Finance 815

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Finance 815

• Instructor Eric Higgins, Ph.D.
• Office 117A Calvin Hall
• Phone [phone]
• Email ehiggins_at_ksu.edu
• Office Hours MW 930-1130 and
• 230-330 or by appt.
• Course info http//info.cba.ksu.edu/higgins

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Finance 815

• Text
• Ross, Westerfield, Jaffe, Corporate Finance,
  Eighth Edition
• Study problems manual
• Web
• Notes, homework assignments, other materials
• Calculators
• Financial calculators allowed
• HP 10BII, TI BAII Plus
• Student is responsible for learning to use the
  calculator

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Finance 815

• Grading
• 2 exams 25 each
• Comprehensive final 30
• Short answer and problems
• Formula sheets provided
• Grading done on basis, strict grade cut-offs
  apply
• Homework 20
• Assignments consist of two or three textbook
  problems plus some other questions that I have
  written (5 total for each assignment)
• Must show work to receive credit
• Questions are representative of things you should
  be able to do for the exams

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Finance 815

• Exam Dates
• Wednesday, February 21
• Wednesday, April 11
• Thursday, May 10, 410-600
• Homework Due Dates
• Monday, Feb. 5
• Monday, Feb. 19
• Wednesday, March 14
• Wednesday, April 4
• Monday, April 30

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Course Outline

• Principal/Agent Relationships
• Financial Statements
• Basic information about a firm
• What do they tell us?
• Forecasting
• Time value of money
• Fundamental to asset valuation
• Valuation
• Bonds
• Stocks

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Course Outline

• Capital Budgeting
• Estimating cash flows and finding value
• Risk and Return
• Basic concepts of diversification
• CAPM
• Beta and required rate of return
• Weighted Average Cost of Capital

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(No Transcript)
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The Common Theme

• Finance touches all aspects of a business
• Both businesses and individuals make financial
  decisions daily

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Forms of Business Organization

• Three major forms in the united states
• Sole proprietorship
• Partnership
• General
• Limited
• Corporation

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Sole Proprietorship

• Advantages
• Easiest to start
• Least regulated
• Single owner keeps all the 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 of ownership 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 personal rate)

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Corporate Securities as Contingent Claims on
Total Firm Value

• Corporations issue two types of claims against
  their assets
• Debt and equity (shareholders)
• The basic feature of a debt is that it is a
  promise by the borrowing firm to repay a fixed
  dollar amount of by a certain date.
• The shareholders claim on firm value is the
  residual amount that remains after the
  debtholders are paid.
• If the value of the firm is less than the amount
  promised to the debtholders, the shareholders get
  nothing.

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Debt and Equity as Contingent Claims
If the value of the firm is more than F, debt
holders get a maximum of F.
If the value of the firm is less than F, share
holders get nothing.
F
If the value of the firm is more than F, share
holders get everything above F.
Debt holders are promised F.
If the value of the firm is less than F, they
get the whatever the firm if worth.
Algebraically, the bondholders claim is
MinF,X
Algebraically, the shareholders claim is
Max0,X F
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Combined Payoffs to Debt and Equity
If the value of the firm is less than F, the
shareholders claim is Max0,X F 0 and
the debt holders claim is MinF,X X. The
sum of these is X
F
If the value of the firm is more than F, the
shareholders claim is Max0,X F X F
and the debt holders claim is MinF,X F.
The sum of these is X
Debt holders are promised F.
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Financial Markets

• Primary Market
• When a corporation issues securities, cash flows
  from investors to the firm.
• Usually an underwriter is involved
• Secondary Markets
• Involve the sale of used securities from one
  investor to another.
• Securities may be exchange traded or trade
  over-the-counter in a dealer market.

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Goal of the Corporation

• Maximize Shareholder Wealth

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Maximize Shareholder Wealth

• Implications?
• Socially good?
• Ethical issues?
• Is this the only goal?

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What Affects Shareholder Wealth?

• Projected cash flows to shareholders
• Timing of cash flows to shareholders
• Risk level of the cash flows that shareholders
  receive

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What Affects Cash Flow?

