46170020-fi-515-week-1-ll
TRANSCRIPT
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CHAPTER 1
Overview of Financial Management and the Financial Environment
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Topics in Chapter Forms of business organization Objective of the firm: Maximize
wealth Determinants of fundamental
value Financial securities, markets and
institutions
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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.
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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.
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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.
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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)
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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.
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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
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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 . .)
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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
...
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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
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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).
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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
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What four factors affect the cost of money?
Production opportunities Time preferences for consumption Risk Expected inflation
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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
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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
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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.
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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
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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 . .)
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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%
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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
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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
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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.
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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)
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Chapter 2
Financial Statements, Cash Flow, and Taxes
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Topics in Chapter
Income statement Balance sheet Statement of cash flows Free cash flow MVA and EVA Corporate taxes Personal taxes
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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
...
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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.
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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.)
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Economic Value Added (EVA)
WACC is weighted average cost of capital
EVA = NOPAT- (WACC)(Capital)
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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.
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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
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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…)
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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
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Key Features of the Tax Code
Corporate Taxes Individual Taxes
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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%
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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%.
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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.
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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?
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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)
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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)
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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.
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Taxable versus Tax Exempt Bonds
State and local government bonds (municipals, or “munis”) are generally exempt from federal taxes.
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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.
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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%.
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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.