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Financial Management and Institutions


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Title: Financial Management and Institutions

Chapter 17 Financial Management and Institutions
Learning Goals
Identify the likely sources of short-term and
long-term funds for business operations. Describe
the financial system and major financial
institutions. Explain the Federal Reserve System
and its tools. Describe the global financial
Identify the functions performed by a firms
financial managers. Describe the characteristics
and functions of money. Identify the various
measures of the money supply. Explain how a firm
uses funds. Compare the two major sources of
funds for a business.
Finance Business function of planning, obtaining,
and managing a companys funds in order to
accomplish its objectives effectively and
MANAGER Financial manager Executive who develops
and implements the firms financial plan and
determines the most appropriate sources and uses
of funds.  Chief financial officer Head of an
organizations finance operation.  Reports
directly to CEO or COO.  Often a member of the
board of directors.
 Three executives typically report to the
CFO  Vice president for financial management
or planning Responsible for preparing financial
forecasts and analyzing major investment
decisions.  Treasurer Responsible for all of
the companys financing activities, including
cash management, tax planning and preparation,
and shareholder relations.  Controller Chief
accounting manager keeps the companys books,
prepares financial statements, and conducts
internal audits.  Often balance risk with
expected financial returns
Reward Gain or loss from an investment over a
specified period of time
Risk Uncertainty of gain or loss
Risk-return trade-off Optimal balance between the
expected payoff from an investment and the
investments risk.
Reward Gain or loss from an investment over a
specified period of time
Risk Uncertainty of gain or loss
The risk reward tradeoff did not work very well
for this couple.
The Financial Plan Financial plan Document that
specifies the funds a firm will need for a
period of time, the timing of inflows and
outflows, and the most appropriate sources and
uses of funds.  Built based on the answers to
three questions  What funds will the firm
require during the appropriate period of
operations?  How will it obtain the necessary
funds?  When will it need more funds?  Also
involves financial control, the process of
checking actual revenues, costs, and expenses and
comparing them against forecasts.
MONEY Characteristics of Money Money Anything
generally accepted as payment for goods and
services.  To be efficient, money must have
certain characteristics Divisibility  Allows
for easy exchange of a wide variety of products.
Portability  Light weight of modern paper
currency facilitates the exchange process.
Durability  U.S. dollar bills survive an average
of twelve to eighteen months.  Coins can last 30
or more years. Difficulty in Counterfeiting  Coun
terfeit money undermines a nations monetary
system and economy by ruining the value of
legitimate money. Stability  Fluctuating values
make people reluctant to use a form of currency.
Functions of Money
THE MONEY SUPPLY  M1 Total value of coins,
currency, travelers checks, bank checking
account balances, and the balances in other
demand deposit accounts.  M2 Financial assets
that are almost as liquid as cash but do not
serve directly as a medium of exchange.  Example
s various savings accounts, certificates of
deposit, and money market mutual funds.
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 Use of credit cards growing rapidly.  Amount
of outstanding credit card debt has risen by more
than 400 percent in the last 20
years.  Percentage of college students with at
least one credit card now exceeds 50 percent.
 Companies issue credit cards to both
individuals and businesses.  Branded credit
cards Organization partners with bank to issue
branded credit cards and receives a payment from
the bank based on how much the card is used.
 Emergence of prepaid shopping cards.
 Convenient and easy to use, but a very
expensive source of business or consumer
credit  Fraud is also a concern.
operations.  Compensate employees and hire new
ones.  Pay for inventory.  Make interest
payments on loans.  Pay dividends to
shareholders.  Purchase property, facilities,
and equipment.  Use financial planning process
to determine how to address shortfalls and
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Generating Funds from Excess Cash  Most excess
cash balances are invested in marketable
securities.  Close to cash because they are
easy to convert into cash.  Most popular
marketable securities U.S. Treasury
billsshort-term securities issued by the U.S.
Treasury and backed by the full faith and
credit of the U.S. government.  Commercial
papersecurities sold by corporations maturing
anywhere from 1 to 270 days from the date of
issue.  Repurchase agreementsan arrangement
in which one party sells a package of U.S.
government securities to another party, agreeing
to buy back the securities at a higher price on
a later date.  Certificates of deposita time
deposit at a financial institution, such as a
commercial bank, savings bank, or credit union.
SOURCES OF FUNDS Debt capital Funds obtained
through borrowing. Equity capital Funds provided
by the firms owners when they reinvest
earnings, make additional contributions, or
issue stock to investors. Even established
firms may not generate sufficient funds to cover
all of the costs of expansion or a significant
equipment upgrade.
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Short-Term Sources of Funds  Repaid within one
year.  Used to meet short-term needs, such as
building inventory for holiday shopping season.
 Three major sources1 Trade credit extended
by suppliers when a firm receives goods or
services, agreeing to pay for them at a later
date. 2 Short-term loans from commercial banks
and other sources.  Unsecured, firm does not
pledge any assets as collateral.  Secured,
specific assets pledged as collateral.
3 Commercial paper, which has interest rates
typically 1 or 2 percent lower than short-term
bank loans  Only large firms with considerable
financial strength and stability can sell
commercial paper.
Long-Term Sources of Funds  Repaid over many
years.  Used for major investments.  Three
common sources 1 Long-term loans. 2 Bond
Certificate of indebtedness sold to raise
long-term funds for a corporation or government
agency. 3 Equity financing from selling stock in
the firm or reinvesting company profits.
