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Fin 1101: Introductory Corporate Finance

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Fin 1101: Introductory Corporate Finance Lecture 1 C.L. Mattoli * (C) Red Hill Capital Corp., Delaware 2008 Finance in a nutshell: most important Some people ... – PowerPoint PPT presentation

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Title: Fin 1101: Introductory Corporate Finance


1
Fin 1101 Introductory Corporate Finance
  • Lecture 1
  • C.L. Mattoli

2
How to pass FIN1101
  • Start work now and keep up to date
  • Take notes in class. Make notes using the
    textbook and other materials, which are handed
    out each week.
  • Do the self-assessment exercises in the study
    book and answer the questions in the weekly
    workshop materials.
  • It is a difficult course, for some, and a
    difficult book.

3
Course Notes
  • Lectures will cover broad concepts of modules.
  • In tutorials, you will be required to do problems
    and questions to hand in before start of class.
    Then, problems will be done on the board.
  • In workshops you will be given problems to work
    on, in class, to test yourself at each stage of
    the course.

4
Course Structure
  • Attendance is required and roles will be taken in
    almost every class.
  • You will be required to do tutorial problems
    before class and hand them in at the start of the
    tutorial sessions. Although grades on the
    problems will not count for your grade in the
    course, grades will be reported to the
    administration, and, if you do not keep up with
    the work, you might be asked to drop the course.
  • Workshops will be used to cover extra materials
    and for in-class quizzes.
  • Bring textbooks to Lecture, WS, and Tutorials!

5
Information Information
  • Lecturer Craig Mattoli
  • Email clm_at_clmattioli.com
  • Phone (text messages only) 136 3241 0877 include
    your name and course in message.
  • Office hours by appointment. Located in room
    505.
  • Dont be shy. Ask Questions of your Instructor,
    not just your classmates. No one cares as much
    as he does!
  • Sometimes, I talk fast, use words that you might
    not know, and write abbreviations on the board.
    Again, if you dont understand my written or
    spoken word, ask. Its ok!

6
Prologue
  • Introduction to finance was revamped last spring,
    so notes and exams from previous semesters will
    be of limited use.
  • The book for the course is Essentials of
    Corporate Finance by Ross, Trayler, Bird,
    Westerfield Jordan.
  • Do not use or even look at the old book, as it
    has confused concepts and logic.

7
Prologue
  • The new layout of the course should be
    particularly useful to you as it builds on the
    basic accounting that is used in business. Thus,
    you will be able to relate the financial theory
    to the actual accounting numbers that are the
    basis for evaluating and running businesses and
    other investments.
  • Your grade for the course will come from an
    assignment and a final exam.

8
What is Finance?
  • Finance can be considered in both its macro and
    micro dimensions.
  • At the macro level, finance encompasses the study
    of the operations of financial institutions and
    markets within the economy in the allocation of
    funds (money) to various uses.
  • At the micro level, finance essentially involves
    the processes of investment decision making and
    funding (financing) of investments, by firms,
    financial institutions and individuals.
  • In this unit we will be looking at finance from
    the point of view of the money manager or
    financial manager of a business.

9
Finance in a nutshell
  1. Some people have extra money/some need extra
    money how to get it from one to the other is
    part of the field of finance.
  2. Finance is the study of the allocation of money
    under conditions of risk.
  3. Financial markets and intermediaries connect the
    two groups surplus and deficit cash units.

10
Finance in a nutshell
  1. People value investments, like buying a new piece
    of machinery or buying stocks and bonds by
    valuing the future cash flows that they expect to
    get from those investments (present value).
  2. The other important thing in valuation is
    riskiness the riskier the prospect of getting
    your money in the future, the more of a return
    you will ask for.
  3. There are instruments, like futures and options
    to help manage risk.

11
Introduction to Financial Management
  • Module 1

12
Overview
  • In this introductory module and lecture, we will
    cover the following topics
  • What is finance and what are its sub-disciplines.
  • How does finance relate to other jobs in the
    business world.
  • What do financial managers do and what decisions
    do they make for a business.
  • What are the ways that a business can be
    structured.

13
Overview
  1. The proper goals of financial management.
  2. What conflicts arise when the owners of a
    business are not the managers (corporate
    structure).
  3. What are financial markets. What kinds of
    markets are there. And what do they have to do
    with business.
  4. These concepts will form the basis to study
    further and will ask some questions that the
    course will answer.

14
What is Finance and Why Study it?
15
The 4 Basic Branches of Finance
  • Traditional finance is broken into 4 basic
    topics
  • Corporate Finance, which is the main topic of
    this course.
  • Investments
  • The study of financial institutions.
  • International finance.
  • We shall look at brief overviews of each

16
Corporate and Business Finance
  • Corporate or business finance studies all of the
    financial ideas, operations, jobs and decisions
    that go into running a business.
  • It is the main topic of this course.
  • Moreover, business finance includes topics from
    the other major areas because they cover topics
    that are relevant to business finance.
  • On the other hand, the ideas contained in this
    topic apply also to the others.

17
Investments Investing
  • I am sure that you have all heard your friends
    talking about investing is stocks, but they are
    just playing at investing.
  • The field of investment, both in theory and in
    practice, is a discipline, not a game, and for
    those who understand its simple precepts, it can
    be rewarding, in terms of both money and
    satisfaction.

