Chapter 1
An Overview of Financial
Management
1
Topics in Chapter


Basic Goal: to create shareholder value
Agency relationships:

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
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Stockholders versus managers
Stockholders versus creditors
Transparency in financial reporting
The Cost of Money
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
What should be management’s
primary objective?

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.
4
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
5
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
6
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)
7
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.
8
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:


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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
9
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
10
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:
Value =
FCF1
(1 + WACC)1
+
FCF2
(1 + WACC)2
+…
FCF∞
(1 + WACC)∞
11
What is an agency
relationship?
An agency relationship arises
whenever one or more individuals,
called principals, (1) hires another
individual or organization, called an
agent, to perform some service and
(2) then delegates decision-making
authority to that agent.
12
If you are the only employee, and only
your money is invested in the business,
would any agency problems exist?
No agency problem would exist. A
potential agency problem arises
whenever the manager of a firm owns
less than 100 percent of the firm’s
common stock, or the firm borrows.
You own 100 percent of the firm.
13
Would hiring additional people
create agency problems?
An agency relationship could exist
between you and your employees if you,
the principal, hired the employees to
perform some service and delegated some
decision-making authority to them.
14
Might acquiring capital lead to
agency problems?
If you needed additional capital to buy
computer inventory or to develop software
then you might end up with agency
problems if the capital is acquired from
outside investors.
15
Does the source of the capital
affect agency problems?
Agency problems are less for secured
than for unsecured debt, and different
between stockholders and creditors. So it
matters whether the new capital comes in
the form of an unsecured bank loan, a
bank loan secured by your inventory of
computers, or from new stockholders.
16
There are 2 potential agency
conflicts:


Conflicts between stockholders and
managers.
Conflicts between stockholders and
creditors.
17
Would expansion increase or
decrease potential agency problems?
Increase. If you expanded to additional
locations you could not physically be at
all locations at the same time.
Consequently, you would have to
delegate decision-making authority to
others.
18
What actions might make a
loan feasible?
Creditors can protect themselves by (1)
having the loan secured and (2) placing
restrictive covenants in debt
agreements. They can also charge a
higher than normal interest rate to
compensate for risk.
19
What actions might mitigate your
agency problems if you expanded
beyond your home campus?



Structuring compensation packages to
attract and retain able managers whose
interests are aligned with yours.
Threat of firing.
Increase “monitoring” costs by making
frequent visits to “off campus” locations.
(More…)
20
Would going public in an IPO
increase or decrease agency
problems?
By going public through an IPO, your firm
would bring in new shareholders. This
would increase agency problems,
especially if you sell most of your stock
and buy a yacht. You could minimize
potential agency problems by staying
on as CEO and running the company.
21
Why might you want make your
financial statements look artificially
good?
A manager might inflate a firm's reported
earnings or make its debt appear to be
lower if he or she wanted the firm to look
good temporarily. For example just prior to
exercising stock options or raising more
debt.
22
What are the potential consequences
of inflating earnings or hiding debt?
If the firm is publicly traded, the stock price
will probably drop once it is revealed that
fraud has taken place. If private, banks may
be unwilling to lend to it, and investors may
be unwilling to invest more money.
23
What kind of compensation program
might you use to minimize agency
problems?



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“Reasonable” annual salary to meet
living expenses
Cash (or stock) bonus
Options to buy stock or actual shares of
stock to reward long-term performance
Tie bonus/options to EVA
24
Are financial management skills
important to your career?
Yes! Investors are forcing managers to
focus on value maximization. Successful
firms (those who maximize shareholder
value) will not continue to promote
individuals who lack an understanding of
financial management.
25
Students who understand this focus have
a major advantage in the job market.
This applies both to the initial job, and
the career path that follows.
26
What is transparency in
financial reporting?

When all market participants have
reliable, accurate information about a
particular company.
27
What safeguards help market
transparency?

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Public companies use GAAP rules
established by the FASB for accounting
Public companies must have their
financial statements audited
These statements are made available to
the investing public by the SEC
Firms must release information to
everyone at the same time
28
What is Sarbanes-Oxley?


An act passed in 2002 that established
new regulations for auditors, corporate
officers, and securities analysts.
The goal was to make it less likely that
companies and securities analysts
would mislead investors, and increase
the penalties for doing so.
29
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
30
What four factors affect the
cost of money?

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Production opportunities
Time preferences for consumption
Risk
Expected inflation
31
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
32
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
33
What two factors lead to exchange
rate fluctuations?

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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.
34
Financial Securities
Debt
Money
Market
•T-Bills
•CD’s
•Eurodollars
•Fed Funds
Capital
Market
•T-Bonds
•Agency bonds
•Municipals
•Corporate bonds
Equity
Derivatives
•Options
•Futures
•Forward
contract
• Common
stock
• Preferred stock
•LEAPS
•Swaps
35
Typical Rates of Return
Instrument
U.S. T-bills
Banker’s acceptances
Commercial paper
Negotiable CDs
Eurodollar deposits
Commercial loans:
Tied to prime
or LIBOR
Rate (July 2008)
1.96%
2.80
2.31
3.08
3.25
5.00 +
3.12 +
(More . .)
36
Typical Rates (Continued)
Instrument
Rate (April 2007)
U.S. T-notes and T-bonds
3.83%
Mortgages
6.04
Municipal bonds
4.56
Corporate (AAA) bonds
5.49
Preferred stocks
6% to 9%
Common stocks (expected)
9% to 15%
37