Understanding Financial Management and Securities Markets PDF

This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. CHAPTER SIXTEEN Understanding Financial Management and Securities Markets CHAPTER SUMMARY...

This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. CHAPTER SIXTEEN Understanding Financial Management and Securities Markets CHAPTER SUMMARY This chapter focuses on the financial management of a firm and the securities markets in which firms raise funds. The chapter begins with an overview of the role of finance and of the financial manager in the firm’s overall business strategy. Financial management is the art and science of managing a firm’s money so that it can meet its goals. The financial manager must decide how much money is needed and when, how best to use the available funds, and how to get the required financing. The financial manager’s responsibilities include financial planning, investing (spending money), and financing (raising money). A firm invests in short-term expenses to support current production, marketing, and sales activities. The financial manager manages the firm’s investment in current assets so that the company has enough cash to pay its bills and support accounts receivable and inventory. Long-term expenditures are made for fixed assets such as land, buildings, machinery, and equipment. Firms raise money by borrowing money, selling ownership shares, and retaining earnings. The financial manager must assess all these sources and choose the one most likely to help maximize the firm’s value. Finance managers must match the term of the financing to the period over which benefits are expected to be received from the associated outlay. Short-term items should be financed with short-term funds, and longterm items should be financed with long-term funds. Equity refers to 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, by retaining earnings, or for small and growing, typically hightech, companies, through venture capital. September 17, 2018 1 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. LECTURE OUTLINE I. The Role of Finance and the Financial Manager > Learning Outcome 1 Financial management – the art and science of managing a firm’s money so it can meet its goals – is not just the responsibility of the finance department. All business decisions have financial consequences. Managers in all departments must work closely with financial personnel. Financial managers focus on cash flows, the inflow and outflow of cash. A. The Financial Manager’s Responsibilities and Activities Financial managers analyze financial data prepared by accountants, monitor the firm’s financial status, and prepare and implement financial plans. The key activities of the financial manager are financial planning, investment, and financing. B. The Goal of the Financial Manager The main goal of the financial manager is to maximize the value of the firm to its owners. To maximize the firm’s value, the financial manager must consider both short- and long-term consequences of the firm’s actions. In finance, the opportunity for profit is termed return; the potential for loss, or the chance that an investment will not achieve the expected level of return, is risk. A basic principle in finance is that the higher the risk, the greater the return that is required. This widely accepted concept is called the riskreturn trade-off. II. How Organizations Use Funds > Learning Outcome 2 The financial manager decides how best to use the firm’s money. A. Short-Term Expenses. Short-term expenses, called operating expenses, are outlays used to support current selling and production activities. They typically result in current assets, which include cash and any other asset that can be converted into cash within one year. 1. Cash management: Assuring Liquidity. An important duty of the financial manager is cash management, or making sure that enough cash September 17, 2018 2 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. in on hand to pay bills as they come due and to meet unexpected expenses. 2. Managing accounts receivable. Accounts receivable represent sales for which the firm has not yet been paid. Accounts receivable management involves setting credit policies, guidelines on offering credit, credit terms, and specific repayment conditions. 