Business Finance Lecture Notes PDF

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Rachel Sopp was the lecturer. ...

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Business Finance Lecture Notes Lecture 1: Introduction to Corporate Finance (1,2) 1.1 Corporate Finance and the Financial Manager !

The three pillars of corporate finance!

No matter what type of business you start, you would have to answer the following questions in one way or another: ! 1. What long term investments should you make? For example, what lines of business will you be in, and what sort of buildings, machine and equipment would you need? ! 2. Where will you get the long-term financing to pay for your investment? Will you bring in other owners, or will you borrow the money? ! 3. How will you manage your everyday financial activities, such as collecting from customers and paying suppliers? (i.e. liquidity) ! Broadly speaking, corporate finance is the study of ways to answer these questions. ! ! Investment: what do you need to start a firm?

Capital budgeting ! Capital budgeting — the process of planning and managing a firm’s long-term investments. ! In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. This means that the value of the cash flow generated by an asset exceeds the cost of that asset. Evaluating the size, timing and risk of future cash flows is the essence of capital budgeting. For example, the decision for Tesco to open up another store would be an important capital budgeting decision.! 1  of 117 

Financing Cash invested in assets must be matched by an equal amount of cash raised by financing, as shown on the figure to the left. ! The balance figure represents that both accounts need to be balanced appropriately. ! Capital structure ! Capital structure — the mixture of long-term debt and equity maintained by a firm. ! The second question that needs to be answered concerns ways in which the firm obtains and manages the long-term financing it needs to support its long term investments. The financial manager needs to consider how much it should borrow (debt and equity) and what the least expensive sources of funds are. In addition to that, he/she need to decide exactly how and where to raise the money.! Liquidity Liquidity — the availability of cash. Having sufficient cash to meet your obligations. ! Working capital management ! Working capital — a firm’s short-term assets and liabilities. ! Managing the firm’s working capital is a day-to-day activity which ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions. The financial manager should answer questions like:! • How much cash and inventory should we keep on hand? ! • Should we sell on credit, and if so, what terms will we offer, and to whom will we extend them?! • How will we obtain any needed short-term financing?!

Who makes the decisions? The Financial Manager ! A striking feature of large corporations is that the owners (shareholders) are not usually directly involved in making business decisions, especially on a day-to-day basis. Instead, the corporation employs managers to represent the owners’ interests and make decisions on their behalf. In a large corporation the financial manager would be in charge of answering the three questions raised earlier. ! The financial management function is usually associated with a top officer of the firm, such as a finance director (FD) or chief financial officer (CFO). ! Typical company reporting structure Below is a simplified organisational chart that highlights the finance activity in a large firm.! 2  of 117 

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The diagram highlights that: • The finance director (chief financial officer) coordinates the activities of the treasurer and the controller! • The controller’s office handles cost and financial accounting, tax payments and management information systems ! • The treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures ! Difference between finance and accounting functions The accounting function takes all the financial information and data that arises as a result of ongoing business activities, and presents this in ways that allow management to assess the performance and risk of their firm (financial accounting) and make informed decisions on future corporate activity (management accounting). ! Responsibilities of a financial manager Maximise value from cash:! • Buy assets that earn more cash than they cost! • Choose long-term investments that increase firm value ! • Raise cheap external financing ! • Ensure efficient tax policy ! Case study Jessica Uhl became Shell’s CFO in March 2017. Her responsibilities include: ! • • • • •

Business and Corporate Finance ! Planning and Appraisal ! Internal Audit ! Tax! Business Integrity !

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1.2 The Goal of Financial Management Why are you starting a firm?! For for-profit businesses, the main goal of financial management is to make money or add value for the owners. ! !

Showing value — the balance sheet Equity— the amount of money raised by the firm that comes from the owners’ (shareholders’) investments. ! Equity = shares. If you were to invest some money in a business in the form of shares, the money you put in would be called equity. !

Different goals in practice ! • • • • • • •

Survive! Maximise profits ! Minimise costs ! Maximise sales ! Avoid financial distress and bankruptcy ! Maintain steady earnings growth ! Beat the competition/be the best !

The financial manager acts in the shareholders’ best interests by making decisions that increase the value of the equity. Hence, there is one overriding aim for businesses: maximising firm value/current value per share of the existing equity.

1.3 Financial Markets and the Corporation Financial markets play a fundamental role in the operations of large corporations. The stock market will always be important because it can inform management the performance of their competitors, suppliers, customers and the economy as a whole. The primary advantage of financial markets is that they facilitate the flow of money from those that have surplus cash to those that need financing. ! 4  of 117 

Different sources of financing • • • • •

Private investors ! Bank loans ! Equity (shares) ! Bonds (tradable and interest, return of money in the end) ! Short-term financing !

