Introduction to finance

P R E FAC E iiiPart 1 Institutions and Markets 1 1 The Financial Environment 3 2 Money and the Monetary System 21 3 Banks and Other Financial Institutions 45 4 Federal Reserve System 76

Introduction to Finance Markets, Investments, and Financial Management

16th Edition

R O N A L D W M E L I C H E R

Professor of Finance University of Colorado at Boulder

E D GA R A N O RTO N

Professor of Finance Illinois State University

EDITORIAL DIRECTOR Michael McDonald

This book was set in 10/12 Stix by Aptara Corp and printed and bound by LSI.

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To my best friend and wife, Becky;

our son Matthew and his wife, Angie;

our daughter Amy and her husband, Jake

Edgar A Norton

The sixteenth edition of Introduction to Finance: Markets,

Investments, and Financial Management builds upon the

suc-cesses of its earlier editions while maintaining fresh and

up-to-date coverage of the fi eld of fi nance This edition introduces

several new electronic features to assist with student access to

the textbook and with learning

Our text is designed to present a more-balanced fi rst

course in fi nance, one that off ers students perspectives on fi

nan-cial markets, investing, and fi nannan-cial management We use a

successful pedagogy that reviews, fi rst, markets and

institu-tions; then, the world of investments; and fi nally, the concepts

and applications of business fi nancial management

Unlike other textbooks with a singular “corporate fi nance”

focus, our text off ers a balanced fi rst course in fi nance Eighteen

chapters cover the three major fi nancial areas involving the

fi nancial system, investments, and business fi nance For the

stu-dent who does not plan to take additional courses in fi nance,

this book provides a valuable overview of the discipline’s

major concepts For the student who wants to take additional

courses in fi nance, the overview presented provides a solid

foundation upon which future courses can build

Introduction to Finance is meant to be used in a course

whose purpose is to survey the foundations of the fi nance

dis-cipline As such, it is designed to meet the needs of students in

various programs Specifi cally, Introduction to Finance can be

used in any of the following four ways:

1 As the fi rst course in fi nance at a college or university where

the department wants to expose students to a broad

founda-tional survey of the discipline

2 As the fi rst and only course in fi nance for nonfi nance business

students

3 As an appropriate text to use at a school that seeks to provide

liberal arts majors with a business minor or business

concen-tration The writing level is appropriate to provide students

with a good foundation in the basics of our discipline

4 As a “lower division” service course whose goal is to

attract freshmen and sophomores to business and to attract

them to become fi nance majors

The philosophy behind the book is threefold First, we

believe that a basic understanding of the complex world of

fi nance should begin with a survey course that covers an

introduction to fi nancial markets, investments, and fi nancial

management or business fi nance Students can gain an

integ-rated perspective of the interrelationships among these three

areas They will appreciate how businesses and individuals

are aff ected by markets and institutions, as well as of how

markets and institutions can be used to meet the goals of

individuals or fi rms Given the events in the fi nancial markets

and the economy in 2007–2009 and the fi nancial implications

of the United Kingdom’s 2016 decision to withdraw from

the European Union (known as “Brexit”), this integrated

perspective adds value to student learning and an ing of the fi eld

understand-Second, we wrote the book as an introductory survey of

fi nance with a readable and user-friendly focus in mind We seek to convey basic knowledge, concepts, and terms that will serve the nonfi nance major into the future and that will form

a foundation upon which the fi nance major can build Some

fi ner points, discussions of theory, and complicated topics are reserved for “Learning Extensions” in selected chapters We aim to make students using our text fi nancially literate and cognizant of the richness of fi nance The book provides a good foundation for students to build upon in later courses in fi nan-cial management, investments, or fi nancial markets

Third, we focus on the practice of fi nance in the settings of markets, investments, and fi nancial management We focus on the descriptive in each of these fi elds We don’t want students to be unable to see the forest of fi nance because the trees of quantitative methods obscure their view or scare them away When we do in-troduce equations and mathematical concepts that are applicable

to fi nance, we will show step-by-step solutions

By learning about markets (including gaining knowledge about institutions), investments, and management as the three major strands of fi nance, students will fi nish their course with

a greater understanding of how these three fi elds interrelate Financial markets will be seen as the arena to which businesses and fi nancial institutions go to raise funds, and as the mechan-ism through which individuals can invest their savings to meet their future goals The topic of investments is important in facilitating the savings–investment process Understanding the trade-off of risk and return, as well as the valuation of bonds and stocks, is essential to investors and businesses raising

fi nancial capital Understanding how securities markets work

is equally important Financial management uses information

it obtains from securities and other fi nancial markets to effi ciently and profi tably manage assets and to raise needed funds

-in a cost-effi cient manner

A broad exposure to the discipline of fi nance will meet the needs of nonmajors who should know the basics of fi nance

so they can read the The Wall Street Journal, visit

business-related Internet sites, and analyze other business information sources intelligently It will help the nonfi nance major work

as a member of a cross-functional work team, a team that will include fi nance professionals In addition, this overview of fi n-ance will start the fi nance major off on the right foot Rather than receiving a compartmentalized idea of fi nance—often viewed through the corporate fi nance lens that many texts use—the fi nance major will receive a practical introduction to the diff erent disciplines of fi nance, and will better appreciate the relationships among them

Part 1 of the book contains six chapters on the fi nancial system, with primary emphasis on fi nancial markets and the tools and skills necessary to better understand how such markets work We begin with an overview of the three main subfi elds

of fi nance, identify the “six principles of fi nance,” and discuss

career opportunities The principles of fi nance are the following:

1 Money has a time value.

2 Higher returns are expected for taking on more risk.

3 Diversifying one’s investments can reduce risk.

4 Financial markets are effi cient in pricing securities

5 The objectives of managers and stockholders may diff er.

6 Reputation matters

We discuss fi nance and the role and functions of the fi

nacial system to a nation’s economy The role of banks, other fi

n-ancial intermediaries, and the Federal Reserve are reviewed, as

are their functions in the fi nancial system Part 1 introduces the

international role of fi nance and how modern economies are

aff ected by exchange rates, trade, and the fl ow of global funds

Following this introduction to the fi nancial system, Part 2

focuses on investments We review the role of savings in an

economy and the ways in which funds fl ow to and from

dif-ferent sectors Interest rates are introduced, and the discussion

centers on making the student aware of the diff erent infl uences

on interest rate levels and why the rates change over time

Be-cause interest rates measure the cost of moving money across

time, this section reviews basic time-value-of-money concepts

with many worked-out examples, including the keystrokes that

students can use when working with fi nancial calculators

Next, after reviewing the characteristics of bonds and

stocks, students will learn to apply time-value-of-money

con-cepts to fi nd the prices of these securities Continuing our

overview of investments, we discuss investment banking basics

and the operations of securities markets, as well as the

funda-mentals of investment risks and returns, to conclude Part 2

Advanced classes may want to review the fi nancial

deriv-atives basics, which are explained in a Learning Extension of

Chapter 11’s discussion of securities and markets

The raising of funds by businesses in the institutional and

market environments is covered in Parts 1 and 2 Next, in Part 3,

the fi nal six chapters of the text introduce students to fi nancial

management The discussion begins with the diff erent ways in

which to organize a business, and the fi nancial implications of

each organizational form We introduce accounting concepts,

such as the balance sheet, income statement, and statement of

cash fl ows, with simple examples We discuss fi nancial ratios,

which assist in the process of analyzing a fi rm’s strengths and

weaknesses We review their use as a means of helping

man-agers plan ahead for future asset and fi nancing needs Strategies

for managing a fi rm’s current assets and current liabilities are

examined, as are the funding sources fi rms use to tap the fi

nan-cial markets for short-term fi nancing Finally, we introduce

stu-dents to capital budgeting basics and capital structure concepts

New and Improved

Many new pedagogical features are included in the textbook,

including the following:

• An e-book format for electronic and “cloud” access to the

textbook and related learning material A black-and-white,

binder-ready version is available as well for those preferring

a paper copy

• Coordinated chapter learning objectives, chapter ies, and end-of-chapter review questions Each chapter learning objective is numbered; the expanded chapter sum-maries review each individual learning objective and each review question is keyed to a specifi c learning objective number

summar-• Every chapter contains 3 or 4 Discussion Questions that can be used in class, assigned to students, or used by the instructor on learning management systems such as Black-board, Moodle, Sakai, and others to form the basis of graded

or ungraded class participation and critical thinking

• The e-book version presents, at the end of each section (corresponding to each learning objective) several multiple choice questions for students to use as a review of chapter concepts

• Some of the tables, charts, and graphics include interactive features that allow students to sort, categorize, or focus on a single graph feature at a time as it changes values over time Other downloadable spreadsheets allow students to practice some of the chapter’s calculations

• Excel templates have been updated and revised to refl ect the book’s content

• Existing test bank items were re-examined and new tions added to refl ect the many content changes and to better test student knowledge

ques-The content of Introduction to Finance has been updated

to incorporate many of the economic and fi nancial events of the past few years The fi nancial crisis of 2007–2008, the subsequent recession and recovery—along with the behavior of the Federal Reserve and securities markets—provide a means to highlight causes, eff ects, and the integration of fi nance into our everyday lives, as well as the implications for markets, investments, and

business fi nance A fi nancial crisis colored label, denoting a

“Focus Point,” is placed next to relevant text material

We continue with our innovation found in previous tions, featuring a real fi rm (Walgreens, the retail drugstore chain) in many of the chapters on investments and fi nancial management as a means of presenting and analyzing data

edi-In addition to these broad improvements, all chapters have been updated and revised to refl ect recent events and data Specifi c notable changes in this sixteenth edition include the following:

Chapter 1, The Financial Environment, provides an

over-view of the fi nancial system and environment including nomic and fi nancial developments during the 2007–2008 fi n-ancial crisis and the 2008–2009 Great Recession The chapter has been reorganized with “careers in fi nance” being presented near the end of the chapter after students have been introduced

eco-to basic fi nance terms and concepts

Chapter 2, Money and the Monetary System, discusses

the process of moving savings into investments and provides

an overview of the monetary system While physical money

(coin and paper currency) in the United States continues to be

our focus, we recognize possible growth in the use of digital

currencies including bitcoin The relationship between money

supply and economic activity is discussed in light of continued

easy monetary policies

Chapter 3, Banks and Other Financial Institutions,covers

the types and roles of fi nancial institutions During the 2007–09

period, falling housing prices, mortgage loan defaults, and

declining values on mortgage-backed securities that resulted

in many fi nancial institutions not having adequate equity

cap-ital to continue to operate, and, thus, needing to merge or be

“bailed out.” The ability of banks to maintain sound balance

sheets, including adequate capital ratios, continues to be of

concern to regulators, politicians, and others

Chapter 4, Federal Reserve System, describes the current

structure and operations of the Federal Reserve (the Fed)

The Fed’s response to the recent fi nancial crisis and economic

downturn as well as its eff orts to stimulate economic growth

through quantitative easing and other means is covered The

Fed used quantitative easing, among other things, to stimulate

economic growth and is fi nding it diffi cult to move towards

more-traditional interest rate levels Janet Yellen, the current

chair of the Fed’s board of governors, is faced with the diffi cult

task of simultaneously maintaining economic growth raising

interest rates that are near zero

Chapter 5, Policy Makers and the Money Supply, describes

how the four policy maker groups (Federal Reserve System,

the president, Congress, and the U.S Treasury) are

respons-ible for carrying out the national economic policy objectives

of economic growth, high employment, and price stability We

cover the U.S government’s response to the perfect fi nancial

storm involving the fi nancial crisis and the subsequent Great

Recession New material on the current size of the national

debt and the eff orts of the U.S Treasury to manage the national

debt are presented

Chapter 6, International Finance and Trade, covers the

evolution of the international monetary system and eff orts

by European countries to achieve unifi cation, although the

recent decision by the United Kingdom to withdraw from

the European Union has caused concern about the future

economic and fi nancial viability of the European Union

Material on currency exchange rates and the factors that

af-fect currency exchange rates have been substantially

rewrit-ten We discuss the use of hedging, forward contracts, and

forward rates in the section that covers managing currency

exchange risk We also have added a Learning Extension

that discusses the use of forward contracts in international

business transactions

Chapter 7, Savings and Investment Process, discusses the

re-lationship between gross domestic product and capital

forma-tion, and covers the major sources of income and outlays

in-volved in the annual federal budget Recent data on personal

and corporate savings are presented and discussed The role

played by individuals in the 2007–09 fi nancial crisis and the

Great Recession is also covered

Chapter 8, Interest Rates, discusses the supply and demand

for loanable funds and the components of market interest rates This chapter was substantially rewritten and uses current in-terest rates when examining interest rates The relationship between interest rates and the maturity of comparable-quality debt remains at historically low levels and is due, in part, to the Fed’s easy monetary policy Recent default risk premium levels are also presented and discussed

