Overview of Fin and Fin Mkts
1Brigham & EhrhardtFinancial Management:Theory and Practice
14e 2014 Cengage Learning. All Rights Reserved. May not be copied,
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use. 2014 Cengage Learning. All Rights Reserved. May not be copied,
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use.2CHAPTER 1
Overview of Financial Management and the Financial Environment
2014 Cengage Learning. All Rights Reserved. May not be copied,
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service or otherwise on a password-protected website for classroom
use. 2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.3Topics in ChapterForms of business organizationObjective of
the firm: Maximize wealthDeterminants of fundamental valueFinancial
securities, markets and institutions
2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.4Why 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. 2014 Cengage Learning.
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whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a
password-protected website for classroom use.5Business Organization
from Start-up to a Major CorporationSole
proprietorshipPartnershipCorporation(More . .) 2014 Cengage
Learning. All Rights Reserved. May not be copied, scanned, or
duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise
on a password-protected website for classroom use.6Starting as a
ProprietorshipAdvantages:Ease of formationSubject to few
regulationsNo corporate income taxesDisadvantages:Limited
lifeUnlimited liabilityDifficult to raise capital to support growth
2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.7Starting as or Growing into a PartnershipA partnership has
roughly the same advantages and disadvantages as a sole
proprietorship. 2014 Cengage Learning. All Rights Reserved. May not
be copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.8Becoming a CorporationA corporation is a legal entity separate
from its owners and managers.File papers of incorporation with
state.CharterBylaws 2014 Cengage Learning. All Rights Reserved. May
not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for
classroom use.9Advantages and Disadvantages of a
CorporationAdvantages:Unlimited lifeEasy transfer of
ownershipLimited liabilityEase of raising
capitalDisadvantages:Double taxationCost of set-up and report
filing 2014 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.10Becoming a Public Corporation and Growing AfterwardsInitial
Public Offering (IPO) of StockRaises cashAllows founders and
pre-IPO investors to harvest some of their wealthSubsequent issues
of debt and equity
2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.11Agency Problems and Corporate GovernanceAgency 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 companys behavior towards its directors, managers, employees,
shareholders, creditors, customers, competitors, and community.
Corporate governance can help control agency problems.
2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.12What should be managements 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. 2014
Cengage Learning. All Rights Reserved. May not be copied, scanned,
or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use.13Is
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(Continued) 2014 Cengage Learning. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part,
except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for
classroom use.14Is 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 viewemployees who like working there
2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.15What three aspects of cash flows affect an investments
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) 2014 Cengage Learning. All Rights Reserved. May not
be copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.16Free 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.
2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.17What is the weighted average cost of capital (WACC)? WACC is
the average rate of return required by all of the companys
investors.WACC is affected by:Capital structure (the firms relative
use of debt and equity as sources of financing)Interest ratesRisk
of the firmInvestors overall attitude toward risk 2014 Cengage
Learning. All Rights Reserved. May not be copied, scanned, or
duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise
on a password-protected website for classroom use.18What determines
a firms fundamental, or intrinsic, value?Intrinsic value is the sum
of all the future expected free cash flows when converted into
todays dollars:
Value = + + +FCF1FCF2FCF(1 + WACC)1(1 + WACC)(1 + WACC)2See big
picture diagram on next slide.(More . .) 2014 Cengage Learning. All
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whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a
password-protected website for classroom use.19Value = + +
+FCF1FCF2FCF(1 + WACC)1(1 + WACC)(1 + WACC)2Free cash
flow(FCF)Market interest ratesFirms business riskMarket risk
aversionFirms debt/equity mixCost of debtCost of equityWeighted
averagecost of capital(WACC)Sales revenuesOperating costs and
taxesRequired investments in operating capital=Determinants of
Intrinsic Value: The Big Picture... 2014 Cengage Learning. All
Rights Reserved. May not be copied, scanned, or duplicated, in
whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a
password-protected website for classroom use.20Who are the
providers (savers) and users (borrowers) of capital?Households: Net
saversNon-financial corporations: Net users (borrowers)Governments:
U.S. governments are net borrowers, some foreign governments are
net saversFinancial corporations: Slightly net borrowers, but
almost breakeven 2014 Cengage Learning. All Rights Reserved. May
not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for
classroom use.The Capital Allocation
Process21BusinessBusinessBusinessSaversSaversSaversInvestment
BankFinancial IntermediaryBusinesss SecuritiesBusinesss
Securities1. Direct Transfer2. Through Investment Bank3. Through
Financial IntermediaryDollarsBusinesss
SecuritiesDollarsDollarsDollarsDollarsBusinesss
SecuritiesIntermediarysSecurities 2014 Cengage Learning. All Rights
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part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected
website for classroom use.22Transfer of Capital from Savers to
BorrowersDirect transferExample: 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 intermediaryExample:
An individual deposits money in bank and gets certificate of
deposit, bank makes commercial loan to a company (bank gets note
from company). 2014 Cengage Learning. All Rights Reserved. May not
be copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.23Cost of MoneyWhat do we call the price, or cost, of debt
capital?The interest rateWhat do we call the price, or cost, of
equity capital?Cost of equity = Required return = dividend yield +
capital gain 2014 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.24What four factors affect the cost of money?Production
opportunitiesTime preferences for consumptionRiskExpected inflation
2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.25What economic conditions affect the cost of money?Federal
Reserve policiesBudget deficits/surplusesLevel of business activity
(recession or boom)International trade deficits/surpluses 2014
Cengage Learning. All Rights Reserved. May not be copied, scanned,
or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use.26What
international conditions affect the cost of money?Country risk.
