1. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Mastering Financial Management

2. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objectives 16-1Understand why financial management is important in today’s uncertain economy. 16-2Identify a firm’s short- and long-term financial needs. 16-3Summarize the process of planning for financial management. 16-4Identify the services provided by banks and financial institutions for their business customers.

3. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objectives 16-5Describe the advantages and disadvantages of different methods of short-term debt financing. 16-6Evaluate the advantages and disadvantages of equity financing. 16-7Evaluate the advantages and disadvantages of long-term debt financing.

4. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financial Management  Activities concerned with obtaining money and using it effectively  Can make the difference between success and failure for both large and small businesses  Financial management can be viewed as a two- sided problem The uses of funds often dictate the type or types of financing needed by a business The activities a business can undertake are determined by the types of financing available

5. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Need for Financial Management Proper financial management must ensure: Financing priorities are established in line with organizational goals and objectives Spending is planned and controlled Sufficient financing is available when it is needed A firm’s credit customers pay their bills on time and the number of past due accounts is reduced Bills are paid promptly The funds required for paying the firm’s taxes are available Excess cash is invested

6. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financial Reform After the Economic Crisis  President Obama signed the Dodd–Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010  New regulations will protect American families from unfair, abusive financial and banking practices

7. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Goals  Hold Wall Street firms accountable for their actions  End taxpayer bailouts  Tighten regulations for major financial firms  Increase government oversight Debate  Limiting executive pay and bonuses  Limiting the size of the largest firms  Curbing previously used speculative investment techniques Dodd–Frank Wall Street Reform and Consumer Protection Act

8. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Careers in Finance  Chief financial officer (CFO): High-level corporate executive who manages firm’s finances and reports directly to the company’s chief executive officer  Managers and employees in the finance area must: Have a strong background in accounting or mathematics Know how to use a computer to analyze data Be an expert at both written and oral communication

9. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short-Term Financing Money that will be used for one year or less Cash flow: Movement of money into and out of an organization Speculative production: Time lag between production and the selling of goods

10. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short-Term Financing Needs  Cash flow is the movement of money into and out of an organization  Speculative production refers to the time lag between the actual production of goods and when the goods are sold  To increase production

11. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Flow for a Manufacturing Business

12. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Long-Term Financing  Money that will be used for longer than one year  Involves large amounts of money

13. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Risk–Return Ratio  High risk decision should generate higher financial returns for a business  More conservative decisions generate lower returns

14. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Developing the Financial Plan  A financial plan is a plan for obtaining and using the money needed to implement an organization’s goals and objectives  Budget: Financial statement that projects income and/or expenditures over a specified future period  Cash budget: Financial statement that estimates cash receipts and cash expenditures over a specified period

15. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Three Steps of Financial Planning

16. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Budget for Stars and Stripes Clothing

17. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Budgeting for Financial Needs  Zero-base budgeting: Budgeting approach in which every expense in every budget must be justified  Capital budget: Estimates a firm’s expenditures for major assets and its long-term financing needs

18. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Identifying Sources of Funds  Four primary sources of funds: Sales revenue Equity capital: Money received from the owners or from the sale of shares of ownership in a business Debt capital: Borrowed money obtained through loans of various types Proceeds from the sale of assets

19. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Monitoring and Evaluating Financial Performance  Financial plans are implemented properly  Prevents minor problems from becoming major ones  Interim budgets may be prepared for comparison purposes

20. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Establishing Organizational Goals  An end result that an organization expects to achieve over a one- to ten-year period  Must be specific and measurable  Must be realistic

21. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financial Services Provided by Banks and Other Financial Institutions  Traditional banking services for business clients Checking accounts Savings accounts Short- and long-term loans  Electronic banking services  International banking services

22. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Savings and Checking Accounts  Provide a safe place to store money  Conservative means of investing  Certificate of deposit (CD): A document stating that the bank will pay the depositor a guaranteed interest rate on money left on deposit for a specified period of time  Check: Written order for a bank or other financial institution to pay a stated dollar amount to the business or person indicated on the face of the check

23. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Business Loans  Line of credit: Loan approved before the money is actually needed  Revolving credit agreement: Guaranteed line of credit  Collateral: Real estate or property pledged as security for a loan

24. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Basics of Getting a Loan  Know potential lenders  Fill out an application; submit a business plan and financial statements; compile references  Meet with loan officer  If denied, determine why

25. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Credit and Debit Card Transactions  For the merchant, credit and debit card transactions can be converted to cash and improve a firm’s cash flow  A debit card electronically subtracts the amount of a purchase from bank account when the purchase is made

26. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Electronic Banking Services  An electronic funds transfer (EFT) system is a means of performing financial transactions through computer terminal  EFT applications Automated teller machines (ATMs) Automated clearinghouses (ACHs) Point-of-sale (POS) terminals Electronic check conversion (ECC)

27. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. International Banking Services  Letter of credit: Legal document issued by a bank or other financial institution guaranteeing to pay a seller a stated amount for a specified period of time  Banker’s acceptance: Written order for a bank to pay a third party a stated amount of money on a specific date  Currency exchange

28. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sources of Short-Term Debt Financing Short-term debt financing is easier to obtain than long-term Shorter repayment period means less risk of nonpayment Amounts of short-term loans are smaller than long- term loans A close working relationship normally exists between borrower and lender

29. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sources of Unsecured Short-Term Debt Financing  Unsecured financing: Financing not backed by collateral  Trade credit: Financing extended by a seller who does not require immediate payment  Promissory notes: Written pledge by a borrower to pay a certain sum of money to a creditor at a specified future date Is legally binding and an enforceable contract Is a negotiable instrument

30. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Unsecured Bank Loan  Interest rates vary with each borrower’s credit rating  Prime interest rate: Lowest rate charged by a bank for a short-term loan  Compensating balance: 10 to 20 percent of the borrowed funds

31. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Commercial Paper  Short-term promissory note issued by a large corporation  Maturity date is normally 270 days or less  Interest rates are usually below that charged by banks for short-term loans  Secured only by the reputation of the issuing firm; no collateral is involved

32. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sources of Secured Short-Term Financing  Loans secured by inventory—Inventory is pledged as collateral Control of the inventory passes to the lender until the loan is repaid If the lender requires storage of inventory used as collateral in a public warehouse, the borrow pays storage fees  Loans secured by receivables—Amounts owed to a firm by its customers are pledged as collateral

33. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Factoring Accounts Receivable  A factor is a firm that specializes in buying other firms’ accounts receivable  Buys accounts receivable for less than their face value  Collects the full face value dollar amount when each account is due  The amount of profit the factor receives is based on the risk the factor assumes

34. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of Short-Term Financing Methods  Trade credit is the least expensive  Factoring of accounts receivable is typically the highest cost method

35. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sources of Equity Financing  For sole proprietorships or partnerships Owner or partners invest money in the business Venture capital  For corporations Sale of stock Use of profits not distributed to owners Venture capital

36. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Selling Stock  Initial public offering: When a corporation sells common stock to the general public for the first time  Primary market: Investors purchase financial securities directly from the issuer of the securities  Investment banking firm: Assists corporations in raising funds usually by helping to sell new issues of stocks, bonds, or other financial securities  Advantages of selling stock Firm does not have to repay money received from sale of stock Firm does not have to pay dividends to stockholders

37. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Secondary Market  The secondary market is for existing financial securities that are traded between investors  A securities exchange is a marketplace where member brokers meet to buy and sell securities  The over-the-counter (OTC) market is a network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange

38. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Types of Stock  Common stock: Stock whose owners may vote on corporate matters Claims on profits and assets are subordinate to the claims of others Stockholders are also asked to approve or disapprove of major corporate actions  Preferred stock: Stock whose owners usually do not have voting rights Claims on dividends and assets are paid before those of common-stock owners

39. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Retained Earnings  The portion of a corporation’s profits not distributed to stockholders  Considered a form of equity financing  Amount is determined by corporate management and approved by the board of directors

40. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Venture Capital  Venture capital is money invested in small firms that have the potential to become very successful and extremely profitable  Investors receive an equity or ownership position in the business and share in its profits  Generally, a venture capital firm consists of one of the following: Pool of investors Partnership established by a wealthy family Joint venture formed by corporations with money to invest

41. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Angel Investor  An angel investor is an investor who provides financial backing for small business startups or entrepreneurs  May be an entrepreneur’s family member or a wealthy friend  Often focused on helping an entrepreneur succeed rather than earning profits  Often provide more favorable financial terms when compared with venture capitalists, bankers, and other financial institutions Can become an owner with equity in the firm Become a lender like a bank or other financial institution

42. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Private Placement  A private placement occurs when stock and other corporate securities are sold directly to: Insurance companies Pension funds Large institutional investors  Often fewer government regulations  Cost is generally less  Terms between buyer and seller are negotiated

43. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sources of Long-Term Debt Financing  Financial leverage: Use of borrowed funds to increase the return on owners’ equity  As the firm’s earnings are larger than the interest charged for the borrowed money, there is a positive effect on return on owners’ equity

44. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Long-Term Loans  Term-loan agreement: Promissory note that requires a borrower to repay a loan in monthly, quarterly, semiannual, or annual installments  Interest rate and repayment terms are based on: Reasons for borrowing Firm’s credit rating Value of collateral

45. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Corporate Bonds  A corporate bond is a corporation’s written pledge that it will repay a specified amount of money with interest; interest rate impacted by: Corporation’s ability to pay interest each year until maturity Corporations ability to repay the bond at maturity  Registered bond: Bond registered in the owner’s name by the issuing company  Maturity date: Date on which a corporation is to repay borrowed money

46. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Risk–Return Ratio for Corporate Bond Investors High-quality corporate bonds pay less interest when compared to bonds that are more speculative

47. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Types of Bonds  Debenture bond: Bond backed only by the reputation of the issuing corporation  Mortgage bond: Bond secured by various assets of issuing firm  Convertible bond: Bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock

48. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Repayment Provisions for Corporate Bonds  Bond indenture: Legal document that details all the conditions relating to a bond issue  Corporation may use one of three methods to ensure that it has sufficient funds available to redeem a bond issue Issue serial bonds—Bonds of a single issue that mature on different dates Establish a sinking fund—Sum of money to which deposits are made each year for the purpose of redeeming a bond issue Sell new bonds

49. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost Comparisons  Although the initial flotation cost of issuing stock is high, selling common stock is generally a popular option for most financial managers  Once the stock is sold and upfront costs are paid, the ongoing costs of using stock to finance a business are low  The type of long-term financing that generally has the highest ongoing costs is a long-term loan (debt)

50. Copyright ©2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of Long-Term Financing Methods