CHAPTER 1

Overview of Financial Management and the

Financial Environment

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 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

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 Starting as a Proprietorship

• Advantages:
• Ease of formation
• Subject to few regulations (lower compliance costs)
• No corporate income taxes (taxed as personal income)
• Disadvantages:
• Limited life (no continuity)
• 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.
• It is possible to form limited partnership.
• However, one of the partners must be an unlimited partner.

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 Becoming a Corporation

• A corporation is a legal entity separate from its owners

and managers.
• File papers of incorporation with state.
• Charter
• Bylaws
• These are know in many parts of Asia as
• Memorandum of Association
• Articles of Association
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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 for company to expand its business and grow
• Allows founders and pre-IPO investors to “harvest” some of
their wealth
• Subsequent issues of debt and equity
• Issue of equity after the IPO is known as Seasoned Equity
Offering (SEO) or follow-on offering.

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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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 Is maximizing stock price good for society,
employees, and customers? (1 of 2)
• 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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 Is maximizing stock price good for society,
employees, and customers? (2 of 2)
• 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 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:

See “big picture” diagram on next slide.

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Determinants of Intrinsic Value: The Big Picture

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 Who are the providers (savers) and users
(borrowers) of capital?
• Households: Net savers
• Non-financial corporations: Net users (borrowers)
• Governments: U.S. governments are net borrowers,
some foreign governments are net savers
• Financial corporations: Slightly net borrowers, but
almost breakeven

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The Capital Allocation Process

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 Transfer of Capital from Savers to Borrowers

• Direct transfer
• Example: A corporation issues commercial paper to an
insurance company.
• Through an investment banking house
• Example: In an IPO, seasoned equity offering, or debt
placement, company sells security to investment banking
house, which then sells security to investor.
• Through a financial intermediary
• Example: An individual deposits money in bank and gets
certificate of deposit, bank makes commercial loan to a
company (bank gets note from company).
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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?
• Central bank policies
• Budget deficits/surpluses
• Level of business activity (recession or boom)
• International trade deficits/surpluses

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 Financial securities in the US

Debt Equity Derivatives

• T-Bills
• Options
Money • CD’s
• Futures
Market • Eurodollars
• Forward contract
• Fed Funds
• T-Bonds
Capital • Agency bonds • Common stock • LEAPS
Market • Municipals • Preferred stock • Swaps
• Corporate bonds

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 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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 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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 Primary vs. Secondary Security Sales

• Primary
• New issue (IPO or seasoned)
• Key factor: issuer receives the proceeds from the sale.
• Secondary
• Existing owner sells to another party.
• Issuing firm doesn’t receive proceeds and is not directly
involved.

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 Alternative financial services platforms in Asia

• Digital payment platforms used to focus on payment

solutions that bridge transactions between consumers
and businesses, e.g. digital giants like Alibaba and
Tencent have created e-wallets.
• Shadow banking has served as a major purpose in
supplementing the shortcomings of the banking system
in Asia.
• Microfinance, also known as microcredit, is another
alternative solution to conventional banking system.
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 Along what two dimensions can we classify
trading procedures??
• By “location”
• Physical location exchanges where trading is face-to-face
• Computer/telephone networks
• By the way that orders from buyers and sellers are
matched
• Open outcry auction with face-to-face trading
• Dealers (i.e., market makers) buy from and sell to clients
from an inventory of stocks. Orders are not always
automatically matched by computers.
• Automated trading platforms match orders and execute
trades automatically.
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 Types of Orders

• Instructions on how a transaction is to be completed

• Market Order– Transact as quickly as possible at current
price
• Limit Order– Transact only if specific situation occurs. For
example, buy if price drops to $50 or below during the next
two hours.

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 Broker-Dealer Networks

• Registered with the SEC, but less regulated than alternative trading
systems (ATS) and registered stock exchanges.
• Broker-dealer purchases stock being offered for sale by a client and then
immediately sells it to another client who wished to buy the stock.
• Broker-dealer is the counterparty to each of the clients. Called
internalization.
• Broker-dealer must report the transactions, but not any information prior
to the trade.
• Trades in broker-dealer networks are called “off exchange” or
over-the-counter (OTC).
• Trades can be with individuals (called retail trades) or with institutions.
Large trades (10,000 shares or more) are called block trades and are
sometimes called “upstairs” trades.
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 Alternative Trading System (ATS)

• A broker-dealer than registers with the SEC as an ATS.

• ATS usually has an automated trading platform to
match orders from clients.
• Owner of the ATS is not always the counterparty, in contrast
to a broker-dealer network.
• The ATS must report trades, but not any pre-trade
information.
• Therefore, an ATS is often called a dark pool

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 Registered Stock Exchange

• Stocks can only be listed at a registered stock

exchange
• May be traded elsewhere
• Must comply with more regulations than an ATS.
• Must report:
• Trades
• Pre-trade information regarding bids and quotes

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 NYSE versus NASDAQ

• The NYSE is the oldest U.S. registered stock

exchange.
• The NASDAQ Stock Market has the most listings
because it is willing to list smaller corporations than the
NYSE.
• NYSE’s listings have a much bigger market value than
NASDAQ’s listed stocks.

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 Stock Exchange Listings (1 of 2)

Market Value of Listings

Exchange Number of Listings
(Trillions)
NYSE 3,131 $27.9
NASDAQ 3,274 11.3
NYSE MKT 362 0.2
6,767 $39.4

Source: [Link]/screening/[Link], November, 2017.