Primary vs. secondary markets ! Primary markets Primary markets — the original sale of securities by governments and corporations; where you initially raised the money. E.g. when you first issue a bond.! The corporation is the seller, and the transaction raises money for the corporation. These can occur in two types of transactions: public offerings and private placements.! Secondary markets Secondary markets — those in which securities are bought and sold after the original sale. E.g. when you sell a bond to someone else, it goes on the secondary market. ! Involves one owner or creditor selling to another. Therefore the secondary markets provide the means for transferring ownership in corporate securities. ! Dealer versus auction markets ! In secondary markets, there exists two types of markets: dealer and auction. In a dealer market, the dealer buys and sells for himself, at his own risk. ! Example: If dealer A has ample inventory of XYZ stock — which is quoted in market by other makers at $10/$10.05 — and wishes to offload some of its holdings, it can post its bid-ask quote as $9.98/$10.03. Rational investors looking to buy this company would then take Dealers A’s offer price of $10.03, since it is 2 cents cheaper than the $10.05 price at which it is offered by other market makers. Conversely, investors looking to sell XYZ’s stock (shares) would have little incentive to “hit the bid” of $9.98 posted by Dealer A, since it is 2 cents less than the $10 price that other dealers are willing to pay for the stock. **stocks = shares ! Auction markets differ from dealer markets firstly because they have a physical location. Second, most of the buying and selling is done by the dealer. However, the primary purpose of an auction market is to match those who wish to sell with those who wish to buy. Dealers play a limited role. ! Example: Imagine that four buyers want to buy a share of XYZ and make the following bids: $10.00, $10.02, $10.03 and $10.06. Conversely, there are four sellers that desire to sell XYZ, and they submitted offers to sell their shares at the following prices: $10.06, $10.09, $10.12 and $10.13. In this scenario, the individuals that made bids/offers for XYZ at $10.06 will have their orders executed. All remaining orders will not immediately be executed, and the current price of XYZ will then be $10.06.! 5  of 117 

Trading in corporate securities The equity of most large firms trade in organised auction markets. NASDAQ is one of such which is one of the world’s largest. Because of globalisation, financial markets have reached the point where trading in many investments never stops; it just travels around the world. ! Listing Securities that trade on an organised exchange are said to be listed on that exchange. To be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. These criteria differ from one exchange to another. !

2.1 Corporate Governance Corporate governance — concerned with how firms manage themselves, and the way in which this performance is monitored. ! When shareholders hire professional managers to run their company, it is important to ensure that business decisions are made that maximise the wealth of shareholders, and not the personal wealth of managers. !

Forms of business organisation ! There are three different legal forms of business organisation: ! Sole proprietorship — a business owned by a single individual. ! Partnership — a business formed by two or more individuals or entities. ! Corporation — a business created as a distinct legal entity composed of one or more individuals or entities. ! Sole Proprietorship

Partnership

Limited Corporation

• Owned and managed by one person ! • Very easy to form ! • Profits taxed as personal income ! • Unlimited liability ! • Life of company linked to life of owner! • Amount of funding is limited by owner’s personal wealth and limited options of capital!

• Easy to form ! • Requires a partnership agreement ! • Limited and unlimited partners ! • Partnership is terminated when a partner dies or leaves the firm ! • Difficult to raise cash ! • Profits taxed as personal income ! • Controlled by general partners — sometimes votes are required on major business decisions

• Articles and memorandum of incorporation required — i.e. more complicated than other forms of business organisation! Limited liability ! • • Profits taxed at corporate tax rate ! • Board of directors ! • Life of company is hypothetically unlimited

Memorandum of Association — the rules by which the corporation is organised. For example the memorandum describes how directors are elected. !

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Articles of Incorporation: ! • Name of the corporation ! • Intended life of the corporation (it may be forever) ! • Business purpose ! • Number of shares that the corporate is authorised to issue with a statement of limitations and rights of different classes of shares ! • Nature of the rights granted to shareholders ! • Number of members of the initial board of directors ! Partnership

Corporation

Liquidity and marketability

Restricted trading

Traded easily, sometimes on exchange

Voting rights

Partners have control

Each share gives a voting right

Taxation

Profits taxed at personal tax rate

Profits taxed at corporate tax rate

Reinvestment and dividend payout

All profits allocated to partners

Total freedom in dividend decisions

Liability

General Partners have unlimited liability

Shareholders have limited liability

Continuity of existence

Limited life

Unlimited life

2.2 The Agency Problem and Control of the Corporation Type I agency relationships ! These are relationships between managers and shareholders. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests. In all such relationships, there is a possibility there may be a conflict of interest between the principal and the agent, i.e. a type I agency problem.! Management goals Managers want to maximise their own wealth and power, while shareholders want managers to maximise the value of the company. ! Type I agency costs Agency costs — the cost of the conflict of interest between shareholders and management, which can be direct or indirect. ! Direct costs — corporate expenditure that benefits managers at the expense of shareholders.! Indirect costs — corporate expenditure to monitor and control manager activities.! Type I agency problem — the possibility of conflict of interest between the shareholders and management of a firm. ! Examples: private jet, payment of auditors, large administrative tiers. ! 7  of 117 

Do managers act in shareholders’ interests? Whether managers will, in fact, act in the best interests of shareholders depends on two factors. First, how closely are management goals aligned with shareholder goals? Second, can managers be replaced if they do not pursue shareholder goals? There are a number of reasons to think that, even in the largest firms, management have a significant incentive to act in the interests of shareholders. ! • Managerial compensation — management will frequently have a significant economic incentive to increase share value for two reasons. Firstly, managerial compensation is usually tied to financial performance, especially at the top. Secondly, better performers within the firm will tend to get promoted. !

