SOM 122 Exam 2 (Finance)

Finance activities

1. establish budgets and financial controls

2. determine long-term investments

3. analyze cash flows

4. plan the expenditure of funds

5. manage the firm’s financial risks

Titles of the top Financial Manager (highest → lowest)

1. Chief Financial Officer (CFO)

2. Vice President

3. Treasurer

4. Controller

Risk-return Trade-off

financial managers continually try to balance the firm’s investment risk with the expected return, or payoff, from its investments

What does financial managers do?

• Oversee bill payment

• oversee collection of money owed

• minimize taxes

• monitor accounting

3 purposes of financial managers activities

1. solvency: being able to pay debts when they become due

2. efficiency: managing money in the optimum way

3. end goal is profitability

3 parts of a firm’s financial plan

1. forecasting

2. budgeting

3. financial controls

Forecasting

there are 3 types of forecasts: cash flow, short-term, and long-term

Cash Flow Forecasts

Predictions about money flows in the next one to three months

Short-Term Forecasts

Predictions for the next year or less

Long-Term Forecasts

Predictions for the next 1, 5, or 10 years

Budgeting

a detailed financial plan showing estimated revenues and expenses for a particular future period, usually one year

4 types of budgets

1. operating budgets

2. capital budgets

3. cash budgets

4. master budgets

Operating Budgets

identify a firm’s sales and production goals and specify the cost required to meet those goals

Capital Budgets

estimate a firm’s expenditures for purchasing long-term assets that require significant sums of money

• such as buildings, machinery, and equipment

Cash Budgets

forecast cash inflows and outflows for a stated period, usually 1-3 months

• show management where it may have cash shortages or surpluses through the year

Master Budgets

tie together operating, capital, and cash budgets-to present the company’s overall plan of action for a particular time period

Financial Budgets

are capital budgets and cash budgets

Financial control

compares of actual revenues and expenses with those predicted in the budget

4 reason firms borrow money

1. managing everyday business activities

2. extending credit to their customers

3. keeping enough product (inventory) available

4. making major investments

Sources of short-term financing

• trade credit

• short-term loans

• pledging and factoring

• commercial paper

Trade Credit (short-term)

firms buy a product, then receive a bill from the supplier, then pay it later, usually in 30 to 90 days

Net Period

the length of time for which the supplier (the seller) extends credit

What is the most common form of trade credit?

promissory note

Promissory Note

a written contract prepared by the buyer who agrees to pay the seller a certain amount by a certain time

Secured loan (short-term)

the borrower pledges some sort of asset, such as personal property, that is forfeited if the loan is not repaid (collateral)

Unsecured loan

borrower does not pledge some sort of asset as collateral

• lenders normally make unsecured loans only to people they have known a long time

Interest Rate

the price paid for the use of money over a certain period of time

Sources of short-term loans

• family and friends

• banks and finance companies

• credit cards

• angel investors (individuals who invest their own money in a private company, typically a start-up)

• crowdfunding (funding a project or venture by raising money from a large number of people, typically through an online site)

What percentage of small businesses reseve their loans from commercial banks?

50%

Commercial finance companies

organizations willing to make short-term loans to borrowers who can offer collateral

Types of Loans Available from Banks

• line of credit

• revolving credit agreement

• transaction loans

Line of Credit

a bank specifies how much it is willing to lend the borrow during a specified period of time

Revolving Credit Agreements

the bank guarantees the loan and is obligated to loan funds up to the credit limit

Transaction Loans

a credit extended by a bank for a specific purpose

Pledging Accounts Receivable

a firm uses its accounts receivable as collateral to obtain a short-term loan

Factoring Accounts Receivable

a firm sells its accounts receivable at a discount to a financial institution

Commercial Paper

consist of unsecured, short-term promissory notes

• issued by large banks, corporations, insurance companies, pension funds, public utilities, and state and local governments

usually become due in 30 to 90 days

• interest rates are less than those charged by commercial banks

3 sources of long-term financing

• long-term loans

• debt financing

• equity financing

Long-Term Loans

Borrowing from financial institutions

• generally require repayment in 3-7 years

Who do you receive long-term loans from?

commercial banks, life insurance companies, pension funds, and commercial finance companies

Term-Loan Agreement

a promissory note indicating specific installments, such as monthly or yearly for repayment

Debt Financing

Issuing bonds, secured, and unsecured

Bonds

contract between the issuer and buyer in which the purchase price represents a loan by the buyer and for which the issuing firm pays the buyer interest

Indenture Terms

terms of the bond lending agreement

Equity Financing

involves selling ownership in the firm

• selling stock

• retaining earnings and reinvesting them in the firm

• receiving venture investment capital

Selling Stock (Equity Financing)

selling ownership shares in a firm

Private Placement (Selling Stock)

selling stock to only small group of large investors

Public Offerings (Selling Stock)

selling stock to the general public in securities market

Retaining Earnings (Equity Financing)

Reinvesting profits in the firm

• retained earnings = net profits - dividend payments made to stockholders

Receiving Investment Capital (Equity Financing)

getting money from wealthy individuals and institutions

• venture capital

Financial Leverage, or simple leverage

the technique of using borrowed funds to increase a firm’s rate of return

Peer-to-Peer Lending (P2P)

individuals generate income from interest payments, borrowers have access to financing they may not be approved for by traditional lending institutions

5 Characteristics of Money

• portability

• divisibility

• durability

• uniqueness

• stability

3 Functions of Money

• medium of exchange

• store of wealth

• standard of value

Who produces coins?