18
Investments Investing
  • Moreover, investment covers a much broader range
    of things than you would normally think of. Even
    the time that you are spending in this college
    and this course are an investment, and you will
    be able to value it by the end of this course.
  • You can buy a bicycle, and look at it as money
    spent, or you can rent it out. Then, it is an
    investment whose value far exceeds the cost of
    the bike.

19
Investments Investing
  • The field of investment looks at the broad topics
    of
  • What determines the values and prices of assets,
    like shares of stock or businesses?
  • What are the potential risks and rewards of
    investing?
  • What is the appropriate mix of financial assets
    to have, either as an owner or issuer of such
    assets?

20
Financial Institutions
  • Financial institutions are businesses that deal
    in financial business.
  • They include things, like banks, insurance
    companies and financial markets.
  • The study of financial institutions looks at how
    funds are transferred from those who have extra
    funds to those who need extra funds.
  • The study of finance is built on the idea some
    people forego consumption, and save. Then, the
    question becomes how do those funds get to those
    who want to consume more, now, and how much
    should be charged for both the intermediation
    process and the use?

21
International Finance
  • International finance covers, basically, those
    areas that involve finance in an extra-national
    setting.
  • For example, an Australian bank that has
    customers in other countries is dealing in
    international finance.
  • A portfolio manager that holds stocks and bonds
    of companies of varied national origin is in
    international finance.
  • A company that has subsidiaries or operations in
    foreign countries also will be interested in
    international finance topics.

22
Why Should You Study Finance?
  • Finance is about money, and money is at the heart
    of business and even your personal life.
  • If you are going to be an accountant, you will be
    dealing in financial data, and it will help you
    to understand what you are doing and why.
  • The two basic engines of business are marketing
    and finance, after coming up with an idea for
    your business.

23
Finance and Marketing, e.g.
  • There is a strong interplay between marketing and
    finance, in business.
  • Marketing partly determines the prices that are
    charged for things. It costs money to market,
    and the return on the investment in that is a big
    part of business.
  • Often, the sales department will work the finance
    department of a company to come up with price,
    revenue, and cost projections to analyze
    potential products and projects, which we will
    study later in the course.

24
Finance and Marketing, e.g.
  • What most people dont realize is how important
    marketing is in the financial business, like
    stock brokers, investment banking, and even
    banking.
  • Brokers call clients and try to talk them into
    buying more shares of stock or a new product or
    issue.
  • New financial products are created and sold by
    banks, insurance companies and financial markets .

25
Finance and Accounting
  • In smaller businesses, accountants are usually
    also called upon to make financial decisions, so
    it is important for them to understand about
    finance, if they are to do a good service for
    their clients.
  • Another reason that accountants need to
    understand finance, better, is that, as the
    financial world becomes more complex, with newer
    and newer financial products and contracts, they
    need to understand their benefits, their
    pitfalls, and their affects on financial
    statements. (current crisis)
  • Cost accounting makes use of finance, and
    investment analysis makes use of accounting
    information, so there is more interplay. Finance
    will help accountants understand how the
    information that they put together is used or
    misused by others.

26
Finance and Business Management
  • Business managers, invariably, need to understand
    financial matters.
  • Indeed, many top managers of corporations are
    financial types.
  • In a larger business, many people will be
    required to understand finance, since they have
    to understand how what they do will affect
    profitability, and finance studies the value of
    things.

27
Finance and the rest of your life
  • To live, you need money.
  • Right now you are investing in your future. You
    pay money, now, for college in the hopes that it
    will help you earn more in the future. The extra
    earning power that you get from your education
    will somehow have to exceed how much you are
    spending, now.
  • When you get a job, you will get income, and you
    will have to pay expense, like rent and food.
    You will have to manage your expenses to fit your
    revenue and more.

28
Finance and the rest of your life
  • Maybe you want to open your own business then,
    you will really need to understand financial
    management since you will have to invest money
    to start the business, then, earn enough to cover
    your initial investment and to cover expenses on
    a day-to-day basis.
  • More important, some day you will retire, so,
    during your working years you will have to save
    and invest for retirement. Those decisions will
    affect when you can retire and how well off you
    will be when you retire.
  • Thus, understanding finance will help you with
    your whole life.

29
Business Finance the Financial Manager
30
Business Finance
  • Starting a business cannot be done,
    thoughtlessly.
  • Many people believe that starting a business is
    the key to getting rich, but they rarely
    understand what it takes to start and run a
    business, successfully.
  • The first step in starting a business is
    investment. You decide what your business will
    be, e.g., selling eggs or making candles. You
    will have to find a place to run the business.
    You might have to invest in equipment or just
    display counters. You will have to have extra
    money to pay expense, while you are in the start
    up phase. (Capital Budgeting)

31
Business Finance
  • You will need money for all of this initial
    investment. Where will you get it?
  • Thus, the second step is financing your business.
    Will you risk your own money? Will you borrow
    money? Or will you find others to invest in your
    business as partners or part owners. (Capital
    Structure)

32
Business Finance
  • Then, once you start the business, you will have
    to manage your day-to-day financial affairs, like
    collecting money from customers and paying
    suppliers, employees, and your landlord. This
    third step of business finance will be important
    for keeping you in business. (Working Capital
    Management)
  • These are the 3 basic topics that we will study
    in business finance.

33
The Role of the Financial Manager
  • In a large company, like a corporation (see,
    below), the financial management position is
    usually a senior position in the firm because of
    its importance to the health of the business.
  • The top financial person in the firm is usually
    called the CFO, Chief Financial Officer, or VP
    (vice president) of Finance.
  • In the next slide, we show a typical
    organizational chart for a corporation.

