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FIN 330. Principles Of Financial Management Dr. Rhoades, Finance Department WKU Gordon Ford College of Business Email: email@example.com Text message: 352.228.1672 CLASS PREPARATION ASSIGNMENT #1. (Questions Only.) Please refer to “CPA_1.doc” or “CPA_1.pdf” for the complete Class Preparation Assignment. Please use this form to submit your answers to the questions, via Blackboard, prior to the start of class. CPA QUESTIONS. Please answer in your own words, unless indicated otherwise. 1. Please describe what duties a “financial analyst” might perform. A financial analyst uses data in order to determine investment and financing decisions. Investment decisions largely surround assets, or what the firm already owns, like land, labor, or capital. Financing decisions are more “fundraising”, using cash flow to meet liability obligations and purchase other assets to increase the value of the firm. 2. Please describe the duties of a loan officer. A loan officer is someone who analyzes loan applications and determines whether or not they should be approved based on a variety of factors. They are the intermediary between creditors and borrowers, evaluating the potential borrowers for their need for a loan and the ability to pay it back. 3. Please set forth 5-10 of the issues that a personal financial advisor (or Certified Financial Planner™) might address with a client. A CFP is more personal than a financial manager, dealing with clients in a more one-on-one basis. They deal with “life planning” for individuals, setting forth financial advice that pertains to certain financial goals people may have. They also undergo personal budgeting, which encompasses both savings levels and expenditures levels that enables people to effectively save for vacations, college, etc. A big component of a being a CFP also deals with retirement planning, which can be further broken down in accumulation, or the build-up to retirement, through either a 401k or a Roth IRA, and decumulation, or making sure that the money saved through accumulation isn’t too quickly spent. Financial planners deal with risk management as well, evaluation certain insurance options with clients based on their individual risk factors and financial situations. Also estate planning, or dealing with the will of clients upon death, and making sure that everything is financially stable in that regard. CFPs also largely deal with personal investment portfolios, enabling clients to invest into the stock market. A CFP FIN 330 Class Preparation Assignment 1 1 provides investment advice on stocks and strategies in that regard, once again dependent on the client’s personal financial situation. 4. Describe the distinctions between a corporation’s shareholders, directors, and officers. What role or function does each perform? A shareholder is an owner of the corporation, acquiring their stake through the purchase of either preferred or common stock. Among deciding on other company, they are responsible for voting for the Board of Directors, who are responsible for outlining what the corporation plans to accomplish. The BOD sets forth goals, policies, and approves anything major that the company might undertake. The BOD also decides on the management of the company, or the officers, who are responsible for daily operation and implementing the plan set forth by the Board of Directors. 5. How might the owners of a corporation (i.e., the shareholders) receive rewards for the risks they take in contributing monetary capital to the corporation? The shareholders are risk-averse, meaning that they have to be financially compensated for any risk that they undertake with certain corporations. So they are offered dividends, or distribution of company cash, and are able to benefit from increases in share price. Both compensations financially reward the shareholders for their investment. 6. What legal form of business is responsible for 80% of the revenues seen in business today? Corporations are responsible for actually 90% of all receipts in business, even though only 20% of business fall under that category. Sole proprietorships are the most numerous of all the legal forms of business, but generate less than 5% of all receipts. 7. What is the difference in a “pass-through” entity, for purposes of federal income taxation, such as an “S corporation,” in contrast to a “C corporation”? An pass-through entity doesn’t pay income taxes at the corporate level (like a corporation would). Rather, each owner of the business files their fraction of the corporate income at the personal tax level. An example of this is the S corporation, a limited liability corporation. In contrast, the C Corporation is “double taxed” meaning that the corporate income is taxed once, and then the distributions to shareholders is taxed as well. 8. What is the maximum number of individual shareholders for an S corporation in 2016? (You will need to do online research to find the answer.) According to the IRS, the maximum number of shareholders in an S corporation is 100, and these shareholders must be allowable (cannot be partnerships, corporations or non-resident aliens). 9. What are the tax brackets for C corporations, for federal income tax purposes, in 2016? What are the tax brackets for C corporations, as to their operations in the 2 FIN 330 Class Preparation Assignment State of Kentucky, for state income tax purposes? (You will need to do additional online research to answer these questions.) Over But Not Tax Rate Of amount Over over $0 $50k 15% $0 50k 75k 7500 + 25% 50k 75k 100k 13750 + 34% 75k 100k 335k 22250 + 39% 100k State Income Taxes 10 million 15 million 3.4 million + 10 million 35% Taxable net income up to $50k is taxed 15 million 18,333,333 5.15 million + 15 million at 4% 38% Taxable net income over $50 k and up 1833333 - 35% 0 3 to $100k is taxed at 5% Taxable net income over $100k is taxed at 6% 10.Why might a corporation with operations in many states in the United States have as its home office, and place of incorporation, the State of Delaware? The state of Delaware is one of the seven states without a corporate income tax rate. By moving there, corporations are able to avoid the corporate and personal state income tax, avoiding double taxation, and taxation in general. 