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 US also rise.  So the cost to borrow money to start or grow your business will also rise.


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
an obligation in accordance with the terms of the obligation;

§        Nature of and provisions of the obligation; and

§        Protection afforded by, and relative position of, the obligation in the event of bankruptcy, reorganization, or
other arrangement under the laws of bankruptcy and other laws affecting creditors’ rights.

An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.

An obligation rated ‘AA’ differs from the highest-rated obligations only in small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong.

obligation rated ‘A’ is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher-rated categories. However, the obligor’s capacity to meet its financial commitment on the obligation is still strong.

An obligation rated ‘BBB’ exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.

BB, B, CCC, CC, and C
Obligations rated ‘BB’, ‘B’, ‘CCC’, ‘CC’, and ‘C’ are regarded as having significant speculative characteristics. ‘BB’ indicates the least degree of speculation and ‘C’ the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions.

Bond Investment Quality Standards

Under present commercial bank regulations issued by the Comptroller of the Currency, bonds rated in the top four categories (‘AAA’, ‘AA’, ‘A’, ‘BBB’, commonly known as investment-grade ratings) generally are regarded as eligible for bank investment. Also, the laws of various states governing legal investments impose certain rating or other standards for obligations eligible for investment by savings banks, trust companies, insurance companies, and fiduciaries in general.


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 Wisconsin?


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 US government actually ran budget balances and paid off debt, but starting in 2000 the government went back into debt and has been running huge imbalances every year.  When it runs short of money, it borrows by selling government bonds.  At the Treasury Department web site ( you can buy these bonds directly.


Government borrowing has an impact on business.  Since we assume the return on a US treasury bond is guaranteed, these bonds are attractive.  Interest rates are currently about 5%.  If an investor is guaranteed a return of 5% from a bond thought to be very safe, the investor will probably expect to receive a higher interest return from a less secure loan to a company.  So, as US treasury rates go up, the amount businesses have to pay for loans also goes up.  This also affects consumer loans like car loans and home mortgages.


Activity #8: Here are example rates for treasury bonds of various maturity lengths:























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 (, 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


























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?