Chapter # 01

WhAT IS FINANCE?
Finance can be defined as the science and art of managing money. At the personal level, finance is
concerned with individuals’ decisions about how much of their earnings they spend, how much
they save, and how they invest their savings. In a business context, finance involves the same types
of decisions: how firms raise money from investors, how firms invest money in an attempt to earn a
profit, and how they decide whether to reinvest profits in the business or distribute them back to
investors.
Financial Services
Financial services is the area of finance concerned with the design and delivery of advice and financial
products to individuals, businesses, and governments. It in- volves a variety of interesting career
opportunities within the areas of banking, personal financial planning, investments, real estate, and
insurance.

Managerial Finance
Managerial finance is concerned with the duties of the financial manager working in a business.
Financial managers administer the financial affairs of all types of businesses: private and public,
large and small, profit seeking and not for profit. They perform such varied tasks as developing a
financial plan or budget, extend- ing credit to customers, evaluating proposed large expenditures,
and raising money to fund the firm’s operations. In recent years, a number of factors have increased
the importance and complexity of the financial manager’s duties. These factors include the recent
global financial crisis and subsequent responses by regulators, increased competition, and
technological change. For example, globalization has led U.S. corporations to increase their
transactions in other countries, and foreigncorporations have done likewise in the United States.
These changes increase de-mand for financial experts who can manage cash flows in different
currencies and protect against the risks that arise from international transactions. These changes
increase the finance function’s complexity, but they also create opportunities for a more rewarding
career. The increasing complexity of the financial manager’s du- ties has increased the popularity of
a variety of professional certification programs outlined in the Focus on Practice box below.
Financial managers today actively develop and implement corporate strategies aimed at helping
the firm grow and improve its competitive position. As a result, many corporate presidents and
chief executive officers (CEOs) rose to the top of their organizations by first demon- strating
excellence in the finance function.
A sole proprietorship is a business owned by one person who operates it for his or her own profit.
About 61 percent of all businesses are sole proprietorships. The typical sole proprietorship is small,
such as a bike shop, personal trainer, or plumber. The majority of sole proprietorships operate in the
wholesale, retail, service, and construction industries.
Typically, the owner (proprietor), along with a few employees, operates the proprietorship. The
proprietor raises capital from personal resources or by bor- rowing, and he or she is responsible
for all business decisions. As a result, this form of organization appeals to entrepreneurs who
enjoy working independently. A major drawback to the sole proprietorship is unlimited liability,
which means that liabilities of the business are the entrepreneur’s responsibility and that creditors
can make claims against the entrepreneur’s personal assets if the busi- ness fails to pay its debts.
A partnership consists of two or more owners doing business together for profit. Partnerships account
for about 8 percent of all businesses, and they are typically larger than sole proprietorships.
Partnerships are common in the finance, insur- ance, and real estate industries. Public accounting and
law partnerships often have large numbers of partners.
Most partnerships are established by a written contract known as articles of partnership. In a

Matter of fact
BizStats.com Total Receipts by Type of U.S. Firm
general (or regular) partnership, all partners have unlimited lia- bility, and each partner is legally
liable for all of the debts of the partnership.