34
The CFO in the Corp.
Board of Directors
Board Chairman
CEO
CFO
GM Production
GM Marketing
Treasurer
Controller
Credit Manager
Cash Manager
Tax Manager
Cost Acct Mgr
Cap Expend Mgr
MIS
Fin Acct Mgr
Fin Plan Mgr
35
Basic Financial Management Functions
  • Directly under top management of the company is
    the CFO
  • The CFO is in charge of all financial management
    of the firm and has 2 departments that answer to
    him or her the Treasurer and the Controller.
  • The Treasurers office manages cash, credit,
    capital expenditures, and financial planning.

36
Basic Financial Management Functions
  • The Controller (chief accountant) is in charge of
    cost and financial accounting, tax payments and
    management information systems (MIS).
  • In a smaller company, the two main functions,
    treasurer and controller might be merged into
    each other and even into the CFO function.
  • The study of business finance will focus on the
    treasury function. You will learn about the
    other functions in your accounting courses.

37
Financial Management Decisions1. Capital
Budgeting
  • We have to take a long-term view of our business,
    when we begin it, if we want to be in business
    for more than a minute, and, then, to keep the
    business going.
  • First, we invest in a business or a business
    project. That is our cash outflow.
  • The first thing that we need to consider is the
    size ( amount) of the initial cash outflow
    (investment).
  • From that investment of money, we will get
    future cash inflows, no matter if our investment
    is in a stock, in the stock market, or in plant
    and equipment to produce noodles.

38
Financial Management Decisions1. Capital
Budgeting
  • The objective of investment (business) is for the
    future inflows to, somehow, exceed the outflows.
  • We say somehow because money will not be worth
    as much (be able to buy as much), in the future,
    as it is now (time value). If you have money,
    now, you could put it in bank and earn interest
    and have more money (opportunity cost).

39
Financial Management Decisions1. Capital
Budgeting
  • So, we need to, next, look at the timing of
    future cash flows and take that into account in
    our financial analysis.
  • The final component of our capital budgeting
    decision has to do with the fact that, just
    because you open a business it does not guarantee
    that we will get customers and make money.

40
Financial Management Decisions1. Capital
Budgeting
  • We make projections about our future cash inflows
    and expenses when we evaluate the decision to
    invest, and we get a figure for net projected
    future inflows of cash. Those projections are
    just dreams.
  • There is a risk that the future will be different
    than what we expected, and we must evaluate the
    risks.

41
Financial Management Decisions1. Capital
Budgeting
  • These are the major decision categories of
    capital budgeting.
  • They incorporate two of the fundamental things
    that finance does describe the time value of
    money and incorporating and evaluating risk.

42
Financial Management Decisions2. Working
Capital Management
  • After you start a business you have to deal with
    the day to day running of the business. That
    involves several things.
  • First, being sure that you have money to pay
    bills
  • You will have to also have enough inventory in
    your store to sell.
  • You will have to decide whether or not to sell
    things on credit, and you will have to have the
    financial room to be able to sell now and get
    paid later.

43
Financial Management Decisions2. Working
Capital Management
  • You will have to plan for short-term financing,
    in case you have a shortfall between your cash
    inflows, at any time, and your necessary
    outflows.
  • This prong of financial decision-making is called
    Working Capital Management because it deals with
    the working capital of the firm, the short-term
    assets and liabilities portion of the balance
    sheet.

44
Financial Management Decisions3. Capital
Structure.
  • Now that you have your business up and running,
    and you have managed the short-term, you have to
    think of the long-term, in order to stay in
    business.
  • Will you just use your own money, or will you get
    other co-owners to contribute funds, or will you
    borrow more money? How much will you get of each
    type of funding? How will you match payment to
    those others with the long-term expected future
    inflows from your investment.

45
Financial Management Decisions3. Capital
Structure.
  • The mix of capital, long-term debt and ownership
    equity, the rest of the balance sheet, is called
    the capital structure of the company.
  • Then, there are the questions of how much to pay
    for debt and equity capital (cost of capital).
    How much will it cost to raise the capital
    (issuance or intermediation costs). Where should
    you get it borrow from a bank or insurance
    company or issue debt securities (bonds) in the
    public or private financial markets?

46
Financial Management Decisions3. Capital
Structure.
  • Those types of decisions must be made before you
    start the business and, on a continuing basis,
    after you are in business. You dont want to get
    started, and just when it is getting good, you
    have stop because everyone wants their investment
    money back.
  • You need to always be planning for the long-term
    financial health of your company.

47
Accounting for decisions
Working Capital
Current Assets Cash A/R Inventory
Current Liabilities Accrued Expenses A/P SR Debt
Long term debt Equity
Long term assets
Capital Structure
Capital Budgeting
48
The 3 Forms of Business Organization
49
How businesses are organized
  • Businesses can be set up in several different
    forms
  • Sole proprietor
  • Partnership
  • Corporation
  • Trust
  • We shall concentrate on the first three, in this
    course.

50
Sole proprietorship
  • A sole proprietorship, also called sole trader,
    is a business owned by an individual, who owns
    the assets used in the business, incurs
    liabilities and reaps the annual profits or
    losses.
  • This form of business can involve as little as
    opening the doors to your new business.
  • Sometimes called mom and pop businesses. The
    corner shop or local newsagent, for example,
    might be owner-operated sole proprietorships.
    This is the main form of businesses organization.

