The Financial

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Chapter 2
The Financial Environment

Mila Getmansky Sherman
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Topics Covered

• The Goals of the Corporation
• CEO Pay
• The Flow of Savings to Corporations
• Functions of Financial Markets
• Functions of Financial Intermediaries

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Goals of The Corporation

• Shareholders desire wealth maximization
• Do managers maximize shareholder wealth?
• Agency Problems represent the conflict of
  interest between management and owners

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Goals of The Corporation

• Agency Problem Solutions
• 1 - Compensation plans
• 2 - Board of Directors
• 3 - Takeovers
• 4 - Specialist Monitoring
• 5 - Auditors

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CEO Pay
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Financial Markets
Investors
Firm's
Financial
operations
Manager
(stockholders save and invest in closely held
firm.)
Real assets (timberland)
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Financial Markets

• Markets
• Primary
• Secondary
• Trading
• Major exchanges NYSE, international
• OTC NASDAQ

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Other Financial Markets

• Fixed-Income (debt)
• Capital Market (long-term financing)
• Money Market (short-term financing)
• Foreign-Exchange Market (currencies)
• Commodities Market (wheat, oil)
• Options and Derivatives

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Financial Intermediaries

• Mutual Funds
• Pension Funds

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Financial Markets


Bank of America
Windsor Fund
Investors
Sells shares
Issues shares
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Financial Intermediaries

• Banks
• Insurance Companies

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Financial Markets
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Financial Markets
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Financial Markets
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Functions of Financial Markets and Intermediaries

• Transporting cash across time
• Liquidity
• Payment mechanism
• Reducing Risk

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U.S. Financing

• Information Provided by Financial Markets
• Commodity prices
• Interest rates
• Company values

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Cost of Capital

• Cost of capital is the minimum acceptable rate of
  return on capital investment
• If an investment project offers a rate of return
  which is greater than cost of capital, this
  project adds value to the firm
• If an investment project offers a rate of return
  which is smaller than cost of capital, this
  project should not be started as it destroys the
  value of the firm

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An Example of Cost of Capital

• Say Vision Inc. want to invest in making a new
  generation of monitors. Financial manager of
  Vision Inc. thinks that he will get 10 return on
  the investment.
• Question Should he go ahead and invest 1
  million into the project?

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An Example of Cost of Capital , Cont.

• Answer depends
• Case 1 If production of monitors is a safe
  investment and Vision Inc. will for sure make
  10, and currently safe investments like Treasury
  bills pay only 5, then the financial manager
  should go ahead as 10 gt 5. The cost of capital
  is 5 in this case, and it is smaller than rate
  of return on investment.

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An Example of Cost of Capital, Cont.

• Case 2 If production of monitors is risky, and
  the risk is similar to investing in a stock
  market, and investors can make 12 by investing
  in a stock market, then the cost of capital
  12. 10 lt 12 therefore, it is better for
  investors to invest their money into the stock
  market and not into the new project by Vision Inc.