Lecture 1 - Overview of Financial

Management and the Financial

Environment

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

What Should Managements Primary

Objective Be?
The primary objective should be
shareholder wealth maximization, which
usually 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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Shareholder Wealth Maximization

Considers the timing and risk of the benefits from stock

ownership
Determines that a good decision increases the price of the
firm's common stock ( c/s )
Is an impersonal objective
Is concerned for social responsibility

Social Responsibility
Ethical issues will constantly confront financial managers
as they achieve the goal of the firm ( SWM ).

Managers Must:

Avoid personal conflicts

Maintain confidentiality
Be objective
Act fairly
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Maximizing Stock Price Is it 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
What about SOEs?
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What Three Aspects of Cash Flows

Affect an Investments 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.
Free cash flows are determined by:
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.)

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 companys investors (stockholders and
creditors)
The weighted average cost of capital is affected by:
Capital structure (the firms 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 Firms Value?

A firms value is the sum of all the future
expected free cash flows when converted
into todays dollars:
Value =

FCF1
(1 + WACC)1

FCF2
(1 + WACC)2

FCF
(1 + WACC)

Determinants of Intrinsic Value and

Stock Prices

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Different Definitions of Value

Intrinsic value
Stock valuation based on an individuals expected free cash
flows
Market value
Market price is the value quoted in the market.
Based on aggregate markets expectations and is set by the
marginal investor. It is the marginal investors intrinsic value.
Fundamental Value
This is the intrinsic value an analyst would calculate given
complete and accurate information about a companys expected
future free cash flows and risk.
Also called true intrinsic value.
Market value may not equal fundamental value over short term,
but will tend towards it over the long term.

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Short-Term vs. Long-Term Price

Management can impact the market price over
the short term by releasing incomplete or
inaccurate information.
Over the long term the market price will tend
towards the fundamental value as more
information becomes available.

What about the recent financial crisis?

Credit Crisis Explained
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Financial Assets or Instruments

A financial asset is a contract that entitles the
owner to some type of payoff.
Debt
Equity
Derivatives - a security, such as an option or futures
contract, whose value depends on the performance of an
underlying security or asset.

In general, each financial asset involves two

parties, a provider of cash (i.e., capital) and a user
of cash.
Give examples of financial assets or instruments
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Transfer of Funds from Surplus to

Deficit Spending Units

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How to Become a Public Corporation and

Keep 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 is an Agency Relationship?

An agency relationship arises whenever one or more individuals,
called principals, (1) hires another individual or organization, called
an agent, to perform some service and (2) then delegates decisionmaking authority to that agent.
If you are the only employee, and only your money is invested in
the business, would any agency problems exist?
No agency problem would exist.
A potential agency problem arises whenever the manager of a firm owns less
than 100 percent of the firms common stock

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An agency relationship could exist between you and your employees if you, the principal, hired
the employees to perform some service and delegated some decision-making authority to them.
If you needed additional capital to buy computer inventory or to develop software then you might
end up with agency problems if the capital is acquired from outside investors.
Agency problems are less for secured than for unsecured debt, and different between
stockholders and creditors.
It matters whether the new capital comes in the form of an unsecured bank loan, a bank loan
secured by your inventory of computers, or from new stockholders.

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Two Potential Agency Conflicts

Conflicts between stockholders and
managers.
Compensation
Direct intervention
Threat of firing
Hostile Takeovers

Conflicts between stockholders and creditors.

Question: Would expansion increase or decrease potential

agency problems?
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What Actions Might Make a Loan Feasible?

Creditors can protect themselves by (1) having the loan secured and (2) placing restrictive covenants in debt agreements. They can also charge
a higher than normal interest rate to compensate for risk.

Structuring compensation packages to attract and retain able managers whose interests are aligned with yours.

Threat of firing.

What actions might mitigate your agency problems

if you expanded beyond your home campus?

Increase monitoring costs by making frequent visits to off campus locations.