Depends on the countrys economic, political, and social
environment.Exchange rate risk. Non-dollar denominated investments
value depends on what happens to exchange rate. Exchange rates
affected by:International trade deficits/surplusesRelative
inflation and interest ratesCountry risk
2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.27What 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 countrys currency to
fall. 2014 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.28Financial
SecuritiesDebtEquityDerivativesMoneyMarketT-BillsCDsEurodollarsFed
FundsOptionsFuturesForward contractCapitalMarketT-BondsAgency
bondsMunicipalsCorporate bondsCommon stockPreferred stockLEAPSSwaps
2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.29Typical Rates of ReturnInstrumentRate (January 2009)U.S.
T-bills 0.41%Bankers acceptances5.28Commercial paper0.28Negotiable
CDs1.58Eurodollar deposits2.60Commercial loans:Tied to prime3.25 +
or LIBOR2.02 +(More . .) 2014 Cengage Learning. All Rights
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part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected
website for classroom use.30Typical Rates (Continued)InstrumentRate
(January 2009)U.S. T-notes and T-bonds 3.04%Mortgages 5.02Municipal
bonds 4.39Corporate (AAA) bonds 5.03Preferred stocks6% to 9%Common
stocks (expected)9% to 15% 2014 Cengage Learning. All Rights
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part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected
website for classroom use.31What are some financial
institutions?Commercial banksInvestment banksSavings & Loans,
mutual savings banks, and credit unionsLife insurance
companiesMutual fundsExchanged Traded Funds (ETFs)Pension
fundsHedge funds and private equity funds 2014 Cengage Learning.
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whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a
password-protected website for classroom use.32What are some types
of markets?A market is a method of exchanging one asset (usually
cash) for another asset.Physical assets vs. financial assetsSpot
versus future marketsMoney versus capital marketsPrimary versus
secondary markets 2014 Cengage Learning. All Rights Reserved. May
not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for
classroom use.33Primary vs. Secondary Security SalesPrimaryNew
issue (IPO or seasoned)Key factor: issuer receives the proceeds
from the sale.SecondaryExisting owner sells to another
party.Issuing firm doesnt receive proceeds and is not directly
involved. 2014 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.34How are secondary markets organized?By locationPhysical
location exchangesComputer/telephone networksBy the way that orders
from buyers and sellers are matchedOpen outcry auctionDealers
(i.e., market makers)Electronic communications networks (ECNs) 2014
Cengage Learning. All Rights Reserved. May not be copied, scanned,
or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or
otherwise on a password-protected website for classroom
use.35Physical Location vs. Computer/telephone NetworksPhysical
location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock
ExchangeComputer/telephone: e.g., Nasdaq, government bond markets,
foreign exchange markets 2014 Cengage Learning. All Rights
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part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected
website for classroom use.36Types of OrdersInstructions on how a
transaction is to be completedMarket Order Transact as quickly as
possible at current priceLimit Order Transact only if specific
situation occurs. For example, buy if price drops to $50 or below
during the next two hours. 2014 Cengage Learning. All Rights
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part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected
website for classroom use.37Auction MarketsParticipants have a seat
on the exchange, meet face-to-face, and place orders for themselves
or for their clients; e.g., CBOT.NYSE and AMEX are the two largest
auction markets for stocks. NYSE is a modified auction, with a
specialist. 2014 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for use
as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.38Dealer MarketsDealers keep an inventory of the stock (or
other financial asset) and place bid and ask advertisements, which
are prices at which they are willing to buy and sell.Often many
dealers for each stockComputerized quotation system keeps track of
bid and ask prices, but does not automatically match buyers and
sellers.Examples: Nasdaq National Market, Nasdaq SmallCap Market,
London SEAQ, German Neuer Markt. 2014 Cengage Learning. All Rights
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part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected
website for classroom use.39Electronic Communications Networks
(ECNs)ECNs:Computerized system matches orders from buyers and
sellers and automatically executes transaction.Low cost to
transactExamples: Instinet (US, stocks, owned by Nasdaq);
Archipelago (US, stocks, owned by NYSE); Eurex (Swiss-German,
futures contracts); SETS (London, stocks). 2014 Cengage Learning.
