CHAPTER 20: FINANCIAL DECISIONS AND RISK MANAGEMENT THE ROLE OF THE FINANCIAL MANAGER Production managers = planning

g and controlling the output of goods and services Marketing managers = plan and control the development and marketing of products Financial managers = plan and control the acquisition and dispersal of the firms financial assets In other words, they are responsible for planning and overseeing the financial resources of a firm Finance (or corporate finance) typically involves four responsibilities: Determining a firms long-term investments Obtaining funds to pay for those investments Conducting the firms everyday financial activities Helping to manage the risks that the firm takes Objectives of the Financial Manager: Collect funds, pay debts, establish trade credit, obtain loans, control cash balances, and plan for future financial needs But overall objective is to increase a firms value and thus stockholders wealth Make decisions for improving the firms financial status Responsibilities of the Financial Manager: Responsibility of the financial manager to increase a firms wealth falls into three categories: cash flow management, financial control and financial planning Cash Flow Management: Is managing the pattern in which cash flows in to the firm in the form of revenues and out of the firm in the form of debt payments Financial Control: Is the process of checking actual performance against plans to ensure that the desired financial status is achieved Financial Planning: Describes a firms strategies for reaching some future financial position; includes projections for sources and uses of funds WHY DO BUSINESSES NEED FUNDS? Short-Term (Operating) Expenditures: Firms make them regularly in their everyday business activities To handle these expenditures, financial managers must pay attention to accounts payable and receivable, inventories, and working capital Credit Policy: rules governing a firms extension of credit to customers; also sets payment terms Example of payment term: 2/10, net 30 selling company offers 2% discount if the customer pays within 10 days, and customer has 30 days to pay the regular price 1. Inventories Are materials and goods currently held by a firm that will be sold within a year Three basic types of inventories: raw materials, work-in-process, and finished goods Raw Materials Inventory: the basic supplies a firm buys to use in its production process; denim Levi Work-In-Process Inventory: consists of goods partway through the production process (i.e. jeans that are cut but not yet sewn) Finished Goods Inventory: items that are ready for sale (completed jeans)

2. Working Capital Is the difference between a firms current assets and current liabilities Is a liquid asset out of which current debts can be paid Calculated by adding up inventories and accounts receivable minus accounts payable Reducing working capital = more useful cash flow and raises earnings permanently; basically means saving money Long-Term (Capital) Expenditures: Fixed assets = items that have a lasting use or value, such as land, building, and machinery Differ from short-term outlays in the following ways (all of which influence the ways that long-term outlays are funded): They are not normally sold or converted into cash Their acquisition requires a very large investment They represent a binding commitment of company funds that continues long into the future SOURCES OF SHORT-TERM FUNDS Include trade credit, secured and unsecured loans, and factoring accounts receivable Trade Credit: Are the granting of credit by a selling firm to a buying firm Is effectively a short-term loan

Can take several firms: Most common form, open-book credit, in which sellers ship merchandise on faith that the payment will be forthcoming Promissory notes buyers sign promise-to-pay agreements before merchandise is shipped Trade draft buyers must sign statements of payment terms attached to merchandise by seller; once signed, the document becomes a trade acceptance Secured Short-Term Loans: Secured Loan: a short-term loan for which the borrower is required to put up collateral any asset that a lender has the right to seize if a borrower does not repay a loan Generally carry lower interest rates than unsecured loans Most short-term business borrowing is secured by inventories and accounts receivable Pledging Accounts Receivable: using accounts receivable as collateral for a loan Unsecured Short-Term Loans: Is a short-term loan in which the borrower is not required to put up collateral For many of these cases, the bank requires the borrower to maintain a compensating balance the borrower must keep a portion of the loan amount on deposit with the bank in a non-interest bearing account To receive an unsecured loan, firm must ordinarily have a good banking relationship with the lender Although some unsecured loans are one-time-only arrangements, many take the form of lines of credit, revolving credit agreements, or commercial paper 1. 2. Lines of Credit Is a standing agreement with a bank to lend a firm a maximum amount of funds in request The bank does not guarantee that the funds will be available when requested Revolving Credit Agreements Are similar to credit cards, for which the firm pays the bank interest on funds borrowed as well as a fee for extending the line of credit Bank guarantees that the funds will be available when sought by the borrower

3. Commercial Paper In this, a firm sells unsecured notes for less than the face value and then repurchases them at the face value within 270 days Factoring Accounts Receivable: A firm can raise funds by factoring selling the firms accounts receivable Purchaser of the accounts receivable is known as the factor Factor pays some percentage of the full amount of the receivables; seller gets money immediately SOURCES OF LONG-TERM FUNDS Firms need long-term funding to finance expenditures on fixed assets May seek them through debt financing (from outside the firm), equity financing (by drawing on internal sources), or hybrid financing (a middle ground) In making decisions about sources of long-term funds, companies must consider the risk-return relationship Debt Financing: Is long-term borrowing from outside the company Two primary sources of such funding are long-term loans and corporate bonds 1. Long-Term Loans Most corporations get them from chartered banks, credit companies, insurance companies, and pension funds Long-term loans are attractive to borrowers because: Number of parties involved is limited, loans can often be arranged very quickly Firm doesnt need to make public disclosures of its business plans or purpose for loan Duration of loan can be matched to the borrowers needs If the firms needs change, the terms of the loan can usually be changed Also have disadvantages Large borrowers may have trouble finding lenders to supply enough funds, may have restrictions placed on them as conditions of the loan, may have to pledge long-term assets as collateral, and may have to agree not to take on any more debt until the borrowed funds are repaid Corporate Bonds

2.

