EDITION
6
Entrepreneurial
Finance
Philip J. Adelman
DeVry University
Alan M. Marks
DeVry University
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Library of Congress Cataloging-in-Publication Data
Adelman, Philip J.
Entrepreneurial finance / Philip J. Adelman, DeVry University, Alan M. Marks, DeVry University.—6 Edition.
pages cm
ISBN-13: 978-0-13-314051-4 (alk. paper)
ISBN-10: 0-13-314051-2 (alk. paper)
1. Small business—Finance. I. Marks, Alan M. II. Title.
HG4027.7.A338 2013
658.15’92—dc23
2012050973
10 9 8 7 6 5 4 3 2 1
ISBN 10:
0-13-314051-2
ISBN 13: 978-0-13-314051-4
T
o my wife, Hannah B. Adelman,
for her support and continued belief in my abilities;
and to my children, Eddie, Danny, and Tova; my daughters-in-law,
Connie and Cherie; my son-in-law, Jason Gilbert; and my wonderful grandchildren,
Ellie, Jed, Erin, Joey, Emily, Abby, and Naomi, for being my cheerleaders.
Philip J. Adelman
T
o my loving and supportive family—my wife, Cheryl; my children, Jamie and Jared;
my daughter-in-law Jessica; and my wonderful grandchildren, Kellen, Spencer, Preston, and
Beckett, who gave me the encouragement to realize that my goal is achievable.
Alan M. Marks
T
o DeVry University, who gave us the
opportunity to use our creative talents to teach.
In memory of Philip Pomerantz whose story gave us
the inspiration to pursue small business case studies.
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Contents
Preface ix
Chapter 1
Financial and Economic Concepts 1
Basic Financial Concepts 2 ● Importance of Finance 3 ● Economic Concepts of
Finance 3 ● Scarce Resources 4 ● Opportunity Costs 6 ● Savings, Income, Expenditures, and
Taxes 8
Policy 18
●
Supply of Money Saved 11
Inflation 18 ● Risk 20
●
Demand for Borrowed Funds 15
●
Federal Reserve
●
●
Conclusion 23 ● Review and Discussion
Questions 24 ● Exercises and Problems 24 ● Recommended Team Assignment 25
●
Case Study: Macy’s Housewares, Incorporated 25
Chapter 2
Financial Management and Planning 29
Management Functions 30 ● Planning 30 ● Organizing 31 ● Staffing 32
●
Directing 32
Controlling 33 ● Business Organizations and Ownership 33 ● Sole Proprietorship 34
●
Partnership 36 ● Corporation 38 ● Limited Liability Company 41 ● Franchise 43
●
Nonprofit Organizations 43 ● Starting a Business 44 ● Development of a Business
Plan 46 ● Executive Summary 46 ● General Company Description 47 ● Business Ownership
Succession Plans 52 ● Financing a Business or Raising Capital 52 ● Sources of Financing 54
●
●
●
Conclusion 56 ● Review and Discussion Questions 57 ● Exercises and Problems 57
Suggested Group Project 58 ● Case Study: Introduction to Entrepreneurship 59
Chapter 3
Financial Statements 63
Personal Cash Flow Statement 66 ● Income Statement 67
●
Statement of Financial Position 72 ● Balance Sheet 74
●
●
Chart of Accounts 67
Sole Proprietorship 78
●
Partnership 78 ● Public Corporations 79 ● Owner’s Equity 82 ● Statement of Cash
Flows 82 ● Problems with Financial Statements 85 ● Conclusion 87 ● Review
and Discussion Questions 88 ● Exercises and Problems 88 ● Recommended Team
Assignments 89 ● Case Study: DPSystems, LLC 90
Chapter 4
Analysis of Financial Statements 95
Vertical Analysis 97 ● Horizontal Analysis 99 ● Ratio Analysis 101 ● Types of
Business Ratios 101 ● Liquidity Ratios 101 ● Current Ratio 102 ● Quick (Acid Test) Ratio 102
●
●
●
Activity Ratios 103 ● Inventory Turnover Ratio 103 ● Accounts Receivable Turnover Ratio 104
Fixed Asset Turnover Ratio 105 ● Total Asset Turnover Ratio 105 ● Leverage Ratios 106
Debt-to-Equity Ratio 106 ● Debt-to-Total-Assets Ratio 107 ● Times-Interest-Earned Ratio 107
v
vi
Contents
Profitability Ratios 108 ● Gross Profit Margin Ratio 108 ● Operating Profit Margin Ratio 109
Net Profit Margin Ratio 109 ● Operating Return on Assets Ratio 110 ● Net Return on Assets
Ratio 110 ● Return on Equity Ratio 110 ● Market Ratios 111 ● Earnings per Share Ratio 111
●
Price Earnings Ratio 112 ● Operating Cash Flow per Share Ratio 113 ● Free Cash Flow per Share 114
●
●
●
Sources of Comparative Ratios 116 ● Conclusion 116 ● Review and Discussion Questions 117 ● Exercises and Problems 118 ● Recommended Team Assignment 122 ● Case
Study: Mosbacher Insurance Agency 122 ● Background 122 ● Gaining Experience 123
●
Mosbacher Insurance Company 124 ● Entrepreneurship at Work 124 ● The result 125
Chapter 5
Profit, Profitability, and Break-Even Analysis 127
Efficiency and Effectiveness 128 ● Profit 129 ● Profitability 129 ● Earning Power 130
Break-Even Analysis 131 ● Break-Even Quantity 132 ● Break-Even Dollars 136 ● BreakEven Charts 137 ● Leverage 138 ● Operating Leverage 139 ● Financial Leverage 140
●
Bankruptcy 143 ● Conclusion 146 ● Review and Discussion Questions 147
Exercises and Problems 147 ● Recommended Team Assignment 150 ● Case
Study: Mark Wheeler Craftsman, Inc. 150
●
●
Chapter 6
Forecasting and Pro Forma Financial Statements
153
Forecasting 154 ● Types of Forecasting Models 156 ● Mean Absolute Deviation 161 ● Practical
Sales Forecasting for Start-Up Businesses 175 ● Pro Forma Financial Statements 178
●
Pro Forma Income Statement 178 ● Pro Forma Cash Budget 180 ● Pro Forma Balance
Sheet 184 ● Monitoring and Controlling the Business 188 ● Start-Up Business Costs Revisited 188
Gantt Chart 189 ● Conclusion 191 ● Review and Discussion Questions 191
●
●
Exercises and Problems 192 ● Recommended Team Assignment 195 ● Case Study:
Hannah’s Donut Shop 196 ● Historical Background 197 ● Environmental Changes 198
●
Changes in Measurement Systems 198 ● Changes in Strategy 199 ● Implementing
the Five-Step Process and Drum Buffer Rope 202 ● Step 1 202 ● Step 2 202 ● Step 3 203
The Change Process 203 ● Step 4 204
Constraints 205 ● Summary 206
●
●
Step 5 204
●
Results 204
●
Shifting
Chapter 7
Working Capital Management 207
Working Capital 208 ● Working Capital Management 208 ● Current Asset
Management 210 ● Cash Management 210 ● Marketable Securities Management 213
●
Accounts Receivable Management 214 ● Inventory Management 219 ● Economic Order Quantity
Formula 219 ● Types of Inventories 224 ● Current Liabilities Management 228 ● ShortTerm Debt Management 228 ● Accrued Liabilities Management 230 ● Accounts Payable Management 231 ● Conclusion 236 ● Review and Discussion Questions 237 ● Exercises
and Problems 238 ● Recommended Team Assignment 240
Steel Trading, LLC 240 ● Background 240
●
Case Study: Associated
Chapter 8
Time Value of Money—Part I: Future and Present Value
of Lump Sums 243
Simple Interest 245 ● Fixed Principal Commercial Loans 246 ● Bridge Loans 249 ● Bank
Discount 250 ● Compound Interest 254 ● Financial Calculators 255 ● Rounding
Errors 256 ● Effective Rate 257 ● Time-Value-of-Money Methods 259 ● Future Value
of a Lump Sum 260
●
Present Value of a Future Lump Sum 263
●
Internal Rate of Return 268
Conclusion 271 ● Review and Discussion Questions 272 ● Exercises and Problems 272 ● Recommended Team Assignment 274 ● Case Study: Blue Bonnet Café 275
●
Contents
vii
Chapter 9
Time Value of Money—Part II: Annuities 279
Future Value of an Ordinary Annuity 280 ● Future Value of an Annuity Due 286
●
Present Value of an Ordinary Annuity 291 ● Present Value of an Annuity Due 294
●
Present Value and Amortization 298 ● Amortization 300 ● Combining Lump Sum and
Annuities into the Same Problem 304 ● Conclusion 308 ● Review and Discussion
Questions 308 ● Exercises and Problems 309 ● Recommended Team Assignment 311
●
Case Study: Entrepreneurial Spirit 311
Chapter 10
Capital Budgeting 315
Capital Budgeting 316 ● Factors Affecting Capital Budgeting 317
●
Changes in Government
Research and Development 318 ● Changes in Business Strategy 318 ● Formulating a Proposal 319 ● Costs in Capital Budgeting 319 ● Benefits in Capital Budgeting 320
●
Evaluating the Data (Techniques of Capital Budgeting) 323 ● Payback 324 ● Net Present
Value 324 ● Profitability Index 330 ● Internal Rate of Return 331 ● Accounting Rate of Return 335
●
Lowest Total Cost 336 ● Making the Decision 338 ● Following Up 339 ● Taking
Regulations 317
●
Corrective Action 339 ● Conclusion 340 ● Review and Discussion Questions 341
Exercises and Problems 342 ● Recommended Group Activity 345 ● Case Study:
SWAN Rehabilitation Company: A Great Success Story 345
●
Chapter 11
Personal Finance
349
Risk 350 ● Identification of Risk Exposure 351 ● Risk Management 351 ● Life, Health, Disability,
Property, and Liability Insurance 353 ● Financial Planning Goals 358 ● Investments 358
●
Cash Equivalents 358 ● Certificates of Deposit 359 ● Bonds 360 ● Stock 364 ● Mutual
Funds 370 ● Real Estate 373 ● Precious Metals 375 ● Collectibles 375 ● Investment
Strategies 376 ● Short-Term Investment Strategies 376 ● Long-Term Investment Strategies 377
●
Pension Planning 377 ● Retirement Plans 378 ● Retirement Strategies 383 ● Retirement
Strategy Examples 384 ● Estate Planning 387 ● Conclusion 391 ● Review and
Discussion Questions 391 ● Exercises and Problems 392 ● Recommended Group
Activities 395 ● Case Study: The Gilberts: An Entrepreneurial Family 396
Appendix A Working with Spreadsheets
Spreadsheet Basics 399 ● Formula Entry 403
Interest or Future Value of a Lump Sum 403 ●
●
Future Value of an Ordinary Annuity 406 ●
●
Present Value of an Ordinary Annuity 409 ●
●
Working with Calculators 412
Appendix B
and Calculators
399
●
Simple Interest 403 ● Compound
Present Value of a Future Lump Sum 405
Future Value of an Annuity Due 408
Present Value of an Annuity Due 411
Time-Value-of-Money Tables
417
Appendix C Answers to Even-Numbered Exercises and Problems 425
Chapter 1 425 ● Chapter 2 425 ● Chapter 3 426 ● Chapter 4 427
●
Chapter 5 430 ● Chapter 6 431 ● Chapter 7 435 ● Chapter 8 435
●
Chapter 9 438 ● Chapter 10 442 ● Chapter 11 444
Case Studies 447
Glossary 463
Index 477
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Preface
NEW
TO THE
SIXTH EDITION
In this edition, we include short case studies of small businesses at the end of each
chapter. We have also added some additional case studies at the end of the textbook.