3. Managing Inventory. Another use of funds is to buy inventory needed by the firm. Total inventory includes its purchase price, but also ordering, handling, storage, interest, and insurance costs. B. Long-Term Expenditures. A firm also invests in long-lived assets such as land, buildings, machinery, equipment, and information systems. These are called capital expenditures. III. Obtaining Short-Term Financing > Learning Outcome 3 Firms raise funding by borrowing money (debt), selling ownership shares (equity), and retaining earnings (profits). Short-term financing is shown as a current liability on the balance sheet. Short-term loans can be secured or unsecured. A. Unsecured Short-Term Loans Unsecured loans are made based on the firm’s creditworthiness and the lender’s previous experience with the firm. 1. Trade Credit: Accounts Payable. With trade credit – the seller extends credit to the buyer between the time the buyer receives the goods or services and when it pays for them. Trade credit is a major source of short-term business financing. The buyer enters the credit on its books as an account payable. Experts estimate that small businesses use trade credit for as much as 40 percent of their financing in the form of accounts payable. It is typically certainly the largest operating current liability on a small business' balance sheet. The smaller the firm, typically the higher the percentage of trade credit as a current liability. Source: Peavler, Rosemary. “What Trade Credit Really Costs Your Business.” The Balance Small Business, The Balance Small Business, www.thebalancesmb.com/the-cost-of-trade-credit-accounts-payable392835. 2. Bank Loans. Unsecured bank loans are a source of short-term business financing. A line of credit is an agreement between a bank and a September 17, 2018 3 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. business. It specifies the maximum amount of unsecured short-term borrowing the bank will allow the firm over a given period, typically one year. The revolving credit agreement is basically a guaranteed line of credit. 3. Commercial Paper. Commercial paper is an unsecured short-term debt (an IOU) issued by a financially strong corporation. B. Secured Short-Term Loans Secured loans require the borrower to pledge specific assets as collateral, or security. Another form of short-term financing using accounts receivable is factoring, in which a firm sells its accounts receivable outright to a factor (another financial institution) that buys accounts receivable at a discount. Factoring allows a firm to turn its accounts receivable into cash without worrying about collections. Why do businesses use a factor? Factoring is a quick way for businesses to obtain money. Often, a factoring deal can be completed in less than 24 hours. Applying for a loan and waiting to hear back is time consuming. Especially if a company hasn’t been in business very long or has had problems repaying past loans, factoring may be the only source for additional funds. Businesses with seasonal sales can leverage the benefits of a factor’s accounts receivable management systems and do not have the cost of a credit or collection department within their business. Factors provide financing alternatives that may not be available from usual sources for small and rapidly expanding businesses. Source: Curtin, Chris. “5 Good Reasons A Company Should Factor.” Paragon Financial, Paragon Financial Group, 17 Aug. 2018, www.paragonfinancial.net/how-factoring-works/articlesresources/factoring-articles/5-good-reasons-a-company-should-factor/. IV. Raising Long-Term Financing Learning Outcome 4 Long-term financing sources include both debt (borrowing) and equity (ownership). Equity financing comes either from selling new ownership interests or from retaining earnings. A. Debt versus Equity Financing The major advantage of debt financing is the deductibility of interest expense for income tax purposes, which lowers its overall cost. In addition, September 17, 2018 4 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. there is no loss of ownership. The major drawback is financial risk – the chance that the firm will be unable to make scheduled interest and principal payments. On the other hand, equity financing gives common stockholders voting rights that provide them with a voice in management. Equity is costlier than debt. Unlike the interest on debt, dividends to owners are not tax-deductible expenses. B. Debt Financing Long-term debt is used to finance long-term expenditures. Three important forms of long-term debt are term loans, bonds, and mortgage loans. A term loan is a business loan with a maturity of more than one year. Bonds are long-term debt obligations (liabilities) issued by corporations and governments. Mortgage loans are long-term loans made against real estate as collateral. While most every large corporations carries debt, Facebook has a balance sheet with no debt. Facebook boasted more than $40 billion of sales in 217, with an 87 percent gross margin and $42 billion in cash and investments. Source: Campbell, Todd. “The Only 10 Debt-Free Companies in the S&P 500.” The Motley Fool, The Motley Fool, 5 Apr. 2018, www.fool.com/slideshow/only-10-debt-free-companies-sp500/?slide=6. V. Equity Financing > Learning Outcome 5 Equity is the owners’ investment in the business. A firm obtains equity financing by selling new ownership shares (external financing) or by retaining earnings (internal financing). 