Is a contract a promise by the issuing company or organization to pay the holder a certain amount of money on a specified date Are the major source of long-term debt financing for most corporations Are attractive when companies need large amounts of funds for long periods of time Bond Indenture: statement of the terms of a corporate bond, including the amount to be paid, the interest rate, the maturity (payoff) date; also identifies which of the firms assets, if any, are pledged as collateral for the bonds Equity Financing: Is raising money to meet long-term expenditures by issuing common stock or retaining earnings 1. Issuing Common Stock Can be expensive because paying dividends is more expensive than paying bond interest since bond interest is a business expense and is a tax deduction for the firm while stock dividends are not

2. Retained Earnings These earnings represent profits not paid out in dividends Using retained earnings means that the firm will not have to borrow money and pay interest on loans or bonds Hybrid Financing: Preferred Stock Is preferred stock (mixture of debt and equity financing) Have payments on preferred stock for fixed amounts, but they never mature (unlike bonds) Can be held indefinitely (like common stock) For issuing company, theyre flexible, secure funds for the firms without relinquishing control, since preferred shareholders have no voting rights, and it does not require payment of principal or payment of dividends in lean times (times when cash flow is thin; no profit is earned) Choosing Between Debt and Equity Financing: Capital Structure: relative mix of a firms debt and equity financing Financial plans contain targets for the capital structure (i.e. 40% debt and 60% equity) Theres a wide range of debt-vs.-equity mixes possible Most conservative strategy = use all equity financing and no debt At the other extreme = use all debt financing and no equity The Risk-Return Relationship: Shows the amount of risk and the likely rate of return on various financial instruments The riskier; the higher the payments Junk Bonds: have high default rates; promise uncommonly high yields, very risky FINANCIAL MANAGEMENT FOR SMALL BUSINESSES Many new businesses fail because entrepreneurs often underestimate the value of establishing bank credit as a source of funds and use trade credit ineffectively Also, they often fail to consider venture capital as a source of funding and they are notorious for not planning cash flow needs properly Venture Capital: Is the outside equity funding provided in return for part ownership of the borrowing firm Because failure rates are high, venture capital firms (those that supply the funding) typically demand high returns RISK MANAGEMENT Risk: uncertainty about future events Coping With Risk: There are two basic types of risk: speculative risks (involve the possibility of gain or loss) and pure risks (involve only the possibility of loss or no loss) For a company to survive and prosper, it must manage both types of risks in a cost-effective manner Risk Management: conserving a firms (or an individuals) financial power or assets by minimizing the financial affect of accidental issues Risk management process usually involves five steps: Step 1: Identify Risks and Potential Losses Step 2: Measure the Frequency and Severity of Losses and Their Impact Step 3: Evaluate Alternatives and Choose the Techniques That Will Best Handle the Losses There are generally four choices; risk avoidance, control, retention, or transfer Risk Avoidance: stopping participation in or refusing to participate in ventures that carry any risk Risk Control: techniques to prevent, minimize, or refuse losses or the consequence of losses Risk Retention: the covering of a firms unavoidable losses with its own funds

 Risk Transfer: the transfer of risk to another individual or firm, often by contract (i.e. insurance) Step 4: Implementing the Risk-Management Program Step 5: Monitor Results Insurance as Risk Management: Insurance companies divide potential sources of loss into insurable and uninsurable risks Only issue policies for insurable risks An insurable risk must generally satisfy the four criteria: Predictability insurer must be able to use statistical tools to forecast the likelihood of a loss Casualty a loss must result from an accident, not from an intentional act by policyholder Unconnectedness potential losses must be random and must occur independently of other losses Verifiability insured losses must be verifiable as to cause, time, place, and amount 1. a) b) c) 2. The Insurance Product The types of insurance coverage they offer often distinguish insurance companies Some offer only one area (life insurance) while others offer a broad range Three major categories of business insurance: liability, property, and life Liability Insurance Covers losses resulting from damage to people or property when the insured party is judged liable Property Insurance Covers injuries to firms resulting from physical damage to or loss of real estate or personal property Life Insurance Pays benefits to survivors of a policyholder Most companies buy group life insurance life insurance underwritten for a group as a whole rather than for each individual member Special Forms of Business Insurance Many businesses choose to protect themselves against loss of the talents and skills of key employees, called Key Person Insurance Business Continuation Agreements: an agreement in which owners of a business make plans to buy the ownership interest of a deceased associate from his or her heirs