Chapter 9, Time Value of Money, conveys the importance

of compounding (earning interest on interest) in building wealth over time We continue to present examples of how

to perform time value calculations using formulas, interest factor tables, step-by-step fi nancial calculator keystrokes, and Excel spreadsheets While historically low interest rates make

it attractive to fi nance the purchase of homes and other able goods, low rates also make it diffi cult for individuals to build wealth over time

dur-Chapter 10, Bond and Stocks: Characteristics and ations, has its bond valuation section rewritten to use the

Valu-“annual percentage rate” (APR) approach as opposed to the

“eff ective interest rate” (EAR) approach The chapter contains updated data and improved discussions of bonds and stocks

We have revised the discussion of the risks facing investors in the low interest rate environment sustained by the Fed since the Great Recession Spreadsheet examples show how to apply time value concepts to calculate bond prices and stock prices

Chapter 11, Securities and Markets,incorporates changes in securities trading, including high-frequency trading and events such as the New York Stock Exchange and Intercontinental Exchange (NYSE–ICE) merger, as well as an overview of the Facebook initial public off ering (IPO) and some of its issues This chapter’s Learning Extension on futures and options has been revised to refl ect reviewer suggestions

Chapter 12, Financial Returns and Risk Concepts, is one of

the more mathematical chapters; it shows how to do tions with step-by-step calculator keystrokes and spreadsheet functions Its content is updated, especially evidence regarding the diffi culty in “beating the market” by active investors

calcula-Chapter 13, Business Organization and Financial Data,

features data from Walgreens’ fi nancial statements, with lights about the merger with Boots Alliance We maintain that

high-a fi rm’s gohigh-al is to mhigh-aximize shhigh-areholder wehigh-alth, high-and we cuss “sustainability” in light of this goal

dis-Chapter 14, Financial Analysis and Long-Term Financial Planning, uses updated data from Walgreens and the retail

drugstore industry in a practical example of fi nancial ratio analysis using industry averages We focus on changes in Walgreens’ fi nancial ratios following its merger with Boots Alliance to form Walgreens Boots Alliance

Chapter 15, Managing Working Capital, expands the

dis-cussion of managing cash in a diffi cult business environment with low interest rates We discuss a new reason why fi rms hold large amounts of cash, with the tax cost of repatriating the funds back to the home country

Chapter 16, Short-Term Business Financing, contains

in-formation on real fi rms’ working capital fi nancing strategies

and on the implications of the fi nancial crisis on a fi rm’s

abil-ity to obtain short-term fi nancing, including the role of

“sup-ply chain fi nancing” by some banks and suppliers We include

a section on the American Energy and Infrastructure Jobs Act

of 2012 (JOBS Act of 2012), a tool to help small fi rms obtain

fi nancing, including the use of “crowdfunding.”

Chapter 17, Capital Budgeting Analysis, relates the cash

fl ow estimation process for a project to the fi rm’s statement

of cash fl ows found in Chapter 13 and reviews standard

cap-ital budgeting analysis tools, such as net present value (NPV),

internal rate of return (IRR), profi tability index (PI), and

mod-ifi ed internal rate of return (MIRR)

Chapter 18, Capital Structure and the Cost of Capital,

contains updated discussions of trends in the use of debt by

corporations and the use of debt fi nancing in the low interest

rate environment that has existed since the Great Recession

We include information of how managers compute capital

costs from the Cost of Capital Survey issued by the

Associ-ation of Finance Professionals

Learning and Teaching Aids

The sixteenth edition of Introduction to Finance off ers the

fol-lowing aids for students and instructors:

Chapter Openers: Each chapter begins with the following:

• Chapter Learning Objectives, which students can use to

re-view the chapter’s main points and which instructors can

use as a basis for in-class lecture or discussion;

• Where We Have Been statements that remind students of

what was covered in the previous chapters;

• Where We Are Going, which are previews of chapters to

come;

• How This Chapter Applies To Me that explain how the

con-tent of the chapter, no matter how technical or business

spe-cifi c, has applications to the individual student

Applying Finance To: These boxes show how the topic

of each chapter relates to the fi nance fi elds of institutions and

markets, investments, and fi nancial management

Learning Activities: We direct the student to relevant

websites at diff erent points in each chapter

Margin Defi nitions: Margin defi nitions of key terms are

provided to assist students in learning the language of fi nance

Focus Icons: Icons are placed by relevant text to indicate

discussions of fi nance principles, implications of the recent

fi nancial crisis, fi nancial or business ethical issues, and global

or international discussions

Spreadsheet Illustrations: We show how to use sheets to solve problems, and to teach students about the power

spread-of spreadsheet functions and analysis

Boxed Features: Throughout the book, boxes are used to focus on current topics or applications of interest They are designed to illustrate concepts and practices in the dynamic

fi eld of fi nance

• Small Business Practice boxes highlight aspects of the chapter topics relating directly to small businesses and entrepreneurship

• Career Opportunities in Finance boxes provide information about various careers in fi nance and appear in many chapters

• Personal Financial Planning boxes provide insight into how the chapter’s content can be applied to an individual’s fi nances

Learning Extensions: Chapter appendixes, called ing Extensions, are included in many chapters Learning Extensions provide additional in-depth coverage of topics related to their respective chapters, and many challenge stu-dents to use their mathematical skills

Learn-End-of-Chapter Materials: Each chapter provides the following:

• Review Questions, keyed to specifi c chapter learning jectives that review chapter material

ob-• Exercises for students to solve and exercise their atical skills

mathem-• Problems that are more diffi cult and that should be solved

by using spreadsheets Downloadable templates are ble for each problem

availa-Companion Website: The text’s website at www.wiley.com/college/melicher contains a myriad of resources and links

to aid learning and teaching

Instructor’s Manual and Test Bank: The Instructor’s Manual is available to adopters of this text It features detailed chapter outlines, lecture tips, and answers to end-of-chapter review questions and problems

Computerized Test Bank: There is a test bank for the text A Test-Generating Program that allows instructors to cus-tomize their exams also is provided

Powerpoint Presentations: Created by the authors, a PowerPoint presentation is provided for each chapter of the text Slides include outline notes on the chapter, additional presentation topics, and fi gures and tables from the text

Spreadsheet Templates: Excel-compatible templates, developed by Robert Ritchey of Texas Tech University, are available on the text website Students can use the fi nancial analysis tools worksheets and templates to help apply what they’ve learned in the text and solve some of the end-of-chapter problems and challenge problems

We would like to thank the Wiley Publishing team of Acquisitions Editor,

Emily McGee, Senior Production Editor, Suzie Pfi ster, Development

Editor, Courtney Jordan, and Product Designer, Matthew Origoni for

their role in preparing and publishing the sixteenth edition of

Introduc-tion to Finance.

In addition, we are especially grateful to the reviewers for

their comments and constructive criticisms of this and previous

editions:

Saul W Adelman, Miami University, Ohio

Tim Alzheimer, Montana State University

Allan Blair, Palm Beach Atlantic College

Stewart Bonem, Cincinnati State Technical and Community College

Linda K Brown, St Ambrose University

Joseph M Byers, Community College of Allegheny County, South

Campus

Robert L Chapman, Orlando College

William Chittenden, Texas State University

Sara J Conroy, Community College of Allegheny County

Will Crittendon, Bronx Community College

David R Durst, University of Akron

Sharon H Garrison, Florida Atlantic University

Asim Ghosh, Saint Joseph’s University

Stephen S Gray, Western Illinois University

Lester Hadsell, University of Albany

Irene M Hammerbacher, Iona College

Kim Hansen, Mid-State Technical College

Jeff Hines, Davenport College

Jeff Jewell, Lipscomb University

Lisa Johnson, Centura College

Ed Krohn, Miami Dade Community College

Jessica Lancaster, McCann School of Business and Technology

P John Limberopoulos, University of Colorado Boulder

Leslie Mathis, University of Memphis

Michael B McDonald, Fairfi eld University

Acknowledgments

John K Mullen, Clarkson University Michael Murray, Winona State University Napoleon Overton, University of Memphis Michael Owen, Montana State University Marco Pagani, San Jose State University Jason Powers, Strayer University Barbara L Purvis, Centura College Alan Questell, Richmond Community College Ernest Scarbrough, Arizona State University Raymond Shovlain, St Ambrose University Amir Tavakkol, Kansas State University Jim Washam, Arkansas State University Howard Whitney, Franklin University Lawrence Wolken, Texas A&M University

K Matthew Wong, St John’s University David Zalewski, Providence CollegeLikewise, we appreciate the comments from students and teachers, who have used previous editions, and the assistance from the dozens of reviewers, who have commented about the early editions Special recognition goes to Carl Dauten, who coauthored the fi rst four editions, and Merle Welshans, who was a coauthor on the fi rst nine editions of the book Finally, and perhaps most importantly, we wish to thank our families for their understanding and support during the writing of the sixteenth edition

RONALD W MELICHER,

Boulder, Colorado

EDGAR A NORTON,

Normal, Illinois

Author Bios

RON M E LIC H ER is professor emeritus of fi nance and

previously served three diff erent terms as chair of the Finance

Division, Leeds School of Business, University of Colorado,

Boulder He is a past president of the Financial Management

Association Ron earned undergraduate, M.B.A., and doctoral

degrees from Washington University in St Louis, Missouri

While at the University of Colorado, he received several

distin-guished teaching awards and was designated a university-wide

President’s Teaching Scholar Ron has taught corporate fi nance

and fi nancial strategy and valuation in M.B.A and Executive

M.B.A programs in addition to entrepreneurial fi nance and

investment banking to undergraduate students He also has

taught fi nancial management materials in executive education

courses and in in-house corporate programs His research has

been published in major fi nance journals, including the Journal

of Finance, Journal of Financial and Quantitative Analysis,

and Financial Management He is also the coauthor of

Entre-preneurial Finance, fi fth edition (Cengage Learning, 2015).

E D GA R A NORT ON is professor of fi nance and director

of the Institute for Financial Planning and Analysis in the lege of Business at Illinois State University He holds a double major in computer science and economics from Rensselaer Polytechnic Institute and received his M.S and Ph.D from the University of Illinois at Urbana–Champaign A Chartered Financial Analyst (CFA), he regularly receives certifi cates

Col-of achievement in the fi eld Col-of investments He has consulted with COUNTRY Financial, Maersk, and the CFA Institute; does pro bono fi nancial planning; and is a past president of the Midwest Finance Association His research has appeared

in numerous journals, such as Financial Review, Journal of Business Venturing, and Journal of Business Ethics He has coauthored four textbooks, including Introduction to Finance.

