FINANCE FIN2004

Lecture 1: Financial Management Overview

Education Objectives
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 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
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What is Finance?
A discipline concerned with determining value (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.
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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 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 theyll finance their operations. Will they borrow or will they bring in new investors/shareholders?
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Personal Finance Applications - Examples:

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. 2. 3. 4. 5. When to start saving for retirement and how much to save? How to evaluate the terms for a home mortgage? Whether a car loan or a lease is more advantageous? Is a particular stock a good investment? Is a particular fund a good investment? How to finance a childs education?
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Scope of Study in Finance

Main Areas of Finance:
1. Investments 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 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?
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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 commercial banks, investment banks, and insurance companies) that facilitate the flow of money from savers to demanders of money.

Corporate Finance
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 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 Decision

New 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 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
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Example: Corporate Finance Financing Decision

DreamWorks Animation files for 650-million-dollar share offering
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. 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 10

The Investment Vehicle Model

Investors provide financing to the firm in exchange for financial securities (various claims on the firms cash flows). The firm invests these funds in assets. Income generated by the firms assets is distributed to the investors (i.e., the holders of the firms financial securities).
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The Investment Vehicle Model

Exchange of Money and Real Assets

The Firm Investment Decisions Financing Decisions

Financial Markets Exchange of Money and Investors Financial Assets

The World

Financial Intermediaries
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Investment Vehicle Model - The Flow of Cash in a Firm

Firm's Operations

(2)

Financial Manager

(1) Financial Investors

(4a)

(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)

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Investment Vehicle Model - The Flow of Cash in a Firm

Firm's Operations Financial Manager Financial Markets

The question here is what will the firm invest in?

The question here is how will the firm fund that investment?
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The Balance Sheet Model

Also known as the Accounting Model of the Firm Investment decisions are represented on the 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.
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Relating Value back to the Balance Sheet

Total Value of Assets: Total Firm Value to Investors: Current Liabilities Long-Term Debt

Current Assets

Fixed Assets 1 Tangible 2 Intangible Shareholders Equity

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Relating Value back to the Balance Sheet

The Capital Budgeting Decision
Current Assets Current Liabilities Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

What longterm investments should the firm engage in?

Shareholders Equity
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Relating Value back to the Balance Sheet

The Capital Structure Decision
Current Assets Current Liabilities

Fixed Assets 1 Tangible 2 Intangible

How can the firm raise the money for the required investments?

Long-Term Debt

Shareholders Equity
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Relating Value back to the Balance Sheet

The Net Working Capital Investment Decision
Current Liabilities
Net Working Capital

Current Assets

Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

How much shortterm cash flow does a company need to pay its bills?

Shareholders Equity
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Relating Value back to the Balance Sheet

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. 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.

Assets

Or
25% Debt 75% Equity 70% Debt 30% Equity

Or...

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An Organization Chart

Financial Manager
The top financial manager within a firm is usually the Chief Financial Officer (CFO)
Treasurer: oversees cash management, credit management, capital expenditures and financial planning Controller: oversees taxes, cost accounting, financial accounting and data processing
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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 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
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Alternative Forms of Business Organization

1. Sole proprietorship 2. Partnership 3. Corporation

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Sole Proprietorship
Under this organization method, an individual owns and manages the business Disadvantages Advantages Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income Limited to life of owner Equity capital limited to owners personal wealth Unlimited liability Difficult to sell ownership interest
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Partnership
Under this organization method, a group of individuals collectively own and manage the business. A partnership has roughly the same advantages and disadvantages as a sole proprietorship. Advantages Two or more owners More capital available Relatively easy to start Disadvantages Unlimited liability General partnership Limited partnership

Income taxed once as personal Partnership dissolves when one income partner dies or wishes to sell Difficult to transfer ownership
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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. 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 27 for checking/monitoring managements actions.

Corporate Structure - Separation of Ownership and Control

Board of Directors Shareholders Debtholders Management

Assets

Debt Equity

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Corporation
Advantages
Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital

Disadvantages
Separation of ownership and management (and the resulting potential for agency costs) Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate)*
* Not for Singapore
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Corporation
Private Companies firms 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 capitalists) and others. Shares are not traded on any exchange. Public Companies firms shares are listed on a stock exchange, whereby the companys shares are widely dispersed and traded in the secondary markets.
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Corporations: Two Main Sources of External Financing - Equity & Debt

II. Debt Lenders By lending money to the corporation, debt holders become the corporations creditors and lenders. 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.
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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. Shareholders Payoffs shareholders receive monetary returns in the following ways: Dividend per share, paid to investors from the corporations after tax dollars. Capital gain from the sale of shares (ownership rights) at a price higher than they were purchased for.
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Possible Goals of Financial Management

What should be the goal of a corporation?
Commonly cited goals:
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
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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 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 finances systematic value maximizing investment and financing decision criteria. This will maximize the value of the residual.

