1 - 1 CHAPTER 1 Overview of Financial Management and the Financial Environment  Financial management  Forms of business organization  Objective of the firm: Maximize wealth  Determinants of stock pricing  The financial environment  Financial instruments, markets and institutions  Interest rates and yield curves 1 - 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. 1 - 3  Sole proprietorship  Partnership  Corporation What are some forms of business organization a company might have as it evolves from a start-up to a major corporation? 1 - 4  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 a Sole Proprietorship 1 - 5  A partnership has roughly the same advantages and disadvantages as a sole proprietorship. Starting as or Growing into a Partnership 1 - 6 Becoming a Corporation  A corporation is a legal entity separate from its owners and managers.  File papers of incorporation with state.  Charter  Bylaws 1 - 7  Advantages:  Unlimited life  Easy transfer of ownership  Limited liability  Ease of raising capital  Disadvantages:  Double taxation  Cost of set-up and report filing Advantages and Disadvantages of a Corporation 1 - 8 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  Agency problem: managers may act in their own interests and not on behalf of owners (stockholders) 1 - 9  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. What should management’s primary objective be? 1 - 10 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 [...]... firm’s relative amounts of debt and equity)  Interest rates  Risk of the firm  Stock market investors’ overall attitude toward risk 1 - 17 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: FCF1 FCF2 FCF∞ Value = + + 1 2 (1 + WACC) (1 + WACC) (1 + WACC)∞ 1 - 18 What are financial assets?  A financial asset is a... labor, etc.) and taxes  Required investments in operations (buildings, machines, inventory, etc.) 1 - 15 What is 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) 1 - 16 What factors affect the weighted average cost of capital?  Capital structure (the firm’s... a contract that entitles the owner to some type of payoff Debt Equity Derivatives  In general, each financial asset involves two parties, a provider of cash (i.e., capital) and a user of cash 1 - 19 What are some financial instruments? Instrument Rate (April 2003) U.S T-bills 1. 14% Banker’s acceptances 1. 22 Commercial paper 1. 21 Negotiable CDs 1. 24 Eurodollar deposits 1. 23 Commercial loans Tied... face-to-face, and place orders for themselves or for their clients; e.g., CBOT  Market orders vs limit orders 1 - 29 Dealer Markets  “Dealers” keep an inventory of the stock (or other financial asset) and place bid and ask “advertisements,” which are prices at which they are willing to buy and sell  Computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and. .. sold  Now the OTC market is the equivalent of a computer bulletin board, which allows potential buyers and sellers to post an offer No dealers Very poor liquidity 1 - 32  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? Required Dividend Capital = yield + gain return 1 - 33 What four factors affect the cost of money?... better)  Timing of the cash flow stream (sooner is better)  Risk of the cash flows (less risk is better) 1 - 13 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 1 - 14 Determinants of Free Cash Flows... Tied to prime (4.25%) or LIBOR (1. 29%) (More ) 1 - 20 Financial Instruments (Continued) Instrument Rate (April 2003) U.S T-notes and T-bonds 5.04% Mortgages 5.57 Municipal bonds 4.84 Corporate (AAA) bonds 5. 91 Preferred stocks 6 to 9% Common stocks (expected)9 to 15 % 1 - 21 Who are the providers (savers) and users (borrowers) of capital?  Households: Net savers  Non -financial corporations: Net users... company) 1 - 23 What are some financial intermediaries?  Commercial banks  Savings & Loans, mutual savings banks, and credit unions  Life insurance companies  Mutual funds  Pension funds 1 - 24 The Top 5 Banking Companies in the World, 12 /20 01 Bank Name Country Citigroup U.S Deutsche Bank AG Germany Credit Suisse Switzerland BNP Paribas France Bank of America U.S 1 - 25 What are some types of markets?... Markt 1 - 30 Electronic Communications Networks (ECNs)  ECNs: Computerized system matches orders from buyers and sellers and automatically executes transaction Examples: Instinet (US, stocks), Eurex (Swiss-German, futures contracts), SETS (London, stocks) 1 - 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.. .1 - 11  Consumer welfare is higher in capitalist free market economies than in communist or socialist economies  Fortune lists the most admired firms In addition to high stock returns, these firms have: high quality from customers’ view employees who like working there 1 - 12 What three aspects of cash flows affect an investment’s value?  Amount of expected cash flows (bigger . 1 - 1 CHAPTER 1 Overview of Financial Management and the Financial Environment  Financial management  Forms of business organization  Objective of the firm: Maximize wealth  Determinants. dollars: ∞ ∞ + + + + + = )WACC1( FCF )WACC1( FCF )WACC1( FCF Value 2 2 1 1 1 - 18 What are financial assets?  A financial asset is a contract that entitles the owner to some type of payoff.  Debt  Equity  Derivatives  In. is the average rate of return required by all of the company’s investors (stockholders and creditors) 1 - 16 What factors affect the weighted average cost of capital?  Capital structure (the