Fin 1101: Introductory Corporate Finance Lecture 1 C.L. Mattoli 1 (C) Red Hill Capital Corp., Delaware 2008

Fin 1101: Introductory Corporate Finance

Lecture 1

C.L. Mattoli

1(C) Red Hill Capital Corp.,

Delaware 2008

How to pass FIN1101

Start work now and keep up to date Take notes in class. Make notes using the

textbook and other materials, which are handed out each week.

Do the self-assessment exercises in the study book and answer the questions in the weekly workshop materials.

It is a difficult course, for some, and a difficult book.


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Course Notes Lectures will cover broad concepts of

modules. In tutorials, you will be required to do

problems and questions to hand in before start of class. Then, problems will be done on the board.

In workshops you will be given problems to work on, in class, to test yourself at each stage of the course.


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Course Structure Attendance is required and roles will be taken

in almost every class. You will be required to do tutorial problems

before class and hand them in at the start of the tutorial sessions. Although grades on the problems will not count for your grade in the course, grades will be reported to the administration, and, if you do not keep up with the work, you might be asked to drop the course.

Workshops will be used to cover extra materials and for in-class quizzes.

Bring textbooks to Lecture, WS, and Tutorials!


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Information Information Lecturer: Craig Mattoli Email: [email protected] Phone (text messages only) 136 3241 0877; include

your name and course in message. Office hours: by appointment. Located in room 505. Don’t be shy. Ask Questions of your Instructor, not

just your classmates. No one cares as much as he does!

Sometimes, I talk fast, use words that you might not know, and write abbreviations on the board. Again, if you don’t understand my written or spoken word, ask. It’s ok!


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Prologue

Introduction to finance was revamped last spring, so notes and exams from previous semesters will be of limited use.

The book for the course is: Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield &Jordan.

Do not use or even look at the old book, as it has confused concepts and logic.


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Prologue The new layout of the course should be

particularly useful to you as it builds on the basic accounting that is used in business. Thus, you will be able to relate the financial theory to the actual accounting numbers that are the basis for evaluating and running businesses and other investments.

Your grade for the course will come from an assignment and a final exam.


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What is Finance? Finance can be considered in both its macro and

micro dimensions. At the macro level, finance encompasses the

study of the operations of financial institutions and markets within the economy in the allocation of funds (money) to various uses.

At the micro level, finance essentially involves the processes of investment decision making and funding (financing) of investments, by firms, financial institutions and individuals.

In this unit we will be looking at finance from the point of view of the ‘money manager’ or financial manager of a business.


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Finance in a nutshell

1. Some people have extra money/some need extra money: how to get it from one to the other is part of the field of finance.

2. Finance is the study of the allocation of money under conditions of risk.

3. Financial markets and intermediaries connect the two groups: surplus and deficit cash units.


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Finance in a nutshell4. People value investments, like buying a new

piece of machinery or buying stocks and bonds by valuing the future cash flows that they expect to get from those investments (present value).

5. The other important thing in valuation is riskiness: the riskier the prospect of getting your money in the future, the more of a return you will ask for.

6. There are instruments, like futures and options to help manage risk.


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Introduction to Financial Management

Module 1


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OverviewIn this introductory module and lecture, we will

cover the following topics:

1. What is finance and what are its sub-disciplines.

2. How does finance relate to other jobs in the business world.

3. What do financial managers do and what decisions do they make for a business.

4. What are the ways that a business can be structured.


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Overview

5. The proper goals of financial management.

6. What conflicts arise when the owners of a business are not the managers (corporate structure).

7. What are financial markets. What kinds of markets are there. And what do they have to do with business.

8. These concepts will form the basis to study further and will ask some questions that the course will answer.


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What is Finance and Why Study it?


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The 4 Basic Branches of FinanceTraditional finance is broken into 4 basic

topics:

1. Corporate Finance, which is the main topic of this course.

2. Investments

3. The study of financial institutions.

4. International finance.

We shall look at brief overviews of each


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Corporate and Business Finance Corporate or business finance studies all of

the financial ideas, operations, jobs and decisions that go into running a business.

It is the main topic of this course. Moreover, business finance includes topics

from the other major areas because they cover topics that are relevant to business finance.

On the other hand, the ideas contained in this topic apply also to the others.


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Investments & Investing

I am sure that you have all heard your friends talking about investing is stocks, but they are just playing at investing.

The field of investment, both in theory and in practice, is a discipline, not a game, and for those who understand its simple precepts, it can be rewarding, in terms of both money and satisfaction.


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Investments & Investing Moreover, investment covers a much

broader range of things than you would normally think of. Even the time that you are spending in this college and this course are an investment, and you will be able to value it by the end of this course.

You can buy a bicycle, and look at it as money spent, or you can rent it out. Then, it is an investment whose value far exceeds the cost of the bike.


