Overview of the Global Financial Reporting Environment â€" D ...
Chapter 1 Overview and Financial Environment
Transcript of Chapter 1 Overview and Financial Environment
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CHAPTER 1Overview of Financial
Management &Environment
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Overview of FinancialManagement
Role of financial managementForms of business organization
Goals of the corporation
Agency relationships
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All Successful Firms Accomplish 2 Goals
They identify, create, & deliver productsor services that are highly valued
This happens only if the firm provides morevalue than its competitors (in the form of eitherlower prices or better products)
They sell at prices high enough to covercosts and to compensate owners andcreditors for their exposure to risk
The profit must be high enough to adequatelycompensate investors
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3 Key Attributes for Success
1. Skilled People at all levelsLeaders, managers and work force
2. Strong Relationships with groups outsidethe company
Successful companies develop win-winrelationships with suppliers, who thendeliver high-quality materials on time and ata reasonable cost
3. Enough Capital to execute their plans &support operations
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3 Key Attributes for Success
3. Enough Capital to execute their plans &support operations
Most companies need cash to purchaseland, buildings, equipment, and materialsCompanies can reinvest a portion of theirearnings, but most must also raiseadditional funds externally,
by some combination of selling stock and/orborrowing in the financial markets
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What causes a company to have aparticular stock value?
How can managers make choices thatadd value to their companies?
How can managers ensure that theircompanies dont run out of cash whileexecuting their plans?
3 questions FinancialManagement must answer
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5 Primary Activities ofFinancial Management
Cash ManagementMinimize Cost of Capital
Strategic Investment (CapitalBudgeting) Allocation of Income (Dividends vs.Retained Earnings)Risk Management
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Sole proprietorship
Partnership
Corporation
Alternative Forms of Business Organization
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Factors to consider
Ease of formationTaxation
Liability of ownersLife of enterpriseEase/difficulty of raising capitalTransfer of ownership
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Sole Proprietorship
Unincorporated business owned by oneindividual (1 owner) Advantages:
Easily and inexpensively formedSubject to few regulationsIts income is not subject to corporatetaxation but
it is taxed only as a part of the proprietorsincome
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Sole Proprietorship
Disadvantages:Difficult to raise capital
It is difficult for a single owner to obtain the
capital needed for growthUnlimited liabilityThe proprietor has unlimited personal liabilityfor the businesss debts
Limited lifeThe life of a proprietorship is limited to the lifeof its founder
Used primarily for small businesses
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Partnership
More than 1 ownerExists whenever two or more personsassociate to conduct a business forprofitPartnership agreements
Formal or informalDefine the ways any profits and losses areshared between partners
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Partnership
Major advantageIts low cost and ease of formation
Partnerships income is not subject tocorporate taxation but is taxed only as a
part of the partners personal income
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Partnership
DisadvantagesUnlimited liabilityLimited life of the organization
Difficulty transferring ownershipDifficulty raising large amounts of capital
Regarding liabilityThe partners can potentially lose all of theirpersonal assets, even assets not invested in thebusiness
Under partnership law, each partner is liable forthe businesss debts
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Partnership
It is possible to limit the liabilities ofsome of the partners by establishing alimited partnership
Certain partners are designated generalpartners and others limited partners
Limited partners are liable only for the amountof their investment in the partnershipLimited partners typically have no controlGeneral partners have unlimited liability
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Partnership
In both regular and limited partnership, at leastone partner is liable for the debts of thepartnership
In a limited liability partnership (LLP) , orlimited liability company (LLC)
All partners enjoy limited liability with regard to the
businesss liabilitiesTheir potential losses are limited to their investmentThis increase the risk faced by an LLPs lender,customers, and suppliers
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Many owners
Legal entity created by a state, and itis separate and distinct from itsowners and managers
Corporation
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Advantages:Unlimited life
A corporation can continue after its originalowners and managers are deceased
Easy transfer of ownershipOwnership interests can be divided intoshares of stock, which can be transferred
easilyLimited liabilityLosses are limited to the actual fundsinvested
Ease of raising capital
Corporation
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Disadvantages:Corporate earnings may be subject todouble taxation
The earnings of the corporation are taxed atthe corporate level, and thenearnings paid out as dividends are taxedagain as income to the stock holders
Cost of set-up and report filingSetting up a corporation involves preparing acharter, writing a set of bylaws and filling themany required reports
Corporation
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Charter: Establishing Separate Legal EntityName
Activities Amount of Capital Stock Number of DirectorsNames & Addresses of Directors
Bylaws: Rules for conduct of ActivitiesHow Directors will be electedPreemptive Right to new stock issuesProcedures for changing Bylaws, if required
Corporation
