01 02 Overview Fin Mngt

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Introduction to

Corporate Finance

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Learning Objectives

1. Understand the importance of finance inyour personal and professional lives andidentify the three primary businessdecisions that financial managers make.

2. Identify the key differences between threemajor legal forms of business.

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Learning Objectives

3. Understand the role of the financialmanager within the firm and the goal formaking financial choices.

4. Explain the four principles of finance thatform the basis of financial managementfor both businesses and individuals.

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Learning Objectives

5. Describe the structure and functions of

financial markets.6. Distinguish between commercial banks

and other financial institutions in the

financial marketplace.7. Describe the different securities markets

for bonds and stock.

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What Is Finance?

Determining value.

Value = what something is worth now.Making the best decision when that decisioninvolves money.

Finance is concerned with:

Finance is the study of how peopleand businesses evaluate investmentsand raise capital to fund them.


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Three Questions Addressed by the

Study of Finance:1. What long-term investments should the firm

undertake? (capital budgeting decisions)

2. How should the firm fund these investments?(capital structure decisions)

3. How can the firm best manage its cash flows as

they arise in its day-to-day operations?(working capital management decisions)

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Three Areas of Finance

Corporate Financial Management

Viewpoint of an individual firmInvestments

Viewpoint of individual investors

Financial Markets and Intermediaries Viewpoint of a third party facilitating investor-firm

interactions


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How do we use corporate resourcesefficiently to further the goals of thefirm?

Decisions are based on The Principlesof Finance

Corporate Financial Management


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Investments

The study of financial transactions from theviewpoint of investors outside the firm.

Examples include: How do we place a dollar value on a share of stock

or a bond issued by the corporation?

How do we assess the risk of these financialsecurities?

How do we manage a portfolio of financial

securities to achieve a stated objective of the

investor?


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Financial Markets and Intermediaries

The study of markets where financialsecurities (such as stocks and bonds) are

bought and sold.

The study of financial institutions (such ascommercial banks, investment banking

firms, and insurance companies) that helpthe flow of money from savers todemanders of money.


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Why Study Finance?

Knowledge of financial tools is critical to makinggood decisions in both professional world and

personal lives.Finance is an integral part of corporate world

Many personal decisions require financial knowledge

(for example: buying a house, planning forretirement, leasing a car)

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Business Organizational Forms

BusinessForms

SoleProprietorships

PartnershipsCorporations

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Sole Proprietorship

It is a business owned by a single individual that isentitled to all the firms profits and is responsible

for all the firms debt.

There is no separation between the business andthe owner when it comes to debts or being sued.

Sole proprietorships are generally financed bypersonal loans from family and friends andbusiness loans from banks.

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Sole Proprietorship (cont.)

Advantages: Easy to start

No need to consult others while makingdecisions

Taxed at the personal tax rate

Disadvantages: Personally liable for the business debts Ceases on the death of the proprietor

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Partnership

A general partnership is an association of twoor more persons who come together as co-

owners for the purpose of operating a businessfor profit.

There is no separation between the partnershipand the owners with respect to debts or beingsued.

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Partnership (cont.)

Advantages:

Relatively easy to start

Taxed at the personal tax rate

Access to funds from multiple sources orpartners

Disadvantages:

Partners jointly share unlimited liability

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Corporation

Corporation is an artificial being, invisible,

intangible, and existing only in the contemplation

of the law.

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Corporation (cont.)

Corporation can individually sue and be sued,purchase, sell or own property, and its personnel

are subject to criminal punishment for crimescommitted in the name of the corporation.

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Corporation (cont.)

Corporation is legally owned by its currentstockholders.

The Board of directors are elected by the firms

shareholders. One responsibility of the board of

directors is to appoint the senior management ofthe firm.

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Corporation (cont.)

Advantages

Liability of owners limited to invested funds

Life of corporation is not tied to the owner

Easier to transfer ownership

Easier to raise Capital

Disadvantages Greater regulation

Double taxation of dividends

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How Does Finance Fit into the Firms

Organizational Structure?

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The Goal of the Financial Manager

The goal of the financial manager must beconsistent with the mission of the corporation.

What is the generally accepted mission of acorporation?