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Investments & Investing The field of investment looks at the

broad topics of:

1. What determines the values and prices of assets, like shares of stock or businesses?

2. What are the potential risks and rewards of investing?

3. What is the appropriate mix of financial assets to have, either as an owner or issuer of such assets?


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Financial Institutions Financial institutions are businesses that deal in

financial business. They include things, like banks, insurance

companies and financial markets. The study of financial institutions looks at how

funds are transferred from those who have extra funds to those who need extra funds.

The study of finance is built on the idea some people forego consumption, and save. Then, the question becomes: how do those funds get to those who want to consume more, now, and how much should be charged for both the intermediation process and the use?


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International Finance International finance covers, basically, those

areas that involve finance in an extra-national setting.

For example, an Australian bank that has customers in other countries is dealing in international finance.

A portfolio manager that holds stocks and bonds of companies of varied national origin is in international finance.

A company that has subsidiaries or operations in foreign countries also will be interested in international finance topics.


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Why Should You Study Finance? Finance is about money, and money is at

the heart of business and even your personal life.

If you are going to be an accountant, you will be dealing in financial data, and it will help you to understand what you are doing and why.

The two basic engines of business are marketing and finance, after coming up with an idea for your business.


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Finance and Marketing, e.g. There is a strong interplay between

marketing and finance, in business. Marketing partly determines the prices that

are charged for things. It costs money to market, and the return on the investment in that is a big part of business.

Often, the sales department will work the finance department of a company to come up with price, revenue, and cost projections to analyze potential products and projects, which we will study later in the course.


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Finance and Marketing, e.g. What most people don’t realize is how

important marketing is in the financial business, like stock brokers, investment banking, and even banking.

Brokers call clients and try to talk them into buying more shares of stock or a new product or issue.

New financial products are created and sold by banks, insurance companies and financial markets .


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Finance and Accounting In smaller businesses, accountants are usually also

called upon to make financial decisions, so it is important for them to understand about finance, if they are to do a good service for their clients.

Another reason that accountants need to understand finance, better, is that, as the financial world becomes more complex, with newer and newer financial products and contracts, they need to understand their benefits, their pitfalls, and their affects on financial statements. (current crisis)

Cost accounting makes use of finance, and investment analysis makes use of accounting information, so there is more interplay. Finance will help accountants understand how the information that they put together is used or misused by others.


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Finance and Business Management Business managers, invariably, need to

understand financial matters. Indeed, many top managers of

corporations are financial types. In a larger business, many people will be

required to understand finance, since they have to understand how what they do will affect profitability, and finance studies the value of things.


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To live, you need money. Right now you are investing in your future.

You pay money, now, for college in the hopes that it will help you earn more in the future. The extra earning power that you get from your education will somehow have to exceed how much you are spending, now.

When you get a job, you will get income, and you will have to pay expense, like rent and food. You will have to manage your expenses to fit your revenue and more.

Finance and the rest of your life


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Maybe you want to open your own business: then, you will really need to understand financial management since you will have to invest money to start the business, then, earn enough to cover your initial investment and to cover expenses on a day-to-day basis.

More important, some day you will retire, so, during your working years you will have to save and invest for retirement. Those decisions will affect when you can retire and how well off you will be when you retire.

Thus, understanding finance will help you with your whole life.

Finance and the rest of your life


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Business Finance & the Financial Manager


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Business Finance Starting a business cannot be done, thoughtlessly. Many people believe that starting a business is the

key to getting rich, but they rarely understand what it takes to start and run a business, successfully.

The first step in starting a business is investment. You decide what your business will be, e.g., selling eggs or making candles. You will have to find a place to run the business. You might have to invest in equipment or just display counters. You will have to have extra money to pay expense, while you are in the start up phase. (Capital Budgeting)


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Business Finance

You will need money for all of this initial investment. Where will you get it?

Thus, the second step is financing your business. Will you risk your own money? Will you borrow money? Or will you find others to invest in your business as partners or part owners. (Capital Structure)


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Business Finance Then, once you start the business, you will

have to manage your day-to-day financial affairs, like collecting money from customers and paying suppliers, employees, and your landlord. This third step of business finance will be important for keeping you in business. (Working Capital Management)

These are the 3 basic topics that we will study in business finance.


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The Role of the Financial Manager In a large company, like a corporation (see,

below), the financial management position is usually a senior position in the firm because of its importance to the health of the business.

The top financial person in the firm is usually called the CFO, Chief Financial Officer, or VP (vice president) of Finance.

In the next slide, we show a typical organizational chart for a corporation.


