D076-Study-Guide-Unit-2
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D076-Finance Skills for Managers
Unit 2: Overview of Finance
**Note: Unit 1 is the introduction, suggested pacing information, information regarding Excel assignments and how to install the add-in on Excel. No study guide was created for that information by me**
Module 1: What is Finance?
1. Lesson 1: What is Finance?
a.
Finance vs Accounting
i.
Finance and accounting, though related to a firm's financial numbers, differ significantly. Finance is future-oriented, involving the management and allocation of capital for activities such as investing, forecasting, and budgeting. It utilizes information from accounting to make decisions about
a firm's future, including investment choices and financial allocations. Finance has three subspecialties: Business Finance (for corporations and
start-ups), Investments (managing others' money), and Financial Institutions (dealing with banks and other large institutions).
On the other hand, accounting is past-focused, centered on recording, reporting, and summarizing past financial information and transactions. It aims to provide an accurate representation of the past, involving the meticulous recording of expenses, costs, and financial activities for a specific period.
b.
Example of differences:
i.
Consider a baking company as an example. Accounting involves keeping careful records of the past year's earnings, such as discovering that the bakery made around two million dollars. Now, the bakery faces a decision
– much of its equipment is wearing out. The choice of whether to invest in
new equipment, potentially boosting overall output and sales, is a
financial decision. To make this decision, the owners will not only rely on past accounting information but will likely conduct a financial analysis to assess the potential impact of purchasing new equipment compared to other opportunities available to the bakery.
c.
Lesson 1 Summary:
i.
Finance is the study of managing and allocating funds at the personal or business level.
ii.
Accounting is backward-looking, while finance is forward-looking.
iii.
Corporate finance is an area of finance that involves activities used to increase shareholder wealth.
iv.
Investments is an area of finance that deals with investment allocation and asset pricing.
v.
Financial institutions are an area of finance that involves organizations that accept deposits, offer investment products, loan money, or broker financial transactions.
d.
Skill Check:
i.
Which area of finance deals with sources of funding and the capital structure of corporations and seeks to increase the value of a firm to its owners?
1.
Financial institutions
2.
Investments
3.
Business Finance
a.
Correct! Business finance is the area of finance that deals with uses and sources of funding to increase the value of the firm.
4.
Real estate
ii.
What is the primary difference between finance and accounting?
1.
Finance provides financial data to decision-makers, and accounting involves making decisions using that data.
2.
Accounting involves investing and forecasting, while finance summarizes a company’s financial information.
3.
Finance focuses on the future, while accounting is generally backward-looking.
a.
Correct! Finance is the management and allocation of capital with the objectives of investing, forecasting, budgeting, saving, lending, and borrowing.
4.
Accounting focuses on the future, while finance is generally backward-looking.
iii.
Which subspecialty of finance primarily involves deciding which assets will create more wealth and earn positive returns?
1.
Financial institutions
2.
Accounting
3.
Investments
a.
Correct! Investments is the area of finance that seeks to create wealth in the future by deciding where to allocate money.
4.
Capital structure.
2. Lesson 2: Goals and Applications of Finance
a.
Personal vs Business Finance
i.
Personal Finance:
1.
Personal finance involves the financial decisions you make in your
own life, such as whether to buy or rent a home, deciding on a car
purchase, choosing an interest rate, or planning for retirement. Questions you might ask yourself include whether to rent or buy a house, how much to save each month for retirement, whether to take out an auto loan or pay in cash, and what makes a good stock market investment.
Individuals have varied personal financial goals, but the common objective is to maximize individual utility, representing the satisfaction derived from consuming goods and services. Utility reflects the happiness resulting from consumer decisions. Since preferences differ, not everyone shares the same financial goals.
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Achieving a goal involves weighing the benefit of increased utility against associated costs, like sacrificing present luxuries for future
financial security. The decision-making process is influenced by individual priorities, with some choosing to save for a comfortable retirement by making sacrifices in the present for future financial well-being.
ii.
Business Finance
1.
Businesses, like individuals, make financial decisions that impact their overall value. They decide what assets to purchase, how to finance them, and how it contributes to the value for their owners.
At the business level, questions include whether launching a new product adds value, whether to outsource production, how to raise
capital for a new project (bank loan, bonds, or stocks), and whether purchasing new equipment will cut production costs.
This course focuses on business finance, setting the groundwork for related areas. In some corporations, direct owner control is challenging due to equity issuance, like Microsoft having over 5.61
billion shares in 2019. The financial manager plays a crucial role in
representing owners, managing investments, and financing to achieve the firm's goal, whether maximizing shareholder wealth for public firms or owner wealth for private companies.
b.
Lesson 2 Summary:
1.
In both personal finance and business finance, the main principle that underlies decision-making is whether the benefits outweigh the costs.
2.
Individuals can set personal financial goals to maximize their utility.
3.
The goal of business finance is to maximize owner wealth for a privately held company and to maximize shareholder wealth for a publicly held company.
c.
Skill Check:
i.
What is the primary goal of the financial manager of a firm?
1.
To maximize the manager’s utility
2.
To maximize owner wealth
a.
Correct! The financial manager should make decisions based on the primary goal of maximizing owner wealth.
3.
To minimize the costs of the firm
4.
To minimize the asset holdings of the firm
ii.
What should be the main question a firm asks when considering any investment decision?
1.
Do the benefits of this investment outweigh the costs?
a.
Correct! For any investment, you should expect to receive a benefit worth at least as much as the initial cost.
2.
Will this investment add value to the firm?
3.
Will this investment help the company reduce costs?
4.
What is the best investment in the stock market?
iii.
What is the primary aim of personal finance goals?
1.
To create more wealth and returns on investments.
2.
To maximize shareholders’ utility by increasing a firm’s value
3.
To increase consumption of goods and services
4.
To maximize satisfaction from products purchased and services obtained.
a.
Correct! The objective of personal financial goals is to maximize one’s utility.
3. Lesson 3: The Role of Finance in Business Environments
a.
Finance in Business
i.
In business environments, finance focuses on three main rules: investing decisions, financing decisions, and managing working capital. 1.
Investment Decisions
a.
The main job of a financial manager is to decide how a company should invest its money. This involves carefully weighing the costs and benefits of potential investments to use shareholders' funds efficiently. For instance, when Microsoft was considering launching Xbox, the financial manager assessed the value of investing in research and development (R&D). After analyzing the costs and benefits,
it was found that the investment in Xbox R&D would bring in more money than it cost.
2.
Financing Decisions
a.
After deciding on investments, the financial manager then turns attention to how to finance them. For significant investments, the company might choose to raise money by
selling new stocks (ownership shares) or bonds (debt).
3.
Working Capital
a.
The financial manager not only deals with long-term investments and financing but also manages everyday working capital. This includes handling cash for daily operations, setting credit standards for customers, working with the supply chain manager on inventory control, and taking care of daily operational tasks like paying suppliers.
b.
Careers in Finance
i.
Having financial skills is important for both small and large companies, regardless of their profit status. Even the smallest businesses need to make smart financial decisions and assess investment and growth opportunities. Different careers in finance, like corporate finance, investment banking, and private equity, deal with financial matters within organizations and transactions between businesses. Financial skills are also crucial in analyzing assets, risk, and investment opportunities in areas like real estate management, insurance, and personal financial planning.
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1.
Corporate Finance a.
Businesses, regardless of size (small enterprises, nonprofits, or large conglomerates), aim to enhance shareholder value or fulfill their mission (in the case of nonprofits). Corporate financial skills are valuable for all firms, but larger corporations usually have a higher demand for corporate finance graduates. Fresh graduates often start as financial analysts in major companies like Dell, Microsoft, or Ford. Financial analysts manage financial reports, provide analytical insights for strategic decisions, and collaborate with different levels of management on initiatives like strategic planning, budgeting, and forecasting. Key aspects of financial analysis include investing and financing decisions, cash management, tax strategies, and implementing financial policies. Beyond the financial analyst role, there are multiple levels of financial leadership in corporations. At the
top is the chief financial officer (CFO), the highest-ranking position in corporate finance. The CFO is responsible for all financial decisions, working closely with the CEO on financial matters, overseeing overall financial analysis, and
making decisions for the firm.
2.
Investment Banking
a.
In investment banking, people with an undergraduate degree can apply for an analyst position, usually in a two-
year program. Analysts create presentations, analyze companies' finances, and handle administrative tasks, especially making pitch books for client meetings. Some analysts pursue further education, and high performers may become associates. Associates, often with a master's degree, typically stay in the role for three to five years before moving up to positions like vice president. Associates share responsibilities with analysts and connect
them with senior bankers, sometimes working directly with clients. More promotions lead to senior banker roles, such as vice presidents and managing directors, where individuals find deals, maintain client relationships, and show a deep industry understanding. Senior bankers predict client needs and create pitches to secure deals. Investment banks handle tasks like mergers and acquisitions (M&As), corporate offerings, and sales and trading. M&A specialists assist mergers, corporate offerings help firms raise capital for projects, and sales and
trading involve buying and selling securities for institutional
and retail clients.
