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Chapter 1
An Overview of Financial Management and the Financial Environment
Topics in Chapter
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Attributes of successful companies Forms of business organization Objective of the firm: maximize wealth Determinants of fundamental value Financial securities, financial institutions, and financial markets
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Like a stool needs all three legs to stand, a successful business relies on:
Skilled people Strong external relationship Sufficient capital
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No two companies will develop in exactly the same way A business usually begins as a small potato and hopefully finishes up as a major giant Structures of business organizations:
Sole proprietorship Partnership Corporation Income trust
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Starting as a Proprietorship
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Advantages:
Ease of formation Subject to few regulations No corporate income taxes
Disadvantages:
Difficult to raise capital to support growth Unlimited liability Limited life span
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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A partnership involves two or more entities with various privileges and responsibilities
General vs. limited partner Limited liability partnership
A partnership has roughly the same advantages and disadvantages as a sole proprietorship.
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Becoming a Corporation
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A corporation is a legal entity separate from its owners and managers. File papers and prepare reports with Corporation Canada.
Articles of incorporation Bylaws
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Advantages:
Unlimited life Easy transfer of ownership Limited liability Ease of raising capital
Disadvantages:
Double taxation Higher setup cost Endless report filing
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Expand 100 times to a market capitalization of $192 billion from 1994 to 2007 Growth ends as government has announced plans in 2006 to tax trusts at the same rate as corporations In the past, income trust cash distributions are only taxed in the hands of investors, not at the firm level Investors see trusts as tax-efficient and are willing to pay more for a company converted to a trust
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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The primary objective should be shareholder wealth maximization, which translates to maximizing the fundamental share price, not just the current market price. Should firms behave ethically? YES! Business ethics are a companys attitude and conduct toward its employees, customers, community and shareholders
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Employment growth is higher in firms that try to maximize stock price. On average, employment goes up in:
firms that make managers into owners (such as LBO firms) firms that were owned by the government but that have been sold to private investors
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Improve a firms ability to generate cash flows now and in the future by focusing on:
Amount of expected cash flows (bigger is better) Timing of the cash flow stream (sooner is better) Risk of the cash flows (less risk is better)
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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There are many ways firms can increase free cash flows FCF are cash flows available (or free) for distribution to all investors (stockholders and creditors). FCF = sales revenues - operating costs - operating taxes - required investments in operating capital.
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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WACC is the average rate of return required by all of the companys investors. WACC is affected by:
Capital structure (the firms relative amounts of debt and equity) Interest rates Risk of the firm Investors overall attitude toward risk
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Households: Net savers Non-financial corporations: Net users (borrowers) Governments: Net borrowers Financial corporations: Slightly net borrowers, but almost breakeven
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Direct transfer (e.g., corporation issues commercial paper to insurance company) Indirect transfer through an investment banker (e.g., IPO, seasoned equity offering, or debt placement) Indirect transfer through a financial intermediary (e.g., individual deposits money in bank, bank loans to a firm)
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Cost of Money
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Supply and demand of funds determine the price of money. What do we call the price (or cost) of debt capital? Of equity capital?
Interest rate Cost of equity = required return = dividend yield + capital gain
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Bank of Canada policies Budget deficits/surpluses Level of business activity (recession or boom) International trade deficits/surpluses Country risk depending on its economic, political, and social environment Exchange rate risk
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Financial Securities
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Financial securities are contracts granting owners specific rights and claims on specific values Vary in risk and maturity Nature of claims: debt, equity, and derivatives Money market instrument (T<1), and capital market instrument (T1)
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Financial Securities
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Equity
Derivatives
Options Futures Forward contract
Capital Market
LEAPS Swaps
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Instrument Govt of Canada T-bills Bankers acceptances Commercial paper Money Market mutual funds EuroCanadian market time Commercial loans: Tied to prime or LIBOR
5.25 + 3.05 +
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Instrument Govt of Canada bonds Mortgages Corporate bonds Leases Common Stock
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Investment banks Commercial banks Trust companies Credit unions Life insurance companies Mutual funds
Money Market Funds (MMMFs) Exchanged Traded Funds (ETFs)
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A financial market brings together savers and borrowers. Physical asset vs. financial asset markets Spot versus future markets Money versus capital markets Primary versus secondary markets Private versus public markets
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Futures markets
Assets are bought or sold for delivery at some future date
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Primary
New issue (IPO or seasoned) Key factor: issuer receives the proceeds from the sale.
Secondary
Existing owner sells to another party. Issuing firm doesnt receive proceeds and is not directly involved.
Copyright 2011 by Nelson Education Ltd. All rights reserved.
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Private markets
Transactions are worked out directly between two parties Lack of liquidity
Public markets
Standardized contracts are traded on an organized More liquid and transparent
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