transfers also can be made through a financial intermediary such as a bank or
mutual fund, as shown in Panel C. The intermediary obtains funds from providers in
exchange for its own securities or ownership of savings accounts. The intermediary then
uses this money to purchase the business’s securities. For example, an individual might
provide dollars to a bank and receive a certificate of deposit; the bank then might lend to
a small business, receiving in exchange a legal document from the borrower promising to
repay the loan. Thus, intermediaries literally create new types of securities.
There are three important features of the capital allocation process. First, new financial securities are created. Second, different types of financial institutions often act as intermediaries
Figure 1-2
Diagram of the Capital Allocation Process
Panel A: Direct Transfer
Business’s Securities
Panel B: Through Investment Bank
Investment Bank
Panel C: Through Financial Intermediary
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