Ch01 Show Rev 1.pptx

8/12/2019 Ch01 Show Rev 1.pptx

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CHAPTER 1

Overview of Financial

Management and the FinancialEnvironment


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Topics in Chapter Forms of business organization

Objective of the firm: Maximize wealth

Determinants of fundamental value

Financial securities, markets and institutions


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Why is Corporate Finance

Important to all Managers?

Corporate finance provides the skillsmanagers need to:

Identify and select the corporate strategiesand individual projects that add value totheir firm.

Forecast the funding requirements of theircompany, and devise strategies foracquiring those funds.


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Business Organization from

Start-up to a Major Corporation

Sole proprietorship

Partnership

Corporation


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Starting as a Proprietorship

Advantages:

Ease of formation

Subject to few regulations

No corporate income taxes

Disadvantages:

Limited life Unlimited liability

Difficult to raise capital to support growth


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Starting as, or Growing into,a Partnership

A partnership has roughly the sameadvantages and disadvantages as a sole

proprietorship. Another advantage: Partners back each

other up.

Another disadvantage: Major decisionsrequire agreement between partners

Strategy

Financing

Sale of business


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Becoming a Corporation

A corporation is

a legal entity

separate from its owners and managers.

Must file papers of incorporation with a state.

Charter

Bylaws


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Advantages and Disadvantagesof a 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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Becoming a Public Corporation,and Growing Afterwards

Initial Public Offering (IPO) of Stock

Raises cash

Allows founders and pre-IPO investors toharvest some of their wealth

Subsequent issues of debt and equity

Equity issue after IPO is called a seasoned issue

Mix of debt and equity is called the firms capitalstructure

Most companies try to maintain a fairly constant capitalstructure


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Agency Problemsand Corporate Governance

Agency problem: Managers may act in their own interests and not

on behalf of owners (stockholders)

Corporate governance: Set of rules that control a companys behavior

towards its directors, managers, employees,

shareholders, creditors, customers, competitors,and community.

Corporate governance can help controlagency problems.


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What should be ManagementsPrimary Objective?

Primary Objective should be shareholderwealth maximization

translates to maximizing the fundamental stockprice.

Should firms behave ethically? YES!

Do firms have any responsibilities to societyat large? YES!

Shareholders are also members of society.


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Is Maximizing Stock Price Good forSociety, 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)

were once owned by the government, but were sold

to private investors, i.e., privatized

(More . . .)


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Is Maximizing Stock Price Good?(cond)

Consumer welfare is higher in capitalist freemarket economies than in communist or

socialist economies. Fortunelists themost admired firms. In

addition to high stock returns, these firmshave:

high quality from customers view employees who like working there


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What Three Aspects of Cash Flows

Affect an InvestmentsValue?

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


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Free Cash Flows (FCF)

Definition: The cash flows that are available(or free) for distribution to all investors

includes both stockholders and creditors

FCF = Sales revenues

- operating costs- operating taxes

- reqdinvestment in operating capital


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What is the Weighted AverageCost of Capital (WACC)?

WACC is the weighted average rate of returnrequired by all of the companys investors

WACC is affected by:

Risk of the firms core business

Capital structure (the firms relative use of debt

and equity for financing) Interest rates

Investors overall attitude toward risk


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What Determines a FirmsFundamental, or Intrinsic, Value?

Definition: Intrinsic value is the sum of all thefuture expected free cash flows, when converted

into todaysdollars:

Value = + + +

FCF1 FCF2 FCF

(1 + WACC)1 (1 + WACC)(1 + WACC)2

(More . .)


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Value = + + +FCF1 FCF2 FCF

(1 + WACC)1 (1 + WACC)(1 + WACC)2

Free cash flow(FCF)

Market interest rates

Firms business riskMarket risk aversion

Firms debt/equity mixCost of debt

Cost of equity

Weighted average

cost of capital(WACC)

Sales revenues

Operating costs and taxes

Required investments in operating capital

=

Determinants of Intrinsic Value: The Big Picture

...


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Who are the Providers (savers)and Users (borrowers) of Capital?

Households: Net savers

Non-financial corporations: Net users (borrowers)

Financial corporations: Slightly net users (borrowers), but almost breakeven

Governments: U.S. government(s) are net borrowers

Some foreign governments are net savers


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How does Capital Transferfrom Savers to Borrowers?

Direct transfer A corporation issues commercial paper to an

insurance company.

