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CHAPTER 1

Overview of Financial Management and the Financial Environment

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Areas in Finance

Corporate finance Investment Financial markets

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Topics in Chapter Forms of business organization Objective of the firm: Maximize

wealth Determinants of fundamental

value Financial securities, markets and

institutions

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Why is corporate finance important to all managers?

Corporate finance provides the skills managers need to: Identify and select the corporate

strategies and individual projects that add value to their firm.

Forecast the funding requirements of their company, and devise strategies for acquiring those funds.

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Business Organization from Start-up to a Major Corporation

Sole proprietorship Partnership Corporation

(More . .)

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Starting as a Proprietorship One owner (the manager) Advantages:

Ease of formation Subject to few regulations No corporate income taxes, but

personal income taxes Disadvantages:

Unlimited liability Difficult to raise capital to support

growth

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Starting as or Growing into a Partnership

More than one owner. A partnership has roughly the

same advantages and disadvantages as a sole proprietorship.

Limited partnership in some cases.

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Becoming a Corporation

A corporation is a legal entity that separates its owners from managers.

File papers of incorporation with state. Charter (name, types of business,

amount of capital, directors…) Bylaws (a set of rules by the

founders)

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Advantages and Disadvantages of a Corporation

Advantages: Unlimited life Easy transfer of ownership Limited liability Ease of raising capital

Disadvantages: Double taxation Cost of set-up stricter regulation

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Becoming a Public Corporation and Growing Afterwards

Initial Public Offering (IPO) of Stock Raises cash Allows founders and pre-IPO investors

to “harvest” some of their wealth Subsequent issues of debt and

equity

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Agency Problems and Corporate Governance Agency problem: managers may act in

their own interests and not on behalf of owners (stockholders)

Corporate governance is the set of rules that monitor and control a company’s (mainly the management’s) behavior. Corporate governance can help control agency problems.

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What should be management’s primary objective?

The primary objective should be shareholder wealth maximization, which translates to maximizing the stock price.

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What determines a firm’s value?

The cash flows generated in the future.

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What three aspects of cash flows affect an investment’s value?

Amount of expected cash flows (bigger is better)

Timing of the cash flow stream (sooner is better)

Why is timing important? Risk of the cash flows (less risk is

better)

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Free Cash Flows (FCF) Free cash flows are the cash flows that

are available (or free) for distribution to all investors (stockholders and creditors).

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Cost of Capital (1)

The cost to finance the firm and operation.

Cost of equity vs. cost of liability (debt).

Weighted average cost of capital (WACC)

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Cost of Capital (2)

What do we call the price, or cost, of debt capital? The interest rate

What do we call the price, or cost, of equity capital? Cost of equity = Required return =

dividend yield + capital gain

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A firm’s fundamental value

Intrinsic value is the sum of all the future expected free cash flows when converted into today’s dollars:

Value = + + … +FCF1 FCF2 FCF∞

(1 + WACC)1

(1 + WACC)∞(1 + WACC)2

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Capital Allocation Process

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Who are the providers (savers) and users (borrowers) of capital?

Households Non-financial corporations Financial corporations Governments

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What economic conditions affect the cost of money? Federal Reserve policies Budget deficits/surpluses Level of business activity (recession or

boom) International trade deficits/surpluses

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What international conditions affect the cost of money? Country risk. Depends on the country’s

economic, political, and social environment.

Exchange rate risk. Non-dollar denominated investment’s value depends on what happens to exchange rate.

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Financial Markets (1) Primary market:

Markets in which companies raise money by selling securities to investors.

Every security sells only once in the primary market. Example: IPO

Secondary market: Markets in which already issued securities trade. Trading is among investors.

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Financial Markets (2) Money market: markets for trading of debt

securities with less than one-year maturity. Capital markets: market for trading of

intermediate-term and long-term debt and common stock.

Spot markets: securities are bought and sold for ‘on-the-spot’ delivery.

Futures markets: trading takes place now, but full payment and delivery of the asset takes place in the future, e.g., 6 months or 1-year.

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Financial Securities Money Market Securities

Treasury Bill (T-bill); Commercial paper; negotiable CD by banks

Capital Market Securities Bonds, Mortgages, Stocks

Derivative Securities Futures, Options, Swaps, Forwards

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Debt vs. EquityDebt security Equity security

1) Holder is a creditor of the firm.No say in running of the firm.

1) Holder is an owner of the firm.Have a say in running of the firm (by voting).

2) Fixed payment. 2) Payment is not fixed. No guaranteed cash flow from firm.

3) Receives payment before anything is paid to equity holders.

3) Receives what’s left over after all debt holders/creditors are paid.

4) If firm cannot pay, debt holders will take over ownership of firm assets.

4) If firm cannot pay debt holders, loses control of firm to debt holders.

5) Limited liability. 5) Limited liability.

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What are some financial institutions? Commercial banks Investment banks Savings & Loans, mutual savings banks,

and credit unions Life insurance companies Mutual funds Pension funds Hedge funds and private equity funds

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Types of Stock Transaction Orders

Instructions on how a transaction is to be completed Market Order– Transact as quickly as

possible at current price Limit Order– Transact only if specific

situation occurs. For example, buy if price drops to $50 or below during the next two hours.

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Auction Markets Participants have a seat on the

exchange, meet face-to-face, and place orders for themselves or for their clients

NYSE and AMEX are the two largest auction markets for stocks.

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Dealer Markets “Dealers” keep an inventory of the

stock (or other financial asset) and place bid and ask

Often many dealers for each stock Computerized quotation system keeps

track of bid and ask prices, but does not automatically match buyers and sellers.

Examples: Nasdaq

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Over the Counter (OTC) Markets In the old days, securities were kept in a

safe behind the counter, and passed “over the counter” when they were sold.

Now the OTC market is the equivalent of a computer bulletin board (e.g., Nasdaq Pink Sheets), which allows potential buyers and sellers to post an offer. No dealers Very poor liquidity

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Financial Securities Quotation Quotes can be found in a variety of print

sources (Wall Street Journal) and online sources (Yahoo!Finance, CNNMoney).

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After Chapter Homework

Questions: (1-3) Mini case: b, c, d, e, f.