Corporations
A corporation is an entity created by law. A corporation has the legal powers of an individual in that it can
sue and be sued, make and be party to contracts, and acquire property in its own name. Although only
about 20 percent of all U.S. businesses are incorporated, the largest businesses nearly always are;
corpora- tions account for roughly 80 percent of total business revenues. Although corpo- rations engage
in all types of businesses, manufacturing firms account for the largest portion of corporate business
receipts and net profits. Table 1.1 lists the key strengths and weaknesses of corporations.
The owners of a corporation are its stockholders, whose ownership, or eq- uity, takes the form of
common stock or, less frequently, preferred stock. Unlike the owners of sole proprietorships or
partnerships, stockholders of a corporation enjoy limited liability, meaning that they are not personally
liable for the firm’s debts. Their losses are limited to the amount they invested in the firm when they
purchased shares of stock. In Chapter 7, you will learn more about common stock, but for now it is
enough to say that common stock is the purest and most basic form of corporate ownership.
Stockholders expect to earn a return by re- ceiving dividends—periodic distributions of cash—or by
realizing gains through increases in share price. Because the money to pay dividends generally comes
from the profits that a firm earns, stockholders are sometimes referred to as re- sidual claimants,
meaning that stockholders are paid last, after employees, suppliers, tax authorities, and lenders receive
what they are owed. If the firm does not generate enough cash to pay everyone else, there is nothing
available for stockholders.
As noted in the upper portion of Figure 1.1, control of the corporation func- tions a little like a
democracy. The stockholders (owners) vote periodically to elect members of the board of directors and to
decide other issues such as amending the corporate charter. The board of directors is typically
responsible for approving strategic goals and plans, setting general policy, guiding corporate affairs, and
ap- proving major expenditures. Most importantly, the board decides when to hire or fire top managers
and establishes compensation packages for the most senior ex- ecutives. The board consists of “inside”

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 directors, such as key corporate execu- tives, and 4“outside” or “independent” directors, such as
executives from other companies, major shareholders, and national or community leaders. Outside di-
rectors for major corporations receive compensation in the form of cash, stock, and stock options. This
compensation often totals $100,000 per year or more.
The president or chief executive officer (CEO) is responsible for managing day-to-day operations
and carrying out the policies established by the board of directors. The CEO reports periodically to
the firm’s directors.
TABLE 1.2 Career Opportunities in Managerial Finance

Position Description
Financial analyst Prepares the firm’s financial plans and budgets. Other duties include financial fore-
casting, performing financial comparisons, and working closely with accounting.
Capital expenditures manager Evaluates and recommends proposed long-term investments. May be involved in the
financial aspects of implementing approved investments.
Project finance manager Arranges financing for approved long-term investments. Coordinates consultants, in-
vestment bankers, and legal counsel.
Cash manager Maintains and controls the firm’s daily cash balances. Frequently manages the firm’s
cash collection and disbursement activities and short-term investments and coordi-
nates short-term borrowing and banking relationships.
Credit analyst/manager Administers the firm’s credit policy by evaluating credit applications, extending
credit, and monitoring and collecting accounts receivable.
Pension fund manager Oversees or manages the assets and liabilities of the employees’ pension fund.
Foreign exchange manager Manages specific foreign operations and the firm’s exposure to fluctuations in ex-
change rates.

Goal of the Firm

MAXIMIZE SHAREHOLDER WEALTH
Finance teaches that managers’ primary goal should be to maximize the wealth of the firm’s owners, the
stockholders. The simplest and best measure of stockholder wealth is the firm’s share price, so most
textbooks (ours included) instruct man- agers to take actions that increase the firm’s share price. A
common misconcep- tion is that when firms strive to make their shareholders happy, they do so at the
expense of other constituencies such as customers, employees, or suppliers. This line of thinking ignores
that in most cases, to enrich shareholders, managers must first satisfy the demands of these other interest
groups. Dividends that stockhold- ers receive ultimately come from the firm’s profits. It is unlikely that a
firm whosecustomers are unhappy with its products, whose employees are looking for jobs at other firms,
or whose suppliers are reluctant to ship raw materials will make shareholders rich because such a firm will
likely be less profitable in the long run than one that better manages its relations with these stakeholder
groups.
Therefore, we argue that the goal of the firm, and also of managers, should be to maximize the wealth of the
owners for whom it is being operated, which in most instances is equivalent to maximize the stock price. This
goal translates into a straightforward decision rule for managers: Only take actions that are expected to
increase the wealth of shareholders. Although that goal sounds simple, imple- menting it is not always easy.
To determine whether a particular course of action will increase or decrease shareholders’ wealth, managers
have to assess what re- turn (that is, cash inflows net of cash outflows) the action will bring and how
risky that return might be. Figure 1.2 depicts this process. In fact, we can say that the key variables that
managers must consider when making business decisions are return (cash flows) and risk.
MAXIMIZE PROFIT?
It might seem intuitive that maximizing a firm’s share price is equivalent to max- imizing its profits. That
thought is not always correct, however.
Corporations commonly measure profits in terms of earnings per share (EPS), which represent the
amount earned during the period on behalf of each outstand-ing share of common stock. EPS are