Chapter 2 has updated material on the Small Business Administration (SBA), with
a discussion of new programs including loans and grants that have been developed
to assist veterans and severely disabled veterans. We also added updated sources
of financing, the requirements for obtaining federal contracts, and the need for
businesses to develop succession plans. Chapter 4 has updated financial ratios that
include averaging information from two balance sheets when data for the ratio is
taken from both the income statement and balance sheet (statement of financial
position). Chapter 8 introduces fixed interest loans to include both fixed principal
commercial loans and bridge loans. New to this edition are examples of Time Value
of Money problems using both Microsoft Excel and the TI (Texas Instruments)
BA II Plus calculator. We include step-by-step diagrams for the solution to TVM
problems. Chapter 9 includes a discussion of adjustable rate mortgages (ARMs)
and illustrates the problem with an upside-down mortgage when real estate values
decline. We also include step-by-step diagrams for the solution to TVM annuity
problems using the TI BA II Plus calculator. Chapter 11 is updated to show changes
in retirement programs and now includes a discussion of Medicare insurance and an
explanation of the new Medicare Prescription Drug Plan and income replacement
insurance policies. Chapter 11 also includes the requirements for an annual financial tuneup. Appendix A has been updated to show solutions to typical financial
problems using both Microsoft Excel and the TI BA II plus calculator. We include
screenshots of Microsoft Excel spreadsheets. We also include screenshots of how to
enter time-value-of-money formulas using the function wizard fx. Appendix A also
includes step-by-step solutions to sample problems using the TI BA II Plus financial
calculator.
We have written this textbook for the more than 99 percent of business owners
and managers in the United States who manage sole proprietorships, partnerships,
ix
x
Preface
limited liability companies, or small non-public corporations. We are targeting
those individuals and students who wish to learn more about the financial aspects
of business entrepreneurship. We make complex theory easy to understand and
discuss vital issues with a direct and clear delivery of material. We apply many of
the techniques that are found in traditional corporate finance texts to businesses at
an understandable level.
Most people who want to start a business come from all types of occupations
(e.g., blue collar, trade, professional, technical, engineering). Their formal education may be in something other than business. This book is written primarily as
a textbook for the education institution that caters to the concerns of individuals
wishing to enhance their abilities in those areas of business that lead to successful
entrepreneurship. This text can also be used by universities, community colleges,
and technical colleges offering programs in finance and entrepreneurship. Of the
more than 31 million businesses in the United States, approximately 72 percent are
sole proprietorships, 10 percent are partnerships, 6 percent are C corporations, and
13 percent are Subchapter S corporations; less than 1 percent are publicly traded
corporations. However, almost all financial textbooks are written for the large corporation and do not address the needs of more than 99 percent of all business. In
addition, the majority of these business establishments have fewer than 20 employees.1 For these businesses, the owner is pretty much the chief financial officer, the
chief executive officer, and the chief operating officer. Such a business owner needs
a working knowledge of finance, because he or she has no staff support on a fulltime basis to assist in planning.
Our textbook differs from the typical financial textbook. Traditional financial
texts are written for college juniors, seniors, or graduate students with the assumption that the student has had several courses in accounting and that this student will
be working for a major corporation. This is not usually the case. Our textbook
provides the critical financial information required for the majority of students and
entrepreneurs entering the business world today. The resources used in writing a
business plan often omit many of the financial aspects that the owner may need
to determine the financial health of an existing or future business. Because many
students may come from a non-business background rather than having a prior
formal business education, we begin our text by outlining the basic economic factors affecting finance. We then discuss the advantages and disadvantages of various
forms of business ownership. The text provides examples of financial statements for
each type of business ownership. We devote more time than most financial texts
discussing working capital and inventory management, because even though the
sales may increase, a new business may fail because of poor working capital and
inventory management techniques.
1
Internal Revenue Service, Statistics of Income Bulletin, Historical Table, Winter 2011. U.S. Securities
and Exchange Commission filings. Retrieved July 25, 2012, from http://www.irs.gov/newsroom/
article/0,,id=238252,00.html
Preface
Most business managers have been trained to judge the profitability of a project in terms of payback and break-even analysis. We have taken corporate capital
budgeting techniques and adapted them by showing the weighted average cost of
capital as it exists for most business owners. We also demonstrate the importance of
the time value of money as a tool in both business planning and personal financial
planning, and we simplify the use of this tool. We provide the reader with specific
examples in which each of the six time-value-of-money formulas is actually used
by individuals and businesses.
All individuals, regardless of whether they work for the traditional publicly
traded corporation, must make decisions about their retirement plans. Traditional
financial textbooks do not cover personal financial planning. Because of this, we
devote all of Chapter 11 to this vital topic, which includes an in-depth discussion of
risk management as well as those investment vehicles that enable the entrepreneur
to plan for personal financial goals. We believe that it is imperative for business
managers not only to run their business successfully on a day-to-day basis, but to
have those skills that enable them to plan for their personal and family’s future as
well.
Thanks to Timothy Ackley and Joyce Barden at DeVry University, Phoenix,
Arizona, for their expert assistance and advice. Special thanks to the reviewers of
this text: Craig Armstrong, University of Alabama Tuscaloosa; Thomas Bilyeu,
Southwestern Illinois College; Josh Detre, Louisiana State University.
Philip J. Adelman
Alan M. Marks
xi
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CHAPTER
1
Financial and Economic
Concepts
Learning Objectives
When you have completed this chapter, you should be able to:
♦ Understand the basic concept and importance of finance as it relates to
individuals and business.
♦ Understand the basic economic concepts of finance.
♦ Distinguish between marginal revenue and marginal cost.
♦ Distinguish between economic capital and financial capital.
♦ Determine the opportunity cost of making decisions.
♦ Identify the relationships among savings, income, expenditures, and taxes.
♦ Identify the factors that affect interest rates.
♦ Understand the relationships between supply and demand for money and
prevailing market interest rates.
♦ Describe the role of the Federal Reserve and the tools used to achieve the
goals of economic growth, price stability, and full employment.
♦ Understand the relationship between risk and return on investment.
♦ Compare systematic risk to unsystematic risk and discuss their impact on
business.
This book is written to give the individual who has no formal education in finance a brief overview of finance from both personal and business
perspectives. The book is primarily for people who want to start their own
business or those who want to analyze companies and investments but who do
not have the time to pursue a formal course of study in a traditional business
1
2
Chapter 1 Financial and Economic Concepts
college setting. This book can be used as a supplementary text in any college
business course, as well as in a traditional college finance course. In the United
States, approximately 31 percent of all employer-established businesses close
within the first two years and 51 percent close within the first five years.1
Usually, this is not because the businesses offer poor products or services, but
because of poor financial management or a lack of adequate financial capital.
BASIC FINANCIAL CONCEPTS
Finance is essentially any transaction in which money or a money-like instrument is exchanged for another money or money-like instrument. An individual
who finances a car typically has a specific amount of money set aside for a
down payment. That individual must obtain the balance of the sale price to
purchase the car. He or she can finance the car by signing a promissory note
(a loan agreement) for the cash needed to pay the car dealer. The financial part
of purchasing the car involves the money used for the down payment and the
signing of a promissory note. The actual sale of the car is an exchange process
that can be associated with marketing: The seller exchanges the car for the
buyer’s money; however, the car has been financed by the exchange of a promissory note for money. It is important to note that in any financial transaction
there are suppliers and users of funds. In purchasing a car, the down payment
is funds supplied by the buyer of the car, whereas the funds for the promissory
note are supplied by the lender. The buyer is the user of the lender’s funds.
For the business manager who wants to build a new plant, methods
of financing may include using cash generated from current sales, borrowing funds from financial institutions such as banks or insurance companies,
borrowing funds from select individuals, selling stocks, or using personal
savings. Bonds, which are discussed in Chapter 11, are not really a viable
source of financial capital for the majority of businesses. Bonds are normally
available only to large corporations. Therefore, business entrepreneurs rely
predominantly on lending institutions or their own funds to satisfy their needs
for additional financial capital.
Businesses acquire capital assets through the use of financial capital.
A plant, facility, or factory is a fixed, or capital, asset, and include buildings,
machinery, and equipment. Capital assets are used by businesses to increase
revenue or sales. Financial assets such as stocks, bonds, or savings may also be
used to increase revenue, because they can be used to acquire capital assets.
For most individuals and businesses, financial transactions are undertaken
for the purpose of exchanging a sum of money today for the expectation of
1
SBA Office of Advocacy, Frequently Asked Questions, U.S. Small Business Administration.
Retrieved June 14, 2012, from http://www.sba.gov/sites/default/files/sbfaq.pdf.
Economic Concepts of Finance
obtaining more money in the future. We buy stock at today’s price because
we believe that the stock will increase in value or that the corporation will
generate a profit and provide us with cash or stock dividends in the future.
