1、1-1CHAPTER 1Overview of Corporate Finance and the Financial Environmentn Corporate financelForms of business organizationlObjective of the firm:Maximize wealthlDeterminants of stock pricingn The financial environmentlFinancial instruments,markets and institutionslInterest rates and yield curves1-2Wh
2、y is corporate finance important to all managers?nCorporate finance provides the skills managers need to:lIdentify and select the corporate strategies and individual projects that add value to their firm.lForecast the funding requirements of their company,and devise strategies for acquiring those fu
3、nds.1-3nSole proprietorshipnPartnershipnCorporationWhat are some forms ofbusiness organization?1-4n Advantages:lEase of formationlSubject to few regulationslNo corporate income taxesn Disadvantages:lLimited lifelUnlimited liabilitylDifficult to raise capitalSole Proprietorship1-5nA partnership has r
4、oughly the same advantages and disadvantages as a sole proprietorship.Partnership1-6n Advantages:lUnlimited lifelEasy transfer of ownershiplLimited liabilitylEase of raising capitaln Disadvantages:lDouble taxationlCost of set-up and report filingCorporation1-7nThe primary objective should be shareho
5、lder wealth maximization,which translates to maximizing stock price.lShould firms behave ethically?YES!lDo firms have any responsibilities to society at large?YES!Shareholders are also members of society.What should managements primary objective be?1-8Is maximizing stock price good for society,emplo
6、yees,and customers?nEmployment growth is higher in firms that try to maximize stock price.On average,employment goes up in:lfirms that make managers into owners(such as LBO firms)lfirms that were owned by the government but that have been sold to private investors1-9nConsumer welfare is higher in ca
7、pitalist free market economies than in communist or socialist economies.nFortune lists the most admired firms.In addition to high stock returns,these firms have:lhigh quality from customers viewlemployees who like working there1-10nAmount of cash flows expected by shareholdersnTiming of the cash flo
8、w streamnRisk of the cash flowsWhat three factors affect stock prices?1-11nSales revenueslCurrent levellShort-term growth rate in saleslLong-term sustainable growth rate in salesnOperating expenses(e.g.,raw materials,labor,etc.)nNecessary investments in operating capital(e.g.,buildings,machines,inve
9、ntory,etc.)What factors determine of cash flows?1-12What factors affect the level and risk of cash flows?n Decisions made by financial managers:lInvestment decisions(product lines,production processes,geographic market,use of technology,marketing strategy,etc.)lFinancing decisions(choice of debt pol
10、icy and dividend policy)n The external environment(taxes,regulation,etc.)1-13What are financial assets?nA financial asset is a contract that entitles the owner to some type of payoff.lDebtlEquitylDerivativesnIn general,each financial asset involves two parties,a provider of cash(i.e.,capital)and a u
11、ser of cash.1-14What are some financial instruments?InstrumentRate(9/01)U.S.T-bills2.3%Bankers acceptances2.6Commercial paper2.4Negotiable CDs2.5Eurodollar deposits2.5Commercial loansTied to prime(6.0%)or LIBOR(2.6%)(More.)1-15Financial Instruments(Continued)InstrumentRate(9/01)U.S.T-notes and T-bon
12、ds5.5%Mortgages6.8Municipal bonds5.1Corporate(AAA)bonds7.2Preferred stocks7 to 9%Common stocks(expected)10 to 15%1-16Who are the providers(savers)and users(borrowers)of capital?nHouseholds:Net saversnNon-financial corporations:Net users(borrowers)nGovernments:Net borrowersnFinancial corporations:Sli
13、ghtly net borrowers,but almost breakeven1-17n Direct transfer(e.g.,corporation issues commercial paper to insurance company)n Through an investment banking house(e.g.,IPO,seasoned equity offering,or debt placement)n Through a financial intermediary(e.g.,individual deposits money in bank,bank makes c
14、ommercial loan to a company)What are three ways that capital is transferred between savers and borrowers?1-18nCommercial banksnSavings&Loans,mutual savings banks,and credit unionsnLife insurance companiesnMutual fundsnPension fundsWhat are some financial intermediaries?1-19The Top 5 Banking Companie
15、sin the World,12/1999Bank NameCountryTotal assetsDeutsche Bank AG Frankfurt$844 billionCitigroupNew York$717 billionBNP ParibasParis$702 billionBank of TokyoTokyo$697 billionBank of AmericaCharlotte$632 billion1-20What are some types of markets?nA market is a method of exchanging one asset(usually c
16、ash)for another asset.nPhysical assets vs.financial assetsnSpot versus future marketsnMoney versus capital marketsnPrimary versus secondary markets1-21How are secondary markets organized?nBy“location”lPhysical location exchangeslComputer/telephone networksnBy the way that orders from buyers and sell
17、ers are matchedlOpen outcry auctionlDealers(i.e.,market makers)lElectronic communications networks(ECNs)1-22Physical Location vs.Computer/telephone NetworksnPhysical location exchanges:e.g.,NYSE,AMEX,CBOT,Tokyo Stock ExchangenComputer/telephone:e.g.,Nasdaq,government bond markets,foreign exchange ma
18、rkets1-23Auction MarketsnNYSE and AMEX are the two largest auction markets for stocks.nNYSE is a modified auction,with a“specialist.”nParticipants have a seat on the exchange,meet face-to-face,and place orders for themselves or for their clients;e.g.,CBOT.nMarket orders vs.limit orders1-24Dealer Mar