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calculated by dividing the period’s total earn-ings available for the firm’s common stockholders by
the number of shares of common stock outstanding.
Does profit maximization lead to the highest possible share price? For at least three
reasons, the answer is often no. First, timing is important. An invest- ment that provides a lower
profit overall may be preferable to one that earns a lower profit in the short run. Second, profits
and cash flows are not identical. The profit that a firm reports is simply an estimate of how it is
doing, an estimate that is influenced by many different accounting choices firms make when
assembling their financial reports. Cash flow is a more straightforward measure of the money
flowing into and out of the company than profit is. Companies have to pay their bills with cash, not
earnings, so cash flow is what matters most to financial man- agers. Third, risk matters a great
deal. A firm that earns a low but reliable profit might be more valuable than another firm with
profits that fluctuate a great deal (and therefore can be very high or very low at different times).
Timing
Because the firm can earn a return on funds it receives, the receipt of funds sooner rather than later is
preferred. In our example, even though the total earnings from Rotor are smaller than those from Valve,
Rotor provides much greater earnings per share in the first year. It’s possible that by investing in Rotor,
Neptune Manu- facturing can reinvest the earnings that it receives in year 1 to generate higher profits
overall than if it had invested in project Valve. If the rate of return that Neptune can earn on reinvested
earnings is high enough, project Rotor may be preferred even though it does not alone maximize total
profits.

Cash Flows
Profits do not necessarily result in cash flows available to the stockholders. There is no guarantee that the
board of directors will increase dividends when profits increase. In addition, the accounting assumptions
and techniques that a firm adopts can sometimes allow a firm to show a positive profit even when its cash
outflows exceed its cash inflows.
Furthermore, higher earnings do not necessarily translate into a higher stock price. Only when
earnings increases are accompanied by increased future cash flows is a higher stock price expected.
For example, a firm with a high-quality product sold in a very competitive market could increase its
earnings by signifi- cantly reducing its equipment maintenance expenditures. The firm’s expenses
would be reduced, thereby increasing its profits. If the reduced maintenance re- sults in lower
product quality, however, the firm may impair its competitive posi- tion, and its stock price could
drop as many well-informed investors sell the stock in anticipation of lower future cash flows. In this
case, the earnings increase was accompanied by lower future cash flows and therefore a lower
stock price.
Risk
Profit maximization also fails to account for risk, the chance that actual out- comes may differ from
those expected. A basic premise in managerial finance is that a trade-off exists between return (cash
flow) and risk. Return and risk are, in fact, the key determinants of share price, which represents the
wealth of the own-ers in the firm.
Cash flow and risk affect share price differently: Holding risk fixed, higher cash flow is generally
associated with a higher share price. In contrast, holding cash flow fixed, higher risk tends to
result in a lower share price because the stockholders do not like risk. In general, stockholders
are risk averse, which means that they are only willing to bear risk if they expect compensation for
do- ing so. In other words, investors expect to earn higher returns on riskier invest- ments, and they
will accept lower returns on relatively safe investments.
WHAT ABOUT STAKEHOLDERS?
Although maximization of shareholder wealth is the primary goal, many firms broaden their focus to
include the interests of stakeholders as well as shareholders. Stakeholders are groups such as employees,

