An Overview of Financial

Management & the Financial

Environment
CHAPTER 1
 1-3 Companies Ownership and
Corporate lifecycle
There is 3 kinds of ownership:
• Proprietorship
• Partnership
• Corporation

Proprietorship Partnership Corporation

Unincorporated business Two or more than Legal entity created

owned by one individual. persons or entities under state laws, and it
associate to conduct a is separate and distinct
noncorporate business from its owners and
for profit. managers.
 Companies Ownership and
Corporate lifecycle (Cont.)
• Advantages and disadvantages:
Proprietorship Partnership Corporation

Advantage • Ease of • Unlimited life

formation • Easy transfer
• Subject to few of ownership
regulations • Limited liability
• No corporate • Ease of raising
income taxes capital

Disadvantage • Limited life • Double

• Unlimited taxation
liability • Cost of set-up
• Difficult to raise and report
capital to filing
support growth
 Companies Ownership and
Corporate lifecycle (Cont.)
• Corporate life cycle:
Growing a Corporation: Going Public

• 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
Initial Public Offering (IPO) Vs. Seasoned Equity Offering
(SEO)

• In summary, an SEO is the issuance of additional shares by an already

public company to raise capital, while an IPO is the first-time issuance of
shares by a private company to become publicly traded.
Managing a Corporation’s Value
 A company’s ability to generate cash flows now & in the future.
 Company’s value is determined by 3 properties of it’s cash flows:
1. Size of expected future cash flows. (bigger is better)
2. Timing of cash flows. (sooner is better)
3. Risk of the cash flows. (less risk is better)
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.
 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:
1. Capital structure (the firm’s relative amounts of debt and equity)
2. Interest rates
3. Risk of the firm
4. Investors’ overall attitude toward risk
Governing a Corporation
 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.
Primary Objective of a Corporation –
Management’s & Ethics

 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.
Employees At Value – Maximizing Companies

 Employment growth is higher in firms that try to maximize stock price. On

average, employment goes up in:
1. Firms that make managers into owners (such as LBO firms)
2. Firms that were owned by the government but that have been sold to private
investors.

 Firms that make managers into owners, like in Management Buyouts (MBOs) or
Leveraged Buyouts (LBOs), involve current managers or executives acquiring a
significant stake in a company. This aligns their interests with shareholders,
motivates better performance, and leverages their familiarity with the business.
While it can lead to stability and innovation, potential conflicts and increased debt
levels are also considerations. This strategy requires careful planning for success.
Consumer's & Competitive Markets

 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:
1. High quality from customers’ view
2. Employees who like working there
Financial Markets – Providers & Users

 Households: Net savers – Individuals

 Non-financial corporations: Net users (borrowers)
 Governments: Net borrowers
 Financial corporations: Slightly net borrowers, but almost breakeven.

 In summary, providers of capital supply funds to the financial system, seeking

returns on their investments. Users of capital are entities or individuals that
require funds for various purposes, and they often pay interest or provide
returns to the providers of capital. This dynamic is fundamental to the
functioning of financial markets and the broader economy.
Getting Cash from Providers to Users

 Direct transfer (corporation issues commercial paper to insurance company)

 Indirect through an investment banking house (IPO, seasoned equity offering,
or debt placement)
 Indirect through a financial intermediary (individual deposits money in bank,
bank makes commercial loan to a company)
1-6 Types of financial securities:
 Definition: tradable financial instruments or assets that represent a financial
claim or ownership interest in a company or entity.
 Debt, equity, derivative, hybrid
 Securities financial assets:
 The process of securitization
 Mortgage-backed securities
The required rate of return (the cost of money):

 Definition: It represents the minimum return that an investor or company must earn
on their investment to compensate for the level of risk associated with that
investment.
 Fundamental factors that affect the required rate of returns:
 Production opportunities
 Time preferences for consumption
 Risk
 Expected Inflation
 Economic conditions and policies that affect the required rate of returns
 Federal Reserve policy
 The federal budget deficit and surplus
 The level of business activity
 International factors
The functions of financial institutions:
 Financial institutions play a crucial role in the field of financial management.
 Their functions are diverse and encompass various aspects of the financial system
1. Investment banks and brokerage activities
2. Deposit-taking financial intermediaries
 Saving and loan associations
 Credit unions
 Commercial banks
3. Investment funds
 Mutual funds
 Hedge funds
 Private equity funds
 Life insurance companies and pension funds
 Regulation of financial institutions
1-9 Financial Markets

Providers of Users
funds

Purpose:
For claims on
EXCHANGING
future cash
cash now
Note.- Trading security is provided with the trasaction
Types of Financial Markets
 Types of instruments
 Customer
 Geographic locations

Physical Assets VS Financial Assets

Physical assets also called as tangible or

real asset market

Financial asset market deal with stocks,

bonds, notes, mortgages etc.
Time of Delivery: Spot VS Future
 Spot market; assets are bought or sold for “on_the_spot” delivery (within a few days).
 Futures markets; the delivery of the assets is at some future date, such 6 months or a
year into the future.