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To maximize firm value shareholderswealth (as measured by share prices)


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Corporate Mission: Coca-Cola

To achieve sustainable growth, we have

established a vision with clear goals: Maximizing

return to shareholders while being mindful of ouroverall responsibilities (part of Coca-Colasmission statement)

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Corporate Mission: GraceKennedy

We will grow long term shareholder value by

satisfying the unmet needs of Caribbean

people (part of GraceKennedys visionstatement)

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Corporate Mission

While managers have to cater to all the stakeholders(such as consumers, employees, suppliers etc.), they

need to pay particular attention to the owners of thecorporation i.e. shareholders.

If managers fail to pursue shareholder wealth

maximization, they will lose the support of investors andlenders. The business may cease to exist andultimately, the managers will lose their jobs!

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Limitations of Profit Maximization

Static nature of standard microeconomic

model (Lack of time dimension)Variable definition of profit

Provides no direct way for managers toconsider the risk of alternative decisions


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Ethics in Finance

What do we mean by Ethics?

Give examples of recent financial scandals anddiscuss what went wrong from an ethicalperspective.

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Agency Considerations in Corporate

FinanceAgency relationship exists when one or morepersons (known as the principal) contracts with

one or more persons (the agent) to makedecisions on their behalf.

In a corporation, the managers are the agentsand the stockholders are the principal.

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Agency Considerations in Corporate

Finance (cont.)Agency problems arise when there is conflict ofinterest between the stockholders and the managers.

Such problems are likely to arise more when themanagers have little or no ownership in the firm.

Examples:

Not pursuing risky project for fear of losing jobs, stealing,expensive perks.

All else equal, agency problems will reduce the firmvalue.

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How to Reduce Agency Problems?

1. Monitoring

(Examples: Reports, Meetings, Auditors, board ofdirectors, financial markets, bankers, credit agencies)

2. Compensation plans(Examples: Performance based bonus, salary, stockoptions, benefits)

3. Others

(Examples: Threat of being fired, Threat of takeovers,Stock market, regulations such as SOX)

The above will help to reduce agency problems/costs. 32


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Copyright 2011 Pearson Prentice Hall. All rights reserved.

THE FOUR BASIC

PRINCIPLES OF FINANCE


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PRINCIPLE 1: Money Has a Time

Value.A dollar received today is more valuable than adollar received in the future.

We can invest the dollar received today to earninterest. Thus, in the future, you will have more thanone dollar, as you will receive the interest on yourinvestment plus your initial invested dollar.

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PRINCIPLE 2: There is a Risk-

Return Trade-off.We only take risk when we expect to becompensated for the extra risk with additional

return.Higher the risk, higher will be the expectedreturn.

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PRINCIPLE 3: Cash Flows Are The

Source of Value.Profit is an accounting concept designed tomeasure a businesss performance over an

interval of time.

Cash flow is the amount of cash that can actuallybe taken out of the business over this sameinterval.

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Profits versus Cash

It is possible for a firm to report profits but haveno cash.

For example, if all sales are on credit, the firmmay report profits even though no cash is being

generated.

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Incremental Cash Flow

Financial decisions in a firm should considerincremental cash flow i.e. the difference

between the cash flows the company willproduce with the potential new investment its

thinking about making and what it would make

without the investment.

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PRINCIPLE 4: Market Prices Reflect

Information.Investors respond to new information bybuying and selling their investments.

The speed with which investors act andthe way that prices respond to newinformation determines the efficiency ofthe market. In efficient markets likeUnited States, this process occurs veryquickly. As a result, it is hard to profitfrom trading investments on publicly

released information. 39


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PRINCIPLE 4: Market Prices Reflect

Information. (cont.)Investors in capital markets will tend to reactpositively to good decisions made by the firm

resulting in higher stock prices.

Stock prices will tend to decrease when there is

bad information released on the firm in thecapital market.

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Three Players in the Financial Markets

1. Borrowers: Individuals and businesses that needmoney to finance their purchases or investments.

2. Savers (Investors): Those who have money toinvest. These are principally individuals althoughfirms also save when they have excess cash.

3. Financial Institutions (Intermediaries): Thefinancial institutions and markets help bringborrowers and savers together.

