Chapter 1

Introduction to Finance

Chapter Outline

1.1 So Just What Is “Finance” Anyway? 1.2c3 Employee Relative to the

Management/Shareholder
1.1a Finance in the Corporate
Collection
Pyramid
1.2c4 Household Relative to
1.1b Finance Sub-disciplines
Government
1.1c Finance Certifications in
1.2d Wealth Creation and the
Industry and Practice
Company Goal
1.2 The Company Cash Flow Cycle
1.3 Clones of the Company Cash Flow
1.2a Stakeholders
1.2b Financial Markets
Cycle
1.3a Corporate Business
1.2c Agency Problems
1.3b Noncorporate Business
1.2c1 Shareholder Relative to
Management 1.3c Households As Companies

1.2c2 Creditor Relative to the

Management/Shareholder
Collection

1
2 Chapter 1

1.1 So Just What Is “Finance” Anyway?

Definition 1.1 Finance Finance is an unusually rich subject. Notice it is one of the few college
(verb): To finance means the courses for which the course name has two definitions, one as action
act of borrowing money. verb and the other as noun.
Example: How did you Although many types of wealth exist, society and history seem to
finance your car? suggest that money is a very important type. Finance, accordingly, has a
(noun): Finance is the study lot to do with money. Because everyone somewhat relies on money, ev-
of wealth management. eryone benefits from understanding basic principles of finance.
Example: This book Finance is a relatively new science. The prestigious Journal of Fi-
explains basic principles of
nance began in 1942. In 1990 the Nobel Prize in Economic Science was
finance.
awarded for the first time to discoveries taught primarily in finance
(noun): Financial science classes. The prize was shared by Harry Markowitz from the City Uni-
is the specification of
versity of New York, William Sharpe of Stanford University, and Merton
processes determining
cash flow rates and wealth Miller at the University of Chicago. Again in 1996 a finance discovery
balances. by William Vickrey of Columbia University received the Nobel Prize in
Example: Financial science Economic Science. The 1997 discovery receiving the 1997 Nobel Prize
studies equilibrating forces by Myron Scholes (Stanford) and Robert Merton (Harvard) uses insights
that when managed may from heat transfer physics to model the valuation of financial stock
help us sustain the wealth
of a company, household,
options! The 2013 prizes recognized advancements in financial eco-
maybe even planet. nomics by Robert Shiller (Yale University), Eugene Fama (University of
Chicago), and Lars Peter Hansen (University of Chicago).
The rigor of financial science assists a large financial industry with
the theory for applications. The practical implications of most financial
principles is diverse. Keeping track often requires strong familiarity
with accounting fundamentals. In short, finance is a wonderful science
because it uses the pragmatism of accounting to apply the rigor of eco-
nomics to the study of wealth management. A rich subject indeed…
People in households, business, and government use financial
knowledge everyday to make wealth management decisions. But
exactly how, and who, uses finance? Glean insight from several
perspectives.

1.1a Finance in the Corporate Pyramid

Figure 1.1 takes a perspective focusing on the “finance group” within
the corporate pyramid. This particular hierarchy is for IBM at a par-
ticular dated moment in time, but the layout is fairly typical of any
large corporation today.
 Introduction to Finance 3

Figure 1.1 Finance in the Corporate Hierarchy

Board of Directors (IBM, historical snapshot)

Cathleen Black, President of Hearst Magazines
Harold Brown, General Partner at Warburg, Pincus & Co.
Juergen Dormann, Chairman of Hoedhst AG
Louis Gerstner, Jr., Chairman of the Board and CEO of IBM
Nannerl Keohane, President of Duke University
Charles Knight, CEO of Emerson Electric Co.
Lucio Noto, CEO of Mobil Co.
John Slaughter, President of Occidental College
Alex Trotman, CEO of Ford Motor Co.
Lodewijk vanWachem, Chairman of Royal Dutch Petroleum Co.
Charles Vest, President of Mass. Institute of Technology

Chief Executive Officer (CEO)

Louis Gerstner

senior management that report directly to the CEO

Software Operations Human Resources Strategy Research

John Thompson Thomas Bouchard Bruce Harreld Paul Horn

General Counsel Communications Marketing

Lawrence Ricciardi Chief Financial David Kalis Abby Kohnstamm
Officer (CFO)
PC Operations Richard Thomas Server Operations Sales & Service
Robert Stephenson Nicholas Donofrio Ned Lautenbach

The finance group generally reports to the Chief Financial Officer

(“CFO”). The CFO reports directly to the Chief Executive Officer (“CEO”).
The figure shows eleven different groups at IBM report to the CEO.
The finance group headed by the CFO is very important, but equally
important is the Strategy group that ponders question of corporate
mission, the Marketing group that creates a positive corporate image,
the Sales & Service group that generates revenues, the General Counsel
group that keeps the company compliant, etc. There is a lot more to
business than simply finance, but finance is essential.
The CEO is the most senior employee. The CEO reports to the Board
of Directors. The Board of Directors hires and fires the CEO. Persons on
the Board of Directors typically are not employees of the company. Di-
rectors are individuals with careers unrelated to IBM’s mission. The
figure shows that on IBM’s board is a president of a publishing empire,
several university presidents, oil company presidents, etc. Presumably,
external Directors see the big picture and assess the sensibility of the
company’s efforts. But who hires and fires the Board of Directors?
Shareholders, that’s who! Shareholders of a corporation elect Directors
from a slate of nominees. Typically one share of common stock casts
one vote. The chain-of-command is thus: shareholders elect or oust the
Board of Directors; the Board of Directors hires and fires the CEO, the
CEO hires and fires senior management, senior management hire and
fire middle management, and middle management hire (seldom fire,
hopefully) college graduates that are just starting-out. When you buy
common stock, you get more than hoped-for profits; you get control
4 Chapter 1

over management (don’t get too excited, though, IBM has over half-
billion shares outstanding and it’s one vote per share!)
Figure 1.2 shows typical units within the finance group.

Figure 1.2 Typical Finance Group in the Company

Chief Financial Officer

Office of the Controller Office of the Treasurer

Departments that report to the Controller Departments that report to the Treasurer

Tax Management Cost Accounting Cash Management Credit Management

Information Mgmt. Payroll Capital Budgeting Financial Planning

Generally speaking, the Controller administers accounting func-

tions whereas the Treasurer administers finance functions. The Cash
management department assures that checks don’t bounce and that
a prudent amount of cash is on-hand. Credit management pertains
to customer loan policies, collections, and payments. Capital bud-
geting pertains to long-term decisions about investing or financing of
plant, property, and equipment. Financial planning assesses current
and future financial health given likely trends. Basic finance functions
in the Office of the Treasurer generally monitor how the company’s
wealth is or should be allocated, where the wealth is coming from, and
where the wealth is going. These essential business functions rely on
employees that use financial science.