Maturity of Financial Asset: Short VS Long

 Money market; market for short-term, example highly liquid debt securities
 Capital market; market for corporate stocks and debt maturing more than a year in the
future.
Purpose of loans to individuals: Long-Term
Asset purchases VS Shorter-Term spending
 Mortgage market; deal with loans on residential, agricultural, commercial and
industrial real estate.
 Consumer credit markets; involve loan for autos, appliances, education,
vacations and so on.

Private VS Public
 Private market; worked out between 2 parties. The transaction is structured in
any manner that appeals to the 2 parties.
 Public markets; contracts are standardized, the securities that are traded in public
market are held by a large number of individuals that’s why they must have
standardized contractual features.
Geographic Extent
 It will depend on the size of the organization and the scope of its operations, the
organization be able to borrow, or lend all around the world, regional, confined to
a strictly local market or even neighborhood market.

Primary markets VS Secondary markets

Primary market; are the markets in which
corporation raise new capital, for example: if a
public company sells a new issue of common
stocks to raise capital this would be a primary
market transaction.
 Secondary markets; are markets in which existing already-outstanding securities are
traded among investors. So if you decidid to buy 1000 shares of Starbucks stocks the
purchase would occur in the secondary market.

Why are secondary markets important ?

Secondary markets are vital for a well-functioning economy because they:
 Provide liquidity
 Foster entrepreneurship
 Provide a measure of value as perceived by buyers and sellers, making it easy to quickly
compare different investments.

Without active secondary markets, investors would be stuck with the securities they
purchase.
Trading Procedures in the Secondary
Markets
The secondary markets trading occurs in a site known as trading venue. There are many
trading venues for a wide variety of securities. Trading procedures are classified along 2
dimensions: location and method of matching orders.

Physical location VS Electronic Network

Physical location exchange; traders meet and
trade in a specific place, example the New York
Stock exchange conduct some trading at physical
location.
Electronic network; traders do not meet really, example US treasury bonds and
foreign exchange primarily operate via telephone and/or computer network.

Matching orders: Open outcry auctions, dealer markets, and automated trading
platforms
Open outcry auctions; traders meet face to face, communicate by shouts and hand
signals and when the price is agreed the trasaction is finalized and reported to the
organization that manage the auction.
Dealer markets and market makers; there are market makers in a dealer market,
they keep an inventory of the stock (or other financial instrument) in much the
same way that any merchant keeps an inventory of goods. So dealers list bid quotes
and ask quotes, which are the prices at which they are willing to buy or sell.
 Automated trading platforms with automated matching engines;
an automated matching engine is part of a computer system in which
buyers and sellers post their orders and then let the computer
automatically determine whether a match exists, the omputer
automatically executes and reports the trade. The entire system is
called and automated trading platform.
1-10 Overview of the U.S. Stock Markets
 A publicly traded company first registers with the SEC, applies to be listed at a stock
exchange, and then has an IPO, after which its stock can be traded in public markets.
An company can list its stock only at a single SEC-registered stock exchange.
 Before 1970 there was just one major US stock exchange, the NYSE. Today, however
there are more exchanges for trading stock, such the NASDAQ stock market and the
NYSE MKT (formerly called the American Stock Exchange). NASDAQ has the most
listings, but the NYSE’s listings have a much bigger market value. The two primary
trading venues, the NYSE and NASDAQ had very different trading procedures: NYSE
trading took place face to face at a physical location (on Wall Street) and NSDAQ
trading was a dealer market with computerized quotation system. Today very little
stock trading is conducted face to face but instead executed with automated trading
platforms.
1-11 Trading in the Modern Stock Markets
 The NYSE and NASDAQ

 A Reg NMS: Stock Transactions, Quotes, and

 the “Market Price”
 an exchange-listed stock-
 Several free sources, including
 CNBC, -
 report the most recent transaction price. -
 reporting transactions-
 registered stock exchanges must also report certain
 information about limit order bid and ask quotes to a consolidated quote system,
 System (Reg NMS) in 2005 and implemented it in 2007. Among its provisions, Reg NMS requires all registered stock exchanges to
report their best (highest) bid price and best (lowest) ask price for each stock in their order books. After collecting this information from
all the exchanges, a computer system identifies and reports the overall best bid and best ask. These best overall quotes are called the
National Best Bid and Offer (NBBO),which is the overall best (highest) bid price and best (lowest) ask price (the price at which an
investor offers to sell stock). In other words, the NBBO represents the best prices at which an investor could buy or sell on any of the
exchange.
Where Is Stock Traded?

 NYSE before 1970. Even as recently as 2005.

 HOW A STOCK TRADE BEGIN ?

