Corporate Finance

Corporate Finance is a body of knowledge which focuses on explaining and interpreting capital markets. It provides an analytical framework to guide managers of firms and to assist them to evaluate corporate financial decisions.
Bishop, Crapp, Faff and Twite (1993)

What is Finance?
Finance is a sub field of economics where the primary focus is on the working of capital markets and the supply and pricing of capital assets. A fundamental concern of finance is valuation - what is something worth? In the end all prices depend on someones estimate of future income
Williams J.B. The Theory of Investment Value (1938)

eg the value today of an investment equals the present value of its expected future returns

Value Of A Firm
A Firm is a collection of real assets (eg

plant, equipment, tools, stock, buildings, land, Intellectual capital) that generate cashflows How to Value the Firm? one approach is to value the real assets of the firm Problem: real assets are not frequently traded

Alternative Approach value the Income Claims/ Financial Assets ( eg debt and equity) of those having a claim on the income produced by the real assets of the firm by having provided financing to the firm.

Cash Flows Between the Firm and the Financial Markets

Total Value of Firms Assets

Total Value of the Firm to Investors in the Financial Markets

B. Firm invests in assets Current Assets Fixed Assets

A. Firm issues securities

Financial Markets

E. Retained cash flows

Short-term debt F. Dividends and Long-term debt Equity shares debt payments

C. Cash flow from firms assets

D. Government

Financial DecisionMaking

Financial decision-making involves the application of a coherent body of theory to enable individuals and firms to choose among alternatives and allocate risky cash flows through time to achieve a desired goal

Conceptual Framework

Goal of the Firm

Maximise Market Value

Two Decision Areas

Investment Decision

Financing Decision

Three Critical Factors

Cash

Time

Risk

Critical Factors In Financial DecisionMaking

Cash: Focus is always on cash flows, not accounting earnings. Money has a time value. Decision making in finance must take account of the timing of the cash flows. Risk refers to variability of a cash flow stream. Adjustments must be made to take account of differing degrees of variability

Time:

Risk:

The risk-return relationship must always be kept in mind

Cash Flow Timing

A dollar today is worth more than a dollar at some future date. There is a trade-off between the size of an investments cash flow and when the cash flow is received.

Cash Flow Timing

Which is the better project?

Year 1 2 3 Total

Project A $0 $10 000 $20 000 $30 000

Project B $20 000 $10 000 $0 $30 000

Project B is a better project based on the time value of money

Cash Flow Timing

A firm is faced with the following investment proposal: Year 0 1 2 25

Cash Flow

-100

11

11

11

If the required rate of return of the firm is 10% p.a. is this a worthwhile investment?

Cash Flow Timing

Suggestion 1: After 9 years you have already received $99 and still have a further 16 years to continue receiving $11 per year an additional $176. However this ignores the time value of money

Cash Flow Timing

Suggestion 2: This investment is returning 11% interest. If the firm requires a return of 10% then it must be a worthwhile investment. However this ignores the notion of interest on interest (compounding)

Cash Flow Timing

Not really earning a true return of 11%

In order to earn a true return of 11%..........

If we invested $100 today (time 0) at 11% End of Year 1 $111

If we re-invested $111 at the end of year 1 at 11% End of Year 2 $123.21

If we re-invested $123.21 at the end of year 2 at 11%

End of Year 3 $136.76

Amount of money re-invested each year increases so interest earned in year 25 would be $135 not $11.

Cash Flow Risk

The role of the financial manager is to deal with the uncertainty associated with investment decisions. Assessing the risk associated with expected future cash flows is critical to investment decisions.

Certainty, Uncertainty And Risk

Certainty: Where the projected cash flows occur as they are expected to occur Risk: Where the projected cash flows do not occur as they are expected to occur Probabilities can be assigned to thepossible outcomes Uncertainty: Where the projected cash flows do not occur as they are expected to occur But unable to assign probabilities or estimate the likelihood of variations from expected outcomes

The Goal of the Firm

Goal of the firm is

to maximise its
market value

The Goal Of The Firm

Individuals are utility maximisers

Utility is a function of consumption

Consumption is a function of wealth Utility maximising individuals wish to maximise their wealth

Individuals hold part of their wealth in the form of shares in companies

The market value of a company is represented by its share price

The greater the market value of a company's shares, the greater will be The wealth of its shareholders and therefore the greater will be their utility

Economic Profit

Economic profit for a period is measured by the change in the value of the firm over the period Firm value at a point in time is equal to the present value of the future net cash flows Given these concepts of economic profit and value, the maximisation of a firm's value and the maximisation of economic profit are equivalent

Other Corporate Goals

Survival Avoid financial distress and bankruptcy Beat the competition Minimise costs Maintain steady earnings growth

Earnings per share maximisation

Sales maximisation Satisficing EPS growth Market share maximisation

Other Corporate Goals

Pursuit of other goals will not necessarily result in the maximisation of the market value of the firm Each of these goals presents problems. These goals are either associated with increasing profitability or reducing risk. It is necessary to find a goal that can encompass both profitability and risk. There is nothing intrinsically objectionable in these goals. However, given the model of the firm put forward, they are subsidiary to the goal of maximising the market value of the firm

Agency Problems
Agency problems arise when one party (principal) engages another party (agent) to perform actions on their behalf Agents may not always act in best interest of principal

A firm is an example where an agency problem arises because of the separation of ownership and control Managers/agents may not always act in the best interests of shareholders/principals

Do Managers Act in Shareholders Interests?

The answer to this will depend on two factors: how closely management goals are aligned with shareholder goals; and the ease with which management can be replaced if it does not act in shareholders best interests. The conflict of interests is limited due to: monitoring of management; management compensation and the threat of takeover. Principals incur agency costs Monitoring Costs Bonding costs

schemes;

Investment/Capital Budgeting Decision

Deals with the evaluation of investment opportunities Involves evaluating the: size of future cash flows; timing of future cash flows; and risk of future cash flows. Which real assets should the firm invest in, in order to maximise its market value Wealth is created by adding value to raw materials or providing services. These activities are represented by the asset side of the balance sheet

Financing Decision

Deals with determination of the firm's capital structure How should the firm finance the investment in real assets, in order to maximise its market value Is it possible to create wealth on the financing side of the balance sheet? Can the value of the firm be affected by the way it is financed?

Finance and Accounting

Both disciplines are concerned with a firms assets and liabilities Accounting, with its emphasis on review and compliance, generally has an historical outlook Finance, with its emphasis on valuation and decision-making, generally has a focus on the future

Problems with Accounting Numbers

The primary focus of accounting is stewardship/compliance Accounting standards give discretion in the selection of accounting procedures which can

cause comparability problems when analysing reports of different companies enable deliberate manipulation of financial reports ( creative accounting or window dressing)

Problems With Accounting Profit

What profit? a $ amount or a % return over what time period before-tax or after-tax Neglect of time ignores the time value of money Neglect of risk profit streams are not adjusted for risk Neglect of cash flows accounting earnings/profits are calculated on an accrual basis not cash flows Arbitrary allocations e.g. Depreciation, provisions Changes in asset values not consistently treated

Financial Markets
Financial markets bring together the buyers and sellers of debt and equity securities. Money markets involve the trading of short-term debt securities. Capital markets involve the trading of long-term debt securities and equity securities. Primary markets involve the original sale of securities. Secondary markets involve the continual buying and selling of already issued securities.