A dividend is an after-tax payment that may be made by a corporation to a
stockholder. However, dividend payments are not guaranteed. We can sell
the stock after it appreciates (goes up in value), or not sell and possibly receive
dividends. Similarly, we invest money in a business today because we expect
greater returns for our money in the future. We can stay with the business and
pay ourselves from our profits, or wait for the business to appreciate and sell it
to another business owner.
IMPORTANCE OF FINANCE
Any individual who starts or manages a business must have a basic understanding of finance—a fact which is especially true in today’s volatile market. Prime
interest rates (the rate of interest that banks charge their best business customers)
have been as low as 1.5 percent (December 1934) and as high as 21.5 percent
(December 1980).2 If we expect to obtain greater returns from our investments
in the future, we must understand finance, its relationship to interest rates, and
how to obtain proper financing. Without this understanding, our individual
and business efforts may fail. However, before we can develop more of an
understanding of finance, we must begin by understanding the basic economic
concepts that relate to finance.
ECONOMIC CONCEPTS
OF FINANCE
The U.S. economy operates on the basic principle that within the confines of
the market, all individuals can achieve their own objectives in a free-enterprise
system. Such a system is known as a market economy. A market economy such
as in the United States consists of several markets. A market is any organized
effort through which buyers and sellers freely exchange goods and services.
Some of these markets in our economy include real estate markets, in which
property is exchanged; retail markets, in which final goods and services are
exchanged; the Internet, in which information is exchanged; and the commodity market, in which basic commodities (raw materials such as agricultural
products, precious metals, and oil) are exchanged. The financial market is the one
that deals with finance. The three primary participants in this financial market
2
Federal Reserve Bank of St. Louis, Historical Prime Rate Table, Retrieved December 5, 2012,
from http://research.stlouisfed.org/fed2/data/PRIM.txt.
3
4
Chapter 1 Financial and Economic Concepts
are individual households, businesses, and government. In our free-enterprise
financial-market system, the primary savers of funds are households. They are
the suppliers of funds to other individuals, businesses, and government, who
are the users of funds.
SCARCE RESOURCES
The central theme of economics is one of scarcity. Items are scarce because
normal people want more than they currently have. Humans have unlimited desires for goods and services. We live in a world of scarce resources,
so we are willing to pay a positive price to obtain goods and services. For
the individual, financial means and time are limited resources. Because individuals have limited financial means, they must make choices about which
resources they want to obtain and in what time period they want to obtain
them. The four types of scarce resources of typical concern in both business
and economics are natural resources, human resources, capital resources, and
entrepreneurial resources.
Natural Resources
Natural resources consist of natural products such as minerals, land, and
wildlife. They exist in nature and have not been modified by human activity.
In economic terms, we consider the payment made for natural resources to be
rent. Natural resources are referred to in some economic textbooks as land.
Human Resources
Human resources are the mental and physical talents of people. Human
resources are also referred to by economists as labor. The economic payment
for human labor is wages. There are, of course, different levels of wages. Wages
are paid by business owners and are based on the marginal revenue product of
the human resource and the availability of the human resource. We have heard
many arguments about the value of professional athletes and their high salaries,
but the fact remains that based on marginal revenue product, these people are
paid a fair salary.
Before continuing our discussion of scarce resources, we must define
some terms. The word marginal, as we use it here, is related to the addition of one more unit of measurement. It is an incremental change. Marginal
revenue product is the additional revenue we obtain by selling one more unit
of product to create an incremental increase in revenue. Marginal physical
product is the additional product that results from hiring one more unit of
labor. Marginal cost is the incremental cost of hiring that one more unit of
labor or the incremental cost of producing one more unit of output.
Economic Concepts of Finance
For example, say that you own a professional basketball team. Your team
is average, and for the past two years you have averaged 16,000 ticket sales per
game for an arena that seats 20,000 people. However, you have noticed that
when the Oklahoma Thunder comes to town, you sell all 20,000 seats. You
determine that the additional seats are sold because the Thunder have a player,
Kevin Durant, who people are willing to pay to see. Therefore, you seek to
hire someone like Kevin. How much would you be willing to pay this basketball player?
You estimate that if you hired Kevin Durant, who would then become
your marginal physical product, you would sell out the arena every game. The
average price of a ticket is $89. You could sell 4,000 more tickets for each
game and bring in extra revenue of $356,000 ($89 a seat times 4,000 seats)
for each home game. Because there are 41 home games, you would make an
additional $14.596 million in ticket sales. The $14.596 million in ticket sales is
your marginal revenue product. This figure does not include additional television revenue or sales of food, beverages, team sports memorabilia, or other
endorsements. Based on the marginal revenue product of a player like Kevin
Durant, you would be willing to pay a marginal cost of up to $14.596 million
to hire this basketball player. If you owned this team and could get a player
like Kevin for $13 million a year, would you hire him? Of course you would,
because you would clear a profit of $1.596 million (14.596 million revenue –
$13 million salary).3
These athletes are obviously a scarce resource. If you advertise in the
paper, how many people with the talents of this basketball player will apply
for the job? Conversely, if you own a pizza parlor and advertise for a delivery
driver, how many people with the mental and physical talent to deliver pizza
will apply for the job? You will probably have several applicants, because there
are hundreds of people in your community who have pizza-delivery skills.
What is the marginal revenue product of pizza delivery? If your average pizza
sells for $14 and the average driver can deliver 4 pizzas an hour, then the
marginal revenue product is $56 per hour. Therefore, the absolute maximum
amount you would be willing to pay a driver is $56 per hour; however, considering both marginal revenue product and the availability of pizza-delivery
people, you may be able to hire a new driver for a minimum wage of $7.25 per
hour. On May 25, 2007, the Fair Labor Standards Act (FLSA) was amended to
increase the federal minimum wage in three steps: to $5.85 per hour effective
July 24, 2007; to $6.55 per hour effective July 24, 2008; and to $7.25 per hour
effective July 24, 2009.4
3
NBA Ticket Prices have fallen for second straight season. Associated Press, November 24, 2010.
Retrieved January 7, 2012, from http://sports.espn.go.com/nba/news/story?id=5846998.
4
U.S. Department of Labor, Employment Law Guide. Retrieved January 12, 2012, from http://
www.dol.gov/compliance/guide/minwage.htm.
5
6
Chapter 1 Financial and Economic Concepts
Capital Resources
Capital resources are grouped into two categories: economic capital and financial capital. Economic capital consists of those items that people manufacture
by combining natural and human resources. Examples include buildings and
equipment of business and government enterprises, such as roads and bridges.
The economic payment for capital, which includes both economic and financial
capital, is interest. It is absolutely essential that we distinguish between economic
capital and financial capital. Economic capital is interchangeable with the terms
physical capital and fixed assets—those capital resources that are used to
make more items. Financial capital is a dollar-value claim on economic capital and, therefore, it may include several types of assets, such as cash, accounts
receivable, stocks, and bonds. When a provider of funds holds financial capital,
the provider has a dollar-value legal claim on the economic asset. For example,
if you borrowed money from a bank to finance a new delivery truck for your
business, the bank supplied you with financial capital. The title to your vehicle
is actually in the name of the bank. The promissory note that you signed with
the bank is the dollar-value claim that the bank has on your fixed asset (vehicle).
A promissory note is an account payable that has in it a written promise to pay
a sum of money by one party, the maker or payer, to the payee. The payer
pays interest to the payee at an interest rate for a specific amount of time (e.g.,
90 days). The maturity value of the note is the principal plus interest that is paid
to the payee.
Entrepreneurial Resources
Entrepreneurial resources are the individuals who assume risk and begin
business enterprises. The entrepreneur combines land, labor, and capital to
produce a good or service that we value more than the sum of the individual
parts. Without the entrepreneur, resources would not normally be combined,
except as needed for subsistence, or just enough to sustain life. The economic
payment made to the entrepreneur is profit. The entrepreneur seeks to make as
much profit as possible. Therefore, when entrepreneurs form businesses, they
try to make profits that exceed the wages paid to labor. The owner of a professional sports team—the entrepreneur—normally makes more than any player
on that team. The owner of the pizza shop should make more in profit than
any employee makes in wages.
OPPORTUNITY COSTS
In any market transaction, both the buyer and the seller usually believe that
they obtained the best use of their scarce resources. The economic basis for
this belief revolves around the concept of opportunity costs, which is the
highest value surrendered when a decision to invest funds is made. Opportunity
Economic Concepts of Finance
cost is a quantifiable term. For example, an individual who has $20,000 may
decide to invest in stocks or bonds, place the money in savings, buy a new
car, or place a down payment on a house. The individual investor determines
what annual return can be expected from these choices and constructs a table
based on expected financial return. Table 1–1 lists the investment opportunities mentioned here and the expected annual gain or loss from each alternative.
The investor naturally takes other factors into consideration, such as the risk
associated with investing in the stock market or the pleasure received from
driving a new car.
TABLE 1–1 Expected Financial Returns of Investment Opportunity
Investment Opportunity
Purchase stock
Purchase home
Purchase bonds
Place money in bank savings account
Purchase new car
Expected Annual Return (%)
11
9
6
2
–15
In looking at Table 1–1, we see that the car actually depreciates (loses economic value) over time, whereas all other assets increase in value. Nevertheless,
the investor decides to buy the car. As mentioned, factors other than pure
finance, such as a requirement for transportation or the enjoyment that can be
obtained from driving a car, go into the decision. When the decision is made
to purchase the car, the purchaser spends $20,000. He loses the opportunity
to purchase the 11-percent yielding stock for $20,000. This percentage is the
return that the investor can expect to realize if he invested in stock, and it
is also the highest value surrendered when the car is purchased, because he
bought the car instead of the stock. For example, if we had decided to purchase stock, then the opportunity cost would have been the return from the
purchase of a home, or 9 percent. The return from the home purchase would
have been the highest value surrendered when we chose stock. Once again,
choosing to purchase an asset is the actual decision. The highest value that we
surrender in purchasing the stock is the return from the home, so its return of
9 percent is the opportunity cost of the decision. In other words, we surrender the opportunity to purchase a home, which would appreciate in value at
9 percent, if we chose to invest in stocks at an 11 percent return. Any purchase
decision from the choices in Table 1–1 other than stock results in an opportunity cost of 11 percent.