51
Sole proprietorship
  • For the sole proprietor, business income is
    personal income, so taxes are charged at his
    personal income tax rate.
  • There are 3 negatives about this form of
    business.
  • First, the owner bears unlimited personal
    liability, beyond his investment in the business.

52
Sole proprietorship
  1. Second, the only forms of capital that he can use
    in his business are his personal equity and
    borrowed funds. That could limit the businesss
    growth.
  2. Finally, to sell the business means selling all
    of the assets to a new owner. Otherwise the
    business dies with the owner.

53
Partnership
  • A partnership is an association of two or more
    people carrying on a business in common with a
    view to profit. It is the next step in business
    evolution. Anytime another person is brought
    into the business, it has to go from sole
    property to partnership. The partnership
    agreement can be formal or a handshake.
  • A local (or international) accounting or legal
    practice, for example, might be partnerships

54
Partnership
  • In a general partnership, all the partners share
    in unlimited liability and profits.
  • In a limited partnership, there is a general
    partner who runs the business and has unlimited
    liability and limited partners who contribute
    money, do not manage and are limited in their
    liability to their investment.
  • Limited partnerships are a common vehicle for
    investment in real estate or securities.

55
Partnership
  • Net profits before tax are distributed to
    partners, and each partner does his own taxes.
  • Again, the limitations of this form of business
    are raising capita, unlimited liability, and
    transfer may not be that easy. For a general
    partnership, a new partnership must be formed, if
    a partner dies or wants to exit. A limited
    partner might be able to sell his share, but how
    and to whom?

56
Corporation
  • A company is an entity, formed under the
    Corporations Act 2001, which is legally separate
    from its owners.
  • A corporation is a legal person and can borrow
    money, own property, enter into contracts, and
    sue and be sued, in court.
  • Because a corporation is a legal person, its
    owners have limited liability, limited to the
    money that they invest.
  • Thus, other names for corporation are names, like
    limited liability companies.

57
Corporation
  • Forming a corporation involves writing articles
    of incorporation (charter) and by-laws. Filings
    of documents must be made with state authorities,
    and the corporation becomes a resident of that
    state for legal purposes.
  • The charter must contain things, like the name,
    the intended life, its business, and the number
    of equity shares that it will issue.

58
Corporation
  • The by-laws have to do with how the corporation
    regulates itself and includes things, like how
    directors will be elected. They can be amended
    by agreement of the shareholders.
  • Because of the limited liability nature of
    corporate organization, many countries, including
    Australia, have made it possible to set up,
    one-director/one-share-of-stock corporations, so
    that sole traders can reorganize in the corporate
    form.
  • For large corporations, the owners are usually
    separate from the managers.

59
Features of companies
  • The thing that distinguishes corporations, either
    private or public, is that they issue ownership
    certificates called shares of stock.
  • In a private company, shares are held by a small
    number of people and cannot be readily sold. The
    term public company means that the stock is held
    by the general public and can be sold to anyone
    else.

60
Features of companies
  • Private companies can be relatively small family
    businesses. But some of the largest companies in
    the world are private.
  • Public companies tend to be larger and will have
    a greater number of shareholders
  • Stock shareholders (the owners of companies) have
    limited liability. They can only lose their
    investment in the stock.

61
How the Corporation is Run
  • A corporation has owners, who own shares of the
    equity of the company in the form of stock
    certificates.
  • The owners might or might not manage or operate
    the corporation, themselves. This is especially
    true of large public corporations.

62
How the Corporation is Run
  • The stockholder owners usually elect directors of
    the corporation. These are their direct agents.
    The election is by vote according to the number
    of shares each owner holds.
  • Then, directors hire managers, who become
    secondary agents of the stockholders and who are
    paid to manage the company for the owners benefit.

63
Ownership Transfer
  • One of the downsides of buying any type of
    investment is that you might lose some or all of
    your money.
  • Sole proprietorships, some partnership shares,
    and large business investment projects, like
    investment in PPE, might be difficult to divest.
  • Moreover, sole traders have no source of equity
    capital but their own money, and partnerships
    might have difficulty finding new partners to
    contribute equity.

64
Ownership Transfer
  • If you can easily resell (transfer ownership of)
    an investment, you will feel better about making
    the investment, in the first place.
  • Ease of transfer is one of the greatest benefits
    of the corporate organizational form of business.
  • As a result of ease of transfer, corporations
    will have an easier time raising capital.
  • As we will discover, shortly, it will be even
    easier to raise more equity capital, if the
    corporation is a public company. It will also
    help them raise debt.

65
Taxes
  • The difference between corporations and other
    forms of business is that corporations are taxed
    under a different system from individuals
  • Moreover, whereas income to a sole proprietor or
    partner is taxed once, in a classical tax system,
    the corporation earns money, gets taxed, pays out
    some earnings as dividends to shareholders, and
    they get taxed again.
  • In Australia, this double taxation system has
    been eliminated by the imputation system in which
    shareholders get a tax credit for taxes paid by
    the company (franking).

66
The Goal of Financial Management
67
Not Profit
  • In order to make financial decisions, we need
    criteria for making decisions.
  • While most people might think that it is profit
    maximization, that is actually a shortsighted
    goal, and we have to take a long-term view of
    investment and business.

68
Not Profit
  • To come up with a more proper goal we will even
    have to look more carefully at accounting numbers
    and what they mean because finance is different
    from accounting.
  • Another basic problem with using simple profit
    maximization as a goal is that it does not
    account for the trade-off between present and
    future, which is the essence of the time-value
    aspect of finance, which we shall discuss more
    fully as we progress through the course.

