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Chapter 1

An Overview of Financial Management

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Topics in Chapter

Basic Goal: to create shareholder value

Agency relationships: Stockholders versus managers Stockholders versus creditors

Transparency in financial reporting The Cost of Money

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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.

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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.

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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

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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

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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)

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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.

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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

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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

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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 FCF2 FCF∞

(1 + WACC)1

(1 + WACC)∞

(1 + WACC)2

+ +…

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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.

What is an agency relationship?

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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.

If you are the only employee, and only your money is invested in the business, would any agency problems exist?

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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.

Would hiring additional people create agency problems?

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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.

Might acquiring capital lead to agency problems?

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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.

Does the source of the capital affect agency problems?

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There are 2 potential agency conflicts:

Conflicts between stockholders and managers.

Conflicts between stockholders and creditors.

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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.

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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.

What actions might make a loan feasible?

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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…)

What actions might mitigate your agency problems if you expanded beyond your home campus?

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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.

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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.

Why might you want make your financial statements look artificially good?

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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.

What are the potential consequences of inflating earnings or hiding debt?

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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

What kind of compensation program might you use to minimize agency problems?

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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.

Are financial management skills important to your career?

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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.

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What is transparency in financial reporting?

When all market participants have reliable, accurate information about a particular company.

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What safeguards help market transparency? 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

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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.

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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

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What four factors affect the cost of money?

Production opportunities Time preferences for consumption Risk Expected inflation

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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

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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

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What two factors lead to exchangerate 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.

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Financial Securities

Debt Equity Derivatives

MoneyMarket

•T-Bills•CD’s•Eurodollars•Fed Funds

•Options•Futures•Forward contract

CapitalMarket

•T-Bonds•Agency bonds•Municipals•Corporate bonds

• Common stock

• Preferred stock

•LEAPS•Swaps

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Typical Rates of Return

Instrument Rate (July 2008)

U.S. T-bills 1.96%

Banker’s acceptances 2.80

Commercial paper 2.31

Negotiable CDs 3.08

Eurodollar deposits 3.25

Commercial loans:

Tied to prime 5.00 +

or LIBOR 3.12 +(More . .)

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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%