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 customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. A firm with
a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The goal is
not to maximize stakeholder well-being but to preserve it.
The stakeholder view does not alter the goal of maximizing shareholder wealth. Such a view is
often considered part of the firm’s “social responsibility.” It is expected to provide long-run
benefit to shareholders by maintaining positive relationships with stakeholders. Such relationships
should minimize stakeholder turnover, conflicts, and litigation. Clearly, the firm can better achieve
its goal of shareholder wealth maximization by fostering cooperation with its other stake- holders
rather than conflict with them.
THE ROLE OF BUSINESS ETHICS
Business ethics are the standards of conduct or moral judgment that apply to per-sons engaged in
commerce. Violations of these standards in finance involve a vari-ety of actions: “creative
accounting,” earnings management, misleading financial forecasts, insider trading, fraud, excessive
executive compensation, options back-dating, bribery, and kickbacks. The financial press has
reported many such viola- tions in recent years, involving such well-known companies as JP Morgan
and Capital One. As a result, the financial community is developing and enforcing ethical standards.
The goal of these ethical standards is to motivate business and market participants to adhere to
both the letter and the spirit of laws and regula-tions concerned with business and professional
practice. Most business leaders believe that businesses actually strengthen their competitive positions
by maintain- ing high ethical standards.
Managerial Finance Function
ORGANIZATION OF THE FINANCE FUNCTION
The size and importance of the managerial finance function depend on the size of the firm. In small
firms, the finance function is generally performed by the ac- counting department. As a firm
grows, the finance function typically evolves into a separate department linked directly to the
company president or CEO through the chief financial officer (CFO).
Reporting to the CFO are the treasurer and the controller. The treasurer (the chief financial
manager) typically manages the firm’s cash, investing surplus funds when available and securing
outside financing when needed. The treasurer also oversees a firm’s pension plans and manages
critical risks related to move- ments in foreign currency values, interest rates, and commodity
prices.
The con- troller (the chief accountant) typically handles the accounting activities, such as
corporate accounting, tax management, financial accounting, and cost account- ing. The
treasurer’s focus tends to be more external, whereas the controller’s focus is more internal.
If international sales or purchases are important to a firm, it may well em- ploy one or more finance
professionals whose job is to monitor and manage the firm’s exposure to loss from currency
fluctuations. A trained financial manager can “hedge,” or protect against such a loss, at a reasonable cost
by using a varietyof financial instruments. These foreign exchange managers typically report to the firm’s
treasurer.

RELATIONSHIP TO ECONOMICS
The field of finance is closely related to economics. Financial managers must un- derstand the
economic framework and be alert to the consequences of varying levels of economic activity and
changes in economic policy. They must also be able to use economic theories as guidelines for
efficient business operation. Ex- amples include supply-and-demand analysis, profit-maximizing
strategies, and price theory. The primary economic principle used in managerial finance is mar-
ginal cost–benefit analysis, the principle that financial decisions should be made and actions taken
only when the added benefits exceed the added costs. Nearly all financial decisions ultimately

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come down to an assessment of their marginal benefits and marginal costs.
RELATIONSHIP TO ACCOUNTING
The firm’s finance and accounting activities are closely related and generally overlap. In small
firms, accountants often carry out the finance function; in large firms, financial analysts often
help compile accounting information. There are, however, two differences between finance and
accounting; one is related to the emphasis on cash flows, and the other is related to decision
making.
Emphasis on Cash Flows
The accountant’s primary function is to develop and report data for measuring the performance of the
firm, assess its financial position, comply with and file reports required by securities regulators, and file
and pay taxes. Using generally accepted accounting principles, the accountant prepares financial
statements that recognize revenue at the time of sale (whether payment has been received or not) and
recognize expenses when they are incurred. This approach is referred to as the accrual basis.
The financial manager, on the other hand, places primary emphasis on cash flows, the intake and
outgo of cash. He or she maintains the firm’s solvency by planning the cash flows necessary to
satisfy its obligations and to acquire assets needed to achieve the firm’s goals. The financial manager
uses this cash basis to recognize the revenues and expenses only with respect to actual inflows and out-
flows of cash. Whether a firm earns a profit or experiences a loss, it must have a sufficient flow of
cash to meet its obligations as they come due.
Decision Making
The second major difference between finance and accounting has to do with decision making.
Accountants devote most of their attention to the collection and presentation of financial data.
Financial managers evaluate the accounting statements, develop additional data, and make
decisions on the basis of their assessment of the associated returns and risks. Of course, it does
not mean that accountants never make decisions or that financial managers never gather data but
rather that the primary focuses of accounting and finance are distinctly different.
Governance and Agency
CORPORATE GOVERNANCE
Corporate governance refers to the rules, processes, and laws by which compa- nies are operated,
controlled, and regulated. It defines the rights and responsibili-ties of the corporate participants such as
the shareholders, board of directors, officers and managers, and other stakeholders as well as the rules
and procedures for making corporate decisions. A well-defined corporate governance structure is
intended to benefit all corporate stakeholders by ensuring that the firm is run in a lawful and ethical
fashion, in accordance with best practices, and subject to all corporate regulations.
A firm’s corporate governance is influenced by both internal factors such as the shareholders, board
of directors, and officers as well as external forces such as clients, creditors, suppliers, competitors, and
government regulations. The cor- porate organization, depicted in Figure 1.1 on page 54, helps shape a
firm’s corporate governance structure. In particular, the stockholders elect a board of directors, who in
turn hire officers or managers to operate the firm in a manner consistent with the goals, plans, and
policies established and monitored by the board on behalf of the shareholders.

