CHAPTER 1CHAPTER 1
Overview of Financial
M t d th Fi i l
1
Management and the Financial
Environment
Topics in Chapter
 Fo...
Corporate ManagerCorporate Manager
(Agent)(Agent)
Overview of Financial
Management
Multinational Corporate Balance SheetMu...
Business Organization from Start-
up to a Major Corporation
Sole proprietorship Sole proprietorship
 Partnership
 Corpo...
Starting as or Growing into a
Partnership
A partnership has roughly the same A partnership has roughly the same
advantage...
Advantages and Disadvantages of
a Corporation
 Advantages: Advantages:
 Unlimited life
 Easy transfer of ownership
 L...
Agency Problems and
Corporate Governance
 Agency problem: managers may act in their Agency problem: managers may act in ...
What three aspects of cash flows
affect an investment’s value?
Amount of expected cash flows (bigger Amount of expected c...
What is the weighted average
cost of capital (WACC)?
 WACC is the average rate of return required WACC is the average ra...
Who are the providers (savers)
and users (borrowers) of capital?
Households: Net savers Households: Net savers
 Non-fina...
Cost of Money
What do we call the price or cost of What do we call the price, or cost, of
debt capital?
 The interest ra...
What economic conditions
affect the cost of money?
 Federal Reserve policies Federal Reserve policies
 Budget deficits/...
Primary vs. Secondary
Security Sales
Primary Primary
 New issue (IPO or seasoned)
 Key factor: issuer receives the proc...
Physical Location vs.
Computer/telephone Networks
Physical location exchanges: e g Physical location exchanges: e.g.,
NYS...
Dealer Markets
 “Dealers” keep an inventory of the stock (or Dealers keep an inventory of the stock (or
other financial ...
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ch 01; overview and fin environment

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Fundamentals of corporate finance

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ch 01; overview and fin environment

