1 finance and the firm. the field of finance the duties of financial managers the basic goal of a...

1

Finance and Finance and the Firmthe Firm

The field of finance The duties of financial managers The basic goal of a business firm Legal and ethical challenges for

financial managers Forms of business organization

2

Financial Management• Analyze and forecast a firm’s

performance• Evaluate investment opportunities

Financial Markets and Institutions• The flow of funds through institutions• Markets in which financial assets are sold• Impact of interest rates on that flow of

funds Investments

• Locate, select, and manage moneyproducing assets.

3

Liabilities and equity represent sources of funds.

Assets represent uses of funds. Liabilities represent a debt claim. Equity represents an ownership claim.

4

Balance Sheet

Assets Liabilities

Equity

Financial Statements

Capital Budgeting Capital Structure Policy Working Capital Management

5

6

Financial ManagementFinancial Management

ST Assets

LT Assets

ST Liabilities

LT LiabilitiesEquity

LT Assets

Deals with the firm’s investment in long-term real assets

e.g., in what projects should the firm invest?

Capital Budgeting

7


ST Assets

LT Assets

ST Liabilities

Deals with long-term financing of the firm’s activities

e.g., what mix of long term debt and equity will the firm use?

Capital Structure Policy


8

Deals with management of short-term (current) assets.

e.g., will the firm purchase supplies on credit or pay cash?


ST Assets

LT Assets

ST Liabilities


ST Assets

Working Capital Management

9

InvestmentsInvestments

Stockholders are owners of the firm Bondholders are creditors of the firm

Looks at financial analysis from perspective of investor

Risk-return tradeoff: Investors prefer high returns to low returns and low risk to high risk.

From the firm’s perspective this rate of return represents a cost of funds.

From investor’s perspective, what matters is the rate of return on a security

Financial markets and institutions facilitate the flow of funds in the economy

10

This makes society more productive, thus increasing social welfare

Topics include:

How interest rate levels are determinedHow the Fed controls the money supplyRelationships between macroeconomic

variables such as inflation, interest rates, money supply and GDP.

Measure a firm’s performance Forecast financial consequences Recommend new investment Locate external financing Recommend best financing mix Determine financial expectations of

owners

11

The primary financial goal of the business firm is to maximize the wealth of the firm’s owners (or the value of the firm).

This is not necessarily the same as “maximizing profits”.

12

The value of a firm is determined by what people are willing to pay for it.

The financial manager should make decisions that cause people to think more favorably about the firm.

Value depends on future prospects and risk.

13

14

Cash flows– Necessary to pay the bills– Not the same as sales or profits

Timing of cash flows– Cash received sooner is better than cash

received later

Risk– Definite cash inflows are generally

preferred to uncertain cash inflows

Managers are agents for the firm’s owners but they may have interests that conflict with those owners.

These agency conflicts impose costs (such as the cost of accounting audits).

15

Agency issues

Interests of non-owner stakeholders Workers, creditors, suppliers,

customers, and others are not owners, but may have a stake in the business.

16

Legal and Ethical ChallengesLegal and Ethical Challenges

The interests of society as a whole may not coincide with the interests of owners of a firm. Costs of disposing of toxic waste reduce

owners’ profits. There may be goodwill generated by

voluntary actions that benefit society. Sometimes the right thing must be done in

spite of the cost to the company Government often imposes rules that

force companies to respond to the best interests of society.

timg

Switches to slide 17, too soon.