11.Describe in your own words the primary goal of a corporation’s managers. The primary goal of managers is to maximize the wealth of the shareholders. This is done by increasing the share price of the company, allowing stockholders to benefit from the subsequent profits. To do this, managers must balance risk and reward, making decisions in which the benefit is greater than the cost. 12.Name various “stakeholders” in a firm. How might these stakeholders be influenced by the corporation’s adherence, or lack of adherence, to a strong code of ethics? A stakeholder is anyone with a direct economic connection to a firm, thus, they are effected by the firm’s financial decisions. Stakeholders include employees, cusomers, suppliers, creditors, and owners. When a firm follows an effective ethical program, the stakeholders generally see the firm in a better light. They are more loyal to the company, not afraid that kickbacks or briberies will negatively impact them, and are more committed to the corporation’s ideology, as they believe it to be concrete. When there is a lack of adherence to an ethical code, not only is stakeholder loyalty and commitment lost, but respect for the company is diminished as well, as it is viewed as a “cheater”. FIN 330 Class Preparation Assignment 3 3 13.PLEASE REVIEW THE CASE STUDY: “MARKET BASKET” A) Why do you think Market Basket is able to keep prices low, despite paying its employees total compensation (salary, bonuses, benefits, and profit- sharing) much higher than industry averages? I think that Market Basket is able to keep prices low because they have a very strong customer base, and avoid debt. Also, these workers who are compensated handsomely have more incentive to work harder for the company, and are probably on average, more loyal and committed to Market Basket than other supermarket employees are to their respective employers. It also sounds as though Market Base has integrated itself into the community, becoming a part of the customer and employee lives that definitely works in the favor of the company. Also, the fact that they have less administrative staff enables them to devote more to in-store employees, which works to enhance the productivity and profitability of the company as well. B) Why do you think the customers of the store were so loyal to the CEO, Arthur T. Demoulas, when he was fired as CEO? I think that their loyalty stemmed from the fact that Arthur T. treated them as family, rather than just employees. He branched out to include their family members as well, and to have your CEO show up at your mother’s birthday party is something unique and special. Having that connection creates a bond, which fosters a strong sense of loyalty. C) How does employee morale, attracting the best talent, and retaining good employees, affect the productivity of a business and its relationships with its customers? Employee morale is a big part of productivity. Unmotivated employees simply don’t work as hard, and because of that, the business suffers. Customers go into the store, and see the employee’s half-heartedly working, and become disenchanted. Companies are generally judged by the presentation of employees. Attracting the best talent obviously enhances the productivity of the business in that the employees are willing to work hard, and know how to work hard. This enables customers to receive quality treatment, which helps to build a strong customer- company relationship. Retaining employees like this furthers the productivity of the company, as good employees enhance long-term productivity over time. Relationships are also strengthened over time as good employees are kept, and the customer base becomes more loyal, and continues to grow by good word of mouth. 14.In your view, should Glidewell have been required to reimburse MBI for the bonus he received, even though he did not directly participate in the misconduct that occurred? Why or why not? 4 FIN 330 Class Preparation Assignment “Requires CEO and CFO to forfeit bonuses, compensation and any stock sale profits if a restatement of financial statements is required because of material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws” In my opinion, there is no way that Glidewell wasn’t aware of the misconduct that was occurring, Also, as listed above, there is a direct order under the SOX act that the CEO and CFO are required to forfeit bonuses during a time of misconduct. It doesn’t require any level of knowledge of misconduct for them to be forced to reimburse, it simply states that it must be done. Therefore, I think that he should be required to reimburse the company. FIN 330 Class Preparation Assignment 5 5 FIN 330 – DR. RHOADES CPA #4: READINGS AND VIDEOS CHAPTER 3: FINANCIAL STATEMENTS AND RATIO ANALYSIS We will use two classes to cover the content and the problems in this chapter. th Wednesday, Sept. 7 – CPA #4, covering Section 3.1 th Friday, Sept. 9 : CPA #5, covering the rest of the chapter (CPA #5 requires more time!) NOTE: We also begin our use of MyFinanceLab with this chapter. See the separate Class Preparation Assignment questions document, for the assigned MyFinanceLab questions. LEARNING OBJECTIVES (FOR ALL OF CHAPTER 3): Review the contents of a stockholder’s annual report. Understand the four key financial statements required in annual reports. o Income statement o Balance sheet o Statement of retained earnings o Statement of cash flow Ratio analysis: Understand the distinctions between a “cross-sectional analysis,” “time-series analysis,” and “combined analysis” Understand the types of financial ratios commonly utilized o Liquidity ratios: Current ratio Quick ratio (aka acid-test ratio) o Activity ratios: Inventory turnover Average age of inventory 1 Average collection period Average payment period (average age of accounts payable) Total asset turnover o Debt ratios: Degree of indebtedness ratios: Debt ratio Debt-to-equity ratio Ability to service debt ratios: Times interest earned ratio Fixed payment coverage ratio o Profitability ratios: Gross profit margin Operating profit margin Net profit margin Earnings per share (EPS) Return on total assets (ROA) Return on equity (ROE) o Market Price-to-earnings (P/E) ratio Market-to-book (M/B or MtB) ratio The Dupont System of Analysis: o The Dupont Formula o The Modified Dupont Formula o Understand that the DuPont analysis system caught world-wide attention and played a huge role in the enterprise management for it specified direction of improving business performance and ROE for managers which decomposes ROE to several financial indexes to reflect the changes in different aspects and factors of business performance. 