fina2303 topic 01 introduction to corporate finance

8/18/2019 FINA2303 Topic 01 Introduction to Corporate Finance

1/88

Topic 1: Introduction to Corporate

Finance


2/88

Topic 1 Introduction to Corporate Finance M K Lai Page 2

Learning Outcomes

what is corporate finance?

financial manager

stock market

financial institutions


3/88


What is Corporate Finance?

corporate finance/financial management/business finance is the study of ways to addressthe financial decisions of a company

investment in the mix of long-term assets(capital budgeting)

Should your company launch a new product?

Should your company undertake a newproject?

Should your company produce a part of the

product or outsource production?


4/88Topic 1 Introduction to Corporate Finance M K Lai Page 4


raise capital through different sources of

financing, e.g. debt and equity (corporatefinancing and capital structure)

Should your company issue new stock or

borrow money instead?How can you raise money for your start-up

firm?

What is the optimal mix of debt and equity

for your company?




manage current assets and current liabilities

to avoid cash flow/liquidity problem (working

capital/treasury management)

Should your company grant credit to a

customer?How much of inventory should be

maintained?

Which supplier should your company choose?



risk

and

return

timevalue

of

money

cash

flows

buildingblocks

in

finance

Three Building Blocks in Making

Financial Decisions finance can be complicated, but it can be

reduced to three basic concepts




Financial Decisions size, timing and risk of cash flows

cash flows (size of cash flows) (this topic)

time value of money (timing of cash flows)

(topic 2)

positive relationship between risk and return

(risk of cash flows) – modern financial theories

(topic 5)




Financial Decisions an application is valuation

determine the fair value of an asset, a liability

or an equity (usually accompanied with an

investment recommendation in financeindustry)

take into account costs and benefits in terms

of cash flows (cost-benefit analysis)



Application: Valuation

source: ABCI Securities

fair value of stockinvestment recommendation


10/88


Accounting vs. Finance

accounting: use accounting standards set byaccounting professional bodies or regulators to

prepare financial statements (preparers offinancial statements)

finance: use financial statements to analyze thehistorical operating performance and currentfinancial position of a company (financialanalysis), project future performance of the

company through pro forma financial statements,cash and capital budgets and financial plans(financial planning/modeling), and compare

actual results to projected ones (financial control)(users of financial statements)


11/88



current financialposition and past

operating

performance

pro-formas, cashand capital

budgets, financial

plans

assumptions

implementation of

financial plans

actual results

analysis

control

financial

statements and

market data

planning

feedback


12/88



illustrate with a company research report

difference between accounting and finance

net income/profits vs.

sustainable/underlying/recurring income

what is the difference?


13/88


source: ABCI Securities


actual figures forecast figures


14/88


Cash Flows

net income vs. cash flows

book value vs. market value

financial statements vs. market information


15/88


Net Income

net income = total revenue – total expenses

(including tax payments to government)

total revenue and expenses are recognized

according to accounting standards (accrual basis)

summary of total revenue and expenses of acompany can be found in the income statement


16/88


Cash Flows

sample


17/88


Cash Flows

different definitions in finance industry

cash flows from operating activities (cash flow

statement)

change in cash and cash equivalents (cash

flow statement)

free cash flows (finance professionals, our

focus here, discussed in capital budgeting)


18/88


Net Income vs. Cash Flows

what are the differences between the net incomeand cash flows?

1.

2.

3.

which is more important to a finance practitioner?


19/88


Book Value

book value is the value recorded in the

accounting books and records of a company

book value is recognized according to accounting

standards (historical cost, mark to market)

summary of book value of assets, liabilities andequity can be found in the statement of financial

position (balance sheet)


20/88


Market Value

if we own an item, we are concerned about its

market value

market value is the cash inflows we obtain by

selling an item in an open market, say, a stock prevailing stock price

market capitalization (usually as a measure ofcompany’s size) = stock price * number of

shares outstanding


21/88


Market Value

source: aastocks


22/88


source: HSI Co. Ltd.

