IntroductionFINS1613: Business Finance

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School of Banking and FinanceAustralian School of Business

UNSW

Robert Tumarkinr.tumarkin@unsw.edu.au

Business FinanceWorld View

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Our world view

Companies

What projects should I fund?

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Owners

In which companies should I own stock?

Our world view

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Project Cash Flows Risk

Discount RateProject Funding Decision

Our world view

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Key assumptions

Firm with professional management that does not own the firm

Firm has many owners, each is invested in many firms

Types of Firms

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Terminology

Ownership

The right to share in a firm’s profits

Control

The right to directly manage or elect management of a firm

Personal liability

The responsibility to pay a firm’s financial obligations using personal assets when the firm cannot

Limited liability

A limit that the owner can only lose the value of their investment when the firm cannot pay its financial obligations

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Sole trader

Business owned and controlled by a single person

Sole trader is personally liable for firm’s debts

Business ceases existence with death or withdrawal of the sole trader

Profits taxed at personal level

Also known as sole proprietorships

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Partnership

Business owned by several partners

• General partners:Ownership, control and personal liability

• Limited partners:Ownership, no control and limited liability

Profits taxed at personal level

Business ceases to exist with death or withdrawal of a single general partner unless other provisions are made

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Comparison

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Sole trader Partnership Limited PartnershipLimited Partnership

Type of owner N/A General partner General partner Limited partner

Number One Several One or more Several

Control Yes Yes Yes No

Liability Personal Personal Personal Limited

Taxation Personal Personal Personal Person

Corporations

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Board of directors

•Each director is elected by the firm’s owners

•Hires the Chief Executive Officer

•Monitors firm and sets high level strategy

•Objective is to maximize firm value

A B C D

CEO

CFO

Organizational structure

Corporations

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Chief Executive Officer (CEO)

•Everyday manager of the firm

• Implements rules and policies set by board of director

•Advised by high level executives

•Objective is to maximize firm value

A B C D

CEO

CFO

Organizational structure

Corporations

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Chief Financial Officer (CFO)

•Evaluates investment decisions for the firm

•Evaluates financing decisions for the firm

•Objective is to maximize firm value

A B C D

CEO

CFO

Organizational structure

The Financial Manager

We will focus on two primary responsibilities of the financial manager:

Investment decisions

• Which projects should the firm pursue?

Financing decisions

• How should the firm raise capital to finance these projects?

• How should the firm distribute profits to investors?

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Corporations

Capital structure

• Describes how firm value is split among different types of financial securities

• Common securities include

• Equity

• Debt

• Preference shares

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Total firm value(e.g. $100 million)

Capital structure

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Equity value(e.g. $60 million)

Debt value(e.g. $40 million)

Equity value(e.g. $20 million)

Debt value(e.g. $80 million)

or

Total Firm Value = Market Value of Equity + Market Value of Debt

Capital structure

Equity

• Ownership of a company is divided into common stock

• Stock owners, called shareholders, elect the Board of Directors

• Stock owners share in firm profits, which are uncertain and may be zero

• Public stock is traded on stock exchanges

Debt

• Lender of capital to a firm hold bonds

• Bond holders have no role in electing directors

• Bond holders receive prescribed payments

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Capital structure

Absolute priority

Requires a firm to make payment on debt before distributing money to equity holders

Administration (bankruptcy) and liquidation

Occurs when a firm cannot pay its prescribed payments to debt holders, an event called default

Control of the firm is given to the debt holders

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Capital structure

Example

Imagine a firm that has promised to pay bond holders $90 million in one year. Assume the firm will either earn $80, $100, or $120 million in one year.

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10

90

30

9080

Equity Value

Debt Value

Capital structure

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Equity Debt

Control Elects Board of Directors

Seizes firm on default

Payment amount Uncertain Prescribed

Payment order Last First

Risk High Low

Corporations!

Key features of a corporation

It is its own legal entity, distinct from the owners

There is a separation between ownership and management

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Corporations

Advantages over partnerships and sole traders

Limited liability for the owners

Business continues operation when ownership changes

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Agency costs

Definition

We assume that employees have their own personal objectives

These personal objectives may not always agree with the value maximizing objective of the firm’s owners

An agency cost arises when an employee takes an action that serves their own interests instead of maximizing firm value

Examples

A CEO may not invest in a profitable, but risky project if they are afraid of getting fired should the project fail

An employee may arrive late and leave early due to lack of interest and no managerial oversight

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TaxationFirm profits generate different after-tax values to owners depending on firm structure and the tax system

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Firm owner Limited partner ShareholderShareholder

Tax System Imputation Classical

Firm profits $100 $100 $100

Distribution method

Corporate Tax (30%)

Distributed Profits

Personal tax basis

Personal tax (45%)

Franking credit (equal to corporate tax)After-tax to owner

Corporations

Advantages over partnerships and sole traders

Limited liability for the owners

Business continues operation when ownership changes

Disadvantages compared to partnerships and sole traders

Agency costs between owners and management

Taxation (in jurisdictions with “classical” tax systems)

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Ownership comparison

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Sole trader Partnership Limited PartnershipLimited Partnership Corporation

Type of owner N/AGeneral partner

General partner

Limited partner

Shareholder

Number One Several One or more Several Many

Control Yes Yes Yes No Yes

Liability Personal Personal Personal Limited Limited

Taxation Personal Personal Personal Personal

Corporate and Personal

(depending on tax system)

Review

Firm structures

• Characteristics of sole trader, partnerships, corporations

Corporations

• Responsibilities of the financial manager

• Difference between equity and debt

• Advantages and disadvantages versus sole traders and partnerships

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Administrative

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Staff

Lecturers

Robert Tumarkin

• Weeks 1 -8

• Consultation: Thursday 2-4

Gloria Tian

• Weeks 9 - 12

• Consultation: Monday 3-5

Tutor

Peter Andersen (Tutor-in-charge)

Ning Ding, Yan Su, Bobby Wang, Howie Zhang

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Resources

Blackboard

Lecture slides

Tutorial assignments

Announcements

MyFinanceLab

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Assessments

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Assessments

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Stock Weight

Tutorial

Participation 15%

Attendance 5

Quizzes (Lowest of the 4 quizzes dropped) 40

Final Exam 40

100%

How to succeed

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Tutorials

Attend

Participate

Quizzes and final exam

Practice

• Questions in tutorials and the text

• MyFinanceLab

Know strategies for Multiple Choice Questions

Next week

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Next week

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Project Cash Flows Risk

Discount RateProject Funding Decision