• Control of the firm — are shareholders powerful? Control of the firm usually rests with shareholders. They elect the board of directors, who in turn hire and fire managers: e.g. when working at Apple, shareholders decided that Steve Jobs should be fired, and so he was. ! • Shareholder rights — do shareholders have a facility to call managers to account? The conceptual structure of the corporation assumes that shareholders elect directors, who in turn hire managers to carry out their directives. Shareholders therefore control the corporation through the right to elect the directors. Voting exists in two forms: cumulative and straight voting. ! It is important to note that each share of equity has one vote, e.g. the owner of 10,000 shares will have 10,000 votes. ! Cumulative voting ! Cumulative voting — a procedure in which a shareholder may cast all votes for one member of the board of directors. ! • To permit minority participation ! • Directors are elected all at once ! If there are N directors up for election, then 1/(N + 1) x 100 of the shares + 1 share will guarantee you a seat. For example, let’s say there are 4 directors up for election: ! 8  of 117 

N=4! 1/(4+1) = 0.2 x 100 (20%) ! 20% + 1 share = 21 ! Hence, the more seats that are up for election at one time, the easier (and cheaper) it is to win one. ! Straight voting ! Straight voting — a procedure in which a shareholder may cast all votes for each member of the board of directors.! • Directors are elected one at a time ! • The only way to guarantee a seat is to own 50% + 1 share! Let’s say that Smith has 20 shares and Jones has 80 shares. Each time voting occurs, Smith can cast 20 votes and Jones can cast 80. As a consequence, Jones will elect all of the candidates. For example, let’s say a company has 100 shares in issue and there are two director vacancies. How many shares do you need to vote in one director under straight voting?! 50% x 100 = 50 ! 50 + 1 = 51 shares! However, straight voting can ‘freeze out’ minority shareholders: that is why many companies have mandatory cumulative voting. In companies where cumulative voting is mandatory, devices have been worked out to minimise its impact. ! • Proxy voting — a grant of authority by a shareholder allowing another individual to vote his or her shares. For convenience, much of the voting pin large public corporations is actually done by proxy.! • Classes of shares — some firms have more than one class of ordinary equity; often the classes are created with unequal voting rights. A primary reason for creating dual or multiple classes of equity capital has to do with the control of the firm. If such shares exist, management of a firm can raise equity by issuing non-voting or limited-voting shares while maintaining control. ! • Pre-emptive rights — a company that wishes to sell equity must first offer it to the existing shareholders before offering it to the general public; the purpose is to give shareholders the opportunity to protect their proportionate ownership in the corporation.! • Dividends — payments by a corporation to shareholders, made in either cash or shares. Dividends paid to shareholders represent a return on the capital directly or indirectly contributed to the corporation by the shareholders.!

Type II agency relationships ! These relationships exist between shareholders who own a significant amount of a company’s shares (controlling/majority shareholders) and other shareholders who own only a small proportional amount (minority shareholders). ! 9  of 117 

Type II agency costs Type II agency problem — the possibility of conflict of interest between controlling and minority shareholders. ! Such a relationship exists whenever a company has a concentrated ownership structure. When an investor owns a large percentage of a company’s shares, they have the ability to remove or install a board of directors through their voting power. This means that, indirectly, they can make the firm’s objectives align to their own personal objectives, which may not be the same as that of other shareholders with a smaller proportionate stake. ! Related party transaction — when a dominant shareholder may benefit more from having one of her firms trading at advantageous prices with another firm she owns. ! However, a controlling shareholder may need cash for an investment in company A, and wish to take the cash from company B through an extraordinary dividend. This will obviously not be in the interests of company B’s other shareholders, but in aggregate the action may be more profitable for the controlling shareholder of company B if it stands to make more money from an investment in company A. !

2.3 International Corporate Governance Different countries will deal with corporate governance in different ways due to variations in economic, social and religious cultures. The main areas of importance in international corporate governance include: ! • • • •

Investor protection (different from country to country) ! The financial system (e.g. Sharia Law in Islamic countries) ! Control mechanisms (different hierarchical structures within the business) ! Firm corporate governance systems !

Financial systems: legal systems around the world ! ! The figure to the right demonstrates countries that follow different legal systems. Many countries do not follow one system alone, and the exact legal environment can be a hybrid of two systems. !

• In a common law system, the law • •

evolves as a result of the judgement decisions of courts ! In a civil law system, judges interpret the law; they cannot change it (UK, Ireland)! Under religious law, specific religious principles form the basis of legal decisions ! 10  of 117

Investor protection! What are the country-level legal rights of shareholders? • • • • • •

Proxy vote by mail is allowed ! Votes are not blocked before the annual general meeting ! Cumulative voting or proportional representation exists ! Oppressed minorities mechanisms exist ! Pre-emptive rights exist ! There is a minimum percentage to call an extraordinary shareholders’ meeting!

Many...