An overview of Financial Management &

Financial Environment

CHAPTER 1

Chapter 1 outline

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The corporate Life cycleThe primary objective of the corporation: Value

MaximizationThe capital allocation processFinancial securitiesThe cost of moneyFinancial institutionsFinancial marketsTrading procedures in financial marketsTypes of stock market transactionsThe secondary stock marketThe stock market returnsThe global economic crisis

Introduction

Financial management concerns the acquisition, financing, and management of assets with some overall goal in mind.3 types of decisions

Financing decisions: Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet)• What is the best type of financing? • What is the best financing mix?• What is the best dividend policy (e.g., dividend-

payout ratio)?• How will the funds be physically acquired? 3

Intro …con

Investments decisions• What is the optimal firm size?• What specific assets should be acquired?• What assets (if any) should be reduced or

eliminated?

Asset management decisions• Greater emphasis on current asset

management than fixed asset management.• How do we manage existing assets efficiently?• Financial Manager has varying degrees of

operating responsibility over assets.4

The corporate Life cycle

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Forms of business a company might take from a start-up to a major corporation?

Sole proprietorship

Partnership

Corporation

Sole Proprietorship

Advantages:Ease of formation and Inexpensive Subject to few regulationsNo corporate income taxes (only taxed for

personal income)

Disadvantages:Limited life (to the life of its founder)Unlimited personal liability (creditors may

seize owner’s belongings)Difficult to raise capital to support growth

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PartnershipRegular liability partnership has roughly the

same advantages and disadvantages of proprietorship.

Limited liability company (LLC): potential losses are limited only to partner’s business liabilities

A partnership may have: limited & regular partners The first has limited liabilities but with no control over

businessThe second has unlimited personal liabilities but with

control

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A Corporation (many owners)

A legal entity separate from its owners & managers.

Advantages:Ease of raising capitalUnlimited lifeEasy transfer of ownershipLimited liability

Disadvantages:Double taxation (corporate level & personal

income level)Cost & complication of setting-up charter &

bylaws88

Growing & managing a corporation

In the beginning financing come from personal resources

If it grows financing may rely on selling stocks to othersIf grow more it may attract lending from banksOR selling stocks using Initial Public Offering (IPO)Then issuing debt, or selling extra shares of stocks

IMPORTANT: ability to grow depend on financial marketsAgency problem in corporations: managers may act in

their own interests and not on behalf of owners (stockholders)

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The primary objective of the corporation: Value

Maximization

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i.e. maximizing intrinsic (i.e. fundamental) stock price, not merely market price. (ethical difference)

Maximizing stock price benefit society through: the owners of stock are societyConsumers benefit- as the business increase their

welfare: become efficient, use high quality products & services …etc

Employees benefit- they like working for good companies, add more employees

Most admired companies are the ones with high stock prices

Value Maximization …con

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IMPORTANT: A company’s ability to generate cash flows now and in the future, determines its value

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)

What matters is the “free cash flows (FCF)”. It is Available (or free) for distribution & to all investors

Determinants of FCFFCF = Sales revenues – operating costs – taxes – required

new investments for growth

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 company’s investors (stockholders and creditors)

factors affect the weighted average cost of capitalCapital structure (the firm’s relative amounts of debt

and equity)Interest ratesRisk of the firmStock market investors’ overall attitude toward risk

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What determines a firm’s value?

A firm’s value is the sum of all the future expected free cash flows when converted into today’s dollars:

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)WACC1(

FCF....

)WACC1(

FCF

)WACC1(

FCFValue

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three ways for transferring capital between savers and

borrowers?

Direct transfer (e.g., corporation issues commercial paper to insurance company)

Through an investment banking house (e.g., IPO, seasoned equity offering, or debt placement)

Through a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company)

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An overview of the capital allocation

process

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Three ways to transfer money from savers to Businesses

Financial securities

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They are pieces of paper with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values.

type of claim classification: Debt; Equity; Derivatives

Debt instruments= specified payments & maturityEquity instruments are a claim upon a residual

value, i.e. after bondholders, creditors & other claimants.