3.
Private Equity a.
Private equity (PE) involves investors like angel investors, venture capitalists, and takeover firms. They focus on investing in privately held, non-publicly traded companies. PE firms often perform buyouts, including leveraged buyouts (LBOs), with compensation similar to hedge funds.
Analysts in PE select and manage portfolio firms. Angel investors and venture capitalists invest in start-ups, hoping for profit through an IPO or acquisition. PE buyout firms invest in entire companies, often using debt to revive struggling firms for profit. Careers in private equity begin with analysts and associates handling deal sourcing and investment evaluation. Entry positions may be available with a bachelor's degree or through graduate-level internships, while higher-level associates may need a graduate degree. Associates can advance to become principals, leading investments and participating on boards. The managing partner represents the highest leadership level in most private equity and venture firms. Angel investors independently invest personal funds in business opportunities without firm involvement.
4.
Commercial Banking
a.
A commercial bank is a financial institution that takes deposits, provides basic financial services like checking and savings accounts, and offers various loans such as auto loans and home mortgages. The bank makes a profit by charging higher interest on loans than the interest paid on deposits. Entry-level roles, like tellers, involve customer interaction and may not require a four-year college degree.
Above tellers, credit analysts assess lending risks, deciding whether to approve loans. Personal bankers attract new clients, contributing to the bank's loan capacity and profitability. While credit analysts need strong quantitative skills, personal bankers require a mix of quantitative and interpersonal abilities. Management is the highest career level, often reached by individuals who have
progressed through the bank's ranks. Examples include people like Peter Villegas, who started as tellers and became executives at major banks. Those aspiring to become banking executives are advised to take classes in financial analysis and financial institutions to prepare for leadership roles.
5.
Financial Planning
a.
Financial planners work with individuals to help them reach
financial goals like budgeting, retirement planning, and managing investments. They also assist with tax planning, including trusts and wills, either within a group or independently. Financial planners can be found in local banks or major investment banks.
To become a financial planner, one typically needs the Certified Financial Planner (CFP) designation, earned by passing the CFP exam. There are test preparation materials available, like Wiley's "Rattiner’s Review for the CFP Certification Examination" by Jeffery H. Rattiner, to
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help candidates prepare for the exam. The CFP exam covers various topics, with percentages allocated as follows:
i.
Professional Conduct and Regulation: 7%
ii.
General Financial Planning Principles: 17%
iii.
Education Planning: 6%
iv.
Risk Management and Insurance Planning: 12%
v.
Investment Planning: 17%
vi.
Tax Planning: 12%
vii.
Retirement Savings and Income Planning: 17%
viii.
Estate Planning: 12%
6.
Insurance
a.
Insurance offers various roles such as agents, underwriters, loss adjusters, risk managers, claims investigators, actuaries, appraisers, and more. Insurance companies make money by pooling risks from individuals and charging premiums, aiming for total income to exceed claims paid out. Agents sell insurance products, needing educational qualifications. Underwriters assess risks, analyze data, and set premiums, often requiring a four-
year college degree. Insurance branches include property/casualty (e.g., auto insurance), consumer (e.g., life insurance), and corporate (risk management). Corporate insurance helps firms manage unforeseen risks,
often overseen by Risk Management and Insurance (RMI) departments in universities. Students may find opportunities with large firms like Aon, specializing in providing insurance plans for other companies. Corporate insurance roles demand strong analytical skills, often involving reinsurance—insurance for insurers. These jobs can be quantitative, requiring a solid understanding of math and statistics.
7.
Real Estate
a.
Real estate involves land or buildings and is considered an
asset for investment or financial transactions. Like businesses, real estate assets can generate recurring revenue and profits. While many think of real estate careers as working with firms like Coldwell Banker or Century 21, university real estate finance programs typically focus on investing in and managing real property. These skills are valuable for individuals, investors, and can
be applied in larger corporations with real estate holdings. The Vault Career Guide to Real Estate offers a comprehensive resource for students interested in real estate careers, listing various areas:
i.
Residential real estate agents/brokers
ii.
Commercial real estate brokerage: tenant representation
iii.
Commercial real estate brokerage: leasing agent
iv.
Investment sales broker
v.
Mortgage-backed securities rating agencies
vi.
Real estate appraisal
vii.
Property management
viii.
Real estate advisory
ix.
Real estate investment banking
x.
Development
Construction management, although not listed in the Vault Guide, is also a potential career within real estate. c.
Lesson Summary
i.
A financial manager completes three main tasks: making investment decisions, making financing decisions, and managing working capital.
ii.
Investment decisions are made based on the costs and benefits of potential projects in achieving the goal of a firm.
iii.
After the investment decisions are made, the financial manager must decide how to finance such projects.
iv.
Financial managers must pay attention to the firm’s short-term obligations.
v.
Different career areas in the field of finance include corporate finance, investment banking, private equity, commercial banking, financial planning, insurance, and real estate.
d.
Skill Check
i.
Which task does a financial manager perform when choosing to obtain a loan to purchase a piece of equipment for a new project?
1.
Making investment decisions
2.
Making financing decisions
a.
Correct! The manager is deciding where to get the funds to
support a new project, which means the manager is making a financing decision.
3.
Making credit standard decisions
4.
Making inventory control decisions
ii.
Which financial career focuses on investing capital into firms whose shares are not currently sold on any public stock exchange?
1.
Private equity
a.
Correct! Private equity deals with investments in firms that are privately held and whose ownership is not yet bought or sold on any public stock exchange.
2.
Insurance
3.
Financial planning
4.
Corporate finance
iii.
Which task does a financial manager perform when assessing the costs and benefits of potential projects?
1.
Implementing financial policies
2.
Managing working capital
3.
Making financing decisions
4.
Making investment decisions
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a.
Correct! Understanding how benefits weigh up against costs is the first priority before moving forward with financing and managerial decisions.
4. Lesson 4: Finance and Personal Decision-
Making
a.
Finance and Personal Decision-Making
i.
Every day, you likely make various financial decisions, from grocery shopping choices to deciding on a car. It could also involve more complex
decisions like financing education, saving for retirement, or planning a dream vacation. Regardless of the financial decisions you make, understanding financial management principles can be beneficial. These principles help set future financial goals, choose suitable investments, and make wise decisions to meet your desired future returns.
ii.
Analyzing Financial Data: Budgeting
1.
An important part of personal finance is looking at financial information to make a budget, with a key emphasis on understanding how money moves in and out. It's crucial to know your monthly income, and to stay within your means, your spending should be less than what you earn. After figuring out your income, it's important to identify and organize expenses to create a budget that matches your income. Just like a financial manager manages working capital for a company, you, as the financial manager of your household, need to understand the day-
to-day movement of money for effective cash management in your
life.
iii.
Assessing Financial Goals
1.
Once you have a budget and know your essential expenses, the next step is to set financial goals and figure out the savings needed to reach them. It's wise to prioritize goals, ranging from
necessities to luxuries, and consider personal happiness beyond basic needs. Financial goals might involve building an emergency fund, buying a car or a house, or saving for retirement. It's crucial to evaluate the costs and benefits of these goals to see if they are achievable. Similar to a financial manager assessing investment decisions, individuals can use these principles to manage their own finances effectively.
iv.
Financing Your Goals 1.
After deciding on investments, the next step is to fund them. This might mean getting loans from a bank or credit union for big purchases like a house, car, or education. It's important to make sure that monthly payments are manageable, and this requires knowing how to live within your means. To achieve financial goals,
especially those involving saving, it's necessary to find ways to cut
daily expenses. Knowing essential costs allows you to reduce spending by being mindful of eating out, shopping wisely, using coupons, and similar strategies. This helps in achieving long-term goals like a comfortable retirement or funding children's education.
v.
Investing to Achieve Goals
1.
Achieving long-term financial goals, like saving for retirement or contributing to children's education, is better done through strategic investments instead of keeping money idle. Quick-
access options such as checking accounts or savings accounts are suitable for emergency funds, even if the interest is limited. However, for long-term goals like retirement savings, it's smart to consider investing in stocks and bonds that offer higher returns. It's important to understand the risks and expected returns to make informed and wise financial decisions in any situation.
vi.
Remember What Finance Is
1.
Finance is about handling and assigning money for activities like investing, forecasting, budgeting, saving, borrowing, and lending.
This also applies to personal decision-making. To achieve saving and investing goals, it's important to make financially sensible choices where the benefits outweigh the costs. Effective budgeting
of cash flows improves the ability to predict future financial situations. The tools and knowledge gained from a finance course can be useful in making informed decisions for personal finance.
b.
Lesson Summary
i.
Personal financial decision-making is aligned with the definition of finance, and you are the financial manager of your own household.
ii.
