Corporate Finance: Pros & Cons of Corporations and Securitization, Slides of Financial Management

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CHAPTER 1 Overview of Financial Management and the Financial Environment docsity.com Topics in Chapter  Forms of business organization  Objective of the firm: Maximize wealth  Determinants of fundamental value  Financial securities, markets and institutions docsity.com Starting as a Proprietorship  Advantages:  Ease of formation  Subject to few regulations  No corporate income taxes  Disadvantages:  Limited life  Unlimited liability  Difficult to raise capital to support growth docsity.com Starting as or Growing into a Partnership  A partnership has roughly the same advantages and disadvantages as a sole proprietorship. docsity.com Becoming a Corporation  A corporation is a legal entity separate from its owners and managers.  File papers of incorporation with state.  Charter  Bylaws docsity.com 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. docsity.com 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. docsity.com Is maximizing stock price good for society, employees, and customers?  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 (Continued) docsity.com 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. docsity.com 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 docsity.com 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: Value = + + … + FCF1 FCF2 FCF∞ (1 + WACC)1 (1 + WACC)∞ (1 + WACC)2 See “big picture” diagram on next slide. (More . .) docsity.com 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). docsity.com 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 docsity.com What four factors affect the cost of money?  Production opportunities  Time preferences for consumption  Risk  Expected inflation docsity.com What two factors lead to exchange rate fluctuations?  Changes in relative inflation will lead to changes in exchange rates.  An increase in country risk will also cause that country’s currency to fall. docsity.com Financial Securities Debt Equity Derivatives Money Market •T-Bills •CD’s •Eurodollars •Fed Funds •Options •Futures •Forward contract Capital Market •T-Bonds •Agency bonds •Municipals •Corporate bonds • Common stock • Preferred stock •LEAPS •Swaps docsity.com Typical Rates of Return Instrument Rate (January 2009) U.S. T-bills 0.41% Banker’s acceptances 5.28 Commercial paper 0.28 Negotiable CDs 1.58 Eurodollar deposits 2.60 Commercial loans: Tied to prime 3.25 + or LIBOR 2.02 + (More . .) docsity.com 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 docsity.com 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. docsity.com How are secondary markets organized?  By “location”  Physical location exchanges  Computer/telephone networks  By the way that orders from buyers and sellers are matched  Open outcry auction  Dealers (i.e., market makers)  Electronic communications networks (ECNs) docsity.com Auction Markets  Participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients; e.g., CBOT.  NYSE and AMEX are the two largest auction markets for stocks.  NYSE is a modified auction, with a “specialist.” docsity.com Dealer Markets  “Dealers” keep an inventory of the stock (or other financial asset) and place bid and ask “advertisements,” which are prices at which they are willing to buy and sell.  Often many dealers for each stock  Computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers.  Examples: Nasdaq National Market, Nasdaq SmallCap Market, London SEAQ, German Neuer Markt. docsity.com Electronic Communications Networks (ECNs)  ECNs:  Computerized system matches orders from buyers and sellers and automatically executes transaction.  Low cost to transact  Examples: Instinet (US, stocks, owned by Nasdaq); Archipelago (US, stocks, owned by NYSE); Eurex (Swiss-German, futures contracts); SETS (London, stocks). docsity.com 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 docsity.com 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 docsity.com 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. docsity.com 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). docsity.com Other Assets Can be Securitized  Car loans  Student loans  Credit card balances docsity.com The Dark Side of Securitization  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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