1. ADAPTED FOR THE SECOND CANADIAN EDITION BY: THEORY & PRACTICE JIMMY WANG LAURENTIAN UNIVERSITY FINANCIAL MANAGEMENT

2. CHAPTER 1 AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT

3. CHAPTER 1 OUTLINE The Five-Minute Business Degree The Corporate Life Cycle The Primary Objective of the Corporation: Value Maximization An Overview of the Capital Allocation Process Financial Securities and the Cost of Money Financial Institutions Types of Financial Markets The Big Picture Copyright © 2014 by Nelson Education Ltd.1-3

4. The Five-Minute Business Degree Two main goals of all successful companies: – Having products or services highly valued by customers – Selling products/services at prices high enough to cover costs and reward investors The key attributes of successful companies: – Having skilled people – Having strong external relationships – Having sufficient capital Copyright © 2014 by Nelson Education Ltd.1-4

5. The Corporate Life Cycle No two companies will develop in exactly the same way. A business usually begins as a small potato and hopes to finish up as a major giant. Structures of business organizations: – Sole proprietorship – Partnership – Corporation Copyright © 2014 by Nelson Education Ltd.1-5

6. Starting Up as a Proprietorship Advantages: – Ease of formation – Subject to few regulations – No corporate income taxes Disadvantages: – Difficult to raise capital to support growth – Unlimited liability – Limited life span Copyright © 2014 by Nelson Education Ltd.1-6

7. Starting as, or Growing Into, a Partnership A partnership involves two or more entities with various privileges and responsibilities. – General vs. limited partner – Limited liability partnership (LLP) A partnership has roughly the same advantages and disadvantages as a sole proprietorship. Copyright © 2014 by Nelson Education Ltd.1-7

8. Becoming a Corporation A corporation is a legal entity separate from its owners and managers. File papers and prepare reports with Corporation Canada. – Articles of incorporation – Bylaws Copyright © 2014 by Nelson Education Ltd.1-8

9. Advantages and Disadvantages of a Corporation Advantages: – Unlimited life – Easy transfer of ownership – Limited liability – Ease of raising capital Disadvantages: – Double taxation – Higher setup cost – Endless report filing Copyright © 2014 by Nelson Education Ltd.1-9

10. Special Types of Corporations Professional corporations (PCs) – For professionals such as doctors, lawyers, and accountants Income trusts – Created to distribute all of a business’s free cash flow to investors in a tax-efficient manner – Appropriate for businesses with stable cash flows and not requiring significant capital expenditures – Only allowable for real estate (REIT) now Copyright © 2014 by Nelson Education Ltd.1-10

11. Growing and Managing a Corporation In addition to having products/services that attract customers, a corporation must attract investors. – Founder’s own resources and from friends, family, other private investors – Initial public offering (IPO) – Borrowing from banks, issuing bonds and additional shares Separation of ownership and management – Agency problem – Corporate governance Copyright © 2014 by Nelson Education Ltd.1-11

12. The Primary Objective of the Corporation: Value Maximization What should be management’s primary objective? Stock price maximization and social welfare Managerial actions to maximize shareholder wealth Copyright © 2014 by Nelson Education Ltd.1-12

13. What Should Be Management’s Primary Objective? The primary objective should be shareholder wealth maximization, which translates to maximizing the fundamental share price, not just the current market price. – Should firms behave ethically? YES! Business ethics are a company’s attitude and conduct toward its employees, customers, community, and shareholders. Copyright © 2014 by Nelson Education Ltd.1-13

14. Stock Price Maximization and Social Welfare Do firms have any responsibilities to society at large? Yes! Unethical behaviour destroys public trust and confidence. Maximizing share price is good for society. Why? Shareholders are also members of society. Copyright © 2014 by Nelson Education Ltd.1-14

15. Is Maximizing Stock Price Good for Consumers? To maximize stock price, corporations have to produce and deliver high-quality goods and services at the lowest possible cost to consumers. Consumers can improve quality of life by the direct or the indirect investments in the stock market. Copyright © 2014 by Nelson Education Ltd.1-15

16. Is Maximizing Stock Price Good for Employees? 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 previously owned by the government but that have been sold to private investors. Copyright © 2014 by Nelson Education Ltd.1-16

17. Managerial Actions to Maximize Shareholder Wealth Improve a firm’s ability to generate cash flows now and in the future by focusing on: – the amount of expected cash flows (bigger is better). – the timing of the cash flow stream (sooner is better). – the risk of the cash flows (less risk is better). Copyright © 2014 by Nelson Education Ltd.1-17

