Understanding Financial Management and Securities Markets Chapter 16 Understanding Financial Management and Securities Markets Understanding Financial Management and Securities Markets CHAPTER 16 Managing the firm’s finances is increasingly complex—activities include financial planning, investing money, raising funds. Financial managers need an understanding of the firm’s business and industry, as well as having roles in creativity and leadership. The primary goal of the financial manager is to maximize the value of the firm to its owners. Financial management is a science (analyzing cash flows) and an art (effective use of financial resources). The Future of Business The Essentials 4th Edition Gitman & McDaniel © Ryan McVay / Digital Vision / Getty Images Prepared by Deborah Baker Chapter 16 Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved

Learning Goals CHAPTER 16 Understanding Financial Management and Securities Markets 1 How do finance and the financial manager affect the firm’s overall strategy? 2 What types of short-term and long-term expenditures does a firm make? 3 What are the main sources and costs of unsecured and secured short-term financing? 4 What are the key differences between debt and equity, and the major types and features of long-term debt? CHAPTER 16

Learning Goals (continued) Chapter 16 Understanding Financial Management and Securities Markets 5 When and how do firms issue equity, and what are the costs? 6 How do securities markets help firms raise funding, and what securities trade in the capital markets? 7 Where can investors buy and sell securities, and how are securities markets regulated? 8 What are the current developments in financial management and the securities markets? CHAPTER 16

The Role of Finance and the Financial Manager Chapter 16 Understanding Financial Management and Securities Markets The Role of Finance and the Financial Manager 1 How do finance and the financial manager affect the firm’s overall strategy? Financial management is the art and science of managing a firm’s money so it can meet its goals. It is not just the responsibility of the finance department, since all business decisions have financial consequences. 1

The Role of Finance and the Financial Manager Chapter 16 Understanding Financial Management and Securities Markets financial management The art and science of managing a firm’s money so that it can meet its goals. 1

The Role of Finance and the Financial Manager Chapter 16 Understanding Financial Management and Securities Markets cash flows The inflows and outflows of cash for a firm. 1

Key Activities of the Financial Manager Chapter 16 Understanding Financial Management and Securities Markets Key Activities of the Financial Manager Financial planning Investing (spending money) Financing (raising money) Activities: Financial planning: preparing the financial plan, which projects revenues, expenditures, and financing needs Investing: investing the firm’s funds in projects and securities that provide high returns in relationship to risks Financing: obtaining funding for the firm’s operations and investments, and seeking the proper balance between debt and equity 1

The Goal of the Financial Manager Chapter 16 Understanding Financial Management and Securities Markets Maximize the Value of the Firm Return Risk Versus The main goal of the financial manager is to maximize the value of the firm to its owners. The financial manager has to consider both short- and long-term consequences of the firm’s actions. Maximizing profits is one approach, but not the only one. Financial managers strive for balance between the opportunity for profit (return) and the potential for loss (risk). A basic principle in finance is that the higher the risk, the greater the return that is required. This concept is called the risk-return trade-off. 1

The Goal of the Financial Manager Chapter 16 Understanding Financial Management and Securities Markets risk-return trade-off A basic principle in finance that holds that the higher the risk, the greater the return that is required. 1

CONCEPT check 1 What is the role of financial management in a firm? Chapter 16 Understanding Financial Management and Securities Markets What is the role of financial management in a firm? How do the three key activities of the financial manager relate? What is the main goal of the financial manager? How does the risk-return trade-off relate to the financial manager’s main goal? 1

How Organizations Use Funds Chapter 16 Understanding Financial Management and Securities Markets 2 What types of short-term and long-term expenditures does a firm make? 2

Short-Term Expenses 2 Manage Current Assets Cash Accounts Receivable Chapter 16 Understanding Financial Management and Securities Markets Manage Current Assets Cash Accounts Receivable Inventory The financial manager’s goal is to manage current assets so that the firm has enough cash to pay its bills and to support accounts receivable and inventory. Cash management is the process of making sure that a firm has enough cash on hand to pay bills as they come due and to meet unexpected expenses. Accounts receivable represent sales for which the firm has not yet been paid. Inventory is nearly 20 percent of total assets. Financial managers want the least inventory possible without harming production efficiency or sales. 2

Balancing Cash Outflow and Inflow Chapter 16 Understanding Financial Management and Securities Markets Collect money owed to the firm quickly (accounts receivable) Pay money owed to others as late as possible without damaging credit reputation (accounts payable) Minimize funds tied up in inventory The three strategies to balance cash outflows and cash inflows are shown on this slide. 2

Accounts Receivable Management Chapter 16 Understanding Financial Management and Securities Markets Credit policies Guidelines on offering credit Credit terms Specific repayment conditions Collection policies 2

