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1. Eugene F. Brigham, Joel F. Houston, Yao-Min Chiang, Hon-Sing Lee and Bany Ariffin, Essentials of Financial Management, Cengage Learning, 2nd edition, 2010 [EUGENE]
2. Financial Management : Core Principles and Applications, 3rd Edition Ross Westerfield Faffe and Jordan (2011) [ROSS]
3. Financial Management, 3rd Edition Megginson, Smart , Graham (2010) [SMART]
AC4331 - Topic 1
.
Corporate Financial Policy
Semester A 2012-13
City University of Hong Kong
Week 1
1-2
1 Introduction to Financial Management 2 Fundamental Concepts in Financial Management : Free Cash Flow; Financial Planning and Forecasting 3 Financial Assets and Time Value of Money; Interest Rates, Risk and Rates of Return 4 Bonds and Stock Valuations 5 Cost of Capital 6 Cash Flow Estimation and Risk Analysis 7 Capital Structure and Leverage MID TERM TEST (S01,SO2,SO3) Venue: LT-2, AC1 Date and Time:
18/10/2012 (Thursday) 6:30pm-8:30pm 8 Guest Lecture (1):Treasury and Valuation 9 Guest Lecture (2): Enterprise Risk Management 10 Dividends and Share Repurchase 11Guest Lecture (3):Merger and Acquisitions* 12 Working Capital Management Group Project Presentations
Know the main concerns of corporate financial management
Identify the goal of financial management Enumerate the financial benefits and
drawbacks of differing forms of business organization
Understand the conflicts of interest that can arise between owners and managers
Comprehend that corporate organizations are enhanced by financial markets
Revisit the core principles of corporate finance
1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Goal of Financial Management
1.4 The Agency Problem and Control of the Corporation
1.5 Financial Markets
1.6 Core Principles of Finance
1.7 Regulations
1-4
Corporate Finance addresses the following key questions:
1. What long-term investments should the firm
choose?
2. How should the firm raise funds for the selected investments?
3. How should short-term assets be managed and financed?
4. How is risk managed?
5. How to comply with regulations?
1-5
Concerns the _____, _____, and _______ of assets with some overall goal in mind.
Keeps track of resources in terms of dollars Primary concern is the
firm and its operations
Focus on corporations
1-8
Financing
(Raising Capital)
Financial Management
Capital Budgeting
Risk Management
Corporate Governance
1 - 8
1-9
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Total Firm Value to Investors:
1-
10
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
What long-term investments should the firm choose?
1 - 11
Capital Budgeting: Selecting the best projects in which to invest the firm’s
resources
The capital budgeting process consists of three steps. Step 1 - Identifying potential investments
Step 2 - Analyzing those investments to identify which will create shareholder value
Step 3 - Implementing and monitoring the investments selected in Step 2
1 - 12
1-
13
How should the
firm raise funds
for the selected
investments?
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Businesses can raise money in 2 ways: ◦ Externally from investors or creditors
Venture capital
Initial public offering (IPO)
Money market
Long-term debt
◦ Internally by retaining operating cash flows
Most common method
1-
14
1 - 14
1 - 15
Primary vs. secondary market transactions or offerings
Most financing from internal rather than external sources.
Most external financing is debt.
Financial intermediaries declining as a source of capital for large firms
Securities markets growing in importance 1 - 15
The Financial Management Function
Managing daily cash inflows and outflows
Forecasting cash balances
Building a long-term financial plan
Choosing the right mix of debt and equity
1 - 16 1-
16
1-
17
How should short-term assets be managed and financed?
Net
Working
Capital
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Current Assets
Fixed Assets
1 Tangible
2 Intangible
1-
18
How should the firm raise funds for the selected investments?
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Current Assets
Fixed Assets
1 Tangible
2 Intangible
1-
19
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.
The Capital Structure
decision can be viewed as
how best to slice the pie.
If how you slice the pie affects the size of the pie,
then the capital structure decision matters.
50%
Debt
50%
Equity
25%
Debt
75%
Equity
70%
Debt 30%
Equity
Identifying, measuring, and managing all types of risk exposures
Some risks are insurable, and some risks can be reduced through diversification.
