FIN 3301, Financial Management 1
Course Learning Outcomes for Unit I Upon completion of this unit, students should be able to:
1. Explain foundational finance theories. 1.1 Discuss the meaning of finance and how it affects the business environment. 1.2 Explain the trade-off between risk and return. 1.3 Analyze a recent financial crisis to include why it occurred and how it could have been
2. Analyze a financial forecast using relevant data. 2.1 Explore the use of forecasts and financial tools for planning.
Learning Outcomes Learning Activity
1.1 Unit Lesson Chapter 1 Unit I Assessment
1.2 Unit Lesson Chapter 1 Unit I Assessment
1.3 Unit Lesson Chapter 1 Unit I Assessment
Unit Lesson Chapter 1 Chapter 2 Unit I Assessment
Required Unit Resources Chapter 1: The Financial Environment Chapter 2: Money and the Monetary System Unit Lesson Welcome to the course! In this first unit, we will focus on the basics of the financial environment as well as the monetary system. While most of us are impacted by finance every day, very few of us realize how important it is to understand and appreciate this field of business. The material in this unit concentrates on the six principles of finance in addition to creating an overview of the financial system. Each of the principles will be explored as we focus on their contributions to not only the field of business but to the marketplace.
UNIT I STUDY GUIDE The Financial Environment
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Time Value of Money The first principle of finance is the time value of money. Yes, this is a broad concept, but the time value of money simply means a dollar received today is more valuable than a dollar received one year from now. This is because we can invest the dollar we have today to earn interest so that at the end of one year, we will have more than one dollar. In other words, money has time value. For instance, suppose you have a choice of receiving $1,000 either today or one year from today. If you decide to receive it a year from now, you will have passed up the opportunity to earn a year’s interest on the money. In other words, you would have suffered an opportunity loss/cost. The cost is the interest you could have earned on the $1,000 if you invested it for one year. The only way to combat the time value of money is to invest the money into securities, savings, etc. There are many external factors that influence the value of money including inflation, political and economic factors, the cost of living, Gross Domestic Product (GDP), and the strength or weakness of the currency. We will visit the time value of money concept throughout the course as we utilize methods such as the Net Present Value (NPV) method to evaluate investments. This short video Time Value of Money is a great review of the time value of money concept. The video explores how the concept functions and who is impacted. A transcript and closed captioning are available once you access the video. When we think about the time value of money, we focus on the measurement of value. To measure value, we use the concept of time value of money to bring the future benefits and costs of a project, measured by its cash flows, back to the present. Then, if the benefits or inflow of cash is greater than the costs, the project is beneficial and should be taken on. If, on the other hand, the benefits or inflow of cash is outweighed by the costs, the project is not a good choice for the organization. If the time value of money is not recognized, there is no way that projects can be evaluated in a meaningful way. We will learn more about the time value of money in Unit IV.
Risk and Return One has to consider the tradeoff that exists between risk and return. With so many investment opportunities available, one has to consider not only the risk involved but also the return that is expected on the investment. Why would you make an investment that would not at least pay you something for delaying consumption? You would not, even if there is no risk. In fact, investors will want to receive at least the same return that is available for risk-free investments, such as the rate of return being earned on U.S. government securities. While no one likes to face risk, it is part of doing business. Risky investments are less attractive unless they offer the likelihood of higher returns. Thus, the more unsure people are about how an investment will perform, the higher the return they will demand for making the investment. So, if you are trying to persuade investors to put money into a risky venture you are pursuing, then you will have to offer a higher expected rate of return to lure them in.
The six principles of finance (Melicher & Norton, 2020)
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Keep in mind that expected rate of return and actual return are not the same thing. As an investor, you have expectations about what returns you will earn. However, you will not know for certain what they return will be. For instance, if investors could have seen into the future, no one would have bought stock in the women’s retailer Ann Taylor Stores in 2009. In March of 2009, the company announced a larger-than-expected fourth quarter loss. The result was that, within minutes of the announcement, the firm’s stock price dropped a staggering 38% (Cheng, 2009).
Diversification is another key point to consider. This concept simply means that you do not invest all of your money into one account. Instead, you spread out the investment across multiple investments such as mutual funds, stock, bonds, or certificates of deposit (CDs). Assume you invested in two stocks, Apple and Sears. Ten years after your investment, you decide to check on how your investments are doing. You bought Apple stock for $10 and the stock is now trading at almost $45. Then, you look at the Sears stock and see that the stock is selling at $5 but you paid $25 per share. Clearly, the Apple stock is performing better. The stock value changed over time due to operations, performance, and market trends, among other things. Ideally, you would have invested all the funds in the Apple stock, but the uncertainty of how the stock would do is part of the inherent risk in investing. We are risk averse! We would like to reduce the risk associated with our investment portfolio without having to accept lower expected returns. Thank goodness for diversification because that is the best way of managing risk!
