Contemporary Business - Chapter 17.pdf - po ang - Januszek66

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Managing Financial Resources

Par 6

Chapter 17

Financial Management and Institutions

Financing and Investing

through Securities Markets

Chapter 18

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Chapter 17

Identify the functions performed by

a firm’s financial managers.

Describe the characteristics a form

of money should have, and list the

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.

Identify the likely sources of short-

and long-term funds for business

operations.

Describe the financial system and

the major financial institutions.

Explain the functions of the Federal

Reserve System and the tools it uses

to control the supply of money and

credit.

Describe the global financial system.

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F annie Mae and Freddie Mac are two of the largest

financial institutions in the United States. Their odd names

are shortened forms of their official titles, the Federal

National Mortgage Association and the Federal Home

Loan Mortgage Corporation. Both were created by the

federal government and have special charters, even

though they are stockholder owned. Their purpose is

to increase the supply of mortgage credit available to

the public, especially to low- and moderate-income

families in all areas of the country and under all eco-

nomic conditions. Fannie and Freddie, as they are known,

buy mortgage loans from banks, mortgage bankers, and

other private sources. They finance these purchases by

selling bonds and a variety of other types of securities.

Over the years Fannie and Freddie have helped mil-

lions of new homeowners and worked to ensure fair

the results were that the validity of its past financial reports

was called into question. A report by the Office of Fed-

eral Housing Enterprise Oversight found what it called

“pervasive misapplication of accounting rules” in the

Reining in Fannie and Freddie

company’s records, some of which allowed Fannie Mae’s

managers to receive bonuses in a recent year that would

not otherwise have been paid. The company was accused

of maintaining a corporate culture that encouraged such

problems to continue unchecked. Fannie Mae was fined

$400 million, one of the largest penalties in an account-

ing fraud case.

The Senate Banking Committee passed a bill to rein

in the two companies with tighter controls as well as by

shrinking their investment portfolios, which add up to

about $1.5 trillion, by forcing the companies to sell

assets that are not related to their mortgage businesses.

Passage of the bill in the House remains in doubt, how-

ever, and both Fannie Mae and Freddie Mac have criti-

cized its provisions. 1

lending practices. They help finance half the home mort-

gage loans granted in the United States each year and

make money from the difference in value between the

mortgages they buy and their cost of financing. Thanks to

them, says one congressional representative, “we have

the strongest, most dynamic housing market in the world.”

But recently members of Congress, the Federal Reserve

chairman, and some prominent economists have expressed

concern that Fannie and Freddie are too loosely regulated.

First, Freddie Mac was found to be improperly account-

ing for its use of certain exotic financial instruments called

derivatives, and the company was slapped with a $125

million fine. A management shake-up followed.

A few months later, government investigators turned

their attention to Fannie Mae. Soon Fannie was criticized

too for also using improper accounting methods; among

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Previous chapters discuss two essential functions that a

business must perform. First, the company must pro-

duce a good or service or contract with suppliers to

produce it. Second, the firm must market its good or

service to prospective customers. This chapter intro-

duces a third, equally important function: a company’s

managers must ensure that it has enough money to per-

form its other tasks successfully, in both the present

and the future. Adequate funds must be available to

buy materials and equipment, pay bills, purchase addi-

tional facilities, and compensate employees. This third

business function is finance —planning, obtaining, and

managing the company’s funds in order to accomplish

its objectives effectively and efficiently.

An organization’s financial objectives include not only

meeting expenses but also maximizing its overall worth,

often determined by the value of the firm’s common stock.

Financial managers are responsible for meeting expenses

and increasing profits to shareholders.

This chapter focuses on the role of financial man-

agers, the reasons businesses need funds, and the various

types and sources of funds. It discusses the role of money

and measures of the money supply. The chapter explains

the purpose and structure of the financial system, the oper-

ations of financial institutions, and the way the Federal

Reserve System functions. A discussion of the role of the

financial system in the global business environment con-

cludes the chapter.

THE ROLE OF THE FINANCIAL MANAGER

finance business func-

tion of planning, obtain-

ing, and managing a

company’s funds in

order to accomplish its

objectives effectively

and efficiently.

Organizations are placing greater emphasis on measuring and reducing the costs of conducting

business as well as increasing revenues and profits. As a result, financial managers —execu-

tives who develop and implement their firm’s financial plan and determine the most appropri-

ate sources and uses of funds—are among the most vital people on the corporate payroll.

The finance organization of a typical company might look like this: at the top is the chief

financial officer (CFO). The CFO usually reports directly to the company’s chief executive offi-

cer (CEO) or chief operating officer (COO), if the firm has one. In some companies, the CFO is

also a member of the board of directors. Robert Wayman, for instance, is CFO of Hewlett-

Packard and is also a member of the HP board of directors. Reporting directly to the CFO are

often three senior managers. While titles can vary, these three executives are commonly called the

vice president for financial management (or planning ), the treasurer, and the controller.

