1 - 1 CHAPTER 1 Overview of Corporate Finance and the Financial Environment Corporate finance 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

1 - 2 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.

1 - 3 Sole proprietorship Partnership Corporation What are some forms of business organization?

1 - 4 Advantages: Ease of formation Subject to few regulations No corporate income taxes Disadvantages: Limited life Unlimited liability Difficult to raise capital Sole Proprietorship

1 - 5 A partnership has roughly the same advantages and disadvantages as a sole proprietorship. Partnership

1 - 6 Advantages: Unlimited life Easy transfer of ownership Limited liability Ease of raising capital Disadvantages: Double taxation Cost of set-up and report filing Corporation

1 - 7 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. What should management’s primary objective be?

1 - 8 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

1 - 9 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

Amount of cash flows expected by shareholders Timing of the cash flow stream Risk of the cash flows What three factors affect stock prices?

Sales revenues Current level Short-term growth rate in sales Long-term sustainable growth rate in sales Operating expenses (e.g., raw materials, labor, etc.) Necessary investments in operating capital (e.g., buildings, machines, inventory, etc.) What factors determine of cash flows?

What factors affect the level and risk of cash flows? Decisions made by financial managers: Investment decisions (product lines, production processes, geographic market, use of technology, marketing strategy, etc.) Financing decisions (choice of debt policy and dividend policy) The external environment (taxes, regulation, etc.)

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.

What are some financial instruments? InstrumentRate (9/01) U.S. T-bills2.3% Banker’s acceptances2.6 Commercial paper2.4 Negotiable CDs2.5 Eurodollar deposits2.5 Commercial loansTied to prime (6.0%) or LIBOR (2.6%) (More..)

Financial Instruments (Continued) InstrumentRate (9/01) U.S. T-notes and T-bonds5.5% Mortgages6.8 Municipal bonds5.1 Corporate (AAA) bonds7.2 Preferred stocks7 to 9% Common stocks (expected)10 to 15%

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

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) What are three ways that capital is transferred between savers and borrowers?

Commercial banks Savings & Loans, mutual savings banks, and credit unions Life insurance companies Mutual funds Pension funds What are some financial intermediaries?

The Top 5 Banking Companies in the World, 12/1999 Bank NameCountryTotal assets Deutsche Bank AGFrankfurt$844 billion CitigroupNew York$717 billion BNP ParibasParis$702 billion Bank of TokyoTokyo$697 billion Bank of AmericaCharlotte$632 billion

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

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)

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

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

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.

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).

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

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 return yield gain = +.

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

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 r RF

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.

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

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.

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.

Step 1:Find the average expected inflation rate over years 1 to n: n   INFL t t = 1 n IP n =. Assume investors expect inflation to be 5% next year, 6% the following year, and 8% per year thereafter.

IP 1 = 5%/1.0 = 5.00%. IP 10 = [ (8)]/10 = 7.5%. IP 20 = [ (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).

Step 2: Find MRP based on this equation: MRP t = 0.1%(t - 1). MRP 1 = 0.1% x 0= 0.0%. MRP 10 = 0.1% x 9= 0.9%. MRP 20 = 0.1% x 19= 1.9%. Assume the MRP is zero for Year 1 and increases by 0.1% each year.

Step 3: Add the IPs and MRPs to r*: r RF t = r* + IP t + MRP t. r RF =Quoted market interest rate on treasury securities. Assume r* = 3%: r RF1 = 3% + 5% + 0.0% = 8.0%. r RF10 = 3% + 7.5% + 0.9% = 11.4%. r RF20 = 3% % + 1.9% = 12.65%.

Hypothetical Treasury Yield Curve Years to Maturity Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% Real risk-free rate Inflation premium Maturity risk premium

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.

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 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.

Hypothetical Treasury and Corporate Yield Curves Years to maturity Interest Rate (%) 5.2% 5.9% 6.0% Treasury yield curve BB-Rated AAA-Rated

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. Long-term rates are an average of current and future short-term rates. If PEH is correct, you can use the yield curve to “back out” expected future interest rates.

Observed Treasury Rates If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now? MaturityYield 1 year6.0% 2 years6.2% 3 years6.4% 4 years6.5% 5 years6.5%

% 34 x% 6.2% PEH tells us that one-year securities will yield 6.4%, one year from now (x%). 6.2%= 12.4%= x% 6.4%= x%. (6.0% + x%) 2

% 34 x% 6.5% [ 2(6.2%) + 3(x%) ] 5 PEH tells us that three-year securities will yield 6.7%, two years from now (x%). 6.5%= 32.5%= 12.4% + 3(x%) 20.1%= 3(x%) 6.7%= x%.

Some argue that the PEH isn’t correct, because securities of different maturities have different risk. General view (supported by most evidence) is that lenders prefer S-T securities, and view L-T securities as riskier. Thus, investors demand a MRP to get them to hold L-T securities (i.e., MRP > 0). Conclusions about PEH

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 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.

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.