FIN2004 Session 1

FINANCEFINANCE

FIN2004FIN2004FIN2004FIN2004

Lecture 1: Financial Management Overview

1. What is Finance? Know the basic types of financial

management decisions and the role of the financial

manager

2. Know the financial implications of the different

Education Objectives

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2. Know the financial implications of the different

forms of business organization

3. Know the goal of financial management

4. Understand the conflicts of interest that can arise

between owners and managers (agency relationships)

5. Understand the various types of financial markets

A discipline concerned with determining value

(what something is worth today) and making

What is Finance?

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(what something is worth today) and making

decisions based on that value assessment. The

finance function allocates resources, including

the acquiring, investing, and managing of

resources.

Business Finance Applications:

•A company wants to replace its current production line with a line of new

more expensive and more efficient machines. Should the company buy the

new machines or leave the old ones in place?

•A firm needs to purchase a piece of equipment. Should it buy a cheaper

machine with a shorter lifespan or a more expensive machine that lasts

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longer?

•A company is trying to decide whether to develop a new product - how can

it deal with the fact that most of the development costs will be incurred

before any sale revenues have been realized?

•All businesses, from international conglomerates to small “hawker” shops,

have to decide how they’ll finance their operations. Will they borrow or

will they bring in new investors/shareholders?

The principles behind making correct business finance decisions are the

same as those used for individual finance decisions. So the good news

is that the lessons of this course can benefit you in many areas of your

personal life. You can begin to theoretically and quantitatively address:

1. When to start saving for retirement and how much to save?

Personal Finance Applications - Examples:

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1. When to start saving for retirement and how much to save?

2. How to evaluate the terms for a home mortgage?

3. Whether a car loan or a lease is more advantageous?

4. Is a particular stock a good investment? Is a particular fund a good

investment?

5. How to finance a child’s education?

Main Areas of Finance:

1. Investments

Scope of Study in Finance

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2. Financial Markets and Intermediaries

3. Corporate Finance (or Business Finance)

Investments

• The study of financial transactions from the perspective of

investors outside the firm.

• Examples:

– How do we assess the risk of various financial

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– How do we assess the risk of various financial

securities?

– How do we manage a portfolio (a grouping) of financial

securities to achieve a stated objective of the investor?

– How do we evaluate portfolio performance?

Financial Markets and Intermediaries

• The study of markets where financial securities

(such as stocks and bonds) are bought and sold.

• The study of financial institutions (such as

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• The study of financial institutions (such as

commercial banks, investment banks, and

insurance companies) that facilitate the flow of

money from savers to demanders of money.

• Corporate Finance addresses the following:

– What long-term investments should the firm take on? (capital

budgeting decision)

– Where will we get the long-term financing to pay for the

investment? (capital structure decision)

– How will we manage the everyday financial activities of the

Corporate Finance

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– How will we manage the everyday financial activities of the

firm? (working capital management decision)

• Examples of Financial decisions affecting firms:

Dell computer expands its product line.

Gap builds additional stores.

Nike closes a production plant in Asia.

Ford borrows $3 billion.

Perot Systems issues stock valued at $3 billion.

Example: Corporate Finance

Investment DecisionNew plant for Rolls-Royce

In a major boost to Singapore's aerospace ambitions, Rolls-Royce

has unveiled plans for a new facility to make engine fan blades

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has unveiled plans for a new facility to make engine fan blades

for large aircraft - its first outside England - at the Seletar

Aerospace Park. Also in the pipeline: A new regional training

centre. The projects will take to more than $700 million the total

amount that the British power systems and engines giant is

pumping into Singapore's future aviation hub.

July 28, 2009, The Straits Times

Example: Corporate Finance

Financing Decision

DreamWorks Animation files for 650-million-dollar share

offering

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Goldman Sachs and JP Morgan are listed as lead underwriters of the

initial public offering for the company, headed by Jeffrey Katzenberg

and founded in 1994 by the studio mogul along with music industry

honcho David Geffen and star director Steven Spielberg.22/7/2004, AFP

NEW YORK : DreamWorks Animation said it filed to go public in a

deal that would raise up to 650 million dollars for the studio behind

the hit "Shrek" movies.