1.1b Finance Sub-disciplines

Glean another perspective of finance by examining traditional
sub-disciplines:
• Corporate Finance—topics include working capital management,
capital budgeting, obtaining financing, capital structure deci-
sions, and dividend payout policies;
• Investments—topics include company and security analysis,
portfolio theory and management, futures and options;
• Markets and Institutions—topics include banking, analysis of in-
terest rates, and financial market microstructure;
 Introduction to Finance 5

• Specialty Areas—topics include real estate, insurance, law and fi-

nancial economics, personal financial planning, enterprise fi-
nance, risk management, etc.
Many universities offer one or more courses organized around
these sub-disciplines. Until the mid-1990’s, in fact, the accrediting
agency “American Assembly of College Schools of Business” (AACSB)
required that undergraduate business programs include two finance
courses. Typically one course was “Corporate Finance” and the other
was “Markets and Institutions.” The AACSB rescinded the two-finance-
course rule and as a result most undergraduate business students today
study only one finance course. The curriculum for today’s singular in-
troductory course overviews all traditional sub-disciplines of finance.
The maturation of financial science blurs lines separating traditional
sub-disciplines and a continuous discipline of finance is emerging.

1.1c Finance Certifications in Industry and Practice

One final perspective about finance comes from inspecting profes-
sional certifications. Perhaps most widespread is the Chartered Fi-
nancial Analyst (“CFA”). The CFA designation for finance is analogous
to the CPA designation that accountants earn (the “Certified Public Ac-
countant”). Earning the CFA title requires taking a series of exams, as
well as satisfying on-the-job experience requirements. Other designa-
tions often are seen following individual names on office doors or in
professional advertisements. Each certification suggests that the in-
dividual satisfies the stringent criteria promulgated by the respective
professional organization. Many of the more visible certifications
appear in Table 1.1.

Table 1.1 Professional Certifications in Finance

Certificate Description Contact

Chartered Financial The CFA is a recognized standard of [Link]
Analyst (CFA) competency for financial analysts in more programs/cfaprogram/Pages/
than 70 nations worldwide [Link]
Association for Investment
Management & Research
NASD Stock Broker’s NASD brokers represent more than 5,500 [Link]
License securities firms with more than 82,000 National Association of
branch offices across the U.S. Acquiring Securities Dealers
the license requires multiple applications
and qualifications
Certified Financial Recognized by institutions and individuals [Link]
Consultant (CFC) as a sign of integrity and professional Institute of Financial
excellence. Many employers require the Consultants
CFC designation when hiring or promoting

(Continues)
6 Chapter 1

Certified in Financial The CFM is for students, practitioners, and [Link]

Management (CFM) academicians, that understand techniques Financial Management
defining the field of finance Association
Certified Financial Holders of the CFP meet rigorous [Link]
Planner (CFP) requirements in banking, estate, insurance, Certified Financial Planner
investment, and tax planning Board of Standards
Chartered Financial Granted to individuals completing a com- [Link]
Consultant (ChFC) prehensive 10-course practical program Society of Financial Services
that includes economics, taxes, insurance, Professionals
and investing
Chartered Life This is the undisputed professional [Link]
Underwriter (CLU) credential for persons involved in the [Link]/ads/clu
protection and preservation of financial The American College
wealth through life insurance
Commodity Trading A registered adviser regarding the value of [Link]
Advisor (CTA) securities or of the advisability of investing Securities Exam Preparation,
in securities. Inc.
Financial Risk Earned by individuals who have been [Link]
Management (FRM) qualified to legally give clients financial Risk and Insurance
planning service and advice Management Society

1.2 The Company Cash Flow Cycle

Definition 1.2 Wealth There are many types of wealth, just as there are many types of busi-
Any capital or asset that nesses, markets, or human wants. All wealth, however, possesses
provides returns over time a common characteristic. Typical examples include: (a) This IBM
common stock represents a lot of her wealth ; or (b) This building repre-
sents a lot of the company’s wealth. Clearly a building is a useful asset
that provides services for many years, so a building is a type of wealth.
Likewise, the IBM stock promises to return money in the future, so it
too is a type of wealth. Of course, a building made from bricks and
mortar is quite different than a security made from paper. Both assets,
nonetheless, represent wealth because they promise future returns.
Markets transfer ownership of wealth. There are as many different
markets as there are asset types. Yet at the broadest level a market
is either (a) a financial market, or (b) a real asset market. Financial
markets trade exclusively paper claims and obligations. Paper claims
and obligations represent contracts that promise either implicitly or
explicitly to deliver returns through time. These pieces of paper are
called “securities,” and examples include stocks, bonds, and loan obli-
gations. The paper itself does not possess intrinsic traits that endear it;
you can’t eat the paper or use it for anything useful. Instead, the paper
represents wealth because it promises future returns (usually more
paper!). Real asset markets trade goods and services. The market that
trades buildings is a real asset market. Other examples of real asset
markets include the markets for books, automobiles, steel, groceries,
 Introduction to Finance 7

and haircuts or massages. Real goods provide economic utility. Real

goods are real things!
Financial securities and real assets represent wealth because both
provide returns over time. Some economists, notably Don Patinkin
(1957) and Joe Stiglitz (1982) argue that financial markets lie like a veil
on top of the economic community of real assets. They question the
extent to which financial wealth leads to creation of real assets. This is
a complex issue. Inspection of economies around the globe reveals that
nations possessing the most real assets also have the most highly de-
veloped financial markets. Whether financial markets lead to sophis-
tication of real asset markets or vice versa is like asking whether the
chicken or the egg was first on base. It is a largely irrelevant question.
The cointegration of forces in the financial markets is strong. Once we
can count it, as Leonarhd Euler says (1762 Elements of Algebra), once
we count the flows then the rest is easy. Examine the cash flow cycle
in Figure 1.3 that simply illustrates the relation between financial and
real asset markets:

Figure 1.3 The Cash Flow Cycle

$ $
CAPITALISTS IN
$ $ $ $ STAKEHOLDERS IN
FINANCIAL MARKETS REAL ASSET MARKETS

PPE/Inventory
SUPPLIERS
EQUITY Stocks Infrastructure
MARKET THE
COMPANY
Time & Skill LABOR
Dividends & Interest:
the normal rate of return

Infrastructure GOVT

CREDIT Bonds & Notes

$$
$
MARKET

Goods & Services

$
CLIENTS

ECONOMIC PROFIT

The “company” in Figure 1.3 is any economic agent with a balance

sheet and every household, enterprise, institution, nation, planet,
person or collection has one. The company regardless of definition
brings together resources from diverse sectors of the financial economy
8 Chapter 1

in order to produce goods and services. The company deals with capi-
talists in the financial markets and with stakeholders in the real asset
markets. Positive economic profit represents worldly gain. When eco-
nomic costs surpass economic income the net economic loss can even-
tuate with devastating earthly effects.