One economic concept of finance central to any market transaction is that
every party to the transaction has the expectation of gain from the transaction.
In the case of the car purchase, the buyer obviously valued the car more than
the $20,000. To the buyer, surrendering the $20,000 to buy the car resulted in
7
8
Chapter 1 Financial and Economic Concepts
a greater benefit than would have been obtained by picking some other item.
Otherwise, the car would not have been purchased. The car dealer, however,
valued the $20,000 more than the car. Otherwise, the dealer would not have
sold the car. This win–win situation is central to all free-enterprise market
transactions. Both the buyer and the seller believe that they stand to gain from
a transaction.
SAVINGS, INCOME, EXPENDITURES,
AND TAXES
Let us look at how the $20,000 was made available to purchase the car in the
previous example. Most people generate savings to make large market transactions. Savings can only be achieved if all expenditures are less than total
income. Therefore, it is essential to determine exactly where savings originate.
We begin with the concept of gross income.
Gross income for the individual is the total money received from all
sources during a year, including wages, tips, interest earned on savings and
bonds, income from rental property, and profits to entrepreneurs. Gross income
is subject to taxation by the government. One reason for taxation is that there
are items that we consume or have available to us that we do not pay for
directly—examples include public education, good roads, safe drinking water,
and police and fire protection. The money that we use to finance these public
goods comes from taxes and government user fees. Taxes are payments to a
government for goods and services provided by the government. For most of
us, the government collects taxes on our wages before we are paid for our labor.
If you have income from sources other than wages, the federal government
requires that you pay estimated taxes, normally on a quarterly basis, to lessen
what may be a great financial burden when annual income taxes are due.
There are three basic forms of taxes that a government can, and does, collect: progressive taxes, regressive taxes, and proportional taxes. Progressive
taxes take a larger percentage of income as that income increases. With each
step up in income, a greater percentage of taxes is due. For example, if Tom
Childress makes $20,000 in wages a year and pays $3,000 in taxes, and Jane
Smith earns $60,000 and pays $16,800 in taxes, then Tom pays 15 percent
of his income in taxes, whereas Jane pays 28 percent. The actual tax rates are
established by legislation at the federal, state, and local levels. The percentage
is a proportion and is calculated by taking the amount paid, dividing it by the
gross income received, and multiplying the answer by 100. Thus the formula
for tax percentage is as follows:
Tax percentage =
Tax payment in dollars
* 100
Income in dollars
Economic Concepts of Finance
For Tom Childress,
Tax percentage =
$3,000
* 100 = 15%
$20,000
For Jane Smith,
Tax percentage =
$16,800
* 100 = 28%
$60,000
Regressive taxes take a higher percentage of your income as your
income decreases. Sales taxes are a typical example of regressive taxes. Lowerincome individuals must use a higher percentage of their income to purchase
goods and services. For example, a person making $800 per month will
probably have to spend all of his income to survive. If we have a 5 percent sales
tax, this individual will pay $40 per month in sales taxes on his $800 income.
If, however, another individual makes $5,000 a month, she may spend only
$4,000 and save the remaining $1,000 each month. Therefore, she pays a
5 percent sales tax on $4,000, or $200 per month in sales tax. However, the
$200 is only 4 percent of her $5,000 income. Thus, the wealthier individual
pays 4 percent of income in sales taxes, whereas the lower-income individual
pays 5 percent. Consequently, the tax is regressive. Because many politicians
realize the hardship that regressive taxes may place on lower-income individuals, there are several cities and states that exempt food and medicine from
sales taxes.
Regarding proportional taxes, the percentage paid stays the same
regardless of income. For many of us, Social Security and Medicare taxes are
proportional. As income increases by $1.00, 7.65 percent of that dollar, or
$0.0765, is paid in Social Security and Medicare taxes. It is important to note
that the employee in an employee–employer relationship pays 7.65 percent
tax, which consists of 6.2 percent for Social Security and 1.45 percent for
Medicare; the employer also pays 7.65 percent, which adds up to 15.30 percent tax. The self-employed entrepreneur pays the full 15.30 percent. The
only true proportional tax in the United States currently is the Medicare tax,
which is 1.45 percent of wages, with no upper limit. Social Security has a tax
rate of 6.2 percent, but it was capped at an income level of $110,100 for 2012.5
Therefore, Social Security is proportional for wages up to $110,100, but it
becomes a regressive tax for people earning more than $110,100. For example,
we previously discussed an athlete making $7 million per year. His Medicare
5
Social Security Administration located on the Internet at http://www.ssa.gov.
9
10
Chapter 1 Financial and Economic Concepts
tax of 1.45 percent is proportional, and he pays 1.45 percent of $7 million, or
$101,500, in Medicare taxes. His Social Security tax for 2012 was $6,826.20
($110,100 times 6.2 percent). The percentage of his salary that he pays in Social
Security taxes is only 0.000975. Note that a basis point is one-one hundredth of
1 percent (0.0001).
Flat-Tax Proposals
A flat-tax proposal goes something like this: There is no tax paid on the first
$30,000 of income for a family of four; then there is a 17 percent flat tax on all
income that exceeds $30,000. Given the previous description, would implementation of this proposal mean a progressive, regressive, or proportional tax?
The answer is not obvious, but the proposal is for a progressive income tax,
which is illustrated in Table 1–2.
When evaluating Table 1–2, we notice that there are no taxes paid on our
$30,000 income; therefore, the percentage of income paid in taxes is 0 percent.
However, we pay an additional $1,700 in taxes on each $10,000 earned above
$30,000. Thus, the family earning $70,000 pays $6,800 in taxes, or 17 percent
of the $40,000 that was earned above the $30,000 exemption. Notice that this
equates to a 9.71 percent income tax on the family income of $70,000. Also, we
see that as income increases from $30,000 to $140,000, the tax rate continues
to increase as a percentage of income. Therefore, the flat-tax proposal is actually a progressive income tax proposal.
Various taxes are levied by federal, state, and local governments to collect
part of income, which is then used to provide goods and services to the people.
When we subtract taxes from gross income, we are left with disposable
income—that which one has after paying federal, state, and local taxes.
TABLE 1–2 Flat Tax Proposal
Gross Income ($)
Taxes Paid ($)
Percentage of Income
Paid in Taxes %
30,000
40,000
50,000
60,000
70,000
80,000
90,000
100,000
110,000
120,000
130,000
140,000
—
1,700
3,400
5,100
6,800
8,500
10,200
11,900
13,600
15,300
17,000
18,700
0.00
4.25
6.80
8.50
9.71
10.63
11.33
11.90
12.36
12.75
13.08
13.36
Economic Concepts of Finance
Disposable income is used to pay fixed monthly expenses such as rent, utilities, and insurance. Discretionary income is disposable income minus fixed
expenses. Discretionary income can be either spent on variable expenses like
food, entertainment, and clothing or saved.
Gross Income - Taxes = Disposable Income
Disposable Income - Fixed Costs = Discretionary Income
Many households generate incomes that exceed their required expenditures. Households can save this excess income or invest it however they
choose with businesses, financial institutions, or brokerage institutions and
can become suppliers of funds to the financial market. In the financial market,
the buyers or users of funds are those people and institutions (government
and business) requiring money, which they obtain through loans. A loan is a
principal amount of money that is exchanged for a promise to repay this principal amount plus interest. The interest charged can be said to be the annual
rent for the principal amount of money. The amount of rent paid in dollars
and cents is determined by the interest rate in effect at the time of the loan.
There are many factors that affect these interest rates, but five are of primary
concern: the supply of money saved, the demand for borrowed funds, the
Federal Reserve policy, inflation, and risk. These factors are discussed in the
following sections.
SUPPLY
OF
MONEY SAVED
The supply of money saved is primarily the total money that is placed in
demand deposit (checking) accounts, savings accounts, and money market
mutual funds. Money market mutual funds can be purchased separately, but
they may be held as cash in brokerage accounts. The law of supply states that
as the payment for, or the price, of an item increases, the quantity of the item
supplied to the market will increase, ceteris paribus. (Ceteris paribus is a Latin
phrase that means “all else remains the same.”) In economic terms, the law of
supply relates to the price paid and the quantity of a resource that is provided
at that price. In finance, the concept of the law of supply can be demonstrated
by comparing the amount of money saved with interest rate amounts paid for
the money. A simple illustration of this can be given with a supply table that
depicts the incomes and expenses of several families. Table 1–3 provides the
income and expenses of seven individual households or small businesses. As we
see in Chapter 2, most small businesses (more than 92 percent) are organized as
sole proprietorships, partnerships, or Subchapter S corporations. Profits earned
by these businesses are transferred to the individual owner’s personal tax forms.
Subsequently, taxes paid by these businesses are actually paid by the individual
household on his or her income tax form.
11
12
Chapter 1 Financial and Economic Concepts
TABLE 1–3 Income and Expenses of Variable Households
Household
Name
Jones
Roberts
Smith
Brown
Meeks
Adams
Charles
Gross
Income ($)
Income, SS,
& Medicare
Taxes ($)
Federal Taxes
Paid as a % of
Gross Income
Disposable
Income ($)
Fixed
Expenses ($)
Discretionary
Income ($)
30,000
50,000
70,000
90,000
110,000
130,000
150,000
5,228
9,758
16,502
23,432
29,912
36,202
42,492
17.43
19.52
23.57
26.04
27.19
27.85
28.33
24,773
40,243
53,499
66,569
80,088
93,798
107,508
19,673
32,683
40,179
41,369
41,208
46,998
49,620
5,100
7,560
13,320
25,200
38,880
46,800
57,888
Source: Department of the Treasury, Internal Revenue Service, Publication 15 (Rev. January 2012).
Table 1–3 shows several factors of gross income and discretionary income:
1. We have a progressive income tax system. As income increases, the
amount of income paid in federal taxes also increases as a percentage
of income. The Jones family, earning $30,000, pays 17.43 percent of
its annual income in federal taxes; however, the Charles family earns
$150,000 and pays 28.33 percent of its annual income in federal taxes.6
2. Fixed expenses decrease as a percentage of income, as income increases.
For the Jones family, fixed expenses consume 65.58 percent of annual
income ($19,673 ÷ $30,000); but the Charles family spends only 33.08
percent of its income on fixed expenses ($49,620 ÷ $150,000).
