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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

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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.

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What are some forms of business organization a company might have as it evolves from a start-up to a major corporation? Sole proprietorship Partnership Corporation

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Starting as a Sole 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 same advantages and disadvantages as a sole proprietorship.

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Becoming a Corporation

A corporation is a legal entity separate from its owners and managers.

File papers of incorporation with state. Charter

Bylaws

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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 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 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)

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What should managements primary objective be?

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.

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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

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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

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What three aspects of cash flows affect an investments 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)

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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.

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Determinants of Free Cash Flows 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.)

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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 companys investors (stockholders and creditors)

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What factors affect the weighted average cost of capital?

Capital structure (the firms relative amounts of debt and equity)

Interest rates

Risk of the firm

Stock market investors overall attitude toward risk

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What determines a firms value?

A firms value is the sum of all the future expected free cash flows when converted into todays dollars:
FCF1 FCF 2 FCF Value .... 1 2 (1 WACC ) (1 WACC ) (1 WACC )

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What are financial assets? A financial asset is 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.

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What are some financial instruments?

Instrument U.S. T-bills Bankers acceptances Commercial paper Rate (April 2003) 1.14% 1.22 1.21

Negotiable CDs
Eurodollar deposits

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Commercial loans

Tied to prime (4.25%) or LIBOR (1.29%)

(More . .)

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Financial Instruments (Continued) Instrument Mortgages Municipal bonds Corporate (AAA) bonds Preferred stocks Rate (April 2003)

U.S. T-notes and T-bonds

5.04%
5.57 4.84 5.91 6 to 9%

Common stocks (expected)

9 to 15%

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Who are the providers (savers) and users (borrowers) of capital?

Households: Net savers Non-financial corporations: Net users (borrowers) Governments: Net borrowers Financial corporations: Slightly net borrowers, but almost breakeven

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What are three ways that capital is transferred between savers and borrowers?
Direct transfer (e.g., corporation issues commercial paper to insurance company) Through an investment banking house (e.g., IPO, seasoned equity offering, or debt placement) Through a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company)

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What are some financial intermediaries? Commercial banks Savings & Loans, mutual savings banks, and credit unions

Life insurance companies

Mutual funds Pension funds

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The Top 5 Banking Companies in the World, 12/2001

Bank Name Citigroup Country U.S.

Deutsche Bank AG Germany Credit Suisse Switzerland

BNP Paribas
Bank of America

France
U.S.

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What are some types of markets? A market is a method of exchanging one asset (usually cash) for another asset. Physical assets vs. financial assets

Spot versus future markets

Money versus capital markets

Primary versus secondary markets

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How are secondary markets organized? By location Physical location exchanges Computer/telephone networks By the way that orders from buyers and sellers are matched Open outcry auction Dealers (i.e., market makers) Electronic communications networks (ECNs)

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Physical Location vs. Computer/telephone Networks Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock Exchange Computer/telephone: e.g., Nasdaq, government bond markets, foreign exchange markets

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Auction Markets NYSE and AMEX are the two largest auction markets for stocks. NYSE is a modified auction, with a specialist. Participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients; e.g., CBOT. Market orders vs. limit orders

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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 sellers. Examples: Nasdaq National Market, Nasdaq SmallCap Market, London SEAQ, German Neuer Markt.

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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).

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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, which allows potential buyers and sellers to post an offer. No dealers Very poor liquidity

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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

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What four factors affect the cost of money? Production opportunities Time preferences for consumption Risk Expected inflation

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Real versus Nominal Rates

r*

= Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities.

r rRF

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r = r* + IP + DRP + LP + MRP.

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.

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Premiums Added to r* for Different Types of Debt

ST Treasury: only IP for ST inflation LT Treasury: IP for LT inflation, MRP ST corporate: ST IP, DRP, LP LT corporate: IP, DRP, MRP, LP

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What is the term structure of interest rates? What is a yield curve?

Term structure: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve.

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How can you construct a hypothetical Treasury yield curve?

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.

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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:

IPn =

t=1

INFLt
n .

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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).

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Assume the MRP is zero for Year 1 and increases by 0.1% each year.

Step 2: Find MRP based on this equation:

MRPt = 0.1%(t - 1). MRP1 = 0.1% x 0 = 0.0%. MRP10 = 0.1% x 9 = 0.9%. MRP20 = 0.1% x 19 = 1.9%.

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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%.

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Hypothetical Treasury Yield Curve

Interest Rate (%)
15
Maturity risk premium

1 yr 10 yr 20 yr

8.0% 11.4% 12.65%

10

Inflation premium

5
Real risk-free rate

0 1 10

Years to Maturity
20

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What factors can explain the shape of this yield curve? This constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity risk premium.

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What kind of relationship exists between the Treasury yield curve and the yield curves for corporate issues? Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not necessarily parallel to the Treasury curve. The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases.

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Hypothetical Treasury and Corporate Yield Curves

Interest Rate (%)
15

BB-Rated
10

AAA-Rated
5.9%

5.2%

Treasury 6.0% yield curve

0 0 1 5 10 15 20

Years to maturity

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What is the Pure Expectations Hypothesis (PEH)? Shape of the yield curve depends on the investors expectations about future interest rates.

If interest rates are expected to increase, L-T rates will be higher than S-T rates and vice versa. Thus, the yield curve can slope up or down.
PEH assumes that MRP = 0.

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What various types of risks arise when investing overseas?

Country risk: Arises from investing or doing business in a particular country. It depends on the countrys economic, political, and social environment.
Exchange rate risk: If investment is denominated in a currency other than the dollar, the investments value will depend on what happens to exchange rate.

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What two factors lead to exchange rate fluctuations?

Changes in relative inflation will lead to changes in exchange rates.

An increase in country risk will also cause that countrys currency to fall.