Finance and The Firm

Finance and
the Firm
1
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
2
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 money
producing assets. 3
Financial Statements
Balance Sheet
Assets Liabilities
Equity
 Liabilities and equity represent sources of

funds.
 Assets represent uses of funds.
 Liabilities represent a debt claim.
 Equity represents an ownership claim. 4
Financial Management
Capital Budgeting
Capital Structure Policy
Working Capital Management
5
ST Assets ST Liabilities
LT Assets LT Liabilities
Equity
 Capital Budgeting
 Deals with the firm’s investment
in long-term real assets
 e.g., in what projects should the
firm invest? 6
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?
7
Equity
 Working Capital Management

 Deals with management of short-term
(current) assets.
 e.g., will the firm purchase supplies on
credit or pay cash? 8
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 cost of funds.
9
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.
10
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
11
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”.
12
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.
13
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
14
Legal and Ethical Challenges
 Agency issues
 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).
 Interests of non-owner stakeholders
 Workers, creditors, suppliers,
customers, and others are not owners,
but may have a stake in the business.
15
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.
16
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
17
 General Partnership
 Advantages
• Minimal Organizational Requirements
• Negligible Government Regulations
 Disadvantages
• Unlimited Liability
• Must be Dissolved or Reorganized if a
Partner Leaves or Dies
18
 Limited Partnership (LP)

 Two classes of partners
• General Partners
• Limited Partners
 Every partnership must have at

least one general partner
19

General Partners
Advantages
•Participate actively in management
•More favorable allocation of
ownership/profit/losses
Disadvantages
•Unlimited Liability
20

Limited Partners
Advantages
•Limited liability
Disadvantages
•not active in management
•less favorable allocation of
ownership/profit/losses
21
 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
22
 Corporation
 A legal “person” separate and distinct
from its owners
• Advantages
– Limited Liability
– Permanency
– Transferability of Ownership
– Better Access to Capital
• Disadvantages
– Double Taxation
– Time and Cost of Incorporation 23
 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
24
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?
25
Financial Markets
and Interest Rates
26
Learning Objectives
• Operation of U.S. financial system.

• Financial securities.
• Function of financial intermediaries.
• Financial markets.
• Securities traded in the money and capital
markets.
27
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.
28
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.
29
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.
30
Financial Markets
The Circular Flow of Income
Funds
Primary
Market
Securities
Primary Market handles IPO’s (new public offerings)
31
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.
32
Financial Markets
Funds
Secondary
Market
Securities
The Circular Flow of Income

33
Financial Markets
• Money Market vs. Capital

Market
34
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)
35
Financial Markets
Intermediaries such as commercial banks and
insurance companies help to facilitate the
flow of funds in the financial marketplace.
$$ Securities
Securities $$
36
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.
37
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.
38
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
39

– Certificates
• T-Bills: of Deposit
are short-term (CDs)issued by the
securities
Federal government.
• After initial sale, they have an active secondary
– Eurodollars
market.
• They are bought at a discount and at maturity
the investor receives the full face value.
40

• Negotiable
– Commercial
CDs: are interest-bearing securities
Paper
issued by financial institutions.
– Eurodollar
• They have maturities of one year or less.
41

• Commercial
– Eurodollars
paper: is unsecured debt issued
by corporations with good credit ratings.
• Most buyers are large institutions.
42

– Eurodollars
• Eurodollars: areAcceptances
– Banker’s dollar denominated, deposits,
located in non-US banks.
• Buyers and sellers are large institutions.
43

– Eurodollars
•Banker’s Acceptances: are debt securities that
have been guaranteed by a bank. They are used
to facilitate international transactions. 44

– Eurodollars
45
• 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.
46
 Capital Market Securities

– Bonds
Treasury
• Treasury Bonds
Bonds: are issued by the federal
Municipal Bonds
government.
Corporate
• Municipal Bonds
Bonds: are issued by state and local
governments.
• Corporate Bonds: are issued by corporations.
47
– Stock
• Companies can also raise funds by selling
shares of stock
48

– Stock
Common
• Common Stock
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.
49

