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FINANCIAL

MANAGEMENT
THEORY &
PRACTICE

ADAPTED FOR THE SECOND CANADIAN


EDITION BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
CHAPTER 1

AN OVERVIEW OF
FINANCIAL
MANAGEMENT AND THE
FINANCIAL
ENVIRONMENT
CHAPTER 1 OUTLINE

The Five-Minute Business Degree


The Corporate Life Cycle
The Primary Objective of the
Corporation: Value Maximization
An Overview of the Capital Allocation
Process
Financial Securities and the Cost of
Money
Financial Institutions
Types of Financial Markets
The Big Picture
Copyright 2014 by Nelson Education Ltd. 1-3
The Five-Minute Business
Degree
Two main goals of all successful
companies:
Having products or services highly valued
by customers
Selling products/services at prices high
enough to cover costs and reward investors
The key attributes of successful
companies:
Having skilled people
Having strong external relationships
Having sufficient
Copyright capital
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The Corporate Life Cycle
No two companies will develop in
exactly the same way.
A business usually begins as a small
potato and hopes to finish up as a
major giant.
Structures of business organizations:
Sole proprietorship
Partnership
Corporation
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Starting Up as a Proprietorship
Advantages:
Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages:
Difficult to raise capital to support
growth
Unlimited liability
Limited life span
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Starting as, or Growing Into,
a Partnership
A partnership involves two or more
entities with various privileges and
responsibilities.
General vs. limited partner
Limited liability partnership (LLP)
A partnership has roughly the same
advantages and disadvantages as a
sole proprietorship.
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Becoming a Corporation
A corporation is a legal entity
separate from its owners and
managers.
File papers and prepare reports with
Corporation Canada.
Articles of incorporation
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
Higher setup cost
Endless report filing
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Special Types of Corporations
Professional corporations (PCs)
For professionals such as doctors,
lawyers, and accountants
Income trusts
Created to distribute all of a businesss
free cash flow to investors in a tax-
efficient manner
Appropriate for businesses with stable
cash flows and not requiring significant
capital expenditures
Only allowable for real estate (REIT) now
Copyright 2014 by Nelson Education Ltd. 1-10
Growing and Managing a
Corporation
In addition to having products/services
that attract customers, a corporation
must attract investors.
Founders own resources and from friends,
family, other private investors
Initial public offering (IPO)
Borrowing from banks, issuing bonds and
additional shares
Separation of ownership and
management
Agency problem
Corporate governance

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The Primary Objective of the
Corporation: Value Maximization

What should be managements


primary objective?
Stock price maximization and social
welfare
Managerial actions to maximize
shareholder wealth

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What Should Be Managements

Primary Objective?
The primary objective should be
shareholder wealth maximization,
which translates to maximizing the
fundamental share price, not just the
current market price.
Should firms behave ethically? YES!
Business ethics are a companys
attitude and conduct toward its
employees, customers, community, and
shareholders.
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Stock Price Maximization and
Social Welfare
Do firms have any responsibilities to
society at large? Yes!
Unethical behaviour destroys public
trust and confidence.
Maximizing share price is good for
society. Why?
Shareholders are also members of
society.
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Is Maximizing Stock Price
Good for Consumers?
To maximize stock price, corporations
have to produce and deliver high-
quality goods and services at the
lowest possible cost to consumers.
Consumers can improve quality of
life by the direct or the indirect
investments in the stock market.

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Is Maximizing Stock Price
Good for Employees?
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 previously owned by the
government but that have been sold to
private investors.

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Managerial Actions to Maximize
Shareholder Wealth
Improve a firms ability to generate
cash flows now and in the future by
focusing on:
the amount of expected cash flows
(bigger is better).
the timing of the cash flow stream
(sooner is better).
the risk of the cash flows (less risk is
better).
Copyright 2014 by Nelson Education Ltd. 1-17
Free Cash Flows (FCF)
FCF are cash flows available (or free)
for distribution to all investors
(stockholders and creditors).
FCF = sales revenues operating
costs operating taxes required
investments in operating capital.
There are many ways firms can
increase free cash flows.