3. Discretionary income increases as wealth increases. Therefore, the
Jones family has 17 percent ($5,100 ÷ $30,000) of its income to save or
spend as it wishes, but the Charles family has 38.59 percent ($57,888 ÷
$150,000) of its annual income to save or spend as it wishes.
Thus, as wealth increases, the amount of discretionary income increases.
Because discretionary income can be either consumed or saved, we expect
that the supply of money saved increases as the price paid for money (interest
rate) increases. Supply tables are generated by determining how much of a
product or service people or businesses are willing and able to provide to the
market at various prices. Because money is a scarce resource, we can generate
a supply table by determining how much money people place in their savings
as interest rates increase. We ask several individuals with different amounts of
6
The tax system treats earned income and unearned income differently. The tax tables only apply
to earned income, which is income earned by individuals in salary and hourly wages. Unearned
income includes dividends, interest on bonds, capital gains, and many other categories. This allows
those with high levels of unearned income to pay tax at a much lower rate than those with earned
income. For example, municipal bonds, those issued by city and state governmental agencies,
are exempt from Federal and state income tax in the geographic state of issue. Thus, if you hold
$50 million dollars of 3 percent Arizona bonds and live in Phoenix, you will receive an income of
$1,500,000 per year, which is totally tax free.
Economic Concepts of Finance
13
TABLE 1–4 Supply Table: Money Saved for Seven Sample Families
Annual Savings ($000)
Annual
Interest
Rate (%)
Jones
Roberts
Smith
Brown
Meeks
Adams
Charles
0
2
4
6
8
10
12
14
16
18
20
22
24
$—
—
—
—
100
200
250
300
400
500
500
500
$500
$ —
—
—
—
200
500
750
1,000
1,200
1,500
1,700
1,700
$1,700
$ —
—
—
670
930
1,500
2,500
3,250
4,500
6,000
8,000
8,000
$8,000
$
$
$ —
—
1,940
2,720
3,890
7,000
10,000
15,000
23,000
28,000
32,000
33,000
$33,000
$
—
—
500
1,250
1,760
3,000
5,000
9,000
12,000
15,000
18,000
18,000
$18,000
—
—
780
1,940
2,020
3,500
6,000
12,000
18,000
25,000
30,000
30,000
$30,000
—
—
5,790
7,530
12,000
16,000
20,000
25,000
31,000
38,000
40,000
41,000
$41,200
discretionary income what percentage of their money they save at different and
varying interest rates.
Table 1–4 shows how much money families are willing to save as interest
rates increase. Note that some people save money at a 4 percent interest rate,
whereas others do not invest in savings until interest rates reach 6 percent or
8 percent. As interest rates approach 20 percent, virtually every family puts some
of its discretionary income into savings. Notice that there is a definite limit to
the amount of money that can be supplied regardless of the interest rate. People
are limited in their amount of discretionary income. Even though everyone
would like to save more money, financial situations dictate that every household
has a limit to the amount of money that can be saved, because money is scarce.
For example, the Jones family has a gross income of $30,000. After paying
taxes, rent, utilities, and other contractual obligations, it is left with a discretionary income of only $5,100. This money is all that the family has left to pay
for items such as food, entertainment, clothing, and savings. For a family in
this situation, virtually all the discretionary income is consumed just to survive.
Therefore, regardless of how high interest rates on savings rise, this family can
never afford to save more than $500 a year.
Conversely, the Charles family, with a gross income of $150,000, is left
with discretionary income of $57,888. Therefore, this family can afford to
save much more as a percentage of its total income. The Charles family can
save 71 percent of its discretionary income ($41,200 ÷ $57,888) and still have
$16,688 per year ($57,888 – $41,200) for food, clothing, and entertainment.
This gives the Charles family almost $1,400 per month for spending, even after
it saves 71 percent of its discretionary income.
Total
$
—
—
9,010
14,110
20,900
31,700
44,500
65,550
90,100
114,000
130,200
132,200
$132,400
Chapter 1 Financial and Economic Concepts
The total supply of money available in the market can be shown graphically with a supply curve (Figure 1–1). The curve is generated from the
supply table (Table 1–4) by horizontally summing the total money saved by
the seven families at varying interest rates. At an interest rate of 10 percent, we
can calculate $31,700 in total savings for all these families. At an interest rate
of 20 percent, we calculate $130,200 in savings. Of course, if we obtained this
figure for all families in the United States, then we would have a supply curve
that represented the total supply of money saved.
For the United States, there are four measures of the money supply: M1,
M2, M3, and L. Of primary interest to us is M1, which consists mostly of
money in circulation and money in checking accounts (demand deposits),
and M2, which includes M1 plus money in passbook savings accounts, retail
money-market accounts (accounts that use short-term securities), and smalltime deposits (certificates of deposit, or CDs, in amounts of less than $100,000).
For our purposes, when we discuss the money supply and personal savings, we
are referring to M2. If we could survey the entire population and add across
the supply table to obtain the total amount of money that could be saved
by the population at varying interest rates, we could calculate the amount of
money in savings accounts and money-market funds for the United States,
or M2 minus M1. The problem is that the figures for the United States are
difficult to comprehend because the numbers are so large. For example, for
November 2011, M1 was $2,149.1billion; M2 was $9,641.7 billion; and the
savings accounts in commercial and thrift institutions totaled $6,012.3 billion,
24
22
20
Annual Interest Rate (%)
14
18
16
14
12
10
8
6
4
2
0
$-
$20
$40
$60
$80
$100
$120
Money Saved ($000)
FIGURE 1–1
Supply of money.
$140
$160
$180
Economic Concepts of Finance
giving the United States more than $6.0 trillion in savings.7 The numbers are
so large that the government typically rounds to the closest $100 million. In
other words, the figures are fairly accurate, give or take $100 million.
Because of the size of these numbers, we will stay with our micro-examples. When we plot our sample supply curve, we see that the quantity of money
supplied for the sample population slopes upward and is based on summing the
results of the supply table horizontally. In the example given for our sample
families (Table 1–4), we find that there is no money in savings at an interest
rate of 2 percent; approximately $31,700 in savings at an interest rate of 10 percent; and $130,200 in savings at a rate of 20 percent.
DEMAND
FOR
BORROWED FUNDS
Another factor that determines interest rates is the demand for money. The
demand for borrowed funds is all the money that is demanded in our economy
at a given price. The law of demand states that as the price of an item decreases,
people will demand a larger quantity of that item, ceteris paribus. Therefore, as
interest rates go down, borrowing increases. It becomes cheaper for us to borrow
more money so that we can purchase additional capital assets (Table 1–5).
TABLE 1–5 Ann Smith’s Demand for Money
7
Interest Rate (%)
Amount Financed ($)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
$180,000
155,454
135,274
118,595
104,731
93,141
83,396
75,154
68,142
62,141
56,975
52,503
48,609
45,200
42,199
39,543
37,181
35,071
33,177
31,468
29,922
28,516
27,233
26,059
24,980
Federal Reserve Statistical Release H.6, Money Stock Measures, January 5, 2012.
Interest Paid ($)
$
—
24,546
44,726
61,405
75,269
86,859
96,604
104,846
111,858
117,859
123,025
127,497
131,391
134,800
137,801
140,457
142,819
144,929
146,823
148,532
150,078
151,484
152,767
153,941
155,020
15
Chapter 1 Financial and Economic Concepts
In our example, Ann Smith decides that she wants a new home and can
afford monthly payments of $500. If she did not have to pay any interest to
finance the home and could obtain a 30-year mortgage (360 monthly payments times $500 per month), she could afford to purchase a $180,000 home.
However, if she had to pay 10 percent interest and wanted to maintain a $500
monthly payment, she would have less money available for financing. She
could only afford to buy a house worth $56,975, because the total interest on
the mortgage would be $123,025. The total amount financed plus the total
interest paid must be $180,000 (360 monthly payment times $500 per payment). Details about calculation of these numbers are covered in Chapter 9.
What holds true for the individual in general holds true for the economy. We
see that the dollar amount demanded for housing increases as interest rates go
down. In addition, more families in the economy can afford to purchase homes
at lower interest rates. This relationship between the cost of financing, or market interest rates, and the demand for items of high-dollar value holds true for
governments and businesses, as well as for individuals.
A demand table (Table 1–5) is generated by determining how much
individuals are willing to borrow at varying interest rates. We used the home
purchase as an example, but in reality, the quantity demanded for big-ticket
items and, literally, thousands of other items increases as the cost of borrowing decreases. The demand curve (Figure 1–2) is nothing more than the
horizontal summation of a demand table—in this case, plotting Ann Smith’s
demand for borrowed funds at varying interest rates.
24
22
20
Annual Interest Rate (%)
16
18
16
14
12
10
8
6
4
2
0
0
20
40
60
80
100
120
140
Amount of Money Borrowed ($000)
FIGURE 1–2
Demand for money.
160
180
Economic Concepts of Finance
We cannot look at supply and demand separately. To determine the actual
market interest rate, we must integrate both the supply curve and the demand
curve. Supply and demand are obtained by combining the two curves. The
interest rate at which the supply curve and the demand curve intersect is known
as the equilibrium point, and theoretically, at that interest rate, the financial
market will be cleared. In other words, the quantity of money supplied to the
market is exactly equal to the quantity of money demanded in the market.
Equilibrium, therefore, is the point at which the quantity supplied and the quantity demanded are equal. If the market is in equilibrium, then the market price
is the equilibrium price. If we compare Table 1–4 with Table 1–5, or look at
Figure 1–3, we note that Ann Smith can borrow approximately $45,000 at an
interest rate between 12 and 13 percent. If she wants to borrow more than this
amount, she must pay a higher rate, because the households are not willing to
save more than $45,000 unless interest rates are higher.
Households borrow funds to invest in businesses if interest rates are within
some range that makes the investment seem profitable. If market interest rates
are above that range, households prefer to save their money rather than invest
in a business or some other capital asset. At 18 percent, households save more
and borrow less. As this procedure continues, the quantity of money saved
increases. When the supply of money saved exceeds the demand for money,
there is a surplus of money in the market. Institutions pay less for savings and
interest rates begin to fall. Therefore, as more and more people save, and borrow
24
22
Annual Interest Rate (%)
20
18
16
14
Supply (Saved)
12
10
8
Demand (Borrowed)
6
4
2
0
0
20
40
60
80
100
120
140
Amount of Money Borrowed ($000)
FIGURE 1–3
Supply and Demand curves for money.