viii

P R E FAC E iii

Part 1 Institutions and Markets 1

1 The Financial Environment 3

2 Money and the Monetary System 21

3 Banks and Other Financial Institutions 45

4 Federal Reserve System 76

5 Policy Makers and the Money Supply 102

6 International Finance and Trade 130

Part 2 Investments 163

7 Savings and Investment Process 165

8 Interest Rates 190

9 Time Value of Money 218

10 Bonds and Stocks: Characteristics and Valuations 252

11 Securities and Markets 298

12 Financial Return and Risk Concepts 342

Part 3 Financial Management 379

13 Business Organization and Financial Data 381

14 Financial Analysis and Long-Term Financial Planning 422

15 Managing Working Capital 454

16 Short-Term Business Financing 490

17 Capital Budgeting Analysis 520

18 Capital Structure and The Cost of Capital 565

Part 1 Institutions and Markets 1

1 The Financial Environment 3

1.1 What Is Finance? 4

Two Themes 5

1.2 Why Study Finance? 6

1.3 Six Principles of Finance 8

Time Value of Money 8

Risk Versus Return 8

Diversification of Risk 8

Financial Markets Are Eff icient 9

Management Versus Owner Objectives 10

Reputation Matters 10

1.4 Overview of the Financial System 11

Characteristics and Requirements 11

Financial System Components and Financial

Functions 12

Creating Money 13

Transferring Money 13

Accumulating Savings 13

Lending and Investing Savings 13

Marketing Financial Assets 13

Transferring Financial Assets 14

1.5 Financial Markets: Characteristics

and Types 14

Money and Capital Markets 14

Primary and Secondary Markets 15

Major Types of Financial Markets 15

1.6 Careers in Finance 16

1.7 The Plan of Study 18

Applying Finance To 19

Summary 19

Key Terms 19

Review Questions 19

Exercises 20

2 Money and the Monetary System 21

2.1 The 2007–2008 Financial Crisis 22

2.2 Process of Moving Savings Into Investments 23

2.3 Overview of the Monetary System 25

2.4 Importance and Functions of Money 26

2.5 Development of Money in the United

States 28

Physical Money (Coin and Paper Currency) 28

Credit Money and Deposit Money 32

2.6 Money Market Securities 33

2.7 Measures of the U.S Money Supply 35

M1 Money Supply 35

M2 Money Supply 36

Exclusions from the Money Supply 37

2.8 Money Supply and Economic Activity 37

2.9 International Monetary System 39

Applying Finance To 40

3.3 Overview of the Banking System 51

Commercial, Investment, and Universal Banking 51

Functions of Banks and the Banking System 53

3.4 Historical Development of the U.S Banking System 54

Before the Civil War 55

Entry of Thrift Institutions 56

3.5 Regulation of the Banking System 56

General Banking Legislation 57

The Savings and Loan Crisis 59

Protection of Depositors’ Funds 60

3.6 Structure of Banks 61

Bank Charters 61

Degree of Branch Banking 61

Bank Holding Companies 62

3.7 The Bank Balance Sheet 62

5.4 Treasury Cash and General Management Responsibilities 109

Managing the Treasury’s Cash Balances 110

Powers Relating to the Federal Budget and to Surpluses

or Deficits 110

Recent Financial Crisis Related Activities 112

5.5 Treasury Deficit Financing and Debt Management Responsibilities 113

5.6 Changing the Money Supply 115

Checkable Deposit Expansion 115

Off setting or Limiting Factors 119

Contraction of Deposits 120

5.7 Factors Aff ecting Bank Reserves 121

Changes in the Demand for Currency 121

Federal Reserve System Transactions 122

5.8 The Monetary Base and the Money Multiplier 124

Applying Finance To 126

6.1 International Monetary System 131

Development of International Finance 131

How the International Monetary System Evolved 132

6.2 European Unification 133

European Union 133

Eurozone Members 134

The Euro 134

European Union Financial Crises 134

6.3 Currency Exchange Markets and Rates 135

Currency Exchange Markets 135

Exchange Rate Quotations 136

Currency Exchange Rate Appreciation and Depreciation 137

6.4 Factors that Aff ect Currency Exchange Rates 138

Arbitrage 141

6.5 Conducting Business Internationally 142

Exchange Rate Developments for the U.S Dollar 142

Managing Currency Exchange Risk 143

Ethical Considerations 144

6.6 Financing International Trade 145

Financing by the Exporter 145

Financing by the Importer 147

Banker’s Acceptance 149

Other Aids to International Trade 150

6.7 Developments in U.S International Transactions 151

International Business Issues 151

Balance-of-Payments Accounts 151

Review Questions 73

Exercises 74

Problems 74

4 Federal Reserve System 76

4.1 U.S Central Bank Response to the Financial

Crisis and Great Recession 77

4.2 The U.S Banking System Prior to the Fed 78

Weaknesses of the National Banking System 79

The Movement to Central Banking 80

4.3 Structure of the Federal Reserve System 80

Role of the Chair of the Fed Board of Governors 84

4.4 Monetary Policy Functions and Instruments 86

Implementation of Monetary Policy 92

4.5 Fed Supervisory and Regulatory Functions 93

Specific Supervisory Responsibilities 93

Specific Regulatory Responsibilities 94

4.6 Fed Service Functions 95

The Payments Mechanism 95

Transfer of Credit 97

Other Service Activities 97

4.7 Central Banks in Other Countries 98

Applying Finance To 98

Domestic and International Implications 105

5.2 Four Policy Maker Groups 105

Ethical Behavior in Government 106

Policy Makers in the European Economic Union 106

5.3 Government Influence on the Economy 107

Government Reaction to the Perfect Financial Storm 108

Applying Finance To 186

8.1 Supply and Demand for Loanable Funds 191

Historical Changes in U.S Interest Rate Levels 193

Loanable Funds Theory 194

8.2 Components of Market Interest Rates 197

8.3 Default Risk-Free Securities: U.S Treasury Debt Instruments 198

Marketable Obligations 198

Dealer System 200

Tax Status of Federal Obligations 200

Ownership of Public Debt Securities 200

Maturity Distribution of Marketable Debt Securities 202

8.4 Term or Maturity Structure of Interest Rates 203

Relationship Between Yield Curves and the Economy 205

Term Structure Theories 205

8.5 Inflation Premiums and Price Movements 207

Historical International Price Movements 207

Inflation in the United States 208

Types of Inflation 210

8.6 Default Risk Premiums 212

Applying Finance To 214

9 Time Value of Money 218

9.1 Basic Time Value Concepts 219

9.2 Compounding to Determine Future Values 221

Inflation or Purchasing Power Implications 225

9.3 Discounting to Determine Present Values 225

Equating Present Values and Future Values 228

9.4 Finding Interest Rates and Time Requirements 230

Solving for Interest Rates 230

Solving for Time Periods 231

Rule of 72 231

9.5 Future Value of an Annuity 232

9.6 Present Value of an Annuity 235

9.7 Interest Rates and Time Requirements for Annuities 237

Solving for Interest Rates 237

Solving for Time Periods 238

Applying Finance To 154

6.8 Exchange Rate Risks in Global Business 158

Hedging Cash Flows 159

Speculating or Taking Educated Guesses on Exchange

Saving and Investment 169

7.2 Federal Government Receipts and

Life Stages of the Individual Saver 179

Life Stages of the Corporation and Other Business

Credit Ratings and Scores 184

Major Participants in the Secondary Mortgage

Risk in Stock Valuation 287

Valuation and the Financial Environment 287

Global Economic Influences 287

Domestic Economic Influences 288

Industry and Competition 288

Applying Finance To 289

Summary 289

Key Terms 290

Review Questions 290

Problems 291

10.9 Holding Period Returns 295

Annualized Rates of Return 295

Summary 297

Problems 297

11 Securities and Markets 298

11.1 Issuing Securities: Primary Securities Markets 299

Primary Market Functions of Investment Bankers 299

11.2 The Facebook IPO 303

11.3 Other Ways to Assist Issuing Firms 306

Shelf Registration 306

Sell Securities to a Private Party 306

Rights Off erings 306

Competitive Bidding 307

11.4 Cost of Going Public 308

11.5 Investment Banking Firms: Other Functions, Innovations, Regulations 312

Investment Banking Regulation 312

Innovations among Investment Banking Firms 313

11.6 Trading Securities—Secondary Securities Markets 314

Organized Security Exchanges 314

Structure of The New York Stock Exchange 315

Third and Fourth Security Markets 321

High Frequency Trading 321

11.9 What Makes a Good Market? 322

11.11 Inside Information and Other Ethical Issues 327

Ethics and Job Opportunities in Investments 328

9.8 Determining Periodic Annuity Payments 239

Examples Involving Annual Payments 239

Real Estate Mortgage Loans with Monthly Payments 240

9.9 More Frequent Time Intervals and The Cost of

Consumer Credit 241

More Frequent Than Annual Compounding or

Discounting 241

Cost of Consumer Credit 242

Applying Finance To 244

9.10 Annuity Due Problems 248

Future Value of an Annuity Due 248

Present Value of an Annuity Due 249

Interest Rates and Time Requirements for Annuity

Due Problems 250

Summary 251

Questions and Problems 251

10 Bonds and Stocks: Characteristics

Global Bond Market 259

Reading Bond Quotes 260

10.3 Diff erent Types of Bonds 262

Time to Maturity 263

Income From Bonds 264

10.4 Corporate Equity Capital 266

Common Stock 266

Preferred Stock 268

Reading Stock Quotes 269

10.5 Dividends and Stock Repurchases 270

How Do Firms Decide on the Dollar Amount of

Determining a Bond’s Present Value 277

Calculating the Yield to Maturity 279

Risk in Bond Valuation 281

Interest Rate Risk 282

10.8 Valuation of Stocks 284

Valuing Stocks with Constant Dividends 285

Valuing Stocks with Constant Dividend Growth Rates 285

13.2 Forms of Business Organization in the United States 384

13.6 Statement of Cash Flows 396

13.7 Financial Statements of Diff erent Companies 399

Common-Size Financial Statements 399

The Auto Bailout and Financial Statements 400

13.8 Goal of a Firm 402

Measuring Shareholder Wealth 402

Linking Strategy and Financial Plans 404

Criterion for Nonpublic Firms 404

What About Ethics? 404

13.9 Corporate Governance 405

Principal-Agent Problem 406

Reducing Agency Problems 407

13.10 Finance in the Organization Chart 409

Applying Finance To 411

Review Questions and Problems 421

14 Financial Analysis and Long-Term Financial Planning 422

14.1 Financial Statement Analysis 423

Ratio Analysis of Balance Sheet and Income Statement 424

Types of Financial Ratios 425

14.2 Liquidity Ratios and Analysis 427

14.3 Asset Management Ratios and Analysis 429

14.4 Financial Leverage Ratios and Analysis 432

14.5 Profitability Ratios and Analysis 435

14.6 Market Value Ratios and Analysis 437

Summary of Ratio Analysis for Walgreens 439

14.7 DuPont Method of Ratio Analysis 440

14.8 Long-Term Financial Planning 442

Percentage of Sales Technique 442

Asset Investment Requirements 443

Applying Finance To 330

12.1 Historical Return for a Single Financial Asset 343

Arithmetic Average Annual Rates of Return 344

12.2 Historical Risk Measures for a Single Financial

Asset 345

Standard Deviation as a Measure of Risk 346

12.3 Where Does Risk Come From? 348

12.4 Expected Measures of Return and Risk 350

12.5 Historical Returns and Risk of Diff erent Assets 354

12.6 Eff icient Capital Markets 355

12.7 Portfolio Returns 358

Expected Return on a Portfolio 359

12.8 Variance and Standard Deviation of Return on a

Portfolio 359

To Diversify or Not to Diversify? 361

12.9 Portfolio Risk and the Number of Investments

in the Portfolio 362

Systematic and Unsystematic Risk 363

12.10 Capital Asset Pricing Model 364

Applying Finance To 368

Summary 368

Key Terms 369

Review Questions 369

Problems 370

12.11A Estimating Beta 373

12.11B Security Market Line 375

Summary 376

Problems 376

Part 3 Financial Management 379

13 Business Organization and

Financial Data 381

13.1 Starting a Business 382

Strategic Plan with a Vision or Mission 383

Business and Financial Goals 383

14.9 Cost-Volume-Profit Analysis 445

14.10 Degree of Operating Leverage 446

Applying Finance To 448

Summary 449

Key Terms 450

Review Questions 450

Problems 450

15 Managing Working Capital 454

15.1 Importance of Working Capital 455

15.2 Operating and Cash Conversion Cycles 457

Operating Cycle 457

Cash Conversion Cycle 457

Determining the Length of the Operating Cycle and

Cash Conversion Cycle 458

15.3 Investments in Receivables, Inventory,

and Payable Financing 460

15.4 Cash Budgets 463

Minimum Desired Cash Balance 463

Estimated Cash Inflows 464

Estimated Cash Outflows 465

Constructing the Cash Budget 465

Seasonal Versus Level Production 466

15.5 Management of Current Assets 468

Cash Management 468

Marketable Securities 470

15.6 Getting—and Keeping—the Cash 476

15.7 Accounts Receivable Management 479

16 Short-Term Business Financing 490

16.1 Strategies for Financing Working Capital 491

Other Influences in Short-Term Financing 498

16.3 Providers of Short-Term Financing 499

Bank Lines of Credit 499

Computing Interest Rates 501

Revolving Credit Agreements 501

Small Business Administration 502

16.4 Nonbank Short-Term Financing Sources 504

Trade Credit from Suppliers 504

Commercial Finance Companies 505

Loans Secured by Stocks and Bonds 514

Other Forms of Security for Loans 514

16.7 The Cost of Short-Term Financing 515

Applying Finance To 515

Summary 516

Key Terms 516

Review Questions 517

Problems 517

17 Capital Budgeting Analysis 520

17.1 Mission, Vision, and Capital Budgeting 521

Identifying Potential Capital Budget Projects 522

17.2 Capital Budgeting Process 524

17.3 Capital Budgeting Techniques—Net Present Value 527

Using Spreadsheet Functions 530

17.4 Capital Budgeting Techniques—Internal Rate

Diff erent Cash Flow Patterns 538

Diff erent Time Horizons 538

Diff erent Sizes 539

Diff erence Between Theory and Practice 539

17.9 Estimating Project Cash Flows 540

Isolating Project Cash Flows 540

Approaches to Estimating Project Cash Flows 542

17.10 Keeping Managers Honest 546

17.11 Risk-Related Considerations 547

What Do Businesses Use as Their Cost of Capital? 576

Diff iculty of Making Capital Structure Decisions 578

18.5 Planning Growth Rates 579

Internal Growth Rate 579

Sustainable Growth Rate 580

Eff ects of Unexpectedly Higher (or Lower) Growth 581

18.6 EBIT/Eps Analysis 582

Indiff erence Level 582

Implications of EBIT/Eps Analysis 583

18.7 Combined Operating and Financial Leverage Eff ects 584

Unit Volume Variability 585

Price-Variable Cost Margin 585

Fixed Costs 585

Degree of Financial Leverage 586

Total Risk 586

18.8 Insights From Theory and Practice 588

Taxes and Nondebt Tax Shields 588

Bankruptcy Costs 588

Agency Costs 590

A Firm’s Assets and Its Financing Policy 590

The Pecking Order Hypothesis 591

Market Timing 591

Beyond Debt and Equity 592

Guidelines for Financing Strategy 592

Applying Finance To 594

Cash Flows During the Project’s Operating Life 555

Salvage Value and NWC Recovery at Project

Termination 555

17.13 Applications 556

Cash Flow Estimation for a Revenue Expanding

Project 556

Cash Flow Estimation for a Cost-Saving Project 558

Setting a Bid Price 561

18.1 Why Choose a Capital Structure? 566

Trends in Corporate Use of Debt 567

Cashing in on Low Interest Rates 568

18.2 Required Rate of Return and The Cost of

Capital 569

18.3 Cost of Capital 571

Cost of Debt 571

Cost of Preferred Stock 572

Cost of Common Equity 572

Cost of New Common Stock 573

18.4 Weighted Average Cost of Capital 574

Capital Structure Weights 574

Measuring The Target Weights 574

INSTITUTIONS AND MARKETS

Introduction

Ask someone what he or she thinks “fi nance” is about You’ll probably get a variety of

