ADMN 201 — Ch15: Financial Decisions and Risk Management

Chapter Overview

This chapter covers how businesses fund themselves (short-term and long-term), how securities markets work, and how firms manage risk. It sits at the intersection of accounting, strategy, and operations.

mindmap
  root((Ch15: Financial Decisions))
    Financial Manager
      4 Responsibilities
      Cash-Flow Management
      Financial Control
      Financial Planning
    Short-Term Financing
      Trade Credit
      Secured Loans
      Unsecured Loans
        Line of Credit
        Revolving Credit
        Commercial Paper
    Long-Term Financing
      Debt Financing
        Long-Term Loans
        Bonds
      Equity Financing
        Common Stock
        Preferred Stock
        Retained Earnings
      Capital Structure
    Securities Markets
      Primary vs Secondary
      IPOs
      Stock Exchanges
      Market Indexes
      Buying & Selling
    Investment Vehicles
      Mutual Funds
      ETFs
      Hedge Funds
      Commodities
    Risk Management
      5-Step Process
      Speculative vs Pure Risk

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LO 15.1 — Role of the Financial Manager

Finance = decisions about a firm’s long-term investments and obtaining the funds to pay for them.

The financial manager plans and controls the acquisition and distribution of a company’s financial assets. Four responsibilities:

Determining a firm’s long-term investments
Obtaining funds to pay for those investments
Conducting everyday financial activities
Managing risks the firm takes

Two key operational areas:

Area	What it is
Cash-flow management	Ensuring enough cash on hand for daily obligations; managing timing of inflows and outflows
Financial control	Checking actual performance against plans to ensure desired financial status is achieved

A financial plan describes how a business will reach a future financial position — projections for sources and uses of funds. Key questions: What funds are needed now? When will more be needed? Where can the firm get them?

LO 15.2 — Short-Term vs Long-Term Expenditures

Type	Time Frame	Examples
Short-term (operating)	< 1 year	Payroll, inventory, utilities, accounts payable
Long-term (capital)	> 1 year	Buildings, machinery, equipment

Short-term concerns: accounts payable (what the firm owes), accounts receivable (what it’s owed), inventories.

LO 15.3 — Three Sources of Short-Term Financing

1. Trade Credit

The granting of credit by a selling firm to a buying firm — effectively a short-term loan.

Open-book credit: Informal; buyer receives goods with invoice, pays later
Promissory notes: Legally binding signed agreement before shipment
Trade draft / trade acceptance: Document attached to shipment; buyer signs to receive goods, stating payment date

2. Secured Short-Term Loans

Backed by collateral (an asset the lender can seize on default).

Borrower signs a promissory note
Common collateral: accounts receivable, inventory

3. Unsecured Short-Term Loans

No collateral required, but bank may require a compensating balance (portion of loan kept on deposit in non-interest-bearing account).

Three types:

Line of credit: Standing agreement; bank commits to lend up to a maximum on short notice
Revolving credit agreement: Guaranteed line of credit; firm pays a commitment fee (0.5%–1%) on the unused portion
Commercial paper: Large creditworthy firms sell unsecured notes at a discount; repurchased at face value within 30–270 days. Difference = buyer’s interest earned.

LO 15.4 — Three Sources of Long-Term Financing

Debt Financing

Long-term borrowing from outside the company — usually long-term loans or bonds.

Long-term loans:

From chartered banks, insurance companies, pension funds
Fixed or floating (prime rate + X%) interest
Advantages: quick to arrange, flexible terms
Disadvantages: large borrowers may struggle to find lenders; restrictions placed on borrower

Bonds (corporate bond):

Contract to pay bondholder principal on a set date + interest in the interim
Governed by a bond indenture (terms, interest rate, maturity date, collateral)
Bond types by registration: Registered (named holders) vs Bearer/coupon (anonymous; clip coupons)
Bond types by security: Secured (assets pledged as collateral) vs Debentures (unsecured; inferior claims)
Bond types by maturity:
- Callable: Issuer can call them in early (usually after 5 years), pays a call price (face + premium)
- Serial: Firm retires portions in preset stages (e.g., $5 M / ye a ro f a$ 100M issue)
- Convertible: Holder can convert to common stock at a specified ratio

Bond ratings (default risk):

Rating Agency	High Grade	Medium/Investment	Speculative	Poor/Junk
Moody’s	Aaa, Aa	A, Baa	Ba, B	Caa, C
Standard & Poor’s	AAA, AA	A, BBB	BB, B	CCC, D

Poor ratings → issuer must offer higher interest to attract investors.

Bond price vs yield: A bond with a higher stated rate than the “going rate” sells at a premium; lower stated rate sells at a discount. Bond yield = annual interest / current market price.

Equity Financing

Raising money by issuing stock or retaining earnings — putting owners’ capital to work.

