LA 1 Key Principles of Finance and Investment PDF

Learning area 1 Introduction to finance and investment  2 Objectives ➜ Define what financial management is. ➜ Understand the objective of financial management in maximising the value of an enterprise for its stakeholders ➜ Defi...

Learning area 1 Introduction to finance and investment  2 Objectives ➜ Define what financial management is. ➜ Understand the objective of financial management in maximising the value of an enterprise for its stakeholders ➜ Define the role of the financial manager within the enterprise ➜ Understand the role of corporate finance in relation to accounting and the economic environment and markets  3 Objectives ➜ Describe the various forms of an organisation found ➜ Identify ways in which the forms of an ownership can change ➜ Understand the role of financial and non-financial objectives of the firm, with particular emphasis being placed on sustainable wealth creation, shareholder value maximisation, the environmental and social contexts within which an enterprise operates and the trade-off often required in meeting objectives  4 Objectives ➜ Define the agency problem and understand the role and importance of the agency theory in an enterprise ➜ Differentiate between financial reporting (financial accounting) and management accounting ➜ Understand the decision-making process and identify the different types of information which management needs depending on the stage at which management is at in the decision-making process ➜ Understand the impact of the changing competitive environment on the enterprise  5 Class Representative ➜ Voting process  6 Why do I start a business?  7 Where do I get money vs How do I spend money 1. Finance and real resources 8 Finance Business Assets (Projects) Finance decision: Investment decision: Which finance should be obtained (risk, cost)? Which assets/projects should be invested in (risk, ➜ Equity profit)? (Capital budget) ➜ Debt ➜ Current assets ( working capital -stock) ➜ Fixed assets: (machinery) NB Different types of entities are financed differently - Cost of errors - Capital is committed for longer period Complex question! - Difficulty of estimating future profits  9 Equity  10 Debt  11 What is debt and equity? ➜ Debt - Debt is borrowed money, either between people, businesses, or banks, as well as a financial instrument used as leverage by corporations to borrow or purchase  12 What is debt and equity? ➜ Equity - Equity is the amount of capital invested or owned by the owner of a company. The equity is evaluated by the difference between liabilities and assets recorded on the balance sheet of a company. The worthiness of equity is based on the present share price or a value regulated by the valuation professionals or investors.  13 Management Investment Corporate finance accounting Management Deals with the Management The professional sources of funding, accounting tends to asset management of and the capital have a much stronger various securities, structure of focus on internal including businesses, the systems and shareholdings, bonds, actions that managers processes, and other assets, take to increase the and seeks to identify such as real estate, to value of the firm to the and analyze how to meet specified shareholders, and the streamline these and investment goals for tools and analysis maximize their the benefit of used to allocate efficiency investors. financial resources  14 Management Investment Corporate finance accounting Management FBS 210/320 FBS 220/310 IVM 200/300 CIMA/CFA/ACCA CIMA CFA Financial Project manager Stock analyst/manager Chief Financial broker/investment CFO/CEO Officer analyst Treasurer Finance Manager Fund managers Consulting Management Brokers Consultant Risk management Management Accountant Finance Business Partner  FBS course during your studies Management accounting Financial Management Accounting ► Focus: Internal operating ► Funding of company’s activities of the company activities eg. Shares issue/ ► E.g. Cost of production or Use of retained earnings/ services // replacement or Loans / Debentures, etc. expansion of plant vs. benefit // internal ► Valuations of companies manufacturing of a product or component vs. external ► Financial analysis of purchasing of that product companies or component 1 Finance and organization’s objectives ➜ What real assets should firm invest in (investment or capital budgeting decision) ➜ How should finance (cash) be raised (financing decision) ➜ Firms can be thought of as collection of projects: - Revenues of projects > costs incurred = profits for shareholders ➜ Complicated questions! - More than one profitable project - Difficult to estimate future profitability  17 1 Responsibilities for financial decisions ➜ Role of the CFO (or controller) - What company should invest in ➜ Role of the treasurer - Company cash - Raises new capital - Maintains relationships with other stakeholders 1 Importance of capital budgeting ➜ Complexity of analysis ➜ Cost of bad decisions ➜ Investment in working capital (What is working capital? – current assets and current liabilities) ➜ Investment in fixed capital - Alternative capital assets - Dates of commencement - Methods of financing 1 Financial analysis ➜ Financial analysis - Analyzing financial implications of different courses of action - How profitable? - How risky ➜ Why? - Better understanding/insight - Highlight and reduce risks - Objectivity in decision making  20 1 Financial analysis ➜ Financial analysis can help: - Identify risks involved in the project - Highlight salient factors - Suggest ways to reduce risk ➜ Financial analysis brings together different areas of company including marketing, technology, accounting, tax, law  21 2 Definition of Financial Management A managerial activity which, through planning and controlling of the organisation's financial resources, ensures that the objectives of the organisation are met. This is accomplished by planning, directing, monitoring, organising and controlling the monetary resources of an organisation  22 Thoughts… How are the organization’s goals ➜ Are assets utilized going to be achieved? Availability of funding to effectively? ➜ support operations as Do management well as expanding the act in the best organization? interest of the shareholders? Financial management requires financial decision making: Investments? Sources of finance? Dividends?  