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The CFO in the Corp.Board of Directors

Credit ManagerCash Manager Tax Manager

CEO

Board Chairman

CFO GM ProductionGM Marketing

Cap Expend Mgr

Cost Acct Mgr

Treasurer Controller

MISFin Acct MgrFin Plan Mgr


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Basic Financial Management Functions Directly under top management of the

company is the CFO The CFO is in charge of all financial

management of the firm and has 2 departments that answer to him or her: the Treasurer and the Controller.

The Treasurer’s office manages cash, credit, capital expenditures, and financial planning.


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Basic Financial Management Functions The Controller (chief accountant) is in

charge of cost and financial accounting, tax payments and management information systems (MIS).

In a smaller company, the two main functions, treasurer and controller might be merged into each other and even into the CFO function.

The study of business finance will focus on the treasury function. You will learn about the other functions in your accounting courses.


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Financial Management Decisions:1. Capital Budgeting We have to take a long-term view of our business,

when we begin it, if we want to be in business for more than a minute, and, then, to keep the business going.

First, we invest in a business or a business project. That is our cash outflow.

The first thing that we need to consider is the size ($ amount) of the initial cash outflow (investment).

From that investment of money, we will get future cash inflows, no matter if our investment is in a stock, in the stock market, or in plant and equipment to produce noodles.


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Financial Management Decisions:1. Capital Budgeting The objective of investment (business) is

for the future inflows to, somehow, exceed the outflows.

We say “somehow” because money will not be worth as much (be able to buy as much), in the future, as it is now (time value). If you have money, now, you could put it in bank and earn interest and have more money (opportunity cost).


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Financial Management Decisions:1. Capital Budgeting So, we need to, next, look at the timing of

future cash flows and take that into account in our financial analysis.

The final component of our capital budgeting decision has to do with the fact that, just because you open a business it does not guarantee that we will get customers and make money.


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Financial Management Decisions:1. Capital Budgeting We make projections about our future

cash inflows and expenses when we evaluate the decision to invest, and we get a figure for net projected future inflows of cash. Those projections are just dreams.

There is a risk that the future will be different than what we expected, and we must evaluate the risks.


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Financial Management Decisions:1. Capital Budgeting These are the major decision

categories of capital budgeting. They incorporate two of the

fundamental things that finance does: describe the time value of money and incorporating and evaluating risk.


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Financial Management Decisions:2. Working Capital Management

After you start a business you have to deal with the day to day running of the business. That involves several things.

First, being sure that you have money to pay bills

You will have to also have enough inventory in your store to sell.

You will have to decide whether or not to sell things on credit, and you will have to have the financial “room” to be able to sell now and get paid later.


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Financial Management Decisions:2. Working Capital Management You will have to plan for short-term

financing, in case you have a shortfall between your cash inflows, at any time, and your necessary outflows.

This prong of financial decision-making is called Working Capital Management because it deals with the working capital of the firm, the short-term assets and liabilities portion of the balance sheet.


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Financial Management Decisions:3. Capital Structure. Now that you have your business up and

running, and you have managed the short-term, you have to think of the long-term, in order to stay in business.

Will you just use your own money, or will you get other co-owners to contribute funds, or will you borrow more money? How much will you get of each type of funding? How will you match payment to those others with the long-term expected future inflows from your investment.


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Financial Management Decisions:3. Capital Structure. The mix of capital, long-term debt and

ownership equity, the rest of the balance sheet, is called the capital structure of the company.

Then, there are the questions of how much to pay for debt and equity capital (cost of capital). How much will it cost to raise the capital (issuance or intermediation costs). Where should you get it: borrow from a bank or insurance company or issue debt securities (bonds) in the public or private financial markets?


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Financial Management Decisions:3. Capital Structure. Those types of decisions must be made

before you start the business and, on a continuing basis, after you are in business. You don’t want to get started, and just when it is getting good, you have stop because everyone wants their investment money back.

You need to always be planning for the long-term financial health of your company.


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Accounting for decisions

Current AssetsCashA/RInventory

Current LiabilitiesAccrued ExpensesA/PSR Debt

Working Capital

Long term assetsLong term debtEquity

Capital StructureCapital Budgeting


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The 3 Forms of Business Organization


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How businesses are organized Businesses can be set up in several

different forms:

1. Sole proprietor

2. Partnership

3. Corporation

4. Trust

We shall concentrate on the first three, in this course.


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Sole proprietorship A sole proprietorship, also called sole

trader, is a business owned by an individual, who owns the assets used in the business, incurs liabilities and reaps the annual profits or losses.

This form of business can involve as little as opening the doors to your new business.

Sometimes called “mom and pop” businesses. The corner shop or local newsagent, for example, might be owner-operated sole proprietorships. This is the main form of businesses organization.


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Sole proprietorship For the sole proprietor, business

income is personal income, so taxes are charged at his personal income tax rate.

There are 3 negatives about this form of business.

