Managerial Finance Chapter 1

Chapter 1 - An overview of Financial Management

1. The Five Minute MBA
   For a company to be successful it must 1) provide more value that it's competitors and 2)Sell products at enough of a cost to meet expenses and compensate owners and creditors for their exposure to risk.
   
   1. The Key Attributes Required for success
      The first thing that successful companies have is skilled people at all levels in the company. Secondly they must have a strong relationship with groups outside the company. Third they need to have enough capital to execute the plans and to support their operation.
   2. The MBA, Finance, and Your Career
      This course will meet the needs of the third need. That is the need to have enough capital. It also will deal with choosing the best projects and proposals.
2. The Corporate Life Cycle
   1. Starting Up as a Proprietorship
      This is an unincorporated business owned by one individual. All profits go to the individual and all expenses are his responsibility as well.
      Benefits: Easy to form, subject to few government regulations, income taxed as part of personal income.
      Limitations: Difficult to obtain money needed for growth, unlimited liability for owner, life of company is limited to life of individual.
      Primarily for small businesses, account for 13% of sales but 80% of companies are like this.
   2. More Than One Owner: A Partnership
      This is when two or more people join together to create an organization in either formal or semiformal way.
      benefits are the same as proprietorship but liabilities are different. They include the proprietorship as well as difficulty in transferring ownership.
      All partners are liable in results of debts in company. If one can not pay, the others may be forced into doing it. This can be changed by creating a limited partnership. General partners have control of the company, limited partners have limited liability (to what they invested) but have limited returns as well.
      In any case, at least one partner has to accept the majority of the business liability.
   3. Many Owners: A Corporation
      Corporation is a legal entity created by the state that is separate and distinct from its owners.
      benefits: Unlimited life, easy to transfer ownership of the company interests, limited liability (to what person invests).
      Disadvantages: Earnings subject to double taxing (in the company and when the dividends are paid to individual investors), difficultly in setting one up.
      To start one must have a charter that explains the name, type of business, amount of capital stock, number of directors, name and addressees of all directors. This charter is filed in state incorporated in.
      Also needed is a set of bylaws that will explain how directors are to be elected, if current stockholders get first choice on new stock sales, and how bylaws are changed if necessary.
   4. Growing and Managing a Corporation
      Many companies start as a sole owner with them putting all the money in. Eventually they borrow money to stay growing. Maybe later they will have an Initial Public Offering (IPO) to raise needed money by selling stocks to people so they can raise money for the company. As a corporation they can better borrow money from banks and investors.
      When a company is small, the investors are usually the owners and put best interest of the company forward. This is not necessarily true of corporations who hire a manager. This creates a problem as a manager will work for his best interests and not the stockholders. This is called the agency problem.
      Self test questions
      What are the key differences between proprietorships, partnerships, and corporations?
      The key differences are the ability to raise money and the liability. In proprietorships it all falls on the one person. In a partnership it gets spread around about the liability is still there. In a corporation, the liability gets to the shareholders, and there seems to be an easier time in raising money.
      Describe some special types of partnerships and corporations, and explain the differences among them.
      In a partnership there is a limited liability partnership that limits the liability of most of the members. In a corporation, a professional corporation allows for most benefits of corporation but also leaves in place the professional liabilities face by the professional (doctors, lawyers, etc.).


