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Big Picture of Finance

What is finance? The Science of Managing Money.

1. Who manages money? Individuals and

corporation.

Is there any reason to distinguish individuals from

corporation?

Yes, corporations have more complicated financial

issues than individuals. (capital raising, agencyproblem)


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2. Topics covered by Finance:

Individual

Earn money spend for necessities save or

invest the remaining Personal finance investment

Corporation

Find a project Find a funding resources for theproject.

Perform the project. Evaluate theperformance of the project.

Corporate finance

We will focus on investments and corporate finance.


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3. How to manage money: By doing

valuation

Finance theories are mostly about valuation

(determining the value of bond, stock, project,

company). Please refer to our syllabus or

chapters in textbooks.

Discounted cash flow valuation!


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Course outline

Topic ChaptersIntroduction and Overview of Corporate Finance 1

Financial Statements and Cash Flow 2

Working with financial statements 3

Introduction to Time Value of Money 5Discounted Cash Flow Valuation 6

Bond Valuation 7

Stock Valuation 8

History of Capital Markets 12

Risk, Return, and Security Market Line 13

Cost of Capital 15

Net Present Value and Other Investment Criteria 9

Capital Investment Decisions 10

Project Analysis 11


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Chapter1:Introduction To Corporate

Finance


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Chapter 1 Outline

Overview ofFinancial Management

The Goal of

Financial Management

The Agency Problem and Control of the

Corporation

Financial Markets and the Corporation


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Corporate Finance

Some important questions that are answered

using finance

What long-term investments should the firm

take on? (Capital Budgeting)

Where will we get the long-term financing to

pay for the investment? (Raising Capital)

How will we manage the everyday financial

activities of the firm? (Cash Management)


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Financial Manager

Financial managers try to answer some or all

of these questions

The top financial manager within a firm is

usually the ChiefFinancial Officer (CFO)

Video :Video : This video looks at the changing role

of the ChiefFinancial Officer (CFO) at the

Fortune

500 company, Abbot Laboratories.


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Forms of Business Organization

Three major forms in the United States

Sole proprietorship

Partnership

General

Limited

Corporation

Limited liability company


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Sole Proprietorship

Advantages

Easiest to start

Least regulated

Single owner keeps allthe profits

Taxed once as personal

income

Disadvantages

Limited to life of owner

Equity capital limited to

owners personal wealth Unlimited liability

Difficult to sell

ownership interest


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Partnership

Advantages

Two or more owners

More capital available

Relatively easy to start Income taxed once as

personal income

Disadvantages

Unlimited liability

General partnership

Limited partnership Partnership dissolves

when one partner dies

or wishes to sell

Difficult to transfer

ownership


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Corporation

Advantages

Limited liability

Unlimited life

Separation ofownership and

management

Transfer of ownership is

easy

Easier to raise capital

Disadvantages

Separation of

ownership and

management

Double taxation

(income taxed at the

corporate rate and then

dividends taxed at the

personal rate)


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Goal Of Financial Management

What should be the goal of a corporation?

(hint: who are owners of the firm?)

Maximize profit?

Minimize costs?

Maximize market share?

Maximize the current value of the companys

stock?


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Goal Of Financial Management

A letter to stockholders written by formerCoca-

Cola CEO Roberto Goizueta

AtThe Coca-Cola Company, our publicly stated

mission is to create value overtime forthe

owners of our business. In fact, in our society,

that is the mission of any business: to create

value for its owners.


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How Coke is Kicking Pepsis Can,

Fortune, October 28, 1996. Coke focused on softdrinks while Pepsi-Co diversified

into other areas. Pepsi-Cos goal was to double revenuesevery 5 years, while Mr. Goizueta focused on return on

invest

ment

and st

ock price.

Goizueta "has created more wealth for stockholders thanany other CEO in history.

In mid-1996, Pepsi-Co sold at23 times earnings withreturn on equity of about23% and Coke sold at36timesearnings with a return on equity of around 55%.

.


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The Agency Problem

Agency relationship

Principal hires an agent to represent his/her interest

Stockholders (principals) hire managers (agents) to

run the company Agency problem

Conflict of interest between principal and agent

Agency costs

Direct agency costs the purchase of something for

management that cant be justifiedIndirect agency costs managements tendency tomake value reducing investment decisions (e.g., M&A)


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Mechanisms To Reduce Agency

Problem Managerial compensation

Incentives can be used to align management andstockholder interests

The incentives need to be structured carefully tomake sure that they achieve their goal

A 1993 study performed atthe Harvard BusinessSchool indicates thatthe total return to shareholdersis closely relatedto the nature of CEO

compensat

ion; specifically, higher ret

urns wereachieved by CEOs whose pay package includedmore option and stock components. (See The WallStreetJournal, November 12, 1993, p. B1).


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Mechanisms To Reduce Agency

Problem Threat of hostile takeover

The threat of a takeover may result in bettermanagement

Movie, Pretty Woman Why does the threat of a takeover might make

managers work towards the goals ofstockholders?

High stock price discourages takeovers. Shareholder intervention

Threat of firing


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Work the Web Example

The Internet provides a wealth of information

about individual companies

One excellent site is finance.yahoo.com


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