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The primary goal is shareholderwealth maximization , which
translates to maximizing stockprice
Goals of the Corporation
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Factors that affect stock price
Projected cashflows toshareholders
Timing of thecash flow stream
Riskiness of thecash flows
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1. Sales revenues depend on theCurrent level of unit sales
Price per unitShort-term growth rate in salesLong-term sustainable growth rate in sales
2. Operating costs and taxes3. Required investments in operations
Three Determinants ofCash Flows
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Operating costs and taxes
The second determinant of cash flowsThe combined impact of operating costsand taxes which
Determines the amount of after-tax profitthat is available to investors after thecompany pays its employees and suppliers
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Required investments inoperations
The third factor affecting cash flows Amount of money a company mustinvest in its operations
including assets such as factories,equipment, computer systems, inventory
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Factors that Affect the Level& Risk of Cash Flows
Decisions made by financial managers:Investment decisionsproduct lines, production processes, geographic market,use of technology, marketing strategy
Financing decisionschoice of debt policy and dividend policy
The firms capital structure and the risk of its
operations determine the total risk of the cashflowsThis risk is combined with the level of interest rates inthe economy and investors overall attitude toward risk,resulting in the rate of return that investors require
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An agency relationship existswhenever a principal hires an agent toact on his or her behalf
Within a corporation, agencyrelationships exist between:
Shareholders and managersShareholders and creditors
Agency Relationships
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Managers are naturally inclined to act intheir own best interestsBut the following factors affectmanagerial behavior:
Managerial compensation plansDirect intervention by shareholdersThe threat of firingThe threat of takeover
Shareholders versusManagers
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Shareholders (through managers)could take actions to maximize stock
price that are detrimental to creditors
In the long run, such actions will raisethe cost of debt and ultimately lowerstock price
Shareholders versusCreditors
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The Financial Environment:Markets, Institutions, andInterest Rates
Financial marketsTypes of financial institutionsDeterminants of interest rates
Yield curves
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What is a market?
A market is a venue where goods andservices are exchanged A financial market is a place whereindividuals and organizations wanting toborrow funds are brought together with
those having a surplus of funds
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Physical assets vs. Financial assets
Physical asset marketsCalled tangible or real asset markets,Those for such products as wheat,computers and real estate
Financial asset markets
Deal with stocks, bonds, notes, mortgages,and other claims on real assetsFutures and options (derivatives)
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Money vs. Capital
Money marketsThe markets for short-term (less than one year),highly liquid debt securitiesThe New York and London money markets -worlds largest
Capital marketsThe markets for intermediate (one to five years)or long-term (more than five years) debt andcorporate stocksNew York Stock Exchange
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Primary vs. Secondary
Primary marketsThe markets in which corporations raise newcapital
Example - if Microsoft were to sell a new issue ofcommon stock to raise capital, this would be a primarymarket transaction
Secondary markets
Markets in which existing, already outstanding,securities are traded among investors
Exist for stocks, bonds, mortgages and other financialassets
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Spot vs. Futures
Spot markets and futures markets areterms that refer to whether the assetsare being bought or sold for
on-the-spot delivery (within a few days)or fordelivery at some future date (six months ora year into the future)
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Public vs. Private
Public marketsWhere standardized contracts are tradedon organized exchanges
Public market securities are more liquidPrivate markets
Where transactions are worked out directly
between two partiesExamples of private market transactions
Bank loans and private placements of debt with
insurance companies
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How is capital transferred betweensavers and borrowers?
Direct transfersIndirect transfersthrough Investment
Bankers (Investmentbanking house)Indirect transfers
through FinancialIntermediation
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Types of financial intermediaries
Commercial banksSavings and loan associationsMutual savings banksCredit unionsPension fundsLife insurance companiesMutual funds
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The way orders from sellersand buyers are matched
Auction systemWhere traders actually meet in a pit andsellers and buyers communicate with one
another through shouts and hand signals(CBOT)
Dealer market
Electronic communications network
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Dealer market
There are market makers who keep aninventory of the stock Dealers list bid and ask quotes (the
prices at which they are willing to buy orsell)Computerized quotation system keep
track of all bid and ask pricesTraders must contact a specific dealer tocomplete transaction
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Electronic communicationsnetwork (ECN)
Participants in an ECN post their ordersto buy and sell, and the ECNautomatically matches orders
The two largest ECNs for trading U.S.stocks are Instinent (owned by Reuters)and Island
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Interest Rates
The cost of moneyThe price, or cost, of debt capital?
