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Real Sector The Firm Financial SectorCorporate Investment Corporate FinancingDecisions: Utilization of Funds Decisions: Acquisition of Funds
Business Markets Financial MarketsThe Firm's Balance Sheet
__________________________________________________________Cash A/PA/R Other CurrentInventory Liabilities_________________ _____________________
Products Total Current Assets Total Current Liabilities
Customers
Competitors Fixed Assets: Capital: Savers/Employees Plant & Equipment Debt InvestorsTangible Assets Preferred StockTechnology Common Equity
--Retained Earnings--Common Stock
________________ _____________________Total Assets Total Liabilities & Equity
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Financing (sources of funds) must equal the investment inassets (use of funds).
Managers make investment decisions that generateearnings so that investors get a return on investment.
Financial Management is defined as the planning for,acquiring, and utilization of funds in a manner thatmaximizes the firms economic efficiency.
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The Corporate Finance View of the World:
Bus. Transactions $$
$$ Securities
Commercial
Sector
-Customers
-Products-Technology
-Competitors
Firms Balance
Sheet
Assets Liab.
Capital
Firms Income
Statement
Revenue-Expenses
-Taxes
Net IncomeRetained
Earnings?
Dividends?
Financial Sector
Savers/Investors:
-Individuals
-Corporations-Partnerships
-Banks
Return on
Investment
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The corporation has advantages over the other forms ororganization:
Unlimited lives that extend beyond the lives of the
founders or original managers.
Simple transferability of ownership: investors andmanagers are two separate groups, so investors can buyor sell the common stock without disrupting corporateoperations.
Limited liability in the corporation: investors can loseonly the total amount they invested in the commonstock.
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The stock market monitors the publicly-traded corporations performance:
Stock price changes signal whether managerialdecisions are good (stock price goes up) are bad(stock price goes down).
Because of the requirements to disclose
information that publicly-traded corporationsface, the stock market can monitor these firmsbetter than it can the other forms oforganization.
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The stock market disciplines the firm bycausing the stock price to decline. Inresponse, the firm can:Change strategies.
The Board of Directors can replace themanagers ( this is called internal governance).
The firm can be merged/taken over (this iscalled the market for corporate control).
Declare bankruptcy.
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In the Theory of Finance, the appropriate goal of
the firm is to maximize the value of shareholder
wealth.
Shareholders commit part of their wealth to the
firm when they buy the firms common stock.
Equivalent ways of stating this goal are:
To maximize the market value of the firm.
To maximize the stock price of the firm.
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An equation that is central to the Theory ofFinance is:
A Firms Stock Price = The Present Value ofAll Future Dividends
DIV1 DIV2 DIV3 DIV DIVt= ----------- + ----------- + ------------ + ... + ----------- = -------------
(1 + k)1 (1 + k)2 (1 + k)3 (1 + k) t=1 (1 + k)t
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This equation says that value (i.e., the stock price)depends on: The stream of dividends.
Risk, reflected in the discount rate, k. The timing of the dividends. Note that value depends on all future dividends
and not only on next quarter's dividends.
Where do dividends come from? Dividends = (Earnings) Earnings = (Revenue, Expenses, Interest Exp.,Other) Revenue = (Business Decisions, Strategy)
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Agency Problems and Costs. Investors(principals) provide funds, but managers (agents)formulate and implement strategies and tactics: the
problem ofseparation of ownership and control. The goal is to maximize shareholder wealth, but
investors cannot be sure that managers will act inshareholders best interests. Managers might:
Shirk their duties. Use corporate resources to pay for perquisites.
Shift funds into higher risk projects than thestockholders desire.
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Observability, asymmetric information, & moralhazard: Investors cannot observe everything managers do.
Managers have more information about the firm.
Investors monitor the firm, and the firm incursmonitoring costs.
Investor relations staffs, annual reports, SEC and other
regulatory reports consume resources. If managers actions cannot be observed directly,
then periodic disclosure must be made: Disclosure: information sets become more symmetric.
Are bank loan officers' salaries a monitoring cost?
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Agency problems can be solved if the interests ofmanagers and investors are aligned, if bothmanagers and investors have the same incentives.
Agency theory suggests if managers are bondedto the firm, managers would behave in theshareholders' best interests. This entails bonding costs. For example, stock options
or stock purchase programs (like at 85% of the marketprice) transform managers into owner/managers.
But managers are buying into the firm at below-marketprices. The bonding cost is the loss of wealth sufferedby other shareholders when the stock is sold cheap.
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These costs cause shareholder wealth to be lessthan if managers didn't pose a moral hazard. We live in an imperfect world.
A perfect world of symmetric information no moralhazards is not attainable.
Financial contracting solutions are often used. For example, bond indenture contracts often contain
restrictive covenants that limit the behavior ofmanagers, like no new mortgages on the assets.
Bank loans also contain restrictions, like limitations onpaying dividends, the amount of additional borrowing,or a minimum current ratio requirement.