Common stock:

Three values:
- Par value: Arbitrary value set by board; used by accountants, not meaningful to investors
- Book value: Total shareholders’ equity ÷ number of shares
- Market value: Current price on the secondary market — the “real” value
Market capitalization: Outstanding shares × market price per share
More expensive than debt (dividends not tax-deductible; bond interest is)
Issuing stock may dilute management control

Preferred stock (hybrid):

Fixed dividend paid before common shareholders
No voting rights → firm keeps control
Never matures (unlike bonds); dividends can be skipped if no profit
Often callable at a specified call price
Dividend expressed as % of par value (e.g., 6% of $100 p a r =$ 6/share/year)

Retained earnings:

Profits not paid as dividends; reinvested in the firm
No new borrowing or interest payments
Downside: reduces dividend payments → may lower stock price/demand

Capital Structure

The relative mix of debt and equity a firm uses. Financial plans include capital structure targets.

All equity: Most conservative (no debt obligations), but most expensive
All debt: Cheapest per dollar, but most risky (fixed obligations regardless of profit)
Goal: find the mix that maximizes shareholders’ wealth

Key trade-off comparison:

Dimension	Debt	Equity
Repayment	Fixed deadline	No limit
Income claim	Regular and fixed	Only residual
Asset claim in liquidation	Creditors first	Shareholders last
Management control	No effect	May cause challenge
Tax	Interest is deductible	Dividends are not
Management flexibility	Many constraints	Few constraints

LO 15.5 — Common Stock and Preferred Stock

See concepts above (LO 15.4). Secondary markets for each:

Common stock: Traded on stock exchanges and OTC markets
Preferred stock: Also traded on exchanges and OTC; less volatile than common

LO 15.6 — Securities Markets

Securities = stocks, bonds, and mutual funds representing secured (asset-based) claims by investors.

Primary securities market: New shares sold (IPOs or private placements) — firm receives the money. Secondary securities market: Existing shares traded (TSX, NYSE) — firm receives nothing from these trades.

Investment banking: Firms that underwrite and sell new securities to the public. MDA’s IPO was underwritten by BMO, Scotiabank, and Morgan Stanley Canada.

Stock quotations (from newspapers/online): Company, volume (in 100s), high, low, close price, net change.

Bond quotations: Issuer, coupon rate, maturity date, price (as % of $1,000 face value), yield.

Market indexes — summaries of price trends:

Dow Jones Industrial Average: 30 largest US industrial firms on NYSE; “blue-chip” indicator
S&P/TSX: 246 large Canadian stocks; topped 20,000 for first time in 2021
S&P 500: 500 US stocks weighted by market cap
Nasdaq Composite: All Nasdaq-listed companies; tech-heavy; hit 14,000+ in mid-2021

Bull market = rising prices (investors expect prices to rise) Bear market = falling prices (investors expect prices to fall)

Buying and selling:

Market order: Buy/sell at current prevailing price
Limit order: Buy only if price ≤ specified limit (e.g., buy only if ≤ $80)
Stop order: Sell if price falls to specified level (e.g., sell if price hits $85 or below)
Round lot: 100 shares or multiples thereof
Odd lot: Fractions of round lot; usually more expensive (odd-lot broker fee)
Margin trading: Put down only a portion (e.g., 50%) of the stock price; borrow the rest from broker. Amplifies both gains and losses.
Short sale: Borrow shares from broker and sell them; later buy replacement shares (hopefully at a lower price). Profit if price falls; loss if price rises.
Stock option: Right to buy (call option) or sell (put option) a stock at a specified price until a specified date.

LO 15.7 — Investment Vehicles

Vehicle	What it is	Key features
Mutual fund	Pool of investor money buying a portfolio of securities	Managed by experts; load (2–8% commission) vs no-load (no commission); various risk/return profiles
ETF	Bundle of stocks/bonds tracking an index	Trades throughout the day (unlike mutual funds); much lower fees (~0.04%) vs mutual funds (~1.4%); passive management
Hedge fund	Private pool; tries to earn positive return regardless of market direction	Available only to accredited investors; highly speculative strategies
Commodities	Physical goods (oil, wheat, coffee) traded via futures contracts	Futures = agreement to buy specified amounts at a given price on a preset date; often traded on margin

Mutual funds vs ETFs key insight: most mutual funds fail to beat the market index over time (only ~1/70 in the US beat S&P 500 over 3 years). This is why ETFs have grown so rapidly.

LO 15.8 — Risk Management

Risk = uncertainty about future events; factor in every managerial decision.

Two types:

Speculative risk: Gain OR loss possible (e.g., investing in a new market)
Pure risk: Only a loss or no loss is possible (e.g., fire, theft, flood)

The 5-Step Risk Management Process:

flowchart LR
    A[Step 1\nIdentify Risks\n& Potential Losses] --> B[Step 2\nMeasure Frequency\n& Severity of Losses]
    B --> C[Step 3\nEvaluate\nAlternatives]
    C --> D[Step 4\nImplement Risk\nManagement Program]
    D --> E[Step 5\nMonitor Results]
    E -->|Ongoing review| A