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 Owner of Trading Venue % of Dollar Volume
Cboe Global Markets 18%
NASDAQ OMX 22%
Intercontinental Exchange: (includes NYSE) 22%
Others 3%
Total trading on all exchanges: 65%
Dark pools (ATS): 34 13%
Broker-dealer networks: Over 250
Retail trades 8%
Institutional trades 14%
Total broker-dealer trades: 22%
Total trading off-exchange: 35%
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 Asian stock markets

• Asian firms can list on the stock exchange of their

home market, especially when the issuance is small.
• May wish to consider listing on overseas exchanges
elsewhere in Asia or the World, to be closer to
investors and consumers.
• An example would be V3 (formerly known as Osim
International), a Singapore based company, which chose to
list on the Hong Kong Exchange in 2017 because of the
proximity to the huge Chinese market for their products.

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 Asian stock markets

• Asian stock markets have grown dramatically in the

last decade, both in absolute and in relative terms.
• According to a report by OECD, Asian companies have
become the largest users of public equity markets.
• As a corollary, Asian stock exchanges and institutions
have become increasingly important players in the
global capital markets scene.

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 Asian stock markets

• China has emerged as one of the most significant

exchanges in the World for IPOs.
Figure 1-2
Top 20 jurisdictions by number of non-financial company IPOs from 2008 to 2017

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 Asian stock markets

• Per OECD, Asian companies’ share of all public equity

capital raised in the world in 2017 was 43%.
• Such share of the capital market by Asian firms have
increased substantially in the last decade.
Figure 1-3
Share of Asian non-financial companies in global public equity capital markets (2000 to 2017)

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 Institutional vs. government ownership in Asia

• One of the unique features of the Asian market is the

relatively high level of government ownership,
compared to the Western economies
Figure 1-4
Government and institutional ownership in the listed corporations (as of end 2017)

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 Home Mortgages Before S&Ls

• The problems if an individual investor tried to lend

money to an aspiring homeowner:
• Individual investor might not have enough money to fund an
entire home
• Individual investor might not be in a good position to
evaluate the risk of the potential homeowner
• Individual investor might have difficulty collecting mortgage
payments

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 S&Ls Before Securitization

• Savings and loan associations (S&Ls) solved the

problems faced by individual investors
• S&Ls pooled deposits from many investors
• S&Ls developed expertise in evaluating the risk of
borrowers
• S&Ls had legal resources to collect payments from
borrowers

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 Problems faced by S&Ls Before Securitization

• S&Ls were limited in the amount of mortgages they

could fund by the amount of deposits they could raise
• S&Ls were raising money through short-term
floating-rate deposits, but making loans in the form of
long-term fixed-rate mortgages
• When interest rates increased, S&Ls faced crisis
because they had to pay more to depositors than they
collected from mortgagees

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 Taxpayers to the Rescue

• Many S&Ls went bankrupt when interest rates rose in

the 1980s.
• Because deposits are insured, taxpayers ended up
paying hundreds of billions of dollars.

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 Securitization in the Home Mortgage Industry

• After crisis in 1980s, S&Ls now put their mortgages

into “pools” and sell the pools to other organizations,
such as Fannie Mae.
• After selling a pool, the S&Ls have funds to make new
home loans
• Risk is shifted to Fannie Mae

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 Fannie Mae Shifts Risk to Its Investors

• Risk hasn’t disappeared, it has been shifted to Fannie

Mae.
• But Fannie Mae doesn’t keep the mortgages:
• Puts mortgages in pools, sells shares of these pools to investors
• Risk is shifted to investors.
• But investors get a rate of return close to the mortgage rate,
which is higher than the rate S&Ls pay their depositor.
• Investors have more risk, but more return
• This is called securitization, since new securities have
been created based on original securities (mortgages in
this example)
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 Collateralized Debt Obligations (CDOs)

• Fannie Mae and others, such as investment banks, can also

split mortgage pools into “special” securities
• Some securities might pay investors only the mortgage interest, others
might pay only the mortgage principal.
• Some securities might mature quickly, others might mature later.
• Some securities are “senior” and get paid before other securities from
the pool get paid.
• Rating agencies give different
• Risk of basic mortgage is parceled out to those investors who
want that type of risk (and the potential return that goes with it).

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 Other Assets Can be Securitized

• Car loans
• Student loans
• Credit card balances
• In short, any asset that has recurring cash flows

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 The Dark Side of Securitization (1 of 2)

• Homeowners wanted better homes than they could afford.

• Mortgage brokers encouraged homeowners to take
mortgages even thought they would reset to payments that
the borrowers might not be able to pay because the
brokers got a commission for closing the deal.
• Appraisers thought the real estate boom would continue
and over-appraised house values, getting paid at the time
of the appraisal.
• Originating institutions (like Countrywide) quickly sold the
mortgages to investment banks and other institutions.

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 The Dark Side of Securitization (2 of 2)

• Investment banks created CDOs and got rating agencies

to help design and then rate the new CDOs, with rating
agencies making big profits despite conflicts of interest.
• Financial engineers used unrealistic inputs to generate
high values for the CDOs.
• Investment banks sold the CDOs to investors and made
big profits.
• Investors bought the CDOs but either didn’t understand or
care about the risk.
• Some investors bought “insurance” via credit default
swaps.
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 The Collapse

• When mortgages reset and borrowers defaulted, the

values of CDOs plummeted.
• Many of the credit default swaps failed to provide
insurance because the counterparty failed.
• Many originators and securitizers still owned sub-prime
securities, which led to many bankruptcies, government
takeovers, and fire sales, including:
• New Century, Countrywide, IndyMac, Northern Rock, Fannie Mae,
Freddie Mac, Bear Stearns, Lehman Brothers, and Merrill Lynch.

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