It’s hard to define finance—the term has many facets, which makes it difficult to provide a clear

and concise definition. The discussion in this section will give you an idea of what finance
people do and what you might do if you enter the finance field after you graduate. 1-1a Finance
versus Economics and Accounting Finance as we know it today grew out of economics and
accounting. Economists developed the notion that an asset’s value is based on the future cash
flows the asset will provide, and accountants provided information regarding the likely size of
those cash flows. Finance then grew out of and lies between economics and accounting, so
people who work in finance need knowledge of those two fields. Also, as discussed next, in the
modern corporation, the accounting department falls under the control of the chief financial
officer (CFO). 1-1b Finance within an Organization Most businesses and not-for-profit
organizations have an organization chart similar to the one shown in Figure 1-1. The board of
directors is the top governing body, and the chairperson of the board is generally the highest-
ranking individual. The CEO comes next, but note that the chairperson of the board often serves
as the CEO as well. Below the CEO comes the chief operating officer (COO), who is often also
designated as a firm’s president. The COO directs the firm’s operations, which include
marketing, manufacturing, sales, and other operating departments. The CFO, who is generally a
senior vice president and the third ranking officer, is in charge of accounting financing, credit
policy, decisions regarding asset acquisitions, and investor relations, which involves
communications with stockholders and the press. If the firm is publicly owned, the CEO and the
CFO must both certify to the Securities and Exchange Commission (SEC) that reports released to
stockholders, and especially the annual report, are accurate. If inaccuracies later emerge, the
CEO and the CFO could be fined or even jailed. This requirement was instituted in 2002 as a part
of the Sarbanes-Oxley Act. The Act was passed by Congress in the wake of a series of corporate
scandals involving now-defunct companies such as Enron and WorldCom, where investors,
workers, and suppliers lost billions of dollars due to false information released by those
companies. 1-1c Corporate Finance, Capital Markets, and Investments Finance as taught in
universities is generally divided into three areas: (1) financial management, (2) capital markets,
and (3) investments. Financial management, also called corporate finance, focuses on decisions
relating to how much and what types of assets to acquire, how to raise the capital needed to
buy assets, and how to run the firm so as to maximize its value. The same principles apply to
both for-profit and not-for-profit organizations; and as the title suggests, much of this book is
concerned with financial management. Capital markets relate to the markets where interest
rates, along with stock and bond prices, are determined. Also studied here are the financial
institutions that supply capital to businesses. Banks, investment banks, stockbrokers, mutual
funds, insurance companies, and the like bring together “savers” who have money to invest and
businesses, individuals, and other entities that need capital for various purposes. Governmental
organizations such as the Federal Reserve System, which regulates banks and controls the
supply of money, and the SEC, which regulates the trading of stocks and bonds in public
markets, are also studied as part of capital markets. Investments relate to decisions concerning
stocks and bonds and include a number of activities: (1) Security analysis deals with finding the
proper values of individual securities (i.e., stocks and bonds). (2) Portfolio theory deals with the
best way to structure portfolios, or “baskets,” of stocks and bonds. Rational investors want to
hold diversified portfolios in order to limit risks, so choosing a properly balanced portfolio is an
important issue for any investor. (3) Market analysis deals with the issue of whether stock and
bond markets at any given time are “too high,” “too low,” or “about right.” Behavioral finance,
where investor psychology is examined in an effort to determine if stock prices have been bid up
to unreasonable heights in a speculative bubble or driven down to unreasonable lows in a fit of
irrational pessimism, is a part of market analysis. Although we separate these three areas, they
are closely interconnected. Banking is studied under capital markets, but a bank lending officer
evaluating a business’ loan request must understand corporate finance to make a sound
decision. Similarly, a corporate treasurer negotiating with a banker must understand banking if
the treasurer is to borrow on “reasonable” terms. Moreover, a security analyst trying to
determine a stock’s true value must understand corporate finance and capital markets to do his
or her job. In addition, financial decisions of all types depend on the level of interest rates; so all
people in corporate finance, investments, and banking must know something about interest
rates and the way they are determined. Because of these interdependencies, we cover all three
areas in this book

Next to health care, jobs in finance have been growing faster than any other area. Finance
prepares students for jobs in banking, investments, insurance, corporations, and the
government. Accounting students need to know finance, marketing, management, and human
resources; they also need to understand finance, for it affects decisions in all those areas. For
example, marketing people propose advertising programs, but those programs are examined by
finance people to judge the effects of the advertising on the firm’s profitability. So to be
effective in marketing, one needs to have a basic knowledge of finance. The same holds for
management—indeed, most important management decisions are evaluated in terms of their
effects on the firm’s value. This is called value-based management, and it is the “in” thing today.
