1 finance and the firm. the field of finance the duties of financial managers the basic goal of a...
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Finance and Finance and the Firmthe Firm
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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
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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.
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Liabilities and equity represent sources of funds.
Assets represent uses of funds. Liabilities represent a debt claim. Equity represents an ownership claim.
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Balance Sheet
Assets Liabilities
Equity
Financial Statements
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Capital Budgeting Capital Structure Policy Working Capital Management
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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
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Financial ManagementFinancial Management
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
LT LiabilitiesEquity
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Deals with management of short-term (current) assets.
e.g., will the firm purchase supplies on credit or pay cash?
Financial ManagementFinancial Management
ST Assets
LT Assets
ST Liabilities
LT LiabilitiesEquity
ST Assets
Working Capital Management
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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
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Financial markets and institutions facilitate the flow of funds in the economy
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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.
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Measure a firm’s performance Forecast financial consequences Recommend new investment Locate external financing Recommend best financing mix Determine financial expectations of
owners
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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”.
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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.
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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
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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).
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Agency issues
Interests of non-owner stakeholders Workers, creditors, suppliers,
customers, and others are not owners, but may have a stake in the business.
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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.
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Sole Proprietorship Advantages
• Easily Established• Minimal Organizational Costs• Keep all Generated Profits
Disadvantages
• Unlimited Liability• Losses absorbed by owner• Limited Capital• Limited Life
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Minimal Organizational Requirements
Negligible Government Regulations
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General Partnership Advantages
• Unlimited Liability• Must be Dissolved or
Reorganized if a Partner Leaves or Dies
Disadvantages
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Limited Partnership (LP)
Two classes of partners• General Partners• Limited Partners
Every partnership must have at least one general partner
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Limited Partnership (LP)
General Partners
Advantages
•Participate actively in management•More favorable allocation of ownership/profit/losses
Disadvantages
•Unlimited Liability
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Limited Partnership (LP)
Limited PartnersLimited Partners
Advantages
•Limited liability
Disadvantages
•not active in management•less favorable allocation of ownership/profit/losses
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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
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Double Taxation Time and Cost of Incorporation
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Corporation
• Advantages
• Disadvantages
A legal “person” separate and distinct from its owners
– Limited Liability– Permanency– Transferability of Ownership– Better Access to Capital
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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
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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?
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Financial MarketsFinancial Marketsand Interest Ratesand Interest Rates
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Operation of U.S. financial system. Financial securities. Function of financial intermediaries. Financial markets. Securities traded in the money and
capital markets.
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The purpose of the financial system is to bring together individuals, businesses, and government entities (economic units) that generate and spend funds.
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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.
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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.
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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.
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Securities
Funds
PrimaryPrimaryMarketMarket
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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.
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Securities
Funds
SecondarySecondaryMarketMarket
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Money Market vs. Capital Market
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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)
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Securities
Securities$$
$$
Intermediaries such as commercial banks andinsurance companies help to facilitate theflow of funds in the financial marketplace.
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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.
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• 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.
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Why is market efficiency important?Why is market efficiency important?
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Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)• Commercial Paper• Eurodollars• Banker’s Acceptances
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Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)• Commercial Paper• Eurodollars• Banker’s Acceptances
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• 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.
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Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)• Commercial Paper• Eurodollar• Banker’s Acceptances
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• Negotiable CDs:Negotiable CDs: are interest-bearing securities issued by financial institutions.
•They have maturities of one year or less.
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Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)
•Commercial Paper• Eurodollars• Banker’s Acceptances
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• Commercial paper:Commercial paper: is unsecured debt issued by corporations with good credit ratings.
•Most buyers are large institutions.
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Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)• Commercial Paper
•Eurodollars• Banker’s Acceptances
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• Eurodollars:Eurodollars: are dollar denominated, deposits, located in non-US banks.
•Buyers and sellers are large institutions.
