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CHAPTER 1

Overview of Corporate Finance and the Financial Environment

Topics in Chapter

Financial management

Forms of business organization Objective of the firm: Maximize wealth Determinants of stock pricing Financial instruments, markets and institutions Interest rates and yield curves
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The financial environment

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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Business Organization from Startup to a Major Corporation


Sole proprietorship Partnership Corporation

Starting as a Proprietorship

Advantages:

Ease of formation Subject to few regulations No corporate income taxes Limited life Unlimited liability Difficult to raise capital to support growth
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Disadvantages:

Starting as or Growing into a Partnership

A partnership has roughly the same advantages and disadvantages as a sole proprietorship.

Becoming a Corporation

A corporation is a legal entity separate from its owners and managers. File papers of incorporation with state.

Charter Bylaws

Advantages and Disadvantages of a Corporation

Advantages:

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

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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What should be managements primary objective?

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.

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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
(Continued)
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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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What three aspects of cash flows affect an investments 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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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 companys investors (stockholders and creditors)

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What factors affect the weighted average cost of capital?

Capital structure (the firms 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 firms value?


A firms value is the sum of all the future expected free cash flows when converted into todays dollars:
Value = FCF1 (1 + WACC)1 + FCF2 (1 + WACC)2 + FCF (1 + WACC)

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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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Bonus Slide: Derivatives Terminology


Options Basic Positions


Futures Basic Positions


Call / Put Long / Short

Long (Buy) Short (Sell) Futures Price Delivery Date Assets

Terms

Terms

Exercise Price Expiration Date Assets

CBOE

CBOT
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Financial Assets and Markets


Primitives Debt
Money Market Capital Market
T-Bills CDs Eurodollars Fed Funds

Derivatives Options
Stock Indexes Futures Currency

Equity

Futures
Indexes Commodities Interest Rates Currency

T-Bonds

Common Agency bonds stock Municipals Preferred Corporate bonds stock

LEAPS

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Financial Instruments and Rates


Instrument U.S. T-bills Bankers acceptances Commercial paper Negotiable CDs Eurodollar deposits Commercial loans: Tied to prime or LIBOR Rate (March 2004) 0.94% 1.04 1.00 1.04 1.04 4.00 + 1.11 +

(More . .)
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Financial Instruments and Rates (Continued)


Instrument U.S. T-notes and T-bonds Mortgages Municipal bonds Corporate (AAA) bonds Rate (March 2004) 4.73% 5.08 4.41 5.28

Preferred stocks
Common stocks (expected)

6 to 9%
9 to 15%

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Bonus Slide: Domestic Stock Indexes


Dow Jones Industrial Average Standard & Poors 500 Composite Nasdaq Composite NYSE Composite Wilshire 5000

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Bonus Slide: International Stock Indexes


Nikkei 225 Tokyo FTSE 100 London Dax 30 Germany Hang Seng Hong Kong Region and Country Indexes

Example: Morgan Stanley Capital International (MSCI) Euro Index


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Bonus Slide: Stock Weighting in Indexes

Price weighted

DJIA S&P500 Nasdaq Composite Value Line Index


http://www.quickmba.com/finance/invest/indices.shtml

Market-value weighted

Equally weighted

See

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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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Transfer of Capital from Savers to 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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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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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 doesnt receive proceeds and is not directly involved.
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Secondary

Bonus Slide: Investment Banking

Underwritten vs. Best Efforts

Underwritten: firm commitment on proceeds to the issuing firm. Best Efforts: no firm commitment. Negotiated: issuing firm negotiates terms with investment banker. Competitive bid: issuer structures the offering and secures bids.
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Negotiated vs. Competitive Bid

Bonus Slide: Public Offerings

Public offerings: registered with the SEC and sale is made to the investing public.

Shelf registration (Rule 415, since 1982) allows firms to register an offering and sell parts of the offering over time. UnderpricingAverage increase is 14% on first day. Performance Underperforms similar stock during three years after IPO.

