FM11 Ch 01 for sp 2010
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Transcript of FM11 Ch 01 for sp 2010
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CHAPTER 1Overview of Financial Management
and the Financial Environment
Financial management
Forms of business organization
Objective of the firm: Maximize wealth
Determinants of stock pricing
The financial environmentFinancial instruments, markets and
institutions
Interest rates and yield curves
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Why is corporate finance important to
all managers?
Corporate finance provides the skillsmanagers need to:
Identify and select the corporatestrategies and individual projectsthat add value to their firm.
Forecast the funding requirementsof their company, and devisestrategies for acquiring thosefunds.
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Sole proprietorship
Partnership
Corporation
What are some forms of business
organization a company might have asit evolves from a start-up to a major
corporation?
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Advantages:
Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages:
Limited life
Unlimited liability
Difficult to raise capital to supportgrowth
Starting as a Sole Proprietorship
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B
ecoming a Corporation
A corporation is a legal entityseparate from its owners and
managers.
File papers of incorporation withstate.
Charter
Bylaws
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Advantages:
Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capitalDisadvantages:
Double taxation
Cost of set-up and report filing
Advantages and Disadvantages of a
Corporation
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Becoming a Public Corporation and
Growing Afterwards
Initial Public Offering (IPO) ofStock
Raises cash
Allows founders and pre-IPO investorsto harvest some of their wealth
Subsequent issues of debt and equity
Agency problem: managers may act intheir own interests and not on behalf ofowners (stockholders)
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The primary objective should beshareholder wealth maximization,
which translates to maximizing stockprice.
Should firms behave ethically? YES!
Do firms have any responsibilities tosociety at large?YES! Shareholdersare also members of society.
What should managements primary
objective be?
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Is maximizing stock price good for
society, employees, and customers?
Employment growth is higher in firmsthat try to maximize stock price. On
average, employment goes up in:
firms that make managers intoowners (such as LBO firms)
firms that were owned by thegovernment but that have been soldto private investors
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Consumer welfare is higher incapitalist free market economiesthan in communist or socialisteconomies.
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
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Amount of expected cash flows(bigger is better)
Timing of the cash flow stream(sooner is better)
Risk of the cash flows (less risk isbetter)
What three aspects of cash flows
affect an investments value?
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What are free cash flows (FCF)
Free cash flows are the cash flowsthat are:
Available (or free) for distribution
To all investors (stockholders andcreditors)
After paying current expenses,taxes, and making the investmentsnecessary for growth.
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Determinants of Free Cash Flows
Sales revenues
Current level
Short-term growth rate in sales
Long-term sustainable growth rate insales
Operating costs (raw materials, labor,
etc.) and taxesRequired investments in operations
(buildings, machines, inventory, etc.)
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What 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 companysinvestors (stockholders andcreditors)
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What factors affect the weighted
average cost of capital?
Capital structure (the firms relativeamounts of debt and equity)
Interest rates
Risk of the firm
Stock market investors overallattitude toward risk
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What determines a firms value?
A firms value is the sum of all thefuture expected free cash flows when
converted into todays dollars:
g
g
!
)WACC1(
FCF....
)WACC1(
FCF
)WACC1(
FCFValue
2
2
1
1
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What are financial assets?
A financial asset is a contract thatentitles the owner to some type ofpayoff.
Debt
Equity
Derivatives
In general, each financial assetinvolves two parties, a provider ofcash (i.e., capital) and a user of cash.
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Direct transfer(e.g., corporation issuescommercial paper to insurance company)
Through an investment banking house(e.g., IPO, seasoned equity offering, ordebt placement)
Through a financial intermediary (e.g.,individual deposits money in bank, bankmakes commercial loan to a company)
What are three ways that capital is
transferred between savers and
borrowers?
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Commercial banks
Savings & Loans, mutual savingsbanks, and credit unions
Life insurance companies
Mutual funds
Pension funds
What are some financial intermediaries?
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What are some types of markets?
A market is a method ofexchanging one asset (usuallycash) for another asset.
Physical assets vs. financial assets
Spot versus future markets
Money versus capital markets
Primary versus secondary markets
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Dealer Markets
Dealers keep an inventory of the stock (orother financial asset) and place bid and askadvertisements, which are prices at
which they are willing to buy and sell.
Computerized quotation system keepstrack of bid and ask prices, but does notautomatically match buyers and sellers.
Examples: Nasdaq National Market, NasdaqSmallCap Market, London SEAQ, GermanNeuer Markt.
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Electronic Communications Networks
(ECNs)
ECNs:
Computerized system matchesorders from buyers and sellersand automatically executestransaction.
Examples: Instinet (US, stocks),Eurex (Swiss-German, futurescontracts), SETS (London,stocks).
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Over the Counter (OTC) Markets
In the old days, securities were keptin a safe behind the counter, andpassed over the counter when they
were sold.Now the OTC market is the equivalent
of a computer bulletin board, whichallows potential buyers and sellers to
post an offer.No dealers
Very poor liquidity
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What do we call the price, or cost,ofdebt capital?
The interest rate
What do we call the price, or cost,ofequity capital?
Required Dividend Capitalreturn yield gain
= + .
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What four factors affect the cost
of money?
Production opportunities
Time preferences for consumption
Risk
Expected inflation