978-0134728391 Chapter 17 Part 1

Chapter 17: Managing Business Finances

Chapter Outline

Retirement! Now there’s something that most students do not think about, yet it is something that

we all must strategically plan for. This chapter introduces us to the concept of the time value of

money and the principle of compound growth that is central to our creation of wealth—wealth

that we will need to fund our retirements!

The chapter introduces the student to the investment opportunities offered by mutual funds and

exchange-traded funds. It describes the role of securities markets and identifies the major stock

exchanges in the world. The chapter introduces students to the concept of the risk-return

relationship and discusses the value of diversifying an investment portfolio. Finally, the chapter

examines how a firm can raise funds through equity or debt financing.

Learning Objectives

17-1. Explain the concept of the time value of money and the principle of compound growth,

and discuss the characteristics of common stock.

17-2. Identify reasons for investing and the investment opportunities offered by mutual funds

and exchange-traded funds.

17-4. Describe the risk-return relationship and discuss the use of diversification and asset

allocation for investments.

17-6. Identify the reasons a company might make an initial public offering of its stock,

17-7. Explain how securities markets are regulated.

LIST OF IN-CLASS ACTIVITIES: INSTRUCTOR’S CHOICE

Activity

Description

Time Limit

1. Ice-Breaker: What Should I

Buy?

Students make preliminary purchasing

decisions about stocks based on what they

already know about the companies and the

stock market in general.

30 min.

2. Up for Debate: What’s

Wrong with a Little Inside

Scoop?

Students are divided into teams to debate the

ethics of insider trading.

30 min.

CHAPTER OUTLINE

Learning Objective 17-1:

Explain the concept of the time value of money and the principle of compound growth, and

discuss the characteristics of common stock.

Maximizing Capital Growth

Wise investment is the key to growing your money, especially if you are seeking to build capital

to start your own business or simply as a cushion for a sound financial future. A number of

concepts come into play when searching for investment opportunities.

A. The Time Value of Money and Compound Growth

The time value of money is a concept that recognizes that if we invest money, it makes more

money over time through the addition of compound interest. Compound growth is the

cumulative growth from interest paid to the investor over given time periods. With each

additional time period, an investment grows as interest payments accumulate and earn more

interest, thus multiplying the earning capacity of the investment.

1. The Rule of 72 is a handy rule of thumb to estimate how long it will take to double an

investment. You can find the number of years it will take to double an investment by

2. Making Better Use of Your Money. Each year, interest is added to our investments. If

we continually reinvest the principal amount and the interest, the growth of our money

will become larger each year.

B. Common Stock Investments

A stock is a portion of the ownership of a corporation. The company’s total ownership is

divided into small parts, called shares, which can be bought and sold to determine how much

of the company (how many shares of stock) is owned by each shareholder.

1. Common Stock. A share of common stock is the most basic form of ownership in a

company. Individuals and other companies purchase a firm’s common stock in the hope

2. Investment Traits of Common Stock. Common stocks are among the riskiest of all

3. Dividend. A dividend is a payment to shareholders, on a per-share basis, out of the

company’s earnings. Blue chip stocks are stocks of well-established firms that

consistently provide investors with secure income from dividend payouts. Not all strong

firms pay dividends, however. Some focus on reinvesting in the company toward future

growth.

KEY TEACHING TIPS

 Remind students that compound interest will either work for them or against them. It

works for them when they invest, but against them when they borrow.

 Reiterate that continued reinvestment of interest and principal maximizes the return

achieved by the investment.

 Reinforce the point that a stock is a portion of the ownership of a corporation. Common

stocks represent the most basic form of ownership in a company.

 Common stocks are risky securities, but blue chip stocks are issued by the strongest, most

financially sound firms that often provide investors with steady income.

QUICK QUESTIONS

 What is meant by the time value of money? What is meant by compound growth?

 What is common stock?

 What is different about the market value and the book value of a share?

 What is a dividend? Why do some investors receive dividends?

Use In-Class Activity 1: Ice-Breaker: What Should I Buy?

Time Limit: 30 minutes

Learning Objective 17-2:

Identify reasons for investing and the investment opportunities offered by mutual funds

and exchange-traded funds.

Investing to Fulfill Financial Objectives

Mutual funds and exchange-traded funds are popular alternatives to stocks because they offer

attractive investment opportunities for various financial objectives and often do not require large

sums of money for entry.

Mutual Funds

Mutual funds are created by companies such as T. Rowe Price and Vanguard that pool cash

A. Reasons for Investing

Mutual funds are flexible in their investment goals. It is relatively easy to open a mutual fund

account. The three most common objectives for opening a mutual fund account are:

1. Stability and Safety. Funds stressing safety seek only modest growth with little

2. Conservative Capital Growth. Preservation of capital and current income, alongside

3. Aggressive Growth. Aggressive growth funds seek maximum long-term capital growth;

they sacrifice current income and safety by investing in stocks of new and sometimes

troubled companies, firms developing new products and technologies, and other high-risk

securities.

