Financial Management Test

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~ l ~ ̀ ~ cc1~ 1 Overview, Objectives and Readings

Overview

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We'll begin our coverage with an overview of the field of financial management, a look at the fundamental concepts of risk & return and how interest rates function in the marketplace.

The chapter on financial statements and cash flows: How much of this chapter you read and in how much detail will depend largely on your prior experience with accounting and your level of comfort with basic accounting concepts and financial statements. For some a quick skim will do, for others an in depth reading may be required.

Practice Problems -Please see the syllabus for problems assigned for homework/practice.

Objectives

After completing this module, you will be able to:

• Discuss the field of financial management • Identify and distinguish between the three basic forms of

business • List the advantages of the corporate form • Illustrate each advantage with a short example or explanation

• Explain the ways in which a corporation's standing as a separate legal entity confers advantages

• Identify the components of risk • Define and distinguish between diversifiable and non-

diversifiable risk

Readings

See syllabus for weekly reading assignments

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Lecture

Content Contributors

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Louise August, CPA, PhD

I've been teaching at Walsh since 1996, primarily in the MSF and MBA programs. I remember the "good old days" of on- ground only classes delivered in a 14-week semester format. Things have changed a lot since then. Well, let's see, I have a BA in Accounting, a MS in Finance - from Walsh, and a PhD in Postsecondary Education from the University of Michigan.

As a CPA, I was in public practice (with Pannel, Kerr, Forster, which merged with BDO Seidman) for about seven years with a small and emerging client practice -meaning that I worked with many small clients rather than one or two large ones. Consequently, I came in contact with many different types of businesses, accounting systems and financial issues. I also came across a number of unusual accounting decisions and questionable practices, particularly in my role as independent auditor.

After that, I was the assistant controller for apublicly-traded chain of supermarkets and warehouse distribution centers. This was a very exciting business in financial terms. In the space of six years, the company made two major acquisitions and one divestiture, sold a bond issue, constructed several new stores, and put together amerger/leveraged buyout. Unable to manage the resulting high level of debt and related debt service, the firm ultimately filed bankruptcy and went out of business. it was quite a ride.

I n my last position in the corporate world I spent ten years as CFO of a US/Canadian service business. It was quite a change from the razor-thin margins of grocery to a firm with substantial cash flow and profits. This firm conducted business in two currencies, had union and non-union workforces in both countries, and engaged in major construction/renovation projects. Originally a NASDAQ firm, it delisted, bought back the majority of outstanding shares and went private.

Finally, I left corporate for academe and was a Research Consultant at the University of Michigan where my research focus was on workplace policy and practice that promotes

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Stephen L. Sholty, MBA, CTP

Stephen Sholty is an assistant professor and member of the clinical finance faculty at Walsh College. He teaches finance classes and a treasury management course for undergraduate and graduate students and manages the Walsh College Finance Lab.

Mr. Sholty spent most of his corporate career as a treasury manager with Ford Motor Credit Company and Ford Motor Company where he managed and marketed commercial paper and medium-term note programs to i nstitutional investors throughout North America. He has been registered and served as a securities representative, asecurities principal and a financial and operations principal.

Mr. Sholty received a B. A. degree from Michigan State University with a major in Spanish and as a result of attending classes at the University of Madrid, he has a professional working proficiency in the Spanish language. He received his M. B. A. degree in finance from Wayne State University and began working for Ford Export Corporation shortly thereafter.

Mr. Sholty began teaching as an adjunct instructor at Walsh College from 1982 to 1985 and returned to adjunct instruction at Walsh College in 2008. He is a Certified Treasury Professional (CTP) and is a member of the Detroit Treasury Management Association and the Association for Financial Professionals.

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Lecture

Goals of the Corporation

Content Author: Louise August, CPA, PhD.

What is the primary goal of a corporation? The answer often given to that question is to create wealth for the shareholders (owners). Think like an investor for a moment...

Q.;._ W h.y.._d o...y o_u.._b uy_s h a re s __i n.._a corporation? A: Because you think iYs a good investment, and that means you think it will increase in value over time.

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There may be various other factors that lead you to invest, such as liking the company's products/services, or because it's involved in an industry you like or a cause you support. You may also value the dividends the stock might pay (more on that in a later week). But these are all secondary to the desire to see the value one's investment portfolio increase over time.

Q. _How„would .y„o,u,,,measure_that...increase,,,in.._va.lue?. A: The value of your investment is equal to the number of shares you own times the share price.

So the corporation's managers could create wealth for the shareholders by striving to maximize the price of the firm's shares. There is one problem with having the maximization of share price as managements main goal —share price can be manipulated. So while shareholders may measure their wealth using share price, it may be more appropriate for managers to have the creation of firm value and long-term sustainability as their main goal.

Corporations may also be motivated to act in a socially responsible or ethical manner. Social responsibility is the idea that a business should be actively concerned with the welfare of all its stakeholders: its employees, customers, suppliers, and community, not just those of its shareholders. Maximizing profits to the detriment of those other constituents is unlikely to result in long term value or sustainability. Over time such behavior has earned corporations (and capitalism in general) a somewhat tainted reputation. On the other hand, acting in a socially responsible manner can be costly, and that may not always be consistent with maximizing shareholder wealth. There are two readings in this week's module that address these conflicting goals.

In general, management has a lot of autonomy and a great deal of influence over how transactions are recorded and subsequently reported. You'll read more about that in the lecture and readings on Agency in this week's module. We also cover this topic fairly heavily in the course on Financial Statement Analysis.

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The Case Against corpora#e Social Res~nsibili#y l he idea thaw companies hau~ a duty to address soda! ills is nat just ~iawed, aspues R~neel Karnani, ~t also m~~es i# morr likely that we9l ~~;ntsrc tha real st~}utians Fa the3e problems,

Cary cr>mpanies do well by doing pood~ Y+es~-sometimes. But the ides chat torripanies have ~ rezpo~sibiiity to act in the public interest and will profit from dgin~ so is iundam~ntal(y flawed.

Large companies yaw r~ocr3ineiy cla3m~that ihey aren`t in busir~ss Just~ior the profits, thaz~they're also i»c~n~ on serving, some largo s<r~i~1 purposr. Thcy irump+~t their c~fnrts to produce lar~ttheer fopds or m~rc lucF citicic nt vehicles, cor~s~+ve c+~er~ arx! other resources in their aper~tions, pr oih~rwfs~ makr. the +~vor~d a betc~r place. In~+~enti~i institutions IiRe 1~ Rrademy aE Mana~emer~t an~i clue Ur~ized NaYipns, ~naong many others, Cntc~ur~ge tnmpanir5 to pursue such sKr~tegirs.

li`s not su~prisin~ that this idea has vran over sn many peapte—it"s a very appealing proposition. You pan have your cakr end eat it taa! Uvt ii's an illusion, end a potentially dangerous t~nr~ Very simply. in lases when priva~e profits sand public lnterest5 are ali~n~ed, the idea oi` co►porate social resporasit~i~ty is ~r~retevant: Companies tfiat simply da everything tt~cy can to ba4st prgfits will end up inc~rasin~ social wel~~~c. ~~ c~r~umstanc~s ~n which p~nCts ~~ad scrci~l w~lfar~~ ~r~ in di~~ct ~opp~sition, ~n appeal ao rorpArate social responsibility wi~i ~Imosk ~iways 1~! ir~effecEive, b~aase executives are ~rtiikely to pct voluntarily i~ the public Interest and ag~ins~ sharehnld~rbntsresLs.

lrreievant ~r inels~ective, take your pick, Buff it's worse than that. The danger is that a tours on soc~ai respdnsibiiity wii~ drlay nr discaura~~~ more-c#fc*c#nom mensur~~ to enhance social welfaro in "thasc cases where pra~ts and the public load are at odds, J1s society looks to companies to address these problems, the re~~i soius ons nosy be ~~nored.

1NelI ar~d Good To get a better fix an the irreleuance ar lneffect~reness of corporate social responsibility efforts. iex's first Ic~vk at situaaions whrrr profits end snciai wrlfare are in synch.

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Consider the market for hralthier food. Fast-food o~dr. is havr ~~rofitrd by rxpandin~ their offerings to

include salads and nthc~ options designed to ~ppcal to health conscious consumers. Othc~ companies

have found new sources of revenue in Iow fat, whole grin and other typrs of foods that have grown in

popularity. Sntial welf;~rr .z imp~nvrd. Cvcrybody wins.

Similarly, auto makers haver profited from respandin~ to consumer demand for more fuel-efficient

vehicles, o plus for the environment_ And many companies twve boosted profits while enhancing social

welfare by teduting their energy Consumption and thus their casts.

12ut social welfare isn't the driving Corer bchinci she+c trcncls. Healihicr foods anc! mnrc fuel efficien► vehicles didn't become so common uncd they became ~rotic:~bte for their makers. Energy conservation didn't hecorne So impori~nt ►p many companies anti) energy became more cpsNy. These companies arc beneflUng society while ac'ng ~n their own interests; soul activists urging, them io change their ways had Iftde impact. t~ is the relentless maximization of profits, not a Commitment to social responsibiflly, that has proved to be a boon to the public in these cases.

Unfortunately, not all companies take advantage at such opportunit{es, and in those cases both serial wNtarc and profits suffer, Thcsr tcxnpani~s h~vc one o! twro problems; Their executives art either incompetent or arc hutting their own inu~rests ahead of ~hc company s iong•tern~ Rrwncisl interests. for instance, an executive might be averse to any risk, including the development of new products, that might jeopardize the short-term fir7antial performrnte of Cher company and the~ctay af(CCL hiS compensation, evrn H taking; that risk would improve the cortrpany's longer•Cerm prospects.

An appeal to social responsibility won't solve either of those problems, pmssure from shareholders for sustai~ablc growth in profitability can. tt can lead to incompetent managers t>einR replaced and to a realignmc~t of incentiucs for executives, so that their compensation is tied more directly to the company"s long-term success.

When There's a Choice Still, the fact is that while companies sametimrs can do well by doing good, mare often they can't. Because inmost li~+s+es, doing what's best for society means sacrificing profits.

This IS true for most of sncicty's pervasivr. and persistent problems; if it wcren'1, those problems would have been salved long ago by companies u:eking to maxinilze their profits. A prime efcampte is the palluNon caused by manufacturing. Reducing than ~Ilutio~ is costly to the manufacturors, and that eats into profits. Aoverty is another obvious exartiple. Compaia~es Could pay their workers more and charge less for their products, but the+r protiu would salter.

So now what Should executives in these situations heed chc caQ for cor}>orale social ~esporutbility even without the allure of profiting from it? You can arPuc that t hey should. But you shouldn'k expect th:1t that' wiU.