Initial Public Offerings (IPOs)


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Bonus Slide: Private Placement

Sale to a limited number of sophisticated investors not requiring the protection of registration.
- Dominated by institutions. - Very active market for debt securities. - Not active for stock offerings.

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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, CBOT, Tokyo Stock Exchange Computer/telephone: e.g., Nasdaq, government bond markets, foreign exchange markets

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Types of Orders

Instructions on how a transaction is to be completed

Market Order Transact as quickly as possible at current price Limit Order Transact only if specific situation occurs. For example, buy if price drops to $50 or below during the next two hours.
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Bonus Slide: Costs of Trading


Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer

Price Impact Large sales or purchase might cause prices to change. Payment for Order Flow Exchange will pay brokers to direct orders to them.
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Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid

Auction Markets

NYSE and AMEX are the two largest auction markets for stocks. Participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients; e.g., CBOT. NYSE is a modified auction, with a specialist.

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Bonus Slide: The Specialist at the NYSE

One per stock (each specialist handles around 10-20 stocks) All trades in these stocks at the specialists post Makes a market by matching buyers/seller and by buying/selling from own inventory Goal is to maintain a fair and orderly market so that price changes are smooth
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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. Often many dealers for each stock 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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Electronic Communications Networks (ECNs)

ECNs:

Computerized system matches orders from buyers and sellers and automatically executes transaction. Low cost to transact Examples: Instinet, Island, and Archipelago (US, stocks); Eurex (Swiss-German, futures contracts); SETS (London, stocks).
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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 (e.g., Nasdaq Pink Sheets), which allows potential buyers and sellers to post an offer.

No dealers Very poor liquidity


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Bonus Slide: Trading Away from Exchanges

Third Market trading listed stocks but not through exchange

Institutional market: to facilitate trades of larger blocks of securities. Involves services of dealers and brokers

Fourth Market institutions trading with institutions

No middleman involved in the transaction


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Bonus Slide: Margin Trading

Investor uses only a portion of own capital for an investment. Borrows remaining component. Margin arrangements differ for stocks and futures.

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Bonus Slide: Stock Margin Trading

Maximum initial margin


Currently 50% Set by the Fed Minimum level of equity margin if prices change Call for more equity funds
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Maintenance margin

Margin call

Bonus Slide: Short Sales Mechanics

Opening a short position:


Borrow stock through a dealer. Sell it Deposit proceeds and margin in account. Buy the stock Return to the party from which it was borrowed.
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Closing out the position:


Bonus Slide: Short Sales Purposes and Features

Purpose: to profit from a decline in the price of a stock or security. Uptick restrictions Unlimited loss potential

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Bonus Slide: Regulation of Securities Markets


Government Regulation such as SEC. Self-Regulation such as NASD. Circuit Breakers automatic halt in trading if stock prices have exceptional changes. Insider trading oversight ECNs and Fragmentation makes regulation more difficult
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Cost of Capital

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?

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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Real versus Nominal Rates

r* = Real risk-free rate. This is T-bond rate if no inflation; around 1% to 4%.

r = Any nominal rate.


rRF = Rate on Treasury securities.
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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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Premiums Added to r* for Different Types of Debt


ST Treasury: only IP for ST inflation LT Treasury: IP for LT inflation, MRP ST corporate: ST IP, DRP, LP LT corporate: IP, DRP, MRP, LP

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Term Structure Yield Curve

Term structure of interest rates: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve.

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Constructing a Hypothetical Treasury Yield Curve

Estimate the inflation premium (IP) for each future year. This is the estimated average inflation over that time period. Step 2: Estimate the maturity risk premium (MRP) for each future year.

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Step 1: Find IPn, the average expected inflation rate (INFLt) over years 1 to n.

IPn =
t=1

INFLt

n
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Assume investors expect inflation to be 5% next year, 6% the following year, and 8% per year thereafter. IP1 = 5%/1.0 = 5.00%. IP10 = [5 + 6 + 8(8)]/10 = 7.5%.

IP20 = [5 + 6 + 8(18)]/20 = 7.75%.


