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FINANCE & BANKING: CHAPTER 2 FINANCIAL ENVIRONMENT OF BUSINESS FINANCIAL ENVIRONMENT OF BUSINESS 2-1 BASIC ECONOMIC SYSTEMS AND PRINCIPLES FINANCIAL ENVIRONMENT OF BUSINESS DEFINING ECONOMICS • ECONOMICS: The science of decision making about the allocation of scarce resources. • Economists are scientists who study how decisions can be made that result in the best match of needs and resources. FINANCIAL ENVIRONMENT OF BUSINESS DEFINING ECONOMICS • The science of economics can help an individual decide how to plan a personal budget in order to satisfy both immediate and long-term needs. • Economics can also help politicians and bureaucrats decide on the best monetary policies to increase a country’s standard of living. FINANCIAL ENVIRONMENT OF BUSINESS ECONOMIC PRINCIPLES • The following important principles define the science of economics: scarcity and choice, limited resources, and supply and demand. FINANCIAL ENVIRONMENT OF BUSINESS SCARCITY AND CHOICE • SCARCITY: Means that people have wants and needs that are greater than can be satisfied with the available products and services. • Because of scarcity, individuals have to make choices. • CHOICE: Deciding which wants and needs will be satisfied and which will go unsatisfied. FINANCIAL ENVIRONMENT OF BUSINESS LIMITED RESOURCES • RESOURCES: The means available to develop solutions for unsatisfied wants and needs. • An individual’s resources are time, money, and skills. • They can use their time and skills to earn money so they can purchase the products and services they want. FINANCIAL ENVIRONMENT OF BUSINESS LIMITED RESOURCES • Companies and countries also have resources in the following categories: natural resources, capital resources, and human resources. • These resources are needed to produce the goods and services that satisfy human needs and wants. FINANCIAL ENVIRONMENT OF BUSINESS LIMITED RESOURCES • NATURAL RESOURCES: The raw materials supplied by nature. • All of the materials that come from the earth, the water, or the air are natural resources. • All of the goods we use today began with one or more natural resources. FINANCIAL ENVIRONMENT OF BUSINESS LIMITED RESOURCES • The supply of many natural resources is limited. • EXAMPLES: Oil and metals from earth, fish from water, and oxygen from air for carbonated drinks. FINANCIAL ENVIRONMENT OF BUSINESS LIMITED RESOURCES • CAPITAL RESOURCES: The humanmade goods, such as tools, equipment, buildings, supplies, and money that are used to create products and services. • EXAMPLES: Office buildings, factories, tractors, computers, and delivery trucks. FINANCIAL ENVIRONMENT OF BUSINESS LIMITED RESOURCES • HUMAN RESOURCES: People and their skills who work to produce goods and services; also called labor. • EXAMPLES: People who run factories, manage banks, design buildings, process food, announce the news on TV, check out purchases at the supermarket, and police the streets. FINANCIAL ENVIRONMENT OF BUSINESS SUPPLY AND DEMAND • DEMAND: The quantity of a product or service that individuals want to buy to satisfy their wants and needs. • Understanding demand tells a business what type and what quantity of products and services to supply. FINANCIAL ENVIRONMENT OF BUSINESS SUPPLY AND DEMAND • If many people want (demand) a particular product or service, its price will tend to go up. • If products or services do not meet the needs of individuals or if there are better alternatives, the demand for those products or services will be low. FINANCIAL ENVIRONMENT OF BUSINESS SUPPLY AND DEMAND • SUPPLY: The quantity of a product or service that has been produced by businesses with the hope of making a profit from sales to customers. • If businesses cannot obtain the resources needed to produce a product or service or if those resources are very expensive, the supply will be low. FINANCIAL ENVIRONMENT OF BUSINESS SUPPLY AND DEMAND • Sometimes businesses will try to restrict supply of products in order to obtain a higher price. • That will only work if customer demand is high and if there are no good substitutes for the product. • Consequently, if there is a supply surplus of a particular product or service, its price will tend to go down. FINANCIAL ENVIRONMENT OF BUSINESS SUPPLY AND DEMAND • MARKET PRICE: The point where supply and demand are equal. • Prices of goods and services rise and fall based on supply and demand. FINANCIAL ENVIRONMENT OF BUSINESS TYPES OF ECONOMIC SYSTEMS • The three main types of economic systems throughout the world are traditional, command, and market. FINANCIAL ENVIRONMENT OF BUSINESS TYPES OF ECONOMIC SYSTEMS • TRADITIONAL ECONOMY: Goods are produced the way they have always been produced, generation after