Finance
Reading Comment – Chapter 14 (pp 431-436) &
Appendix 1 (pp 482- 488)
These pages do a good job of
describing many fundamental concepts of finance. Our chief topics of interest will be the
Federal Reserve System (pp 431-436), and financial needs of businesses
(pp482-488).
Lecture Notes
Lecture Summary
·
The Federal
Reserve System. Introduction to interest
rates.
·
Raising capital: issuing new equity and debt, difference between primary
and secondary markets, publicly versus privately held firms
·
Bonds –
government and private.
·
Personal finance
-
Reducing debt
-
Increasing
income
-
Increasing
investment income
Major Points
The Federal Reserve System
The Federal Reserve System
has a variety of important national banking functions. If you look at a dollar bill and see the top
line, you will observe one of their most important functions, producing
money. They must also control
money. If too much money is in
circulation, it can breed inflation. Too
little money can lead to deflation and make it difficult for companies to
transact business. How does the fed decide how much money to keep in
circulation? Their board meets regularly
to review economic conditions. While
board members are appointed by the President, the board is at least nominally
independent of any president and can set economic policy based on their beliefs
of what is best for the country rather than what might be best for a president
or a political party (for instance, making money more available just before an
election might help the incumbent party).
How is the money supply
controlled? First, the Fed buys bonds
from the government. The bills used to
buy the bonds can then be spent by the government. These bills in circulation can be controlled
in three ways: the fed can require banks
to keep more on-hand (on-reserve), so they have fewer to loan out, the Fed can
raise the interest rates (discount rate) banks have to pay each other for
money, thereby increasing the costs of loans to consumers, and the Fed can
absorb bills by selling bonds or securities.
Another important function
of Federal Reserve System of banks is to handle check processing. This is how money from your account makes it
from your bank to the bank of the company you purchase from. The figure on page 433 does a nice job of
showing the flow of paper and money. One
thing to note is that actual dollar bills rarely have to move. The “money” is just accounting records. In theory, one bank could move money to every
other bank every day, but this would be burdensome and expensive. So the “money” is just computer records. You can see why computers in these banks
would be so strongly protected – the real ”money” is
not in a bank’s vault, but in its database records.
What impact does the Fed
have on average businesses? As the Fed
raises interest rates, other banks and lending institutions follow. In the last two years, the Fed has raised its
interest rate from an historically low 1% to just over
5%. As it does so, all other interest
rates in the
Activity #1: What are current interest rates on home
mortgages? What impact has that had on
home prices? Why? What would the impact be if the Fed raised
the discount rate another 3%? Why might
it want to do that?
Activity #2: What impact does the Fed rate have on the interest
your might earn on a savings account, or pay on a credit card account?
Raising Capital
Companies need significant
amounts of money to get started, to expand product offerings or to grow into
new markets. They can get that money in
many ways.
Borrowing
– Smaller businesses are often started by people borrowing money from family
and friends, using credit card balances, taking out a personal loan from a bank
(a loan without collateral, given on the assumption that you will repay because
you have a good credit history), or obtaining an equity loan based on the value
of a residence (a “secured” loan, since they will take your house if you do not
repay). Since businesses usually need an
infusion of cash more than once, business owners may use any of these sources
multiple times.
In every case, the amount
you are able to borrow, and the interest rate you will be asked to pay, will be
based on assumptions of risk. What is the risk you will not pay? For a young person starting a new business,
risks are very high, so your borrowing costs will likely be very high. Risk is also applied to more substantial
loans taken out by larger companies in the form of bonds.
Larger companies can also
secure financing by selling bonds. These
are promissory notes due to be repaid over a period of time with a stated level
of interest. Bonds can be secured - the
bond holder takes some corporate asset if the bond is not repaid), or unsecured
(“Debentures’). Bonds are rated by
Standard and Poor’s and Moody’s so potential lenders know how much risk to
expect. The greater the risk of
non-repayment, the greater the interest companies must pay to find lenders.
Here are the ratings used by
Standard and Poor’s:
|
|
Credit Ratings Issue
credit ratings are based in varying degrees, on the following considerations: §
Likelihood of payment—capacity and willingness of the
obligor to meet its financial commitment on §
Nature of and provisions of the obligation; and §
Protection afforded by, and relative position of, the
obligation in the event of bankruptcy, reorganization, or AAA |
|
Copyright (c) Standard
& Poor's, a division of The McGraw-Hill Companies, Inc. All rights
reserved. |
Activity #3: What advantages would a business owner have
if he/she owned a home rather than rented?
Given current economic conditions which parts of the country would be
most advantageous for smaller business owners?
Activity
#4: If a friend came to you with an idea for a business, and asked for a
loan, what would you want to know before you gave him a loan? What kind of
interest would you expect?
Activity
#5:
If you were buying corporate bonds, how low an S&P rating would you
be willing to accept? How much more
interest would you expect to receive for each level lower than AAA?
Selling equity (stock) in your company – The other way of raising money is to sell a
portion of the company. You could take
on one or two partners, or you could sell a share of the company. For instance, you could declare that the
company has 100 shares. Each share represents
one percent of the assets and profits of the company. If it is likely that your company will grow
and create a profit, people might be eager to buy a portion of your
company. So the price of one share might
be very high. By selling shares of the
company you lose a part of your company, but you gain the money of investors to
use to pay off debts or expand into new products or regions.
Shares can be sold
privately. You go to people you know and
ask them if they want to buy part of your company. Recently groups of wealthy
investors (“angel investors”) have started forming investment groups to search
out smaller and newer companies that might like this kind of investment. “Venture capitalists” also buy parts of
smaller companies.
