Management Chapter 16 Credit Rating Agencies Provide Investors With Credible And Accurate Evaluation The Risk

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Ferrell / Hirt / Ferrell:

Business

Instructor’s Manual – Chapter 16

B O X E D T E X T D I S C U S S I O N Q U E S T I O N S

ENTER THE WORLD OF BUSINESS—Standard & Poor’s Defends Ratings

Credit rating agencies are facing regulatory scrutiny for actions leading up to the 2008–2009 financial crisis.

Standard and Poor’s, Moody’s Investors Services, and Fitch Ratings are three major credit rating agencies,

holding approximately 95 percent of the market share. Credit rating agencies provide investors with a

1. Do you think that credit rating agencies had the incentive to rate securities highly even if they were

risky?

Students’ answer may vary.

2. Should credit rating agencies such as Standards and Poor’s be forced to pay for their erroneous

ratings?

Students’ answer may vary.

3. What can credit rating agencies do to ensure that their ratings remain objective?

Students’ answers may vary.

GOING GREEN—Finance Executives Recognize the Benefits of Method’s Green Efficiencies

Thanks to companies like Method, finance executives are beginning to realize the financial benefits of going

green. Eco-friendly options such as decreasing energy use, using recycled materials, and reducing packaging

1. If greener operations cut company costs, how will this affect a company’s current assets and liabilities?

2. Why might Method decide to pursue greener business activities that are costly in the short run?

By adopting additional costs in the short run Method will be able to save money over the long term.

Ferrell / Hirt / Ferrell:

Business

Instructor’s Manual – Chapter 16

3. Do you think other household supply companies are beginning to realize how green products can

improve their financial conditions?

Method’s long–term perspective, efficient operations, and popularity with customers are catching on

CONSIDER ETHICS AND SOCIAL RESPONSIBILITY—JPMorgan Struggles to Repair Reputation

A trader known as the London Whale (because of his large portfolio and extensive trading) became the

center of a trading loss that cost JPMorgan more than $6 billion. Two traders in JPMorgan’s London offices

1. What are some of the ethical issues involved with the JPMorgan trading scandal?

2. Why is JPMorgan facing a civil suit if executives did not have knowledge of the wrongdoing?

3. Describe some of the lapses in JPMorgan’s oversight of its trades.

Two traders in JPMorgan’s London offices face charges from the U.S. and U.K. governments for allegedly

Ferrell / Hirt / Ferrell:

Business

Instructor’s Manual – Chapter 16

S U P P L E M E N T A L L E C T U R E

The Dow Jones Industrial Average

The editorial page of each issue of The Wall Street Journal indicates that the publication was first published in

1889. It was shortly after that date that the founders of the Journal—three young men named Dow, Jones,

and Bergstresser—wanted a quick way to convey to market watchers just what the market was doing.

The solution was to select a small group of representative common stocks traded on the New York Stock

Exchange and follow their movements. They decided to add up the values of these representative stocks and

divide by the number of stocks to arrive at an arithmetic mean or “average” of those values. Thus, the Dow

Jones Industrial Average was born.

Ferrell / Hirt / Ferrell:

Business

Instructor’s Manual – Chapter 16

Here’s how it works. The following is a list of firms that could be called the Dow Jones Industrial Five, as of

1928. Figures are market values:

General Company

Erickson Tire

Bluehills Emerson

Tarkington Co.

Spells Cargo

General Company

Erickson Tire

Bluehills Emerson

(a 2-for-1 split)

Tarkington Co.

Spells Cargo

be 4.5238095. Dividing the new divisor into the new total of 57 gives the following:

57  4.5238095 = 12.6

In 1928, when the Dow Jones personnel changed their procedure, the divisor went from 30 (in the 30 stocks)

to around 15. At that moment, the Dow Jones Industrial Average ceased being an average and became an

Ferrell / Hirt / Ferrell:

Business

Instructor’s Manual – Chapter 16

Although there have been those who might question the capability for accuracy of a small sample of 30

stocks in comparison to the broader indexes, the Dow Jones Industrial Average is probably the best known

and most often quoted stock market yardstick.

1. Why can’t the Dow Jones Industrial Average remain the same as the 1928 DJ Industrial Average?

Numerous stock splits made calculating the Dow Jones Industrial average a mathematical nightmare.

2. Would it be better to use the average of all stocks traded on a given exchange, such as the New

York Stock Exchange Index?

Students’ answers will vary.

3. Why do investors follow the indexes and averages of the stock market?

C O N T R O V E R S I A L I S S U E

The Historical Struggle: Sales Manager versus Credit Manager

The current chapter in your textbook has pointed out that careful handling of accounts receivable is a must

for a successful firm that sells on credit. As in so many aspects of finance, the precarious equilibrium is the

secret of astute management, and when that equilibrium is allowed to deteriorate, there will be problems

Ferrell / Hirt / Ferrell:

Business

Instructor’s Manual – Chapter 16

The sales manager might approach a client by saying, “Out of work now, Mr. Cline? But those relief payments

are coming in regularly, aren’t they? Good. Then you can easily afford $50 monthly payments on this sofa.

Sign here, and we’ll have our truck deliver the sofa to your house today. Thanks for the business.”

You can imagine how the credit manager would react when he interviews Mr. Cline and sees the firm is

expecting $50 a month from a relief recipient. The credit manager will refuse credit to Mr. Cline—and the

1. Can you devise strategies for the two viewpoints in a firm to live together harmoniously?

2. How can both the sales manager and credit manager learn to appreciate each other’s

responsibilities?

Students’ answers may vary. One possible way, however, would be for the firm to stress the

S O Y O U W A N T T O W O R K I N F I N A N C I A L M A N A G E M E N T O R

S E C U R I T I E S

What has led to the downturn of the financial industry, and therefore the decrease of finance jobs?