generation. • There is very little government influence or control in a traditional economy. • This type of economy occurs in less developed countries that are not yet participating in the global economy. FINANCIAL ENVIRONMENT OF BUSINESS TYPES OF ECONOMIC SYSTEMS • They often use the natural resources readily available to them and the hand tools they make. • They will consume most of what they produce and sell or trade the rest with people who live close to them. • The traditional economy is usually centered on meeting the basic needs of people such as food, clothing, and shelter. FINANCIAL ENVIRONMENT OF BUSINESS TYPES OF ECONOMIC SYSTEMS • COMMAND ECONOMY: All resources are owned and controlled by the government. • Government officials decide what and how goods will be produced and how they will be shared and distributed. FINANCIAL ENVIRONMENT OF BUSINESS TYPES OF ECONOMIC SYSTEMS • They plan all phases of the economy and command that the plans be carried out, using the military or police if necessary. • The average citizen has little say in the economy and their economic freedom is limited. FINANCIAL ENVIRONMENT OF BUSINESS TYPES OF ECONOMIC SYSTEMS • MARKET ECONOMY: Based on the combination of the decisions made by individual consumers and businesses. • All businesses can decide what to produce, how to produce them, and also set appropriate prices. • Individual consumers can also decide how they will spend their money. FINANCIAL ENVIRONMENT OF BUSINESS TYPES OF ECONOMIC SYSTEMS • The U.S. system fits the definition of a market economy (also called capitalism or free/private enterprise). • CAPITALISM: The economic resources are usually privately owned by individuals rather than by government. • Government plays a limited role in a free enterprise economy. FINANCIAL ENVIRONMENT OF BUSINESS TYPES OF ECONOMIC SYSTEMS • The two primary ways governments are involved in the organization of businesses are in legal requirements and taxation. • Government has a responsibility to protect the health and safety of citizens, prevent a major imbalance of competition among businesses, and encourage economic growth. FINANCIAL ENVIRONMENT OF BUSINESS 2-2 LEGAL FORMS OF BUSINESS FINANCIAL ENVIRONMENT OF BUSINESS LEGAL FORMS OF BUSINESS OWNERSHIP • Determining the legal form of organization for a business should be done carefully to obtain the best circumstances for financing the business, maintaining profitability, and meeting government operating and taxation requirements. • The three most common forms for U.S. businesses are sole proprietorship, partnership, and corporation. FINANCIAL ENVIRONMENT OF BUSINESS SOLE PROPRIETORSHIP • SOLE PROPRIETORSHIP: A business owned and managed by one person. • All financial and operating decisions are made by the owner of the business. • The proprietor must provide financing to start the business from his or her own savings or obtain additional financing from investors. FINANCIAL ENVIRONMENT OF BUSINESS SOLE PROPRIETORSHIP • The single owner is totally responsible for the success or failure of the business. • If the business fails, any money or asset owned by the proprietor, whether used in the business or not, can be obtained by creditors to pay business debts. • In return for financial risks, the sole proprietor receives all profits made by the business. FINANCIAL ENVIRONMENT OF BUSINESS SOLE PROPRIETORSHIP • A sole proprietorship can be formed with almost no legal requirements. • More than two-thirds of U.S. businesses are operated as proprietorships. • EXAMPLES: Many jewelry stores, restaurants, gas stations, and hair-styling salons. FINANCIAL ENVIRONMENT OF BUSINESS PARTNERSHIP • PARTNERSHIP: A business owned and controlled by two or more people who have entered into a legal written agreement. • The agreement identifies each partner’s financial obligations, managerial and operational responsibilities, and how the partnership can be expanded or dissolved. FINANCIAL ENVIRONMENT OF BUSINESS PARTNERSHIP • Partnerships are similar to sole proprietorships from a financing viewpoint. • The individual partners are responsible for providing and obtaining the financing. • Each partner has responsibility and liability for the debts of the business. • The advantage of a partnership is that there are more financial resources from two or more people than from one owner. FINANCIAL ENVIRONMENT OF BUSINESS PARTNERSHIP • Because the combination of partners adds expertise and skill as well as greater coverage for any business liabilities, it may be easier to obtain financing from banks and other investors. • A disadvantage is that management decision making is shared, sometimes complicating business matters. FINANCIAL ENVIRONMENT OF BUSINESS PARTNERSHIP • A special form of partnership is the limited partnership. • LIMITED PARTNERSHIP: Includes one or more general partners and other limited partners. • General partners have operating responsibilities and are liable for all of the business’s debts. FINANCIAL ENVIRONMENT OF BUSINESS PARTNERSHIP • Limited partners are investors and cannot participate in day-to-day operations and management decisions. • In return, their liability is limited to the amount of their investment. FINANCIAL ENVIRONMENT OF BUSINESS CORPORATION • CORPORATION: A business that is a separate legal entity and operated under written permission from the state in which it is located. • It is owned by one or more shareholders who have invested in the business and managed by a board of directors. • The corporation acts as a single individual on behalf of its owners/shareholders. FINANCIAL ENVIRONMENT OF BUSINESS CORPORATION • By purchasing shares of stock, people become owners of corporations. • A private corporation can limit the number of owners and who is allowed to purchase stock. • A public corporation issues stock that is sold on the open market, so anyone with the money to pay for a share of stock can be an owner. FINANCIAL ENVIRONMENT OF BUSINESS CORPORATION • Because stock can be bought and sold, the life of the corporation is unlimited; it can continue as long as the company is financially successful. • The ownership and management of a corporation is separated. • Overall direction of the corporation is in the hands of a board of directors. FINANCIAL ENVIRONMENT OF BUSINESS CORPORATION • Day-to-day leadership and operations is handled by people with management expertise hired by the directors. • Because of this specialized expertise, the success rate of corporations is much greater than sole proprietorships or partnerships. FINANCIAL ENVIRONMENT OF BUSINESS CORPORATION • They have a much lower financial risk for investors offering financing to the business. • Corporations protect the liability of stockholders to only the amount of money they have invested. • The major financial disadvantage of corporations is that profits can be taxed twice. FINANCIAL ENVIRONMENT OF BUSINESS CORPORATION • First, corporations must pay taxes on their profits. • Stockholders must also pay individual income tax on the value of dividends received. • DVIDENDS: A percentage of corporate earnings allocated to each share of stock. FINANCIAL ENVIRONMENT OF BUSINESS CORPORATION • Corporations are also much more difficult to form than either proprietorships or partnerships. FINANCIAL ENVIRONMENT OF BUSINESS 2-3 TYPES OF FINANCIAL MARKETS FINANCIAL ENVIRONMENT OF BUSINESS PRINCIPLES OF FINANCIAL EXCHANGE • People who need to borrow money from others must pay to do so. • People who loan or invest money with others do so to obtain a financial return. • FINANCIAL RETURN: A profit earned from an investment. • Most investments are made to gain the greatest financial return, however, investments come with financial risks. FINANCIAL ENVIRONMENT OF BUSINESS PRINCIPLES OF FINANCIAL EXCHANGE • FINANCIAL RISK: The possibility that an expected profit will not be achieved. • Investments are evaluated to determine the level of risk. • Investments with higher financial risks offer the opportunity for a greater financial return, while low-risk investments offer a lower return. FINANCIAL ENVIRONMENT OF BUSINESS PRINCIPLES OF FINANCIAL EXCHANGE • With greater risk, there is a higher probability that the expected return will not be realized. • The low-risk investments pay less but have a greater likelihood of achieving the expected return. • TERM: The length of time the invested money is controlled by others. FINANCIAL ENVIRONMENT OF BUSINESS PRINCIPLES OF FINANCIAL EXCHANGE • Long-term investments may be made for many years or even without an ending date identified. • Short-term investments may only have a term of a few days or a few months. FINANCIAL ENVIRONMENT OF BUSINESS COMMON FINANCIAL MARKETS • FINANCIAL MARKET: An organized process for the exchange of capital and credit. • Financial markets assist in the exchange between buyers and sellers. • When a large group of people have interests in the same products and financial resources, a market serves as a common location where those resources can be bought and sold. FINANCIAL ENVIRONMENT OF BUSINESS COMMON FINANCIAL MARKETS • Sellers want to obtain the highest possible price for the resources they own. • Buyers want to purchase those resources at the lowest possible price. • Financial markets help to identify the supply and demand for a specific resource in order to determine its current market price. FINANCIAL ENVIRONMENT OF BUSINESS COMMON FINANCIAL MARKETS • The financial market also manages the exchange between buyers