Page 496 - Introduction to Business

470 PART 5 Finance

Summary

LEARNING OBJECTIVE 1 issuance of bonds and stocks in the financial market-
Explain how financial managers fit into the organi- place. Debt financing, or bank loans and bonds, tends
zational structure of a firm and what their role is. to be lower cost than equity financing, or common
stock, due to the tax deductability of interest payments.
In this chapter we have reviewed the roles of financial
Financial managers attempt to use an optimal mix of
managers and investment managers. Firms rely on
sources of funds that minimizes their overall cost.
financial managers to make capital budgeting decisions
and raise funds to finance the production and sale of
LEARNING OBJECTIVE 5
products and services. Their main goal is to turn
accounting profits into economic profits, as measured Describe different types of investment managers
and the services they provide investors.
by higher common stock prices. Agency costs arise
when managers undertake activities that benefit them- Investment managers seek to buy and sell securities
selves but do not increase common stock prices. issued by firms to make a profit for their clients. Bro-
kers and dealers execute the buy-and-sell orders of the
LEARNING OBJECTIVE 2
public for a service fee. Investment bankers help firms
Use the time value of money to differentiate issue their bonds and stocks. Also, institutional
between present values and future values of money. investors assist in securities transactions for individu-
To perform capital budgeting analyses, it is necessary als, businesses, and the government.
to understand the time value of money. Simply put, a
dollar received tomorrow is worth less than a dollar LEARNING OBJECTIVE 6
received today. Interest rates link future values to pres- Give details of how to measure investment
ent values. The main components of nominal interest returns and what investment risks confront
rates are the real interest rate, inflation rate, and default investors.
risk premium. When money is invested for more than A fundamental concept in investment analysis is the
one period, it can grow at an increasing rate over time. risk-return trade-off. Higher risk securities require
higher expected returns as compensation to investors
LEARNING OBJECTIVE 3
for bearing risk. The rate of return on a share of com-
Apply net present value analyses to the basic capital mon stock is comprised of a dividend yield and a capi-
budgeting decisions facing financial managers.
tal gains yield. The rate of return on a bond is the sum
To evaluate alternative products or services, financial of the coupon rate plus the capital gain yield. Since
managers need to calculate the net present value (NPV) returns must be balanced against risks, investors need
of earnings over time. The NPV is the present value of to carefully evaluate security risks. Total risk includes
future earnings minus the initial investment cost of the market risk, interest rate risk, liquidity risk, tax risk,
product or service. If an investment project has an NPV firm-specific risk, and reinvestment risk.
greater than or equal to zero, it is considered accept-
able. Such projects have economic value in the sense of LEARNING OBJECTIVE 7
increasing or not changing the value of common stock. Provide sound advice on how to manage invest-
ment risks and make investment choices.
LEARNING OBJECTIVE 4
To properly manage these risks and earn fair returns,
Identify the sources of funds and their usage in some important investment tips are to not entirely
financing decisions.
avoid risk, invest for long periods of time, invest regu-
Once acceptable products and services are identified by larly over time, save more to earn more, and diversify in
capital budgeting analyses, financial managers must different securities. Modern portfolio management sug-
acquire the necessary funds to pay for their initial gests that investors should purchase securities that
investment costs. Most funds are generated internally together reduce risk. Given the existence of a riskless
by profits in the form of retained earnings. Retained rate of return, all investors should purchase the same
earnings are affected by the firm’s dividend policy. If market portfolio to maximize their returns per unit of
shareholders demand high dividend payments, risk. Stock market indexes are believed to be a good
retained earnings will likely be inadequate to finance proxy for the market portfolio. Mutual funds offer a
acceptable projects. In this case the firm must seek number of different stock market indexes that investors
external financing, including bank loans or the can readily purchase.

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