responses: “It deals with money.” “It is what my bank does.” “The New York Stock Exchange

has something to do with it.” “It’s how businesses and people get the money they need—you

know, borrowing and stuff like that.” And they’ll all be correct!

Finance is a broad fi eld It involves national and international systems of banking and the

fi nancing of business It also deals with the process you go through to get a car loan and what

a business does when planning for its future needs

It is important to understand that while the U.S fi nancial system is quite complex, it

gen-erally operates very effi ciently However, on occasion, imbalances can result in economic, real

estate, and stock market “bubbles” that, when they burst, cause havoc on the workings of the

fi nancial system The decade of the 2000s began with the bursting of the “tech” or technology

bubble and the “dot.com” bubble Then, in mid-2006, the real estate bubble, in the form of

excessive housing prices, burst This was followed by peaking stock prices in 2007 that were,

in turn, followed by a steep decline that continued into early 2009 Economic activity began

slowing in 2007 and deteriorated into an economic recession beginning in mid-2008, which was

accompanied by double-digit unemployment rates The result was the 2007–09 “perfect fi

nan-cial storm” that produced the most distress on the U.S fi nannan-cial system since the Great

Depres-sion years of the 1930s Of course, new economic and fi nancial concerns will continue to occur

Within the general fi eld of fi nance, there are three areas of study—fi nancial institutions

and markets, investments, and fi nancial management Financial institutions collect funds from

savers and lend them to, or invest them in, businesses or people that need cash Examples

of fi nancial institutions are commercial banks, investment banks, insurance companies, and

mutual funds Financial institutions operate as part of the fi nancial system The fi nancial

sys-tem is the environment of fi nance It includes the laws and regulations that aff ect fi nancial

transactions The fi nancial system encompasses the Federal Reserve System, which controls

the supply of money in the U.S economy It also consists of the mechanisms that have been

constructed to facilitate the fl ow of money and fi nancial securities among countries Financial

markets represent ways for bringing those who have money to invest together with those who

need funds Financial markets, which include markets for mortgages, securities, and

curren-cies, are necessary for a fi nancial system to operate effi ciently Part 1 of this book examines the

fi nancial system, and the role of fi nancial institutions and fi nancial markets in it

Securities markets play an important role in helping businesses and governments raise

new funds Securities markets also facilitate the transfer of securities between investors A

securities market can be a central location for the trading of fi nancial claims, such as the New

York Stock Exchange It may also take the form of a communications network, as with the

over-the-counter market, which is another means by which stocks and bonds can be traded

When people invest funds, lend or borrow money, or buy or sell shares of a company’s stock, they are participating in the fi nancial markets Part 2 of this book examines the role of secur-ities markets and the process of investing in bonds and stocks.

The third area of the fi eld of fi nance is fi nancial management Financial management studies how a business should manage its assets, liabilities, and equity to produce a good or service Whether or not a fi rm off ers a new product or expands production, or how to invest excess cash, are examples of decisions that fi nancial managers are involved with Financial managers are constantly working with fi nancial institutions and watching fi nancial market trends as they make investment and fi nancing decisions Part 3 discusses how fi nancial con-cepts can help managers better manage their fi rms

The three areas of fi nance interact with, and overlap, one another Financial institutions operate in the environment of the fi nancial markets, and work to meet the fi nancial needs of individuals and businesses Financial managers do analyses and make decisions based on information they obtain from the fi nancial markets They also work with fi nancial institutions when they need to raise funds and when they have excess funds to invest Participants invest-ing in the fi nancial markets use information from fi nancial institutions and fi rms to evaluate diff erent investments in securities such as stocks, bonds, and certifi cates of deposit A person working in one fi eld must be knowledgeable about all three Thus, this book is designed to provide you with a survey of all three areas of fi nance

Part 1, Institutions and Markets, presents an overview of the fi nancial system and its important components: policy makers, monetary system, fi nancial institutions, and fi nancial markets Finan-cial institutions operate within the fi nancial system to facilitate the work of the fi nancial markets For example, you can put your savings in a bank and earn interest But your money just doesn’t sit in the bank The bank takes your deposit and the money from other depositors and lends it to Kathy, who needs a short-term loan for her business; to Ian for a college loan; and to Roger and Jayden, who borrow the money to help buy a house Banks bring together savers and those who need money, such as Kathy, Ian, Roger, and Jayden The interest rate the depositors earn and the interest rate that borrowers pay are determined by national and even international economic forces Just what the bank does with depositors’ money and how it reviews loan applications is determined

to some extent by bank regulators and fi nancial market participants, such as the Federal Reserve Board Decisions by the president and Congress relating to fi scal policies and regulatory laws may also directly infl uence fi nancial institutions and markets and alter the fi nancial system

Chapter 1 provides an overview of the fi nancial environment Chapter 2 covers the role and functions of money, money market securities, and the interaction of money supply and economic activity in the monetary system Depository institutions, such as banks and savings and loan associations, as well as other fi nancial institutions involved in the fi nancial inter-mediation process are the topics of Chapter 3 The Federal Reserve System, the U.S central bank that controls the money supply, is discussed in Chapter 4 Chapter 5 places the previous chapters in perspective, discussing the role of the Federal Reserve and the banking system in helping meet national economic goals for the United States, such as economic growth, high levels of employment, and stable prices Part 1 concludes with a discussion of the international monetary system, currency exchange markets and rates, and international trade in Chapter 6

INSTITUTIONSAND MARKETS

FINANCIALMANAGEMENTINVESTMENTS

The Financial Environment

L E A R N I N G O B J E C T I V E S

After studying this chapter, you should be able to do the following:

LO 1.1 Defi ne fi nance and describe the three areas of fi nance

LO 1.2 Explain why fi nance should be studied.

LO 1.3 Describe and discuss the six principles of fi nance.

LO 1.4 Identify the four components of the fi nancial system and describe their roles.

LO 1.5 Describe fi nancial markets characteristics and the four types of fi nancial markets.

LO 1.6 Identify several major career opportunities in fi nance.

LO 1.7 Describe this textbook’s plan of study.

W H E R E W E H A V E B E E N

As we progress through this book, we will start each chapter with a brief review of

previ-ously covered materials This will provide you with a reference base for understanding the

transition from topic to topic After completing the text, you will be at the beginning of what

we hope is a successful business career

W H E R E W E A R E G O I N G

The fi nancial environment within which we live and work is composed of a fi nancial system,

institutions, and markets Part 1 of this text focuses on developing an understanding of the

fi nancial institutions and markets that operate to make the fi nancial system work effi ciently

Chapter 2 describes the U.S monetary system, including how it is intertwined with the

capital formation process and how it has evolved Current types of money are described, and

we discuss why it is important to control the growth of the money supply In following

chapters, we turn our attention to understanding how fi nancial institutions, policy makers,

and international developments infl uence how the fi nancial system functions

H O W T H I S C H A P T E R A P P L I E S TO M E

While it is impossible to predict what life has in store for each of us in terms of health,

fam-ily, and career, everyone can be a productive member of society Nearly all of us will take

part in making social, political, and economic decisions A basic understanding of the fi

nan-cial environment that encompasses economic and fi nannan-cial systems will help you in making

informed economic choices

Let us begin with the following quote by George Santayana, a U.S philosopher and poet:

Those who cannot remember the past are condemned to repeat it.1

While this quotation refers to the need to know something about history so that individuals can avoid repeating bad social, political, and economic decisions, it is equally important to the

fi eld of fi nance It is the responsibility of all individuals to be able to make informed public choices involving the fi nancial environment By understanding the fi nancial environment and studying the fi nancial system, institutions and markets, investments, and fi nancial manage-ment, individuals will be able to make informed economic and fi nancial choices that will lead

to better fi nancial health and success After studying the materials in this book, you will be better informed in making choices that aff ect the economy and the fi nancial system, as well as

be better prepared for a business career—possibly even one in the fi eld of fi nance

Almost every day we hear news reports about economic conditions, unemployment, price changes, interest rates, stock prices, government expenditures and taxes, and monetary policy Many of us are often overwhelmed trying to understand and interpret developments and inter-

actions among these topics We begin this textbook by defi ning fi nance and describing the

fi nancial environment and the three areas of fi nance

Finance is the study of how individuals, institutions, governments, and businesses acquire, spend, and manage money and other fi nancial assets Understanding fi nance is important to all students regardless of the discipline or area of study, because nearly all business and economic decisions have fi nancial implications The decision to spend or consume now (for new clothes

or dinner at a fancy restaurant) rather than save or invest (for spending or consuming more in the future) is an everyday decision that we all face

The fi nancial environment encompasses the fi nancial system, institutions or diaries (we will use these terms interchangeably throughout this text), fi nancial markets, business fi rms, individuals, and global interactions that contribute to an effi ciently operating economy Figure 1.1 depicts the three areas of fi nance—institutions and markets, investments, and fi nancial management—within the fi nancial environment Note that while we identify three distinct fi nance areas, these areas do not operate in isolation but rather interact or inter-sect with each other Our focus in this book is to provide the reader with exposure to all three areas, as well as to show how they are integrated Of course, students pursuing a major or area

interme-of emphasis in fi nance will take multiple courses in one or more interme-of these areas

Financial institutions are organizations or intermediaries that help the fi nancial system operate effi ciently and transfer funds from savers and investors to individuals, businesses, and governments that seek to spend or invest the funds in physical assets (inventories, buildings, and equipment) Financial markets are physical locations or electronic forums that facilit-ate the fl ow of funds among investors, businesses, and governments The investments area involves the sale or marketing of securities, the analysis of securities, and the management of investment risk through portfolio diversifi cation Financial management involves fi nancial planning, asset management, and fund-raising decisions to enhance the value of businesses.Finance has its origins in economics and accounting Economists use a supply-and-demand framework to explain how the prices and quantities of goods and services are determ-ined in a free-market economic system Accountants provide the record-keeping mechanism for showing ownership of the fi nancial instruments used in the fl ow of fi nancial funds between savers and borrowers Accountants also record revenues, expenses, and profi tability of organ-izations that produce and exchange goods and services

fi nance study of how individuals,

institutions, governments, and

businesses acquire, spend, and

manage fi nancial resources

fi nancial environment fi nancial

system, institutions, markets,

businesses, individuals, and global

interactions that help the economy

operate effi ciently

fi nancial institutions

intermediaries that help the

fi nancial system operate effi ciently

and transfer funds from savers

to individuals, businesses, and

governments that seek to spend or

invest the funds

fi nancial markets locations or

electronic forums that facilitate

the fl ow of funds among investors,

businesses, and governments

investments involves the sale or

marketing of securities, the analysis

of securities, and the management

of investment risk through portfolio

diversifi cation

fi nancial management involves

fi nancial planning, asset

management, and fund-raising

decisions to enhance the value of

businesses

1

George Santayana, Reason in Common Sense, The Life of Reason, Vol 1 (Charles Scribner’s Sons, 1905), p 284.

