FIN222 Autumn2015 Lectures Lecture 1

7/25/2019 FIN222 Autumn2015 Lectures Lecture 1

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FIN922 Corporate Finance

Dr. Kashif Saleem

E-mail: [email protected]

Office: Room 105, 1st floor

Consultation Hours for Autumn 2015

Suda! 1":00-1#:00 $%hrs&

'uesda! 1":(0 ) 15:(0 $1hr& * 1+:(0-1:(0 $1hr&

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The objective of this subject is to provide an introduction to the fundamental quantitative

techniques and underlying concepts and theories in investment, financing and working capital

management decisions facing corporations.

Time Value of Money

Stock and ond Valuation

!nvestment "ecision #ules

$apital udgeting "ecisions

#isk % #eturn, $ost of $apital

$apital Structure

"ividends % &ayout &olicy

'orking $apital Management


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UPON COMP!"ION OF "HI# #U$%!C" #"U&!N"# 'I $! A$! "O(

"emonstrate an understanding of how financial system works and calculate the value of different types

of cash flow streams including financial assets such as shares and bonds.

"emonstrate an understanding of risk, return and the $apital )sset &ricing Model and be able to

quantify risk and return and calculate the cost of equity.

*valuate the value of productive assets using a range of capital budgeting techniques.

$alculate the cost of capital and other quantitative measures used in working capital management

decision.

$ompute, interpret and apply diverse quantitative measures in making an optimal and socially

responsible investment decision. *+plain capital structure and dividend policy and their impact on the value of a company.


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COU(#! MA"!(IA#)

#oss, S., 'esterfield, #. ordan, ., and ley, . -/01Fundamentals of

Corporate Finance, Middle *astern *dition, Mc2raw34ill. -"e*t +oo,1

C-apter 1. 5/10. 1/1. 1/13

A44itional (ea4ins

righam, *., -/0/1Financial Management: Theory & Practice, Thomson South3'estern.

2itman, 5., uchau, #., and 6lanagan, . -/001Principles of Managerial Finance, &earson7)ddison 'esley.

6rin, )., 8hian, $., and 4ill, ). -/01 Introduction to Corporate Finance, &earson *ducation.

& ar r i no , #., 9 i dwel l , "., : ong , 4., M or k el 3 9 i ng s bur y , ;., " em ps e y, M. a nd M ur r ay, . -/ 0/1

Fundamentals of Corporate Finance, ohn 'iley.

&eirson, 2., rown, #., *aston, S., 4oward, &., &inder, S. -//


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Tutorial Tasks = Selected problem sets, 0/>, Sessions 3?, @ % , Sessions

D % 00 3 No ma,e/up 6ui77eswill be allowed

Mid3Session Test = />, covers all the topics till end of week E and includes

essay questions, problems, % M$Bs , 'eek ? during the lecture

6inal *+am = M$Bs, problem3solving and7or short essay questions, E/>, during

the official e+amination period


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#A"I#FAC"O(8 COMP!"ION

(!UI(!M!N"#

F:ou are e+pected to complete all assessments tasks for this

subject. !n addition, you must achieve a total mark of E/>

or over and obtain a minimum of E/> in the finale+amination.Students who do not meet these minimum

performance level requirements will be given a 6ail grade

of T6 -Technical 6ail1 grade on their )cademic Transcript,

in accordance with the 2eneral $ourse #ules.F


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To study of modern corporate finance and financial management, we

need to address two central issues.

6irst, what is corporate finance and what is the role of the financial

manager in the corporationG

Second, what is the goal of financial managementG

To describe the financial management environment,

we consider the corporate form of organiCation and discuss some

conflicts that can arise within the corporation.

'e also take a brief look at financial markets in the Hnited States.


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Intro4uction to CO(PO(A"!

FINANC!

: Finance( M);)2!;2 MI;*: Trade3off between the present and future

: )t the personal level(

earnings

savings

investing

: !n a business conte+t(

raise money invest money

reinvest profits

distribute them back to investors.


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'HA" I# CO(PO(A"!