Executives are hired to maximize profess; that is chcir responsibility to theirtompany'S shareholders. Cven if executives wanted to forgo some profit to benefit society, they could expect to lose Lheir)obs if they tried—•and be replaced by managers why tivould restore profit as the Cop priority. 'I he movement for totporate social responsibility is in direct opposition, in such cases, ro the movement for better cor~orategwrrrianer., whicto dam~~nds that m~in.~g~•rs fulfill chair liduci~ry dirty to.tict in ttNe

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_ _ __ _ _ __ sharcholdcrs' interest or be relieved of thci~ responsibilito~s, 7hat'i nnc mason so many comp~nics t~ik a great deal about social responsibiMicy but do nothing—a tactic known as Freenwashing.

M~r~~g~rs who ~arri(ite profit for t}it ~wnrnnr~ good alsn ;rre in efirct impaling ~ tax un lhCir sh~rehoiders and arbitrarily deciding haw that money stx ulri be spent. In that sense they are usurping the role of elected government officials, ii Qnl~+ on a small scale,

PnvatelY o+Amcd campa~ics are a diNerent story.. If an gw~er~operated business ct►~oses to accept diminished profit in order t<~ rnh~nce social welfare, tha4 clecisinn is~ t being imposad on sharehalde~`s. And, a! course, it is ~dmi~~b~c end desirable for tttc ~~dcrs ~nl succeuful public tornpanles to use so►+re of their personal fortan~ for charitabir. purppses, as many havr. throuQhnwt history and many d4 nAw. But those Ihaders shaultin't presume to pursue their philanthropic goats wiCh sharohald~r annney. Indeed, rtr~ny shareholders themselves usr stgnifitanC amounts at the money they nnake irom'the~r imestmenis to help fund charities nor ozherwKe improve social weilare.

This is not to say, of ccw~se, t~aC companies should be I~ft tree co pursue the greatest ~ssible profits without regard fir the social canKc~uences. Eiut, appeals to corporate social responsi4ilirtyorc not an attec~ivc w:~y to strike ;~ balance bctwci~n prnt;ts and the public good.

. The Power of

So how can that. balance best be struck? The ultimate solution is government regulalion. lts greatrst appeal is that it is binding, Government has the power to enforce regulation. No need zo rely on d~ly0ne's best irrtentibns. But yovemment regulation isn't perfect, and it can even end up reducing public wrtfa~e because of Rs ~o~i or ineffitiancy. Tho government also rtiay lack the r~sourees and tampetence to design end administer app~ppriatr regulatimns, particularly far Complex industries requiring much specialised knawie~e, And industry groups miphl find ways to influents r~ufation to the point whsre ~t ix ineftect~ve or rven ends up benefiting the industry at the expense of the genaral population,

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..... Outright corruption can make the situatipn even worse. WhaYs more, all the problems of govcrnmrnt

failure are exacerbated ire developi+~g countries with weak and often corruWt govrmmcnts. Suil, w+th al)

their faults, gove~'nments are a far more effective protector of the public good than any campaign for

Carpor<~RC xbCial rrspansibility.

Watchdogs and Advocates Civll society also plays. role in constraining corporate behavior that reduces social welfare, actin; as a

watchdog and advocate. Various nonprofit organizations anJ movements provide a voice (or a wide

variety of nodal, politiWl, environmental, ethnic, cultural end community interests.

The Rainforest Attion Network, for rumple, is ~n organiration ~h:n agitates, oNen quite cticctively, for ~nvironrraental protection and sustainability. Its website states, "O~ir campaigns ie~erage public opinion

and consurt►er pressure to turn the public stigma of environmental destruction into a business niph[mar~ for any American company that refuses to adopt responsible environmen[al policies." Tha['s quite a different approach from trying to convince executives that they should do what's best far sc~riety because it's tht right thing to do and won't hurt their bottom line.

OvePall, though, such .~ttivism h8s a mined trick rr, cord, and it can't be rclieJ nn as the primary mechanism far Imposing consi~aints on corporate behavior —especially inmost developing countries, where civic societp lacks adequate resources to exert much influence and there is insuf ticient awarenexs of public issues among the paputat~on.

5elf•Cont~ol SeIF regulation is another ~Itcrnatfve, but it su►fen from the same drawback as the concept of corporate social responsibility: Companies are unNkely to voluntarily act in the public interest ac the expense of sharohaldcr int0restS.

Uut self-regufaetan can be useful. It tends to promote food practices and tarpec specific problems within industries, impose lower compliance coos on businesses than government rcgulatio~, and offer qu(ck, low•tost disputaresolution procedufes. Sclf•rc~ulation wn also be more [lrxiblc than government regulation, allowing it to respond more effectively to thar~ging circumstances.

The challCnge is to design se~F~egulatinn in a nwnner that emphasizes transparency and ~ccountabllity, consistent with what the public experts From government regulation. It is up to the government to ensure that any sQi(~regulation meets that standard. llrui the gavernm~nr must be prepared ~a step in and impose its own regulaCtons if khc industry tails ro police ikself eftecUvefy,

Finawcial Cglculation In the end, social ~esponsibiHty is a tinancinl calculation i~r executives, just like any other aspect of their business. The only sure way to influence corpnr~te decision making, is to impose an unacceptable cost— regulatorymandates, ta7ces, punitive fines, public embarrassment —on sadally unacc~ptablc behavior.

Pleas far corporate social responsibility will be roily embraced only by chase execu~ives who are smart enough to see that doing, the right. thing is a byproduct ~(thelr pursuit of profit. And that renders such pleas pointless.

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TAB Ecgnomist F~o1~~ber 24tH 2ot2

Sehumpeter ~ ~~ltirx~ ~~~c~ ~u~~~; ~°~~j~.

The pursuit of ehMrebalder velum is attrxrting cd~t~am-nqt alt of 1~ t'{astl~h

T,'~ IS the chief` ~t~cuuve ai # mul~3naiWn~1 ~+arpnratic>n, but C1 PauF Pt~lman some►tmes saumts mare f(ks a spokesman for x'~ccupy Wail Srteeti Tits bass of Unilever tan hnglo~Dutch t:~tt- sumrr-RondsArmwith brands ranging fromTSmotei si~ampoo Io Ben A ]cry's see crew agonises about untmpkrymeni, gM6a1 w~scming and baby-boomergceed.He putssomeot~he blame for Ih~.sr iilson ~riemost in9uential management iAeorya[the past thr~s daade~ Iht jdea that companies shnuidaimab~rve sit else ~o nwximhe returns io ~amtu~Wers.

(ieap~x~~stotnearti't.Sincetektngehar~eirowos,MrAotnsan has stti~►pcd Unfi;evcr trcm pu~,tfshtng tuf! finan<ia1 tesuNs ~evtcy quarter. He nefiises io c~fl~er eaminps guidance ~atquisy a3~al~lssts. Wehas introduced lmg~hy"suslainahle livingpian" and at~r~c~ ed a stew cadre of 1ppg-tcrmsnvrsaors, paniruiatly In emerging markets, Fie even toEd an audience in Aavoa that hedge-fund managers wo~1d sefllhcir own &tendmotheislo rnake a profit.

Mt lb(men wqu one of several iilanx Ia decry the cult of shara- lioWer value at thrPeter DEusker Cwtum taM annual gathcringof a dmirers of thelate Austriambom management gurul in Y~enna on November nth and ~ih, Rc~er Martin. the dean of the Rot- man5chtml at hien&gement atthr, Unlvtrsnyal~rant~c~IJed tt a "ccuma~y ~rirkiple fhat ~.S undermining American tap latism". ti Wrg IC~Wsth of tea fet3rration oC Austrian tndustr{rs urg~td the wvrid tambanclan Ct. HFck Warizmxn, the directpr nt she Oruckrr Listitute, said itsc[iUcs were gatning mwnentum.

71~e curt hurertainlyyietAedperverse i~sulu.The fashion ter71e IinklnR PAY so pikes hu spurred s~n~e boxses ~o mantpu~ late (hose prices (~1ore~cample, a manger withshart upUons gets nnrhingifthesha=egriramissesitstargei,sohemaytnkeunwiso ~lski ~o MIS ti.short-~ermtsm isrifean vVali ~rrcnG: eh~~+~rage ►tme char people paid a ssotlr na the kew York SN~k 6xchan~ hoc crumbled (ream. eight yeses in apbo is (our monthsin zfau~,The em• ph~sis t>n short-ier~mm.resultshas tetnp~ed some firentto skimp on research an~i inn~x n. robbing thr futux~ t~ tl:atle+ this year's ptnfits.'Longterm tesul~s cannot be xrhie~red by riling sliott• term results ~n xhwtterm tesutts,"Drucker once remarked..

One study shcrwx khan (sshd rnmpaotts have ini~es~ed only ~'s of ihesr total assets, compared with to~4 Cot "obserrabty 3lmilar` privare}Y lizfdc~,ntpantes. A sernnd!~hotv~th~t(3a%o(ma~ta~+:rs

9usiness 75

art wiit~txg to reduce xpending on a8n m adverlls ~s~ to tail 4he numbers, )ohn Kay> a Br~t~sh ecana~m~as tand autbnr of a govern• meat report an stwat,te~mistnf a~ge~es that the pursuit ~i short tgrm profit nay hava undrr~niE~td twro ~t 8rilain`x g~ta~ts~ t.~m- panies, st:~ and tt e~:..

Bur i~ng on a secc~~ad. Are itce critics many rs~hr to abut thsF mo&rn capital markets invarsa6lp peg shoriterm results baftire lon~erna ones? Amssw~ has. never found it {~srd ~0 BNrastinves~ ~on,desplte the way it plonghrt its prafitx intraiong•ttcm plans far vrorld dornina~iop~, P#e»tgof other tech s~cxka ~re w,ildly popular dps~ite neRli~ibt~ x1mr1-~er~at ~rturns. Ancl me cnmpanirs atW,~y€ took#h to tenet sharply to ShcxrCerm waxainY wgns? Nnkia. a EYnn~teiecUms firm. rvauld bamuchhcaithier tadny tf xisrdre.. aaad m4r~ swifilp cpmarkc[warnu~gs, r~the~ than kcepinga stc- ond-rate boss in plea while Apple des~Nycd E1s busfne~.