An efficient market is one in which the prices of assets traded fully reflect the value based on everything known at the time. Whether a security market such as the National Association of Securities Dealers Automated Quotations (NASDAQ) is efficient depends on the speed with which newly released information impacts prices. In other words, an efficient stock market is characterized by a large number of profit-driven individuals who act quickly by buying/selling shares of stock based on new information. For instance, while Nike CEO William Perez flew aboard the company’s Gulfstream one day in November 2005, traders on the ground sold off a major amount of Nike’s stock. Why? Because the plane’s landing gear was malfunctioning, and they were watching TV coverage of the event as it was happening! Before the CEO landed safely, Nike’s stock dropped by almost 2% (Cain, 2005). Once Perez’s plane landed, Nike’s stock price bounced back. This example illustrates just how time-sensitive trading and valuation can be.
Management Versus Owner Perspectives Another principle to study is the conflict of interest between management and the owners. Managers might have goals that are different than the owners, and these goals might lead to decisions that decrease the overall value of the firm. When it happens, it is mainly because the manager’s own interest is best served by ignoring shareholder interests. Thus, there is a conflict of interest between what is best for the managers and the stockholders. For instance, it may be the case that shutting down an unprofitable plan is in the best interests of the firm’s stockholders, but in doing so, the managers will find themselves out of a job or having to transfer to a different job. This conflict of interest could lead the management of the plant to continue running the plant at a loss. Further, managers might decide to avoid projects that have risk associated with them, even if they are great projects with huge potential returns and a small chance of failure. Why is this? Well, if the project does not turn out to be successful, these agents of the shareholders may lose their jobs.
When you diversify, you divide your money into multiple investments. (Nexusby, n.d.)
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The costs associated with this conflict can percolate into the marketplace. If the market feels management is damaging shareholder wealth, there may be a positive reaction in stock price to the removal of that management. For instance, on the announcement of the death of Roy Farmer, the CEO of Farmer Brothers, a seller of coffee products, Farmer Brothers’ stock price rose about 28% (Hirsch, 2004). Generally, a loss of a company’s top executive raises concerns over leadership, causing the stock to drop. However, in the case of Farmer Brothers, investors thought a change in management would have a positive impact on the future of the company.
Reputation Matters Finally, we evaluate the sixth principle: importance of reputation within an organization and how it translates into the marketplace. Much of this principle has to do with the company’s ability to perform and function using a high level of ethics. When investors evaluate potential areas of investment, they consider not only the ability of a firm to make profits, but also the ability of a firm to sustain those level of profits into the future. Much of that success draws on how the firm is perceived based on its history of giving, strong moral code, and relationship with the public and consumers. For instance, when the Enron and WorldCom scandals were exposed, no one wanted to take responsibility for what happened, and the public washed its hands of the firms in terms of support. These days, consumers and investors look for firms and investments that are in demand based on how they are perceived, such as the way Whole Foods supports and nurtures programs that incorporate free trade programs with other countries or how Ben & Jerry’s gives back much of its profits to grass roots organizations, such as the Vermont Community Action Team Grant Program. This program focuses on those communities dealing with extreme poverty. Overall, these Six Principles of Finance not only provide a framework within which finance is based, but they incorporate all of the core areas of the field from conflict to profit on one end of the spectrum to social responsibility and risk and reward on the other end. By understanding these basic building blocks of finance, we can start to focus on the details of how each principle impacts the financial environment.
Cain, B. (2005, November 22). Nike CEO, other executives safely on ground after landing-gear scare. Lawrence Journal-World. http://www2.ljworld.com/news/2005/nov/22/nike_ceo_other_executives_safely_ground_after_land/
Cheng, A. (2009, August 21). Ann Taylor posts fourth straight loss. MarketWatch.
https://www.marketwatch.com/story/ann-taylor-swings-to-loss-on-slumping-sales-2009-08-21-83400 Hirsch, J. (2004, March 17). Roy F. Farmer, 87: Built family coffee company. Los Angeles Times.
http://articles.latimes.com/2004/mar/17/local/me-farmer17 Melicher, R. W., & Norton, E. A. (2020). Introduction to finance: Markets, investments, and financial
management (17th ed.). Wiley. https://bookshelf.vitalsource.com/#/books/9781119560579 Nexusby. (n.d.). ID 141216841 [Image]. Dreamstime. https://www.dreamstime.com/diversification-diversified-
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Suggested Unit Resources In order to access the following resource, click the link below. The article below relates events from the past to concepts covered in this unit including risk and diversification. Taking a few minutes to read it will help to make the connection between these concepts and the real world. Habal, H. (2001, September 21). Play it safe in a risky financial environment. Dallas Business Journal, 25(6),
24. http://link.galegroup.com/apps/doc/A78903566/ITOF?u=oran95108&sid=ITOF&xid=5b8d3631 Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. How well do you know the unit material? Take the Unit I Knowledge Check Quiz to find out! (PDF of Unit I Knowledge Check Quiz)