Lecture 1

Introduction to ACFI2070
READINGS: CHAPTER 1, PEIRSON ET AL. 2015

Course Coordinator: Van Vu

Agenda
Introduction to course
◦Teaching staff
◦Assessments
◦Course content
◦Workshop structure
Introduction to finance

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Teaching staff contact
Dr. Van Vu
◦Course coordinator and lecturer
◦Email: Van.Vu@Newcastle.edu.au
Please include the unit code in email title (ACFI2070)

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Assessments
In-class tests: 20% (total)
◦ Four tests over the semester
◦ 5% each
◦ Duration: 30 minutes
◦ See unit outline for further details
Mid-term test: 30%
◦ Week 7 (exact time to be
confirmed)
◦ More information will be
provided closer to the test
◦ Duration: 2 hours + 10 minutes
reading
Exam: 50%
◦ Duration: 3 hours + 10 minutes
reading

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Course content
This course has 4 modules
1. Financial maths (Chapter 3) – covered in weeks 2 and 3
2. Project valuation (Chapters 5 and 6) – covered in weeks 4, 5 and 6
3. Modern investment theory (Chapter 7) – covered in weeks 8, 9
and 10
4. Sources of finance (Chapters 4, 9 and 10) – covered in weeks 11
and 12
5. Revision in week 13

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 Introduction to finance
1. The functions of a capital market.
2. Financial agency institutions, financial intermediaries
and investing institutions.
3. Types of business entities.
4. The financial manager’s key objective and the agency
issue.
5. The key characteristics of financial assets
6. The rate of return

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 Corporate finance theory - Overview
Financial input
- Shares, bonds,
owners’ equity etc etc
Other input (eg, skilled
workers, social values,
legal institutions
Investment outcome
Corporations - Project valuation
- Legal entity - M&A
- Series of contracts
binding different
people together
Shareholder payout
- Dividends
- Capital gains

We view a corporation as a combination of contracts. We model the payout

of each party accordingly

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Corporate Decisions
Corporate finance is concerned with…

…the investment decision (expected wealth-creating activities)

and…

… the financing decision (the provision of funds that allows

these activities to proceed).

… the payout decision (what to do with excess cash).

(we don’t have to worry about this now)
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 Recent Financing & Investment Decisions
Source: Brealey, Myers, Allen “Principles of Corporate Finance” 5th
Edition, page 3.
Company Recent Investment Decisions Recent Financing Decisions
LVMH Acquires Italian jeweller, Bulgari, Pays for the acquisition with a
for $5 billion. mixture of cash and shares.
Boeing Delivers first Dreamliner after Reinvests $1.7 billion in profits.
investing a reported $30 billion in
development costs.
Vale (Brazil) Opens a huge copper mine at Maintains credit lines with its
Salobo in Brazil. The project cost banks that allow the company to
nearly $2 billion. borrow at any time up to $1.6
billion.
Procter & Spends $8 billion on advertising. Raises 100 billion Japanese yen
Gamble by an issue of 5 year bonds.
GlaxoSmithKline Spends $4 billion on research and Pays $3.2 billion as dividends.
development for new drugs.

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Financing Decisions
Equity or debt?
Short term or long term?
Internal cash?
Pay dividends or retain the cash?
Does it really matter?
◦ e.g. Microsoft – historically very little debt or dividends
◦ http://www.bloomberg.com/news/articles/2015-02-09/microsoft-said-to-
seek-7-billion-in-its-biggest-u-s-bond-sale
Bad financing decisions can lead to disaster e.g. sub-prime mortgages, high
debt levels on newspaper businesses
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Where do companies raise funds?
Financial System In A Nutshell

Deficit Units

Surplus Units

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 Surplus and Deficit Units
Surplus Units
Savers (those with an ‘excess’ of money) or providers of funds.
Funds are available for lending or investment (related to the
investment decision), with some expectation of earning further
money.

Deficit Units
Borrowers (those with a ‘lack’ of money) requiring funds.
Funds may be used for consumption or further investment
(related to the financing decision).

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Financial Assets: Instruments &
Securities
Financial Instruments
Financial assets that exist in paper or electronic form, and are
not traded in a market.
Examples: bank accounts, mortgages, personal loans, etc.

