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CHAPTER 1
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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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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
Sole proprietorship

Partnership

Corporation
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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
Advantages:

Ease of formation

Subject to few regulations

No corporate income taxes

Disadvantages:

Limited life

Unlimited liability


Difficult to raise capital to support
growth
Starting as a Sole Proprietorship
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
A partnership has roughly the same
advantages and disadvantages as a
sole proprietorship.
Starting as or Growing into a
Partnership
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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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
Advantages:

Unlimited life

Easy transfer of ownership


Limited liability

Ease of raising capital

Disadvantages:

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) of Stock

Raises cash

Allows founders and pre-IPO investors
to “harvest” some of their wealth

Subsequent issues of debt and equity

Agency problem: managers may act in
their own interests and not on behalf of
owners (stockholders)
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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.
What should management’s primary
objective be?
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Is maximizing stock price good for
society, employees, and customers?

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)
What three aspects of cash flows
affect an investment’s value?
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What are “free cash flows (FCF)”

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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Determinants of Free Cash Flows

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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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)
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What factors affect the weighted
average cost of capital?

Capital structure (the firm’s relative
amounts of debt and equity)

Interest rates

Risk of the firm

Stock 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:
∞
∞
+
+
+
+
+
=
)WACC1(

FCF

)WACC1(
FCF
)WACC1(
FCF
Value
2
2
1
1
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What are financial assets?

A financial asset is a contract that
entitles the owner to some type of
payoff.

Debt

Equity

Derivatives

In general, each financial asset
involves two parties, a provider of
cash (i.e., capital) and a user of cash.
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What are some financial instruments?
Instrument Rate (April 2003)

U.S. T-bills 1.14%
Banker’s acceptances 1.22
Commercial paper 1.21
Negotiable CDs 1.24
Eurodollar deposits 1.23
Commercial loans Tied to prime (4.25%)
or LIBOR (1.29%)
(More . .)
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Financial Instruments (Continued)
Instrument Rate (April 2003)
U.S. T-notes and T-bonds 5.04%
Mortgages 5.57
Municipal bonds 4.84
Corporate (AAA) bonds 5.91
Preferred stocks 6 to 9%
Common stocks (expected)9 to 15%
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Who are the providers (savers) and
users (borrowers) of capital?

Households: Net savers

Non-financial corporations: Net
users (borrowers)

Governments: Net borrowers

Financial corporations: Slightly
net borrowers, but almost

breakeven
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
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)
What are three ways that capital is
transferred between savers and
borrowers?
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
Commercial banks

Savings & Loans, mutual savings
banks, and credit unions

Life insurance companies

Mutual funds

Pension funds
What are some financial intermediaries?
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The Top 5 Banking Companies
in the World, 12/2001
Bank Name Country
Citigroup U.S.
Deutsche Bank AG Germany
Credit Suisse Switzerland
BNP Paribas France
Bank of America U.S.
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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