Introduction to Corporate Finance

Learning Objectives
1. Understand the importance of finance in your personal and professional lives and identify the three primary business decisions that financial managers make. 2. Identify the key differences between three major legal forms of business.
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Learning Objectives
3. Understand the role of the financial manager within the firm and the goal for making financial choices.
4. Explain the four principles of finance that form the basis of financial management for both businesses and individuals.
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Learning Objectives
5. Describe the structure and functions of financial markets. 6. Distinguish between commercial banks and other financial institutions in the financial marketplace. 7. Describe the different securities markets for bonds and stock.
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What Is Finance?
Finance is concerned with:
Determining value. Value = what something is worth now. Making the best decision when that decision involves money.

Finance is the study of how people and businesses evaluate investments and raise capital to fund them.
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Three Questions Addressed by the Study of Finance:

1. What long-term investments should the firm undertake? (capital budgeting decisions) 2. How should the firm fund these investments? (capital structure decisions) 3. How can the firm best manage its cash flows as they arise in its day-to-day operations? (working capital management decisions)
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Three Areas of Finance

Corporate Financial Management
Viewpoint of an individual firm

Investments
Viewpoint of individual investors

Financial Markets and Intermediaries

Viewpoint of a third party facilitating investor-firm interactions
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Corporate Financial Management

How do we use corporate resources efficiently to further the goals of the firm? Decisions are based on The Principles of Finance
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Investments
The study of financial transactions from the viewpoint of investors outside the firm. Examples include: How do we place a dollar value on a share of stock
or a bond issued by the corporation? How do we assess the risk of these financial securities? How do we manage a portfolio of financial securities to achieve a stated objective of the investor?

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 banking firms, and insurance companies) that help the flow of money from savers to demanders of money.
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Why Study Finance?

Knowledge of financial tools is critical to making good decisions in both professional world and personal lives. Finance is an integral part of corporate world Many personal decisions require financial knowledge (for example: buying a house, planning for retirement, leasing a car)

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Business Organizational Forms

Business Forms

Sole Proprietorships

Partnerships

Corporations

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Sole Proprietorship
It is a business owned by a single individual that is entitled to all the firms profits and is responsible for all the firms debt.
There is no separation between the business and the owner when it comes to debts or being sued. Sole proprietorships are generally financed by personal loans from family and friends and business loans from banks.
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Sole Proprietorship (cont.)

Advantages: Easy to start No need to consult others while making decisions Taxed at the personal tax rate Disadvantages: Personally liable for the business debts Ceases on the death of the proprietor
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Partnership
A general partnership is an association of two or more persons who come together as coowners for the purpose of operating a business for profit.
There is no separation between the partnership and the owners with respect to debts or being sued.
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Partnership (cont.)
Advantages: Relatively easy to start Taxed at the personal tax rate Access to funds from multiple sources or partners Disadvantages: Partners jointly share unlimited liability
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Partnership (cont.)
In limited partnerships, there are two classes of partners: general and limited. The general partners runs the business and face unlimited liability for the firms debts, while the limited partners are only liable on the amount invested. One of the drawback of this form is that it is difficult to transfer the ownership of the general partner.
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Corporation
Corporation is an artificial being, invisible, intangible, and existing only in the contemplation of the law.

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Corporation (cont.)
Corporation can individually sue and be sued, purchase, sell or own property, and its personnel are subject to criminal punishment for crimes committed in the name of the corporation.

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Corporation (cont.)
Corporation is legally owned by its current stockholders.
The Board of directors are elected by the firms shareholders. One responsibility of the board of directors is to appoint the senior management of the firm.
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Corporation (cont.)
Advantages
Liability of owners limited to invested funds Life of corporation is not tied to the owner Easier to transfer ownership Easier to raise Capital

Disadvantages
Greater regulation Double taxation of dividends
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How Does Finance Fit into the Firms Organizational Structure?

