TOPIC ONE

Cpts 1 & 2

Goals of firms• Range of goals that could be

pursued by firms includes– maximal wealth for owners– maximal profits– adequate profits and/or limited working

hours– high revenue growth and/or large market

share– high reputation for product quality and

service– good employee relations, minimising

environmental damage, good corporate citizenship

Goals of firms (cont.)

• Some of these goals can be interdependent (e.g. good employee relations and owners’ wealth maximisation)

• Not all of these goals can be achieved simultaneously (e.g. limited working hours for owner-operator and owner’s wealth maximisation

Goals of firms (cont.)

• The size of the business will have an impact on the goals of the owners

• Profit maximisation implies a business is managed to maximise the difference between revenues and expenses in any period

Goals of firms (cont.)

• Wealth maximisation implies that the business is managed so thatthe present and future cash flows discounted at an appropriate rate will give a present value (PV) which is maximised

Goals of firms (cont.)

• A goal of maximising wealth leads to a long-term view that considers future cash flows, the time value of money and risk

• Thus, maximising wealth is superior to a goal of profit maximisation

Goals of firms (cont.)

• The time value of money is the concept that a dollar is worth more the sooner it is received.

• Discounting is the process of calculating the present value (PV) of a future amount. The discount factor incorporates the possible or required earning rate for the funds.

Goals of firms (cont.)

• The value of a firm at a given time should be the present value of its future expected cash flows

Goals of firms (cont.)

• The value of a corporation is the market capitalisation of the company

• Market capitalisation is the total value of a corporation as measured by the price of each issued share multiplied by the number of issued shares.

Goals of firms (cont.)

• The value of a firm that is not a corporation is its market value

• The market value of a firm is the price that willing buyers are prepared to pay and willing sellers are prepared to accept

Goals of firms (cont.)

• Maximising owners’ wealth means having the highest possible valuefor the firm

Roles of financial managers

• accounting and reporting functions

• cash management, raising and managing funds

• taxation management – compliance, forecasting and planning

• risk management of revenues and expenses

Roles of financial managers (cont.)

• analysing proposed investments, capital restructures, etc.

• forecasting the impact of financial decisions

• internal and external audit management

• investor relations

Roles of financial managers (cont.)

• Financial derivatives are contracts that are derived from the value of some underlying assets and are used to manage risk

• They can be used by financial managers to manage risk

Financial governance and financial decisions

• Financial governance comprisesall the financial and management accounting systems and other financial processes which are put in place to achieve the objectives of the firm

• is critical to the work of the financial manager

Roles of financial managers (cont.)

• Major financial management decisions– which new investments?– how to fund investments– how to manage short-term funding– how to manage long-term funding– which dividend policy?– how to manage risk

The principal–agent problem

• The principal–agent problem is the scope for conflict or division between principals (owners) and agents (managers) over the goals of the firm which are being pursued by its policy and management decisions

The principal–agent problem (cont.)

• Agency costs are the losses borne by the owners of the firm that canbe attributed to the agent having different objectives from the owners (or principals).

• HIH example of CEO making large donations of corporate funds for his personal gain

The principal-agent problem (cont.)

• Agency costs come from managers having different objectives from those of the owners of the company

• They are only an issue when thereis a separation of ownership and management

Ethics in business

• Ethics are moral principles or rules of conduct which indicate the acceptability of behaviour within a community

• Unethical actions may be legal (e.g. shifting production to a country that has lower legal standards for worker and/or environmental protection)

Ethics in business (cont.)

• Ethical behaviour can be consistent with wealth maximisation because it maintains the company’s reputation

• Whistle-blowing means informing (usually by employees of the perpetrators) the relevant authorities of malpractice or dangers to the public or the environment

Ethics in business (cont.)

• Corporate social responsibility (CSR) means that the business firm has wider responsibilities in relation to objectives and people apart from the owners or shareholders

• Stakeholders include employees, customers, suppliers, regulators and the general public

Forms of business organisation

4 main forms of business organisation:

1. sole trader or sole proprietor

2. partnership

3. company

4. trust

Sole proprietorship

• A sole proprietorship is a business owned by an individual, who owns assets used in the business, incurs liabilities and reaps the annual profits or losses

• The corner shop or local newsagent, for example

Partnership

• A partnership is an associationof two or more people carrying ona business in common with a viewto profit

• The local (or international) accounting or legal practice, for example

Company

• A company is an entity, formed under the Corporations Act 2001, which is legally separate from its owners

• Corporate governance means the management of corporations

Company (cont.)

