Financing the Enterprise CHAPTER 14 Accounting and Financial Statements This is the final chapter. Chapter sixteen examines the importance of financial markets and securities markets. We will consider options available for short and long-term financing and capital budgeting. We will discuss the use of equity financing by issuing stock and conclude with a discussion on the various securities markets in the United States. CHAPTER 15 Money and the Financial System CHAPTER 16 Financial Management and Securities Markets FHF 16-2

Working Capital Management The management of short-term assets and liabilities Current Assets: Short-term resources Cash Investments Accounts receivable Inventory Current Liabilities: Short-term debts Accounts payable Accrued salaries Accrued taxes Short-term bank loans Working capital management only involves short-term assets and liabilities because they continually flow through an organization and therefore are said to be ‘working’. FHF 16-3

[ ] Transaction Balance Cash kept on hand by a firm to pay normal daily expenses such as employee wages and bills for supplies and utilities Managers in charge of working capital need to try to keep just enough cash on hand for normal expenses. FHF 16-4

Lockbox [ ] An address, usually a commercial bank, at which a company receives payments in order to speed collections from customers A lockbox manager (usually a bank) collects payments from the lockbox several times a day and deposits them in the company’s bank account. A lockbox is quicker than sending payments to the company’s main address and processing them from there– is only cost-effective for the largest companies. FHF 16-5

Electronic Funds Transfer Frequently used to speed up collections Also being used to pay bills online Companies want to collect bills quickly and pay them slowly Paying electronically increases the speed of collections and disbursements to one day Checks are the slowest way to pay bills (generally 3-4 days) This method is best for large organizations, especially international ones, that face slow and sometimes uncertain delivery of payments. FHF 16-6

…continued on next page Investing Idle Cash Marketable Securities Temporary investment of extra cash by organizations up to one year in U.S. Treasury bills, certificates of deposit, commercial paper, or eurodollar loans Treasury Bills (T-bills) Short-term debt obligations the U.S. government sells to raise money Maturities between 1 week to 1 year Sometimes cash comes in more quickly than it is needed. Rather than leaving it idle, businesses will often invest it until it is needed (from one night to one year). …continued on next page FHF 16-7

Investing Idle Cash Commercial Certificates of Deposit (CDs) Issued by commercial banks and brokerages available in minimum amounts of $100,000, typically $1 million, and can be traded prior to maturity Commercial Paper A written promise from one company to another to pay a specific amount of money Restricted only to the largest and most respected companies Eurodollar Market A market for trading U.S. dollars in foreign countries Any U.S. dollar-denominated deposit in non-U.S. bank is called eurodollar The eurodollar market includes all countries outside the U.S.– not only Europe. The eurodollar market was originally developed by London banks (hence the name), but applies to all U.S. dollars deposited in foreign banks. FHF 16-8

Accounts Receivable and Inventory Occurs on the balance sheet after cash and marketable securities Accounts Receivable Money owed to a business by credit customers Companies often offer discounts for early payment and penalties for late payments Optimizing Inventory Objective is to minimize firm’s investment in inventory without experiencing production cutbacks Radio frequency identification (RFID) technology helps firms track and optimize their inventories Accounts receivable discounts and penalties are usually in the 1-2% range. Discounts reduce profits, but they also provide a company with cash sooner. Inventory surpluses and shortages can both be expensive and reduce a company’s efficiency. Optimizing inventory is an important task. FHF 16-9

Managing Current Liabilities Accounts Payable Money an organization owes to suppliers for goods and services Trade Credit Credit extended by suppliers for the purchase of their goods and services The most important account payable and most widely used source of short-term financing Trade credit varies depending on the organizations involved and the value of the items purchased. FHF 16-10

Current Liabilities: Bank Loans Line of Credit An arrangement by which a bank agrees to lend a specified amount of money to an organization upon request Similar to a credit card, but often for millions of dollars Secured Loans Loans backed by collateral that the bank can claim if the borrowers do not repay the debt Nearly all organizations receive short-term financing for operations from banks. …continued on next page FHF 16-11

Current Liabilities: Bank Loans Unsecured Loans Loans backed only by the borrower’s good reputation and previous credit rating Prime Rate The interest rate that commercial banks charge their best customers for short-term loans Interest rates on commercial loans can be fixed or variable (floating- rate loan) Floating rate loans are appealing when interest rates are falling, but not when they rise Businesses and individuals build their credit rating from their history of borrowing and repaying on time and in full. A complaint during the most recent financial meltdown was that banks were unwilling to lend. This stemmed from two main causes: banks were trying to rebuild capital, and they did not want to take on extra risk. FHF 16-12

Non-Bank Liabilities Short-term loans from insurance companies, pension funds, money market funds, or finance companies Factor An organization that purchases accounts receivables at a discount and assumes responsibility for collecting the accounts Taxes and Employees’ Wages Debt obligations to the firm Additional nonbank liabilities that must be efficiently managed to ensure maximum profitability Banks are not the only source of short-term funding available to organizations. Organizations are responsible for paying many different kinds of taxes that differ depending on the type of business the organization conducts. FHF 16-13

Managing Long-Term (Fixed) Assets Expected to last for many years Production facilities (plants), offices and equipment Tend to be high-cost, making financing critical Organizations need the most high-tech, up-to-date facilities and equipment they can afford in order to be competitive Obtaining long-term financing can be difficult Leasing is a way of obtaining assets without purchasing them Most business failures stem from poor short-term financial planning, but long-term management of financial assets and liabilities is essential to the continued health of a business. FHF 16-14

