Chapter 13 Managing Financial Resources

Medium of Exchange

Money serves as a medium of exchange because people will accept it in exchange for goods and services. Because people can use money to buy the goods and services that they want, everyone’s willing to trade something for money. The laborer will take money for clearing your fields because he can use it to buy food. You’ll take money as payment for his food because you can use it not only to pay him, but also to buy something else you need (perhaps seeds for planting crops).

For money to be used in this way, it must possess a few crucial properties:

1. It must be divisible—easily divided into usable quantities or fractions. A $5 bill, for example, is equal to five $1 bills. If something costs $3, you don’t have to rip up a $5 bill; you can pay with three $1 bills.
2. It must be portable—easy to carry; it can’t be too heavy or bulky.
3. It must be durable. It must be strong enough to resist tearing and the print can’t wash off if it winds up in the washing machine.
4. It must be difficult to counterfeit; it won’t have much value if people can make their own.

Measure of Value

Money simplifies exchanges because it serves as a measure of value. We state the price of a good or service in monetary units so that potential exchange partners know exactly how much value we want in return for it. This practice is a lot better than bartering because it’s much more precise than an ad hoc agreement that a day’s work in the field has the same value as three meals.

Store of Value

Money serves as a store of value. Because people are confident that money keeps its value over time, they’re willing to save it for future exchanges. Under a bartering arrangement, the laborer earned three meals a day in exchange for his work. But what if, on a given day, he skipped a meal? Could he “save” that meal for another day? Maybe, but if he were paid in money, he could decide whether to spend it on food each day or save some of it for the future. If he wanted to collect on his “unpaid” meal two or three days later, the farmer might not be able to “pay” it; unlike money, food could go bad.

The Money Supply

Now that we know what money does, let’s tackle another question: How much money is there? How would you go about “counting” all the money held by individuals, businesses, and government agencies in this country? You could start by counting the money that’s held to pay for things on a daily basis. This category includes cash (paper bills and coins) and funds held in demand depositsChecking accounts that pay given sums to “payees” when they demand them.—checking accounts, which pay given sums to “payees” when they demand them.

Then, you might count the money that’s being “saved” for future use. This category includes interest-bearing accounts, time deposits (such as certificates of deposit, which pay interest after a designated period of time), and money market mutual fundsAccounts that pay interest to investors who pool funds to make short-term loans to businesses and the government., which pay interest to investors who pool funds to make short-term loans to businesses and the government.

M-1 and M-2

Counting all this money would be a daunting task (in fact, it would be impossible). Fortunately, there’s an easier way—namely, by examining two measures that the government compiles for the purpose of tracking the money supply: M-1 and M-2.

• The narrowest measure, M-1Measure of the money supply that includes only the most liquid forms of money, such as cash and checking-account funds., includes the most liquid forms of money—the forms, such as cash and checking-accounts funds, that are spent immediately.
• M-2Measure of the money supply that includes everything in M-1 plus near-cash. includes everything in M-1 plus near-cash items invested for the short term—savings accounts, time deposits below $100,000, and money market mutual funds.

So what’s the bottom line? How much money is out there? To find the answer, you can go to the Federal Reserve Board Web site. The Federal Reserve reports that in December 2008, M-1 was about $1.6 trillion dollars and M-2 was $8.2 trillion. Figure 13.2 "The U.S. Money Supply, 1980–2008" shows the increase in the two money-supply measures since 1980.

Figure 13.2 The U.S. Money Supply, 1980–2008

If you’re thinking that these numbers are too big to make much sense, you’re not alone. One way to bring them into perspective is to figure out how much money you’d get if all the money in the United States were redistributed equally. According to the U.S. Census Population Clock, there are 305,726,680 people in the United States. Your share of M-1, therefore, would be about $5,200 and your share of M-2 would be about $27,000.

Depository and Nondepository Institutions

Now you know why we have financial institutions: they act as intermediaries between savers and borrowers and they direct the flow of funds between them. With funds deposited by savers in checking, savings, and money market accounts, they make loans to individual and commercial borrowers. In the next section, we’ll discuss the most common types of depository institutions (banks that accept deposits), including commercial banks, savings banks, and credit unions. We’ll also discuss several nondepository institutions (which provide financial services but don’t accept deposits), including finance companies, insurance companies, brokerage firms, and pension funds.

Credit Unions

To bank at a credit unionFinancial institution that provides services to only its members (who are associated with a particular organization)., you must be linked to a particular group, such as employees of United Airlines, employees of the state of Nevada, teachers in Orange County, California, or current and former members of the U.S. Navy. Credit unions are owned by their members, who receive shares of their profits. They offer almost anything that a commercial bank or savings and loan does, including savings accounts, checking accounts, home and car loans, credit cards, and even some commercial loans.Pennsylvania Association of Community Bankers, “What’s the Difference?,” http://www.pacb.org/banks_and_banking/difference.html (accessed May 30, 2006). Collectively, they hold about $685 billion in assets (around 6 percent of the total).

Figure 13.3 "Where Our Money Is Deposited" summarizes the distribution of assets among the nation’s depository institutions.