Inventory Management Chapter 16 Understanding Financial Management and Securities Markets Cost of inventory includes its purchase price, ordering, handling, storage, interest, and insurance costs. Marketing managers want finished goods on hand to fill customer orders. Financial managers prefer the least inventory possible without harming production efficiency or sales. In retail operations, inventory turnover rates are closely monitored. 2

Capital Expenditures 2 Land Buildings Machinery Equipment Chapter 16 Understanding Financial Management and Securities Markets Machinery Buildings Land Equipment Information Systems A firm also uses funds for its investments in long-lived assets, such as land, buildings, machinery, equipment, and information systems. These are called capital expenditures. 2

Capital Expenditures 2 Reasons for Capital Expenditures Expand Chapter 16 Understanding Financial Management and Securities Markets Reasons for Capital Expenditures Expand Replace or renew fixed assets Develop new products 2

CONCEPT check 2 Distinguish between short- and long-term expenses. Chapter 16 Understanding Financial Management and Securities Markets Distinguish between short- and long-term expenses. What is the financial manager’s goal in cash management? List the three key cash management strategies. Describe a firm’s main motives in making capital expenditures. 2

Obtaining Short-Term Financing Chapter 16 Understanding Financial Management and Securities Markets 3 What are the main sources and costs of unsecured and secured short-term financing? 3

Funding 3 Profit Equity Debt Retain earnings Sell ownership shares Chapter 16 Understanding Financial Management and Securities Markets Funding Profit Equity Debt Retain earnings Sell ownership shares Borrow money Firms raise funds by borrowing money, selling ownership shares, and retaining earnings. The financial manager must assess all these sources to choose the one likely to maximize the firm’s value. 3

Unsecured Short-Term Loans Chapter 16 Understanding Financial Management and Securities Markets Unsecured Short-Term Loans Bank Loans Trade Credit Commercial Paper Lines of credit Revolving credit agreement Unsecured loans are made on the basis of the firm’s creditworthiness and the lender’s previous experience with the firm. An unsecured borrower does not have to pledge specific assets as security. The three main types of unsecured short-term loans are trade credit, bank loans, and commercial paper. Commercial paper is an unsecured short-term debt (an IOU), which is usually 1 to 3 percent below bank interest rates. 3

Secured Short-Term Loans Chapter 16 Understanding Financial Management and Securities Markets Secured Short-Term Loans Secured Loans Loans for which the borrower is required to pledge specific assets as collateral, or security. Factoring A firm sells its accounts receivable at a discount to a factor, such as a commercial bank or commercial finance company. Secured loans require the borrower to pledge specific assets as collateral, or security. The secured lender can legally take the collateral if the borrower doesn’t repay the loan. Another form of short-term financing using accounts receivable is factoring. A firm sells its accounts receivable outright to a factor, a financial institution that buys accounts receivable at a discount. Factoring allows a firm to turn its accounts receivable into cash without worrying about collections. 3

CONCEPT check Chapter 16 Understanding Financial Management and Securities Markets Distinguish between unsecured and secured short-term loans. Briefly describe the three main types of unsecured short-term loans. Discuss the two ways that accounts receivable can be used to obtain short-term financing. 3

Raising Long-Term Financing Chapter 16 Understanding Financial Management and Securities Markets 4 What are the key differences between debt and equity, and the major types and features of long-term debt? 4

Debt versus Equity Financing Chapter 16 Understanding Financial Management and Securities Markets financial risk The chance that a firm will be unable to make scheduled interest and principal payments on its debt. 4

Chapter 16 Understanding Financial Management and Securities Markets Debt Financing Mortgage loans Bonds Term loans A long-term loan made against real estate as collateral. Long-term debt obligations issued by corporations and governments. A business loan with a maturity of more than one year. Unsecured or secured. Long-term debt is used to finance long-term (capital) expenditures. Three forms of long-term debt are term loans, bonds, and mortgage loans. 4

Equity Financing Chapter 16 Understanding Financial Management and Securities Markets 5 When and how do firms issue equity, and what are the costs? 5

Dividends & Retained Earnings Selling New Issues of Common Stock Equity Financing Chapter 16 Understanding Financial Management and Securities Markets Venture Capital Preferred Stock Dividends & Retained Earnings Selling New Issues of Common Stock Equity is the owners’ investment in the business. In corporations, the preferred and common stockholders are the owners. A firm obtains equity financing by selling new ownership shares, or by retaining earnings. Small and growing companies also use venture capital. Common stock is a security that represents an ownership interest in a corporation. Going public initiates its first sale of stock to the public. Dividends are payments to stockholders from a corporation’s profits. Retained earnings are profits that have been reinvested in a firm. Preferred stock is an equity security for which the dividend amount of set at the time the stock is issued. Venture capital is another source of equity capital. Venture capitalists invest in new businesses in return for part of the ownership. 5