B. Most Mutual Funds Don’t Match the Market

Many, but not all, mutual funds are managed by ―experts‖ who select the stocks, bonds, and

securities in which the fund will invest. Some estimates indicate that up to 80 percent of

mutual funds underperform a market’s average return due to management expenses and

C. Exchange Traded Funds

An exchange-traded fund (ETF) is a bundle of stocks (or bonds) that are in an index that

tracks the overall movement of a market. ETFs can be traded like a stock.

1. Advantages of ETFs. ETFs offer three advantages over mutual funds:

a. They can be traded throughout the day like a stock.

b. They have low operating expenses.

c. They do not require high initial investments.

KEY TEACHING TIPS

 Students often confuse mutual funds and exchange-traded funds. While both are bundles

of stocks or bonds, ETFs can be traded like a stock. Each share of the ETF rises and falls

as the market process changes.

 Remind students that securities include stocks as well as corporate and municipal bonds

and mutual funds; they represent secured, financially valuable claims on the part of

investors.

 Reinforce that mutual funds are an attractive investment since a drop in the price of one

or two stocks in the pool is likely to have little impact on the total value of the fund; this

is especially true with index funds.

QUICK QUESTIONS

 What are mutual funds?

 Why might an investor find mutual funds attractive?

 What are the advantages of ETFs?

Learning Objective 17–3:

Describe the role of securities markets and identify the major stock exchanges and stock

markets.

The Business of Trading Securities

Stocks and bonds are referred to as securities because they represent secured, or financially

valuable, claims on the part of investors. Stocks and bonds are sold in securities markets. By

facilitating the buying and selling of securities, the securities markets provide the capital that

companies rely on for survival.

A. Primary and Secondary Securities Markets

Newly issued stocks and bonds are bought and sold in primary securities markets. To bring a

new security to market, the issuing firm must get approval from the Securities and

Exchange Commission (SEC)—the government agency that regulates U.S. securities

markets.

Investment Banks issue and resell new securities, as well as create the distribution networks

for selling the securities. Investment banks provide three important services:

1. They advise companies on the timing and financial terms of new issues.

3. They create distribution networks to move new securities through groups of banks and

brokers to individual investors.

B. Stock Exchanges

A stock exchange is an organization of individuals that provides an institutional auction

setting in which stock can be bought or sold.

1. The Trading Floor. Each exchange governs the places and times when trading occurs.

Trading is allowed only on the trading floor, which can be a physical location, or an

2. The Major Stock Exchanges. Among the stock exchanges that operate on trading floors

a. The New York Stock Exchange (NYSE). The NYSE is a hybrid market that utilizes

both electronic transfers as well as a trading floor in New York. Many firms list their

stocks regionally, as well as on one of the national exchanges.

b. Global Stock Exchanges. The value of shares listed on foreign exchanges continues

to grow. Major overseas stock exchanges are found in Shanghai, Tokyo, London, and

Hong Kong.

c. The NASDAQ. The NASDAQ was the first electronic stock market. NASDAQ

orders are gathered and executed solely on a worldwide computer network. NASDAQ

is working to replace trading floors of traditional exchanges.

d. International Consolidation and Cross-Border Ownership. Analysts expect

technological advances and regulatory factors to drive together the separate stock

markets in various parts of the world. Stock markets that are not able to cope with

C. Non-Exchange Trading: Electronic Communication Networks. ECNs are electronic

systems that bring buyers and sellers together at specified prices outside traditional stock

exchanges. Their popularity has grown rapidly, primarily because they have made the

transfer of shares easier and less costly.

D. Individual Investor Trading.

While many investors rely heavily on the advice they receive from brokers, more

experienced and well-informed investors often prefer to invest independently without outside

guidance.

1. Stock Brokers. Stock brokers receive and execute orders from non-exchange members

and earn commissions as a result.

E. Tracking the Market Using Stock Indexes

Investors have used stock indexes to track market performance for decades. Market indexes

provide some summaries of overall market price trends.

Bull Markets. Bull markets are periods of rising stock prices in which investors are

motivated to buy because they are confident of continuing rising prices. Bear Markets. Bear

1. The Dow Jones. The Dow Jones Industrial Average (simply referred to as the Dow) is

2. The S&P 500.

3. The NASDAQ Composite.

4. The Russell 2000. The Russell 2000 is a specialized index that tracks the performance of

the smallest U.S. companies based on their market capitalization.

5. Index-Matching ETFs. ETFs are available that track the performance of various

indexes. For example, the Fidelity NASDAQ Composite Index Tracking Stock holds a

portfolio of equities for tracking the NASDAQ Composite Index.

KEY TEACHING TIPS

 Remind students that a stock exchange is an organization of individuals formed to

provide an institutional auction setting in which stock can be bought and sold.

 Students may not know that each stock exchange regulates the places and times at which

trading may occur; the trading floor is the physical location where trading takes place,

though much trading occurs electronically today.