Understanding the management and allocation of money in your personal life is critical for making smart financial decisions.
iii.
There are many tools that help us achieve our financial goals, including budgeting and investing.
c.
Skill Check
i.
What tool can you use to understand your overall personal cash flows?
1.
Setting financial goals
2.
Investing
3.
Budgeting
a.
Correct! Budgeting helps you to understand your income and expenses and to analyze your cash flows.
4.
Saving
ii.
What is a reasonable alternative to keeping an emergency stash of cash?
1.
Investing in a savings account
a.
Correct! Investing in a readily withdrawable account that still earns some interest is a value-preserving alternative.
2.
Investing in long-term bonds
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3.
Investing in high-risk growth stocks
4.
Investing the money in a nicer car
iii.
You want to buy a house, so you obtain a mortgage for which you can afford the monthly payments. What process have you engaged in as part of your financial decision-making?
1.
Assessing
2.
Investing
3.
Analyzing data
4.
Financing
a.
Correct! Part of the personal finance process is figuring out how to finance your goals in a way that is within your means.
5. Module 1 Summary
a.
Finance is the study of managing and allocating funds at the personal or business level.
b.
There are three subspecialties in finance: business finance, investments, and financial institutions.
c.
The goal of business finance is to maximize shareholder or owner wealth, while the goal of personal finance is to maximize an individual’s utility.
d.
Different careers in finance include commercial banking, corporate finance, financial planning, insurance, investment banking, and private equity.
e.
At the personal level, you manage money and allocate it to achieve financial goals that bring you greater utility.
f.
There are many tools to help to achieve financial goals.
6. Module 1 Quiz
a.
What area of finance involves deciding which assets to invest in to create wealth in the future?
i.
Financial institutions
ii.
Investment banking
iii.
Investments
1.
Correct! Investments are an area of finance that involves deciding which assets to invest in to create wealth in the future.
iv.
Organizational finance
b.
Hannah is the financial manager of a firm. A project that she has recommended has been approved and will cost $5 million. Since the company does not have enough cash on reserve, Hannah must figure out how to raise enough money to start the project. She can choose whether to issue new bonds, new stocks, a mortgage loan, or some combination of those options. What task is Hannah performing in this scenario?
i.
Managing working capital
ii.
Managing financial investments
iii.
Making an investment decision
iv.
Making a financing decision
1.
Correct! Since the project has already been approved, Hannah is trying to find a way to finance the investment and considering its capital structure.
c.
Maria and Mateo are setting financial goals. They decide that they need to save $200 each month to reach their goal of taking their children to visit their grandparents in Spain next summer. What is the objective of setting such a goal?
i.
To set priorities in personal finances
ii.
To make personal finances predictable
iii.
To minimize personal expenses
iv.
To maximize individual utility
1.
Correct! While everyone has different personal financial goals, the objectives of such goals are to maximize individual utility.
d.
Which professional works with individuals to help them achieve their financial goals?
i.
Private equity manager
ii.
Commercial banker
iii.
Financial planner
1.
Correct! Professional financial planners work with individuals to help them achieve their financial goals.
iv.
Corporate financial analyst
e.
Omar is about to purchase a new car for $30,000. He knows he wants to buy the car, but he is still trying to decide how to pay for it. He has barely over $30,000 in his bank account. He can either take out an auto loan from a bank or use a mix of cash and an auto loan. In this scenario, what is Omar doing?
i.
Assessing a financial goal
ii.
Budgeting
iii.
Financing a goal
1.
Correct! He has already decided to purchase the car and is now deciding on financing options.
iv.
Investing to achieve a goal.
Module 2: Financial Markets and Institutions
1. Lesson 5: Financial Securities and Financial Markets
a.
Introduction
i.
Various financial securities exist, including U.S. Treasury securities, corporate bonds, and derivatives like options, futures, and forwards. A familiar security is a stock, which represents ownership in a firm. Financial managers, aiming to raise capital and maximize shareholder wealth, may issue new bonds (debt) or new stock (equity), impacting the firm's value, reflected in the stock price. An increase in the stock price often indicates enhanced shareholder value for a public firm with shares traded on organized markets.
Key takeaways:
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1.
Public firms, unlike private ones, have numerous owners, and their shares are traded on organized markets.
2.
The lesson covers financial securities, followed by various types of
financial markets, their activities, and roles.
3.
Organized markets determine market prices based on supply and demand, providing liquidity, enabling investors to convert securities into cash without significant value loss easily.
b.
Financial Securities
i.
Treasuries
1.
Treasuries, short for Treasury securities, are bonds issued by the U.S. government to fund projects like national defense and infrastructure improvements. When tax revenues fall short, the U.S. Treasury issues bonds. These bonds, acting as loans from the public to the government, come in different durations, from short-term, like 60-day loans, to long-term bonds with repayment periods up to 30 years.
ii.
Corporate Bonds
1.
Corporate bonds are issued by companies, like Alphabet Inc., to get funds from the public for new projects. For example, if Alphabet Inc. plans a $50 billion investment in satellites, it can't get such a big loan from a local bank. So, the company issues individual bonds, which are like loans. Each bond has a set interest payment and repayment date. These bonds may have a principal value, generate annual interest payments (coupons), and
have a repayment period, like 20 years. If the company defaults, bondholders can access the company's assets during bankruptcy proceedings.
iii.
Stocks
1.
A stock represents ownership in a company, and if Alphabet Inc. decides not to borrow money through bonds for a $50 billion satellite project, it can sell shares of ownership. Investors who buy
these shares expect profits from the satellite project. The money from selling the stocks funds the project. If the company fails, bondholders have priority over shareholders in claiming assets during liquidation. Bondholders get paid first before shareholders if
the company goes under.
c.
Money Market and Capital Market
i.
Financial securities are traded in financial markets, and when we talk about "the market" in finance, it usually includes the money market and the capital market.
1.
The money market is where governments and companies borrow and lend for the short term, usually holding assets for less than a year.
2.
The capital market is mainly used for long-term assets held for over one year, like stock and bond markets.
Together, the money market and capital market make up a big part of the financial market. These markets are essential for managing liquidity and risk for governments, companies, and individuals.
d.
Primary Financial Market
i.
The primary market is where securities are first issued, often through processes like initial public offerings (IPOs) where companies release shares or bonds. In the primary market, these securities are sold, and companies usually get help from a syndicate, made up of big investment banks or institutional investors, to handle the issuance. Syndicates, which
can also act as underwriters, are responsible for selling the securities, buying them from the issuer, and then selling them to other investors. For bond issuance, there are two common methods: competitive sale, where syndicates bid based on bond price and interest rate, and negotiated sale, which involves a detailed proposal process. In stock issuance, a firm
going public does an IPO or new equity offering, and though the terms may differ, the underwriting process is similar to bond issuance in the primary market.
e.
Secondary Financial Market
i.
The secondary financial markets, represented by stock exchanges like the New York Stock Exchange (NYSE) and NASDAQ, come into play after securities make their debut in the primary market. In contrast to the primary markets where securities are first sold, secondary markets are bustling hubs where these securities are traded among investors, similar to a lively dance in the stock market. In the secondary financial markets, especially for stocks, prices are determined by the forces of supply and demand. It's like an economic seesaw, with prices responding to changes in supply and demand, influenced by new information. There are two main
types of secondary markets. The auction market, like the NYSE, has a physical location where public bids determine prices. The highest bidder gets the prize, making it the world's largest secondary financial market. The second type, a dealer market, doesn't need a physical place. Dealers
trade securities among themselves in this setup. NASDAQ, the world's second-largest secondary market, follows this model. With multiple dealers for each stock, they compete, enhancing liquidity and reducing transaction costs for investors. As of December 2018, the NYSE leads the
global pack with a market cap of $20,679.5 billion, followed by NASDAQ at $9,756.8 billion, showcasing the colossal scale of these secondary financial markets.
f.
The Role of Financial Markets
i.
Financial markets play a vital role in the overall economy by efficiently directing capital and encouraging corporate growth. They make it easier for companies to raise funds for important projects like medical research. For instance, developing a cancer treatment might be challenging without financial markets. These markets significantly cut down the cost for companies to get financing by enabling the exchange of securities between buyers and sellers, ensuring there's enough money available. In the secondary financial markets, like the NYSE and NASDAQ, specialists or multiple dealers are key players. The NYSE specialist maintains a fair market by holding a stock inventory, buying from sellers, and selling to buyers. To cover risks, the specialist charges a slightly higher ask price
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for buyers and pays a slightly lower bid price for sellers, creating a bid-
ask spread. NASDAQ works similarly with multiple dealers providing liquidity. This bid-ask spread is the compensation for the specialist's risk in ensuring market liquidity.
g.
Trading in Financial Markets
i.