Figure 13.3 Where Our Money Is Deposited

Financial Services

You can appreciate the diversity of the services offered by commercial banks, savings banks, and credit unions by visiting their Web sites. For example, Wachovia (a subsidiary of Wells Fargo) promotes services to four categories of customers: individuals, small businesses, corporate and institutional clients, and affluent clients seeking “wealth management.” In addition to traditional checking and savings accounts, the bank offers automated teller machine (ATM) services, credit cards, and debit cards. It lends money for homes, cars, college, and other personal and business needs. It provides financial advice and sells securities and other financial products, including individual retirement accounts (IRAs)Personal retirement account set up by an individual to save money tax free until retirement., by which investors can save money that’s tax free until they retire. Wachovia even offers life, auto, disability, and homeowners insurance. It also provides electronic banking for customers who want to check balances, transfer funds, and pay bills online.See Wachovia Bank, NA, “Wachovia,” http://www.wachovia.com (accessed May 30, 2006).

Bank Regulation

How would you react if you put your life savings in a bank and then, when you went to withdraw it, learned that the bank had failed—that your money no longer existed? This is exactly what happened to many people during the Great Depression. In response to the crisis, the federal government established the Federal Depository Insurance Corporation (FDIC)Government agency that regulates banks and insures deposits in its member banks up to $100,000. in 1933 to restore confidence in the banking system. The FDIC insures deposits in commercial banks and savings banks up to $250,000. So today if your bank failed, the government would give you back your money (up to $250,000). The money comes from fees charged member banks.

To decrease the likelihood of failure, various government agencies conduct periodic examinations to ensure that institutions are in compliance with regulations. Commercial banks are regulated by the FDIC, savings banks by the Office of Thrift Supervision, and credit unions by the National Credit Union Administration. As we’ll see later in the chapter, the Federal Reserve System also has a strong influence on the banking industry.

Crisis in the Financial Industry (and the Economy)

What follows is an interesting, but scary, story about the current financial crisis in the banking industry and its effect on the economy. In the years between 2001 and 2005, lenders made billions of dollars in subprime adjustable-rate mortgages (ARM) to American home buyers. Subprime loans are made to home buyers who don’t qualify for market-set interest rates because of one or more risk factors—income level, employment status, credit history, ability to make only a very low down payment. In 2006 and 2007, however, housing prices started to go down. Many homeowners with subprime loans, including those with ARMs whose rates had gone up, were neither able to refinance (to lower their interest rates) nor to borrow against their homes. Many of these homeowners got behind in mortgage payments, and foreclosures became commonplace—1.3 million in 2007 alone.Justin Lahart, “Egg Cracks Differ in Housing, Finance Shells,” Wall Street Journal, July 13, 2008. By April 2008, 1 in every 519 American households had received a foreclosure notice.RealtyTrac Inc., “Foreclosure Activity Increases 4 Percent in April, realtytrac.com, May 14, 2008. By August, 9.2 percent of the $12 trillion in U.S. mortgage loans was delinquent or in foreclosure.Mortgage Bankers Association, “Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey,” September 5, 2008, http://www.mbaa.org/NewsandMedia/PressCenter/64769.htm (accessed September 25, 2008); Charles Duhigg, “Loan-Agency Woes Swell from a Trickle to a Torrent,” nytimes.com, July 11, 2008, http://www.nytimes.com/2008/07/11/business/11ripple.html?ex=1373515200&en=8ad220403fcfdf6e&ei=5124&partner=permalink&exprod=permalink.

The repercussions? Banks and other institutions that made mortgage loans were the first sector of the financial industry to be hit. Largely because of mortgage-loan defaults, profits at more than 8,500 U.S. banks dropped from $35 billion in the fourth quarter of 2006 to $650 million in the corresponding quarter of 2007 (a decrease of 89 percent). Bank earnings for the year 2007 declined 31 percent and dropped another 46 percent in the first quarter of 2008.Federal Deposit Insurance Corporation, Quarterly Banking Profile (Fourth Quarter 2007), http://www.2.fdic.gov/qbp/2007dec/qbp.pdf (accessed September 25, 2008); FDIC, Quarterly Banking Profile (First Quarter 2008), at http://www.2.fdic.gov/qbp/2008mar/qbp.pdf (accessed September 25, 2008).

Losses in this sector were soon felt by two publicly traded government-sponsored organizations, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Both of these institutions are authorized to make loans and provide loan guarantees to banks, mortgage companies, and other mortgage lenders; their function is to make sure that these lenders have enough money to lend to prospective home buyers. Between them, Fannie Mae and Freddie Mac backed approximately half of that $12 trillion in outstanding mortgage loans, and when the mortgage crisis hit, the stock prices of the two corporations began to drop steadily. In September 2008, amid fears that both organizations would run out of capital, the U.S. government took over their management.

Freddie Mac also had another function: to increase the supply of money available in the country for mortgage loans and new home purchases, Freddie Mac bought mortgages from banks, bundled these mortgages, and sold the bundles to investors (as mortgage-backed securities). The investors earned a return because they received cash from the monthly mortgage payments. The banks that originally sold the mortgages to Freddie Mac used the cash they got from the sale to make other loans. So investors earned a return, banks got a new influx of cash to make more loans, and individuals were able to get mortgages to buy the homes they wanted. This seemed like a good deal for everyone, so many major investment firms started doing the same thing: they bought individual subprime mortgages from original lenders (such as small banks), then pooled the mortgages and sold them to investors.

