BUA 651 Financial Management

CHAPTER 1Overview of Financial Management and the Financial Environment

Financial managementForms of business organizationObjective of the firm: Maximize wealthDeterminants of stock pricing

The financial environmentFinancial instruments, markets and

institutions Interest rates and yield curves

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.

Sole proprietorship Partnership Corporation

What are some forms of business organization a company might have as

it evolves from a start-up to a major corporation?

Advantages: Ease of formation Subject to few regulations No corporate income taxes

Disadvantages: Limited life Unlimited liability Difficult to raise capital to support growth

Starting as a Sole Proprietorship

A partnership has roughly the same advantages and disadvantages as a sole proprietorship.

Starting as or Growing into a Partnership

Becoming a Corporation

A corporation is a legal entity separate from its owners and managers.

File papers of incorporation with state.CharterBylaws

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

Disadvantages: Double taxation Cost of set-up and report filing

Advantages and Disadvantages of a Corporation

Consumer welfare is higher in capitalist free market economies than in communist or socialist economies.

Fortune lists the most admired firms. In addition to high stock returns, these firms have:high quality from customers’ viewemployees who like working there

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 Agency problem: managers may act in their own

interests and not on behalf of owners (stockholders) Netscape IPO case (pg 250 casebook)

The primary objective should be shareholder wealth maximization, which 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.

Role of government?

What should management’s primary objective be?

Financial Goals of the Corporation

The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price. Do firms have any responsibilities to society

(safety, pollution, antitrust- price gouging,fair hiring) at large? (DSEFX [ETF=KLD-show how to locate], SPX, VICEX – 3yrs)

Priced out of mkt Shunned by investors Social objectives have to be mandated – role of Govt

Is stock price maximization good or bad for society (efficient production, new technology,new jobs)?

Is maximizing stock price 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

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

Shareholders versus Managers Managers are naturally inclined to act in their own best

interests (ICC). But the following factors affect managerial behavior:

Managerial compensation plans Direct intervention by shareholders (free rider problem

– Satellite Dish example) The threat of firing The threat of takeover (poison pills, greenmail)

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)

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

What are “free cash flows (FCF)”

Free cash flows are the cash flows that are:Available (or free) for distributionTo all investors (stockholders and

creditors)After paying current expenses, taxes, and

making the investments necessary for growth.

Is stock price maximization the same as profit maximization (Rev-Cost)?* Ford goes up when workers laid off.

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

Current stock price relies upon current earnings, as well as future earnings and cash flow.

Some actions may cause an increase in earnings, yet cause the stock price to decrease – risk impact (and vice versa).

What are financial assets?

A financial asset is a contract that entitles the owner to some type of payoff.DebtEquityDerivatives

In general, each financial asset involves two parties, a provider of cash (i.e., capital) and a user of cash.

What are some financial instruments?

Instrument Rate (April 2003)

U.S. T-bills 1.14%

Banker’s acceptances 1.22

Commercial paper 1.21

Negotiable CDs 1.24

Eurodollar deposits 1.23

Commercial loans Tied to prime (4.25%) or LIBOR (1.29%)

(More . .)

Financial Instruments (Continued)

Instrument Rate (April 2003)U.S. T-notes and T-bonds

5.04%Mortgages

5.57Municipal bonds

4.84Corporate (AAA) bonds

5.91Preferred stocks 6 to 9%Common stocks (expected) 9 to 15%

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

Households: Net savers Non-financial corporations: Net users

(borrowers) Governments: Net borrowers Financial corporations: Slightly net

borrowers, but almost breakeven

Direct transfer (e.g., corporation issues commercial paper to insurance company)

Through an investment banking house (e.g., IPO, seasoned equity offering, or debt placement)

Through a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company)

What are three ways that capital is transferred between savers and borrowers?

Commercial banks Savings & Loans, mutual savings banks, and

credit unions Life insurance companies Mutual funds Pension funds

What are some financial intermediaries?

Examples: Top 5 Banking Companiesin the World, 12/2001

Bank Name Country

Citigroup U.S.

Deutsche Bank AG Germany

Credit Suisse Switzerland

BNP Paribas France

Bank of America U.S.

What are some types of markets?

A market is a method of exchanging one asset (usually cash) for another asset.

Physical assets vs. financial assets (Destruction) Spot versus future markets Money (cd’s, cash, t-bills , < 1 yr) versus capital

markets (lt debt and stocks) (Duration) Primary (IPO) versus secondary markets (NYSE)

Financial Mkts ->

1.Money Mkts ->Debt and Money market instruments (T bills, 10K FV, no state taxes, up to 6 months) ** Low risk does not risk free

Risk = f(liquidity, interest rate risk, inflation risk, default risk, callability) – Show table (T-1-1-pp 14, Riskiness)

2.Capital Markets

T notes/bonds and Corp Bonds

Common stock

Preferred stock

Derivative securities

How are secondary markets organized?

By “location”Physical location exchangesComputer/telephone networks

By the way that orders from buyers and sellers are matchedOpen outcry auctionDealers (i.e., market makers)Electronic communications networks

(ECNs)

Physical Location vs. Computer/Telephone Networks

Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock Exchange

Computer/telephone: e.g., Nasdaq, government bond markets, foreign exchange markets

Auction Markets

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

NYSE is a modified auction, with a “specialist.” Participants have a seat on the exchange, meet

face-to-face, and place orders for themselves or for their clients; e.g., CBOT.