The interest rate
The price, or cost, of equity capital?The required return on equity
The required return investors expect iscomposed of compensation in the form ofdividends and capital gains
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Production opportunities
The ability to turn capital into benefits
Time preferences for consumptionProviders can use their funds forconsumption or savings
By saving, they give up consumption nowin the expectation of having moreconsumption in the future
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Risk
If an investment is risky, thenproviders require a higher expectedreturn to induce them to take the
extra risk
Inflation Also leads to higher interest rates
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Nominal vs. Real ratesr = represents any nominal rater* = (r-star) represents the real risk-free
rate of interest. It is the rate that wouldexist on a riskless security if there wasno inflation. Typically ranges from 1% to4% per year (USA)
rRF = it is the quoted (nominal) risk-free rate of
interest on a security such as a U.S.Treasury billrRF includes the premium for expected inflation
rRF = r* + IP
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Determinants of interest rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt security
r* = real risk-free rate of interestIP = inflation premiumDRP = default risk premiumLP = liquidity premiumMRP = maturity risk premium
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r = r* + IP + DRP + LP + MRPDRP = default risk premium
(this premium reflects the possibility that theissuer will not pay interest or principal)
LP = liquidity premium
(this is a premium charged by lenders toreflect the fact that some securities cannot beconverted to cash on short notice at a
reasonable price)
MRP = maturity risk premium(long-term bonds are exposed to a significantrisk of price declines, and a maturity riskpremium is charged by lenders to reflect thisrisk)
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Premiums added to r* fordifferent types of debt
L-T Corporate
S-T Corporate
L-T Treasury
S-T Treasury
LPDRPMRPIP
ld d h
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Yield curve and the termstructure of interest rates
Term structure relationship betweeninterest rates (or yields)and maturities
The yield curve is agraph of the termstructure
A Treasury yield curvefrom October 2002 canbe viewed at the right
What is the relationship between the
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pTreasury yield curve and the yieldcurves for corporate issues?
Corporate yield curves are higher thanthat of Treasury securities. However,corporate yield curves are not
necessarily parallel to the TreasurycurveThe spread between corporate andTreasury yield curves widens as thecorporate bond rating decreases (risk
increases)
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Illustrating the relationship betweencorporate and Treasury yield curves
0
5
10
15
0 1 5 10 15 20
Years toMaturity
InterestRate (%)
5.2%
5.9% 6.0%TreasuryYield Curve
BB-Rated
AAA-Rated
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Pure Expectations Hypothesis
The PEH contends that the shape of theyield curve depends on investorsexpectations about future interest rates
If interest rates are expected toincrease, L-T rates will be higher thanS-T rates, and vice-versa
the yield curve can slope up, down, or evenbow
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Assumptions of the PEH
Assumes that the maturity risk premiumfor Treasury securities is zero (MRP=0)Long-term rates are an average of
current and future short-term ratesIf PEH is correct, you can use the yieldcurve to back out expected futureinterest rates
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An example:Observed Treasury rates and the PEH
Maturity Yield1 year 6.0%2 years 6.2%3 years 6.4%4 years 6.5%5 years 6.5%
If PEH holds, what does the market expectwill be the interest rate on one-yearsecurities, one year from now? Three-yearsecurities, two years from now?
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One-year forward rate
6.2% = (6.0% + x%) / 212.4% = 6.0% + x%6.4% = x%
PEH says that one-year securities will yield 6.4%, oneyear from now.
Th i
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Three-year security, two yearsfrom now
6.5% = [2(6.2%) + 3(x%) / 532.5% = 12.4% + 3(x%)
6.7% = x%PEH says that three-year securities will yield 6.7%, twoyears from now.
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Conclusions about PEH
Some would argue that the MRP 0, andhence the PEH is incorrectMost evidence supports the general view
that lenders prefer S-T securities, and viewL-T securities as riskierThus, investors demand a MRP to get
them to hold L-T securities (i.e., MRP > 0)