But then the bubble burst. When many home buyers couldn’t make their mortgage payments (and investors began to get less money and consequently their return on their investment went down), these mortgage-backed securities plummeted in value. Institutions that had invested in them—including investment banks—suffered significant losses.Shawn Tully, “Wall Street’s Money Machine Breaks Down,” Fortune, CNNMoney.com, November 12, 2007, http://money.cnn.com/magazines/fortune/fortune_archive/2007/11/26/101232838/index.htm (accessed September 25, 2008). In September 2008, one of these investment banks, Lehman Brothers, filed for bankruptcy protection; another, Merrill Lynch, agreed to sell itself for $50 billion. Next came American International Group (AIG), a giant insurance company that insured financial institutions against the risks they took in lending and investing money. As its policyholders buckled under the weight of defaulted loans and failed investments, AIG, too, was on the brink of bankruptcy, and when private efforts to bail it out failed, the U.S. government stepped in with a loan of $85 billion.See Greg Robb et al., “AIG Gets Fed Rescue in Form of $85 Billion Loan,” MarketWatch, September 16, 2008, http://www.marketwatch.com/News/Story/aig-gets-fed-rescue-form/story.aspx?guid=%7BE84A4797%2D3EA6%2D40B1%2D9DB5%2DF07B5A7F5BC2%7D (accessed September 25, 2008). The U.S. government also agreed to buy up risky mortgage-backed securities from teetering financial institutions at an estimated cost of “hundreds of billions.”Mortgage Bankers Association, “Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey,” Press Release, September 5, 2008, http://www.mbaa.org/NewsandMedia/PressCenter/64769.htm (accessed September 25, 2008). And the banks started to fail—beginning with the country’s largest savings and loan, Washington Mutual, which had 2,600 locations throughout the country. The list of failed banks kept getting longer: by November of 2008, it had grown to nineteen.

The economic troubles that began in the banking industry as a result of the subprime crisis spread to the rest of the economy. Credit markets froze up and it became difficult for individuals and businesses to borrow money. Consumer confidence dropped, people stopped spending, businesses cut production, sales dropped, company profits fell, and many lost their jobs. It would be nice if this story had an ending (and even nicer if it was positive), but it might take us years before we know the ending. At this point in time, all we do know is that the economy is going through some very difficult times and no one is certain about the outcome.

How Banks Expand the Money Supply

When you deposit money, your bank doesn’t set aside a special pile of cash with your name on it. It merely records the fact that you made a deposit and increases the balance in your account. Depending on the type of account, you can withdraw your share whenever you want, but until then, it’s added to all the other money held by the bank. Because the bank can be pretty sure that all its depositors won’t withdraw their money at the same time, it holds on to only a fraction of the money that it takes in—its reserves. It lends out the rest to individuals, businesses, and the government, earning interest income and expanding the money supply.

The Money Multiplier

Precisely how do banks expand the money supply? To find out, let’s pretend you win $10,000 at the blackjack tables of your local casino. You put your winnings into your savings account immediately. The bank will keep a fraction of your $10,000 in reserve; to keep matters simple, we’ll use 10 percent. The bank’s reserves, therefore, will increase by $1,000 ($10,000 × 0.10). It will then lend out the remaining $9,000. The borrowers (or the parties to whom they pay it out) will then deposit the $9,000 in their own banks. Like your bank, these banks will hold onto 10 percent of the money ($900) and lend out the remainder ($8,100). Now let’s go through the process one more time. The borrowers of the $8,100 (or, again, the parties to whom they pay it out) will put this amount into their banks, which will hold onto $810 and lend the remaining $7,290. As you can see in Figure 13.4 "The Effect of the Money Multiplier", total bank deposits would now be $27,100. Eventually, bank deposits would increase to $100,000, bank reserves to $10,000, and loans to $90,000. A shortcut for arriving at these numbers depends on the concept of the money multiplierThe amount by which an initial bank deposit will expand the money supply., which is determined using the following formula:

Money multiplier = 1/Reserve requirement

In our example, the money multiplier is 1/0.10 = 10. So your initial deposit of $10,000 expands into total deposits of $100,000 ($10,000 × 10), additional loans of $90,000 ($9,000 × 10), and increased bank reserves of $10,000 ($1,000 × 10). In reality, the multiplier will actually be less than 10. Why? Because some of the money loaned out will be held as currency and won’t make it back into the banks.

Figure 13.4 The Effect of the Money Multiplier

Key Takeaways

• Financial institutions serve as financial intermediaries between savers and borrowers and direct the flow of funds between the two groups.
• Those that accept deposits from customers—depository institutions—include commercial banks, savings banks, and credit unions; those that don’t—nondepository institutions—include finance companies, insurance companies, and brokerage firms.
• Financial institutions offer a wide range of services, including checking and savings accounts, ATM services, and credit and debit cards. They also sell securities and provide financial advice.
• A bank holds onto only a fraction of the money that it takes in—an amount called its reserves—and lends the rest out to individuals, businesses, and governments. In turn, borrowers put some of these funds back into the banking system, where they become available to other borrowers. The money multiplier effect ensures that the cycle expands the money supply.