2 GENERATION QUESTIONS: Which of the terms and concepts noted above, under the Learning Objectives, do you already know? Can you define them, in your own words, out loud? 3 READINGS AND VIDEOS. 1. Please read Section 3.1 – The Stockholder’s Report. Generally Accepted Accounting Principles- guidelines used to prepare financial reports Authorized by the Financial Accounting Standards Board SOX 2002- enacted to eliminate the disclosure and conflict of interest problems Established the Public Company Accounting Oversight Board- oversees auditors of public corporations Protect interest of investors and prepare informative & fair audit reports Publically owned corporations w > $5 million in assets or > 500 stockholders are required by the SEC (governs sale and listing of securities) Provide stockholders with an annual stockholders report- summarizes firm’s financial activities during the past year Annual Stockholder’s Report Letter to Stockholders: primary communication of management; describes events that had biggest effect on firm this year 4 Key Financial Statements 1. Income statement- Financial summary of operating results during a specified period (fiscal year) Sales Revenue- total dollar amount of sales during this period Less: COGS Gross Profit- amount remaining for operating, financial, and tax costs Less: Operating Expenses- selling, general and administraitive, lease and depreciation exp. Operating Profits- profits earned from producing and selling products Less: Interest Expense Net Profits Before Taxes Less: Taxes Net Profits after Taxes Less: Preferred Stock Dividends Earnings Available for Common Stockholders Earnings per share = Earnings Available / # of shares of common stock outstanding # of dollars earned during the period on each share of common stock Dividend per share – dollar amount of cash distributed on each share of stock 2. Balance sheet- summary of a firm’s financial position at a given time 4 Balances assets (what it owns) with financing (debt-owes; equity-other ownership) Current assets and current liabilities are short-term converted into cash or paid in <1yr All other assets are fixed because they are expected to remain on the book >1yr Assets are listed from most liquid (Cash) to least liquid Marketable securities- very liquid “near cash” short term government investments Accounts receivable- what the customers owe the firm Inventories- raw materials, work in progress, and finished goods Gross fixed assets = original cost of all fixed (long-term) assets owned by the firm Net fixed assets = different between gross fixed assets & accumulated depreciation Value of net fixed assets = book value Liabilities and equities are listed short-term to long-term too Accounts payable- amounts owed by the firm Notes payable- short term loans from commercial banks Accruals- amounts owed for services (taxes and wages) Long term debt- payment of which is not due in current year Stockholders equity- owner’s claim on the firm Preferred stock- proceeds from sale of preferred stock Common stock- par value of common stock Paid in capital in excess of par- proceeds > par value on common stock Common stock + Paid in Capital / # of shares outstanding = original price per share Retained earnings- cumulative total of all earnings, net of dividends- retained and reinvest 3. Statement of Retained Earnings Abbreviated form of statement of stockholder’s equity – reconciles net income earned and any cash dividends paid with the change in RE between start and end of year Beginning Retained Earnings + Net Profits – Dividends = End Retained Earnings 4. Statement of Cash Flows Summary of cash flows over the period – operating, investment, and financing cash flows and reconciles them with changes in cash and marketable securities Notes to the Financial Statement 5 Provide detailed info on accounting policies, procedures, calculations, and transactions Use info provided to estimate the value of the securities FASB No. 52- US based companies translate their foreign-currency denominated assets into dollars to consolidate with the parent company financial statements Current rate (Translation) Method- uses the current rate to translate monies Equity accounts use the historical rate (when the parent company was made) 2. Please watch this video on YouTube: The Four Core Financial Statements, by Larry Walther https://www.youtube.com/watch?v=7BAcIA5qpEM (5:45) Accounting provides the information for financial decision making Income statement- revenue, expenses, results of operation Difference between revenue and expenses is the net income of company Statement of retained earnings: income in business not paid out in dividends Retained earnings + net income – dividends = end retained earnings Balance sheet- assets, liabilities, stockholder’s equity (uses RE from RE statement Statement of cash flow- how cash is generated and expended Operating: cash received and paid; investing: purchase of land, and financing: paid dividends Net income reported on retained earnings, RE reported on stockholders equity portion of the balance sheet 3. Review the Brown-Forman 2016 Annual Report (posted to Blackboard) and please try to define these terms, in your own words (verbally). This is not a “quiz” or a “test” – nor will you be called upon to answer these questions in class. Rather, this is a way of illustrating, in the “real world,” the accounting and finance concepts you are learning. a. Can you define, in your own words: “generally accepted accounting principles (GAAP)” rules and procedure that a company must follow when creating and reporting financial statements i. APPLICATION: See page 24 of the Brown-Forman 2016 Annual Report (in the PDF file, this is page 39 of the PDF 6 document) for a discussion of their use of Non-GAAP Financial Measures. Why would Brown-Forman be interested in the level of distributor inventories? If the inventory of a certain brand is higher, it might mean that it isn’t selling as much, and therefore is not as profitable as it could be. ii. APPLICATION: Many companies may be making customized adjustments to their GAAP financial measures. Some in the industry have termed this trend as “earnings before bad stuff.” Recent articles report a growing difference between companies’ advertised financial measures and what they earned under generally accepted accounting principles. A recent news article reported that companies in the S&P 500 had advertised earnings that were 25% higher than their earnings as reported under generally accepted accounting principles. AND … this certainly makes financial statement analysis for finance