Topic 1 (2012-13A)MP

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1. Eugene F. Brigham, Joel F. Houston, Yao-Min Chiang, Hon-Sing Lee and Bany Ariffin, Essentials of Financial Management, Cengage Learning, 2nd edition, 2010 [EUGENE]

2. Financial Management : Core Principles and Applications, 3rd Edition Ross Westerfield Faffe and Jordan (2011) [ROSS]

3. Financial Management, 3rd Edition Megginson, Smart , Graham (2010) [SMART]

AC4331 - Topic 1

.

Corporate Financial Policy

Semester A 2012-13

City University of Hong Kong

Week 1

1-2

1 Introduction to Financial Management 2 Fundamental Concepts in Financial Management : Free Cash Flow; Financial Planning and Forecasting 3 Financial Assets and Time Value of Money; Interest Rates, Risk and Rates of Return 4 Bonds and Stock Valuations 5 Cost of Capital 6 Cash Flow Estimation and Risk Analysis 7 Capital Structure and Leverage MID TERM TEST (S01,SO2,SO3) Venue: LT-2, AC1 Date and Time:

18/10/2012 (Thursday) 6:30pm-8:30pm 8 Guest Lecture (1):Treasury and Valuation 9 Guest Lecture (2): Enterprise Risk Management 10 Dividends and Share Repurchase 11Guest Lecture (3):Merger and Acquisitions* 12 Working Capital Management Group Project Presentations

Know the main concerns of corporate financial management

Identify the goal of financial management Enumerate the financial benefits and

drawbacks of differing forms of business organization

Understand the conflicts of interest that can arise between owners and managers

Comprehend that corporate organizations are enhanced by financial markets

Revisit the core principles of corporate finance

1.1 What is Corporate Finance?

1.2 The Corporate Firm

1.3 The Goal of Financial Management

1.4 The Agency Problem and Control of the Corporation

1.5 Financial Markets

1.6 Core Principles of Finance

1.7 Regulations

1-4

Corporate Finance addresses the following key questions:

1. What long-term investments should the firm

choose?

2. How should the firm raise funds for the selected investments?

3. How should short-term assets be managed and financed?

4. How is risk managed?

5. How to comply with regulations?

1-5

Concerns the _____, _____, and _______ of assets with some overall goal in mind.

Keeps track of resources in terms of dollars Primary concern is the

firm and its operations

Focus on corporations

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Financing

(Raising Capital)

Financial Management

Capital Budgeting

Risk Management

Corporate Governance

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Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders’

Equity

Current

Liabilities

Long-Term

Debt

Total Firm Value to Investors:

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Current Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders’

Equity

Current

Liabilities

Long-Term

Debt

What long-term investments should the firm choose?

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Capital Budgeting: Selecting the best projects in which to invest the firm’s

resources

The capital budgeting process consists of three steps. Step 1 - Identifying potential investments

Step 2 - Analyzing those investments to identify which will create shareholder value

Step 3 - Implementing and monitoring the investments selected in Step 2

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1-

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How should the

firm raise funds

for the selected

investments?

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders’

Equity

Current

Liabilities

Long-Term

Debt

Businesses can raise money in 2 ways: ◦ Externally from investors or creditors

Venture capital

Initial public offering (IPO)

Money market

Long-term debt

◦ Internally by retaining operating cash flows

Most common method

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1 - 14

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Primary vs. secondary market transactions or offerings

Most financing from internal rather than external sources.

Most external financing is debt.

Financial intermediaries declining as a source of capital for large firms

Securities markets growing in importance 1 - 15

The Financial Management Function

Managing daily cash inflows and outflows

Forecasting cash balances

Building a long-term financial plan

Choosing the right mix of debt and equity

1 - 16 1-

16

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How should short-term assets be managed and financed?

Net

Working

Capital

Shareholders’

Equity

Current

Liabilities

Long-Term

Debt

Current Assets

Fixed Assets

1 Tangible

2 Intangible

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How should the firm raise funds for the selected investments?

Shareholders’

Equity

Current

Liabilities

Long-Term

Debt

Current Assets

Fixed Assets

1 Tangible

2 Intangible

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The value of the firm can be

thought of as a pie.