Exercises

1. (AACSB) Analysis

   Does the phrase “The First National Bank of Wal-Mart” strike a positive or negative chord? Wal-Mart isn’t a bank, but it does provide some financial services: it offers a no-fee Wal-Mart Discovery credit card with a 1 percent cash-back feature, cashes checks and sells money orders through an alliance with MoneyGram International, and houses bank branches in more than a thousand of its superstores. Through a partnering arrangement with SunTrust Banks, the retailer has also set up in-store bank operations at a number of outlets under the cobranded name of “Wal-Mart Money Center by SunTrust.” A few years ago, Wal-Mart made a bold attempt to buy several banks but dropped the idea when it encountered stiff opposition. Even so, some experts say that it’s not a matter of whether Wal-Mart will become a bank, but a matter of when. What’s your opinion? Should Wal-Mart be allowed to enter the financial-services industry and offer checking and savings accounts, mortgages, and personal and business loans? Who would benefit if Wal-Mart became a key player in the financial-services arena? Who would be harmed?

2. (AACSB) Analysis

   Congratulations! You just won $10 million in the lottery. But instead of squandering your newfound wealth on luxury goods and a life of ease, you’ve decided to stay in town and be a financial friend to your neighbors, who are hardworking but never seem to have enough money to fix up their homes or buy decent cars. The best way, you decide, is to start a bank that will make home and car loans at attractive rates. On the day that you open your doors, the reserve requirement set by the Federal Reserve System is 10 percent. What’s the maximum amount of money you can lend to residents of the town? What if the Fed raises the reserve requirement to 12 percent? Then how much could you lend? In changing the reserve requirement from 10 percent to 12 percent, what’s the Fed trying to do—curb inflation or lessen the likelihood of a recession? Explain how the Fed’s action will contribute to this goal.

The Tools of the Fed

The Fed has three major goals:

1. Price stability
2. Sustainable economic growth
3. Full employmentFederal Reserve System, “Monetary Policy FAQs,” FED101, http://www.federalreserveeducation.org/fed101_html/policy/basics_print.htm (accessed May 30, 2006).

Recall our definition of monetary policy in Chapter 1 "The Foundations of Business" as the efforts of the Federal Reserve System to regulate the nation’s money supply. We also defined price stability as conditions under which the prices for products remain fairly constant. Now, we can put the two concepts together: the Fed seeks to stabilize prices by regulating the money supply and interest rates. In turn, stable prices promote economic growth and full employment—at least in theory. To conduct monetary policy, the Fed relies on three tools: reserve requirements, the discount rate, and open market operations.

The Federal Funds Rate

In conducting open market operations, the Fed is trying to do the same thing that it does in using its other tools—namely, to influence the money supply and, thereby, interest rates. But it also has something else in mind. To understand what that is, you need to know a few more things about banking. When a bank’s reserve falls below its required level, it may, as we’ve seen, borrow from the Fed (at the discount rate). But it can also borrow from other member banks that have excess reserves. The rate that banks pay when they borrow through this channel is called the federal funds rateThe interest rate that a Federal Reserve member bank pays when it borrows from other member banks to meet reserve requirements..Federal Reserve System, “Monetary Policy FAQs,” FED101, http://www.federalreserveeducation.org/fed101_html/policy/basics_print.htm (accessed May 30, 2006).

How does the federal funds rate affect the money supply? As we’ve seen, when the Fed sells bonds in the open market, the reserve balances of many member banks go down. To get their reserves back to the required level, they must borrow, whether from the Fed or from other member banks. When Bank 1 borrows from Bank 2, Bank 2’s supply of funds goes down; thus, it increases the interest rate that it charges. In short, the increased demand for funds drives up the federal funds rate.

All this interbank borrowing affects you, the average citizen and consumer. When the federal funds rate goes up, banks must pay more for their money, and they’ll pass the cost along to their customers: banks all over the country will raise the interest rates charged on mortgages, car loans, and personal loans. Figure 13.6 "Key Interest Rates, 1995–2008" charts ten-year fluctuations in the discount rate, federal funds rate, and prime rateRate that banks charge their best customers.—the rate that banks charge their best customers. Because all three rates tend to move in the same direction, borrowers—individuals, as well as organizations—generally pay more to borrow money when banks have to pay more and less when banks have to pay less. Notice that the prime rate (which banks charge their customers) is higher than both the federal funds and discount rates (which banks must pay when they need to borrow). That’s why banks make profits when they make loans. Note, too, that the Fed lowered the discount rate and federal funds rate drastically in 2008 in an attempt to stimulate a weakening economy.

Figure 13.6 Key Interest Rates, 1995–2008

The Banker’s Bank and the Government’s Banker

The Fed performs another important function: it serves its member banks in much the same way as your bank serves you. When you get a check, you deposit it in your checking account, thereby increasing your balance. When you pay someone by check, the dollar amount of the check is charged to your account, and your balance goes down. The Fed works in much the same way, except that its customers are member banks.

