Chapter 1- Overview

1
Chapter 1- Overview Markets

• Managerial Finance I
• Keldon Bauer, PhD

2
Primary Objective of the Firm

• Maximization of shareholder wealth.
• Shareholders are society
• Consumers benefit
• Employees benefit

3
Maximizing Shareholder Wealth
Value of the Firm
To maximize Value we must maximize FCF and/or
minimize WACC.
4
Maximizing Firm Value
Free Cash Flows FCF
How can FCF be maximized?
5
Maximizing Firm Value
Weighted Average Cost of Capital (WACC)
Over which of these does the manager have control?
6
Economic Markets

• Market for real assets
• Physical assets
• Market for financial assets
• Financial assets Claims on real assets with
  respect to the distribution of cash flow
• Financial markets Systems, procedures,
  individuals and institutions that satisfy the
  need/surplus of funds

7
Types of Financial Markets

• Debt vs equity market
• Money market vs capital market
• Mortgage vs consumer credit market
• World, national, and regional markets
• Primary vs secondary market
• Spot vs futures market

8
Financial Markets - Institutions
1. Direct Transfer
Securities (Stocks or Bonds)
Business
Savers
Dollars
9
Financial Markets - Institutions
2. Indirect Transfer
Investment Banking Houses
Securities
Securities
Business
Savers
Dollars
Dollars
10
Financial Markets - Institutions
Why investment bankers?

• Help firms tailor their offers for market
• They are experts at raising money for the first
  time - the firm is probably not
• They buy securities from the firm - they sell all
  securities
• They resell them to the public

11
Financial Markets - Institutions
3. Intermediary
Businesss Securities
Intermed.s Securities
Financial Intermediary
Business
Savers
Dollars
Dollars
12
Financial Markets - Intermediaries

• Commercial banks
• Thrifts (savings loans, savings banks)
• Credit unions
• Pension funds
• Life Insurance Companies
• Mutual Funds

13
Equity Market

• Primary market
• Secondary market
• Organized markets (NYSE, AMEX)
• Brokers, specialists, dealers
• Over-the-counter markets
• Electronic, after-hours

14
Interest - Important Concepts

• Production opportunities
• Time preferences for consumption
• Risk
• Inflation

15
Economics of Interest
Example Fed Funds Market
ie
16
Economics of Interest
Example Demand Increases
ie
17
Economics of Interest
Example Money Supply Decreases
ie
18
Interest - Important Components

• Real interest r (the outcome of supply demand
  from previous slides)
• Nominal interest r is the rate quoted
• The nominal rate is a function of the real rate
  for money in the economy
• Other characteristics of the financial asset add
  or detract from the supply or demand for each
  specific debt contract

19
Interest - Important Components

• Inflation premium IP (a function of expected
  inflation over the life of the asset - same for
  all debts)
• Default risk premium DRP (this and all subsequent
  components are debt specific)
• Liquidity premium LP
• Liquidity means how quickly can turn to cash

20
Interest - Important Components

• Market risk premium MRP
• A composite of
• Interest rate risk (how it can change over life
  of asset)
• Maturity risk premium (I may need money sooner
  than I thought)
• Reinvestment rate risk (interest rate risk
  associated with reinvesting proceeds)

21
Interest - Important Components

• Nominal rate depends on all components
• r r IP DRP LP MRP

22
Interest - Term Structure

• Term Structure of Interest Rates
• Relationship between interest required by the
  market and the maturity of the contract
• Visualized by looking at the Yield Curve
• Yield Realized interest on a debt instrument
  over the life of the instrument

23
Interest - Term Structure
Yield Curve on Treasury Securities
Maturity in Years
24
Interest-Term Structure Theories

• Treasury securities have no default risk (DRP
  0).
• rt r IPt MRPt
• r is random, and unpredictable.
• IP does vary greatly based on econ info.
• MRP also varies greatly.

25
Illustrative Treasury Yield Curve
26
Illustrative Treasury Yield Curve
27
Interest - Other Determinants

• Federal Reserve policy
• Open market operations - selling Treasury
  securities reduces supply of funds
• Federal deficits
• Increased deficits increases the demand for funds

28
Interest - Other Determinants

• Foreign trade balance
• Deficits mean we are borrowing more - increasing
  demand
• Business activities
• As business sell more, they will need to expand à
  increase in demand for funds

29
Interest - Effect on Stock Prices

• Increases in interest increase costs to firms,
  reducing profits à lower stock prices
• Increases in interest dont allow business to
  expand as cheaply, slowing the economy

30
Interest - Impact on Decisions

• Question If short-term loans are cheaper (see
  term structure) why not use short-term loans to
  buy buildings?
• Answer Interest rate risk
• Both are irrelevant to most small businesses,
  since they are only offered adjustable rate loans

31
(No Transcript)