Chapter I An Overview of Financial Management

l-l What is Finance?

l-la Finance vs. Economics and Accounting
Finance grew out of economics and accounting.
Economists - asset value is based on the future cash flows
the asset will provide
Accountants - provided information regarding the likely
size of cash flows
1-1b Finance within an Organization
BOD - top governing body
CEO - chairperson of the board; highest-ranking individual
COO - firm's president; directs the firm's operations
(marketing, manufacturing, sales, human resources, and
other operatin g depB.(cnicf Ope.ral,ng ey'fiZcr)
CFO - senior VP; 3rd ranking officer; in charge of
accounting, financing, credit policy, decisions regarding asset
acquisitions and investor relations-communication with
stockholders and press.
(C n
;c1
7,
rcnci a r
e
fJl'
6c
r)
.Sarbanes-Qxley
Act - law passed by congress that
l
CFo
requires the CEO to certify that their firm's financial statements
i
are accurate
I - I c Corporate Finance, Capital Markets and Investments
1. t (Corporate Finance)
assets to acquire
- how to needed to buy assets
- how to run the firm so as to maximize its value
2 tg -
dcatg ut/ ttcttnAes nerkclT
r
fhan
"
ia t
1ag5?v' tt'on5
are
y'financial
institutions that supply capital to business
include a number of activities:
A) Security Analysis - frnding the proper values of
individual securities
.-2) Portfulio Theory - best way to structure portfolio of
stock and bonds
4) Market Analysis - issue whether stock and bond
markets at any given time are "too high", "too low" or "about
right"
e - investor psychology is
examined in an effort to determine if stock prices have been bid
up to unreasonable heights in a speculative bubble or driven
down to unreasonable lows in a fit of irational pessimism.
1-2 Jobs in Finance
.Value-based
management - management decisions are
evaluated in terms of their effects on the firm's value
.Defined
contribution pension plans - each year the company
puts a specified amount of money into an account that belongs to
the employee the employee must decide how those funds are to
be invested
l-3 Forms of Business Organization
l) Proprietorship - an unincorporated business owned by one
individual
few
government regulation bject to lower income taxes than a
corporation
Disadvantages: unlimited personal liabili mited life,
dfficult to raise capital
2) Partnership - an unincorporated business owned by two or
more persons
tablished relatively easy and inexpensively
come allocated on a pro rata basis to the partners
ed on an individual basis
4rnl im it e d p ers o n al I i abil ity
4fficulty to raise large amounls of capital
3) Corporation - a legal entity created by stat arale and
bject to double taxalion-eamings are taxed and then when
its after tax eamings are paid out as dividends, those earnings are
taxed again as personal income. (C Corporation)
proprietorship/partnership rather than a corporation.
4) Limited Liability Company (LLC) - relatively new tlpe of
5-4 The Stock Market
ean
- two leaders of stock markets
5-4a Physical Location Stock Exchanges
.Ph1'sical
Location Exchanges - formal organizations
having tangible physical locations that conduct auction
markets in desi*srated (lined) securities.
5-lb Orer-the-Counter and the \a:daq Stock llarkets
.Over-the-Counter
\larket - 3large collection of
brokers and dealers. connecld elecronicallv by
telephones and computers that prorrds tbr trading in
unlised securities.
.Dealer
illarket - includes all tacrlrues rhat are needed to
conduct secuntr transaclrons nol condus-ted on the
physical I ocation exchanges.
The dealer market svstem consr*s of:
llrelativell fet
dealers rho hold tn\en:oncs o.irhese
seatrities and tho are said to
'mai.e
a dart:c:' tn these
secltnttes;
thousands of brokers t ho act os agerJs n bnnging the
dealers together xiIfr inrastor-; and
onputers, terntitwls ond clec:arac ne:rorks thot
protide o conntuntcdtion ltnJ;.:v.-,rfcn Je;r'ers end
brokers-
-
Bid price
-
price aI s hrch ther srl t-!:r lhe 5aock
-
Ask price
-
price at s hich they urll 31es
-
Bid-ask spread - difference berueen brd and ask prices,
.
IIACD-
represents the dealer's markup or prol'il
Nah'ota|tl<.oc.o{ eatl'/ie9 DcaletT
-
*{-y7,uQ
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e/ arrT rrar*.l
5-5 The Market for Common Stock
losely Held Corporation (Priretell Orrned) - owned
by a few individuals sho are assrxiared *ith the firm's
management. (Closely Held Srockt
blicly Owned Corporation - o*ned b1 relatively
large number of indi"'iduals sho are not acri\el) involved
in the firm's management (Pubticli Held Stock)
5-5a Types of Stock Market Transactions
1. s of established publicll owned
com.panies that ore troded : secondarl' market
2. sold b1 established publicly ow'ned
co m pa nies' primarl, market
3. Initial public offerings made by privately heldf rms:
IPO market
Going Public - act of selling stock to the public at
large by a closely held corporation or its principal
stockholders
Stock Markets and Returns
+There
are generally large differences between expected
and realized prices and returns.
5-6a Stock Market Reporting
+Up
until a few years ago, the best source
{tto.t
quotations was the business section of daily newspapers
one problem is that they report yesterday's prices. Now it
is possible to obtain real-time quotes through the Internet.