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Financial Intermediaries

Financial institutions like commercial banks,finance companies, insurance companies,

investment banks, and investment companiesare called financial intermediaries as they helpbring together those who have money (savers)

and those who need money (borrowers).

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Security Markets

Firms make direct transactions in financialmarkets.

The concepts and principles that apply tofinancial markets also apply to themanagement of real assets.

Security markets provide information andsignals that help managers make decisions.

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Why Security Markets Exist

Security markets facilitate the transfer ofcapital (i.e financial) assets from one owner to

another.They provide liquidity.

Liquidity refers to how easily an asset can be

transferred without loss of value.A side benefit of security markets is that thetransaction price provides a measure of the

value of the asset. 45


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Money versus Capital Market

The money market refers to debt instrumentswith maturity of one year or less.

Examples: Treasury bills (T-bills), Commercial paper(CP).

The capital market refers to long-term debt and

equity instruments. Examples: Common stock, Preferred stock,

Corporate bond, Treasury bond, Municipal bond.

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Non-Bank Financial Intermediaries

These include:

Financial services corporations, like GE Capital

Division, First Global Financial; Insurance companies, like Prudential, Sagicor;

Investment banks, like Goldman Sachs, NCB

Capital Markets;

Investment companies including mutual funds,hedge funds and private equity firms.

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Mutual Funds and Exchange TradedFunds (ETFs)

Mutual funds are professionally managedaccording to a stated investment objective.

Individuals can invest in mutual funds by buyingshares in the mutual fund at the net asset value(NAV). NAV is calculated daily based on the total

value of the fund divided by the number ofmutual fund shares outstanding.

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Mutual Funds and Exchange TradedFunds (ETFs) (cont.)

Mutual funds can either be load or no-loadfunds. The term load refers to the sales

commission that you pay when acquiringownership shares in the fund. Thesecommissions typically range between 4.0 to

6.0%.A mutual fund that does not charge acommission is referred to as a no-load fund.

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An exchange-traded fund (ETF) is similar to amutual fund except that the ownership shares in

the ETF can be bought and sold on the stockexchange.

Most ETFs track an index, such as the Dow

Jones Industrial Average or the S&P 500, andgenerally have relatively low expenses.

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Mutual funds and ETFs provide a cost-effectiveway to diversify and reduce risk.

If you had only $10,000 to invest, it would bedifficult to diversify since you will have to paycommission for each individual stock. However, bybuying a mutual fund that invests in S&P 500,youcan indirectly purchase a portfolio that tracks 500stocks with just one transaction. Alternatively, youmight purchase an ETF, such as SPDR S&P 500

(SPY), which tracks S&P 500. 53


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Hedge Funds

Hedge funds are similar to mutual funds butthey tend to take more risk and are generally

open only to high net worth investors.Management fees also tends to be higher forhedge funds and most funds include an incentive

fee based on the funds overall performance,which typically runs at 20% of profits.

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Private Equity Firms

Private equity firms include two major groups:Venture capital (VC) firms and Leveraged buyout

firms (LBOs).

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Private Equity Firms (cont.)

Venture capital firms raise money frominvestors (wealthy individuals and other financial

institutions) that they then use to providefinancing for private start-up companies whenthey are first founded.

For example, Venture capital firm, KleinerPerkins Caufield & Byers (KPCB) was involvedin the initial financing of Google.

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Private Equity Firms (cont.)

Leveraged buyout firms acquire established firmsthat typically have not been performing very well withthe objective of making them profitable again and

selling them. An LBO typically uses debt to fund thepurchase of a firm. LBO transactions grew from $7.5billion in 1991 to $500 billion in 2006.

Prominent LBO private equity firms include CerberusCapital Management, L.P., TPG (formerly TexasPacific Group), and KKR (Kohlberg, Kravis, and

Roberts). 57


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Security

A security is a negotiable instrument thatrepresents a financial claim and can take the

form of ownership (such as stocks) or debtagreement (such as bonds).

The securities market allow businesses andindividual investors to trade the securities issuedby public corporations.

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Primary versus Secondary Market

A primary market is a market in whichsecurities are bought and sold for the first time.

In this market, the firm selling securities actuallyreceives the money raised. For example,securities sold by a corporation to investment

bank.