1.2a Stakeholders
A stakeholder is an economic entity in the real asset markets that ex-
changes goods and services with the company. There are four major
classes of stakeholders: suppliers, labor, government, and clients.
Suppliers provide the company with inventory, raw materials, and
plant, property, and equipment. Those factors of production are real
goods and services that the company needs to make its product. The
company sends money to the suppliers. Labor includes management
and employees. These individuals provide the labor services that the
company needs to function. The company sends labor wages, sal-
aries, and bonuses. The government is another major stakeholder with
the company. The government provides highways and airports, they
protect property and maintain civil obedience with police, firefighters,
and military. The government also educates the workforce, and they
maintain a regulatory environment that is politically responsive to the
company. The company in return pays taxes to local, state, and federal
governments. Clients, too, are stakeholders with the company. Notice
in the cash flow diagram that the direction of money flow is different
for the client than the other stakeholders. The company delivers goods
and services to the client. The client sends money to the company.
Why does the company exist? Some people claim that the client is the
sole reason for the company to exist. The argument has merit because
the company stays financially healthy only as long as clients continue
to buy the goods and services that the company produces.
Employees often claim that they sacrifice a lot for their company
and, therefore, the company owes them a decent wage and reasonable
job security. The claim that companies exist to provide people a way to
make a living has merit, too.
At times in history, government has claimed that some particular
company is so vital to the national interest that the government na-
tionalizes the company. That is, the government forces the company to
work toward a specific public objective. The claim that companies exist
to promote national welfare has merit, too.
Between the company and each stakeholder there is a relationship.
For example, a company may hire and train labor in expectation that
labor will grow to become loyal and productive workers. Or a supplier
may expect to make future sales to the company as long as the cost
and quality of its supplies is best. Or a government may invest in in-
frastructure and expect the company to employ the populace. Stake-
holders and the company often make decisions with the expectation
of continuing a relationship. When a stakeholder relationship unex-
pectedly ends, then sometimes a stakeholder, the company, or both,
 Introduction to Finance 9

seem to lose something valuable. So to whom does the company

owe its highest allegiance? That is, what is the goal of the company?
Before answering this question, let’s examine the relation between the
company and financial markets.

1.2b Financial Markets

Companies receive money by selling securities to capitalists in financial
markets. Financial securities do not provide real goods and services.
Securities, just like money, are paper. More than likely, however, secu-
rities represent an ownership claim on assets or goods and services.
There are many types of financial markets, and there are many
schemes for categorizing them. Table 1.2 summarizes three common
schemes. One scheme is primary versus secondary financial market. In
the “primary financial market” companies receive money by selling or
issuing securities to capitalists. Sometimes capitalists re-sell securities
to other investors in “secondary financial markets” and, in turn, the se-
curity may pass from hand-to-hand many times. IBM stock exists be-
cause once, and only once, the company issued that particular stock
in a primary market transaction. Every subsequent trade between two
different financial investors is a secondary market transaction. Most
exchanges of marketable securities occur in the secondary market be-
cause one investor simply sells to another without direct involvement
of the company.
A second scheme for categorizing financial markets is by the
length of the financial contract’s time horizon: money market versus
capital market. The “money market” includes financing that is repayable
within one year. Examples of money market transactions include
short-term bank loans, overnight repurchase agreements, installment
loans, and trade credit from suppliers. When a company obtains a
short-term loan (or any other credit agreement) they sign a legal con-
tract stipulating terms of repayment. The loan contract is a financial
security. Sometimes the loans can be re-sold to other investors in a
secondary market transaction, sometimes they can’t. As the arrows
in the cash flow cycle show, the company receives money from the
financial market—the financial market receives a security from the
company. Money market securities have a relatively short life because
the financing is totally repaid within one year. “Capital markets” are
at the other extreme of the time horizon because they represent long-
term financing arrangements. The prominent types of capital market
securities include stocks, bonds, and mortgages. Perhaps some bonds
may stipulate repayment, say, in five or ten years. Stocks, in principle,
possess uncertain maybe long life.
10 Chapter 1

Table 1.2 Common Schemes for Categorizing Financial Markets FF25

Distinguishing Category 1 & Description Category 2 & Description

Criterion
new vs. seasoned primary market, secondary market,
security stocks & bonds issued by company to stocks & bonds sold by one
investor investor to another investor
length of financial money market, capital market,
contract financing repayable within one year financing repayable in more than
one year
type of repayment credit market, equity market,
promise trade credit, notes, and bonds that stocks that do not specify
stipulate specific payments and/or repayment but instead represent a
interest claim on residual cash flows

A third scheme for categorizing financial markets is by type of re-

payment promise: credit markets versus equity markets. Credit markets
include all short-term financing arrangements available in the money
market. Credit markets also include all long-term debt arrangements
such as bonds and mortgages. A common characteristic of credit market
financing is a promise by the company to repay to the creditor all prin-
cipal plus interest. Typically credit market contracts specify exact re-
payment terms and conditions. If the company encounters financial
difficulties and is unable to satisfy the promised repayment schedule
then bankruptcy may occur. Conversely, if the company strikes it rich
there is no upward adjustment to the scheduled repayment. Credit
markets do not receive the windfall gains that a company may earn—
the repayment schedule is fixed.
Windfall gains and losses earned by the company flow to equity.
Equity markets are sometimes called stock markets. Companies issue
stocks to capitalists in exchange for money. The company does not
make a legally binding promise about repaying stockholders. Instead,
the motivation for stock investing is to have a controlling interest in
the corporation (usually 1 vote per share of common stock), or because
the investor anticipates financial gains such as dividends or share
price appreciation. Stockholders may own the stocks but eventually
they may sell the stocks to other investors. The company has no legal
obligation to pay dividends to shareholders. Because shareholders
control the Board of Directors and therefore can fire top management,
however, the company likes to treat shareholders as fairly as possible.
The income statement, as the next chapter explains, shows how
a company’s revenues pay for the various factor costs of production.
The profit, that is net income, either is paid-out as dividends to share-
holders or else is plowed-back into the company to support growth.
Company growth helps push-up the stock price. That benefits share-
holders. Shareholders are residual claimants on company cash flows be-
cause they get that which is leftover after all costs have been paid.
 Introduction to Finance 11

Shareholders sometimes are beneficiaries of unexpected windfall

gains when the company strikes it rich, but they bear the burden of
windfall losses when things unexpectedly go sour. Windfalls accrue to
equity!