• Private companies can be relatively small family businesses

• Public companies tend to be larger and will have a greater number of shareholders

• Shareholders (the owners of companies) have limited liability

Trust

• A trust is a legal structure where property is nominally owned by one party, the trustee, on behalf of others who are the beneficiaries

• Are a popular form of business structure when they can get benefits from the current taxation legislation

• The ‘best’ business structure depends on the personal circumstances of the owners

Overview of Australian tax

• Income tax is levied in Australia on individuals’ and companies’ taxable income

• Taxable income is assessable income less legitimate deductions

• Income is normally received regularly (or frequently)

Overview of Australian tax (cont.)

• For businesses, the general rule for allowable deductions are those expenditures incurred to earn assessable income.

• Marginal rates of tax are important for analysing alternative activities for the impact on marginal income.

Overview of Australian tax (cont.)

• Capital gains tax (CGT) is paidon gains made on the disposalof assets purchased after19 September 1985.

• Goods and services tax (GST) isa type of consumption tax that is paid irrespective of the individual’s level of income.

Importance of dividend imputation

• Dividend imputation is the system where dividends carry an additional benefit in the form of an attached tax credit for the relevant amount of tax paid by the company on its profits.

• The system avoids the double taxation of company profits.

• A fully franked dividend carries a tax credit equal to the full 30% company tax paid on the underlying profit.

• A partly franked dividend carries a tax credit less than the full 30% company tax paid on the underlying profit.

• An unfranked dividend carries no tax credit.

• Shareholders only pay tax on dividends when their marginal tax rate is higher than the level of franking credits on the dividends they receive.

• Are there implications for financial decision making?

• When shareholders can fully utilise imputation credits– tax paid by the company is irrelevant

when the financial manager is making the decision

• When shareholders cannot utilise imputation credits– tax paid by the company is relevant to

corporate financial decision making

Challenges facing modern firms

Important aspects of change

1. external environment (e.g. deregulation)

2. advancing technology (e.g. electronic commerce)

3. social expectations (e.g. employee working conditions)

People and decision making

• Rational behaviour implies decisions are made after an amount of reasoning so that ultimate decisions are not foolish or absurd, and are based on the desire to satisfy objectives and maximise, or at least optimise, outcomes

• Assumed when people make decisions!

INTRODUCING CORPORATE FINANCE

Chapter 2: Business and the Financial Markets

By Diana Beal and

Michelle Goyen

Roles of financial markets

• The financial markets in Australia fulfil many roles including:

1. matching supply and demand for funds

2. facilitating business and trade

3. facilitating the saving of individualsfor future consumption

4. provision of financial services

Financing business operations

• Sources of finance are direct or indirect

• Direct finance – the supplier of funds and the fund user transact directly

• Intermediated finance – the intermediary collect funds from suppliers and deals with the fund users

• Transaction costs are the costs,in terms of both time and explicit cash costs, of effecting a transaction or deal

Types of financial institutions

• Main types of Australian financial institutions:

1. Authorised deposit-taking institutions

2. Registered financial corporations

• Authorised deposit-taking institutions (ADIs)

• Take deposits and make loans to borrowers– Banks– Building societies– Credit unions

• Registered financial corporations (RFCs)

• Use their capital or borrow so they can make loans– money market corporations, pastoral

finance companies, finance companies, general financiers and intra-group financiers

Classifying the markets

• There are three main divisions in financial markets:

1. primary or secondary

2. public or private

3. money or capital markets

• Securities – documents which provide evidence of a loan or the purchase of shares, a bond or a commercial bill

• Price discovery – the process of finding and settling on a price which is acceptable to both parties

• primary market – where securities are offered for the first time– money goes to the issuer

• secondary markets – trading securities which have been issued – secondary market trades do not

increase the stock of securities– money goes to previous security holder

Two ways to issue securities:

1. Private placements are made by negotiation directly with purchasers

2. Public issues are made to the public and require the use of a prospectus

• prospectus – a document which provides details of a new issue of securities to the public

• public issues are– usually larger than private ones– more expensive due to the application

and issuing processes– sponsoring broker and/or underwriter

fees

• merchant bank – a financial institution which is not registered nor regulated under the Banking Act 1959 but which carries out many of the functions of a bank

