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CHAPTER 1
Overview of Corporate Finance and the
Financial Environment
Corporate finance
Forms of business organization
Objective of the firm: Maximize wealth
Determinants of stock pricing
The financial environment
Financial instruments, markets and
institutions
Interest rates and yield curves

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Why is corporate finance important to

all managers?
Corporate finance provides the skills
managers need to:
Identify and select the corporate
strategies and individual projects
that add value to their firm.
Forecast the funding requirements
of their company, and devise
strategies for acquiring those
funds.

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What are some forms of

business organization?
Sole proprietorship
Partnership
Corporation

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Sole Proprietorship
Advantages:
Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages:
Limited life
Unlimited liability
Difficult to raise capital

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Partnership

A partnership has roughly the same

advantages and disadvantages as a
sole proprietorship.

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Corporation
Advantages:
Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Disadvantages:
Double taxation
Cost of set-up and report filing

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What should managements primary

objective be?
The primary objective should be
shareholder wealth maximization,
which translates to maximizing stock
price.
Should firms behave ethically? YES!
Do firms have any responsibilities to
society at large? YES! Shareholders
are also members of society.

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Is maximizing stock price good for

society, employees, and customers?
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

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Consumer welfare is higher in

capitalist free market economies
than in communist or socialist
economies.
Fortune lists the most admired firms.
In addition to high stock returns,
these firms have:
high quality from customers view
employees who like working there

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What three factors affect stock

prices?
Amount of cash flows expected by
shareholders
Timing of the cash flow stream
Risk of the cash flows

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What factors determine of cash flows?

Sales revenues
Current level
Short-term growth rate in sales
Long-term sustainable growth rate in sales

Operating expenses (e.g., raw materials,

labor, etc.)
Necessary investments in operating
capital (e.g., buildings, machines,
inventory, etc.)

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What factors affect the level and

risk of cash flows?
Decisions made by financial managers:
Investment decisions (product lines,
production processes, geographic
market, use of technology, marketing
strategy, etc.)
Financing decisions (choice of debt
policy and dividend policy)
The external environment (taxes,
regulation, etc.)

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What are financial assets?

A financial asset is a contract that
entitles the owner to some type of
payoff.
Debt
Equity
Derivatives
In general, each financial asset
involves two parties, a provider of
cash (i.e., capital) and a user of cash.

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What are some financial instruments?

Instrument

Rate (9/01)

U.S. T-bills

2.3%

Bankers acceptances

2.6

Commercial paper

2.4

Negotiable CDs

2.5

Eurodollar deposits

2.5

Commercial loans

Tied to prime (6.0%)

or LIBOR (2.6%)
(More . .)

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Financial Instruments (Continued)

Instrument

Rate (9/01)

U.S. T-notes and T-bonds

5.5%

Mortgages

6.8

Municipal bonds

5.1

Corporate (AAA) bonds

7.2

Preferred stocks

7 to 9%

Common stocks (expected)10 to 15%

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Who are the providers (savers) and

users (borrowers) of capital?
Households: Net savers
Non-financial corporations: Net
users (borrowers)
Governments: Net borrowers
Financial corporations: Slightly
net borrowers, but almost
breakeven

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What are three ways that capital is

transferred between savers and
borrowers?
Direct transfer (e.g., corporation issues
commercial paper to insurance company)
Through an investment banking house
(e.g., IPO, seasoned equity offering, or
debt placement)
Through a financial intermediary (e.g.,
individual deposits money in bank, bank
makes commercial loan to a company)

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What are some financial intermediaries?

Commercial banks
Savings & Loans, mutual savings
banks, and credit unions
Life insurance companies
Mutual funds
Pension funds

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The Top 5 Banking Companies

in the World, 12/1999
Bank Name

Country

Total assets

Deutsche Bank AG Frankfurt

$844 billion

Citigroup

New York

$717 billion

BNP Paribas

Paris

$702 billion

Bank of Tokyo

Tokyo

$697 billion

Bank of America

Charlotte

$632 billion

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What are some types of markets?

A market is a method of
exchanging one asset (usually
cash) for another asset.
Physical assets vs. financial assets
Spot versus future markets
Money versus capital markets
Primary versus secondary markets

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How are secondary markets organized?

By location
Physical location exchanges
Computer/telephone networks
By the way that orders from buyers
and sellers are matched
Open outcry auction
Dealers (i.e., market makers)
Electronic communications
networks (ECNs)

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Physical Location vs.

Computer/telephone Networks
Physical location exchanges:
e.g., NYSE, AMEX, CBOT, Tokyo
Stock Exchange
Computer/telephone: e.g.,
Nasdaq, government bond
markets, foreign exchange
markets

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Auction Markets
NYSE and AMEX are the two largest
auction markets for stocks.
NYSE is a modified auction, with a
specialist.
Participants have a seat on the
exchange, meet face-to-face, and place
orders for themselves or for their clients;
e.g., CBOT.
Market orders vs. limit orders

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Dealer Markets
Dealers keep an inventory of the stock (or
other financial asset) and place bid and ask
advertisements, which are prices at which
they are willing to buy and sell.
Computerized quotation system keeps track
of bid and ask prices, but does not
automatically match buyers and sellers.
Examples: Nasdaq National Market, Nasdaq
SmallCap Market, London SEAQ, German
Neuer Markt.

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Electronic Communications Networks

(ECNs)
ECNs:
Computerized system matches
orders from buyers and sellers
and automatically executes
transaction.
Examples: Instinet (US, stocks),
Eurex (Swiss-German, futures
contracts), SETS (London,
stocks).