160
180
17
18
Chapter 1 Financial and Economic Concepts
less, lending institutions find themselves with money that they cannot loan out.
They do not want to attract any more savings, and interest rates begin to fall as
lending institutions cut the price they are willing to pay to attract savers.
FEDERAL RESERVE POLICY
Supply of and demand for money are the critical factors affecting interest rates,
all other things being equal. In a totally free-market system, those factors alone
dominate the interest rates paid for money. We currently do not have a totally
free market for money; thus, other factors must be included, such as the Federal
Reserve.
The Federal Reserve is the central bank of the United States. It is often
referred to as the Fed, and is responsible for controlling the monetary policy
of the United States. Monetary policy is governmental action to change the
supply of money so as to expand or contract economic activity. The U.S. government has some broad general goals, and the Fed is responsible for trying to
achieve and maintain these goals. The three basic goals are economic growth,
price stability, and full employment. We must have growth in our economy
because every year, more people enter the nation’s workforce and the economy
must create jobs for these people. We must have price stability if consumers
are to maintain their confidence in the economic system. We must have full
employment to ensure that Americans who want to work can find work.
As we write this book the United States is slowly recovering from the
worst recession since the Great Depression of the 1930s. Because of this the Fed
has used some unusual methods to keep interest rates low so that small business
will have money available for loans. This system is referred to as Quantitative
Easing. It is used by the Central Bank to increase the supply of money by purchasing large quantities of securities in an economy where the bank interest
rate, discount rate, and interbank discount rate are at or close to zero.8 This
method has been used three times since 2010 and the rounds are referred to as
QE1, QE2, and QE3.
Unfortunately, some of these goals are diametrically opposed to one
another and the government must seek to strike a balance between them. For
example, we will not have price stability if we have inflation.
INFLATION
Inflation occurs when the average price of goods and services increases. The
measure of inflation that is most often used is the consumer price index
(CPI), which represents a market basket of goods and services that the average
8
Bernanke, B. Emerging from the Crisis: Where do we stand? November 19, 2010.
Retrieved January 12, 2012, from http://www.federalreserve.gov/newsevents/speech/
bernanke20101119b.htm.
Economic Concepts of Finance
American consumer purchases each month. The government prices this basket
of goods and services each month and determines if the basket has increased in
price (inflation) or decreased in price (deflation). As individual consumers, we
cannot determine if we have inflation because we do not purchase the entire
basket every month, and we normally get mixed signals from our purchases.
For example, if gasoline increases in price and food decreases in price, then we
do not know if we have inflation. It is only when the average price of the entire
basket of goods and services increases that inflation exists for the economy. If
the CPI changes and the inflation rate increases by 7 percent between January
of one year and January of the next year, then a basket of goods and services
that cost $100 in January of the first year will cost $107 the next January.
Based on our previous discussion of supply and demand, we can see that
when we have inflation, the demand for the items in the basket is exceeding the supply of goods in the basket. This is the result of too many dollars
chasing too few goods. Therefore, consumers are bidding up the price of the
basket of goods and services. The Fed has goals for inflation. If these goals are
exceeded, the Fed intervenes by making adjustments in the money supply to
dampen demand. If the supply of money available in the market is reduced,
then interest rates go up and consumers are not able to purchase as many goods
and services as before. When this happens, the demand for items in the basket
decreases and prices begin to fall. The Federal Reserve has three primary tools
that it uses to control the money supply: open market operations, bank reserve
requirements, and the discount rate.
Open market operations consist of the Fed purchasing or selling U.S.
securities. Because security obligations (Treasury bills, notes, and bonds) of
the United States are considered to be the safest possible investment, there
is always a demand for these instruments. Open market operations are the
most significant tool of the Fed, and this tool is in constant use. The Fed can
determine exactly how much the money supply is being expanded or contracted by its open market operations. To increase the money supply, the Fed
purchases government securities and pays for them with cash. This provides
the economy with more money to lend. Subsequently, the money supply
is increased, and the net effect is that banks have more money to lend. The
Fed Funds Rate allows a bank to borrow needed funds from another bank
that has a surplus in its account with the Fed. The interest rate that the first
bank pays to the second bank in return for borrowing the funds is negotiated
between the two banks, and the weighted average of this rate is the effective
federal funds rate. When the Fed wants to decrease the money supply, it sells
securities. These securities are paid for with cash by households and institutions. The money supply is decreased because the Fed takes this currency out
of circulation.
The Fed also establishes a reserve requirement for banks in the United
States. These reserves are the percentage of deposits placed in banks that must
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Chapter 1 Financial and Economic Concepts
be maintained to conduct daily operations and that cannot be used for lending purposes. These reserves may be kept on deposit with the Fed or can be
maintained in each bank’s vault. The banking institution must hold a particular amount of the fund in reserves. For example, if the reserve requirement is
10 percent and a bank has $100 million on deposit, then the bank can only
loan out $90 million because it must keep $10 million in reserves. If the Fed
increased the reserve requirement to 15 percent, then the bank could only loan
$85 million. Obviously, a small change in reserve requirements drastically affects
the money supply. Changes to the reserve–requirement ratio are seldom used.
The discount rate is the rate of interest that the Fed charges banks to
borrow money from the Fed. Banks can borrow money from the Fed when
they want to make loans but find that they do not have sufficient reserves.
This makes the Fed the lender of last resort for the banking industry. Although
the Fed does not control market interest rates directly, it does have an effect
on them. Because banks earn their profits on loans, there must be a difference
between what the banks pay for money and what they charge for money that
is borrowed by households, governments, and businesses. The discount rate
charged by the Fed to its member banks is normally the nation’s lowest lending
rate. Occasionally, the Federal Funds rate, the interest rate that banks charge
each other for overnight loans, is one of the lowest interest rates, as can be seen
in Table 1–6.
If the Fed believes that there is too much borrowing in the market, it may
tighten credit by increasing the discount rate. When interest rates increase, it
becomes more difficult for us to borrow as the payments on our loans increase.
This situation dampens the demand for money and cools off the economy.
RISK
We discussed four of the five major variables that affect market interest rates—
supply of money, demand for money, Federal Reserve monetary policy, and
inflation. The fifth factor is risk.
TABLE 1–6 Money Rates, as of January 6, 2012
Type of Rate
Definition
Discount
The charge on loans to depository institutions by
the New York Federal Reserve Bank
The rate banks charge each other for overnight
loans in minimum amounts of $1 million
The rate on government treasury bills sold at a
discount of face value in units of $10,000
The interest rate that banks charge their most
creditworthy customers
Federal Funds
T-bill, three months
Prime
Source: Federal Reserve Statistical Release H.15—January 9, 2012.
Rate (%)
0.75
0.05
0.02
3.25
Economic Concepts of Finance
Risk involves the probability that the actual return on an investment will
be different from the desired return. When we talk about risk taking in business
or finance, we are discussing an individual’s tolerance for investments. These
investments may or may not return what is desired. In general, younger people
tend to be risk takers and older people tend to be risk averse. For example, the
purchase of a U.S. bond or Treasury bill is considered to be a risk-free investment. The probability that the government will not pay interest and principal
on the bond is negligible. Conversely, investing in a new business is more
risky. As noted earlier, approximately 31 percent of all new businesses in the
United States fail in the first four years. If we were to invest in a new business,
we would, therefore, demand a higher probable return on our investment than
if we invested in government securities. It would not be wise to take more
risk and not expect a higher return. If we expected the business investment to
provide us with the same return as a government bond, we would purchase the
bond and eliminate the risk factor.
Risk can be divided into two categories: systematic risk and unsystematic
risk. Systematic risk is associated with economic, political, and sociological
changes that affect all participants on an equal basis. For example, the September
11, 2001, terrorist attack on the World Trade Center and the Pentagon resulted
in a great deal of change. Economically, people became afraid to fly, and
demand for air travel decreased so drastically that most major airlines laid off
substantial numbers of employees. By January 2002, airfares were at their lowest level in 12 years as airlines tried to lure travelers back to flying. In addition,
unemployment rose to 5.4 percent in October 2001, the largest one-month
increase in a generation. Politically, Congress passed legislation to increase
homeland security and alleviate risk. The overall Defense Department budget was increased by $48 billion. The war in Afghanistan cost $1.8 billion per
month, and an additional $10 billion was allocated to the war on terrorism.9
Sociologically, people became uncertain about their future and were willing to
accept many changes in security clearances when attending, for example, sporting events and concerts. People began converting stocks to cash in anticipation
of an uncertain future. All these are factors of systematic risk because the effect
was national.
Unsystematic risk is unique to an individual, firm, or industry. In business, unsystematic risk is often based on management capabilities, competition
within the industry, vendor reliability, and several microeconomic variables.
With the failure of Bear Stearns and other investment banking houses and the
continued reporting of decreased home values and foreclosures, the perception of American financial stability has changed in the mind of the investment
community. For the 12 years between January 2000 and January 2012, the
Dow Jones Industrial Average reacted to the recession by swinging wildly
9
Newsday.com online reports, January 22, 2002, November 3, 2001, and February 5, 2002.
21
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Chapter 1 Financial and Economic Concepts
from a little over 11,000 points in January 2000 to a low of 7,000 in March
of 2009 and then to 12,624 in January of 2012. Oil prices were also a problem, rising from $25 per barrel to more than $110 between January 2000 and
January 2012.10
The total risk of a business is based on a series of variables and incorporates
both systematic and unsystematic risk. When a person starts a business, lenders
consider unsystematic factors such as the type of business and the uncertainty
that exists with respect to the firm’s earnings and future profitability. Lenders
also consider the experience of the business owner, his financial and capital
assets, business location, and several other factors that relate directly to the
business. The lenders consider all risk factors and determine if they will grant
the loan. If unsystematic risk is perceived to be too high, the loan is denied. If
unsystematic risk is within the acceptable range in the lender guidelines, the
loan is granted. The interest rate charged for this loan represents a combination of the systematic and unsystematic risk factors. If the prime lending rate is
3.5 percent and the unsystematic risk factor is considered to be 3 percent, then
the financial institution will grant the loan at an interest rate of 6.5 percent or
more, but never less than 6.5 percent. In effect, the borrower is paying a risk
premium of 3 percent to get the loan.