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The Goal of the Financial Manager

The goal of the financial manager must be consistent with the mission of the corporation. What is the generally accepted mission of a corporation?
To maximize firm value shareholders wealth (as measured by share prices)

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Corporate Mission: Coca-Cola

To achieve sustainable growth, we have established a vision with clear goals: Maximizing return to shareholders while being mindful of our overall responsibilities (part of Coca-Colas mission statement)

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Corporate Mission: GraceKennedy

We will grow long term shareholder value by satisfying the unmet needs of Caribbean people (part of GraceKennedys vision statement)

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Corporate Mission
While managers have to cater to all the stakeholders (such as consumers, employees, suppliers etc.), they need to pay particular attention to the owners of the corporation i.e. shareholders.
If managers fail to pursue shareholder wealth maximization, they will lose the support of investors and lenders. The business may cease to exist and ultimately, the managers will lose their jobs!
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Limitations of Profit Maximization

Static nature of standard microeconomic model (Lack of time dimension)

Variable definition of profit

Provides no direct way for managers to consider the risk of alternative decisions

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Ethics in Finance
What do we mean by Ethics?
Give examples of recent financial scandals and discuss what went wrong from an ethical perspective.

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Agency Considerations in Corporate Finance

Agency relationship exists when one or more persons (known as the principal) contracts with one or more persons (the agent) to make decisions on their behalf.
In a corporation, the managers are the agents and the stockholders are the principal.
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Agency Considerations in Corporate Finance (cont.)

Agency problems arise when there is conflict of interest between the stockholders and the managers. Such problems are likely to arise more when the managers have little or no ownership in the firm. Examples:
Not pursuing risky project for fear of losing jobs, stealing, expensive perks.

All else equal, agency problems will reduce the firm value.
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How to Reduce Agency Problems?

1. Monitoring (Examples: Reports, Meetings, Auditors, board of directors, financial markets, bankers, credit agencies) 2. Compensation plans (Examples: Performance based bonus, salary, stock options, benefits) 3. Others (Examples: Threat of being fired, Threat of takeovers, Stock market, regulations such as SOX) The above will help to reduce agency problems/costs.
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THE FOUR BASIC PRINCIPLES OF FINANCE

Copyright 2011 Pearson Prentice Hall. All rights reserved.

PRINCIPLE 1: Money Has a Time Value.

A dollar received today is more valuable than a dollar received in the future.
We can invest the dollar received today to earn interest. Thus, in the future, you will have more than one dollar, as you will receive the interest on your investment plus your initial invested dollar.

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PRINCIPLE 2: There is a RiskReturn Trade-off.

We only take risk when we expect to be compensated for the extra risk with additional return. Higher the risk, higher will be the expected return.

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PRINCIPLE 3: Cash Flows Are The Source of Value.

Profit is an accounting concept designed to measure a businesss performance over an interval of time. Cash flow is the amount of cash that can actually be taken out of the business over this same interval.

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Profits versus Cash

It is possible for a firm to report profits but have no cash.
For example, if all sales are on credit, the firm may report profits even though no cash is being generated.

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Incremental Cash Flow

Financial decisions in a firm should consider incremental cash flow i.e. the difference between the cash flows the company will produce with the potential new investment its thinking about making and what it would make without the investment.

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PRINCIPLE 4: Market Prices Reflect Information.

Investors respond to new information by buying and selling their investments.
The speed with which investors act and the way that prices respond to new information determines the efficiency of the market. In efficient markets like United States, this process occurs very quickly. As a result, it is hard to profit from trading investments on publicly released information.
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PRINCIPLE 4: Market Prices Reflect Information. (cont.)

Investors in capital markets will tend to react positively to good decisions made by the firm resulting in higher stock prices.
Stock prices will tend to decrease when there is bad information released on the firm in the capital market.
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Three Players in the Financial Markets

1. Borrowers: Individuals and businesses that need money to finance their purchases or investments. 2. Savers (Investors): Those who have money to invest. These are principally individuals although firms also save when they have excess cash. 3. Financial Institutions (Intermediaries): The financial institutions and markets help bring borrowers and savers together.
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Financial Intermediaries
Financial institutions like commercial banks, finance companies, insurance companies, investment banks, and investment companies are called financial intermediaries as they help bring together those who have money (savers) and those who need money (borrowers).

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Security Markets
Firms make direct transactions in financial markets. The concepts and principles that apply to financial markets also apply to the management of real assets. Security markets provide information and signals that help managers make decisions.
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Why Security Markets Exist

Security markets facilitate the transfer of capital (i.e financial) assets from one owner to another. They provide liquidity.
Liquidity refers to how easily an asset can be transferred without loss of value.