Financial Securities
Financial assets that exist in paper or electronic form, and are
traded in a market, allowing for transfer of claims (contracts).
Examples: shares, bonds, promissory notes, etc.
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 Types of Markets
Primary Market
Primary market transactions relate to the creation of a new financial asset.
For example, a company issues new shares or the government issues new Treasury
bonds.
New funds are raised, and new securities are created.
Secondary Market
Secondary market transactions relate to the sale and transfer of existing financial
assets.
For example, the sale of a share from one investor to another investor – no new
shares are created.
Secondary markets help with liquidity – the ability readily convert a financial asset
into cash at the given market price.

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 Primary Markets
Direct Finance
An entity raises the funds via primary issuance, obtaining the new funds directly from
(investors in) the market.
For example, a new company is created, and for funding it sells newly created shares
directly to investors.
Wholesale markets are direct flows of funds between institutional investors and
borrowers. They typically involve large value transactions.
Intermediated Finance
An entity obtains the funds via an intermediary.
For example, a new company is created, and for funding it gets a loan from a bank.
Retail markets are transactions conducted mainly with financial intermediaries by the
household and small- to medium-sized business sectors. They typically involve smaller
value transactions.
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 Financial Intermediation
Financial Intermediaries
Act as the principal by:
◦ Providing funds to the borrowers (deficit units), whom are now obligated to pay the
intermediary (the principal).
◦ Borrow funds from the lenders (surplus units), and the lenders now have a claim
against the intermediary.

Include: banks, building societies, credit unions, and finance companies.

For example:
◦ The bank takes deposits, it has an obligation to repay its depositors.
◦ The bank also makes a loan to a company, the company has an obligation to repay the
bank.
◦ Note: ‘indirect’ because the company (the ultimate borrower) does not have a
contractual obligation to repay the depositors.
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 Financial Intermediation

The process of financial Intermediation can:

Harmonise the differences in size, maturity, and risk preferences
between surplus and deficit units.
Generate economies of scale as a result of specialist skills.
Result in a pooling of risks associated with lending across a range of
deficit units, yet benefit from diversification across industries and
geographies.
However, obtaining funds through an intermediary may be more
expensive than through direct financing.
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 Financial Agency Institutions
Financial Agency Institutions: arrange or facilitate the direct transfer of funds
from lenders (surplus units) to borrowers (deficit units) for fees or
commissions.

Stockbrokers – earn a fee or commission for their services helping to buy and
sell shares; may be discount or full-service.

Investment Banks – participate in wholesale banking; trading and market

making in securities, foreign exchange, and derivatives; investment
management; corporate advice including legal, and on mergers and
acquisition; underwriting; and stockbroking.

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 Investing Institutions
Investing Institutions : Accept funds from the public and invests them in assets.
Superannuation Funds – Funds that represent the pooled savings of future retirees. Monies
invested in a wide range of asset classes.
Life Insurance Companies – Collect premiums from customers, investing the proceeds, and
make payments in the event of death or accidents, subject to the terms and conditions of the
insurance policy.
General Insurance Companies – Collect premiums from customers, investing the proceeds,
and make payments in the event of car accidents, theft, fire, etc., subject to the terms and
conditions of the insurance policy.
Unit Trusts – A collective investment where the funds of the investors are pooled and invested
by a professional management company in a wide range of investments typically of a specific
asset type ; Real estate investment trusts (REITs) allow investors to acquire an interest in a
professionally managed portfolio of real estate.

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 Maturity and Markets
Maturity
A financial asset is considered to have a maturity date, or ‘lifespan’, after which
it will cease to exist.
For example, a loan must be fully repaid by the end of five years. The maturity
of this loan is five years.
Capital Markets
Capital markets are where long-term financial securities (with maturities greater
than 1 year) are created and traded.
Money Markets
Money markets are where short-term financial securities (with maturities less
than 1 year) are created and traded.

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Other Market Characteristics
Domestic Exchange Traded
Use of a market by residents of that A financial asset created and traded on a
country. formal exchange.
For example, an Australian company issues Typically a public market and
shares to domestic investors. standardised.