1. First, the owner bears unlimited personal liability, beyond his investment in the business.


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Sole proprietorship

2. Second, the only forms of capital that he can use in his business are his personal equity and borrowed funds. That could limit the business’s growth.

3. Finally, to sell the business means selling all of the assets to a new owner. Otherwise the business dies with the owner.


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Partnership A partnership is an association of two or

more people carrying on a business in common with a view to profit. It is the next step in business evolution. Anytime another person is brought into the business, it has to go from sole property to partnership. The partnership agreement can be formal or a handshake.

A local (or international) accounting or legal practice, for example, might be partnerships


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Partnership In a general partnership, all the partners

share in unlimited liability and profits. In a limited partnership, there is a general

partner who runs the business and has unlimited liability and limited partners who contribute money, do not manage and are limited in their liability to their investment.

Limited partnerships are a common vehicle for investment in real estate or securities.


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Partnership Net profits before tax are distributed to

partners, and each partner does his own taxes.

Again, the limitations of this form of business are raising capita, unlimited liability, and transfer may not be that easy. For a general partnership, a new partnership must be formed, if a partner dies or wants to exit. A limited partner might be able to sell his share, but how and to whom?


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Corporation A company is an entity, formed under the

Corporations Act 2001, which is legally separate from its owners.

A corporation is a legal person and can borrow money, own property, enter into contracts, and sue and be sued, in court.

Because a corporation is a legal person, its owners have limited liability, limited to the money that they invest.

Thus, other names for corporation are names, like limited liability companies.


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Corporation Forming a corporation involves writing

articles of incorporation (charter) and by-laws. Filings of documents must be made with state authorities, and the corporation becomes a resident of that state for legal purposes.

The charter must contain things, like the name, the intended life, its business, and the number of equity shares that it will issue.


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Corporation The by-laws have to do with how the

corporation regulates itself and includes things, like how directors will be elected. They can be amended by agreement of the shareholders.

Because of the limited liability nature of corporate organization, many countries, including Australia, have made it possible to set up, one-director/one-share-of-stock corporations, so that sole traders can reorganize in the corporate form.

For large corporations, the owners are usually separate from the managers.


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Features of companies The thing that distinguishes

corporations, either private or public, is that they issue ownership certificates called shares of stock.

In a private company, shares are held by a small number of people and cannot be readily sold. The term public company means that the stock is held by the general public and can be sold to anyone else.


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Features of companies Private companies can be relatively

small family businesses. But some of the largest companies in the world are private.

Public companies tend to be larger and will have a greater number of shareholders

Stock shareholders (the owners of companies) have limited liability. They can only lose their investment in the stock.


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How the Corporation is Run

A corporation has owners, who own shares of the equity of the company in the form of stock certificates.

The owners might or might not manage or operate the corporation, themselves. This is especially true of large public corporations.


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How the Corporation is Run

The stockholder owners usually elect directors of the corporation. These are their direct agents. The election is by vote according to the number of shares each owner holds.

Then, directors hire managers, who become secondary agents of the stockholders and who are paid to manage the company for the owners benefit.


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Ownership Transfer One of the downsides of buying any type of

investment is that you might lose some or all of your money.

Sole proprietorships, some partnership shares, and large business investment projects, like investment in PP&E, might be difficult to divest.

Moreover, sole traders have no source of equity capital but their own money, and partnerships might have difficulty finding new partners to contribute equity.


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Ownership Transfer If you can easily resell (transfer ownership of)

an investment, you will feel better about making the investment, in the first place.

Ease of transfer is one of the greatest benefits of the corporate organizational form of business.

As a result of ease of transfer, corporations will have an easier time raising capital.

As we will discover, shortly, it will be even easier to raise more equity capital, if the corporation is a public company. It will also help them raise debt.


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Taxes The difference between corporations and other

forms of business is that corporations are taxed under a different system from individuals

Moreover, whereas income to a sole proprietor or partner is taxed once, in a classical tax system, the corporation earns money, gets taxed, pays out some earnings as dividends to shareholders, and they get taxed again.

In Australia, this double taxation system has been eliminated by the imputation system in which shareholders get a tax credit for taxes paid by the company (franking).


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The Goal of Financial Management


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Not Profit

In order to make financial decisions, we need criteria for making decisions.

While most people might think that it is profit maximization, that is actually a shortsighted goal, and we have to take a long-term view of investment and business.


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Not Profit To come up with a more proper goal we will

even have to look more carefully at accounting numbers and what they mean because finance is different from accounting.

Another basic problem with using simple profit maximization as a goal is that it does not account for the trade-off between present and future, which is the essence of the time-value aspect of finance, which we shall discuss more fully as we progress through the course.


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A Proper Corporate Goal

Since financial managers at corporations are hired to act on the shareholder-owners’ behalf, their goal should be to do what is in the best interests of the shareholders.

The assumed goal of the owners is to make money and increase their wealth.

