Lecture 1 - Overview of Financial Management and the Financial Environment

1. Lecture 1 - Overview of Financial Management and the Financial Environment

2. Why is Corporate Finance Important to All Managers? • Corporate finance provides the skills managers need to: • Identify and select the corporate strategies and individual projects that add value to their firm. • Forecast the funding requirements of their company, and devise strategies for acquiring those funds

3. What Should Management’s Primary Objective Be? • The primary objective should be shareholder wealth maximization, which usually 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.

4. Shareholder Wealth Maximization • Considers the timing and risk of the benefits from stock ownership • Determines that a good decision increases the price of the firm's common stock ( c/s ) • Is an impersonal objective • Is concerned for social responsibility Social Responsibility • Ethical issues will constantly confront financial managers as they achieve the goal of the firm ( SWM ). Managers Must: • Avoid personal conflicts • Maintain confidentiality • Be objective • Act fairly

5. Maximizing Stock Price – Is it 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 • What about SOEs?

6. What Three Aspects of Cash Flows Affect an Investment’s Value? • Amountof expected cash flows (bigger is better) • Timing of the cash flow stream (sooner is better) • Risk of the cash flows (less risk is better)

7. What are “Free Cash Flows (FCF)” • Free cash flows are the cash flows that are: • Available (or free) for distribution to all investors (stockholders and creditors) after paying current expenses, taxes, and making the investments necessary for growth. • Free cash flows are determined by: • Sales revenues • Current level • Short-term growth rate in sales • Long-term sustainable growth rate in sales • Operating costs (raw materials, labor, etc.) and taxes • Required investments in operations (buildings, machines, inventory, etc.)

8. The Weighted Average Cost of Capital (WACC) • The weighted average cost of capital (WACC) is the average rate of return required by all of the company’s investors (stockholders and creditors) • The weighted average cost of capital is affected by: • Capital structure (the firm’s relative amounts of debt and equity) • Interest rates • Risk of the firm • Stock market investors’ overall attitude toward risk

9. FCF1 FCF2 FCF∞ + +… Value = (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞ What Determines a Firm’s Value? • A firm’s value is the sum of all the future expected free cash flows when converted into today’s dollars:

10. Determinants of Intrinsic Value and Stock Prices

11. Different Definitions of Value • Intrinsic value • Stock valuation based on an individual’s expected free cash flows • Market value • Market price is the value quoted in the market. • Based on aggregate market’s expectations and is set by the marginal investor. It is the marginal investor’s intrinsic value. • Fundamental Value • This is the intrinsic value an analyst would calculate given complete and accurate information about a company’s expected future free cash flows and risk. • Also called true intrinsic value. • Market value may not equal fundamental value over short term, but will tend towards it over the long term.

12. Short-Term vs. Long-Term Price • Management can impact the market price over the short term by releasing incomplete or inaccurate information. • Over the long term the market price will tend towards the fundamental value as more information becomes available. What about the recent financial crisis? Credit Crisis Explained

13. Financial Assets or Instruments • A financial asset is a contract that entitles the owner to some type of payoff. • Debt • Equity • Derivatives - a security, such as an option or futures contract, whose value depends on the performance of an underlying security or asset. • In general, each financial asset involves two parties, a provider of cash (i.e., capital) and a user of cash. • Give examples of financial assets or instruments

14. Transfer of Funds from Surplus to Deficit Spending Units

16. How to Become a Public Corporation and Keep Growing Afterwards • 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 • Agency problem: managers may act in their own interests and not on behalf of owners (stockholders)

17. 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. • 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

18. An agency relationship could exist between you and your employees if you, the principal, hired the employees to perform some service and delegated some decision-making authority to them. • 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. • Agency problems are less for secured than for unsecured debt, and different between stockholders and creditors. • 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.

19. Two Potential Agency Conflicts • Conflicts between stockholders and managers. • Compensation • Direct intervention • Threat of firing • Hostile Takeovers • Conflicts between stockholders and creditors. Question: Would expansion increase or decrease potential agency problems?

20. What Actions Might Make a Loan Feasible? Creditors can protect themselves by (1) having the loan secured and (2) placing restrictive covenantsin debt agreements. They can also charge a higher than normal interest rateto compensate for risk. • 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. What actions might mitigate your agency problems if you expanded beyond your home campus?

21. Why Might You Want to 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. 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.

22. 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 value of the company

23. Transparency in Financial Reporting Transparency requires that market participants have reliable, accurate information about a particular company. • An act passed in 2002 that established new regulations for auditors, corporate officers, and securities analysts. • The goal was to make it less likely that companies and securities analysts would mislead investors, and increase the penalties for doing so. Sarbanes-Oxley (USA)

24. Asymmetric Information:  Adverse Selection and Moral Hazard • Adverse Selection • Before transaction occurs - Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected • Due to Asymmetric Information:   • Moral Hazard • After transaction occurs - Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back • Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

25. Factors that Affect the Cost of Money The Price, or Cost, of Debt Capital is Called The Interest Rate The Price, or Cost, of Equity Capital is Required Dividend Capital return yield gain = + • Production opportunities • Time preferences for consumption • Risk • Expected inflation

26. = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. r* r or i rRF r = r* + IP + DRP + LP + MRP Real versus Nominal Rates Here: r = Required rate of return on a debt security. r* = Real risk-free rate. IP = Inflation premium. DRP = Default risk premium. LP = Liquidity premium. MRP = Maturity risk premium.

27. The Term Structure of Interest Rates and the Yield Curve • Term structure: the relationship between interest rates (or yields) and maturities. • A graph of the term structure is called the yield curve. How to Construct a Yield Curve • Step 1: Estimate the inflation premium (IP) for each future year. This is the estimated average inflation over that time period. • Step 2: Estimate the maturity risk premium (MRP) for each future year. • Step 3: Add to r*

28. Assume investors expect inflation to be 5% next year, 6% the following year, and 8% per year thereafter. Step 1: Find the average expected inflation rate over years 1 to n: n INFLt t = 1 n IPn = IP1 = 5%/1.0 = 5.00%. IP10 = [5 + 6 + 8(8)]/10 = 7.5%. IP20 = [5 + 6 + 8(18)]/20 = 7.75%. Must earn these IPs to break even versus inflation; that is, these IPs would permit you to earn r* (before taxes).

29. Step 2: Find MRP based on this equation: Assume the MRP is zero for Year 1 and increases by 0.1% each year. MRPt = 0.1%(t - 1). MRP1 = 0.0%. MRP10 = 0.1% x 9 = 0.9%. MRP20 = 0.1% x 19 = 1.9%.

30. Step 3: Add the IPs and MRPs to r*: rRFt = r* + IPt + MRPt . rRF = Quoted market interest rate on treasury securities. Assume r* = 3%: rRF1 = 3% + 5% + 0.0% = 8.0%. rRF10 = 3% + 7.5% + 0.9% = 11.4%. rRF20 = 3% + 7.75% + 1.9% = 12.65%.

31. Hypothetical Treasury Yield Curve Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% 15 Maturity risk premium 10 Inflation premium 5 Real risk-free rate Years to Maturity 0 1 20 10 http://stockcharts.com/charts/YieldCurve.html

32. Types of Risks From Investing Overseas • Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment. • Exchange rate risk: If investment is denominated in a currency other than the dollar, the investment’s value will depend on what happens to exchange rate.