Derivatives are derived from, the values of some other traded assets (ex. options & futures).

Some financial instruments?

Instrument Rate (April 2003)U.S. T-bills 1.14%Preferred stocks 6 to 9%Common stocks (expected)

9 to 15%Commercial loans Tied to prime (4.25%) or

LIBOR (1.29%)

Municipal bonds 4.84Mortgages 5.57%

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Some financial intermediaries

Commercial banksSavings & Loans, mutual savings

banks, and credit unionsLife insurance companiesMutual fundsPension funds

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The cost of money

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Allocating capital from providers’ supply to users’ demand come thru a price or cost of money

It is the rate users pay to providersFor debt it is called interest rateFor equity it is called cost of equity (dividends + capital

gains)

Four fundamental factors affect cost of moneyProduction opportunities (turn money into benefit)Time preferences for consumption (which increase saving)RiskExpected inflation

Economic conditions affect

Cost of money

Federal Reserve policy;federal budget deficit or surplus;level of business activity; international factors (foreign trade

balance, international business climate, & exchange rates).

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Federal Reserve policy

To stimulate economy Fed may work to Increase supply of loanable cash, by purchasing treasury securities held by banks , this will lower interest rates

This may increase inflation on the long run– which may lead to increasing interest rates

To slow down inflation Fed may do the opposite, by selling treasury securities to banks to decrease money supply, which decrease interest rate and then decrease inflation

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Federal budget deficit or surplus

deficit must be covered (by borrowing thru issuing treasury securities or printing money) which increase money supply, which increase interest rates

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level of business activity

interest rates and inflation typically rise prior to a recession and fall afterward. Why?Consumer demand slows in recessions which

reduce inflationCompanies reduce investments in new

operationsEmployment decrease which cut inflation

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International Trade Deficits or Surpluses

Deficit main source of finance is debt which increase interest rates

if the Fed attempts to lower interest rates to fall below rates abroad, investors will sell treasury securities and this will increase interest rates

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International Country Risk

It is the risk that arises from investing or doing business in a particular country, and it depends on the country’s economic, political, and social environment.

It includes risks associated with changes in tax rates, regulations, currency conversion, and exchange rates

It may increase the cost of money.25

Financial institutions

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Deposit-Taking Financial IntermediariesCommercial BanksSavings and Loan Associations (S&Ls) (acquired

by banks now)Credit Unions (as cooperative associations)

Investment banks help companies raise capitalUnderwrite security offerings (primary market)Provide consulting & Advisory servicesProvide brokerage servicestrading securities for their own accounts

Financial institutions …con

Investment fundsMutual fundsHedge funds (institutional investors, less

regulated, sophisticated) Private equity funds (own & control companies,

not traded in the stock market)

Life Insurance Companies and Pension Funds

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Financial markets

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A market is a method of exchanging one asset (usually cash) for another asset.

Physical assets vs. financial assetsMoney versus capital marketsPrimary versus secondary marketsMortgage vs. consumer credit

marketSpot versus future markets

Trading procedures in financial markets

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Secondary markets classified by “location”Physical location exchanges (e.g., NYSE, AMEX, CBOT,

…)Computer/telephone networks (Nasdaq, government

bond markets, foreign exchange markets)Classified by the way that orders are

matchedOpen outcry auction (buyer & seller meet &

communicate)Dealers i.e., market makers (list bid & ask quotes )

buyers & sellers must contact dealersElectronic communications networks (ECNs)

Over the counter market OTC (unofficial)No dealersVery poor liquidity

Types of stock market transactions

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initial public offerings IPO (public for the first time)

seasoned equity offerings, (issue additional shares )

secondary market (trading outstanding shares)

The big picture: determinants of the intrinsic value of the

firm

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