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CHAPTER 1Introduction to Financial Management

What is corporate finance? Forms of Businesses Goals of the Corporation Conflicts Between Managers

and Shareholders

Careers in FinanceCareer Annual SalaryCommercial Banking

Loan Officer $ 90,000 +Department Manager $ 200,000 +

Corporate FinanceFinancial Analyst $ 61-78,000Credit Manager $ 73-92,000Chief Financial Officer $ 222-367,000

Investment Banking (bulge bracket)First Year Analyst $ 90-180,000First Year Associate $ 200-350,000Assistant Vice President $ 300-900,000Director/Principal $ 500k - 2 milManaging Director/Partner $ 600k - 30 milDepartment Head $ 1 mil - 70 mil

Money ManagementPortfolio Manager $ 500,000 +Bank Trust Department $ 60k - 150,000

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Course OverviewFinance: what is it?

Corporations InvestorsFinancial Markets:Banks, Stock Exchanges

Corporate Finance Money and capital markets Investments

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If you are an investor In investments we seek to value

securities and maximize the value of our portfolio (Valuation of bonds and stocks).

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If you are the CEO of an industrial company

In corporate finance we are concerned with making decisions that enhance firm value. you can make your company more valuable

by choosing “better” projects (capital budgeting decision)

you can make your company more valuable by changing the mixture of your financing, i.e. the ratio of debt to equity (capital structure decision)

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Financial decisions Capital budgeting decisions (how to invest

money) Real capital investments/Intangible Assets Mergers; acquisitions

Capital structure decisions (how to raise and return money)

Equity Debt Distribution (Dividend, share repurchase)

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Balance-Sheet of the Firm

What long-term investments should the firm engage in?

The Capital Budgeting Decision

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Current Liabilities

Long-Term Debt

Shareholders’ Equity

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Balance-Sheet of the Firm

How can the firm raise the money for the required investments?

The Capital Structure Decision

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Current Liabilities

Long-Term Debt

Shareholders’ Equity

Corporate finance: what is it? A set of concepts, theories and

approaches that help the firm make financial decisions.

Corporate finance boils down to the investment and financing decisions made by corporations.

FinancialManager

Firm'soperations Investors

(debt&equity)

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

The Role of The Financial Manager

Real assets Financial assets

FIN 351: course organization

FIN 351

Module 1Fundamentals of valuation

Module 2Valuing risky investments

Risk and return

Module 3 Corporate financial decisions

Module 4 Market efficiency and options

Fundamentals of PVFinancial decision

Interest rates

Perpetuities and annuities calculation

Valuing stocks and bonds

NPV and other criteria

Portfolio theoryDiversification and covariance

Modigliani-Miller theorems Tangency portfolio, CAPM

risk and return

WACC and discount rate

Weak, semi-strong and strong form efficiency

Information and stock prices

Types of securitiesStocks, bonds and other

Course organization This course is broken-down into

four modules Module 1: time value of money Module 2: risk and return Module 3: capital structure Module 4: financial markets

Time value of money A basic building block We will soon have the necessary skills

needed to value stocks and bonds In this module, we don’t consider risk

It is assumed that future cash flows are riskless

It is assumed that the discount rate is riskless

Risk and return This part teaches us about

uncertainty How do we measure risk? How much is a risky cash flow in

the future worth (today)? conceptually more difficult

Financing decisions If you are the CEO of an industrial

company you can make your company more

valuable by choosing “better” projects you can also make your company

more valuable by changing the mixture of your financing (i.e. the ratio of debt to equity)

The efficiency of financial markets We will look at how information

gets absorbed into security prices We will learn three forms market

efficiency We will examine the implication of

market efficiency on financing

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Alternative Forms of Business Organization Proprietorship Partnership Corporation

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Proprietorships & Partnerships Advantages

Ease of formation Subject to few regulations No corporate income taxes

Disadvantages Difficult to raise capital Unlimited liability Limited life

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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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Organizing a Business Sole

Proprietorship Partnership Corporation

Who owns the business?

The manager

Partners Shareholders

Are managers and owners separate?

No No Usually

What is the owner’s liability?

Unlimited Unlimited Limited

Are the owner & business taxed separately?

No No Yes

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A Comparison of Partnershipand Corporations

  Corporation PartnershipLiquidity Shares can easily be

exchanged.Subject to substantial restrictions.

Voting Rights Usually each share gets one vote

General Partner is in charge; limited partners may have some voting rights.Taxation Double Partners pay taxes on distributions.

Formation difficult easy

Liability Limited liability General partners may have unlimited liability. Limited partners enjoy limited liability.

Continuity Perpetual life Limited life

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What should be the financial Goal of a company?

Maximizing revenue, cut cost, secure market share?

The primary financial goal is shareholder wealth maximization, which (generally) translates to maximizing stock price.

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Is stock price maximization the same as profit maximization?

No, despite a generally high correlation amongst stock price, EPS, and cash flow.

Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa). E.g., cut R&D.

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Factors that affect stock price

Projected cash flows to shareholders

Timing of the cash flow stream

Riskiness of the cash flows

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Agency relationships An agency relationship exists

whenever a principal hires an agent to act on their behalf.

Within a corporation, agency relationships exist between: Shareholders and managers Shareholders and creditors

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Shareholders versus Managers Managers are naturally inclined to

act in their own best interests (Shirking, empire building, corporate jets, entrenchment).

To mitigate the problem: Bonus, stock options Direct intervention by shareholders The threat of firing The threat of takeover

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Shareholders versus Creditors Shareholders (through managers)

could take actions to maximize stock price that are detrimental to creditors.

For example: taking too risky projects. (Are you willing to lend money to someone who gamble a lot?)

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When the outcome is very good, shareholders enjoy the fruit.

When the outcome is bad, shareholders are protected by limited liability. E.g., can get away by declaring bankruptcy.

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