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CHAPTER 1
Overview of Financial
Management and the FinancialEnvironment
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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 skillsmanagers need to:
Identify and select the corporate strategiesand individual projects that add value totheir firm.
Forecast the funding requirements of theircompany, and devise strategies foracquiring those funds.
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Business Organization from
Start-up to a Major Corporation
Sole proprietorship
Partnership
Corporation
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Starting as a Proprietorship
Advantages:
Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages:
Limited life Unlimited liability
Difficult to raise capital to support growth
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Starting as, or Growing into,a Partnership
A partnership has roughly the sameadvantages and disadvantages as a sole
proprietorship. Another advantage: Partners back each
other up.
Another disadvantage: Major decisionsrequire agreement between partners
Strategy
Financing
Sale of business
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Becoming a Corporation
A corporation is
a legal entity
separate from its owners and managers.
Must file papers of incorporation with a state.
Charter
Bylaws
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Advantages and Disadvantagesof a Corporation
Advantages:
Unlimited life
Easy transfer of ownership Limited liability
Ease of raising capital
Disadvantages:
Double taxation
Cost of set-up and report filing
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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 toharvest some of their wealth
Subsequent issues of debt and equity
Equity issue after IPO is called a seasoned issue
Mix of debt and equity is called the firms capitalstructure
Most companies try to maintain a fairly constant capitalstructure
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Agency Problemsand Corporate Governance
Agency problem: Managers may act in their own interests and not
on behalf of owners (stockholders)
Corporate governance: Set of rules that control a companys behavior
towards its directors, managers, employees,
shareholders, creditors, customers, competitors,and community.
Corporate governance can help controlagency problems.
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What should be ManagementsPrimary Objective?
Primary Objective should be shareholderwealth maximization
translates to maximizing the fundamental stockprice.
Should firms behave ethically? YES!
Do firms have any responsibilities to societyat large? YES!
Shareholders are also members of society.
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Is Maximizing Stock Price Good forSociety, 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)
were once owned by the government, but were sold
to private investors, i.e., privatized
(More . . .)
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Is Maximizing Stock Price Good?(cond)
Consumer welfare is higher in capitalist freemarket economies than in communist or
socialist economies. Fortunelists themost admired firms. In
addition to high stock returns, these firmshave:
high quality from customers view employees who like working there
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What Three Aspects of Cash Flows
Affect an InvestmentsValue?
Amount of expected cash flows
bigger is better
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 (FCF)
Definition: The cash flows that are available(or free) for distribution to all investors
includes both stockholders and creditors
FCF = Sales revenues
- operating costs- operating taxes
- reqdinvestment in operating capital
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What is the Weighted AverageCost of Capital (WACC)?
WACC is the weighted average rate of returnrequired by all of the companys investors
WACC is affected by:
Risk of the firms core business
Capital structure (the firms relative use of debt
and equity for financing) Interest rates
Investors overall attitude toward risk
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What Determines a FirmsFundamental, or Intrinsic, Value?
Definition: Intrinsic value is the sum of all thefuture expected free cash flows, when converted
into todaysdollars:
Value = + + +
FCF1 FCF2 FCF
(1 + WACC)1 (1 + WACC)(1 + WACC)2
(More . .)
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Value = + + +FCF1 FCF2 FCF
(1 + WACC)1 (1 + WACC)(1 + WACC)2
Free cash flow(FCF)
Market interest rates
Firms business riskMarket risk aversion
Firms debt/equity mixCost of debt
Cost of equity
Weighted average
cost of capital(WACC)
Sales revenues
Operating costs and taxes
Required investments in operating capital
=
Determinants of Intrinsic Value: The Big Picture
...
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Who are the Providers (savers)and Users (borrowers) of Capital?
Households: Net savers
Non-financial corporations: Net users (borrowers)
Financial corporations: Slightly net users (borrowers), but almost breakeven
Governments: U.S. government(s) are net borrowers
Some foreign governments are net savers
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How does Capital Transferfrom Savers to Borrowers?
Direct transfer A corporation issues commercial paper to an
insurance company.
Through an investment banking house In an IPO, seasoned equity offering, or debt
placement, company sells security to investmentbanking house, which then sells security to investor.
