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

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.

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 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

Financing
Decisions

The World

Investment
Decisions

Exchange of Money
and Real Assets

The Firm

Financial
Markets
Exchange of
Money and
Investors
Financial Assets

Financial
Intermediaries
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Investment Vehicle Model - The Flow of Cash in

a Firm
Firm's Operations

(2)

(1) Financial Investors

Financial Manager

(4a)

(4b)

(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors

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Investment Vehicle Model - The Flow of Cash in

a Firm
Firm's Operations

Financial Manager

The question here is

what will the firm
invest in?

Financial Markets

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:

Current
Assets

Total Firm Value to Investors:

Current
Liabilities
Long-Term
Debt

Fixed Assets
1 Tangible
2 Intangible

Shareholders
Equity
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Relating Value back to the Balance Sheet

The Capital Budgeting Decision
Current
Liabilities

Current
Assets

Fixed Assets
1 Tangible
2 Intangible

Long-Term
Debt

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
Liabilities

Current
Assets

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
Assets

Fixed Assets
1 Tangible
2 Intangible

Current
Liabilities
Net
Working
Capital

How much shortterm cash flow

does a company
need to pay its
bills?

Long-Term
Debt

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

Or...
70%
Debt

30%
Equity

75%
Equity

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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

Limited to life of owner

Least regulated

Equity capital limited to

owners personal wealth

Single owner keeps all

the profits
Taxed once as personal
income

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

Disadvantages
Unlimited liability

More capital available

General partnership

Relatively easy to start

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
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for checking/monitoring managements actions.

Corporate Structure - Separation of Ownership

and Control
Board of Directors
Shareholders

Assets

Debt

Debtholders

Management

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).
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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.

2.

Monitoring by lenders, stock market analysts and

investors.

3.

The threat that poorly performing managers will be

fired.

4.

The growing awareness of the importance of good

Corporate Governance.
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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

Share
Issuance

Retained
Earnings

Residual Claims

Debt

Bank
Borrowing

Bond
Issuance

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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