Financial markets have seen more liquidity, emphasizing the ease of exchanging assets. Liquidity in financial markets means the ability to exchange assets. This improvement is clear in the increasing trading volume on the New York Stock Exchange (NYSE) over the years. In trading, there are two important types of orders: limit orders and market orders. Limit orders let investors set a specific price for execution, while market orders execute immediately at the current market price. Trading in
financial markets is sophisticated and crucial for efficient capital allocation. Electronic trading has reduced the role of specialists on the NYSE but has significantly increased liquidity. The graph of U.S. stock trading volume shows a big increase from about 1.1 trillion shares in 1984
to slightly over 33 trillion shares in 2018. This rise in volume indicates more trade occurrences, contributing to the growing liquidity of financial markets. High-frequency traders, often computer-based, engage in rapid trading with complex algorithms, aiming to profit from bid-ask spreads multiple times a day. Their activity highlights the changing nature of financial markets and the pursuit of liquidity.
h.
Efficiency in Market Prices
i.
In this part, we're looking at how well financial markets work, specifically in terms of price efficiency. Nobel Prize-winning economist Milton Friedman stressed the importance of prices in conveying information, influencing incentives, and impacting income distribution. Efficient markets are those where prices fully incorporate all available information about a security, making sure securities are not wrongly priced. We're focusing on the first role of prices in financial markets: conveying information. An efficient market quickly adjusts stock prices to include all relevant information, like unexpected earnings announcements or legal
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issues. For example, if a company reports strong earnings, an efficient market will rapidly increase the stock price to reflect this positive development. In contrast, an inefficient market may take a long time to show such information, suggesting mispricing. Efficient financial markets support firms by offering a measure—stock prices—indicating if they are effectively maximizing shareholder value, connecting to the goal of firms to maximize shareholder value.
i.
Financial Regulators
i.
Government agencies, both federal and state, have an important job in regulating and watching over financial markets and institutions. The U.S. Securities and Exchange Commission (SEC), which is an independent federal agency, has three main jobs: (1) protecting investors, (2) making sure markets are fair, organized, and efficient, and (3) helping companies raise capital. The SEC does this by putting into action and enforcing rules and regulations about securities. Its focus is on promoting transparency by making information public, encouraging fair practices, and stopping fraud in financial markets.
j.
Lesson Summary
i.
The purpose of financial markets is to determine the market price of financial securities based on supply and demand and to provide liquidity.
ii.
The money market is for short-term borrowing and lending while a capital market is for long-term borrowing and lending.
iii.
Companies use the primary market to sell their financial securities to raise
capital, while the secondary market is where securities are traded after the initial issuance.
iv.
A specialist provides liquidity and lowers the cost of trading stocks between sellers and buyers.
v.
Prices convey information, affect incentives, and affect the distribution of income.
vi.
The SEC oversees financial markets to protect investors.
k.
Skill Check
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i.
What are the purposes of financial markets?
1.
To affect the distribution of income for investors
2.
To willingly take risk and capture returns
3.
To maintain fair, orderly, and efficient markets
4.
To provide liquidity and determine prices
a.
Correct! The purposes of financial markets are to provide liquidity and to determine prices.
ii.
In which financial market are securities such as stocks and bonds are traded after their initial issuance?
1.
Dealer market
2.
Initial market
3.
Primary market
4.
Secondary market
a.
Correct! Financial securities are first sold in the primary financial market and then traded among investors in the secondary financial market.
iii.
What kind of market primarily allows institutions to borrow and lend in the short term?
1.
Futures and options markets
2.
Capital market
3.
Primary market
4.
Money market
a.
Correct! Assets in money markets are typically highly liquid
and intended for use within a year or less.
iv.
A local start-up company just hit its five-year anniversary and is planning an initial public offering sometime this year. In order to issue public stock, which market will the company use?
1.
Futures and options market
2.
Dealer market
3.
Primary market
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a.
Correct! When a company issues stock for the first time to raise capital, shares must initially be sold through a primary market.
4.
Secondary market
2. Lesson 6: Financial Institutions
a.
Introduction:
i.
Financial institutions, like banks, credit unions, and asset management entities, play a crucial role in the economy by making money flow smoothly. Banks collect deposits from people, pay them interest, and then
lend these funds to others, earning interest in return. Other financial institutions, such as asset management entities, help individuals invest in things like bonds and securities, allowing them to save for retirement or make more money. Private equity, involving firms, venture capital, and angel investors, gives money to companies before they become public, helping them grow and progress. Private equity adds a unique aspect to the market, allowing companies to get funding before going public.
b.
How Does Money Circulate
i.
Money moves through the economy in a straightforward way. People who save and invest can put their money in banks. The banks then lend this money to others who use it to make more money, and they repay the loans. This cycle repeats, allowing more people to get loans. Savers can also invest by buying stocks, giving money to companies for profitable projects. When these projects make money, it gets distributed to investors. Savers can then reinvest by buying more stocks, continuing the
cycle. Financial institutions are crucial in making this money circulation process work.
c.
Three Types of Financial Institutions
i.
Depository Institution:
a.
A depository institution is a financial entity that takes deposits and offers loans. Examples include savings
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banks, commercial banks, savings and loan associations, and credit unions. Notable banks include JP Morgan Chase and Bank of America.
i.
Savings and Loans Association:
1.
Also known as a "thrift," this depository institution specializes in offering loans for residential mortgages and real estate.
ii.
Non-Depository Institution:
a.
A non-depository institution is a financial entity that can't take deposits but can lend money and connect savers with
lenders. Examples include brokerage firms, investment firms, mutual funds, and hedge funds.
i.
Securities Firm:
1.
This type of financial institution helps with investing and buying securities in financial markets.
2.
Services include underwriting, trading securities on secondary markets, and selling securities.
ii.
Investment Firm:
1.
These companies invest investors' money in
financial securities, like mutual funds and investment trusts. They may also issue securities.
iii.
Contractual Savings Institution:
1.
This financial intermediary raises capital for long-term agreements.
2.
Examples include insurance companies and
private pension funds.
iii.
Depository and Non-Depository Financial Institutions
1.
Financial institutions provide two main types of services: depository and non-depository.
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a.
Depository Institutions:
i.
Examples: Banks, credit unions, savings institutions.
ii.
They help individuals and organizations save money or obtain loans.
iii.
Profit is generated by charging more interest on loans than paid to depositors.
iv.
They take deposits, pay interest, and offer loans like mortgages and auto loans.
b.
Non-Depository Institutions:
i.
Examples: Mortgage brokerage firms, investment firms, mutual funds, hedge funds.
ii.
These institutions don't take deposits but connect savers with lenders.
iii.
Mortgage brokers provide loans without taking deposits.
iv.
Investment firms manage capital for investors, while mutual and hedge funds pool money from multiple investors.
c.
Contractual Savings Institutions:
i.
A type of non-depository intermediary, such as insurance companies.
ii.
They raise capital through contracts, invest in securities, and focus on longer-term investments like stocks and bonds.
iv.
Securities and Investment Firms
1.
Securities and investment firms are crucial financial intermediaries
in buying and selling securities.
a.
Securities Firms:
i.
They help sell securities when initially issued (primary market) by companies or governments.
ii.
Assist investors in buying or selling securities on the secondary market.
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iii.
Examples include Morgan Stanley, JP Morgan, etc.,
that facilitated Zoom's IPO in 2019.
b.
Investment Firms:
i.
Manage buying and selling of securities on secondary markets.
ii.
Examples include Vanguard, Fidelity, and Charles Schwab.
c.
Pension Funds:
i.
Act as investment companies, using contributions to buy securities for retirement funds.
ii.
Considered contractual savings institutions, benefiting employees contributing to retirement accounts.
d.
Private Equity Funds:
i.
Investment companies funded by wealthy individuals and endowments.
ii.
Invest in private companies or buy entire ones, aiming for financial return through future sales.
d.
Lesson Summary
i.
Money circulates through financial institutions in two ways: (1) individuals and organizations lend and borrow money and (2) individuals and organizations purchase financial securities to provide capital to companies and receive dividends.
ii.
There are several major types of financial institutions: depository institutions, non-depository institutions, and securities and investment firms.
iii.
Each type of financial institution plays a role in circulating money through the economy.
e.
Skill Check
i.
What is the primary role of financial institutions?
1.
To provide liquidity when trading financial assets
2.
To deal with financing, capital structuring, and investment decisions
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3.
To conduct financial transactions such as investments, loans, and deposits
a.
Correct! Financial institutions conduct transactions to circulate money.
4.
To provide financial information to the stakeholders of a business
ii.
What is a depository institution?
1.
An institution that has a goal to maximize owner or shareholder wealth
2.
An institution that accepts and pays interest on deposits of money,
as well as extends loans
a.
Correct! This is the definition of a depository institution. Examples include banks and credit unions.
3.
An institution that is a financial intermediary that raises capital on a contractual basis
4.
An institution that provides individuals and firms access to financial markets
3. Lesson 7: The Roles of Financial Institutions
a.
Introduction
i.