• Buyers and sellers must have brokerage accounts through which they place orders by
stockbrokers or computer systems either way investors must pay to have their orders placed,
executed, and recorded.
• There are three types of trading venues
• (1) standard broker dealer networks
• (2) alternative trading systems
• (3) registered stock exchanges.
• Because an investor initiates a trade by placing an order with a broker, we begin by describing
broker-dealer networks.
ALTERNATIVE TRADING SYSTEMS
(ATS): DARK POOLS
 The broker dealer is a counterparty in all trades—the broker-dealer buys stock from
selling clients and sells the stock to buying clients also provide a different trading
venue in which the broker-dealer is no longer a counterparty in all trades. Instead
buyers can trade directly with sellers. This is called an alternative trading system
(ATS). The pre-trade information (i.e., bid and ask prices) from an ATS is not available
to the general public and is not included when the national best bid and offer (NBBO)
prices
 Are reported. Therefore, an ATS is commonly called a dark pool.
High-Frequency Trading (HFT)

• Investors, broker-dealers, and high-frequency traders buy and sell stocks. Here are some
differences among them.
• High-frequency trading (HFT) is similar to broker-dealer internalization in that the HF
trader buys stock and immediately sells it, profiting if the selling price is higher than the
purchase price.19 Unlike broker-dealer networks, HFT does not provide any infrastructure
or other direct service for the other buyers and sellers. Because the HFT trader is buying
and selling many times a day (or even a second!), the process is called “high frequency
trading.” HFT requires expensive computer systems and highly paid programmers, so most
HFT is done by firms that are created for this purpose rather than by individual investors.
 Stock Market Returns
• As investors trade, stock prices change. When demand is high (lots of bids at high prices
and for large quantities), stock prices go up; when demand is low (bids are only at low
prices), stock prices go down.
Finance and the Great Recession of 2007
The Globalization of Mortgage Market Securitization

 A national TV program ran a documentary on the travails of ,Norwegian retirees resulting from defaults on Florida mortgages. Your
first reaction might be to wonder how Norwegian retirees became financially involved with risky Florida mortgages. We will break the
answer to that question into two parts. First, we will identify the different links in the financial chain between the retirees and
mortgagees. Second, we will explain why there
1. were so many weak links.
2. HOME PURCHASE
3. MORTGAGE ORIGINATION
4. SECURITIZATION AND RESECURITIZATION.
5. THE INVESTORS.

 The Dark Side of Securitization: The Sub-Prime Mortgage Meltdown.

 REGULATORS APPROVED SUB-PRIME STANDARDS
 In the 1980s and early 1990s, regulations did not permit a non-qualifying mortgage to be securitized, so most originators mandated that
borrowers meet certain requirements, including having at least a certain minimum level of income relative to the mortgage payments
and a minimum down payment relative to the size of the mortgage.
 THE FED HELPED FUEL THE REAL ESTATE BUBBLE
 the Fed slashed interest rates to historic lows after the
 terrorist attacks of 9/11 to prevent a recession, and it kept them low for a long time. These low rates made mortgage payments lower,
which made home ownership seem even more affordable, again contributing to an increase in the demand for housing.
 REAL ESTATE APPRAISERS WERE LAX
 The relaxed regulations didn’t require the mortgage broker to verify the borrower’s income, so these loans were
called “liar loans” because the borrowers could overstate their income. But even in these cases the broker had to
get an appraisal showing that the house’s value was greater than the loan amount.
 ORIGINATORS AND SECURITIZERS WANTED QUANTITY, NOT QUALITY
 Originating institutions made money when they sold the mortgages, long before any of the mortgages defaulted.
 The same is true for securitizing firms Their incentives were to generate volume through originating loans, not to
ensure that the loans were safe investments. This started at the top—CEOs and other top executives received stock
options and bonuses based on their firms’ profits, and profits depended on volume. Thus, the top officers pushed
their subordinates to generate volume, those subordinates pushed the originators to write more mortgages, and the
originators pushed the appraisers to come up with high values.
 From Sub-Prime Meltdown to Liquidity Crisis to Economic Crisis
 sub-prime mortgages, spread across the globe securitization allocated the sub-prime risk to many investors and
financial institutions. The huge amount of credit default swaps linked to sub-prime–backed securities spread the
risk to even more institutions.
 banks were more vulnerable than at any time since the 1929 Depression.
 Congress had “repealed” in 1999, allowing commercial banks and investment banks to be part of a single financial
institution.
 The SEC compounded the problem in 2004 a small increase in the value of its investments would create
enormous gains for the equity holders and large bonuses for the managers; conversely, a small decline would ruin
the firm.
 When the sub-prime market mortgages began defaulting, mortgage companies were the first to fall. Many
originating firms had not sold all of their sub-prime mortgages, and they failed Securitizing firms also crashed,
partly because they kept some of the new securities they created.
 The Big Picture
 Finance has vocabulary and tools that might be new to you. To help you avoid getting
bogged down in the trenches, Figure 1-7 presents the big picture. A manager’s primary
job is to increase the company’s intrinsic value, but how exactly does one go about
doing that? The equation in the center of Figure 1-7 shows that intrinsic value is the
present value of the firm’s expected free cash flows, discounted at the weighted average
cost of capital. Thus, there are two approaches for increasing intrinsic value: improve
FCF or reduce the WACC. Observe that several factors affect FCF and several factors
affect the WACC. we will typically focus on only one of these factors, systematically
building the vocabulary and tools that you will improve your company’s intrinsic
value. It is true that every manager needs to understand financial vocabulary and be
able to apply financial tools, but successful managers also understand how their
decisions affect the big picture. So keep in mind where each topic fits into the big
picture.