69
A Proper Corporate Goal
  • Since financial managers at corporations are
    hired to act on the shareholder-owners behalf,
    their goal should be to do what is in the best
    interests of the shareholders.
  • The assumed goal of the owners is to make money
    and increase their wealth.
  • Thus, to increase owner wealth, the manager
    should do things that increase the value of
    owners equity interest in the company.

70
A Proper Corporate Goal
  • Since owners equity is represented by their
    shares of stock in the company, the proper goal
    becomes to maximize the current value of shares
    of stock in the company.
  • That goal, as we shall learn, in due course,
    eliminates the questions of trade-offs between
    present and future. After all, no one cares
    about possibly maximizing value later. They only
    care about now.
  • For a public corporation whose shares of stock
    are traded in the stock market, the goal
    translates into maximizing the current stock
    market price of the companys shares.

71
A Proper Corporate Goal
  • However, the goal of maximizing current value of
    equity should be adapted to any form of business,
    including sole traders and partnerships.
  • Of course, we cannot take this goal too far. We
    must consider this goal within the context of
    what is legal and ethical.
  • The goal is implemented by identifying and
    investing in business projects that will add to
    the value of the company.

72
Ethics in business
  • Ethics are moral principles or rules of conduct
    which indicate the acceptability of behaviour
    within a community
  • Unethical actions may be legal (eg shifting
    production to a country that has lower legal
    standards for worker and/or environmental
    protection). They might also be illegal, like
    using insider information to profit from the
    stock market. How about lying to a customer?

73
Ethics and wealth maximisation
  • Ethical behaviour can be consistent with wealth
    maximisation because it maintains the companys
    reputation. Intangibles, like honesty and fair
    dealing, will ultimately result in good
    relationships with customers, which will lead
    them to tell their friends, which will give us
    more future business and more wealth. Dishonesty
    could lead to the opposite result.

74
Corporate Governance
  • Corporate governance has to do with the fairness
    and honesty shown by the managers to the owners
    and to other stakeholders of corporations.
  • Corporate governance is a hot issue, around the
    world, and many countries are adopting guidelines
    for governance. In 2003, for example, the
    Australian Stock Exchange (ASX) adopted
    guidelines that set 10 core principals for proper
    governance.
  • The importance of corporate governance for
    countries is not only to protect their own
    residents who invest but, in a global financial
    world, to also attract investors from other
    countries.

75
The Agency Problem Corporate Control
76
An agency relationship
  • Any time someone (the principal) hires someone
    else (an agent) to work for them, we say that an
    agency relationship has been formed.
  • You hire a real estate broker to sell your house,
    and she is your agent. You use a fund manager to
    manage your investments, and he is your agent.
  • In a corporation, the managers are agents of the
    shareholders.

77
Potential for conflict
  • People, in general, are self-interested. Thus,
    we expect that agents will be self-interested to
    some extent.
  • When you hire a broker to help you buy a house,
    for example, he is paid a commission that is a
    percentage of the value of the sale. Thus, he
    will not necessarily be interested in getting you
    the best price.
  • Therefore, there is potential for conflict of
    interest in all agency relationships. This is
    known as the agency problem.

78
The agent-principal problem
  • Especially in a large corporation that is managed
    by agent-managers, not the owners, the managers
    are effectively in control of the company.
  • In general, the agent-manager wants to take the
    most that he can for his position, but we, as
    owner-principals, want to pay him the least since
    his cost is our expense.

79
The agent-principal problem
  • It is a fine line to walk if we, as owners, pay
    too little, we might not get good management. If
    we pay too much, it also affects our wealth
  • What managers wants might not be all in terms of
    dollars but will include their desire for power.
  • Thus, it has been argued that, if not put in
    check, managers would tend to try to maximize the
    resources over which they have control.

80
The agent-principal problem
  • Thus, not only might managers try to get as much
    financial compensation as they can, but they also
    might make decisions that are in their interest,
    not the shareholders.
  • They might not take on potentially lucrative
    projects because they are afraid that they will
    not do a good job and they will lose their jobs.

81
The agent-principal problem
  • They might buy other companies at too high a
    price, just so they can have control over an even
    larger corporation. They might try to increase
    current profits at the sacrifice of future
    profits to make the stock market price high
    because their compensation is in the form of
    options to buy stock. The higher the stock
    price, the more they will earn.
  • Thus, there are a number of different ways that
    management might not follow their mandate of
    maximizing owners wealth.

82
Agency costs
  • Agency costs are the losses borne by the owners
    of the firm that can be attributed to the agent
    having different objectives to the owners (or
    principals).
  • For example
  • HIH had a CEO making large donations of corporate
    funds for his personal gain and the company went
    bust.
  • A corporate executive uses the company jet for to
    visit his model girlfriend in New York City every
    weekend.

83
Whos interested?
  • To get management interested in shareholders
    interest can be affected by two things
  • How are managements interests aligned with
    shareholders? If they own a lot of stock and
    they are partly compensated in stock, they might
    be more interested, but there are pitfalls, as we
    mentioned in a previous slide.
  • How easily can management be replaced? Then,
    they would lose their status and control.

84
Compensation
  • People might say that it is good for management
    to have ownership and compensation in shares.
  • After all, increasing shareholder wealth affects
    their own compensation and wealth.
  • We already looked at one counterexample in a
    previous slide. Another might come when the
    managers wealth depends too much on the stock
    price. That led the CEO of MCI, in the U.S., to
    actually commit fraud in the companys accounting.