majors more difficult! b. Financial Accounting Standards Board (FASB) i. APPLICATION: Accounting standards change, over time. For examples, see page 55 of the Brown-Forman 2016 Annual Report. Note that certain measures, such as price- earnings, price-sales, and other financial ratios may also, as a result, vary over time. Some imprecision exists in contrasting financial ratios from 2000 with those used in 2016. ii. APPLICATION: The FASB is supported by “accounting support fees” paid by publicly traded companies. c. Public Company Accounting Oversight Board (PCAOB) i. APPLICATION: There is a cost to being a large, publicly- traded entity. Not only must financial statements be prepared, but also an “annual support fee” must be paid to fund the operations of the PCAOB. The PCAOB provides external, independent oversight of the auditors of U.S. public companies. Generally, equity issuers with an average, monthly U.S. equity market capitalization greater than $75 million pay the fee, which is allocated based upon market value. Public companies provide $221 million to 7 fund the PCAOB in 2016. About 55% of the fees fund inspections of accounting firms. d. Income statement i. APPLICATION: Look at pages 49-50 of the Brown-Forman Annual Report. As shown, at times an “income statement” is named as something different – in this instance, a “Consolidated Statements of Comprehensive Income.” e. Dividends per share i. APPLICATION: See page 74 of the Brown-Forman Annual Report. How often are dividends paid out by the company? Have dividends been increasing or decreasing recently? Dividends are paid out 2x a year. Dividends have been increasing f. Balance sheet i. APPLICATION: View Brown-Forman’s Balance Sheet in its 2016 Annual Report – see p.51. g. Current assets i. APPLICATION: View Brown-Forman’s 2016 Annual Report – see p.51. Look for “Total current assets” – what do those assets consist of? Cash and cash equivalents, accounts receivable, inventories, current deferred tax assets, and other current assets i. APPLICATION: On page 54 of the annual report, it states: “Because we age most of our whiskeys in barrels for three to six years, we bottle and sell only a portion of our whiskey inventory each year. Following industry practice, we classify all barreled whiskey as a current asset. We include warehousing, insurance, ad valorem taxes, and other carrying charges applicable to barreled whiskey in inventory costs. Does this fit within the definition of “short-term assets” set forth in the textbook, at page 56? No because short term assets are meant to be sold in less than a year, and they are aging them for 3 – 6: not short term. h. Current liabilities 8 i. Long-term debt i. APPLICATION: View Brown-Forman’s 2016 Annual Report – see p.51; contrast the amount of “total current liabilities” with the amount of “long-term debt.” Current liabilities were greater than long term debt for 2015, but in 2016, long term debt increased past current liabilities j. Paid-in capital in excess of par i. APPLICATION: View Brown-Forman’s 2016 Annual Report – see p.51. Look for the line: “Additional Paid-In Capital.” k. Retained earnings i. APPLICATION: View Brown-Forman’s 2016 Annual Report – see p.51: did the amount of retained earnings increase from 2015 to 2016? yes l. Statement of stockholders’ equity i. APPLICATION: View Brown-Forman’s 2016 Annual Report – see p.53. m. Statement of retained earnings i. APPLICATION: View Brown-Forman’s 2016 Annual Report – see p.51. n. Statement of cash flows i. APPLICATION: View Brown-Forman’s 2016 Annual Report – see p.52. o. Effective tax rate: i. APPLICATION: View Brown-Forman’s 2016 Annual Report – see p.70. What was the company’s “effective rate” of tax for 2016? Is this significantly lower than the 2016 corporate federal (statutory) income tax rate of 35%? Because their income is so high, it is significantly lower. PROBLEM SET IN MYFINANCELAB. We now use MyFinanceLab’s questions for the first time. Please tackle the following in MyFinanceLab … the following problems are assigned: 9 3 “Orientation” questions: 1 point each x 3 Warm-Up 3-2 : 1 point P3-1: 2 points P3-5: 2 points P3-7: 2 points Please complete the foregoing problems prior to the beginning of class. 10 FIN 330. Principles Of Financial Management Dr. Rhoades, Finance Department WKU Gordon Ford College of Business Email: firstname.lastname@example.org Text message: 352.228.1672 CLASS PREPARATION ASSIGNMENT #2. ‘Da Bear is here for you. If you are READINGS, VIDEOS struggling, overly anxious, or AND SELF-TEST “READING become depressed, see ‘Da Bear. While I might not always have the COMPREHENSION” QUESTIONS. answer, personally, I can seek out others at WKU who can assist you. LEARNING OBJECTIVES - Please Review: In Chapter 1 we undertook a survey of the role of managerial finance in a corporation. We reviewed corporate governance structures – and the role of shareholders, directors, and officers (including the CFO). We noted that risk and return are the key determinants of share price. We discussed the role of corporate management – to maximize shareholder wealth, although other stakeholders exist in the corporation. We briefly reviewed that financial managers are most concerned with cash flow of a corporation. And we discussed “the agency problem” that shareholders face, and how recent reforms (including clawback provisions mandated by SOX) are designed to more closely align the incentives of managers with those of shareholders. In this CPA, covering Chapter 2 of the text, we first seek to understand the role that different financial institutions play in our capital markets. We examine the differences between the “capital markets” and “money markets.” We review the causes of the 2008-9 financial crisis. We further examine the major governmental agencies involved in the regulation of the financial markets. We explore further the role of taxes upon business enterprises, and the importance of taxes in many financial decisions. GENERATION. Please review this list. Which of these terms and concepts can you already describe, in your own words? 