3. The Primary Objective of the Corporation: Value Maximization
   Shareholders own corporations and hire managers to run company for them. The objectives of the manager should be stockholder wealth maximization. In stocks the market price is what the stock is currently worth. By hiding information a manager can cause the stock price to go up for the short term but it will eventually settle back down. By using this time of inflated price to sell his shares, the manager is looking at his objectives over the stockholders.
   1. Stock Price Maximization and Social Welfare
      Owners of stock are society so looking out for society interests is not a conflict with stockholders interests.
      To keep stock prices high a company must operate efficiently. This is good for consumers as it keeps costs down.
      A well run company should be increasing in employment, not letting people go. Since employment increases, society benefits as a whole.
   2. Managerial Actions to Maximize Shareholder Wealth
      A firm's value revolves around being able to generate cash flows now and in the future. There are three basic rules for this:
      1) Any financial asset is valuable only to the extent it generates cash flows
      2) timing of cash flows matter, sooner is better
      3)investors do not like risk, so will pay more for stock with less risk.
      The cash flows that matter are those of the cash available to spend or 'free cash flows'. What determines this is sales revenues, operating costs (including taxes) and required investments in operations.
      Sales revenue is current level of sales times price of unit plus expected future growth sales. Companies need to understand how changing prices can affect things in the long run and understand how customers will react. Operating costs deal with what a company pays out to make its products or services. Cheep supplies do not always result in lower costs as there may be much waste. Money invested in operations is what is needed to keep equipment running and inventory coming in. To increase cash flow these costs need to be kept down.
      Also to be looked at is the financing of the company. What debt should be incurred and what equity from the company should be used? What dividends should be paid out to shareholders. This comes into the mix as the Weighted Average Cost of Capital (WACC).
      Self test questions
      What is management's primary objective?
      To increase stockholders wealth.
      How does stock price maximization benefit society?
      People own stock, directly or indirectly. High value stocks mean an efficient company and an efficient company means lower prices. Lastly, a well run company will be hiring people regularly.
      What three factors determine the price of a stock?
      Could not find answer
      What three factors determine cash flow?
      Sales revenues, operating costs (and taxes) and investments in operations.
      
4. The Financial Markets
   1. Types of Markets
      • Physical asset markets (real) and Financial Asset markets - paper that shows ownership in the company and what they company will do for them.
      • Spot (futures) market - items bought for relatively immediate delivery.
      • Money markets - markets for short term and highly liquid debt securities.
      • Mortgage Markets
      • World/National/Regional/Local markets
      • Primary Market - where new stock is sold
      • Initial Public Offering (IPO) market - where shares are sold when a firm goes public for the first time.
      • Secondary Market - where securities are sold amongst people
      • Private/Public Markets - agreements between two organizations under their own rules (private) or well established rules (public).
      
      Do not try to pigeon hole any type of market as the lines blur easily. These markets are necessary for a functioning economy.
   2. Recent trends
   
   With our new global economy and everything happening so quick, policy makers are having a hard time keeping up. And though the countries of the world should get together on these things there is much reluctance. derivatives are in high use. Also, 48% of the households own stock but 58% is in the hands of professional investors. Since the own large amount of shares they try to influence how a company is run with relationship investing.
   Self test questions
   Distinguish between (1) Physical asset markets and financial asset markets, (2) spot and future markets, (3) money and capital markets, (4) private and public markets
   1)Physical deal with things that are produced that are real, cars, food, etc. Financial are markets that deal in paper (stocks, bonds, etc.).
   2)Spot is now, futures deal with something in future, generally in 6 months.
   3)Money - short term; capital - long term.
   4)Private - between two parties openly; public - organized selling with where many parties can purchase.
   What are derivatives
   A derivative is a financial instrument that derives its value from the value of other financial instruments or an underlying asset such as a future, forward, commodity, futures contract, stock, bond, currency, index or interest rate.
   What is relationship investing
   Since most stocks are in the hands of people investing for others, they feel they can force managers to deal with their wants or they can deflate the value of the stock by selling off large chunks of stock.
   the close governance of corporations exercised by large institutional shareholders.
5. Financial Institutions
   Money is transferred through one of three types of financial institutions. The first is by a direct transfer, in which there is no middle-man between the buyers and sellers. The second would be through an investment bank. The bank buys, or underwrites a business and then sells the securities (hopefully at a profit). The last is through Financial intermediaries. Savers buy securities in the Banking house and the banking house invests in the businesses. The major classes of this third type are as follows:
   • Commercial banks - wide variety of needs met. Now includes investment services to keep up with foreign countries.
   • Savings and loan associations - traditionally where small borrowers would go, takes income from small savers and invests in projects wisely. Due to scandals a few years ago they have been absorbed by other institutions.
   • Mutual Savings Banks - similar to S & L but limited to NE states.
   • Credit Unions - joining together of people with common background to invest only in the members needs.
   • Life Insurance companies - takes in money to pay out when problems arise to people.
   • Mutual Funds - accept income from savers and invest it in financial instruments.
   • Pension funds - money set aside for retirement. Comes as two types. Defined benefits are created by the company a person works for and managed for them. Defined contribution plans are more prevalent now and require the worker to have some knowledge of investing as they have to decide where there and/or companies money is to go.
   Institutions have been regulated a lot but now are having those regulations eased up on a little bit.
   Self test questions
   Identify three ways capital is transferred between savers and borrowers
   Directly, through investment banks, through financial intermediaries.
   What is the difference between a commercial bank and an investment bank?
   A commercial bank is for saving, checking and loans. An investment bank would be for connecting savers and institutions that need money.
   Distinguish between investment banking houses and financial intermediaries.
   Investment banking house takes on a risk by buying securities that it hopes to sell to people at a profit. Financial intermediaries take money from investors and pool it with other monies invested to invest it in securities.
6. Secondary Markets
   After the initial stock sale, stocks are then traded in exchanges as are other securities. They can be done in a physical location (where people see each other in a building of some sort) or in an electronic network of some sort (where buy and sells are matched by computers). Auction systems allow for bidding of the securities. Electronic networks allow for some limitations to be put on the transactions.
   Self test questions
   What are the major differences between physical location exchanges and computer /telephone networks?
   Physical location exchanges have a location where people meet to bid on the securities, computer/telephone networks use computers to exchange the bids.
   What are the differences among open outcry auctions, dealer's markets, and ECN's.
   Open outcry have people meet face to face and yell out what they are they are buying and selling and the price. In a dealer's market, an inventory of these is kept and matched. Lastly ECN's are like the dealer's market except that it is done on computers.
7. The Stock Market
   1. The New York Stock Exchange
      NYSE is a physical location exchange. Members buy 'seats; in the exchange which vary in price depending on the current value for them. Most members are from investment banking houses. They basically do an open cry auction system though much is automated.
   2. The Nasdaq Stock Market
      NASDAQ is run by the National Association of Securities Dealers though its Automated Quotation System (NASDAQ). It has various levels where securities are exchanged at. It is unusually heavy on high tech industries.
   
