CHAPTER 1

Overview of Financial Management and the Financial Environment

Topics in Chapter
   

Forms of business organization Objective of the firm: Maximize wealth Determinants of fundamental value Financial securities, markets and institutions

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)

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

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 (1 + WACC)1 + FCF2 (1 + WACC)2 + + FCF (1 + WACC)

See big picture diagram on next slide.

(More . .)
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Determinants of Intrinsic Value: The Big Picture

Sales revenues Operating costs and taxes Required investments in operating capital Free cash flow (FCF)

Value =

FCF1 FCF2 FCF + + ... + (1 + WACC)1 (1 + WACC)2 (1 + WACC)

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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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. 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).

Through an investment banking house



Through a financial intermediary



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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 exchange rate 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 Money Market
T-Bills CDs Eurodollars Fed Funds
T-Bonds Agency bonds Municipals Corporate bonds

Equity

Derivatives
Options Futures Forward contract

Capital Market

Common stock Preferred stock

LEAPS Swaps

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Typical Rates of Return

Instrument U.S. T-bills Banker s acceptances Commercial paper Negotiable CDs Eurodollar deposits Commercial loans: Tied to prime or LIBOR Rate (January 2009) 0.41% 5.28 0.28 1.58 2.60 3.25 + 2.02 +

(More . .)
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Typical Rates (Continued)

Instrument U.S. T-notes and T-bonds Mortgages Municipal bonds Corporate (AAA) bonds Preferred stocks Common stocks (expected) Rate (January 2009) 3.04% 5.02 4.39 5.03 6% to 9% 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. Existing owner sells to another party. Issuing firm doesn t receive proceeds and is not directly involved.
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Secondary
 

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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Determinants of Intrinsic Value: Calculating FCF

Sales revenues Operating costs and taxes Required investments in operating capital Free cash flow (FCF)

Value =

FCF1 FCF2 FCF + + ... + (1 + WACC)1 (1 + WACC)2 (1 + WACC)

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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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. 2. 3. 4. 5. Pay interest on debt. Pay back principal on debt. Pay dividends. Buy back stock. 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 EVA10 = NOPAT- (WACC)(Capital) = $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 Stock price # of shares EPS DPS $8.50 100,000 $0.88 $0.22 2010 $6.00 100,000 -$0.95 $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 value of equity book

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Key Features of the Tax Code

 

Corporate Taxes Individual Taxes

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2009 Corporate Tax Rates

Taxable Income 0 -50,000 50,000 - 75,000 75,000 - 100,000 100,000 - 335,000 335,000 - 10M 10M - 15M 15M - 18.3M 18.3M and up Tax on Base 0 7,500 13,750 22,250 113,900 3,400,000 5,150,000 6,416,667 Rate on amount above base 15% 25% 34% 39% 34% 35% 38% 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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Example (Continued)

Operating income Interest income Taxable dividend income Taxable income

$100,000 5,000 3,000* $108,000

*Dividends - Exclusion = $10,000 - 0.7($10,000) = $3,000. 40

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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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.

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