chapter 1 overview and financial environment

8/12/2019 Chapter 1 Overview and Financial Environment

1/60

1-1

CHAPTER 1Overview of Financial

Management &Environment


2/60

1-2

Overview of FinancialManagement

Role of financial managementForms of business organization

Goals of the corporation

Agency relationships


3/60

1-3

All Successful Firms Accomplish 2 Goals

They identify, create, & deliver productsor services that are highly valued

This happens only if the firm provides morevalue than its competitors (in the form of eitherlower prices or better products)

They sell at prices high enough to covercosts and to compensate owners andcreditors for their exposure to risk

The profit must be high enough to adequatelycompensate investors


4/60

1-4

3 Key Attributes for Success

1. Skilled People at all levelsLeaders, managers and work force

2. Strong Relationships with groups outsidethe company

Successful companies develop win-winrelationships with suppliers, who thendeliver high-quality materials on time and ata reasonable cost

3. Enough Capital to execute their plans &support operations


5/60

1-5

3 Key Attributes for Success

3. Enough Capital to execute their plans &support operations

Most companies need cash to purchaseland, buildings, equipment, and materialsCompanies can reinvest a portion of theirearnings, but most must also raiseadditional funds externally,

by some combination of selling stock and/orborrowing in the financial markets


6/60

1-6

What causes a company to have aparticular stock value?

How can managers make choices thatadd value to their companies?

How can managers ensure that theircompanies dont run out of cash whileexecuting their plans?

3 questions FinancialManagement must answer


7/60

1-7

5 Primary Activities ofFinancial Management

Cash ManagementMinimize Cost of Capital

Strategic Investment (CapitalBudgeting) Allocation of Income (Dividends vs.Retained Earnings)Risk Management


8/60

1-8

Sole proprietorship

Partnership

Corporation

Alternative Forms of Business Organization


9/60

1-9

Factors to consider

Ease of formationTaxation

Liability of ownersLife of enterpriseEase/difficulty of raising capitalTransfer of ownership


10/60

1-10

Sole Proprietorship

Unincorporated business owned by oneindividual (1 owner) Advantages:

Easily and inexpensively formedSubject to few regulationsIts income is not subject to corporatetaxation but

it is taxed only as a part of the proprietorsincome


11/60

1-11

Sole Proprietorship

Disadvantages:Difficult to raise capital

It is difficult for a single owner to obtain the

capital needed for growthUnlimited liabilityThe proprietor has unlimited personal liabilityfor the businesss debts

Limited lifeThe life of a proprietorship is limited to the lifeof its founder

Used primarily for small businesses


12/60

1-12

Partnership

More than 1 ownerExists whenever two or more personsassociate to conduct a business forprofitPartnership agreements

Formal or informalDefine the ways any profits and losses areshared between partners


13/60

1-13

Partnership

Major advantageIts low cost and ease of formation

Partnerships income is not subject tocorporate taxation but is taxed only as a

part of the partners personal income


14/60

1-14

Partnership

DisadvantagesUnlimited liabilityLimited life of the organization

Difficulty transferring ownershipDifficulty raising large amounts of capital

Regarding liabilityThe partners can potentially lose all of theirpersonal assets, even assets not invested in thebusiness

Under partnership law, each partner is liable forthe businesss debts


15/60

1-15

Partnership

It is possible to limit the liabilities ofsome of the partners by establishing alimited partnership

Certain partners are designated generalpartners and others limited partners

Limited partners are liable only for the amountof their investment in the partnershipLimited partners typically have no controlGeneral partners have unlimited liability


16/60

1-16

Partnership

In both regular and limited partnership, at leastone partner is liable for the debts of thepartnership

In a limited liability partnership (LLP) , orlimited liability company (LLC)

All partners enjoy limited liability with regard to the

businesss liabilitiesTheir potential losses are limited to their investmentThis increase the risk faced by an LLPs lender,customers, and suppliers


17/60

1-17

Many owners

Legal entity created by a state, and itis separate and distinct from itsowners and managers

Corporation


18/60

1-18

Advantages:Unlimited life

A corporation can continue after its originalowners and managers are deceased

Easy transfer of ownershipOwnership interests can be divided intoshares of stock, which can be transferred

easilyLimited liabilityLosses are limited to the actual fundsinvested

Ease of raising capital

Corporation


19/60

1-19

Disadvantages:Corporate earnings may be subject todouble taxation

The earnings of the corporation are taxed atthe corporate level, and thenearnings paid out as dividends are taxedagain as income to the stock holders

Cost of set-up and report filingSetting up a corporation involves preparing acharter, writing a set of bylaws and filling themany required reports

Corporation


20/60

1-20

Charter: Establishing Separate Legal EntityName

Activities Amount of Capital Stock Number of DirectorsNames & Addresses of Directors

