financial management - chapter 7 summary

the prices of each share of a firm's common stock is the value of each ownership interest. Although common stockholders typically have voting rights, which indirectly give them a say in management, they are only significant right is their claim on the residual cash flows of the firm. This claim is subordinate to those of vendors, employees, customers, lenders, the government (for taxes), and preferred stockholders. The value of the common stockholders claim is embodied in the cash flows they are entitled to receive from now to infinity. The present value of those expected cash flows is the firms share value.

to determine this present value, forecast cash flows are discounted at a rate that reflects their risk. Riskier cash flows are discounted at higher rates, resulting in lower present values than less risky expected cash flows, which are discounted at lower rates. The value of the firm's common stock is therefore driven by its expected cash flows (returns) and risk (certainty of the expected cash flows.)

in pursuing the firm's goal of maximizing the stock price, the financial manager must carefully consider the balance of return and risk associated with each proposal and must undertake only those actions that create value for owners -- that is, increased share price. By focusing on value creation and by managing and monitoring the firms cash flows and risk, the financial manager should be able to achieve the firm's goal of share price maximization.

Debt versus equity capital
Holders of equity capital (common and preferred stock) are owners of the firm. Typically, only common stockholders have a voice in management. Equity holders claims on income and assets are secondary to creditors claims, there is no maturity date, and dividends paid to stockholders are not tax deductible, as is interest paid to debt holders.

Common and preferred stock
The common stock of a firm can be privately owned, closely owned, or publicly owned. It can be sold with or without a par value. Preemptive rights allow common stockholders to avoid dilution of ownership when new shares are issued. Not all shares authorized in the corporate charter are outstanding. If a firm has treasury stock, it will have issued more shares than are outstanding. Some firms have two or more classes of common stock that deferred mainly in having on equal voting rights. Proxies transfer voting rights from one party to another. The decision to pay dividends to common stockholders is made by the firm's board of directors. Firms can issue stock in foreign markets. The stock of many foreign corporations is traded in the form of American depositary receipts (ADRs) in US markets.

Preferred stockholders have preference over common stockholders with respect to the distribution of earnings and assets. They do not normally have voting privileges. Preferred stock issues may have certain restrictive covenants, cumulative dividends, a call feature, and a conversion feature.

Issuing stock
The initial non-founder financing for business startups with attractive growth prospects typically comes from private equity investors. These investors can be either angel capitalists or venture capitalists (VCs). VCs usually invest in both early stage and later stage companies that they hope to take public so as to cash out their investments.

The first public issue of the firm's stock is called an initial public offering (IPO). The company selects an investment banker to advertise it and to sell the securities. The lead investment banker may form a selling syndicate with other investment bankers. The IPO process includes getting SEC approval, promoting the offering to investors, and pricing the issue.

Stock quotations provide information on calendar year change in price, 52 week high and low, dividend, dividend yield, P/E ratio, volume, closing price, and net price change from the prior trading day.

Market efficiency
Market efficiency as soon set the quake reactions of rational investors to new information cause the market value of common stock to adjust upward or downward quickly. The efficient market hypothesis (EMH) suggests that securities are fairly priced, that they reflect fully all publicly available information, and that investors should therefore not waste time trying to find and capitalize on mispriced securities. Behavioral finance advocates challenged this hypothesis by arguing that emotion and other factors play a role in investment decisions.

The value of a share of common stock is the present value of all future dividends it is expected to provide over an infinite time horizon. Three dividend growth models -- 0 growth, constant growth, and variable growth -- can be considered in common stock valuation. The most widely cited model is the constant growth model.

models and approaches
The free cash flow valuation model values start ups, firms that have no dividend history, or operating units of a larger public company. The model finds the value of the entire company by discounting the firms expected free cash flow at its weighted average cost of capital. The common stock value is found by subtracting the market values of the firm's debt and preferred stock from the value of the entire company.

relationships among financial decisions, return, risk, and the firm's value
In a stable economy, any action of the financial manager that increases the level of expected return without changing risk should increase share value; any action that reduces the level of expected return without changing risk should reduce share value. Similarly, any action that increases risk will reduce share value; any action that reduces risk will increase share value. An assessment of the combined effect of return and risk on stock value must be part of the financial decision-making process.