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Principles of Finance

1.6 Microeconomic and Macroeconomic Matters

Principles of Finance1.6 Microeconomic and Macroeconomic Matters

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Define microeconomics and macroeconomics.
  • Discuss the relationship between microeconomics and macroeconomics.
  • Explain the importance of macroeconomic variables in finance markets.

Microeconomics

In the business setting, finance is the intersection of economics and accounting. Financial decision makers rely on economic theory and empirical evidence combined with accounting data to make informed decisions for their organization. Economics is the study of the allocation of scarce resources. Economists attempt to understand the how and why of human and financial capital allocation to governments, businesses, and consumers.

We typically separate economics into two major areas, microeconomics and macroeconomics. Microeconomics is devoted to the study of these decisions of allocation by individual businesses, persons, or organizations. Microeconomics helps us understand incentives and behavior, consumer choices and consumption, and supply and demand.

Our understanding of microeconomics aids in financial forecasting, planning, and budgeting by understanding how individuals are likely to respond to changes in product or service functionality, price, supply, quality, marketing, or other firm-induced stimulus. Empirical research by individuals, businesses, academics, and government provide evidence of what is going on and suggest what may change or stay the same.

Macroeconomics

Whereas microeconomics studies the decisions of individuals, macroeconomics examines the decisions of groups. Macroeconomic areas of study and concern include inflation, income, economic growth, and unemployment. When Bacon Signs developed a financial and operating plan to expand the business, the firm had to consider unemployment and inflation when estimating its price of labor and materials. Bacon Signs also had to consider interest rates when estimating the cost of borrowing money to expand the business.

Macroeconomic modeling is limited because models cannot capture every variable in testing and application. However, financial forecasting must incorporate macroeconomic assumptions and expectations into individual firm and industry forecasts. Economic Foundations expands on our discussion of micro- and macroeconomics.

Importance of Macroeconomic Variables in Financial Markets

To make financial forecasts, managers need good information to understand the relationship among several economic variables. Working from small to large, sales forecasts estimate the likely price and quantity of goods sold. In doing so, the forecaster will consider local, regional, state, national, and international economic conditions. Inflation is an important macroeconomic variable that influences prices. Every quarter, financial information hubs, such as the Wall Street Journal (WSJ), and government agencies and regulatory bodies, such as the Treasury Department and the Federal Reserve, release estimates about expected and current inflation. This information informs policy makers how to adjust the money supply to meet target objectives. Financial forecasters pay close attention to current and expected interest rates, as they have a fundamental impact on the cost of raising money and determining the required rate of return for investment.

The unemployment rate helps inform financial forecasters about the expected cost of labor and the ability of employers to hire people if a firm plans to increase the production of goods or services. The stock market is a forward-looking macroeconomic variable and measures investor expectations about future cash flows and economic growth. Political economic variables such as changes in regulation or tax policy can also affect forecasting models.

Each of the variables we have identified—inflation, interest rates, unemployment, economic growth, the stock market, and government fiscal policy—are macroeconomic factors. They are beyond the scope and influence of individual firms, but combined, they play a critical role in establishing the market in which firms compete. A better understanding of the interaction of these macro variables with each other and with individual micro or firm-specific variables can only strengthen financial forecasting and management decision-making.

Concepts In Practice

Here, There, and Everywhere: Where Did Your iPhone Come From?

How do international macroeconomic factors affect investment decisions for businesses and individuals? Foreign investment adds risk and potential return to the decision-making process. Macroeconomic factors such as different inflation rates, unexpected changes in currency exchange rates, and mismatched economic growth all add to the uncertainty of making investments abroad. Just as important are government regulations limiting pollution, exploitation of precious minerals, labor laws, and tariffs. Toss in a pandemic, and a bottleneck or two, and suddenly international macroeconomic factors can affect almost every aspect of commerce and international trade.

For example, how far did your new iPhone travel before it got into your hands? Apple is an American company headquartered in Cupertino, California, and worth over $2 trillion.8 However, your phone may have visited as many as six continents before it reached you. Each location touched by the Apple corporate hand requires an understanding of the financial impact on the product cost and a comparison with alternative designs, resources, suppliers, manufacturers, and shippers. This is where finance can get really fun!

(Sources: Magdalena Petrova. “We Traced What It Takes to Make an iPhone, from Its Initial Design to the Components and Raw Materials Needed to Make It a Reality.” CNBC. December 14, 2018. https://www.cnbc.com/2018/12/13/inside-apple-iphone-where-parts-and-materials-come-from.html; Natasha Lomas. “Apple’s Increasingly Tricky International Trade-offs.” TechCrunch. January 6, 2019. https://techcrunch.com/2019/01/06/apples-increasingly-tricky-international-trade-offs/; Kif Leswing. “Here’s Why Apple Is So Vulnerable to a Trade War with China.” CNBC. May 13, 2019. https://www.cnbc.com/2019/05/13/why-is-apple-so-vulnerable-to-a-trade-war-with-china.html)

Relationship between Microeconomics and Macroeconomics

In the parable, a group of blind people happen upon an elephant for the first time, and they each touch one part—but one part only—of the elephant. Subsequently, when they each describe what they have discovered, the descriptions are vastly different. The group's members become upset, accusing one another of inaccurate descriptions or worse. The parable demonstrates how individuals can make absolute truths from their own limited and subjective information. Financial decision makers run a similar risk, if they choose to recognize only their own findings and ignore other microeconomic or macroeconomic information and the interaction of these factors.

A common view to understanding economics states that macroeconomics is a top-down approach and microeconomics is a bottom-up approach. Financial decision makers need to see both the forest and the individual trees to chart a course and move toward a strategic objective. They need both the macro data, so important for strategic thinking, and the micro data, required for tactical movement. For example, the national rate of unemployment may not have been much help when Bacon Signs was searching for skilled laborers who could form neon signs. However, the unemployment rate helped inform the company about the probability of demand for new businesses and the signs they would need.

Footnotes

  • 8Sergei Klebnikov. “Apple Becomes First U.S. Company Worth More Than $2 Trillion.” Forbes. August 19, 2020. https://www.forbes.com/sites/sergeiklebnikov/2020/08/19/apple-becomes-first-us-company-worth-more-than-2-trillion/
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