long-run strategic policy decisions that chart a future course for the firm. These policy
decisions, along with the general level of economic activity and the level of corporate
income taxes, influence expected cash flows, their timing, and their perceived risk.
These factors all affect the price of the stock, but so does the overall condition of the fi-
nancial markets.
What is management’s primary objective?
How does stock price maximization benefit society?
What three basic factors determine the price of a stock?
What three factors determine cash flows?
The Financial Markets
Businesses, individuals, and governments often need to raise capital. For example,
suppose Carolina Power & Light (CP&L) forecasts an increase in the demand for
electricity in North Carolina, and the company decides to build a new power plant.
Because CP&L almost certainly will not have the $1 billion or so necessary to pay for
the plant, the company will have to raise this capital in the financial markets. Or sup-
pose Mr. Fong, the proprietor of a San Francisco hardware store, decides to expand
into appliances. Where will he get the money to buy the initial inventory of TV sets,
washers, and freezers? Similarly, if the Johnson family wants to buy a home that costs
$100,000, but they have only $20,000 in savings, how can they raise the additional
$80,000? If the city of New York wants to borrow $200 million to finance a new sewer
plant, or the federal government needs money to meet its needs, they too need access
to the capital markets.
On the other hand, some individuals and firms have incomes that are greater than
their current expenditures, so they have funds available to invest. For example, Carol
Hawk has an income of $36,000, but her expenses are only $30,000, leaving $6,000 to
invest. Similarly, Ford Motor Company has accumulated roughly $16 billion of cash
and marketable securities, which it has available for future investments.
Types of Markets
People and organizations who want to borrow money are brought together with those
with surplus funds in the financial markets.Note that “markets” is plural—there are
a great many different financial markets in a developed economy such as ours. Each
market deals with a somewhat different type of instrument in terms of the instrument’s
maturity and the assets backing it. Also, different markets serve different types of cus-
tomers, or operate in different parts of the country. Here are some of the major types
of markets:
1.Physical asset markets(also called “tangible” or “real” asset markets) are those
for such products as wheat, autos, real estate, computers, and machinery. Financial
asset markets,on the other hand, deal with stocks, bonds, notes, mortgages, and
other financial instruments.All of these instruments are simply pieces of paper
with contractual provisions that entitle their owners to specific rights and claims on
real assets. For example, a corporate bond issued by IBM entitles its owner to a
specific claim on the cash flows produced by IBM’s physical assets, while a share of
IBM stock entitles its owner to a different set of claims on IBM’s cash flows. Unlike
these conventional financial instruments, the contractual provisions of derivatives
12 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment
10 An Overview of Corporate Finance and the Financial Environment