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A closer look at financial contracting. Bonds areloan contracts, and common stocks have legal tiesto the firm via the firm's charter.
Bonds are fixed income securities that have finite lives:bonds have a fixed maturity date, pay a set amount ofinterest each period, and borrowings must be repaid.
Stocks are variable income securities that have infinitelives. Dividends are not guaranteed and stock nevermaturesas long as the firm is alive. Stocks can berepurchased by the firm, but that is different: stockcan be retired but it does not mature. Stocks representan equity, or ownership, interest in the firm.
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Security Payment Priority_______________________________________________________________________________________________________________________________________
Debt Fixed, periodic interest Priority in bankruptcy
Par value at maturity Preference over preferred & common
Can force bankruptcy if not paid
Preferred Fixed, periodic dividend Paid before common dividends
Stock No maturity date Preference over common
Div. must be declared
Common No fixed dividend Residual position in dividend
Stock No maturity date payment and bankruptcy
Div. must be declared
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The Relationship Between Discount Rates and Value:
Like stock, bond prices also equal the present value ofthe cash flows that investors expect to receive:
Bond Price = P.V. of interest + P.V. of maturity value Bond Interest = coupon rate X maturity value
Maturity Value = $1,000.00; called the bondsprincipal
Consider a 10% , 1-year bond or a 10%, 5-year bond;both have a maturity value of $1,000.
Currently, bond interest rates are 10%, but rates mayvary between 8% and 12% over the next few months.
How do changing interest rates affect bond values?Interest = .10 x $1,000 = $100 per year
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8.0%
k = the Market Rate of Interest
10.0% 12.0%
A. 1-Year bond
Present value of:
Interest
Maturity value
Price of bond
B. 5-Year Bond
Present value of:
Interest
Maturity value
Price of bond
$ 92.59
925.92
$1,108.52
$ 399.27
680.58
$1,079.85
$ 90.91
909.09
$1,000.00
$ 379.07
620.93
$1.000.00
$ 89.28
892.96
$ 982.14
$ 360.48
567.42
$ 927.90
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Define k as the Market Rate of Interest. Theexample shows that that k and a bonds price areinversely related:
Bond prices goes up as k goes down.Bond prices goes down as k goes up.
Note that the bond with the longer maturity (the 5-yr bond) has greater price volatility for the same
changes in the interest rate. The 5-yr bond has a higher price at 8% and a lower
price at 12% than the 1-yr bond.
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Project evaluation techniques. Developing newproducts or services are essential if a firm is tocontinue growing. Capital budgeting involves:
Long-term investment opportunities as projects. Conducting a cost/benefit analysis for each project.
Accepting projects when benefits exceed the costs.
Picking good projects allows the firm to grow and to
increase its stock price. The preferred technique is called Net Present
Value (NPV).
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NPV = P.V. of Inflows - P.V. of Outflows
n NCFtNPV = ------------------- - Cost of the project
t=1 (1 + MCC)t
where: NCFt = Net Cash Flow at time tMCC = the Marginal Cost of Capital,
a risk-adjusted discount rate
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This gives rise to the following set of decisionrules that are used in capital budgeting:
IRR is the Internal Rate of Return and is defined as the
discount rate that makes NPV = 0.
Criterion Accept Reject
NPV
IRR
NPV O
IRR MCC
NPV < 0
IRR < MCC
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Who gets the NPV > 0 and how does it achieve thegoal of the firm? Common shareholders, the residual claimants.
Bondholders and preferred shareholders get what theyexpect, and common shareholders get what is left over.
The larger the residual, the more wealth commonshareholders receive (think of the positive NPV that Intelcreates with each new generation of microprocessors.)
If managers select all of the projects with NPV > 0, this isthe best that shareholders can hope for and the stock pricewill be maximized.
Negative NPVs would make the stock price go down.
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Informational efficiency: This important conceptis the idea that having accurate information iscrucial to making good investment decisions.
Financial markets are informationally efficientifsecurity prices fully reflect all information andreact immediately to impound new information. For example, if the financial markets are efficient, then
Intels stock price reflects all information about Intel. Any new information about Intel will make its stock
price go up or down immediately.
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One implication is that it is hard to "beat themarket" in an efficient market.
The greatest rewards exist for those who have the
best information; there is much competition forinformation. The "big players" who have the most resources gain
information first and grab the available profits first.
You and I, who are far from Wall Street and who spendlittle on information, find it difficult to beat the market.
Getting information first, or immediately, is very costlyand it is difficult to beat the market and to cover thecosts of obtaining information.
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Nevertheless, information efficiency is animportant concept, and financial markets arepretty efficient in my opinion. Competitive markets are key: as information becomes
available, investors revise their decisions to buy or sella stock or bond, so there must be markets in which theycan actually buy or sell.
Economics and finance profs love markets: supply anddemand come together and individuals are free to makebuy or sell decisions that are in their best own interests.
As information arrives, it becomes reflected in prices,so price changes signal good news (prices up) or bad
news (prices down).