1.2c Agency Problems

An agency problem potentially exists when a source of financing del-
egates decision-making authority for using the funds. The source that
owns the funds is called the principal, and the decision-maker con-
trolling the funds is called the agent. A principal-agent relationship
exists when the owner of wealth is different from the controller of
wealth.
An agency problem exists when objectives of the principal and
agent are different. The resulting misalignment of interests may result
in sub-optimal company performance. The direct and indirect decline
in wealth resulting from a principal-agent problem is called an agency
cost. The company expends substantial resources to minimize agency
costs. There are four important principal-agent relationships in the fi-
nancial economy.

1.2c1 Shareholder Relative to Management

Shareholders supply, as the next chapter explains, a source of fi-
nancing called Stockholders equity. Stockholders lend money to the
company and management decides how to use the money. Mana-
gerial decisions generally advance the interests of shareholders be-
cause, after all, shareholders can pressure the Board of Directors to
fire management. Yet managers naturally pursue their own self-in-
terests. Sometimes, for example, management may buy a company jet
or spruce up the office unnecessarily. Determining the proper amount
of perquisite consumption by managers is a difficult but largely mana-
gerial decision. Perhaps managers over-invest in assets, product lines,
or empire building, simply because managerial salaries tend to cor-
relate directly with company size. Sometimes managers in pursuit of
self-interest may make decisions that reduce the amount of residual
wealth available to shareholders. That is an agency problem!
Several control mechanisms help align management and shareholder
interests.
1. Shareholders can lobby to fire management.
2. Managers can be given clever incentive compensation con-
tracts.
3. Shareholders can closely monitor and/or restrict managerial
decisions.
4. Languishing stock prices can increase the threat of take-over.
5. Managers wish to maintain pristine reputations for the next
job.
12 Chapter 1

Operation of the first control mechanism is clear. Management cannot

ignore shareholder interests too much lest they be terminated.
The second control mechanism links compensation with stock
price performance. In today’s world a significant fraction of man-
agement compensation depends on movement in the company stock
price. These clever contracts ring similar to professional athlete con-
tracts wherein, for example, there may be bonuses for making the
all-star game or winning the conference title, etc. Managers earn big
bonuses when during their tenure the company stock price rises. So
managers have an incentive to make decisions maximizing the stock
price. Clever compensation contracts align shareholder and mana-
gerial interests because both parties benefit from stock price increases.
Compensation contracts unexpectedly introduce agency costs
when the company stock price rises for reasons unrelated to mana-
gerial actions. Strong bull markets tend to raise all share prices and,
like a boat with the tide, a particular manager may be the beneficiary
of an unanticipated windfall gain. The windfall would flow to equity
if not for the compensation package. Instead, however, management
gets more than its fair share of the windfall. Certainly hiring good
managers is expensive. But when top management earns, for example,
$60 million from executive stock options, then surely shareholders
are paying more than management’s reservation wage. Management
would have performed the same services for less. The excess compen-
sation, that is the amount above the manager’s reservation wage, rep-
resents a drain from shareholder wealth and is an indirect agency cost.
The third control mechanism consists of financial audits and con-
straints on managerial decision-making. Audits ascertain that share-
holders have full information about the company’s financial actions.
When management knows shareholders are watching, management
is more responsive to shareholder interests. Constraints on mana-
gerial decision-making take many forms. There may be a requirement,
for example, that major strategic decisions require presentation and
approval at the annual shareholder meeting. This control mechanism
introduces direct and indirect agency costs.
The fourth control mechanism is not written in any contract but
instead is a naturally occurring market mechanism. When man-
agement does a bad job that results in a low share price the company
assets become relatively cheap to acquire. Outside entrepreneurs may
sense an opportunity to gain control of the company assets by pur-
chasing the relatively cheap stock. Attainment of majority stock own-
ership allows the takeover group to oust extant management. The new
shareholders install new management and set a new direction for the
company. This control mechanism does not introduce obvious agency
costs. Instead, managers have a natural incentive to maximize stock
price in order to avoid being a takeover target.
The fifth control mechanism recognizes that managers have ca-
reers that evolve over time. Maintenance of reputation and dignity are
important incentives. Being a good manager with one company natu-
rally opens doors for advancement with other companies. Shareholders
 Introduction to Finance 13

surely will not hire an executive who screwed shareholders at his or

her previous job.

1.2c2 Creditor Relative to the Management/Shareholder Collection

Creditors are a financing source for the company. Management de-
cides how to use the money. The creditor is a principal, management is
an agent, and there is a problem due to misalignment of interests. Be-
cause management is directly responsive to shareholders, however, we
also may view this as an agency problem between creditors and share-
holders. Several control mechanisms help align creditor and man-
agement/shareholder interests.
1. threat of bankruptcy induces fiduciary responsibility
2. restrictive covenants stipulate precise uses for creditor financing
3. managers wish to maintain a good reputation to maybe borrow
again.
Operation of the first control mechanism is clear. If management
misuses credit then the creditor can force bankruptcy and everybody
loses.
Operation of the second control mechanism is less obvious. Credit
agreements vary by the degree to which they restrict the use of bor-
rowed funds. At one extreme is the line-of-credit agreement that
basically allows the company to borrow money for any purpose what-
soever. At the other extreme is the mortgage bond that lends money
for purchase of a specific property, perhaps ties the repayment
schedule to revenues the company realizes from the property, and
further disallows additional borrowing against the property. The es-
sence of this principal-agent problem is that the creditor lends money
to managers at a fixed interest rate. The manager, however, is first-
most responsive to shareholders. By pursuing high-risk high-return
investments the manager potentially obtains windfalls that flow
through to shareholders (and perhaps his/her own bonus, too). Cred-
itors do not want managers to invest low-cost financing in high-risk
investments. Sometimes creditors may impose covenants restricting
the uses of the funds.
The third control mechanism recognizes the existence of a long-
term relationship between company and creditor that transcends
a single credit arrangement. Irresponsible company behavior by the
manager may signal to the creditor irreconcilable differences. Com-
panies, just like households, need financing and burning a bridge with
a creditor diminishes future financing opportunities.