1 Financial institution Commercial bank o Savings and loans o Credit unions Insurance companies Investment bank Glass-Steagall Act (repealed) Shadow banking system Mutual fund Pension fund Financial markets Private placement of securities (Public) Capital markets o Public offering of securities Initial public offering (IPO) Primary market (for securities) o Secondary market (for securities) Security exchanges Stock exchanges New York Stock Exchange / Euronext Nasdaq Over-the-counter (OTC) market Broker market; securities brokers Dealer market; securities dealers Market makers o Bonds o Common stock o Preferred stock The “money market” o Demanders vs. suppliers of short-term funds o Marketable securities 2 U.S. Treasury bills Commercial paper Negotiable certificates of deposit o Eurocurrency market READINGS & VIDEOS: (1) Please read “Financial Institutions” in Section 2.1, “Financial Institutions and Markets” Financial institution accepts savings and transfers them to those that need funds. Financial market is where suppliers and demanders can make transactions of various types of funds. Private placement is the final way for firms to obtain funds, but it is rather unstructured. Financial institutions are intermediaries that channel the savings of users into loans or investments. Pay users interest or charge a service fee, lending the money out or investing into stocks -Individuals are the net suppliers of financial institutions- they save more than they borrow -Firms are net demanders, meaning that they borrow more than they save. -Governments do not borrow directly from financial institutions, but they sell their debt securities to them. Gov is a net demander (borrow more than they save). Major financial institutions: Financial Markets- suppliers of funds and demanders of funds can transact directly Know where funds are going (unlike financial institution loans) 1. Money market- transaction in short term debt securities/marketable securities 2. Capital market- trading long term securities- stocks and bonds Raise money: private placement or public offering Private placement- sale of new security directly to an investor Public offering- sale of stocks or bonds to the general public (more common) Primary market- sell stocks or bonds and receives cash in return “new securities” Issuer receives no money after the first transaction Secondary market- when securities trade between investors “preowned securities” Suppliers of Funds: give funds to financial institutions, demanders of funds (through private placement) and to financial markets; receive deposits/shares (instit.), securities (markets, demanders) in return Financial institutions: give funds and accept loans from demanders, accept securities from frinancial markets in exchange for funds Money market: relationship between suppliers and demanders of short-term funds (1 yr or less) Brings together short term investors with short term loans Transactions made in marketable securities- US treasury bills, commercial paper, certificates of deposit (not very risky investments) International equivalent = Eurocurrency Market short term bank deposits in form of securities (depositing American $ in a London bank) 3 Time deposit- bank will pay back deposit with interest at a fixed date in the future In the meantime, bank can loan out the foreign currency Capital market- long-term funds transaction (bond and stock) Bonds- long term debt Helps businesses raise money from a lot of different lenders Corporate bonds- interest semi-annually (6 months) at a coupon interest rate Maturity of 10 to 30 years; par/face value of $1000 that must be repaid Ex. a 9% coupon interest rate, 20 year bond with $1000 par value that pays semiannual interest Have right to $90 annual interest (9% x $1000) distributed as $45 every 6 months for 20 years plus the $1000 par value at the maturity date Common and preferred stock- equity Own the business- receive a return in the form of dividends or increases in share price Preferred stock- get a fixed dividend that is paid before common stockholders Secondary market can be divided into broker and dealer markets Broker market- consists of securities exchange that provides a marketplace to sell new securities and resell old ones right “on the floor” (seller and buyer are brought together) Ex. NYSE- only takes really large firms has centralized trading floors (60% of shares) Dealer market- buyer and seller are never brought directly together Buy/sell orders executed by market-makers- there is always a dealer in the transaction Made up of the Nasdaq market, and the over-the-counter market (smaller securities) No central trading floor- large number of market makers connected electronical 40% of shares Maker makes a market by utilizing bid (highest buy) and ask (lowest sale) Pay the ask price, and receive the bid price when selling securities International Capital Markets Eurobonds- issue bonds in US $ and sell them outside the US Foreign bond market- international market for long term debt securities Foreign bond- a US bond issued in Mexican pesos and sold in Mexico International equity market- sell blocks of shares to investors in different countries same time Role of capital Market Firms: to be liquid so they can raise money Investor: to be efficient so they can have productive money Price of a security is determined by interaction between buyers and sellers in the market 4 Efficient market: price of stock is unbiased estimate of true value; returns to a mean Behavioral finance- stock prices will act wacky for a long period of time (2) Additional reading: The Distinction between Commercial Banks, Savings Institutions, and Credit Unions. a. Banks, Credit Unions and Savings Institutions all have their deposits, up to $250,000, are insured by one of two federal agencies: the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA). b. All of these types of institutions are subject to periodic regulatory and federal insurance examination. [geography, profitability, equity, administration] c. Commercial banks are community, regional or national for-profit business corporations owned by private investors and governed by a board of directors chosen by the stockholders. Commercial banks can be small, but they are also some of the largest financial institutions in the world today. Here is a chart from Sept. 2014 showing the four largest U.S. banks, in terms of annual revenue: d. Savings institutions (also called savings & loans or savings banks) typically specialize in real estate financing. They can be either corporations or mutual associations (a type of business where making a deposit is like purchasing stock in the organization). i. Mutual savings associations were formed to encourage savings and home ownerships. Until a few decades ago, they specialized in home mortgage loans and rarely provided loans to businesses. 