FINANCIAL MANAGEMENT
THEORY & PRACTICE
ADAPTED FOR THE SECOND CANADIAN
EDITION BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
CHAPTER 1
AN OVERVIEW OF FINANCIAL
MANAGEMENT AND THE
FINANCIAL ENVIRONMENT
CHAPTER 1 OUTLINE
• The Five-Minute Business Degree
• The Corporate Life Cycle
• The Primary Objective of the Corporation: Value
Maximization
• An Overview of the Capital Allocation Process
• Financial Securities and the Cost of Money
• Financial Institutions
• Types of Financial Markets
• The Big Picture
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The Five-Minute Business Degree
• Two main goals of all successful companies:
– Having products or services highly valued by
customers
– Selling products/services at prices high enough to
cover costs and reward investors
• The key attributes of successful companies:
– Having skilled people
– Having strong external relationships
– Having sufficient capital
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The Corporate Life Cycle
• No two companies will develop in exactly the
same way.
• A business usually begins as a small potato and
hopes to finish up as a major giant.
• Structures of business organizations:
– Sole proprietorship
– Partnership
– Corporation
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Starting Up as a Proprietorship
• Advantages:
– Ease of formation
– Subject to few regulations
– No corporate income taxes
• Disadvantages:
– Difficult to raise capital to support growth
– Unlimited liability
– Limited life span
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Starting as, or Growing Into, a
Partnership
• A partnership involves two or more entities
with various privileges and responsibilities.
– General vs. limited partner
– Limited liability partnership (LLP)
• A partnership has roughly the same
advantages and disadvantages as a sole
proprietorship.
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Becoming a Corporation
• A corporation is a legal entity separate from its
owners and managers.
• File papers and prepare reports with
Corporation Canada.
– Articles of incorporation
– Bylaws
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Advantages and Disadvantages of a
Corporation
• Advantages:
– Unlimited life
– Easy transfer of ownership
– Limited liability
– Ease of raising capital
• Disadvantages:
– Double taxation
– Higher setup cost
– Endless report filing
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Special Types of Corporations
• Professional corporations (PCs)
– For professionals such as doctors, lawyers, and
accountants
• Income trusts
– Created to distribute all of a business’s free cash
flow to investors in a tax-efficient manner
– Appropriate for businesses with stable cash flows
and not requiring significant capital expenditures
– Only allowable for real estate (REIT) now
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Growing and Managing a Corporation
• In addition to having products/services that
attract customers, a corporation must attract
investors.
– Founder’s own resources and from friends, family,
other private investors
– Initial public offering (IPO)
– Borrowing from banks, issuing bonds and additional
shares
• Separation of ownership and management
– Agency problem
– Corporate governance
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The Primary Objective of the
Corporation: Value Maximization
• What should be management’s primary
objective?
• Stock price maximization and social welfare
• Managerial actions to maximize shareholder
wealth
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What Should Be Management’s
Primary Objective?
• The primary objective should be shareholder
wealth maximization, which translates to
maximizing the fundamental share price, not just
the current market price.
– Should firms behave ethically? YES!
• Business ethics are a company’s attitude and
conduct toward its employees, customers,
community, and shareholders.
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Stock Price Maximization and Social
Welfare
• Do firms have any responsibilities to society at
large? Yes!
• Unethical behaviour destroys public trust and
confidence.
• Maximizing share price is good for society.
Why?
• Shareholders are also members of society.
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Is Maximizing Stock Price Good for
Consumers?
• To maximize stock price, corporations have to
produce and deliver high-quality goods and
services at the lowest possible cost to
consumers.
• Consumers can improve quality of life by the
direct or the indirect investments in the stock
market.
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Is Maximizing Stock Price Good for
Employees?
• 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 previously owned by the
government but that have been sold to private
investors.
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Managerial Actions to Maximize
Shareholder Wealth
• Improve a firm’s ability to generate cash flows
now and in the future by focusing on:
– the amount of expected cash flows (bigger is
better).