   Self test questions
   What are some major differences between the NYSE and the Nasdaq stock market?
   NYSE is open face to face auction, NASDAQ is an automated computerized system.
8. The Cost of Money and Interest Rate Levels
   1. Factors That Affect the Cost of Money
      Four factors influence the cost of money. 1)Production opportunities (turn capital into benefits), 2) time preferences for consumption (how quickly providers want to use their money), 3) risk (chance money will be gotten back), 4) inflation (the growing cost of living).
   2. Interest Rate Levels
      There are different markets for different needs in finances, from home loans to businesses. The cost of the money depends on what the market is that you are dealing with and how the current economy is doing.
   
   Self test questions
   What four fundamental factors affect the cost of money?
   1)Production opportunities (turn capital into benefits), 2) time preferences for consumption (how quickly providers want to use their money), 3) risk (chance money will be gotten back), 4) inflation (the growing cost of living).
   Why does the price of capital change during booms and recessions?
   During boons, rates go up as money is need for projects so that businesses can expand. In the recessions, companies do not expand as much and interest rates will go down as an enticement to borrow.
   How does inflation affect interest rates?
   inflation will keep interest rates high as people will want to earn the money back and then some to pay back the inflation.If the interest charged does not at least pay back the rate of inflation, they will loose money.
9. The Determinants of Market Interest Rates
   The quoted rate of interest is refereed to as r and is composed of the real risk-free rate of interest (r*) plus several other factors.
   1. The Real Risk-Free Rate of Interest
      r* is defined as the interest rate that would exist in no inflation was expected. Usually short-term US Treasury securities are used for this number. It is not a static number.
   2. Inflation Premium (IP)
      Since we have inflations, an inflation premium needs to be figured in to the final interest rate charged so we can keep up with it. The inflation rate is what we expect it to be, not what it has been in the past. This is usually the interest charged on a default-free US Treasury Bill.
      r_T-bill = r_RF = r* + IP
      if r* was .6% and inflation was 1.0% then r_RF = .6% + 1% or 1.6%
   3. The Nominal, or Quoted, Risk Free Rate of Interest, r_RFThis would be the risk-free and the Inflation Premium together with no other premium added. In practice it is a theoretical value since the other values need to be added to it.
   4. Default Risk Premium (DRP)
      Since a company or person could not pay back the interest or the principal on a loan, this is the amount charged to protect the party making the loan in taking the risk. It varies with the type of company and the its past history.
   5. Liquidity Premium (LP)
      The LP is the premium paid based on how quick the money can be converted back to money if the investor needs it back. The less liquid it is (the longer it takes to turn it back to cash) the higher this will be.
   6. Maturity Risk Premium (MRP)
      As a general rule, the longer it is set to pay back a debt, the higher the interest rate will be.
   
