1. Cores of Learning in This Chapter
 The determinants of interest rates
 Term structure
 Pure expectations hypothesis
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2. Overview of Financial Management
 Definition of finance
 Financial management functions
 Goals of the corporation
 Financial markets
 Interest rates and yield curves
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3. Definition of finance
Definition of finance
 Finance is concerned with the
process, institutions, markets, and
instruments involved in the transfer
of money among individuals and
organizations.
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4. Relationships among investors, firms,
and financial markets
Funds Funds
Financial
Deposit Institutions Loan
certificates contracts
Investors Firms
Securities Financial Securities
Markets
Funds Funds
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5. Financial management functions
 Forecasting and planning
 Investment and financing decisions
 Coordination and control
 Transactions in the financial
markets
 Managing risk
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6. Goals of the Corporation
 The primary goal is 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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7. Is maximizing stock price good for
society, employees, and customers?
 Actions maximizing stock price also benefit
society:
managers that maximize stock price improve
the quality of lives of their owners, a lot of
whom are ordinary citizens
stock price maximization requires efficient,
low-cost operations that produce high quality
products that benefit consumers
Companies that successfully increase stock
price also grow and add more employees, thus
benefiting employees
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8. Factors that Affect
Company Value (Stock Price)
 Amount of cash flows expected by
shareholders
 Timing of the cash flow stream
 Risk of the cash flows
Figure 1-1 (slide 12).
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9. Factors that Affect the Amount
of Cash Flows
 Sales Revenues (investment decisions)
Increase unit sales 单位销售额 by
providing what customers want
Develop new products for higher prices
 Operating costs and taxes
Reduce operating costs by supply chain
management and employee training, etc.
 Investments in operations
Reduce asset requirements: e.g. JIT
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10. Factors that Affect the Risk
of Cash Flows (WACC)
 Financing decisions: wd, wce
Capital structure
Specific type of financing
 Interest rate: rRF
 Firm risk: beta
Business characteristics
 Market risk: rM - rRF
Stock market investors’ overall attitude
toward risk
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11. The Influence of Timing on
Value of Operations
Company Value
FCF1 FCF2 FCF∞
Value = + + ....
(1 + WACC) (1 + WACC)
1 2
(1 + WACC) ∞
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12. DeterminantsOperations Value
Value of of A Firm’s
Operating Required
Sales Financing Interest Firm Market
Costs and Investments
Revenues Taxes in Operations Decisions Rates Risk Risk
Weighted Average
Free Cash Flows
Amount of cash flows Cost of Capital Risk of cash flows
(FCF) (WACC)
Value of the Firm
FCF1 FCF2 FCF∞
Value = + + ....
(1 + WACC)1 (1 + WACC) 2 (1 + WACC) ∞
Timing of cash flows
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13. The Financial Environment
 Financial markets
 Determinants of interest rates
 Yield curves 产出曲线
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14. Define these markets
 A market is a method of exchanging one
asset (usually cash) for another asset.
 Markets for physical assets
 Markets for financial assets
 Money versus capital markets
 Primary versus secondary markets
 Spot versus futures markets
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15.  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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16. What four factors affect the cost
of money?
 Production opportunities (r*)
 Time preferences for consumption
(r*)
 Risk (DRP, LP, MRP)
 Expected inflation (IP)
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17. Real versus Nominal Rates
r = Any nominal rate.
r* = Real risk-free rate.
T-bond rate if no inflation;
1% to 4% (0.67% for an inflation-indexed
treasury bond of 4-year maturity in Apr. 2003)
rRF = Rate on Treasury securities
= r* + IP.
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18. 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 (0.6-
3.5%).
LP = Liquidity premium (2-5%).
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MRP= Maturity risk premium (1-3%).

19. 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: LT IP, DRP, LP, MRP
(Besides MRP, DRP and LP are also larger for long-term bond.
• There is a higher default risk in a longer maturity.
• Due to low DRP and MRP of short-term bond, a buyer can buy it
without doing much credit checking.  higher liquidity)
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20. 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.
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21. Data for yield curve construction
 Inflation rate – 5% next year, 6% the
following year, and 8% thereafter.
 Maturity risk premium – 0 for
securities that mature within 1 year,
0.1% for 2-year security, MRP
increase by 0.1% point per year
thereafter up to year 20, after which it
is stable.
 Real risk-free rate is 3%.
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22. Yield Curve Construction
Step 1: Find the average expected
inflation rate over years 1 to n:
n
Σ INFLt
IPn = t=1 .
n
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23. 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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24. Step 2: Find MRP based on this
equation:
MRPt = 0.1%(t - 1).
MRP1 = 0.1% x 0 = 0.0%.
MRP10 = 0.1% x 9 = 0.9%.
MRP20 = 0.1% x 19 = 1.9%.
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25. Step 3: Add the IPs and MRPs to r*:
rRFt = r* + IPt + MRPt .
rRF = Quoted market interest
rate on treasury securities.
If 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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26. Hypothetical Treasury Yield Curve
Interest
Rate (%) 1 yr 8.0%
15 Maturity risk premium 10 yr 11.4%
20 yr 12.65%
10 Inflation premium
5
Real risk-free rate
0 Years to Maturity
1 10 20
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27. 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.
 A yield curve can be downward sloping
if the expected inflation is lower in the
long-term than in the short-term.
(decreasing IP, increasing MRP)
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28. 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 necessarily parallel to
the Treasury curve (The spread widens in
maturity since DRP and LP are larger in
longer maturity only for corporate bonds).
 The spread between a corporate yield curve
and the Treasury curve widens as the
corporate bond rating decreases (DRP, LP).
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29. Hypothetical Treasury and
Corporate Yield Curves
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
Treasury
6.0%
5 5.9% yield curve
5.2%
Years to
0
maturity
0 1 5 10 15 20
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30. The Pure Expectations Hypothesis
(PEH)
 As large bond traders buy and sell long-term
bonds as frequently as short-term bonds to pick
up short-term profit, they are not exposed to MRP.
Thus MRP = 0. (for long-term bonds, they are
exposed to more LP, exposed to the same DRP
compared to short-term bonds)
 Shape of the yield curve depends on the
investors’ expectations about future interest
rates. Interest rate is an average of current and
expected future short-term interest rates.
1 n *
rRFn = ∑ ( ri + IPi )
n i =1
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