Financial institutions provide services like taking deposits, giving loans, and handling investments. They connect people who lend money (savers)
with those who borrow (consumers). Examples include central banks, consumer and business banks, insurance companies, investment banks, mortgage companies, and pension fund managers.
b.
Roles of Financial Institutions
i.
Financial institutions have different roles:
1.
Central banks
oversee and manage all other banks. In the U.S., the Federal Reserve Bank ensures a healthy economy through monetary policy and regulatory oversight.
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2.
Banks and credit unions
provide products and services to individuals and businesses, including checking and savings accounts, lending, and financial advice.
3.
Insurance companies
help individuals and businesses manage the risk of financial loss due to various factors. They charge premiums for coverage and invest the money in stocks and bonds.
4.
Mutual funds
continually offer investments and buy financial securities on behalf of investors. They create portfolios of stocks and bonds, with their performance determining the company's value.
5.
Pension funds
manage retirement funds, collecting contributions to invest in the market and provide retirement benefits.
6.
Investment banks
offer services like underwriting, facilitating mergers, and buying/selling financial securities for large institutions.
7.
Private equity firms
invest in non-public entities using funds from
institutional investors and wealthy individuals, often focusing on entities not publicly listed or traded.
c.
Lesson Summary
i.
Financial institutions provide financial services including but not limited to accepting deposits, offering loans, and managing investments.
ii.
The seven primary financial institutions include central banks, banks and credit unions, insurance companies, mutual funds, pension funds, investment banks, and private equity.
d.
Skill Check
i.
Which financial institution ensures that a nation’s economy remains healthy by controlling the amount of money circulating in the economy?
1.
Mutual fund
2.
Central bank
a.
Correct! Central banks control the supply of money in the economy.
3.
Credit union
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4.
Commercial bank
ii.
How do insurance companies pay policyholders when a claim is made?
1.
They withdraw funds from their corporate savings account.
2.
They raise premiums for everyone who filed a claim during the year.
3.
They use returns from stocks and bonds.
a.
Correct! Insurance companies invest the money that they earn from premiums into stocks and bonds, and then the returns are used to fill claims.
4.
They withdraw funds from policyholders’ premium accounts.
iii.
Which type of financial institution deals mainly with providing for retirement through employers?
1.
Mutual fund
2.
Credit union
3.
Pension fund
a.
Correct! Through employers, individuals can contribute to pension funds, which then invest their money in the market
to provide retirement funds.
4.
Investment bank
iv.
A large corporation is looking to merge with another large corporation. Which financial institution can help them do this?
1.
Investment bank
a.
Correct! Investment banks facilitate complex financial deals, like mergers.
2.
Central bank
3.
Private equity institution
4.
Pension fund
4. Lesson 8: Major Economic Indicators
a.
Introduction
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i.
Economic indicators, like GDP, unemployment, and inflation, provide insights into the economy's health. There are three types: leading, lagging, and coincident. Leading indicators predict future events, like the inverted yield curve signaling potential economic issues. Lagging indicators, such as inflation measured by the Consumer Price Index (CPI), show changes after they occur. Coincident indicators, like personal income and GDP, happen simultaneously with market changes. Knowing these indicators is vital for assessing economic health and their impact on
financial markets and institutions.
b.
Types of Indicators
i.
Economic indicators fall into three types: leading, lagging, and coincident.
1.
Leading Indicators:
a.
Yield Curve: Displays interest rates for different bond maturities, predicting economic growth or downturn based on the curve's shape.
b.
Stock Market Return: Reflects economic health; a rising market suggests improvement, but caution is needed as it could result from inflation rather than genuine growth.
2.
Lagging Indicators:
a.
Unemployment Rate: Shows jobless percentage, changing
after economic shifts; rises during recessions and decreases in a thriving economy.
b.
Consumer Price Index (CPI): Tracks inflation by examining average prices of consumer goods; increasing CPI indicates inflation and decreasing signals deflation.
3.
Coincident Indicators:
a.
Gross Domestic Product (GDP): Represents the total value
of goods and services produced; increasing GDP indicates
a strong economy, while decreasing suggests a recession.
b.
Personal Income: Reflects consumer spending; rising personal income leads to increased spending in a thriving economy, while declining income results in reduced
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spending during economic struggles.
c.
The Influence of Financial Markets and Institutions
i.
Economic indicators are influenced by both financial markets and institutions. For example, in August 2019, trade conflicts between the U.S. and China caused the U.S. market to drop by over 4%, signaling potential economic challenges. The yield curve also hinted at a possible recession, causing concern among investors.
Financial markets aren't the only influencers; central banks, like the Federal Reserve (Fed), also play a crucial role. The Fed uses economic indicators to make decisions and regulate the money and
credit supply, focusing on controlling inflation and unemployment. During the 2008 recession, the Fed lowered interest rates to stimulate borrowing for growth and job creation. In 2019, facing global concerns, the Fed reduced the benchmark interest rate by 0.25% to support the seemingly well-performing U.S. economy.
The graph illustrates how the Fed's interest rate decisions impact personal finance rates. Both the 30-year mortgage rate and 10-year
U.S. Treasury rate follow similar patterns, showcasing their interconnectedness influenced by the Fed's actions.
d.
Lesson Summary i.
Leading indicators change before the economy changes and include yield
curve and stock market return.
ii.
Lagging indicators change after the economy changes and include unemployment rate and CPI.
iii.
Coincident indicators are collected and analyzed as economic shifts happen and include GDP and personal income.
iv.
Both financial markets and financial institutions influence and are influenced by these key indicators.
e.
Skill Check
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i.
Unemployment rate is which type of economic indicator?
1.
Coincident
2.
Lagging
a.
Correct! Lagging indicators change after the economy changes.
3.
Leading
4.
Concurrent
ii.
The Federal Reserve sometimes adjusts the interest rate at which commercial banks can borrow from it. What is the purpose of adjusting the interest rate?
1.
To regulate inflation and unemployment
a.
Correct! Regulating inflation and unemployment is the main objective of the Federal Reserve and central banks, and it is accomplished by adjusting the interest rate.
2.
To reduce the amount of outstanding debt owed by U.S. citizens
3.
To increase the size of the Federal Reserve
4.
To obtain a positive return for its private investors
iii.
What would an inverted yield curve signal?
1.
It may indicate an economic downturn.
a.
Correct! An inverted yield curve reflects the expectation that the economy will have low or negative growth in the future.
2.
It may indicate that inflation is rising at an unsustainable rate.
3.
It may indicate that the unemployment rate is falling.
4.
It may indicate higher interest rates for long-term bonds.
iv.
In what way are coincident indicators useful?
1.
They are used to predict future economic trends so that recessions can be avoided.
2.
They are useful in conjunction with GDP and personal income to predict the future health of the economy.
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3.
They help investors know which sectors of the economy to invest in.
4.
They are analyzed during economic shifts to provide information about the current state of the economy.
a.
Correct! Coincident indicators help analysts see the big picture of economic trends.
f.
Module Summary i.
Three major types of financial securities are Treasuries, corporate bonds, and stocks.
ii.
In general, the purpose of financial markets is to determine prices of financial securities and provide liquidity for investors.
iii.
The prices determined by the market carry information, affect incentives, and affect the distribution of income.
iv.
Financial institutions circulate money by providing financial services such as accepting deposits, offering loans, and managing investments.
v.
Economic indicators have different roles and information sets and are used to assess the state of the macroeconomy.
g.
Module Quiz
i.
Which responsibility is a focus of the U.S. Securities and Exchange Commission?
1.
To provide liquidity
2.
To protect investors
a.
Correct! The responsibilities of SEC are to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.
3.
To raise interest rates
4.
To regulate inflation
ii.
Which type of financial institution provides individuals and firms access to financial markets?
1.
Depository institutions
2.
Investment institutions
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a.
Correct! Investment institutions provide both individuals and firms access to financial markets.
3.
Credit institutions
4.
Contractual savings institutions
iii.
Which financial institution includes entities that receive money from institutional investors and wealthy individuals to buy troubled companies to improve them and earn returns by selling them or going public?
1.
Private equity
a.
Correct! This is the role of a buyout private equity firm.
2.
Credit union
3.
Mutual fund
4.
Commercial bank
iv.
Yield curve is which type of economic indicator?
1.
Lagging
2.
Coincident
3.
Leading
a.
Correct. Leading indicators change before the economy changes.
4.
Concurrent
v.
About a year ago, the short-term Treasury bill had 1.54% interest and the long-term Treasury note had 2.54% interest. This week, the 1-year Treasury bill has an interest rate of 3.13%, while the 10-year Treasury note has an interest rate of 2.28%. What does this information indicate about the future economy?
1.
It may indicate that the economy is in a steady state.
2.
It may reflect an expectation that the economy will grow in the future along with higher inflation.
3.
It may indicate an economic downturn.
a.
Correct! Since the long-term Treasury interest rate is lower than the short-term rate, it has an inverted yield curve, which may indicate an economic downturn.