85
Compensation
  • In the bigger picture, a corporate executive who
    does a good job at managing a company and
    accomplishing goals the of shareholders will find
    that his value in the labor market will also be
    increased.
  • For bad managers, the opposite will be true.

86
Control
  • Shareholders vote for directors, and directors
    hire and fire managers.
  • If enough shareholders solicit directors to fire
    current management, that might happen.
  • Another means to accomplish a change is to vote
    at a shareholders meeting for a new board of
    directors.
  • That may or may not be easy to accomplish, but
    there are means.

87
How corporate voting works
  • One share of stock of a corporation entitles you
    to one vote. Thus, if you own 10 of the
    outstanding shares, you have 10 of the total
    voting power of the company.
  • Each year, corporations have an annual meeting at
    which board members are elected.
  • Directors solicit proxies from the shareholders
    to vote their shares. A proxy is the
    authorization by the shareholder for the board to
    vote his or her shares.

88
A Proxy Fight
  • One means of replacing directors is by what is
    called a proxy fight.
  • In a proxy fight, a group of people seek the
    proxies of shareholders to vote for an alternate
    board of directors.
  • If the group can convince enough shareholders to
    give them their proxies, they can replace the
    board and the management.

89
Corporate takeover
  • Since ownership of a corporation is represented
    by its shares of stock, the way to buy a
    corporation is by buying all of the shares of
    stock of the corporation.
  • If stock is publicly held and trades in the stock
    market, another company that is seeking to buy
    the company will have to somehow convince all of
    the shareholders to sell them their shares.

90
Corporate takeover
  • This threat of change in control to management
    and the board of directors provides another
    incentive for both to do their jobs properly.
  • Poorly-run companies will tend to be undervalued,
    and more profit can be gained by the buyer.
    Therefore they will be more of a target.

91
Conclusion
  • We have seen both sides of the issue of agents
    and principals in a corporate setting.
  • Those same arguments and problems will apply to
    any situation where there is separation of owners
    and management.
  • There has been response, on both sides over the
    years.

92
Conclusion
  • Now, there are systems of so-called staggered
    boards of directors wherein one-third of the
    directors, for example, can be replaced in any
    one year. Thus, it would take three years to
    replace all of the current directors.
  • There have been and still are multi-tier stock
    systems wherein, for example, class A-shares
    might hold a majority of the votes, while class B
    shares represent most of the actual equity in the
    corporation.

93
Conclusion
  • On the other hand, recent legislation in several
    countries now requires board members to attest,
    in writing, to the truth of accounting numbers.
    That leaves them open to conviction for fraud and
    some jail time, at least.
  • The inventiveness of people will continue to
    shape the issue on both sides.

94
Conclusion
  • In the end, it is all about having the people who
    put up the money for a business to be treated
    fairly since they are the ones who have their
    money at risk.
  • Indeed, other people, besides shareholders, have
    interest in corporations. We shall talk about
    stakeholder interest in the next slide.

95
Stakeholder happiness
  • People other than the owners have interests in
    how the company is run. Stakeholders refers to
    all of the groups that may have an interest in
    the companys conduct.
  • Stakeholders include employees, customers,
    suppliers, debtors, regulators, and the general
    public. Those groups also have an interest in the
    success or failure of your business.

96
Corporate social responsibility
  • Especially, in todays world in which companies
    pollute the environment or treat employees
    unfairly, there has been a call for corporations
    to be more responsible to society as a whole.
  • Corporate social responsibility (CSR) means that
    the firm has a wider range of responsibilities,
    in relation to both objectives and people, apart
    from the owners or stakeholders. For example,
    not polluting a town where they have their plant.

97
Corporations and Financial Markets
98
The corporate advantage
  • Corporations have the advantage that they can get
    both forms of capital, debt and equity, from all
    types of sources, including markets and banks
    (intermediaries).
  • An additional advantage is that the securities
    that they give out, in return for funding, are
    easily transferable between old and new owners.
  • That transferability might be even further
    enhanced, if the securities are traded in a
    market.

99
The Functions of the Financial System
  • Five functions
  • Facilitates settlement of commercial transactions
  • Facilitates the flow of funds
  • Facilitates the transfer of risk
  • Generates price information which provides the
    signals for decentralized decision making.
  • Provides ways of dealing with incentive problems,
    like the agent-principal problem.

100
Financing business operations
  • Sources of financing are direct or indirect
  • In direct finance the supplier of funds (called
    surplus units) and the user of funds (called
    deficit units) deal with one another, directly.
  • This happens when a company issues stock or debt
    securities directly to investors. It could be a
    private placement to a small group (even as small
    as 1) investors or a public offering to the
    general public.
  • In Intermediated finance, a financial
    intermediary collect funds from suppliers and,
    then, dole them out to fund users. Banks, for
    example, take deposits and then make loans from
    the pooled deposits.

101
Costs of Finding Financing
  • Just like everything else, it costs money to
    raise funds for a business, whether its from a
    bank or from investors.
  • Transaction costs are the costs, in terms of both
    time and explicit cash costs, of doing a
    transaction, e.g., getting financing.
  • A loan broker or a bank might charge you a fee.

102
Costs of Finding Financing
  • If you issue (sell) securities, you will have to
    find someone to assist you in the selling.
  • Or you might decide that you dont want to pay
    investment banker, regulators, lawyers,
    accountants, or brokers to get money for your
    business, but it may take years of time, money,
    and energy to find someone on your own, or no one
    at all.