All Rights Reserved. May not be copied, scanned, or duplicated, in
whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a
password-protected website for classroom use.40Over the Counter
(OTC) MarketsIn the old days, securities were kept in a safe behind
the counter, and passed over the counter when they were sold.Now
the OTC market is the equivalent of a computer bulletin board
(e.g., Nasdaq Pink Sheets), which allows potential buyers and
sellers to post an offer.No dealersVery poor liquidity 2014 Cengage
Learning. All Rights Reserved. May not be copied, scanned, or
duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise
on a password-protected website for classroom use.41Home Mortgages
Before S&LsThe problems if an individual investor tried to lend
money to an aspiring homeowner:Individual investor might not have
enough money to fund an entire homeIndividual investor might not be
in a good position to evaluate the risk of the potential
homeownerIndividual investor might have difficulty collecting
mortgage payments 2014 Cengage Learning. All Rights Reserved. May
not be copied, scanned, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for
classroom use.42S&Ls Before SecuritizationSavings and loan
associations (S&Ls) solved the problems faced by individual
investorsS&Ls pooled deposits from many investorsS&Ls
developed expertise in evaluating the risk of borrowersS&Ls had
legal resources to collect payments from borrowers 2014 Cengage
Learning. All Rights Reserved. May not be copied, scanned, or
duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise
on a password-protected website for classroom use.43Problems faced
by S&Ls Before SecuritizationS&Ls were limited in the
amount of mortgages they could fund by the amount of deposits they
could raiseS&Ls were raising money through short-term
floating-rate deposits, but making loans in the form of long-term
fixed-rate mortgagesWhen interest rates increased, S&Ls faced
crisis because they had to pay more to depositors than they
collected from mortgagees 2014 Cengage Learning. All Rights
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part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected
website for classroom use.44Taxpayers to the RescueMany S&Ls
went bankrupt when interest rates rose in the 1980s.Because
deposits are insured, taxpayers ended up paying hundreds of
billions of dollars. 2014 Cengage Learning. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part,
except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for
classroom use.45Securitization in the Home Mortgage IndustryAfter
crisis in 1980s, S&Ls now put their mortgages into pools and
sell the pools to other organizations, such as Fannie Mae. After
selling a pool, the S&Ls have funds to make new home loansRisk
is shifted to Fannie Mae
2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
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service or otherwise on a password-protected website for classroom
use.46Fannie Mae Shifts Risk to Its InvestorsRisk hasnt
disappeared, it has been shifted to Fannie Mae.But Fannie Mae
doesnt keep the mortgages:Puts mortgages in pools, sells shares of
these pools to investorsRisk is shifted to investors.But investors
get a rate of return close to the mortgage rate, which is higher
than the rate S&Ls pay their depositor.Investors have more
risk, but more returnThis is called securitization, since new
securities have been created based on original securities
(mortgages in this example) 2014 Cengage Learning. All Rights
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part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected
website for classroom use.47Collateralized Debt Obligations
(CDOs)Fannie Mae and others, such as investment banks, can also
split mortgage pools into special securitiesSome securities might
pay investors only the mortgage interest, others might pay only the
mortgage principal.Some securities might mature quickly, others
might mature later.Some securities are senior and get paid before
other securities from the pool get paid.Rating agencies give
different Risk of basic mortgage is parceled out to those investors
who want that type of risk (and the potential return that goes with
it). 2014 Cengage Learning. All Rights Reserved. May not be copied,
scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.48Other Assets Can be SecuritizedCar loansStudent loansCredit
card balances 2014 Cengage Learning. All Rights Reserved. May not
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use as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom
use.49The Dark Side of SecuritizationHomeowners wanted better homes
than they could afford.Mortgage brokers encouraged homeowners to
take mortgages even thought they would reset to payments that the
borrowers might not be able to pay because the brokers got a
commission for closing the deal.Appraisers thought the real estate
boom would continue and over-appraised house values, getting paid
at the time of the appraisal.Originating institutions (like
Countrywide) quickly sold the mortgages to investment banks and
other institutions.(More . .) 2014 Cengage Learning. All Rights
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part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected
website for classroom use.50The Dark Side (Continued)Investment
banks created CDOs and got rating agencies to help design and then
rate the new CDOs, with rating agencies making big profits despite
conflicts of interest.Financial engineers used unrealistic inputs
to generate high values for the CDOs.Investment banks sold the CDOs
to investors and made big profits.Investors bought the CDOs but
either didnt understand or care about the risk.Some investors
bought insurance via credit default swaps. 2014 Cengage Learning.
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whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a
password-protected website for classroom use.51The CollapseWhen
mortgages reset and borrowers defaulted, the values of CDOs
plummeted.Many of the credit default swaps failed to provide
insurance because the counterparty failed.Many originators and
securitizers still owned sub-prime securities, which led to many
bankruptcies, government takeovers, and fire sales, including:New
Century, Countrywide, IndyMac, Northern Rock, Fannie Mae, Freddie
Mac, Bear Stearns, Lehman Brothers, and Merrill Lynch.
2014 Cengage Learning. All Rights Reserved. May not be copied,
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permitted in a license distributed with a certain product or
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use.