Thus, to increase owner wealth, the manager should do things that increase the value of owners’ equity interest in the company.


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A Proper Corporate Goal Since owners’ equity is represented by their

shares of stock in the company, the proper goal becomes to maximize the current value of shares of stock in the company.

That goal, as we shall learn, in due course, eliminates the questions of trade-offs between present and future. After all, no one cares about possibly maximizing value later. They only care about now.

For a public corporation whose shares of stock are traded in the stock market, the goal translates into maximizing the current stock market price of the company’s shares.


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A Proper Corporate Goal However, the goal of maximizing current

value of equity should be adapted to any form of business, including sole traders and partnerships.

Of course, we cannot take this goal too far. We must consider this goal within the context of what is legal and ethical.

The goal is implemented by identifying and investing in business projects that will add to the value of the company.


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Ethics in business Ethics are moral principles or rules of

conduct which indicate the acceptability of behaviour within a community

Unethical actions may be legal (eg shifting production to a country that has lower legal standards for worker and/or environmental protection). They might also be illegal, like using insider information to profit from the stock market. How about lying to a customer?


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Ethics and wealth maximisation Ethical behaviour can be consistent with

wealth maximisation because it maintains the company’s reputation. Intangibles, like honesty and fair dealing, will ultimately result in good relationships with customers, which will lead them to tell their friends, which will give us more future business and more wealth. Dishonesty could lead to the opposite result.


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Corporate Governance Corporate governance has to do with the fairness

and honesty shown by the managers to the owners and to other stakeholders of corporations.

Corporate governance is a hot issue, around the world, and many countries are adopting guidelines for governance. In 2003, for example, the Australian Stock Exchange (ASX) adopted guidelines that set 10 core principals for proper governance.

The importance of corporate governance for countries is not only to protect their own residents who invest but, in a global financial world, to also attract investors from other countries.


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The Agency Problem & Corporate Control


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An agency relationship Any time someone (the principal) hires

someone else (an agent) to work for them, we say that an agency relationship has been formed.

You hire a real estate broker to sell your house, and she is your agent. You use a fund manager to manage your investments, and he is your agent.

In a corporation, the managers are agents of the shareholders.


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Potential for conflict People, in general, are self-interested.

Thus, we expect that agents will be self-interested to some extent.

When you hire a broker to help you buy a house, for example, he is paid a commission that is a percentage of the value of the sale. Thus, he will not necessarily be interested in getting you the best price.

Therefore, there is potential for conflict of interest in all agency relationships. This is known as the agency problem.


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The agent-principal problem

Especially in a large corporation that is managed by agent-managers, not the owners, the managers are effectively in control of the company.

In general, the agent-manager wants to take the most that he can for his position, but we, as owner-principals, want to pay him the least since his cost is our expense.


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The agent-principal problem It is a fine line to walk: if we, as owners, pay

too little, we might not get good management. If we pay too much, it also affects our wealth

What managers wants might not be all in terms of dollars but will include their desire for power.

Thus, it has been argued that, if not put in check, managers would tend to try to maximize the resources over which they have control.


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The agent-principal problem

Thus, not only might managers try to get as much financial compensation as they can, but they also might make decisions that are in their interest, not the shareholders’.

They might not take on potentially lucrative projects because they are afraid that they will not do a good job and they will lose their jobs.


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The agent-principal problem They might buy other companies at too high a

price, just so they can have control over an even larger corporation. They might try to increase current profits at the sacrifice of future profits to make the stock market price high because their compensation is in the form of options to buy stock. The higher the stock price, the more they will earn.

Thus, there are a number of different ways that management might not follow their mandate of maximizing owners’ wealth.


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Agency costs Agency costs are the losses borne by the

owners of the firm that can be attributed to the agent having different objectives to the owners (or principals).

For example: HIH had a CEO making large donations of

corporate funds for his personal gain and the company went bust.

A corporate executive uses the company jet for to visit his model girlfriend in New York City every weekend.


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Who’s interested? To get management interested in

shareholder’s interest can be affected by two things:

1. How are management’s interests aligned with shareholder’s? If they own a lot of stock and they are partly compensated in stock, they might be more interested, but there are pitfalls, as we mentioned in a previous slide.

2. How easily can management be replaced? Then, they would lose their status and control.


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Compensation People might say that it is good for

management to have ownership and compensation in shares.

After all, increasing shareholder wealth affects their own compensation and wealth.

We already looked at one counterexample in a previous slide. Another might come when the manager’s wealth depends too much on the stock price. That led the CEO of MCI, in the U.S., to actually commit fraud in the company’s accounting.


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Compensation

In the bigger picture, a corporate executive who does a good job at managing a company and accomplishing goals the of shareholders will find that his value in the labor market will also be increased.

For bad managers, the opposite will be true.


