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# Chapter 1

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• When r is greater than the coupon interest rate, P 0 will be less than par value, and the bond will sell at a discount For Sun, if r &gt; 5%, P 0 will be less than \$1,000 For practice: Value Sun Company, 10-year, 5% coupon rate bond if required return, r =6% and again if r = 4%. Premiums &amp; discounts change systematically as r changes.
• -Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P 0 and hold it until maturity. The YTM on a bond selling at par ( P 0 = Par ) will always equal the coupon interest rate. When P 0  Par , the YTM will differ from the coupon rate. YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P 0 , CFs, n known, can find YTM Use T-Bond with n=2 years, 2n=4, C/2=\$20, P 0 =\$992.43
• Value of any financial asset is the PV of future cash flows Bonds: PV of promised interest &amp; principal payments Stocks: PV of all future dividends Patents, trademarks: PV of future royalties Valuation is the process linking risk &amp; return Output of process is asset’s expected market price A key input is the required [expected] return on an asset Defined as the return an arms-length investor would require for an asset of equivalent risk Debt securities: risk-free rate plus risk premium(s) Required return for stocks found using CAPM or other asset pricing model Beta determines risk premium: higher beta, higher reqd return
• -Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P 0 and hold it until maturity. The YTM on a bond selling at par ( P 0 = Par ) will always equal the coupon interest rate. When P 0  Par , the YTM will differ from the coupon rate. YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P 0 , CFs, n known, can find YTM Use T-Bond with n=2 years, 2n=4, C/2=\$20, P 0 =\$992.43
• The relationship between nominal (observed) and real (inflation-adjusted) interest rates and expected inflation called the Fisher Effect (or Fisher Equation) Fisher said the nominal rate ( r ) is approximately equal to the real rate of interest ( a ) plus a premium for expected inflation ( i ). If real rate equals 3% (a = 0.03) and expected inflation equals 2% (i = 0.02): r  a + i  0.03 + 0.02  0.05  5% The true Fisher Effect is multiplicative, rather than additive: (1+r) = (1+a)(1+i) = (1.03)(1.02) = 1.0506; so r = 5.06%
• ### Transcript

• 1. CHAPTER 1 Introduction to Financial Management <ul><li>Forms of Businesses </li></ul><ul><li>Goals of the Corporation </li></ul><ul><li>Stock Prices and Intrinsic Value </li></ul><ul><li>Some Recent Trends </li></ul><ul><li>Conflicts Between Managers and Shareholders </li></ul>
• 2. Finance Career Opportunities Corporate Finance <ul><li>Budgeting, financial forecasting, cash management, credit administration, investment analysis, fund procurement </li></ul>Commercial Banking <ul><li>Consumer banking </li></ul><ul><li>Corporate banking </li></ul>Investment Banking <ul><li>High income potential </li></ul><ul><li>Very competitive industry </li></ul>Money Management <ul><li>Opportunities in investment advisory firms, mutual fund companies, pension funds, investment arms of financial departments </li></ul>Consulting <ul><li>Advise on business practices and strategies of corporate clients </li></ul>
• 3. Video: Cole, Haines, & Eckmann Smart Finance
• 4. Corporate Finance Functions <ul><ul><li>Corporate Finance Functions </li></ul></ul>Financial Management External Financing Capital Budgeting Risk Management Corporate Governance
• 5. The Capital Budgeting Function Select investments for which the marginal benefits exceed the marginal costs . Capital Budgeting – the process firms use to choose the set of investments that generate the most wealth for shareholders
• 6. The Risk Management Function Managing the firm’s exposure to significant risks: Interest rate risk Exchange rate risk Commodity price risk
• 7. Dimensions of the External Financing Function Equity vs. debt Funding via capital market vs. via financial intermediary Public vs. private capital markets Going public
• 8. The Financial Management Function Managing daily cash inflows and outflows Forecasting cash balances Building long-term financial plans Choosing the right mix of debt and equity
• 9. What Should Managers Maximize? <ul><li>Profit maximization as goal: </li></ul><ul><ul><li>Does not account for timing of returns </li></ul></ul><ul><ul><li>Profits - not necessarily cash flows </li></ul></ul><ul><ul><li>Ignores risk </li></ul></ul>Maximize shareholder wealth <ul><li>Maximize stock price, not profits </li></ul><ul><li>Accounts for risk </li></ul><ul><li>As “residual claimants,” shareholders have better incentives to force management to maximize firm value than do other stakeholders. </li></ul>
• 10. The Corporate Governance Function Ensuring that managers pursue shareholders’ objectives Takeover market disciplines firms that don’t govern themselves. Dimensions of corporate governance <ul><li>Boards of directors </li></ul><ul><li>Ownership structures </li></ul><ul><li>Capital structures </li></ul><ul><li>Compensation plans </li></ul><ul><li>Country’s legal environment - in U.S., Sarbanes-Oxley Act of 2002 </li></ul>
• 11. Video: Nickel Smart Finance
• 12. Agency Costs In Corporate Finance <ul><ul><li>Divergence between interests of managers and shareholders—called agency costs </li></ul></ul>Due to separation of ownership and control Ways to deal with agency costs <ul><ul><li>Possibility of takeover </li></ul></ul><ul><ul><li>Monitoring and bonding </li></ul></ul><ul><ul><li>Compensation contracts </li></ul></ul><ul><ul><li>Controversial method: executive compensation </li></ul></ul><ul><ul><ul><li>Average pay in 2003 for CEOs of large U.S. companies: \$8.1 million </li></ul></ul></ul>
• 13. Forms Of Business Organization In The U.S. Proprietorship <ul><li>No distinction between business and person </li></ul><ul><li>Easy to set up, operate; taxed as personal income </li></ul><ul><li>Personal liability, limited life, difficult to transfer </li></ul>Partnership <ul><li>Two or more business owners </li></ul><ul><li>Partners - liable for every other partner’s actions </li></ul> Limited Partnership <ul><li>One general & many limited partners </li></ul><ul><li>Limited liability of corporation,tax benefits of partnership </li></ul><ul><li>Real-estate, R&D companies </li></ul>
• 14. Forms Of Business Organization - Corporations The Job and Growth Tax Relief Reconciliation Act of 2003 reduced the double taxation problem. What was the major weakness for corporations before passage of the Tax Relief Act of 2003? Double taxation Corporation <ul><li>Legal entity with all the economic rights and responsibilities of a person </li></ul><ul><li>Incorporation occurs at state level; based on state law </li></ul><ul><li>Strengths - limited liability to investors, unlimited business life </li></ul>
• 15. Video: Bryant Smart Finance