Just as your bank clears your check, the Fed clears the checks that pass through its member banks. The monumental task of clearing more than fifteen billion checks a year is complicated by the fact that there are twelve district banks. If someone in one district (for example, Boston) writes a check to a payee in another district (say, San Francisco), the check must be processed through both districts.Federal Reserve System, “Financial Services,” FED101, http://www.federalreserveeducation.org/FED101_HTML/services/index.cfm (accessed May 30, 2006).

In performing the following functions, the Fed is also the U.S. government’s banker:

• Holding the U.S. Treasury’s checking account
• Processing the paperwork involved in buying and selling government securities
• Collecting federal tax payments
• Lending money to the government by purchasing government bonds from the Treasury

The Fed also prints, stores, and distributes currency and destroys it when it’s damaged or worn out. Finally, the Fed, in conjunction with other governmental agencies, supervises and regulates financial institutions to ensure that they operate soundly and treat customers fairly and equitably.Federal Reserve System, “Banking Supervision,” FED101, http://www.federalreserveeducation.org/FED101%5FHTML/supervision (accessed May 30, 2006).

Financing a New Company

Because new businesses usually need to borrow money in order to get off the ground, good financial management is particularly important to start-ups. Let’s suppose that you’re about to start up a company that you intend to run from your dorm room. You thought of the idea while rummaging through a pile of previously worn clothes to find something that wasn’t about to get up and walk to the laundry all by itself. “Wouldn’t it be great,” you thought, “if there was an on-campus laundry service that would come and pick up my dirty clothes and bring them back to me washed and folded.” Because you were also in the habit of running out of cash at inopportune times, you were highly motivated to start some sort of money-making enterprise, and the laundry service seemed to fit the bill (even though washing and folding clothes wasn’t among your favorite activities—or skills).

Developing a Financial Plan

Because you didn’t want your business to be so small that it stayed under the radar of fellow students and potential customers, you knew that you’d need to raise funds to get started. So what are your cash needs? To answer this question, you need to draw up a financial planPlanning document that shows the amount of funds a company needs and details a strategy for getting those funds.—a document that performs two functions:

1. Calculating the amount of funds that a company needs for a specified period
2. Detailing a strategy for getting those funds

Estimating Sales

Fortunately, you can draw on your newly acquired accounting skills to prepare the first section—the one in which you’ll specify the amount of cash you need. You start by estimating your sales (or, in your case, revenue from laundering clothes) for your first year of operations. This is the most important estimate you’ll make: without a realistic sales estimate, you can’t accurately calculate equipment needs and other costs. To predict sales, you’ll need to estimate two figures:

1. The number of loads of laundry that you’ll handle
2. The price that you’ll charge per load

You calculate as follows: You estimate that 5 percent of the ten thousand students on campus will use the service. These five hundred students will have one large load of laundry for each of the thirty-five weeks that they’re on campus. Therefore, you’ll do 17,500 loads (500 × 35 = 17,500 loads). You decide to price each load at $10. At first, this seemed high, but when you consider that you’ll have to pick up, wash, dry, fold, and return large loads, it seems reasonable.

Perhaps more important, when you projected your costs—including salaries (for some student workers), rent, utilities, depreciation on equipment and a truck, supplies, maintenance, insurance, and advertising—you found that each load would cost $8, leaving a profit of $2 per load and earning you $35,000 for your first year (which is worth your time, though not enough to make you rich).

Figure 13.7

Determining a sound financial plan is the first step in starting a successful business. What would you be willing to pay to have someone else deal with your laundry?

© 2010 Jupiterimages Corporation

What things will you have to buy in order to get started? Using your estimate of sales, you’ve determined that you’d need the following:

• Five washers and five dryers
• A truck to pick up and deliver the clothes (a used truck will do for now)
• An inventory of laundry detergent and other supplies, such as laundry baskets
• Rental space in a nearby building (which will need some work to accommodate a laundry)

And, you’ll need cash—cash to carry you over while the business gets going and cash with which to pay your bills. Finally, you’d better have some extra money for contingencies—things you don’t expect, such as a machine overflowing and damaging the floor. You’re mildly surprised to find that your cash needs total $33,000. Your next task is to find out where you can get $33,000. In the next section, we’ll look at some options.

Getting the Money

Figure 13.8 "Where Small Businesses Get Funding" summarizes the results of a survey in which owners of small and medium-size businesses were asked where they typically acquired their financing. To simplify matters, we’ll work on the principle that new businesses are generally financed with some combination of the following:

• Owners’ personal assets
• Loans from families and friends
• Bank loans (including those guaranteed by the Small Business Development Center)

Figure 13.8 Where Small Businesses Get Funding

Remember that during its start-up period, a business needs a lot of cash: not only will it incur substantial start-up costs, but it may even suffer initial operational losses.

Making the Financing Decision

Now that we’ve surveyed your options, let’s go back to the task of financing your laundry business. You’d like to put up a substantial amount of the money you need, but you can only come up with a measly $1,000 (which you had to borrow on your credit card). You were, however, able to convince your parents to lend you $10,000, which you’ve promised to pay back, with interest, in three years. (They were wavering until you pointed out that Fred DeLuca started SUBWAY as a way of supporting himself through college).