The eritics rnakr a d W inctionbetweenlong berm value tgoad! and sha»-term vatc~e tbaQ). But what is long-~trm value if Hat slwr~-tecm resut~s ~i(ed upon each aihrr> And who! is w'otlg wiih mak[n$ reg~ilaa cMaes:ks on yc>ac perCarmance* A cacnpany's yuarteily rrsuils will p~nbahly fe91 y~~i smnaihing ala~ut its long Perna health a~+vei~ as its.per(~p~ m~icc over thr previau> quae~a~~

'fie critics iwvc. alsU tailed ~o product a v alrte ~I~ernaUve measurer~f sucieas. Unr idea is to lr~oic at "cu~metsalistartion" But i~rz'~ ~h~ b~Ki way tcs pk~se cuu~~rn~rs to dive averythireg awxp far notfitng? Anotherldea i~ acs reirpurelyon the jud~rtxnt of managers, but €sn't this like al~o~vinR chiktrcn so mark their own hom~rark?Many entice of the sha~ehaid<r ~nndel emAraG~ a "siskehc>ides"m~7de1 ins~end, i~ut the i~t~vag~re sates much t~f :~ wide. Who art L com oy's atakrholders, and how shailda tE~eir~r~tpeWigniteiests urr~i~t~tdafainxte~chuther~►~aone knvwx, Thegrval viz€uG of a sl9are prlcc is 11r0i i~ pzvvides a dear exlernximeasu~e by which a~arar~ngers ca» be judged,

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Lecture Pabe 1 of 2

Fundamental Economic &Financial Concepts

Content Author: Louise August, CPA, PhD.

These are some of the more important fin/econ concepts. Understanding them will help you understand the world of finance and help you make better decisions about your money and your business.

1. Risk and Reward 2. Time Value of Money (TVM) 3. Opportunity Costs 4. Externalities 5. Scarcity and choice

The first two are covered in their own separate lectures (Risk this week and TVM later in the semester), so let's take a look at the others.

Opportunity Costs

Opportunity cost is an important finance/economic concept thaYs applicable to a wide range of business (and personal) decisions. IYs a term for the very generally applicable idea that "you can't have your cake and eat it, too." Once a choice is made it often means that many, or perhaps all, of the alternative choices are no longer available. If you have a $20-bill, you can only spend it one time, then iYs gone and you obviously can't use that $20 to buy anything else. An opportunity cost won't always have a value thaYs strictly monetary. How will you spend this evening? You could go out with friends, curl up with a book, go to the gym, volunteer at a local charity, etc. You'll pick one ~ and forego all the others. ~ -

Here's a more complicated example: choosing to pursue a college education. There are costs associated with going to college beyond the obvious ones of tuition, books and fees. It's easy to assign a monetary value to those. There are other less easily quantified costs to consider:

• The other ways the monetary cost of college might have been spent • The wages you might have earned if you'd taken a job instead • The value of the work experience you might have gained • All the might-have-beens: the people you might have met, things you might have done.

Pretty tough to assign a dollar value to these and it may not even be necessary to do so to come to a good decision. But they ought to be part of the thought process.

The idea of one choice precluding other choices is pretty straightforward. But in finance we need to be able to ascribe a dollar value to such a decision. The opportunity cost of a choice is the value of the next best alternative (or said a little differently best alternative forgone). And although there may be any number of alternatives, opportunity cost considers only the next most valuable alternative. We'll talk about this more when we consider the topic of Capital Allocation in a later week.

Opportunity costs are an important part of the decision-making processes. They are sometimes challenging to identify and quantify and they are often overlooked in decision making. To make the best decisions, you need to consider the alternatives and the consequences, financial or otherwise, of not choosing them.

Externalities

A general definition is, "the consequence of an economic activity that is experienced by unrelated third parties." I would say that an externality is something that affects us, but over which we have no control.

I n the broader sense, we often can have some level of influence, though not in all circumstances. Second hand smoke for example: research says it's deadly, and a tavern patron might choose to move away from a smoker. Prior to fairly recent legislation to ban smoking in bars and restaurants, bartenders and wait staff were unable to avoid the externality caused by secondhand smoke in the workplace.

An externality can be either positive or negative. Secondhand smoke is obviously negative. I keep two hives of bees in my backyard and my neighbors' fruit trees and vegetable gardens are more productive as a result. For

' them, that's a positive externality... at least I hope they see it that way.

A couple of business-related examples:

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Lecture ~~~1~~ z ~i~?

A company or individual has little or no ability to affect the level of interest rates in the economy. Yet the rate of interest affects not only the cost of borrowing money, but also drives other costs and investors' expectations. A business will be affected by the actions of its competition —either positively or negatively. A competing firm might go out of business —bad for them, but probably good for the remaining ones. Alternately, that competing firm might develop an exciting new product and steal away some of our customers. Good for them, bad for us.

We need to recognize that externalities exist and take them into account. Just because we can't exert influence doesn't mean we should ignore them.

Scarcity

This is an easy one —time, money, and things in general aren't available in unlimited quantities. Resources are scarce but human wants are not, and so we have to make choices. IYs a pervasive and persistent aspect of the human condition. The quantity of available resources may vary, but they are never plentiful enough to fully satisfy the wants of all. Scarcity is why resources have prices —price helps to allocate scarce goods. A thing available to all in unlimited supply (air, perhaps?) would not need the pricing mechanism of the market to help allocate it. Indeed this is the definition of the economic term, "free good". By contrast, most goods are "economic goods" meaning that they are not available in unlimited quantities.

In business, this comes into play in a number of areas. Hiring, purchasing and pricing decisions all deal with scarce economic goods. For example, should our company buy a new piece of heavy equipment, acquire an additional retail sales space, or expand our product line? If all three make sense, can we afford to do them ail in the same year? Later on this semester we'll talk about Capital Allocation —the decision by the firm to make investments of capital in productive assets.

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l~~l~e 1 oi~ ~

Risk &Return

Content Author: Louise August, CPA, PhD.

There are two topics that are the bedrock of financial theory and practice:

1. Risk and Reward, or in more financially orient terms, Risk &Return

2. Time Value of Money -we'll cover this topic very thoroughly in a later week

I n common language, we generally think of "risk" as a negative thing -the chance that something bad or unfortunate will occur. Thesaurus suggests "threat' and "hazard" as synonyms -these terms certainly have negative meaning associated with them. Ii uncertain or even unlikely, but also positive, we usually don't apply the word "risk". For instance we aren't likely to talk about the finding a $100 bill on the ground. But this is not true in the study of finance. Risk is a neutral concept. We could just as easily be benefited by that "something" or harmed.

DEFINITION

Consider asports-related example: the tagline for an old ad for the Olympics - "the thrill of victory Risk is the ~leme and the agony of defeat'. Well that pretty much sums up risk in sports -you play the game and uncertainty ~k out tt you take your chances. You don't know which way it will turn out. Uncertainty! the degree s~f Iikelih

Each of us has a certain amount of liking for risk. There are times when we actually seek out risk: 5~mpthing ~~rill ~r

Casino gambling, buying lottery tickets, skiing, etc. Why? Recreation/Entertainment? Yes, but ~~PP~~• also because we perceive that the potential for harm or loss is outweighed by the benefits, the fun.

We accept the greater risk because we value the reward more highly. ThaYs the Risk /Return Trade

Consider the old saying, "A bird in the hand is worth two in the bush." Its an expression of a risk-ret that a bird in the hand is a certainty, but birds in the bushes are very uncertain. If the birds in questic chickens, we can surely have a little bit for dinner. But if we instead accept the risk of capturing the shrubbery, we might feast...but we might end up empty-handed and be eating noodles.

The amount of risk a person is willing to bear varies - we call this risk aversion or risk tolerance. It is highly subjective and dif between individuals. Yet when it comes to money matters and financial investments, virtually all investors have the same attituc They won't accept risk without an appropriate level of compensation - i.e., a higher return on the investment. Risk might be "fun of gambling or sports, but not so much when it comes to one's money.

Risk and Return are directly related - a highly risky investment will require a higher rate of return to attract investors, who would seek safer opportunities to invest. In other words, the higher the perceived risk, the higher the return will need to be.

Example: Think about your personal finances. In return for investing in a bank savings account, you might find it acceptable to earn 1-2%. On the other hand, for investing in a gold mining operation, you'd likely require much more -perhaps 20-30% -before you'd be willing to invest. ThaYs because there's a high degree of uncertainty (risk) associated with gold mining ventures.

The higher the perceived risk, the higher the return that will be required by the investor to feel adequately compensated for aca level of risk.

Rate of Return

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Page 2 of 4

As in the previous example, we quantify return in terms of a percentage. And the required rate of return is that rate of return necessary for the investor to feel sufficient►y compensated and therefore be willing to part with their money.

Conceptualizing Risk &Return

In finance there are various ways to conceptualize risk to make it more readily understandable. Previously risk was defined as t uncertainty about the future. Let's deconstruct risk as a whole and consider the factors that might contribute to that uncertainty.

Determinants of Market Rates of Return

The Real Rate: Imagine that you could invest your money, knowing that there was absolutely no risk - if you invested $1,000 yc positively certain, beyond any doubt that you would get your $1,000 back.

Q: If this were so, would you be willing to do so for zero return (a return of 0.00%)?

A: Probably not. You'd likely need some small amount to compensate you for temporarily foregoing the use of those func

This minimal rate that you'd require in the absence of all risk is called the Real Rate (rte).

The Risk-Free Rate: Back to the real world where obviously such certainty (absence of risk) isn't possible. Since the Real Rate is entirely theoretical and subjective, how can we determine an appropriate percentage? The closest we can come in reality, is the rate on U.S. Treasury securities, which are nearly riskless except for inflation.

Inflation Premium (IP): The risk that the average price level will rise causing an erosion of purchasing power. Individual prices are always rising or falling and some things do become cheaper over time, but on the whole the trend is upward. In anticipation of inflation, an investor will require "protection" or an addition to the rate of return.

Risk-Free Rate =Real Rate +Inflation Premium (rRF = r~ + IP) but see the note in the red box.

Other Risk Factors: An investor's required rate of return will start with the risk-free rate (rRF) and add additional amounts (pren factors that increase uncertainty or risk.

Required Rate of Return =Risk-Free Rate +Risk Premiums

Default Premium (DP): The risk that the firm will go out of business and the shares will be worthless. From the pers lender rather than an investor, this is the risk that the firm (borrower) will not be able to pay interest or principal.

Liquidity Premium (LP): The risk that the security may not have a ready market and therefore wouldn't be quickly converted into cash, or at least not without an unacceptable loss. This is also called a marketability risk premium.

Maturity Premium (MP): The risk that securities prices will fluctuate with change in market interest rates. This is als Interest Rate Risk. We'll see how that works in a later week when we look at Bonds.

Required Rate of Return (sometimes called r~om;,,ai) = rRF + DP + LP + MP

Categorizing Risk Factors

We might also group risk factors according to their source -internal or external to the firm:

Systemic Risk Firm Specific Risk

Also known as: System Risk or Market Risk Non-Systemic or Stand Alone Risk

Definition: Just what the name implies --the risk associated with a company or investment.