Market Value


23/88


Book Value vs. Market Value

what is the difference between the market value

and the book value?

book value is the value stated in the statement

of financial position, e.g. historical cost or

marking to market (fair value)market value is the selling price of an item in

an open market (consistent with cash flows)

illustrate with the example of a specialized

machine tailored to the needs of a company

which is more important to a finance practitioner?


24/88


Financial Statements

financial statements are prepared in accordance

with a set of rules known as Generally Accepted

Accounting Principles (GAAP, US) and

International Financial Reporting Standards (IFRS,

international) a company releases such information through

the unaudited interim reports and audited annual

reports serve as the primary source of data about a

company


25/88


Financial Statements

source: Sa Sa AR

financial

statements


26/88


Market Information

information that an investor can get hold of in thefinancial markets, e.g. relevant company, stock

exchange, financial information providers,brokerage firms and others

transaction price of security

transaction volume and turnover

transaction time

other pertinent information, e.g. corporateactions (cash dividends, stock dividends,stock repurchases, rights issues, etc. – what

are they?), plan for capital expenditures, etc.


27/88


Market Information: Teletext Screen


28/88


Corporation

corporation/limited liability company: an entityas a legal “person” separate and distinct from its

owners (shareholders/stockholders/equityholders)

types of companies: private companies (shares

cannot be traded on organized exchange andpublic companies (shares can be traded onorganized exchange, listed companies)

limited liability: shareholders are not liable tocompany’s debt and their liability is restrictedto their investment in the shares


29/88


Corporation

separation of ownership (shareholders) and

management (hired professional managers)

shareholders elect members to join board of

directors in the annual general meeting to

oversee managementmanagement runs the corporation’s affairs

in the shareholders’ interests


30/88


Corporation

source: Sa Sa Notice of AGM


31/88


Corporation

ownership of company: company issues

shares/stocks/equity to shareholders

vote on proposed resolutions on one-share-

one-vote basis in shareholders’ meetings

entitled to receive dividends on a pro rata

basis


32/88


Voting on Resolutions

source: Sa Sa Proxy Form


33/88


Corporation

tax implications: tax on corporate profits are

separate from shareholders’ tax obligations

(double taxation)

tax on a corporate level, i.e. corporate incometax in the US (profits tax in Hong Kong)

tax on an individual level, i.e. tax on dividends

in the US (no such tax in Hong Kong)


34/88

Example: Tax Implication on Company’s


35/88


Example: Tax Implication on Company s

Earnings earnings after tax = earnings before tax * (1-tax

rate) = $5,000,000*(1-40%) = $3,000,000

dividends received by shareholder =

$3,000,000*40%*1% = $12,000

dividends after tax received by shareholder =

$12,000*(1-15%) = $10,200


36/88


Financial Manager’s Place in Company

Board of Directors

Chief Executive Officer

Chief Operating Officer Chief Financial Officer

Treasurer Controller


37/88



board of directors: make rules on how the

company should be run, set policy and monitor

the performance of company; usually delegate

the day-to-day running to senior management of

company

chief executive officer (CEO): run the day-to-day

operations by instituting rules and policies set byboard of directors


38/88



financial mangers

chief financial officer (CFO): top company

officer responsible for its finance activities

financial controller: handle cost and financialaccounting, tax payments and management

information systems

treasurer: manage a firm’s cash and credit, its

short-term and long-term financial planning,

and its capital expenditures


39/88


Financial Managers

financial managers are the main companyofficers responsible for making the company’s

financial decisions three major financial decisions

capital budgeting

financing

working capital management

other financial decisionsdividend policy

financial risk management

S f Fi i l P i i M d l


40/88


Statement of Financial Position Model

long term assets long-term liabilities

shareholders’ equity

current assets current liabilities

Statement of Financial Position

capital budgeting

working capital management

financing

dividend policyfinancial risk management

M j Fi i l D i i


41/88


Major Financial Decisions

capital budgeting/investment: process ofplanning and managing a firm’s long term

investments in terms of sorts of property, plantand equipment, and other assets (investment)

financing: how a firm obtains long term financingit needs to support its long-term investments(corporate financing) through a mix of long term

debt and equity (capital structure)