Financial instruments like forwards, futures, options, and swaps may also be used to hedge market risks such as interest-rate, price, and currency fluctuations.
1 - 20
Hires and promotes qualified, honest people, and structures employees’ financial incentives to motivate them to maximize firm value
In practice the incentives of stockholders, managers, and other stakeholders often conflict.
Dimensions of corporate governance: ◦ Board of directors
◦ Securities and Exchange Commission
◦ Sarbanes-Oxley Act of 2002
1 - 21
Board performance and structure
Risk management
Internal control
Related-party transaction disclosure
Other indicators: quality leaders with strong ethical values
Ref: A Plus August 2011 Championing good governance, President’s message (HKICPA)
22
The Financial Manager’s primary goal is to increase the value of the firm by:
1. Selecting value creating projects
2. Making smart financing decisions
1-
23
optimal firm size?
specific assets to be acquired?
assets (if any) to be reduced or eliminated?
Most important of the key decisions.
1-
25
Source: Servaes and Tufano, “CFO Views on the Importance and Execution of the Finance Function” (Deutsche Bank,
2006).
1-
26
Chairman of the Board and Chief Executive Officer (CEO)
President and Chief Operating Officer (COO)
Vice President and Chief Financial Officer (CFO)
Treasurer Controller
Cash Manager
Capital Expenditures
Credit Manager
Financial Planning
Tax Manager
Financial Accounting
Cost Accounting
Data Processing
Board of Directors
1-
27
Cash flow from firm (C)
Taxes (
D)
Government
Retained cash flows (F)
Invests
in assets
(B)
Dividends and debt payments (E)
Current assets
Fixed assets
Short-term debt
Long-term debt
Equity shares
Ultimately, the firm
must be a cash
generating activity.
The cash flows from
the firm must exceed
the cash flows from
the financial markets.
Firm Firm issues securities (A) Financial
markets
The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash.
However, businesses can take other forms.
1-
28
The Sole Proprietorship The Partnership ◦ General Partnership ◦ Limited Partnership
The Corporation
1-
29
1 - 30
Sole Proprietorships
• No distinction between business and owner
• Easy to set up and operate
• Business earnings taxed as personal income
• Limited life, Limited access to capital, Unlimited personal liability
Partnerships • Similar to sole proprietorship, but has two or more owners
• Joint and several liability
• Share of profits taxed as partnership income
Limited Partnerships
• One or more general partners with unlimited personal liability
• Most owners are limited partners, who are passive investors with limited liability
1 - 31
Are there any disadvantages for corporations? YES! Double taxation
Corporations
• Separate legal entity with many of the economic rights and responsibilities of individuals
• Unlimited life, Limited liability, Separable contracting, Improved access to capital
• Owned by shareholders, who elect the Board of Directors
• Board appoints a President or CEO to manage day-to-day operations
• In the U.S., incorporation is executed at state level and governed by state law
1-
32
Corporation
Partnership
Liquidity
Shares can be easily
exchanged
Subject to substantial
restrictions
Voting Rights
Usually each share gets one
vote
General Partner is in charge;
limited partners may have
some voting rights
Taxation
Double
Partners pay taxes on
distributions
Reinvestment and dividend
payout
Broad latitude
All net cash flow is
distributed to partners
Liability
Limited liability
General partners may have
unlimited liability; limited
partners enjoy limited
liability
Continuity
Perpetual life
Limited life
What is the correct goal? ◦ Maximize profit?
◦ Minimize costs?
◦ Maximize market share?
◦ Maximize shareholder wealth?
1-
33
What goals are important for firms globally?
Task: Each group would pick a country and discuss among themselves.
1-
34
1-
35
What stakeholders are important for firms globally?
Task: Each group would pick a kind of stakeholders and discuss among themselves.