The Investment Vehicle Model

• Investors provide financing to the firm in

exchange for financial securities (various claims

on the firm’s cash flows).

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on the firm’s cash flows).

• The firm invests these funds in assets.

• Income generated by the firm’s assets is

distributed to the investors (i.e., the holders of the

firm’s financial securities).

The Investment Vehicle Model

Inv

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Fin

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The Firm FinancialMarkets

Exchange of Money

and Real Assets

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Inv

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The World

Financial

Intermediaries

Investors

Exchange of

Money and

Financial Assets

Investment Vehicle Model - The Flow of Cash in

a Firm

Financial ManagerFirm's Operations

(1)(2)

(4a)

Financial Investors

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(3)

(1) Cash raised from investors

(2) Cash invested in firm

(3) Cash generated by operations

(4a) Cash reinvested

(4b) Cash returned to investors

(4b)

Financial ManagerFirm's Operations Financial Markets

Investment Vehicle Model - The Flow of Cash in

a Firm

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The question here is –

what will the firm

invest in?

The question here is –

how will the firm fund

that investment?

The Balance Sheet Model

• Also known as the Accounting Model of the

Firm

• Investment decisions are represented on the

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asset (i.e. left hand) side of the balance sheet.

• Financing decisions are represented on the

liabilities and equity (i.e., right hand) side of the

balance sheet.

Current

Assets

Total Value of Assets:

Current

Liabilities

Long-Term

Total Firm Value to Investors:

Relating Value back to the Balance Sheet

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Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders

’ Equity

Debt

Current

Assets

Current

Liabilities

Long-Term

The Capital Budgeting Decision


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Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders’

Equity

Long-Term

Debt

What long-term

investments should the firm

engage in?

The Capital Structure Decision

Current

Assets

Current

Liabilities

Long-Term


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How can the firm

raise the money

for the required

investments?

Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders’

Equity

Long-Term

Debt

The Net Working Capital Investment Decision

Net

Working

Current

Liabilities

Long-Term Current

Assets


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How much short-term cash flow does a company need to pay its

bills?

Working

Capital

Shareholders’

Equity

Long-Term

DebtAssets

Fixed Assets

1 Tangible

2 Intangible

Maximizing Value (Investment

Decision): 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 via value maximization.

Assets


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the pie via value maximization.

Capital Structure (Financing

Decision): The Capital

Structure decision can be

viewed as how best to slice up

the pie. This can take on an

infinite range of possibilities.

25%

Debt

75%

Equity

70%

Debt30%

Equity

Or Or...

An Organization Chart

• The top financial manager within a firm is usually

the Chief Financial Officer (CFO)

– Treasurer: oversees cash management, credit

Financial Manager

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management, capital expenditures and financial

planning

– Controller: oversees taxes, cost accounting,

financial accounting and data processing

Quick Review MCQ

1. Corporate finance may be thought of as the analysis of three

primary decision areas. Which of the following correctly

lists these areas?

A. Capital structure, capital budgeting, security analysis

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A. Capital structure, capital budgeting, security analysis

B. Capital budgeting, capital structure, capital spending

C. Capital budgeting, capital structure, net working capital

D. Capital structure, net working capital, capital rationing

E. Capital budgeting, capital spending, net working capital

1. Sole proprietorship

Alternative Forms of Business

Organization

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2. Partnership

3. Corporation

Sole Proprietorship

• Advantages

– Easiest to start

• Disadvantages

– Limited to life of owner

Under this organization method, an individual owns and

manages the business

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– Easiest to start

– Least regulated

– Single owner keeps all

the profits

– Taxed once as personal

income

– Equity capital limited to

owner’s personal wealth

– Unlimited liability

– Difficult to sell ownership

interest

• A partnership has roughly the same advantages and disadvantages

as a sole proprietorship.

Partnership

Under this organization method, a group of individuals collectively own

and manage the business.

