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CHAPTER 1Overview of Financial Management

and the Financial Environment

Financial management

Forms of business organization

Objective of the firm: Maximize wealth

Determinants of stock pricing

The financial environmentFinancial instruments, markets and

institutions

Interest rates and yield curves

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Why is corporate finance important to

all managers?

Corporate finance provides the skillsmanagers need to:

Identify and select the corporatestrategies and individual projectsthat add value to their firm.

Forecast the funding requirementsof their company, and devisestrategies for acquiring thosefunds.

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Sole proprietorship

Partnership

Corporation

What are some forms of business

organization a company might have asit evolves from a start-up to a major

corporation?

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Advantages:

Ease of formation

Subject to few regulations

No corporate income taxes

Disadvantages:

Limited life

Unlimited liability

Difficult to raise capital to supportgrowth

Starting as a Sole Proprietorship

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B

ecoming a Corporation

A corporation is a legal entityseparate from its owners and

managers.

File papers of incorporation withstate.

Charter

Bylaws

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Advantages:

Unlimited life

Easy transfer of ownership

Limited liability

Ease of raising capitalDisadvantages:

Double taxation

Cost of set-up and report filing

Advantages and Disadvantages of a

Corporation

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Becoming a Public Corporation and

Growing Afterwards

Initial Public Offering (IPO) ofStock

Raises cash

Allows founders and pre-IPO investorsto harvest some of their wealth

Subsequent issues of debt and equity

Agency problem: managers may act intheir own interests and not on behalf ofowners (stockholders)

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The primary objective should beshareholder wealth maximization,

which translates to maximizing stockprice.

Should firms behave ethically? YES!

Do firms have any responsibilities tosociety at large?YES! Shareholdersare also members of society.

What should managements primary

objective be?

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Is maximizing stock price good for

society, employees, and customers?

Employment growth is higher in firmsthat try to maximize stock price. On

average, employment goes up in:

firms that make managers intoowners (such as LBO firms)

firms that were owned by thegovernment but that have been soldto private investors

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Consumer welfare is higher incapitalist free market economiesthan in communist or socialisteconomies.

Fortune lists the most admired firms.In addition to high stock returns,these firms have:

high quality from customers view

employees who like working there

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Amount of expected cash flows(bigger is better)

Timing of the cash flow stream(sooner is better)

Risk of the cash flows (less risk isbetter)

What three aspects of cash flows

affect an investments value?

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What are free cash flows (FCF)

Free cash flows are the cash flowsthat are:

Available (or free) for distribution

To all investors (stockholders andcreditors)

After paying current expenses,taxes, and making the investmentsnecessary for growth.

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Determinants of Free Cash Flows

Sales revenues

Current level

Short-term growth rate in sales

Long-term sustainable growth rate insales

Operating costs (raw materials, labor,

etc.) and taxesRequired investments in operations

(buildings, machines, inventory, etc.)

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What is 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 companysinvestors (stockholders andcreditors)

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What factors affect the weighted

average cost of capital?

Capital structure (the firms relativeamounts of debt and equity)

Interest rates

Risk of the firm

Stock market investors overallattitude toward risk

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What determines a firms value?

A firms value is the sum of all thefuture expected free cash flows when

converted into todays dollars:

g

g

!

)WACC1(

FCF....

)WACC1(

FCF

)WACC1(

FCFValue

2

2

1

1

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What are financial assets?

A financial asset is a contract thatentitles the owner to some type ofpayoff.

Debt

Equity

Derivatives

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

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

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

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

What are three ways that capital is

transferred between savers and

borrowers?

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Commercial banks

Savings & Loans, mutual savingsbanks, and credit unions

Life insurance companies

Mutual funds

Pension funds

What are some financial intermediaries?

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What are some types of markets?

A market is a method ofexchanging one asset (usuallycash) for another asset.

Physical assets vs. financial assets

Spot versus future markets

Money versus capital markets

Primary versus secondary markets

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Dealer Markets

Dealers keep an inventory of the stock (orother financial asset) and place bid and askadvertisements, which are prices at

which they are willing to buy and sell.

Computerized quotation system keepstrack of bid and ask prices, but does notautomatically match buyers and sellers.

Examples: Nasdaq National Market, NasdaqSmallCap Market, London SEAQ, GermanNeuer Markt.

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Electronic Communications Networks

(ECNs)

ECNs:

Computerized system matchesorders from buyers and sellersand automatically executestransaction.

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

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Over the Counter (OTC) Markets

In the old days, securities were keptin a safe behind the counter, andpassed over the counter when they

were sold.Now the OTC market is the equivalent

of a computer bulletin board, whichallows potential buyers and sellers to

post an offer.No dealers

Very poor liquidity

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What do we call the price, or cost,ofdebt capital?

The interest rate

What do we call the price, or cost,ofequity capital?

Required Dividend Capitalreturn yield gain

= + .

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What four factors affect the cost

of money?

Production opportunities

Time preferences for consumption

Risk

Expected inflation