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Page 3 of 4

The risk related to market forces that affects the economy as a whole. You might think of it as "a rising tide that floats all boats."

• The general state of the economy 'Business risk -the risk inherent in the firm's core ~

• Fluctuating interest rates •Financial risk -the risk associated with the use of

Factors: • Inflation financing

• Changing currency values •Externalities such as a fire, labor stoppages, or th

the competition

From the perspective of the firm (or of the individual), all the Systemic factors are beyond our effective control. They affect us n~

we might think of them as Externalities, too.

The Capital Asset Pricing Model

Another model thaYs used to assess the relationship between risk and return and estimate an investor's Required Rate of Retui

Capital Asset Pricing Model (CAPM). IYs used almost exclusively for estimating Rolls for equity securities. We'll see how this rr

a later week when we look at Equity Investments.

CAPM = RoR = rRF + (rm - rrf) R

I'rf =risk free rate (here the risk-free rate is = to the rate on Treasury Securities)

r'm =market rate -the overall rate of return for equity securities

(t'm - I'rf) this term is often called the Market Risk Premium (MRP) or Equity Risk Premium (ERP).

R =beta coefficient - a factor that measures the volatility of a particular stock compared to the average or market rate of

serves to "customize" the CAPM result to reflect the particular risk of a single equity investment.

• If (3 > 1.00, then the stock is more risky than the average, and therefor will require a higher return • If (3 < 1.00, then the stock is less risky than the average, and therefor will require a lower return • If (3 = 1.00, then the stock is exactly equal to the risk in the market as a whole.

Remember that anything multiplies by 1 is equal to itself. So (3 = 1.00 it will have no multipliers effect on the MRP.

Example:

Treasury bonds yield 396 Market rate is 7% The firms beta {s 2.4 ~fatrly rlskyj

then arl investor is Ifkefy Ya require a return of 11.QQ9~ - ton5iderably above the market gate.

rc:=3°/a Xm~=7°10 ~=2.0

C,4PM = r~ ~- {r~ —rte} ~

= A3 + .04 '2 .03 ~ .OS

_ .11 or 119'0

Mitigating Risk

Investors can't protect themselves against the effects of Systemic Risk, but they can lessen the impact of Firm Specific Risk by diversified portfolios. Diversification is the process of accumulating a variety of different ty. investments to reduce the risk of loss. For instance, different investment types (stocks, born estate, gold, collectibles, etc.) and/or different industries (retail, wholesale, manufacturing, ;

' like NOT having "all your eggs in one basket'. Just as Individual investors can benefit from firms can do the same thing with varied product lines, vertical integration and conglomerate

The subject of risk and return can be complex and highly theoretical -we've really only covE basics here. But this is a topic that we'll see applied numerous times during the semester.

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Lecture

Practice Activity: Recognizing Risk Categories

Drag the terms or situations on the left to the correct category on the right. This activity is not graded.

The general state Core business of the economy operation

Actions of Business riskcompetitors

Interest rate risk Debt financing

Inflation fluctuating

i nterest rates

Union labor strikes ~h~~9~~9currency values

Financial risk reinvestment

rate risk :ux._~ s

Pale 1 of 1

Categories of Risk Diversifiable Risk (Firm Specific

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Lecture

Forms of Business Organizations

Content Author: Louise August, CPA, Ph.D.

Page 1 of 4

There are a number of ways to structure a business entity. Here we'll look at the main three. Each has advantages and

disadvantages mostly having to do with ease of formation and liability to the business owner(s).The three main forms of

business organization are:

• Sole proprietorship • Partnership • Corporation

Although the majority (nearly three quarters) of businesses are set up as sole proprietorships, the majority of sales dollar

volume is produced by corporations. In this lecture we'll concentrate on the three main forms of businesses. However, there

are several hybrid types of businesses that have some distinct advantages particularly for new and/or small businesses. We'll

look at those in a separate lecture.

Sole Proprietorship

This is an unincorporated business owned by one individual. It has the advantage of being easily and inexpensively formed, it is subject to fewer government regulations, and it avoids corporate income taxes.

We call this a conduit type of business, because like a pipe, the profits (or losses) of the business flow to the owner and are included with other personal earnings (such as wages from another job or earnings on investments) and are reported on the individual's personal tax return. This generally leads to a tax advantage—personal income tax rates are historically lower than corporate tax rates.

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If or when the time comes, a sole proprietorship is difficult to value and sell. There are businesses whose purpose is just that—to determine the value and find buyers for unincorporated, non-publicly traded businesses.

The disadvantages include:

• unlimited personal liability for business debts • limited human capital • limited financial capital • life span is limited to the life of the individual who created it

What does "unlimited liability" mean?

Click to see answer

What is meant by "limited human capital"?

Click to see answer

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Lecture

What is meant by "limited financial capital"?

Click to see answer

Page 2 of 4

We call this a conduit type of business, because like a pipe, the profits (or losses) of the business flood to the owner and are included with other personal earnings (such as wages from another job or earnings on investments) and are reported on the individual's personal tax return. This leads to a tax advantage - personal income tax rates are historically lower than corporate tax rates.

When the time comes, a sole proprietorship is difficult to value and sell. There are businesses whose whole purpose is lust that - to determine the value of, and find buyers for, small businesses.

Partnership

This is an unincorporated business that is conducted by two or more individuals. It has advantages and disadvantages similar to those of a sole proprietorship:

• It is easily formed—partnership agreements can be highly informal, based on nothing more than a handshake, but often there are lengthy formal documents th specify the rights, abiigations and responsibilities of each partner.

• it is also a conduif type of business where the profits or losses flow through to tt_ _ ._ _ _ _ owners so there is a tax advantage.

• Unlimited liability is still a problem. Partners are personally liable for the debts c business. And in the event of a lawsuit, personal liability attaches to all partners r if the act that gave rise. to a lav,[suitv~ras committed by_only one of the partners (although there are ways to lessen the impact for certain types of partners).

• Just as with a Proprietorship: The life of the partnership is limited to the lives of the partners. It has limited access to capital markets. It is difficult to value and sell.

Corporation

This is a business that has gone through the process of incorporation, which may take place at any time - either at the business's inception or at some time in the future if the sole proprietor or partners decides to do so. A corporation is a legal entity created by the state in which it chooses to incorporate (not necessarily the state where it is located). As a legal entity, it has an existence that is separate and distinct from both its owners and its managers.

~ Advantages ~L Disadvantages ~

• A corporation has limited It is more expensive and liability -business debts and complicated to form a obligations are paid with corporation. corporate assets. Lawsuits can only make claims against the assets of the business - the personal assets of the

~•

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Lecture

owners are protected in most circumstances.

• It has unlimited life. This is •The earnings of the easier to understand if we business are taxed twice think about a large once on corporate profits when corporation. When one of the corporation files its tax IBM's many, many return and a second time when shareholders dies, her shares it distributes dividends to may be transferred to her shareholders who must include heirs, but the company goes them as a part of personal on, unaffected b her death. income.

• It is easy to value and •Corporations are subject to transfer of ownership - as a greater reporting burden, easy as calling your broker or particularly a publicly traded oin online to sell shares. cor oration.

• Corporations have greater access to capital markets - they can sell shares and obtain debt, not in the names of the owners, but as entities in their own right. And if the corporation is publicly traded, it can sell to the investing public, thereby expanding the pool of potential investors and lenders.

• Because the corporation is a separate legal entity the owners and managers can be different groups of people. For example, you can invest in Sothe~'s, without ever setting foot in the door or knowing the first thing about the global art auctioning business.

How is the tax system different for corporations?

Click to see answer

Summary of Advantages and Disadvantages

Here is a summary of the advantages and disadvantages of the three main forms of business organizations:

Page 3 of 4

Organization .Advantages Disadvantages

Sole Proprietorship Easy to form Limited financial capital Subject to few government regulations Limited human capital Avoids corporate income tax Unlimited liability

Limited life Difficult to value and sell

Partnership Easy to form Limited financial capital Subject to few government regulations Limited human capital Avoids corporate income tax Unlimited liability

Limited life Difficult to value and sell

Corporation ~~

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Lecture

Unlimited Life Easily transferred ownership Limited liability Greater access to financial capital

Difficult and expensive to create Double taxation More extensive reporting requirements

Page ~ of 4

We will be concentrating on corporations in this course since (1) most business is conducted by corporations, (2) most of us

do—or will—work for corporations, and {3) the majority of securities in the markets are issued by corporations.

Recap

So IeYs recap -the corporate form of business has three big advantages that far outweigh the disadvantages:

1. Greater liquidity (ease of valuation and transfer); 2. Limited liability (risk &value, we'll talk more about this shortly); 3. Greater growth potential (access to funds in the capital markets).

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Lecture

Hybrid Forms of Business

Content Author: Louise August, CPA, Ph.D.

There are several hybrid forms of business that combine features from the three basic forms. These are especially attractive for smaller, newer businesses. They confer some of the advantages, usually limited liability, without some of the more burdensome elements of the corporate form of business.

•Nevada Copp s ~̀ C ~eiawarc cacp . _ _-- S

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• Sub-Chapter S Corporations (Sub-S or S Corp) • Limited Liability Company (LLC) • Limited Liability Partnership (LLP) • Professional Corporation (PC)

Sub-Chapter S Corporations (Sub-S or S Corp)

Page 1 of 2

The Sub-S form is often more attractive than a regular corporation to small-business owners, offering limited liability and some tax benefits.

• It is a form of corporation and confers upon the shareholders the same limitations on liability that a regular corporation does.

IYs a conduit form of business meaning that profits and losses are passed through to shareholders and included on their i ndividual tax returns. That means there's no corporate taxes to pay and personal tax rates are usually lower than corporate tax rates.

There can be up to 100 shareholders. This means that it's possible to have more investors and that means more equity capital for the business.

• Sub-S corporations have perpetual life, just like a C-Corp.

The name refers co the sub- sectian of the fnterna[ Revenue Code that defines and regulates this type of entity —Sub-Sec#ion S.

T)~a Internal Revenue Gc~de (IRC) is the domestic portion of federal statutory tax law created by the Internal Revenue Service (tR5}.

Regular corporations are created b+,~ Sub-Section C and so are ~:omztimes ca11Ec! GCorp~.

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Lecture Page 2 of 2

But of course there are some downsides, too:

• The process to become aSub-S is very like regular incorporation -more complicated and expensive.

• Many of the C-Corp rules apply, like holding shareholder meetings, keeping formal minutes

• Oniy one class or type of stock can be issued that can be owned only by individuals (and certain types of tax-exempt organizations)

LflYlif~Ci Li~F)Ili7}( COiTl~7121i1j/ ~LLI.)

