Ch.1 Overview of Financial
Management and Financial
Environment
1. Types of Business Organization:
1) Sole proprietorship
2) Partnership
3) Corporations
4) Hybrid
1) Sole proprietorship
Advantages:
- Easily and inexpensively formed
- Subject to few government regulations
- Avoid corporate income tax
Limits:
- Unlimited personal liability
- Limited to the life of the individual who create
- Difficult to obtain large sums of capital
2) Partnership – more than one owner.
Advantages:
- Easy and inexpensive to set up
Limits:
- Unlimited liability
- Limited life
- Difficult to transfer ownership
• Limited partnership has limited partners and general partners.
Limited partners do not involve in management and can lose only
his or her investment whereas general partners involve in
management and have unlimited liabilities. In both regular and
limited partnerships, at least, one partner is liable for debts of the
partnership. However, in a Limited Liability Company or Limited
Liability Partnership, all partners enjoy limited liability regard to the
business liabilities and their potential losses.
3) Corporations
Separation of owners from management.
Advantages:
- Unlimited life
- Easy transferability of ownership
- Limited liabilities
Limits:
- Double taxations: corporate and individual levels
- More time consuming documentation and reports:
charter and a set of bylaws
• Charter includes; (1) name of proposed
corporation, (2) types of activities it will pursue,
(3) amount of capital stock, (4) number of
directors, (5) names and addresses of directors.
This charter is filed with the secretary of the state
in which the firm will be incorporated.
• Bylaw includes; (1) how directors are elected, (2)
whether the existing stockholders will have the
first right to buy any new shares the firm issues,
(3) procedure for changing the bylaws.
- Different types:
• Professional Corporation (PC) or Professional
Association (PA). Though Corporation, it does
not allow to relieve professional liability (e.g.
malpractice of doctors, lawyers, etc).
• S Corporation: small size business and 100
owners. Taxed like a proprietorship.
• 2. Growing and managing a Corporation
• Agency problem: conflict of interest between
management and shareholders
• Corporate governance in order to address
agency problem. Here corporate governance
is a set of rules that control company’s
behavior towards its directors, managers,
employees, shareholders, creditors,
customers, competitors, and community.
3. Primary Objective of Corporation
• Stock holders elect directors who then hire
managers to run a corporation
• Goal of management is to maximize the
fundamental or intrinsic price of common
stock rather than the market price.
• Maximizing stock price also benefit social
welfare: (1) owners of stock are society, (2)
Consumer benefit resulting from high quality
and low cost, and (3) employees benefit, .etc
(1) Managerial actions to maximize
shareholder wealth
• Firm value is determined by a company’s
ability to generate free cash flows (FCF) now
and in the future. The improvement of FCF will
improve the intrinsic value of a firm.
• FCF = sale revenue – operating costs –
operating taxes – required new investments in
operating capital.
• Value =
𝐹𝐶𝐹 𝑛
∞
𝑛=1 (1+𝑊𝐴𝐶𝐶)𝑛
• Here WACC is weighted average cost of capital
4. An overview of the Capital
Allocation Process
• 1) Direct Transfers
• 2) Indirect Transfers though Investment
Bankers underwriting the security issues.
• 3) Indirect Transfer through a Financial
Intermediary such as banks and funds.
• Figure 1-1
5. Financial Securities
• 1) Major Financial Instruments (Table 1-1)
• 2) The process of securitization – mortgage
securitization:
• - S&L, banks or specialized mortgage
originating firms originate mortgage and sell
them to investment banks. The investment
bundle them into packages and then use
these package as collateral for bonds sold to
pension funds, insurance and other investors.
• Congress facilitated this process by creating two
stockholder-owned but government sponsored entities –
Federal National Mortgage Association (Fannie Mae) and
Federal Home Loan Mortgage Corporation (Freddie Mac)
which have a small amount of equity and a huge amounts
of debt.
• Since then, S&L and banks originate and pool mortgage and
then sell them to Fannie Mae which uses them as collateral
in order to sell bonds.
• This process (1) increases lendable funds, (2) transfer of risk
of mortgage to Fannie Mae, and (3) increases liquidity for
holders of the debts.
• This process benefit investors (lenders) through
diversification – bundled mortgage and an improved return.
6. Cost of money
Raised capital is not free.
• For debt, borrowers have to pay interest.
• For equity, firms have to pay dividends.
4 fundamental factors affecting the cost of money:
(1) Production opportunities: The returns available within an economy
from investments in productive assets
(2) Time preferences for consumption: The preferences of consumers
for current consumption as opposed to saving for future consumption.
(3) Risk: The chance that an investment will provide a lower or
negative return
(4) Inflation: The amount by which prices increase over time.
