Overview of Financial Management

OVERVIEW OF FINANCIAL MANAGEMENT The Corporation Life Cycle Value Creation & Maximization Financial Institutions & Process of Capital Formation Cost of Money Types of Financial Markets Profit vs Cash Financial Management - Reza Masri2

The Corporation Life Cycle Financial Management - Reza Masri3 Corporation Advantages: Easy transferability of ownership interest; Limited liability → Easy to raise capital Disadvantages: Complex & time consuming formation; Subject to double taxation Partnership Advantages: Easy & inexpensive formation; Subjects to only few regulations; Not subject to corporate taxation Limitations: Difficult to raise capital; Unlimited personal liability; Limited life Proprietorship Advantages: Easy & inexpensive formation; Subjects to only few regulations; Not subject to corporate taxation Limitations: Difficult to raise capital; Unlimited personal liability;

4 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

5 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.

Goal of the Firm 1) Profit Maximization? this goal ignores: a) TIMING of Returns (Time Value of Money) b) UNCERTAINTY of Returns (Risk)

Goal of the Firm 2) Shareholder Wealth Maximization? this is the same as: a) Maximizing Firm Value b) Maximizing Stock Price

8 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)

9 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.

10 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 use of debt and equity as sources of financing) Interest rates Risk of the firm Investors’ overall attitude toward risk

11 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 = + + … + FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2

12 Value = FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business riskMarket risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC) Sales revenues Operating costs and taxes Required investments in operating capital − − = Determinants of Value...

Value Maximization Financial Management - Reza Masri13 Risk & Return Valuation Investment Decisions Financing Decisions Income Distribution Decision Value Maximization

Financial Management & Other Fields of Management Financial Management Math & Statistics Accounting Social Sciences Operation Management ETHICS Economics

Financial Institutions: Capital Formation Process Direct Transfer Business (Borrowers) sell securities directly to Savers Example: A corporation issues securities (equity/debt) to (a group) of investors. Through Investment Banking Houses Business (Borrowers) sell securities to Savers through investment banking houses Example: In an IPO, seasoned equity offering, or debt placement, company sells security to investment banking house, which then sells security to investor. Through Financial Intermediaries Intermediary obtain funds from Savers in exchange for its own securities Intermediaries uses the fund to purchase and hold securities from Business (Borrowers) Commercial Banks, Life Insurance Companies, Mutual Funds, Pension Funds Example: An individual deposits money in bank and gets certificate of deposit, bank makes commercial loan to a company (bank gets note (loan agreement) from company). Financial Management - Reza Masri15

Investment Banking & Investment Management Financial Management - Reza Masri16 Corporations Investment Banking Houses Investors Securities Dollars Sell Side: Underwriting & selling corporations securities to investors Buy Side: Advising investors & managing investors fund in buying securities

17 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

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

19 What economic conditions affect the cost of money? Government/Monetary Authority policies Budget deficits/surpluses Level of business activity (recession or boom) International trade deficits/surpluses

20 What international conditions affect the cost of money? Country risk. Depends on the country’s economic, political, and social environment. Exchange rate risk. Foreign currency 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

21 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

22 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.

Capital Markets: Selected Comparison (ASEAN) as of Nov. 2010

Capital Markets: Selected Comparison (ASEAN) as of Nov. 2010

Capital Markets: Selected Comparison (ASEAN) as of Nov. 2010

Financial Management - Reza Masri26 Financial Markets Implications of active financial markets: FINANCING alternatives for corporations INVESTMENT alternatives for investors

Profit vs Cash Financial Management - Reza Masri27

Profit vs Cash Financial Management - Reza Masri28

Profit vs Cash Financial Management - Reza Masri29 ACCOUNTING

Profit vs Cash Financial Management - Reza Masri30

Profit vs Cash Financial Management - Reza Masri31 ACCOUNTING

Profit vs Cash Financial Management - Reza Masri32

Profit vs Cash Financial Management - Reza Masri33

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35 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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