An LI~C is similar to aSub-S with just a few differences

• Provides shareholders with the same limitations on liability that a regular corporation does.

• It's also a conduit form of business so profits and losses are passed through to shareholders as ordinary income and taxed at personal rates.

• There is no limitation on the number of shareholders -potentially an advantage over Sub-S.

• The process to become aSub-S is very similar to regular incorporation -more complicated and expensive.

• The Life of an LLC is not perpetual. in this way it's more like a partnership than a corporation.

Limited Liability Partnership (LLP)

This is a special type of partnership that provides limited liability and conduit-related tax treatment similar to the other hybrid forms. However, many states restrict LLPs to "professionals" meaning that all the partners must be licensed members of an approved profession such as attorneys, architects, engineers, public accountants, physicians, etc. An LLP is not the same as a Limited Partnership.

Professs~ral Cor~oratior (RC}

PC's are much the same as an LLP, but are formed by and subject to the rules of incorporation rather than partnership. They are also restricted to "professionals."

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Lecture

Agency and Agency Conflicts

Content Author: Louise August, CPA, PhD.

Who owns the business? Of course, the sole proprietor owns the proprietorship and the partners own the partnership. With a corporation, iYs a little more complicated.

The process of incorporation creates a legal entity that is separate and distinct from the owners themselves. The shareholders elect the Board of Directors who, in turn, hires officers /senior management to run the company on a daily basis. This separation of ownership and management creates an agencX relationship and gives rise to a unique set of problems.

Page 1 of 2

DEFINITIQN: "a~i agency r~latioiishi~i

occurs ~vh~n an individual or gi•otip (called the

principal) engages aiiotl~er individual (called

the agent) to act an their behalf."

Because managers are there on the front lines making the decisions in the day-to-day running of the business, iYs easy to slip into the mindset that iYs "our" company. It is not. IYs the shareholders who own the corporation, even though they don't participate in daily operations and in the case of large corporations, may be strangers to both the management and to each other.

Typically an individual shareholder has little influence and management has a lot of autonomy. Within corporations, agency relationships occur primarily between stockholders and managers, but also between stockholders and creditors.

Can you imagine how this might create conflicts of interest? There are various types or sources of agency costs:

Differing goals: The manager may work less than is appropriate or expected or may conduct personal business while at work. Managers may have more interest in the welfare of their employees (i.e., higher salaries and benefits). It might be a sunny day so a manager decides to play a little golf instead of working.

Excessive Perks: Management has control over corporate resources and may grant themselves perks such as 1st class travel or club memberships. They may engage in "empire building" - having a larger staff conveys prestige. This can be accomplished internally by adding unnecessary staff or through acquisitions contrary to the best interests of the shareholders.

Differing Perspectives on Risk: Risk is minimized through diversification (more on this shortly). Shareholders diversify their investments through portfolio investment choices, but managers' fortunes are tied directly to the corporation's fortunes. "Its not my money but, it IS my job". So management may be more averse to risk and turn down potentially profitable projects because personal risk is perceived as too high

Differing Time Horizons: The firm has an indefinite life, but a manager's association with the firm isn't. According to the Bureau of Labor Statistics, average length of time between job moves is 4.6 years (http.//www,bls.gov/news release/ten_ure_nr0 htm). Shareholders are usually invested for the long term, whereas management may be more focused on near term goals as a result of:

• Market Discipline -the financial community expects quarterly earnings targets to be met • Compensation Committees evaluate management investment decisions over a shorter time period than investors use to evaluate the same investment. So managers may evaluate a project based on its immediate impact rather than a more suitable time period

Mitigating Agency Conflicts:

So what can the firm do to motivate managers to act in the best interest of the owners? There are a number of mechanisms that can be used to motivate managers to act in the shareholders' best interests. These include:

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Lecture

Properly structured managerial One method of managerial compensation is performance compensation shares. A performance share is one or more shares of

stock awarded to executives on the basis of the company's performance. Stock options may be granted to executives as part of their compensation package as well. The stock options allow the individual to purchase shares of stock in the future at a predetermined price. So it becomes the best interest of the manager to maximize the price of the stock so as to maximize their own personal wealth.

Direct intervention by shareholders Remember that it is the shareholders who own this corporation. If they become sufficiently dissatisfied with the way management is running their company, they have the option of becoming more involved -think of Kirk Kerkorian and the enormous influence he was able to exert on Chrysler. Institutional investors, such as pension funds and money market funds, own large blocks of stock. They also represent individual investors and are more knowledgeable than the average investor. But even small shareholders can band together and make their voices heard.

The threat of takeover A poorly run, poorly managed company will not be highly valued by the market. A low share price may attract the notice of takeover specialists -sometimes called corporate raiders. They may acquire shares, through various means, gain control of the corporation, and oust the incompetent management. This ultimate threat of takeover and subsequent job loss is a significant incentive to management to keep the goals of the shareholders in mind.

The threat of firing The same goes for the treat of being fired by the board in the absence of any takeover activities.

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You should keep the concepts of Agency and the differing perspectives that it engenders in mind any time decision-making and choice come into play.

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the Econamt;t ttav~iaber 2~rd X013

Free exchange ( "[~~~~~~~ ~~ti; ~~~~~;~~ ~~m~~:~ i~~~~~ ~:~~ .~i~#~~~~~

INANe(k~r#[~arobu tld thew ~gland'x cvtli~~dusttaaftrr khr war

oi'tndepcncfenae, ~,ea3ge Wsshtngto~i signed r taw ray ua2 g+v~ ing shipowncts "aliawonrec" lie, ztiLsidks? to oiTsrt at~r taacl~c shay had ~a pap an their inputs. TNaa mn~litian~ wcm s I~aclir:9 la ii~c support: shipnwnen had 1n sign e yro~'it thering a~6reenunR u~th thttr rscw, with wham thry rviso hid to split the alinwance. 'C3iu~otit++~i Ameti~a'#fi~slSax 6rertc~vras dear&ged9oxncG~ur~rge owncn tosturepro~its wtth thrir wcul~ers.

7fiis was na accidcn~, acca~J~ fo "'ihc C'i[ixen's share'. a view baAk bplaseph Hlsat end Aat~irx Krusr of xu~grrs 1 ~niveasi~ sy end Richntd fr~tman t~' 1(arva+d utuv9ersh~:'rhe aurhan sr•

gue That KmarMa"~ fastndeta~ put ptiofity on shred r~urar!}x and the Maid awnettihlp of capitei~ end wtlx not afraid to use thr Erde~al ~ave~nment w advenec thsm. This mindset, the aullwn cxplrin. haspedndir~Dymo~iva~ed American hu~€iness ~r~d piil#- tic~ ever sdncc, trove+ ~bcsgth-century Fiomcw~cad Arta twhkh dix eribwed land Free w ahcrae willingta tiYi ~i? to the x17t ieglslatSan rreetln~ empfoyet sfoctc orvnrrahip plans 4rss~rs), ~~x•a<i~~n• tagrd truau that borrow money to buy sharor (ur wntketa, As ~ trsuh, surprisingly lsrgc numbers of Amcriwn workerx

~i~aro In same vv~ in lhr r employee' s~tccesu, Bnsa~l ~n n srric s of rutinnal survey, the authors mcic~n Chet ~mc ~7'x at ful{ time woken }uve one or more hums +~f capital ~1~ke in the firm tar which tEfiey wok, vrheiher from pmfit•shsrinp xthcmea {4a%1,stt~ckuwocrxt~ipt~sP.?ors~iuk ohtiansCurSct. About a Icnth of Cattune 3~n campaini~s. fmm Prosier ~ Gamhle t~ t`.~tdmAn Srch~. have employee ~hrrahafdings of 5x sir mom. almost a fiRh nC America's biggest private funs, i~~Auding hal~sninrhs 3Fkr t'.ar~ill and N~I~a~, have ptdFif ~tt~~ing nt ttaarc ~~wr~er~hip

~chrmes, some sompcsiple wwk torcampuaie~ with KncrsR, In mtxt caws thr ztaicex me tai~iy ~+iuil: the median rmyic~yee

slmiclwldip~ js rt~crrih Sur t~aa 17ia sr~tr of wnrker~°equity hav

nut inc~~ucd enough to counter two bigger trcrtds 1hu11aevc dra

trwtic~nitq inerr~sad u,aqual'sty of incomr~ in hmer+ca Laver the past7ayearx Itr~vrive~in9~,N is puy iietween4hs res~, ix andthe

rest,am[ the uvtirail ~yueCtc fn the zharo oC neii~mn, incnmr ga- 3ngto wage3. To counitt thix consmnation of waaith.;ind live {gip to the ideatsc~fthacauptr~'3foundcts, Mrsan alas. P~eman and

Fsuse arg~ix than ~lmaricr a►~a~Y yrw4h~r tlrsss iai~ Washiry~~nt~"~

iina~ue and eco~amics 75

mrdieine: m,?re in~ni;vcs poi ~m{~tayre~ to buil~! rnvrrership s~akrs in the final they work fnr~

Thcu acedrnsies _two erorwmis~s and a sr~ei.~agisr—are nn ~t~e e~eiure &eft.Ihe~amt tupic,huwevCr.is ~tutentlymstC3vdiiri~ p~YN~ y Lw the Cnnsrrvative led gavcrnmrt~tP o[ Xmerics's totme~ c ot~~~ria3 m.~xtrr, erii~in also hac st lradiiion oC e~npTnyte share owuc,3hip. )oiyn Lrwix, n bigret~iEer that is owned by a mast un brhal( s~P its vmptoyers, is not examplt. Tfl boPst wh~i is often dubbed tha "dub» ttvvis rcAnomy~} 9h! gdvEtftm~ilt bA3mat~a it ~hsinr 1~ sat Grp rrnployer share uhcmex, and crcaied somr [5tam tt+►~m? 9f tax ineentivcs to eocoutage ownershi~x by <mp►uyeez 1l~ fhc tcceri pti~~atis~lion ~f the Raya6 Mo$, one-tenth of thr shirrs nacre dicn9hutcd tv the firm's workers.

the ~,~>iltua~ upRe~l a~f c+rnplay~aa shaea awac~b~ ie ~nQt in ciuuhi. 8ro~~der ttnek nwnenhip npptai~ to the ri~hf. HeiFi~M squenzccl rvnrk.~rs appeaiz ~o alx ta#z. Emnvmisall~htturever, ~hz mriisF of using ~ctvertrmeni inee»lives to encourage tti~ phk txotaunau arc Irss clear.

