Overview of FinMan and Fin Mkts*
Why is Corporate Finance Important to All Managers?
Corporate finance provides the skills managers need to:
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The primary objective should be shareholder wealth maximization, which usually translates to maximizing stock price
Should firms behave ethically? YES!
Do firms have any responsibilities to society at large? YES! Shareholders are also members of society.
What Should Management’s Primary Objective Be?
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Shareholder Wealth Maximization
Considers the timing and risk of the benefits from stock ownership
Determines that a good decision increases the price of the firm's common stock ( c/s )
Is an impersonal objective
Social Responsibility
Ethical issues will constantly confront financial managers as they achieve the goal of the firm ( SWM ).
Managers Must:
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Maximizing Stock Price – Is it Good for Society, Employees, and Customers?
Employment growth is higher in firms that try to maximize stock price. On average, employment goes up in:
firms that make managers into owners (such as LBO firms)
firms that were owned by the government but that have been sold to private investors
What about SOEs?
Timing of the cash flow stream (sooner is better)
Risk of the cash flows (less risk is better)
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Free cash flows are the cash flows that are:
Available (or free) for distribution to all investors (stockholders and creditors) after paying current expenses, taxes, and making the investments necessary for growth.
Free cash flows are determined by:
Sales revenues
Current level
Long-term sustainable growth rate in sales
Operating costs (raw materials, labor, etc.) and taxes
Required investments in operations (buildings, machines, inventory, etc.)
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The Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is the average rate of return required by all of the company’s investors (stockholders and creditors)
The weighted average cost of capital is affected by:
Capital structure (the firm’s relative amounts of debt and equity)
Interest rates
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What Determines a Firm’s Value?
A firm’s value is the sum of all the future expected free cash flows when converted into today’s dollars:
Value =
FCF1
FCF2
FCF∞
Stock Prices
Intrinsic value
Stock valuation based on an individual’s expected free cash flows
Market value
Market price is the value quoted in the market.
Based on aggregate market’s expectations and is set by the marginal investor. It is the marginal investor’s intrinsic value.
Fundamental Value
This is the intrinsic value an analyst would calculate given complete and accurate information about a company’s expected future free cash flows and risk.
Also called true intrinsic value.
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Short-Term vs. Long-Term Price
Management can impact the market price over the short term by releasing incomplete or inaccurate information.
Over the long term the market price will tend towards the fundamental value as more information becomes available.
What about the recent financial crisis?
Financial Assets or Instruments
A financial asset is a contract that entitles the owner to some type of payoff.
Debt
Equity
Derivatives - a security, such as an option or futures contract, whose value depends on the performance of an underlying security or asset.
In general, each financial asset involves two parties, a provider of cash (i.e., capital) and a user of cash.
Give examples of financial assets or instruments
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How to Become a Public Corporation and Keep 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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An agency relationship arises whenever one or more individuals, called principals, (1) hires another individual or organization, called an agent, to perform some service and (2) then delegates decision-making authority to that agent.
If you are the only employee, and only your money is invested in the business, would any agency problems exist?
No agency problem would exist.
A potential agency problem arises whenever the manager of a firm owns less than 100 percent of the firm’s common stock
What is an Agency Relationship?
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An agency relationship could exist between you and your employees if you, the principal, hired the employees to perform some service and delegated some decision-making authority to them.
If you needed additional capital to buy computer inventory or to develop software then you might end up with agency problems if the capital is acquired from outside investors.
Agency problems are less for secured than for unsecured debt, and different between stockholders and creditors.
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Compensation
Question: Would expansion increase or decrease potential agency problems?
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Creditors can protect themselves by (1) having the loan secured and (2) placing restrictive covenants in debt agreements. They can also charge a higher than normal interest rate to compensate for risk.
Structuring compensation packages to attract and retain able managers whose interests are aligned with yours.
Threat of firing.
Increase “monitoring” costs by making frequent visits to “off campus” locations.
What Actions Might Make a Loan Feasible?
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A manager might inflate a firm's reported earnings or make its debt appear to be lower if he or she wanted the firm to look good temporarily. For example just prior to exercising stock options or raising more debt.
Why Might You Want to Make Your Financial Statements Look Artificially Good?
What are the Potential Consequences of Inflating Earnings or Hiding Debt?
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Cash (or stock) bonus
Options to buy stock or actual shares of stock to reward long-term performance
Tie bonus/options to value of the company
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An act passed in 2002 that established new regulations for auditors, corporate officers, and securities analysts.
The goal was to make it less likely that companies and securities analysts would mislead investors, and increase the penalties for doing so.
Transparency in Financial Reporting
Sarbanes-Oxley (USA)
Adverse Selection
Before transaction occurs - Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected
Due to Asymmetric Information:  
Moral Hazard
After transaction occurs - Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits
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Required Dividend Capital
return yield gain
The Interest Rate
Production opportunities
Here:
r* = Real risk-free rate.
1% to 4%.
= Any nominal rate.
The Term Structure of Interest Rates and the Yield Curve
Term structure: the relationship between interest rates (or yields) and maturities.
A graph of the term structure is called the yield curve.
How to Construct a Yield Curve
Step 1: Estimate the inflation premium (IP) for each future year. This is the estimated average inflation over that time period.
Step 2: Estimate the maturity risk premium (MRP) for each future year.
Step 3: Add to r*
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Step 1: Find the average expected inflation rate over years 1 to n:
n
INFLt
n
IPn =
Assume investors expect inflation to be 5% next year, 6% the following year, and 8% per year thereafter.
IP1 = 5%/1.0 = 5.00%.
IP10 = [5 + 6 + 8(8)]/10 = 7.5%.
IP20 = [5 + 6 + 8(18)]/20 = 7.75%.
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MRPt = 0.1%(t - 1).
MRP10 = 0.1% x 9 = 0.9%.
MRP20 = 0.1% x 19 = 1.9%.
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rRFt = r* + IPt + MRPt .
rRF = Quoted market interest
rate on treasury securities.
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Types of Risks From Investing Overseas
Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment.