Brigham & Daves

Intermediate Financial
Management, 12th
edition
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1
CHAPTER 1

Overview of Financial
Management and the Financial
Environment

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2
Topics in Chapter
 Forms of business organization
 Objective of the firm: Maximize wealth
 Determinants of fundamental value
 Financial securities, markets and
institutions

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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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Business Organization from Start-
up to a Major Corporation
 Sole proprietorship
 Partnership
 Corporation

(More . .)
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Starting as a Proprietorship
 Advantages:
 Ease of formation
 Subject to few regulations
 No corporate income taxes
 Disadvantages:
 Limited life
 Unlimited liability
 Difficult to raise capital to support growth

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Starting as or Growing into a
Partnership
 A partnership has roughly the same
advantages and disadvantages as a sole
proprietorship.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Becoming a Corporation
 A corporation is a legal entity separate
from its owners and managers.
 File papers of incorporation with state.
 Charter
 Bylaws

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Advantages and Disadvantages of
a 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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Becoming a Public Corporation
and Growing Afterwards
 Initial Public Offering (IPO) of Stock
 Raises cash
 Allows founders and pre-IPO investors to
“harvest” some of their wealth
 Subsequent issues of debt and equity

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Agency Problems and
Corporate Governance
 Agency problem: managers may act in their
own interests and not on behalf of owners
(stockholders)
 Corporate governance is the set of rules that
control a company’s behavior towards its
directors, managers, employees,
shareholders, creditors, customers,
competitors, and community.
 Corporate governance can help control
agency problems.
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What should be management’s
primary objective?
 The primary objective should be
shareholder wealth maximization, which
translates to maximizing the
fundamental 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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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What three aspects of cash flows
affect an investment’s value?
 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)

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Free Cash Flows (FCF)
 Free cash flows are the cash flows that
are available (or free) for distribution to
all investors (stockholders and
creditors).
 FCF = sales revenues - operating costs
- operating taxes - required investments
in operating capital.

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What is the weighted average
cost of capital (WACC)?
 WACC is the average rate of return required
by all of the company’s investors.
 WACC is affected by:
 Capital structure (the firm’s relative use of debt
and equity as sources of financing)
 Interest rates
 Risk of the firm
 Investors’ overall attitude toward risk

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 What determines a firm’s
fundamental, or intrinsic, value?

Intrinsic value is the sum of all the

future expected free cash flows when
converted into today’s dollars:
FCF1 FCF2 FCF∞
Value = + +…+
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

See “big picture” diagram on next slide.

(More . .)
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 Determinants of Intrinsic Value: The Big Picture
Sales revenues

− Operating costs and taxes

− Required investments in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 ... + FCF∞

Value = + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

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Cost of Money
 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?
 Cost of equity = Required return =
dividend yield + capital 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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What economic conditions
affect the cost of money?
 Federal Reserve policies
 Budget deficits/surpluses
 Level of business activity (recession or boom)
 International trade deficits/surpluses

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Financial Securities

Debt Equity Derivatives

Money •T-Bills
•CD’s
•Options
•Futures
Market •Eurodollars •Forward
•Fed Funds contract

Capital •T-Bonds
•Agency bonds
• Common •LEAPS
Market •Municipals
stock •Swaps
•Corporate bonds
• Preferred stock

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Typical Rates of Return
Instrument Rate (July 2013)
U.S. T-bills 0.11%
Commercial paper 0.12
Negotiable CDs 0.26
Eurodollar deposits 0.20
Commercial loans:
Tied to prime 3.25 +
or LIBOR 0.27 +
(More . .)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Typical Rates (Continued)
Instrument Rate (July 2013)
U.S. T-notes and T-bonds 3.40%
Mortgages 4.50
Municipal bonds 4.08
Corporate (AAA) bonds 4.37
Preferred stocks 6% to 9%
Common stocks (expected) 9% to 15%

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What are some financial
institutions?
 Commercial banks
 Investment banks
 Savings & Loans, mutual savings banks, and
credit unions
 Life insurance companies
 Mutual funds
 Exchanged Traded Funds (ETFs)
 Pension funds
 Hedge funds and private equity funds
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.