Introduction to Corporate Finance PDF

Introduction to Corporate Finance What is Corporate Finance? Capital Budgeting: The process of planning and managing a firm’s long- term investments. Capital Structure: Has to do with the ways in which a firm raises and manages the long-term financing it needs to support its long-term investments...

Introduction to Corporate Finance What is Corporate Finance? Capital Budgeting: The process of planning and managing a firm’s long- term investments. Capital Structure: Has to do with the ways in which a firm raises and manages the long-term financing it needs to support its long-term investments. Working Capital Management: Refers to how the firm manages its short- term assets and liabilities. Investment - What do you need to start a firm? Cash invested in assets must be matched by an equal amount of cash raised by financing. Why are you starting a firm? Value Creation in Corporate Finance The Balance Sheet Equation Who makes the decisions? The financial manager, they would be in charge of answering these three questions? - What long term investments should you make? That is, what lines of business will you be in, and what sorts of building’s, machinery, and equipment will you need? - 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? - How will you manage your everyday financial activities, such as collecting from customers and paying suppliers? 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). A Simplified Corporate Organisational Hierarchy This a simple organisational chart that highlights the finance activity in a large firm. The finance director co-ordinates the activities of the treasurer and the controller. The comptroller’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, financial planning and capital expenditures. Finance Management Decisions Capital Budgeting - The financial manager identifies investment opportunities that are worth more to the firm than they cost to acquire. This means the value of the cash flow generated by an asset exceeds the cost of that asset. - Example: a large retailer, like Tesco, opening another superstore, or Apple developing a new type of tablet computer, are both important capital budgeting decisions. Some decisions, such as the type of computer system to purchase, might not depend so much on a particular line of business. - Regardless of the specific nature of an opportunity under consideration, financial managers must be concerned not only with how much cash they expect to receive, but also with then they expect to receive it, and how likely they are to receive it. - Evaluating the size, timing and risk of future cash flows is the essence of capital budgeting. This is by far the most important things we shall consider Capital Structure - This is the mixture of long-term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First, how much should the firm borrow? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm. Second, what is the least expensive sources of funds for the firm? - Firms have a great deal of flexibility in choosing a financial structure. The financial manager must decide exactly how and where to raise the money. The expenses associated with raising long-term financing can be considerable, so different possibilities must be carefully evaluated. - Corporations borrow money from a variety of lenders in several different, and sometimes exotic, ways. Choosing among lenders and among loan types is another job handled by the financial manager. Working Capital Management - This refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. - 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. This involves several activities related to the firm’s receipt and disbursement of cash. Responsibilities of a Finance Manager Cash Flow Considerations The Goal of Financial Management Different Goals in Practice - Survive - Avoid Distress and Bankruptcy - Beat the Competition - Maximize Sales or Market Share - Maximize Profits - Maintain Steady Earnings Growth - Improve Society - Positively Impact the Environment One overriding aim- Maximize Firm Value - Furthermore, each of these possibilities present problems as a goal for the financial manager. - For example, it’s easy to increase market share or unit sales: all we must do is lower our prices or relax our credit terms. Similarly, we can always cut costs simply by doing away with things such as research and development. We can avoid bankruptcy by never borrowing any money or never taking any risks and so on. However, it is not clear that any of these actions are in the shareholders’ best interests. - The goal of maximizing profits may refer to some sort of ‘long-run’ or ‘average’ profits, but it’s still unclear exactly what this means. - The goals we’ve listed here are all different, but they tend ti fall into two classes. - The first of these relates to profitability. The goals involving sales, market share and cost control all relate, at least potentially, to different ways of earning or increasing profits. - The goals in the second group, involving bankruptcy avoidance, stability and safety, relate in some way to controlling risk. Unfortunately, these two types of goal are somewhat contradictory. The pursuit of profit normally involves some element of risk, so it isn’t possible to maximize both safety and profit. What we need, therefore, is a goal that encompasses both factors. - The last two goals listed relate to the environment and society, Sustainability and climate change have become hot topicsand many companies have embraced environment-related goals as objectives. The goal of financial management is to maximize the current value per share of the existing equity The Triple Bottom Line - The concept that corporate objectives should focus equally on society, the environment and profit People - How can you get the most out of your company’s workforce? What investments can you make to create value for shareholders through improving the human capital of your workers and operations that affect the welfare and productivity of your people? How do you measure success? Planet - What activities does your firm engage in that maximizes its positive impact on the environment and sustainable operations? How do you measure success? Profit - What can your firm do to maximize its financial profit? A key issue with the triple bottom line is the difficulty in accurately measuring in monetary terms the effect a company has on society and the environment. The Financial Manager best serves shareholders (the business owners) by making decisions that are valued by shareholders, who in turn reflect the broader societal and environmental concerns of the general population. Shareholder wealth maximisation is therefore consistent with the triple bottom line approach (assuming shareholders have the same objectives and concerns as the general population). The Financial Markets Cash is the center