FINC2011 NOTES
INTRODUCTION TO FINANCE AND FINANCIAL MARKETS
WHAT IS FINANCE?
• Limited providers of funds
o Lenders may be
§ Households (Savings)
§ Companies (Surplus Funds)
§ Gov (Budget Surplus)
• Near limitless users of funds
o Borrowers may be
§ Households (Mortgage)
§ Companies (Buildings)
§ Gov (Budget Deficit)
• Supply and receive funds from financial markets
• Acquire financial and issue financial products
• Financial Markets
o Stock
o Foreign Exchange
o Money
• Financial Derivatives Markets- mainly for risk management
o Stock
o Foreign Exchange
o Money
• Financial Institutions
o Commercial banks
o Investment banks
o Etc
CORPORATION
• Legal entity owned by shareholders
• Articles of incorporation
o Set out purpose of business
o How it is to be governed and operated
• Board of directors elected by shareholders
• Shareholders have limited liability
o Cannot be held personally responsible for corporation’s debts
• Separation of ownership and control
o Gives corporations permanence
• Disadvantages
o Time and money managing legal
machinery
o Tax disadvantage
§ Shareholders taxed when
receiving dividends/sell shares at a profit
§ Corporation pay tax on profits
1
,CORPORATE OBJECTIVE OF A PUBLIC COMPANY
• Goal to maximise value of the firm
• Each stockholder wants 3 things:
1. To maximise wealth
2. To transform wealth into most desirable pattern of consumption
3. To manage risk characteristics of that consumption plan
• Stockholders don’t need financial manager’s help to achieve best time pattern of consumption
• Financial managers therefore help by increasing their wealth
o Therefore increasing market value of firm and current price of shares
MEASURING COMPANY VALUE – MARKET CAPITALISATION
• Market capitalisation = Number of Shares * Sale Price
MAXIMISING PROFIT VS MAXIMISING WEALTH
• Does maximising profit – maximise wealth?
o Corporation may be able to increase current profits by cutting back on outlays that may have added long-term
value
§ Not welcome higher short-term profits if long-term profits are damaged
o Company may be able to increase future profits by cutting year’s dividend and investing additional cash in the
firm
§ Not in shareholders’ best interest if company earns only a modest return on money
• Maximising short-term vs long-term
SUNBEAM – AL DUNLAP
• Albert J. Dunlap appointed CEO of Sunbeam 22 July 1996
• Share price went up 59% ON FIRST DAY – expected improvements
• Proposes large scale firings to improve the company
• Board approves plan in Nov 1996
• 50% of staff fired and 87% products eliminated
• Massive option packages for management team
• Results
o Oct 1997 share price reached $53
o 350% up since Dunlap took over
• Pressure to beat forecasts lead to dubious practices
o Short term decisions to beat forecasts
o Inventories built up as customers were encouraged to ‘pre-
purchase’ products at massive discounts
o Cash shortfalls – salaries being paid out of reserves
o Reserves used to ‘supplement’ revenue – of approx. $21.5
million
• All comes crashing down
o 4th quarter 1997 – EPS $0.24, $0.01 below Wall Street projections
o 3rd April 2998 Investor Relations chief and Internal Auditor resigns, share price falls- releases earnings and
ensures accounting standards
o 13 June 1998 – Al Dunlap fired. CFO fired.
2
, o Sunbeam filed for Chapter 11 protection after revealing losses of $898 million for 1998
o Sunbeam shares drop to $6 for almost a year before declining virtually to 0
SURVEYS
AGENCY PROBLEM
OWNERSHIP VS. MANAGEMENT
• Difference in Info
o Stock prices and returns
o Issues of shares and other securities
o Dividends
o Financing
• Different Objectives
o Managers vs. stockholders
o Top management vs. operating management
o Stockholders vs. banks and lenders
• Agency problems
o Managers, acting as agents for stockholders, may act in their own interests rather than maximising value
• Stakeholder
o Anyone with a financial interest in the firm
• Agency costs are incurred when:
1. Managers do not attempt to maximize firm value and
§ Cost to how money could have been invested
2. Shareholders incur costs to monitor the managers and constrain their actions
§ Management required to produce financial report outlining what happened- costing money
• Agency problem and Corporate Governance Solutions
1. Board of Directors- oversee management and financially compensated
2. Legal and Regulatory Requirements- fiduciary responsibilities
3. Compensation plans- maximise wealth
4. Monitoring
5. Takeovers
6. Shareholder pressure
CORPORATE FINANCE DECISIONS
• Mangers maximise firm value through their decisions
1. Investment decisions = purchase of real assets
2. Financing decisions = sale of financial assets
3. Dividend decisions = dividend policy
3
, THE INVESTMENT DECISION
• AKA capital budgeting/capital expenditure decisions
• What ‘real’ assets should the firm invest in to operate its business and generate cash flows?
