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FIN2004 Session 1
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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
1
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?
2
(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
3
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:
4
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
5
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
6
– 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
7
• 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
8
– 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
9
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
10
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).
11
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
es
tme
nt
De
cis
ion
s
Fin
an
cin
gD
ec
isio
ns
The Firm FinancialMarkets
Exchange of Money
and Real Assets
12
Inv
es
tme
nt
De
cis
ion
s
Fin
an
cin
gD
ec
isio
ns
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
13
(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
14
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
15
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
16
Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders
’ Equity
Debt
Current
Assets
Current
Liabilities
Long-Term
The Capital Budgeting Decision
Relating Value back to the Balance Sheet
17
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
Relating Value back to the Balance Sheet
18
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
Relating Value back to the Balance Sheet
19
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
Relating Value back to the Balance Sheet
20
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
22
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
23
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
24
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
25
– 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
26
• 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.
27
• 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
are
ho
lde
rs
De
bth
old
ers
Corporate Structure - Separation of Ownership
and Control
28
Management
AssetsDebt
Equity
Sh
are
ho
lde
rs
De
bth
old
ers
Corporation
• Advantages
– Limited liability
– Unlimited life
– Separation of ownership
• Disadvantages
– Separation of ownership
and management (and the
resulting potential for
29
– Separation of ownership
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
30
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
31
• 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.
32
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
33
– 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
34
– 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?
35
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
36
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
37
• 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
38
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
39
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?
40
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
41
– 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:
43
– 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?
44
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
45
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.”
46
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
47
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
48
– 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
49
– 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
50
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.
51
• 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
52
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
55
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
56
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.
57
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
58
• For locally listed companies, visit the Singapore
Exchange website at www.sgx.com.
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