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4.
It may indicate a decreasing unemployment rate along with higher wages.
Module 3: Ethics in Finance 1. Lesson 9: Ethical, Legal, and Moral
a.
Ethical, Legal, and Moral
i.
Ethics guides a person's behavior for the best outcome, drawing from social norms, culture, or religious beliefs. Morals reflect personal views on
right and wrong, while legal standards involve following established laws. Organizations, like workplaces, set ethical standards, governments establish legal standards, and morals are personal beliefs. Decisions should consider ethics, legality, and morals. Actions can be ethical but illegal, or unethical but legal. For instance, some investment banks during
the 2008 recession knew selling risky mortgage-backed securities was unethical but legal. Consider the case of breaking a car window to save a dog's life, illegal in Queensland, Australia, yet ethical. Business professionals facing dilemmas should carefully weigh the consequences before deciding.
b.
Lesson Summary
i.
An ethical action is based on accepted standards of conduct.
ii.
A moral action is based on a person’s sense of right and wrong or good and bad.
iii.
A legal action follows the laws and rules set by an authority.
c.
Skill Check
i.
Which term reflects a person’s beliefs about right and wrong, good and bad, or just and unjust?
1.
Ethical
2.
Legal
3.
Moral
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a.
Correct! Moral reflects one’s beliefs about right and wrong, good and bad, or just and unjust.
4.
Standard
ii.
What characterizes an ethical action?
1.
An ethical action is based on accepted standards of conduct.
a.
Correct! An ethical action conforms to accepted standards of conduct.
2.
An ethical action takes into account other individuals’ values over the decision maker’s own.
3.
An ethical action will achieve the best outcome for the decision maker.
4.
An ethical action is based on what is right or wrong, whether or not society agrees.
iii.
Lucas is a financial advisor working for Bullzai, Inc. He is faced with a dilemma. Bullzai has started changing its practices in order to increase profit. As a financial advisor, he is now supposed to suggest to clients to invest in portfolios that will not do as well as the portfolios that Bullzai is invested in. This is an accepted practice done by other businesses in the industry, and it complies with all standards set by the government. However, Lucas knows that this practice is not in his clients’ best interest. What type of dilemma is Lucas facing?
1.
Legal
2.
Moral
a.
Correct! This is not a legal issue because the new practice complies with the law, and it is not an ethical issue because it is a commonly accepted practice within the industry. It is a moral issue because it deals with Lucas’s own sense of right and wrong.
3.
Ethical
4.
Technical
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iv.
Which type of error would result in a set repercussion or penalty given by the government?
1.
Ethical
2.
Spiritual
3.
Legal
a.
Correct! A legal error would result in a predetermined penalty by the government.
4.
Moral
2. Lesson 10: Ethical Dilemmas in Finance
a.
Ethics in Finance
i.
Ethics is crucial in finance. People should act honestly in managing personal finances and be responsible for their financial habits. Finance professionals often face situations where ethical principles can be applied.
b.
What is an Ethical Dilemma?
i.
Ethical dilemmas arise when a person has to make a choice without a clear ethical option. In finance, individuals and businesses often face such decisions, dealing with conflicts between personal interests and those of a company's stakeholders or clients. Wise decisions involve considering both ethical and legal aspects. For instance, deciding whether to cut into traffic unexpectedly is an everyday example that parallels ethical dilemmas in financial situations, requiring careful consideration of what is right both ethically and legally.
c.
Profit versus Shareholder Wealth: Enron
i.
Is it beneficial for society when corporations primarily focus on making a profit? While the pursuit of profit can sometimes lead to unethical actions, as seen in the Enron scandal in 2001, it's crucial to distinguish between greed and unethical behavior. Profitable corporations contribute positively
to society by efficiently providing goods and services, employing workers, and fostering economic growth. This cycle enhances overall economic
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prosperity. While the pursuit of profit is vital, engaging in unethical practices doesn't genuinely maximize shareholder value.
d.
Low Costs versus Ethical Manufacturing: TOMS
i.
A vital financial decision for a company involves determining key factors, such as revenue and costs, for a potential project to benefit the company. Ethical decision-making starts early in business decisions, even before a project is initiated. Some companies, like Nike, have faced ethical dilemmas related to reducing production costs through cheap labor, potentially involving unfair wages, child labor, or forced labor. In contrast, companies like TOMS prioritize ethical standards in manufacturing. TOMS
achieves this by enhancing transparency through audits, setting high partner standards, screening manufacturers, and promoting ethical behavior, including a "zero tolerance policy for violations involving any form of modern slavery."
e.
Customer Demand versus Good Due Diligence: The Financial Crisis
i.
Ethical decision-making can significantly impact individuals, even if they aren't directly involved in the decisions. One notable ethical debate involved banking and financial institutions' potential role in causing the financial crisis starting in 2007. Traditionally, local bankers handled home mortgages, keeping each mortgage on their balance sheets, which limited
risks. However, the mortgage market changed with the securitization of loans. Brokers connected borrowers with banks, reselling loans, and eventually bundling and selling them to investors. This process increased subprime (low-quality) loans to individuals at risk of repayment failure. Underwriting standards declined significantly. The Financial Crisis and the
Collapse of Ethical Behavior report suggests rating agencies may have contributed to the crisis by not objectively rating involved banks. Some in the financial industry sold subprime mortgage-backed securities to clients while secretly betting against the same investments for their gain. Though
legal, this conflicted with clients' best interests. This created an ethical dilemma, as those with knowledge of risks chose not to inform clients, leading to unsuspecting individuals obtaining mortgage loans and
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purchasing subprime securities until the collapse causing the Great Recession.
f.
Examples of Ethical Dilemmas
i.
Examples like Enron, TOMS, and the financial crisis highlight ethical dilemmas in business. Similar situations can occur in our daily financial lives. For instance, your financial advisor might emphasize an investment product's success, use complex terms, or withhold information about alternative options. The advisor may grapple with conflicts like maximizing
their commission or profits for career advancement. If they prioritize their interests, crucial information for your financial decisions might not be disclosed. Entrepreneurs may face ethical dilemmas, like pocketing cash payments without proper reporting or exaggerating to attract funds. On Shark Tank, a team falsely accused others of stealing designs, leading to legal consequences. Ethical dilemmas are widespread, and analyzing situations carefully is essential to address issues ethically, morally, and legally.
g.
Lesson Summary
i.
Ethics is important for maintaining integrity in personal finance and for enhancing performance and promoting efficient markets in the world of corporate finance.
ii.
An ethical dilemma is an issue in the process of deciding between multiple options where no option is completely acceptable from an ethical standpoint.
iii.
Solely focusing on maximizing profit may lead to unethical actions.
h.
Skill Check
i.
Nora is an investment manager, which means that she is paid to invest other people’s money. To meet her goal for the month, she is seeking to invest money from clients in an investment that is risky but potentially has
a higher return. What about this situation represents an ethical dilemma?
1.
Nora is considering investing in a risky asset just to meet her monthly goal.
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a.
Correct! Nora is caught between the obligation to meet her
goal and the obligation to keep her clients’ money safe. As an investment manager, she is obligated to do what is best
for the client.
2.
Nora is not explaining to her clients the riskiness of the specific investment.
3.
Nora is not currently meeting her goal for the month.
4.
Nora is uncertain about the outcome of the investment opportunity.
ii.
What are the effects of attempting to maximize shareholder value for a business in an unethical way?
1.
It often leads to employing more workers and boosting the economy.
2.
It often decreases vulnerability to long and expensive litigations.
3.
It often gives the business an opportunity to improve its branding and reputation.
4.
It often leads to decreased shareholder value for the business.
a.
Correct! Unethical behavior can lead to very costly results.
iii.
Endothon Company has decided to move its production from the United States to a foreign country. Which situation below would constitute an unethical action by the company?
1.
Monitoring public perception of the company
2.
Lowering costs while keeping prices the same for customers
3.
Saving money by paying inadequate wages to workers overseas
a.
Correct! Other countries may not have laws that protect workers, such as minimum wage laws.
4.
Telling current employees about the decision early on
3. Lesson 11: Ethical Conflicts
a.
Parties in a Corporation
i.
In a corporation, financial managers, shareholders, and bondholders collaborate to secure financial capital. Financial managers make strategic
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decisions, shareholders own the company by purchasing shares, and bondholders provide credit. Each party has different incentives and information, leading to distinct interests. Financial managers aim for secure but successful projects for job security and compensation. Shareholders prefer riskier projects to boost stock value and financial return. Bondholders seek projects with a higher chance of recovering their
investment with ample compensation. Conflicting interests may arise, prompting ethical analysis to assess decisions' effects on each stakeholder.
b.
Agency Problems
i.