   Self test questions
   Write out an equation for the nominal interest rate on any debt security.
   r = r* + IP + DRP + LP + MRP
   Distinguish between the real risk free rate of interest r*, and the nominal, or quoted, risk-free rate of interest r_rf.
   The former would be what would be quoted if we believed that there would be no interest charged at all. The later is the former with an Inflation Premium added in.
   How is inflation incorporated into interest rates?
   Inflation is added in by calculating it and designating it as IP in the equation listed above.
   Does the interest rate on a T-bond include a default risk premium? Explain.
   Only by subtracting the non-indexed from the index rates can one calculate what is expected to be the interest rate.
   Identify some assets that are liquid and some that are illiquid.
   Real Estate, in general would be illiquid, gold, in general would be liquid.
   Briefly explain the following statement: "Long-term bonds are heavily exposed to interest rate risks."
   My guess is that since we do not know how interest will go in general, any rate will be set either much to high (benefitting the loaner) or too low (benefitting the borrower).


10. The Term Structure of Interest Rates
    The term structure is the relationship between long and short term interest rates.
    Self test questions
    What is a yield curve, and what information would you need to draw this curve?
    A yield cure is a pictorial explanation of short, intermediate and long term rates (usually out to 20 years) of interest. The information I would need to draw this is the rates for the various bond issues for a company or country we would be interested in.
    Explain the shapes of a "normal" yield curve, an "abnormal" yield curve, and a "humped" curve.
    A normal curve would have short term interest rates low and as they extend out the rates would go up. An abnormal curve would be the opposite, with short term being high and going lower. A humped would have both end level and the middle term rates be high.
11. What determines the shape of a Yield Curve
    The yield cure is determined by what is expected to happen in the future. The major player here would be inflation. The curve here would tend to follow what is expected of inflation. but MRP, DRP and LP can also affect it.
    Self test questions
    How do maturity risk premiums affect the yield curve?
    The longer the security is expected to be held, it can be assumed that the rate would be higher.
    If the rate of inflation is expected to increase, would this increase or decrease the slope of the yield curve?
    It would increase the curve.
    Explain why corporate bonds' default and liquidity premiums are likely to increase with maturity.
    The DRP rate would likely go up because of the need to cover bases if the company did not have a good rating. The LP would go up with length of security because it would not be easy to convert it into cash needed.
12. International Risk Factors
    Dealing with overseas companies one must be aware of risks that could affect the profit that could be made. This would be the country risk. The more difficulties in the foreign country the higher the risk. One also needs to be aware that the currency rates fluctuate and the currency of that country could go up or down in regards to the dollar, therefore wiping out or increasing what could be made in profit. This is exchange rate risk.
13. Economic Factors That Influence Interest Rate Levels
    1. Federal Reserve Policy
       The adjustment of the money supply by the Federal Government can affect both long and short term interest rates, but mostly it is the short term rates.
    2. Budget Deficits or Surpluses
       If the government is running a deficit it must either print or borrow money, both of which will tend to raise interest inflation and then interest rates. If it gets a surplus it can pay debt down quicker thereby reducing this problem.
    3. International Trade Deficits or Surpluses
       Deficits in trade must be taken care of by borrowing money form other countries. This puts our interest rates in line with theirs because they can call for our debt to be redeemed if we do not go along.
    4. Business Activity
       Less business leads to less jobs, leads to less spendable income, etc. Recessions and boons in business can lead to changes in the rates of interest.
14. A Preview of What is Ahead
15. e-Resources
16. Summary