Transcript Overview of Fin and Fin Mkts

CHAPTER 1
Overview of Financial
Management and the Financial
Environment
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Areas in Finance
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Corporate finance
Investment
Financial markets
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Topics in Chapter
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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?
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Corporate finance provides the skills
managers need to:
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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 Startup to a Major Corporation
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Sole proprietorship
Partnership
Corporation
(More . .)
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Starting as a Proprietorship
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One owner (the manager)
Advantages:
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Ease of formation
Subject to few regulations
No corporate income taxes, but personal
income taxes
Disadvantages:
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Unlimited liability
Difficult to raise capital to support growth
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Starting as or Growing into a
Partnership
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More than one owner.
A partnership has roughly the same
advantages and disadvantages as a sole
proprietorship.
Limited partnership in some cases.
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Becoming a Corporation
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A corporation is a legal entity that
separates its owners from managers.
File papers of incorporation with state.
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Charter (name, types of business, amount
of capital, directors…)
Bylaws (a set of rules by the founders)
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Advantages and Disadvantages of
a Corporation
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Advantages:
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Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Disadvantages:
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Double taxation
Cost of set-up
stricter regulation
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Becoming a Public Corporation
and Growing Afterwards
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Initial Public Offering (IPO) of Stock
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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
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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.
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What should be management’s
primary objective?
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The primary objective should be
shareholder wealth maximization, which
translates to maximizing the stock price.
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What determines a firm’s
value?
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The cash flows generated in the future.
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What three aspects of cash flows
affect an investment’s value?
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Amount of expected cash flows (bigger
is better)
Timing of the cash flow stream (sooner
is better)
Why is timing important?
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Risk of the cash flows (less risk is
better)
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Free Cash Flows (FCF)
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Free cash flows are the cash flows that are
available (or free) for distribution to all
investors (stockholders and creditors).
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Cost of Capital (1)
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The cost to finance the firm and
operation.
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Cost of equity vs. cost of liability (debt).
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Weighted average cost of capital (WACC)
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Cost of Capital (2)
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What do we call the price, or cost, of
debt capital?
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The interest rate
What do we call the price, or cost, of
equity capital?
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Cost of equity = Required return =
dividend yield + capital gain
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A firm’s fundamental value
Intrinsic value is the sum of all the
future expected free cash flows when
converted into today’s dollars:
Value =
FCF1
(1 + WACC)1
+
FCF2
(1 + WACC)2
+…+
FCF∞
(1 + WACC)∞
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Capital Allocation Process
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Who are the providers (savers)
and users (borrowers) of capital?
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Households
Non-financial corporations
Financial corporations
Governments
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What economic conditions
affect the cost of money?
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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?
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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.
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Financial Markets (1)
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Primary market:
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Markets in which companies raise money by selling
securities to investors.
Every security sells only once in the primary market.
Example: IPO
Secondary market:
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Markets in which already issued securities trade.
Trading is among investors.
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Financial Markets (2)
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Money market: markets for trading of debt securities
with less than one-year maturity.
Capital markets: market for trading of intermediateterm and long-term debt and common stock.
Spot markets: securities are bought and sold for ‘onthe-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.
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Financial Securities
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Money Market Securities
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Capital Market Securities
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Treasury Bill (T-bill); Commercial paper;
negotiable CD by banks
Bonds, Mortgages, Stocks
Derivative Securities
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Futures, Options, Swaps, Forwards
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Debt vs. Equity
Debt security
Equity security
1) Holder is a creditor of the firm.
No say in running of the firm.
1) Holder is an owner of the firm.
Have a say in running of the firm (by
voting).
2) Fixed payment.
2) Payment is not fixed. No
guaranteed cash flow from firm.
3) Receives payment before anything
is paid to equity holders.
3) Receives what’s left over after all
debt holders/creditors are paid.
4) If firm cannot pay, debt holders will
take over ownership of firm assets.
4) If firm cannot pay debt holders,
loses control of firm to debt holders.
5) Limited liability.
5) Limited liability.
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What are some financial
institutions?
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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
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Types of Stock Transaction
Orders
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Instructions on how a transaction is to
be completed
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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
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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.
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Dealer Markets
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“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
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Over the Counter (OTC)
Markets
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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.
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No dealers
Very poor liquidity
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Financial Securities Quotation
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Quotes can be found in a variety of print
sources (Wall Street Journal) and online
sources (Yahoo!Finance, CNNMoney).
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After Chapter Homework
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Questions: (1-3)
Mini case: b, c, d, e, f.
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