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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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Scope of Financial Management

“If you take a class in corporate finance at any
business school, you will be taught that the job of
corporate managers is to make decisions that
maximize the values of their companies.

But when you take accounting courses, you will be

taught that the way companies are required to
measure earnings can be completely unrelated to the
way they make decisions aimed at maximizing
shareholder value.”

Bennett Stewart
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What should management’s primary
objective be?

What are firm decision-makers hired to do?

“General Motors is not in the business of

making automobiles. General Motors is in
the business of making money.”

Alfred P. Sloan
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What is Financial Management?

Concerns the acquisition,

financing, and management
of assets with some overall
goal in mind.
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Finance Navigation quest in all

Times : proper Investing &
Financing decisions to create
sustainable shareholder value
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Investment Decisions

Most important of the three decisions

 What is the optimal firm size?
 What specific assets should be
acquired?
 What assets (if any) should be
reduced or eliminated?
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Financing Decisions

Determine how the assets

will be financed.
 What is the best type of financing?
 What is the best financing mix?
 What is the best dividend policy?
 How will the funds be physically
acquired?
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Asset Management Decisions

 How do we manage existing assets

efficiently?
 Financial Manager has varying degrees
of operating responsibility over assets.
 Greater emphasis on current asset
management than fixed asset
management.
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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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What is the Goal of the Firm?

Maximization of
Shareholder Wealth!
Value creation occurs when we
maximize the value of the firm
and share price for current
shareholders.
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Disciplined
Investment

Wheel of
Superior Operational
Cash flow
Shareholder Excellence
Value

Industry
Leading
Returns
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The Selection of Investment Decision

Investment
Financing Decision
Decision

Projects and
Debt and Equity
Assets

Optimal Capital Optimal Asset

Structure Structure

Weighted Average
Return on
Cost of Capital
Investment (ROI)
(WACC)

Value Creation
ROI > WACC
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How can managers create value to
their companies?

 Managers can meet their objective of

maximizing shareholders’ wealth by
making investments (on the LHS)
whose value is greater than the
amount of capital utilized (from the
RHS) to finance these investments.
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What are some forms of business

organization a company might have as
it evolves from a start-up to a major
corporation?

 Sole proprietorship
 Partnership
 Corporation
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Starting as a Sole Proprietorship

 Advantages:
Ease of formation
Subject to few regulations
No corporate income taxes
 Disadvantages:
Limited life
Unlimited liability
Difficult to raise capital to support
growth
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Starting as or Growing into a

Partnership

 A partnership has roughly the same

advantages and disadvantages as a
sole proprietorship.
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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 and Disadvantages of a

Corporation
 Advantages:
Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
 Disadvantages:
Double taxation
Cost of set-up and report filing
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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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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
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:

FCF1 FCF2 FCF

Value    .. . .
1
(1  WACC ) (1  WACC ) 2
(1  WACC ) 
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The Financial System

 The purpose of the financial system is to

bring together individuals, businesses,
and government entities (economic units)
that generate and spend funds.
Surplus economic units have funds
left over after spending all they wish
to spend.
Deficit economic units need to
acquire additional funds to sustain
their operations.
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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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What are three ways that capital is

transferred between savers & borrowers?
1. Direct Transfers
Securities (Stocks Or Bonds)

Business Dollars Savers

2. Indirect Transfers Through Investment Bankers

Securities Securities
Investment Banking
Business Houses Dollars Savers
Dollars

3. Indirect Transfers Through A Financial Intermediary

Business’s Intermediary’s
Securities Securities
Financial
Business Dollars Dollars Savers
Intermediary
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The Financial System

Borrow Borrow

Savings Savings
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The Financial System

 To enable funds to move through the

financial system, funds are
exchanged for securities.
 Securities are documents that
represent the right to receive funds
in the future.
 Financial intermediaries often help to
facilitate this process.
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What are some financial intermediaries?

