Ch.1 Overview of Financial Management and Financial Environment

1. Types of Business Organization:1) Sole proprietorship2) Partnership 3) Corporations4) Hybrid

1) Sole proprietorship

Advantages: - Easily and inexpensively formed- Subject to few government regulations- Avoid corporate income taxLimits:- Unlimited personal liability- Limited to the life of the individual who create- Difficult to obtain large sums of capital

2) Partnership – more than one owner.Advantages: - Easy and inexpensive to set upLimits: - Unlimited liability - Limited life - Difficult to transfer ownership

• Limited partnership has limited partners and general partners. Limited partners do not involve in management and can lose only his or her investment whereas general partners involve in management and have unlimited liabilities. In both regular and limited partnerships, at least, one partner is liable for debts of the partnership. E.g.) Limited Liability Company or Limited Liability Partnership

3) CorporationsSeparation of owners from management.

Advantages:- Unlimited life- Easy transferability of ownership- Limited liabilities

Limits:- Double taxations: corporate and individual levels- More time consuming documentation and reports: charter

and a set of bylaws

- Different types:• Professional Corporation (PC) or Professional

Association (PA). Though Corporation, it does not allow to relieve professional liability (e.g. malpractice of doctors, lawyers, etc).

• S Corporation: small size business and 100 owners. Taxed like a proprietorship.

• 2. Growing and managing a Corporation• Agency problem: conflict of interest between

management and shareholders• Corporate governance in order to address

agency problem. Here corporate governance is a set of rules that control company’s behavior towards its directors, managers, employees, shareholders, creditors, customers, competitors, and community.

3. Primary Objective of Corporation

• Stock holders elect directors who then hire managers to run a corporation

• Goal of management is to maximize the fundamental or intrinsic price of common stock rather than the market price.

• Maximizing stock price also benefit social welfare: (1) owners of stock are society, (2) Consumer benefit resulting from high quality and low cost, and (3) employees benefit, .etc

(1) Managerial actions to maximize shareholder wealth

• Firm value is determined by a company’s ability to generate free cash flows (FCF) now and in the future. The improvement of FCF will improve the intrinsic value of a firm.

• FCF = sale revenue – operating costs – operating taxes – required new investments in operating capital.

• Value • Here WACC is weighted average cost of capital

4. An overview of the Capital Allocation Process

• 1) Direct Transfers• 2) Indirect Transfers though Investment

Bankers underwriting the security issues. • 3) Indirect Transfer through a Financial

Intermediary such as banks and funds.• Figure 1-1

5. Financial Securities

• 1) Major Financial Instruments (Table 1-1)• 2) The process of securitization – mortgage

securitization:• - S&L, banks or specialized mortgage

originating firms originate mortgage and sell them to investment banks. The investment bundle them into packages and then use these package as collateral for bonds sold to pension funds, insurance and other investors.

• Congress facilitated this process by creating two stockholder-owned but government sponsored entities – Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) which have a small amount of equity and a huge amounts of debt.

• Since then, S&L and banks originate and pool mortgage and then sell them to Fannie Mae which uses them as collateral in order to sell bonds.

• This process (1) increases lendable funds, (2) transfer of risk of mortgage to Fannie Mae, and (3) increases liquidity for holders of the debts.

• This process benefit investors (lenders) through diversification – bundled mortgage and an improved return.

6. Cost of moneyRaised capital is not free. • For debt, borrowers have to pay interest.• For equity, firms have to pay dividends.

4 fundamental factors affecting the cost of money:

(1) Production opportunities: The returns available within an economy from investments in productive assets(2) Time preferences for consumption: The preferences of consumers for current consumption as opposed to saving for future consumption. (3) Risk: The chance that an investment will provide a lower or negative return(4) Inflation: The amount by which prices increase over time.

Economic conditions and policies that affect the cost of money

(1) Federal reserve policyFED controls money supply by: - open market operation - discount rate - reserve requirement(2) Federal deficit: The larger the deficit, the higher the interest

rates(3) Business activity (4) Foreign trade balance (deficit or surplus): The larger the

trade deficit, the more we must borrow and this will drives up the interest rates

(5) International country risk

7. Financial Institutions

• Investment banks: an organization that underwrites and distributes new investment securities and helps businesses obtain financing.

• Commercial bank: the traditional department store of finance serving a variety of savers and borrowers.

• Financial services corporation: a firm that offers a wide range of financial services, including investment banking, brokerage operations, insurance, and commercial banking.

• Credit union: cooperative association whose members’ savings are loaned only to other members.

• Pension funds: retirement funds. Primarily investing in bonds, stocks, mortgages, and real estate.

• Life insurance companies: take premium and invest in bonds, stocks, etc

• Mutual funds: organizations that pool investor funds to purchase financial instruments and thus reduce risk through diversification.

- Money market funds: investment in low-risk securities and allow investors to write checks against their accounts.

• Exchange Traded Funds (ETFs): similar to mutual funds. ETFs funds buy a portfolio of stocks of certain type and then sell their own shares to the public.

• Hedge funds: similar to mutual funds. - Mutual funds are registered and regulated by

SEC but hedge funds are largely unregistered. - Minimum investment requirement ( $1 million).

• Private Equity Companies: they buy and then manage entire firms.

8. Financial Markets1) Physical asset markets: goods, tangible assets, real

assets markets Financial markets: claims on real assets (financial

securities)

2) Spot and futures markets: assets are bought or sold for “ on the spot” or for delivery at some future date.

3) Money markets: financial markets for short term and high liquid debt securities.

Capital Market: financial markets for intermediate or long term bonds and stocks.

4) Primary Markets: markets in which corporations raise capital by issuing new securities.

Secondary market: markets in which existing, already outstanding, securities are traded. Ex) NYSE

5) Private market: The market where transactions are worked out directly between two parties. Ex) bank loan or private debt placementPublic market: The market where standardized contracts are traded on organized exchange. Ex) issuing securities or public debts

9. Trading Procedure1) Two basic types of stock markets• Physical location exchange: NYSE, AMEX and regional stock exchanges• Electronic dealer-based markets: Nasdaq, over the counter and

electronic communication networks (ECNs)

2) Matching buy and sell orders:- Outcry: meet and communicate with shout and hand signals. E.g)

CBOT- Dealers market: list bid and ask quotes and then contact a specific

dealer to match. E.g) NASDAQ- Electronic communication network (ECN): post buy and sell prices and

then ECN automatically match with close prices. E.g) Instinet and Archipelago.

• 3) Types of stock market transactions:• - Going public and seasoned equity offering.

• 10. Secondary stock market

• 1) New York Stock Exchange • Privately held firm owned by members and merged with Archipelago. The

merged one also has Pacific Exchange.• The NYSE group merged with Euronext in 2007 and became NYSE

Euronext.• Formal organization having tangible physical locations that conduct

auction markets in designated (“listed”) securities. • More than 300 members in NYSE had seats giving rights to trade on the

exchange. The trading license is also leased. Most of the larger investment banks operate brokerage departments or members with the leased trading licenses.

• 2) National Association of Securities Dealers (NASD) or NASDAQ

• Self-regulatory body that licenses brokers and oversees trading practices.

• Its own listing requirement.• More than 400 dealers making a market, generating good

liquidity.• Operate Nasdaq OTC Bulletin Board, which lists quotes for

stocks that are registered with the SEC but are not listed on any exchange because of small size or less profitability.

• Nasdaq operates Pink Sheet which provides quotes on company that are not registered with SEC.

11. Stock market performance

• Figure 1-4.

• 12. The Global Economic Crisis• Assignment 1: Summarize page 36 to 42.