Finance Chapter 1 - An Overview of Financial Management

Determinants of Intrinsic Values & Stock Prices

"True": means the cash flows and risk that investors would expect if they had all the information that existed about the company "Perceived": means what investors expect, given the limited information they have Intrinsic Value: An estimate of a stock's "true" value based on accurate risk and return data. The intrinsic value can be estimated, but not measured precisely. Market Price: The stock value based on perceived but possibly incorrect information as seen by the marginal investor. Marginal Investor: An investor whose views determine the actual stock price. Equilibrium: The situation in which the actual market price equals the intrinsic value, so investors are indifferent between buying and selling a stock. · Intrinsic Value = Stock Price · When equilibrium exists, there is no pressure for a change in the stock's price. · Market prices can and do differ from intrinsic values, but as the future unfolds, the two values tend to be similar

Intrinsic Value

- in equilibrium, a stock's price should equal its "true" or intrinsic value - Are estimates & a long run concept - to the extent that investor perceptions are incorrect, a stock's price in the short run may deviate from its intrinsic value - managers should avoid actions that reduce intrinsic value · even if those decisions increase the stock price in the short run - Important for Security Analysis à what distinguishes successful & unsuccessful investors

Financial Management ( Corporate Finance)

1. Capital Budgeting: what assets to buy? 2. Capital Structure: how to raise the capital to buy them? 3. How to run the firm to maximize its value?

The Main Goal: Creating Value for Investors

1. managers (agents) work on behalf of the shareholders (principals) 2. maximizing the share price is generally the best metrics for maximizing share holder value - maximizing revenues, earnings per share (EPS), market share, minimizing costs 3. In equilibrium, a stock's price should equal its "true" or intrinsic value

Sarbanes-Oxley Act

A law passed by Congress that requires the CEO and CFO to certify that their firm's financial statements are accurate. · passed due to the Enron scandal

Corporations

A legal entity created by a state, separate and distinct from its owners and managers, having unlimited life, easy transferability of ownership, and limited liability · If the company goes bankrupt, stockholders' & owners only lose the amount that they invested into the company · subject to double taxation S-Corporations: A special designation that allows small businesses that meet qualifications to be taxed as if they were a proprietorship or a partnership rather than a corporation. · A company can only have 100 stockholders to be an S-corporation · People usually stay at an S status until they to decide to sell public stock --> then turn into a C-corporation

Limited Liability Company (LLC)

A popular type of organization that is a hybrid between a partnership and a corporation.

Proprietorship

An unincorporated business owned by one individual

Partnership

An unincorporated business owned by two or more persons · Pro Rata: each partner is taxed proportionately Partners are subject to unlimited personal liability: · If the partnership goes bankrupt and if any partner is unable to meet their pro rata share, the remaining partners are now responsible for that as well

Stockholder-Debtholder Conflicts

Debt Holders: receive fixed payments regardless of how well the company does · bankers & bond holders · interested in limited risk Stock Holders: they do better when the company does better · prefer riskier projects, b/c they receive more if the project succeeds More conflict arises over the use of additional debt · the more debt a firm uses to finance assets, the riskier the firm becomes Example: A firms has $100 mil in assets 1. Finances $5 mil of bonds and $95 mil of common stock · Bondholders have a lesser risk of loss 2. Finances $95 mil of bonds and $5 mil of common stock · Bondholders suffer loss even if the asset value declines slightly Bondholders attempt to protect themselves by including covenants in the bond agreements. · Covenants: limit firms' use of additional debt and constrain managers' actions in other ways.

Government Organizations

Federal Reserve System: regulates and controls the supply of money Securities and Exchange Commission (SEC): regulate the trading of stocks and bonds in public markets

Investments

Security Analysis: deals with finding the proper values of individual securities (stocks & bonds) Portfolio Theory: deals with the best way to structure portfolios (baskets) of stocks and bonds · Rational investors want to hold diversified portfolios in order to limit risks · So, choosing a balanced portfolio is an important issue for any investor Market Analysis: deals with the issue of whether stock and bond markets at any given time are "too high" or "too low" or "about right" Behavioral Finance: where investor psychology is examined in an effort to determine whether stock prices have been bid up to reasonable heights or driven down to unreasonable lows

Limited Liability Partnerships (LLP)

Similar to an LLC but used for professional firms in the fields of accounting, law, and architecture. It provides personal asset protection from business debts and liabilities but is taxed as a partnership.

Balancing Shareholder Interests and Society Interests

The primary financial goal of management is shareholder wealth maximization, which translates to maximizing stock price. · Value of any asset is present value of cash flow stream to owners · Most significant decisions are evaluated in terms of their financial consequences · Stock prices change over time as conditions change and as investors obtain new information about a company's prospects Managers recognize that being socially responsible is no inconsistent with maximizing shareholder value · Direct Costs: Fines, lawsuits from externalities · Indirect Costs: Inability to attract talent, boycotts We assume that management's #1 goal is shareholder maximization, but they know it doesn't mean "at all costs" Managers are obligated to behave ethically, follow the laws, and other society-imposed constraints Shareholder Wealth Maximization: The primary financial goal for managers of publicly owned companies implies that decisions should be made to maximize the long-run value of the firm's common stock.

What is Finance?

finance is the study of how we allocate our assets over time in a risky world Finance looks into risk - stocks are riskier than bonds The system includes... · the circulation of money · the granting of credit · the making of investments · the provision of banking facilities

Capital Market

financial institutions or intermediaries

Corporate Raiders

individuals who target corporations for takeover because they are undervalued

Ethics

standards of conduct or moral behavior A company's attitude and conduct toward: its employees, customers, community, and stockholders Ethics Measured by: · The tendency of its employees, from the top down · To adhere to laws, regulations, and moral standards relating to product safety and quality · Fair employment practices · Fair marketing and selling practices · The use of confidential information for personal gain, community involvement, and the use of illegal payments to obtain business. · Most companies have strong written codes of ethical behavior & conduct training · Consequences include: bankruptcy, loss of reputation, and overall loss of stock for all companies · Employees jeopardize their jobs if they come forward over their bosses' objections · Moreover, if employees obey orders regarding actions, they know are illegal, they may end up going to jail.

Hostile Takeover

the acquisition of a company over the opposition of its management · If the raid is successful, then the executives will most likely be fired

Dodd-Frank Act

to implement an aggressive overhaul of US financial regulatory system aimed at preventing reckless actions that would cause another financial crisis

Stake Holder - Manager Risk

· Managers might be more interested in maximizing their own wealth rather than their stockholders' wealth; therefore, managers might pay themselves excessive salaries · Effective executive compensation plans motivate managers to act in their stockholders' best interests Useful Motivational Tools Include: 1. Reasonable compensation packages performance 2. Firing of managers who don't perform well 3. The threat of hostile takeovers

Finance v. Economics v. Accounting

· finance grew out of economics and accounting · Economics: developed the notion that an asset's value is based on the future cash flows that asset will provide · Accounting: provide information regarding the likely size of those cash flows