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Why Might You Want to Make Your Financial

Statements Look Artificially Good?
A manager might inflate a firm's reported earnings or
make its debt appear to be lower if he or she wanted
the firm to look good temporarily. For example just
prior to exercising stock options or raising more
debt.

What are the Potential Consequences of

Inflating Earnings or Hiding Debt?
If the firm is publicly traded, the stock price will
probably drop once it is revealed that fraud has taken
place. If private, banks may be unwilling to lend to it,
and investors may be unwilling to invest more money.
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What Kind of Compensation Program Might

you Use to Minimize Agency Problems?
Reasonable annual salary to meet
living expenses
Cash (or stock) bonus
Options to buy stock or actual shares of
stock to reward long-term performance
Tie bonus/options to value of the company

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Transparency in Financial Reporting

Transparency requires that market participants have
reliable, accurate information about a particular
company.

Sarbanes-Oxley (USA)
An act passed in 2002 that established new
regulations for auditors, corporate officers, and
securities analysts.
The goal was to make it less likely that companies
and securities analysts would mislead investors, and
increase the penalties for doing so.
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Asymmetric Information:
Adverse Selection and Moral Hazard
Adverse Selection
Before transaction occurs - Potential borrowers most likely
to produce adverse outcome are ones most likely to seek
loan and be selected
Due to Asymmetric Information:
Moral Hazard
After transaction occurs - Hazard that borrower has
incentives to engage in undesirable (immoral) activities
making it more likely that won't pay loan back

Financial intermediaries reduce adverse selection

and moral hazard problems, enabling them to make
profits
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The Price, or Cost, of Debt Capital is Called

The Interest Rate
The Price, or Cost, of Equity Capital is
Required = Dividend
return
yield

+ Capital
gain

Factors that Affect the Cost of Money

Production opportunities
Time preferences for consumption
Risk
Expected inflation
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Real versus Nominal Rates

= Real risk-free rate. T-bond rate if no inflation;

r*

1% to 4%.
r or i

= Any nominal rate.

rRF

= Rate on Treasury securities.

r = r* + IP + DRP + LP + MRP
Here:
r
r*
IP
DRP
LP
MRP

=
=
=
=
=
=

Required rate of return on a debt security.

Real risk-free rate.
Inflation premium.
Default risk premium.
Liquidity premium.
Maturity risk premium.
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The Term Structure of Interest Rates

and the 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 to Construct a Yield Curve
Step 1: 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 3: Add to r*

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Assume investors expect inflation to be 5% next year,

6% the following year, and 8% per year thereafter.
Step 1: Find the average expected inflation rate over years 1 to n:
n
INFLt
IPn =
t=1
n

IP1
IP10
IP20

= 5%/1.0 = 5.00%.
= [5 + 6 + 8(8)]/10 = 7.5%.
= [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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Assume the MRP is zero for Year 1 and

increases by 0.1% each year.
Step 2: Find MRP based on this equation:

MRPt = 0.1%(t - 1).

MRP1 = 0.0%.
MRP10 = 0.1% x 9 = 0.9%.
MRP20 = 0.1% x 19 = 1.9%.
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Step 3: Add the IPs and MRPs to r*:

rRFt = r* + IPt + MRPt .
rRF = Quoted market interest
rate on treasury securities.
Assume 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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Hypothetical Treasury Yield Curve

Interest
Rate (%)
15

Maturity risk premium

10

Inflation premium

1 yr
10 yr
20 yr

8.0%
11.4%
12.65%

5
Real risk-free rate

Years to Maturity

0
1

10

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http://stockcharts.com/charts/YieldCurve.html

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Types of Risks From Investing

Overseas
Country risk: Arises from investing or doing
business in a particular country. It depends on the
countrys economic, political, and social environment.
Exchange rate risk: If investment is denominated in
a currency other than the dollar, the investments
value will depend on what happens to exchange rate.

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