Public Sale of Stocks and Bonds  Major source of
funds for corporations.  Provide cash inflows
for the issuing firm in exchange for either a
share in its ownership (for a stock purchaser) or
a specified rate of interest and repayment (for a
bond purchaser). Private Placements  Stock or
bond issues sold only to a small group of large
investors such as pension funds and insurance
companies.  One-third of all new corporate debt
issues are privately placed. Venture
Capitalists  Invest funds in promising firms in
exchange for part ownership of the
business. Leverage Leverage Technique of
increasing the rate of return on an investment
by financing it with borrowed funds.
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INSTITUTIONS Financial system System by which
funds are transferred from savers to users.
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 In U.S., households are generally net savers
while businesses and governments are net
users.  Funds can be transferred through the
financial markets or through financial
institutions. Financial institutions greatly
increase the efficiency and effectiveness of the
transfer of funds between savers and users.
 Because of financial institutions, savers earn
more, and users pay less. Depository institutions
Financial institutions that accept deposits that
can be converted into cash on demand.  Examples
commercial banks, savings banks, and credit
unions. Nondepository institutions include life
insurance companies, pension funds, and the
various government- sponsored financial
institutions such as Fannie Mae and Freddie Mac.
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Commercial Banks  In U.S., approximately 7,600
commercial banks.  Have total assets of
approximately 8.5 trillion.  Offer a wide range
of checking and savings deposit accounts,
consumer loans, credit cards, home mortgage
loans, business loans, and trust
services.  Number of banks has declined almost
in half in last 25 years, but the typical banks
is twice as large as 10 years ago. Growing
countertrend of small community banks, which
typically serve a single city or county and have
millions, rather than billions, of dollars in
assets and deposits. How Banks Operate  Raise
funds by offering checking and savings deposits
to customers.  Then pool these funds and offer
consumer and business loans.
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Electronic Banking  Electronic funds transfer
systems (EFTSs) Computerized systems for
conducting financial transactions over electronic
links.  Examples Direct deposit of paychecks,
ATMs.  Check cards that allow consumers to make
purchases directly from their checking or savings
account. Online Banking  More than one-third of
American households use some form of online
banking.  Five million Bank of America customers
annually pay 80 billion worth of bills
online.  Allows customers to make transactions
at any hour on any day.
Bank Regulation  Among the nations most heavily
regulated businesses. Who Regulates Banks?  Most
are state chartered.  Federally chartered banks
control more than half of all banking
assets.  Regulated by the Federal Deposit
Insurance Corporation and the Comptroller of
Currency.  State banks that are federally
insured are subject to FDIC regulation. Federal
Deposit Insurance  Insures deposits of up to
100,000 per depositor. Enacted in 1933 to
restore public confidence during the Great
Depression.  Shifts risk of bank failure from
depositor to FDIC.
Recent Changes in Banking Laws  Congress revised
Depression-era laws to allow banks to enter
securities and insurance businesses. Also
allowed financial services firms to offer banking
services. Savings Banks and Credit Unions Offer
may of the same services as commercial
banks.  In U.S., 1,300 savings banks with 1.7
trillion in assets.  More than 70 percent of
loans are for home mortgages.  Credit unions are
cooperative financial institutions owned by their
members.  85 million Americans belong to one of
the U.S.s 9,200 credit unions.  Credit unions
have 650 billion in assets.  Laws requiring
that members share similar occupations or other
traits keep their size small.
Nondepository Financial Institutions Insurance
Companies  Households and businesses buy
insurance to transfer risk from selves to
insurance company.  Underwriting The process
insurance companies use to determine whom to
insure and what to charge.  Have total assets of
4 trillion. Pension Funds  Provide retirement
benefits to workers and their families.  Have
6.5 trillion in assets. Finance
Companies  Offer short-term loans to borrowers
in exchange for collateral.
THE FEDERAL RESERVE SYSTEM Federal reserve system
U.S. central bank.  Four basic
responsibilities Regulating commercial
banks  Performing banking-related activities
for the U.S. Treasury  Providing services for
banks  Monetary policy Organization of the
Federal Reserve System  Nation divided into 12
federal districts.  Each district bank supplies
banks within its district with currency and
facilitates the clearing of checks.  Governed
by a board of directors. Federal Open Market
Committee sets monetary and interest rate
Check Clearing and the Fed  Americans write
billions of checks each year.
Money deposited in stores account
Desired outcomes
Consumer writes check
If both use the same bank
Money withdrawn from consumers account
Store deposits check in its bank
If they use different banks
Stores bank deposits check at Federal Reserve
Federal Reserve Bank withdraws funds from
consumers bank transfers funds to stores bank
Monetary Policy Monetary policy Using interest
rates and other tools to control the supply of
money and credit in the economy.  If money
supply grows to slowly, unemployment will
increase.  If money supply grows too quickly,
inflationary pressures will build.  If Fed
raises interest rates  The growth rate in the
money supply will slow.  Economic growth will
slow.  Inflationary pressures will ease.  If
Fed pushes rates down The growth rate in the
money supply will increase.  Economic growth
will pick up  Unemployment will fall.
 Fed has three major policy tools
PERSPECTIVE  Major U.S. banks have extensive
international operations.  U.S. banks have
more than 200 billion in outstanding loans to
international customers.  Only 3 of the 20
largest banks in the world (measured by total
assets) are U.S. institutions  Japans
Mitsubishi UFJ Holdings is worlds
largest.  More than 1.7 trillion in
assets.  Other nations central banks play roles
much like the Fed, often responding to changes in
the U.S. financial system.