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Chapter 1

An Overview of Financial


Topics in Chapter

Basic Goal: to create shareholder value
Agency relationships:

Stockholders versus managers
Stockholders versus creditors

Transparency in financial reporting
The Cost of Money


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.

  Should firms behave ethically? YES! Do firms have any responsibilities to society at large? YES! Shareholders are also members of society. which translates to maximizing stock price.What should be management’s primary objective?  The primary objective should be shareholder wealth maximization. 4 .

On average. and customers?  Employment growth is higher in firms that try to maximize stock price. employees. 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 5 .Is maximizing stock price good for society.

In addition to high stock returns. Fortune lists the most admired firms.Is maximizing stock price good? (Continued)   Consumer welfare is higher in capitalist free market economies than in communist or socialist economies. these firms have:   high quality from customers’ view employees who like working there 6 .

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) 7 .

operating costs .Free Cash Flows (FCF)   Free cash flows are the cash flows that are available (or free) for distribution to all investors (stockholders and creditors).operating taxes .required investments in operating capital. 8 . FCF = sales revenues .

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 9 .What is the weighted average cost of capital (WACC)?   WACC is the average rate of return required by all of the company’s investors.

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 10 .

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: Value = FCF1 (1 + WACC)1 + FCF2 (1 + WACC)2 +… FCF∞ (1 + WACC)∞ 11 .

to perform some service and (2) then delegates decision-making authority to that agent. (1) hires another individual or organization. 12 . called principals. called an agent.What is an agency relationship? An agency relationship arises whenever one or more individuals.

would any agency problems exist? No agency problem would exist. 13 .If you are the only employee. and only your money is invested in the business. A potential agency problem arises whenever the manager of a firm owns less than 100 percent of the firm’s common stock. You own 100 percent of the firm. or the firm borrows.

hired the employees to perform some service and delegated some decision-making authority to them. the principal.Would hiring additional people create agency problems? An agency relationship could exist between you and your employees if you. 14 .

15 .Might acquiring capital lead to agency problems? If you needed additional capital to buy computer inventory or to develop software then you might end up with agency problems if the capital is acquired from outside investors.

So it matters whether the new capital comes in the form of an unsecured bank loan.Does the source of the capital affect agency problems? Agency problems are less for secured than for unsecured debt. a bank loan secured by your inventory of computers. or from new stockholders. and different between stockholders and creditors. 16 .

17 .There are 2 potential agency conflicts:   Conflicts between stockholders and managers. Conflicts between stockholders and creditors.

If you expanded to additional locations you could not physically be at all locations at the same time. you would have to delegate decision-making authority to others. 18 . Consequently.Would expansion increase or decrease potential agency problems? Increase.

19 .What actions might make a loan feasible? Creditors can protect themselves by (1) having the loan secured and (2) placing restrictive covenants in debt agreements. They can also charge a higher than normal interest rate to compensate for risk.

Increase “monitoring” costs by making frequent visits to “off campus” locations. Threat of firing.What actions might mitigate your agency problems if you expanded beyond your home campus?    Structuring compensation packages to attract and retain able managers whose interests are aligned with yours. (More…) 20 .

You could minimize potential agency problems by staying on as CEO and running the company. 21 .Would going public in an IPO increase or decrease agency problems? By going public through an IPO. especially if you sell most of your stock and buy a yacht. This would increase agency problems. your firm would bring in new shareholders.

Why might you want make your financial statements look artificially good? A manager might inflate a firm's reported earnings or make its debt appear to be lower if he or she wanted the firm to look good temporarily. 22 . For example just prior to exercising stock options or raising more debt.

23 . If private.What are the potential consequences of inflating earnings or hiding debt? If the firm is publicly traded. banks may be unwilling to lend to it. the stock price will probably drop once it is revealed that fraud has taken place. and investors may be unwilling to invest more money.

What kind of compensation program might you use to minimize agency problems?     “Reasonable” annual salary to meet living expenses Cash (or stock) bonus Options to buy stock or actual shares of stock to reward long-term performance Tie bonus/options to EVA 24 .

Are financial management skills important to your career? Yes! Investors are forcing managers to focus on value maximization. Successful firms (those who maximize shareholder value) will not continue to promote individuals who lack an understanding of financial management. 25 .

This applies both to the initial job.Students who understand this focus have a major advantage in the job market. 26 . and the career path that follows.

27 . accurate information about a particular company.What is transparency in financial reporting?  When all market participants have reliable.

What safeguards help market transparency?     Public companies use GAAP rules established by the FASB for accounting Public companies must have their financial statements audited These statements are made available to the investing public by the SEC Firms must release information to everyone at the same time 28 .

What is Sarbanes-Oxley?   An act passed in 2002 that established new regulations for auditors. and increase the penalties for doing so. corporate officers. 29 . The goal was to make it less likely that companies and securities analysts would mislead investors. and securities analysts.

of equity capital?  Cost of equity = Required return = dividend yield + capital gain 30 . or cost. of debt capital?   The interest rate What do we call the price.Cost of Money  What do we call the price. or cost.

What four factors affect the cost of money?     Production opportunities Time preferences for consumption Risk Expected inflation 31 .

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 32 .

What international conditions affect the cost of money?   Country risk. Non-dollar denominated investment’s value depends on what happens to exchange rate. Exchange rate risk. and social environment. political. Exchange rates affected by:    International trade deficits/surpluses Relative inflation and interest rates Country risk 33 . Depends on the country’s economic.

34 . An increase in country risk will also cause that country’s currency to fall.What two factors lead to exchange rate fluctuations?   Changes in relative inflation will lead to changes in exchange rates.

Financial Securities Debt Money Market •T-Bills •CD’s •Eurodollars •Fed Funds Capital Market •T-Bonds •Agency bonds •Municipals •Corporate bonds Equity Derivatives •Options •Futures •Forward contract • Common stock • Preferred stock •LEAPS •Swaps 35 .

96% 2. .80 2.08 3.12 + (More .25 5.00 + 3. T-bills Banker’s acceptances Commercial paper Negotiable CDs Eurodollar deposits Commercial loans: Tied to prime or LIBOR Rate (July 2008) 1.) 36 .S.Typical Rates of Return Instrument U.31 3.

56 Corporate (AAA) bonds 5.83% Mortgages 6.04 Municipal bonds 4.S.Typical Rates (Continued) Instrument Rate (April 2007) U. T-notes and T-bonds 3.49 Preferred stocks 6% to 9% Common stocks (expected) 9% to 15% 37 .