1-
36
1-
37
Maximize Profit? ◦ Earnings per share are backward-looking,
dependent on _______________
◦ Does not fully consider cash flow t______
◦ Ignores ______
Maximize Shareholder Wealth? ◦ Maximize stock price, not _______
◦ Shareholders, as residual claimants, have better
incentives to maximize firm _____
1 - 38
If the firm is to prosper, it must: ◦ Buy assets that generate more cash than they cost
◦ Sell financial instruments that raise more cash than they cost
The successful firm generates more cash than it uses
Cash flow from firm (C)
Taxes (
D)
Government
Retained cash flows (F)
Invests
in assets
(B)
Dividends and debt payments (E)
Current assets
Fixed assets
Short-term debt
Long-term debt
Equity shares
Ultimately, the firm
must be a cash
generating activity.
The cash flows from
the firm must exceed
the cash flows from
the financial markets.
Firm Firm issues securities (A) Financial
markets
Do not confuse cash flow and accounting income ◦ Non-Cash expense example: Depreciation
◦ Non-Cash revenue example: Sales on Account
Agency relationship ◦ Principal hires an agent to represent his/her
interest
◦ Stockholders (principals) hire managers (agents) to run the company
Agency problem ◦ Conflict of interest between principal and agent
1-
42
Cost of Conflict of Interest
Example: ◦ Large investment positions firm for long term
positive cash flow but has risk in short run
Owners want this investment – Increases firm value
Managers object – Risk may have personal cost
◦ If managers prevail, foregone long term cash flow is the Agency Cost
Managerial goals may be different from shareholder goals ◦ Expensive perquisites
◦ S__________
◦ I __________
Increased g_____ and s____ are not necessarily equivalent to increased shareholder wealth
1-
44
Managers act as agents of the owners who hired them and gave them decision-making authority to manage the firm for the owners’ benefit.
In practice however, self-interest may cause managers to pursue objectives other than shareholder wealth maximization.
This conflict of goals gives rise to managerial agency problems.
1 - 45
Managerial compensation ◦ Incentives can be used to align management and
stockholder interests ◦ The incentives need to be structured carefully to
make sure that they achieve their intended goal
Corporate control ◦ The threat of a takeover may result in better
management
Influence of other stakeholders
1-
46
Ways to limit agency problems: ◦ Activism by institutional investors
◦ Takeover threat
◦ Monitoring and bonding
◦ Compensation contracts
Tie managerial wealth to stock value
1 - 47
Maximize Profit? ◦ Earnings per share are backward-looking,
dependent on accounting principles
◦ Does not fully consider cash flow timing
◦ Ignores risk
Maximize Shareholder Wealth? ◦ Maximize stock price, not profits
◦ Shareholders, as residual claimants, have better
incentives to maximize firm value.
1 - 48
Primary Market ◦ Issuance of a security for the first time
Secondary Markets ◦ Buying and selling of previously issued securities
◦ Securities may be traded in either a dealer or auction market
NYSE
NASDAQ
1-
49
1-
50
Firms
Investors
Secondary
Market
money
securities Sue Bob
Stocks and
Bonds
Money
Primary Market
The time value of money ◦ The opportunity to earn a return on invested
funds means that a dollar today is worth more than a dollar in the future.
Compensation for risk ◦ Investors expect compensation for bearing risk.
1 - 51
Don’t put all your eggs in one basket. ◦ Investors can achieve a more favorable tradeoff
between risk and return by diversifying their portfolios.
Markets are smart. ◦ Competition for information tends to make
markets efficient.
No arbitrage ◦ Risk-free money-making opportunities are
extremely scarce.
1 - 52
The Securities Act of 1933 and the Securities Exchange Act of 1934
◦ Issuance of Securities (1933)
◦ Creation of SEC and reporting requirements (1934)
Sarbanes-Oxley (“Sarbox”) ◦ Increased reporting requirements and responsibility
of corporate directors
◦ Personal consequences for non-compliance
What are the three basic questions Financial Managers must answer?
What are the three major forms of business organization?
What is the goal of financial management?
What are agency problems, and why do they exist within a corporation?
What major regulations impact public firms?
1-
54
What is the impact of financial crisis on a business and financial department?
1-
55
What are the most important skills for accounting and finance students to develop in time of global economic downturn caused by financial crisis?
1-
56