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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The Cycle of Profit

Figure 15.1

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Four Ways to Use Capital

Figure 15.2

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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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Managing the Short-Term Operating Cycle

Figure 15.3

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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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Breakeven Analysis

Figure 15.4

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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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Breakeven Analysis and Inventory Turnover

Figure 15.4

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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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Methods of Obtaining New Capital

Figure 15.6

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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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How to Read a Corporate Bond Table

Figure 15.7

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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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Types of Stock

• Blue-chip• Growth• Income• Speculative

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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

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Video: Jack Welch

• Several questions are asked of Jack Welch who at the time of this interview had recently authored his book, “Winning.”

• What is the best thing about being a manager, according to Welch?