16

chapter Managing Finances

Business Essentials, 7th Edition

Ebert/Griffin

Instructor
Lecture
PowerPoints
PowerPoint Presentation prepared by
Carol Vollmer Pope Alverno College

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mechanical, photocopying, recording, or otherwise, without the prior written
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 LEARNING OBJECTIVES

After reading this chapter, you should be able to:

1. Explain the concept of the time value of money and the
principle of compound growth.
2. Identify the opportunities offered by mutual funds and
exchange-traded funds.
3. Describe the role of securities markets, and identify the
major stock exchanges and stock markets
4. Explain how securities markets are regulated and tracked.

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 L E A R N I N G O B J E C T I V E S (cont’d)
After reading this chapter, you should be able to:
5. Describe the risk-return relationship, and
discuss the use of diversification and asset
allocation for investments.
6. Describe the various ways firms raise capital
and identify the pros and cons of each method.
7. Identify the reasons a company might make an
initial public offering of its stock, and explain
how stock value is determined.

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 What’s in It for Me?

• By understanding the material in this chapter, you

will understand the various ways individuals gather,
either in person or, increasingly, online looking for
ways to make their money work for them.
• This chapter will help you learn ways to make your
money work for you
– Whether your goals are long- or short-term
– Whether you are motivated by profit or security
– Or simply because you enjoy the challenges inherent in
investing
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 The Time Value of Money

• The time value of money is the most

important concept in business finance
– While money is invested, it grows, earning interest
or yielding some form of return
– This stems from the concept of compound growth
• The time value of money paid to investors over given
time periods

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FIGURE 16.1 The Amount to Which an Initial
$10,000 Investment Grows

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 The Rule of 72

• The rule of 72 is an interesting concept.

– If we want to double our money, how many years
will it take?
• Divide 72 by the interest rate you will receive.
– Also, if you want to know how long it will take to
double your money, divide 72 by the number of
years in which you want this to occur.

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 Common Stock
• A stock is a portion of ownership in a company
– The ownership of the company is divided into small parts
called shares
– These shares can be bought or sold
• This determines who owns what percent of the company
– The most common form of shares is called common stock
• Shares are purchased in the hope that they will increase in value
– Common stock is normally valued in two ways:
• Market value
• Book value

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 Common Stocks (cont’d)

• Investment traits of common stock

– Most risky form of investment
– Offer high growth potential
– Also vary the most with changes in the stock
market
• Dividends
– A payment made to shareholders on a per share
basis from the company’s earnings.

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 Mutual and Exchange Traded Funds

• Mutual Funds and Exchange Traded Funds

– Alternatives to stock
– Easy to purchase with small sums of money
• Mutual funds
– Created by investment firms
– Pool cash investments into various investments to
create a portfolio
– Grow in value across time and produce income

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 Reasons for Investing
• Why should a person or business invest in the
market?
– Stability and safety
• Money market mutual funds preserve capital and
provide more current income
– Conservative capital growth
• Balanced funds stress preservation of capital and
current income, as well as some growth
– Aggressive growth
• Aggressive growth funds seek maximum long-term
growth
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 Exchange Traded Funds
• Exchange traded funds are a bundle of stocks and
bonds that are in an index that tracks the overall
movement of a market
– Unlike mutual funds, they can be traded like stocks
• Advantages of ETFs:
– Can be traded throughout the day like stocks
– Have lower operating costs than mutual funds
– Don’t require large amounts of investment

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 Securities Markets
• Securities
– Represent secured, or financially valuable, claims on the part
of investors
• Securities Markets
– Markets in which stocks and bonds are sold
• Stock
– Represents an ownership claim on the assets of a corporation
• Bond
– Represents a financial claim of money owed by a company to
the bondholder

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 Primary and Secondary Securities Markets
• Primary Securities Markets
– The market in which new stocks and bonds (but not
mutual funds) are bought and sold by firms and
governments
• Secondary Securities Markets
– Where existing stocks and bonds are traded
• Securities and Exchange Commission (SEC)
– The government agency that regulates U.S. securities
markets
– New securities must be approved by the SEC