So you still need $22,000 ($33,000 minus the $11,000 from you and your parents). You talked with someone at the Small Business Development Center located on campus, but you’re not optimistic about getting them to guarantee a loan. Instead, you put together a sound business plan, including projected financial statements, and set off to your local banker. To your surprise, she agreed to a five-year loan at a reasonable interest rate. Unfortunately, she wanted the entire loan secured. Because you’re using some of the loan money to buy washers and dryers (for $15,000) and a truck (for $6,000), you can put up these as collateral. You have no accounts receivable or inventories, so you agreed to put up some personal assets—namely, the shares of Microsoft stock that you got as a high-school graduation present (now worth about $5,000).

Financing the Business During the Growth Stage

Flash-forward two and a half years: much to your delight, your laundry business took off. You had your projected five hundred customers within six months, and over the next few years, you expanded to four other colleges in the geographical area. Now you’re serving five colleges and some three thousand customers a week. Your management team has expanded, but you’re still in charge of the company’s finances. In the next sections, we’ll review the tasks involved in managing the finances of a high-growth business.

Seeking Out Private Investors

So far, you’ve been able to finance your company’s growth through internally generated funds—profits retained in the business—along with a few bank loans. Your success, especially your expansion to other campuses, has confirmed your original belief that you’ve come up with a great business concept. You’re anxious to expand further, but to do that, you’ll need a substantial infusion of new cash. You’ve poured most of your profits back into the company, and your parents can’t lend you any more money. After giving the problem some thought, you realize that you have three options:

1. Ask the bank for more money.
2. Bring in additional owners who can invest in the company.
3. Seek funds from a private investor.

Going Public

Fast-forward another five years. You’ve worked hard (and been lucky), and even finished your degree in finance. Moreover, your company has done amazingly well, with operations at more than five hundred colleges in the Northeast. You’ve financed continued strong growth with a combination of venture-capital funds and internally generated funds (that is, reinvested earnings).

Up to this point, you’ve operated as a private corporation with limited stock ownership (you and your parents are the sole shareholders). But because you expect your business to prosper even more and grow even bigger, you’re thinking about the possibility of selling stock to the public for the first time. The advantages are attractive: not only would you get a huge influx of cash, but because it would come from the sale of stock rather than from borrowing, it would also be interest free and you wouldn’t have to repay it. Again there are some drawbacks. For one thing, going public is quite costly—often exceeding $300,000—and time-consuming. Second, from this point on, your financial results would be public information. Finally, you’d be responsible to shareholders who will want to see the kind of short-term performance results that boosts stock prices.

After weighing the pros and cons, you decide to go ahead. The first step in the process of becoming a public corporation is called an initial public offering (IPO)Process of taking a privately held company public by selling stock to the public for the first time., and you’ll need the help of an investment banking firmFinancial institution that specializes in issuing securities.—a financial institution (such as Goldman Sachs or Morgan Stanley) that specializes in issuing securities. Your investment banker advises you that now’s a good time to go public and determines the best price at which to sell your stock. Then, you’ll need the approval of the SEC, the government agency that regulates securities markets.

Primary and Secondary Markets and Stock Exchanges

Security markets serve two functions:

1. They help companies to raise funds by making the initial sale of their stock to the public.
2. They provide a place where investors can trade already issued stock.

When you went through your IPO, shares were issued through a primary marketMarket that deals in the sale of newly issued securities.—a market that deals in new financial assets. As we’ve seen, the sale was handled by an investment banking firm, which matched you, as a corporation with stock to sell, with investors who wanted to buy it.

Regulating Securities Markets: The SEC

Because it’s vital that investors have confidence in the securities markets, Congress created the Securities and Exchange Commission (SEC)Government agency that enforces securities laws. in 1934. The SEC is charged with enforcing securities laws designed to promote full public disclosure, protecting investors against misconduct in the securities markets, and maintaining the integrity of the securities markets.U.S. Securities and Exchange Commission, http://www.sec.gov (accessed May 30, 2006).

Before offering securities for sale, the issuer must register its intent to sell with the SEC. In addition, the issuer must provide prospective buyers with a prospectusWritten offer to sell securities that provides useful information to prospective buyers.—a written offer to sell securities that describes the business and operations of the issuer, lists its officers, provides financial information, discloses any pending litigation, and states the proposed use of funds from the sale.

The SEC also enforces laws against insider tradingPractice of buying or selling of securities using important information about the company before it’s made public.—the illegal buying or selling of its securities by a firm’s officers and directors or anyone else taking advantage of valuable information about the company before it’s made public. The intent of these laws is to prevent insiders from profiting at the expense of other investors.

Measuring Market Performance: Market Indexes

Throughout the day, you can monitor the general drift of the stock market by watching any major news network and following the band at the bottom of your TV. News channels and broadcasts generally feature a market recap in the evening. Even music-oriented radio stations break for a minute of news every now and then, including a quick review of the stock market. Almost all these reports refer to one or more of the market indexesMeasure for tracking stock prices. with which investors can track trends in stock price. Let’s look more closely at some of these indicators.

