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Overview 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 environment Financial instruments, markets and institutions Interest rates and yield curves
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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.
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What are some forms of business organization a company might have as it evolves from a start-up to a major corporation?
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A partnership has roughly the same advantages and disadvantages as a sole proprietorship.
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Becoming a Corporation
A corporation is a legal entity separate from its owners and managers. File papers of incorporation with state. Charter Bylaws
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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.
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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
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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
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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 is better)
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Free cash flows are the cash flows that are: Available (or free) for distribution To all investors (stockholders and creditors) After paying current expenses, taxes, and making the investments necessary for growth.
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Sales revenues
Current level Short-term growth rate in sales Long-term sustainable growth rate in sales
Operating costs (raw materials, labor, etc.) and taxes Required investments in operations (buildings, machines, inventory, etc.)
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The weighted average cost of capital (WACC) is the average rate of return required by all of the companys investors (stockholders and creditors)
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Capital structure (the firms relative amounts of debt and equity) Interest rates Risk of the firm Stock market investors overall attitude toward risk
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A firms value is the sum of all the future expected free cash flows when converted into todays dollars:
FCF1 FCF2 FCFg Value ! .... 1 2 (1 WACC ) (1 WACC ) (1 WACC )g
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A financial asset is a contract that entitles the owner to some type of payoff. Debt Equity In general, each financial asset involves two parties, a provider of cash (i.e., capital) and a user of cash.
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Financial Instruments (Continued) Instrument Mortgages Municipal bonds Corporate (AAA) bonds Preferred stocks Common stocks (expected) Rate (April 2003) 5.04% 5.57 4.84 5.91 6 to 9% 9 to 15%
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Households: Net savers Non-financial corporations: Net users (borrowers) Governments: Net borrowers Financial corporations: Slightly net borrowers, but almost breakeven
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What are three ways that capital is transferred between savers and borrowers?
Direct transfer (e.g., corporation issues commercial paper to insurance company) Through an investment banking house (e.g., IPO) Through a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company)
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Commercial banks Savings & Loans Life insurance companies Mutual funds Pension funds
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Deutsche Bank AG Germany Credit Suisse BNP Paribas Bank of America Switzerland France U.S.
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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
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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)
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Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock Exchange Computer/telephone: e.g., Nasdaq, government bond markets, foreign exchange markets
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Dealer Markets
Dealers keep an inventory of the stock (or other financial asset) and place bid and ask advertisements, (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, German Neuer Markt.
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ECNs: Computerized system matches orders from buyers and sellers and automatically executes transaction. Examples: Instinet (US, stocks), Eurex (Swiss-German, futures contracts),
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r*
= Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities.
r rRF
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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.
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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
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Term structure: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve.
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Add the IPs and MRPs to r*: rRFt = r* + IPt + MRPt . rRF = Quoted market interest rate on treasury securities. Assume r* = 3%: rRF1 = 3% + 5% + 0.0% = 8.0%. rRF10 = 3% + 7.5% + 0.9% = 11.4%. rRF20 = 3% + 7.75% + 1.9% = 12.65%.
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1 yr 10 yr 20 yr
10
Inflation premium
5
Real risk-free rate
0 1 10
Years to Maturity
20
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This constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity risk premium.
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The relationship between the Treasury yield curve and the yield curves for corporate issues.
Corporate yield curves are higher than that of the Treasury bond. The spread between a corporate yield and the Treasury yield widens as the corporate bond rating decreases.
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BB-Rated
10
AAA-Rated
5.9%
5.2%
0 0 1 5 10 15 20
Years to maturity
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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 countrys economic, political, and social environment. Exchange rate risk: If investment is denominated in a currency other than the dollar, the investments value will depend on what happens to exchange rate.
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Changes in relative inflation will lead to changes in exchange rates. An increase in country risk will also cause that countrys currency to fall.