Chapter 1: 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 firms 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

Financial Statements

• Liabilities and equity represent sources of
  funds.
• Assets represent uses of funds.
• Liabilities represent a debt claim.
• Equity represents an ownership claim.

5
Financial Management

• Capital Budgeting
• Capital Structure Policy
• Working Capital Management

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Financial Management

• Capital Budgeting

• Deals with the firms investment in long-term
  real assets
• e.g., in what projects should the firm invest?

7
Financial Management
LT Liabilities Equity

• Capital Structure Policy

• Deals with long-term financing of the firms
  activities
• e.g., what mix of long term debt and equity will
  the firm use?

8
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?

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Investments

• Looks at financial analysis from perspective of
  investor

• Stockholders are owners of the firm
• Bondholders are creditors of the firm

• From investors 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 firms perspective this rate of return
  represents a cost of funds.

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Financial Markets and Institutions

• Financial markets and institutions facilitate the
  flow of funds in the economy

• 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.

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Duties of Financial Managers

• Measure a firms 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 firms 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 firms 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

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Legal and Ethical Challenges

• Agency issues

• Managers are agents for the firms owners but
  they may have interests that conflict with those
  owners.
• These agency conflicts impose costs (such as the
  cost of accounting audits).

• 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 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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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

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Forms of Business Organization

• General Partnership

• Advantages

• Minimal Organizational Requirements
• Negligible Government Regulations

• Disadvantages

• Unlimited Liability
• Must be Dissolved or Reorganized if a Partner
  Leaves or Dies

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Forms of Business Organization

• Limited Partnership (LP)

• Two classes of partners
• General Partners
• Limited Partners
• Every partnership must have at least one general
  partner

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Forms of Business Organization

• Limited Partnership (LP)

General Partners

• Advantages
• Participate actively in management
• More favorable allocation of ownership/profit/loss
  es

• Disadvantages
• Unlimited Liability

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Forms of Business Organization

• Limited Partnership (LP)

Limited Partners

• Advantages
• Limited liability

• Disadvantages
• not active in management
• less favorable allocation of
• ownership/profit/losses

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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 partners and partners
  are taxed

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Forms of Business Organization

• Corporation

• A legal person separate and distinct from its
  owners

• Advantages

• Limited Liability
• Permanency
• Transferability of Ownership
• Better Access to Capital

• Double Taxation
• Time and Cost of Incorporation

• Disadvantages

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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

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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 Markets and Interest Rates
Chapter 2
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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.

• 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.

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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
The Circular Flow of Income
Funds
Primary Market
Securities
Primary Market handles IPOs (new public
offerings)
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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.
• The secondary market is where investors trade
  previously issued securities with each other.

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Financial Markets
Funds
Secondary Market
Securities
The Circular Flow of Income
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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
Intermediaries such as commercial banks
and insurance companies help to facilitate
the flow of funds in the financial marketplace.
Securities

Securities

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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

• 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.

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Securities in the Financial Market

• Money Market Securities
• Highly liquid, low risk
• Treasury Bills (T-Bills)
• Certificates of Deposit (CDs)
• Commercial Paper
• Eurodollars
• Bankers Acceptances

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Securities in the Financial Market

• Money Market Securities
• Highly liquid, low risk
• Treasury Bills (T-Bills)
• Certificates of Deposit (CDs)
• Commercial Paper
• Eurodollars
• Bankers Acceptances

• 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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Securities in the Financial Market

• Money Market Securities
• Highly liquid, low risk
• Treasury Bills (T-Bills)
• Certificates of Deposit (CDs)
• Commercial Paper
• Eurodollar
• Bankers Acceptances

• Negotiable CDs are interest-bearing securities
  issued by financial institutions.
• They have maturities of one year or less.