Moss wrudrm ¢ anatysra of rr~ypl~ryee nsvrtershfp figve ftr nixed an she gw"rn~ tr, Firrnz. iV!ueker partisiPetRun ~kinly 8e~es nM guatantrc suecess Lehman &vth~rn was 3osc employerowneA, A flagship firm in Mnr~slragon, a ht~gr Spanish co-c~prrative, rr crntly fttcrl for bpnkruptcx But a hnsi of ~tudics show chat work- en apt frr~,a where empin~rees Iwvc a si~ni6canr sake send to bt m~rr prodiativ~ and lnnaystiv~e, to reciin Sp~fT IfMtes and io 5re thane less readily,'ihese findings coma with a pro~rtsu~ hnwevtt: _t7~r effcc~s oven de~eml n~ wheeher the atnpiayrec'ownerabip ss~~e also bnn~s e~ grrnt~r say in hour Etx firm Is run.

YOonid larger gwiors 1>~ncfit employecst Thee, t+>tt. iht annrver is not dear. If share awnenhip rornes at the expenu tai weed, workers may simply be shitting from a sNehic and liquid form of rnmpcnsatian to a re~kier one, A~esxrs Blast, C~teeman ~nd~Cruac nrgue flint shn~e awnenhip xht~uld De. and uswgy is, addilianal ~rornpensatiai. Surveys suggest Uhaf peer 709 of worlcets wha benefit fmm u prafi~•sharing cx other sk~tt-ownership sck3rme gay thru we~ge~e are aror ebmre prevailingmaaiaet tales—ptesum- aAlg aban~sla thrir firms• superiat performa~c~:

Wwari! end ri~1t F.ren if the compensetltm is ~hnuincly addiria~at, employee sh;yrc-nwnbrchipcarr hava disadvantages, ll sney lead wo►kers ao hold San mueh ot'r~~tr wealth in their own ecyrtpnay'a s?t~sk.7'hc authors nrknosvkd~e slits rich tnd recommend that wotke~9 should diversify their pcfrtfolic~s. Hod since most Xmcrllcanx have very [ew sovinRx #hat carat sharplq limits tMs palMtial sxpen stun utrmpliayre ~}tareschetncswc!cprciallyfor poorer peu$le.

All thL~ rests doubt vn the merits of 61~er ~overnmmtincen- t'wes to p~mce+e rmpf oyce share ownership, expecialtp in light of the roxt and dista~lSons inhrmnl in mry lax husk, Growing in- equalitya~adroncentrationo~sheiCdwne~S~ip aretrou6ling,bnl iMer~ an bet~er ways to addresz them. Cspiirl-y~a ns taxes rouW t>c rn~d~ nx~rr ~rn~re~sive; Iadny rkhrr workers hrnefik dispro- ~~>~tisrrFa~tr}y fmm the Inwer tax rate c7n capital ~airms.76x hreaks 1hu1 ensewrugr tht mncentr~tinn o1 capital, such ax the ntried- ia~trrest Ioerphnie.w~airh dranfatically IawetsprivAtP.~egtt#ty paYF Hera` bills, ~t~uulc~ ~ elimiiw~ed_ Amarlctt's iaundinp~ ~thc}s n( krrosd beard rapitalism is adnurabla But ft is beau promoted by gettin~ rid ai epeciaS iricentit°es. not by ttntfn;new onus. ■

i nns,+he.c,nJb~.gy~iroiaetn,nq.

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E~»ployee share ownership hus meal. BuE thin tides not Justi fy i'ur~her suer n ntent inUentir~~es

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5b iUSiners

S+~h~trr~peter ~ "Vtl~~c~n ~c~~°1~~~~r~► x:~~- ~ ~~~ ~~r$~°~~

'S~erreelvett svls~Mtnr4tt~at cmpto}+ce rnvneur~hlp 9s a goxrrt Ihi~~~ru~sins witlrc~vc~ts

s, •~ .H~

~`t' iS papulac Irr lwmcnw cht ~ravrinaY~l~ l~etvu~e~ ~pitxlists and l wvrkerw,ip erne respkct,h~wever,Ihe~p l~ahrinking: ~her~srm. brr o(w~tkcrx vrho own shares in tie b~inexx Thal ernt+luys ~htrn has never been hi;{r:T ~Smetica te~c~ the ~vay: sign Amen• cans own sigcic in their cm~panuss throusn pr+tssan a~td profit• sharing ptptu, anti s`~a~e-awn~rship and :haar~uptfon achcmes. I~~ iclru tantinvcs'h fain mnmeniu«~. Wilara~ t~ia~on's reccn~ speeches au~c~tllh.it may ~~~iu ii an intae~tw~t plank ui her planstoTef9rrot8p~#afix~n ~1t~d sv~ic~~~rapitulisi~aE~alwon ~iaa march in Eum~«e and Asia.

Con~rva!i~ee ':ike emp9ayte owne~d~ip because t~ gives ~xrorkers s Make In the <apitaliu system. I.e1i-wires 11~r ~t be eause iE dices then, a piece aC tfie eupitallst pie. And nsiddle•of• the-roader~ like It because it heipz to close 8 po~enlislly danger- ou4 ~aT kx~ween capitak a~~~ tabzx~c David C.amerssn, Hri~ain'c ~'~znserva[[veprirar minis~er.praises)nhn Lpwi~,Areuti~r eerier ty+~u~net~ byi~ata6 8rcn~Sanderc. A~nerica'xnnly~pci~IkE zen~ ainr and raw a canc'idaie tarihe t:yemt~crnt~< nnmina~ion isee t.tx~ngioncalam~il. tti v champion of emptayea shareKrwnershl}~.

'[he mod is aistt being driven by a fong•mm chili !rom "de- frned het~efit`(nu)pensore ~la~x,in which rmplo~rrsguarantee the rett~m~nt income nt fheit w~aarkers,td "de6nedcontribution` lnc:) sci~emas, in which worker and ~mplsayers put money into a n Investment pat, with no g rarante,es of }ww mu+~ It u+ilf even tualip pay s~u~. 3ntludiog curn!nt wn~ker~ and pensioners there are mare ahpn 9&m nr. plans ~n existener, A tsi~ surrey by Jksn Hewitt, u eur~suiting firm, found shat ~~ of such plans' assets were ii~vesied to ihesharesotl}ce employerin queaion.

A nnmher of studies have &wnd that vrmkers ~t firrm where employees nave ~ significant stiake tend ea be m<rrc producttve andinnnvativ~,andIe~li veteesst~~'sumover.Empinpccowner ship has Sts drawbecics, .however. CNir Is the rink that ww~trs ha~~e tcsp many ems in one baskeC if their pmptaycr goes bust they ~:ars lase thekr penxivns as well as theirjobc.: [:hrp+4 emplay- r.~b K't[e C(1COitFB~ld.IU 5IU~1~1f ji ~+1~Ik~" planstthe most pnpu~~ tar zy~~: aCpeosi~n schrme)wlth min{Nny meek fast befom ~hrU firm we~j! ~ank~upt in wai~he average ernytoyet hefdfi~lcnCl~is orhe~ acn(f~ asxisin Enron shams: ~akew(ax where CAebaECracs• ing warts tsus~ a Eew months i~te& 1t~t m4dpsen1 its sharer wiy~ed

'The Economist Aa~gr,sE ~~nc~ 2iti5

pul a large chu»k t>t tts woekers" peixsinr. wing+. Ltc~a{ril~ ~dviquS initiativex by C~m~rers ~n uop jrn5s ~au~ir~~ thrir shores to enr phsyaes, rexes um s~iU a~ivu~ sun~~ furmar wockcn oC Radin Shack, a xetaiicr thin fifrd iur bpnksuptey in Fcbruotx are tek{ng the firfn 1z~ wutt~ aiguina that it kept ~Ncriri~ to it.ake 3;~ pension coytitcibutiaEas in sloe (orm aE etsmPy~y shires, tvhet~ r s~YuuEc1 hnti~ &r~vwnthay v~~ercgaingla rose vnlu~,

A se~annd prabirm is encrcn~hment, Su~~etc~, ~f waelcc~ vwn~rahip argue that Ic he~~ssompanirs ~akc a. mn~ lung Tenn prrsy~~ivc: C`,titici argur ~I~1 it run ~m~rcnch lrnd muaugement end u~atier~nine a rampAnys long sec m cce~npetisiveness: under• pttforming bsxset are rrauch iuo~e Eikeiy to be able to stay in pPHcr, ~nc~ rex~st hnz~7le tnkcavpes, i( soma ai ahc rnmpany's shu~cs ~~ in liiendly i~at~ds. En i~r~ 'iDnilcd Airtine~ 9rnrsde€3 nanmp ~C9~twc~iksrs~a 559Fstakr,and tepresemationrnt th~~ae+d. in irtwn tar try cups. Bud Q1s ~pnrfurmencc remmCned pc~r, and ti Filed farhanl~ruptey in goo^..

A thin! rick is cntidsment.Thestmngea~ orgun5enti~~ fi~v~ur ud e~pployee rn~vnrrship is than w~atkcra wii9 e~~t ffnHy toit ha~'ticr i1~ thep gat ce at"src n£ ifia pmGtx, but roil) nial:e rurc ihat tf~eSrcnl~ league zdo sn toc~. R:yew paperby li~~~j~inin llun(~rd and othe~c~ prns~nted at Phe ~caci~my of Mana~a meet's annuat maetSn$ In Wanc~~»~er, erBuax Thal ccxmntitmrt~t can tran~anutc ii~ia en~lflr meet: 1'he academies studied e sanx~~le ~~i acre rmpinyrex at a conrmeresr~l prunRriy firm in hhe Midwea~ and fours than lhnre wha intreitcd a higher proportion n("heir ~o~{k} aaaun~s'sn rum• parry itatk expected ltetitr bmefits—in the ~rnm a(promolions and pay tier&—thin tfie rest, and tcm~ mnrr tliurett~trncy leaver. (Wawevcr, ehe study did nntx~asidcr whrthrr, ruvecitu[ess, am~ ptoyceewnerxhrp hnastedthrfitm'suverall perfornaance.)