Through an investment banking house In an IPO, seasoned equity offering, or debt

placement, company sells security to investmentbanking house, which then sells security to investor.

Through a financial intermediary An individual deposits money in bank, or buys a

certificate of deposit (CD)

bank makes commercial loan to a company (bank

gets a note from company).


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The Cost of Money(Yes! Money costs Money!)

What do we call the price, or cost, of debtcapital?

The interest rate

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

capital?

Cost of equity = required return= dividend yield + capital gain


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What Four FactorsAffect the Cost of Money?

Production opportunities

Ability to turn capital into benefits

Time preference for consumption

Immediate vs deferred consumption (saving)

Risk vs reward

Expected inflation


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What Economic ConditionsAffect the Cost of Money?

Federal Reserve policies

Government budget deficits/surpluses

Level of business activity (recession or boom)

International trade deficits/surpluses


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What International ConditionsAffect the Cost of Money?

Country risk

Depends on the countrys economic, political, and

social environment. Exchange rate risk

Non-dollar denominated investments valuedepends on what happens to exchange rate.

Exchange rates affected by:

International trade deficits/surpluses

Relative inflation and interest rates

Country risk

More . . .


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Types of Financial Securities

Debt Equity Derivatives

MoneyMarket

T-BillsCDsEurodollarsFed Funds

OptionsFuturesForwardcontract

CapitalMarket

T-BondsAgency bondsMunicipalsCorporate bonds

CommonstockPreferred stock

LEAPSSwaps


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Financial Securities:Typical Rates of Return

Instrument Rate (January 2009)

U.S. Treasury bills 0.41%

Bankers acceptances 5.28

Commercial paper 0.28

Negotiable CDs 1.58

Eurodollar deposits 2.60Commercial loans:

Tied to prime 3.25 +

or LIBOR 2.02 + (More . .)


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Financial Securities:

Typical Rates of Return(cond)

Instrument Rate (January 2009)

U.S. Treasury notes and bonds 3.04%

Mortgages 5.02

Municipal bonds 4.39

Corporate (AAA) bonds 5.03

Preferred stocks 6% to 9%

Common stocks (expected) 9% to 15%


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What are SomeTypes of Markets?

What is a market ?

A method of exchanging one asset (usually cash,or equivalent) for another asset.

Physical assets vs. financial assets

Spot vs. future markets

Money vs. capital markets Primary vs. secondary markets

More . . .


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Primary vs. SecondarySecurity Sales

Primary

New issue (either an IPO or a seasoned offering)

Key determinant: Issuer receives the proceedsfrom the sale.

Secondary

Existing security owner sells to another party. Original issuing firm does not receive proceeds,

and is not directly involved.


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How areSecondary Markets Organized?

By location

Physical location exchanges

Computer/telephone networks

By the way that orders from buyers andsellers are matched

Open outcry auction

Dealers (i.e., market makers who own securities)

Electronic communications networks (ECNs)

More . . .


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Physical Location vs.Computer/Telephone Networks

Physical location exchanges

New York Stock Exchange (NYSE)

American Stock Exchange (AMEX) (Chicago Board of Trade (CBOT)

Tokyo Stock Exchange

Computer/telephone

Nasdaq

Government bond markets

Foreign exchange markets

More . . .


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Types of Orders

Instructions on how a transaction is to becompleted

Market Order Transact as quickly as possible at current price

Limit Order

Transact only if specific situation occurs.

For example, only buy if the price drops to $50 or belowduring the next two hours.

More . . .


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What are Auction Markets?

Participants have a seat on an exchange

Meet face-to-face

Place orders for themselves, or for their clients

NYSE and AMEX are the two largest auctionmarkets for stocks

NYSE is a modified auction, with a specialist. CBOT also an auction exchange


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What areOver-the-Counter (OTC) Markets?

In theold days, securities were kept in asafe behind the counter

They were passedover the counter when theywere sold. Hence, the name . . .

Now the OTC market is the equivalent of acomputer bulletin board (e.g., Nasdaq Pink

Sheets) Allows potential buyers and sellers to post an offer

There are no dealers

Securities have very poor liquidity


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Thats All for Today !

Next class:

Test No. 1 on Chapter 1 (just what wecovered in class)

Read Chapter 2, and work on assignedhomework problems

PPT slides will be e-mailed tomorrow.

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Ch01 Show Rev 1.pptx