Maximizing shareholder value can lead to agency costs, a problem arising from the separation of owners and management. This disconnect may reduce management's incentive to prioritize shareholders' interests, resulting in an agency problem. When management decisions go against shareholders' best interests, it incurs internal costs called agency costs. For instance, a manager might use company funds to remodel their office,
not maximizing shareholder value. More commonly, management may invest in projects that don't maximize shareholder value. Firms often address this by aligning managers' interests with shareholders' through compensation in the form of company ownership shares. This approach aims to incentivize managers to invest in the most profitable projects. A real-life example is the Wells Fargo scandal where high sales demands led employees to create fake accounts, impacting customers and damaging public confidence. In 2016, Wells Fargo was fined $185 million for this unethical behavior, leading to widespread consequences and executive accountability.
c.
Conflicts between Managers and Shareholders
i.
Agency costs emerge when owners and managers are separate, leading to potential conflicts of interest. Managers may prioritize personal gains over the company's goal of benefiting shareholders, engaging in actions like self-dealing, acquiring companies for personal power, funding wasteful projects, or manipulating accounting. These actions harm
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shareholder wealth maximization. An example is the WorldCom scandal where accounting manipulations concealed financial decline, leading to bankruptcy in 2002. Self-dealing instances are not uncommon, as seen with Samuel Waksal, CEO of ImClone Systems, engaging in insider trading for personal gain. Waksal faced legal consequences, including imprisonment. Martha Stewart, another ImClone stockholder, was convicted of insider trading, resulting in imprisonment and restrictions from serving as a director of a public company.
d.
Conflicts between Shareholders and Bondholders
i.
Shareholders and bondholders have different connections to a company. Shareholders, who own the company through stocks, like riskier projects and higher dividends. On the other hand, bondholders, who lend money to the company, prioritize getting their money back. Bondholders may set strict loan terms or conditions, causing conflicts with shareholders and possibly impacting their interests.
e.
Individual Responsibility and Client Demand
i.
As a professional, you might encounter situations where clients request unethical actions, such as:
1.
Personal Financial Adviser Dilemma:
a.
Your company sets a goal for clients to invest a specific amount in a riskier product.
b.
Your boss pressures you, promising a bonus if the goal is met, or some advisors might be fired.
c.
A client in her 60s seeks advice for a safe investment of $250,000, coincidentally the amount needed to meet the monthly goal.
d.
Ethical Conflict: Balancing the company's goal and your client's interest. Selling the riskier product may save your job and earn a bonus but could harm the client financially.
2.
Investment Reports Dilemma:
a.
You're a stock analyst for a bank analyzing a company tied
to your bank.
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b.
You find issues that would usually lead to a negative recommendation (sell), affecting the stock price.
c.
Your boss pressures you not to give a sell recommendation as the client is entering a big deal with the bank in another division.
d.
Ethical Conflict: Balancing loyalty to your boss and the client with the need to provide honest, accurate information
to other investors relying on your report. Adjusting the report may benefit the bank and the client but could harm other investors.
f.
Conflicts between Work and Personal Affairs
i.
In certain situations, ethical challenges can arise from conflicts between professional roles and personal interests. Consider these scenarios:
1.
Nonprofit Treasurer's Dilemma:
a.
You're the treasurer for a nonprofit, and there's a significant equipment investment needed.
b.
Your brother-in-law could provide the equipment, but at a higher cost. Do you prioritize his benefit or seek competitive bids for the best value?
2.
Financial Manager's Hiring Dilemma:
a.
As a financial manager hiring an analyst, a candidate offers you membership to a prestigious golf course.
b.
The candidate may not be the best analyst, but you believe
his connections could benefit you personally. What do you prioritize?
In such cases, it's crucial to assess legality, morality, and ethics. Professional responsibility requires objectivity, prioritizing the organization's best interests, and adhering to agreed-upon employment terms. Putting personal interests first can lead to unethical decisions. An example from the news involves cancer funds misused for personal gain, underscoring the importance of evaluating situations and making ethical choices.
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g.
What to Do?
i.
Every day, you juggle various roles and responsibilities, whether at work, school, or in your personal life. Balancing these demands can lead to ethical conflicts, impacting not only you but also the society or community around you. When facing such conflicts, follow these steps:
1.
Identify and Define the Problem:
a.
Understand the issue causing conflicts.
b.
Recognize the demands, involved parties, and potential violations of rules or laws.
2.
Consider Alternative Courses of Action:
a.
Assess your moral obligations and legal or ethical responsibilities.
b.
Seek guidance from legal documents, organizational rules,
or trusted advisors.
3.
Evaluate Stakeholders:
a.
Recognize all parties affected by your decision.
b.
Consider the impact on your team, company, customers, and other relevant groups.
4.
Analyze Consequences:
a.
Assess immediate, near-term, and long-term effects.
b.
Identify ways to avoid similar dilemmas in the future.
5.
Choose Ethical Action:
a.
Move forward with the course of action aligning with ethical
and moral standards.
b.
Consider setting clear guidelines, educating clients, and aligning incentives with customers' interests to prevent conflicts.
In the financial industry, like any other business, promoting ethical behavior through guidelines, education, and aligned incentives is crucial to minimizing conflicts and ensuring ethical conduct.
h.
Lesson Summary
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i.
Financial managers, shareholders, and bondholders have different roles, incentives, and interests in a corporation, which can sometimes lead to conflicts of interest.
ii.
In an agency problem, management does not act in the best interest of the owners of a firm.
iii.
When making ethical decisions, first identify and define the problem. Next, evaluate the different courses of actions you can take based on ethical and legal guidelines. Then consider the consequences that each of these actions might have. Finally, move forward with the course of action you feel is ethical and best for the situation.
i.
Skill Check
i.
Why would bondholders set bond contracts that are very strict to deter the
company from taking on risky projects?
1.
Bondholders are primarily interested in maximizing shareholder wealth.
2.
Bondholders are primarily interested in making sure they will be paid back.
a.
Correct! If a company takes on a riskier project, there is a higher probability of the project being unsuccessful, which means that the bondholders may put themselves at a higher risk of not receiving their loan back.
3.
Bondholders are primarily interested in maintaining the company’s
current financial status.
4.
Bondholders are primarily interested in the company paying more dividends.
ii.
Which kind of projects are bondholders interested in?
1.
Projects that allow the company the most freedom in how it spends money
2.
Riskier projects that will provide higher returns
3.
Riskier projects that will increase the value of the company’s stocks and their own financial return
4.
Safe projects with a higher chance of providing sufficient compensation
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a.
Correct! Bondholders provide money for a company for a certain period of time and want companies to pay them back for their investment.
iii.
Which scenario is an example of an agency problem?
1.
An employee takes a potential client to dinner and pays for it using
the company credit card.
2.
The owners of the company offer shares of the company to management.
3.
A manager purchases a company car and allocates it as a company expense.
a.
Correct! This is a luxury that does not improve shareholder
value and costs the company money.
4.
The management team works overtime without pay to complete financial reports.
iv.
How can agency costs be mitigated?
1.
Releasing managers who do not attempt to maximize immediate shareholder value
2.
Creating a corporate hierarchy of several managers
3.
Separating owners from management so their interests do not conflict
4.
Aligning managers’ interests with shareholders’ interests
a.
Correct! This is most commonly done by compensating management with shares of ownership in the company.
v.
What is the third step in finding a solution to an ethical dilemma?
1.
Identify and define the problem
2.
Consider all stakeholders involved
a.
Correct! First, you should identify and define the problem. Second, consider alternative courses of action. Third, consider all stakeholders involved.
3.
Consider alternative courses of action
4.
Move forward with the course of action you have chosen
4. Module Summary
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a.
Ethics refers to accepted standards of conduct, morals reflect one’s beliefs about
right and wrong, and legal means following the laws and rules set by an authority.
b.
An ethical dilemma is an issue in the process of deciding between multiple options where no option seems acceptable from an ethical standpoint.
c.
Ethical dilemmas are often the result of greediness.
d.
An agency problem happens when there are conflicts of interest between two parties with different responsibilities.
e.
When a conflict of interest arises, first attempt to understand the conflict, and then identify alternative courses of actions based on ethical standards.
5. Module Quiz
a.
What does the term legal describe?
i.
An action that is in accordance with the laws and rules set by an authority.
1.
Correct! Legal means to follow the laws and rules set by an authority.
ii.
An action that reflects one’s beliefs about right and wrong, good and bad, or just and unjust.
iii.
An action that conforms to accepted standards of conduct that guide a person’s behavior.
iv.
An idea or thing used as a measure, norm, or model in comparative evaluations.
b.
Jack is a personal financial advisor. He is with a new client, and the client is asking him what he recommends for her portfolio. Jack knows that his firm’s investment product performed well last year, but its performance changes from year to year—some years it is better than the market, and some years it is not. Also, the fee to invest in the product is higher than the fee to invest in a market index fund. If Jack sells his company’s investment product, the customer’s loyalty
to the company is doubled. Which actions should Jack take?
i.
After introducing the product, show the client data about the index fund from only the years that the index fund did poorly.