Individual versus Institutional Investors

To better understand the role that shareholders play in shaping a firm’s corporate governance, it is
helpful to differentiate between the two broad classes of owners: individuals and institutions. Generally,
individual investors own relatively few shares and as a result do not typically have sufficient means to
influence a firm’s corporate governance. To influence the firm, individual investors often find it
necessary to act as a group by voting collectively on corporate matters. The most important corporate
matter individual investors vote on is the election of the firm’s board of directors. The corporate board’s
first responsibility is to the shareholders. The board not only sets policies that specify ethical practices

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 and provide for the protection of stakeholder interests, but it also monitors manage- rial decision
making on behalf of investors.
Although they also benefit from the presence of the board of directors, insti- tutional investors
have advantages over individual investors when it comes to in- fluencing the corporate governance
of a firm. Institutional investors are invest- ment professionals that are paid to manage and hold
large quantities of securities on behalf of individuals, businesses, and governments. Institutional
investors in- clude banks, insurance companies, mutual funds, and pension funds. Unlike indi-
vidual investors, institutional investors often monitor and directly influence a firm’s corporate
governance by exerting pressure on management to perform or communicating their concerns to
the firm’s board. These large investors can also threaten to exercise their voting rights or liquidate
their holdings if the board does not respond positively to their concerns. Because individual and
institutional investors share the same goal, individual investors benefit from the shareholder
activism of institutional investors.
Government Regulation
Unlike the effect that clients, creditors, suppliers, or competitors can have on a particular firm’s corporate
governance, government regulation generally shapes the corporate governance of all firms. During the
past decade, corporate gover- nance has received increased attention due to several high-profile
corporate scandals involving abuse of corporate power and, in some cases, alleged criminal activity by
corporate officers. The misdeeds derived from two main types of is- sues: (1) false disclosures in financial
reporting and other material information releases and (2) undisclosed conflicts of interest between
corporations and their analysts, auditors, and attorneys and between corporate directors, officers, and
shareholders.
Asserting that an integral part of an effective corporate governance regime is provisions for civil
or criminal prosecution of individuals who conduct un-ethical or illegal acts in the name of the firm,
in July 2002 the U.S. Congress passed the Sarbanes-Oxley Act of 2002 (commonly called SOX).
Sarbanes-Oxley is intended to eliminate many of the disclosure and conflict of interest problems
that can arise when corporate managers are not held personally accountable for their firm’s
financial decisions and disclosures. SOX accomplished the follow-ing: established an oversight
board to monitor the accounting industry, tight- ened audit regulations and controls, toughened
penalties against executives who commit corporate fraud, strengthened accounting disclosure
requirements and ethical guidelines for corporate officers, established corporate board struc- ture
and membership guidelines, established guidelines with regard to analyst conflicts of interest,
mandated instant disclosure of stock sales by corporate executives, and increased securities
regulation authority and budgets for audi- tors and investigators.
THE AGENCY ISSUE
We know that the duty of the financial manager is to maximize the wealth of the firm’s owners.
Shareholders give managers decision-making authority over the firm; thus, managers can be viewed as the
agents of the firm’s shareholders. Tech-nically, any manager who owns less than 100 percent of the firm is
an agent act- ing on behalf of other owners. This separation of owners and managers is shown by the
dashed horizontal line in Figure 1.1 on page 54, and it is representative of the classic principal–agent
relationship, where the shareholders are the principals. In general, a contract is used to specify the terms
of a principal–agent relation- ship. This arrangement works well when the agent makes decisions that are
in theprincipal’s best interest but doesn’t work well when the interests of the principal and agent differ.
In theory, most financial managers would agree with the goal of shareholder wealth
maximization. In reality, however, managers are also concerned with their personal wealth,
job security, and fringe benefits. Such concerns may cause The Agency Problem
An important theme of corporate governance is to ensure the accountability of managers in an
organization through mechanisms that try to reduce or elimi-nate the principal–agent problem;
when these mechanisms fail, however, agency problems arise. Agency problems arise when