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Over the Counter (OTC) Markets

In the old days, securities were kept
in a safe behind the counter, and
passed over the counter when they
were sold.
Now the OTC market is the equivalent
of a computer bulletin board, which
allows potential buyers and sellers to
post an offer.
No dealers
Very poor liquidity

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What do we call the price, or cost,

of debt capital?
The interest rate
What do we call the price, or cost,
of equity capital?
Required = Dividend + Capital.
return
yield
gain

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What four factors affect the cost

of money?

Production opportunities
Time preferences for consumption
Risk
Expected inflation

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Real versus Nominal Rates

r*

= Real risk-free rate.

T-bond rate if no inflation;
1% to 4%.

= Any nominal rate.

rRF

= Rate on Treasury securities.

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r = r* + IP + DRP + LP + MRP.
Here:
r = Required rate of return on a
debt security.
r* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.
LP = Liquidity premium.
MRP = Maturity risk premium.

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Premiums Added to r* for Different

Types of Debt

ST Treasury: only IP for ST inflation

LT Treasury: IP for LT inflation, MRP
ST corporate: ST IP, DRP, LP
LT corporate: IP, DRP, MRP, LP

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What is the term structure of interest

rates? What is a yield curve?

Term structure: the relationship

between interest rates (or yields)
and maturities.
A graph of the term structure is
called the yield curve.

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How can you construct a hypothetical

Treasury yield curve?
Estimate the inflation premium (IP)
for each future year. This is the
estimated average inflation over that
time period.
Step 2: Estimate the maturity risk
premium (MRP) for each future year.

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Assume investors expect inflation to be 5%

next year, 6% the following year, and 8% per
year thereafter.

Step 1: Find the average expected

inflation rate over years 1 to n:
n

INFLt
IPn =

t=1

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IP1 = 5%/1.0 = 5.00%.

IP10 = [5 + 6 + 8(8)]/10 = 7.5%.
IP20 = [5 + 6 + 8(18)]/20 = 7.75%.
Must earn these IPs to break even
versus inflation; that is, these IPs
would permit you to earn r* (before
taxes).

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Assume the MRP is zero for Year 1 and

increases by 0.1% each year.

Step 2: Find MRP based on this

equation:
MRPt = 0.1%(t - 1).
MRP1 = 0.1% x 0 = 0.0%.
MRP10 = 0.1% x 9 = 0.9%.
MRP20 = 0.1% x 19 = 1.9%.

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Step 3: Add the IPs and MRPs to r*:

rRFt = r* + IPt + MRPt .
rRF = Quoted market interest
rate on treasury securities.
Assume r* = 3%:
rRF1 = 3% + 5% + 0.0%
= 8.0%.
rRF10 = 3% + 7.5% + 0.9% = 11.4%.
rRF20 = 3% + 7.75% + 1.9% = 12.65%.

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Hypothetical Treasury Yield Curve

Interest
Rate (%)
15

Maturity risk premium

10

Inflation premium

1 yr
10 yr
20 yr

8.0%
11.4%
12.65%

5
Real risk-free rate

Years to Maturity

0
1

10

20

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What factors can explain the shape of

this yield curve?
This constructed yield curve is
upward sloping.
This is due to increasing expected
inflation and an increasing
maturity risk premium.

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What kind of relationship exists

between the Treasury yield curve and
the yield curves for corporate issues?
Corporate yield curves are higher than
that of the Treasury bond. However,
corporate yield curves are not necessarily parallel to the Treasury curve.
The spread between a corporate yield
curve and the Treasury curve widens
as the corporate bond rating
decreases.

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Hypothetical Treasury and

Corporate Yield Curves
Interest
Rate (%)
15

BB-Rated

10

AAA-Rated

Treasury
6.0%
yield curve

5.9%

5.2%

0
0

10

15

20

Years to
maturity

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What is the Pure Expectations

Hypothesis (PEH)?
Shape of the yield curve depends
on the investors expectations
about future interest rates.
If interest rates are expected to
increase, L-T rates will be higher
than S-T rates and vice versa.
Thus, the yield curve can slope up
or down.

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PEH assumes that MRP = 0.

Long-term rates are an average of
current and future short-term rates.
If PEH is correct, you can use the
yield curve to back out expected
future interest rates.

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Observed Treasury Rates

Maturity
Yield
1 year
6.0%
2 years
6.2%
3 years
6.4%
4 years
6.5%
If PEH holds,
what does the
market expect
5 years
6.5%

will be the interest rate on one-year

securities, one year from now? Three-year
securities, two years from now?

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x%
6.0%

1
6.2%

(6.0% + x%)
6.2% =
2
12.4% = 6.0 + x%
6.4% = x%.

PEH tells us that one-year securities will

yield 6.4%, one year from now (x%).

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6.2%
0

x%
2

3
4
5
6.5%
[ 2(6.2%) + 3(x%) ]
6.5% =
5
32.5% = 12.4% + 3(x%)
20.1% = 3(x%)
6.7% = x%.
PEH tells us that three-year securities
will yield 6.7%, two years from now (x%).

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Conclusions about PEH

Some argue that the PEH isnt correct,
because securities of different
maturities have different risk.
General view (supported by most
evidence) is that lenders prefer S-T
securities, and view L-T securities as
riskier.
Thus, investors demand a MRP to get
them to hold L-T securities (i.e., MRP
> 0).

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What various types of risks arise

when investing overseas?
Country risk: Arises from investing or
doing business in a particular country.
It depends on the countrys economic,
political, and social environment.
Exchange rate risk: If investment is
denominated in a currency other than the
dollar, the investments value will depend
on what happens to exchange rate.

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What two factors lead to exchange

rate fluctuations?

Changes in relative inflation will

lead to changes in exchange rates.
An increase in country risk will
also cause that countrys currency
to fall.