19、ketsn“Dealers”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.n Computerized quotation system keeps track of bid and ask prices,but does not automatically match buyers and sellers.n Examples:Nasd
20、aq National Market,Nasdaq SmallCap Market,London SEAQ,German Neuer Markt.1-25Electronic Communications Networks(ECNs)nECNs:lComputerized system matches orders from buyers and sellers and automatically executes transaction.lExamples:Instinet(US,stocks),Eurex(Swiss-German,futures contracts),SETS(Londo
21、n,stocks).1-26Over the Counter(OTC)MarketsnIn the old days,securities were kept in a safe behind the counter,and passed“over the counter”when they were sold.nNow the OTC market is the equivalent of a computer bulletin board,which allows potential buyers and sellers to post an offer.lNo dealerslVery
22、poor liquidity1-27nWhat do we call the price,or cost,of debt capital?The interest ratenWhat do we call the price,or cost,of equity capital?Required Dividend Capital return yield gain=+.1-28What four factors affect the costof money?nProduction opportunitiesnTime preferences for consumptionnRisknExpec
23、ted inflation1-29Real versus Nominal Ratesr*=Real risk-free rate.T-bond rate if no inflation;1%to 4%.=Any nominal rate.=Rate on Treasury securities.rrRF1-30r=r*+IP+DRP+LP+MRP.Here:r=Required rate of return on a debt security.r*=Real risk-free rate.IP=Inflation premium.DRP=Default risk premium.LP=Liq
24、uidity premium.MRP=Maturity risk premium.1-31Premiums Added to r*for Different Types of DebtnST Treasury:only IP for ST inflationnLT Treasury:IP for LT inflation,MRPnST corporate:ST IP,DRP,LPnLT corporate:IP,DRP,MRP,LP1-32What is the“term structure of interest rates”?What is a“yield curve”?nTerm str
25、ucture:the relationship between interest rates(or yields)and maturities.nA graph of the term structure is called the yield curve.1-33How can you construct a hypothetical Treasury yield curve?nEstimate the inflation premium(IP)for each future year.This is the estimated average inflation over that tim
26、e period.nStep 2:Estimate the maturity risk premium(MRP)for each future year.1-34Step 1:Find the average expected inflation rate over years 1 to n:n INFLt t=1 nIPn=.Assume investors expect inflation to be 5%next year,6%the following year,and 8%per year thereafter.1-35IP1=5%/1.0=5.00%.IP10=5+6+8(8)/1
27、0=7.5%.IP20=5+6+8(18)/20=7.75%.Must earn these IPs to break even versus inflation;that is,these IPs would permit you to earn r*(before taxes).1-36Step 2:Find MRP based on this equation:MRPt=0.1%(t-1).MRP1=0.1%x 0=0.0%.MRP10=0.1%x 9=0.9%.MRP20=0.1%x 19=1.9%.Assume the MRP is zero for Year 1 and incre
28、ases by 0.1%each year.1-37Step 3:Add the IPs and MRPs to r*:rRFt=r*+IPt +MRPt.rRF=Quoted market interestrate on treasury securities.Assume r*=3%:rRF1=3%+5%+0.0%=8.0%.rRF10=3%+7.5%+0.9%=11.4%.rRF20=3%+7.75%+1.9%=12.65%.1-38Hypothetical Treasury Yield Curve05101511020Years to MaturityInterestRate(%)1
29、yr 8.0%10 yr 11.4%20 yr 12.65%Real risk-free rateInflation premiumMaturity risk premium1-39What factors can explain the shape of this yield curve?nThis constructed yield curve is upward sloping.nThis is due to increasing expected inflation and an increasing maturity risk premium.1-40What kind of rel
30、ationship exists between the Treasury yield curve and the yield curves for corporate issues?nCorporate yield curves are higher than that of the Treasury bond.However,corporate yield curves are not neces-sarily parallel to the Treasury curve.nThe spread between a corporate yield curve and the Treasur
31、y curve widens as the corporate bond rating decreases.1-41Hypothetical Treasury and Corporate Yield Curves051015015101520Years tomaturityInterest Rate(%)5.2%5.9%6.0%Treasuryyield curveBB-RatedAAA-Rated1-42What is the Pure Expectations Hypothesis(PEH)?nShape of the yield curve depends on the investor
32、s expectations about future interest rates.nIf interest rates are expected to increase,L-T rates will be higher than S-T rates and vice versa.Thus,the yield curve can slope up or down.1-43nPEH assumes that MRP=0.nLong-term rates are an average of current and future short-term rates.nIf PEH is correc
33、t,you can use the yield curve to“back out”expected future interest rates.1-44Observed Treasury RatesIf PEH holds,what does the market expect will be the interest rate on one-year securities,one year from now?Three-year securities,two years from now?MaturityYield1 year6.0%2 years6.2%3 years6.4%4 year
34、s6.5%5 years6.5%1-4501256.0%34x%6.2%PEH tells us that one-year securities will yield 6.4%,one year from now(x%).6.2%=12.4%=6.0+x%6.4%=x%.(6.0%+x%)21-4601256.2%34x%6.5%2(6.2%)+3(x%)5PEH tells us that three-year securities will yield 6.7%,two years from now(x%).6.5%=32.5%=12.4%+3(x%)20.1%=3(x%)6.7%=x%
35、.1-47nSome argue that the PEH isnt correct,because securities of different maturities have different risk.nGeneral view(supported by most evidence)is that lenders prefer S-T securities,and view L-T securities as riskier.nThus,investors demand a MRP to get them to hold L-T securities(i.e.,MRP 0).Conc
36、lusions about PEH1-48What various types of risks arisewhen investing overseas?Country risk:Arises from investing or doing business in a particular country.It depends on the countrys economic,political,and social environment.Exchange rate risk:If investment is denominated in a currency other than the dollar,the investments value will depend on what happens to exchange rate.1-49What two factors lead to exchangerate fluctuations?n Changes in relative inflation will lead to changes in exchange rates.n An increase in country risk will also cause that countrys currency to fall.
