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CHAPTER 1

CHAPTER 1. Overview of Financial Management and the Financial Environment. Areas in Finance. Corporate finance Investment Financial markets . Topics in Chapter. Forms of business organization Objective of the firm: Maximize wealth Determinants of fundamental value

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CHAPTER 1

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  1. CHAPTER 1 Overview of Financial Management and the Financial Environment

  2. Areas in Finance • Corporate finance • Investment • Financial markets

  3. Topics in Chapter • Forms of business organization • Objective of the firm: Maximize wealth • Determinants of fundamental value • Financial securities, markets and institutions

  4. 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.

  5. Business Organization from Start-up to a Major Corporation • Sole proprietorship • Partnership • Corporation (More . .)

  6. Starting as a Proprietorship • One owner (the manager) • Advantages: • Ease of formation • Subject to few regulations • No corporate income taxes, but personal income taxes • Disadvantages: • Unlimited liability • Difficult to raise capital to support growth

  7. Starting as or Growing into a Partnership • More than one owner. • A partnership has roughly the same advantages and disadvantages as a sole proprietorship. • Limited partnership in some cases.

  8. Becoming a Corporation • A corporation is a legal entity that separates its owners from managers. • File papers of incorporation with state. • Charter (name, types of business, amount of capital, directors…) • Bylaws (a set of rules by the founders)

  9. Advantages and Disadvantages of a Corporation • Advantages: • Unlimited life • Easy transfer of ownership • Limited liability • Ease of raising capital • Disadvantages: • Double taxation • Cost of set-up • stricter regulation

  10. 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 • Subsequent issues of debt and equity

  11. Agency Problems and Corporate Governance • Agency problem: managers may act in their own interests and not on behalf of owners (stockholders) • Corporate governance is the set of rules that monitor and control a company’s (mainly the management’s) behavior. Corporate governance can help control agency problems.

  12. What should be management’s primary objective? • The primary objective should be shareholder wealth maximization, which translates to maximizing the stock price.

  13. What determines a firm’s value? • The cash flows generated in the future.

  14. 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) Why is timing important? • Risk of the cash flows (less risk is better)

  15. Free Cash Flows (FCF) • Free cash flows are the cash flows that are available (or free) for distribution to all investors (stockholders and creditors).

  16. Cost of Capital (1) • The cost to finance the firm and operation. • Cost of equity vs. cost of liability (debt). • Weighted average cost of capital (WACC)

  17. Cost of Capital (2) • 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? • Cost of equity = Required return = dividend yield + capital gain

  18. FCF1 FCF2 FCF∞ Value = + + … + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞ Afirm’s fundamental value Intrinsic value is the sum of all the future expected free cash flows when converted into today’s dollars:

  19. Capital Allocation Process

  20. Who are the providers (savers) and users (borrowers) of capital? • Households • Non-financial corporations • Financial corporations • Governments

  21. 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

  22. What international conditions affect the cost of money? • Country risk. Depends on the country’s economic, political, and social environment. • Exchange rate risk. Non-dollar denominated investment’s value depends on what happens to exchange rate.

  23. Financial Markets (1) • Primary market: • Markets in which companies raise money by selling securities to investors. • Every security sells only once in the primary market. • Example: IPO • Secondary market: • Markets in which already issued securities trade. • Trading is among investors.

  24. Financial Markets (2) • Money market: markets for trading of debt securities with less than one-year maturity. • Capital markets: market for trading of intermediate-term and long-term debt and common stock. • Spot markets: securities are bought and sold for ‘on-the-spot’ delivery. • Futures markets: trading takes place now, but full payment and delivery of the asset takes place in the future, e.g., 6 months or 1-year.

  25. Financial Securities • Money Market Securities • Treasury Bill (T-bill); Commercial paper; negotiable CD by banks • Capital Market Securities • Bonds, Mortgages, Stocks • Derivative Securities • Futures, Options, Swaps, Forwards

  26. Debt vs. Equity

  27. What are some financial institutions? • Commercial banks • Investment banks • Savings & Loans, mutual savings banks, and credit unions • Life insurance companies • Mutual funds • Pension funds • Hedge funds and private equity funds

  28. Types of Stock Transaction Orders • Instructions on how a transaction is to be completed • Market Order– Transact as quickly as possible at current price • Limit Order– Transact only if specific situation occurs. For example, buy if price drops to $50 or below during the next two hours.

  29. Auction Markets • Participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients • NYSE and AMEX are the two largest auction markets for stocks.

  30. Dealer Markets • “Dealers” keep an inventory of the stock (or other financial asset) and place bid and ask • Often many dealers for each stock • Computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers. • Examples: Nasdaq

  31. Over the Counter (OTC) Markets • 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 sellers to post an offer. • No dealers • Very poor liquidity

  32. Financial Securities Quotation • Quotes can be found in a variety of print sources (Wall Street Journal) and online sources (Yahoo!Finance, CNNMoney).

  33. After Chapter Homework • Questions: (1-3) • Mini case: b, c, d, e, f.

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