Effi cient methods of production and specialization of labor can exist only if there is an

eff ective means of paying for raw materials and fi nal products Businesses can obtain the

money needed to buy capital goods, such as machinery and equipment, only if a mechanism

has been established for making savings available for investment Similarly, federal and other

governmental units, such as state and local governments and tax districts, can carry out their

wide range of activities only if effi cient means exist for raising money, for making payments,

and for borrowing

Financial institutions, fi nancial markets, and investment and fi nancial management are

crucial elements of the fi nancial environment and well-developed fi nancial systems Financial

institutions are intermediaries, such as banks, insurance companies, and investment companies

that engage in fi nancial activities to aid the fl ow of funds from savers to borrowers or investors

Financial markets provide the mechanism for allocating fi nancial resources or funds from

savers to borrowers Individuals make decisions as investors and fi nancial managers Investors

include savers and lenders as well as equity investors

While we focus on fi nancial managers in this book, we recognize that individuals also

must be continuously involved in managing their personal fi nances Investment management

involves making decisions relating to issuing and investing in stocks and bonds Financial

management in business involves making decisions relating to the effi cient use of fi nancial

resources in the production and sale of goods and services The goal of the fi nancial manager

in a profi t-seeking organization should be to maximize the owners’ wealth This is

accom-plished through eff ective fi nancial planning and analysis, asset management, and the

acquis-ition of fi nancial capital Financial managers in not-for-profi t organizations aim to provide

a desired level of services at acceptable costs and perform the same fi nancial management

functions as their for-profi t counterparts

Two Themes

As we progress through this book, we off er two themes within the fi nancial institutions and

markets, investments, and fi nancial management topic areas In each chapter we provide boxed

materials relating to small business practice and personal fi nancial planning Successful

businesses typically progress through a series of life-cycle stages—from the idea stage to

FIGURE 1.1 Graphic Illustration of the Financial Environment

Three Areas of Finance

Principles of Finance

Institutions and Markets

exiting the business More specifi cally, the successful business typically moves through fi ve stages: development, start-up, survival, rapid growth, and maturity Individuals who choose to become small business owners do so for a number of diff erent reasons Some small business owners focus on salary-replacement opportunities, where they seek income levels comparable

to what they could have earned by working for much larger fi rms Other individuals pursue lifestyle small business opportunities, where they get paid for doing things they like to do Entrepreneurs seek to own and run businesses that stress high growth rates in sales, profi ts, and cash fl ows

Entrepreneurial fi nance is the study of how growth driven, performance focused, early stage fi rms (from development through early rapid growth) raise fi nancial capital and manage their operations and assets Our small business practice boxes focus on operational and fi nan-cial issues faced by early stage fi rms Personal fi nance is the study of how individuals prepare for fi nancial emergencies, protect against premature death and the loss of property, and accu-mulate wealth over time Our personal fi nancial planning boxes focus on planning decisions made by individuals, regarding saving and investing their fi nancial resources

LEARNING ACTIVITY

Go to the Small Business Administration website, http://www.sba.gov, and explore what

is involved in deciding whether to start a new business.

The fi rst 15 years of the twenty-fi rst century have been a diffi cult time in the United States and worldwide Whereas the 1990s decade was a period of economic growth and prosperity, the early part of the twenty-fi rst century has been characterized by economic and fi nancial markets volatility, along with many individuals just “treading water” in trying to maintain the standards of living they had previously achieved

A “price bubble” for technology stocks, including so-called “dot.com” start-ups, burst

in the United States in 2000 An economic downturn followed and was exacerbated by the terrorist attack on September 11, 2001 Economic recovery occurred over several years until the housing price bubble burst in 2006 and housing values declined sharply Securities tied to housing prices also declined sharply, causing concerns that “over-borrowed” fi nancial insti-tutions might fail because they held insuffi cient equity capital resources to cover the decline

in values of the home mortgages and housing-related debt securities they held This led to the 2007–2008 fi nancial crisis A major economic recession (sometimes called the Great Recession) began in early 2008 and continued through mid-2009 and turned out to be the deepest and

entrepreneurial fi nance study of

how growth driven, performance

focused, early stage fi rms raise

fi nancial capital and manage

operations and assets

personal fi nance study of how

individuals prepare for fi nancial

emergencies, protect against

premature death and property

losses, and accumulate wealth

Importance of Small Firms in the U.S Economy

As the U.S economy moved from the industrial age to the

infor-mation age, dramatic changes occurred in the importance of small

businesses While large fi rms with fi ve hundred or more

employ-ees continued to downsize and restructure throughout the 1990s

and into the twenty-fi rst century, small fi rms provided the impetus

for economic growth.

During the mid-1970s through the 1980s period, fi rms with

fewer than fi ve hundred employees provided over one-half of total

employment and nearly two-thirds of the net new jobs in the United

States Small fi rms provided most of the net new jobs during the

1990s And, while the decade of the 2000s involved a housing

price collapse, a major fi nancial crisis, and economic recession,

small fi rms continued to be the primary supplier of new jobs

Why have small fi rms been so successful in creating new jobs? A Small Business Administration white paper suggests two reasons First, small fi rms play a crucial role in technolo- gical change and productivity growth Market economies change rapidly, and small fi rms are able to adjust quickly Second, small

fi rms provide the mechanism and incentive for millions of viduals to pursue the opportunity for economic success.

indi-Others may argue that it is the entrepreneurial spirit and activity that account for the importance of small fi rms in the U.S economy Whatever the reasons, the ongoing growth of small businesses continues to be an important stimulus to the economy

in the early years of the twenty-fi rst century For current tics, visit the Small Business Administration, Offi ce of Advocacy website at http://www.sba.gov/advo.

statis-Small Business Practice

longest recession since the Great Depression of the 1930s While unemployment rates in the

United States exceeded 10 percent in 2009 and remained above the 7 percent level as of the

end of 2012, they were reduced to about 5 percent by late 2015

The health of economies and fi nancial institutions and markets are linked throughout the

world European and other major foreign fi nancial institutions were caught in the 2007–2008

fi nancial crisis and most foreign economies suff ered economic downturns near the end of

the 2000s decade Since then, European and many other economies have been slow to recover

and some remain in recessions at the end of 2015 Even China, which had been growing its

economy at a double-digit rate during the fi rst decade of the 2000s, has been characterized by

slowing economic activity during the past couple of years This has worldwide implications

since many developed and developing (emerging market) economies are tied to demand for

natural resources and other products manufactured by Chinese fi rms Even as China attempts to

move from an exports-based economy to a consumer-based economy, their economic slowdown

has made it diffi cult for many U.S., and other foreign companies to grow their sales in China

We believe the analysis and understanding of past developments in economic activity and

fi nancial markets are useful to governments, businesses, and individuals in planning their futures

By learning from the past, we may be able to avoid, or mediate, similar pitfalls in the future

There are several reasons to study fi nance Knowledge of the basics of fi nance covered

in this text should help you make informed economic decisions, personal and business

invest-ment decisions, and career decisions

1 To make informed economic decisions.

As we will see, the operation of the fi nancial system and the performance of the

econ-omy are infl uenced by policy makers Individuals elect many of these policy makers in the

United States, such as the president and members of Congress Since these elected offi cials

have the power to alter the fi nancial system by creating laws, and since their decisions can

infl uence economic activity, it is important that individuals be informed when making

political and economic choices Do you want a balanced budget, lower taxes, free

interna-tional trade, low infl ation, and full employment? Whatever your fi nancial and economic

goals may be, you need to be an informed participant if you wish to make a diff erence

Every individual should attain a basic understanding of fi nance as it applies to the fi nancial

system Part 1 of this book focuses on understanding the roles of fi nancial institutions and

markets and how the fi nancial system works

2 To make informed personal and business investment decisions.

An understanding of fi nance should help you better understand how the institution,

gov-ernment unit, or business that you work for fi nances its operations At a personal level, the

understanding of investments will enable you to better manage your fi nancial resources and

provide the basis for making sound decisions for accumulating wealth over time Thus, in

addition to understanding fi nance basics relating to the fi nancial system and the economy,

you also need to develop an understanding of the factors that infl uence interest rates and

security prices Part 2 of this book focuses on understanding the characteristics of stocks

and bonds and how they are valued, on securities markets and how to make risk versus

return investment decisions

3 To make informed career decisions based on a basic understanding of business fi nance.

Even if your business interest is in a nonfi nance career or professional activity, you likely will

need to interact with fi nance professionals both within and outside your fi rm or organization

Doing so will require a basic knowledge of the concepts, tools, and applications of fi nancial

management Part 3 of this book focuses on providing you with an understanding of how

fi nance is applied within a fi rm by focusing on decision making by fi nancial managers

Of course, you may be interested in pursuing a career in fi nance or at least want to know what

people who work in fi nance actually do Throughout this text, you will fi nd discussions of career

opportunities in fi nance, as well as a boxed feature entitled Career Opportunities in Finance

DISCUSSION QUESTION 1

Are individuals in the United States “better off ” economically now than they were at the

beginning of the twenty-fi rst century? Why?

1.3 Six Principles of Finance

FINANCE Finance is founded on six important principles The fi rst fi ve relate to the economic behavior of individuals, and the sixth focuses on ethical behavior Knowing about these prin-ciples will help us understand how managers, investors, and others incorporate time and risk into their decisions, as well as why the desire to earn excess returns leads to information-effi cient

fi nancial markets in which prices refl ect available information Unfortunately, sometimes greed associated with the desire to earn excess returns causes individuals to risk losing their reputations by engaging in questionable ethical behavior and even unethical behavior in the form of fraud or other illegal activities The bottom line is, “Reputation matters!” The follow-ing are the six principles that serve as the foundation of fi nance:

• Money has a time value

• Higher returns are expected for taking on more risk

• Diversifi cation of investments can reduce risk

• Financial markets are effi cient in pricing securities

• Manager and stockholder objectives may diff er

is worth more than a dollar received a year from now The time-value-of-money principle helps us to understand the economic behavior of individuals and the economic decisions of the institutions and businesses that they run This fi nance principle pillar is apparent in many

of our day-to-day activities, and knowledge of it will help us better understand the tions of time-varying money decisions We explore the details of the time value of money in Chapter 9, but this fi rst principle of fi nance will be apparent throughout this book

implica-Risk Versus Return

A trade-off exists between risk and expected return in all types of investments—both assets and securities Risk is the uncertainty about the outcome or payoff of an investment in the future For example, you might invest $1,000 in a business venture today After one year, the

fi rm might be bankrupt and you would lose your total investment On the other hand, after one year your investment might be worth $2,400 This variability in possible outcomes is your risk Instead, you might invest your $1,000 in a U.S government security, where after one year the value may be $950 or $1,100 Rational investors would consider the business venture investment to be riskier and would choose this investment only if they feel the expected return

is high enough to justify the greater risk Investors make these trade-off decisions every day Business managers make similar trade-off decisions when they choose between diff er-ent projects in which they could invest Understanding the risk/return trade-off principle also helps us understand how individuals make economic decisions While we specifi cally explore the trade-off between risk and expected return in greater detail in Part 2, this second principle

of fi nance is involved in many fi nancial decisions throughout this text

Diversification of RiskWhile higher returns are expected for taking on more risk, all investment risk is not the

same In fact, some risk can be removed or diversifi ed by investing in several diff erent

assets or securities Let’s return to the example involving a $1,000 investment in a business

venture, where after one year the investment could provide a return of either zero dollars

or $2,400 Now let’s assume that there also is an opportunity to invest $1,000 in a second,

unrelated business venture in which the outcomes would be zero dollars or $2,400 Let’s

further assume that we will put one-half of our $1,000 investment funds in each investment

opportunity such that the individual outcomes for each $500 investment would be zero dollars

or $1,200

While it is possible that both investments could lose everything (i.e., return zero dollars)

or return $1,200 each (a total of $2,400), it is also possible that one investment would go broke

and the other would return $1,200 So, four outcomes are now possible:

Possible

Outcomes

Combined Investment

Possible Returns

Combined Return

If each outcome has an equal, one-fourth (25 percent), chance of occurring, most of us

would prefer this diversifi ed investment While it is true that our combined investment of

$1,000 ($500 in each investment) at the extremes could still return zero dollars or $2,400, it is

also true that we have a 50 percent chance of getting $1,200 back for our $1,000 investment

As a result, most of us would prefer investing in the combined or diversifi ed investment rather

than in either of the two investments separately We will explore the benefi ts of investment

diversifi cation in Part 2 of this text

Financial Markets Are Eff icient

A fourth fi nance-related aspect of economic behavior is that individuals seek to fi nd

under-valued and overunder-valued investment opportunities involving both real and fi nancial assets