103
Debt and Equity Defined
  • Debt is a contractual arrangement to borrow money
    that will be repaid in the future.
  • Equity represents an ownership interest, so there
    is no expectation that it will be repaid in the
    future. Equity holders can get their money back
    by selling their ownership interest. For
    corporations, that ownership interest is
    represented by shares of stock.
  • In accounting terms, A L E, Assets less
    liabilities Book equity.

104
Financial markets direct financing
  • Direct financing is done in the financial
    markets, like the stock market, but we have to be
    more precise.
  • There are various types of markets for different
    purposes and for different types of transactions.
  • They all provide an alternative to intermediated
    finance for which there are real costs of
    intermediation.

105
Roles of financial markets
  • The financial markets in Australia fulfill many
    roles including
  • Matching supply and demand for excess
    savings/investment funds.
  • Facilitating business and trade through the
    clearing of transactions.
  • Facilitating the saving of individuals for future
    consumption
  • Providing of financial services
  • Providing Price Information for securities and
    other commodities (Price discovery function).

106
What Market ??
  • What is it a market of? A market must have
    goods, like the vegetable market, the flower
    market. In the financial market we have
  • Securities are documents (contracts) which
    provide evidence of a loan, a bond or a
    commercial bill, for example, or shares of stock,
    which represent equity of a corporation
  • Price discovery is the process of finding and
    settling on a price which is acceptable to both
    parties. It is thus a source of price
    information for all.

107
Picture of a Bond
Face Value
108
Picture of Stock
International securities tracking system number
Craig L. Mattoli
Registration serial number just like on paper
money
109
Financial definitions
  • Maturity (or term to maturity) is the contracted
    time that may elapse before the borrowed funds
    are to be repaid. Bonds for example have a date
    on which they are due for payoff. Equity is
    usually perpetual (forever), unless the company
    goes bust.
  • Then, we define
  • Financial structure of a business as the mix,
    the percentage, of debt and equity which fund the
    assets owned by the business. Assets
    Liabilities (including various maturities of
    debt) Equity

110
Debt definitions
  • Face value is the amount that will be repaid upon
    maturity of the debt security
  • Face value is specified at the time the debt
    security is issued. It will be shown on the face
    (front) of the security.
  • Debt discount securities are issued at a price
    less than the face value. Examples, for
    short-term, are promissory notes and commercial
    bills. Long-term examples are zero-coupon bonds.

111
Financial markets
  • The financial markets are not a specific place.
  • Financial markets include all of the means of
    making financial contracts, which is what
    securities and other types of financial
    instruments are.
  • The other important function is providing a means
    of buying and selling of those contracts.

112
Financial markets
  • For markets we also speak of their
    decentralization.
  • I dont have to walk to Tokyo to buy shares of
    Toyota.
  • The decentralization of financial markets can be
    attributed to the price discovery mechanism,
    which provides price, readily, to buyers and
    sellers, and information and communication
    networks, which allow information to flow freely
    and trades (buying and selling), to be done at a
    distance.

113
Classifying the markets
  • There are 4 main types of binary divisions in
    financial markets
  • primary or secondary
  • public or private
  • money or capital markets
  • Exchange traded OTC traded

114
First Dichotomy
  • A primary market is where securities are offered
    for the first time that is its only function
  • A company sells debt or equity securities
    directly to investors.
  • We call that selling issuing because the company
    has to make up the security (contract) and give
    it (issue it) to investors.

115
First Dichotomy
  • Money goes to the issuer from the investor. That
    can be done by public offer (IPO) or private
    placement.
  • In that regard, securities are issued for the
    first time, in this market
  • Since securities are issued for the first time,
    issues increase the amount of securities
    outstanding.

116
First Dichotomy
  • Secondary markets are markets for trading
    securities, which have already been issued -
    second-hand securities.
  • Secondary market trades do not increase the stock
    of securities. They do, however, offer owners of
    the securities liquidity, the ability to dump the
    investment. That liquidity is also important in
    deposit taking institutions you can get money
    when you need it.
  • Money goes to previous security holder.

117
Issuing Securities
  • There are 2 ways to issue securities
  • In a public offering, securities are offered for
    sale to the general public.
  • In order to do that, a company will have to hire
    lawyers, accountants, investment bankers
    (underwriters) and brokers. That can cost a lot
    of money.
  • It will also have to file a prospectus, which is
    a detailed information document, and register the
    securities with the ASIC (Australian Securities
    and Investments Commission).

118
Issuing Securities
  • Then, the securities will be transferable among
    the general public.
  • The other alternative for issuance is by private
    placement.
  • The advantage of private placement is that the
    securities do not have to be registered.
  • It also avoids all of the expense of public
    offer, but the securities will not be
    transferable.

119
The Importance of secondary markets
  • Price discovery is an important aspect.
  • The ability to convert maturity is important. In
    that regard, you do not have to hold a 30-year
    bond to maturity. You can sell it and shorten
    your holding period, thus, controlling the
    maturity of your investment horizon.
  • The secondary market also promotes the primary
    market. It is one thing to buy an investment.
    You will feel a lot better and will not ask for
    such a good price, if you know that you can sell
    it. You can sell it in the secondary market.

120
Trading Division
  • For Public securities, there are two means of
    trading (buying and selling) of securities
    auction markets and dealer markets.
  • Physical exchanges, like the ASX, are central
    marketplaces where securities are traded.
  • To be traded on an exchange, they must first meet
    requirements set by the exchange for listing of
    the security by the exchange.
  • These are also called auction markets because
    they run continuous auctions in the securities.