• 2 important considerations involved:
o Type of assets firm should use
o How many assets it needs to run its business
• Development of a process to evaluate the desirability of asset purchases
o Capital budgeting evaluations
• Acquisition of ‘real’ assets normally the most important consideration
o Refers to physical assets
§ E.g. buildings/machinery used to manufacture a product for sale/to provide a particular service
• Often need to select the best real asset from a range of alternatives
• Investment decisions concerned with purchase of more intangible assets
o E.g. patents/shares in another company
• Cash returns not guaranteed
o Longer the wait, greater cash flow required to justify
• As long as corporation’s proposed investments offer higher rates or return than shareholders can earn for themselves
o Applaud investments and increase stock price
• Hurdle rate/cost of capital
o Minimum acceptable rate of return
• Opportunity cost of capital
o Depends on investment opportunities available to investors in financial markets and risk
THE FINANCING DECISIONS
• How should the firm raise funds to purchase assets?
o Capital structure decision- between debt and equity long-term financing
• Equity financing
o Issue shares of stock
o Take cash flow generated by existing assets and reinvest
• How does firm choose its gearing ratio?
• What are costs of each different source of finance?
• Should the firm issue short/long-term securities?
THE DIVIDEND DECISION
• Any decision or action that involve redistributing wealth to the owners of the corporation
• How should the firm pass on returns to shareholders?
o E.g. capital gains/dividends
• Payout decision
o Pay dividends or
o Repurchase shares
• This is dividend policy
NATURE OF ASSETS
• Assets can be divided into
o Real assets
§ Assets that can be put to productive use to generate a return
§ E.g. machinery and equipment
o Financial assets
§ Assets that represent a claim to a series of cash flows against an economic unit
§ E.g. bonds
4
INTRODUCTION TO FINANCE AND FINANCIAL MARKETS
WHAT IS FINANCE?
• Limited providers of funds
o Lenders may be
§ Households (Savings)
§ Companies (Surplus Funds)
§ Gov (Budget Surplus)
• Near limitless users of funds
o Borrowers may be
§ Households (Mortgage)
§ Companies (Buildings)
§ Gov (Budget Deficit)
• Supply and receive funds from financial markets
• Acquire financial and issue financial products
• Financial Markets
o Stock
o Foreign Exchange
o Money
• Financial Derivatives Markets- mainly for risk management
o Stock
o Foreign Exchange
o Money
• Financial Institutions
o Commercial banks
o Investment banks
o Etc
CORPORATION
• Legal entity owned by shareholders
• Articles of incorporation
o Set out purpose of business
o How it is to be governed and operated
• Board of directors elected by shareholders
• Shareholders have limited liability
o Cannot be held personally responsible for corporation’s debts
• Separation of ownership and control
o Gives corporations permanence
• Disadvantages
o Time and money managing legal
machinery
o Tax disadvantage
§ Shareholders taxed when
receiving dividends/sell shares at a profit
§ Corporation pay tax on profits
1
,CORPORATE OBJECTIVE OF A PUBLIC COMPANY
• Goal to maximise value of the firm
• Each stockholder wants 3 things:
1. To maximise wealth
2. To transform wealth into most desirable pattern of consumption
3. To manage risk characteristics of that consumption plan
• Stockholders don’t need financial manager’s help to achieve best time pattern of consumption
• Financial managers therefore help by increasing their wealth
o Therefore increasing market value of firm and current price of shares
MEASURING COMPANY VALUE – MARKET CAPITALISATION
• Market capitalisation = Number of Shares * Sale Price
MAXIMISING PROFIT VS MAXIMISING WEALTH
• Does maximising profit – maximise wealth?