1.2c3 Employee Relative to the Management/Shareholder Collection

Balance sheets show, as the next chapter explains, that employees
are a significant financing source for many companies. Employees
usually do not give direct loans to the company. Instead, employees
provide financing by deferring compensation. Under guidelines for tra-
ditional pension plans, for example, an employee may provide labor
services to the company that are worth $60,000 but accept immediate
14 Chapter 1

compensation for only $50,000. The company retains the $10,000 of de-
ferred compensation and promises to pay the employee a pension in
the remote future. Employees for many companies are an important fi-
nancing source and own the wealth, but manager/shareholders control
the wealth. This is an agency problem!
Several control mechanisms help align employee and management/
shareholder interests.
1. threat of litigation induces fiduciary responsibility
2. assignment of pension contributions to third parties
Dozens of court cases about pension assets dot the legal landscape.
When the manager/shareholder reneges on promises it made to em-
ployees about pension benefits, employees often sue. The threat
of litigation helps align the interests of employees and manager/
shareholders.
Many companies are disbanding traditional pension plans and in-
stead offer a “defined contribution plan.” With this type of plan the em-
ployee is not a financing source for the company because all deferred
compensation is typically transferred to a third party. Ownership of
the funds clearly belongs to the employee, and fund management is
not by company managers. Instead, the company usually hires an in-
dependent management company such as Scudder Management Co.,
or Merrill Lynch, etc. The pension management company communi-
cates with employees to make sure employee interests are pursued.

1.2c4 Household Relative to Government

Households own a lot of wealth. They own private goods as well as
financial assets that represent claims on business wealth. Much of
this wealth is managed by the government. The wealth that the gov-
ernment owns is a public good for which households are a primary fi-
nancing source. The government manages the wealth of the nation
in order to satisfy the wants and needs of households in the financial
economy. There exists an agency problem because the households are
principals that ultimately have residual claims on the wealth that gov-
ernment agents manage.
Government decisions generally advance the interests of the
households because, after all, households either elect or tolerate the
government or they revolt when the agency problem becomes intol-
erable. Yet governments often have difficulty managing global wealth.
Difficulties arise for well-known reasons and stories of severe agency
costs induced by government mismanagement dot the historical land-
scape. One difficulty is that households have different objectives and
endowments. Another difficulty is that we lack complete scientific
knowledge about how the real economy interacts with the financial
economy. Governments manage the global wealth claimed by the pop-
ulations that share the planet. That is an agency problem that we’ve
been working to solve for millennia!
 Introduction to Finance 15

1.2d Wealth Creation and the Company Goal

The cash flow cycle in Figure 1.3 shows the many wealth transfers that
exist between the company, stakeholders in real asset markets, and
capitalists in financial markets. The next chapter explains that wealth
transfers represent a flow per time period, and later chapters explain
the crucial relation between time and the valuation process. The oc-
currence in the real world every period of all the flows in the diagram
creates a very complicated mosaic of wealth transfers between capi-
talists, stakeholders and company. Grab hold of the financial economy
by focusing in Figure 1.3 on economic profit (or loss), the droplet Definition 1.3
whether golden honey gains, charred earth losses, or money. Economic profit
Participants in real asset and financial markets compete for com- Periodic economic profit
pensation from the company. Suppliers want to charge the highest equals company economic
possible price for plant, property, and equipment, but the company income minus economic
wants to pay the least possible purchase price (all else equal). Labor cost
wants the highest possible wages, but the company pays only what the
market will bear. Governments collect taxes to build infrastructure in
response to political pressures, and companies hire lobbyists to inform
politicians about constraints on business. Capitalists look for invest-
ments providing the highest risk-adjusted real rate of return, yet com-
panies search for the best available financing terms. And of course,
clients and customers always are on the lookout for the best deal and,
in competitive markets, pay a price exactly equal to their perceived
value of the good or service. Economic theory suggests in the long-run
you get what you pay for and equilibrium economic profits equal zero!
The company adds value by transforming real factors of production
into a good or service that clients demand. The sales transaction be-
tween company and client consummates wealth creation. The real
value of the sales revenue exceeds the real value of the inputs from
stakeholders and capitalists by the amount of real wealth created. The
wealth created equals the transformation value from production. The
company subsequently distributes the new wealth to stakeholders and
capitalists. This simplistic scenario in which economic profit equals
zero is not as bad as it sounds—stakeholders and capitalists receive
fair prices, wages, and rates of return and wealth accumulates through
time.
Economic theory establishes that in realistic and dynamic sit-
uations, economic profits (and losses) exist because of population
and demand growth, technological innovation, market maturation,
product development, and myriad other phenomena such as fads,
changing preferences, or plain old luck. Company management, too,
potentially creates economic profit through superior foresight and
decision-making.
Consider the distribution of economic profit in the cash flow cycle.
One fact is clear: residual wealth flows to equity. If no stakeholders or
creditors lobby for the economic profit then surely it accrues to equity.
But when stakeholders and creditors see the wealth droplet forming,
mouths move toward the funnel. Competition and market structure
determines who sips from the font of economic profit.
16 Chapter 1

For example, perhaps suppliers make technological breakthroughs

that reduce economic costs of production. Surely in the long run, and
in the absence of barriers, the company pays a lower price for sup-
plies and clients pay a lower price for goods and services. In the short-
run, however, suppliers and company management negotiate the
distribution of economic profit. Suppliers want to pocket the profit by
charging the same price for supplies as before. Management, under
the shadow of an agency problem, tries to pay lower costs but charge
the same price for the final product and pass the economic profit on
to capitalist shareholders. So who gets it? Well, it depends on who has
the strongest negotiating position. Capitalists and stakeholders most
likely share economic profit in our modern financial economy.
Other examples abound. Consider a company venturing into a new
cheaper production process for which there is a scarcity of labor with
exactly the right skill package. Who gets the economic profit? Skilled
and highly sought labor tries to get it, or possibly even managers lobby
for bonuses claiming superior foresight for product development.
Clearly in the absence of action the residual flows to equity. But don’t
count on inaction by stakeholders. They are just as smart and greedy
as capitalists!
The creation of wealth in a competitive economy helps the world,
irrespective of who gets it (as long as no one is made worse off in
which case the situation is maddeningly complex), and irrespective of
whether economic profit is zero. This leads to a statement of a proper
and ethical objective for company management:

RULE 1.1 The Objective for Company Management

Management should maximize wealth creation by the company ir-

respective of the distribution of economic profit and in response to
forces from principal-agent relations between stakeholders, capi-
talists, and economic factors of production.