As noted in Table 1–6, the prime lending rate is the rate charged by banks
to their best customers. As risk increases, so does the interest rate. Banks may
charge less than prime to a customer who they perceive will repay the loan
with no problems. Banks may charge prime plus 3 or 4 percent to a company
they consider to be risky.
In addition, the amount of the down payment on capital purchases such as
land, buildings, and machinery may vary based on risk assessment by the bank.
For example, a veteran may be entitled to a Veterans Administration (VA)
loan with no down payment. If the veteran defaults on the loan, the loan is
guaranteed by the government of the United States. If another person with the
same income tries to obtain a conventional home loan from a bank, the bank
may require a down payment of 10 to 20 percent of the home value, because
the bank perceives unsystematic risk as being higher for the second individual.
This loan is guaranteed only by the income of the individual. The base lending
rate for business loans is normally the prime rate in existence at the time of the
loan request.
Businesses often face the risk of interest rate fluctuations. This risk can
have an impact on a business if the business has a variable-rate loan. In periods of low interest rates, businesses tend to borrow more because capital can
be obtained at a lower cost. In periods of rising interest rates, capital becomes
10
OilNergy, NYMEX Light Sweet Crude Oil Price. Retrieved January 20, 2012, from http://www.
oilnergy.com.
Conclusion
expensive to obtain and maintain. For example, one of the authors had
a $150,000 business loan that was granted by a bank at prime plus 2 percent.
When the prime rate rose by 2 percent during one year, the payments on this
loan increased by $246 per month. As interest rates move up, businesses are
forced to pay a higher price for money they have previously borrowed, which
eats away at their profitability.
Home mortgage rates for 2010 through 2012 were very low; this might
be a problem for the business person. Many people obtained mortgages called
adjustable rate mortgages (ARMs) with either interest-only loans or variable rate loans, which are loans that have fluctuating interest rates. Because of
their initial low rates, borrowers start off with lower monthly payments than
fixed-rate mortgage borrowers pay. ARMs are normally tied to some specific
Government Security index or the Prime Lending Rate. As an entrepreneur
with an adjustable rate mortgage, your business could be harmed severely if
rates go up because you have incurred an additional cost. Can the entrepreneur cover these costs? Interest-only loans do not reduce the principal. When
interest rates increase, many of these people may be unable to make their loan
payments because the rate charged for the loan has increased. For example, if
you have a $200,000 interest-only 30-year mortgage financed at 3.78 percent,
the monthly interest payment is $630.00. If the lending rate increases by 4 percent to 7.78 percent, the monthly interest payment rises to $1,296.67. This is
an increase of $666.67. What you are essentially doing is renting money, and as
the rates go up, the rent becomes more expensive. You can verify these numbers by using the link to the Excel amortization table, located on the Internet
at www.prenhall.com/adelman.
The management of risk is dealt with extensively in Chapter 11. If we are
to succeed in business, we must reduce our risk to acceptable limits; otherwise,
bankruptcy may be the result. Therefore, to succeed, the business owner must
develop plans to minimize risk and place the business in a competitive and
profitable position.
CONCLUSION
In this chapter, we introduced basic financial concepts. We discussed the importance of finance and its relationship to those economic concepts involving the
scarcity of resources, opportunity costs, savings, income, expenditures, and taxes.
Because the business owner or manager usually makes decisions concerning the
acquisition of financial capital, interest rates are fully discussed with respect to supply and demand, Federal Reserve policy, inflation, and risk.
It is essential that we have a basic knowledge of these concepts before
we attempt to set goals, establish ownership of a business, and write a business
plan. These topics are covered in Chapter 2.
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Chapter 1 Financial and Economic Concepts
REVIEW
AND
DISCUSSION QUESTIONS
1. What is finance?
2. What is a market?
a. Name five types of markets in which you participate.
b. What markets trade economic resources?
3. Compare marginal revenue, marginal cost, and marginal revenue product.
4. Distinguish between economic and financial capital.
5. Discuss the value of the entrepreneur. What distinguishes the entrepreneur
from the labor resource? Why are entrepreneurs unique?
6. What is opportunity cost?
7. What makes up gross income?
8. Compare progressive, regressive, and proportional taxes. Give at least one
example of each type of tax.
9. What is the law of supply?
10. What is a supply table? How do you obtain a supply curve from a supply table?
11. What is the law of demand?
12. Explain the concept of a surplus of money versus a shortage of money.
13. What is the Federal Reserve? What are the Fed’s three tools for controlling
the money supply?
14. What is risk? What is the difference between systematic and unsystematic risk?
EXERCISES
AND
PROBLEMS
1. Carry Yoki’s Lounge consists of the following: Carry, the owner, believed
that people would come to hear a band play on Friday, Saturday, and
Sunday evenings. During the remainder of the week, she believed her
customers would watch sporting events on several television sets located
throughout the lounge. Carry employed two bartenders, three servers, two
assistant servers, two cooks, one dishwasher, and a cleanup person. She had
a bar, 15 bar stools, 4 tables, 40 chairs, 4 television sets, and a satellite dish.
She had an oven, stove, grill, refrigerator, sinks, dishes, and glassware. Carry
started this business with $50,000 of her own money, and she borrowed
$150,000 from the bank. From this description, list each of the scarce
resources that are used in Carry Yoki’s Lounge.
2. Joe Fixit has an appliance-repair business. He has more business than he
can handle and wants to hire another repair person. Joe estimates that
three appliances can be repaired each hour by a qualified person. Joe bills
out labor at $45 per hour, but he stipulates that the minimum charge for
appliance-repair estimates is $30 plus parts. What is the marginal revenue
product of a qualified repair person? What is the maximum hourly wage
that he would pay an employee?
3. Sam Smith is currently employed as a mechanical engineer and is paid
$65,000 per year plus benefits that are equal to 30 percent of his salary.
Case Study: Macy’s Housewares, Incorporated
4.
5.
6.
7.
Sam wants to begin a consulting firm and decides to leave his current job.
After his first year in business, Sam’s accountant informs him that he has
made $45,000 with his consulting business. Sam also notices that he paid
$6,000 for a health insurance policy, which was his total benefit during his
first year. What was Sam’s opportunity cost?
Sara Lee just graduated from college with a degree in accounting. She had
five job offers: Bean Counters CPA, $35,000; Assets R Us, $27,000; The
Debit Store, $30,000; J & J’s CPAs, $33,000; and The Double Entry Shop,
$40,000. What was her opportunity cost if she accepted the job with The
Double Entry Shop?
Sam Club earned $50,000 and paid taxes of $10,000. Samantha Heart
earned $60,000 and paid taxes of $12,000. If these taxes were paid to the
same government agency, is the tax on income progressive, regressive, or
proportional? How did you reach this conclusion?
You read an article in this morning’s paper that states that inflation is accelerating and will reach 6 percent this year. If the Fed believes this statement
and has set a goal of 3 percent inflation, what will it likely do at the next
meeting of the Federal Open Market Committee?
A friend came into your office and said that his bank was out to kill local
business. You asked him what he meant by this remark, and he said that
he read an article that said his bank had just loaned $10 million to a major
automobile manufacturer at a rate of 3 percent, which is less than prime.
But your friend just borrowed $50,000 from the same bank, which charged
him prime plus 4 percent, or 7.5 percent. Your friend has been in business
for two years, and last year he had a loss of $2,000. How can you explain
this difference in interest rates to your friend?
RECOMMENDED TEAM ASSIGNMENT
1. Using online resources, describe what measures the Federal Reserve Bank
adopted in the past year to make adjustments in the U.S. economy in order
to reach the Fed’s goals.
2. Using two teams, initiate an argument that agrees (Pro) with the Fed action
and an argument that opposes (Con) the Fed action.
CASE STUDY: MACY’S HOUSEWARES, INCORPORATED
© 2008 by Philip J. Adelman and Alan M. Marks
Philip Pomerantz was raised in Poughkeepsie, New York, and as long as he
can remember he always wanted to run his own business. He started his first business
venture as a paperboy with a morning, afternoon, and Sunday route at the age of 12.
He learned about customer service and placed the papers between the screen door and
25
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Chapter 1 Financial and Economic Concepts
the front door. When people in the neighborhood heard about his excellent service,
he received more and more orders. He soon built the route into a business with more
than 150 customers and soon had two other kids helping him deliver the papers. This
was in the 1930s, during the Depression, and Phil often made more in a month than
his customers. On graduating high school, he went to the University of Wisconsin and
majored in labor economics. He graduated during World War II, and went to work in
Buffalo, New York, for War Industries, with various factories making materials for the
Armed Forces. While working in Buffalo, he met his wife, Kayla, and got married in
1943. Phil continued to want his own business and while working in War Industries,
he decided to get some practical experience in retailing. He got a part-time job with
W. T. Grant, one of the largest chain stores in the United States, in the hardware
department. He soon exceeded the sales of all clerks in the store and asked his boss to
take him off of hourly wages and place him on a commission. His boss explained that
W. T. Grant only paid hourly wages and fired him.
After being fired, Phil started looking around for hardware stores to purchase
and got a pamphlet from the state of New York entitled, “How to Start Your Own
Business.” The state pamphlet stressed the fact that one was better off buying an existing business that had established customers than to try and begin a business from
scratch. With his degree in labor economics and his experience in retailing, he looked
at several stores that were for sale. He soon determined that they were all in declining areas and the books confirmed that annual revenue in these stores was decreasing
rather than increasing.
Phil had several uncles who were successful entrepreneurs and were also looking
for a business that he might purchase. They notified him that Macy’s Housewares in
Hudson, New York, was for sale. The first time he looked at the store, he was really
taken aback when he saw pots and pans hanging from the ceiling. However, when he
looked at their books, he found that sales were steady and the margin of profit was
good. The business was a typical country store that sold housewares (pots, pans, dishes,
small appliances, etc.) and farm supplies, which included seeds in bulk and fertilizer.