– the timing of the cash flow stream (sooner is
better).
– the risk of the cash flows (less risk is better).
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Free Cash Flows (FCF)
• FCF are cash flows available (or free) for
distribution to all investors (stockholders and
creditors).
• FCF = sales revenues – operating costs –
operating taxes – required investments in
operating capital.
• There are many ways firms can increase free
cash flows.
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Weighted Average Cost of Capital (WACC)
• In addition to FCF, another factor of determining a
firm’s value and its long-term stock price is 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 amounts of debt
and equity)
– interest rates
– risk of the firm
– investors’ overall attitude toward risk
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An Overview of the Capital
Allocation Process
• Who are the providers (savers) and users
(borrowers) of capital?
• Financial securities and the cost of money
• Financial institutions
• Financial markets
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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 break-even
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Transfer of Capital from Savers to
Borrowers
• Direct transfer (e.g., corporation issues
commercial paper to insurance company)
• Indirect transfer through an investment
banker (e.g., IPO, seasoned equity offering, or
debt placement)
• Indirect transfer through a financial
intermediary (e.g., individual deposits money
in bank, bank loans to a firm)
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Financial Securities
• Simply, pieces of paper with contractual
provisions entitling their owners to specific
rights and claims on specific cash flows or
values
• Can be classified along two dimensions:
– Time until maturity
– Debt or equity
• Can also be distinguish between primary
securities and derivatives
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Financial Securities cont’d
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Financial Securities cont’d
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The Cost of Money
• Supply and demand of funds determine the
cost or price of money.
• What do we call the price (or cost) of debt
capital? Of equity capital?
– Interest rate
– Cost of equity = required return = dividend yield +
capital gain
• Both are the rate fund users pay to fund
providers.
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Fundamental Factors That Affect
the Cost of Money
•
•
•
•
Production opportunities
Time preferences for consumption
Risk
Expected inflation
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Economic Conditions and Policies That
Affect the Cost of Money
•
•
•
•
•
Bank of Canada policies
Budget deficits/surpluses
Business activity (recession or boom)
International trade deficits/surpluses
Country risk depending on its economic,
political, and social environment
• Exchange rate risk
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Financial Institutions
•
•
•
•
•
Investment banks
Commercial banks
Trust companies
Credit unions
Life insurance
companies
• Mutual funds
– Money market funds
(MMFs)
– Exchanged traded
funds (ETFs)
• Pension funds
• Hedge funds
• Private equity funds
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Regulation of Financial Institutions
• Rationale: Ensure their safety and protect
investors
• Examples: Separation of different types of
services and limiting the types of services an
institution could provide
• Regulatory changes
– Deregulation to ensure free flow of capital and
efficiency of capital markets
– Blurring the distinctions between different types of
institutions and leading to financial “superstores”
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Types of Financial Markets
• A financial market brings together savers and
borrowers.
• Physical asset vs. financial asset markets
• Spot vs. futures markets
• Money vs. capital markets
• Primary vs. secondary markets
• Private vs. public markets
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Physical vs. Financial Asset Markets
• Physical (a.k.a. tangible or real) asset markets
– Products such as wheat, autos, and real estate
• Financial asset markets
– Primitive securities and derivative securities
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Spot vs. Futures Markets
• Spot (a.k.a. cash) markets
– Assets are bought or sold for “on-the-spot”
delivery.
• Futures markets
– Assets are bought or sold for delivery at some
future date.
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Primary vs. Secondary Markets
• 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
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Private vs. Public Markets
• Private markets
– Transactions are worked out directly between two
parties.
– Lack of liquidity
• Public markets
– Standardized contracts are traded on organized
exchanges.
– More liquid and transparent
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The Big Picture
• A manager’s primary job is to increase the firm’s
intrinsic value.
• Intrinsic value: The present value of the firm’s
expected free cash flows (FCF), discounted at
WACC
• Two approaches to increasing intrinsic value:
– improve FCF and/or
– reduce WACC
• You are to learn tools used to make decisions to
increase intrinsic value.
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