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managers deviate from the goal of maximization of shareholder wealth by placing their personal
goals ahead of the goals of shareholders. These problems in turn give rise to agency costs. Agency
costs are costs borne by shareholders due to the presence or avoidance of agency problems and
in either case represent a loss of shareholder wealth. For example, shareholders incur agency
costs when managers fail to make the best investment decision or when managers have to be
monitored to ensure that the best investment decision is made because either situation is likely to
result in a lower stock price.
Management Compensation Plans
In addition to the roles played by corporate boards, institutional investors, and government regulations,
corporate governance can be strengthened by ensuring that managers’ interests are aligned with those
of shareholders. A common ap- proach is to structure management compensation to correspond with
firm perfor- mance. In addition to combating agency problems, the resulting performance- based
compensation packages allow firms to compete for and hire the best managers available. The two key
types of managerial compensation plans are in- centive plans and performance plans.
1. Incentive plans tie management compensation to share price. One incentive plan grants stock
options to management. If the firm’s stock price rises over time, managers will be rewarded by
being able to purchase stock at the market price in effect at the time of the grant and then to
resell the shares at the prevailing highermarket price.
Many firms also offer performance plans that tie management compensation to performance
measures such as earnings per share (EPS) or growth in EPS. Compensation under these plans is
often in the form of performance shares or cash bonuses. Performance shares are shares of stock
given to management as a result of meeting the stated performance goals, whereas cash bonuses
are cash payments tied to the achievement of certain performance goals.
The Threat of Takeover
When a firm’s internal corporate governance structure is unable to keep agency problems in check, it is
likely that rival managers will try to gain control of the firm. Because agency problems represent a misuse
of the firm’s resources and impose agency costs on the firm’s shareholders, the firm’s stock is generally
de- pressed, making the firm an attractive takeover target. The threat of takeover by another firm that
believes it can enhance the troubled firm’s value by restructur- ing its management, operations, and
financing can provide a strong source of external corporate governance. The constant threat of a takeover
tends to moti- vate management to act in the best interests of the firm’s owners.
Unconstrained, managers may have other goals in addition to share price maximization, but much
of the evidence suggests that share price maximization— the focus of this text—is the primary goal
of most firms.
Short Notes
finance
The science and art ofmanaging money.
financial services
The area of finance concerned with the design and delivery ofadvice and financial products to individuals, businesses,
and governments.
managerial finance
Concerns the duties of the financial manager in a business.

financial manager
Actively manages the financial affairs of all types of businesses,whether private or public, large or small, profit seeking or
not for profit.

sole proprietorship
A business owned by one person and operated for his orher own profit.

unlimited liability
The condition of a sole proprietorship (or general partnership), giving creditors the right to make claims against the owner’s personal
assets to recoverdebts owed by the business.
partnership