The Dow

By far the most widely reported market index is the Dow Jones Industrial Average (DJIA)Market index that reflects the total value of a “market basket” of thirty large U.S. companies., or “the Dow.” The Dow is the total value of a “market basket” of thirty large companies headquartered in the United States. They aren’t the thirty largest or best-performing companies, but rather a group selected by the senior staff members at the Wall Street Journal to represent a broad spectrum of the U.S. economy, as well as a variety of industries. The thirty selected stocks change over time, but the list usually consists of household names, such as AT&T, Coca-Cola, Disney, IBM, General Electric, and Wal-Mart.

The graph in Figure 13.9 "DJIA for Ten-Year Period Ended May 2008" tracks the Dow for the ten-year period ended May 2008. The market measured by the Dow was on an upward swing from 1996 until 2000. At that point, it headed down until it reached its low point in 2002 and started its rebound. The path of the DOW during this ten-year period has been volatile (subject to up and down movements in response to unstable worldwide economic and political situations). Then came the big plunge—in 2008 the Dow declined by 34 percent.

Figure 13.9 DJIA for Ten-Year Period Ended May 2008

The NASDAQ Composite and the S&P 500

Also of interest is the performance of the NASDAQ Composite IndexMarket index of all stocks listed on the NASDAQ Stock Exchange., which includes many technology companies. Note in Figure 13.10 "NASDAQ for Ten-Year Period Ended May 2008" that the NASDAQ peaked in early 2000 at an index of over 5,000, but as investors began reevaluating the prospects of many technologies and technology companies, prices fell precipitously. Difficult economic times in 2008 spelled trouble for the NASDAQ composite index, and it declined by 41 percent. Another broad measure of stock performance is Standard & Poor’s Composite Index (S&P 500)Market index of the stocks of five hundred large U.S. companies., which lists the stocks of five hundred large U.S. companies. It followed the same pattern as the Dow and the NASDAQ Composite and declined by 37 percent in 2008.

Figure 13.10 NASDAQ for Ten-Year Period Ended May 2008

When the stock market is enjoying a period of large stock-price increases, we call it a bull marketPeriod of large stock-price increases.; when it’s declining or sluggish, we call it a bear marketPeriod of declining or sluggish stock prices.. The year 2008 was definitely a bear market.

How to Read a Stock Listing

Businesspeople—both owners and managers—monitor their stock prices on a daily basis. They want the value of their stock to rise for both professional and personal reasons. Stock price, for example, is a sort of “report card” on the company’s progress, and it reflects the success of its managers in running the company. Many managers have a great deal of personal wealth tied directly to the fortunes of the companies for which they work.

If you have any interest in investing, you’ll want to know how to interpret stock market information. Step one is learning how to read a stock listing like those printed daily in the Wall Street Journal and other newspapers. Figure 13.11 "Stock Listing for Hershey Foods" reports the information on Hershey Foods for December 31, 2008. Let’s use the explanations in Table 13.1 "Interpreting a Stock Quotation" to examine each item in greater detail.

Figure 13.11 Stock Listing for Hershey Foods

What, exactly, does Hershey Food’s stock listing tell us? Here are some of the highlights: The stock has done poorly for the past twelve-month period. Its price has dropped by more than 25 percent. The closing stock price of $37.28 falls right in the middle of the annual high of $44.32 and the annual low of $32.10. The company pays an annual dividend of $1.19 per share (which gives investors a fairly good cash return on their stock of 3.20 percent). At its current PE ratio, investors are willing to pay $19 for every $1 of Hershey’s earnings per share.

Stock

If you decide to sell stock to finance your expansion, the proceeds from the sale will increase your stockholders’ equityAmount invested in a corporation by its shareholders.—the amount invested in the business by its owners (which is the same thing that we called owner’s equity in Chapter 12 "The Role of Accounting in Business"). In general, an increase in stockholders’ equity is good. Your assets—specifically, your cash—will increase because you’ll have more money with which to expand and operate your business (which is also good). But if you sell additional shares of stock, you’ll have more stockholders—a situation that, as we’ll see later, isn’t always good.

The Risk/Reward Trade-Off

To issue additional shares of stock, you’ll need to find buyers interested in purchasing them. You need to ask yourself this question: Why would anyone want to buy stock in your company? Stockholders, as we know, are part owners of the company and, as such, share in the risks and rewards associated with ownership. If your company does well, they may benefit through dividendsEarnings distributed to stockholders.—distributed earnings—or through appreciation in the value of their stock, or both. If your company does poorly, the value of their stock will probably decline. Because the risk/reward trade-off varies according to the type of stock—common or preferred—we need to know a little more about the difference between the two.

Bonds

Now, let’s look at the second option: debt financing—raising capital through the sale of bonds. As with the sale of stock, the sale of bonds will increase your assets (again, specifically your cash) because you’ll receive an inflow of cash (which, as we said, is good). But as we’ll see, your liabilities—your debt to outside parties—will also increase (which is bad). And just as you’ll need to find buyers for your stock, you’ll need to find buyers for your bonds. Again, we need to ask the question: Why would anyone want to buy your company’s bonds?