It is human nature, economically speaking, to search for investment opportunities that

will provide returns higher than those expected for undertaking a specifi ed level of risk

This attempt by many to earn excess returns, or to “beat the market,” leads to

information-effi cient fi nancial markets However, at the same time it becomes almost impossible to

consistently earn returns higher than those expected in a risk/return trade-off framework

Rather than looking at this third pillar of fi nance as a negative consequence of human

economic behavior, we prefer to couch it positively in that it leads to information-effi cient

fi nancial markets

A fi nancial market is said to be information effi cient if at any point the prices of

securit-ies refl ect all information available to the public When new information becomes available,

prices quickly change to refl ect that information For example, let’s assume that a fi rm’s stock

is currently trading at $20 per share If the market is effi cient, both potential buyers and sellers

of the stock know that $20 per share is a fair price Trades should be at $20, or near to it, if the

demand (potential buyers) and supply (potential sellers) are in reasonable balance Now, let’s

assume that the fi rm announces the production of a new product that is expected to

substan-tially increase sales and profi ts Investors might react by bidding up the price to, say, $25 per

share to refl ect this new information Assuming this new information is assessed properly, the

new fair price becomes $25 per share This informational effi ciency of fi nancial markets exists

because a large number of professionals are continually searching for mispriced securities Of

course, as soon as new information is discovered, it is immediately refl ected in the price of

the associated security Information-effi cient fi nancial markets play an important role in the

marketing and transferring of fi nancial assets between investors by providing liquidity and fair

prices The importance of information-effi cient fi nancial markets is examined throughout this

text and specifi cally in Chapter 12

Management Versus Owner Objectives

A fi fth principle of fi nance relates to the fact that management objectives may diff er from owner objectives Owners, or equity investors, want to maximize the returns on their investments but often hire professional managers to run their fi rms However, managers may seek to emphasize the size of fi rm sales or assets, have company jets or helicopters available for their travel, and receive company-paid country club memberships Owner returns may suff er as a result of man-ager objectives To bring manager objectives in line with owner objectives, it often is necessary

to tie manager compensation to measures of performance benefi cial to owners Managers are often given a portion of the ownership positions in privately held fi rms and are provided stock options and bonuses tied to stock price performance in publicly traded fi rms

The possible confl ict between managers and owners is sometimes called the principal-agent problem We will explore this problem in greater detail and describe how owners provide incent-

ives to managers to manage in the best interests of equity investors, or owners, in Chapter 13

Reputation Matters

ETHICAL The sixth principle of fi nance is, “Reputation matters!” An individual’s reputation refl ects his or her ethical standards or behavior Ethical behavior ishow an individual or organization treats others legally, fairly, and honestly Of course, the ethical behavior of organ-izations refl ects the ethical behaviors of their directors, offi cers, and managers For institutions

or businesses to be successful, they must have the trust and confi dence of their customers, employees, and owners, as well as that of the community and society they operate in All would agree that fi rms have an ethical responsibility to provide safe products and services, to have safe working conditions for employees, and not to pollute or destroy the environment Laws and regulations exist to ensure minimum levels of protection and maintain the diff erence between unethical and ethical behavior Examples of high ethical behavior include when fi rms establish product safety and working-condition standards well above the legal or regulatory standards.Unfortunately, and possibly due in part to the greed for excess returns (such as higher salaries, bonuses, more valuable stock options, personal perquisites, etc.), directors, offi cers, managers, and other individuals sometimes are guilty of unethical behavior for engaging in fraudulent or other illegal activities Reputations are destroyed, criminal activities are prose-cuted, and involved individuals may receive jail sentences The unethical behavior of directors,

offi cers, and managers also may lead to a loss of reputation and even destruction of the tutions and businesses for which they work

insti-Many examples of fraudulent and illegal unethical behavior have been cited in the fi nancial press over the past few decades, and most seem to be tied to greed for personal gain In such cases, confi dential information was used for personal benefi t, illegal payments were made to gain business, accounting fraud was committed, business assets were converted to personal use, and so forth In the early 1980s, a number of savings and loan association managers were found

to have engaged in fraudulent and unethical practices, and some managers were prosecuted and sent to prison while their institutions were dissolved or merged with other institutions

In the late 1980s and early 1990s, fraudulent activities and unethical behavior by ment banking fi rms resulted in several high-profi le fi nancial wheeler-dealers going to prison This led to the collapse of Drexel Burnham Lambert and the near collapse of Salomon Brothers

invest-By the early part of the twenty-fi rst century, such major fi rms as Enron, its auditor Arthur Andersen, and WorldCom ceased to exist because of fraudulent and unethical behavior on the part of their managers and offi cers.In addition, key offi cials of Tyco and Adelphia were charged with illegal actions and fraud

In 2009, Bernie Madoff was convicted and sent to prison for operating a “Ponzi scheme” that resulted in investor losses of billions of dollars Returns in a Ponzi scheme are fi ctitious and not earned Early investors receive their “returns” from the contributions of subsequent investors Ultimately, the scheme collapses when there are no substantial new investors and when existing investors want to sell their investments As of late 2015, executives of the Volk-swagen Corporation were being questioned about the use of computer software that resulted

in government emissions tests that were misleading concerning the amount of pollution that was being emitted by their diesel engine automobiles

ethical behavior how an individual

or organization treats others legally,

fairly, and honestly

While the fi nancial press chooses to highlight examples of unethical behavior, most

indi-viduals exhibit sound ethical behavior in their personal and business dealings and practices

In fact, the sixth principle of fi nance depends on most individuals practicing high-quality

eth-ical behavior and believing that reputation matters To be successful, an organization or

busi-ness must have the trust and confi dence of its various constituencies, including customers,

employees, owners, and the community High-quality ethical behavior involves treating others

fairly and honestly, and goes beyond just meeting legal and regulatory requirements High

repu-tation value refl ects high-quality ethical behavior, so employing high ethical standards is the

right thing to do Many organizations and businesses have developed and follow their own code

of ethics The importance of practicing sound ethical behavior is discussed throughout this text

DISCUSSION QUESTION 2

Would you purchase an automobile from a manufacturer that may have been modifying

the pollution control equipment on its vehicles in order to pass government regulations?

The fi nancial system is a complex mix of fi nancial intermediaries, markets, instruments,

policy makers, and regulations that interact to expedite the fl ow of fi nancial capital from

savings into investment We present a brief overview of the fi nancial system in Chapter 1 and

then follow with more-detailed coverage in the remaining chapters of Part 1

Characteristics and Requirements

Figure 1.2 provides a graphical review of the four major components of the U.S fi nancial

system First, an eff ective fi nancial system must have several sets of policy makers who pass

fi nancial system interaction

of intermediaries, markets, instruments, policy makers, and regulations to aid the fl ow from savings to investments

FIGURE 1.2 Graphical View

of the Major Components of the U.S Financial System

Policy Makers

President, Congress, and U.S Treasury Federal Reserve Board Role: pass laws and set fiscal and monetary policies

Monetary System

Federal Reserve Central Bank Commercial Banking System Role: create and transfer money

Financial Markets

Debt Securities Markets Equity Securities Markets Derivative Securities Markets Foreign Exchange Markets Role: market and facilitate transfer of financial assets

Financial Institutions

Depository Institutions

Contractual Savings Organizations

Securities Firms Finance Firms Role: accumulate and

lend/invest savings

laws and make decisions relating to fi scal and monetary policies These policy makers include the president, Congress, and the U.S Treasury, plus the Federal Reserve Board Since the United States operates within a global economy, political and economic actions of foreign policy makers infl uence, although indirectly, the U.S fi nancial system and its operations Major economic goals are identifi ed and policy-maker actions designed to achieve those goals are discussed in Chapter 5.

Second, an eff ective fi nancial system needs an effi cient monetary system that is composed

of a central bank and a banking system that is able to create and transfer a stable medium of exchange called money In the United States, the dollar is the medium of exchange, the central bank is the Federal Reserve System, and the banking system is commonly referred to as the commercial banking system Characteristics of money and the monetary system are discussed

in Chapter 2, and the Federal Reserve System is covered in Chapter 4

Third, an eff ective fi nancial system also must have fi nancial institutions, or

interme-diaries, that support capital formation either by channeling savings into investment in real assets or by fostering direct fi nancial investments by individuals in fi nancial institutions and businesses

Four types of fi nancial intermediaries are listed in Figure 1.2 Depository institutions, tractual savings organizations, securities fi rms, and fi nance fi rms are discussed in Chapter 3 The process of accumulating and then lending and investing savings is referred to as the savings-investment process We cover the types of fi nancial asset instruments and securities used in the United States throughout the text and discuss how the savings-investment process works

con-in Chapter 7

Fourth, an eff ective fi nancial system must also have fi nancial markets that facilitate

the transfer of fi nancial assets among individuals, institutions, businesses, and governments Figure 1.2 identifi es three types of fi nancial markets—debt securities markets, equity secur-ities markets, and derivative securities markets We briefl y discuss these markets later in this chapter and then provide more-detailed coverage of the various securities markets throughout the text Foreign exchange markets are discussed in Chapter 6

Financial System Components and Financial Functions

As previously noted, the role of policy makers is to pass laws and to set both fi scal and tary policy Here we focus on the monetary system, fi nancial institutions, and fi nancial markets components by expressing their roles as fi nancial functions that are necessary

mone-in an eff ective fi nancial system Figure 1.3 indicates that the role of monetary system is creating and transferring money Financial institutions carry out their role by effi ciently accumulating savings and then lending or investing these savings Financial institutions play

FIGURE 1.3 Three Financial

System Components and the

Financial Functions Used to

Carry Out Their Roles

COMPONENTS

ROLES EXPRESSED AS FINANCIAL FUNCTIONS

Marketing financial assets

Transferring financial assets

an important role in the savings-investment process both through fi nancial intermediation

activities and by facilitating direct investments by individuals Financial markets, along

with certain securities fi rms, are responsible for marketing and transferring fi nancial assets

or claims

Creating Money

Since money is something that is accepted as payment for goods, services, and debts, its value

lies in its purchasing power Money is the most generalized claim to wealth, since it can be

exchanged for almost anything else Most transactions in today’s economy involve money, and

most would not take place if money were not available

One of the most signifi cant functions of the monetary system within the fi nancial system

is creating money, which serves as a medium of exchange In the United States, the Federal

Reserve System is primarily responsible for the amount of money that is created, although

most of the money is actually created by depository institutions A suffi cient amount of money

is essential if economic activity is to take place at an effi cient rate Having too little money

constrains economic growth Having too much money often results in increases in the prices

of goods and services

Transferring Money

Individuals and businesses hold money for purchases or payments they expect to make in the

near future One way to hold money is in checkable deposits at depository institutions When

money is held in this form, payments can be made easily by check The check is an order to

the depository institution to transfer money to the party who received the check This is a

great convenience, since checks can be written for the exact amount of payments, be safely

sent in the mail, and provide a record of payment Institutions can also transfer funds between

accounts electronically, making payments without paper checks Funds transfers can be made

by telephone, at automated teller machines (ATMs) connected to a bank’s computer, and via

the Internet

Accumulating Savings

A function performed by fi nancial institutions is the accumulation or gathering of individual

savings Most individuals, businesses, and organizations do not want to take the risks involved

in having cash on hand Even if cash amounts are relatively small, these are put into a

depos-itory institution for safekeeping When all the deposits are accumulated in one place, they can

be used for loans and investments in amounts much larger than any individual depositor could

supply Depository institutions regularly conduct advertising campaigns and other

promo-tional activities to attract deposits

Lending and Investing Savings

Another basic function of fi nancial institutions is lending and investing The money that has

been put into these intermediaries may be lent to businesses, farmers, consumers, institutions,

and governmental units It may be lent for varying periods and for diff erent purposes, such as

to buy equipment or to pay current bills Some fi nancial institutions make almost all types of

loans Others specialize in only one or two types of lending Still other fi nancial institutions

invest all or part of their accumulated savings in the stock of a business or in debt obligations

of businesses or other institutions

Marketing Financial Assets

New fi nancial instruments and securities are created and sold in the primary securities market

For example, a business may want to sell shares of ownership, called stock, to the general

public It can do so directly, but the process of fi nding individuals interested in investing funds

in the business is likely to be diffi cult, costly, and time consuming One particular fi nancial intermediary—an investment banking fi rm—can handle the sale of shares of ownership The function of the investment banking fi rm is essentially one of merchandising Brokerage fi rms market existing, or “seasoned,” instruments and securities.