The management job is tough. A good manager faces the difficult

challenge of ascertaining fair and competitive prices and wages for
stakeholders. Sometimes those payments include economic profit,
but not always. Sometimes equity receives all economic profit, some-
times economic profit is zero. Yet as long as managers transfer wealth
to creditors, labor, and suppliers at competitive market prices, and
likewise sell final goods and services to clients at competitive market
prices, the company maximizes wealth creation for capitalists and
stakeholders alike.
The change through time of the equity stock price is a useful indi-
cator of managerial effectiveness. A later chapter explains that stock
prices depend on market assessments of long-run company profit-
ability. A rising stock price indicates (all else equal) a rising forecast of
residual cash flows to equity. A rising stock price (all else equal) gen-
erally confirms that management pursues wealth-creating projects. In
 Introduction to Finance 17

cases when stakeholders with inelastic competitive positions capture

a share of economic profits, the stock price still rises because the fair
rate of return to capitalists includes a real increase in wealth. The
stock price would rise even faster, of course, if the manager could ne-
gotiate lesser payments for stakeholders and divert all economic profit
toward equity. That cannot always be accomplished because stake-
holders sometimes control scarce factors of production. Still, em-
ploying scarce factors of production and getting shareholders half of
something is better than getting them all of nothing. In the rare case
where a stakeholder holds all the cards and receives all economic
profit, management should pursue a policy that creates incremental
wealth for the stakeholder, even though none flows to the shareholder.
The fair rate of return to shareholders excludes economic profit yet
still provides a wealth-increasing risk-adjusted rate of return. The
world becomes a better place when the company pursues policies that
maximize wealth creation, irrespective of the distribution of economic
profit, as long as all capitalist and stakeholder exchanges with the
company occur at competitive prices and rates.
A falling stock price (all else equal) is an indication that man-
agement either is overpaying stakeholders or is selling the final good
or service for less than the economic cost of production. Once again,
running a company is a tough balancing act and the stock price is an
indicator variable for managerial effectiveness.

1.3 Clones of the Company Cash Flow Cycle

The cash flow cycle in Figure 1.3 depicts economic activity applicable
for many different scenarios. Minor interpretive changes allow the
cash flow cycle to depict scenarios in which the company is (1) a cor-
porate business, (2) a noncorporate business, and (3) a household or in-
dividual. Principles of financial science pertain to all these economic
entities with surprising uniformity. It behooves us to discuss the listed
alternative scenarios.

1.3a Corporate Business

The preceding sections identify the company as a corporation. Un-
derstanding basic characteristics of the corporate sector is important
and generally eye opening. The corporate sector in the U.S.A. contains
business names that almost every citizen recognizes: General Electric,
AT&T, Microsoft, Disney, etc. Table 1.3 presents information about
several of these American corporate titans.
18 Chapter 1

Table 1.3 American Corporate Titans (all dollars in millions, 2013)

Number of Annual
Ticker Full-time Total Annual Net Market
Corporation Name Symbol Employees Assets Sales Income Cap
Apple AAPL 84,400 207,000 170,910 37,037 428,700
Walt Disney Company DIS 175,000 81,241 45,041 6,136 116,082
Exxon Mobil Corporation XOM 75,000 346,808 390,247 32,580 438,702
Ford Motor Company F 181,000 202,026 146,917 7,155 60,853
General Electric Company GE 307,000 656,560 142,937 13,057 282,006
General Motors Corp. GM 219,000 166,344 155,427 5,346 61,305
IBM IBM 431,212 126,223 99,751 16,483 197,772
Pfizer Inc. PFE 77,700 172,101 51,452 22,003 196,001
AT&T Corporation T 243,360 277,787 128,752 18,249 183,757
Wal-Mart Stores, Inc. WMT 2,200,000 204,751 474,259 16,022 241,440
Microsoft Corporation MSFT 99,000 142,431 77,849 21,863 287,691

Source: Compiled by author

Every corporation has common stock. The common stocks that

trade on a stock exchange have a company identifier called the “ticker
symbol.” The table shows, for example, that the ticker for Exxon Mobil
is XOM, and for Ford it simply is F. Armed with a ticker symbol one can
easily find on the internet a recent stock price and other news or sta-
tistics for exchange-traded companies.
The range in number of full-time employees is huge. Over 2.2
million walk the floors of Wal-Mart. At Exxon Mobil, which has roughly
three-quarters as much annual sales, the number of employees is
about one-thirtieth as large. Exxon Mobil has significantly more total
assets than Wal-Mart, too. Clearly, sales per employee and sales per
dollar of asset is much higher at Exxon Mobil than Wal-Mart. But the
energy and retail industries differ so significantly that this comparison
is simply amusing trivia.
The rightmost column of Table 1.3 lists company market capital-
ization. Market “cap,” as the next chapter explains, measures the com-
pany’s value in the stock market. Exxon Mobil in 2013 had the largest
stock market value of any company in the U.S.A., $438 billion. Next
highest was Apple at $428 billion. In 2014 (not in table) the market cap
of Apple grew bigger than Exxon Mobil. Notice that net incomes in year
2013 for IBM and Wal-Mart were very similar ($16.5 billion versus $17.0
billion; the next chapter explains that net income is the company profit
from the income statement), but the number of employees and annual
sales are far apart. Compare Pfizer with IBM. The two have roughly the
same stock market value but comparison of employees, assets, and
sales shows differences of incredible magnitude.
 Introduction to Finance 19

The corporate titans in Table 1.3 are not typical corporations. Public
stock exchanges in the U.S.A. trade stocks for more than 10,000 dif-
ferent corporations. Table 1.4 shows quartile breakpoints for a large
sample of these listed companies circa year-end 2013.

Table 1.4 Q
 uartile Breakpoints on Key Variables for 3,412 Public
Companies, 2013 (all dollars in millions)

% of Exchange-
traded Nonfinancial
Corporations with
Less Than Number at Number of Full-
Right time Employees Annual Sales Total Assets Market Cap
100% 2,200,000 $474,259 $346,808 $438,702
75% 5,016 1,802 2,337 2,419
50% 875 338 430 484
25% 120 38 76 72

Companies are sorted by variable in the column header. Excludes financial

companies (SIC 60); companies with incomplete data are dropped (full sample
size is over 9,000 companies).
Source: Compiled by author

While true that Wal-Mart has over 2 million employees, 75% of ex-
change-traded nonfinancial companies have less than 5,016 em-
ployees. One-fourth have fewer than 120 full-time employees. The
American corporate titans are huge compared to average.
Similar tendencies apply to the other variables in Table 1.4. The
maximum annual sales of any corporation in the U.S.A. is $474,259
million (WMT) yet over 50% of all exchange-traded nonfinancial com-
panies have annual sales less than $338 million. Total assets and
market cap are skewed, too. Comparing the biggest company to the
median is like comparing Jane and John Doe’s wealth to Microsoft’s Bill
and Melinda Gates. Yet the same financial principles apply to all.
The biggest companies may be atypical, and there may be few of
them, but they command huge influence in the financial and real asset
markets. Table 1.5 lists the sum for all companies in the sample within
each quartile.
20 Chapter 1

