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Financial Institutions
Companies that specialize in financial matters
Banks – commercial and investment, credit unions,
savings and loans
Insurance companies
Brokerage firms
Job opportunities
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International Finance
This is an area of specialization within each of the
areas discussed so far
It may allow you to work in other countries or at
least travel on a regular basis
Need to be familiar with exchange rates and
political risk
Need to understand the customs of other countries;
speaking a foreign language fluently is also helpful
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Why Study Finance?
Marketing
Budgets, marketing research, marketing financial products
Accounting
Dual accounting and finance function, preparation ofnanca statements
Management
Strategic thinking, job performance, profitability
Personal finance
Budgeting, retirement planning, college planning, day-to-day cash flow issues
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Business Finance
Some important questions that are answered
using finance
What long-term investments should the firm take on?
Where will we get the long-term financing to pay for
the investments?
How will we manage the everyday financial activities
of the firm?
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Financial Manager
Financial managers try to answer some, or all, of
these questions
The top financial manager within a firm is usually
the Chief Financial Officer (CFO)
Treasurer – oversees cash management, credit
management, capital expenditures, and financial
planning
Controller – oversees taxes, cost accounting, financial
accounting, and data processing
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Financial Management Decisions
Capital budgeting
What long-term investments or projects should thebusiness take on?
Capital structure
How should we pay for our assets?
Should we use debt or equity?
Working capital management
How do we manage the day-to-day finances of thefirm?
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Goal Of Financial Management
What should be the goal of a corporation?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the company’s stock?
Does this mean we should do anything and
everything to maximize owner wealth?
Balance Sheet Model of the Firm
Current Assets
Total Value of Assets:
Current
Liabilities
Long-Term
Total Firm Value to Investors:
Fixed Assets
1 Tangible
2 Intangible Shareholders’Equity
Debt
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The Capital Budgeting Decision
Current Assets
Current
Liabilities
Long-Term
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
e t
What long-terminvestmentsshould the firmchoose ?
The Capital Structure Decision
Current Assets
Current
Liabilities
Long-Term
How should the
firm raise funds
for the selected
investments?Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
e t
Short-Term Asset Management
Net
Working
Current
Liabilities
Long-Term
Current Assets
How should short-term assets bemanaged and
financed ?
Capital
Shareholders’Equity
e t
Fixed Assets
1 Tangible
2 Intangible
Capital Structure
The value of the firm can be
thought of as a pie.
The goal of the manager is
to increase the size of the
50%
Debt
25%
Debt
70%
Debt30%
E uit
pie.
The Capital Structure
decision can be viewed as
how best to slice the pie.
If how you slice the pie affects the size of the pie,
then the capital structure decision matters.
50%
Equity
75%
Equity
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The Financial Manager
The Financial Manager’s primary goal is to increase
the value of the firm by:
• Selectin value creatin ro ects
• Making smart financing decisions
The Firm and the Financial Markets
Retainedcash flows (F)
Invests
in assets
(B)Short-term debt
Firm Firm issues securities (A) Financial
markets
Cash flowfrom firm (C)
T a x e s
( D )
Government
Dividends anddebt payments (E)
Current assets
Fixed assetsLong-term debt
Equity shares
Ultimately, the firm
must be a cash
generating activity.
The cash flows from
the firm must exceed
the cash flows from
the financial markets.
The Goal of Financial Management
What is the correct goal ?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize shareholder wealth?
Managerial Goals
Managerial goals may be different from
shareholder goals
Expensive perquisites
Survival
Independence
Increased growth and size are not necessarily
equivalent to increased shareholder wealth
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Managing Managers
Managerial compensation
Incentives can be used to align management and stockholder
interests
The incentives need to be structured carefully to make sure
t at t ey ac ieve t eir inten e goa
Corporate control
The threat of a takeover may result in better management
Other stakeholders
Financial Markets
Primary Market
Issuance of a security for the first time
Secondary Markets
Securities may be traded in either a dealer or auction
market
NYSE
IDX
Financial Markets
InvestorsStocks and
Bondsirms
Secondary
Market
money
securitiesSueBobMoney
Primary Market
Primary and secondary markets
Primary market – primary issues of securities aresold, allows governments, banks, corporations toraise money by directly selling financial instrumentsto the public.
econ ary mar et – a ows investors to tra efinancial instruments between themselves.Secondary transactions take place.
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The Agency Problem
Agency relationship
Principal hires an agent to represent its interests
Stockholders (principals) hire managers (agents) torun the company
gency pro em
Conflict of interest between principal and agent
Management goals and agency costs
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Managing Managers
Managerial compensation
Incentives can be used to align management and
stockholder interests
The incentives need to be structured carefully to make
sure t at t ey ac ieve t eir goa
Corporate control
The threat of a takeover may result in better
management
Other stakeholders
Financial decisions
Financing decision – where is money going to come from
Investment decision – how much to invest and in what assets
Operations Financial
markets
Financial
Manager
I nv e s t m en t s
F i n an c i n g
Financial decisions
Capital structure and cost of
capital
Operations Financial
markets
Financial
Manager
I nv e s t m en t s
F i n an c i n g
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The goal of financial management
Maximizing shareholder’s wealth
Maximizing stock prices
Objectives for financial manager
Maximizing earnings and earnings growth
Maximizing return on investments and return on
equity
Financing decisions
Financingdecisions
Internal corporatefinancing
External sourcesof funds
Retainedearnings
Direct financing(financial markets
Instruments)
Stocks
Debt instruments(bonds, CPs etc.)
