Financing the Enterprise

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

CHAPTER 14 Accounting and Financial Statements

CHAPTER 15 Money and the Financial System

CHAPTER 16 Financial Management and Securities Markets

APPENDIX D Personal Financial Planning

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Enter the World of Business

Is Bank of America too Big to Fail? • Too-big-to-fail firms are linked to so many organizations that if

they fail, the repercussions would destroy the economy • BofA is in a precarious situation due to a series of high-risk

decisions and investment in mortgage-related securities • BofA has cut costs by eliminating jobs and Berkshire

Hathaway purchased $5 billion in BofA’s preferred stock ? What are some of the economic repercussions that might

occur if Bank of America fails? ? Why has Bank of America’s acquisition of Countrywide been

criticized? ? How might Berkshire Hathaway’s preferred stock purchase

help Bank of America? 16-3

Managing Current Assets and Liabilities

Since short-term assets and liabilities continually flow through an organization, they are said to be “working”

The terms current and short-term are used interchangeably Current assets: cash, investments, accounts receivable

and inventory – goal is maximize return on these assets Current liabilities: accounts payable, accrued salaries,

accrued taxes and short-term bank loans

Working Capital Management • The managing of short-term assets and liabilities

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Going Green

Finance Executives Recognize the Benefits of Green Efficiencies • Method is a green company selling green products, and raking

in more than $100 million in annual sales • Method aligns its green objectives with its cost-saving goals • Method’s long-term perspective, efficient operations and

popularity with customers is catching on with competitors ? If greener operations cut company costs, how will this affect

current assets and liabilities? ? Why might Method decide to pursue greener business

activities that are costly in the short run? ? Do you think Method’s competitors are beginning to realize

how green products can improve their financial conditions? 16-5

Managing Current Assets

Idle cash does not make money and managers try to keep just enough to pay bills as they fall due

Transaction Balances • Cash kept on hand by a firm to pay normal daily

expenses, such as employee wages and bills for supplies and utilities

Lockbox • An address, usually a commercial bank, at which a

company receives payments in order to speed collections from customers

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Managing Current Assets

Sometimes cash comes in faster than needed to pay bills

Marketable Securities • Temporary investment of “extra” cash by organizations

for up to one year in U.S. Treasury bills, certificates of deposit, commercial paper, or Eurodollar loans

Treasury Bills (T-Bills) • Short-term debt obligations the U.S. government sells

to raise money T-bills are considered risk free

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Managing Current Assets

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Managing Current Assets

• Certificates of deposit issued by commercial banks and brokerage companies, available in minimum amounts of $100,000 which may be traded prior to maturity

Commercial Certificates of Deposit (CDs)

• A written promise from one company to another to pay a specific amount of money

Commercial Paper

• A market centered in London for trading U.S. dollars in foreign countries

Eurodollar Market

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Managing Current Assets

Many businesses make a majority of sales on credit, so managing receivables is important

Discounts for early payment and extending credit comes at the cost of lowered profits

Credit ratings can be provided by credit bureaus, credit-rating agencies such as Dun and Bradstreet and industry trade groups

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Managing Current Assets

Financial managers have to coordinate inventory purchases to manage cash flows

Optimal inventory levels are determined mainly by method of production

Excess inventory ties up money unnecessarily but inventory shortages could drive a customer to a competitor – forever

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• Trade Credit is extended by suppliers for the purchase of their goods and services

Accounts Payable

Managing Current Liabilities

Averting a cash shortfall with short-term funds

Most suppliers offer discounts for early payment, offered as “1/10 net 30,” meaning a

1% discount is given if paid in 10 days and the full amount is due in 30 days

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Managing Current Liabilities Most organizations obtain short-term funds from banks

• An arrangement by which a bank agrees to lend a specified amount of money to an organization upon request

Line of Credit

• Loans backed by collateral the bank can claim if the borrowers do not repay them

Secured Loans

• Loans backed only by the borrowers’ good reputation and previous credit rating

Unsecured Loans

• The interest rate commercial banks charge their best customers (usually large corporations) for short-term loans Prime Rate

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Managing Current Liabilities

o Other nonbank liabilities include: taxes owed to the government and wages owed to employees

o Taxes and employees’ wages represent debt obligations and the financial manager must plan to meet them as they come due

Factor • A finance company to which businesses sell their

accounts receivable – usually for a percentage of the total face value

Banks are not the only source of short-term funds

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Managing Fixed Assets

Long-Term (Fixed) Assets • Production facilities (plants), offices, and equipment

– all of which are expected to last for many years Modern facilities and equipment are

expensive, requiring long-term financing Options include capital leases and

operating leases, where a company pays a fee for usage rather than owning an asset

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Managing Fixed Assets

Capital Budgeting • The process of analyzing the needs of the business

and selecting the assets that will maximize its value This process continues after

purchase as all assets and projects must be continually reevaluated against the company’s needs

