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• Real Sector The
  Firm Financial Sector
• Corporate Investment
  Corporate Financing
• Decisions Utilization of Funds
  Decisions Acquisition of Funds
•   Business Markets Financial Markets
•   The Firm's Balance Sheet
• _______________________________________________
  ___________
•   Cash A/P
• A/R Other Current
• Inventory Liabilities
• _________________ __________
  ___________
• Products Total Current Assets Total Current
  Liabilities
• Customers
• Competitors Fixed Assets Capital
  Savers/
• Employees Plant Equipment Debt
  Investors
• Tangible Assets Preferred Stock
• Technology Common Equity
• --Retained Earnings
• --Common Stock ________________ ______
  _______________
•   Total Assets Total Liabilities Equity

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• Financing (sources of funds) must equal the
  investment in assets (use of funds).
• Managers make investment decisions that generate
  earnings so that investors get a return on
  investment.
• Financial Management is defined as the planning
  for, acquiring, and utilization of funds in a
  manner that maximizes the firms economic
  efficiency.

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• The Corporate Finance View of the World
• Bus. Transactions
• Securities

Commercial Sector -Customers -Products -Technolog
y -Competitors
Firms Balance Sheet Assets Liab.
Capital
Financial Sector Savers/Investors -Individuals -C
orporations -Partnerships -Banks Return on
Investment
Firms Income Statement Revenue -Expenses -Taxes N
et Income ?Retained Earnings? ?Dividends?
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• The corporation has advantages over the other
  forms or organization
• Unlimited lives that extend beyond the lives of
  the founders or original managers.
• Simple transferability of ownership investors
  and managers are two separate groups, so
  investors can buy or sell the common stock
  without disrupting corporate operations.
• Limited liability in the corporation investors
  can lose only the total amount they invested in
  the common stock.

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• The stock market monitors the publicly-traded
  corporations performance
• Stock price changes signal whether managerial
  decisions are good (stock price goes up) are bad
  (stock price goes down).
• Because of the requirements to disclose
  information that publicly-traded corporations
  face, the stock market can monitor these firms
  better than it can the other forms of
  organization.

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• The stock market disciplines the firm by causing
  the stock price to decline. In response, the
  firm can
• Change strategies.
• The Board of Directors can replace the managers (
  this is called internal governance).
• The firm can be merged/taken over (this is called
  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 of
  Finance is
• A Firms Stock Price The Present Value of
• All
  Future Dividends 
• DIV1 DIV2
  DIV3 DIV8 8
  DIVt
• ----------- -----------
  ------------ ... ----------- S
  -------------
• (1 k)1 (1 k)2 (1
  k)3 (1 k)8 t1
  (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 of separation of ownership and
  control.
• The goal is to maximize shareholder wealth, but
  investors cannot be sure that managers will act
  in shareholders best interests. Managers might
• Shirk their duties.
• Use corporate resources to pay for perquisites.
• Shift funds into higher risk projects than the
  stockholders desire.

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• Observability, asymmetric information, moral
  hazard
• Investors cannot observe everything managers do.
• Managers have more information about the firm.
• Investors monitor the firm, and the firm incurs
  monitoring 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 of
  managers and investors are aligned, if both
  managers and investors have the same incentives.
• Agency theory suggests if managers are bonded to
  the firm, managers would behave in the
  shareholders' best interests.
• This entails bonding costs. For example, stock
  options or stock purchase programs (like at 85
  of the market price) transform managers into
  owner/managers.
• But managers are buying into the firm at
  below-market prices. The bonding cost is the
  loss of wealth suffered by other shareholders
  when the stock is sold cheap.

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• These costs cause shareholder wealth to be less
  than if managers didn't pose a moral hazard.
• We live in an imperfect world.
• A perfect world of symmetric information no
  moral hazards is not attainable.
• Financial contracting solutions are often used.
• For example, bond indenture contracts often
  contain restrictive covenants that limit the
  behavior of managers, like no new mortgages on
  the assets.
• Bank loans also contain restrictions, like
  limitations on paying dividends, the amount of
  additional borrowing, or a minimum current ratio
  requirement.

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• A closer look at financial contracting. Bonds
  are loan contracts, and common stocks have legal
  ties to 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 of interest each period, and
  borrowings must be repaid.
• Stocks are variable income securities that have
  infinite lives. Dividends are not guaranteed and
  stock never maturesas long as the firm is alive.
  Stocks can be repurchased by the firm, but that
  is different stock can be retired but it does
  not mature. Stocks represent an 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 of the 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
  bonds principal
• 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
  may vary 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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• Define k as the Market Rate of Interest. The
  example shows that that k and a bonds price are
  inversely 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 new
  products or services are essential if a firm is
  to continue 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 NCFt
• NPV ? ------------------- - Cost
  of the project
• t1 (1 MCC)t
•  
• where NCFt Net Cash Flow at time t
• MCC the Marginal Cost of
  Capital,
• a
  risk-adjusted discount rate

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• This gives rise to the following set of decision
  rules that are used in capital budgeting
• IRR is the Internal Rate of Return and is defined
  as the discount rate that makes NPV 0.

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• Who gets the NPV gt 0 and how does it achieve the
  goal of the firm?
• Common shareholders, the residual claimants.
• Bondholders and preferred shareholders get what
  they expect, and common shareholders get what is
  left over.
• The larger the residual, the more wealth common
  shareholders receive (think of the positive NPV
  that Intel creates with each new generation of
  microprocessors.)
• If managers select all of the projects with NPV gt
  0, this is the best that shareholders can hope
  for and the stock price will be maximized.
• Negative NPVs would make the stock price go down.

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• Informational efficiency This important concept
  is the idea that having accurate information is
  crucial to making good investment decisions.
• Financial markets are informationally efficient
  if security prices fully reflect all information
  and react 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 the
  market" in an efficient market.
• The greatest rewards exist for those who have the
  best information there is much competition for
  information.
• 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
  spend little on information, find it difficult to
  beat the market.
• Getting information first, or immediately, is
  very costly and it is difficult to beat the
  market and to cover the costs of obtaining
  information.

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• Nevertheless, information efficiency is an
  important concept, and financial markets are
  pretty efficient in my opinion.
• Competitive markets are key as information
  becomes available, investors revise their
  decisions to buy or sell a stock or bond, so
  there must be markets in which they can actually
  buy or sell.
• Economics and finance profs love markets supply
  and demand come together and individuals are free
  to make buy 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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• A basic principle of Finance more risk should
  be rewarded with a higher return.
• In the Theory of Finance, taking risk is a good
  thing since it creates new wealth (new products,
  new technologies, etc.)
• Thus, there should be rewards for bearing risk.

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• A life-cycle view of the growth of a
  technology-driven firm. Corporate Finance
  textbooks typically 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
  based on no more than a product or service
  concept.
• The value of a publicly-traded firm is based on
  assets in place, a start-ups value is based on
  its growth options.

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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 development but 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
  public in 6-12 months often repaid from IPO
  proceeds.
• Management/Leveraged Buyout (MBO/LBO) and
  Turnaround
• later-stage companies buying out existing firms
  or financing firms with operational or financial
  difficulties.

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