Chapter 1: Financial Management Overview PDF

CHAPTER 1: An Overview of Financial Management and the Financial Environment  ALVIN DAVIS PUFFER 2  ALVIN DAVIS PUFFER Born in Stow Massachusetts in 1819. Attended high school at Framingham Academy and trained as an engineer. In 1842 opened a plumbin...

CHAPTER 1: An Overview of Financial Management and the Financial Environment  ALVIN DAVIS PUFFER 2  ALVIN DAVIS PUFFER Born in Stow Massachusetts in 1819. Attended high school at Framingham Academy and trained as an engineer. In 1842 opened a plumbing business in Boston. On his off time, he tinkered with the mechanics of soda fountains. In 1871 he filed his first patent. He decided to start a company to manufacture and sell soda fountains using his patented technology. Uncle Al has the intellectual property for a new product. He wants to start a business to mass produce them and bring better soda fountains to the world. 3  ALVIN DAVIS PUFFER 4  WHAT DOES UNCLE AL NEED? Working Capital Capital Assets Inventory Vehicles and Equipment Accounts Land and Receivable buildings 5 Where will he get the money to buy all this?  CORPORATE STRUCTURE Before even getting into that, Uncle Al needs to decide on a legal structure for his company. Companies tend to take on certain structures depending on their stage in the life cycle. Start-up phase – Proprietorship Growth phase – Partnership Mature phase – Corporation 6  PROPRIETORSHIP When just starting out, most business owners structure their companies as sole proprietorship. In a way this really isn’t a business since all the assets and activities are personal property: Advantages ▪ Easy and cheap to create ▪ Low government intervention ▪ Low taxes (individual rather than corporate) Disadvantages Hard to get funding Unlimited personal liability No transfer of ownership 7  PARTNERSHIP As the company grows, the owner can take on partners. The financial responsibility is spread among multiple people: Advantages, same as proprietorship plus Additional sources of equity Partners can provide expertise and connections Disadvantages, same as a proprietorship plus Shared control Shared profit Easier to dissolve but still hard On the show Shark Tank, the business owners ask for an infusion of cash in exchange for a percentage ownership of the business. They are asking for a partnership. 8  PARTNERSHIP In a pure partnership, all partners function as proprietors with unlimited liability. The law provides a way around the unlimited liability with the Limited Liability Partnership (LLP) structure: General Partner (GP) – One of the partners in the venture who has a managerial role in the company. The GPs usually have a larger stake in the company than the others and have unlimited liability. Limited Partner (LP) – A partner who has invested money in the business, has a voting voice in the company, and may also contribute expertise to the venture. However, an LP does not exercise day-to-day management of the venture and is not personally liable for the business. 9  CORPORATION As the company matures, management may choose to convert it to a corporation. In this structure the ownership is formalized and sold in discreet units: Advantages Unlimited lifespan Ownership is easily transferable Owner liability is limited to company assets Disadvantages Difficult and expensive to establish and maintain Profits taxed twice, company and investor The professional name of a corporation is a C-Corp. Another version, an S-Corp., has a limited number of owners and is only taxed once as personal income. 10  CORPORATION Most of the largest companies use a type of corporation structure where they sell shares of ownership to the general public. When a company sells its equity to the public for the fist time it is referred to as an initial public offering (IPO). This is a long and complicated process, involving a lot of regulatory paperwork and expensive services of an investment bank. Once it happens, the company has to maintain high standards of transparency and live up to heavy regulation. The upside is it can access a huge pool of funding and can raise new money anytime by issuing even more shares. 11  CORPORATION The ownership of a corporation can be highly fragmented, making it hard to manage by the owners. Best practice is for the owners to hire a manager to run the day-to-day operations. This can give rise to the agency problem. The manager is charged with running a company without a vested interest in its success. This can lead to a variety of problems, such as the manager using company funds for his/her own benefit. We see that in the news all the time. This can be mitigated by structuring the manager’s compensation to increase when the company gains value. Paying in stock options is a popular way to do that. 12  INCREASE COMPANY VALUE However the company is structured, the owner’s main concern is increasing its value over the long term. How is the value of a company determined? The value of any business asset is how much money it can make for the owners in the future. These future payments are measured by size, timing, and risk associated with getting them. The primary measure of these payments is free cash flow: FCF = revenue – operating costs – taxes – business investments The timing of the cash flows is considered by discounting them according to a weighted average cost of capital. More on all this later. 13  BUT ALSO, BE ETHICAL While companies might get wrapped up in their ability to make money, they also have to keep in mind their responsibility to the public. A company should commit to: Appropriate use of confidential information Attention to product safety and quality Fair employment practices Fair marketing and selling practices Community involvement Over the long term, ethical failures can cause reputational, legal and other types of damage that hurt a company’s growth and income, reducing its value. 14  BACK TO THE MONEY The financial system exists to match entities that have money with entities that want to put that money to work. The hard part is getting the two sides to find each other. For that we have financial companies like banks and other financial intermediaries. 