23 2 Definition of financial management The key objectives of financial management: ► Create wealth for the business ► Generate cash, and ► Providean adequate return on investment bearing in mind the risks that the business is taking and the resources invested  1. Dividends What do shareholders get in return? 2. Capital growth  25 2. Stakeholders 2 Stakeholders ➜ Shareholder’s objective = Maximizing value of shares (higher return on investment) ➜ CLASS EXAMPLE: Give examples of objectives of: - Managers - Banks and lenders - Employees - Customers - Government 2 Conflicting objectives Shareholders vs. Managers - Shareholders = high returns - Managers = Focus rather pursue projects of interest and mergers & acquisitions (grow business) - Solve: Incentive bonus linked to share price Owners vs. Lenders - Owners focus = Higher risk: higher return - Lenders rather opt for promised interest and capital payments  28 2 Conflicting objectives ➜ Shareholders and managers - Shareholders want high return on investment in company - Managers might pursue projects of interest, build an empire or relaxed work environment - Solve: incentive bonus for managers  29 2 Conflicting objectives ➜ Providers of finance - Shareholders would tolerate riskier investments for higher profit - Debt providers rather want to receive promised interest and capital payments ➜ Lenders short-term security vs shareholders’ long- term interest in growing company  30 3. Capital markets and shareholder wealth maximization  31 3. Capital markets ➜ Markets for long-term finance for companies (financing question) - Shares (stock) market - Bond market ➜ Share price = market perception of firm’s current and expected future performance ➜ Capital markets stimulates efficiency and provides incentives to improve performance (how?) 3. Capital markets ➜ Capital markets are the markets in long-term finance for companies - Where equity, bonds and other instruments are traded ➜ The information from capital markets will be used to: - Monitor performance of the financial manager - Assist financial manager in decision making  33 3. Capital markets ➜ Market determines the share price - The share price reflect the market’s perception of the firm’s future performance. ➜ If share price is too low = risk of a take-over!  34 3. Capital markets ➜ Financial markets provide useful information ➜ Key effects of capital markets on firm decisions: - Accurate measurement of cost of capital - Methods of raising finance - Threats and opportunities to be exploited - Externalities 3 The role of information ➜ Problems may be resolved easier if all parties share the same insight into the fortunes of the company. ➜ However, information asymmetries will often exist between the various classes of stakeholder. ➜ Why? ➜ Private debt/venture capital vs publicly quoted companies  36 3 The value of a company ➜ Market value ➜ Present value of future cash flows ➜ Valuation requires: - Stream of expected returns - Required rate of return (discount rate) ➜ Intrinsic value of firm measured by discounted cash flow techniques, for example DDM 37  38 3 The value of a company ➜ Valuation requires: - The stream of expected returns - The required rate of return ➜ Example page 16: - 100/(1.02) = $98.04  39 Example ➜ A project costs R1.5 million, and is expected to bring in a net cashflow of R500 000 each year for the next 4 years. If the discount rate is 10%, is this project worth doing?  40 Example ➜ The company will consider the present value of all future cashflows. ➜ R100 now is worth more than R100 next year because the R100 now could be invested at 10% and be worth R110 next year. ➜ The R100 received next year is therefore worth R90.91 now.  41 Example  42 Example ➜ Since the net present value is positive, this project is worth doing. The project will earn at least a 10% return.  43 4 The goal of the financial manager ➜ Ultimate goal of the Financial Manager - Maximizing shareholder value ➜ Needs of shareholders differ – why? - Attitude towards risk - Time preference (investment now or later?) - Income (dividends) vs capital growth - Tax position (impact decision: dividend / capital gain)  44 4 The goal of the financial manager ➜ Solution: the market - = Shareholders choose investment to match their needs ➜ Opportunity cost of capital - = Income that shareholder lose by investing in another investment 4.2 Opportunity cost of capital ➜ Value of project = set of cash flows it generates ➜ Initial outflows vs future inflows ➜ The income a shareholder might lose by choosing one investment over another. (Will do in detail second semester FBS122) ➜ Question p.18  46 4.2 Opportunity cost of capital ➜ Question page 18 - = -1 500 + 500/(1.1) + 500/(1.1)² + 500/(1.1)3 + 500/(1.1)4 - = 84.95  47 4.2 Opportunity cost of capital ➜ Net present value (NPV) of project can be calculated as present value of