– Stock
Common Stock
Preferred Stock
• Preferred stockholders do not generally have
voting rights, but have priority in receiving
dividends and are paid dividends at a pre-set
rate.
50
Interest Rates
 Interest Rates Determined by

– Real Rate of Interest
– Expected Inflation
– Default Risk
– Maturity Risk
– Illiquidity Risk
51
Interest Rates
 Real Rate of Interest

– Compensates for the lender’s lost
opportunity to consume.
52
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.
53
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.
54
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.
55
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.
56
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.”
57
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
58
Interest Rates
• Term Structure
 Relationship between long and
short
term interest rates
 Yield curve
59
Treasury Yield Curve
8.00%
7.50%
3 month
7.00% T-Bill
6.50%
6.00%
5.50%
5.00%
Jan 10, 2006
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr. maturities
. 60
8.00%
7.50%
7.00%
6 month
6.50% T-Bill
6.00%
5.50%
5.00%
Jan 10, 2006
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr. maturities
. 61
8.00%
7.50%
1 year
7.00% T-Bill
6.50%
6.00%
5.50%
5.00%
Jan 10, 2006
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr. maturities
. 62
8.00%
7.50%
2 year
7.00% T-Note
6.50%
6.00%
5.50%
5.00%
Jan 10, 2006
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr. maturities
. 63
8.00%
7.50%
7.00%
6.50%
6.00%
5.50% 3 year
T-Note
5.00%
Jan 10, 2006
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr. maturities
. 64
8.00%
7.50%
7.00%
6.50%
5 year
6.00% T-Bond
5.50%
5.00%
Jan 10, 2006
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr. maturities
. 65
8.00%
7.50%
7.00%
6.50%
6.00%
5.50%
5.00%
Jan 10, 2006
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr. maturities
. 66
8.00%
7.50%
7.00%
6.50%
6.00%
5.50%
5.00%
Jan 10, 2006
4.50% March 22,1995
August 1, 2008
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos yr. maturities
. 67
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?
68
Financial
Institutions
69
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.
70
The Role of Financial Institutions
as 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.
71
Services offered by
Financial Institutions
• Denomination matching
72
Services offered by
– Households generally have small amounts of
surplus funds to invest. They can put small
amounts into savings at a time.
73
Services offered by
– 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.
74
Services offered by
• 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.
75
Services offered by
• 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.
76
Services offered by
• 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.
77
Services offered by
• 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.
78
The Role of Financial Institutions
Intermediaries help to facilitate the

flow of funds in the financial marketplace.
$$ Securities
Securities $$
79
Financial Intermediation
Example 1
$$ Checking
accounts
Commercial Households
Businesses Bank
Commercial $$
loans
80
Financial Intermediation
Example 2
$$ Insurance
policies
Insurance
Businesses Households
Company
Stocks, $$
Bonds
81
Types of Financial
Institutions
• Commercial Banks
82
Types of Financial Institutions
The primary purpose of commercial banks

is to take in business deposits and to lend
funds to businesses.
83
• Savings and Loans
84
Savings and loans’ primary purpose is to
take in deposits from households and to
lend funds for home mortgages.
85
• Credit Unions
86
• Credit Unions
Credit Unions are owned by depositors
(actually share owners) who are individuals,
not businesses. Credit Unions take in
funds and primarily make personal loans.
87
• Credit Unions
} Depository
Institutions
88
• Credit Unions
} Depository
Institutions
•Take in deposits
•Make loans
89
• Finance Companies
90
Non-bank firms that borrow funds to
make short and medium term loans to
higher risk borrowers.
91
Types of Financial
Institutions
• Insurance Companies
92
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.)
93
Finance Companies
Insurance Companies
Pension Funds
94
• Pension Funds
Workers and/or employers
contribute funds. Defined Benefit
Plans (DBP) versus Defined
Contribution Plans (DCP).
95
• Finance Companies Non-

• Pension Funds
} Depository
Institutions
96
Non-
• Pension Funds } Depository
Institutions
•Funds come from borrowing,

selling insurance policies, and
other claims.
•Funds used to buy securities
and make loans.
97
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.
98
Simplified Balance Sheet of
Commercial Bank
Reserves Deposits
Investments Borrowed Funds
Loans Bank Capital (Equity)
Fixed Assets
99
The Federal Reserve System
• The Fed is the central bank of the United

States
• Created in 1913
100
Purpose of the Fed
Monetary authority
i.e., control the money supply
101
Purpose of the Fed
Lender of last resort
Fed makes “discount loans” to depository
institutions
102
Purpose of the Fed
Fed makes “discount loans” to depository
institutions
Check clearing
103
Purpose of the Fed
Fed makes “discount loans” to
depository institutions
Check clearing
Bank Supervision
104
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
105
How the Fed Influences Interest Rates
• Open Market Operations

• Discount Rate Policy
• Reserve Requirements
106
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.
107
T-bills
The Fed $ The public
When the Fed buys T-Bills
108
When the Fed buys T-Bills
T-bills
Reserves are
injected into
the economy
109
When the Fed buys
T-bills
Bank reserves increase.
110
When the Fed buys T-bills

This makes banks more willing to
lend, increasing the supply of
loanable funds.
111

This makes banks more willing to
lend, increasing the supply of
loanable funds.
{Supply of LF } {i }
112
• 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.
113
T-bills
When the Fed sells T-Bills
114
When the Fed sells T-Bills
T-bills
Reserves are
extracted from
the economy
115
When the Fed sells
T-bills
Bank reserves decrease
116
When the Fed sells T-bills

This makes banks less willing to
lend, decreasing the supply of
loanable funds.
117

This makes banks less willing to
lend, decreasing the supply of
loanable funds.
{Supply of LF } {i }
118
• 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 }
119
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.
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.
• 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.
121
Reserve Requirements
 When the Fed increases reserve
requirements
– This decreases the amount of funds

available for lending
122
requirements
– {Supply of LF } {i }
123
requirements
– {Supply of LF } {i }
 When the Fed decreases reserve
requirements
– This increases the amount of funds
124
• When the Fed increases reserve requirements
– {Supply of LF } { i}
• When the Fed decreases reserve requirements

– This increases the amount of funds available
for lending
– {Supply of LF } { i}
125
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.
126
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.
127
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.
128

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Finance and The Firm

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Finance and

 The field of finance

 Liabilities and equity represent sources of

 Capital Structure Policy

 Working Capital Management

 From investor’s perspective, what

 Financial markets and institutions facilitate the

 How interest rate levels are determined

 The primary financial goal of the

 Managers are agents for the firm’s

 Limited Partnership (LP)

 Every partnership must have at

 Limited Partnership (LP)

 Limited Partnership (LP)

 Limited Liability Partnership (LLP)

Similar to General Partnership

 Limited Liability Company (LLC)

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

4. Why would someone choose a limited partnership share over a

5. How do agency problems arise? What are some examples of

• Operation of U.S. financial system.

The purpose of the financial system is to

additional funds to sustain their operations.

• To enable funds to move through the financial

• Classified according to the characteristics

Primary Market handles IPO’s (new public offerings)

The Circular Flow of Income

• Money Market vs. Capital

• Market efficiency refers to the ease, speed, and

• Money Market Securities

• Money Market Securities

• Money Market Securities

• Money Market Securities

• Money Market Securities

• Money Market Securities

• Money Market Securities

• Capital Market Securities

 Capital Market Securities

 Capital Market Securities

 Capital Market Securities

 Capital Market Securities

 Interest Rates Determined by

 Real Rate of Interest

k = the nominal, or observed rate

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

4. The economy is suffering from a recession, explain what will

5. Explain how you earn a return on a Treasury bill. How is this

• A household with surplus funds can “purchase”

Intermediaries help to facilitate the

The primary purpose of commercial banks

Receive premiums for insurance policies.

• Finance Companies Non-

•Funds come from borrowing,

• A specified percentage of deposits must be

Investments Borrowed Funds

Loans Bank Capital (Equity)