Indirect financing(financial
Intermediaries)
Loans
Financial markets
Financial markets
Primary marketsSecondary markets
Money marketCapital market
Organizedexchanges
Over-the-counter
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Money and capital markets
Money markets – short-term assets (maturity less than 1year) are traded:
Certificates of deposits (CDs)
Commercial papers (CPs)
Treasury bills
Capital markets – long-term assets (maturity longer than 1year) are traded:
Stocks
Corporate bonds
Long-term government bonds
Organized exchanges and over-the-counter
Organized exchange – most of stocks, bonds and
derivatives are traded. Has a trading floor where floor
traders execute transactions in the secondary market for
their clients.
toc s not iste on t e organize exc anges are tra e
in the over-the-counter (OTC) market. Facilitates
secondary market transactions. Unlike the organized
exchanges, the OTC market doesn’t have a trading floor.
The buy and sell orders are completed through a
telecommunications network.
Prices of financial instruments are determined in
equilibrium by demand and supply forces
They reflect market expectations regarding the
future as inferred from currentl available
information
Financial instruments issued by government:
goals
To finance any shortfall between expenditures and
taxes (deficit)
To refinance maturing debt
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Financial instruments issued by government
Treasury coupon issues:
- Treasury notes (T-notes): maturity of 1-10 years
- Treasury bonds (T-bonds): maturity of 10-30 years
Considered free of default risk
Subject to interest rate risk
Interest is subject to federal tax (but exempted from state andlocal taxes)
Bank rates
Prime rate – base rate on corporate loans postedby at least 75% of American 30 largest banks
Federal funds – reserve traded among commercialbanks in amounts of $1 mln or more
Discount rate – the charge on loans to depositoryinstitutions by the Federal Reserve banks
Prime rate
The Prime Interest Rate is the interest rate charged
by
banks
to
their
most
creditworthy
customers
(usually
the
most
prominent
and
stable
business
customers).
The
rate
is
almost
always
the
same
among
major
banks.
Adjustments
to
the
prime
lending
rate
are
made
by
banks
at
the
same
time;
although,
the
prime
rate
does
not
adjust
on
any
regular
basis.
Financial instruments issued by corporations:
goals
To finance operations
To invest in new projects
To repay debt or repurchase shares
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Commercial paper – short-term debt with maturity
of not more than 270 days
Issued by larger, known corporations (GE – $80 bln)
Financial instruments issued bycorporations: CPs
Higher rates than comparable Treasury bills
because of smaller default risk and less liquidity
than government securities
Corporate bond – long-term debt security, promising abondholder interest payments on a regular basis andpayback of a par (face) value at maturity.
Maturities
Financial instruments issued bycorporations: bonds
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Intermediate-term: 5-10 years
Long-term: 10-20 years
Exceptions: Ford and Disney – 100 years
Interest is quoted as a percentage from face value
Financial instruments issued by corporations:
bonds ratings
Moody’s S&P Meaning Expected
return
Investment grade
Aa AA High quality Lower
A A Favorable Middle
Baa BBB Medium-grad
Middle/Upper
Financial instruments issued by corporations:
bonds ratings
Moody’s S&P Meaning Expected
return
Speculative grade
element
B B Not
desirable.Smal
l long-term
assurance of
payments
Higher
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Financial instruments issued by corporations:
bonds ratings
Moody’s S&P Meaning Expectedreturn
Speculative grade
Caa CCC Poor standing, Very high
Default or danger of
default
Ca CC Highly speculative
standing
C C Very speculative.
Very poor prospects
of ever attaining
investment standing
D In default
Junk bonds – bonds with below investment grade
rating
High yield (high risk) bonds
Financial instruments issued bycorporations: bonds ratings
Corporate bonds
Debentures-unsecured debt. Backed only by the general
assets of the issuing corporation
Secured debt (mortgage debt) – secured by specific
assets
Subordinated debt – in default, holders get payments
only after other debtholders get their full payment
Senior debt – in default holders get payment before
other debtholders get.
Corporate bonds
Bonds that pay face value at maturity and no
payment until then
Sell today at a discount from face value
Taxed based on accrued interest
No reinvestment risk or reinvestment cost
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Financial instruments issued by corporations:
common stocks
The common stockholders are the owners of the
corporation’s equity
Do not have a specified maturity date and the firm
is not o ige to pay ivi en s to s are o ers
Returns come from dividends and capital gains
Common stockholders are called the residual
claimants of the firm
Stockholders have only limited liabilities
Financial instruments issued bycorporations: common stocks
Derivative securities
Securities whose value is derived from the value of
some underlying asset
Most important derivatives are options and futures
. ,
method of compensation
The basic borrowing interest rate for Eurodollar loanshas long been tied to the
London Interbank Offered Rate (LIBOR) – theaverage of Interbank offered rates for
International Financial Markets
urocurrency eposits in on on mar et