• Managerial decisions
• Investment decisions
• Financing decisions (debt vs. equity)
• Dividend policy decisions
• External factors

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Ownership vs. Management

• Difference in Information
• Stock prices and returns
• Issues of shares and other securities
• Dividends
• Financing

• Different Objectives
• Managers vs. stockholders
• Top mgmt vs. operating mgmt
• Stockholders vs. banks and lenders

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Theory of the Firm

• The nature of the contracts within a corporation
  and the separation of management and ownership
  lead to two important theories as to what drives
  decisions and actions within a corporation
• Asymmetric Information
• Principal/Agent Relationships

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Asymmetric Information

• What?
• Managers have better information than
  shareholders, and shareholders know it
• All managerial actions are going to be viewed by
  shareholders in the context of asymmetric
  information

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Asymmetric Information

• What does asymmetric information mean for
  shareholders?
• Managerial actions convey information about the
  true state of the company
• For example, if managers start selling all of the
  shares that they own, this may be a sign that
  that company is in trouble

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Asymmetric Information

• How can managers utilize asymmetric information
• Signaling
• Managers can send shareholders (markets) signals
  about the true value of the company by their
  actions
• For a signal to be credible, it must be costly
• Only good firms should be able to engage in the
  signaling activity, otherwise bad firms could
  falsely signal

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Agency Theory

• An agency relationship exists whenever a
  principal hires an agent to act on their behalf.
• Within a corporation, agency relationships exist
  between
• Shareholders and managers
• Shareholders and creditors

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Agency Theory

• Shareholders and creditors
• Managers act on behalf of the shareholders
• Should act in a risk neutral fashion
• Creditors do not want bankruptcy
• Not necessarily an issue when maximizing
  shareholder wealth

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Agency Theory

• Shareholders and creditors
• What is the result of the conflict?
• In the long run, such actions will raise the cost
  of debt and ultimately lower stock price
• How can the conflict be avoided?
• Debt covenants
• Restrict the actions of managers

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Agency Theory

• Shareholders and managers
• Managers are risk-averse
• What does that mean?
• As wealth increases, manager gets less utility
  from increases in wealth
• Example
• You have the following choice for your salary in
  the first year that you graduate
• 50,000 for certain
• A coin-flip where you get either 100,000 or 0

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Agency Theory

• Shareholders and managers
• Shareholders are risk neutral
• What does that mean?
• A risk neutral person wants only to maximize
  expected value
• Why is this relevant for shareholders?

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Agency Theory

• Shareholders and managers
• How does the conflict manifest itself?
• Avoiding risk
• Reduced effort
• Perqs
• Entrenching investment
• Empire building
• Taking excessive risk?

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Reduced Effort and Perq Consumption

• Occurs when compensation is not tied to
  shareholder performance
• No incentive to maximize shareholder wealth
• Just out to maximize personal wealth
• Obviously, these activities reduce shareholder
  wealth
• Many classic examples of this
• RJR Nabisco
• Enron

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Entrenched Management

• Occurs when there is little chance that poorly
  performing managers will be replaced.
• Two causes
• Anti-takeover provisions in the charter
• Targeted share repurchases (i.e., greenmail)
• Shareholder rights provisions (i.e., poison
  pills)
• Restricted voting rights plans
• Weak board of directors
• Weak boards have many insiders (i.e., those who
  also have another position in the company)
  compared with outsiders.
• Interlocking boards are weaker (CEO of company A
  sits on board of company B, CEO of B sits on
  board of A).

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How are entrenched managers harmful to
shareholders?

• Management accepts projects (or acquisitions) to
  make firm larger even if projects are negative
  NPV.
• Goal is to make it difficult to remove management
  firm becomes too complex for anyone else to
  manage it

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Taking excessive risk

• What happens when performance may be less than
  anticipated?
• Will management do anything to reach certain
  earnings targets?
• Nothing left to lose?
• No one to catch them?
• Enron and Worldcom are perfect examples of this
  type of behavior

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Agency Theory

• Shareholders and managers
• How can the conflict be resolved?
• Effective corporate governance
• The carrot and the stick
• Managerial compensation plans
• Direct intervention by shareholders
• The threat of firing
• The threat of takeover