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Weighted Average Cost of Capital
(WACC)
In addition to FCF, another factor of
determining a firms value and its long-
term stock price is WACC.
WACC is the average rate of return
required by all of the companys investors.
WACC is affected by:
capital structure (the firms relative amounts
of debt and equity)
interest rates
risk of the firm
investors overall attitude toward risk

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An Overview of the Capital
Allocation Process
Who are the providers (savers) and
users (borrowers) of capital?
Financial securities and the cost of
money
Financial institutions
Financial markets

Copyright 2014 by Nelson Education Ltd. 1-21


Who Are the Providers (Savers)
and Users (Borrowers) of
Capital?
Households: Net savers
Non-financial corporations: Net users
(borrowers)
Governments: Net borrowers
Financial corporations: Slightly net
borrowers, but almost break-even

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Transfer of Capital from
Savers to Borrowers
Direct transfer (e.g., corporation
issues commercial paper to
insurance company)
Indirect transfer through an
investment banker (e.g., IPO,
seasoned equity offering, or debt
placement)
Indirect transfer through a financial
intermediary (e.g., individual
Copyright 2014 by Nelson Education Ltd. 1-24
Financial Securities
Simply, pieces of paper with
contractual provisions entitling their
owners to specific rights and claims on
specific cash flows or values
Can be classified along two
dimensions:
Time until maturity
Debt or equity
Can also be distinguish between
primary securities and derivatives
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Financial Securities contd

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Financial Securities contd

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The Cost of Money
Supply and demand of funds
determine the cost or price of money.
What do we call the price (or cost) of
debt capital? Of equity capital?
Interest rate
Cost of equity = required return =
dividend yield + capital gain
Both are the rate fund users pay to
fund providers.

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Fundamental Factors That
Affect the Cost of Money
Production opportunities
Time preferences for consumption
Risk
Expected inflation

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Economic Conditions and Policies
That Affect the Cost of Money
Bank of Canada policies
Budget deficits/surpluses
Business activity (recession or boom)
International trade deficits/surpluses
Country risk depending on its
economic, political, and social
environment
Exchange rate risk
Copyright 2014 by Nelson Education Ltd. 1-30
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Financial Institutions
Investment banks
Commercial banks
Trust companies
Credit unions
Life insurance companies

Mutual funds
Money market funds (MMFs)
Exchanged traded funds (ETFs)
Pension funds
Hedge funds
Private equity funds

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Regulation of Financial
Institutions
Rationale: Ensure their safety and protect
investors
Examples: Separation of different types
of services and limiting the types of
services an institution could provide
Regulatory changes
Deregulation to ensure free flow of capital
and efficiency of capital markets
Blurring the distinctions between different
types of institutions and leading to financial
superstores

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Types of Financial Markets
A financial market brings together
savers and borrowers.
Physical asset vs. financial asset
markets
Spot vs. futures markets
Money vs. capital markets
Primary vs. secondary markets
Private vs. public markets
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Physical vs. Financial Asset
Markets
Physical (a.k.a. tangible or real) asset
markets
Products such as wheat, autos, and real
estate
Financial asset markets
Primitive securities and derivative
securities

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Spot vs. Futures Markets
Spot (a.k.a. cash) markets
Assets are bought or sold for on-the-
spot delivery.
Futures markets
Assets are bought or sold for delivery at
some future date.

Copyright 2014 by Nelson Education Ltd. 1-36


Primary vs. Secondary Markets
Primary
New issue (IPO or seasoned)
Key factor: Issuer receives the proceeds
from the sale
Secondary
Existing owner sells to another party
Issuing firm doesnt receive proceeds
and is not directly involved

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Private vs. Public Markets
Private markets
Transactions are worked out directly
between two parties.
Lack of liquidity
Public markets
Standardized contracts are traded on
organized exchanges.
More liquid and transparent

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The Big Picture
A managers primary job is to increase
the firms intrinsic value.
Intrinsic value: The present value of the
firms expected free cash flows (FCF),
discounted at WACC
Two approaches to increasing intrinsic
value:
improve FCF and/or
reduce WACC
You are to learn tools used to make
decisions to increase intrinsic value.
Copyright 2014 by Nelson Education Ltd. 1-39

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