17

Sole Proprietorship Advantages

• Easily Established• Minimal Organizational Costs• Keep all Generated Profits

Disadvantages

• Unlimited Liability• Losses absorbed by owner• Limited Capital• Limited Life

Minimal Organizational Requirements

Negligible Government Regulations

18

General Partnership Advantages

• Unlimited Liability• Must be Dissolved or

Reorganized if a Partner Leaves or Dies

Disadvantages

19

Limited Partnership (LP)

Two classes of partners• General Partners• Limited Partners

Every partnership must have at least one general partner

20


General Partners

Advantages

•Participate actively in management•More favorable allocation of ownership/profit/losses

Disadvantages

•Unlimited Liability

21


Limited PartnersLimited Partners

Advantages

•Limited liability

Disadvantages

•not active in management•less favorable allocation of ownership/profit/losses

22

Limited Liability Partnership (LLP)

Similar to General Partnership

•operates like a corporation

•limited liability

•partnership not taxed

•income passed through to partners and partners are taxed

Double Taxation Time and Cost of Incorporation

23

Corporation

• Advantages

• Disadvantages

A legal “person” separate and distinct from its owners

– Limited Liability– Permanency– Transferability of Ownership– Better Access to Capital

24

Limited Liability Company (LLC)

• Advantages

• Disadvantages

A form of business organization that is a state-approved, unincorporated association.

– Limited Liability– No Double Taxation

– Relatively New - Some Legal Issues Not Yet Defined

25

Answer the following Questions on Answer the following Questions on your power-point homework pageyour power-point homework page

What is the fiduciary responsibility of an agent?

What is meant by double taxation?

Explain which type of business organization form affords the most control to the owner?

Why would someone choose a limited partnership share over a sole proprietorship?

How do agency problems arise? What are some examples of agency problems? What can corporations do to monitor these costs?

26

Financial MarketsFinancial Marketsand Interest Ratesand Interest Rates

Operation of U.S. financial system. Financial securities. Function of financial intermediaries. Financial markets. Securities traded in the money and

capital markets.

27

The purpose of the financial system is to bring together individuals, businesses, and government entities (economic units) that generate and spend funds.

28

Surplus economic units Surplus economic units have funds left over have funds left over after spending all they wish to spend.after spending all they wish to spend.

Deficit economic units Deficit economic units need to acquire need to acquire additional funds to sustain their operations.additional funds to sustain their operations.

To enable funds to move through the financial system, funds are exchanged for securities.

Securities are documents that represent the right to receive funds in the future.

Financial intermediaries discussed in Chapter 3 often help to facilitate this process.

29

Classified according to the characteristics of participants and securities involved.

The primary market is where deficit economic units sell new securities to raise needed funds.

30

31

Securities

Funds

PrimaryPrimaryMarketMarket

Classified according to the characteristics of participants and securities involved.

The primary market is where deficit economic units sell new securities.

The secondary market is where investors trade previously issued securities with each other.

32

33

Securities

Funds

SecondarySecondaryMarketMarket

Money Market vs. Capital Market

34

Money Market• Trade short term (1 year or less) debt

instruments (e.g. T-Bills, Commercial Paper)• Major money centers in Tokyo, London and

New York Capital Market

• Trades long term securities (Bonds, Stocks)• NYSE, ASE, over-the-counter (Nasdaq and

other OTC)

35

36

Securities

Securities$$

$$

Intermediaries such as commercial banks andinsurance companies help to facilitate theflow of funds in the financial marketplace.

Market efficiency refers to the ease, speed, and cost of trading securities.• The market for the securities of large

companies is generally efficient: Trades can be executed in a matter of seconds and commissions are very low.

• The real estate market is not generally efficient: It can take months to sell a house and the commission is 6-7% of the price.

37

• The more efficient the market, the easier it is to transfer idle funds to those parties that need the funds.

• If funds remain idle, this results in lower growth for the economy and higher unemployment.

• Investors can adjust their portfolios easily and at low cost as their needs and preferences change.

38

Why is market efficiency important?Why is market efficiency important?

Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)• Commercial Paper• Eurodollars• Banker’s Acceptances

39


40

• T-Bills:T-Bills: are short-term securities issued by the Federal government.

•After initial sale, they have an active secondary market.

•They are bought at a discount and at maturity the investor receives the full face value.

Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)• Commercial Paper• Eurodollar• Banker’s Acceptances

41

• Negotiable CDs:Negotiable CDs: are interest-bearing securities issued by financial institutions.

•They have maturities of one year or less.

Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)

•Commercial Paper• Eurodollars• Banker’s Acceptances

42

• Commercial paper:Commercial paper: is unsecured debt issued by corporations with good credit ratings.

•Most buyers are large institutions.

Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)• Commercial Paper

•Eurodollars• Banker’s Acceptances

43

• Eurodollars:Eurodollars: are dollar denominated, deposits, located in non-US banks.

•Buyers and sellers are large institutions.

Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)• Commercial Paper• Eurodollars

•Banker’s Acceptances

44

•Banker’s AcceptancesBanker’s Acceptances:: are debt securities that have been guaranteed by a bank. They are used to facilitate international transactions.


45

Capital Market Securities• Bonds

46

•BondsBonds:: are “IOUs” issued by the borrower and sold to investors.

•The issuer promises to repay the face amount on the maturity date and to pay interest each year in the amount of the coupon rate times the face value.

• BondsTreasury BondsMunicipal BondsCorporate Bonds

47

• Treasury Bonds:Treasury Bonds: are issued by the federal government.

• Municipal Bonds:Municipal Bonds: are issued by state and local governments.

• Corporate Bonds:Corporate Bonds: are issued by corporations.

Capital Market SecuritiesCapital Market Securities

• Stock

48

•Companies can also raise funds by selling shares of stock


• StockCommon Stock

49

• Common stockholders:Common stockholders: own a portion of the company and can vote on major decisions.

•They receive a return on their investment in the form of dividends and capital gains.


• StockCommon StockPreferred Stock

50

• Preferred stockholdersPreferred stockholders do not generally have voting rights, but have priority in receiving dividends and are paid dividends at a pre-set rate.


• Real Rate of Interest• Expected Inflation• Default Risk• Maturity Risk• Illiquidity Risk

51

Interest Rates Determined byInterest Rates Determined by

• Compensates for the lender’s lost opportunity to consume.

52

Real Rate of InterestReal Rate of Interest

• For most securities, there is some risk that the borrower will not repay the interest and/or principal on time, or at all.

• The greater the chance of default, the greater the interest rate the investor demands and the issuer must pay.

53

Default RiskDefault Risk

Expected Inflation

54

Inflation erodes the purchasing power of Inflation erodes the purchasing power of money.money.

Example: If you loan someone $1,000 and they Example: If you loan someone $1,000 and they pay it back one year later with 10% interest, pay it back one year later with 10% interest, you will have $1,100. But if prices have you will have $1,100. But if prices have increased by 5%, then something that would increased by 5%, then something that would have cost $1,000 at the outset of the loan will have cost $1,000 at the outset of the loan will now cost $1,000(1.05) = $1,050.now cost $1,000(1.05) = $1,050.

Maturity Risk

55

If interest rates rise, lenders may If interest rates rise, lenders may find that their loans are earning find that their loans are earning rates that are lower than what they rates that are lower than what they could get on new loans.could get on new loans.

The risk of this occurring is higher The risk of this occurring is higher for longer maturity loans.for longer maturity loans.

Maturity Risk

56

Lenders will adjust the premium they Lenders will adjust the premium they charge for this risk depending on whether charge for this risk depending on whether they believe rates will go up or down.they believe rates will go up or down.

Illiquidity

57

Investments that are easy to sell without Investments that are easy to sell without losing value are more liquid.losing value are more liquid.

Illiquid securities have a higher interest Illiquid securities have a higher interest rate to compensate the lender for the rate to compensate the lender for the inconvenience of being “stuck.”inconvenience of being “stuck.”

k = the nominal, or observed rate on security

k* = real rate of interestIRP = Inflation Risk

PremiumDRP = Default Risk PremiumMP = Maturity PremiumIlP = Illiquidity Premium

58

k = k* + IRP + DRP + MP + ILPk = k* + IRP + DRP + MP + ILP

Determination of Rates

Term Structure

59

Relationship between long and short Relationship between long and short term interest ratesterm interest rates

Yield curveYield curve

60

8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. yr.

maturities

Jan 10, 2006

3 month T-Bill

3 month T-Bill

61

8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. maturitiesyr.

