1 Chapter 2 Operating Environment of Financial Management

2 Chapter 2 – Operating Environment of Financial Management Circular Flow of Income – shows the interactive nature between household income, the purchase of goods and services, and business expenditures. Production of Goods and Services (Business) Providers of Resources (Households) Goods and Services Consumption Expenditures Money Income Economic Resources

3 Chapter 2 – Operating Environment of Financial Management Depository Financial Institutions – called such because they accept demand and savings deposits. Commercial Banks – represent largest type of financial institutions in terms of assets held. Businesses depend on such banks for both borrowing and lending transactions. Mutual Savings Banks – invest primarily in mortgages guaranteed by the Federal Housing Administration (FHA) and Veterans Administration (VA). Mutual Savings Banks are primarily located in the northeast.

4 Chapter 2 – Operating Environment of Financial Management Depository Financial Institutions (cont) Savings and Loan Associations – chartered by either federal government or the state in which they operate. Savings and loans specialize on mortgages. Credit Unions – this type of institution is composed of a group of people with common ties such as church, fraternal order or labor union. Members own, control and operate the credit union under either a federal or state charter.

5 Chapter 2 – Operating Environment of Financial Management Insurance Companies – divided into the following two broad categories. Life Insurance Companies – collect premiums from customers that will permit them to cover the necessary payments based upon prior mortality statistics. These premiums are invested until needed in corporate securities and mortgages. Property and Casualty Insurance Companies – collect premiums from policyholders to offer protection against financial losses and other such perils.

6 Chapter 2 – Operating Environment of Financial Management Other Financial Institutions Pension Funds – established to provide income to retired or disabled persons. Private Pension Funds – generally controlled by commercial banks and life insurance companies and invested heavily in stocks. Government-Sponsored Pension Funds - controlled by legislation and invested in corporate bonds and stocks. Mutual Funds – acquires small amounts of monies from many different individuals and invest in a wide variety of corporate securities.

7 Chapter 2 – Operating Environment of Financial Management Other Financial Institutions (cont) Finance Companies – depend heavily on open market commercial paper and borrow funds from commercial banks. These companies use these funds to make loans. Many times finance companies are formed by parent companies to assist with the financing of their goods and services. One such example is GMAC, a subsidiary of General Motors.

8 Chapter 2 – Operating Environment of Financial Management Financial Markets – consists of capital markets and money markets and serve to bring deficit spenders and surplus savers together to transact business. Money Markets – consists of a group of markets where short-term instruments are traded. Generally, such instruments are issued by those with the highest credit ratings and characterized by a high degree of safety. Maturities may be as long as one year but are usually 90 days or less.

9 Chapter 2 – Operating Environment of Financial Management Money Markets (cont) Treasury Bills – direct obligations of the U.S. government and perhaps the most important type of money market instrument. T-bills with maturities of 91 – 182 days are auctioned on a weekly basis and sold on a discount basis. Commercial Paper – represents unsecured promissory notes sold by finance companies among others. Commercial paper bears the name of the issuer. Bankers’ Acceptance – short-term credit instruments that arise out of foreign transactions. They are time drafts issued by business firms (often an importer of goods) and accepted by a bank.

10 Chapter 2 – Operating Environment of Financial Management Money Markets (cont) Negotiable Certificates of Deposits – large denomination CDs issued by commercial banks to attract idle corporate assets. Repurchase Agreements - agreement whereby a dealer sells it short term securities along with a simultaneous agreement to buy them back at a later date. Federal Funds – loans between bank on an overnight basis.

11 Chapter 2 – Operating Environment of Financial Management Capital Markets – deal with long-term securities such as stock, bonds and mortgages. Such markets are comprised of “Primary” and “Secondary” markets. Primary markets – when firms sell new securities they take place in primary markets. New securities are offered in either an initial public offering (IPO) or private placement. Secondary markets - deals with securities that have been previously issued and sold. The major secondary markets include the NYSE, AMEX (both physical exchanges) and the NASDAQ (over-the-counter or OTC).

12 Chapter 2 – Operating Environment of Financial Management Capital Markets (cont) Bonds – an agreement to make interest and principal payments to the bondholder. Generally issued in denomination of $1,000 and referred to as a fixed income security because interest payments are fixed. Bonds fall into one of four categories U.S. Treasury U.S. Agency Municipal Corporate

13 Chapter 2 – Operating Environment of Financial Management Capital Markets (cont) Stocks – common stockholders represent ownership of the company and have a claim to any asset return after all debt obligations are fully satisfied.

14 Chapter 2 – Operating Environment of Financial Management Inflation – a percentage measure in the increase in the level of prices. Quantity theory of money – hypothesis that states that commodity prices are primarily determined by the quantity of money in circulation. “Too much money chasing too few goods” Demand-pull inflation – product prices increase due to the products demand exceeding its supply. Cost-push inflation – prices are increasing due to the rising level of labor costs.

15 Chapter 2 – Operating Environment of Financial Management Interest Rates – represents the market’s price of money and serves as the pricing mechanism for the flow of monies between surplus savers and deficit spenders. Nominal rate of interest – consists of the real interest rate and the expected rate of inflation. Real rate of interest – nominal rate minus expected inflation rate. Thought to be relatively stable over time. Risk-free rate of interest – typically estimated with U.S. treasury bill.

16 Chapter 2 – Operating Environment of Financial Management Forms of Business Organization Sole Proprietorship – a business owned by an individual who is responsible for all aspects of the business. As a sole proprietor, the owner is entitled to all profits but is also personally responsible for all debts. Partnership – a business that is jointly owned by two or more individuals. A contractual agreement specifies the amount of each partner’s capital contribution, how profits will be distributed and provisions for withdrawal from the partnership.

17 Chapter 2 – Operating Environment of Financial Management Forms of Business Organization (cont.) Corporation – a legal entity capable of owning assets, incurring liabilities and engaging in certain activities. One of the major advantages of a corporation is that investors liability is limited to their initial investment. Other advantages include the ease in the transfer of ownership and raising additional capital.

18 Chapter 2 – Operating Environment of Financial Management Tax Treatment of Corporate Income Depreciation Straight-line Double declining-balance Sum-of-Years Digits Accelerated Cost Recovery System

19 Chapter 2 – Operating Environment of Financial Management Tax Treatment of Corporate Income Interest and Dividends Interest payments by a corporation are treated as a tax deductible expense. Dividends paid are not tax deductible