15  SECURITIES The investment in a business can me made directly through a relationship with the provider of capital. This can be a partnership investment like on Shark Tank, or a loan from a bank. An indirect transaction uses discreet units created and sold in a financial market. There are two major categories: Debt – A unit of debt is a bond. It entitles the holder to a series of payments from the borrower over a set period of time. It can be short-term (money market) or long-term (capital market). Risk varies by maturity and other terms. Equity – This is a unit of ownership of the entity. The holder is entitled to all value that is not already committed to other sources, known as residual value. It perpetual and high risk. 16  OTHER INSTRUMENTS Securities are a claim against the assets of an entity. Other instruments sold in financial markets are backed by those securities and represent their value: Derivatives – Options, futures and other instruments are contracts to trade underlying securities at specific prices. These contracts make a profit or loss based on the strike price relative to the security price. Securitization – An instrument can be created to represent a group of securities. For instance, a bank can collect a portfolio of auto loans and sell bonds against it that have specific terms around the default and pre-payment of those loans. These instruments exist to accomplish certain goals, although they can also be abused and cause a lot of damage. 17  COST OF MONEY Providers of capital are motivated to invest their money with companies by the promise of a return. For every investment, the investor has a required rate of return in mind. A company that obtains money with the promise of paying that return had better be able to use the money to earn a higher return through its operations. The required return depends on the risk of the project, as well as macro factors like expected inflation of money over time of the investment. The prevailing interest rates in the market play a big role in determining the required rates of return for specific investments. The actions of the Federal government and central bank influence those rates, as well as the impact of international trade. 18  FINANCIAL INTERMEDIARIES Investment banks help companies raise capital by structuring the offerings, buying them from the companies and then selling them on to investors. The issuing of new securities is called a primary market transaction. The issuing company is raising money by opening obligations to investors. After the securities are sold to investors, they are free to trade them with each other in secondary market transactions. Investment banks also advise companies on executing corporate actions, like acquiring other companies. Many investment banks also have retail divisions that manage the investments of individuals and help them plan for retirement. 19  FINANCIAL INTERMEDIARIES Savings and loan associations (S&Ls) are entities that take money from individuals in the form of bank deposits and loan that money out to individuals and companies in the form of mortgages, car loans, and business loans. Some of them are organized as mutual companies, meaning they are owned by their customers. Credit unions are essentially the same as above, but they are structured as non-profit organizations. They are hyper-local, only serving a specific group of people like residents of a city or employees of a large company. Commercial banks are like the other two above, but they are for profit and raise money in the capital markets. They often use a lot more debt than equity to fund their operations. 20  FINANCIAL INTERMEDIARIES Investment funds are vehicles by which investors pool their money and invest it using the skills of professional managers. Mutual fund – Open to anyone. There are many different types including passive and active, money market, equity and fixed income. Exchange traded funds (ETFs) are a recent addition that uses an innovative structure to change a lower fee. Hedge fund – Can hold more complicated investments that are not open to mutual funds. They are less regulated and only open to certain investors who are “more educated.” Private fund – Can be private equity or private debt. Invest in holdings that are not listed on public markets. Investments are long-term, high risk and high reward. 21  FINANCIAL INTERMEDIARIES Insurance company might not be expected on the same list as hedge funds. The same process is similar to that of an investment fund. The individual pays money into the insurer and gets a payout if a certain event occurs. In this case that event is an accident, and the payment is to make the person whole rather than give them a benefit. Pension fund is an investment fund run by a company for the benefit of its employees. From the employee’s perspective, upon retirement he/she gets lifetime income. The company needs to be able to provide that lifetime income from the investment returns of a portfolio. 22  FINANCIAL MARKETS First let’s cover a few terms that parse the financial markets: Physical vs. financial assets – Financial assets are stocks and bonds that are used to buy physical assets. Spot vs. future price – The spot price is the price you would pay for something today, while the future price is that price quoted on a contract for sale of something in the future. Money vs. capital – “Money” is a short-term asset or debt. Capital is long-term wealth like stocks and bonds, as well as long- term assets like property plant and equipment. Public vs. private – Markets where the assets are traded, if they are open to the public or negotiated personally. Primary vs. secondary – Whether an entity makes new securities to raise money, or investors sell them to each other. 23  FINANCIAL MARKETS There are several types of secondary markets that have key differences: The NYSE is an exchange where buyers and sellers meet. It is an auction market, meaning bids and offers are submitted at once and the most favorable are executed. The NASDAQ is an electronic order book where dealers post quotes that a trader can then fill directly with that dealer. 