Professional Documents
Culture Documents
Topics in Chapter
Forms of business organization Objective of the firm: Maximize wealth Determinants of fundamental value Financial securities, markets and institutions
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 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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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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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)
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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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
(More . .)
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Value =
Weighted average cost of capital (WACC) Market interest rates Market risk aversion Cost of debt Cost of equity Firm s debt/equity mix Firm s business risk
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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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Direct transfer
Example: A corporation issues commercial paper to an insurance company. Example: In an IPO, seasoned equity offering, or debt placement, company sells security to investment banking house, which then sells security to investor. 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
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Federal Reserve policies Budget deficits/surpluses Level of business activity (recession or boom) International trade deficits/surpluses
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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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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 Money Market
T-Bills CDs Eurodollars Fed Funds
T-Bonds Agency bonds Municipals Corporate bonds
Equity
Derivatives
Options Futures Forward contract
Capital Market
LEAPS Swaps
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(More . .)
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Commercial banks Investment banks Savings & Loans, mutual savings banks, and credit unions Life insurance companies Mutual funds
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
New issue (IPO or seasoned) Key factor: issuer receives the proceeds from the sale. Existing owner sells to another party. Issuing firm doesn t receive proceeds and is not directly involved.
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Secondary
By location
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 =
Weighted average cost of capital (WACC) Market interest rates Market risk aversion Cost of debt Cost of equity Firm s debt/equity mix Firm s business risk
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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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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 value of equity book
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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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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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Example (Continued)
Example (Continued)
Taxable Income = $108,000 Tax on base = $22,250 Amount over base = $108,000 - $100,000 = $8,000 Tax = $22,250 + 0.39 ($8,000) = $25,370.
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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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State and local government bonds (municipals, or munis ) are generally exempt from federal taxes.
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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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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.
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