Chapter 17Financial Management and Institutions

Learning Goals

Identify the functions performed by a firm’s financial managers.

Describe the characteristics and functions of money.

Identify the various measures of the money supply.

Explain how a firm uses funds.

Compare the two major sources of funds for a business.

Identify the likely sources of short-term and long-term funds for business operations.

Describe the financial system and major financial institutions.

Explain the Federal Reserve System and its tools.

Describe the global financial system.

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Finance Business function of planning, obtaining, and managing a company’s funds in order to accomplish its objectives effectively and efficiently.

THE ROLE OF THE FINANCIAL MANAGER

Financial manager Executive who develops and implements the firm’s financial plan and determines the most appropriate sources and uses of funds.

• Chief financial officer Head of an organization’s finance operation.

• Reports directly to CEO or COO.

• Often a member of the board of directors.

• Three executives typically report to the CFO:

• Vice president for financial management or planning

• Treasurer

• Controller

Risk-return trade-off Optimal balance between the expected payoff from an investment and the investment’s risk.

The Financial PlanFinancial plan Document that specifies 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 the necessary funds?

• When will it need more funds?

CHARACTERISTICS AND FUNCTIONS OF MONEY

Characteristics of MoneyMoney Anything generally accepted as payment for goods

and services.

• To be efficient, money must have certain characteristics:

• Divisibility

• Portability

• Durability

• Difficulty in counterfeiting

• Stability

Functions of Money

THE MONEY SUPPLY

• M1 Total value of coins, currency, traveler’s checks, bank checking account balances, and the balances in other demand deposit accounts.

• M2 Financial assets that are almost as liquid as cash but do not serve directly as a medium of exchange.

• Examples: various savings accounts, certificates of deposit, and money market mutual funds.

• Use of credit cards growing rapidly.

• Amount of outstanding credit card debt has risen by more than 400 percent in the last 20 years.

WHY ORGANIZATIONS NEED FUNDS

• Run day-to-day operations, compensate employees and hire new ones, may for inventory, make interest payments on loans, pay dividends to shareholders, purchase property, facilities, and equipment.

• Use financial planning process to determine how to address shortfalls and surpluses.

Generating Funds from Excess Cash• Most excess cash balances are invested in marketable securities.

• Most popular marketable securities:

• U.S. Treasury bills

• Commercial paper

• Repurchase agreements

• Certificates of deposit

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.

• Even established firms may not generate sufficient funds to cover all of the costs of expansion or a significant equipment upgrade.

Short-Term Sources of Funds1 Trade credit extended by suppliers when a firm receives

goods or services, agreeing to pay for them at a later date.

2 Short-term loans from commercial banks and other sources.

3 Commercial paper, which has interest rates typically 1 or 2 percent lower than short-term bank loans.

Long-Term Sources of Funds• Loans, bonds, and equity financing.

• Public Sale of Stocks and Bonds

• Private Placements

• Venture Capitalists

Leverage Technique of increasing the rate of return on an investment by financing it with borrowed funds.

FINANCIAL SYSTEMS AND FINANCIAL INSTITUTIONS

Financial system System by which funds are transferred from savers to users.

• In U.S., households are generally net savers while businesses and governments are net users.

• Because of financial institutions, savers earn more, and users pay less.

Depository institutions Financial institutions that accept deposits that can be converted into cash on demand.

• Nondepository institutions include life insurance companies, pension funds, and the various government- sponsored financial institutions such as Fannie Mae and Freddie Mac.

Commercial Banks• Offer a wide range of checking and savings deposit accounts, consumer loans,

credit cards, home mortgage loans, business loans, and trust services.

How Banks Operate

• Raise funds by offering checking and savings deposits to customers.

• Then pool these funds and offer consumer and business loans.

Electronic Banking

• Electronic funds transfer systems (EFTSs) Computerized systems for conducting financial transactions over electronic links.

Online Banking

• More than one-third of American households use some form of online banking.

• Allows customers to make transactions at any hour on any day.

Bank Regulation• Among the nation’s most heavily regulated businesses.

Who Regulates Banks?

• Most are state chartered.

• State banks that are federally insured are subject to Federal Deposit Insurance Corporation regulation.

Federal Deposit Insurance

• Insures deposits of up to $100,000 per depositor.

• Shifts risk of bank failure from depositor to FDIC.

Recent Changes in Banking Laws

• Congress revised Depression-era laws to allow banks to enter securities and insurance businesses.

• Also allowed financial services firms to offer banking services.

Savings Banks and Credit Unions• In U.S., 1,300 savings banks with $1.7 trillion in assets.

• Credit unions are cooperative financial institutions owned by their members.

• 85 million Americans belong to one of the U.S.’s 9,200 credit unions.

Nondepository Financial Institutions

Insurance Companies

• Underwriting The process insurance companies use to determine whom to insure and what to charge.

Pension Funds

• Provide retirement benefits to workers and their families.

Finance Companies

• Offer short-term loans to borrowers in exchange for collateral.

THE FEDERAL RESERVE SYSTEM

Federal reserve system U.S. central bank.

Organization of the Federal Reserve System

• Nation divided into 12 federal districts.

• Each district bank supplies banks within its district with currency and facilitates the clearing of checks.

• Governed by a board of directors.

• Federal Open Market Committee sets monetary and interest rate policies.

Check Clearing and the Fed• Clears checks and transfers money to and from financial institutions to improve

the efficiency of the financial system.

Monetary PolicyMonetary policy Using interest rates and other tools to control the supply of

money and credit in the economy.

U.S. FINANCIAL INSTITUTIONS: A GLOBAL PERSPECTIVE

• Major U.S. banks have extensive international operations.

• U.S. banks have more than $200 billion in outstanding loans to international customers.

• Only 3 of the 20 largest banks in the world (measured by total assets) are U.S. institutions

• Japan’s Mitsubishi UFJ Holdings is world’s largest.

• Other nation’s central banks play roles much like the Fed, often responding to changes in the U.S. financial system.