Chapter 1, Fundamentals by Ross et. al.

1
Introduction

• Chapter 1, Fundamentals by Ross et. al.
• 3040.02 notes by A.P. Palasvirta, Ph.D.

2
Course of Study

• Corporate Finance
• Investments
• International finance
• Derivatives

3
Corporate Finance

• Time value of money
• Capital Budgeting
• Risk and Return
• Capital Stucture

4
Investment

• Markets
• Valuation
• Portfolio Selection
• Equity Valuation Model

5
International Finance

• Exchange Rate
• Exchange Markets
• Parity Conditions Exposure
• Foreign (Direct Portfolio) Investment

6
Derivatives

• Options
• Option Strategies
• Futures
• Swaps

7
Corporate finance

• What are the responsibilities of the CEO
• Strategic management (create a business plan)
• Tactical management (implement strategy)
• Capital budgeting
• What projects to take on
• How much to spend on research and development
• Financing
• Debt, equity
• Short-term, long-term
• Working capital management
• Current asset management
• Current liability management

8
Capital budgeting

• Information requirements
• Pro forma income statement tracks expected cash
  flows for the length of the investment
• Pro forma means guesses about what these will be
• Positive cash flows (revenues)
• Negative cash flows (costs)
• Weighted average cost of capital
• What return the firm will have to pay investors
  on average whether equity or bond holders
• Needed to discount future cash flows back to the
  present

9
Capital structure

• Where the firms obtains its financing
• Some financing options
• Retain earnings
• Issue new equity
• Issue debt
• Bills (discount, zero-coupon)
• Bonds (debentures, coupon bonds)
• Mortgage bonds
• Bank financing
• Sale of assets
• Lease

10
Capital structure (cont)

• Equity versus debt financing
• Risk of default
• Equity holders lose control of the firm
• GM, Ford, Citibank
• Lower cost of financing
• Interest cost lower
• Tax deductibility of interest payments
• Measures
• debt ratio
• debt to equity ratio
• Times interest earned (TIE ratio)

11
Working capital management

• Current asset management
• Cash
• Marketable securities
• Receivables
• Inventories (input output)
• Current liability management
• Payables
• Accrual accounts
• Wages, salaries
• Interest payments
• Taxes
• Benefits (pensions, health insurance)

12
Business organization

• sole proprietorship
• complete control
• unlimited liability
• general partnership
• all partners share in gains and losses
• unlimited liability
• limited partnership
• liability limited to amount contributed to
  partnership

13
Corporations

• articles on incorporation
• set out basics of the firm, name, etc.
• bylaws
• rules determining how the organization is to be
  run
• ownership based on shares owned
• limited liability to the value of the shares
• shares easily traded on exchanges

14
Goal of financial management

• long-term - increase the value of the firm
• Maximize PV of net cash flows of the firm
• increase revenues and other income
• capital budgeting decisions adding new projects
• decrease costs
• substituting less expensive for more expensive
  factors
• reduce the weighted average cost of capital
• ethical questions
• green solutions?

15
Agency

• conflict between principal and agent
• management hired by stockholders to maximize
  value
• management would prefer to maximize benefits
• direct agency costs
• diversion of resources to managememt
• cost of monitoring (auditing function)
• managerial compensation
• corporate control

16
Agency cont

• Managerial compensation
• Optimal compensation
• Salary
• Stock options
• Bonuses
• Who controls the firm
• Stockholders?
• Board of directors?
• CEO?

17
Stakeholders in the firm

• stockholders
• management
• labor
• customers
• suppliers
• tax authorities (local, provincial, national)
• Neighbors

18
Financing the firm money markets

• Short-term instruments
• Commercial bills
• Finance general liquidity needs
• Issued through investment banks, traded in
  secondary markets
• Lines of credit
• Finance general liquidity needs
• Issued through commercial banks, traded in
  secondary markets
• Bankers acceptances
• Trade credit
• Issued through commercial banks, traded in
  secondary markets

19
Financing the firm capital markets

• Coupon bonds
• Finance general long-term financing needs
• Issued through investment banks, traded in
  secondary markets
• Mortgage bonds
• Finance specific capital intensive projects
• Issued through investment banks, traded in
  secondary markets
• Preferred common stock
• Finance both general and specific needs
• Issued through investment banks, traded in
  secondary markets

20
Financing the firm - primary markets

• chartered banks
• lines of credit
• loans
• export financing
• investment banks
• commercial bills
• bonds
• preferred stock
• common stock)

21
Financing the firm - secondary markets

• insurance companies discount
• mortgages
• receivables
• bankers acceptances
• auction markets (central location)
• TSE, CDNX, NYSE, etc.
• over-the-counter (OTC) markets
• foreign exchange markets
• NASDAQ (dealers hold position in assets)

22
Derivatives

• compartmentalize risk
• options truncate the return distribution
• forwards forwards
• eliminate the price volatility
• generally at a cost (bid-ask) spread
• swaps