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How Can Managers Maximize Stock Price?

What determines stock prices the underlying firms ability to generate cash flows Three aspects of cash flows that affect asset value and thus 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 stocks Intrinsic Value*
*Your text refers to this as Market Value (If markets are efficient, then actual intrinsic value should be equal to market value).
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Intrinsic Value vs. Market Price

The intrinsic value is an estimate of an assets 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 known measure

The market price is based on perceived information as seen by the marginal investor in the market trying to assess an assets intrinsic value (can be theoretically incorrect). 36

Financial Management Decisions

Affecting Firm Value and thus Stock Price
Capital budgeting What long-term investments or projects should the business take on? 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?
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The Role & Decisions of the Financial Manager

Maximise Value of the Firm

Capital Budgeting

Capital Structure

Working Capital Management

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Quick Review MCQ

2. The primary goal of financial management is to:
A. Maximize current sales. B. Maximize the current value per share of the existing stock. C. Avoid financial distress. D. Minimize operational costs. E. Maintain steady earnings growth
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What is the Agency Problem?

Agency relationship:
Principal hires an agent to represent their interest Stockholders (principals) hire managers (agents), via the 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
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Agency Costs
Direct agency costs
expenditures that benefit management: car and accommodation, big office, high pay monitoring costs: auditors, audit committee, corporate governance

Indirect agency costs

lost opportunities which would increase firm value in the long run, if accepted
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Agency Costs Example: HSBC Faces Investor Anger Over Proposed Pay Rise For Top Team
by 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. 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.
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Shareholders versus Managers

Managers are naturally inclined to act in their own best interests. But the following factors affect managerial behavior:
Compensation plans tied to share value Direct intervention by shareholders The threat of firing The threat of takeover
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How To Handle The Agency Problem?

1. Compensation plans that tie the fortunes of the managers to the fortunes of the firm. Monitoring by lenders, stock market analysts and investors. The threat that poorly performing managers will be fired. The growing awareness of the importance of good Corporate Governance.
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2.

3.

4.

Disneys Former CEO Compensation Package

Michael Eisners compensation packages 3 main components:
1. A base annual salary of $750,000 2. An annual bonus of 2% of Disneys 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.
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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. 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.

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Quick Review MCQ

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 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.

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The Firm & Its Sources of Funds

Financial Markets
What are financial markets? markets where financial instruments are traded act as intermediaries between savers and borrowers Money Markets vs Capital Markets Primary Market vs Secondary Market

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Money Markets vs. Capital Markets

Money markets
where debt securities of less than one year are traded: treasury securities, commercial paper, bills, inter-bank loans 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
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Example: Money Markets

OCBC to set up commercial paper programme, sell USD floating-rate notes
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
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Example Capital Markets: Chinese Bank May Be

World's Biggest IPO
cnnmoney.com, 6/7/2010

One of China's biggest banks is on track to become the largest IPO in history. 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.

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Primary Market vs. Secondary Market

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 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
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Example: Primary Market

Visa 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 between $37 and $42. 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.
March 19, 2008, Guardian.co.uk
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Example: Secondary Market

Dow 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) -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 losses August 7 2009, CNNMoney.com

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Firms Sources Of Funds

The Firm
Equity Debt

Share Issuance

Retained Earnings

Bank Borrowing

Bond Issuance

Residual Claims

Contractual Obligations
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Summary
1. The scope of financial studies involves business finance, financial markets and investments. 2. Business finance involves investment and financing decisions & working capital management. 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
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Last Quick Review MCQ

4. The process of planning and managing a firms long-term investments is called:
A. Working capital management. B. Financial depreciation. C. Agency cost analysis. D. Capital budgeting. E. Capital structure.
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Information on the Web

The Internet provides a wealth of information about individual companies One excellent site is finance.yahoo.com For locally listed companies, visit the Singapore Exchange website at www.sgx.com.

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