o Corporation may be able to increase current profits by cutting back on outlays that may have added long-term
value
§ Not welcome higher short-term profits if long-term profits are damaged
o Company may be able to increase future profits by cutting year’s dividend and investing additional cash in the
firm
§ Not in shareholders’ best interest if company earns only a modest return on money
• Maximising short-term vs long-term
SUNBEAM – AL DUNLAP
• Albert J. Dunlap appointed CEO of Sunbeam 22 July 1996
• Share price went up 59% ON FIRST DAY – expected improvements
• Proposes large scale firings to improve the company
• Board approves plan in Nov 1996
• 50% of staff fired and 87% products eliminated
• Massive option packages for management team
• Results
o Oct 1997 share price reached $53
o 350% up since Dunlap took over
• Pressure to beat forecasts lead to dubious practices
o Short term decisions to beat forecasts
o Inventories built up as customers were encouraged to ‘pre-
purchase’ products at massive discounts
o Cash shortfalls – salaries being paid out of reserves
o Reserves used to ‘supplement’ revenue – of approx. $21.5
million
• All comes crashing down
o 4th quarter 1997 – EPS $0.24, $0.01 below Wall Street projections
o 3rd April 2998 Investor Relations chief and Internal Auditor resigns, share price falls- releases earnings and
ensures accounting standards
o 13 June 1998 – Al Dunlap fired. CFO fired.
2
, o Sunbeam filed for Chapter 11 protection after revealing losses of $898 million for 1998
o Sunbeam shares drop to $6 for almost a year before declining virtually to 0
SURVEYS
AGENCY PROBLEM
OWNERSHIP VS. MANAGEMENT
• Difference in Info
o Stock prices and returns
o Issues of shares and other securities
o Dividends
o Financing
• Different Objectives
o Managers vs. stockholders
o Top management vs. operating management
o Stockholders vs. banks and lenders
• Agency problems
o Managers, acting as agents for stockholders, may act in their own interests rather than maximising value
• Stakeholder
o Anyone with a financial interest in the firm
• Agency costs are incurred when:
1. Managers do not attempt to maximize firm value and
§ Cost to how money could have been invested
2. Shareholders incur costs to monitor the managers and constrain their actions
§ Management required to produce financial report outlining what happened- costing money
• Agency problem and Corporate Governance Solutions
1. Board of Directors- oversee management and financially compensated
2. Legal and Regulatory Requirements- fiduciary responsibilities
3. Compensation plans- maximise wealth
4. Monitoring
5. Takeovers
6. Shareholder pressure
CORPORATE FINANCE DECISIONS
• Mangers maximise firm value through their decisions
1. Investment decisions = purchase of real assets
2. Financing decisions = sale of financial assets
3. Dividend decisions = dividend policy
3
, THE INVESTMENT DECISION
• AKA capital budgeting/capital expenditure decisions
• What ‘real’ assets should the firm invest in to operate its business and generate cash flows?
• 2 important considerations involved:
o Type of assets firm should use
o How many assets it needs to run its business
• Development of a process to evaluate the desirability of asset purchases
o Capital budgeting evaluations
• Acquisition of ‘real’ assets normally the most important consideration
o Refers to physical assets
§ E.g. buildings/machinery used to manufacture a product for sale/to provide a particular service
• Often need to select the best real asset from a range of alternatives
• Investment decisions concerned with purchase of more intangible assets
o E.g. patents/shares in another company
• Cash returns not guaranteed
o Longer the wait, greater cash flow required to justify
• As long as corporation’s proposed investments offer higher rates or return than shareholders can earn for themselves
o Applaud investments and increase stock price
• Hurdle rate/cost of capital
o Minimum acceptable rate of return
• Opportunity cost of capital
o Depends on investment opportunities available to investors in financial markets and risk
THE FINANCING DECISIONS
• How should the firm raise funds to purchase assets?
o Capital structure decision- between debt and equity long-term financing
• Equity financing
o Issue shares of stock
o Take cash flow generated by existing assets and reinvest
• How does firm choose its gearing ratio?
• What are costs of each different source of finance?
• Should the firm issue short/long-term securities?
THE DIVIDEND DECISION
• Any decision or action that involve redistributing wealth to the owners of the corporation
• How should the firm pass on returns to shareholders?
o E.g. capital gains/dividends
• Payout decision
o Pay dividends or
o Repurchase shares
• This is dividend policy
NATURE OF ASSETS
• Assets can be divided into
o Real assets
§ Assets that can be put to productive use to generate a return
§ E.g. machinery and equipment
o Financial assets
§ Assets that represent a claim to a series of cash flows against an economic unit
§ E.g. bonds
4