6 month T-Bill

6 month T-Bill

Treasury Yield CurveTreasury Yield Curve

Jan 10, 2006

62

8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. yr.

maturities

1 year T-Bill

1 year T-Bill


Jan 10, 2006

63

8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. yr.

maturities

2 year T-Note

2 year T-Note


Jan 10, 2006

64

8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. yr.

maturities

3 year T-Note

3 year T-Note


Jan 10, 2006

65

8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. yr.

maturities

5 year T-Bond

5 year T-Bond


Jan 10, 2006

66

8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. yr.

maturities


Jan 10, 2006

67

8.00%

7.50%

7.00%

6.50%

6.00%

5.00%

5.50%

4.50%

4.00%

3.50%3 6 1 2 3 5 7 2010

mos. yr.

maturities


Jan 10, 2006

March 22,1995August 1, 2006

68

Answer the following Questions on Answer the following Questions on your power-point homework pagesyour power-point homework pages

Would the default premium on an investment grade corporate bond be higher or lower than that on a junk bond? Explain.

Explain the difference between a dealer and a broker.

The more liquid the financial instrument, the wider the spread between the bid and ask price. Explain why you agree or disagree with this statement.

The economy is suffering from a recession, explain what will happen to the yield spread between a Treasury bond and a BBB rated corporate bond.

Explain how you earn a return on a Treasury bill. How is this different from the manner in which you earn a return on a Treasury note or bond?

69

FinancialInstitutions

Learning ObjectivesThe role of financial intermediaries.Commercial banks and the impact of

reserve requirements.Federal Reserve regulation of financial

institutions.The difference between savings and

loans and commercial banks.Operation of credit unions.Distinguish among finance companies,

insurance companies, and pension funds.

70

The Role of Financial Institutionsas Intermediaries (“Middle Persons”)

A household with surplus funds can “purchase” a savings account at a financial institution. The bank, S&L, or credit union channels those surplus funds to a firm, government entity, or a household that needs them.

In this way, small surplus units can be packaged together to meet the needs of large deficit economic units.

71

Services offered by Financial Institutions Denomination matching

72

Services offered by Financial Institutions

Denomination matchingHouseholds generally have small amounts of

surplus funds to invest. They can put small amounts into savings at a time.

73

Services offered by Financial Institutions Denomination matching

Households generally have small amounts of surplus funds to invest. They can put small amounts into savings at a time.

Those who need loans usually require larger amounts of funds. They can borrow for business purposes, or to buy a home or automobile.

74


Maturity MatchingHousehold and business savers

generally want to lend for only a short time. Savings and checking accounts are usually available for immediate withdrawal.

75


Maturity MatchingHousehold and business savers

generally want to lend for only a short time. Savings and checking accounts are usually available for immediate withdrawal.

Borrowers often want long-term financing. Institutions can give 30 year mortgages and long-term loans to businesses and government entities.

76


Absorbing Credit RiskIndividual lenders cannot easily

evaluate the credit risk of borrowers. They also cannot generally afford to take the risk of losing their limited savings.

77


Absorbing Credit RiskIndividual lenders cannot easily evaluate

the credit risk of borrowers. They also cannot generally afford to take the risk of losing their limited savings.

Institutions have the necessary expertise and also are in a better position to absorb an occasional loss.

78

The Role of Financial Institutions

79

Securities

Securities$$

$$

Intermediaries help to facilitate theflow of funds in the financial marketplace.

80

Financial Intermediation

Commercial loans

$$

Businesses Households

$$ Checking accounts

CommercialBank

Example 1

81

Financial Intermediation

Stocks,Bonds

Businesses

InsuranceCompany

Households

$$ Insurancepolicies

$$

Example 2

Types of Financial Institutions

Commercial Banks

82

Types of Financial InstitutionsCommercial Banks

83

The primary purpose of commercial banksis to take in business deposits and to lend funds to businesses.