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Source Complete Dissemination(day = 0) (day = 1)
Insiders know beforeannouncement
Industry analysts and
informed investors getinformation "on line
Recipients of analysts'reports and less informedinvestors are next; theremay be many substages sothat there are degrees ofbeing informed
You and I come last:since we have lowinformation costs (t.v.,radio, press, periodicals,etc.), the information ispicked over and its valuealready extracted by thetime we obtain the info.
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Types ofInformational Efficiency. Note how the Strong Form lines up with the first column above (the source),
the Semi-Strong Form lines up with the middle two columns, and the Weak Form lines up with the last column.
Strong Form: Semi-Strong Form Weak form
Considers all information
fromthe source, including
insider information
The strong form does not
hold: there is value to
insider information
Considers all publicly available information from when
the information is disseminated
The semi-strong form has been found to hold pretty
well, but not completely
Considers only historical
security prices; by thetime you and I receive the
Wall St. Journal on our
doorsteps, the information
has been fully
disseminated; all we have
is yesterday's prices
The weak form has been
found to hold very well
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A basic principle of Finance: more risk
should be rewarded with a higher return.
In the Theory of Finance, taking risk is agood thing since it creates new wealth (new
products, new technologies, etc.)
Thus, there should be rewards for bearingrisk.
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Expected Return
Risk-free Risk premiumRate: kf
Time value of money______________________________________________________________Risk
Treasury Corporate Common New Ventures,Bonds Bonds Stock Options, Futures,
and other Derivatives
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A life-cycle view of the growth of a technology-driven firm. Corporate Finance textbookstypically concentrate on firms that have gone
beyond the start-up stage and are publicly-traded. Publicly-traded firms have developed products and
services that generate earnings from the assets in place.
Start-ups have no assets in place, and maybe are basedon no more than a product or service concept.
The value of a publicly-traded firm is based on assets inplace, a start-ups value is based on its growth options.
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Sales/Earnings./Cash Flow
__________________________________________________________________ Time
R&D Early growth Rapid growth Maturity Decline(Seed & start-up) (First stage start-up) (Late stage start-up) (---- Publicly-traded ----)
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Venture Economics Stage Definitions: Early Stage
Seed. A relatively small amount of capital provided to
prove a concept, maybe involving product developmentbut not initial marketing.
Startup. Financing for product development and initial
marketing; no product sales, management team
assembled, business plan written, market research done.
First Stage. Financing for initial commercial
manufacturing and sales.
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Expansion Second Stage. Working capital financing provided;
likely to have no profits.
Third Stage. Financing for plant expansion, marketing,and working capital.
Bridge Stage. Financing for firm expected to go publicin 6-12 months; often repaid from IPO proceeds.
Management/Leveraged Buyout (MBO/LBO) andTurnaround later-stage companies: buying out existing firms or
financing firms with operational or financial difficulties.
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Large Publicly-Traded Firms
______________________________________
Easy access to financial markets: banks,
bond markets, and stock markets
Face scrutiny of financial markets:
--much information available about firm and
industry
--analysts perform monitoring function and
makes recommendations
--periodic disclosure keeps everybody happy
--stock market disciplines firms through
price changes force firm to behave as expected
Disclosure: through annual reports, SEC
announcements
--markets are more "informationally efficient"
New Ventures
_________________________________________
Financial markets in general are not
accessible: new ventures are privately held
Face scrutiny of VCs:
--little information about firm or its concept/idea
--VC have to monitor and invest
--VCs are quasi-insiders, often on the Bd. of Dir.
--markets are thin and illiquid; stock not publicly
traded
Disclosure: through business plans, and
and direct examination by investors
--markets are less "informationally efficient
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__________________________________________Large Publicly-Traded Firms
______________________________________
Problem of separation of ownership and control:
--stock options and stock purchase plan help bondmanagers to firm
Sound management expected and scrutinized:
--complex organizations the norm--reorganizations the norm--hierarchical organization--lots of written policies--expertise already developed (i.e., hire MBAs)
Goal is to maximize the firms' stock price:--it can generate a stream of earnings from
ongoing operations (or assets-in-place)--it can undertake capital budgeting
--firms are in mature stage
New Ventures_________________________________________
VCs have more direct monitoring ability:
--Entrepreneurs keep a large percent of sharesand key personnel get stock options
Management development just beginning:
--VCs know what is expected and offer networking--understaffed operation coping with explosion of
tasks and functions--what's a policy?--VCs "groom" management
Goal is to maximize the firms' stock price:--real goal is IPO or merger, or harvest, or cash
out for VC and entrepreneur (a liquidity event)--firms are in rapid growth stage
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Early Stage Late State Small Publicly Large PubliclyStart-up Private Firm -Traded Firm -Traded Firm_____________________________________________________________________________
VC invests,monitors, andgrooms firm
VC prepares firm forliquidity event (i.e.IPO, merger)
Liquidity eventoccurs: VC andentrepreneur harvest
Not what VCs investin; bank loansprobably available,but financing still abig problem
Financial marketsgenerally available
_____________________________________________________________________________