Budgeting is not an exact process and managers must be flexible

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Assessing Risk

Introduce a New Product in

Foreign Markets Expand into a New Market

Introduce a New Product in a

Familiar Market

Add to a Product Line

Buy New Equipment for Established

Market

Repair Old Machinery

Highest Risk

Lowest Risk

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Assessing Risk

Pharmaceutical companies spend millions of dollars

developing new drugs without knowing if the

drug will pass FDA approval and have a

significant margin of risk

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Assessing Risk

Every investment carries some risk »The longer a project or asset is expect to last, the greater its potential risk because it may become obsolete or wear out prematurely »Risk is also affected by the stability and competitive nature of the marketplace and the world economy

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Pricing Long-Term Money

Returns from any project must cover not only operating costs but interest expenses on the debt used to finance the project

The most efficient and profitable companies attract the lowest-cost funds because they typically offer reasonable returns for low relative risk

New companies have a strong motivator to use financial resources wisely because they will, over time, reduce the costs of their funds and increase profit

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Financing with Long-Term Liabilities

These take many different forms but the in the end, the key word is debt

Heavily indebted companies may not make it through a recession and be forced into bankruptcy

Two common sources for long-term funds: Attracting new owners (equity financing)

Long-term liabilities (debt financing)

Long-Term Liabilities • Debts that will be repaid over a number of years,

such as long-term loans and bond issues

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Financing with Long-Term Liabilities

Bonds • Debt instruments that larger companies

sell to raise long-term funds o Bondholders enter into a contract, or

indenture, with the bond issuer o Bondholders receive regular interest payments and the

face value of the bond on or before the maturity date o The annual interest rate (often called coupon rate) is

the percentage of face value the company pays yearly

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Types of Bonds • Debentures, or bonds that are not backed by

specific collateral Unsecured

Bonds

• Bonds backed by specific collateral that must be forfeited in the event the issuing firm defaults Secured Bonds

• A sequence of small bond issues of progressively longer maturity Serial Bonds

• Bonds with interest rates that change with current interest rates otherwise available in the economy

Floating-Rate Bonds

• A special type of high interest-rate bond that carries higher inherent risks Junk Bonds

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Financing with Owners’ Equity

Retained Earnings • Earning after expenses and taxes that are reinvested in

the assets of the firm and belong to the owners in the form of equity

Corporate owners own shares of the company and stockholders’ equity includes common stock, preferred

stock and retained earnings

Retained earnings are the only long-term funds the company can generate internally

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Financing with Owners’ Equity

Dividend Yield

The dividend per share divided by the stock

price

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Investment Banking

Primary Market • The market

where firms raise financial capital

Secondary Markets

• Stock exchanges and over-the-counter markets where investors can trade their securities with others

Investment Banking

• The sale of stocks and bonds for corporations

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The Securities Markets

» In the broadest sense, stocks and bonds markets are providers of liquidity

» Without liquid securities markets, investors would not risk their savings on securities

Securities Markets • The mechanism for buying and selling

securities

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Stock Markets

Stock markets exist around the world; the two biggest U.S. stock markets are the New York Stock Exchange (NYSE) and the NASDAQ market

Both exchanges are now publicly traded organizations, no longer not-for-profit

Electronic trading is faster and less expensive than floor trading and now accounts for most of the stock trading done worldwide

NASDAQ was traditionally an electronic market and the NYSE was traditionally a floor-traded market

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Securities Markets

Over-The-Counter (OTC) Market • A network of dealers all over the country linked by

computers, telephones and Teletype machines

Most corporate bonds and all U.S. securities are traded over the counter

Therefore, the OTC accounts for the largest total dollar value of all the secondary markets

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Measuring Market Performance

Investors and financial managers need to know how a companies’ securities are performing compared with competitors’

Performance measures – averages and indexes – are very important to many different people

An index compares current stock prices with those in a specified base period

An average is the average of certain stock prices and some are weighted averages

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Measuring Market Performance

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Measuring Market Performance

The Dow Jones Industrial Average gained 10 times from August 1982 to the beginning of 2000

This was the Internet bubble and they are difficult to see until they burst

Before the housing bubble burst in October 2007, the Dow Jones hit an all time high

For investors to make sound financial decisions, it is important that they stay in touch with business news, markets and indexes

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Responding to Business Challenges

Advancing Gender Diversity in Finance • More than half of accounting majors undergraduate

programs are women, yet only 9% of CFOs at major companies are female

• Theorists say female employees do not have the same connections with higher-level financial executives as men do

• Some companies have mentorship programs for women ? Why do you think there are so few female CFOs? ? Describe some ways companies are trying to promote

management positions to female finance employees ? Do you feel a mentorship program will help close the gap?

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Solve the Dilemma

Surviving Rapid Growth • Glasspray Corporation is a small firm making industrial

fiberglass spray equipment • The firm has run into trouble with its current assets and

liabilities resulting from rapid and consistent sales increases • President and founder, Stephen T. Rose said “Our current

assets aren’t, and our current liabilities are!” ? Normally, rapidly increasing sales are a good thing. What

seems to be the problem here? ? What are some management techniques applied to current

liabilities that Glasspray might use to improve its working capital positions?

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