 Commercial banks
 Savings & Loans, mutual savings
banks, and credit unions
 Life insurance companies
 Mutual funds
 Pension funds
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Financial Markets

Intermediaries such as commercial banks and

insurance companies help to facilitate the
flow of funds in the financial marketplace.

$$ Securities

Securities $$
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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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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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Financial Markets

 Money Market
Trade short term (1 year or less) debt
instruments (e.g. T-Bills, Commercial
Paper)
Major money centers in Tokyo, London
and New York
 Capital Market
Trades long term securities (Bonds,
Stocks)
NYSE, ASE, over-the-counter (NASDAQ
and other OTC)
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Money Market Securities

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Money Market Securities

 Money Market Securities

Highly liquid, low risk
Treasury Bills (T-Bills)
Certificates of Deposit (CDs)
Commercial Paper
Eurodollars
Banker’s Acceptances
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Capital Market Securities

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Capital Market Securities

 Capital Market Securities

Bonds
Treasury Bonds
Municipal Bonds
Corporate Bonds
Stock
Common Stock
Preferred Stock
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Capital Market Securities

 Capital Market Securities

Bonds

•Bonds are “IOUs” issued by corporations

and sold to investors.
•The corporation promises to repay the
face amount on the maturity date and to
pay interest each year in the amount of
the coupon rate times the face value.
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Capital Market Securities

 Capital Market Securities

Bonds

• Treasury Bonds are issued by the

federal government.
• Municipal Bonds are issued by state
and local governments.
• Corporate Bonds are issued by
corporations.
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Capital Market Securities
 Capital Market Securities
Stock
• Companies can also raise funds by selling
shares of stock.
• Common stockholders own a portion of the
company and can vote on major decisions.
• They receive return on their investment in the
form of dividends and capital gains.
• Preferred stockholders do not generally have
voting rights, but have priority in receiving
dividends and are paid dividends at a pre-set
rate.
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Financial Markets

 Classified according to the

characteristics of participants and
securities involved.
 The primary market is where deficit
economic units sell new securities.
 The secondary market is where
investors trade previously issued
securities with each other.
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Financial Markets

Funds

Primary
Market
Securities
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Financial Markets

Funds

Secondary
Market
Securities
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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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Physical Location vs.

Computer/telephone Networks

 Physical location exchanges:

e.g., NYSE, AMEX, Tokyo Stock
Exchange
 Computer/telephone: e.g.,
Nasdaq, government bond
markets, foreign exchange
markets
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Auction Markets

 NYSE and AMEX are the two largest

auction markets for stocks.
 NYSE is a modified auction, with a
“specialist.”
 Participants have a seat on the
exchange, meet face-to-face, and place
orders for themselves or for their clients.
 Market orders vs. limit orders
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Dealer Markets
 “Dealers” keep an inventory of the stock (or
other financial asset) and place bid and ask
“advertisements,” which are prices at
which they are willing to buy and sell.
 Computerized quotation system keeps
track of bid and ask prices, but does not
automatically match buyers and sellers.
 Examples: Nasdaq National Market, Nasdaq
SmallCap Market, London SEAQ, German
Neuer Markt.
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Over the Counter (OTC) Markets

 In the old days, securities were kept
in a safe behind the counter, and
passed “over the counter” when they
were sold.
 Now the OTC market is the equivalent
of a computer bulletin board, which
allows potential buyers and sellers to
post an offer.
No dealers
Very poor liquidity
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Interest Rate
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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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Real versus Nominal Rates

r* = Real risk-free rate.

T-bond rate if no inflation;
1% to 4%.

r = Any nominal rate.

rRF = Rate on Treasury securities.

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Interest Rates

 Interest Rates Determined by

Real Rate of Interest
Expected Inflation
Default Risk
Maturity Risk
Liquidity Risk
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r = r* + IP + DRP + LP + MRP.

Here:
r = Required rate of return on a
debt security.
r* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.
LP = Liquidity premium.
MRP = Maturity risk premium.
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Interest Rates

 Default Risk
For most securities, there is some
risk that the borrower will not
repay the interest and/or principal
on time, or at all.
The greater the chance of default,
the greater the interest rate the
investor demands and the issuer
must pay.
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Interest Rates

 Expected Inflation
Inflation erodes the purchasing power
of money.
Example: If you loan someone $1,000
and they pay it back one year later with
10% interest, you will have $1,100. But
if prices have increased by 5%, then
something that would have cost $1,000
at the outset of the loan will now cost
$1,000(1.05) = $1,050.
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Interest Rates

 Maturity Risk
If interest rates rise, lenders may
find that their loans are earning rates
that are lower than what they could
get on new loans.
The risk of this occurring is higher
for longer maturity loans.
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Interest Rates

 Maturity Risk
Lenders will adjust the premium
they charge for this risk depending
on whether they believe rates will go
up or down.
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Interest Rates

 Liquidity
Investments that are easy to sell
without losing value are more
liquid.
Illiquid securities have a higher
interest rate to compensate the
lender for the inconvenience of
being “stuck.”