and sellers with policies and procedures for placing orders, making payments, and transferring ownership. • Common financial markets are stock markets, bond markets, commodity markets, and currency markets. FINANCIAL ENVIRONMENT OF BUSINESS COMMODITY MARKETS • COMMODITY MARKETS: Trade raw materials and other basic production resources. • Oil, electricity, grain, livestock, chemicals, metals, and gold are examples of commodities. • Major commodity markets include the Chicago Board of Trade and the New York Mercantile Exchange. FINANCIAL ENVIRONMENT OF BUSINESS COMMODITY MARKETS • Two types of markets exist for the sale of commodities. • Spot markets buy and sell products for immediate (on-the-spot) delivery. • Futures markets are contracts negotiated for the sale of products at some future date. FINANCIAL ENVIRONMENT OF BUSINESS STOCK MARKETS • STOCK MARKET: The organized exchange of the ownership shares of public corporations. • The buying and selling of stock occurs in stock exchanges. • Stock exchanges used to be physical locations where representatives of buyers and sellers actually met to negotiate for the purchase and sale of stocks. FINANCIAL ENVIRONMENT OF BUSINESS STOCK MARKETS • Today with the development of computer technologies and the Internet, sales are often completed electronically. • The New York Stock Exchange still places buy and sell orders on the trading floor of the exchange located on Wall Street in New York City. • Another major U.S. stock exchange, NASDAQ, is a virtual exchange. FINANCIAL ENVIRONMENT OF BUSINESS OTHER FINANCIAL MARKETS • CAPITAL MARKETS: Used to finance intermediate or long-term debt of one year or longer. • Stock markets and bond markets are types of capital markets. FINANCIAL ENVIRONMENT OF BUSINESS OTHER FINANCIAL MARKETS • BOND: A financial instrument that obligates the issuer to pay the bondholder the principal plus agreed-upon interest at the end of a designated period. • Bonds are often issued for terms of 5, 10, and 20 years or even longer. FINANCIAL ENVIRONMENT OF BUSINESS OTHER FINANCIAL MARKETS • BOND MARKETS: Offer newly issued bonds of companies and government agencies for sale as well as buying and selling existing bonds. • MONEY MARKETS: Specialize in buying and selling financial instruments for short time periods of a year or less. FINANCIAL ENVIRONMENT OF BUSINESS OTHER FINANCIAL MARKETS • The federal government offers short-term securities known as treasury bills. • Some cities offer municipal notes to obtain cash for city operations. • The government securities are repaid from taxes or other revenues. • A common form of money market financing is certificates of deposit (CDs) offered by banks and other financial institutions. FINANCIAL ENVIRONMENT OF BUSINESS OTHER FINANCIAL MARKETS • Some businesses raise money needed for short-term operating expenses by selling commercial paper. • COMMERCIAL PAPER: Unsecured, short-term debt instruments issued by corporations to meet short term debt obligations (for example, payroll) backed only by a promise to pay the face amount on the specified maturity date. FINANCIAL ENVIRONMENT OF BUSINESS OTHER FINANCIAL MARKETS • Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. • Commercial paper is usually sold at a discount from face value, and carries shorter repayment dates than bonds. FINANCIAL ENVIRONMENT OF BUSINESS OTHER FINANCIAL MARKETS • The longer the maturity on a note, the higher the interest rate the issuing institution must pay. FINANCIAL ENVIRONMENT OF BUSINESS PRIMARY AND SECONDARY OFFERINGS • PRIMARY OFFERING: When an organization makes stock available for the first time or issues new bonds. • The primary offering is also referred to as the initial public offering (IPO). • Primary offerings are used to raise new capital for an organization. • Buyers may choose to hold the stock and bonds or they may decide to resell them. FINANCIAL ENVIRONMENT OF BUSINESS PRIMARY AND SECONDARY OFFERINGS • SECONDARY OFFERING: When an investor offers stocks and bonds for resale. • The original organization is not involved in the secondary sale, so it does not receive any money. • The value of securities increase and decrease based on supply, demand, economic conditions, and other market FINANCIAL ENVIRONMENT factors. OF BUSINESS PRIMARY AND SECONDARY OFFERINGS • Investors buy and sell securities on the secondary market with the hope of making a profit on their eventual sale. FINANCIAL ENVIRONMENT OF BUSINESS CLASSWORK • • • • • • Define Ch. 2 Vocab Words (20). 2-1 Assessment Questions, pg. 40: 1-3, 5. 2-2 Assessment Questions, pg. 47: 1-3, 5. 2-3 Assessment Questions, pg. 52: 1-5. Ch. 2 Assessment, pg. 59: 1-10 & 13-14. Stock Market Activity, pg. 61: 1 page. FINANCIAL ENVIRONMENT OF BUSINESS