~P 1'abl~as Arqument~ alxsu~ am.plopee ownership can eas~ty b~cnme tcw sweeping: grorid ciaim4fr~otn supp~rtett inviter vigorovsrehuilalrt by critics. h great deal depends fen hew schemes arc scc~ctumd. anci the motive tat inhpducin~ them. AnoRher recent psper, by H~~ Kim arn1 p~~ puimet, at the itnivrrsiry of hikl~ig:n and IJ'niver~icy of Narrh C:pratinA res~cuvetyt considerz lhr sizes at e~arxandnf the firtt~ ~hnR ~fferthem,lfir~+find ihntunall xsows twhicli control a stake aflessifian5~sin She sompanyin gaesttun) are far rrlpre iilaety to boast ~ductivilq thin large ~nr~, hecau#c firms That introduce Ia~Xe uors arc oAen iresubled ants ttylrtg ~a tt~nserve cash byaubstitu~ingshans?orpay, orseekingto Pend n!f hosrile ~akcovcn by giving shares tofcicndty insidrrs.'lThry also argot that create seer rnurh mart likely to work i~ stnalkr fiEms than Ca~sr ones beCeur~ employer-nwncrs can maim cisify penraifa+~ each pthex and aharebgttcsas# swe~~tl grcr~ls~ctfvity. Ihet~ i~ plrnry to be eerie] fc~r eropl~yee rnvr~i~i4[p, t4 rah

sharpen workers' mofiYarinn and go vwne way ieo hee~tin~ a po 2e~st ally dangerous d9vide befweera the wtxking c[sss and the £~+r s clacs~ Ant if pgliticwns ore serinw about the idea+, they need do thinl has~Irr a~nui haw to meikr of w~aric in pcac~ite. Tfiey should day c'~ ~ :i~~c~~ion as haw ~cfiemec ere designed. and tank €~r :siti, i, .~Irr regufmtir~ns end tax'in~ctcnt(ve~xo os ro em ~+rirra~r, , I ~ i.:,ard s~}te~~¢s. 71rey alxo need tts cleat v✓ith 4be problen, ~ , ,~~ ~ rrrr~tln~tislrin a single rd~rnn~ny'~ si~arc~. Giv~ enil ki6e:~~eyageliftcxp~c~~nryoC6orl:oneg<x~~rspanic~hers falters fmm T5 ycAn'in tl~evt3~s io perhspsjuxtfi, yenrx i~ttay. sir sou rx~irtg empEoyees to inv~tt ~hairsavinya with Fhe ~ompAnlet 1halrmptoythemtsarecipetarmPsrrablptr~iremrnls. •

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Chapter 01: "I he Goals and I~unctions of I~inanrial \9anagcmcnt

Chapter• 1 The Go<~Is and Tunctions of Financial 11'lana~;ement

Discussion Questions

1 -I. Fio~~• did the recession of ZU07—'_009 compare ~~~i~h other recessions since the

Great Depression in tcnns of length'?

lc was the IonRes;t c.

1-?. 1~1%ha[ et~ect did the recession of 2007-2009 have on government regulation:'

n It was greatly increases'

1-3. s "dhat advantages does. a sole proprietorship offer'? 1'~'hat is a major drawback of

this ty~c of organization'?

A sole proprietorship offers the advantage ofsimplicity of decision making and

lo~~• urganir_ational anal uperatin~; costs. A major ~rt~wback is that ~hcrc is

'."ntimited liability to the owne~~, r. 1-4. 'Vhat forni uf'partncrship allows soct~c of the in~~cstors to limit their liability'?

ytxplain briefly.

t1 limited panncrship allows some of the p~rtncars to limit their liability. Under

this arrangement, one or more partners are designated general p~rtncrs and have

unlimited liability for the debts of the firm; other p~rtncrs arc designated limited

partners and are liable only for their initial c~nMbution. "fhe limited partners are

'~omially prohibited from being active in the manabcmcnt of the fim',-̀

1-5. In a corporation, ~vhttt group i~as the ultimate responsibility for protecting and

manabing the stockhol~tcrs' interests?

Thy board of director:,,

~. 1-6. What document is necessary to form n corporation'?

The articles of incorporation.

Copyright ~!; 2Q17 Mc('rrnw•-Hill liduwtinn. All ribhls resn~~•cJ. No rcprcxtuclion or distribution wiihnu( the prior wrillen consent

ofMcGruw-hill [ilucaliun.

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Chap~cr 01: 'fhc (foals and Ivnctionx of financial ~I~nagcmcnt

I -7. ~~~~~`Irti i~suc dues agency theory cxamin~? Why is it impiirtant in a public corpoi~uion rather than in a prira~c cnrporation".

A~rncy tlicor~~ examines the rrJnlionship tx°t~vccn the o~vnrrs cif the Finn and the managers of the firm. In privatcl~r owned firnis, management and the muncrs are usually the samr pwplc. I~•9ana~cmcnt operates the firm to satisfy its own goals, needs, fin.uuial requirements and the like. Ax a cc~mnany mo~•es from pri~~ate to public o~vnciship. managcmcni no~v rcprcscnts all owners. 'this places mana5emcnt in thr agenc~~ position of making decisions in the tx~st interrst of a41 shareholdri;~

;. 1'8• t~ '~'hy ire institution.jl investors impc~rt~nt in today's business ~~~gr1d''

~r t3ecause institutional invextors such as pension fiends and mutuUl funcLc awn a large percentaL~ of major U.S. companies, they are having more to say about the way publie:l~r owned companies are managed. As a group. they have the ability to vote large blacks ~f shares for die election of a Uoard of directors, ~~~hich is supposed tip run ~hc company in an cflicicnt, compctiti~~c manner. The threat of being Bible to replace pocir performing boards c~FJinnctorsma~kes instihrtional investors quite intlucntiaL Since these instihttioiis, like pension funds :►nd mutual

' "`1ncLs, represent individual workers end investors, dity hFive a responsibility to see that the firm is managed in an zfficient and ethicfl) way

~• 1-9. ~'1'hy is profit maximization, by itself, an inappropriate goal? What is meant by the

~O:fI Of ~]11XIIT7V,~Yf011 Ot SII~~~~~r,o~~i~~~ ~t~«~tt,~r_ _ _ _ __ 'i'he prablcm with a profit maximizutian boa! is that it fails to tAke account of risk, the timing of the benrfits is not cunsidc:red, and profit measurement is ~ very ine~~ct prcx;ess. The dual c>f shareholders' wealth maximization.implies that the time will attempt to achieve the highest possible total v;~luation in the marketplace. !t is the one ovemding objective of the firm and shquld influene~ every decision,•

C+ipyright ~G 2017 Mc(haw+l till fduralion. all righle nsenal. No repraluction or JLtlribution witliuut the prior w~ritlen conatnt ofMcGr,~w-Bill Education.

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Chapter QI: The (ivals and Functions of Financial ~t:~nagcmcnt

-10. 1~1~hcn does insider trading occur? 1i'hat government a~cncy i~ responsible for ~~rotccting against the unethical practic c of'insiilcr n~ading?

Insider trilling occurs ~~~hen anponc ~G•ith non-public inforn~.ition btrys or sells

securities to take ad~•antage of that privaec intixmation. The Securities and l:xc:hange Commission is respimsiblc fi>r protcctin~ markets against insider trading. In the past, people ha4•c gone ro jail for trading on non-public

infi~nnation. This has included cump~iny o('(iccrs. im~cstmcnt bankers, printers who have inforniatitm be:fon it is puhlisheJ. and even tnick driven adio deli~~rr

business ma~azincs and read pi~siti<<c or ncg:~rivc articles about. a company before fhc magazine is on the nc~~~sstands and then place trailcs ar have friends place tr<~des based nn drat information. "I~he SE<' his prosecuted anyone why protits 1'rorn inside infi~itnatioi""

~. 1-1 I. ~' i terms ot'the life of thr securities offered, ~vhnt is the dif~crence ben~~een money

and capital markets`>

Money markets refer to ~hosc rnarkcts ilcaling with short-term securities that have a life of c>ne year or less. Capital markets refer t<~ securities ~vitli a life of more

''tan one yea„'

t-12. What is the difference lx t~~~ccn a primary and a secondary mackct?

~A prim~rp market refers to die use of the financial markets to raise new funds for the corporation. After the securities ire sold to the public (institutions and individuals), they trade in the secondary market between investors. It is in the secondary market that prices aro continually changing as investors buy and sell securities based on the expectations of corporate prospect,,

s. i-13. ~'~ssume you are looking at many companies with equal risk. Which ones will

hove the highest stock prices?

Given ~omp~nies with equal risk. those companies with expect ttions of high renirn evil) ha~~e higher common stock prices relative to those companies with expeccatiuns of poor return„

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of Vtd craw-Ilill &locution.

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Printable Presentatirn~

('hapicr 111: 7'hc Goals and Function, of Pinanci;d \4anagcmcnt

1 -14. ~ i'hat changes can take dace under restructuring'? In rec4nt times, «hat s;roun of` itn~cstors has a}icn fi~rccd resh-ucturin~ t~~ take place°

Resrructueine enn r~suit in changes in the capi[al structure (liabilitic and equity ~~n the balance shccl). !t ctln also resuit in QtC scliin~; of li~w-profit-rnar~in divisions with the ~>raceeds rcin~~c~tcd in better inti°istment opportunities, and sometimes restnicturing results in the rcmovai uf'thc ctnrcm management team or large. reduetic>ns in the workfixce. Restnicturin~ has also included incrgen and acquisitions.

Instirirtionnl investors ha~~e been very intluential in ti>rcing restructuring to take place in recent year;;,

~. I -1 ~. Wow did tttc Sacbancs--iJxlcy Act impact corporacic~ns' tinanci:il rcpoi~ts7

-e 'I'hc Stirbanes—Oxley Act of 2002 set ttp alive-member Piibl~c Company Accounting Ovcrsighc E3garil with the resp~nsibility i'or establishing auditing sttindarcis within companies, eontrc>Ilp~g the quality o1'audits, and setting nibs and standards for the inclependcnce of the aaciitc~rs. It als« puts great responsibility tin the intem~l ttttdit committee o~each ~niblicly traded ce~mpany to enforce compliance Frith the act. "I'tic major focus of the act is to make sure that publicly trnded cornorations ciccuraicly presee~t their asscEs, liabilities, and ci~uity and incom~•on their fint~nciat st<~tcment:

~. 1-16. ~lan~e the ~3epartments, offices, c>r agencies that were created by the Dodd-Drank

legislation.

I) The act created the Financial Stability O~~crsight Council ~~~ithin the Treasury Department.

2) The act crc;ated the Office of f5nancial Research ~~ithin the 7'rcasury Department.

3} Dodd-rank established the Fcdc~al Insurance Ofticc within the "Crca~ury Department to oversee the insurance industry and streamline state-based insuragce regulation.

4} The act created the Bureau of Consumer f financial Protection. The oversight given to the Bureau of Consumer financial 1'rntection allows it to dictate the fees that bank.,, barge and the types of~products they uffc;,

Cc~pyrigl~t v 2017 McYiraw-Dill GJuCAliwt. All ri~hlr rt~~rvcYl. No n-~xuduCiion or diclribulion wi1liuut ~hc prior writlen cua+ent of McCitaw•Hill G~iucauon.