18. Free Cash Flows (FCF) FCF are cash flows available (or free) for distribution to all investors (stockholders and creditors). FCF = sales revenues – operating costs – operating taxes – required investments in operating capital. There are many ways firms can increase free cash flows. Copyright © 2014 by Nelson Education Ltd.1-18

19. Weighted Average Cost of Capital (WACC) In addition to FCF, another factor of determining a firm’s value and its long-term stock price is 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 amounts of debt and equity) – interest rates – risk of the firm – investors’ overall attitude toward risk Copyright © 2014 by Nelson Education Ltd.1-19

20. Copyright © 2014 by Nelson Education Ltd.1-20

21. An Overview of the Capital Allocation Process Who are the providers (savers) and users (borrowers) of capital? Financial securities and the cost of money Financial institutions Financial markets Copyright © 2014 by Nelson Education Ltd.1-21

22. 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 break-even Copyright © 2014 by Nelson Education Ltd.1-22

23. Copyright © 2014 by Nelson Education Ltd.1-23

24. Transfer of Capital from Savers to Borrowers Direct transfer (e.g., corporation issues commercial paper to insurance company) Indirect transfer through an investment banker (e.g., IPO, seasoned equity offering, or debt placement) Indirect transfer through a financial intermediary (e.g., individual deposits money in bank, bank loans to a firm) Copyright © 2014 by Nelson Education Ltd.1-24

25. Financial Securities Simply, pieces of paper with contractual provisions entitling their owners to specific rights and claims on specific cash flows or values Can be classified along two dimensions: – Time until maturity – Debt or equity Can also be distinguish between primary securities and derivatives Copyright © 2014 by Nelson Education Ltd.1-25

26. Copyright © 2014 by Nelson Education Ltd.1-26 Financial Securities cont’d

27. Copyright © 2014 by Nelson Education Ltd.1-27 Financial Securities cont’d

28. The Cost of Money Supply and demand of funds determine the cost or price of money. What do we call the price (or cost) of debt capital? Of equity capital? – Interest rate – Cost of equity = required return = dividend yield + capital gain Both are the rate fund users pay to fund providers. Copyright © 2014 by Nelson Education Ltd.1-28

29. Fundamental Factors That Affect the Cost of Money Production opportunities Time preferences for consumption Risk Expected inflation Copyright © 2014 by Nelson Education Ltd.1-29

30. Economic Conditions and Policies That Affect the Cost of Money Bank of Canada policies Budget deficits/surpluses Business activity (recession or boom) International trade deficits/surpluses Country risk depending on its economic, political, and social environment Exchange rate risk Copyright © 2014 by Nelson Education Ltd.1-30

31. Copyright © 2014 by Nelson Education Ltd.1-31

32. Financial Institutions Investment banks Commercial banks Trust companies Credit unions Life insurance companies Mutual funds – Money market funds (MMFs) – Exchanged traded funds (ETFs) Pension funds Hedge funds Private equity funds Copyright © 2014 by Nelson Education Ltd.1-32

33. Regulation of Financial Institutions Rationale: Ensure their safety and protect investors Examples: Separation of different types of services and limiting the types of services an institution could provide Regulatory changes – Deregulation to ensure free flow of capital and efficiency of capital markets – Blurring the distinctions between different types of institutions and leading to financial “superstores” Copyright © 2014 by Nelson Education Ltd.1-33

34. Types of Financial Markets A financial market brings together savers and borrowers. Physical asset vs. financial asset markets Spot vs. futures markets Money vs. capital markets Primary vs. secondary markets Private vs. public markets Copyright © 2014 by Nelson Education Ltd.1-34

35. Physical vs. Financial Asset Markets Physical (a.k.a. tangible or real) asset markets – Products such as wheat, autos, and real estate Financial asset markets – Primitive securities and derivative securities Copyright © 2014 by Nelson Education Ltd.1-35

36. Spot vs. Futures Markets Spot (a.k.a. cash) markets – Assets are bought or sold for “on-the-spot” delivery. Futures markets – Assets are bought or sold for delivery at some future date. Copyright © 2014 by Nelson Education Ltd.1-36

37. Primary vs. Secondary Markets 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 Copyright © 2014 by Nelson Education Ltd.1-37

38. Private vs. Public Markets Private markets – Transactions are worked out directly between two parties. – Lack of liquidity Public markets – Standardized contracts are traded on organized exchanges. – More liquid and transparent Copyright © 2014 by Nelson Education Ltd.1-38

39. The Big Picture A manager’s primary job is to increase the firm’s intrinsic value. Intrinsic value: The present value of the firm’s expected free cash flows (FCF), discounted at WACC Two approaches to increasing intrinsic value: – improve FCF and/or – reduce WACC You are to learn tools used to make decisions to increase intrinsic value. Copyright © 2014 by Nelson Education Ltd.1-39