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 Primary and Secondary Securities Markets (cont’d)

• Investment banks help bring new securities to

the market by:
– Advising companies on the timing and financial
terms of new issues
– Underwriting—or buying—new securities, bearing
some of the risks of issuing them
– Distributing new securities through banks and
brokers to individual investors

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The Major Exchanges and Markets

New York Stock Global Stock

Exchange Exchanges

American
Stock
Exchange

Regional Stock NASDAQ

Exchanges

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 The Major Exchanges and Markets (cont’d)
• The New York Stock Exchange
– For many people, “the stock market” means the New York
Stock Exchange (NYSE)
• The American Stock Exchange (AMEX)
– The second-largest floor-based U.S. exchange is also
located in New York City
• Regional Stock Exchanges
– Seven regional stock exchanges were organized to serve
investors in places other than New York
• Global Stock Exchanges
– The value of shares listed on foreign exchanges continues
to grow
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TABLE 16.1 Selected Global Stock Exchanges and
Markets

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 The Major Exchanges and Markets (cont’d)

• National Association of Securities Dealers

Automated Quotation (NASDAQ) system
– The world’s oldest electronic stock market
– Orders are gathered and executed on a
computer network
• Electronic communication networks have
allowed for:
– Cross-border ownership
– International consolidation of markets

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 Individual Investor Trading
• Stock Brokers
– Earn commissions by executing buy-and-sell orders from
nonexchange members
• Discount Brokers
– Offer lower fees to investors than do full-service stock brokers
• Full-Service Brokers
– Offer full services to investors who do not have the time to
manage their own portfolios
• Online Trading
– Conditions favoring online trading
• Convenient access to the Internet
• Fast, no-nonsense transactions
• Opportunity for self-directed investors to manage their own
investments while paying low fees for trading
• Ownership records have been helped by book-entry ownership

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 Market Indexes

Dow Jones Industrial Average

The S&P The NASDAQ

500 Composite
The Russell Index-matching
2000 FTFs
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 Market Indexes
• The Dow Jones Industrial Average (DJIA)
– The most widely cited U.S. market index
– Measures the performance of financial markets
by focusing on 30 blue-chip companies as
reflectors of economic health
• The S&P 500 Composite Index
– Consists of 500 stocks, including 400 industrial
firms, 40 utilities, 40 financial institutions, and 20
transportation companies

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 Market Indexes (cont’d)
• NASDAQ Composite Index
– All NASDAQ-listed companies are
included in the index, for a total of
more than 3,300 firms (both
domestic and foreign)
• The Russell 2000
– A specialty index that measures the
smallest companies based on
market capitalization
• Index matching ETFs
– Includes countless other specialty
indexes

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FIGURE 16.2 Bull and Bear Markets

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 The Risk Return Relationship

• Each type of investment has a risk return

relationship
• There are three main types of returns:
– Dividends
– Price appreciation
– Total return

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FIGURE 16.3 Uncertainty About Financial
Returns on Investments

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 Reducing Risk With Diversification and Asset
Allocation
• Diversification
– Buying several different kinds of investments, rather than
just one, so that the risk of loss is reduced by spreading
the total investment across more stocks
• Asset Allocation
– The proportion—the relative amounts—of funds invested
in (or allocated to) each of the investment alternatives
• Performance Differences for Different Portfolios
– A portfolio is the combination of all the investments—
stocks, bonds, real estate, and mutual funds
– Portfolios have different investment objectives, and can be
managed through asset allocation

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 Financing the Business

• Secured loans for equipment

– Businesses usually need some financing to start
operations
– Secured loans provide capital for such loans
• With a secured loan, the borrower needs to guarantee
repayment
• The loan needs to be secured by pledging the asset as
collateral to the lender
• If the borrower defaults and doesn’t pay the loan, the
lender can claim the equipment in lieu of payment

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 Financing the Business (cont’d)
• Principal and Interest Rates
– Loan Principal is the amount of money that is
owed on a loan
– Interest is also paid at an annual percentage rate
(APR) agreed to by the commercial lender and the
borrower
• Interest is a fee paid by the borrower to the lender for
the use of the loan principal

