Overview of Financial Management and the Financial Environment Main Source: BE Chapter 1

Company’s Objective Maximization of shareholders’ wealth, Maximization company’s value by maximization free cash flows and minimization cost of capital. See Figure 1.1. (BE) Watch carefully: Market price of company’s stock.

Determinants of Free Cash Flows Sales revenues Operating costs (raw materials, labor, etc.) and taxes Required investments in operations (buildings, machines, inventory, etc.)

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:

The Markets Two groups: Real (tangible) markets for physical assets Financial markets for financial instruments Money markets Capital markets See table 1-1 for major financial instruments

Financial institutions Capital formation process (See fig 1-2 (BE) for the diagram of capital formation process) Direct transfers Indirect transfers, through investment bankers financial intermediaries

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.

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

What are three ways that capital is transferred between savers and 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)

What are some financial intermediaries? Commercial banks Savings & Loans, mutual savings banks, and credit unions Life insurance companies Mutual funds Pension funds

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

The Cost of Money Interest rate (the “price of money”) is an interaction point between money supply and money demand. Determinants: Production opportunities Time preferences for consumption Risk Inflation

Required Dividend Capital return yield gain = + . 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 = + .

Real versus Nominal Rates = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. r rRF

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. LP = Liquidity premium. MRP = Maturity risk premium.

Financial Management How to run firm financially to achieve the objective, under a certain condition of financial environment. Main elements of financial environment: Financial markets Financial institutions Financial regulations