Your financial projections show that you need $8 million to finance your expansion. If you decide to borrow this much money, you aren’t likely to find one individual or institution that will loan it to you. But if you divided up the $8 million loan into eight thousand smaller loans of $1,000 each, you’d stand a better chance of getting the amount you need. That’s the strategy behind issuing bondsDebt securities that require annual interest payments to bondholders.: debt securities that obligate the issuer to make interest payments to bondholders (generally on a periodic basis) and to repay the principal when the bond matures. In other words, a bond is an IOU that pays interest. Like equity investors, bondholders can sell their securities on the financial market.

From the investor’s standpoint, buying bonds is a way to earn a fairly good rate of return on money that he or she doesn’t need for a while. The interest is better than what they’d get on a savings account or in a money market fund. But there is some risk. Investors who are interested in your bonds will assess the financial strength of your company: they want to feel confident that you’ll be able to make your interest payments and pay back the principal when the time comes. They’ll probably rely on data supplied by such bond-rating organizations as Moody’s and Standard & Poor’s, which rate bonds from AAA (highly unlikely to default) to D (in default).

Choosing Your Financing Method

Let’s say that after mulling over your money-raising options—equity financing versus debt financing—you decide to recommend to the board that the company issue common stock to finance its expansion. How do you explain your decision? Issuing bonds is an attractive option because it won’t dilute your ownership, but you don’t like the idea of repaying interest-bearing loans: at this point, you’re reluctant to take on any future financial obligation, and money obtained through the sale of stock doesn’t have to be paid back. Granted, adding additional shareholders will force you to relinquish some ownership interest: new shareholders will vote on your board of directors and could have some influence over major decisions. On balance, you prefer the option of selling stock—specifically, common stock. Why not preferred stock? Because it has drawbacks similar to those of debt financing: you’d have to make periodic dividend payments, requiring an outflow of cash. Once the matter has been settled, you take a well-deserved vacation. Unfortunately, you can’t stop thinking about what you’ll do the next time you want to expand. In particular, franchising seems to be a particularly attractive idea. It’s something you’ll need to research when you get a chance.

Positions in Commercial Banking

Commercial banks employ finance professionals as loan officers to work with clients requesting personal or business loans. It’s the borrower’s responsibility, of course, to present a clear and coherent application, and it’s the loan officer who evaluates it—who decides whether the borrower will be able to meet the terms of the loan. Finance professionals also manage the deposits made at commercial banks, providing the bank with additional revenue by investing funds that don’t go into loans.

Positions in Corporate Finance

Every organization needs financial expertise. Large companies need finance professionals to manage their cash, their debt requirements, and their pension investments. They’re responsible for securing capital (whether through debt or equity), and they may be called on for any of the following tasks:

• Analyzing industry trends
• Evaluating corporate investment in new plants, equipment, or products
• Conducting financial planning
• Evaluating acquisitions (deciding, for example, whether to buy another company)
• Reviewing the financial needs of top management

In smaller firms, all these tasks may fall to a single finance professional. In addition, both large and small companies may occasionally use the services of financial consultants. They may be provided by investment bankers, by specialized consulting firms, or by the financial-advisory departments of a major accounting firm.

From an entry-level position—usually called analyst or junior analyst—the finance professional will advance from senior analyst to a managerial position. With each step, you’ll have greater exposure to senior management and face more important and more complex issues. Within ten to fifteen years, you may become a director or vice president. The rungs on the career ladder are pretty much the same in consulting and investment banking.

Positions in the Investment Industry

In the investment industry, finance professionals can be stockbrokers, investment analysts, or portfolio managers. Each of these positions requires an ability to assimilate great quantities of information, not only about specific companies and their securities, but also about entire industries and, indeed, the economy itself.

Some investment professionals work directly with individual clients. Others provide support to those who make sell or buy recommendations. Still others manage portfolios in the mutual fund industry. A mutual fund gathers money—ranging upward from a few hundred dollars—from thousands or even millions of investors and invests it in large portfolios of stocks and other investment securities. Finance professionals review and recommend prospective investments to company managers.

Because real estate (both commercial and personal) and insurance are investment fields, many financial professionals can be found working in these areas, as well.

Graduate Education and Certification

After completing the undergraduate degree with a major or concentration in finance, accounting, or economics, a finance professional may start to think about graduate school. The typical path is an MBA with a finance track. Though some schools offer a master’s in finance degree, such a program is highly specialized, with rigorous math requirements that may not appeal to everyone with an interest in finance.

Certification is a means of achieving professional distinction in a finance career. The most popular certifications include the following:

• CFA or Chartered Financial Analyst (usually an investment-analyst designation)
• CFM or Certified Financial Manager (usually a corporate-finance designation)
• CCM or Certified Cash Manager (usually a corporate-treasury designation)
• CFP or Certified Financial Planner (usually an individual stockbroker designation)

The insurance and real estate industries have their own certifications. In addition, because the federal government requires anyone who sells securities to be licensed, there is an entire set of licensing procedures that must be followed.