  1. 1. CHAPTER 1CHAPTER 1 Overview of Financial M t d th Fi i l 1 Management and the Financial Environment Topics in Chapter  Forms of business organization Forms of business organization  Objective of the firm: Maximize wealth  Determinants of fundamental value  Financial securities, markets and institutions 2
  2. 2. Corporate ManagerCorporate Manager (Agent)(Agent) Overview of Financial Management Multinational Corporate Balance SheetMultinational Corporate Balance Sheet AssetsAssets LiabilitiesLiabilities Short Term Short TermShort Term Short Term Current AssetsCurrent Assets Current LiabilitiesCurrent Liabilities Long TermLong Term Long TermLong Term LandLand DebtDebt PlantPlant Preferred StockPreferred Stock Financial MarketFinancial Market Corporate /Corporate / GovtGovt SecuritiesSecurities BondsBonds PreferredPreferred StockStock Product MarketProduct Market Cash OutlayCash Outlay Cash RevenueCash Revenue Cash ExpenseCash Expense Net Cash FlowsNet Cash Flows (Agent)(Agent) EquipmentEquipment Equity (Owner)Equity (Owner) Shareholder’s Wealth MaximizationShareholder’s Wealth Maximization (Agency Problems)(Agency Problems) Capital BudgetingCapital Budgeting Maximize:Maximize: NPV / IRRNPV / IRR Cost of CapitalCost of Capital Minimize:Minimize: Cost of DebtCost of Debt Cost of PreferredCost of Preferred Cost of EquityCost of Equity Why is corporate finance important to all managers? Corporate finance provides the skills Corporate finance provides the skills managers need to:  Identify and select the corporate strategies and individual projects that add value to their firm. f f 4  Forecast the funding requirements of their company, and devise strategies for acquiring those funds.
  3. 3. Business Organization from Start- up to a Major Corporation Sole proprietorship Sole proprietorship  Partnership  Corporation 5 Starting as a Proprietorship  Advantages: Advantages:  Ease of formation  Subject to few regulations  No corporate income taxes  Disadvantages: f 6  Limited life  Unlimited liability  Difficult to raise capital to support growth
  4. 4. Starting as or Growing into a Partnership A partnership has roughly the same A partnership has roughly the same advantages and disadvantages as a sole proprietorship. 7 Becoming a Corporation A corporation is a legal entity separate A corporation is a legal entity separate from its owners and managers.  File papers of incorporation with state.  Charter  Bylaws 8 Bylaws
  5. 5. Advantages and Disadvantages of a Corporation  Advantages: Advantages:  Unlimited life  Easy transfer of ownership  Limited liability  Ease of raising capital Di d t 9  Disadvantages:  Double taxation  Cost of set-up and report filing Becoming a Public Corporation and Growing Afterwards Initial Public Offering (IPO) of Stock 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 10 q q y
  6. 6. Agency Problems and Corporate Governance  Agency problem: managers may act in their Agency problem: managers may act in their own interests and not on behalf of owners (stockholders)  Corporate governance is the set of rules that control a company’s behavior towards its directors, managers, employees, shareholders creditors customers 11 shareholders, creditors, customers, competitors, and community.  Corporate governance can help control agency problems. What should be management’s primary objective? The primary objective should be The primary objective should be shareholder wealth maximization, which translates to maximizing the fundamental stock price. 12
  7. 7. What three aspects of cash flows affect an investment’s value? Amount of expected cash flows (bigger 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 13  Risk of the cash flows (less risk is better) Free Cash Flows (FCF) Free cash flows are the cash flows that Free cash flows are the cash flows that are available (or free) for distribution to all investors (stockholders and creditors).  FCF = sales revenues - operating costs 14 p g - operating taxes - required investments in operating capital.
  8. 8. What is the weighted average cost of capital (WACC)?  WACC is the average rate of return required WACC is the average rate of return required by all of the company’s investors.  WACC is affected by:  Capital structure (the firm’s relative amounts of debt and equity)  Interest rates 15  Interest rates  Risk of the firm  Investors’ overall attitude toward risk What determines a firm’s fundamental, or intrinsic, value? Intrinsic value is the sum of all the future expected free cash flows when converted into today’s dollars: Value = FCF1 FCF2 FCF∞+ +… 16 Value = (1 + WACC)1 (1 + WACC)∞(1 + WACC)2
  9. 9. Who are the providers (savers) and users (borrowers) of capital? Households: Net savers Households: Net savers  Non-financial corporations: Net users (borrowers)  Governments: Net borrowers  Financial corporations: Slightly net 17  Financial corporations: Slightly net borrowers, but almost breakeven Transfer of Capital from Savers to Borrowers  Direct transfer (e g corporation issues 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 18  Through a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company)
  10. 10. Cost of Money What do we call the price or cost of What do we call the price, or cost, of debt capital?  The interest rate  What do we call the price, or cost, of equity capital? 19 q y p  Cost of equity = Required return = dividend yield + capital gain What four factors affect the cost of money? Production opportunities Production opportunities  Time preferences for consumption  Risk  Expected inflation 20
  11. 11. What economic conditions affect the cost of money?  Federal Reserve policies Federal Reserve policies  Budget deficits/surpluses  Level of business activity (recession or boom)  International trade deficits/surpluses 21 Financial Securities Debt Equity Derivatives Money Market •T-Bills •CD’s •Eurodollars •Fed Funds •Options •Futures •Forward contract Capital Market •T-Bonds •Agency bonds •Common stock •LEAPS 22 Market •Agency bonds •Municipals •Corporate bonds stock •Preferred stock •Swaps
  12. 12. Primary vs. Secondary Security Sales Primary Primary  New issue (IPO or seasoned)  Key factor: issuer receives the proceeds from the sale.  Secondary 23 y  Existing owner sells to another party.  Issuing firm doesn’t receive proceeds and is not directly involved. How are secondary markets organized?  By “location” By location  Physical location exchanges  Computer/telephone networks  By the way that orders from buyers and sellers are matched Open outcry auction 24  Open outcry auction  Dealers (i.e., market makers)  Electronic communications networks (ECNs)
  13. 13. Physical Location vs. Computer/telephone Networks Physical location exchanges: e g Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock Exchange  Computer/telephone: e.g., Nasdaq, government bond markets, foreign 25 g , g exchange markets Auction Markets  Participants have a seat on the exchange Participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients; e.g., CBOT.  NYSE and AMEX are the two largest auction markets for stocks. NYSE is a modified auction with a 26  NYSE is a modified auction, with a “specialist.”
  14. 14. Dealer Markets  “Dealers” keep an inventory of the stock (or 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.  Often many dealers for each stock  Computerized quotation system keeps track of bid and ask prices, but does not 27 p , automatically match buyers and sellers.  Examples: Nasdaq National Market, Nasdaq SmallCap Market, London SEAQ, German Neuer Markt. Over the Counter (OTC) Markets  In the old days securities were kept in a safe 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 (e.g., Nasdaq Pink Sheets) which allows potential buyers and 28 Sheets), which allows potential buyers and sellers to post an offer.

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