1. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. Chapter 17 Financial Management and Institutions

2. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-2 The Role of the Financial Manager Finance—business function of planning, obtaining, and managing a company’s funds in order to accomplish its objectives in the most effective possible way. Finance manager—responsible for the firm’s financial plan and determining the most appropriate sources and uses of funds.

3. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-3 Organizational Structure of the Finance Function

4. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-4 The Role of the Financial Manager Address the risk-return trade-off – optimal balance between the expected payoff from an investment and the investment’s risk. Risk- uncertainty about gain or loss Return - The gain or loss of a security in a particular period

5. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-5 The Financial Plan Document specifying the funds a firm will need for a period of time, the timing of inflows and outflows, and the most appropriate sources and uses of funds.  What funds will the firm require during the appropriate period of operations?  How will it obtain necessary funds?  When will it need more funds?

6. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-6 Money—anything generally accepted as payment for goods and services. Characteristics of Money Difficulty in Counterfeiting: Currency should be hard for anyone, other than the government, to produce Stability: Should maintain a relatively stable value Portability: Ability to be easily moved from place to place Durability: Ability to survive repeated usage over time Divisibility: Ability to be broken down into smaller units

7. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-7 The New Color of Money

8. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-8 Characteristics and Functions of Money Basic Functions of Money

9. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-9 The Money Supply The money supply measures reflect the different degrees of liquidity—or spendability—that different types of money have. M1, the narrowest measure, is restricted to the most liquid forms of money (currency in the hands of the public; travelers checks; demand deposits, and other deposits against which checks can be written.) M2 includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds. Do not serve directly as a medium of exchange.

10. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-10 The Financial Planning Process

11. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-11 Why Organizations Need Money Generating Funds from Excess Cash Many financial managers invest the majority of their firms’ excess cash balances in marketable securities The most popular marketable securities include:  U.S. Treasury bills  Commercial paper  Repurchase agreements  Certificates of deposit

12. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-12 Sources of Funds Debt capital—funds obtained through borrowing. Equity capital—funds provided by the firm’s owners when they reinvest earnings, make additional contributions, or issue stock to investors.

13. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-13 Comparison of Debt and Equity Capital

14. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-14 Sources of Funds Short-Term Sources of Funds Short-term sources of funds are repaid within one year Major sources of short-term funds include:  Trade credit  Short-term loans  Commercial paper

15. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-15 Sources of Funds Long term Sources of Funds Long-Term Loans Public Sale of Stock Public Sale of Bonds

16. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-16 Sources of Funds Long term Sources of Funds Private Placements—stock or bond issues sold to a small, select group of large investors such as pension funds and life insurance companies Venture Capitalists—raise money from wealthy individuals and institutional investors and invest these funds in promising firms

17. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-17 How Leverage Works Leverage — using borrowed funds, debt, to attempt to increase returns  The key is ensuring that the company’s earnings remain larger than its interest payments,

18. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-18 Financial System—process by which funds are transferred from savers to users.

19. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-19 The Financial System and Financial Institutions Depository Institutions—financial institutions that accept deposits that customers can withdraw on demand. Nondepository Financial Institutions Accept funds from businesses and households, much of which they then invest (do not offer checking accounts)  Insurance Companies  Pension Funds  Finance Companies

20. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-20 The Financial System and Financial Institutions Commercial Banks How Banks Operate  Banks raise funds by offering checking and savings accounts  They then pool these deposits and lend most of them out to consumers and businesses

21. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-21 The Financial System and Financial Institutions Bank Regulation Who Regulates Banks?  State chartered banks are regulated by the appropriate state banking authorities  Most are federally insured, and also subject to FDIC regulation  Federally chartered banks are regulated by the Federal Reserve, the Federal Deposit Insurance Corporation, and the Comptroller of the Currency

22. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-22 The Financial System and Financial Institutions Bank Regulation Federal Deposit Insurance  Deposits are insured by the FDIC up to a set amount – currently $100,000  Federal deposit insurance was enacted by the Banking Act of 1933 to restore public confidence in the banking system

23. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-23 The Federal Reserve System (Fed) Central bank of the United States. Has four basic responsibilities: 1.Regulating commercial banks 2.Performing banking-related activities for the U.S. Treasury 3.Servicing member banks 4.Monetary policy

24. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-24 The Federal Reserve System Organization of the Federal Reserve System Nation is divided into 12 federal reserve districts, each with its own Federal Reserve Bank Each district Bank supplies banks within its district with currency and facilitates the clearing of checks District banks are run by a nine-member board of directors

25. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-25 The Federal Reserve System Board of Governors – governing body of Fed The board consists of 7 members, appointed by the president and confirmed by the Senate The Fed is designed to be politically independent  Fed Governors are appointed to 14-year terms – staggered so that a president could not appoint a majority during a single term Federal Open Markets Committee (FOMC)  Sets most policies regarding monetary policy and interest rates.

26. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-26 The Federal Reserve System Monetary Policy — managing the growth rate in the supply of money and credit, usually through the use of interest rates. Fed’s job is to ensure that the money supply grows at an appropriate rate allowing the economy to expand and inflation to remain in check If money supply grows too slowly economic growth will slow, unemployment will increase, and the risk of recession will increase If the money supply grows to rapidly, inflationary pressures build

27. Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 17-27 Federal Reserve Tools Tool Brief Description Impact on the Growth Rate of the Money Supply Impact on Interest Rates and the Economy Frequency of Use Reserve Requirement Change in the % of deposits held as reserves. Increase – slows the growth rate of the money supply. Increase – push interest rates up and slows economic growth. Rarely. Discount Rate Change in the rate the Fed charges banks for loans. Increase – slows the growth rate in the money supply. Increase – push interest rates up and slows economic growth Used only in conjunction with open market operations. Open market operations Buy & sell government securities to increase or decrease bank reserves. Selling -reduces bank reserves and slows the growth rate in the money supply. Selling – push interest rates up and slows economic growth. Frequently.