Chapter 1.pptx

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1
Brigham & Ehrhardt
Financial Management:
Theory and Practice 14e

2
CHAPTER 1
Overview of Financial
Management and the Financial
Environment

3
Topics in Chapter
 Forms of business organization
 Objective of the firm: Maximize wealth
 Determinants of fundamental value
 Financial securities, markets and
institutions

4
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.

5
Business Organization from Start-
up to a Major Corporation
 Sole proprietorship
 Partnership
 Corporation
(More . .)

6
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

7
Starting as or Growing into a
Partnership
 A partnership has roughly the same
advantages and disadvantages as a sole
proprietorship.

8
Becoming a Corporation
 A corporation is a legal entity separate
from its owners and managers.
 File papers of incorporation with state.
 Charter
 Bylaws

9
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

10
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

11
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.

12
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.

13
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)

14
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

15
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)

16
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.

17
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

18
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 = + + … +
FCF1 FCF2 FCF∞
(1 + WACC)1 (1 + WACC)∞
(1 + WACC)2
See “big picture” diagram on next slide.
(More . .)

19
Value = + + +
FCF1 FCF2 FCF∞
(1 + WACC)1 (1 + WACC)∞
(1 + WACC)2
Free cash flow
(FCF)
Market interest rates
Firm’s business risk
Market 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 Intrinsic Value: The Big Picture
...

20
Who are the providers (savers)
and users (borrowers) of capital?
 Households: Net savers
 Non-financial corporations: Net users
(borrowers)
 Governments: U.S. governments are
net borrowers, some foreign
governments are net savers
 Financial corporations: Slightly net
borrowers, but almost breakeven

The Capital Allocation Process
21
Business
Business
Business
Savers
Savers
Savers
Investment
Bank
Financial
Intermediary
Business’s Securities
1. Direct Transfer
2. Through Investment Bank
3. Through Financial Intermediary
Dollars
Dollars Dollars
Dollars Dollars
Intermediary’s
Securities

22
Transfer of Capital from
Savers to Borrowers
 Direct transfer
 Example: A corporation issues commercial paper to an
insurance company.
 Through an investment banking house
 Example: In an IPO, seasoned equity offering, or debt
placement, company sells security to investment banking
house, which then sells security to investor.
 Through a financial intermediary
 Example: An individual deposits money in bank and gets
certificate of deposit, bank makes commercial loan to a
company (bank gets note from company).

23
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

24
What four factors affect the
cost of money?
 Production opportunities
 Time preferences for consumption
 Risk
 Expected inflation

25
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

26
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

27
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.

28
Financial Securities
Debt Equity Derivatives
Money
Market
•T-Bills
•CD’s
•Eurodollars
•Fed Funds
•Options
•Futures
•Forward
contract
Capital
Market
•T-Bonds
•Agency bonds
•Municipals
•Corporate bonds
•Common
stock
•Preferred stock
•LEAPS
•Swaps

29
Typical Rates of Return
Instrument Rate (January 2009)
U.S. T-bills 0.41%
Banker’s acceptances 5.28
Commercial paper 0.28
Negotiable CDs 1.58
Eurodollar deposits 2.60
Commercial loans:
Tied to prime 3.25 +
or LIBOR 2.02 + (More . .)

30
Typical Rates (Continued)
Instrument Rate (January 2009)
U.S. T-notes and T-bonds 3.04%
Mortgages 5.02
Municipal bonds 4.39
Corporate (AAA) bonds 5.03
Preferred stocks 6% to 9%
Common stocks (expected) 9% to 15%

31
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)
 Pension funds
 Hedge funds and private equity funds

32
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

33
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.

34
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)

35
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

36
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.

37
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.”

38
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.

39
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).

40
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

41
Home Mortgages Before S&Ls
 The problems if an individual investor
tried to lend money to an aspiring
homeowner:
 Individual investor might not have enough
money to fund an entire home
 Individual investor might not be in a good
position to evaluate the risk of the potential
homeowner
 Individual investor might have difficulty
collecting mortgage payments

42
S&Ls Before Securitization
 Savings and loan associations (S&Ls)
solved the problems faced by individual
investors
 S&Ls pooled deposits from many investors
 S&Ls developed expertise in evaluating the
risk of borrowers
 S&Ls had legal resources to collect
payments from borrowers

43
Problems faced by S&Ls
Before Securitization
 S&Ls were limited in the amount of
mortgages they could fund by the amount of
deposits they could raise
 S&Ls were raising money through short-term
floating-rate deposits, but making loans in the
form of long-term fixed-rate mortgages
 When interest rates increased, S&Ls faced
crisis because they had to pay more to
depositors than they collected from
mortgagees

44
Taxpayers to the Rescue
 Many S&Ls went bankrupt when
interest rates rose in the 1980s.
 Because deposits are insured, taxpayers
ended up paying hundreds of billions of
dollars.

45
Securitization in the Home
Mortgage Industry
 After crisis in 1980s, S&Ls now put their
mortgages into “pools” and sell the
pools to other organizations, such as
Fannie Mae.
 After selling a pool, the S&Ls have
funds to make new home loans
 Risk is shifted to Fannie Mae

46
Fannie Mae Shifts Risk to Its
Investors
 Risk hasn’t disappeared, it has been shifted to
Fannie Mae.
 But Fannie Mae doesn’t keep the mortgages:
 Puts mortgages in pools, sells shares of these pools to
investors
 Risk is shifted to investors.
 But investors get a rate of return close to the mortgage
rate, which is higher than the rate S&Ls pay their
depositor.
 Investors have more risk, but more return
 This is called securitization, since new securities
have been created based on original securities
(mortgages in this example)

47
Collateralized Debt Obligations
(CDOs)
 Fannie Mae and others, such as investment banks,
can also split mortgage pools into “special” securities
 Some securities might pay investors only the mortgage
interest, others might pay only the mortgage principal.
 Some securities might mature quickly, others might mature
later.
 Some securities are “senior” and get paid before other
securities from the pool get paid.
 Rating agencies give different
 Risk of basic mortgage is parceled out to those
investors who want that type of risk (and the
potential return that goes with it).

48
Other Assets Can be
Securitized
 Car loans
 Student loans
 Credit card balances

49
The Dark Side of Securitization
 Homeowners wanted better homes than they could
afford.
 Mortgage brokers encouraged homeowners to take
mortgages even thought they would reset to
payments that the borrowers might not be able to
pay because the brokers got a commission for closing
the deal.
 Appraisers thought the real estate boom would
continue and over-appraised house values, getting
paid at the time of the appraisal.
 Originating institutions (like Countrywide) quickly sold
the mortgages to investment banks and other
institutions. (More . .)

50
The Dark Side (Continued)
 Investment banks created CDOs and got rating
agencies to help design and then rate the new CDOs,
with rating agencies making big profits despite
conflicts of interest.
 Financial engineers used unrealistic inputs to
generate high values for the CDOs.
 Investment banks sold the CDOs to investors and
made big profits.
 Investors bought the CDOs but either didn’t
understand or care about the risk.
 Some investors bought “insurance” via credit default
swaps.

51
The Collapse
 When mortgages reset and borrowers defaulted, the
values of CDOs plummeted.
 Many of the credit default swaps failed to provide
insurance because the counterparty failed.
 Many originators and securitizers still owned sub-
prime securities, which led to many bankruptcies,
government takeovers, and fire sales, including:
 New Century, Countrywide, IndyMac, Northern Rock, Fannie
Mae, Freddie Mac, Bear Stearns, Lehman Brothers, and
Merrill Lynch.

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