The business was evaluated on location, inventory, 5 years of sales, and average
markup. Phil offered to purchase the business for the purchase price of the existing
inventory. The owner, Frank Macy, accepted this bid and agreed to stay with the business for one month. Mr. Macy also owned the building and Phil negotiated a lease for
the premises. After 10 years, Phil bought the building. Coming from a big city, there
were several items that were for sale in this rural community that he had never seen.
For example, most of the farms used outhouses and didn’t have indoor plumbing, so
on cold nights they actually used an indoor chamberpot (commode), which was kept
in the bedroom, under the bed.
In the 1940s, it took a long time to evaluate inventory, because every item was
marked with a code that let the owner know how much had been paid for the item.
They also had fair-trade laws that required that all national brands be fair-traded,
meaning that the manufacturer set the retail price based on a 40 percent markup.
This included large manufacturing firms like Corning, Revereware, and Rubbermaid.
There were no discount stores and the only thing that separated one business from
another was customer service, as all retailers had to sell fair-traded items at the same
price. Items like seeds, which were not covered by fair-trade laws, provided the largest
Case Study: Macy’s Housewares, Incorporated
profit margins. A pound of garden seeds like radishes could be purchased by Macy’s for
$1.00. Phil could sell a quarter of an ounce of seeds for 15 cents, because most people
with a small backyard garden didn’t need more than that. Kayla and Phil worked this
store together for more than 30 years. Both of their children were raised in the store
and worked there until they went away to college.
When Phil bought the store, he and his wife determined that they really couldn’t
afford to purchase items in large quantities because they didn’t have the cash and
definitely didn’t have storage space. They decided that the product distributors could
actually be the warehouse. The distributor’s salespeople called on Macy’s Housewares
on a monthly basis, but because he sold items from many manufacturers, he had at least
one salesperson call on him every week. With a good inventory system and ordering
essentially replacement items for those that had been sold, Phil was able to turn his
inventory nine times a year, as opposed to the industry average of three times.
Phil and Kayla actually had no savings and no bank credit when they bought
Macy’s. Financing the store was done by having his uncles, who were businessmen
with established credit, sign the note for the bank. Phil soon learned that banks can be
used to make money, as all of his vendors sent invoices that included “2/10 net 30.”
When cash was short, he would go to the bank and borrow money against his credit
line at 5 percent and take the cash discounts, which saved him more than 31 percent
on the money. During the Christmas season, he learned that if you paid the vendors in
cash for deliveries, they would often provide discounts in excess of 2 percent.
What’s in a name? Macy’s Housewares’ original owner was Frank Macy, who
was a cousin of R. H. Macy. Knowing this, Phil immediately incorporated the business and registered his trademark to protect the name and assets. He would often call
vendors and state that he was Macy’s primary buyer and arrange to obtain shipments at
the same price given to R. H. Macy.
As time went by, the fair-trade laws were rescinded and the distributors were
put out of business. A small retailer then had to purchase directly from the manufacturer. The manufacturers required purchases in much larger lot sizes, and discounters,
who were open on Sunday, began advertising product prices that were often less than
Macy’s purchase price. Phil could not compete against these discounters and decided
to upgrade his merchandise lines and provide better lines than the discounters. He
knew that wealthier people had a tendency to shop quality rather than price, and Phil
began carrying lines like Noritake China. He attended trade shows and arranged to
pay for one complete service of several patterns of china, which he displayed in the
store. He sold complete sets and individual pieces and backordered all sales because he
carried no stock. One of his advantages was that he could order individual pieces to
replace items that were broken by the user. Larger department stores typically didn’t
provide this level of customer service.
During their 30 years in business, Phil and Kayla set aside enough for their future.
When he turned 65, they decided to sell their business and retire. There was one
serious problem. Although the markup on items was 40 percent, the actual net profit
margin was about 10 percent. Phil wanted to sell the business during the early 1980s
when banks were paying depositors 15 percent interest on their savings accounts. The
Pomerantzes, therefore, could find no buyers for their business as people could just
deposit money in a savings account and earn more than if they invested in a business
27
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Chapter 1 Financial and Economic Concepts
like Macy’s. As a result, they decided to liquidate their inventory and closed the business. Phil hired a liquidating company and managed to sell most of his inventory at
a price that was equal to or greater than what he had paid for it. They purchased the
building for $12,000 in the early 1970s and sold it in 1986 for $30,000. The entire
business district where Macy’s Housewares was located in Hudson, New York, is now
an upscale art colony, and the entire retail district is no longer in existence. On retiring, Phil and Kayla moved to Arizona, where they reside today.
QUESTIONS
1. What effect did changes in government regulations have on the way Macy’s
had to conduct its business?
2. What effect did the economy and current interest rates have on the ability
of Macy’s to sell its business?
CHAPTER
2
Financial Management
and Planning
Learning Objectives
When you have completed this chapter, you should be able to:
♦ Describe the five basic functions of a manager and how they relate to
a business.
♦ Distinguish between strategic plans and functional plans.
♦ Understand the three factors that must be addressed when establishing goals.
♦ Describe the financial goals of a for-profit organization.
♦ Trace the three-step process to take when using control.
♦ Compare and contrast the basic forms of business ownership (sole proprietorship, partnership, corporation, and limited liability company (LLC).
♦ Distinguish between limited and unlimited liability.
♦ Compare and contrast general partnership, limited partnership, and
a limited liability company.
♦ Understand the role that the franchise plays when establishing a business.
♦ Understand the basic components of a SWOT analysis.
♦ Know what basic factors are required to complete a business plan.
♦ Understand the basic sources of financing for a business.
♦ Know how important it is to have a business succession plan.
T
o achieve a financial objective, a businessperson must be both a manager and a leader. Although there are no universally accepted definitions of
management, for our purposes here, we can essentially define it as the process
of working with or through others to achieve an individual or business goal by
efficiently and effectively using resources.
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Chapter 2 Financial Management and Planning
MANAGEMENT FUNCTIONS
A manager performs five basic functions: planning, organizing, staffing, directing, and controlling. These functions are discussed in the following sections.
PLANNING
Planning is a systematic process that takes us from some current state to some
future desired state. Planning involves establishing goals and developing processes and methods for achieving those goals. There are several types of planning
with which we should be concerned as business owners and managers.
Strategic planning is the development of long-term plans for our business. Strategic planning involves establishing overall company priorities. In
addition, the strategic planner allocates resources and takes the steps necessary
to meet the strategic goals. The strategic plan answers the following question:
Where do we want our business to be at some future date? It is important to
note that strategic plans have a time horizon that usually exceeds 1 year, and
most often have time horizons of 5 years or more. Some industries require strategic plans that cover 15 years.
Functional plans for business are driven by the strategic plan. They are
related to specific functional areas such as accounting, marketing, or human
resources. If you currently own a pizza-parlor restaurant and would like to
open 10 additional restaurants in your community within 5 years, your goal can
be accomplished by using a strategic plan. Each of these restaurants, however,
must hire personnel; as a result, you must have a personnel plan. This functional plan supports the strategic plan. Each restaurant also requires equipment;
as a result, you must have a capital budgeting plan. Each restaurant requires a
marketing strategy, so you must also have to have a marketing plan. Each restaurant must provide products and services to customers in a specific manner
to guarantee consistency of quality with respect to the product; as a result, you
must have an operational plan. All of the preceding are functional plans that
support the strategic plan of your business.
Another functional plan involves financial planning, which consists of
gathering all a firm’s monetary requirements for the support of each functional
plan. The company, therefore, must convert these functional plans into an
overall budget for the firm. This budget then drives the financial and financing requirements. The reason so many businesses fail is because of a lack of
adequate financial planning. Nobody begins a business with a plan for failure,
but too many businesses have been started with a failure to plan.
Goal setting is a precursor to establishing a plan. A goal is a measurable objective that can be reached in a specified time frame. All goals must
have three characteristics: (1) They must be measurable (e.g., 10 restaurants);
(2) they must be achievable (e.g., Is it feasible to open the 10 restaurants?); and
Management Functions
(3) they must have a time frame connected to them (e.g., within 5 years). In
many texts, the terms goals and objectives are interchangeable; however, there is
a difference. Goals are normally considered to be long term; objectives are intermediate goals that measure progress toward the overall long-term goal.
Continuing with the previous example, you might set an objective of
having two more restaurants operating next year and an additional two in the
following year. By opening two restaurants each year over the next 5 years,
you will achieve all intermediate goals (objectives) and accomplish the strategic
goal of opening 10 restaurants in 5 years.
There are three basic financial goals required by a for-profit organization:
maximize the wealth of the business owners (investors) over the life of the
business, meet interest payments on debt, and grow.
These goals require that our company have one overall goal: to make
money now and to make more money in the future.1 If a satisfactory return on
investment is not reached by the individual owner, that owner may become
discouraged and look to invest elsewhere. A business that is not making a profit
may cease to exist. In addition, if interest payments on debt are not made,
banks or other creditors may force the enterprise into bankruptcy. For the
individual business owner, bankruptcy can make it difficult, if not impossible,
to obtain future credit. Finally, a business enterprise must grow. If it does not
grow, it probably will not be competitive in the market and will cease to exist.
To avoid these problems, the manager must develop business plans based
on definite and obtainable goals. Once definite goals have been established, then
plans should be written that allow accomplishment of each goal. The beginning
of financial planning requires basic knowledge of financial analysis, financial forecasting, and the development of budgets, which are plans converted to financial
terms. These items are covered in detail in subsequent chapters (e.g., financial
analysis is covered in Chapters 3 and 4; forecasting is covered in Chapter 6;
different types of budgets, such as pro forma financial statements, are covered in
Chapter 6; and capital budgeting is covered in Chapter 10).
ORGANIZING
The second function of the manager is organizing. Once a plan has been written, the owners (managers) must develop an organization that allows them to
carry out the plan. For most start-up companies, structure is fairly simple, with
one or two employees and virtually no departments. As the business grows,
however, definite structures and departments must be established. If you are
the single owner of a restaurant, you can probably interview and hire every
employee. If you reach your goal of having 10 restaurants, you need someone
1
Eliahu Goldratt, The Haystack Syndrome: Sifting Information Out of the Data Ocean (Croton-onHudson, NY: North River Press, 1990).
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Chapter 2 Financial Management and Planning
to recruit for you. You must decide whether you will give (or delegate) the
responsi...
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