The goal of the manager is

to increase the size of the

pie.

The Capital Structure

decision can be viewed as

how best to slice the pie.

If how you slice the pie affects the size of the pie,

then the capital structure decision matters.

50%

Debt

50%

Equity

25%

Debt

75%

Equity

70%

Debt 30%

Equity

Identifying, measuring, and managing all types of risk exposures

Some risks are insurable, and some risks can be reduced through diversification.

Financial instruments like forwards, futures, options, and swaps may also be used to hedge market risks such as interest-rate, price, and currency fluctuations.

1 - 20

Hires and promotes qualified, honest people, and structures employees’ financial incentives to motivate them to maximize firm value

In practice the incentives of stockholders, managers, and other stakeholders often conflict.

Dimensions of corporate governance: ◦ Board of directors

◦ Securities and Exchange Commission

◦ Sarbanes-Oxley Act of 2002

1 - 21

Board performance and structure

Risk management

Internal control

Related-party transaction disclosure

Other indicators: quality leaders with strong ethical values

Ref: A Plus August 2011 Championing good governance, President’s message (HKICPA)

22

The Financial Manager’s primary goal is to increase the value of the firm by:

1. Selecting value creating projects

2. Making smart financing decisions

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optimal firm size?

specific assets to be acquired?

assets (if any) to be reduced or eliminated?

Most important of the key decisions.

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Source: Servaes and Tufano, “CFO Views on the Importance and Execution of the Finance Function” (Deutsche Bank,

2006).

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Chairman of the Board and Chief Executive Officer (CEO)

President and Chief Operating Officer (COO)

Vice President and Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager

Capital Expenditures

Credit Manager

Financial Planning

Tax Manager

Financial Accounting

Cost Accounting

Data Processing

Board of Directors

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Cash flow from firm (C)

Taxes (

D)

Government

Retained cash flows (F)

Invests

in assets

(B)

Dividends and debt payments (E)

Current assets

Fixed assets

Short-term debt

Long-term debt

Equity shares

Ultimately, the firm

must be a cash

generating activity.

The cash flows from

the firm must exceed

the cash flows from

the financial markets.

Firm Firm issues securities (A) Financial

markets

The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash.

However, businesses can take other forms.

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The Sole Proprietorship The Partnership ◦ General Partnership ◦ Limited Partnership

The Corporation

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1 - 30

Sole Proprietorships

• No distinction between business and owner

• Easy to set up and operate

• Business earnings taxed as personal income

• Limited life, Limited access to capital, Unlimited personal liability

Partnerships • Similar to sole proprietorship, but has two or more owners

• Joint and several liability

• Share of profits taxed as partnership income

Limited Partnerships

• One or more general partners with unlimited personal liability

• Most owners are limited partners, who are passive investors with limited liability

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Are there any disadvantages for corporations? YES! Double taxation

Corporations

• Separate legal entity with many of the economic rights and responsibilities of individuals

• Unlimited life, Limited liability, Separable contracting, Improved access to capital

• Owned by shareholders, who elect the Board of Directors

• Board appoints a President or CEO to manage day-to-day operations

• In the U.S., incorporation is executed at state level and governed by state law

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Corporation

Partnership

Liquidity

Shares can be easily

exchanged

Subject to substantial

restrictions

Voting Rights

Usually each share gets one

vote

General Partner is in charge;

limited partners may have

some voting rights

Taxation

Double

Partners pay taxes on

distributions

Reinvestment and dividend

payout

Broad latitude

All net cash flow is

distributed to partners

Liability

Limited liability

General partners may have

unlimited liability; limited

partners enjoy limited

liability

Continuity

Perpetual life

Limited life

What is the correct goal? ◦ Maximize profit?

◦ Minimize costs?

◦ Maximize market share?

◦ Maximize shareholder wealth?

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What goals are important for firms globally?

Task: Each group would pick a country and discuss among themselves.

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What stakeholders are important for firms globally?

Task: Each group would pick a kind of stakeholders and discuss among themselves.