Market orders vs. limit orders

Dealer Markets

“Dealers” keep an inventory of the stock (or other financial asset) and place bid and ask “advertisements,” which are prices at which they are willing to buy and sell.

Computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers.

Examples: Nasdaq National Market, Nasdaq SmallCap Market, London SEAQ, German Neuer Markt.

Electronic Communications Networks (ECNs)

ECNs:Computerized system matches orders

from buyers and sellers and automatically executes transaction.

Examples: Instinet (US, stocks), Eurex (Swiss-German, futures contracts), SETS (London, stocks).

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, which allows potential buyers and sellers to post an offer.No dealersVery poor liquidity

What do we call the price, or cost, of debt capital? (the price for uncertainty).

The interest rate

What do we call the price, or cost, of equity capital?

Required Dividend Capital return yield gain= + .

What four factors affect the costof money?

Production opportunities Time preferences for consumption Risk Expected inflation

Real versus Nominal Rates

r* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%.

= Any nominal rate.

= Quoted Rate on Treasury securities.= r* + IP (on ST Treasuries)

r

rRF

r = r* + IP + DRP + LP + MRP.r = rf + DRP + LP + MRP.

k = k* + IP + DRP + LP + MRP k = nominal return on a debt security k* = real risk-free rate of interest: changes over time depending on

economic conditions [range of 1 to 5 percent] IP = inflation premium: equal to the average expected (not past)

inflation rate of the life of the security DRP = default risk premium: the difference between the interest rate on a

U.S. Treasury bond and a corporate bond of equal maturity and marketability LP = liquidity premium: charged for assets that cannot be converted into

cash on short notice at a reasonable price MRP = maturity risk premium: increases as bond maturity increases – due

to int. rate risk – reinvestment rate risk ~1.3%/year over past 80 years Pg 30 footnote

Premiums Added to r* for Different Types of Debt

ST Treasury: only IP for ST inflation LT Treasury: IP for LT inflation, MRP ST corporate: ST IP, DRP, LP LT corporate: IP, DRP, MRP, LP

Premiums added to k* for different types of debt

IP MRP DRP LP

S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate

What is the “term structure of interest rates”? What is a “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 can you construct a hypothetical Treasury yield curve?

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 1: Find the average expected inflation rate over years 1 to n:

n

INFLt

t = 1

nIPn = .

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%.

[{(1+r1)*…*(1+r10)}^ (1/10) ] -1 =7.495%

Pg 28 footnote

IP20 = [5 + 6 + 8(18)]/20 = 7.75%.

Must earn these IPs to break even versus inflation; that is, these IPs would permit you to earn r* (before taxes).

Step 2: Find MRP based on this equation:

MRPt = 0.1%(t - 1).

MRP1 = 0.1% x 0 = 0.0%.

MRP10 = 0.1% x 9 = 0.9%.

MRP20 = 0.1% x 19 = 1.9%.

Assume the MRP is zero for Year 1 and increases by 0.1% each year.

Step 3: Add the IPs and MRPs to r*:

rRFt = r* + IPt + MRPt .

rRF = Quoted market interestrate on treasury securities.

Assume r* = 3%:

rRF1 = 3% + 5% + 0.0% = 8.0%.rRF10 = 3% + 7.5% + 0.9% = 11.4%.rRF20 = 3% + 7.75% + 1.9% = 12.65%.

Hypothetical Treasury Yield Curve

0

5

10

15

1 10 20

Years to MaturityPg 32

InterestRate (%) 1 yr 8.0%

10 yr 11.4%20 yr 12.65%

Real risk-free rate

Inflation premium

Maturity risk premium

What factors can explain the shape of this yield curve?

This constructed yield curve is upward sloping.

This is due to increasing expected inflation and an increasing maturity risk premium.

What kind of relationship exists between the Treasury yield curve and the yield curves for corporate issues?

Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not neces-sarily parallel to the Treasury curve.

The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases (DRP factor).

Hypothetical Treasury and Corporate Yield Curves

0

5

10

15

0 1 5 10 15 20

Years tomaturity

Interest Rate (%)

5.2%5.9%

6.0%Treasuryyield curve

BB-Rated

AAA-Rated

What is the Pure Expectations Hypothesis (PEH)?

Shape of the yield curve depends on the investors’ expectations about future interest rates.

If interest rates are expected to increase, L-T rates will be higher than S-T rates and vice versa. Thus, the yield curve can slope up or down.

PEH assumes that MRP = 0.

Assumptions of the PEH

Assumes that the maturity risk premium for Treasury securities is zero.

Long-term rates are an average of current and future short-term rates.

If PEH is correct, you can use the yield curve to “back out” expected future interest rates.

What various types of risks arisewhen 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.Exchange rate risk: If investment is denominated in a currency other than the dollar, the investment’s value will depend on what happens to exchange rate.

What two factors lead to exchangerate fluctuations?

Changes in relative inflation will lead to changes in exchange rates (increased domestic inflation causes currency to lose value – foreign currency adjusts to the fact that more $’s are needed to buy the same basket – so $ would weaken).

An increase in country risk will also cause that country’s currency to fall (default premiums cause k to rise and diminishes currency value).

http://finance.yahoo.com/q/bc?s=EURUSD=X&t=5y Or FXE or FXB or FXF

HW 1

ST1, pp 42 1-1 through 1-5, pp 42