Equity Financing 5 Preferred Stock Chapter 16 Understanding Financial Management and Securities Markets Preferred Stock An equity security for which the dividend amount is set at the time the stock is issued. Common Stock A security that represents an ownership interest in a corporation. Preferred stock dividends must be paid before the company can pay dividends to common stockholders. Also, if the firm goes bankrupt, preferred stockholders receive money from asset sales prior to common stockholders. 5 29 29

CONCEPT check Chapter 16 Understanding Financial Management and Securities Markets Compare the advantages and disadvantages of debt and equity financing. Discuss the costs involved in issuing common stock. Briefly describe these sources of equity: retained earnings, preferred stock, and venture capital. 5

Securities Markets Chapter 16 Understanding Financial Management and Securities Markets 6 How do securities markets help firms raise funding, and what securities trade in the capital markets? 6

Types of Securities Markets Chapter 16 Understanding Financial Management and Securities Markets Types of Securities Markets Secondary Market The securities market where old (already issued) securities are bought and sold, or traded, among investors. Primary Market The securities market where new securities are sold to the public, usually with the help of investment bankers. Securities markets can be divided into primary and secondary markets. The primary market is where new securities are sold to the public, usually with the help of investment bankers. Later transactions take place in the secondary market where already issued securities are bought and sold, or traded, among investors. The vast majority of securities transactions take place in secondary markets. You’ll see tombstones--announcements of both primary and secondary stock and bond offerings-- in the Wall Street Journal and other newspapers. 6 32 32

Institutional Investors Chapter 16 Understanding Financial Management and Securities Markets Securities Markets Stockbroker Investment Bankers Institutional Investors A person who is licensed to buy and sell securities on behalf of clients. Firms that act as intermediaries, buying securities and reselling them to the public (underwriting). Investment professionals who are paid to manage other people’s money. On an average day, individual and institutional investors trade billions of shares of stock in more than 10,000 companies through securities markets. Individual investors invest their own money to achieve their personal financial goals. Institutional investors are investment professionals who are paid to manage other people’s money. Two types of investment specialists play key roles in the functioning of the securities market. Investment bankers help companies raise long-term financing. These firms act as intermediaries, buying securities from corporations and governments and reselling them to the public. This process, called underwriting, is the main activity of the investment banker, who acquires the security and hopes to resell it at a higher price to make a profit. A stockbroker is a person who is licensed to buy and sell securities on behalf of clients. These investment professionals work for brokerage firms and execute the orders customers place for stocks, bonds, mutual funds, and other securities. 6 33 33

Government Securities and Municipal Bonds Chapter 16 Understanding Financial Management and Securities Markets Municipal Bonds Treasury Bonds U.S. Treasury Treasury Notes Treasury Bills Revenue Bonds General Obligation Bonds Both the federal government and local government agencies also issue bonds. The U.S. treasury sells three major types of federal debt securities, commonly called “governments”: Treasury bills, Treasury notes, and Treasury bonds. All three are viewed as risk-free. Municipal bonds are issued by states, cities, counties, and other state and local government agencies. General obligation bonds are backed by the full faith and credit (and taxing power) of the issuing government. Revenue bonds are repaid only from income generated by the specific project being financed. Revenue bonds are more risky, and therefore have higher interest rates than general obligation bonds. Municipal bonds are attractive because interest earned on them is exempt from federal income tax. 6

Bond Ratings Chapter 16 Understanding Financial Management and Securities Markets Investors can use bond ratings, letter grades assigned to bond issues to indicate their quality or level of risk. The two best-known rating agencies are Moody’s and Standard & Poor’s. Exhibit 16.3 lists the letter grades assigned by Moody’s and Standard & Poor’s rating systems. 6 35 Exhibit 16.3 35

Other Popular Securities Chapter 16 Understanding Financial Management and Securities Markets Mutual Funds Exchange-Traded Funds Futures Contracts Options 6 36 36

CONCEPT check Chapter 16 Understanding Financial Management and Securities Markets Distinguish between primary and secondary securities markets. How does an investment banker work with companies to issue securities? Describe the types of bonds available to investors and the advantages and disadvantages they offer. Why do mutual funds and exchange-traded funds appeal to investors? Discuss why futures contracts and options are risky investments. 6

Buying and Selling at Securities Exchanges Chapter 16 Understanding Financial Management and Securities Markets 7 Where can investors buy and sell securities, and how are securities markets regulated? 7

Secondary Markets 7 Secondary Markets Broker Markets Dealer Markets Chapter 16 Understanding Financial Management and Securities Markets Secondary Markets Broker Markets National Exchanges Regional Exchanges Dealer Markets NASDAQ OTC In the secondary markets, which handle most securities trading activity, there are two segments: broker markets and dealer markets. The differences in the two markets are the ways each executes securities trades. The broker market consists of national and regional securities exchanges. The New York Stock Exchange lists the shares of over 2,800 corporations. Regional exchanges are located in Boston, Chicago, Cincinnati, and Philadelphia. The dealer markets, which do not operate on centralized trading floors but instead use telecommunications networks, consist of NASDAQ and over-the-counter markets. 7 39 39