24  FINANCIAL INTERMEDIARIES An orders can be specified with certain characteristics: Market order – The order is executed at whatever is the market price when the trader pushes the button. Limit order – The order is only executed on the right side of a given threshold price. “Only sell if the price is more than X.” “Only buy if the price is less than Y.” Ask - The lowest price a dealer is willing to take to sell you shares. Bid - The highest price a dealer will bid to buy shares from you. Bid-ask spread is the difference between the two. 25  BID-ASK SPREAD 26  BID-ASK SPREAD As you can see, the bid-ask spread is for Polaris is nine cents: If I want to sell my shares, the inside bid is 76.92. If I want to buy shares, the inside ask is 77.01. This difference is the profit the dealer gets from serving as a market maker for the stock. You’ll also notice a size of the inside bid and ask. If I want to buy more than 800 shares of this stock, I’ll fill the entire inside quote and then have to go to another quote, taking a higher price. A large order is called a block trade, and some of them can get pretty big. An institutional investors who wants to trade a lot of shares might want to use a limit order to make sure the price doesn’t get out of control. 27  ORDER BOOK Here is a theoretical order book for the stock XYZ. A block trader who wants to buy 2,000 shares would look to the “ask” side of the book: Fill the inside quote, buying 500 shares at 100.45. Fill the second quote, buying 900 shares at 100.51. Partially fill the third quote, buying 600 shares at 100.58. Bid Size Ask Size 100.12 1,000 100.45 500 100.09 800 100.51 900 100.00 1,500 100.58 1,200 99.92 1,200 100.70 700 28  HIGH FREQUENCY TRADING An HFT is a type of trader that seeks to profit from trading faster than other traders in a market. The HFT trader hi-jacks the inside quote, placing a quote for a small number of shares on the book. A block trader who wants to place a large order has to start by filling that quote. Bid Size Ask Size 100.40 5 100.12 1,000 100.45 500 100.09 800 100.51 900 100.00 1,500 100.58 1,200 99.92 1,200 100.70 700 29  HIGH FREQUENCY TRADING When that small quote is filled, the HFT swings into action. It has a computer so powerful it can buy up all the quotes on the book before the block trader even has time to go to the next one. Then it takes all the shares it just bought and puts a single ask quote on the book for a much higher price. In the blink of an eye, the block trader has filled the order for a ridiculously high price. Bid Size Ask Size 100.40 5 100.12 1,000 100.09 800 100.00 1,500 99.92 1,200 110 3,300 30  SECURITIZATION Securitization is a tool used by banks to liquidate the assets on their books and free up cash to do more business. It’s an interesting innovation that helps boost activity in the financial markets. Unfortunately, it was also the main driver of the great recession crash of 2007. EXAMPLE: ABC Credit Union is in the business of taking in deposits from individuals and writing loans to homeowners. Those loans go onto ABC’s balance sheet as “loans receivable” until they are paid off. If more people want loans than make deposits, ABC can literally run out of money. 31  SECURITIZATION ABC Credit Union $ $ 32  SECURITIZATION ABC is dying of thirst in the middle of an ocean. It has a lot of assets in the form of loans payable, but it needs cash. It creates a shell company called Loan Bucket, that buys the loans off its books and pays in cash. Loan Bucket gets the money to buy the loans by selling bonds in the open market, backed by the loans payable. The loans back the bonds so that if they default the bondholders can take the loans as payment, like a bank repo’ing your car if you can’t make the payments. 33  SECURITIZATION Loans receivable ABC Credit Union Loan Bucket $ $ $ Secured Bonds Investors 34  SECURITIZATION The bonds are structured in layers or tranches. If one of the mortgages defaults that backs the bonds, then the loss comes out of the lowest tranche. The highest tranche has a lot of protection from default of the underlying assets, and so is rated investment grade. Investment grade bonds Mezzanine grade bonds “Equity” grade bonds 35  SECURITIZATION In the run up to the 2007 crisis, this became an insanely popular investment. Investors wanted so many of these that their demand started to drive banks like ABC to write more mortgages just to have something to securitize. Banks were pushing people into buying houses they wouldn’t have been able to afford under normal circumstances. Houses were getting sold at a pace that made real estate prices rise to an unprecedented level. Bonds were being issued against mortgages that were more and more risky, but as long as they were structured in layers investors thought they were safe. 36  SECURITIZATION What held it together was interest rates on mortgages were low enough that homeowners were still able to make their payment. When rates started to rise, the defaults started rolling in. Property values dropped, the MBS bonds defaulted, and the crisis spread. Even areas of the economy crashed that had nothing to do with mortgages. Lehman Brothers – 158 years old (bankrupt) Bear Stearns – 85 years old (acquired in a rescue) Merrill Lynch – 95 years old (acquired in a rescue) Northern Rock – 162 years old (annexed by UK gov’t) Washington Mutual – 120 years old (acquired in a rescue) Wachovia Financial – 129 years old (acquired in a rescue) 37  WHAT HAPPENED TO UNCLE AL? In 1871 Uncle Al filed his first patent for soda fountain technology. Throughout his life he filed over 100 patents. Shortly thereafter, he founded A.D. Puffer & Sons Manufacturing Company with his sons Daniel, Luther and Al Jr. By 1891 A.D. Puffer & Sons was one of the four largest soda fountain manufacturers in the country, with executive offices in Beacon Hill, Boston and manufacturing in Winchester MA. That year he merged the company with the other three major competitors to form the American Soda Fountain Company. Then age 72, Uncle Al retired in the Boston area where he managed his real estate investments and traveled extensively. He died in 1906 at the age of 87, a very wealthy man. 38  AND I NEVER SAW A DIME!!! 39