U.S. Mint

Who produces paper money?

Bureau of Engraving and Printing

Money Supply

the amount of money the Federal Reserve System makes available for people to buy goods and services

2 ways money supply is referred

• M1: the narrowest measure

• M2: more generous and more commonly used measure

M1 (money supply)

money that can be accessed quickly and easily

• currency, traveler’s checks, bank checking account balance, and the balance in other demand deposit accounts

M2 (money supply)

1. money that can be accessed quickly and easily (M1) and

2. money that takes more time to access

• small time deposits, various saving accounts, certificates of deposit (CD), money market accounts, and mutual funds

Time Deposits

bank funds that can’t be withdrawn without notice or transferred by check

• saving accounts

Federal Reserve System Structure

• the board of governors

• federal reserve banks

The Board of Governors

seven members appointed by the president for 14-year terms

• chairperson works with the board to set monetary policy

Federal Reserve Banks

made up of 12 administrative districts, each with its own Federal Reserve bank

Commercial Bank

a federal-or state- chartered profit-seeking financial institution that accepts deposits from individuals and businesses and uses part of them to make person, residential, and business loans

How does the Fed get money to commercial banks

• making currency available

• making loans available

too much money in the money supply

leads to inflation

too little money in the money supply

leads to deflation

How the Fed Control the Money Supply

1. the reserve requirement

2. open-market operations

3. the discount rate

Reserve Requirement

an increase or a decrease in the percentage of deposits banks must reserve as cash

• infrequently used

• increase reduces the money supply, raises interest rates, and slows economic growth

• decrease increases the money supply, lowers interest rates, and speeds up economic growth

Open-Market Operations

sells bond to the public or buys bonds from the public

• frequently used

• sell bonds reduces the money supply, raises interest rates, and slows economic growth

• buy bonds increases the money supply, lowers interest rates, and speeds up economic growth

Discount Rate

increases or decreases the rate it charges banks for loans

• only used with open-market operations

• increase discount rate reduces the money supply, raise interest rates, and slows economic growth

• decrease discount rate increase the money supply, lowers interest rates, and speeds up economic growth

Electronic Funds Transfer Systems (EFTSs)

computerized systems that move funds from one institution to another over electronic links

• allows online bill paying, automatic deposit systems, and online banks offering same-day money transfers

The banking system consists of:

1. banks: commercial banks, saving institutions, and credit unions

2. nonbank institutions: offer some banking service-insurance companies, pension funds, finance companies, and brokerage firms

Types of Deposit Accounts

1. checking

2. savings

3. NOW

4. money market

5. certificate of deposit (CD)

Checking Accounts

accounts that pay no interest and allow check writing

Saving Accounts “near money”

Accounts that pay low interest and don’t allow check writing

NOW Accounts (negotiable order of withdrawal)

minimum-balance accounts that pay interest and allow unlimited check writing

Money Market Accounts

Accounts that pay brokerage-competitve interest and offer some check writing

Certificate of Deposit (CD)

Saving accounts that pay interest upon a certificate’s maturity date

• agrees not to withdraw funds until that date

How Commercial Banks Make Money

1. by charging interest on loans

2. by charging fees for other services

3. by offering other financial products

Saving and Loan Associations

financial institutions that accept deposits and were originally intended to make loans primarily for home mortgages

Mutual Saving Banks

for-profit institutions similar to saving and loans, except that they are owned by their depositors rather than by shareholders

Credit Unions

depositor-owned nonprofit financial cooperatives that offer a range of banking service to their member

Insurance Companies (nonbanks)

nondeposit companies that accept payments from individuals or firms who have purchased insurance policies that guarantee financial protection in the even something goes wrong

Pension Funds (nonbanks)

nondeposit institutions that provide retirement benefits to workers and their families

Finance Companies

nondeposit companies that make short-term loans at higher interest rates to those who can’t meet regular bank requirements

Brokerage Firms

companies that buy and sell stocks and bonds for individuals and offering high-interest-rate checking and saving accounts

3 Major Sources of Protection for Money

• The Federal Deposit Insurance Corporation (Protection for Banks) (FDIC)

• The Savings Association Insurance Fund (Protection for Savings and Loans) (SIAF)

• The National Credit Union Administration (Protection for Credit Unions) (NCUA)

The Federal Deposit Insurance Corporation (Protection for Banks) (FDIC)

an independent agency of the U.S. government that insures bank deposits up to $250,000

• covers mostly commercial banks

The Savings Association Insurance Fund (Protection for Savings and Loans) (SAIF)

insures up to $250,000 per depositor per bank

The National Credit Union Administration (Protection for Credit Unions) (NCUA)

an independent federal agency that provides up to $250,000 insurance coverage per individual per credit union

FinTech

used to describe the integration of technology and finance

Blockchain

A decentralized digital ledger technology that records transactions across multiple computers in a secure and immutable manner

Cryptocurrency Considerations

• Market Volatility: extreme price fluctuation

  • can lead to high returns, but also significant losses in short period

• Regulatory Changes: The legal status and regulations governing cryptocurrencies are still evolving, which can lead to market uncertainty and potential impact on value and legality

• Security Concerns: despite blockchain tech, cryptocurrency investments are still vulnerable to cyber threats, including hacking and fraud

• Technological Complexity: makes it challenging for some investors to fully understand and manage their crypto assests