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,; K . ~~_::~~~' Learning Objectives

t, ~ ~ f n ~ ~~ • Finance integrates concepts from economics, accounting and other areas

The Goals aid Ac~ivi~ies of ~ Firms can have different forms of organization ~ n~n~~a[ M~~a~emen~ • Central to finance is the relationship of risk to

return

Block, Hirt, and Danielsen 'The primary goal is to maximize wealth of

shareholders Foundations of Financial Management

Achieve wealth maximization through daily 16th edition activities

a New regulatory oversight of financial markets

The Field of Finance

Economics provides broad pictures of economic environments for decision making

Accounting provides financial data through: I ncome statements

Balance sheets

°- Statement of cash flows

Finance links economic theory with accounting numbers

Evolution of the Field of Finance

• 1900s— Finance emerges as separate field from economics

1930s— Financial practices revolve around such topics as

• Capital preservation

Maintenance of liquidity

• Reorganization of financially troubled corporations

• Bankruptcy process

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Evolution of the Field of Finance

1950s— Finance becomes more analytical

Financial capital (money) used to purchase real

capital (long-term plant and equipment)

Cash and inventory management

Capital structure theory

Dividend policy

Financial manager making day-to-day decisions

Modern Issues in Finance

• Focus has been on

Risk-return relationships

• Maximizing return for given risk level

a Portfolio management

• Capital structure theory

New financial products focusing on hedging are now widely used

• Reducing risk by changing interest rates

Modern Issues in Finance Risk Management and a

Review of the Financial Crisis

• Inflation (increase of prices) —key variable in

financial decisions

• Disinflation (a slowing down of price

increases)

• Significant factors during decision making

• Effects of inflation/deflation on financial forecast

• Required rates of return for capital budgeting

decisions

- Cost of capital

Reasons for recent financial crisis

• Extension of credit to high-risk borrowers

Creation/sale of mortgage-backed securities

• Losses from credit defaults in excess of banks' capital in many cases

Creation of complicated, unregulated financial

products like credit default swaps (CDS)

Government action and bail-outs

a Federal Reserve money

New regulations for financial institutions

The Dodd-Frank Act

• Wal( Street Reform and Consumer Protection

Act of 2010

Passed in response to financial crisis

• Improve accountability and transparency

Protected taxpayers through financial institutions

Protected consumers from abusive practices in the

financial industry

First major financial regulatory change since the

Great Depression

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The Dodd-Frank Act

Provides for orderly liquidation/bankruptcy of non-bank financial companies

• Consolidates regulators

Hedge funds and investment advisors must register with Securities Exchange Commission

Established Federal Insurance Office

Volcker Rule Limits speculative investing by regulated

i nstitutions

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The Dodd-Frank Act

Created the Financial Stability Oversight

Council

r Created the Office of Financial Research

within Treasury Department

Identify systematic risks

Reduce moral hazard

Maintain stability of US financial system

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The Dodd-Frank Act

Bureau of Consumer Financial Protection

Dictates fees that banks charge and products they

offe r

Power widely criticized; attack on free markets

Issues

Rulemaking, implementation left to agencies

charged with enforcement

Rulemaking delayed by different regulators

Grey area in many financial activities

The Impact of the Internet The Impact of the Internet

I nternet accelerates e-commerce solutions for "old economy" companies

• E-commerce solutions for existing companies

• Business to consumer (B2C)

Business to business (B2B)

Creation of new business models and companies Amazon.com and eBay (retail)

• Facebook and Twitter (social media)

• Netflix and Google (entertainment &information)

• E-commerce affects pattern and speed with which cash flows through firms

B2C model Y Orders placed with credit cards

• Selling firms get cash flow faster

• New ways to reach customers

B2B model Lower cost of managing inventory, accounts receivable, cash

Efficient way to interact with suppliers

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Activities of Financial Management Activities of Financial Management

Financial management concerned with managing entity's money

Functions

• Allocate funds to current and fixed assets

Obtain best mix of financing alternatives

• Develop appropriate dividend policy within

context of firm's objectives

n Day-to-day credit management, inventory control

and receipt and disbursement of funds

• Risk-return trade-off determined to maximize the market value

• Influences operational side (capital vs. labor or

Product A vs. Product B)

• Influences financial mix (stock vs. bonds vs. retained earnings)

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Figure 1-1 Functions of the

Financial Manager

Gaily Occasional Profifabilily

Credit management Stock issue Goal: Inventory control Bond Issue

Trade-oH Maximize

Aoceipt and disburse- Capital budgeting shareholder menl of funds pivido~d decision wealth

Risk

Forms of Organization

Sole Proprietorship

Represents single-person ownership

Advantages

Simplicity ofdecision-making

Low organizational and operational costs

Drawback —unlimited liability to owner

Profits and losses taxed as though they belong to

i ndividual owner

Forms of Organization

Partnership

• Similar to sole proprietorship except with two or

more owners

• Articles of partnership specify:

• Ownership interest

• Methods for distributing profits

• Means of withdrawing from the partnership

• Carries unlimited liability for the owners

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Forms of Organization

• Partnership (cont'd)

• Limited liability partnership

• One or more partners designated general

partners and have unlimited liability for debts

of firm

• Other partners designated limited partners and

liable only for initial contribution

• Not all financiai institutions extend funds to

limited partnership firms

Forms of Organization

1 ~~

• Corporation (cont'd)

• Corporation •Disadvantage

• Unique; legal entity unto itself •Potential of double taxation of earnings

• May sue or be sued, engage in contracts and acquire • S corporation

property ° Income taxed as direct income to stockholders, thus taxed only once as normal income

Formed through articles or incorporation, which • Limited liability company (LLC) specify rights and limitations of entity •Provides limited liability for the owners

Owned by shareholders who enjoy limited liability •Can be taxed as sole proprietorship, partnership, corporation, or S corporation, depending upon

• Has continual life elections made by owners

• Key feature —easy divisibility of ownership interest

by issuing shares of stock

Corpora~e Governance

• Agency theory

• Examines relationship between owners and

managers of firm

Identify and reduce potential conflicts of interest

I nstitutional investors

• Have more to say about how publicly-owned

companies are managed

Able to vote large blocks of shares for election of

board of directors

The Sarbanes-Jx!e~,r act

Set upfive-member Public Company Accounting Oversight Board (PCAOB) with responsibility for

t Auditing standards within companies

Controlling quality of audits

Setting rules and standards for independence of the auditors

Major focus is to make sure publicly-traded corporations accurately present

Assets

Liabilities

Equity and income on financial statements

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Goals of Financial Management

• Primary goal —maximization of profit

• Drawbacks

• Change in profit may also represent change in risk

• Fails to consider timing of benefits

• Impossible task of accurately measuring key

variab►e "profit" • Problems with inflation and international

currency transactions further complicate the issue

Valuation Approach

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Maximizing Shareholder Wealth

• Shareholder wealth maximization is the broad goal of the firm • Achieved through high value for the firm

Long-term wealth is difficult with changing investor expectations Financial problems following 2012 led investors to remain conservative • Causing valuations to be depressed from format

highs 2014 investors questioning Dow Jones Industrial Average highs

Ultimate measure of performance —how earnings are valued by investor Investor will consider • Risk inherent in firm's operation • Time pattern of firm's earnings increase or

decrease • Quality and reliability of reported earnings

p Question impact of each decision on firm's overall valuation • If it increases the firm's overall value, it is

acceptable

Management and Stockholder Wealth

• Only way to retain power in long run is by becoming sensitive to shareholder concerns Sufficient stock-option incentives to motivate achievement of market-value maximization Powerful institutional investors making management more responsive to shareholders

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Social Responsibility and Ethical Behavior Social Responsibility and Ethical Behavior

6 Adopting policies that maximize values in market

Attract capital Provide employment Offer benefits to society

Certain cost-increasing activities may initially have to be mandatory rather than voluntary, to ensure burden falls equally over all business firms

Insider trading Using information not available to public, making undue profit from trading in company's publicly traded securities Unethical and illegal practice protected against by Securities Exchange Commission (SECS Has a negative impact on shareholder's interest

Ethical behavior creates invaluable reputation

Role of the Financial Markets

Financial markets —meeting place for people, corporations and institutions

Have either a need to lend, borrow or invest

money

Narticipants can be national, state and iocai governments

y Their markets are Public financial markets

Corporate participants raise funds in corporate financial markets

Structure and Functions of the Financial Markets

Distinct parts of financial markets

• Domestic and international markets

• Corporate and government markets

• Monev and capital markets

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Structure and. Functions of the Financial Markets

Structure and .Functions of the Financial Markets

t Money markets

Deal with short-term securities with life of one year or less

Securities include

• Commercial paper sold by corporations to finance daily operations

Certificates of deposit with maturities of less than 12 months sold by banks

Capital markets

• Deal with securities that have life of more than

one year

• Long-term markets

Defined as either 1-10 years or greater than 10 years

Securities include

• Common stock

Preferred stock

6 Corporate and government bonds

~!l~~ati~n of Capita!

Primary market

When corporation uses financial markets to raise

new funds, sale of securities made through new issue is tailed initial public offering (fP0)

Secondary market

Securities bought/sold amongst investors

Prices of securities Keep changing continually

Financial managers given feedback about firms' performance

~I!ecat;~r ~f CaN;t~l

Return maximization and risk minimization

I nvestors can choose risk level that meets objective, maximizes return for given risk level

Companies rewarded with high-priced securities can raise new funds in money and capital markets at lower cost than competitors

Firms pay penalty for failing to perform

competitively

Institutional Pressure on Public

Companies to Restructure

• Restructuring can result in:

• Changes in capital structure (liabilities and equity

on balance sheet)

• Sale of low-profit-margin divisions with proceeds

from sale reinvested in better investment

opportunities

• Removal of current management team or large

reductions in workforce

Also includes mergers and acquisitions

internationalization

of Financial Markets

• Allocation of capital and search for lower-cost

sources of financing in global market

• Impact of international affairs and technology has resulted in need for managers to understand

• International capital flows

Computerized electronic-funds-transfer systems

• Foreign currency-hedging strategies

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The Internet and Changes in the The Internet and Changes in the Capital Markets Capital Markets

• Cost reduction in trading securities driven down

• Many stock markets brokerage firms have merged with domestic and international partners

• Creation of electronic communication networks (ECNs) • Has speed and cost advantages over traditional

markets • Electronic markets like NASDAQ have gained

popularity against traditional organized exchanges such as NYSE

Retail stock trading allow customers to directly compete with full-service brokers • Charles Schwab • E*TRADE • Ameritrade

• Change to price quotes in decimals From the traditional 1/16, 1/8 , 1/4, and 1/2 price quotes Lower cost environment for customers and a profit squeeze on markets and brokers

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