Fundamentals of corporate finance

1. CHAPTER 1CHAPTER 1
Overview of Financial
M t d th Fi i l
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Management and the Financial
Environment
Topics in Chapter
 Forms of business organization Forms of business organization
 Objective of the firm: Maximize wealth
 Determinants of fundamental value
 Financial securities, markets and
institutions
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2. Corporate ManagerCorporate Manager
(Agent)(Agent)
Overview of Financial
Management
Multinational Corporate Balance SheetMultinational Corporate Balance Sheet
AssetsAssets LiabilitiesLiabilities
Short Term Short TermShort Term Short Term
Current AssetsCurrent Assets Current LiabilitiesCurrent Liabilities
Long TermLong Term Long TermLong Term
LandLand DebtDebt
PlantPlant Preferred StockPreferred Stock
Financial MarketFinancial Market
Corporate /Corporate / GovtGovt SecuritiesSecurities
BondsBonds
PreferredPreferred
StockStock
Product MarketProduct Market
Cash OutlayCash Outlay
Cash RevenueCash Revenue
Cash ExpenseCash Expense
Net Cash FlowsNet Cash Flows
(Agent)(Agent)
EquipmentEquipment Equity (Owner)Equity (Owner)
Shareholder’s Wealth MaximizationShareholder’s Wealth Maximization
(Agency Problems)(Agency Problems)
Capital BudgetingCapital Budgeting
Maximize:Maximize:
NPV / IRRNPV / IRR
Cost of CapitalCost of Capital
Minimize:Minimize:
Cost of DebtCost of Debt
Cost of PreferredCost of Preferred
Cost of EquityCost of Equity
Why is corporate finance
important to all managers?
Corporate finance provides the skills Corporate finance provides the skills
managers need to:
 Identify and select the corporate strategies
and individual projects that add value to
their firm.
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 Forecast the funding requirements of their
company, and devise strategies for
acquiring those funds.

3. Business Organization from Start-
up to a Major Corporation
Sole proprietorship Sole proprietorship
 Partnership
 Corporation
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Starting as a Proprietorship
 Advantages: Advantages:
 Ease of formation
 Subject to few regulations
 No corporate income taxes
 Disadvantages:
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 Limited life
 Unlimited liability
 Difficult to raise capital to support growth

4. Starting as or Growing into a
Partnership
A partnership has roughly the same 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 A corporation is a legal entity separate
from its owners and managers.
 File papers of incorporation with state.
 Charter
 Bylaws
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Bylaws

5. Advantages and Disadvantages of
a Corporation
 Advantages: Advantages:
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Ease of raising capital
Di d t
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 Disadvantages:
 Double taxation
 Cost of set-up and report filing
Becoming a Public Corporation
and Growing Afterwards
Initial Public Offering (IPO) of Stock 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
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6. Agency Problems and
Corporate Governance
 Agency problem: managers may act in their Agency problem: managers may act in their
own interests and not on behalf of owners
(stockholders)
 Corporate governance is the set of rules that
control a company’s behavior towards its
directors, managers, employees,
shareholders creditors customers
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shareholders, creditors, customers,
competitors, and community.
 Corporate governance can help control
agency problems.
What should be management’s
primary objective?
The primary objective should be The primary objective should be
shareholder wealth maximization, which
translates to maximizing the
fundamental stock price.
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7. What three aspects of cash flows
affect an investment’s value?
Amount of expected cash flows (bigger 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
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 Risk of the cash flows (less risk is
better)
Free Cash Flows (FCF)
Free cash flows are the cash flows that Free cash flows are the cash flows that
are available (or free) for distribution to
all investors (stockholders and
creditors).
 FCF = sales revenues - operating costs
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- operating taxes - required investments
in operating capital.

8. What is the weighted average
cost of capital (WACC)?
 WACC is the average rate of return required WACC is the average rate of return required
by all of the company’s investors.
 WACC is affected by:
 Capital structure (the firm’s relative amounts of
debt and equity)
 Interest rates
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 Interest rates
 Risk of the firm
 Investors’ overall attitude toward risk
What determines a firm’s
fundamental, or intrinsic, value?
Intrinsic value is the sum of all the
future expected free cash flows when
converted into today’s dollars:
Value =
FCF1 FCF2 FCF∞+ +…
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Value =
(1 + WACC)1 (1 + WACC)∞(1 + WACC)2

9. Who are the providers (savers)
and users (borrowers) of capital?
Households: Net savers Households: Net savers
 Non-financial corporations: Net users
(borrowers)
 Governments: Net borrowers
 Financial corporations: Slightly net
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 Financial corporations: Slightly net
borrowers, but almost breakeven
Transfer of Capital from
Savers to Borrowers
 Direct transfer (e g corporation issues 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
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 Through a financial intermediary (e.g.,
individual deposits money in bank, bank
makes commercial loan to a company)

10. Cost of Money
What do we call the price or cost of 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?
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 Cost of equity = Required return =
dividend yield + capital gain
What four factors affect the
cost of money?
Production opportunities Production opportunities
 Time preferences for consumption
 Risk
 Expected inflation
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11. What economic conditions
affect the cost of money?
 Federal Reserve policies Federal Reserve policies
 Budget deficits/surpluses
 Level of business activity (recession or boom)
 International trade deficits/surpluses
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Financial Securities
Debt Equity Derivatives
Money
Market
•T-Bills
•CD’s
•Eurodollars
•Fed Funds
•Options
•Futures
•Forward
contract
Capital
Market
•T-Bonds
•Agency bonds
•Common
stock
•LEAPS
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Market •Agency bonds
•Municipals
•Corporate bonds
stock
•Preferred stock •Swaps

12. Primary vs. Secondary
Security Sales
Primary Primary
 New issue (IPO or seasoned)
 Key factor: issuer receives the proceeds
from the sale.
 Secondary
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y
 Existing owner sells to another party.
 Issuing firm doesn’t receive proceeds and
is not directly involved.
How are secondary markets
organized?
 By “location” By location
 Physical location exchanges
 Computer/telephone networks
 By the way that orders from buyers and
sellers are matched
Open outcry auction
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 Open outcry auction
 Dealers (i.e., market makers)
 Electronic communications networks (ECNs)

13. Physical Location vs.
Computer/telephone Networks
Physical location exchanges: e g Physical location exchanges: e.g.,
NYSE, AMEX, CBOT, Tokyo Stock
Exchange
 Computer/telephone: e.g., Nasdaq,
government bond markets, foreign
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g , g
exchange markets
Auction Markets
 Participants have a seat on the exchange Participants have a seat on the exchange,
meet face-to-face, and place orders for
themselves or for their clients; e.g., CBOT.
 NYSE and AMEX are the two largest auction
markets for stocks.
NYSE is a modified auction with a
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 NYSE is a modified auction, with a
“specialist.”

14. Dealer Markets
 “Dealers” keep an inventory of the stock (or 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
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automatically match buyers and sellers.
 Examples: Nasdaq National Market, Nasdaq
SmallCap Market, London SEAQ, German
Neuer Markt.
Over the Counter (OTC)
Markets
 In the old days securities were kept in a safe 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
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Sheets), which allows potential buyers and
sellers to post an offer.