International Over-The-Counter (OTC)

Use of a market by non-residents of that
country.
For example, an Australian bank issues
bonds to non-resident international
investors.
A financial asset created without it trading
on a formal exchange.
Typically a ‘private’ market and non-
standardised.

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Business Structures (the borrower)
Sole Proprietorship
Business is owned by one person.
Partnership
Business is owned by two or more people acting as partners.
Company
Separate legal entity formed under the Corporations Act; shareholders are
the owners of the company.
Shareholders have a limited liability.
A corporation continues to operate regardless of changes in ownership.

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The Company’s Financial Objective
We assume that management aims to maximise shareholders’ wealth.
Market Value of firm
V=D+E
Where:
– D = the market value of the company’s debt.
– E = the market value of the company’s equity (shares).

The value the market puts on a company’s debt will depend on the risk and
expected return of those securities, which, in turn, depends on the risk and
return of the company’s assets.
Financial markets will value debt and equity, taking into account the risk and
expected return from investing in these securities.

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Agency Theory
In an Agency Relationship:
Principal – party who delegates decision-making authority
to another party.
Agent – party to whom the principal has delegated
decision making authority to, to act on their behalf.
E.g. in a company: shareholders and managers.
Will the agent act in the best interests of the principal?

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Agency Theory
–Agency costs occurs when there is a conflict of interest between the
principal and agent.
Eg: Managers may act in their own best interests rather than in the interests
of shareholders or lenders
–Agency costs would come in two forms, including the loss of wealth
because managers do not attempt to maximise shareholders’ wealth
and monitoring costs.
Eg: Shareholders monitor managers via the Board of Directors and by using
attractive remuneration schemes to give managers incentives to maximise
the shareholders’ wealth.

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Financial Assets by Type
Debt
Specify the conditions of some form of loan
agreement which must be repaid, including:
the issuer (borrower), amount borrowed,
return (rate of interest), timing of the cash
flows, and the maturity date.
For example: bank accepted bills, corporate
bonds, government bonds, debentures,
mortgages, promissory notes, etc.
Equity
The sum of the financial interest an investor
has in the company’s assets, representing an
ownership position.
For example: shares.
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Hybrids
A financial security that has characteristics of
both debt and equity.
For example: preference shares.
Derivatives
Are financial instruments/securities which
derive their price from an underlying physical
commodity or security.
Used mainly for managing risks (hedging).
For example: futures, options, swaps
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Four Important Attributes of Financial
Assets
Return (or Yield) – The total financial benefit received (interest,
dividends, capital gains) from an investment, typically expressed as a
percentage.
Risk – The possibility or probability that an actual outcome will vary
from the expected outcome.
Liquidity – the ability to readily convert an asset into cash at the
prevailing market price
◦ How quickly assets can be bought and sold at low cost

Timing of the Cash Flows – The frequency of periodic cash flows

(interest and principal) associated with a financial asset.
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Risks and Information
In finance it is commonly assumed that investors are risk
averse – they have a dislike of risk.
Default Risk – the chance that a borrower will fail to meet
obligations to pay interest and principal as promised.
Arbitrage – simultaneous transactions in different markets
that result in an immediate and risk-free profit.
Market Efficiency considers how rapidly information is
incorporated into prices as well-informed individuals make
transactions based upon this new information.
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Rate of Return
Returns are expressed as:

r = Total Proceeds (Net Inflows) / Initial Investment (Outflow)

Change in the value of

the investment plus
any income or
dividends paid

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Example: Rate of Return
Nick invested $10,000 in a portfolio of shares. At the end of the
year, the shares in the portfolio paid a total of $100 in dividends. At
this point, Nick sold his portfolio for $11,000. What is the return on
investment?
Return = Total Proceeds / Initial Investment
= (Cash Dividend + Capital Gains)/Cost
= [$100 + ($11,000-$10,000)]/$10,000
= 11%

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Example: Rate of Return
Nick later uses his $11,100 to buy pumpkins in September, believing
they will rise in price through the rest of the year. He decides to sell
them in December. At this point, Nick finds a buyer who will only pay
$10,000 for them.
Return = Total Proceeds / Initial Investment
= (Cash Inflow at Time 1 – Cash Outflow at Time 0)/Cash Outflow at
Time 0
= ($10,000 – $11,100)/$11,100
= –9.91%
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