chapter fifteen finance: balancing risk and return to increase profitability © 2007 the mcgraw-hill...
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Chapter Fifteen
Finance: Balancing Risk and Return to Increase
Profitability© 2007 The McGraw-Hill Companies, Inc., All Rights
Reserved.McGraw-Hill/IrwinIntroduction to Business
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Learning Objectives
1. Appreciate the crucial relationship between risk and return and the way it affects all business finance decisions.
2. Understand short-term capital management and the tools managers use to increase the rate of return on capital.
3. Understand long-term capital management and the tools used to manage it, like net present value and breakeven analysis.
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Learning Objectives
4. Describe four different methods companies can use to finance capital investments.
5. Differentiate between the roles debt and equity securities play in financial decision making.
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What is Finance?
• Finance - the set of activities people and companies
engage in to decide how to invest their capital so that it generates more cash, profit, and wealth
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The Relationship Between Risk and Return
Value of the Asset Now – Value at Time of Purchase X 100
Value of the Asset at Time of Purchase
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Question?
What is the extra reward investors demand for bearing the additional risks associated with a speculative investment?
A. SpeculationB. Bond portfolioC. Risk premiumD. Risk leverage
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The Relationship Between Risk and Return
• Risk premium - the extra reward investors demand for
bearing the additional risks associated with a speculative investment
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Business Finance
• The role of business finance is to ensure that the methods a company uses to borrow, invest, spend, and even lend capital lead to a rate of return that maximizes the present market value of its stock
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Capital Investment and Budgeting
• Capital investment and budgeting - the development of a financial plan and
budget to manage and invest capital so that it leads to the highest return on invested capital that can be obtained
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Short-Term Capital Management Decisions
• Short-term capital management - the financial decisions involved when a
company purchases resources to make products that will be sold within a one-year period
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Long-Term Capital Budgeting Decisions
• Long-term capital budgeting - the financial decisions involved when a
company chooses how to invest capital for extended periods of time
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Long-Term Capital Budgeting Decisions
• Net present value analysis - the financial analysis needed to determine
the true rate of return of a proposed capital investment
- tells a manager how much a long-term project would earn in today’s dollars
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Long-Term Capital Budgeting Decisions
• Breakeven point - the sales level that just covers all of a
project’s costs but where no profit is earned
• Variable costs - costs that are only incurred when the firm
makes and sells products
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Long-Term Capital Budgeting Decisions
• Capital budget- a set of rules for allocating funds to the
different functions of a firm to achieve a predetermined rate of return on its investment
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A Company as a Portfolio of Investments
• Brand manager - a manager responsible for managing a brand-name product
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Capital Financing
• Capital financing - the development of a financial plan to allow
a company to obtain the money it needs to fund its activities at the lowest possible cost
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Short-Term Financing Methods
• Cash reserves• Unsecured and secured loans• Accounts receivable financing• Commercial paper
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Question?
What is a loan not backed by valuable assets pledged to guarantee the loan will be paid back?
A. Secured loanB. Unsecured loanC. Line of creditD. Commercial paper
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Short-Term Financing Methods
• Unsecured loan - a loan not backed by valuable assets
pledged to guarantee the loan will be paid back
• Line of credit - a short-term unsecured loan a company
can draw against as its accounts payable become due
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Short-Term Financing Methods
• Secured loan - a loan backed by valuable fixed or current
assets
• Commercial paper - short-term, unsecured debts or notes
issued at a certain rate of interest for up to nine months
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Long-Term Financing Methods
• Leverage - the ability to use borrowed capital in ways
that have the potential to lead to high rates of return
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Long-Term Financing Methods
• Hedge funds - mutual funds that use highly leveraged
investments to try to rapidly increase investors’ capital returns
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Long-Term Financing Methods
• Principal - the amount of money originally borrowed
• Capital structure - the balance between the amount of capital
a company raises through debt and the amount it raises through equity
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Debt Securities: Bonds
• Debt securities - investment documents that provide
evidence of a company’s legal obligation to repay within a certain period of time the money it borrows and make regular interest payments on that money in the meantime
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Debt Securities: Bonds
• Bonds - common types of debt securities issued by
a company for a period of more than one year
Find out how to buy bonds at eHow.com
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Debt Securities: Bonds
• Call provision - a company’s legal right to buy its bonds
back early from bondholders to avoid high interest-rate payments
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Debt Securities: Bonds
• Current yield - a financial measure of a bond’s current rate
of return - obtained by dividing the bond’s original
interest rate by its current closing price
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Equity Securities: Stocks
• Equity securities - the capital stock certificates a company
issues giving shareholders the legal right to its assets and dividends from its profits
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Equity Securities: Stocks
• Initial public offering - the first time the
owners of a company’s stock offer it for sale to the general public
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Equity Securities: Stocks
• Price-to-earnings ratio - a way of valuing a stock by dividing its
closing price by its annual earnings per share
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Non-Operations Investing and Financing
• Treasury stock - stock a company buys back from the public
and becomes part of stockholders’ equity on the firm’s balance sheet