Bylaws: Rules for conduct of ActivitiesHow Directors will be electedPreemptive Right to new stock issuesProcedures for changing Bylaws, if required

Corporation


21/60

1-21

The primary goal is shareholderwealth maximization , which

translates to maximizing stockprice

Goals of the Corporation


22/60

1-22

Factors that affect stock price

Projected cashflows toshareholders

Timing of thecash flow stream

Riskiness of thecash flows


23/60

1-23

1. Sales revenues depend on theCurrent level of unit sales

Price per unitShort-term growth rate in salesLong-term sustainable growth rate in sales

2. Operating costs and taxes3. Required investments in operations

Three Determinants ofCash Flows


24/60

1-24

Operating costs and taxes

The second determinant of cash flowsThe combined impact of operating costsand taxes which

Determines the amount of after-tax profitthat is available to investors after thecompany pays its employees and suppliers


25/60

1-25

Required investments inoperations

The third factor affecting cash flows Amount of money a company mustinvest in its operations

including assets such as factories,equipment, computer systems, inventory


26/60

1-26

Factors that Affect the Level& Risk of Cash Flows

Decisions made by financial managers:Investment decisionsproduct lines, production processes, geographic market,use of technology, marketing strategy

Financing decisionschoice of debt policy and dividend policy

The firms capital structure and the risk of its

operations determine the total risk of the cashflowsThis risk is combined with the level of interest rates inthe economy and investors overall attitude toward risk,resulting in the rate of return that investors require


27/60

1-27

An agency relationship existswhenever a principal hires an agent toact on his or her behalf

Within a corporation, agencyrelationships exist between:

Shareholders and managersShareholders and creditors

Agency Relationships


28/60

1-28

Managers are naturally inclined to act intheir own best interestsBut the following factors affectmanagerial behavior:

Managerial compensation plansDirect intervention by shareholdersThe threat of firingThe threat of takeover

Shareholders versusManagers


29/60

1-29

Shareholders (through managers)could take actions to maximize stock

price that are detrimental to creditors

In the long run, such actions will raisethe cost of debt and ultimately lowerstock price

Shareholders versusCreditors


30/60

1-30

The Financial Environment:Markets, Institutions, andInterest Rates

Financial marketsTypes of financial institutionsDeterminants of interest rates

Yield curves


31/60

1-31

What is a market?

A market is a venue where goods andservices are exchanged A financial market is a place whereindividuals and organizations wanting toborrow funds are brought together with

those having a surplus of funds


32/60


33/60

1-33

Physical assets vs. Financial assets

Physical asset marketsCalled tangible or real asset markets,Those for such products as wheat,computers and real estate

Financial asset markets

Deal with stocks, bonds, notes, mortgages,and other claims on real assetsFutures and options (derivatives)


34/60

1-34

Money vs. Capital

Money marketsThe markets for short-term (less than one year),highly liquid debt securitiesThe New York and London money markets -worlds largest

Capital marketsThe markets for intermediate (one to five years)or long-term (more than five years) debt andcorporate stocksNew York Stock Exchange


35/60

1-35

Primary vs. Secondary

Primary marketsThe markets in which corporations raise newcapital

Example - if Microsoft were to sell a new issue ofcommon stock to raise capital, this would be a primarymarket transaction

Secondary markets

Markets in which existing, already outstanding,securities are traded among investors

Exist for stocks, bonds, mortgages and other financialassets


36/60

1-36

Spot vs. Futures

Spot markets and futures markets areterms that refer to whether the assetsare being bought or sold for

on-the-spot delivery (within a few days)or fordelivery at some future date (six months ora year into the future)


37/60

1-37

Public vs. Private

Public marketsWhere standardized contracts are tradedon organized exchanges

Public market securities are more liquidPrivate markets

Where transactions are worked out directly

between two partiesExamples of private market transactions

Bank loans and private placements of debt with

insurance companies


38/60

1-38

How is capital transferred betweensavers and borrowers?

Direct transfersIndirect transfersthrough Investment

Bankers (Investmentbanking house)Indirect transfers

through FinancialIntermediation


39/60

1-39

Types of financial intermediaries

Commercial banksSavings and loan associationsMutual savings banksCredit unionsPension fundsLife insurance companiesMutual funds


40/60


41/60

1-41

The way orders from sellersand buyers are matched

Auction systemWhere traders actually meet in a pit andsellers and buyers communicate with one

another through shouts and hand signals(CBOT)

Dealer market

Electronic communications network


42/60

1-42

Dealer market

There are market makers who keep aninventory of the stock Dealers list bid and ask quotes (the

prices at which they are willing to buy orsell)Computerized quotation system keep

track of all bid and ask pricesTraders must contact a specific dealer tocomplete transaction


43/60

1-43

Electronic communicationsnetwork (ECN)

Participants in an ECN post their ordersto buy and sell, and the ECNautomatically matches orders

The two largest ECNs for trading U.S.stocks are Instinent (owned by Reuters)and Island


44/60

1-44

Interest Rates

The cost of moneyThe price, or cost, of debt capital?