1. Selling New Issues of Common Stock. Common stock is a security that represents an ownership interest in a corporation. Usually a highgrowth company has an initial public offering (IPO) because it needs to raise more funds to finance continuing growth. September 17, 2018 5 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. What are the trends in IPOs? A surging number of Chinese firms are listing on U.S. exchanges. In 2016, two Chinese companies had IPOs on U.S. exchanges, but in 2017 the number jumped to 24. In the first quarter of 2018, there were already nine IPOs by Chinese companies. Chinese companies prefer to IPO in the U.S. because they often qualify to be listed in Chinese stock market because Chinese regulations require that they must be making a profit. Alibaba, while profitable, chose to IPO in the U.S. because US shareholders have voting powers beyond their shares, so founders or the management team can keep control of the company with less than a majority of shares, which is not possible in China. Source: Potter, Sara B. “IPO Activity Slows in Q1 2018, But IPOs Are Still Up 50% From a Year Ago.” Insight, 4 Apr. 2018, insight.factset.com/ipo-activity-slows-in-q1-2018-but-ipos-are-still-up-50-from-a-year-ago. Why would a company remain private instead of going public through an initial public offering? Remaining a private company gives the owners the freedom to make decisions based on the needs of customers, not the demands of the shareholders. There is also more freedom from regulatory demands and to adjust to changes in the business environment that may happen. Source: Hayzlett, Jeffrey. “Go Public or Stay Private? What's The Right Move For You?” Entrepreneur, 30 Apr. 2018, www.entrepreneur.com/article/312673. 2. Dividends and Retained Earnings. Dividends are payments to stockholders from a corporation’s profits. Stock dividends are payments in the form of more stock. Retained earnings are profits that have been reinvested in a firm; they do not incur underwriting costs. 3. Preferred Stock. Preferred stock usually has a dividend amount that is set at the time the stock is issued. These dividends must be paid before the company can pay any dividends to common stockholders. Also, if the firm goes bankrupt and sells its assets, preferred stockholders get their money back before common stockholders do. 4. Venture Capital. Venture capital is another source of equity capital. It is most often used by small and growing firms that are not big enough to sell securities to the public. This type of financing is especially popular among high-tech companies that need large sums of money September 17, 2018 6 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. VI. Securities Markets > Learning Outcome 6 Stocks, bonds, and other securities are traded in 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. A. Types of Markets 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 can take place in the secondary market, where old securities are bought and sold, or traded, among investors. B. The Role of Investment Bankers and Stockbrokers 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, which acquires the security for an agreed-upon price and hopes to be able 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. C. Online Investing Improvements in internet technology have made it possible for investors to research, analyze, and trade securities online. Today almost all brokerage firms offer online trading capabilities. Lower transaction costs are a major benefit. Although there are many online brokerage firms, the four largest — Charles Schwab, Fidelity, TD Ameritrade, and E*Trade — account for more than 80 percent of all trading volume and trillions in assets in customer accounts. D. Investing in Bonds Bonds are long-term debt obligations of corporations and governments. They can be bought and sold in the securities market. Bonds can be bought and sold in the securities markets. However, the price of a bond changes over its life as market interest rates fluctuate. Corporate bonds are issued by corporations. They usually have a par value of $1,000. They may be secured September 17, 2018 7 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. or unsecured (called debentures), include special provisions for early retirement, or be convertible to common stock. Corporations can also issue mortgage bonds, bonds secured by property such as land, buildings, or equipment. Convertible bonds are issued with an option for the bondholder to convert them into common stock. 1. U.S. Government Securities and Municipal Bonds. Both the federal government and local government agencies also issue bonds. The U.S. Treasury sells three major types of federal debt securities: Treasury bills, Treasury notes, and Treasury bonds. Municipal bonds are issued by states, cities, counties, and other state and local government agencies. 2. Bond Ratings. Bonds vary in quality, depending on the financial strength of the issuer. Investors can use bond ratings, letter grades assigned to bond issues to indicate their quality or level of risk. Ratings for corporate bonds are easy to find. The two largest and best-known rating agencies are Moody’s and Standard & Poor’s (S&P), whose publications are in most libraries and in stock brokerages. E. Other Popular Securities In addition to stocks and bonds, investors can buy mutual funds, a very popular investment category, or exchange-traded funds (ETFs). Futures contracts and options are more complex investments for experienced investors. 