Overview of Intermediate Financial Management

1. Overview of Intermediate Financial Management Fundamental Concepts of Corporate Finance (I & II) Corporate Valuation (I & II) Strategic Financing Decisions Tactical Financing Decisions Working Capital Management Special Topics 1

2. Chapter 1 Fundamental Concepts of Corporate Finance ( I ) Forms of business organization Objective of the firm: Maximize wealth Determinants of fundamental value Financial securities, markets and institutions 2

3. Business Organization from Start-up to a Major Corporation 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 Starting as or growing into a Partnership • A partnership has roughly the same advantages and disadvantages as a sole proprietorship.

4. Business Organization from Start-up to a Major Corporation Becoming a Corporation • A corporation is a legal entity separate from its owners and managers. • File papers of incorporation with state. • Charter • Bylaws • Advantages: • Unlimited life • Easy transfer of ownership • Limited liability • Ease of raising capital • Disadvantages: • Double taxation • Cost of set-up and report filing

5. Business Organization from Start-up to a Major Corporation Becoming a Public Corporation and Growing Afterwards • Initial Public Offering (IPO) of Stock • Raises cash • Allows founders and pre-IPO investors to “harvest” some of their wealth • Dynamics of debt and equity • Debt structure • SEO and equity structure • Firm restructuring • M&A • Divestitures • MBOs • Privatization

6. Objective of the Firm: Maximize Wealth? • The primary objective should be shareholder wealth maximization, which translates to maximizing stock price. • Should firms behave ethically? YES! • Do firms have any responsibilities to society at large? YES! Shareholders are also members of society.

7. Objective of the Firm: Maximize Wealth? Is maximizing stock price good for society, 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) • firms that were owned by the government but that have been sold to private investors

8. What is an agency relationship? An agency relationship arises whenever one or more individuals, called principals, (1) hires another individual or organization, called an agent, to perform some service and (2) then delegates decision-making authority to that agent.

9. Cause Agency Problems? If you are the only employee, and only your money is invested in the business, would any agency problems exist? No agency problem would exist. A potential agency problem arises whenever the manager of a firm owns less than 100 percent of the firm’s common stock, or the firm borrows. You own 100 percent of the firm.

10. Cause Agency Problems? Might acquiring capital lead to agency problems? • If you needed additional capital to buy computer inventory or to develop software then you might end up with agency problems if the capital is acquired from outside investors.

11. Cause Agency Problems? Does the source of the capital affect agency problems? Agency problems are less for secured than for unsecured debt, and different between stockholders and creditors. So it matters whether the new capital comes in the form of an unsecured bank loan, a bank loan secured by your inventory of computers, or from new stockholders.

12. Two Potential Agency Conflicts in Business • Conflicts between stockholders and managers. • Conflicts between stockholders and creditors.

13. Conflicts between Stockholders and Managers Why might you want make your financial statements look artificially good? A manager might inflate a firm's reported earnings or make its debt appear to be lower if he or she wanted the firm to look good temporarily. For example just prior to exercising stock options or raising more debt.

14. Conflicts between Stockholders and Managers What are the potential consequences of inflating earnings or hiding debt? If the firm is publicly traded, the stock price will probably drop once it is revealed that fraud has taken place. If private, banks may be unwilling to lend to it, and investors may be unwilling to invest more money.

15. Cause Agency Problems? Would expansion increase or decrease potential agency problems? Increase. If you expanded to additional locations you could not physically be at all locations at the same time. Consequently, you would have to delegate decision-making authority to others.

16. Conflicts between Stockholders and Bondholders What actions might make a loan feasible? Creditors can protect themselves by (1) having the loan secured and (2) placing restrictive covenants in debt agreements. They can also charge a higher than normal interest rate to compensate for risk.

17. Reduce Agency Problems? What actions might mitigate your agency problems if you expanded beyond your home campus? • Structuring compensation packages to attract and retain able managers whose interests are aligned with yours. • Threat of firing. • Increase “monitoring” costs by making frequent visits to “off campus” locations. (More…)

18. Reduce Agency Problems? Would going public in an IPO increase or decrease agency problems? By going public through an IPO, your firm would bring in new shareholders. This would increase agency problems, especially if you sell most of your stock and buy a yacht. You could minimize potential agency problems by staying on as CEO and running the company.

19. Reduce Agency Problems? What kind of compensation program might you use to minimize agency problems? • “Reasonable” annual salary to meet living expenses • Cash (or stock) bonus • Options to buy stock or actual shares of stock to reward long-term performance • Tie bonus/options to EVA

20. Factors of Investment Value What three aspects of cash flows affect an investment’s value? • 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)

21. Free Cash Flows (FCF) • 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 - operating taxes - required investments in operating capital.

22. What is the weighted average cost of capital (WACC)? • 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 use of debt and equity as sources of financing) • Interest rates • Risk of the firm • Investors’ overall attitude toward risk

23. FCF1 FCF2 FCF∞ Value = + + … + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞ General Formula 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: See “big picture” diagram on next slide. (More . .)

24. Determinants of Intrinsic Value: The Big Picture Sales revenues Operating costs and taxes − Required investments in operating capital − Free cash flow (FCF) = FCF1 FCF2 FCF∞ ... Value = + + + (1 + WACC)2 (1 + WACC)∞ (1 + WACC)1 Weighted average cost of capital (WACC) Market interest rates Firm’s debt/equity mix Cost of debt Cost of equity Market risk aversion Firm’s business risk

25. What economic conditions affect the cost of money? • Federal Reserve policies • Budget deficits/surpluses • Level of business activity (recession or boom) • International trade deficits/surpluses

26. Financial Securities