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Securities in the Financial Market

• Money Market Securities
• Highly liquid, low risk
• Treasury Bills (T-Bills)
• Certificates of Deposit (CDs)
• Commercial Paper
• Eurodollars
• Bankers Acceptances

• Commercial paper is unsecured debt issued by
  corporations with good credit ratings.
• Most buyers are large institutions.

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Securities in the Financial Market

• Money Market Securities
• Highly liquid, low risk
• Treasury Bills (T-Bills)
• Certificates of Deposit (CDs)
• Commercial Paper
• Eurodollars
• Bankers Acceptances

• Eurodollars are dollar denominated, deposits,
  located in non-US banks.
• Buyers and sellers are large institutions.

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Securities in the Financial Market

• Money Market Securities
• Highly liquid, low risk
• Treasury Bills (T-Bills)
• Certificates of Deposit (CDs)
• Commercial Paper
• Eurodollars
• Bankers Acceptances

• Bankers Acceptances are debt securities that
  have been guaranteed by a bank. They are used to
  facilitate international transactions.

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Securities in the Financial Market

• Money Market Securities
• Highly liquid, low risk
• Treasury Bills (T-Bills)
• Certificates of Deposit (CDs)
• Commercial Paper
• Eurodollars
• Bankers Acceptances

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Securities in the Financial Market

• Capital Market Securities
• Bonds

• 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.

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Securities in the Financial Market

• Capital Market Securities

• Bonds Treasury Bonds Municipal Bonds Corporate
  Bonds

• Treasury Bonds are issued by the federal
  government.
• Municipal Bonds are issued by state and local
  governments.
• Corporate Bonds are issued by corporations.

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Securities in the Financial Market

• Capital Market Securities

• Stock

• Companies can also raise funds by selling shares
  of stock

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Securities in the Financial Market

• Capital Market Securities

• Stock Common Stock

• 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.

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Securities in the Financial Market

• Stock Common Stock Preferred Stock

• Capital Market Securities

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

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Interest Rates

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

• Interest Rates Determined by

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Interest Rates

• Real Rate of Interest

• Compensates for the lenders lost opportunity to
  consume.

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Interest Rates

• Default Risk

• 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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Interest Rates

• Expected Inflation

• 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.

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Interest Rates

• Maturity Risk

• 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.

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Interest Rates

• Maturity Risk

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

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Interest Rates

• Illiquidity

• 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.

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Determination of Rates
k k IRP DRP MP ILP

• k the nominal, or observed rate on security
• k real rate of interest
• IRP Inflation Risk Premium
• DRP Default Risk Premium
• MP Maturity Premium
• IlP Illiquidity Premium

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Interest Rates

• Term Structure

• Relationship between long and short term
  interest rates
• Yield curve

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Treasury Yield Curve
3 month T-Bill
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Treasury Yield Curve
6 month T-Bill
Jan 10, 2006
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Treasury Yield Curve
1 year T-Bill
Jan 10, 2006
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Treasury Yield Curve
2 year T-Note
Jan 10, 2006
mos.
yr.
maturities
64
Treasury Yield Curve
3 year T-Note
Jan 10, 2006
65
Treasury Yield Curve
5 year T-Bond
Jan 10, 2006
66
Treasury Yield Curve
Jan 10, 2006
67
Treasury Yield Curve
Jan 10, 2006
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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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Chapter 3
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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, SL, 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 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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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 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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Services offered by Financial Institutions

• 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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Services offered by Financial Institutions

• 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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Services offered by Financial Institutions

• 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
Intermediaries help to facilitate the flow of
funds in the financial marketplace.
Securities

Financial Institution

Securities
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Financial Intermediation
Example 1

Checking accounts
Commercial Bank
Households
Businesses
Commercial loans

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Financial Intermediation
Example 2
Insurance policies

Insurance Company
Households
Businesses
Stocks, Bonds
82
Types of Financial Institutions

• Commercial Banks

83
Types of Financial Institutions

• Commercial Banks

The primary purpose of commercial banks is to
take in business deposits and to lend funds to
businesses.
84
Types of Financial Institutions