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A business owned by two or more people and operated for profit.
articles of partnership
The written contract used to formally establish a business partnership.(Partnership deed)
corporation
An entity created by law.
stockholders
The owners of a corporation, whose ownership, or equity, takes the form of common stock or, less frequently, preferred
stock.
limited liability
A legal provision that limits stockholders’ liability for a corporation’s debt to the amount they initially invested inthe firm
by purchasing stock.
common stock
The purest and most basic form of corporate ownership.
dividends
Periodic distributions of cash tothe stockholders of a firm.
board of directors
Group elected by the firm’s stockholders and typically responsible for approving strategic goals and plans, setting
general policy, guidingcorporate affairs, and approving major expenditures.
president or chief executiveofficer (CEO)
Corporate official responsiblefor managing the firm’s day-
to-day operations and carryingout the policies established by the board of directors.
Limited partnership (LP)
A partnership in which one or more partners have limited liability as long as at least one partner (the general partner) has
unlimited liability. The limited partners are passive investors that cannot take an active role inthe firm’s management.

S corporation (S corp)
A tax-reporting entity that allows certain corporations with 100 orfewer stockholders to choose to be taxed as partnerships.
Its stockholders receive the organizational benefits of a corporation and the tax advantages of a partnership.
Limited liability company (LLC) Permitted in most states, the LLC gives its owners limited liability and taxation as a
partnership. But unlike an S corp, the LLC can own more than 80% of another corporation, and corporations,
partnership, or non-U.S. Residents can own LLCshares.
Limited liability partnership (LLP)
Permitted in most states, LLP partners are liable for their own acts of malpractice, but not for those of other partners.The
LLP is taxed as a partnership and is frequently used by legal and accountingprofessionals.

earnings per share (EPS) The amount earned during theperiod on behalf of each outstanding share of common stock,
calculated by dividing the period’s total earnings
available for the firm’s commonstockholders by the number of shares of common stock outstanding.
risk
The chance that actual outcomes may differ from those expected.
risk averse
Requiring compensation to bear risk.
stakeholders
Groups such as employees, customers, suppliers, creditors, owners, and others who have adirect economic link to the
firm.

business ethics
Standards of conduct or moral judgment that apply to persons engaged in commerce.
treasurer
The firm’s chief financial manager, who manages the firm’s cash, oversees its pensionplans, and manages key risks.

controller
The firm’s chief accountant, who is responsible for the firm’saccounting activities, such as corporate accounting, tax
management, financial accounting, and cost accounting.

foreign exchange manager The manager responsible for managing and monitoring the firm’s exposure to loss from
currency fluctuations.

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 marginal cost–benefitanalysis
Economic principle that states that financial decisions shouldbe made and actions taken only when the added
benefits exceed the added costs.
accrual basis
In preparation of financial statements, recognizes revenueat the time of sale and recognizes expenses when theyare
incurred.

cash basis
Recognizes revenues and expenses only with respect to actual inflows and outflows of cash.
corporate governance
The rules, processes, and laws by which companies are operated, controlled, and regulated.

individual investors
Investors who own relatively small quantities of shares so as to meet personal investment goals.

institutional investors Investment professionals such as banks, insurance companies, mutual funds, andpension
funds that are paid tomanage and hold large quantities of securities on behalf of others.

Sarbanes-Oxley Act of 2002(SOX)

An act aimed at eliminating corporate disclosure and conflict of interest problems. Contains provisions about
corporate financial disclosuresand the relationships among corporations, analysts, auditors, attorneys, directors, officers,
and shareholders.

principal–agent relationshipAn arrangement in which an agent acts on the behalf of a principal. For example,
shareholders of a company (principals) elect management (agents) to act on their behalf.
agency problems Problems that arise when managers place personal goals ahead of the goals of shareholders.
agency costs
Costs arising from agency problems that are borne by shareholders and represent aloss of shareholder wealth.

incentive plans Management compensation plans that tie management compensation to share price;one example
involves the granting of stock options.
stock options
Options extended by the firm that allow management to benefit from increases in stockprices over time.
performance plans
Plans that tie management compensation to measures such as EPS or growth in EPS.Performance shares, cash bonuses,
or both are used as compensation under these plans.
performance shares
Shares of stock given to management for meeting stated performance goals.
cash bonuses
Cash paid to management for achieving certain performance goals.

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