The vice president for financial management or planning is responsible for preparing financial

forecasts and analyzing major investment decisions. Major investment decisions include new

products, new production facilities, and acquisitions. The treasurer is responsible for all of the

company’s financing activities, including cash management, tax planning and preparation, and

shareholder relations. The treasurer also works on the sale of new security issues to investors.

The controller is the chief accounting manager. The controller’s functions include keeping the

company’s books, preparing financial statements, and conducting internal audits.

The growing importance of financial professionals is reflected in an expanding number of

CEOs promoted from financial positions. By one estimate, around 20 percent of all newly

appointed CEOs during a recent year spent time in the finance ranks. A recent example is Louis

Raspino. Prior to becoming CEO of oil services firm Pride International, Raspino served as

the firm’s CFO. 2 The importance of finance professionals is also reflected in how much CFOs

earn today. According to a recent survey, annual compensation for CFOs averages around $2.4

million. 3

In performing their jobs, financial professionals continually seek to balance risks with

expected financial returns. Risk is the uncertainty of gain or loss; return is the gain or loss that

results from an investment over a specified period of time. Financial managers strive to maxi-

mize the wealth of their firm’s shareholders by striking the optimal balance between risk and

financial manager exec-

utive who develops and

implements the firm’s

financial plan and deter-

mines the most appropri-

ate sources and uses of

funds.

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Part 6 Managing Financial Resources

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return. This balance is called the risk-return trade-off. For example, heavy reliance on bor-

rowed funds may increase the return to shareholders, but the more money a firm borrows, the

greater the risks to shareholders. An increase in a firm’s cash on hand reduces the risk of

meeting unexpected cash needs. However, because cash does not earn any return, failure to

invest surplus funds in an income-earning asset—such as in marketable securities—reduces a

firm’s potential return or profitability.

Every financial manager must perform this risk-return balancing act. For example, in the

late 1990s, Airbus wrestled with a major decision: whether to begin development and produc-

tion of the giant A380 jetliner. The development costs for the aircraft—to be the world’s

largest jetliner—were initially estimated at more than $10 billion. Before committing to such

a huge investment, financial managers had to weigh the potential profits of the A380 with the

risk that the profits would not materialize. With its future on the line, Airbus decided to go

ahead with the development of the A380. After spending more than $14 billion, Airbus rolled

out the first A380 in 2005. Airbus has orders for approximately 150 jetliners at a list price of

around $285 million each. It’s unclear, however, whether the A380 investment turns out to be

a smart, and profitable, decision. 4

risk-return trade-off

optimal balance

between the expected

payoff from an invest-

ment and the invest-

ment’s risk.

The Financial Plan

Financial managers develop their organization’s financial plan, a document that specifies the

funds needed by a firm for a period of time, the timing of inflows and outflows, and the most

appropriate sources and uses of funds. The financial plan is based on forecasts of production

costs, purchasing needs, and expected sales activities for the period covered. Financial man-

agers use forecasts to determine the specific amounts and timing of expenditures and receipts.

They build a financial plan based on the answers to three questions:

1. What funds will the firm require during the appropriate period of operations?

2. How will it obtain the necessary funds?

3. When will it need more funds?

Some funds flow into the firm when it sells its goods or services, but funding needs vary.

The financial plan must reflect both the amounts and timing of inflows and outflows of funds.

Even a profitable firm may well face a financial squeeze as a result of its need for funds when

sales lag, when the volume of its credit sales increases, or when customers are slow in making

payments.

The cash inflows and outflows of a business are similar to those of a household. The mem-

bers of a household may depend on weekly or monthly paychecks for funds, but their expen-

ditures vary greatly from one pay period to the next. The financial plan should indicate when

the flows of funds entering and leaving the organization will occur and in what amounts.

A good financial plan also involves financial control, a process of checking actual rev-

enues, costs, and expenses and comparing them against forecasts. If this process reveals sig-

nificant differences between projected and actual figures, it is important to discover them early

to take timely corrective action.

Paula Brock, CFO of the Zoological Society of San Diego (which operates

the famous San Diego Zoo), credits the zoo’s financial plan and planning process

with helping it weather a recent outbreak of an exotic bird disease in South-

ern California. When the disease first appeared, the zoo took immediate

action to protect its valuable bird collection. Thanks to these actions, no birds

got sick, and the damage to the zoo’s finances were minimal, even though the

zoo spent more than half a million dollars. The financial plan raised the alarm

as resources were redirected to fight the disease, allowing managers to make

the necessary adjustments. 5

financial plan document

that specifies the funds a

firm will need for a

period of time, the tim-

ing of inflows and out-

flows, and the most

appropriate sources and

uses of funds.

“ They Said It ”

“When I was young, I

used to think that

money was the most

important thing in life;

now that I am older, I

know it is.”

—Oscar Wilde

(1854–1900)

Humorist and playwright

a ssessment c heck

f in a n ce

549

Chapter 17 Financial Management and Institutions

Contemporary Business - Chapter 17.pdf

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