• Commercial Banks
• Savings and Loans

85
Types of Financial Institutions

• Commercial Banks
• Savings and Loans

Savings and loans primary purpose is to take in
deposits from households and to lend funds for
home mortgages.
86
Types of Financial Institutions

• Commercial Banks
• Savings and Loans
• Credit Unions

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Types of Financial Institutions

• Commercial Banks
• Savings and Loans
• Credit Unions

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Types of Financial Institutions

• Commercial Banks
• Savings and Loans
• Credit Unions

Depository Institutions
89
Types of Financial Institutions

• Commercial Banks
• Savings and Loans
• Credit Unions

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

Non-bank firms that borrow funds to make short
and medium term loans to higher risk borrowers.
92
Types of Financial Institutions

• Finance Companies
• Insurance Companies

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Types of Financial Institutions

• Finance Companies
• Insurance Companies

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 against damage to person
and property (health, autos, homes, theft,
earthquake, etc.)
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Types of Financial Institutions

• Finance Companies
• Insurance Companies
• Pension Funds

95
Types of Financial Institutions

• Finance Companies
• Insurance Companies
• Pension Funds

Workers and/or employers contribute funds.
Defined Benefit Plans (DBP) versus Defined
Contribution Plans (DCP).
96
Types of Financial Institutions

Non- Depository Institutions

• Finance Companies
• Insurance Companies
• Pension Funds

97
Types of Financial Institutions

• Finance Companies
• Insurance Companies
• Pension Funds

Non- Depository Institutions

• Funds come from borrowing, selling insurance
  policies, and other claims.
• Funds used to buy securities and make loans.

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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.

99
Simplified Balance Sheet of Commercial Bank
Reserves
Deposits
Investments
Borrowed Funds
Loans
Bank Capital (Equity)
Fixed Assets
100
The Federal Reserve System

• The Fed is the central bank of the United States
• Created in 1913

101
Purpose of the Fed

• Monetary authority
• i.e., control the money supply

102
Purpose of the Fed

• Monetary authority
• i.e., control the money supply
• Lender of last resort
• Fed makes discount loans to depository
  institutions

103
Purpose of the Fed

• Monetary authority
• i.e., control the money supply
• Lender of last resort
• Fed makes discount loans to depository
  institutions
• Check clearing

104
Purpose of the Fed

• Monetary authority
• i.e., control the money supply
• Lender of last resort
• Fed makes discount loans to depository
  institutions
• Check clearing
• Bank Supervision

105
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

106
How the Fed Influences Interest Rates

• Open Market Operations
• Discount Rate Policy
• Reserve Requirements

107
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.

108
T-bills

When the Fed buys T-Bills
109
When the Fed buys T-Bills
T-bills

Reserves are injected into the economy
110
When the Fed buys T-bills

• Bank reserves increase.

111
When the Fed buys T-bills

• Bank reserves increase.
• This makes banks more willing to lend, increasing
  the supply of loanable funds.

112
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

113
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.

114
T-bills

When the Fed sells T-Bills
115
When the Fed sells T-Bills
T-bills

Reserves are extracted from the economy
116
When the Fed sells T-bills

• Bank reserves decrease

117
When the Fed sells T-bills

• Bank reserves decrease
• This makes banks less willing to lend, decreasing
  the supply of loanable funds.

118
When the Fed sells T-bills

• Bank reserves decrease
• This makes banks less willing to lend, decreasing
  the supply of loanable funds.

Supply of LF i
119
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.

Supply of LF i
120
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.

121
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.

122
Reserve Requirements

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

123
Reserve Requirements

• When the Fed increases reserve requirements
• This decreases the amount of funds available for
  lending
• Supply of LF i

124
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

125
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

126
The Federal Reserve

• As the central bank of the United States, The
  Fed regulates the financial system, the nations
  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.

127
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.

128
Homework 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.