1 Finance and the Firm. Learning Objectives The field of finance The duties of financial managers ...

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Finance and the Firm

Learning Objectives

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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The Field of Finance

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

Financial Management

Capital BudgetingCapital Structure PolicyWorking Capital Management

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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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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


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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

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Investments

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

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.

Duties of Financial Managers

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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Basic Goal of the Business Firm

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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Maximizing the "value” of a firm?

The value of a firm is determined by the discounted value of all future expected cash flows derived from the firms business activities.

The financial manager should make decisions that cause this value to be maximized.

Value depends on future prospects and risk.

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Factors that affect the value of a firm’s stock price:

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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

Legal and Ethical Challenges

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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Switches to slide 17, too soon.

Forms of Business Organization

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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


• Minimal Organizational Requirements• Negligible Government Regulations

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General PartnershipGeneral 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 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


– 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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Homework Questions

1. What is the fiduciary responsibility of an agent?

2. What is meant by double taxation?

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

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

5. 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 Marketsand Interest Rates

Learning Objectives

• 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 Financial System

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

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

The Financial System

• 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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Financial Markets

• 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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Financial Markets

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Securities

Funds

PrimaryMarket

Primary Market handles IPO’s (new public offerings)

The Circular Flow of The Circular Flow of IncomeIncome

Financial Markets

• 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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Financial Markets

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Securities

Funds

SecondarySecondaryMarketMarket

The Circular Flow of IncomeThe Circular Flow of Income

Financial Markets

• Money Market vs. Capital Market

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Financial Markets

• 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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Financial Markets

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Securities

Securities$$

$$

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

Market Efficiency

• 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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Market Efficiency

– 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?

Securities in the Financial Market

• 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: 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

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• 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

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•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

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• 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

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



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• Capital Market Securities– Bonds

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•Bonds: 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

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

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

• Corporate Bonds: are issued by corporations.


– Stock

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•Companies can also raise funds by selling shares of stock

Capital Market Securities


– StockCommon Stock

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• 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

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


Interest Rates

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

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Interest Rates Determined by

Interest Rates

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

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Real Rate of Interest

Interest Rates

– 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 Risk

Interest Rates

• Expected Inflation

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Inflation erodes the purchasing power of money.

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

Interest Rates

• Maturity Risk

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

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

Interest Rates

• Maturity Risk

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

Interest Rates

• Illiquidity

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

Illiquid securities have a higher interest rate to compensate the lender for the 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

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Determination of Rates

Interest Rates

• Term Structure

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Relationship between long and short term interest rates

Yield curve

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Treasury Yield Curve8.00%

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

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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.

Treasury Yield Curve

Jan 10, 2006

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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

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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

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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

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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

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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

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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, 2008

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Homework Questions

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

2. Explain the difference between a dealer and a broker.

3. 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.

4. 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.

5. 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

Learning Objectives

• The 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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• Denomination matching– Households generally have small amounts of

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

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• 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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• Maturity Matching– Household 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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• Maturity Matching– Household 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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• Absorbing Credit Risk– Individual 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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• Absorbing Credit Risk– Individual 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

79Securities

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

BusinessesInsuranceCompany

Households

$$ Insurancepolicies

$$

Example 2

Types of Financial Institutions

• Commercial Banks

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• Commercial Banks

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


• Commercial Banks• Savings and Loans

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• Commercial Banks• Savings 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.


• Commercial Banks• Savings and Loans• Credit Unions

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} Depository Institutions



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} Depository Institutions

•Take in deposits•Make loans


• Finance Companies

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• Finance Companies

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• Finance Companies• Insurance Companies

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• Finance Companies• Insurance 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.)


Finance CompaniesInsurance CompaniesPension Funds

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• Finance Companies• Insurance Companies• Pension Funds

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



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}Non-

Depository Institutions



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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

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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Simplified Balance Sheet of Commercial Bank

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Reserves

Investments

Loans

Deposits

Borrowed Funds

Bank Capital (Equity)

Fixed Assets

The Federal Reserve System

• The Fed is the central bank of the United States

• Created in 1913

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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 Fed


Lender of last resortFed makes “discount loans” to depository

institutions

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Purpose of the Fed


Lender of last resortFed makes “discount loans” to depository

institutions

Check clearing

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Purpose of the FedPurpose of the Fed


Lender of last resortFed makes “discount loans” to

depository institutions

Check clearingBank Supervision

Structure of the Fed• Board of Governors

– Seven members– Located in Washington, DC

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

Reserve Bank presidents– Located in Washington, DC

• Twelve Federal Reserve Banks– Corresponding to twelve districts

• Member Banks

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How the Fed Influences Interest Rates

• Open Market Operations• Discount Rate Policy• Reserve 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 buys T-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 buys 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 }

When the Fed buys T-bills• Bank 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 sells T-Bills

The public

T-bills

The Fed $

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When the Fed sells T-Bills

Reserves are extracted from the economy

The public

T-bills

$The Fed

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When the Fed sells T-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.


When the Fed sells T-bills

• Bank reserves decrease• This 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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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 rate

– This increases the cost of funds to borrowing depository institutions, causing them to increase the rates they charge.

• When the Fed decreases the discount rate– This decreases the cost of funds to

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

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Reserve Requirements

When the Fed increases reserve requirements

– This decreases the amount of funds available for lending

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Reserve Requirements

When the Fed increases reserve requirements– This decreases the amount of funds

available for lending

– {Supply of LF } { i }

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Reserve 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 Requirements• When the Fed increases reserve requirements

– This decreases the amount of funds available for lending

– {Supply of LF } { i}

• When the Fed decreases reserve requirements– This increases the amount of funds available

for lending– {Supply of LF } { i}

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The Federal Reserve• As 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 rate

– Increasing 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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Homework QuestionsHomework Questions

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

2. What is the discount window?

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

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

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

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