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Control Shareholders vote for directors, and directors

hire and fire managers. If enough shareholders solicit directors to fire

current management, that might happen. Another means to accomplish a change is to

vote at a shareholders’ meeting for a new board of directors.

That may or may not be easy to accomplish, but there are means.


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How corporate voting works One share of stock of a corporation entitles

you to one vote. Thus, if you own 10% of the outstanding shares, you have 10% of the total voting power of the company.

Each year, corporations have an annual meeting at which board members are elected.

Directors solicit proxies from the shareholders to vote their shares. A proxy is the authorization by the shareholder for the board to vote his or her shares.


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A Proxy Fight One means of replacing directors is by

what is called a proxy fight. In a proxy fight, a group of people seek the

proxies of shareholders to vote for an alternate board of directors.

If the group can convince enough shareholders to give them their proxies, they can replace the board and the management.


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Corporate takeover

Since ownership of a corporation is represented by its shares of stock, the way to buy a corporation is by buying all of the shares of stock of the corporation.

If stock is publicly held and trades in the stock market, another company that is seeking to buy the company will have to somehow convince all of the shareholders to sell them their shares.


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Corporate takeover This threat of change in control to

management and the board of directors provides another incentive for both to do their jobs properly.

Poorly-run companies will tend to be undervalued, and more profit can be gained by the buyer. Therefore they will be more of a target.


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Conclusion We have seen both sides of the issue

of agents and principals in a corporate setting.

Those same arguments and problems will apply to any situation where there is separation of owners and management.

There has been response, on both sides over the years.


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Conclusion Now, there are systems of so-called

staggered boards of directors wherein one-third of the directors, for example, can be replaced in any one year. Thus, it would take three years to replace all of the current directors.

There have been and still are multi-tier stock systems wherein, for example, class A-shares might hold a majority of the votes, while class B shares represent most of the actual equity in the corporation.


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Conclusion On the other hand, recent legislation

in several countries now requires board members to attest, in writing, to the truth of accounting numbers. That leaves them open to conviction for fraud and some jail time, at least.

The inventiveness of people will continue to shape the issue on both sides.


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Conclusion In the end, it is all about having the

people who put up the money for a business to be treated fairly since they are the ones who have their money at risk.

Indeed, other people, besides shareholders, have interest in corporations. We shall talk about stakeholder interest in the next slide.


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Stakeholder happiness People other than the owners have

interests in how the company is run. Stakeholders refers to all of the groups that may have an interest in the company’s conduct.

Stakeholders include employees, customers, suppliers, debtors, regulators, and the general public. Those groups also have an interest in the success or failure of your business.


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Corporate social responsibility Especially, in today’s world in which

companies pollute the environment or treat employees unfairly, there has been a call for corporations to be more responsible to society as a whole.

Corporate social responsibility (CSR) means that the firm has a wider range of responsibilities, in relation to both objectives and people, apart from the owners or stakeholders. For example, not polluting a town where they have their plant.


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Corporations and Financial Markets


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The corporate advantage Corporations have the advantage that they

can get both forms of capital, debt and equity, from all types of sources, including markets and banks (intermediaries).

An additional advantage is that the securities that they give out, in return for funding, are easily transferable between old and new owners.

That transferability might be even further enhanced, if the securities are traded in a market.


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The Functions of the Financial System Five functions:

Facilitates settlement of commercial transactions

Facilitates the flow of funds Facilitates the transfer of risk Generates price information which provides

the signals for decentralized decision making.

Provides ways of dealing with incentive problems, like the agent-principal problem.


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Financing business operations Sources of financing are direct or indirect In direct finance the supplier of funds (called

surplus units) and the user of funds (called deficit units) deal with one another, directly.

This happens when a company issues stock or debt securities directly to investors. It could be a private placement to a small group (even as small as 1) investors or a public offering to the general public.

In Intermediated finance, a financial intermediary collect funds from suppliers and, then, dole them out to fund users. Banks, for example, take deposits and then make loans from the pooled deposits.


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Costs of Finding Financing

Just like everything else, it costs money to raise funds for a business, whether its from a bank or from investors.

Transaction costs are the costs, in terms of both time and explicit cash costs, of doing a transaction, e.g., getting financing.

A loan broker or a bank might charge you a fee.


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Costs of Finding Financing If you issue (sell) securities, you will have

to find someone to assist you in the selling.

Or you might decide that you don’t want to pay investment banker, regulators, lawyers, accountants, or brokers to get money for your business, but it may take years of time, money, and energy to find someone on your own, or no one at all.


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Debt and Equity Defined Debt is a contractual arrangement to

borrow money that will be repaid in the future.

Equity represents an ownership interest, so there is no expectation that it will be ‘repaid’ in the future. Equity holders can get their money back by selling their ownership interest. For corporations, that ownership interest is represented by shares of stock.