New York Stock Exchange (NYSE) Broker Markets Chapter 16 Understanding Financial Management and Securities Markets New York Stock Exchange (NYSE) Regional Exchanges The oldest and most prestigious U.S. stock exchange is the New York Stock Exchange, located on Wall Street in New York. About 2,800 corporations are listed on the NYSE, and on a typical day, more than 2.6 billion shares of stock are traded. The NYSE trading floor is where all NYSE transactions occur. Each of the companies traded at the NYSE is assigned to a trading post on the floor. Until recently, all NYSE transactions occurred on the trading floor. When an exchange member receives an order to buy or sell a stock, the order is transmitted to a floor broker at the company’s trading post. The floor brokers then compete with other brokers on the trading floor to get the best price for their customers. However, the NYSE created a hybrid market that combines features of the floor auction market and automated trading. Customers now have a choice of how they executive trades. In January 2008, the NYSE acquired AMEX. The top regional exchanges are Boston, Chicago, Philadelphia, and National (formerly Cincinnati). 7 40 40

Dealer Markets Chapter 16 Understanding Financial Management and Securities Markets 1. The selling investor sells his/her securities to one dealer. 2. The buyer purchases the securities from another dealer. A security transaction in the dealer market has two parts: the selling investor sells his securities to one dealer, and the buyer purchases the securities from another dealer ( or in some cases, the same dealer). 7 41 41

Dealer Markets 7 NASDAQ OTC Markets Chapter 16 Understanding Financial Management and Securities Markets NASDAQ OTC Markets The largest dealer market is NASDAQ--the National Association of Securities Dealers Automated Quotation system. OTC markets include the Over-the-Counter Bulleting Board and the Pink Sheets. These markets generally list small companies. 7 42 42

Alternative Trading Systems Chapter 16 Understanding Financial Management and Securities Markets electronic communications networks (ECNs) Electronic trading networks that allow institutional traders and some individuals to make securities transactions directly. In addition to broker and dealer markets, alternative trading systems, such as electronic communications networks make securities transactions, in what is called the fourth market. They are most effective for high-volume, actively traded stocks. 7 43 43

Regulation of Securities Markets Chapter 16 Understanding Financial Management and Securities Markets Securities and Exchange Commission The main federal government agency responsible for regulating the U.S. securities industry. Insider Trading The use of information that is not available to the general public to make profits on securities transactions. The securities markets are regulated by both state and federal governments. In 1934, Congress established the Securities and Exchange Commission (SEC) as the main federal government agency responsible for regulating the securities industry. In 1934, insider trading was also banned. 7 44 44

Self-Regulation 7 circuit breakers Chapter 16 Understanding Financial Management and Securities Markets circuit breakers Measures that, under certain conditions, stop trading in the securities markets for a short cooling-off period to limit the amount the market can drop in one day. In response to “Black Monday”—October 19, 1987, when the Dow Jones Industrial Average plunged 508 points and the trading activity severely overloaded the exchange’s computers—the securities market instituted corrective measures to prevent a repeat of the crisis. Under certain conditions, circuit breakers stop trading for a short cooling-off period to limit the amount the market can drop in one day. 7 45 45

CONCEPT check Chapter 16 Understanding Financial Management and Securities Markets How do the broker markets differ from dealer markets, and what organizations compose each of these two markets? Why is globalization of the securities markets important to U.S. investors? What are some of the other exchanges where U.S. companies can list their securities? Briefly describe the key provisions of the main federal laws designed to protect securities investors. What is insider trading, and how can it be harmful? How does the securities industry regulate itself? 7

Trends in Financial Management and Securities Markets Chapter 16 Understanding Financial Management and Securities Markets Trends in Financial Management and Securities Markets 8 What are the current developments in financial management and the securities markets? 8

Trends in Financial Management and Securities Markets Chapter 16 Understanding Financial Management and Securities Markets Technology Stronger role of SEC Mergers in global securities markets Electronic trading Technological advances continues to improve the efficiency with which financial managers run their operations. In wake of a slowing economy and corporate scandals, the SEC has assumed a stronger role and implemented additional regulations to protect investors. Consolidation continues in global securities markets. Trade-cycle automation improvements dictate that the best electronic bid or offer in a market be protected. 8

CONCEPT check Chapter 16 Understanding Financial Management and Securities Markets How has the role of CFO changed since the passage of the Sarbanes-Oxley Act? Describe the major changes taking place in the U.S. securities markets. What trends are driving these changes? 8