• Advantages • Disadvantages

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• Advantages

– Two or more owners

– More capital available

– Relatively easy to start

– Income taxed once as personal

income

• Disadvantages

– Unlimited liability

• General partnership

• Limited partnership

– Partnership dissolves when one

partner dies or wishes to sell

– Difficult to transfer ownership

Corporation

A corporation is created via Articles of Incorporation. These:

• Set out the purpose of the business.

• Establish the number of shares that can be issued.

• Set the number of directors to be appointed.

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• Set the number of directors to be appointed.

►Ownership and management are separated. A corporation issues

equity shares. The holders of these shares are the owners of the firm.

Although stockholders own the corporation, they do not necessarily

manage it. Instead they vote to elect a Board of Directors (BOD). The

BOD represents the shareholders and in this vein, (i) selects the

management team, (ii) appoints the auditors and (iii) is responsible

for checking/monitoring management’s actions.

Board of Directors

Management

Sh

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De

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old

ers

Corporate Structure - Separation of Ownership

and Control

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Management

AssetsDebt

Equity

Sh

are

ho

lde

rs

De

bth

old

ers

Corporation

• Advantages

– Limited liability

– Unlimited life

– Separation of ownership

• Disadvantages


and management (and the

resulting potential for

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and management

– Transfer of ownership is

easy

– Easier to raise capital

resulting potential for

agency costs)

– Double taxation (income

taxed at the corporate rate

and then dividends taxed at

personal rate)*

* Not for Singapore

Corporation

Private Companies – firm’s shares are usually closely held,

i.e., ownership is closely held by a relatively small number of

shareholders and shareholders often include the companies’

original founders, some financial backers (e.g., venture

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original founders, some financial backers (e.g., venture

capitalists) and others. Shares are not traded on any exchange.

Public Companies – firm’s shares are listed on a stock

exchange, whereby the company’s shares are widely

dispersed and traded in the secondary markets.

II. Debt

• Lenders – By lending money to the corporation, debt holders

become the corporation’s creditors and lenders.

• Relationship Determined by Contract - A debt contract is a legally

Corporations: Two Main Sources of External

Financing - Equity & Debt

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• Relationship Determined by Contract - A debt contract is a legally

binding agreement. It specifies principal, interest, maturity date,

and specific protective covenants.

• Security and Seniority – In case of bankruptcy, debt holders collect

before equity holders. However, different debt holders have

different priority claim to the cash flows and assets of a bankrupt

firm, according to their respective debt contracts.

Corporations: Two Main Sources of External

Financing - Equity & Debt

I. Equity

• Shareholders’ Ownership Rights – by buying shares in the

corporation, shareholders become the owners of the firm.

Shareholders are the residual claimants of the firm.

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Shareholders are the residual claimants of the firm.

• Shareholders’ Payoffs – shareholders receive monetary returns

in the following ways:

– Dividend per share, paid to investors from the corporation’s

after tax dollars.

– Capital gain from the sale of shares (ownership rights) at a

price higher than they were purchased for.

What should be the goal of a corporation?

• Commonly cited goals:

– Maximise sales/market share? lowering price or

Possible Goals of Financial Management

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– Maximise sales/market share? lowering price or

relaxing credit terms

– Minimise costs? lowering quality or R&D

– Maximise profits? short-term nature; definition of

profits, accounting or economic; risk is not addressed

Goal of Financial Management

• The primary goal is shareholder wealth maximization ⇒

which is the same as maximizing stock price

Thus the goal of the firm is to maximize its value.

– Maximize the value of the firm

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– Maximize the value of the firm

– Maximize the wealth of its owners

– Maximize the price of its stock

– Maximize its contribution to the economy

As per finance theory, the above four objectives are all best

realized when the firm uses finance’s systematic value

maximizing investment and financing decision criteria.

This will maximize the value of the “residual”.

• What determines stock prices– the underlying firm’s ability to

generate cash flows

• Three aspects of cash flows that affect asset value and thus

stock prices

How Can Managers Maximize Stock Price?

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stock prices

– Amount of cash flows expected by shareholders

– Timing of the cash flow stream

– Riskiness of the cash flow stream

⇒All three determine the stock’s Intrinsic Value*

*Your text refers to this as “Market Value” (If markets are “efficient”, then actual intrinsic value should be equal to market value).