In accounting terms, A – L = E, Assets less liabilities = Book equity.


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Financial markets: direct financing Direct financing is done in the financial

markets, like the stock market, but we have to be more precise.

There are various types of markets for different purposes and for different types of transactions.

They all provide an alternative to intermediated finance for which there are real costs of intermediation.


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Roles of financial markets The financial markets in Australia fulfill

many roles including:1. Matching supply and demand for excess

savings/investment funds.

2. Facilitating business and trade through the clearing of transactions.

3. Facilitating the saving of individuals for future consumption

4. Providing of financial services

5. Providing Price Information for securities and other commodities (Price discovery function).


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What Market ??

What is it a market of? A market must have goods, like the vegetable market, the flower market. In the financial market we have:

Securities are documents (contracts) which provide evidence of a loan, a bond or a commercial bill, for example, or shares of stock, which represent equity of a corporation

Price discovery is the process of finding and settling on a price which is acceptable to both parties. It is thus a source of price information for all.


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Picture of a Bond Face Value


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Picture of Stock

Registration serial number just like on paper money

International securities tracking system number

Craig L. Mattoli


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Financial definitions Maturity (or term to maturity) is the contracted

time that may elapse before the borrowed funds are to be repaid. Bonds for example have a date on which they are due for payoff. Equity is usually perpetual (forever), unless the company goes bust.

Then, we define: Financial structure of a business– as the mix,

the percentage, of debt and equity which fund the assets owned by the business. Assets = Liabilities (including various maturities of debt) + Equity


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Debt definitions

Face value is the amount that will be repaid upon maturity of the debt security

Face value is specified at the time the debt security is issued. It will be shown on the face (front) of the security.

Debt discount securities are issued at a price less than the face value. Examples, for short-term, are promissory notes and commercial bills. Long-term examples are zero-coupon bonds.


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Financial markets

The financial markets are not a specific place.

Financial markets include all of the means of making financial contracts, which is what securities and other types of financial instruments are.

The other important function is providing a means of buying and selling of those contracts.


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Financial markets For markets we also speak of their

decentralization. I don’t have to walk to Tokyo to buy shares of

Toyota. The decentralization of financial markets

can be attributed to the price discovery mechanism, which provides price, readily, to buyers and sellers, and information and communication networks, which allow information to flow freely and trades (buying and selling), to be done at a distance.


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Classifying the markets

There are 4 main types of binary divisions in financial markets

1. primary or secondary

2. public or private

3. money or capital markets

4. Exchange traded OTC traded


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First Dichotomy

A primary market is where securities are offered for the first time: that is it’s only function A company sells debt or equity

securities directly to investors. We call that selling issuing because

the company has to make up the security (contract) and give it (issue it) to investors.


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First Dichotomy

Money goes to the issuer from the investor. That can be done by public offer (IPO) or private placement.

In that regard, securities are issued for the first time, in this market

Since securities are issued for the first time, issues increase the amount of securities outstanding.


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First Dichotomy Secondary markets are markets for

trading securities, which have already been issued - second-hand securities. Secondary market trades do not increase

the stock of securities. They do, however, offer owners of the securities liquidity, the ability to dump the investment. That liquidity is also important in deposit taking institutions: you can get money when you need it.

Money goes to previous security holder. 116

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Issuing Securities There are 2 ways to issue securities In a public offering, securities are offered

for sale to the general public. In order to do that, a company will have to

hire lawyers, accountants, investment bankers (underwriters) and brokers. That can cost a lot of money.

It will also have to file a prospectus, which is a detailed information document, and register the securities with the ASIC (Australian Securities and Investments Commission).


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Issuing Securities Then, the securities will be transferable

among the general public. The other alternative for issuance is by

private placement. The advantage of private placement is that

the securities do not have to be registered.

It also avoids all of the expense of public offer, but the securities will not be transferable.


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The Importance of secondary markets Price discovery is an important aspect. The ability to convert maturity is important.

In that regard, you do not have to hold a 30-year bond to maturity. You can sell it and shorten your holding period, thus, controlling the maturity of your investment horizon.

The secondary market also promotes the primary market. It is one thing to buy an investment. You will feel a lot better and will not ask for such a good price, if you know that you can sell it. You can sell it in the secondary market.


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Trading Division For Public securities, there are two means

of trading (buying and selling) of securities: auction markets and dealer markets.

Physical exchanges, like the ASX, are central marketplaces where securities are traded.

To be traded on an exchange, they must first meet requirements set by the exchange for “listing” of the security by the exchange.

These are also called auction markets because they run continuous auctions in the securities.


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Trading Division The alternative trading market is called a

dealer market or an over the counter (OTC) market.

In contrast to a central physical marketplace, like an exchange, OTC markets are networks of dealers in securities, interconnected by communications and electronic systems.