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Maximize Profit? ◦ Earnings per share are backward-looking,

dependent on _______________

◦ Does not fully consider cash flow t______

◦ Ignores ______

Maximize Shareholder Wealth? ◦ Maximize stock price, not _______

◦ Shareholders, as residual claimants, have better

incentives to maximize firm _____

1 - 38

If the firm is to prosper, it must: ◦ Buy assets that generate more cash than they cost

◦ Sell financial instruments that raise more cash than they cost

The successful firm generates more cash than it uses

Cash flow from firm (C)

Taxes (

D)

Government

Retained cash flows (F)

Invests

in assets

(B)

Dividends and debt payments (E)

Current assets

Fixed assets

Short-term debt

Long-term debt

Equity shares

Ultimately, the firm

must be a cash

generating activity.

The cash flows from

the firm must exceed

the cash flows from

the financial markets.

Firm Firm issues securities (A) Financial

markets

Do not confuse cash flow and accounting income ◦ Non-Cash expense example: Depreciation

◦ Non-Cash revenue example: Sales on Account

Agency relationship ◦ Principal hires an agent to represent his/her

interest

◦ Stockholders (principals) hire managers (agents) to run the company

Agency problem ◦ Conflict of interest between principal and agent

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Cost of Conflict of Interest

Example: ◦ Large investment positions firm for long term

positive cash flow but has risk in short run

Owners want this investment – Increases firm value

Managers object – Risk may have personal cost

◦ If managers prevail, foregone long term cash flow is the Agency Cost

Managerial goals may be different from shareholder goals ◦ Expensive perquisites

◦ S__________

◦ I __________

Increased g_____ and s____ are not necessarily equivalent to increased shareholder wealth

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Managers act as agents of the owners who hired them and gave them decision-making authority to manage the firm for the owners’ benefit.

In practice however, self-interest may cause managers to pursue objectives other than shareholder wealth maximization.

This conflict of goals gives rise to managerial agency problems.

1 - 45

Managerial compensation ◦ Incentives can be used to align management and

stockholder interests ◦ The incentives need to be structured carefully to

make sure that they achieve their intended goal

Corporate control ◦ The threat of a takeover may result in better

management

Influence of other stakeholders

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Ways to limit agency problems: ◦ Activism by institutional investors

◦ Takeover threat

◦ Monitoring and bonding

◦ Compensation contracts

Tie managerial wealth to stock value

1 - 47

Maximize Profit? ◦ Earnings per share are backward-looking,

dependent on accounting principles

◦ Does not fully consider cash flow timing

◦ Ignores risk

Maximize Shareholder Wealth? ◦ Maximize stock price, not profits

◦ Shareholders, as residual claimants, have better

incentives to maximize firm value.

1 - 48

Primary Market ◦ Issuance of a security for the first time

Secondary Markets ◦ Buying and selling of previously issued securities

◦ Securities may be traded in either a dealer or auction market

NYSE

NASDAQ

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1-

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Firms

Investors

Secondary

Market

money

securities Sue Bob

Stocks and

Bonds

Money

Primary Market

The time value of money ◦ The opportunity to earn a return on invested

funds means that a dollar today is worth more than a dollar in the future.

Compensation for risk ◦ Investors expect compensation for bearing risk.

1 - 51

Don’t put all your eggs in one basket. ◦ Investors can achieve a more favorable tradeoff

between risk and return by diversifying their portfolios.

Markets are smart. ◦ Competition for information tends to make

markets efficient.

No arbitrage ◦ Risk-free money-making opportunities are

extremely scarce.

1 - 52

The Securities Act of 1933 and the Securities Exchange Act of 1934

◦ Issuance of Securities (1933)

◦ Creation of SEC and reporting requirements (1934)

Sarbanes-Oxley (“Sarbox”) ◦ Increased reporting requirements and responsibility

of corporate directors

◦ Personal consequences for non-compliance

What are the three basic questions Financial Managers must answer?

What are the three major forms of business organization?

What is the goal of financial management?

What are agency problems, and why do they exist within a corporation?

What major regulations impact public firms?

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What is the impact of financial crisis on a business and financial department?

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What are the most important skills for accounting and finance students to develop in time of global economic downturn caused by financial crisis?

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