Stock Market Efficiency
Market Price
-
current price of stock
Intrinsic value price at which the stock would sell if all
investors had all knowable information about a stock
Equilibrium price
-
price that balances buy and sell
orders at any given time
Efficient market
-
prices are close to intrinsic values and
stocks seem to be in equilibrium
/oln'ns ic t/alqo 6ased :
1. ;rt
uEh $rocL
ie
n c?ui/ibn'oqn'.
bamcc available < caueet +he- pn'c?-
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f
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pn'c,es
Uhen ta*clc ar< )ne6a'enl:
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5-6
5-7
Clrzrpter 5 Financial llarkcts and lnstitutions
5-1 l'he Capital Allocation Process Capital Formation Process
l) Direct Transfers - business sells its socks or bonds
directlv to savers.
2) Indirect Transfers through Investment Bankers -
sells these same securities to savers.
Underwriter - serves as a middleman and
faci litates the issuance of securities
Primary market transaction - new securities are
involved and the corporation receives the proceeds ofthe sale
3) [ndirect Transfers through a Financial
lntermediary - intermediary obtains from savers in
sec rLl it i es.
markets
Ph;,sical asset markets (tangible/real asset markets)
- products such as wheat, autos, real estate,
computers and mach inery.
z.Financial asset markets - stocks. bonds, notes and
mortgages, and derivative securities - values are
Cerived from changes in the prices ofassets.
Spot markets
yersus
future
ntarkets.
Spot markets - assets are bought or sold for "on the
spot" delivery.
y'Future
markets - participants agree loday to buy or
sell an asset at some future date.
Money ntorkels uersro capital markets
oney nrarkets - short -term. highly liquid debt
securities.
apital markets - intermediate or long term debt
and corporate stocks.
Primary markets versus secondary markets
rimary markets - corporation raise new capital.
econdary markets - existing, already outstanding
securilies are traded among investors.
Private markets versus public markets
rivate markets - transactions are negotiates
directl y between parties.
ublic Markets - standardized contracts are traded
on organized exchanges.
5-3 Financial Institutions
Investment banks - an organization that underwrites
and disributes new investment securities and helps
businesses obtain fi nancing.
Commercial banks - traditional department store of
finance serving a variety ofsavers and borrowers.
.4. Financial services corporation - firm that offers a
wide range of financial services, including investment
banking, brokerage operations, insurance, and
I banY.tng.-
1ar1e
callom
iy,
unions - cooperative
members are supposed to have a common bond.
Pension funds - retirement plans funded by
corporations or govemment agencies for their workers
and administered primarily by the trust departments of
commercial banks or by life insurance companies.
K. tite insurance companics - take savings in the form
of annual premiums. invest these funds in stocks, bonds,
real estate and mortgages; and make payments to the
benefi ciaries of the insured parties.
s(,
Matual funds - organizations that pool investor funds
to purchase hnancial instruments and thus reduce risks
funds often operated by mutual fund companies.
4 Hedge funds - similar to mutual funds, they accept
money from savers and use the funds to buy various
securities; largely unregulated in contrast with nruttral
funds which are registered and legulated by SEC.
Private equity companies - operate much like hedge
funds; but rather than buying some of the stock of a firm,
private equity players buy and then manage entire firms.
the safety ofthese institutions and protect investors.
organization that is a hybrid bet a partnershrp and a corporation
Limited Liability Partnership (LLP) - similar to an LLC but
used for professional firms;
.gp1pg;ation
but
1-4 Stock Prices and Shareholder Value
Primary Goal of the Mgmt. - shareholder wealth maximization
.Shareholder
wealth maximization - the primary goal for
managers of publicly owned companies implies that decisions
should be made to maximize the long-run value of the firm's
common slock
mottira;zt'ng
ihe
Prr'ca
orr /-he
7'inni
ammon s'toc't
1-5 Intrinsic Values, Stock Prices and Executive Compensation
Determinants of Intrinsic Value and Stock Prices
Managerial Actions, Economy, Taxes, and Political Conditions
- determine stock prices thus investors' returns
*investors
like high returns but dislike risk so the larger the
expected profits and the lower the perceived risk th
ue Expected Returns and True Risk
- investor *,ould expect if they had a . that
existed about the company
rceived Returns snd Perceived Risk
- what investors expect given th . they
actually have
trinsic Value
- an estimate of a stock's true value based on accurate risk
rlcet Price
- the stock value based on perceived but possibly
incorrect info. as seen by the marginal investor
' Marginal investor
- views determine the actual stock price
rlcet Equilibrium
- Intrinsic Value
:
Stock Price
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1-6 Important Business Trends
arbanes-Oxley D// - requires the CEO and CFO of a firm to
certify that the firm's financial statements are accurate.
en Increased globalization of business.
y?J Ev er- improvin g info rm ation t echno lo gy.
rporate governance - way the top managers operate and
interface with stockholders
1-7 Business Ethics
ol-...
1-8a Managers versus Stockholders
Useful motivational tools to motivate managers to act in
their shareholder's best interest:
Compensation packages
- should be suffrcient to attract and retain able managers, should
not go beyond u'hat is needed; managers rewarded on the basis of
the stock's performance over the long run.
g of managers who don't perform u,ell
- stockholders can inten'ene directly with managers
Threat of hostile tqkeovers
.Corporate
Raider - an individual who targets a
corporation for takeover because it is undervalued
.Ilostile
Takeover - the acquisition of a company over
the opposition of the management
I -8b Stockholders versus Bondholders
regardless of how well the company does while stockholders do
better when the company does better
2) The use ofadditional debt
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