Must earn these IPs to break even versus inflation; that is, these IPs would permit you to earn r* (before taxes).
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Step 2: Find MRP

Assume the MRP is zero for Year 1 and increases by 0.1% each year:

MRPt = 0.1%(t - 1).

MRP1 = 0.1% x 0 MRP10 = 0.1% x 9 MRP20 = 0.1% x 19

= 0.0%. = 0.9%. = 1.9%.


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Step 3: rRFt = r* + IPt + MRPt


rRF = Quoted market interest rate on treasury securities.

Assume r* = 3%: rRF1 = 3% + 5% + 0.0% = 8.0%.


rRF10 = 3% + 7.5% + 0.9% = 11.4%.

rRF20 = 3% + 7.75% + 1.9% = 12.65%.


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Hypothetical Treasury Yield Curve


14% 12%

Interest Rate

10% 8% 6% 4% 2% 0%

MRP IP r*

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Years to Maturity
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What factors can explain the shape of this yield curve?

This constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity risk premium.

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Relationship Between Treasury Yields and Corporate Yields

Corporate yield curves are higher than that of the Treasury bond. However, corporate yield curves are not necessarily parallel to the Treasury curve. The spread between a corporate yield curve and the Treasury curve widens as the corporate bond rating decreases.
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Hypothetical Treasury and Corporate Yield Curves


12.0% 10.0%

Interest Rate

8.0% 6.0% 4.0% 2.0% 0.0% 1 10 Years to Maturity 20 5.2% 5.9% 6.0%

BB Bond AAA Bond Treasury Bond

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What is the Pure Expectations Hypothesis (PEH)?

Shape of the yield curve depends on the investors expectations about future interest rates. If interest rates are expected to increase, L-T rates will be higher than S-T rates and vice versa. Thus, the yield curve can slope up or down. PEH assumes that MRP = 0.
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What various types of risks arise when investing overseas?

Country risk: Arises from investing or doing business in a particular country. It depends on the countrys economic, political, and social environment. Exchange rate risk: If investment is denominated in a currency other than the dollar, the investments value will depend on what happens to exchange rate.
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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 countrys currency to fall.

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Chapter 1 Web Extension


Pure Expectations Hypothesis of the Term Structure

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The Pure Expectations Hypothesis (PEH)

Long-term rates are an average of current and future short-term rates. If PEH is correct, you can use the yield curve to back out expected future interest rates.

PEH Estimation Example Observed Treasury Rates


Maturity
1 year - y0,1

Yield
6.0%

2 years - y0,2
3 years - y0,3 4 years - y0,4 5 years - y0,5

6.2%
6.4% 6.5% 6.5%

Yields on a Time-Line
Y0,1 = 6.0%

Y0,2 = 6.2%

Y0,5 = 6.5%
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Prices vs. Yields

$100 invested now (t=0) for 2 years will yield 6.2% per year:

$100(1.062)2 = $112.78

$100 invested now (t=0) for 5 years will yield 6.5% per year:

$100(1.065)5 = $137.01

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PEH Estimation Example Observed Treasury Rates

If PEH holds, what does the market expect will be the interest rate on:

One-year securities, one year from now? (y1,2 ) Three-year securities, two years from now? (Y2,5 )

PEH tells us that one-year securities will yield 6.4%, one year from now (x%).
x%
6.0%

1
6.2%

(6.0% + x%) 6.2% = 2 12.4% = 6.0 + x% 6.4% = x%.


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PEH tells us that three-year securities will yield 6.7%, two years from now (x%).
6.2% x%

3 4 5 6.5% [ 2(6.2%) + 3(x%) ] 6.5% = 5 32.5% = 12.4% + 3(x%) 20.1% = 3(x%) 75 6.7% = x%.

Theoretically Correct Estimation Procedure

To solve for y1,2 :


(1.06)(1+x) = (1.062)2 x = 6.4% = y1,2 (1.062)2 x (1+x)3 = (1.065)5 x = 6.7% = y2,5

To solve for y2,5 :


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