Table 1.5 Aggregate Distribution of Resources for 3,412 Public

Companies (all dollars in millions, parentheses list
percent of sample total)

Table Entry Is Sum

for All Nonfinancial
Corporations in Number of Full-
Sample Quartile time Employees Annual Sales Total Assets Market Cap
biggest quartile 28,906,971 $11,322,787 $14,250,088 $14,934,398
(92.4%) (92.8%) (92.5%) (92.5%)
upper middle 1,992,035 740,916 994,972 995,430
(6.4%) (6.1%) (6.1%) (6.2%)
lower middle 334,989 129,092 181,359 196,268
(1.1%) (1.1%) (1.2%) (1.2%)
smallest quartile 34,940 10,124 21,704 22,444
(0.1%) (0.1%) (0.1%) (0.1%)
TOTAL 31,268,935 $12,202,919 $15,398,122 $16,149,540

(Quartiles rebalanced by sorting on each variable.) See Table 1.4 for a description
of the data.

There are 31.3 million full-time employees for this sample of ex-
change-traded nonfinancial corporations. Rank all companies by
number of employees and count the total employees in the biggest 25
percent. The table shows that the biggest 25% employ 92.4 percent of
all employees in the company sample. Combine the smallest two quar-
tiles to see a more startling fact: 50 percent of companies in the sample
employ only 1.2 percent of all employees working for exchange-traded
nonfinancial corporations.
Glean insight on the size of the sample relative to the entire US
economy. According to the Bureau of Census there are 143.9 million
full-time employees in the USA in 2013 working in business forms of
organization. The sample of 31.3 million represents about 22% of total
US employment. The upshot is that our sample of exchange-traded
nonfinancial corporations primarily includes bigger than average
companies. Within our sample, already tilted toward large NFC, em-
ployment tends to tilt toward the largest among the large.
The tendency is true for all variables in the table. Consider this:
almost 92½ percent of NFC stock market wealth in the U.S.A. is due to
only 25 percent of listed companies; 75 percent of corporations rep-
resent 7½ percent of stock market wealth. (The clustering is true even
with inclusion of financial corporations.)
Perhaps small corporations represent a relatively small proportion
of corporate employment, sales, total assets, and stock market value,
but do not trivialize the small company. Any individual is a big-time
success who can establish a corporation that grows to employ 120
people, generates $38 million in annual sales, has $76 million of total
assets, and has a value in the stock market of $72 million. You can
 Introduction to Finance 21

bet, too, that this successful entrepreneur owns a big share of that $72
million and, to 120 different families and countless stakeholders, he or
she is a very important person.
About ten thousand different corporate stocks trade on stock ex-
changes in the U.S.A. Each active corporation in the nation files a tax
return. The Internal Revenue Service received about 6.7 million cor-
porate tax returns in 2010. This suggests that exchange-traded cor-
porations represent less than one percent of all corporations. The
apparent motivation for organizing a company as a corporation is not
so that its stocks can trade on an exchange. Rather, the corporate form
of business organization offers other advantages. These include:
1. limited liability for the owner(s)
2. easy transferability and sharing of ownership
3. potentially infinite life (at least it might surpass the owner’s
lifespan)
4. easier access to the financial markets
Several significant disadvantages include:
5. legal obligations for corporations are sometimes quite complex
6. corporate income is subject to “double taxation”
Shareholders are the corporation owners. Limited liability for the
owners implies that the maximum shareholder wealth at risk equals
the value of the shares. The shareholder of a corporation protects
personal wealth (house, car, savings, etc.) from litigation against the
company. Someone suing a corporation may receive, in an extreme
case, a judgment bankrupting the company, and perhaps sometimes
an unscrupulous manager may be thrown in jail because of actions
on-the-job. But the personal wealth of shareholders is untouchable, as
though shielded behind a firewall.
Advantages 2 and 3 occur because every corporation has common
stock and whoever owns the common stocks possesses control over
management and has claims on residual cash flows. The owner/
manager of a small company cannot sell company shares on stock ex-
changes without satisfying many government and exchange rules. But
the owner/manager may privately sell (or give) shares to key employees,
family members, or capitalists. Selling or sharing common stock im-
plies sharing of corporate control and profits. The transferability of
shares gives the company a lifespan that potentially is infinite.
Advantage 4, access to financial markets, largely occurs because
advantages 1–3 encourage purchase of shares by outside investors.
Furthermore, government regulations place stringent requirements
on corporate financial reporting. These information disclosures, even
though they impose a burden on corporations because preparing re-
ports takes time and money, increase the company’s attraction to
capitalists.
Tax policies for corporate income are interesting and controversial.
Imagine that a man-on-the street generates sales and profits from
22 Chapter 1

goods in his shopping cart. The personal tax on the profit is the same as
if the income for the man were from wages instead of business profit.
Suppose instead that the man-on-the street is organized as a corpo-
ration. The man pays corporate tax on the profit, distributes the profit
to himself since he is the owner, and then as a capitalist he pays per-
sonal tax on the distribution. This is “double-taxation.” Both the corpo-
ration and capitalist pay taxes on the same income stream.
Economists persuasively argue that double-taxation biases the al-
location of capital and makes the economy less wealthy. Politicians,
conversely, argue for popular votes by pointing fingers at mighty cor-
porations that pay few taxes. Politicians generally ignore the claim by
economists that if double-taxation were abolished, corporations would
either (a) pass along the tax savings to capitalists where it would incur
personal taxes, or (b) pass along the tax savings to stakeholders in
the form of higher wages or purchases. The U.S.A. is the only major
economy on the globe that has not abolished double-taxation of cor-
porate income.

1.3b Noncorporate Business

Companies often operate in an organization that is not a corporation.
There are two primary forms of noncorporate business: sole propri-
etorship and partnership. Table 1.6 provides insight by listing number
of tax returns received by the Internal Revenue Service in 2010.