expected future cash flows discounted at appropriate discount rate- eg. (opportunity) cost of capital) ➜ Accept projects with positive NPV as it will add to current shareholder value ➜ Where can cost of capital be found? - Capital Market! - Rate forgone by investing in opportunity rather than somewhere else  48 4.2 Opportunity cost of capital ➜ Not just question of return, but also which alternative opportunities exist - Might increase value, but not maximize wealth ➜ Both risk and return of investment alternatives should be considered ➜ Economic value added (EVA) - Evaluate the ability of managers to add value to firms - Economic profit > cost of capital => managers added value  49 6 Various Forms of Business Organisations ➜ Sole proprietorship ➜ Partnership ➜ Companies  50 6 Sole trader ➜ Owned by 1 person ➜ Unlimited legal liability for business debts ➜ Example: Builder ➜ May have employees ➜ Can draw money ➜ No specific documentation ➜ Normal Income Tax return  51 6 Partnership ➜ Owned by >1 Owner, not a limited company ➜ Liability - Unlimited liability - Owners are jointly and severally liable for business debts ➜ % ownership may vary ➜ Examples: Doctors, Actuary firms ➜ Sleeping partners ➜ Partnership agreement (no legal requirement) ➜ Accounts to SARS  52 6 Limited Companies ➜ = a legal entity – own contracts, property etc in own name ➜ Owners = shareholders ➜ Share certificates – show how many shares held by individual SH in company ➜ Shares – right to vote ➜ Appoint directors – responsible for control ➜ Managers – day to day management ➜ Executive directors – involved day to day management ➜ Independent directors – not involved day to day management and not shareholders  53 6 Limited Companies ➜ Dividends - Share of profits - In proportion to number of shares owned ➜ Limited liability - Limited to fully paid value of shares - Creditors cannot claim further payment from shareholders’ personal wealth  54 6 Limited Companies ➜ Documentation - Memorandum of Association: Name, Objective, Total share capital etc - Articles of Association (Internal rules): Rights of different classes of share capital, rules for electing directors etc. - Audited annual financial statements - Companies tax @ 28% in South Africa  55 6 Private and public limited companies ➜ South Africa - New Act – Widely held companies versus companies that are not widely held - Only widely held companies may register on the JSE.  56 6 South Africa ➜ Private companies - (Pty) Ltd – Proprietary Limited. - It is for profit, does not offer shares to the public, and restricts the transfer of its shares. - Most common type of company in SA. - Private companies include owner-managed, single- shareholder and single-director companies.  57 6 South Africa ➜ Personal liability companies - PLC – Personal Liability Company. - It is for profit and similar to a private company. - The difference is that the directors of PLC’s are personally responsible for the debts of the company. - Professionals, like attorneys and accountants, sometimes register this type of company. An example is the old s53(b) company.  58 6 South Africa ➜ Public companies - Ltd – Limited. - It is for profit and is listed on an exchange (JSE or foreign). - It must be audited and has stricter rules than the other types of companies. 6 Pros and Cons of limited companies 59 ➜ Disadvantages ➜ Advantages: - Creditors: No security if assets - Easier to raise have been large amounts of exhausted capital - Company: SH’s - Separation of interested in ownership and short-term, not management – long-term Ownership change without - Shareholders: Agency problem, interfering Information operations asymmetries - Hire professional managers  60 6 South Africa ➜ Non-profit companies - Are for the public benefit and can have members or no members. - This includes NGOs, charities, and homeowners associations. An example is the old section 21 company. ➜ State-owned companies - Owned by the state. An example is a municipality - Eskom, PRASA, Transnet, SAA, SABC, etc. DECISION-MAKING PROCESS Stage 1: Identifying the objectives (specify goals) Stage 2: The search for alternative courses of action (range of possible courses of action/strategies to achieve goals) Stage 3: Select appropriate alternative courses of action (selects course that best responds to goal) Stage 4: Implementation of the decisions Stage 5: Compare actual and planned outcomes (by preparing performance reports) Stage 6: Respond to divergences from plan (take corrective action) 7 Impact of the changing competitive environment on the enterprise ► One of the objectives of financial management is to increase the wealth of the company…. How is this achieved? ► By delivering products/services in demand ►Faster ►Better ►More cost effectively ► Porter: Focus on value chain– thus focus on those activities within the company that gives the company a competitive edge in the market in which it operates 7 Impact of the changing competitive environment on the enterprise Porter’s Five Forces of Competitive Advantage: 1. Bargaining power of customers 2. Threat of new entrants 3. Threats of substitute products 4. Bargaining power of suppliers 5. Competitive rivalry within an industry  64 8 Financial vs. non-financial objectives ► More focus on “sustainability”. ► Management should focus on financial as well as non-financial goals ► “Triple bottom line” reporting: ►Financial, social and environmental performance ► Financial goals: ► E.g. Net profit percentage, earnings growth, return on equity, return on fixed assets, etc.  65 8 Financial vs. non-financial objectives ► Non-financial goals: ► E.g. Market