Types of Financial InstitutionsCommercial BanksSavings and Loans

84

Types of Financial InstitutionsCommercial BanksSavings and Loans

85

Savings and loans’ primary purpose is to take in deposits from households and to lend funds for home mortgages.

Types of Financial InstitutionsCommercial BanksSavings and LoansCredit Unions

86

Types of Financial InstitutionsCommercial BanksSavings and LoansCredit Unions

87

Credit Unions are owned by depositors (actually share owners) who are individuals, not businesses. Credit Unions take in funds and primarily make personal loans.


Commercial BanksSavings and LoansCredit Unions

88

} Depository Institutions


Commercial BanksSavings and LoansCredit Unions

89

} Depository Institutions

•Take in deposits•Make loans


Finance Companies

90


Finance Companies

91

Non-bank firms that borrow funds to make short and medium term loans to higher risk borrowers.


Finance CompaniesInsurance Companies

92

Types of Financial InstitutionsFinance CompaniesInsurance Companies

93

Receive premiums for insurance policies.This pool of funds is used to reimburse policyholders who incur losses that are covered under the policy .

Life Insurers: Insure against financial hardship caused by death.Property and Casualty: Insure againstdamage to person and property (health, autos,homes, theft, earthquake, etc.)


Finance CompaniesInsurance CompaniesPension Funds

94

Types of Financial InstitutionsFinance CompaniesInsurance CompaniesPension Funds

95

Workers and/or employers contribute funds. Defined Benefit Plans (DBP) versus Defined Contribution Plans (DCP).


96

}Non-

Depository Institutions


97

•Funds come from borrowing, selling insurance policies, and other claims.•Funds used to buy securities and make loans.

}Non-

Depository Institutions

Reserve Requirement of Depository Institutions

A specified percentage of deposits must be held as non-earning reserves.

Required by the Fed.Insures that institutions have some

liquidity to meet demand for withdrawals and helps to control the money supply.

98

99

Reserves

Investments

Loans

Deposits

Borrowed Funds

Bank Capital (Equity)

Fixed Assets

The Fed is the central bank of the United States

Created in 1913

100

The Federal Reserve System

101

Purpose of the FedPurpose of the Fed

Monetary authorityi.e., control the money supply

102



Lender of last resortFed makes “discount loans” to depository

institutions

103



Lender of last resortFed makes “discount loans” to depository

institutions

Check clearing

104



Lender of last resortFed makes “discount loans” to

depository institutions

Check clearingBank Supervision

Structure of the FedBoard of Governors

Seven membersLocated in Washington, DC

Federal Open Market Committee (FOMC)Board of Governors plus five district

Federal Reserve Bank presidentsLocated in Washington, DC

Twelve Federal Reserve BanksCorresponding to twelve districts

Member Banks

105

How the Fed Influences Interest Rates

Open Market OperationsDiscount Rate PolicyReserve Requirements

106

Open Market Operations

The Fed buys and sells government securities in the open market.

Buying securities increases the money supply which tends to decrease interest rates.

Selling securities decreases the money supply which tends to increase interest rates.

107

108

When the Fed When the Fed buysbuys T-BillsT-Bills

The public

T-bills

$The Fed

109

When the Fed When the Fed buysbuys T-Bills T-Bills

Reserves are injected into the economy

The public

T-bills

$The Fed

110

When the Fed When the Fed buysbuys T-bills T-bills

Bank reserves increase.

111


Bank reserves increase.This makes banks more willing to

lend, increasing the supply of loanable funds.

112


Bank reserves increase.This makes banks more willing to

lend, increasing the supply of loanable funds.

{Supply of LF } { i }

When the Fed buys T-billsBank reserves increase.This makes banks more willing to lend,

increasing the supply of loanable funds.{Supply of LF } { i }Fed decreases rates when it wants to

stimulate the economy.