Transferring Financial AssetsSeveral types of fi nancial institutions facilitate or assist in the processes of lending and selling securities Brokerage fi rms market and facilitate the transferring of existing, or seasoned, instruments and securities Also, if shares of stock are to be sold to the general public, it is desirable to have a ready market in which such stocks can be resold when the investor desires Organized stock exchanges and the over-the-counter market provide active secondary markets for existing securities The ability to buy and sell securities both quickly and at fair-market values is important in an effi cient fi nancial system

fi rms Government entities can issue or sell debt securities to fi nance the building of roads and bridges or to provide added services to the people Business fi rms can issue debt securities, and corporations can sell equity securities or stocks to raise funds to invest in and grow their businesses Financial markets also facilitate the transfer of previously issued debt and equity securities from existing to new investors

Money and Capital Markets

Money markets are where debt securities with maturities of one year or less are issued and

traded These markets are generally characterized by high liquidity whereby money market

money markets where debt

securities of one year or less are

issued or traded

People Are the Financial System

The main participant in the fi nancial system is not the large

insti-tution or corporation it’s you and others like you

House-holds, families, and individuals provide up to 80 percent of the

savings fl ows in the U.S economy in any year There are three

main sources of savings: personal savings, business savings (that

is, retained earnings), and government surpluses Personal savings

far outweigh the other two sources combined as a source of savings

fl ows in the United States.

Another way to look at this is to consider this question:

where do fi nancial institutions get the funds they invest and loan?

Banks get their funds mainly from individuals’ checking and savings accounts and certifi cates of deposit (CDs) Pension funds obtain their cash from the savings of working people Insurance

fi rms accumulate funds to invest from policyholders’ payments of premiums for their life, health, car, and home insurance Mutual funds obtain investable cash by selling their shares to investors like you who want to accumulate savings and returns on savings

to fund a future goal such as retirement, a new car, a house down payment, or children’s college expenses.

Personal Financial Planning

securities can be easily sold or traded with little loss of value These short-lived securities

gen-erally have low returns and low risk Money market securities will be discussed in Chapter 2

Capital markets are where debt instruments or securities with maturities longer than one

year and corporate stocks or equity securities are issued and traded Capital market securities

are generally issued to fi nance the purchase of homes by individuals, buildings and

equip-ment by businesses, and for provision of infrastructure (roads, bridges, buildings, etc.) by

governments Business fi rms and governments issue long-term debt securities, called bonds,

to fi nance their assets and operations Mortgages are issued to fi nance homes and buildings

Corporations also issue stocks to meet their fi nancing needs We will cover capital market

securities in Part 2

Primary and Secondary Markets

There are primary and secondary markets for debt (bonds and mortgages) and equity

securit-ies The initial off ering, or origination, of debt and equity securities takes place in a primary

market Proceeds from the sale of new securities after issuing costs go to the issuing business

or government issuer The primary market is the only “market” where the security issuer

directly benefi ts (receives funds) from the sale of its securities Mortgage loans provide fi

nan-cing for the purchase of homes and other real property

Secondary markets are physical locations or electronic forums where debt (bonds and

mortgages) and equity securities are traded Secondary markets for securities facilitate the

trans-fer of previously issued securities from existing investors to new investors Security transactions

or transfers typically take place on organized security exchanges or in the electronic

over-the-counter market Individuals and other investors can actively buy and sell existing securities in

the secondary market While these secondary market investors may make gains or losses on their

securities investments, the issuer of the securities does not benefi t (nor does it lose) from these

activities The secondary market for securities is typically divided into short-term (money) and

long-term (capital) market categories We discuss primary and secondary securities markets in

detail in Chapter 11 There also is an active secondary market for real estate mortgages We will

discuss the basics of secondary markets for mortgages in Chapter 7

Major Types of Financial Markets

There are four main types of fi nancial markets—debt securities markets, equity securities

markets, derivative securities markets, and foreign exchange markets Debt securities are

obligations to repay borrowed funds Debt securities markets are markets where money

market securities, bonds (corporate, fi nancial institution, and government), and mortgages are

originated and traded Bond markets are where debt securities with longer-term maturities

are originated and traded Government entities (federal, state, and local), fi nancial institutions,

and business fi rms can issue bonds While bonds and bond markets are discussed throughout

this text, there is a specifi c focus on them in Chapter 10 Mortgage markets are where loans

to purchase real estate (buildings and houses) are originated and traded Mortgage markets are

discussed in Chapter 7

Equity securities, also called common stocks,are ownership shares in corporations

Equity securities markets are markets where ownership shares in corporations are initially

sold and traded Corporations can raise funds either through a private placement, which

involves issuing new common stocks directly to specifi c investors, or through a public off ering,

which involves selling new common stocks to the general public Financial institutions can

also raise equity capital by selling common stocks in their fi rms Equity securities and markets

are discussed in detail in Chapter 11

In addition to money and capital markets, there are also derivative securities markets,

which are markets for fi nancial contracts or instruments that derive their values from

underly-ing debt and equity securities A familiar form of derivative security is the opportunity to buy

or sell a corporation’s equity securities for a specifi ed price and within a certain amount of time

Derivative securities may be used to speculate on the future price direction of the underlying

fi nancial assets or to reduce price risk associated with holding the underlying fi nancial assets

Organized exchanges handle standardized derivative security contracts, while negotiated

capital markets where debt securities with maturities longer than one year and corporate stocks are issued or traded

primary market where the initial

off ering or origination of debt and equity securities takes place

secondary markets where the transfer of existing debt (bonds and mortgages) and equity securities between investors occurs

debt securities obligations to repay borrowed funds

debt securities markets where money market securities, bonds, and mortgages are originated and traded

bond markets where debt securities with longer-term maturities are originated and traded

mortgage markets where loans to purchase real estate are originated and traded

equity securities ownership shares, called common stocks, in corporations

equity securities markets where corporate ownership shares are initially sold and traded

derivative securities markets

where fi nancial contracts that derive their values from underlying debt and equity securities are originated and traded

contracts are handled in electronic markets often involving commercial banks or other fi nancial institutions We discuss derivative securities in the Learning Extension to Chapter 11.

Foreign exchange markets (also called FOREX markets) are electronic markets in which banks and institutional traders buy and sell various currencies on behalf of businesses and other clients In the global economy, consumers may want to purchase goods produced or services provided in other countries Likewise, an investor residing in one country may wish

to hold securities issued in another country For example, a U.S consumer may wish to chase a product in a foreign country If the product is priced in the foreign country’s currency,

pur-it may be necessary to exchange U.S dollars for the foreign currency in order to complete the transaction Businesses that sell their products in foreign countries usually receive payment in the foreign currencies However, because the relative values of currencies may change, fi rms often use the currency exchange markets to reduce the risk of holding too much of certain currencies We discuss currency exchange rates and foreign exchange markets in Chapter 6

Career opportunities in fi nance are available in business fi nancial management, depository

fi nancial institutions, contractual savings and real property organizations, and securities kets and investment fi rms While you may aspire to own your own business or to be a chief executive offi cer (CEO) or chief fi nancial offi cer (CFO) in a major corporation, most of us must begin our careers in an entry-level position Following are some of the ways to get started

mar-in a fi nance career

1. Business fi nancial management

Larger businesses or corporations divide their fi nance activities into treasury and control functions, whereas smaller fi rms often combine these functions The treasurer is respons-ible for managing the fi rm’s cash, acquiring and managing the fi rm’s assets, and selling stocks and bonds to raise the fi nancial capital necessary to conduct business The controller

is responsible for cost accounting, fi nancial accounting, and tax record-keeping activities Entry-level career opportunities include the following:

• Cash management analyst: involves monitoring and managing the fi rm’s day-to-day

cash infl ows and outfl ows

• Capital expenditures analyst: involves estimating cash fl ows and evaluating asset

invest-ment opportunities

• Credit analyst: involves evaluating credit applications and collecting amounts owed by

credit customers

• Financial analyst: involves evaluating fi nancial performance and preparing fi nancial plans

• Cost analyst: involves comparing actual operations against budgeted operations

• Tax analyst: involves preparing fi nancial statements for tax purposes

2 Depository fi nancial institutions

Banks and other depository institutions off er the opportunity to start a fi nance career in consumer or commercial lending Banks also hold and manage trust funds for individuals and other organizations Entry-level career opportunities include the following:

• Loan analyst: involves evaluating consumer and/or commercial loan applications

• Bank teller: involves assisting customers with their day-to-day checking and banking

transactions

• Investments research analyst: involves conducting research on investment opportunities

for a bank trust department

3 Contractual savings and real property organizations

Insurance companies, pension funds, and real estate fi rms also provide opportunities for starting a career in fi nance These institutions need a variety of employees willing to blend marketing or selling eff orts with fi nancial expertise Entry-level career opportunities include the following:

foreign exchange markets

electronic markets in which banks

and institutional traders buy and

sell various currencies on behalf of

businesses and other clients

• Insurance agent (broker): involves selling insurance to individuals and businesses and

participating in the processing of claims

• Research analyst: involves analyzing the investment potential of real property and

secur-ities for pension fund holdings

• Real estate agent (broker): involves marketing and selling or leasing residential or

com-mercial property

• Mortgage analyst: involves analyzing real estate loan applications and assisting in the

arranging of mortgage fi nancing

4 Securities markets and investment fi rms

Securities fi rms and various investment-related businesses provide opportunities to start a

fi nance career in the investments area Opportunities include buying and selling seasoned

securities, analyzing securities for investment potential, marketing new securities issues,

and even helping individuals plan and manage their personal fi nancial resources

Entry-level career opportunities include the following:

• Stockbroker (account executive): involves assisting clients in purchasing stocks and

bonds and building investment wealth

• Security analyst: involves analyzing and making recommendations on the investment

potential of specifi c securities

• Investment banking analyst: involves conducting fi nancial analysis and valuation of new

securities being issued

• Financial planner assistant: involves analyzing individual client insurance needs and

investment plans to meet retirement goals

While we have focused on entry-level careers in profi t-motivated businesses and fi nancial

organizations, careers in fi nance are also available in government or not-for-profi t

organiza-tions Finance opportunities at the federal or state government levels include managing cash

funds, making asset expenditure decisions, and issuing debt securities to raise funds Hospitals

and other not-for-profi t organizations also need expert fi nancial managers to manage assets,

control costs, and obtain funds Financial and other analysts are hired both by government

units and not-for-profi t organizations to perform these tasks

All of these entry-level fi nance job opportunities also can be found in the international

setting For example, many businesses engaged in producing and marketing products and

ser-vices in foreign markets often off er employees opportunities for international job assignments

Large U.S banks also off er international job experiences through their foreign banking

opera-tions Furthermore, since worldwide securities markets exist, securities analysts and fi nancial

planners often must analyze and visit foreign-based fi rms

Several detailed Career Opportunities in Finance boxes are presented in selected chapters

We hope these materials provide you with a better understanding of some of the many career

opportunities that exist in the fi nance fi eld We are also sure that new fi nance job opportunities

You Are Likely to Have More than One

Business Career

Students are advised today to prepare for several business careers

during their working lifetimes Corporate America continues to

restructure and reinvent itself At the same time, new industries

associated with the information age are developing, and old

indus-tries are dropping by the wayside These developments make it

even more likely that each of you will have the opportunity for

multiple business careers.

Graduates of Harvard University are periodically surveyed

concerning their work experiences and careers Responses to one

survey of individuals 25 years after graduation found that over one-half had worked for four or more employers while one-fourth had been fi red (or, in kinder terms, “involuntarily terminated”) Over half of the men and women respondents had had at least two substantially diff erent careers, and in many instances signifi cant retraining was required.

Remember as you read this book that even if you don’t currently plan on a career in fi nance, learning about fi nance might become very important to you later in your working life- time And, no matter where your business career takes you, you will always need to know and understand your personal

fi nances.

Career Opportunities in Finance

will occur in the future as the fi eld continues to develop and change It is now time to begin learning about fi nance!

LEARNING ACTIVITY

1 Go to The Wall Street Journal website section at http://www.careerjournal.com, and

fi nd information related to job hunting.

2 The Monster.com website, http://www.monster.com, provides information on current

fi nance “Search for “fi nance” jobs and list some of the available entry-level fi nance positions,” and list some of the entry-level fi nance positions available.