M j Fi i l D i i


42/88


Major Financial Decisions

working capital/treasury management: day-to-

day activity to ensure a firm has sufficient cash

resources to continue its operations and avoid

costly interruptions

net working capital = current assets - currentliabilities

cash flow or liquidity problem


43/88

G l f C


44/88


Goal of Company

objective: maximize stock price or shareholders’

wealth

subject to

principal-agent (agency) problem:

management acts in own interests at expense

of shareholders

Goal of Company


45/88


Goal of Company

illegal and unethical actions taken by

management known as corporate mis-

governance to affect interests of different

stakeholders, such as shareholders, creditors,

suppliers, customers, employees and even the

general public

mitigated by corporate governance structure

of corporation

corporate social responsibility for the benefit of

the society

Agency Problem


46/88


Agency Problem

shareholders are principals and managers are

agents

agents owe fiduciary duties to principals and

should act in the best interests of principals

however, in reality, there is always a conflict of

interests between shareholders and managers

managers tend to act in their own interests at

the expense of the shareholders

this is known as the agency problem

Agency Problem


47/88


Agency Problem

luxurious officeprivate jet

company car

huge bonus

nepotism cronyism

Agency Problem


48/88


Agency Problem

ways to mitigate the agency problem

1. , e.g. stock option schemes, share

offerings, compensation packages and job

prospects tied to managerial performance

2. .

3. , e.g. proxy fights, hostile takeovers by

corporate raiders

Corporate Mis governance


49/88


Corporate Mis-governance

corporate mis-governance: misconduct by board

of directors or management of a company

towards different stakeholders, e.g. fraud,misfeasance, failures to adhere to duties of

disclosure

corporate governance: how a firm is directed and

controlled in the best interest of differentstakeholders such as shareholders, creditors,

employees, suppliers, customers, the general

public, etc.

Corporate Governance Report


50/88


Corporate Governance Report

source: Sa Sa Annual Report

Corporate Social Responsibility


51/88


Corporate Social Responsibility

corporate social responsibility: a firm integrates

social and environmental concerns in its business

operations and in its interaction with businessrelevant groups on a voluntary basis

responsible entrepreneurship

voluntary initiatives going beyond legal

requirements and contractual obligations

activities to benefit employees, businessrelevant groups (i.e. society) or environment

positive contribution to individual target groups

regular activities rather than one-time events


52/88


53/88

Financial Intermediaries


54/88


Financial Intermediaries

a financial intermediary stands between the

company and outside investors by facilitating the

transfer of funds from one to the other

the financial institution issues financial

instruments under its own name to be purchasedby outside investors and buys financial

instruments issued by the company

it is called indirect finance or intermediation examples: banks, insurance companies, mutual

funds, pension funds, etc.

Financial Markets


55/88


Financial Markets

a financial market provides a marketplace for the

outside investors to buy financial instruments

issued by the company directly

it is called direct finance or disintermediation

examples: stock market, bond market, money

market, foreign exchange market, derivative

market, etc.

Stock Market


56/88


Stock Market

a stock market/stock exchange/bourse : an

organized market: that provides a physical

central market place for shares to be traded, e.g.New York Stock Exchange (NYSE), Stock

Exchange of Hong Kong (SEHK)

the exchange sets out listing standards

(Listing Rules in Hong Kong) to outline therequirements a company to meet so as to

maintain listing status on the exchange

Stock Market


57/88


Stock Market

over-the-counter market: a decentralized market

that is connected by a computer or

telecommunication network, e.g. NASDAQ(according to the textbook)

notice: since 2006, NASDAQ has been

recognized as a stock exchange by US

Securities and Exchange Commission

Stock Exchange of Hong Kong:

