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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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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 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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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 management’s primary

objective be?
 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
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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 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 and
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  WACC ) (1  WACC )
1 2
(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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What are three ways that capital is

transferred between savers and
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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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;
e.g., CBOT.
 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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Electronic Communications Networks

(ECNs)

 ECNs:
Computerized system matches
orders from buyers and sellers
and automatically executes
transaction.
Examples: Instinet (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, which
allows potential buyers and sellers to
post an offer.
No dealers
Very poor liquidity
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 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 Dividend Capital

return = yield + gain .
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What four factors affect the cost

of money?

 Production opportunities
 Time preferences for consumption
 Risk
 Expected inflation