Capital Budgeting The process of analyzing the needs of business and selecting the assets that will maximize its value Not an exact process Managers must be flexible as new information becomes available Assets and projects must be continuously reevaluated Capital budgeting is one of the most important jobs of a financial manager. FHF 16-15

Pricing Long-Term Money Factors to Consider: How much cash will be generated Cost of financing Supply of funds available for investment Accurately identifying opportunities with the greatest potential for ROI Returns on investment must cover the operating costs of a project, plus interest expenses for the debt. All corporations only have a limited supply of funds to invest, but smaller, newer, riskier companies will have the hardest time getting the best rates for their investments. Costs of financing decrease for companies that manage their finances well over time. FHF 16-16

Financing with Long-Term Liabilities Debts that will be repaid over a number of years Long-term loans Bond issues Companies must raise money in the form of lines of credit or loans Relying too heavily on debt can be dangerous Companies may not earn enough to cover interest payments In order to continue operations, most companies will have to accrue some long-term debt. This should be carefully managed, however. Firms that rely too heavily on debt could run into problems. FHF 16-17

Bonds Common form of long-term debt Sold by large companies to raise long-term funds Like corporate IOUs Bondholders basically loan the issuer cash Indenture: The bond contract specifying all terms of agreement between the bondholder and the issuing organization Specifies interest payments, maturity date, repayment methods, etc. The face value (initial sales price) of the bond is usually $1,000, but its value on the open market fluctuates with the economy. FHF 16-18

…continued on next page Types of Bonds Unsecured Bonds Debentures, or bonds, that are not backed by specific collateral Most common type Secured Bonds Bonds that are backed by specific collateral that must be forfeited in the event the issuing firm defaults Serial Bonds A sequence of small bond issues of progressively longer maturity …continued on next page FHF 16-19

Types of Bonds Floating-Rate Bonds Bonds with interest rates that change with current interest rates otherwise available in the economy Junk Bonds Special type of high interest rate bond that carries higher inherent risks FHF 16-20

Financing with Owner’s Equity Owner’s Equity is the owner’s investment in an organization All money and assets owners have brought into an organization In addition to long-term debt, organizations can use equity as a means of financing. As discussed in chapter 14, owner’s equity is the owner’s investment in an organization. FHF 16-21

Common Stock The most important source of capital for most new companies Gives stockholders voting and control rights Par Value: The amount printed on the stock certificate Market Value: The price at which the stock is trading Capital in Excess of Par: The difference between the market value and the par value Stockholders’ equity is in stock– which is an important source of funds for most new corporations. Stock can help organizations raise capital quickly. Common stock is one of two types of stock. FHF 16-22

Financing with Owner’s Equity Preferred Stock Gives the stockholder preference in distribution of profits, but not voting and control rights Is a safer investment than common stock Retained Earnings Earnings after expenses and taxes Are reinvested in the assets of the firm and belong to the owners in the form of equity The only long-term funds a company generates internally Preferred stock is the second type. Both types of stock have pros and cons, but preferred stock is generally considered desirable because it is more likely to pay reliable dividends. FHF 16-23

When a Company Has Profits Left Over Retained Earnings Reinvested in the assets of the firms Dividend Yield The dividend per share divided by the stock price Not all companies pay dividends When a company has profits left over after paying expenses and taxes, it may choose to reinvest the assets or distribute them as a dividend to shareholders. FHF 16-24

Financing Through Issuing Stock Primary Market New issue (first-time sale of stock) or initial public offering (IPO– when a company offers stock for sale for the first time) Raise cash for issuing corporation Secondary Market Stock exchanges and OTC markets Investors trade securities with each other Does not raise cash for corporation There are two markets for stock. The primary market is for first-time issues– the corporation issuing the stock receives the funds raised through this market. The secondary market is for stocks that have already been issued that are changing hands. FHF 16-25

Investment Banking Is the sale of stocks and bonds for corporations Helps companies raise funds by matching people and institutions who have money to invest with corporations needing resources A way for corporations to obtain financing Many investment banks now offer other banking services “One-stop shopping” Large firms have client relationships with investment banking firms that help match them with investors so they can raise funds. FHF 16-26

Securities Markets Provide the mechanism for buying and selling securities The Stock Market Dramatic shifts in structure of exchanges NY Stock Exchange and NASDAQ now are for-profit businesses Most exchanges are or are becoming electronic– making organized exchanges less centralized and faster Over-the-Counter Market (OTC) A network of dealers all over the country and world No central location Small stocks, illiquid bank stocks and penny stocks Securities markets make it possible for owners to sell stocks and bonds to other investors– one may think of them as providers of liquidity. FHF 16-27

Measuring Market Performance How are investments performing relative to the whole market? Performance measures make comparison possible Index: Compares current stock prices with a base price Average: The average of certain stock prices, usually calculated with complicated formulas Financial bubbles can be hard to recognize, even with performance measures Investors must stay well informed of business news FHF 16-28

Market Performance of Indonesia Capital Market (IDX) While the stock market took a major hit in late 2008, it had begun to recover by summer 2009, but continued to fluctuate in 2010. Source: www.idx.co.id FHF 16-29