A side benefit of security markets is that the transaction price provides a measure of the value of the asset.
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Money versus Capital Market

The money market refers to debt instruments with maturity of one year or less.
Examples: Treasury bills (T-bills), Commercial paper (CP).

The capital market refers to long-term debt and equity instruments.

Examples: Common stock, Preferred stock, Corporate bond, Treasury bond, Municipal bond.
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Commercial Banks Everyones Financial Marketplace

Commercial banks collect the savings of individuals as well as businesses and then lend those pooled savings to other individuals and businesses. They make money by charging a rate of interest to borrowers that exceeds the rate they pay to savers.
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Non-Bank Financial Intermediaries

These include: Financial services corporations, like GE Capital Division, First Global Financial; Insurance companies, like Prudential, Sagicor; Investment banks, like Goldman Sachs, NCB Capital Markets; Investment companies including mutual funds, hedge funds and private equity firms.
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Mutual Funds and Exchange Traded Funds (ETFs)

Mutual funds are professionally managed according to a stated investment objective. Individuals can invest in mutual funds by buying shares in the mutual fund at the net asset value (NAV). NAV is calculated daily based on the total value of the fund divided by the number of mutual fund shares outstanding.

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Mutual Funds and Exchange Traded Funds (ETFs) (cont.)

Mutual funds can either be load or no-load funds. The term load refers to the sales commission that you pay when acquiring ownership shares in the fund. These commissions typically range between 4.0 to 6.0%. A mutual fund that does not charge a commission is referred to as a no-load fund.
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Mutual Funds and Exchange Traded Funds (ETFs) (cont.)

An exchange-traded fund (ETF) is similar to a mutual fund except that the ownership shares in the ETF can be bought and sold on the stock exchange. Most ETFs track an index, such as the Dow Jones Industrial Average or the S&P 500, and generally have relatively low expenses.

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Mutual Funds and Exchange Traded Funds (ETFs) (cont.)

Mutual funds and ETFs provide a cost-effective way to diversify and reduce risk. If you had only $10,000 to invest, it would be difficult to diversify since you will have to pay commission for each individual stock. However, by buying a mutual fund that invests in S&P 500,you can indirectly purchase a portfolio that tracks 500 stocks with just one transaction. Alternatively, you might purchase an ETF, such as SPDR S&P 500 (SPY), which tracks S&P 500.

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Hedge Funds
Hedge funds are similar to mutual funds but they tend to take more risk and are generally open only to high net worth investors. Management fees also tends to be higher for hedge funds and most funds include an incentive fee based on the funds overall performance, which typically runs at 20% of profits.

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Private Equity Firms

Private equity firms include two major groups: Venture capital (VC) firms and Leveraged buyout firms (LBOs).

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Private Equity Firms (cont.)

Venture capital firms raise money from investors (wealthy individuals and other financial institutions) that they then use to provide financing for private start-up companies when they are first founded. For example, Venture capital firm, Kleiner Perkins Caufield & Byers (KPCB) was involved in the initial financing of Google.
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Private Equity Firms (cont.)

Leveraged buyout firms acquire established firms that typically have not been performing very well with the objective of making them profitable again and selling them. An LBO typically uses debt to fund the purchase of a firm. LBO transactions grew from $7.5 billion in 1991 to $500 billion in 2006. Prominent LBO private equity firms include Cerberus Capital Management, L.P., TPG (formerly Texas Pacific Group), and KKR (Kohlberg, Kravis, and Roberts).

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THE FINANCIAL MARKETPLACE SECURITIES MARKET

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Security
A security is a negotiable instrument that represents a financial claim and can take the form of ownership (such as stocks) or debt agreement (such as bonds).
The securities market allow businesses and individual investors to trade the securities issued by public corporations.
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Primary versus Secondary Market

A primary market is a market in which securities are bought and sold for the first time. In this market, the firm selling securities actually receives the money raised. For example, securities sold by a corporation to investment bank.

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Primary versus Secondary Market (cont.)

A secondary market is where all subsequent trading of previously issued securities takes place. In this market, the issuing firm does not receive any new financing. The securities are simply transferred from one investor to another. Thus secondary markets provide liquidity to the investor. For example, the New York Stock Exchange.
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How Securities Markets Bring Corporation and Investors Together

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Types of Securities
Debt Securities: Firms borrow money by selling debt securities in the debt market. If the debt has a maturity of less than one year, it is typically called notes, and is traded in the money market. If the debt has a maturity of more than one year, it is called bond and is traded in the capital market.
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Types of Securities (cont.)

