Overview of Financial

Management and the Financial

Environment
Topics in Chapter
■ Forms of business organization
■ Objective of the firm: Maximize wealth
■ Determinants of fundamental value
■ Financial securities, markets and
institutions

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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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Business Organization from Start-
up to a Major Corporation
■ Sole proprietorship
■ Partnership
■ Corporation

(More . .)
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Starting as a 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.

6
Becoming a Corporation
■ A corporation is a legal entity separate
from its owners and managers.
■ File papers of incorporation with state.
■ Charter
■ Bylaws

7
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

9
Agency Problems and
Corporate Governance
■ 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,
competitors, and community.
■ Corporate governance can help control
agency problems.
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What should be management’s
primary objective?
■ The primary objective should be
shareholder wealth maximization, which
translates to maximizing the
fundamental 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

(Continued)
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Is maximizing stock price good?
(Continued)

■ 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)

14
Free Cash Flows (FCF)
■ 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
- operating taxes - required investments
in operating capital.

15
What is the weighted average
cost of capital (WACC)?
■ 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
■ Risk of the firm
■ Investors’ overall attitude toward risk

16
 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:
FCF1 + FCF2 +… FCF∞
Value =
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

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Who are the providers (savers)
and users (borrowers) of capital?
■ Households: Net savers
■ Non-financial corporations: Net users
(borrowers)
■ Governments: Net borrowers
■ Financial corporations: Slightly net
borrowers, but almost breakeven

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Transfer of Capital from
Savers to 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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Cost of Money
■ 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?
■ Cost of equity = Required return =
dividend yield + capital gain

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

21
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

22
What international conditions
affect the cost of money?
■ Country risk. Depends on the country’s
economic, political, and social environment.
■ Exchange rate risk. Non-dollar denominated
investment’s value depends on what happens
to exchange rate. Exchange rates affected
by:
■ International trade deficits/surpluses
■ Relative inflation and interest rates
■ Country risk

23
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.

24
Financial Securities

Debt Equity Derivatives

Money •T-Bills •Options

Market •CD’s •Futures
•Eurodollars •Forward
•Fed Funds contract

Capital •T-Bonds •Common •LEAPS

Market •Agency bonds stock
•Municipals •Preferred stock •Swaps
•Corporate bonds

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Typical Rates of Return
Instrument Rate (April 2006)
U.S. T-bills 4.79%
Banker’s acceptances 5.11
Commercial paper 4.97
Negotiable CDs 5.07
Eurodollar deposits 5.10
Commercial loans:
Tied to prime 7.75 +
or LIBOR 5.13 + (More . .)
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Typical Rates (Continued)
Instrument Rate (April 2006)
U.S. T-notes and T-bonds 5.04%
Mortgages 6.15
Municipal bonds 4.66
Corporate (AAA) bonds 5.93
Preferred stocks 6 to 9%
Common stocks (expected) 9 to 15%

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What are some financial
institutions?
■ Commercial banks
■ Investment banks
■ Savings & Loans, mutual savings banks, and
credit unions
■ Life insurance companies
■ Mutual funds
■ Exchanged Traded Funds (ETFs)
■ Hedge 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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Primary vs. Secondary
Security Sales
■ Primary
■ New issue (IPO or seasoned)
■ Key factor: issuer receives the proceeds
from the sale.
■ Secondary
■ Existing owner sells to another party.
■ Issuing firm doesn’t receive proceeds and
is not directly involved.
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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)

31
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

32
Types of Orders
■ Instructions on how a transaction is to
be completed
■ Market Order– Transact as quickly as
possible at current price
■ Limit Order– Transact only if specific
situation occurs. For example, buy if price
drops to $50 or below during the next two
hours.

33
Auction Markets
■ 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
“specialist.”

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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.
■ Often many dealers for each stock
■ 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.
■ Low cost to transact
■ Examples: Instinet (US, stocks, owned by
Nasdaq); Archipelago (US, stocks, owned
by NYSE); 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 (e.g., Nasdaq Pink
Sheets), which allows potential buyers and
sellers to post an offer.
■ No dealers
■ Very poor liquidity

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