Eventually, your company
might become large enough to sell shares to the general public. These sales must be approved by the
Securities and Exchange Commission (SEC) to see that everything is done
honestly, and then an investment bank actually creates the shares and handles
their sales. These shares can then be
resold to the public on the “secondary market” – the stock exchanges like the
New York Stock Exchange and NASDAQ.
Activity #6: Which state has the most venture
capitalists? How many VC funds do we
have in
Activity #7: What has been the historic rate of return on
publicly traded stocks? What has the
return been over the last five years?
What causes a stock price to go down?
What would cause it to go up?
Government Borrowing
While most borrowing is done
by individuals and companies, the government borrows money too. During most of the 1990s the
Government borrowing has an
impact on business. Since we assume the
return on a
Activity #8:
Here are example rates for treasury bonds of various maturity lengths:
|
2-YEAR |
|
NOTE |
|
4.014 |
|
3-YEAR |
|
NOTE |
|
4.204 |
|
5-YEAR |
|
NOTE |
|
4.223 |
|
10-YEAR |
|
NOTE |
|
4.350 |
Why do longer bonds pay
higher interest rates? What does the
longer term interest rates tell you about future risks investors expect? Based on the interest rates shown, how much
inflation do experts expect to see in ten years?
Activity #9: If the rates above are for US Treasury bonds,
what rates do you expect would be required for corporate bonds? Would they be higher or lower? Why?
Personal Finance
As an individual you have
three main parts to any financial plan:
- reduce debt,
- increase earnings, and
- improve investment income.
How to reduce debt –
Much of what you owe will come from interest. Especially on credit cards, it takes very
little time before much of your outstanding balance is due to interest
expenses. So the first step to reduce
debt is to cut the amount of interest you pay.
Interest on personal
loans (like credit cards) is based on risk – can they trust you to repay your
debt?. Risk is
based on personal credit histories. Scores
range from 300 to 850 based on payment histories, debt owed and the number of
times you apply for credit (i.e. the more credit cards you have, the worse your
credit rating). Since scores are
computed by Fair Isaac Corp, they are known as FICO scores
700 is
considered a good credit score. The median U.S. FICO score is 723. The higher the score you get, the lower the
interest rate you will be charged, since you are considered a lower risk. According to a Fair Isaac Web site
(http://www.myfico.com), a consumer with a 760 FICO score might pay $843 a
month on a $150,000 thirty-year, fixed-rate mortgage, equal
to a 5.41 percent interest rate. But a consumer with a 659 FICO score might pay $943 a month, equal to a 6.45 percent
rate.
(NOTE: Within the next few months the numbering
system will be changed to 550-990 to be more like scores we all know from
school. A 99 (990) is good, a 55 (550)
is failing. This new system will be easier for loan officers and consumers to
understand.)
The discussion of FICO scores
explains one aspect of debt reduction – the better your FICO score, the better
your interest rate on loans, and the less money you will have to pay over the
life of a loan. Here is one example from
Businessweek (Nov 28, 2005 p 117). It reviews the amount of interest you would
have to pay if you borrowed $175,000 over 30 years to buy a house.
|
FICO score |
Annual Rate |
Monthly Payment |
Total Interest |
|
720-850 |
6.24% |
$1,074 |
$213,000 |
|
700-719 |
6.37 |
$1,090 |
$217,000 |
|
675-699 |
6.90 |
$1,152 |
$240,000 |
|
620-674 |
8.05 |
$1,290 |
$290,000 |
|
560-619 |
8.53 |
$1,350 |
$312,000 |
|
500-559 |
9.29 |
$1,444 |
$345,000 |
Basically, people with poor
credit will have to pay an extra $132,000 for the same house as people with
good credit. Notice also that in every
case, the amount of interest paid back is more than the original amount of the
amount borrowed. Here is how it might
work out for the original home loan:
- House price - $218,000
- Down Payment - $43,000 (20% of house price)
- Loan - $175,000
- Total loan payments (loan plus interest) -
$388,000 to $520,000 (depending upon FICO score)
- Total paid for the house over 30 years -
$431,000 to $563,000 (loan plus down payment
How do you Increase your
Income?
Increasing your income is
easy, and you are already doing it. Most
sources calculate that college graduates earn about $1.1 million dollars more
during their lifetimes than high school graduates. So finish college. What do you get if you drop out? Not much.
College drop outs are marked as “quitters,” and so get little boost in
pay over high school grads.
How do you get more from
your investments?
It may sound odd to talk
about investments when most college students are in debt, but there will come a
time when you have money. The first step
is to spend less. Read a book like “The
Millionaire next door” to learn how simply some very wealthy people can
live. Then consider the 7/10 rule. It gives you a simple way to evaluate how
your money will grow:
At
7% interest, your money doubles in 10 years
At
10% interest, your money doubles in 7 years
Historically American stocks
have returned about 10% in earnings (dividends plus grow in the stock
price). If that holds true, here is the
return you might expect if you can accumulate $10,000 by the time you are 30:
30 $10,000
37
$20,000
44
$40,000
51
$80,000
58
$160,000
65
$320,000
In other words, money can
grow to large amounts if you put some away early in your life.
Activity #10: What could you do to reduce the
amount of interest you will pay on a house?
Book Comments
These two chapters cover a
great many finance concepts. Since they
will all be covered in greater depth in the finance core course, our task here
is to select only those concepts deemed more fundamental by the finance
team. Each concept seems to be
reasonably well described in the text, but I have augmented materials from
common financial web sites.
Business Plan Aspects
How much money will your
company need at start up? During the first year?
After the first year? How will you find that money? Evaluate each of your options. What would it take to lower your costs of
capital?