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Working Capital and Unsecured Loans from Banks

• Firms need cash to operate their businesses

• Working capital = Current assets – current liabilities
– If the result of this equation is positive, the working capital is positive
for the firm and they are able to cover operating expenses
– If the result of this equation is negative, the firm may need to borrow
funds in the short term to pay operating expenses
• Unsecured loans from banks can be obtained without
pledging collateral
– Firms need a good credit rating to obtain this type of loan
– They may be required to keep a portion of the loan balance—called a
compensating balance—in a separate, non-interest-bearing account
with the bank

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 Angel Investors and Venture Capital
• Once a business is started, it may need additional
capital
• Angel investors are a source for this type of
investment
– Angel investors are usually wealthy individuals or
corporations that seek to invest in a new business
– Angel investors require a sizeable return, perhaps up to
50% ownership of the company, in exchange for their
investment
– Angel investors provide what is called venture capital
– In general, firms turn toward angel investors and venture
capital when they are too new to have established credit
with a commercial bank

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 Sale of Corporate Bonds

• Corporations can raise capital by selling

corporate bonds
• A corporate bond is a formal pledge (IOU)
obligating the issuer to pay interest
periodically and repay the principal at
maturity (a preset future date) to the lender
• The government also offers municipal bonds

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 Characteristics of Corporate Bonds
• A bondholder has no claim to corporate ownership
• Each new bond has a bond indenture
– This sets forth the borrower’s obligations
– As well as the financial returns for lenders
• An important point for a bond is its maturity date
– This is the date by which the company must repay the face value (or
par value) of the bond to the lender
• Bond default
– A bond is in default when it fails to make payment to the lender
– If this occurs, the bondholders can file a bondholders’ claim
– If the company cannot pay back its debt, it may declare bankruptcy,
which gives the company relief from repaying some or all of its debts

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TABLE 16.2 Bond Ratings Systems

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 Becoming a Public Corporation
• Initial Public Offerings (IPOs) are a significant form of
funding for corporations
– IPOs are the first sale of a company’s stock to the general
public
• Going public means selling off part of the company
– Means giving up control of some of the company
– Large investors can become corporate raiders

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 Stock Valuation
• Stock valuation
– Prices of stocks vary in value due to many factors
• Why do prices of stocks vary?
– The price of a stock depends on the demand for
and supply of a specific company’s stock
– The corporation may want the stock to be valued
in a specific price range
• Stock split: If the price of a company’s stock gets too
high, it can restore it to its original range by paying a
special dividend in shares of stock to its shareholders

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TABLE 16.3 Financial Comparison
of Coca-Cola and PepsiCo

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TABLE 16.4 Corporation Sizes Based
on Capitalization

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 Pros and Cons of Debt Financing

• Debt financing
– Long-term borrowing from sources outside the
company
– Major source of funding
– Long-term loans are attractive:
• Speed of availability due to limited parties involved
• No public disclosure required

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 Pros and Cons of Equity Financing
• Equity financing
– Looking inside the company for funding sources
• The expense of common stock
– Paying dividends to shareholders is more
expensive than paying interest on corporate
bonds
• Retained earnings as a source of capital
– Means smaller dividends to shareholders
– Means no interest paid on debt

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 Key Terms

aggressive growth funds corporate raiders

Amex debt financing
angel investors default
asset allocation discount brokers
balanced funds diversification
bear market dividends
bond indenture electronic communication networks
bondholders’ claim equity financing
bond rating systems exchange traded funds
bonds face value
book entry ownership full-service brokers
book value initial public offering
bull market interest
collateral investment banks
common stock compound growth loan principal
corporate bond
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 Key Terms (cont’d)

market capitalization shares

market value stock
stock brokers
maturity date
stock split
money market mutual funds
time value of money
mutual funds unsecured loan
NASDAQ venture capital
NYSE working capital
online trading shares
par value stock
portfolio stock brokers
risk return relationship stock split
rule of 72 time value of money
secured loan unsecured loan
securities venture capital
securities market (primary and working capital
secondary)
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