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© 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Modern Issues in Finance
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Modern Issues in Finance
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Risk Management and the Financial
Crisis
• Reasons for recent financial crisis
• Unwarranted extension of credit
• 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
• New regulations for financial institutions
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The Dodd-Frank Act
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Functions of the Financial Manager
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Risk-Return Trade-Off
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Forms of Organization
• Sole Proprietorship
• Represents single-person ownership
• Advantages
• Simplicity of decision-making
• Low organizational and operational costs
• Drawback — unlimited liability to owner
• Profits and losses taxed as though they belong to
individual owner
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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 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 financial institutions extend funds to
limited partnership firms
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Forms of Organization
• Corporation
• Unique; legal entity unto itself
• Formed through articles of incorporation, which
specify rights and limitations of entity
• Owned by shareholders who enjoy limited liability
• Has continual life
• Key feature – easy divisibility of ownership
interest by issuing shares of stock
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Forms of Organization
• Corporation (cont’d)
• Disadvantage
• Potential of double taxation of earnings
• S corporation
• Income taxed as direct income to stockholders, thus
taxed only once as normal income
• Limited liability company (LLC)
• Provides limited liability for the owners
• Can be taxed as sole proprietorship, partnership,
corporation, or S corporation, depending upon elections
made by owners
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Corporate Governance
• Agency theory
• Examines relationship between owners and
managers of firm
• Institutional investors
• Have more to say about how publicly-owned
companies are managed
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Sarbanes-Oxley Act
• Set up five-member Public Company Accounting Oversight
Board (PCAOB) with responsibility for
• 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
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Management and Stockholder Wealth
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Valuation Approach
• Ultimate measure of performance – how earnings are
valued by investor
• In analyzing firm, investor will consider
• Risk inherent in firm’s operation
• Time pattern over which firm’s earnings increase or
decrease
• Quality and reliability of reported earnings
• Finance manager must question impact of each
decision on firm’s overall valuation
• If decision maintains or increases firm’s overall value, it
is acceptable; otherwise, it should be rejected
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Social Responsibility and Ethical Behavior
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Social Responsibility and Ethical Behavior
• Insider trading
• Using information not available to public, making
undue profit from trading
• Unethical and illegal practice
• Protected against by SEC
• Ethical behavior creates invaluable reputation
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Role of Financial Markets
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Structure and Functions
of the Financial Markets
• Distinct parts of financial markets
• Domestic and international markets
• Corporate and government markets
• Money and capital markets
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Structure and Functions
of the Financial Markets
• 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
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Structure and Functions
of the Financial Markets
• Capital markets
• Deal with securities that have life of more than
one year
• Long-term markets
• Securities include
• Common stock
• Preferred stock
• Corporate and government bonds
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Allocation of Capital
• Primary market
• When corporation uses financial markets to raise
new funds, sale of securities made through new
issue is called initial public offering (IPO)
• Secondary market
• Securities bought/sold amongst investors
• Prices of securities keep changing continually
• Financial managers given feedback about firms’
performance
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Return Maximization
and Risk Minimization
• Investors 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/capital markets at lower cost than
competitors
• Firms pay penalty for failing to perform
competitively
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Restructuring
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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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Technological Impact
on Capital Markets
• Cost reduction in trading securities
• Consolidation among major stock markets and
mergers of brokerage firms with domestic and
international partners
• Creation of electronic communication
networks (ECNs)
• Electronic markets like NASDAQ have gained
popularity against traditional organized
exchanges such as NYSE
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