FINANC!;

!magine that you were to start your own business. ;o matter what type

you started, you would have to answer the following three questions

in some form or another(

'hat long3term investments should you take onG That is, what lines

of business will you be in and what sorts of buildings, machinery,

and equipment will you needG

'here will you get the long3term financing to pay for your

investmentG 'ill you bring in other owners or will you borrow the

moneyG

4ow will you manage your everyday financial activities such as

collecting from customers and paying suppliersG


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"H! FINANCIA MANA

owners -the stockholders1 are usually not directly

involved in making business decisions

corporation employs managers to represent the

ownersJ interests and make decisions on their

behalf

!n a large corporation, the financial manager

would be in charge of answering the three

questions we raised


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A #ample #implifie4

Orani7ational C-art


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FINANCIA MANA


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FINANCIA MANA

) firmJs capital structure-or financial structure1 is the specific mi+ture of long3

term debt and equity the firm uses to finance its operations.

The financial manager has two concerns in this area.

6irst, how much should the firm borrowG That is, what mi+ture of debt and equity

is bestG The mi+ture chosen will affect both the risk and the value of the firm.

Second, what are the least e+pensive sources of funds for the firmG = pie diagram

6irms have a great deal of fle+ibility in choosing a financial structure!n addition to deciding on the financing mi+, the financial manager has to decide

e+actly how and where to raise the money.


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FINANCIA MANA


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Forms of $usiness Orani7ation

#O! P(OP(I!"O(#HIP

business owned by one person 3 get a business license and opening your doors.

This is the simplest type of business to start and is the least regulated form of organiCation.

The owner of a sole proprietorship keeps all the profits.

the owner has unlimited lia!ilityfor business debts 3 personal assets

business income is ta+ed as personal income.

The life of a sole proprietorship is limited to the ownerJs life span,

and the amount of equity that can be raised is limited to the amount of the proprietorJs

personal wealth.

Iwnership of a sole proprietorship may be difficult to transfer because this transfer

requires the sale of the entire business to a new owner.


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)dvantages(

Two or more owners

More capital available

#elatively easy to start

!ncome ta+ed once as personal income

"isadvantages(

Hnlimited liability

2eneral partnership

5imited partnership

&artnership dissolves when one partner dies or wishes to sell

"ifficult to transfer ownership


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"H! CO(PO(A"ION

the most important form -in terms of siCe1 of business organiCation

) corporation is a legal Lperson separate and distinct from its owners, and it has many of the rights,

duties, and privileges of an actual person.

$orporations can borrow money and own property, can sue and be sued, and can enter into contracts. )

corporation can even be a general partner or a limited partner in a partnership, and a corporation can ownstock in another corporation.

6orming a corporation involves preparing articles of incorporation-or a charter1 and a set of !ylas.

The articles of incorporation must contain a number of things, including the corporationJs name, its

intended life -which can be forever1, its business purpose, and the number of shares that can be issued.

This information must normally be supplied to the state in which the firm will be incorporated. 6or most

legal purposes, the corporation is a Lresident of that state.

The bylaws are rules describing how the corporation regulates its e+istence. 6or e+ample, the bylaws

describe how directors are elected. The bylaws may be amended or e+tended from time to time by the

stockholders.

!n a large corporation, the stockholders and the managers are usually separate groups.


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)dvantages(

5imited liability

Hnlimited life

Separation of ownership and management Transfer of ownership is easy

*asier to raise capital

"isadvantages(

Separation of ownership and management

"ouble ta+ation -income ta+ed at the corporate rate and then dividends

ta+ed at the personal rate1


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The limited liability company -55$1.

The goal of this entity is to operate and be ta+ed like a partnership but retain limited liability

for owners, so an 55$ is essentially a hybrid of partnership and corporation.

A CO(PO(A"ION $8 ANO"H!( NAM! >

The corporate form of organiCation has many variations around the world. The e+act laws andregulations differ from country to country, of course, but the essential features of public

ownership and limited liability remain.

These firms are often called(

joint stock companies,

public limited companies,

limited liability companies

depending on the specific nature of the firm and the country of origin.


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"-e


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"-e


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"-e


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"-e

financial management decisionG

!f we assume that stockholders buy stock because they seek to gain financially, then the

answer is obvious( 2ood decisions increase the value of the stock, and poor decisions

decrease the value of the stock.

Ma+imiCe the market value of the e+isting ownersJ equity.

good financial decisions increase the market value of the ownersJ equity and poor financial

decisions decrease i

keep in mind that the stockholders in a firm are residual owners.