113

114

When the Fed When the Fed sellssells T-Bills T-Bills

The public

T-bills

The Fed $

115

When the Fed When the Fed sellssells T-Bills T-Bills

Reserves are extracted from the economy

The public

T-bills

$The Fed

116

When the Fed When the Fed sellssells T-billsT-bills

Bank reserves decrease

117

When the Fed When the Fed sellssells T-bills T-bills

Bank reserves decreaseThis makes banks less willing to

lend, decreasing the supply of loanable funds.

118

When the Fed When the Fed sellssells T-billsT-bills

Bank reserves decreaseThis makes banks less willing to

lend, decreasing the supply of loanable funds.


When the Fed sells T-billsBank reserves decreaseThis makes banks less willing to lend,

decreasing the supply of loanable funds.

Fed raises rates when it wants to slow the economy down.

119


120

Discount Rate PolicyDiscount Rate Policy

When the Fed increases the discount rateThis increases the cost of funds to

borrowing depository institutions, causing them to increase the rates they charge.

Discount Rate Policy

When the Fed increases the discount rateThis increases the cost of funds to

borrowing depository institutions, causing them to increase the rates they charge.

When the Fed decreases the discount rateThis decreases the cost of funds to

borrowing depository institutions, causing them to decrease the rates they charge.

121

122

Reserve Reserve RequirementsRequirements

When the Fed When the Fed increasesincreases reserve requirementsreserve requirements– This This decreasesdecreases the amount of the amount of

funds available for lending funds available for lending

123

Reserve Reserve RequirementsRequirements

When the Fed When the Fed increasesincreases reserve reserve requirementsrequirements– ThisThis decreases decreases the amount of funds the amount of funds

available for lendingavailable for lending

– {{Supply of LF Supply of LF }} {{ i i }}

124

Reserve RequirementsReserve Requirements When the Fed When the Fed increasesincreases reserve reserve

requirementsrequirements– This This decreasesdecreases the amount of the amount of

funds available for lendingfunds available for lending

– {{Supply of LF Supply of LF }} {{ i i }} When the Fed When the Fed decreasesdecreases reserve reserve

requirementsrequirements– This increases the amount of funds This increases the amount of funds

available for lendingavailable for lending

Reserve RequirementsWhen the Fed increases reserve

requirementsThis decreases the amount of funds

available for lending {Supply of LF } { i}

When the Fed decreases reserve requirementsThis increases the amount of funds

available for lending {Supply of LF } { i}

125

The Federal ReserveAs the central bank of the United

States, “The Fed” regulates the financial system, the nation’s money supply, and makes loans to financial institutions.

The Fed consists of twelve district banks, the Federal Open Market Committee, and the Board of Governors. The latter two are located in Washington DC.

126

The Fed Influences Interest Rates by:

Buying and selling federal securities (“open market operations”).Selling (buying) securities reduces (increases) the

money supply which tends to increase (decrease) interest rates.

Discount rateIncreasing the cost of funds to financial institutions

tends to increase the rates they charge.Reserve Requirements

Increasing (decreasing) the amount of non-earning reserves that must be held makes funds less (more) available and generally more (less) costly.

127

128

Answer the following Questions on Answer the following Questions on your power-point homework pagesyour power-point homework pages

Explain how the Fed lowers and raises the federal Explain how the Fed lowers and raises the federal funds rate.funds rate.

What is the discount window?What is the discount window?

The Federal Reserve is concerned about a continuing The Federal Reserve is concerned about a continuing recession; what will they most likely do and how will recession; what will they most likely do and how will they accomplish this?they accomplish this?

What would happen to the standard of living if What would happen to the standard of living if financial institutions did not exist? Why?financial institutions did not exist? Why?

Interest rates are about to rise in the near future. Interest rates are about to rise in the near future. Explain how this would impact a negatively interest-Explain how this would impact a negatively interest-rate spread financial institution.rate spread financial institution.

1 finance and the firm. the field of finance the duties of financial managers the basic goal of a...

Documents

financial assets

financial managementdeals

financial managementanalyze

financial analysis

firms owners

primary financial goal

firms perspective

interests of owners