AC4331 - Topic 1

1. 2.

3.

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] Financial Management : Core Principles and Applications, 3rd Edition Ross Westerfield Faffe and Jordan (2011) [ROSS] Financial Management, 3rd Edition Megginson, Smart , Graham

(2010) [SMART]

Week 1
Corporate Financial Policy Semester A 2012-13 City University of Hong Kong

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

1-2

 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

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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?
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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

Financing (Raising Capital) Financial Management

Capital Budgeting

Risk Management

Corporate Governance
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1-8

Total Value of Assets:

Total Firm Value to Investors:

Current Assets

Current Liabilities
Long-Term Debt

Fixed Assets

1 Tangible
2 Intangible

Shareholders Equity
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Current Assets

Current Liabilities

Long-Term Debt

Fixed Assets 1 Tangible

2 Intangible

What long-term investments should the firm choose?

Shareholders Equity
110

Capital Budgeting: Selecting the best projects in which to invest the firms resources

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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

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Current Assets

Current Liabilities

How should the firm raise funds for the selected Fixed Assets investments? 1 Tangible
2 Intangible

Long-Term Debt

Shareholders Equity
113

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

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114

Most financing from internal rather than external sources. Most external financing is debt.

Primary vs. secondary market transactions or offerings

Financial intermediaries declining as a source of capital for large firms Securities markets growing in importance 1 - 15
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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
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116

Current Assets

Current Liabilities
Net Working Capital

Long-Term Debt

Fixed Assets 1 Tangible

2 Intangible

How should short-term assets be managed and financed?

Shareholders Equity
117

Current Assets

Current Liabilities

Fixed Assets 1 Tangible

How should the firm raise funds for the selected investments?

Long-Term Debt

2 Intangible

Shareholders Equity
118

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. 70% 30% 25%50% DebtDebt Equity 75% 50% Equity

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.
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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.
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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, Presidents message (HKICPA)

22

The Financial Managers primary goal is to increase the value of the firm by:
1. 2.

Selecting value creating projects Making smart financing decisions

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Most important of the key decisions.

optimal firm size? specific assets to be acquired? assets (if any) to be reduced or eliminated?

Source: Servaes and Tufano, CFO Views on the Importance and Execution of the Finance Function (Deutsche Bank, 2006).

125

Board of Directors

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

126

Firm
Invests in assets (B) Current assets Fixed assets

Firm issues securities (A)

Retained cash flows (F)

Financial markets

Short-term debt Cash flow from firm (C) Dividends and debt payments (E) Taxes (D) Long-term debt Equity shares

Ultimately, the firm must be a cash generating activity.

Government

The cash flows from the firm must exceed the cash flows from the financial markets.

127

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.

128

The Sole Proprietorship The Partnership The Corporation

General Partnership Limited Partnership

129

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 One or more general partners with unlimited personal liability Most owners are limited partners, who are passive investors with limited liability
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Limited Partnerships

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

Are there any disadvantages for corporations?

YES! Double taxation

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Corporation
Liquidity Shares can be easily exchanged Usually each share gets one vote

Partnership
Subject to substantial restrictions General Partner is in charge; limited partners may have some voting rights

Voting Rights

Taxation
Reinvestment and dividend payout Liability

Double
Broad latitude

Partners pay taxes on distributions

All net cash flow is distributed to partners General partners may have unlimited liability; limited partners enjoy limited liability

Limited liability

Continuity

Perpetual life

Limited life
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What is the correct goal?

Maximize profit? Minimize costs? Maximize market share? Maximize shareholder wealth?

133

What goals are important for firms globally?

Task: Each group would pick a country and discuss among themselves.

134

135

What stakeholders are important for firms globally? Task: Each group would pick a kind of stakeholders and discuss among themselves.

136

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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 _____

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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

Firm
Invests in assets (B) Current assets Fixed assets

Firm issues securities (A)

Retained cash flows (F)

Financial markets

Short-term debt Cash flow from firm (C) Dividends and debt payments (E) Taxes (D) Long-term debt Equity shares

Ultimately, the firm must be a cash generating activity.

Government

The cash flows from the firm must exceed the cash flows from the 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

142

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

144

Managers act as agents of the owners who hired them and gave them decisionmaking 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.
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Managerial compensation

Corporate control

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

Influence of other stakeholders

The threat of a takeover may result in better management

146

Ways to limit agency problems:

Activism by institutional investors Takeover threat Monitoring and bonding Compensation contracts
Tie managerial wealth to stock value

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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.

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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

149

Firms

Stocks and Bonds

Investors
securities Bob Sue

Money

money
Primary Market

Secondary Market
150

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.

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Dont put all your eggs in one basket.

Markets are smart. No arbitrage

Investors can achieve a more favorable tradeoff between risk and return by diversifying their portfolios. Competition for information tends to make markets efficient. Risk-free money-making opportunities are extremely scarce.

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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?

154

What is the impact of financial crisis on a business and financial department?

155

What are the most important skills for accounting and finance students to develop in time of global economic downturn caused by financial crisis?

156