CHAPTER 1

Overview of Corporate Finance and

the Financial Environment

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

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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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 Business Organization from Start-up to a
Major Corporation
• Sole proprietorship
• Partnership
• Corporation

(More . .)

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 Starting as a 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

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 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 control
a company’s behavior towards its directors,
managers, employees, shareholders, creditors,
customers, competitors, and community.
• Corporate governance can help control agency
problems.

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

(Continued)
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Is maximizing stock price good? (Continued)

• 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
investment’s 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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 Free Cash Flows (FCF)
• Free cash flows are the cash flows that are
available (or free) for distribution to all
investors (stockholders and creditors).
• FCF = sales revenues - operating costs -
operating taxes - required investments in
operating capital.

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 What is the weighted average cost of
capital (WACC)?
• WACC is the average rate of return required by all of
the company’s investors.
• WACC is affected by:
– Capital structure (the firm’s relative use of debt and equity
as sources of financing)
– Interest rates
– Risk of the firm
– Investors’ overall attitude toward risk

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What determines a firm’s fundamental, or
intrinsic, value?

Intrinsic value is the sum of all the future

expected free cash flows when converted
into today’s dollars:
FCF1 + FCF2 +… FCF∞
Value
= (1 + (1 + (1 +
WACC)1 WACC)2 WACC)∞

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 Who are the providers (savers) and users
(borrowers) of capital?
• Households: Net savers
• Non-financial corporations: Net users
(borrowers)
• Governments: U.S. governments are net
borrowers, some foreign governments are net
savers
• Financial corporations: Slightly net borrowers,
but almost breakeven

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 Transfer of Capital from Savers to
Borrowers
• Direct transfer
– Example: A corporation issues commercial paper to an insurance
company.
• Through an investment banking house
– Example: In an IPO, seasoned equity offering, or debt placement,
company sells security to investment banking house, which then sells
security to investor.
• Through a financial intermediary
– Example: An individual deposits money in bank and gets certificate of
deposit, bank makes commercial loan to a company (bank gets note
from company).

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 Cost of Money
• 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

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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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 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

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 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. Exchange rates affected by:
– International trade deficits/surpluses
– Relative inflation and interest rates
– Country risk

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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
country’s currency to fall.

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 Financial Securities

Debt Equity Derivatives

Money •T-Bills •Options

Market •CD’s •Futures
•Eurodollars •Forward
•Fed Funds contract

Capital •T-Bonds • Common •LEAPS

•Agency bonds
Market •Municipals
stock •Swaps
•Corporate bonds
• Preferred stock

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 Typical Rates of Return

Instrument Rate (April 2007)

U.S. T-bills 4.84%
Banker’s acceptances 5.28
Commercial paper 5.22
Negotiable CDs 5.31
Eurodollar deposits 5.32
Commercial loans:
Tied to prime 8.25 +
or LIBOR 5.36 + (More . .)

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 Typical Rates (Continued)

Instrument Rate (April 2007)

U.S. T-notes and T-bonds 4.88%
Mortgages 5.87
Municipal bonds 4.39
Corporate (AAA) bonds 6.15
Preferred stocks 6% to 9%
Common stocks (expected) 9% to 15%

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 What are some financial institutions?
• Commercial banks
• Investment banks
• Savings & Loans, mutual savings banks, and credit
unions
• Life insurance companies
• Mutual funds
– Exchanged Traded Funds (ETFs)
• Pension funds
• Hedge funds and private equity funds

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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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 Primary vs. Secondary Security Sales
• Primary
– New issue (IPO or seasoned)
– Key factor: issuer receives the proceeds from the
sale.
• Secondary
– Existing owner sells to another party.
– Issuing firm doesn’t receive proceeds and is not
directly involved.

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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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 Types of 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.

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

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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.
• 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 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.
– Low cost to transact
– Examples: Instinet (US, stocks, owned by Nasdaq);
Archipelago (US, stocks, owned by NYSE); 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 (e.g., Nasdaq Pink Sheets), which
allows potential buyers and sellers to post an offer.
– No dealers
– Very poor liquidity

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