Chapter 1 Introduction to corporate finance PDF

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Chapter 1 : Introduction to corporate finance I – What is corporate finance ? 1 – The balance sheet model of the firm : The assets of the firm (left side). Think of these assets as short-term (current) and long-term (non-current). • Non-current assets : Some non-current assets are tangible (concret) such as machinery and equipment. Other non-current assets are intangible, such as patents and trademarks. • Current assets: Assets that have short lives, such as inventory. To invest, a compagny must obtain financing. These forms of funding are represented on the righ side of the balance sheet. Short term debt is called a current liability (loans, obligations that must be repaid within one year)

2 – Capital Structure The firm can determine its capital structure to issue how the pie is sliced between debt and equity (a value of a company can be measured as the sum of debt and equity). V = D (the market value of the debt) + E (the market value of the equity) 3 – The financial manager

The top officer : can be the chief financial officer (CFO). Reporting to the chief financial officer are the treasurer and the financial controller: (in small firm : same person) • Treasurer: responsible for handling cash flows, managing capital expenditure decisions and making financial plans. • Financial controller: handles the accounting function, which includes taxes, financial and management accounting, and information systems. Their role is to create value from the firm’s capital budgeting, financing and net working capital activities. How do financial managers create value? • Try to buy assets that generate more cash than they cost • Sell bonds, shares and other financial instruments that raise more cash than they cost.

Thus, the firm must create more cash flow than it uses (the cash flows paid to bondholders and shareholders of the firm should be higher than the cash flows put into the firm). We trace the cash flows from the firm to the financial markets and back again:

The value of an investment made by a firm depends on the timing of cash flows. One of the fundamental principles of finance is one euro received today is worth more than one euro received next year. There are two main ways a company can approach risk: • speculate and attempt to benefit by leaving the company exposed to future fluctuations in prices or cash flows. This is risky and may lead to extremely good or bad outcomes. • hedge (minimizer) against the risk and reduce its impact on the company’s future cash flows. If a company hedges too much, it will not benefit from future price or cash flow fluctuations. II – The goal of financial management ? The goal of financial management is to make money or add value for the owners. It we were to consider possible financial goals, we might come up with some ideas like the following : - survive - avoid financial distress and bankruptcy - beat the competition - maximize profits - minimize costs Each of these possibilities presents problems as a goal for the financial manager. Example: it is easy to increase market share or unit sales (by lowering our prices / relax our credit terms) but it will minimize profits… There are two main classes for the goals listed : • These relates to profitability : the goals involving sales, market share, cost control… • The other relates to controlling risk : Involving bankruptcy avoidance, stability and safety…

1 – The goal of financial management The financial manager in a corporation makes decisions for the shareholders. So, from the shareholders’ point of view, what is a good financial management decision? Good decisions increase the value of the company’s shares, and poor decisions decrease the value of the shares (maximize the value of equity shares). That is what we are going to study. Corporate finance can be defined as the study of the relationship between business decisions and the value of the shares in the business. A more general goal is maximizing the market value of the existing owners’ equity. 2 – The triple bottom line : Shareholder value maximization (the profit objective) has attracted criticism because it appears to ignore other important factors, such as employees (the social objective) and sustainability (the environment objective). Since companies consist of people and use the planet’s resources, they have a responsibility not only to shareholders but to society as well. Triple bottom line: Asking companies to maximize not just shareholder value, but also to maximize and measure its contribution to society and the environment. Remark: One major difficulty with the triple bottom line is the difficulty in measuring the effect a company has on society and the environment. III – Financial Markets To invest in projects, companies have to choose efficient cost-effective financing option. First decision : borrow money (debt) or give up money of their firm (equity) When a firm borrows, it can go to a bank for a loan, or it can issue debt securities in the financial markets. • Debt securities: contractual obligations to repay corporate borrowing. A firm gives up ownership through private negotiation or public sale (a public sale is undertaken through marketing and sale of equity securities). • Equity securities are shares (known as ordinary shares or common stock) that represent noncontractual claims to the residual cash flow of the firm. Issues of debt and equity that are publicly sold by the firm are then traded in the financial markets, such as stock markets. The financial markets are composed of the money markets and the capital markets. Money markets are for debt securities that will pay off in the short term (usually less than one year). Capital markets are for long-term debt (for longer than a year) and equities. Difference of dealer and broker (agent). The broker doesn’t own the shares that he is trying to sell, and as result, doesn’t bear risk. 1 – The primary market : Governments and public corporations use the primary markets to sell securities. Two types of primary market : • public offerings • private placements Publicly issued debt and equity must be registered with the local regulatory authority. Every country has its own regulatory authority. Private placements tend not to be registered with regulatory authorities in the same way as public issues. Every country has its own regulatory authority that deals with the registration of publicly traded securities.

2 – Peer-to-peer investing platforms : Peer-to-peer gives companies access to alternative sources of finance without going through the normal stock exchange. Peer-to-peer trading platforms can be used by small companies to borrow without going through the normal stock exchange requirements for listing. There are lower transaction costs with these platforms. For borrowers, the cost of borrowing is lower because they don't need to pay fees to a bank. However, the amount they can borrow tends to be small (maximum of €5 million) and the borrowing period is short (up to five years). With the development of new financial technologies, such as blockchain, expect to see many more investing platforms in the future using not just standard currencies like euros and sterling, but cryptocurrencies, such as bitcoin and Ethereum. 3 – Secondary Market Secondary market transaction: one owner or creditor selling to another. It provides the means for transferring ownership of corporate securities. Although a corporation is only involved in a primary market transaction (when it sells securities to raise cash), the secondary markets are critical to large corporations because investors are more willing to purchase securities in a primary market transaction when they know that those securities can be later resold if desired. There are two kinds of secondary market: • Dealer markets: dealers buy and sell for themselves, at their own risk. (Example: a car dealer buys and sells automobiles.) • Auction markets: brokers and agents match buyers and sellers, but they do not own the commodity that is bought or sold. (Example: An estate agent does not normally buy and sell houses.) An auction market or exchange has a physical location (ex: Wall Street in New York). In a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who want to buy. Dealers play only a limited role. The equities of most large firms trade in organized auction markets. Stock market liquidity is essential to a listed company because more accessible and cheaper it is to trade the firm’s securities, the more demand there will be in the firm. Companies have higher values when their shares are liquid and heavily traded (even after taking out all other factors that may drive valuation differences). Also, having numerous options on where to trade a company’s shares do not harm the value, and in fact can make pricing of the shares more efficient. 4 – Exchange trading of listed companies : On the main market, traders can: • submit orders to buy or sell at a stated price within a reasonable time (limit order) • market order: buy or sell a stated number of shares immediately at the best price. Smaller companies (around 900 firms listed on the AIM) are traded through a dealer system. Dealers compete with by posting buy and sell quotes (estimations).

To be listed, minimum criteria concerning like asset size and number of shareholders. These criteria differ from one exchange to another. For instance, Euronext has three main requirements: - A company must have at least 25% of its shares listed on the exchange - And the value of these shares must be at least €5 million....