 Make sure students understand the distinction between stock brokers, discount brokers,

and full-service brokers.

QUICK QUESTIONS

 What is the role of an investment bank with regard to new issues of stock?

 What type of investor is most likely to be attracted to online trading?

 What type of investor would prefer the services of a full-service broker?

Learning Objective 17-4:

Describe the risk-return relationship and discuss the use of diversification and asset

allocation for investments.

The Risk-Return Relationship

Each type of investment has a risk-return relationship, which reflects the notion that safer

investments tend to offer lower returns, and riskier investments tend to offer higher returns.

A. Investment Dividends (or Interest), Appreciation, and Total Return. Investors invest for

different reasons. In evaluating a potential investment, investors examine returns from

dividends, price appreciation, and total returns.

1. Dividends. The rate of return from stock dividends is known as the current dividend

2. Price Appreciation. Price appreciation is an increase in the dollar value (share price) of

3. Total Return. Total returns are the sum of the dividend yield plus the stock’s capital

gain. It is calculated by the formula:

Total Returns (%) = (Current dividend payment + Capital gain) / Original investment X

100

B. Fantasy Stock Markets

Fantasy stock markets are popular for learning how securities markets work, for trying

various investment strategies, and earning a fantasy fortune (or going broke!). Internet-based

C. Managing Risk with Diversification and Asset Allocation

Most investors select a mixed portfolio of investments that provides an overall level of risk and

return that feels comfortable.

1. Diversification. Through diversification, investors buy several kinds of investments

2. Asset Allocation. Asset allocation is the proportion of funds invested in each of the

investment alternatives. These proportions can be changed at any time.

stocks, bonds, mutual funds, and real estate. Investment portfolios have different

objectives ranging from aggressive high growth portfolios to stable income/low volatility

portfolios.

KEY TEACHING TIPS

 Reinforce that safer investments tend to offer lower returns; riskier investments tend to

offer higher returns.

 Remind students that diversification cuts risk, if only because not all of the funds

invested are in one place.

Learning Objective 17-5:

Describe the various ways that firms raise capital and identify the pros and cons of each

method.

Financing the Business Firm

Although the business owner’s savings may be enough to get a firm up and running, businesses

depend on sales revenues to survive. When current sales are insufficient to cover expenses, firms

turn to other sources of funding. These typically begin with the owner’s personal savings, but

often involve borrowing from banks, soliciting cash from private investors, or selling bonds to

the public.

A. Secured Loans for Equipment

Money to purchase new equipment often comes in the form of loans from commercial banks.

The borrower guarantees repayment of the loan by pledging the asset as collateral.

Principal and Interest Rates. The amount of money that is loaned and has to be repaid is

the principal. Borrowers will also pay interest, expressed in the form of an annual

percentage rate (APR). The interest amount is found by multiplying the APR by the loan

principal.

B. Working Capital and Unsecured Loans from Banks

Firms need more than fixed assets; they also need current, liquid assets available to meet

short-term operating expenses. The firm’s ability to meet these expenses is measured by its

working capital. Working capital is calculated as follows:

Working capital = Current assets – current liabilities

Positive working capital means the firm’s current assets are large enough to pay off current

expect to pay higher interest rates than established companies, because they don’t have a

track record. Evidence of a sound financial plan can help show the firm is a good credit risk.

Cash flow planning shows lenders that the borrower is using available financial resources

prudently.

C. Angel Investors and Venture Capital

rapidly by providing venture capital, private funds from wealthy individuals or companies

that seek investment opportunities.

1. Characteristics of Corporate Bonds. The bondholder (the lender) has no claim to

ownership of the company and does not receive dividends. However, interest payments

2. Default and Bondholder’s Claim. If the borrower fails to make a payment then the bond

3. Risk Ratings. To aid investors in making purchase decisions, several services measure

the default risk of bonds. A rating of AAA is the best and safest rating. Lower ratings do

not necessarily mean that the bond issue will not be successful, but the lower the rating

the higher the interest rate charged is likely to be.

4. Flawed Ratings Misread Recession Risks. The financial crisis of 2008 raised many

questions about whether the credit rating agencies are serving any good purpose. The

5. Mortgage-backed securities became a trillion dollar investment industry during the pre–

2007 housing market boom. Financial institutions bundled home mortgages into packages

and resold them as securities. These investments were given favorable risk ratings by

KEY TEACHING TIPS

 Students often confuse stocks and bonds. A stock represents ownership in a corporation.

A bond represents debt, an issuer’s promise to pay the buyer a certain amount of money

by a specified future date.

 Make sure that students understand the differences between government bonds, municipal

bonds, and corporate bonds.

 Point out that secured bonds are ―backed‖ by company assets in case of default, whereas

unsecured bonds—or debentures—pledge no property as security.

QUICK QUESTION

 What are some circumstances under which a firm might want to issue bonds?