The interest rate

The price, or cost, of equity capital?The required return on equity

The required return investors expect iscomposed of compensation in the form ofdividends and capital gains


45/60


46/60

1-46

Production opportunities

The ability to turn capital into benefits

Time preferences for consumptionProviders can use their funds forconsumption or savings

By saving, they give up consumption nowin the expectation of having moreconsumption in the future


47/60

1-47

Risk

If an investment is risky, thenproviders require a higher expectedreturn to induce them to take the

extra risk

Inflation Also leads to higher interest rates


48/60

1-48

Nominal vs. Real ratesr = represents any nominal rater* = (r-star) represents the real risk-free

rate of interest. It is the rate that wouldexist on a riskless security if there wasno inflation. Typically ranges from 1% to4% per year (USA)

rRF = it is the quoted (nominal) risk-free rate of

interest on a security such as a U.S.Treasury billrRF includes the premium for expected inflation

rRF = r* + IP


49/60

1-49

Determinants of interest rates

r = r* + IP + DRP + LP + MRP

r = required return on a debt security

r* = real risk-free rate of interestIP = inflation premiumDRP = default risk premiumLP = liquidity premiumMRP = maturity risk premium


50/60

1-50

r = r* + IP + DRP + LP + MRPDRP = default risk premium

(this premium reflects the possibility that theissuer will not pay interest or principal)

LP = liquidity premium

(this is a premium charged by lenders toreflect the fact that some securities cannot beconverted to cash on short notice at a

reasonable price)

MRP = maturity risk premium(long-term bonds are exposed to a significantrisk of price declines, and a maturity riskpremium is charged by lenders to reflect thisrisk)


51/60

1-51

Premiums added to r* fordifferent types of debt

L-T Corporate

S-T Corporate

L-T Treasury

S-T Treasury

LPDRPMRPIP

ld d h


52/60

1-52

Yield curve and the termstructure of interest rates

Term structure relationship betweeninterest rates (or yields)and maturities

The yield curve is agraph of the termstructure

A Treasury yield curvefrom October 2002 canbe viewed at the right

What is the relationship between the


53/60

1-53

pTreasury yield curve and the yieldcurves for corporate issues?

Corporate yield curves are higher thanthat of Treasury securities. However,corporate yield curves are not

necessarily parallel to the TreasurycurveThe spread between corporate andTreasury yield curves widens as thecorporate bond rating decreases (risk

increases)


54/60

1-54

Illustrating the relationship betweencorporate and Treasury yield curves

0

5

10

15

0 1 5 10 15 20

Years toMaturity

InterestRate (%)

5.2%

5.9% 6.0%TreasuryYield Curve

BB-Rated

AAA-Rated


55/60

1-55

Pure Expectations Hypothesis

The PEH contends that the shape of theyield curve depends on investorsexpectations about future interest rates

If interest rates are expected toincrease, L-T rates will be higher thanS-T rates, and vice-versa

the yield curve can slope up, down, or evenbow


56/60

1-56

Assumptions of the PEH

Assumes that the maturity risk premiumfor Treasury securities is zero (MRP=0)Long-term rates are an average of

current and future short-term ratesIf PEH is correct, you can use the yieldcurve to back out expected futureinterest rates


57/60

1-57

An example:Observed Treasury rates and the PEH

Maturity Yield1 year 6.0%2 years 6.2%3 years 6.4%4 years 6.5%5 years 6.5%

If PEH holds, what does the market expectwill be the interest rate on one-yearsecurities, one year from now? Three-yearsecurities, two years from now?


58/60

1-58

One-year forward rate

6.2% = (6.0% + x%) / 212.4% = 6.0% + x%6.4% = x%

PEH says that one-year securities will yield 6.4%, oneyear from now.

Th i


59/60

1-59

Three-year security, two yearsfrom now

6.5% = [2(6.2%) + 3(x%) / 532.5% = 12.4% + 3(x%)

6.7% = x%PEH says that three-year securities will yield 6.7%, twoyears from now.


60/60

1-60

Conclusions about PEH

Some would argue that the MRP 0, andhence the PEH is incorrectMost evidence supports the general view

that lenders prefer S-T securities, and viewL-T securities as riskierThus, investors demand a MRP to get

them to hold L-T securities (i.e., MRP > 0)

chapter 1 overview and financial environment

Documents