Intrinsic Value vs. Market Price

• The intrinsic value is an estimate of an asset’s “true”

value based on accurate risk and return data.

– It is an “estimated” value, as it is based on estimated

inputs. As such we do not have a precise objectively

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inputs. As such we do not have a precise objectively

known measure

• The market price is based on perceived information

as seen by the marginal investor in the market trying

to assess an asset’s intrinsic value (can be

theoretically incorrect).

• Capital budgeting

– What long-term investments or projects should the

business take on?

Financial Management Decisions

Affecting Firm Value and thus Stock Price

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• Capital structure

– How should we pay for our assets?

– Should we use debt or equity?

• Working capital management

– How do we manage the day-to-day finances of the firm?

Maximise Value of the Firm

The Role & Decisions of the Financial

Manager

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Capital

Structure

Capital

Budgeting

Working

Capital

Management

2. The primary goal of financial management is to:

A. Maximize current sales.

B. Maximize the current value per share of the existing

Quick Review MCQ

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B. Maximize the current value per share of the existing

stock.

C. Avoid financial distress.

D. Minimize operational costs.

E. Maintain steady earnings growth

• Agency relationship:

– Principal hires an agent to represent their interest

– Stockholders (principals) hire managers (agents), via the

Board of Directors, to run the company

What is the Agency Problem?

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Board of Directors, to run the company

• Agency problem

– Conflict of interest between principal and agent

• Corporate Organization Potential Conflict of Interests:

– Shareholders and managers

– Shareholders and creditors

• Direct agency costs

– expenditures that benefit management: car and

accommodation, big office, high pay

– monitoring costs: auditors, audit committee, corporate

Agency Costs

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– monitoring costs: auditors, audit committee, corporate

governance

• Indirect agency costs

– lost opportunities which would increase firm value in

the long run, if accepted

Agency Costs Example: HSBC Faces Investor

Anger Over Proposed Pay Rise For Top Teamby Katherine Griffiths, Miles Costello,16/2/2010

• HSBC, the global bank that has been praised for its handling of the

financial crisis, has clashed with shareholders over a proposed pay rise

for its executive team. for its executive team.

• Investors are understood to be particularly unhappy with the sum that

HSBC wants to pay Michael Geoghegan, its chief executive, who

relocated his office to Hong Kong on February 1.

• HSBC will pay Michael Geoghegan, chief executive, an extra

£800,000 a year in "allowances" and "benefits in kind" for moving his

family from London to Hong Kong. 42

Shareholders versus Managers

• Managers are naturally inclined to act in their own

best interests.

• But the following factors affect managerial behavior:

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– Compensation plans tied to share value

– Direct intervention by shareholders

– The threat of firing

– The threat of takeover

1. Compensation plans that tie the fortunes of the

managers to the fortunes of the firm.

2. Monitoring by lenders, stock market analysts and

How To Handle The Agency Problem?

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investors.

3. The threat that poorly performing managers will be

fired.

4. The growing awareness of the importance of good

Corporate Governance.

Michael Eisner’s compensation

package’s 3 main components:

1. A base annual salary of $750,000

Disney’s Former CEO Compensation Package

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2. An annual bonus of 2% of Disney’s net income above a

threshold of “normal” profitability

3. A 10-year option that allowed him to purchase 2 million

shares of stock for $14 per share, which was about the

price of Disney stock at the time he was hired as the

CEO.

What is Corporate Governance?

• “Term that refers broadly to the rules, processes, or laws by which

businesses are operated, regulated, and controlled. The term can refer

to internal factors defined by the officers, stockholders or

constitution of a corporation, as well as to external forces such as

consumer groups, clients, and government regulations.”

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consumer groups, clients, and government regulations.”

• “…exists to serve corporate purposes by providing a structure within

which stockholders, directors and management can pursue most

effectively the objectives of the corporation" - US Business Round Table White Paper on

Corporate Governance September 1997

• Good corporate governance requires you to view organizations as a

web of relationships between and among various stakeholders and to

manage their interests in a responsible manner.

