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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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