Economic conditions and policies that affect the cost of
money
(1) Federal reserve policy
FED controls money supply by:
- open market operation to buy or sell treasury securities
- discount rate
- reserve requirement
(2) Budget deficit or surplus: The larger the deficit, the more
money supply and the higher the interest rates
(3) Business activity
(4) International trade balance (deficit or surplus): The larger
the trade deficit, the more we must borrow and this will
drives up the interest rates
(5) International country risk
(6) Exchange rate risk
7. Financial Institutions
1) Investment banks: an organization that underwrites and
distributes new investment securities and helps businesses
obtain financing. It also provide consulting and advisory
services and brokerage services.
2) Deposit-taking financial intermediates
• Savings and Loan Association (S&Ls): accepted deposits
from many small savers and then loaned this money to
home buyers and consumers.
• Credit union: cooperative association whose members’
savings are loaned only to other members.
• Commercial bank: raise money from deposits or by issuing
stock or bonds to investors. Some one with a bank account
can write checks, use debit cards, etc. And investors can
receive dividends or interests.
3) Investment Funds
• Mutual funds: organizations that pool investor
funds to purchase financial instruments and
thus reduce risk through diversification.
- Money market funds: investment in low-risk
securities and allow investors to write checks
against their accounts.
• Exchange Traded Funds (ETFs): similar to mutual funds.
ETFs funds buy a portfolio of stocks of certain type and
then sell their own shares to the public.
• Hedge funds: similar to mutual funds.
- Limited to institution investors and small number of net
worth individuals.
- Mutual funds are registered and regulated by SEC but
hedge funds are less regulated.
- Minimum investment requirement ( $1 million).
• Private Equity Companies: they buy and then manage
entire firms.
- Limited to a small number of large investors.
- Tend to privatize public firms and then sell them later at
premium.
• 4) Insurance and Pension funds
• Pension funds: retirement funds. Primarily investing in
bonds, stocks, mortgages, and real estate.
• Life insurance companies: take premium and invest in
bonds, stocks, etc.
• 5) Regulation of Financial Institutions
• After repealing Glass-Steagall’s separation of
commercial and investment banking in 1999, huge
financial service corporations emerged. These financial
service corporations provide services of commercial
banking, S&Ls, Mortgage, investment banking, etc.
8. Financial Markets
1) Physical asset markets: goods, tangible assets,
real assets markets
Financial markets: claims on real assets (financial
securities)
2) Spot and futures markets: assets are bought or
sold for “ on the spot” or for delivery at some
future date.
3) Money markets: financial markets for short term
and high liquid debt securities.
Capital Market: financial markets for intermediate
or long term bonds and stocks.
4) Mortgage market: loans on residential, agricultural, commercial, and
industrial real estate.
Commercial credit market: loans on autos, appliance, education,
vacations, and so on.
5) World, national, regional and local market
6) Primary Markets: markets in which corporations raise capital by
issuing new securities.
Secondary market: markets in which existing, already outstanding,
securities are traded. Ex) NYSE
7) Private market: The market where transactions are worked out
directly between two parties. Ex) bank loan or private debt
placement
Public market: The market where standardized contracts are traded
on organized exchange. Ex) issuing securities or public debts
9. Trading Procedure
1) Two basic types of stock markets
• Physical location exchange: NYSE, AMEX and regional stock
exchanges
• Electronic dealer-based markets: Nasdaq, over the counter and
electronic communication networks (ECNs)
2) Matching buy and sell orders:
- Outcry auction: meet and communicate with shout and hand
signals. E.g) CBOT
- Dealers market: list bid and ask quotes and then contact a specific
dealer to match. E.g) NASDAQ
- Electronic communication network (ECN): post buy and sell prices
and then ECN automatically match with close prices. E.g) Instinet
and Archipelago.
• 3) Types of stock market transactions:
• - Going public and seasoned equity offering.
• 10. Secondary stock market
• 1) New York Stock Exchange
• Privately held firm owned by members and merged with
Archipelago in 2006. The merged one also has Pacific Exchange. The
combined one is called NYSE group and became a public firm.
• The NYSE group merged with Euronext in 2007 and became NYSE
Euronext.
• Formal organization having tangible physical locations that conduct
auction markets in designated (“listed”) securities.
• More than 300 members in NYSE had seats giving rights to trade on
the exchange. The trading license is also leased. Most of the larger
investment banks operate brokerage departments or members with
the leased trading licenses.
• 2) National Association of Securities Dealers (NASD) or
NASDAQ
• Self-regulatory body that licenses brokers and oversees
trading practices.
• Its own listing requirement.
• More than 400 dealers making a market, generating
good liquidity.
• Operate Nasdaq OTC Bulletin Board, which lists quotes
for stocks that are registered with the SEC but are not
listed on any exchange because of small size or less
profitability.
• Nasdaq operates Pink Sheet which provides quotes on
company that are not registered with SEC.
11. Stock market performance
• Figure 1-4.
• 12. The Global Economic Crisis
• Assignment 1: Summarize the section of “The
Global Economic Crisis” - page 36 to 45.