Presentation on theme: "Forms of business organization Objective of the firm: Maximize wealth"— Presentation transcript:
1CHAPTER 1 Overview of Financial Management and the Financial Environment Forms of business organizationObjective of the firm: Maximize wealthDeterminants of stock pricingThe financial environmentFinancial instruments, markets and institutionsInterest rates and yield curves
2Why 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.
3What are some forms of business organization a company might have as it evolves from a start-up to a major corporation?Sole proprietorshipPartnershipCorporation
4Starting as a Sole Proprietorship Advantages:Ease of formationSubject to few regulationsNo corporate income taxesDisadvantages:Limited lifeUnlimited liabilityDifficult to raise capital to support growth
5Starting as or Growing into a Partnership A partnership has roughly the same advantages and disadvantages as a sole proprietorship.
6Becoming a Corporation A corporation is a legal entity separate from its owners and managers.File papers of incorporation with state.CharterBylaws
7Advantages and Disadvantages of a Corporation Unlimited lifeEasy transfer of ownershipLimited liabilityEase of raising capitalDisadvantages:Double taxationCost of set-up and report filing
8Becoming a Public Corporation and Growing Afterwards Initial Public Offering (IPO) of StockRaises cashAllows founders and pre-IPO investors to “harvest” some of their wealthSubsequent issues of debt and equityAgency problem: managers may act in their own interests and not on behalf of owners (stockholders)
9What should management’s 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.
10Is 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
11Consumer 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’ viewemployees who like working there
12What 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)
13What are “free cash flows (FCF)” Free cash flows are the cash flows that are:Available (or free) for distributionTo all investors (stockholders and creditors)After paying current expenses, taxes, and making the investments necessary for growth.
14Determinants of Free Cash Flows Sales revenuesCurrent levelShort-term growth rate in salesLong-term sustainable growth rate in salesOperating costs (raw materials, labor, etc.) and taxesRequired investments in operations (buildings, machines, inventory, etc.)
15What 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)
16What factors affect the weighted average cost of capital? Capital structure (the firm’s relative amounts of debt and equity)Interest ratesRisk of the firmStock market investors’ overall attitude toward risk
17What 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:
18What are financial assets? A financial asset is a contract that entitles the owner to some type of payoff.DebtEquityDerivativesIn general, each financial asset involves two parties, a provider of cash (i.e., capital) and a user of cash.
19What are some financial instruments? Instrument Rate (April 2003)U.S. T-bills 1.14%Banker’s acceptances 1.22Commercial paper 1.21Negotiable CDs 1.24Eurodollar deposits 1.23Commercial loans Tied to prime (4.25%) or LIBOR (1.29%)(More . .)
20Financial Instruments (Continued) Instrument Rate (April 2003)U.S. T-notes and T-bonds 5.04%Mortgages 5.57Municipal bonds 4.84Corporate (AAA) bonds 5.91Preferred stocks 6 to 9%Common stocks (expected) 9 to 15%
21Who are the providers (savers) and users (borrowers) of capital? Households: Net saversNon-financial corporations: Net users (borrowers)Governments: Net borrowersFinancial corporations: Slightly net borrowers, but almost breakeven
22What 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)
23What are some financial intermediaries? Commercial banksSavings & Loans, mutual savings banks, and credit unionsLife insurance companiesMutual fundsPension funds
24The Top 5 Banking Companies in the World, 12/2001 Bank NameCountryCitigroupU.S.Deutsche Bank AGGermanyCredit SuisseSwitzerlandBNP ParibasFranceBank of America
25What are some types of markets? A market is a method of exchanging one asset (usually cash) for another asset.Physical assets vs. financial assetsSpot versus future marketsMoney versus capital marketsPrimary versus secondary markets
26How are secondary markets organized? By “location”Physical location exchangesComputer/telephone networksBy the way that orders from buyers and sellers are matchedOpen outcry auctionDealers (i.e., market makers)Electronic communications networks (ECNs)
27Physical Location vs. Computer/telephone Networks Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock ExchangeComputer/telephone: e.g., Nasdaq, government bond markets, foreign exchange markets
28Auction MarketsNYSE 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
29Dealer 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.
30Electronic Communications Networks (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).
31Over 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 dealersVery poor liquidity
32What do we call the price, or cost, of debt capital? The interest rateWhat do we call the price, or cost, of equity capital?Required Dividend Capitalreturn yield gain=
33What four factors affect the cost of money? Production opportunitiesTime preferences for consumptionRiskExpected inflation
34Real versus Nominal Rates = Real risk-free rate.T-bond rate if no inflation;1% to 4%.= Any nominal rate.= Rate on Treasury securities.rrRF
35r = 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.
36Premiums Added to r* for Different Types of Debt ST Treasury: only IP for ST inflationLT Treasury: IP for LT inflation, MRPST corporate: ST IP, DRP, LPLT corporate: IP, DRP, MRP, LP
37What 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.
38How 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.
39Step 1: Find the average expected inflation rate over years 1 to n: 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:nINFLtt = 1IPn =
40IP1 = 5%/1.0 = 5.00%.IP10 = [ (8)]/10 = 7.5%.IP20 = [ (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).
41Step 2: Find MRP based on this equation: 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%.
43Hypothetical Treasury Yield Curve InterestRate (%)1 yr %10 yr %20 yr %15Maturity risk premium10Inflation premium5Real risk-free rateYears to Maturity11020
44What 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.
45What 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 neces-sarily parallel to the Treasury curve.The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases.
46Hypothetical Treasury and Corporate Yield Curves InterestRate (%)15BB-Rated10AAA-RatedTreasuryyield curve6.0%55.9%5.2%Years tomaturity15101520
47What 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.
48What various types of risks arise when investing overseas? Country risk: Arises from investing or doing business in a particular country. It depends on the country’s economic, political, and social environment.Exchange rate risk: If investment is denominated in a currency other than the dollar, the investment’s value will depend on what happens to exchange rate.
49What 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.