Finance and the Firm

1. Finance and the Firm Chapter 1

2. 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

3. 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.

4. Balance Sheet Assets Liabilities Equity Financial Statements • Liabilities and equity represent sourcesof funds. • Assets represent uses of funds. • Liabilities represent a debtclaim. • Equity represents an ownershipclaim.

5. Financial Management • Capital Budgeting • Capital Structure Policy • Working Capital Management

6. ST Assets LT Assets ST Liabilities LT Liabilities Equity LT Assets Financial Management • Capital Budgeting • Deals with the firm’s investment in long-term real assets • e.g., in what projects should the firm invest?

7. ST Assets LT Assets ST Liabilities Financial Management LT Liabilities Equity • Capital Structure Policy • Deals with long-term financing of the firm’s activities • e.g., what mix of long term debt and equity will the firm use?

8. ST Assets LT Assets ST Liabilities LT Liabilities Equity Financial Management ST Assets • Working Capital Management • Deals with management of short-term (current) assets. • e.g., will the firm purchase supplies on credit or pay cash?

9. Investments • Looks at financial analysis from perspective of investor • Stockholders are owners of the firm • Bondholders are creditors of the firm • From investor’s perspective, what matters is the rate of return on a security • 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 costof funds.

10. Financial Markets and Institutions • This makes society more productive, thus increasing social welfare • Topics include: • How interest rate levels are determined • How the Fed controls the money supply • Relationships between macroeconomic variables such as inflation, interest rates, money supply and GDP. • Financial markets and institutions facilitate the flow of funds in the economy

11. 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

12. 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”.

13. Maximizing the“value” of a firm? • 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.

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

15. Legal and Ethical Challenges • Agency issues • Interests of non-owner stakeholders • Workers, creditors, suppliers, customers, and others are not owners, but may have a stake in the business. • 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).

16. Legal 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.

17. Forms of Business Organization • Sole Proprietorship • Advantages • Easily Established • Minimal Organizational Costs • Keep all Generated Profits • Disadvantages • Unlimited Liability • Losses absorbed by owner • Limited Capital • Limited Life

18. Forms of Business Organization • General Partnership • Advantages • Disadvantages • Unlimited Liability • Must be Dissolved or Reorganized if a Partner Leaves or Dies • Minimal Organizational Requirements • Negligible Government Regulations

19. Forms of Business Organization • Limited Partnership (LP) • Two classes of partners • General Partners • Limited Partners • Every partnership must have at least one general partner

20. Forms of Business Organization • Limited Partnership (LP) General Partners • Advantages • Participate actively in management • More favorable allocation of ownership/profit/losses • Disadvantages • Unlimited Liability

21. Forms of Business Organization • Limited Partnership (LP) Limited Partners • Advantages • Limited liability • Disadvantages • not active in management • less favorable allocation of ownership/profit/losses

22. Forms of Business Organization • Limited Liability Partnership (LLP) • Similar to General Partnership • operates like a corporation • limited liability • partnership not taxed • income passed through to partnersand partners are taxed

23. Forms of Business Organization • Corporation • A legal “person” separate and distinct from its owners • Limited Liability • Permanency • Transferability of Ownership • Better Access to Capital • Advantages • Disadvantages • Double Taxation • Time and Cost of Incorporation

24. Forms of Business Organization • Limited Liability Company (LLC) • A form of business organization that is a state-approved, unincorporated association. • Advantages • Limited Liability • No Double Taxation • Disadvantages • Relatively New - Some Legal Issues Not Yet Defined

25. Answer the following Questions on your 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?

26. Financial Markets and Interest Rates Chapter 2

27. Learning Objectives Operation of U.S. financial system. Financial securities. Function of financial intermediaries. Financial markets. Securities traded in the money and capital markets.

28. The Financial System • 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 purpose of the financial system is to bring together individuals, businesses, and government entities (economic units) that generate and spend funds.

29. 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.

30. 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.

31. Financial Markets Funds Primary Market Securities

32. Financial Markets Classified according to the characteristics of participants and securities involved. The primary marketis where deficit economic units sell new securities. The secondary marketis where investors trade previously issued securities with each other.

33. Financial Markets Funds Secondary Market Securities

34. Financial Markets Money Market vs. Capital Market

35. 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)

36. Financial Markets Intermediaries such as commercial banks and insurance companies help to facilitate the flow of funds in the financial marketplace. $$ Securities Securities $$

37. 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.

38. Market Efficiency • Why is market efficiency important? • 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.

39. 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

40. Securities in the Financial Market • 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 • Eurodollars • Banker’s Acceptances

41. Securities in the Financial Market • 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 • Eurodollar • Banker’s Acceptances

42. Securities in the Financial Market • 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

43. Securities in the Financial Market • 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

44. Securities in the Financial Market • Banker’s Acceptances:are debt securities that have been guaranteed by a bank. They are used to facilitate international transactions. • Money Market Securities • Highly liquid, low risk • Treasury Bills (T-Bills) • Certificates of Deposit (CDs) • Commercial Paper • Eurodollars • Banker’s Acceptances

45. 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

46. Securities in the Financial Market • 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. • Capital Market Securities • Bonds

47. Securities in the Financial Market • Capital Market Securities • Treasury Bonds: are issued by the federal government. • Municipal Bonds: are issued by state and local governments. • Corporate Bonds: are issued by corporations. • BondsTreasury Bonds Municipal Bonds Corporate Bonds

48. Securities in the Financial Market • Capital Market Securities • Companies can also raise funds by selling shares of stock • Stock

49. Securities in the Financial Market • Capital Market Securities • 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 Stock

50. Securities in the Financial Market • Capital Market Securities • Preferred stockholdersdo not generally have voting rights, but have priority in receiving dividends and are paid dividends at a pre-set rate. • StockCommon StockPreferred Stock