1. Mutual Funds A mutual fund is a financial service company that pools its investors’ funds to buy a selection of securities – marketable securities, stocks, bonds, or a combination of securities – that meet its stated investment goals. 2. Exchange-Traded Funds Another type of investment, the exchange-traded fund (ETF), has become very popular with investors. ETFs are similar to mutual funds because they hold a broad basket of stocks with a common theme, giving investors instant diversification. ETFs trade on stock exchanges (most trade on the American Stock Exchange, AMEX), so their prices change throughout the day, whereas mutual fund share prices, called net asset values (NAVs), are calculated once a day, at the end of trading. September 17, 2018 8 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. What are the advantages of ETFs over mutual funds? ETF expense ratios are usually lower than mutual fund fees. In 2016, the average expense ratio of index ETFs was 0.23 percent compared with a 0.82 percent average expense ratio of actively managed mutual funds. ETFs usually require lower minimum investments than mutual funds. Although some mutual funds don't require you to invest a lot of money at once, many mutual funds have high initial investment requirements. Source: Bieber, Christy. “ETF vs. Mutual Funds: The Pros and Cons.” The Motley Fool, The Motley Fool, 15 Jan. 2018, www.fool.com/investing/etf/2018/01/15/etf-vs-mutual-funds-the-prosand-cons.aspx. 3. Futures Contracts and Options Futures contracts are legally binding obligations to buy or sell specified quantities of commodities or financial instruments at an agreed-on price at a future date. Options are contracts that entitle holders to buy or sell specified quantities of common stocks or other financial instruments at a set price during a specified time. As with futures contracts, investors must correctly guess future price movements in the underlying financial instrument to earn a positive return. Unlike futures contracts, options do not legally obligate the holder to buy or sell, and the price paid for an option is the maximum amount that can be lost. VII. Buying and Selling at Securities Exchanges > Learning Outcome 7 When we think of stock markets, we are typically referring to secondary markets, which handle most of the securities trading activity. The two segments of the secondary markets are broker markets and dealer markets, The securities markets both in the United States and around the world are in flux and undergoing tremendous changes. A. Broker Markets The broker market consists of national and regional securities exchanges on whose premises securities trading takes place. Broker markets account for about 60 percent of the total dollar volume of all shares traded in the U.S. securities markets. September 17, 2018 9 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. 1. New York Stock Exchange. The oldest and most prestigious U.S. stock exchange is the New York Stock Exchange (NYSE), which has existed since 1792. The NYSE lists the shares of approximately 2,400 corporations. Another national stock exchange, the American Stock Exchange (AMEX), lists the securities of more than 700 corporations. 2. Regional Exchanges. The remaining 6 percent of annual share volume takes place on several regional exchanges in the United States. These exchanges list about 100 to 500 securities of firms located in their area. Regional exchange membership rules are much less strict than for the NYSE. B. Dealer Markets Dealer markets are securities markets where buy and sell orders are executed through sophisticated telecommunications networks that link dealers throughout the United States. They work through securities dealers called market makers, who make markets in one or more securities and offer to buy or sell securities at stated prices. 1. NASDAQ. The largest dealer market is the National Association of Securities Dealers Automated Quotation system, known as NASDAQ. Founded in 1971 with its origins in the over-the-counter (OTC) market, today NASDAQ is a separate exchange that is no longer part of the OTC market. The NASDAQ lists more companies and trades more shares than the NYSE, but the NYSE leads in total market capitalization. The securities of many well-known companies such as Starbucks, Dell Computer, Google, Panera Bread, and Coors, which could be listed on organized exchanges, trade on the NASDAQ. 