1

CHAPTER 1

Overview of Financial Management and the Financial Environment

2

Topics in Chapter Forms of business organization Objective of the firm: Maximize

wealth Determinants of fundamental

value Financial securities, markets and

institutions

3

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.

4

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.

5

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.

6

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)

7

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.

8

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

9

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:

Value = + + … +FCF1 FCF2 FCF∞

(1 + WACC)1

(1 + WACC)∞

(1 + WACC)2

See “big picture” diagram on next slide.(More . .)

10

Value = + + +FCF1 FCF2 FCF∞

(1 + WACC)1 (1 + WACC)∞

(1 + WACC)2

Free cash flow(FCF)

Market interest rates

Firm’s business riskMarket risk aversion

Firm’s debt/equity mixCost of debt

Cost of equity

Weighted averagecost of capital

(WACC)

Sales revenues

Operating costs and taxes

Required investments in operating capital

−

−

=

Determinants of Intrinsic Value: The Big Picture

...

11

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

12

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).

13

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

14

What four factors affect the cost of money?

Production opportunities Time preferences for consumption Risk Expected inflation

15

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

16

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

17

What two factors lead to exchangerate 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.

18

Financial Securities

Debt Equity Derivatives

MoneyMarket

•T-Bills•CD’s•Eurodollars•Fed Funds

•Options•Futures•Forward contract

CapitalMarket

•T-Bonds•Agency bonds•Municipals•Corporate bonds

• Common stock

• Preferred stock

•LEAPS•Swaps

19

Typical Rates of Return

Instrument Rate (January 2009)

U.S. T-bills 0.41%

Banker’s acceptances 5.28

Commercial paper 0.28

Negotiable CDs 1.58

Eurodollar deposits 2.60

Commercial loans:

Tied to prime 3.25 +

or LIBOR 2.02 +(More . .)

20

Typical Rates (Continued)

Instrument Rate (January 2009)

U.S. T-notes and T-bonds 3.04%

Mortgages 5.02

Municipal bonds 4.39

Corporate (AAA) bonds 5.03

Preferred stocks 6% to 9%

Common stocks (expected) 9% to 15%

21

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

22

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

23

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.

24

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)

25

Chapter 2

Financial Statements, Cash Flow, and Taxes

26

Topics in Chapter

Income statement Balance sheet Statement of cash flows Free cash flow MVA and EVA Corporate taxes Personal taxes

27

Value = + + +FCF1 FCF2 FCF∞

(1 + WACC)1 (1 + WACC)∞

(1 + WACC)2

Free cash flow(FCF)

Free cash flow(FCF)

Market interest rates

Firm’s business riskMarket risk aversion

Firm’s debt/equity mixCost of debt

Cost of equity

Weighted averagecost of capital

(WACC)

Sales revenuesSales revenues

Operating costs and taxesOperating costs and taxes

Required investments in operating capitalRequired investments in operating capital

−

−

=

Determinants of Intrinsic Value: Calculating FCF

...

28

What is free cash flow (FCF)? Why is it important?

FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.

A company’s value depends on the amount of FCF it can generate.

29

What are the five uses of FCF?

1. Pay interest on debt.2. Pay back principal on debt.3. Pay dividends.4. Buy back stock.5. Buy nonoperating assets (e.g.,

marketable securities, investments in other companies, etc.)

30

Economic Value Added (EVA)

WACC is weighted average cost of capital

EVA = NOPAT- (WACC)(Capital)

31

Economic Value Added(WACC = 10% for both years)

EVA = NOPAT- (WACC)(Capital)

EVA10 = $10,464 - (0.1)($2,257,632)

= $10,464 - $225,763

= -$215,299.

EVA09 = $125,460 - (0.10)

($1,138,600)

= $125,460 - $113,860

= $11,600.

32

Stock Price and Other Data

2009 2010

Stock price $8.50 $6.00

# of shares 100,000 100,000

EPS $0.88 -$0.95

DPS $0.22 $0.11

33

Market Value Added (MVA)

MVA = Market Value of the Firm - Book Value of the Firm

Market Value = (# shares of stock)(price per share) + Value of debt

Book Value = Total common equity + Value of debt

(More…)

34

MVA (Continued)

If the market value of debt is close to the book value of debt, then MVA is:

MVA = Market value of equity – book value of equity

35

Key Features of the Tax Code

Corporate Taxes Individual Taxes

36

2009 Corporate Tax Rates

Taxable Income Tax on Base

Rate on amount above base

0 -50,000 0 15%

50,000 - 75,000 7,500 25%

75,000 - 100,000 13,750 34%

100,000 - 335,000 22,250 39%

335,000 - 10M 113,900 34%

10M - 15M 3,400,000 35%

15M - 18.3M 5,150,000 38%

18.3M and up 6,416,667 35%

37

Features of Corporate Taxation

Progressive rate up until $18.3 million taxable income. Below $18.3 million, the marginal rate

is not equal to the average rate. Above $18.3 million, the marginal

rate and the average rate are 35%.

38

Features of Corporate Taxes (Cont.) A corporation can:

deduct its interest expenses but not its dividend payments;

carry back losses for two years, carry forward losses for 20 years.*

exclude 70% of dividend income if it owns less than 20% of the company’s stock

*Losses in 2001 and 2002 can be carried back for five years.

39

Example

Assume a corporation has $100,000 of taxable income from operations, $5,000 of interest income, and $10,000 of dividend income.

What is its tax liability?

40

Operating income $100,000Interest income 5,000Taxable dividend

income

3,000*Taxable income $108,000

*Dividends - Exclusion = $10,000 - 0.7($10,000) = $3,000.

Example (Continued)

41

Taxable Income = $108,000Tax on base = $22,250Amount over base = $108,000 - $100,000

= $8,000Tax = $22,250 + 0.39 ($8,000)

= $25,370.

Example (Continued)

42

Key Features of Individual Taxation Individuals face progressive tax rates,

from 10% to 35%. The rate on long-term (i.e., more than

one year) capital gains is 15%. But capital gains are only taxed if you sell the asset.

Dividends are taxed at the same rate as capital gains.

Interest on municipal (i.e., state and local government) bonds is not subject to Federal taxation.

43

Taxable versus Tax Exempt Bonds

State and local government bonds (municipals, or “munis”) are generally exempt from federal taxes.

44

ExxonMobil bonds at 10% versus California muni bonds at 7%

T = Tax rate = 25.0%. After-tax interest income: ExxonMobil = 0.10($5,000) -

0.10($5,000)(0.25) ExxonMobil = 0.10($5,000)(0.75)

= $375. CAL = 0.07($5,000) - 0 = $350.

45

Breakeven Tax Rate

At what tax rate would you be indifferent between the muni and the corporate bonds?

Solve for T in this equation:Muni yield = Corp Yield(1-T)

7.00% = 10.0%(1-T)T = 30.0%.

46

Implications

If T > 30%, buy tax exempt munis. If T < 30%, buy corporate bonds. Only high income, and hence high

tax bracket, individuals should buy munis.