Most bonds pay a fixed interest rate on the face or par value of bond. For example, a bond with a face value of $1,000 and semi-annual coupon rate of 9% will pay an interest of $45 every 6 months or $90 per year, which is 9% of $1,000. When the bond matures, the owner of the bond will receive $1,000.

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Types of Securities (cont.)

Equity securities represent ownership of the corporation.
There are two major types of equity securities: common stock and preferred stock.

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Types of Securities (cont.)

Common stock is a security that represents equity ownership in a corporation, provides voting rights, and entitles the holder to a share of the companys success in the form of dividends and any capital appreciation in the value of the security. Common stockholders are residual owners of the firm i.e. they earn a return only after all other security holder claims (debt and preferred equity) have been satisfied in full.

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Types of Securities (cont.)

Dividend on common stock are neither fixed nor guaranteed. Thus a company can choose to reinvest all of the profits in a new project and pay no dividends.

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Types of Securities (cont.)

Preferred stock is an equity security. However, preferred stockholders have preference with regard to:
Dividends: They are paid before the common stockholders. Claim on assets: They are paid before common stockholders if the firm goes bankrupt and sells or liquidates its assets.

Preferred stock is also referred to as a hybrid security as it has features of both common stock and bonds.

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Types of Securities (cont.)

Preferred stock is similar to common stocks in that:
It has no fixed maturity date, The nonpayment of dividends does not result in bankruptcy of the firm, and The dividends are not deductible for tax purposes.

Preferred stock is similar to corporate bonds in that:

The dividends are typically a fixed amount, and There are no voting rights.
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Stock Markets
A stock market is a public market in which the stocks of companies is traded.
Stock markets are classified as either organized security exchanges or over-the-counter (OTC) market.

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Stock Markets (cont.)

Organized security exchanges are tangible entities; that is, they physically occupy space and financial instruments are traded on their premises. For example, the New York Stock Exchange (NYSE) is located at 11 Wall Street in Manhattan, NY. The total value of stocks listed on the NYSE fell from $18 trillion in 2007 to just over $10 trillion at the beginning of 2009.
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NEW YORK STOCK EXCHANGE

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Stock Markets (cont.)

The over-the-counter markets include all security market except the organized exchanges. NASDAQ (National Association of Securities Dealers Automated Quotations) is an over-thecounter market and describes itself as a screenbased, floorless market. In 2009, nearly 3,900 companies were listed on NASDAQ, including Starbucks, Google, Intel.
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Jamaica Stock Market

BROKERS
Barita Investments Ltd Capital & Credit Securities Limited First Global Financial Services Limited JMMB Securities Ltd M/VL Stockbrokers Ltd Mayberry Investments Ltd NCB Capital Markets Ltd Pan Caribbean Financial Services Ltd. Scotia DBG Investments Stocks and Securities Ltd (SSL) Victoria Mutual Wealth Management Ltd.

Securities traded through brokers (regulated by the Financial Services Commission)

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Jamaica Stock Market

Functions through The Jamaica Central Securities Depository (JCSD):

The JCSD is a facility for holding securities which enables share transactions to Internationally, most people who own securities today don't physically hold the

be processed by book entry. A book entry system is an accounting system which facilitates the change of ownership of securities electronically between parties, without the need for the movement of physical documents. In short, the JCSD is an means of recording the ownership of shares.
stock or bond certificates. Instead their securities are kept on their behalf by their investment company which is called keeping securities in "street name". The investment firms will deposit your share and bond certificates with the Jamaica Central Securities Depository Limited which on settlement date (T+3), will electronically settle all purchases and sales of shares and bonds without physically moving the certificates. "segregation" by their brokerage house. This means that they are held separate and apart from those belonging to the broker/custodian and cannot be used by the broker/custodian in his day-to-day business operations. 76

Investors should be aware that their securities are safeguarded by being held in

A Few Words of Advice

If you understand the first principles, every problem and issue can be solved using these principles. Learn the principles not the specific solutions that you see along the way.
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