The subject matter of this book includes the entire scope of the fi nancial environment from the perspective of the fi nancial system and the three areas of fi nance—institutions and markets, investments, and fi nancial management You will learn about the markets

in which funds are traded and the institutions that participate in and assist these fl ows of funds You will learn about the investments area of fi nance, including the characteristics

of debt and equity securities that are issued, the markets where securities are traded, and investment risk/return concepts You will study the fi nancial management principles and concepts that guide fi nancial managers to make sound fi nancial planning, asset acquis-ition, and fi nancing decisions International fi nance applications also are integrated throughout the text

Part 1 focuses on the fi nancial institutions, markets, and other participants that make the U.S fi nancial system operate eff ectively both domestically and within the global economy Chapter 2 introduces the role of money within the overall fi nancial system and its monetary system component Chapter 3 focuses on the fi nancial intermediation roles of depository and other fi nancial institutions, as well as how they operate within the fi nancial system Chapter 4 discusses the Federal Reserve System Chapter 5 discusses economic objectives, the role and actions of policy makers, and how money and credit are provided to meet the needs of the economy We conclude Part 1 with a chapter on international fi nance and trade because of its importance in understanding market economies worldwide

Part 2 is concerned with the investments area of fi nance Chapter 7 discusses the savings and investment process and its major role in the U.S market economy This is followed by Chapter 8, which describes the structure of interest rates Time-value-of-money concepts are covered in Chapter 9, and the characteristics and valuations of bonds and stocks are presented

in Chapter 10 Chapter 11 discusses the characteristics and workings of the securities market Part 2 concludes with Chapter 12, which describes fi nancial return and risk concepts for a single asset or security, and for portfolios of securities

Part 3 focuses on the fi nancial management of businesses We begin Chapter 13 with an introduction and overview of the types of business organizations, and follow with a review of basic fi nancial statements and fi nancial data important to the fi nancial manager Chapter 14 discusses the need for, and the way in which to conduct, fi nancial analysis of past perform-ance and concludes with a section on fi nancial planning for the future Chapter 15 covers the management of working capital, while Chapter 16 focuses on sources of short-term business

fi nancing We then turn our attention in Chapter 17 to the process and methods for conducting capital budgeting analysis We conclude Part 3 with Chapter 18, which provides a discussion

of capital structure and cost of capital concepts

Of course, as we illustrated in Figure 1.1, the three areas of fi nance are not ent but, rather, are continually interacting or overlapping For example, fi nancial institutions provide an important fi nancial intermediation role by getting individual savings into the hands

independ-of businesses so that fi nancial managers can effi ciently use and invest those funds Financial managers also rely heavily on the investments area of fi nance when carrying out their fi nan-cial management activities Corporations often need to raise funds in the primary securities markets, and secondary securities markets, in turn, provide investors with the liquidity of being able to buy and sell previously issued securities Our approach in this book is to provide survey exposure to all three areas of fi nance

Applying Finance To

• Institutions and Markets Financial institutions and fi nancial

markets are necessary components of an effi cient fi nancial system

Institutions perform an important fi nancial intermediation role by

gathering the savings of individuals and then lending the pooled

savings to businesses that want to make investments.

• Investments Securities markets are also important components

of an effi cient fi nancial system The primary securities market

facil-itates raising funds by issuing new debt and equity securities The

secondary market for securities facilitates the transfer of ownership

of existing securities among investors

• Financial Management Business fi rms continually interact with

fi nancial institutions as they carry out their day-to-day operations nesses also often seek to raise additional funds to fi nance investment in inventories, equipment, and buildings needed to support growth in sales Bank loans and mortgage loans are important fi nancing sources, along with the proceeds from the issuance of new debt and equity securities.

Busi-Summary

LO 1.1 Finance is the study of how businesses and others acquire,

spend, and manage money and other fi nancial resources More

spe-cifi cally, fi nance is composed of three areas—fi nancial institutions

and markets, investments, and fi nancial management However, these

three areas are not independent of one another but rather intersect or

overlap This book’s survey approach to the study of fi nance covers

all three areas

LO 1.2 You should study fi nance so that you can make informed

economic, personal and business investment, and career decisions.

LO 1.3 There are six principles of fi nance: (1) money has a time value,

(2) higher returns are expected for taking on more risk, (3) diversifi

ca-tion of investments can reduce risk, (4) fi nancial markets are effi cient

in pricing securities, (5) manager and stockholder objectives may

diff er, and (6) reputation matters

LO 1.4 An eff ective fi nancial system has four major components—

policy makers, a monetary system, fi nancial institutions, and fi

nan-cial markets—to facilitate the fl ow of fi nannan-cial capital from savings

into investments Policy makers pass laws and set fi scal and monetary policies designed to manage the economy A monetary system cre- ates and transfers money Financial institutions accumulate and lend/ invest individual savings Financial markets are needed to market and transfer securities and other fi nancial assets

LO 1.5 Financial markets can be classifi ed as either money or capital

markets, or as primary or secondary markets There are four major types of fi nancial markets—debt securities markets, equity securities markets, derivative securities markets, and foreign exchange markets.

LO 1.6 Career opportunities in fi nance are available in fi nancial

man-agement, depository fi nancial institutions, contractual savings and real property organizations, and securities markets and investment fi rms.

LO 1.7 The plan of study in this book consists of three parts Part 1

focuses on the fi nancial institutions, markets, and other participants that make the U.S fi nancial system operate eff ectively Part 2 covers the investments area of fi nance Part 3 focuses on the fi nancial manage- ment of businesses

Key Terms

bond markets

capital markets

debt securities

debt securities markets

derivative securities markets

entrepreneurial fi nance

equity securities equity securities markets ethical behavior

money markets

mortgage markets personal fi nance primary market secondary market

Review Questions

1 (LO 1.1) What is fi nance?

2 (LO 1.1) What is meant by the term fi nancial environment?

3 (LO 1.1) What are the three areas of fi nance?

4 (LO 1.1) Briefl y describe the terms entrepreneurial fi nance and

personal fi nance.

5 (LO 1.2) Briefl y describe how the fi nancial environment has

changed during the past few years.

6 (LO 1.2) Identify and briefl y describe several reasons for

study-ing fi nance.

7 (LO 1.3) What are the six principles of fi nance?

d 2007–08 (4) technology stock bubble

e 2008–09 (5) housing price bubble

2 The U.S fi nancial system is composed of (1) policy makers, (2) a

monetary system, (3) fi nancial institutions, and (4) fi nancial markets

Indicate which of these components is associated with each of the

following roles.

a Accumulate and lend or invest savings

b Create and transfer money

c Pass laws and set fi scal and monetary policies

d Market and facilitate transfer of fi nancial assets

3 Financial markets may be categorized as (1) debt securities

mar-kets, (2) equity securities marmar-kets, (3) derivative securities marmar-kets,

and (4) foreign exchange markets Indicate in which of these markets

the following securities trade.

a Mortgages

b Bonds

c Common stocks

d Currencies

4 In business, ethical dilemmas or situations occur frequently Laws

and regulations exist to defi ne what unethical behavior is However,

the practicing of high-quality ethical behavior often goes beyond just

meeting laws and regulations Indicate how you would respond to the

following situations.

a Your boss has just told you that tomorrow the Federal Drug Administration will announce its approval of your fi rm’s market- ing of a new breakthrough drug As a result of this information, you are considering purchasing shares of stock in your fi rm this afternoon What would you do?

b In the past, your fi rm has been in compliance with regulatory standards relating to product safety However, you have heard through the company grapevine that recently some of your fi rm’s products have failed, resulting in injuries to customers You are considering quitting your job due to personal moral concerns What would you do?

5 Obtain several recent issues of The Wall Street Journal or

Bloomberg Businessweek Identify, read, and be prepared to discuss

at least one article relating to one of the six principles of fi nance

6 Obtain several recent issues of The Wall Street Journal or

Bloomberg Businessweek Identify, read, and be prepared to discuss

at least one article relating to one of the four types of fi nancial kets identifi ed in Chapter 1.

mar-7 Obtain several recent issues of The Wall Street Journal or

Bloomberg Businessweek Identify, read, and be prepared to discuss

at least one article relating specifi cally to recent changes in the fi cial environment.

nan-8 Go to the U.S Small Business Administration (SBA) website, http://www.sba.gov, and search for sources of information on starting a

new business Identify and prepare a written summary of the start-up

basics described on the SBA site.

8 (LO 1.3) Describe what is meant by ethical behavior.

9 (LO 1.4) What are the four major components of an eff ective

fi nancial system?

10 (LO 1.4) Identify and briefl y describe the fi nancial functions in

the fi nancial system.

11 (LO 1.5) Briefl y describe the diff erences between money and

capital markets.

12 (LO 1.5) What are the diff erences between primary and secondary

markets?

13 (LO 1.5) How do debt securities and equity securities diff er?

14 (LO 1.5) Identify the four types of major fi nancial markets.

15 (LO 1.6) Indicate some of the career opportunities in fi nance

available to business graduates today.

After studying this chapter, you should be able to do the following:

LO 2.1 Discuss the developments that led to the 2007–2008 fi nancial crisis.

LO 2.2 Describe three ways in which money is transferred from savers to businesses.

LO 2.3 Identify the major components of the monetary system.

LO 2.4 Describe the functions of money.

LO 2.5 Discuss how money developed in the United States.

LO 2.6 Describe major types of money market securities.

LO 2.7 Explain the M1 and M2 defi nitions of the money supply.

LO 2.8 Explain possible relationships between money supply and economic activity.

LO 2.9 Describe developments in the international monetary system.

W H E R E W E H A V E B E E N

In Chapter 1, we provided a general overview of the fi nancial environment including the three

areas of fi nance: institutions and markets, investments, and fi nancial management We also hope

that we provided you with a convincing argument as to why you should study fi nance, and an

understanding of the career opportunities that are available in fi nance Six principles of fi nance

were described You should also know what is required for a fi nancial system to be eff ective and

know the types of fi nancial markets that are available to aid the transferring of fi nancial assets

W H E R E W E A R E G O I N G

As we progress through Part 1, we build on our understanding of the U.S fi nancial system

Chapter 3 focuses on understanding the importance of depository and other institutions in

the fi nancial system We discuss how your savings are pooled with the savings of other

individuals in fi nancial institutions and then are made available to businesses, governments,

and other individuals who may want to invest in inventories, invest in highways, or purchase

homes The remaining chapters in Part 1 focus on the Federal Reserve System, the role of

policy makers, and how international developments infl uence the fi nancial system

H O W T H I S C H A P T E R A P P L I E S TO M E

Each of us needs money While you may feel you need more or less money than your friend, money is necessary for each of us to conduct day-to-day activities You may have to buy gas for your car or pay for public transportation to school or work You may need money for lunch or supplies You may even want to borrow money to purchase a house someday After reading this chapter you should have a clearer understanding of the functions and types of money available to you

John Kenneth Galbraith, a U.S economist, said the following about money:

Money is a singular thing It ranks with love as man’s greatest source of joy And with death as his greatest source of anxiety Over all history it has oppressed nearly all people in one of two ways: either it has been abundant and very unreliable, or reliable and very scarce.1

Why should any “one thing” be so important? Money is what makes the fi nancial system work Money is a measure of wealth Money can be used to purchase goods and services Money is acceptable to repay debts Creating and transferring money are integral parts of the capital formation process However, too much money in an economy is associated with unsus-tainable economic growth and rapidly rising prices On the other hand, too little money in an economy is associated with poor economic performance and sometimes recession Of course, the relationships between money supply and economic activity and money supply and rising prices also are impacted by a number of other factors as we will see later in this chapter, as well as in other chapters

CRISIS A number of negative economic and fi nancial trends and events all came together to contribute to the fi nancial crisis of 2007–2008 and the Great Recession of 2008–2009 A rapid decline in housing prices began in 2006 This led to increased unemployment, fi rst in housing-related activities and then more broadly As a result, many homeowners were forced to default

on their home mortgage loans These developments occurred at a time when individuals,

fi nancial institutions, and business fi rms were heavily in debt The result was a so-called fect fi nancial storm” accompanied by a fear that the fi nancial system might collapse

“per-While there continues to be some disagreement as to specifi c causes of the fi nancial crisis, most economists and others trace the beginning of the crisis to the bursting of the U.S housing bubble in mid-2006 For a period of time prior to mid-2006, housing prices were continually rising year over year with some areas of the United States experiencing annual double-digit housing price increases The fi rst part of the twenty-fi rst century was a time when U.S federal government policies encouraged home ownership Lenders were willing to lend to fi nancially “risky” borrowers seeking mortgage loans to make home purchases, and individual borrowers were willing to take on excessive amounts of mortgage debt, all in the belief that housing prices would continue to rise Once housing prices began to decline, many homeowners had the equity in their homes “wiped out” and many mortgage loans became

“underwater,” which occurs when mortgage debt on the home exceeds the value of the home This rapid decline in housing values was accompanied by a major loss of jobs in home con-struction and related industries

Many home mortgage loans were combined into “pools” of loans, and then backed securities were issued with the mortgage loan pools as backing, or collateral Large amounts of mortgage-backed securities were held by banks and other fi nancial

mortgage-1