Ither stakeholders ( employees, suppliers, and creditors

6inally, our goal does not imply that the financial manager should take illegal or unethical

actions in the hope of increasing the value of the equity in the firm.

#A($AN!#?O@!8-//1


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"-e Aenc Pro+lem an4 Control

of t-e Corporation

in large corporations ownership can be spread over a huge number of stockholders.

This dispersion of ownership arguably means that management effectively controls the firm.

!n this case, will management necessarily act in the best interests of the stockholdersG &ut another way,

might not management pursue its own goals at the stockholdersJ e+penseG

A


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of t-e Corporation

To see how management and stockholder interests might differ, imagine that the firm is considering anew investment. The new investment is e+pected to favourably impact the share value, but it is also a

relatively risky venture. The owners of the firm will wish to take the investment -because the stock

value will rise1, but management may not because there is the possibility that things will turn out badly

and management jobs will be lost. !f management does not take the investment, then the stockholders

may lose a valuable opportunity. This is one e+ample of an agency cost.

More generally, the term agency costsrefers to the costs of the conflict of interest between

stockholders and management. These costs can be indirect or direct.

)n indirect agency cost is a lost opportunity, such as the one we have just described.

"irect agency costs come in two forms. The first type is a corporate e+penditure that benefits

management but costs the stockholders.

The second type of direct agency cost is an e+pense that arises from the need to monitor management

actions. &aying outside auditors to assess the accuracy of financial statement information could be one

e+ample.


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of t-e Corporation

&O MANA


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Financial Mar,ets an4 t-e

Corporation

6inancial markets play an e+tremely important role in corporate finance.

CA#H FO'# "O AN& F(OM "H! FI(M

) financial market, like any market, is just a way of bringing buyers and sellers together. !n financial

markets, it is debt and equity securities that are bought and sold. 6inancial markets differ in detail, however.

The most important differences concern the types of securities that are traded, how trading is conducted, and

who the buyers and sellers are.


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Corporation

P(IMA(8 D!(#U# #!CON&A(8 MA(=!"#

6inancial markets function as both primary and secondary markets for debt and equity securities.

The termprimary marketrefers to the original sale of securities by governments and corporations.

Thesecondary marketsare those in which these securities are bought and sold after the original sale.

*quities are, of course, issued solely by corporations. "ebt securities are issued by both governments andcorporations.

Primar Mar,ets

!n a primary market transaction, the corporation is the seller, and the transaction raises money for the

corporation.

$orporations engage in two types of primary market transactions(

) public offering, as the name suggests, involves selling securities to the general public, whereas a private

placement is a negotiated sale involving a specific buyer.

y law, public offerings of debt and equity must be registered with the Securities and *+change $ommission

-S*$1.


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Corporation

&artly to avoid the various regulatory requirements and the e+pense of public offerings, debtand equity are often sold privately to large financial institutions such as life insurance

companies or mutual funds. Such private placements do not have to be registered with the

S*$ and do not require the involvement of underwriters -investment banks that specialiCe

in selling securities to the public1.

#econ4ar Mar,ets

) secondary market transaction involves one owner or creditor selling to another. Therefore,

the secondary markets provide the means for transferring ownership of corporate securities.

)lthough a corporation is directly involved only in a primary market transaction -when it sells

securities to raise cash1, the secondary markets are still critical to large corporations. The

reason is that investors are much more willing to purchase securities in a primary markettransaction when they know that those securities can later be resold if desired.


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Corporation

"ealer versus )uction Markets

There are two kinds of secondary markets( auctionmarkets and dealermarkets.

"ealer markets in stocks and long3term debt are called o#er$the$counter-IT$1 markets.

The e+pression o#er the counterrefers to days of old when securities were literally bought

and sold at counters in offices around the country. Today, many dealers are connectedelectronically.

)uction markets differ from dealer markets in two ways. 6irst, an auction market or e+change

has a physical location -like 'all Street1. Second, in a dealer market, most of the buying

and selling is done by the dealer. The primary purpose of an auction market, on the other

hand, is to match those who wish to sell with those who wish to buy. "ealers play a limitedrole.

Documents

FIN222 Autumn2015 Lectures Lecture 1