5 ii. Mutual savings associations are some of the oldest types of financial institutions in the United States. Savings banks date their creation to 1816 with doors open and accepting deposits in 1817. The founders of these saving societies were philanthropists interested in encouraging savings among the poor." In fact, some savings banks were named for coins, e.g., “The Dime” or “Salem Five Cents," because the savings banks would take deposits as small as a dime or five cents . iii. Savings institutions always have the letters SSB or FSB after the name to indicate whether they are a state savings bank or a federal savings bank, respectively. iv. Both types of savings banks (mutual, non-mutual) are governed by an elected board of directors. v. MSB's profits are distributed to the owner/customers in proportion to the business they do with the institution. (In contrast, credit union profits are distributed to just those who have deposits with the credit union.) e. Credit unions are non-profit financial cooperatives owned by their members and governed by a board of directors elected by, and from among, those members. Usually there is a common bond among the members, such as belonging to the same organization or living in the same geographical area. Credit unions accept deposits from their members and use them to make short-term loans. i. The original purpose of credit unions was not so much to encourage savings as it was to provide people with access to credit. ii. Deposits are regarded as purchases of shares, and all earnings of the credit union are paid out as dividends to members iii. Credit unions tend to offer higher rates of return on savings accounts and lower interest rates on loans. iv. More than 100 million Americans currently use the 6,900 credit unions in the country. v. While membership in a credit union depends on belonging to a particular community, such as a workplace, region or church, most consumers are eligible, though they may not realize it. They might just need to investigate options within their communities. So how do you find one? Websites such as www.mycreditunion.gov and www.asmarterchoice.org can help. Also, ask around – your employer or college may have an affiliation with a credit union. (3) TEST YOUR READING COMPREHENSION. Now, pleases ascertain if you can answer the following questions, in your own words, as a means of testing your 6 understanding of the just-read material. These are “self-test” questions – just answer them verbally, to yourself. No submission of your answers is required. a. When it is said that an individual is a net supplier of funds to financial institutions, what does this mean? It means the individuals saves more than they borrow- they provide the financial institution with the loans. b. When it is said that business firms are net demanders of funds to financial institutions, what does this mean? Firms borrow more than they save- they demand more than they deposit. c. Does the U.S. government save more (from tax and other receipts), or borrow more (by issuing debt, such as U.S. government bills, notes, and bonds), typically, each year? As witnessed by our trade deficit, the government borrows more than it saves. d. What are the key differences between: (1) commercial bank; (2) mutual savings and loan association (a.k.a. savings bank); and (3) credit union? With which of these types of financial institutions would you most likely desire to personally save with, or take personal loans with – and why? Commercial bank is a for-profit financial institution governed by a Board of Directors and owned by private investors. MSB is a business where deposits equate to shares of stock, and your payment is determined by how much business you do with them. Credit Unions are non-profit organizations that offer higher interest rates on savings, and lower interest on loans. They loan out deposits to customers, but all customers receive the credit unions profit in the form of dividends. (4) Please read “Commercial Banks, Investment Banks and the Shadow Banking System” in Section 2.1, “Financial Institutions and Markets” Commercial banks: place to invest funds and offer loans Made a safe place due to deposit insurance by government ($250k) because of bank runs Investment banks- Assist companies in raising capital Advise firms on major transactions Engage in trading and market making activity Commercial and investment banks were separated by the Glass-Stegall Act- but repealed in late 1990 Shadow banking system- groups that lend out, but do not accept deposits: don’t follow regulation Ex. Lehman bros intermediary between pension fund and large corporation 7 (5) Please watch this video, “Understand Investment Banking” (4:29): https://www.youtube.com/watch?v=c84b9my14Cg CIB advises client to create a subsidiary, or joint venture – sustainable, transparent, ease. Issue a bond on capital market to raise $- rate (made of a multitude of issues), maturity date Indirect financing (provides a capital market w lots of investors) and financing (loans) Hedging allows the price of raw material to be fixed to current prices Financial risk management – manage financial uncertainties Investment solutions – acts as intermediary between issuers and investors (insurance companies, pension funds, portfolio managers, asset managers, hedge funds) Advise these investors on how to properly invest their money (6) Please watch this video, “Five Facts About Shadow Banking” (2:58): https://www.youtube.com/watch?v=hxxMIeO-cs0 1. Shadow banks are entities engaged in any bank like activity 2. It is a $71.2 trillion dollar industry- triple the size it was 10 years ago 3. There are concerns over rapid expansion in China- nobody knows how it will end 4. 