It is also worth noting that finance is important to individuals regardless of their jobs. Some
years ago most businesses provided pensions to their employees, so managing one’s personal
investments was not critically important. That’s no longer true. Most firms today provide what’s
called “defined contribution” pension plans, where each year the company puts a specified
amount of money into an account that belongs to the employee. The employee must decide
how those funds are to be invested—how much should be divided among stocks, bonds, or
money funds and how risky the stocks and bonds should be. These decisions have a major effect
on people’s lives, and the concepts covered in this book can improve decision-making skills. 1-3
FORMS OF BUSINESS ORGANIZATION The basics of financial management are the same for all
businesses, large or small, regardless of how they are organized. Still, a firm’s legal structure
affects its operations and thus should be recognized. There are four main forms of business
organizations: (1) sole proprietorships, (2) partnerships, (3) corporations, and (4) limited liability
companies (LLCs) and limited liability partnerships (LLPs). In terms of numbers, most businesses
are sole proprietorships. However, based on the dollar value of sales, about 80% of all business
is done by corporations. Because corporations conduct the most business and because most
successful businesses eventually convert to corporations, we concentrate on them in this book.
Still, it is important to understand the legal differences between firms. A proprietorship is an
unincorporated business owned by one individual. Going into business as a sole proprietor is
easy—a person begins business operations. Proprietorships have three important advantages:
(1) They are easily and inexpensively formed, (2) they are subject to few government
regulations, and To find information about different finance careers, go to www.careers-in-
finance. com. This web site provides information about different finance areas and recommends
different books about jobs in finance. Proprietorship An unincorporated business owned by one
individual. 6 Part 1 Introduction to Financial Management (3) they are subject to lower income
taxes than are corporations. However, proprietorships also have three important limitations: (1)
Proprietors have unlimited personal liability for the business’s debts, so they can lose more than
the amount of money they invested in the company. You might invest $10,000 to start a
business but be sued for $1 million if, during company time, one of your employees runs over
someone with a car. (2) The life of the business is limited to the life of the individual who
created it; and to bring in new equity, investors require a change in the structure of the
business. (3) Because of the first two points, proprietorships have difficulty obtaining large sums
of capital; hence, proprietorships are used primarily for small businesses. However, businesses
are frequently started as proprietorships and then converted to corporations when their growth
results in the disadvantages outweighing their advantages. A partnership is a legal arrangement
between two or more people who decide to do business together. Partnerships are similar to
proprietorships in that they can be established relatively easily and inexpensively. Moreover, the
firm’s income is allocated on a pro rata basis to the partners and is taxed on an individual basis.
This allows the firm to avoid the corporate income tax. However, all of the partners are
generally subject to unlimited personal liability, which means that if a partnership goes
bankrupt and any partner is unable to meet his or her pro rata share of the firm’s liabilities, the
remaining partners will be responsible for making good on the unsatisfied claims. Thus, the
actions of a Texas partner can bring ruin to a millionaire New York partner who had nothing to
do with the actions that led to the downfall of the company. Unlimited liability makes it difficult
for partnerships to raise large amounts of capital.2 A corporation is a legal entity created by a
state, and it is separate and distinct from its owners and managers. It is this separation that
limits stockholders’ losses to the amount they invested in the firm—the corporation can lose all
of its money, but its owners can lose only the funds that they invested in the company.
Corporations also have unlimited lives, and it is easier to transfer shares of stock in a
corporation than one’s interest in an unincorporated business. These factors make it much
easier for corporations to raise the capital necessary to operate large businesses. Thus,
companies such as Hewlett-Packard and Microsoft generally begin as proprietorships or
partnerships, but at some point they find it advantageous to become a corporation. A major
drawback to corporations is taxes. Most corporations’ earnings are subject to double taxation—
the corporation’s earnings are taxed; and then when its after-tax earnings are paid out as
dividends, those earnings are taxed again as personal income to the stockholders. However, as
an aid to small businesses, Congress created S corporations, which are taxed as if they were
partnerships; thus, they are exempt from the corporate income tax. To qualify for S corporation
status, a firm can have no more than 75 stockholders, which limits their use to relatively small,
privately owned firms. Larger corporations are known as C corporations. The vast majority of
small corporations elect S status and retain that status until they decide to sell stock to the
public, at which time they become C corporations. A limited liability company (LLC) is a
relatively new type of organization that is a hybrid between a partnership and a corporation. A
limited liability partnership (LLP) is similar to an LLC; but LLPs are used for professional firms in