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Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)• Commercial Paper• Eurodollars
•Banker’s Acceptances
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•Banker’s AcceptancesBanker’s Acceptances:: are debt securities that have been guaranteed by a bank. They are used to facilitate international transactions.
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Money Market Securities• Highly liquid, low risk• Treasury Bills (T-Bills)• Certificates of Deposit (CDs)• Commercial Paper• Eurodollars• Banker’s Acceptances
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Capital Market Securities• Bonds
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•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.
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• BondsTreasury BondsMunicipal BondsCorporate Bonds
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• 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
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• Stock
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•Companies can also raise funds by selling shares of stock
Capital Market SecuritiesCapital Market Securities
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• StockCommon Stock
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• 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.
Capital Market SecuritiesCapital Market Securities
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• StockCommon StockPreferred Stock
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• Preferred stockholdersPreferred stockholders do not generally have voting rights, but have priority in receiving dividends and are paid dividends at a pre-set rate.
Capital Market SecuritiesCapital Market Securities
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• Real Rate of Interest• Expected Inflation• Default Risk• Maturity Risk• Illiquidity Risk
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Interest Rates Determined byInterest Rates Determined by
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• Compensates for the lender’s lost opportunity to consume.
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Real Rate of InterestReal Rate of Interest
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• 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.
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Default RiskDefault Risk
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Expected Inflation
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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.
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Maturity Risk
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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.
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Maturity Risk
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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.
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Illiquidity
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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.”
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k = the nominal, or observed rate on security
k* = real rate of interestIRP = Inflation Risk
PremiumDRP = Default Risk PremiumMP = Maturity PremiumIlP = Illiquidity Premium
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k = k* + IRP + DRP + MP + ILPk = k* + IRP + DRP + MP + ILP
Determination of Rates
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Term Structure
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Relationship between long and short Relationship between long and short term interest ratesterm interest rates
Yield curveYield curve
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8.00%
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Jan 10, 2006
3 month T-Bill
3 month T-Bill
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mos. maturitiesyr.
6 month T-Bill
6 month T-Bill
Treasury Yield CurveTreasury Yield Curve
Jan 10, 2006
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8.00%
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maturities
1 year T-Bill
1 year T-Bill
Treasury Yield CurveTreasury Yield Curve
Jan 10, 2006
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8.00%
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2 year T-Note
2 year T-Note
Treasury Yield CurveTreasury Yield Curve
Jan 10, 2006
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8.00%
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maturities
3 year T-Note
3 year T-Note
Treasury Yield CurveTreasury Yield Curve
Jan 10, 2006
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5 year T-Bond
5 year T-Bond
Treasury Yield CurveTreasury Yield Curve
Jan 10, 2006
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Treasury Yield CurveTreasury Yield Curve
Jan 10, 2006
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Treasury Yield CurveTreasury Yield Curve
Jan 10, 2006
March 22,1995August 1, 2006
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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?
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FinancialInstitutions
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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.
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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.
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Services offered by Financial Institutions Denomination matching
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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.
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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.
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Services offered by Financial Institutions
Maturity MatchingHousehold and business savers
generally want to lend for only a short time. Savings and checking accounts are usually available for immediate withdrawal.
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Services offered by Financial Institutions
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.
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Services offered by Financial Institutions
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.
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Services offered by Financial Institutions
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.
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The Role of Financial Institutions
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Securities
Securities$$
$$
Intermediaries help to facilitate theflow of funds in the financial marketplace.
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Financial Intermediation
Commercial loans
$$
Businesses Households
$$ Checking accounts
CommercialBank
Example 1
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Financial Intermediation
Stocks,Bonds
Businesses
InsuranceCompany
Households
$$ Insurancepolicies
$$
Example 2
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Types of Financial Institutions
Commercial Banks
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Types of Financial InstitutionsCommercial Banks
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The primary purpose of commercial banksis to take in business deposits and to lend funds to businesses.