2009 crisis: shadow banks helped hide and magnify the financial risk- act more in direct lending now 5. Shadow banks are largely unregulated- rate of growth is accelerating, so people want to clamp down on them (7) Investment banks, structured investment vehicles, hedge funds, non-bank financial institutions, money market funds, mutual funds and exchange-traded funds are all a part of the shadow banking system and are not required to maintain any reserves or emergency capital. According to the Financial Stability Board's Global Shadow Banking Monitoring Report 2015, the United States accounted for the largest shadow-banking sector, with $14.2 trillion in 2014. The figure was more than one-third of global shadow banking assets. (8) In order to address the issue of shadow banks, many politicians have been pushing for the restoration of the Glass-Steagall Act. Prior to the Great Depression in the 1930s, commercial banks were blamed for getting very speculative and greedy, since they were not only investing their assets, but also buying new issues for resale to the public. This led to a collapse of the banking system, which slowly became irresponsible and chaotic. One of the functional reforms that came in the form of banking regulations was called the Glass- Steagall Act, and it clearly outlined the objective of the banks. The proposal was to limit their activities by separating commercial and investment bank functions. The underlying belief of the Glass-Steagall Banking Act of 1933 was that it would 8 reduce risk and create a healthier financial system. Under the Glass-Steagall Act, institutions were given a year to decide whether they would specialize in commercial or investment banking. This Depression-era law was in place for 60 years until Congress and President Bill Clinton repealed it in 1999 under the Gramm-Leach-Bliley Act. (9) TEST YOUR READING COMPREHENSION: (test yourself by verbally answering these questions) a. How is an investment bank different from a commercial bank? An investment bank is more involved in the trading and fundraising (raising capital) side of the marketplace, and advise firms on major transactions (raise capital, advise, trade). A commercial bank is more for a secure place to put your funds and obtain a loan. (deposits and loans) b. Describe a type of firm that engages in shadow banking activities. A firm that engages in shadow banking activities is any entity that basically does what a bank does. They engage in lending activity, but they do not accept deposits, and are therefore not subject to the same types of regulations. c. What was the Glass-Steagall Act, and why are there continued calls for it to be reinstated? The Glass-Steagall Act was an act that separated the commercial and investment banks for reasons as they were perceived to be seen as getting greedy with their investors money. The act outlined the objectives of the bank. There are calls for it to be reinstated because the shadow banking banks are getting out of control. (10) Please Read “Financial Markets” and “The Relationship Between Institutions And Markets” and “The Money Market” in Section 2.1, “Financial Institutions and Markets” Financial Markets- suppliers of funds and demanders of funds can transact directly Know where funds are going (unlike financial institution loans) 1. Money market- transaction in short term debt securities/marketable securities 2. Capital market- trading long term securities- stocks and bonds Raise money: private placement or public offering Private placement- sale of new security directly to an investor Public offering- sale of stocks or bonds to the general public (more common) Primary market- sell stocks or bonds and receives cash in return “new securities” Issuer receives no money after the first transaction Secondary market- when securities trade between investors “preowned securities” Suppliers of Funds: give funds to financial institutions, demanders of funds (through private placement) and to financial markets; receive deposits/shares (instit.), securities (markets, demanders) in return Financial institutions: give funds and accept loans from demanders, accept securities from frinancial markets in exchange for funds 9 Money market: relationship between suppliers and demanders of short-term funds (1 yr or less) Brings together short term investors with short term loans Transactions made in marketable securities- US treasury bills, commercial paper, certificates of deposit (not very risky investments) International equivalent = Eurocurrency Market short term bank deposits in form of securities (depositing American $ in a London bank) Time deposit- bank will pay back deposit with interest at a fixed date in the future In the meantime, bank can loan out the foreign currency (11)Please watch this video: “Financial Markets Explained” (1:30): https://www.youtube.com/watch?v=z7BgrK00o94 Financial marketplace- buyers and sellers participate in selling bonds, currencies, or derivatives Transparent pricing, basic regulations, market forces determine prices Allow only certain participants Some markets are very small, some very large (NYSE) Prices raise when a lot of people trade- downturns may have prices fall below base levels. (12)Please watch this video: “Money Market” (1:25): https://www.youtube.com/watch?v=iAcH892HHFo Safe liquid investments for small investors- treasury bills and commercial paper Short term (Treasury funds <1 year and commercial paper 270 days) Can sell the fund if you need money right away Account requires a minimum balance and it must remain in there for a while Higher interest rates than savings accounts; better for short term investors (13)The two largest U.S. money market funds are Fidelity Government Cash Reserves Fund and the Vanguard Prime Money Market Fund, each of which possess over $100 Billion in assets. a. In response to in response to rules adopted by the Securities and Exchange Commission (SEC) in 2014, the last compliance date for which is in October 2016, many money market funds are shifting their holdings to primarily government-issued debt, in order to maintain a “$1.00 per share net asset value” for individual clients. i. From Bloomberg.com, August 3, 2016: “Obscure Rule to Fix $2.7 Trillion Market Draws Tireless Opponent” by Elizabeth Dexheimer: “Money-market funds are the biggest source of short-term loans to businesses and provide low but reliable returns to investors, who range from retirees to investment firms to local governments … In September 2008, easy withdrawals created a big problem. An investment in the failed Lehman Brothers Holdings Inc. sparked a run on the $62.5 billion Reserve Fund (one of the most respected money market funds in the U.S.), pushing it to the brink of failure, 10 known as “breaking the buck.” At the time, money funds maintained a constant $1 share price -- called stable net asset values, or NAV. The Reserve Fund panic spread to other markets, worsening the credit crunch. b. Money market mutual funds are investments and are not insured. The funds invest in low-risk, highly-liquid investments like U.S. Treasury security (T-bills), certificates of deposit (CDs) and corporate commercial paper. They are regulated by the SEC and their value is determined by underlying investments, but they are not guaranteed investments. c. Money market deposit accounts, held in commercial banks, and like savings accounts, are FDIC insured. A money market