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ii.
Give a personal recommendation of the company’s product while explaining its performance relative to the market over the past several years.
1.
Correct! Giving a recommendation to sell a product is fine, but you
should never hide other information. Sharing information about index funds and comparing your product to others is a fair action to take for the client.
iii.
Introduce the company’s product as the best choice available and offer to waive the fee to invest.
iv.
Give the client a recommendation of the company’s product, and only offer more information about other products if she asks for it.
c.
Why might a manager manipulate accounting procedures?
i.
To spend capital on wasteful projects
ii.
To restrict a firm from taking on risky projects
iii.
To maximize shareholder wealth
iv.
To make the company’s performance look good
1.
Correct! A manager might manipulate accounting procedures to inflate the earnings of a company, which would optimize bonuses and stock-price-related benefits for management.
d.
Which situation is an example of an agency problem?
i.
Managers follow their own interests instead of the owners’ interest.
1.
Correct! An agency problem occurs when the agent (a manager) does not act in the best interest of the owners.
ii.
Owners prevent managers from maximizing profits.
iii.
A firm fails to maximize long-term investment.
iv.
Managers do not agree with employees on material supply issues.
e.
A company is trying to finance a project with a mortgage loan from a bank. The company's assessment of the project indicates that the company may experience
several years of loss until the project becomes profitable. This means that the
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company might lose its ability to pay back the loan and the interest on the mortgage. What action might the bank take to protect its interest?
i.
Set a strict covenant that the company cannot easily achieve.
1.
Correct! By setting a strict covenant, there is a risk that the company may not meet its obligation, which would deter the company from taking on risky projects.
ii.
Let the company manipulate accounting procedures.
iii.
Push the company to pay dividends to the shareholders.
iv.
Let the company take the mortgage loan because of its long partnership with the bank.
Unit Summary 1.
In finance, whether in your personal life or at work, you deal with managing money to reach goals. For businesses, the aim is to maximize owner wealth, and for individuals, it's about maximizing personal satisfaction.
2.
Finance has three main areas: business finance (managing money for businesses), investments (helping clients invest wisely), and financial institutions (circulating money in
the economy). Financial managers make decisions to boost owner wealth, investment managers aid clients in financial goals, and financial institutions keep money flowing.
3.
Despite specific roles, ethical conflicts, like in your personal life, can arise due to conflicting interests. It's crucial to note that legality doesn't guarantee ethics. Always consider the ethics of your actions, both professionally and in your personal finances.
Unit Test
Form A
1.
Which area of finance involves deciding which assets to invest in to create wealth in the future?
a.
Financial institutions
b.
Financial management
c.
Asset pricing
d.
Investments
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i.
Correct! This area involves deciding which assets to invest in to create wealth in the future
2.
What is the main goal of a firm?
a.
To circulate money in the economy
b.
To make investment decisions
c.
To make decisions on how to finance projects.
d.
To maximize owner wealth
i.
Correct! The main goal of a firm is to maximize owner wealth, and the financial manager should make decisions based on this goal.
3.
What are financial managers doing if they evaluate whether it is worth spending money on research and development for a new product?
a.
Making a financing decision
b.
Implementing a financial policy
c.
Making an investment decision
i.
Correct! The financial manager assesses the costs and benefits of potential investments in order to wisely use the investors’ money.
d.
Managing working capital
4.
Which type of financial market is where securities such as stocks and bonds are traded after their initial issuance?
a.
The dealer market
b.
The primary financial market
c.
The secondary financial market
i.
Correct! Financial securities are first sold in the primary financial market and then traded among investors in the secondary financial market.
d.
The initial public offering
5.
What type of financial institution is an insurance company?
a.
Depository
b.
Circulatory
c.
Investment
d.
Contractual
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i.
Correct! Insurance companies are contractual savings institutions.
6.
Which financial institution invests funds contributed by a company to provide retirement funds for the company’s employees?
a.
Mutual fund
b.
Pension fund
i.
Correct! This is the role of pension funds.
c.
Insurance
d.
Central bank
7.
Personal income is which type of economic indicator?
a.
Leading
b.
Coincident
i.
Correct! Coincident indicators change as the economy changes.
c.
Unifying
d.
Lagging
8.
Which term refers to something that conforms with accepted standards of conduct that guide a person’s behavior?
a.
Legal
b.
Moral
c.
Ethical
i.
Correct! Ethical refers to the accepted standards of conduct that guide a person’s behavior
d.
Standard
9.
What is the second step in finding a solution to an ethical dilemma?
a.
Identify and define the problem
b.
Consider alternative courses of action
i.
Correct! First, identify and define the problem. Then, consider alternative courses of action.
c.
Consider the consequences that may come from the action
d.
Calculate the value added to the company
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10. How can agency problems be reduced through corporate control?
a.
Executive compensation
i.
Correct! By compensating the management team with stocks and stock options, management may be willing to take on riskier projects. This creates more value for the owners because riskier projects will increase the value of financial securities.
b.
Accounting manipulations
c.
Acquisition of a foreign subsidiary
d.
Setting strict goals
Form B
1.
What are the main services offered by financial institutions?
a.
Soliciting charitable donations and then managing the distribution of these funds
b.
Evaluating sources of funding for a business project, the capital structure of a firm, or actions managers could take to increase the value of the firm
c.
Deciding which assets to invest in to create wealth in the future
d.
Accepting a wide variety of deposits, offering investment products, providing loans, and brokering financial transactions
i.
Correct! Financial institutions such as banks, insurance companies, and mutual fund companies provide these services.
2.
What is the main objective of personal financial goals?
a.
To maximize individual utility
i.
Correct! You set goals and act to increase your satisfaction or happiness by taking care of necessities and achieving priorities.
b.
To maximize owner wealth
c.
To maximize stock investments
d.
To maximize charity donations
3.
Which task does the financial manager of a firm perform that involves the issuance of new stocks and bonds?
a.
Deciding on accounting standards
b.
Making financing decisions
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i.
Correct! Once investment decisions are made, a financial manager considers different possibilities of financing sources for the investments. This may include issuing new stocks and bonds.
c.
Making investing decisions
d.
Managing working capital
4.
Why is understanding the definition of finance important in managing personal finances?
a.
It helps individuals understand legal issues related to finance.
b.
It helps individuals act ethically with regard to finances.
c.
It allows individuals to find an investment with the highest return possible.
d.
It helps individuals compare the costs and benefits of an action to determine whether to take that action.
i.
Correct! Any financial decision should make sense in terms of its costs and benefits.
5.
In which type of market would a company issue bonds or stocks for the first time?
a.
Secondary market
b.
Primary market
i.
Correct! This is the purpose of a primary market.
c.
Dealer market
d.
Money market
6.
Which type of financial institution is a mutual fund?
a.
Contractual institution
b.
Depository institution
c.
Investment institution
i.
Correct! Investment institutions provide individuals and firms access to financial markets.
d.
Federal institution
7.
Which financial institution specializes in managing and administering retirement funds?
a.
Pension funds
i.
Correct! Pension funds specialize in retirement funds.
b.
Private equity
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c.
Investment banks
d.
Mutual funds
8.
Which type of economic indicator is the consumer price index?
a.
Leading indicator
b.
Lagging indicator
i.
Correct! CPI usually changes after the economy as a whole changes.
c.
Forecasting indicator
d.
Coincident indicator
9.
What does the term ethical refer to?
a.
An idea or thing used as a measure, norm, or model in comparative evaluations
b.
Following the laws and rules set by an authority
c.
The accepted standards of conduct that guide a person’s behavior
i.
Correct! Ethical refers to the accepted standards of conduct that guide a person’s behavior.
d.
One’s beliefs about right and wrong, good and bad, or just and unjust
10. A company’s officers and board of directors are selling their stocks in the firm at higher prices due to false accounting reports that made the stock seem more valuable than it truly was. Which ethical issue is occurring in this situation?
a.
Agency problem due to conflicting interests
i.
Correct! Accounting manipulation by management in pursuit of higher stock-related compensation is an example of an agency problem.
b.
Maximizing shareholder value
c.
Pursuing individual interest over client interests
d.
Conflict between work and personal affairs
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Author:Eugene F. Brigham, Joel F. Houston
Publisher:Cengage Learning
Corporate Finance (The Mcgraw-hill/Irwin Series i...
Finance
ISBN:9780077861759
Author:Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Jeffrey Jaffe, Bradford D Jordan Professor
Publisher:McGraw-Hill Education
Related Questions
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- help please answer in text form with proper workings and explanation for each and every part and steps with concept and introduction no AI no copy paste remember answer must be in proper format with all workingarrow_forwardHello accounting tutors. Can you help me to answer this?. kindly see the attached image below or this link >> https://drive.google.com/file/d/1D4KNMJHHVMxVKdYvbABzQLTSijz2ZU9m/viewarrow_forwardI need to 2 step and final solution no Ai solutions pleasearrow_forward
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