1. 1 - 1 CHAPTER 1 Overview of Financial Management and the Financial Environment Financial management Forms of business organization Objective of the firm: Maximize wealth Determinants of stock pricing The financial environment Financial instruments, markets and institutions Interest rates and yield curves

2. 1 - 2 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.

3. 1 - 3 Sole proprietorship Partnership Corporation What are some forms of business organization a company might have as it evolves from a start-up to a major corporation?

4. 1 - 4 Advantages: Ease of formation Subject to few regulations No corporate income taxes Disadvantages: Limited life Unlimited liability Difficult to raise capital to support growth Starting as a Sole Proprietorship

5. 1 - 5 A partnership has roughly the same advantages and disadvantages as a sole proprietorship. Starting as or Growing into a Partnership

6. 1 - 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. 1 - 7 Advantages: Unlimited life Easy transfer of ownership Limited liability Ease of raising capital Disadvantages: Double taxation Cost of set-up and report filing Advantages and Disadvantages of a Corporation

8. 1 - 8 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 Agency problem: managers may act in their own interests and not on behalf of owners (stockholders)

9. 1 - 9 The primary objective should be 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. What should management’s primary objective be?

10. 1 - 10 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

11. 1 - 11 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

12. 1 - 12 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) What three aspects of cash flows affect an investment’s value?

13. 1 - 13 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.

14. 1 - 14 Determinants of Free Cash Flows 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.)

15. 1 - 15 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)

16. 1 - 16 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

17. 1 - 17 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:

18. 1 - 18 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.

19. 1 - 19 What are some financial instruments? InstrumentRate (April 2003) U.S. T-bills1.14% Banker’s acceptances1.22 Commercial paper1.21 Negotiable CDs1.24 Eurodollar deposits1.23 Commercial loansTied to prime (4.25%) or LIBOR (1.29%) (More..)

20. 1 - 20 Financial Instruments (Continued) Instrument Rate (April 2003) U.S. T-notes and T-bonds5.04% Mortgages5.57 Municipal bonds4.84 Corporate (AAA) bonds5.91 Preferred stocks6 to 9% Common stocks (expected)9 to 15%

21. 1 - 21 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

22. 1 - 22 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 three ways that capital is transferred between savers and borrowers?

23. 1 - 23 Commercial banks Savings & Loans, mutual savings banks, and credit unions Life insurance companies Mutual funds Pension funds What are some financial intermediaries?