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Types of Financial InstitutionsCommercial BanksSavings and Loans
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Types of Financial InstitutionsCommercial BanksSavings and Loans
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Savings and loans’ primary purpose is to take in deposits from households and to lend funds for home mortgages.
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Types of Financial InstitutionsCommercial BanksSavings and LoansCredit Unions
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Types of Financial InstitutionsCommercial BanksSavings and LoansCredit Unions
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Credit Unions are owned by depositors (actually share owners) who are individuals, not businesses. Credit Unions take in funds and primarily make personal loans.
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Types of Financial Institutions
Commercial BanksSavings and LoansCredit Unions
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} Depository Institutions
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Types of Financial Institutions
Commercial BanksSavings and LoansCredit Unions
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} Depository Institutions
•Take in deposits•Make loans
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Types of Financial Institutions
Finance Companies
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Types of Financial Institutions
Finance Companies
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Non-bank firms that borrow funds to make short and medium term loans to higher risk borrowers.
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Types of Financial Institutions
Finance CompaniesInsurance Companies
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Types of Financial InstitutionsFinance CompaniesInsurance Companies
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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.)
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Types of Financial Institutions
Finance CompaniesInsurance CompaniesPension Funds
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Types of Financial InstitutionsFinance CompaniesInsurance CompaniesPension Funds
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Workers and/or employers contribute funds. Defined Benefit Plans (DBP) versus Defined Contribution Plans (DCP).
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Types of Financial InstitutionsFinance CompaniesInsurance CompaniesPension Funds
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}Non-
Depository Institutions
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Types of Financial InstitutionsFinance CompaniesInsurance CompaniesPension Funds
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•Funds come from borrowing, selling insurance policies, and other claims.•Funds used to buy securities and make loans.
}Non-
Depository Institutions
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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.
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Reserves
Investments
Loans
Deposits
Borrowed Funds
Bank Capital (Equity)
Fixed Assets
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The Fed is the central bank of the United States
Created in 1913
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The Federal Reserve System
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Purpose of the FedPurpose of the Fed
Monetary authorityi.e., control the money supply
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Purpose of the FedPurpose of the Fed
Monetary authorityi.e., control the money supply
Lender of last resortFed makes “discount loans” to depository
institutions
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Purpose of the FedPurpose of the Fed
Monetary authorityi.e., control the money supply
Lender of last resortFed makes “discount loans” to depository
institutions
Check clearing
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Purpose of the FedPurpose of the Fed
Monetary authorityi.e., control the money supply
Lender of last resortFed makes “discount loans” to
depository institutions
Check clearingBank Supervision
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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
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How the Fed Influences Interest Rates
Open Market OperationsDiscount Rate PolicyReserve Requirements
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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.
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When the Fed When the Fed buysbuys T-BillsT-Bills
The public
T-bills
$The Fed
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When the Fed When the Fed buysbuys T-Bills T-Bills
Reserves are injected into the economy
The public
T-bills
$The Fed
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When the Fed When the Fed buysbuys T-bills T-bills
Bank reserves increase.
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When the Fed When the Fed buysbuys T-bills T-bills
Bank reserves increase.This makes banks more willing to
lend, increasing the supply of loanable funds.
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When the Fed When the Fed buysbuys T-bills T-bills
Bank reserves increase.This makes banks more willing to
lend, increasing the supply of loanable funds.
{Supply of LF } { i }
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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.
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When the Fed When the Fed sellssells T-Bills T-Bills
The public
T-bills
The Fed $
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When the Fed When the Fed sellssells T-Bills T-Bills
Reserves are extracted from the economy
The public
T-bills
$The Fed
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When the Fed When the Fed sellssells T-billsT-bills
Bank reserves decrease
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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.
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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.
{Supply of LF } { i }
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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.
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{Supply of LF } { i }
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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.
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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.
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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
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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 }}
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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
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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}
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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.
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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.
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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.