3. Agency costs refer to:

A. The total dividends paid to shareholders over the

lifetime of the firm.

B. The costs that result from default and bankruptcy of

Quick Review MCQ

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B. The costs that result from default and bankruptcy of

the firm.

C. Corporate income subject to double taxation.

D. The costs of the conflict of interest between

stockholders and management.

E. The total interest paid to creditors over the lifetime

of the firm.

• What are financial markets?

– markets where “financial instruments” are traded

Financial Markets

The Firm & Its Sources of Funds

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– markets where “financial instruments” are traded

– act as intermediaries between savers and borrowers

• Money Markets vs Capital Markets

• Primary Market vs Secondary Market

• Money markets

– where debt securities of less than one year are traded:

treasury securities, commercial paper, bills, inter-bank loans

– loosely connected dealer markets

Money Markets vs. Capital Markets

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– loosely connected dealer markets

– banks are major players

• Capital markets

– where equity and long-term debt claims are traded

– usually auction markets like the Singapore Exchange

Example: Money Markets

OCBC to set up commercial

paper programme, sell USD

floating-rate notes

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Singapore's OCBC Bank is planning to

set up a US$2 billion, or S$3.4 billion,

commercial paper programme for its

short-term funding needs.

25/5/2004 Channel NewsAsia

Example Capital Markets: Chinese Bank May Be

World's Biggest IPOcnnmoney.com, 6/7/2010

• One of China's biggest banks is

on track to become the largest

IPO in history.IPO in history.

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• Agricultural Bank of China, a lender which boasts more

customers than the entire U.S. population, has raised

$19.2 billion from investors, according to an individual

familiar with the matter.

• Primary market

– for government and corporations initially issued securities

– public offering - where securities are offered to public at large;

needs underwriting, more regulatory requirements, costly

– private offering - where securities are offered to large financial

institutions or wealthy individuals etc.; less costly

Primary Market vs. Secondary Market

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institutions or wealthy individuals etc.; less costly

• Secondary market

– where existing financial claims are traded

– dealer market (e.g. OTC markets)

– auction market (e.g. SGX, NYSE)

– where getting market value of securities is easier

Example: Primary MarketVisa raises $17.9bn in record IPO

• The world's largest credit card

network sold 406m shares at $44

each, raising $17.9bn. The shares

were initially forecast to sell at were initially forecast to sell at

between $37 and $42.

53March 19, 2008, Guardian.co.uk

• Shares opened more than 30% above the offer price - at $59.50 -

and headed up to the $60 level in early trading.

• The San Francisco-based company will make its debut with a

market value of about $36bn.

Example: Secondary MarketDow and S&P at new '09 highs

Wall Street gains after a smaller-than-expected number of jobs

lost and a surprise drop in the unemployment rate. Investors

trading among themselves.

• NEW YORK (CNNMoney.com) --• NEW YORK (CNNMoney.com) --

Stocks rallied Friday, with the Dow

and S&P 500 closing at the highest

point in nine months, after the July

jobs report showed the smallest

number of job losses54

August 7 2009, CNNMoney.com

The Firm

DebtEquity

Firm’s Sources Of Funds

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Share

IssuanceRetained

Earnings

Bank

BorrowingBond

Issuance

Residual Claims Contractual Obligations

1. The scope of financial studies involves business finance,

financial markets and investments.

2. Business finance involves investment and financing

decisions & working capital management.

Summary

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3. The goal of financial management is to make decisions

that maximise the market value of the equity or owners’

wealth.

4. There are conflicts of interest between shareholders and

managers - agency costs

Last Quick Review MCQ

4. The process of planning and managing a firm’s

long-term investments is called:

A. Working capital management.

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A. Working capital management.

B. Financial depreciation.

C. Agency cost analysis.

D. Capital budgeting.

E. Capital structure.

Information on the Web

• The Internet provides a wealth of information

about individual companies

• One excellent site is finance.yahoo.com

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• For locally listed companies, visit the Singapore

Exchange website at www.sgx.com.

Documents

FIN2004 Session 1