T di g H ll


58/88


Trading Hall

source: HKEx

floor trader in red

waistcoat

Trading Through Telecommunications or

C t N t k


59/88


Computer Network

trading

terminals

usually

provided byBloomberg or

Reuters

Stock Markets by Market Capitalization


60/88


y p

source: World Federation of Exchanges

Ranking Exchange 2015 August2015 August2015 August2015 August

1 NYSE 17 931 217.02 NASDAQ OMX 6 981 893.0

3 Japan Exchange Group - Tokyo 4 713 630.2

4 Shanghai SE 4 125 183.45 Euronext 3 326 883.0

6 Hong Kong Exchanges and Clearing 3 059 911.1

7 Shenzhen SE 2 742 061.18 TMX Group 1 749 271.7

9 Deutsche Börse 1 676 240.4

10 SIX Swiss Exchange 1 539 575.5

Domestic market capitalization (USD millions)

Functions of Stock Market


61/88


allow companies to raise funds by issuing shares

primary market: a fund raising or financing

market that a company issues new shares to

raise funds

provide liquidity for trading company’s shares

liquidity: a stock can be converted into cash

quickly at a competitive market price

secondary market: a market for trading

already-issued shares among investors

Functions of Stock Market


62/88


help determine the share price (price discovery)

share price reflects demand and supply

conditions in stock market

investors react to arrival of new information by

trading shares and share price changesaccordingly

a feedback to company’s management about

investors’ views and decisions to company’sshares

Trading Systems of Stock Market


63/88


auction market: a market where share prices are

set through direct interaction between buyers and

sellers

two major trading systems

order-driven

quote-driven/dealer market

Order-Driven System


64/88


order-driven: a trade is concluded between a

buying investor and a selling investor, e.g. stock

transactions on the Stock Exchange of Hong Kong

the trade may be facilitated by brokers to act onbehalf of the investors and earn

brokerage/commission


65/88

Dealer Market


66/88


dealer provides two-way quotes and investor can

trade with dealer as long as he agrees with price

quotations

bid price: buying price of dealer

ask/offer price: selling price of dealer

which price should be higher?

what is the difference between a broker and a

dealer?

Dealer Market


67/88


bid-ask spread: difference between bid and ask

prices

transaction cost to investor

profit to dealer as compensation for bearing

inventory risk

Financing Cycle


68/88


funds

rent, wages, profits and

interest

savers, lenders

and investors

(fund surplus

units)

companies with

projects and

ideas (fund

deficit units)

Financial Institutions


69/88


financial institutions: entities that provide

financial services, such as taking deposits,

managing investment, brokering financialtransactions or making loans, to facilitate the

transfer of funds from the surplus units to the

deficit units



70/88


commercial banking: .

investment banking: .

financial conglomerates/groups: provide awide range of financial products and services

help companies raise additional funds through the issue of new securities,

mergers and acquisitions, corporate restructuring, securities trading.

to accept deposits from the investors and make loans to individuals and

corporates.



71/88


financial institutions ources of money uses of money

commercial banks depositsloans to individuals and

businesses

insurance companiespremiums and investment

earnings

invest mostly in bonds and some

stocks, and use the investment

to pay claims

mutual funds investments by a large ofinvestors

buy stocks, bonds and other

financial instrumetns on behalf

of investors

pension fundscontributed by employers and

employees through the

workplace

buy stocks, bonds and other

financial instrumetns on behalfof investors with the purpose of

providing retirement income

(accrued benefit)

issue their own shares

limitations



72/88


financial institutions ources of money uses of money

hedge funds

investments by institutional and

high net worth investors, e.g.

wealthy individuals and

endowments

invest in any kind of investment

in an attempt to maximize

returns in any market conditions

(absolute return)

venture capital funds




endowments

invest in start-up, entrepreneurial

firms

private equity funds




endowments

buy whole companies by using a

small amount of equity and

borrowing the rest (leveraged

buyout)listed new companies?