• sometimes handles private issues

• Money markets deal in short-term debt– bills, promissory notes and certificates

of deposit

• Capital markets deal in long-term instruments– debentures, secured or unsecured

notes, leases, loans, shares and convertible notes

Debt and equity

• Debt is a contractual arrangement to borrow money that will be repaid in the future

• Equity represents an ownership interest, so there is no expectation that it will be ‘repaid’ in the future

• Equity holders get their money back by selling their ownership interest

• maturity (or term to maturity) is the contracted time that may elapse before the borrowed funds are to be repaid

• financial structure – the mix of debt and equity which fund the assets owned by the business

• Risk – the chance that the actual outcome from an investment will be different from the expected outcome

• suppliers demand higher returns for riskier securities (discussed in Chapter 4)

• Financial risk is the risk involved in using debt as a source of finance

• Financial distress – a firm’s financial obligations cannot be met or can only be met with major difficulty

• creditors rank higher than owners if a firm is liquidated

• debtholders receive interest payments from the borrower

• interest payments provide a tax deduction for the borrower

• equity holders receive dividends

• dividends are not tax deductible,but give the shareholder imputation credits if they are franked

Debt instruments

• Trade credit allows a purchase to be made without the immediate payment of cash – usually have a 7- or 30-day term

• An overdraft is a permitted over-drawing of funds beyond the credit balance in the account

• Inventory finance (or floor-plan finance) is provided to car and whitegoods dealers to buy stock to place on showroom floors and is secured by the stock itself

– for retailers with high value inventories

• Promissory notes (‘P-notes’) are promises by the borrowers to – repay the face value of the instrument

at a stated future date

• Commercial bills are promises by the borrowers to – repay at a stated future date the face

value of the instrument – the promise is normally guaranteed by

a third party such as a bank

• Face value is the amount that will be repaid upon maturity of the debt security

• Face value is specified at the time the debt security is issued

• Discount securities are issued at a price less than the face value

• Debentures are fixed-term debt securities issued under a prospectus– secured by assets

• Unsecured notes are fixed-term debt securities issued under a prospectus– are not secured by assets

• Both are issued by companies

• Corporate bonds – debt instruments where the issuer receives the face value of the bonds at the outset– face value is repaid when the

bonds mature – pay a regular coupon

• Coupon is the stated rate of interest paid on a bond

• Corporate bonds usually receivea credit rating that indicates the level of credit risk

• Junk bonds have a rating of ‘BBB’ or lower

Equity instruments

Three main types of equity instruments:

1. ordinary shares (fully paid)

2. contributing shares (partly paid ordinary shares)

3. preference shares

• An ordinary share is evidence of part-ownership of a company

• Contributing shares or partly-paid shares are ordinary shares where the full cost has not yet been paid to the issuing company

• Preference shares are hybrid equity instruments with some characteristics of equity and some of debt

• normally have a fixed dividend which has preference over the payment of ordinary dividends

Regulators and regulation

Australian Government regulates financial markets via the:

1. Reserve Bank of Australia (RBA)

2. Australian Prudential Regulation Authority (APRA)

3. Australian Securities and Investments Commission (ASIC)

• Reserve Bank

– objective of ensuring the stability of the financial system

– controls monetary policy by setting the cash rate of interest

– conducts open market operations in Commonwealth Government Securities

• Re-purchase agreements or repos are securities that are bought or sold with an agreement to reverse the original transaction at a later date

• Used by the RBA to manage the economy

• Australian Prudential Regulation Authority (APRA)– prudential regulator of ADIs

– ‘prudential’ means that management of the ADI have the responsibility to behave ‘sensibly’

– uses the Bank of International Settlements (BIS) guidelines for capital adequacy

• Australian Securities and Investments Commission (ASIC)– administers the Corporations Act 2001

– management and maintenance of financial market integrity

– consumer protection

– maintenance of confidence by stakeholders in the financial system

• Australian Stock Exchange (ASX)

– Regulates listed companies with respect to the handling and release of company information

– non-compliance by companies can mean share trading is suspended

• Australian Competition and Consumer Commission (ACCC) also watches markets for competition and consumer protection issues

People dimensions

• Framing is the context or environment from which information or data are extracted

• Dominance implies that the most outstanding attribute or benefit will consistently maintain its premier position, no matter how it is presented

• Rational investors chose the dominant alternative no matterhow the choice is framed