Dealers maintain inventories of securities and buy and sell for themselves.

The NASDAQ in the US is one such OTC market.


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Securities and Secondary Markets. After a security makes its public début, it does

not automatically appear on a secondary market.

An application for listing the security must be made in a particular market.

Listing requirements on the ASX, for example, require that the market value of shares is $10 million with 5,000 holders of at least $2,000 value of holdings.

After it finds a home in a secondary market, it can be traded (bought and sold).

Those transactions are among old and new owners. The company is no longer involved.


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Temporal Market Division Money markets deal in short-term

debt bills, promissory notes and certificates of

deposit, usually a year or less Capital markets deal in long-term

instruments debentures, secured or unsecured notes,

leases, loans, stock shares and convertible notes


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What you Get Debt holders receive interest payments

from the borrower (and eventually, at maturity, the principal amount of the loan)

Interest payments provide a tax deduction for the borrower.

Interest income is taxable income for the holders of bonds and other debt.

Equity holders may receive dividends, periodically, or not. They own shares of stock.

Dividends are not tax deductible, but give the shareholder imputation credits if they are franked


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Seniority: Ranking securities

The name security for a piece of paper like a stock or bond certificate came from the idea that some loans and equity are secured by the underlying assets of a business.

Securities have seniority in liquidation. Secured debt is the most senior, gets paid off, first; next, unsecured debt; then, preferred stock, and finally common equity.


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Corporate market value The value of a publicly-traded corporation is

the market capitalisation of the company Market capitalisation is the total value of a

corporation as measured by the price of each issued share multiplied by the number of issued shares. For example, if XYZ Corp. has 1 million shares, which are priced at $50/share, in the stock market, the total market capitalization is $50/share x 1 million shares = $50 million.

Market value of a debt or any security is calculated as the value of each security times the number outstanding.


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Summary: Making a company1. You want to start a company.2. You will, first, need funding for both long-term

assets and working capital.3. Assuming that you are big enough, you hire an

investment banker to help you issue equity (stock) and debt (bonds, debentures, notes, commercial bills) securities in the primary markets.

4. Investors buy your securities. You get the net proceeds from the sales, after paying transaction costs to underwriters, lawyers, accountants, etc.

5. With those funds (the liability and equity side of your balance sheet), you buy business assets.


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Summary: Making a company6. You start and run your business.

7. If the business goes well, you will generate cash flows from your assets.

8. Those cash flows will go to pay interest to debt holders and dividends to stockholders, expenses to stakeholders and taxes.

9. If there is any extra money leftover, you reinvest it in the business to make your business grow.

10.You might also go back to the markets to issue more securities to get additional capital.


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Summary

StakeholdersGovernment

Company gets money by issuing securities

Reinvestment

We summarize the corporation, in terms of the cash flows that we discussed, in this chapter.

CF from assets

Payments to security holders

Firm investsmoney in assets

Financial markets

Invest in and value firm


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Finance in a nutshell: most important slide

1. Some people have extra money that they want to save.

2. Other people need extra money and they want to borrow savings from the savers.

3. Savers want not only the money they lent but also payment, in the form of interest or another return.

4. Companies issue contracts, bonds, stocks, promissory notes, that promise future payments.

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Finance in a nutshell: most important slide5. Money that comes in the future is not who

what it is today because inflation of prices of goods means that $1 will buy less in the future than it will now.

6. So, to make a return, savers (investors) have to value the future payments to know what to pay for them now and also make extra to be able to have more future buying power with the money they get in the future.


Finance in a nutshell: most important slide7. Companies, in turn, invest the money that

they get from investors in new business projects.

8. The companies will need to use their cost of capital (COC), the percentage rate of annual return that they pay for funds to investors, to evaluate business projects to make sure that those projects pay enough return to pay the company’s COC and maybe have some extra return for the owners, the stockholders.


Tutorial problems for hand-in

Attempt questions 1.1 to 1.6, 1.10 and 1.12 of chapter one in your text.

Due for hand in at tutorial.


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Thinking Question

A frog falls into a 50 meter deep well. He climbs up the well wall 2 meters a day, but he slips back down 1 meter, each night. How many days will it take him to get out of the well?


Exam caliber question

1. Should a the managers of a company do anything and everything possible to maximize shareholders’ wealth? If there should be some limitations, can management still achieve that goal?


Ask yourself

1. What are securities?

2. Why do people buy them?

3. Why do other people issue them?

4. What is the difference between a bond and a stock?

5. How can you find out what a security is worth?


Ask yourself

1. What is an agent?

2. What is a principal?

3. Why should they have problems with one another?


End


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Documents

Fin 1101: Introductory Corporate Finance Lecture 1 C.L. Mattoli 1 (C) Red Hill Capital Corp., Delaware 2008