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Primary versus Secondary Market(cont.)

A secondary market is where all subsequenttrading of previously issued securities takes

place. In this market, the issuing firm does notreceive any new financing. The securities aresimply transferred from one investor to another.

Thus secondary markets provide liquidity to theinvestor. For example, the New York StockExchange.

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H S i i M k B i


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How Securities Markets BringCorporation and Investors Together

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Types of Securities

Debt Securities: Firms borrow money by sellingdebt securities in the debt market.

If the debt has a maturity of less than one year, itis typically called notes, and is traded in themoney market.

If the debt has a maturity of more than one year,it is called bond and is traded in the capitalmarket.

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Types of Securities (cont.)

Most bonds pay a fixed interest rate on the faceor par value of bond.

For example, a bond with a face value of $1,000and semi-annual coupon rate of 9% will pay aninterest of $45 every 6 months or $90 per year,

which is 9% of $1,000. When the bond matures,the owner of the bond will receive $1,000.

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Equity securities represent ownership of thecorporation.

There are two major types of equity securities:common stock and preferred stock.

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Dividend on common stock are neither fixed norguaranteed. Thus a company can choose to

reinvest all of the profits in a new project and payno dividends.

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Preferred stock is an equity security. However,preferred stockholders have preference withregard to:

Dividends: They are paid before the commonstockholders.

Claim on assets: They are paid before commonstockholders if the firm goes bankrupt and sellsor liquidates its assets.

Preferred stock is also referred to as a hybridsecurity as it has features of both common stock

and bonds. 68


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Preferred stock is similar to common stocks in that:

It has no fixed maturity date,

The nonpayment of dividends does not result inbankruptcy of the firm, and

The dividends are not deductible for tax purposes.

Preferred stock is similar to corporate bonds in that:

The dividends are typically a fixed amount, and

There are no voting rights.

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Stock Markets

A stock market is a public market in which thestocks of companies is traded.

Stock markets are classified as either organizedsecurity exchanges or over-the-counter (OTC)

market.

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Stock Markets (cont.)

Organized security exchanges are tangibleentities; that is, they physically occupy space

and financial instruments are traded on theirpremises. For example, the New York StockExchange (NYSE) is located at 11 Wall Street inManhattan, NY. The total value of stocks listedon the NYSE fell from $18 trillion in 2007 to justover $10 trillion at the beginning of 2009.

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NEW YORK STOCK EXCHANGE

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Stock Markets (cont.)

The over-the-counter markets include allsecurity market except the organized

exchanges.NASDAQ (National Association of SecuritiesDealers Automated Quotations) is an over-the-

counter market and describes itself as a screen-based, floorless market. In 2009, nearly 3,900companies were listed on NASDAQ, includingStarbucks, Google, Intel.

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Jamaica Stock Market

Securitiestraded throughbrokers(regulated by

the FinancialServicesCommission)

BROKERSBarita Investments Ltd

Capital & Credit Securities Limited

First Global Financial Services Limited

JMMB Securities Ltd

M/VL Stockbrokers Ltd

Mayberry Investments Ltd

NCB Capital Markets LtdPan Caribbean Financial Services Ltd.

Scotia DBG Investments

Stocks and Securities Ltd (SSL)

Victoria Mutual Wealth Management Ltd.


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Jamaica Stock MarketFunctions through The Jamaica Central Securities Depository (JCSD):

The JCSD is a facility for holding securities which enables share transactions tobe processed by book entry. A book entry system is an accounting system which

facilitates the change of ownership of securities electronically between parties,

without the need for the movement of physical documents. In short, the JCSD is

an means of recording the ownership of shares.

Internationally, most people who own securities today don't physically hold thestock or bond certificates. Instead their securities are kept on their behalf by their

investment company which is called keeping securities in "street name". The

investment firms will deposit your share and bond certificates with the Jamaica

Central Securities Depository Limited which on settlement date (T+3), will

electronically settle all purchases and sales of shares and bonds without physicallymoving the certificates.

Investors should be aware that their securities are safeguarded by being held in"segregation" by their brokerage house. This means that they are held separate

and apart from those belonging to the broker/custodian and cannot be used by

the broker/custodian in his day-to-day business operations.


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