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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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Big Picture of Finance
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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Big Picture of Finance
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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End ofChapter