bài giảng chapter 1 overview of financial management and the financial environment

CHAPTER 1Overview of Financial Management and the Financial Environment  Financial management Forms of business organization Objective of the firm: Maximize wealth Determinants of s

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

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.

Sole proprietorship

Partnership

Corporation

What are some forms of business

organization a company might have as

it evolves from a start-up to a major

corporation?

 Advantages:

Ease of formation

Subject to few regulations

No corporate income taxes

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

Starting as or Growing into a

Partnership

Becoming a Corporation

A corporation is a legal entity

separate from its owners and

Cost of set-up and report filing

Advantages and Disadvantages of a

Corporation

Becoming a Public Corporation and

Growing Afterwards

to “harvest” some of their wealth

their own interests and not on behalf of owners (stockholders)

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.

What should management’s primary

objective be?

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

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

Amount of expected cash flows

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.

Determinants of Free Cash Flows

Sales revenues

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)

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

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:

(

FCF

.

)

WACC 1

(

FCF )

WACC 1

(

FCF

1 1

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.

What are some financial instruments?

Financial Instruments (Continued)

Instrument Rate (April 2003) U.S T-notes and T-bonds 5.04%

Who are the providers (savers) and

users (borrowers) of capital?

Households: Net savers

Non-financial corporations: Net

users (borrowers)

Financial corporations: Slightly

net borrowers, but almost

breakeven

 Direct transfer (e.g., corporation issues commercial paper to insurance company)

(e.g., IPO, seasoned equity offering, or

debt placement)

individual deposits money in bank, bank makes commercial loan to a company)

What are three ways that capital is transferred between savers and

borrowers?

The Top 5 Banking Companies

in the World, 12/2001

Deutsche Bank AG Germany

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

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)

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

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

Dealer Markets

other financial asset) and place bid and ask

“advertisements,” which are prices at which they are willing to buy and sell.

of bid and ask prices, but does not

automatically match buyers and sellers.

SmallCap Market, London SEAQ, German

Neuer Markt.

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).

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

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 = +

What four factors affect the cost

Real versus Nominal Rates

r* = Real risk-free rate.

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

= Any nominal rate.

= Rate on Treasury securities.

r

r RF

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

What is the “term structure of interest

rates”? What is a “yield curve”?

Term structure : the relationship

between interest rates (or yields)

and maturities.

A graph of the term structure is

called the yield curve

How can you construct 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.

Step 1: Find the average expected

inflation rate over years 1 to n:

Step 2: Find MRP based on this

Assume the MRP is zero for Year 1 and

increases by 0.1% each year.

Step 3: Add the IPs and MRPs to r*:

r RFt = r* + IP t + MRP t

r RF = Quoted market interest

rate on treasury securities.

Assume r* = 3%:

r RF1 = 3% + 5% + 0.0% = 8.0%.

r RF10 = 3% + 7.5% + 0.9% = 11.4%.

r RF20 = 3% + 7.75% + 1.9% = 12.65%.

Hypothetical Treasury Yield Curve

What factors can explain the shape of

this yield curve?

This constructed yield curve is

What kind of relationship exists

between the Treasury yield curve and the yield curves for corporate issues?

Corporate yield curves are higher than that of the Treasury bond However, corporate yield curves are not neces- sarily parallel to the Treasury curve.

The spread between a corporate yield curve and the Treasury curve widens

as the corporate bond rating

decreases.

Hypothetical Treasury and Corporate Yield Curves

AAA-Rated

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.

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 country’s economic,

political, and social environment.

Exchange rate risk : If investment is

denominated in a currency other than the dollar, the investment’s value will depend

on what happens to exchange rate.

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.