121
Trading Division
  • The alternative trading market is called a dealer
    market or an over the counter (OTC) market.
  • In contrast to a central physical marketplace,
    like an exchange, OTC markets are networks of
    dealers in securities, interconnected by
    communications and electronic systems.
  • Dealers maintain inventories of securities and
    buy and sell for themselves.
  • The NASDAQ in the US is one such OTC market.

122
Securities and Secondary Markets.
  • After a security makes its public début, it does
    not automatically appear on a secondary market.
  • An application for listing the security must be
    made in a particular market.
  • Listing requirements on the ASX, for example,
    require that the market value of shares is 10
    million with 5,000 holders of at least 2,000
    value of holdings.
  • After it finds a home in a secondary market, it
    can be traded (bought and sold).
  • Those transactions are among old and new owners.
    The company is no longer involved.

123
Temporal Market Division
  • Money markets deal in short-term debt
  • bills, promissory notes and certificates of
    deposit, usually a year or less
  • Capital markets deal in long-term instruments
  • debentures, secured or unsecured notes, leases,
    loans, stock shares and convertible notes

124
What you Get
  • Debt holders receive interest payments from the
    borrower (and eventually, at maturity, the
    principal amount of the loan)
  • Interest payments provide a tax deduction for the
    borrower.
  • Interest income is taxable income for the holders
    of bonds and other debt.
  • Equity holders may receive dividends,
    periodically, or not. They own shares of stock.
  • Dividends are not tax deductible, but give the
    shareholder imputation credits if they are franked

125
Seniority Ranking securities
  • The name security for a piece of paper like a
    stock or bond certificate came from the idea that
    some loans and equity are secured by the
    underlying assets of a business.
  • Securities have seniority in liquidation.
    Secured debt is the most senior, gets paid off,
    first next, unsecured debt then, preferred
    stock, and finally common equity.

126
Corporate market value
  • The value of a publicly-traded corporation is the
    market capitalisation of the company
  • Market capitalisation is the total value of a
    corporation as measured by the price of each
    issued share multiplied by the number of issued
    shares. For example, if XYZ Corp. has 1 million
    shares, which are priced at 50/share, in the
    stock market, the total market capitalization is
    50/share x 1 million shares 50 million.
  • Market value of a debt or any security is
    calculated as the value of each security times
    the number outstanding.

127
Summary Making a company
  1. You want to start a company.
  2. You will, first, need funding for both long-term
    assets and working capital.
  3. Assuming that you are big enough, you hire an
    investment banker to help you issue equity
    (stock) and debt (bonds, debentures, notes,
    commercial bills) securities in the primary
    markets.
  4. Investors buy your securities. You get the net
    proceeds from the sales, after paying transaction
    costs to underwriters, lawyers, accountants, etc.
  5. With those funds (the liability and equity side
    of your balance sheet), you buy business assets.

128
Summary Making a company
  1. You start and run your business.
  2. If the business goes well, you will generate cash
    flows from your assets.
  3. Those cash flows will go to pay interest to debt
    holders and dividends to stockholders, expenses
    to stakeholders and taxes.
  4. If there is any extra money leftover, you
    reinvest it in the business to make your business
    grow.
  5. You might also go back to the markets to issue
    more securities to get additional capital.

129
Summary
  • We summarize the corporation, in terms of the
    cash flows that we discussed, in this chapter.

Company gets money by issuing securities
Financial markets Invest in and value firm
Firm invests money in assets
Reinvestment
CF from assets
Payments to security holders
Stakeholders Government
130
Finance in a nutshell most important slide
  1. Some people have extra money that they want to
    save.
  2. Other people need extra money and they want to
    borrow savings from the savers.
  3. Savers want not only the money they lent but also
    payment, in the form of interest or another
    return.
  4. Companies issue contracts, bonds, stocks,
    promissory notes, that promise future payments.

131
Finance in a nutshell most important slide
  1. Money that comes in the future is not who what it
    is today because inflation of prices of goods
    means that 1 will buy less in the future than it
    will now.
  2. So, to make a return, savers (investors) have to
    value the future payments to know what to pay for
    them now and also make extra to be able to have
    more future buying power with the money they get
    in the future.

132
Finance in a nutshell most important slide
  1. Companies, in turn, invest the money that they
    get from investors in new business projects.
  2. The companies will need to use their cost of
    capital (COC), the percentage rate of annual
    return that they pay for funds to investors, to
    evaluate business projects to make sure that
    those projects pay enough return to pay the
    companys COC and maybe have some extra return
    for the owners, the stockholders.

133
Tutorial problems for hand-in
  • Attempt questions 1.1 to 1.6, 1.10 and 1.12 of
    chapter one in your text.
  • Due for hand in at tutorial.

134
Thinking Question
  • A frog falls into a 50 meter deep well. He
    climbs up the well wall 2 meters a day, but he
    slips back down 1 meter, each night. How many
    days will it take him to get out of the well?

135
Exam caliber question
  1. Should a the managers of a company do anything
    and everything possible to maximize shareholders
    wealth? If there should be some limitations, can
    management still achieve that goal?

136
Ask yourself
  1. What are securities?
  2. Why do people buy them?
  3. Why do other people issue them?
  4. What is the difference between a bond and a
    stock?
  5. How can you find out what a security is worth?

137
Ask yourself
  • What is an agent?
  • What is a principal?
  • Why should they have problems with one another?

138
End
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