of all financial decisions The arrows in the figure trace the passage of cash from the financial markets to the firm, and from the firm back to the financial markets. - Suppose we start with the firm selling shares of equity and borrowing money to raise cash. - Cash flows to the firm from the financial markets (A) - The firm invests the cash in assets (B) - These can be short term (current) or long term (non-current), and they generate cash (C) - Some of which goes to pay corporate taxes (D) - After taxes are paid, some of this cash flow is reinvested in the firm (E) - The rest goes back to the financial markets as cash paid to creditors and shareholders (F) - The financial markets are not funded just by corporations paying cash to creditors or shareholders. The savings of households (G), also find their way into the financial markets - For example: whenever your salary goes into your bank account, whenever you pay insurance on your car, house of computers, and every time you pay your pension premium, this money will end up in the financial markets.  - This happens because the financial institutions (H) you pay your money to use it to invest in the financial markets. The difference between what financial institutions earn in the financial markets and what they must pay you (in terms of monthly interest, random insurance payouts, and pensions) is their profit Different sources of financing - Private Investors - Bank Loans - Equity - Bonds - Short-term Financing Primary versus Secondary Markets Financial markets function as both primary and secondary markets for debt and equity securities. Equities are, of course, issued solely by corporations. Debt securities are issued by both governments and corporations. Primary Markets - The original sale of securities by governments and corporations. - The corporation is the seller and the transaction raises money for the corporation. - Corporation engage in two types of primary market transaction: public offerings and private placements. - A public offering involves selling securities to the general public - A private placement is a negotiated sale involving a specific buyer By law, public offerings of debt and equity must be registered with the securities regulator in the country where the offerings are made. Registration requires the firm to disclose a great deal of information before selling any securities. The accounting, legal and selling costs of public offerings can be considerable. Secondary Markets - Securities bought and sold after the original sale. - The secondary markets provide the means for transferring ownership of corporate securities. - Although a corporation is directly involved only in a primary market transaction (when it sells securities to raise cash), the secondary markets are still critical to large corporations The reason is that the investors are much more willing to purchase securities in a primary market transaction when they know that those securities can later be resold if desired. Dealers versus Action Markets - There are two kinds of secondary market: auction markets and dealer markets. - Dealers buy and sell for themselves, at their own risk. A car dealer for example, buys and sells automobiles. - In contrast, brokers and agents match buyers and sellers but they do not actually own the commodity that is bought or sold, A real estate agent, for example, does not normally buy and sell houses. Dealer Markets - Dealer markets in equities and long-term debt are called over-the- counter (OTC) markets. - Most trading in debt securities takes place over-the-counter. - The expression over-the-counter refers to days of old when securities were literally bought and sold counters in offices around the country - Today, a significant fraction of the market for equities and almost all of the market for long-term debt have no central location; the many dealers are connected electronically Auction Markets - These differ from dealer markets in two ways - First, an auction market of exchange has a physical location - Second, 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 wish to buy. Dealers play a limited role Trading in Corporate Securities The equity shares of most large firm’s trade in organized auction markets. Because of globalization, 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 organized 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 The Economic Environment We may use measures to support businesses through challenging period such as in 2020 because of the COVID pandemic. We categorize these measures into three main groups, which is collectively known as the macroeconomic policy. Macroeconomic Policy Levers - This is concerned with government decisions that impact the economic environment.  - In a well-governed economy, productivity is growing, price levels are under control (not growing too fast or falling), almost everyone is in a job, and imports are roughly equal to exports. - It is not possible to guarantee this happening at any single point of time and so governments pull economic levers to achieve their objectives Monetary Policy - The use of monetary variables including interest rates and money supply - High interest rates make it more expensive to borrow and better to save - More money supply will increase price inflation Fiscal Policy - The use of fiscal variables including government spending and taxes - High taxation will theoretically reduce consumer and corporate spending, thereby providing more money for the government to spend on infrastructure Exchange Rate Policy - The management of exchange rates to improve country trade competitiveness. - Relatively low exchange rates will make exports cheaper in foreign countries and imports more expensive - Relatively high exchange rates will do the opposite. - Governments can have fixed exchange rates where the domestic currency is fixed against a benchmark - Floating exchange rates fluctuate in response to demand and suplly of a country’s currency - If demand increases, the exchange rate will strengthen and if demand falls, the currency will weaken  The European Union - The European monetary union represents the agreement among a number of EU member countries to combine their individual currencies into one basket currency. - There are three components to the European monetary union: - The Euro: A common currency to all members of the European monetary union - European Central Bank: They are the economic bloc’s central bank. As a central bank, the ECB issues the euro, and is the lender of last resort - Centralized Monetary Policy: The ECB is responsible for the unified monetary and exchange policy of the group of countries that have adopted the euro Corporate Finance in Action- Google Case Study Google’s Early Days… Business Idea/Plan→ Formation of Company→Raise Initial Financing Google as a Multinational Business Running the Business→ Google IPO→ Global Public Company