Overview Flashcards
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.
Legal organization of the firm has impact on corporate finance
Business Organization from Start up to a major corporation
- Sole proprietorship
- partnership
- corporation
Explain the sole proprietorship
Advantages: - Ease of formation - Subject to few regulations - No corporate income taxes Disadvantages: - Limited life - Unlimited liability - Difficult to raise capital to support growth
Explain a partnership
A partnership has roughly the same advantages and disadvantages as a sole proprietorship.
Becoming a corporation
A corporation is a legal entity separate from its owners and managers.
File papers of incorporation with state.
- Charter
- Bylaws
Advantages and Disadvantages of a corporation
Advantages: - Unlimited life - Easy transfer of ownership - Limited liability - Ease of raising capital Disadvantages: - Double taxation - Cost of set-up and report filing
Becoming a public corporation and growing afterwards
Initial Public Offering (IPO) of Stock
- Raises cash
- Allows founders and pre-IPO investors to “harvest” some of their wealth
Subsequent issues of debt and equity
Agency Problems and corporate governance
- Agency problem: managers may act in their own interests and not on behalf of owners (stockholders)
- Corporate governance is the set of rules that control a company’s behavior towards its directors, managers, employees, shareholders, creditors, customers, competitors, and community.
- Corporate governance can help control agency problems.
What should be a management’s primary objective?
The primary objective should be shareholder
wealth maximization, which translates to
maximizing the fundamental stock price.
- Should firms behave ethically? YES!
- Do firms have any responsibilities to society at large? YES! Shareholders are also members of society.
- Corporate social responsibility
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
The big picture
Intrinsic value of the firm is the sum of all the future expected free cash flows when converted into today’s value (i.e. discounted by the weighted average cost of capital).
Free Cash Flows
Free cash flows are the cash flows that are available (or free) for distribution to all investors (stockholders and creditors).
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)
What is the weighted avarage cost of capital?
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
Who are the providers (savers) and users (borrowers) of capital?
- Households: Net savers
- Non-financial corporations: Net users (borrowers)
- Governments: U.S. governments are net borrowers, some foreign governments are net savers
- Financial corporations: Slightly net borrowers, but almost breakeven
The capital allocation process
Slide (19)
Transfer of capital from savers to borrowers:
Direct transfer
- Example: A corporation issues commercial paper to an insurance company.
Through an investment banking house
- Example: In an IPO, seasoned equity offering, or debt placement, company sells security to investment banking house, which then sells security to investor.
Through a financial intermediary
- Example: An individual deposits money in bank and gets certificate of deposit, bank makes commercial loan to a company (bank gets note from company).
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
What four factory affect the cost of money?
- Production opportunities
- Time preferences for consumption
- Risk
- Expected inflation
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
Financial securities
Slide (24)
What are some financial institutions?
- Commercial banks
- Investment banks
- Savings & Loans, mutual savings banks, and credit unions
- Life insurance companies
- Mutual funds
- Pension funds
- Hedge funds and private equity funds
What are some types of markets?
- A market is a method of exchanging one asset (usually cash) for another asset.
- Physical assets vs. financial assets
- Spot versus future markets -
- Money versus capital markets - Primary versus secondary markets
Primary vs. secondary security sales
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.
