16 chapter Managing Finances Business Essentials 7 th

16 chapter Managing Finances Business Essentials, 7 th Edition Ebert/Griffin Instructor Lecture Power. Points Power. Point Presentation prepared by Carol Vollmer Pope Alverno College © 2009 Pearson Education, Inc.

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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. © 2009 Pearson Education, Inc.

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. © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

FIGURE 16. 1 The Amount to Which an Initial $10, 000 Investment Grows ©

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. © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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. © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

The Major Exchanges and Markets New York Stock Exchange Global Stock Exchanges American Stock

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 © 2009 Pearson Education, Inc.

TABLE 16. 1 Selected Global Stock Exchanges and Markets © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

Market Indexes Dow Jones Industrial Average The S&P 500 The NASDAQ Composite The Russell

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

FIGURE 16. 2 Bull and Bear Markets © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

FIGURE 16. 3 Uncertainty About Financial Returns on Investments © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

TABLE 16. 2 Bond Ratings Systems © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

TABLE 16. 3 Financial Comparison of Coca-Cola and Pepsi. Co © 2009 Pearson Education,

TABLE 16. 4 Corporation Sizes Based on Capitalization © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

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 © 2009 Pearson Education, Inc.

Key Terms aggressive growth funds Amex angel investors asset allocation balanced funds bear market bond indenture bondholders’ claim bond rating systems bonds book entry ownership book value bull market collateral common stock compound growth corporate bond corporate raiders debt financing default discount brokers diversification dividends electronic communication networks equity financing exchange traded funds face value full-service brokers initial public offering interest investment banks loan principal © 2009 Pearson Education, Inc.

Key Terms (cont’d) market capitalization market value maturity date money market mutual funds NASDAQ NYSE online trading par value portfolio risk return relationship rule of 72 secured loan securities market (primary and secondary) shares stock brokers stock split time value of money unsecured loan venture capital working capital © 2009 Pearson Education, Inc.