2. The Over-the-Counter Market. The over-the-counter markets refer to those other than the organized exchanges described above. The two main OTC markets are the Over-the Counter Bulletin Board (OTCBB) and the Pink Sheets. These markets generally list small companies and have no listing or maintenance standards, making them attractive to young companies looking for funding. C. Alternative Trading Systems Alternative trading systems (ATSs) such as electronic communications networks (ECNs) also make securities transactions. ECNs are trading networks that allow intuitional traders and some individuals to make securities transactions directly in what is called the fourth market. September 17, 2018 10 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. D. Global Trading and Foreign Exchanges Improved communications and the elimination of many legal barriers are helping the securities markets go global. The number of securities listed on exchanges in more than one country is growing. Foreign securities are now traded in the United States. Likewise, foreign investors can easily buy U.S. securities. More than 60 countries operate their own securities exchanges. What risks are unique to investing in emerging or foreign markets? At least three risks are unique to investing in emerging or other foreign markets. One risk is political unrest could dramatically affect the economy. International business leaders worry about the long-run stability of a government, as well as investing in manufacturing plants in a country with political unrest. A second risk associated with investing in emerging or foreign markets is that investors will not be able to obtain relevant and reliable information to use in making investment decisions. The amount and reliability of financial information disclosed by companies in different countries varies significantly. Finally, liquidity risk is a third factor associated with investing in emerging or foreign markets. If the market is small and trading is infrequent, there is added risk that investors will not be able to sell their shares quickly without incurring a loss. Investors refer to this type of risk as liquidity risk. Source: “Potential Risks and Rewards of Investing Internationally.” International Jobs at Wells Fargo - Wells Fargo Careers, 2018, www.wellsfargo.com/financial-education/investing/international-investingrisks-and-benefits/. E. Regulation of Securities Markets The securities markets are regulated by both state and federal governments. In addition to legislation, the industry has self-regulatory groups and measures. In 1934, Congress established the Securities and Exchange Commission (SEC) as the main federal government agency responsible for regulating the U.S. securities industry. 1. Securities Legislation. The Securities Act of 1933 was passed by Congress in response to the 1929 stock market crash and subsequent problems during the Great Depression. It protects investors by requiring full disclosure of information about new securities issues. The Securities Act of 1934 formally gave the SEC power to control the organized securities exchanges. The act was amended in 1964 to give the SEC authority over the OTC market as well. The 1934 act also banned insider September 17, 2018 11 This OpenStax ancillary resource is © Rice University under a CC BY 4.0 International license; it may be reproduced or modified but must be attributed to OpenStax, Rice University and any changes must be noted. trading, the use of information that is not available to the public to make profits on securities transactions. In response to corporate scandals that hurt thousands of investors, the SEC passed new regulations designed to restore public trust in the securities industry. It issued Regulation FD (for “fair disclosure”) in October 2000. Regulation FD requires public companies to share information with all investors at the same time, leveling the information playing field. The Sarbanes-Oxley Act of 2002 has given the SEC more power when it comes to regulating how securities are offered, sold, and marketed. 2. Self-Regulation. The investment community also regulates itself, developing and enforcing ethical standards to reduce the potential for abuses in the financial marketplace. Now, under certain conditions, circuit breakers stop trading for a short cooling-off period to limit the amount the market can drop in one day. VIII. Trends in Financial Management > Learning Outcome 8 Many of the key trends shaping financial management as we enter the new millennium echo those in other disciplines. A. Finance Looks Outward Finance professionals need a broad view of company operations to communicate effectively with business unit managers, board members, creditors, and investors. The goal is productive cooperation and teamwork between finance and the business units to meet corporate objectives. CFOs are more highly visible and active in company management than ever before. They serve as both business partner to the chief executive and a fiduciary to the board. B. Vying for the U.S. Crown The NYSE and NASDAQ continue to wage a heated battle for supremacy in the global securities markets. It remains to be seen whether either U.S. exchange is ready to purchase an international exchange; however, their recent strategic moves have made them stronger and more competitive. September 17, 2018 12