share, client satisfaction, employee satisfaction, environmental impact ► E.g. Woolworths Holdings Ltd ► MOST IMPORTANT asset of a company = IT’S GOOD NAME!!! 8 Accounting vs Management Accounting Financial Accounting Management Accounting There is statutory requirements (Companies Management accounting is optional and Act) information is only produced if its benefits exceed its costs. Financial statements are prepared using There is no prescribed form in which generally accepted accounting principles, in management accounting information can be South Africa this is the International Financial presented. Information is provided based on Reporting Standards (IFRS). management needs for decision-making. Financial accounting report, financial Management accounting focuses on all parts of statements, are prepared for the entire entity. the organisation, from the organisation as a whole to product lines. Financial statements are mostly prepared on a Management accounting is concerned with historical basis. future information as well as past information. Financial statements are produced on an Management accounting requires information annual basis for most entities, some sectors much quicker than annual. Some reports might require less detailed financial statements might be daily, weekly or monthly. more frequent than annual.  67 8 Environmental and social governance goals ➜ Environmental and social governance goals (ESG) - Company performs as steward of the environment - Company manages relationships with employees, supply chain, customers and communities - Deal with executive pay and shareholder rights 9 Agency theory ➜ Considers the relationship between principles (owners) and agents (managers) ➜ Conflicts of interests (principal-agent problems) cause problems, therefore increase agency costs namely: - Monitor (independent directors) - Influence managers (incentive bonuses) - Cost due to managers acting not in owners’ best interest (e.g. choose less profitable project) 9 Agency theory ➜ Two factors that encourage managers to operate in the interest of the shareholders: - Job security - Remuneration packages  70 9 Responsibilities of principals and agents ➜ Shareholder theory - Managers have a duty to maximize shareholder returns ➜ Stakeholder theory - Balance shareholders’ interests against interests of other stakeholders  71 9 Responsibilities of principals and agents ➜ Milton Friedman – “The social responsibility of business is to increase profits” - Moral and contractual obligation to meet objectives of shareholders - Moral views of managers doesn’t change responsibilities if they choose to work for a company - Owners determine social objectives - Companies should comply to rules of society  72 9 Ethical considerations in finance and corporate governance Responsibilities of principals and agents ➜ Agents act on behalf of principals and should act in line with principals’ priorities and ethics ➜ Codes of conduct can give advice on whistleblowing ➜ Different views exist on to which extent ethics should influence company behaviour  73 10 Regulating financial reporting ➜ Financial reports (“accounts”, “financial statements” etc.) ➜ Reliable and useful ➜ Provide information on: - Financial performance (profits = income – expenses) - Financial position (assets and liabilities) ➜ Accounting bodies: - International Accounting Standards Board (IASB) – IFRS) - Financial Reporting Council (FRC – UK) - SAICA - SA  74 10 Corporate governance and organisation ➜ Corporate governance: - System by which companies are directed and controlled ➜ Boards of directors are responsible for governance ➜ Shareholders have to appoint directors and auditors ➜ Board has to set company’s strategic aims, provide leadership, supervise management, and report to shareholders  75 10 Corporate governance and organisation Main principles of the code (self-study) ➜ Board leadership and company purpose ➜ Division of responsibilities ➜ Composition, succession and evaluation ➜ Audit, risk and internal control ➜ Remuneration  76 10 Corporate governance and organisation ➜ South Africa – King report - "the most effective summary of the best international practices in corporate governance“ - King IV (2016) - Compliance with the King Reports is a requirement for companies listed on the JSE  77 10 Corporate governance and organisation ➜ “The King IV Code ('Code') is an important South African corporate governance code which adopts an inclusive approach and was first introduced in 1994 by the King Committee, chaired by Mervyn King. The Code has been revised multiple times to maintain national and international standards”  78 10 Corporate governance and organisation ➜ King IV identified four governance outcomes: - Ethical culture - Good performance - Effective control, and - Legitimacy  79 10 Corporate governance and organisation ➜ King IV incorporates a number of global emerging governance trends: - Alternative dispute resolution - Risk-based internal audit - Shareholder approval of non-executive directors’ remuneration - Evaluation of board and directors’ performance: - IT governance - Business Rescue - Fundamental and affected transactions in terms of director’s responsibilities during mergers, acquisitions and amalgamations  Homework  Read through the comprehensive study guide which is on ClickUP  Revise principles of slides  Read and understand all pages from Learning area 1’s handout  Do homework questions (3 MCQ’s and 3 short questions)  Hint: The best way to benefit from the homework exercises is to answer the questions yourself. Use the solution to mark your answer and to see where you made an error.