Table 1.6 Type of Economic Entities in U.S.A., 2010

Approximate Number of Tax Returns Received by the

IRS from the Economic Entity at Left
nonfarm sole proprietorship 29.7 million
partnership 3.4 million
corporation (form 1120) 3.3 million
S-corporation (form 1120S) 4.4 million
individuals 141.5 million

Source: Compiled by author

The sole proprietorship is, by number, the most prevalent type of

business organization. Any individual may operate a business as a sole
proprietorship so long as the company is compliant with local and
state regulations. The federal government does not require that sole
proprietors obtain I.R.S. permission to operate. Sole proprietors file in-
dividual income tax returns (form 1040) and attach a Schedule C sum-
marizing business income and expenses.
 Introduction to Finance 23

Almost half of all business receipts for nonfarm sole proprietor-

ships lie within three industry groups. Retail trade is the largest in-
dustry for sole proprietors, garnering 19.1% of the total. Construction
is second (15.9%), and Professional Services third (11.0%). Individuals
in these industries pursue an entrepreneurial dream by setting-up
shop as sole proprietor. Advantages of the sole proprietorship form of
business organization include:
1. relatively easy start-up and record-keeping requirements
2. there is no double-taxation
Disadvantages generally are that the sole proprietor does not have the
corporate advantages:
3. the sole proprietor has unlimited liability and his/her personal
wealth is at risk
4. ownership is not easily transferred so company lifetime is
somewhat limited
5. access to financial markets is linked to collateral provided by
the proprietor
A hybrid form of sole proprietorship is the “S-corporation.” The In-
ternal Revenue Service allows companies meeting certain conditions,
such as fewer than 75 shareholders, to organize as S-corporations. An
S-corporation files form 1120S but does not pay any corporation taxes.
Instead, all profits pass through to shareholders. The shareholders file
a Schedule E with their individual tax form 1040. Profits earned by S-
corporations incur personal taxes but avoid double-taxation.
Partnerships are the least common form of business organization.
There are two types: general partnerships and limited partnerships.
The general partnership has the same advantages and disadvantages
as the sole proprietorship. The income and profits of the partnership
are distributed among the partners, and each partner declares his/
her share on an individual tax return. The partnership also files a tax
return (form 1065), but double-taxation does not exist.
The limited partnership allows each partner to insulate personal
wealth from litigation against the partnership. This attribute is similar
to the limited liability enjoyed by corporate shareholders.
The cash flow cycle in Figure 1.3 is a fair depiction for sole propri-
etorships and partnerships. The only difference occurs in definition
of the equity market. These two forms of business organizations do
not have shareholders as a financing source. The source of equity fi-
nancing for these business forms is, respectively, the sole proprietor or
the partners.

1.3c Households As Companies

Many people realize that managing a household may be as complex
as managing a company or institution. Households, like corporate
and noncorporate companies, bring together resources from financial
24 Chapter 1

markets and stakeholders in order to create real goods and services.

Households are the largest economic entity in the U.S.A. Financial fore-
casts of economic recession or expansion often begin by stating the
importance of household financial behavior on aggregate spending,
employment and production. Two-thirds of U.S. gross national product
is the result of household spending for real goods and services. Table
1.7 compares corporate and household balances.
Total assets are nearly three times larger in the household sector
($92.7 trillion) than in the nonfinancial corporate sector ($34.7 trillion).
The two largest types of assets for households include real estate and
pension assets. Pension assets are financial assets, and households
own a lot of financial assets. A lot of the financial assets that house-
holds own include equities issued by the nonfinancial corporate sector.
People living in households are, after all, the shareholders that own
corporations.
Perhaps you are surprised how much wealth households own
compared to businesses. But drive around town and notice all the
real goods and services that you see. Businesses undeniably have a
lot of stuff: stores and service stations seemingly are everywhere.
Keep driving, though, and begin to notice that people own so much
more: houses, cars, plus tens of trillions of dollars in financial assets
causing a feeding frenzy by institutions competing for management of
household financial assets!
The wealthiest households, just like the biggest companies, are
atypical and there are few of them. Yet they command huge influence
in politics and financial and real asset markets. Recent statistics from
the Internal Revenue Service report that the top 1 percent of taxpayers
now furnishes more than one-third of income tax receipts. The top 50
percent pay 96 percent of revenues that the government receives in
personal income taxes.
The company cash flow cycle in Figure 1.3 depicts households, too.
The funnel represents the household acting as a company. Managing
households requires many of the same functional skills as managing
companies. Households depend on credit markets as a financing source
for buying homes, cars, and college education. Households, like non-
corporate companies, do not have shareholders. Still, the household
inhabitants are a source of equity financing, and households accu-
mulate net worth. Net worth equals total assets minus total liabilities.
Household net worth of $78.9 trillion is more than four times larger
than corporate net worth of $19.1 trillion.
 Introduction to Finance 25

Table 1.7 B
 alance Sheets for the Nonfarm Nonfinancial Corporate
Sector and for Households (Including Nonprofit
Organizations), Year-end 2013 (dollars in billions)

Nonfarm Nonfinancial Corporations Household and Nonprofit Economic Entities

total assets $34,708 total assets $92,660
real estate 10,217 real estate 22,300
trade receivables 2,432 durable goods 4,942
equipment & inventories 6,409 currency & deposits 9,699
Financial & other assets 15,650 corporate equities 12,457
equity in noncorporate business 8,971
pension fund reserves 19,890
other financial assets 6,675
total liabilities $15,591 total liabilities $13,794
credit market securities 7,121 credit market instruments 13,171
trade payables 1,951 other liabilities 623
other liabilities 2,527
net worth $19,117 net worth $78,866
market value of equity $20,800 market value of equity not traded

All entries at market value or replacement cost

Source: “Flow of Funds Accounts of the United States,” Board of Governors of the
Federal Reserve System, tables B100 and B102

Households also develop stakeholder relationships in real asset

markets. Households go to suppliers such as grocery stores, clothiers,
car dealers, etc. Households hire labor such as carpenters, carpet
cleaners, baby sitters, etc. Certainly households pay taxes; Table 1.6
shows that households are filing over 141 million tax returns in year
2010.
Clients of households are of two types. First, employers are clients
because the household sells its labor services in exchange for wages
(revenue). Second, household inhabitants are clients to themselves. In-
dividuals and/or family units realize benefits of the goods and services
that households create. And the objective of the household is to max-
imize the wealth that it creates. That is, the household maximizes the
utility of the goods and services created from transformation of capi-
talist and stakeholder inputs.
Several important components of national wealth are not in Table
1.7. Most significant is government wealth. The government owns
schools, fire stations, parks, aircraft carriers, and on and on. It almost
is incomprehensible to consider how much wealth the local, state, and
federal governments own. These institutions carry-forward balance
sheets that capitalize the wealth from countless millennia of human
industry, discipline, and cumulative learning. In almost every way,
the citizenry are sources of equity, shareholders and owners of gov-
ernment wealth subject to incredible agency cost.
26 Chapter 1

finance.