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Business

Instructor’s Manual – Chapter 16

C H E C K Y O U R P R O G R E S S

1. Define working capital management.

2. How can a company speed up cash flow? Why should it?

Cash flow may be speeded up through the following:

a. Lockboxes—with lockboxes, funds are sent to a local post office box and cleared through a local

3. Describe the various types of marketable securities.

a. Treasury bills are short-term debt obligations of the federal government. They are issued weekly,

may have a maturity of up to one year, and are perhaps the safest investment.

4. What does it mean to have a line of credit at a bank?

5. What are fixed assets? Why is assessing risk important in capital budgeting?

Fixed, or long-term, assets are those assets expected to last for many years. Examples include production

facilities (plants), offices, and equipment. Assessing risk is important in capital budgeting because it

Ferrell / Hirt / Ferrell:

Business

Instructor’s Manual – Chapter 16

6. How can a company finance fixed assets?

7. What are bonds and what do companies do with them?

8. How can companies use equity to finance their operations and long-term growth?

9. What are the functions of the securities markets?

10. What were some of the principle causes of the most recent recession?

There are a number of different causes for the most recent recession. One of the early causes was a

housing bubble that began to burst in 2007 and into 2008. Subprime mortgages and dubious lending

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Instructor’s Manual – Chapter 16

G E T I N V O L V E D

1. Using your local newspaper or The Wall Street Journal, find the current rates of interest on the

following marketable securities. If you were a financial manager for a large corporation, which would

you invest extra cash in? Which would you invest in if you worked for a small business?

a. Three-month T-bills

Student answers will depend upon when they conduct this research.

2. Select five of the Dow Jones Industrials from Table 16.5 in the textbook. Look up their earnings,

dividends, and prices for the past five years. What kind of picture is presented by this information?

Which stocks would you like to have owned over this past period? Do you think the next five years will

present a similar picture?

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Instructor’s Manual – Chapter 16

B U I L D Y O U R S K I L L S

This series of questions is designed to get students to examine the factors that influence risk, return, and the

expenditure of money on a capital budgeting project. Questions 1 and 3 examine risk; question 2 examines

cost; and questions 4 and 5 examine the ability to diversify risk by taking on more than one project. It is clear

1. The professor should not be too concerned about the actual ranking because there is not enough data

given to rank in a quantitative sense. Rankings will vary based on assumptions the students make. One

possible answer (lowest to highest risk) is:

Project 3 – The oil is already there and being produced. This has the highest probability of producing oil

in the least amount of time.

Project 5 – The oil is in the ground, and an 80 percent chance of finding more oil in adjacent tracts is a

very high probability, and thus, low risk.

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Instructor’s Manual – Chapter 16

2. Ranked lowest to highest cost:

Projects 3 and 5 would have the lowest costs. Some students may argue that project five could have the

lowest cost.

Project 4 would have lower costs than Project 1 because the pipeline and infrastructure already exist.

3. The fact that Russia (project 6) has had an unstable government and only a limited history of capitalism is

certainly a political consideration. Brazil (project 2) has had unstable governments and foreign exchange

4. This question is difficult to answer without knowing project costs and capital availability. Most students

5. Clearly, the first four projects are highly correlated to High Octane’s existing production capabilities, and

projects 5 and 6 (Brazil and Russia) are not. If the firm wants to diversify the geographical location of its

oil resources, it might consider either Russia or Brazil. If High Octane wants to diversify its oil output, it

should consider taking Brazil and any of the other two projects but avoid Russia. High Octane would

certainly have to consider the costs and expected revenue of each project before actually making the

decision.

Ferrell / Hirt / Ferrell:

Business

Instructor’s Manual – Chapter 16

B U I L D Y O U R B U S I N E S S P L A N

An approach to this chapter would be for students to assume that business is an initial success (oh, if wishes

were horses, all beggars would ride!). Involve the students in a discussion of what they should do with their

money. Should they re-invest it in the business? Pay off new equipment early? Try to impress on them that

many businesses are seasonal or experience declining profits during an economic decline and they need to

be prepared for it. Those who fail to plan, plan to fail!

S E E F O R Y O U R S E L F V I D E O C A S E:

M O R N I N G S T A R I N C. M A K E R S I N V E S T I N G E A S I E R

Case Overview

Morningstar, Inc. provides independent investment research to individuals, financial advisers, and

institutional advisers. Founder Joe Mansueto wanted to make financial information easier to find and

1. What is it about investing that Mansueto discovered is so confusing for the average investor?

2. How does Morningstar, Inc. make investing easier for individuals?

3. Why does Mansueto recommend investing early in life, even in high school?

Ferrell / Hirt / Ferrell:

Business

Instructor’s Manual – Chapter 16

T E A M E X E R C I S E

Students will compare and contrast financing with long-term liabilities, such as bonds versus financing with

owner’s equity, typically retained earnings, common stock, and preferred stock. They will then form groups

and suggest a good mix of long-term liabilities and owner’s equity for a new firm that makes wind turbines

for generating alternative energy and would like to grow quickly.

T E R M P A P E R O R P R O J E C T T O P I C S

These topics may be assigned as individual or collaborative projects:

2. The Eurodollar Market

4. Investing in U.S. Treasury Bills

G U E S T S P E A K E R S U G G E S T I O N S

2. A representative of a firm dealing in marketable securities, such as U.S. Treasury bills.

4. A stock broker or investment banker to discuss different aspects of stocks and bonds.

T E A C H I N G S U G G E S T I O N S

1. The “Get Involved” exercises at the end of the chapter would make a good out–of-class assignment. As an

3. Present a lecture using the “Lecture Outline and Notes” with slides to reinforce major points.