account is like a "souped-up" savings account that can also invest your money in treasury notes, CDs and other short-term investments to give you a slightly better yield than a regular savings account. As with a savings account, the federal government insures your deposits in a money market account up to $250,000. (14) Please read: “The Capital Market” in Section 2.1, “Financial Institutions and Markets” Capital market- long-term funds transaction (bond and stock) Bonds- long term debt Helps businesses raise money from a lot of different lenders Corporate bonds- interest semi-annually (6 months) at a coupon interest rate Maturity of 10 to 30 years; par/face value of $1000 that must be repaid Ex. a 9% coupon interest rate, 20 year bond with $1000 par value that pays semiannual interest Have right to $90 annual interest (9% x $1000) distributed as $45 every 6 months for 20 years plus the $1000 par value at the maturity date Common and preferred stock- equity Own the business- receive a return in the form of dividends or increases in share price Preferred stock- get a fixed dividend that is paid before common stockholders Secondary market can be divided into broker and dealer markets Broker market- consists of securities exchange that provides a marketplace to sell new securities and resell old ones right “on the floor” (seller and buyer are brought together) Ex. NYSE- only takes really large firms has centralized trading floors (60% of shares) Dealer market- buyer and seller are never brought directly together Buy/sell orders executed by market-makers- there is always a dealer in the transaction 11 Made up of the Nasdaq market, and the over-the-counter market (smaller securities) No central trading floor- large number of market makers connected electronical 40% of shares Maker makes a market by utilizing bid (highest buy) and ask (lowest sale) Pay the ask price, and receive the bid price when selling securities International Capital Markets Eurobonds- issue bonds in US $ and sell them outside the US Foreign bond market- international market for long term debt securities Foreign bond- a US bond issued in Mexican pesos and sold in Mexico International equity market- sell blocks of shares to investors in different countries same time Role of capital Market Firms: to be liquid so they can raise money Investor: to be efficient so they can have productive money Price of a security is determined by interaction between buyers and sellers in the market Efficient market: price of stock is unbiased estimate of true value; returns to a mean Behavioral finance- stock prices will act wacky for a long period of time (15)How is capital raised by corporations? Either by private placements or public offerings: a. Private Placements i. Private placement investments were typically purchased by institutional investors that specialize in private investments, rather than being offered to investors who typically buy smaller lots in the marketplace. ii. Yet, private placements can also be relatively small. For example, a group of physicians may all invest, along with other investors, in a limited liability company in order to build, or purchase, an office building complex. iii. Please watch this video: “Thinking About a Private Placement? Think Again!” (3:20): https://www.youtube.com/watch? v=nqztAmY0GVo FINRA- offering of securities not registered with SEC and not offered to public at large; only available to big-time investors (> 1 million worth or > $200k income) There are transparency and liquidity problems- exercise due diligence Very few investors are qualified to determine if private placement is fair in light of risks 12 The funds underperformed the S&P 500 by 3%- risk not worth reward b. Public Offerings are undertaken in the “primary market” – when new stock or bonds are sold by a company to individual investors, through brokerage firms, in the “public market.” i. This contrasts with the “secondary market” – when stocks or bonds are sold between investors, such as on stock exchanges. “preowned” c. Exploring The Impact of the Internet on Private Placements: Equity Crowdfunding Begins! i. Please watch this video: “Bob’s Buzzword of the Day: ‘Private Placements’” (3:24): https://www.youtube.com/watch?v=8eFFL52E0No Private placement- sales of securities to institutional investors historically without general advertisement- but the internet made it so more of the public could invest (you can have general solicitation) Different from IPO because you can only sell to those accredited investors- hedge funds 1. Recently the rules on private placements were relaxed by the SEC. Before you could only “solicit” investments from institutions and from others you personally knew. Now you can solicit investments in private placements from people you don’t know. 2. Elio Motors, one of the very first companies to take advantage of new Regulation A+ rules (a type of private offering) created by the JOBS Act of 2012, has provided an update on their equity crowdfunding campaign. As of today, Elio has raised almost $16 million and has topped their hurdle of $12.6 million deemed necessary to fund engineering and testing of the E-Series prototype car, using a listing on StartEngine, an equity crowdfunding site. 3. Please watch this video: “Jason Paltrowitz, OTC Markets Group EVP interviews Ron Miller, CEO of StartEngine” (6:24): https://www.youtube.com/watch?v=NYO8eQC7txk Help entrepreneurs get the capital they need to accelerate and create their companies Digital marketplace where entrepreneurs can connect with investors Equity crowdfunding rules- allows owners to advertise broadly and lets non-accredited and accredited investors invest in these companies 13 Owners can spread the word that they are looking for equity shares Have to prove the concept to the market- preserve entrepreneurs 4. Take a moment to visit the www.stargengine.com web site. (16) Please watch this video: “What Does a Brokerage Do?” (1:54) https://www.youtube.com/watch?v=3P3R19fiH_Q Broker is an intermediary between buyers and sellers of securities- charges a commission Actually broker/dealer- can buy securities and sell securities from its own inventory Charges a markup = net price – dealer price Dealer may buy a security for a markdown Clients cannot be charged a commission AND a markup in a singular transaction (17)TEST YOUR READING COMPREHENSION: (test yourself by verbally answering these questions) a. Define the term “money market.” Financial relatio
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