Through a financial intermediary An individual deposits money in bank, or buys a
certificate of deposit (CD)
bank makes commercial loan to a company (bank
gets a note from company).
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The Cost of Money(Yes! Money costs Money!)
What do we call the price, or cost, of debtcapital?
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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What Four FactorsAffect the Cost of Money?
Production opportunities
Ability to turn capital into benefits
Time preference for consumption
Immediate vs deferred consumption (saving)
Risk vs reward
Expected inflation
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What Economic ConditionsAffect the Cost of Money?
Federal Reserve policies
Government budget deficits/surpluses
Level of business activity (recession or boom)
International trade deficits/surpluses
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What International ConditionsAffect the Cost of Money?
Country risk
Depends on the countrys economic, political, and
social environment. Exchange rate risk
Non-dollar denominated investments valuedepends on what happens to exchange rate.
Exchange rates affected by:
International trade deficits/surpluses
Relative inflation and interest rates
Country risk
More . . .
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Types of Financial Securities
Debt Equity Derivatives
MoneyMarket
T-BillsCDsEurodollarsFed Funds
OptionsFuturesForwardcontract
CapitalMarket
T-BondsAgency bondsMunicipalsCorporate bonds
CommonstockPreferred stock
LEAPSSwaps
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Financial Securities:Typical Rates of Return
Instrument Rate (January 2009)
U.S. Treasury bills 0.41%
Bankers acceptances 5.28
Commercial paper 0.28
Negotiable CDs 1.58
Eurodollar deposits 2.60Commercial loans:
Tied to prime 3.25 +
or LIBOR 2.02 + (More . .)
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Financial Securities:
Typical Rates of Return(cond)
Instrument Rate (January 2009)
U.S. Treasury notes and bonds 3.04%
Mortgages 5.02
Municipal bonds 4.39
Corporate (AAA) bonds 5.03
Preferred stocks 6% to 9%
Common stocks (expected) 9% to 15%
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What are SomeTypes of Markets?
What is a market ?
A method of exchanging one asset (usually cash,or equivalent) for another asset.
Physical assets vs. financial assets
Spot vs. future markets
Money vs. capital markets Primary vs. secondary markets
More . . .
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Primary vs. SecondarySecurity Sales
Primary
New issue (either an IPO or a seasoned offering)
Key determinant: Issuer receives the proceedsfrom the sale.
Secondary
Existing security owner sells to another party. Original issuing firm does not receive proceeds,
and is not directly involved.
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How areSecondary Markets Organized?
By location
Physical location exchanges
Computer/telephone networks
By the way that orders from buyers andsellers are matched
Open outcry auction
Dealers (i.e., market makers who own securities)
Electronic communications networks (ECNs)
More . . .
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Physical Location vs.Computer/Telephone Networks
Physical location exchanges
New York Stock Exchange (NYSE)
American Stock Exchange (AMEX) (Chicago Board of Trade (CBOT)
Tokyo Stock Exchange
Computer/telephone
Nasdaq
Government bond markets
Foreign exchange markets
More . . .
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Types of Orders
Instructions on how a transaction is to becompleted
Market Order Transact as quickly as possible at current price
Limit Order
Transact only if specific situation occurs.
For example, only buy if the price drops to $50 or belowduring the next two hours.
More . . .
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What are Auction Markets?
Participants have a seat on an exchange
Meet face-to-face
Place orders for themselves, or for their clients
NYSE and AMEX are the two largest auctionmarkets for stocks
NYSE is a modified auction, with a specialist. CBOT also an auction exchange
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What areOver-the-Counter (OTC) Markets?
In theold days, securities were kept in asafe behind the counter
They were passedover the counter when theywere sold. Hence, the name . . .
Now the OTC market is the equivalent of acomputer bulletin board (e.g., Nasdaq Pink
Sheets) Allows potential buyers and sellers to post an offer
There are no dealers
Securities have very poor liquidity
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Thats All for Today !
Next class:
Test No. 1 on Chapter 1 (just what wecovered in class)
Read Chapter 2, and work on assignedhomework problems
PPT slides will be e-mailed tomorrow.
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