Role of Financial Institutions


73/88


help transfer of funds from surplus units to deficit

units

help solve problem of mismatching in maturity,

risk and denomination

Mismatching in Maturity


74/88


deficit unit wants

to borrow for3 years

surplus unit wants

to lend for3 months

financial

institution

lend for 3

months

lend for 3

years

Mismatching in Risk


75/88


deficit unit

involvesin high risk

investment

surplus unit wants

to have low riskinvestment

financial

institution

make low risk

investment

make high risk

investment

Mismatching in Denomination


76/88


deficit unit wants

to borrow $5million

surplus unit wants

to lend out$50,000

financial

institution

lend out

$50,000

lend out $5

million

Challenging Questions


77/88


1. Discuss two scenarios under which a companyis in financial distress?

2. If the fair value of a stock is $50 and the currentstock price is $55, what is your investmentrecommendation to a client?

3. One of the reasons that cash flows areconsidered as a better measure than netincome in finance is that net income can be

manipulated by the senior management of acompany. Discuss two ways to manipulate thenet income.



78/88


4. In the record of the Inland Revenue Department,the value of a machine owned by a company is

$50,000. The company sells the machine at$80,000. The tax corporate tax rate is 30%. Thecapital gain from the sale is $30,000. The tax

on the capital gain is $$9,000. A. The book value of the machine is .

B. The market value of the machine is .

C. The capital gain is considered as an itemof calculating .

D. The tax on the capital gain is considered

as an item of calculating .



79/88


5. Explain whether the depreciation expense of a

machine is a cash flow item. The Inland

Revenue Department allows a company toreduce its taxable income by deducting the

depreciation expense from its revenue. The tax

saving is known as the depreciation tax shield.Is the depreciation tax shield a cash flow item?

6. What is the implication of limited liability of acompany on its stock price?



80/88


7. What are the impacts of the following corporate

actions on the net assets, the number of shares

outstanding and the stock price of a company? A. cash dividend: a company pays cash back

to the shareholders

B. stock dividend: a company gives new

shares free-of-charge to the shareholders

8. In economics, the objective is profitmaximization. Why don’t we use profit

maximization as the goal of a company?



81/88


9. Which characteristic of a company gives rise to

the agency problem? Explain.

10.Suppose that an investor owns stock in acompany. The current price per share is $10.

Another company has just announced that it

wants to buy the company and will pay $15 per

share to acquire all shares outstanding. The

company’s management immediately beginsfighting off this hostile bid. Is the company

management acting in the shareholders’

interests? Why or why not?



82/88


11.If a hedge fund offers partnership interests toinstitutional and high net worth investors and

uses the pool of funds to invest in the financialmarkets, it involves in financing. Explain.

12.Discuss what types of financial instruments are

traded in the following financial markets A. stock market

B. bond market

C. money market

D. foreign exchange market

E. derivative market


83/88



84/88


C. If a company gives rights free-of-charge to

the shareholders and it is at the discretion of

the shareholders to pay a specifiedsubscription price in exchange for new shares

issued by the company, it is a market

activity. (rights issue)

D. If a company issues new shares to the

general public for subscription for the first

time, it is a market activity. (initial public

offering, IPO)


85/88



86/88


16.Hong Kong, a stock transaction is concluded by

matching a buy order with a sell order in terms

of stock price, quantity of shares, etc. Is it anauction market? Why or why not?

17.In the foreign exchange market, large financial

institutions (mainly banks) provide the market

to the investors by trading with them at

specified exchange rates, it is a(n) market.

18.What is the difference between an auction

market and a dealer market?


87/88



88/88


20.Discuss the impact of the following events on

the size of the bid-ask spread quoted by a dealer

on a financial instrument. A. The liquidity of the financial instruments

becomes lower.

B. The price of the financial instrument

becomes more volatile.

C. The dealer wants to lay off its largeposition in the financial instrument.

fina2303 topic 01 introduction to corporate finance

Documents