Financial Decision Making Lecture Notes PDF

BMAN 10522 & 10522(M) Financial Decision Making Lectures 1/2—Introduction to finance 1 Introduction What does the subject of finance cover? A very simple definition is as follows. Definition: Finance is concerned with the values of future cash flows, and what affects these values. Although such a si...

BMAN 10522 & 10522(M) Financial Decision Making Lectures 1/2—Introduction to finance 1 Introduction What does the subject of finance cover? A very simple definition is as follows. Definition: Finance is concerned with the values of future cash flows, and what affects these values. Although such a simple statement as this cannot possibly capture the richness and variety of finance as an academic or practical discipline, valuation does lie at the heart of finance. Examples are the value of a company’s equity shares, a company’s debt, share options, or the value of a proposed investment project for a company. All involve future cash flows that come from acquiring the security or investment. The essential elements of financial decisions are therefore money and time. The time dimension brings additional elements: financial decisions are directly affected by the resolution of uncertainty over time and by the information available to financial decisionmakers when they make their decisions. A final element of finance that is important in many decision contexts, and is institutional rather than arising naturally, is taxation. The main elements of finance are therefore, 1. time 2. money 3. uncertainty or risk 4. information 5. taxation EXAMPLE 1 Investing in the stock market A classic example of a financial decision involving all the elements is investment in the stock market. Buying shares on the stock market is done for the monetary return received in the future. The current equilibrium price of a company’s shares is the price that matches investor demand with the supply of shares. This price reflects the market’s valuation of the future monetary return. For shares, the monetary return comprises, (a) dividends paid to shareholders, and (b) the remaining value of the shares, given by the price quoted on the stock market. When investors make the investment, they do not know future dividends and share prices for certain. As events unfold over time, these will affect future dividends and prices for companies to different extents. There may be greater uncertainty or risk involved in buying the shares in some companies than others. Information can affect the investment return in several ways. A company’s share price changes because investors become aware of information that has consequences for the value of the company—the information resolves a piece of uncertainty about this value. 1 A further effect of information arises because not everyone has the same information. For example, investors are less well-informed about certain aspects of the company than are the managers of the company. It may be difficult for managers to inform investors directly of some types of information and so investors will try to infer this information from management decisions. Announcing a dividend that is higher than investors were expecting may signal management’s confidence in the future prospects of the company. Finally, taxation affects the amount investors are willing to pay for shares because they can only spend after-tax returns. Company profits are taxed. Investors fall into different tax brackets. Monetary returns are taxed differently depending on the form they take. Tax rates on dividends received are typically different from tax rates when shares are sold. All this means that share values may differ under different tax regimes. 2 Perspectives on finance Finance can be taught from one of three perspectives. Each is concerned with the same general set of transactions, but each adopts a different viewpoint. Figure 1 illustrates the three perspectives. Financial intermediaries Individual investors banks, pension funds, unit trusts, etc Investments Financial markets stocks, bonds, options, futures, foreign exchange, etc. Corporate finance investment, financing, liquidity decisions Government Exchanges of money and financial assets 9 Figure 1: Alternative Financial Perspectives Corporate finance is concerned with the operation of a firm or company largely from the company’s perspective. This can be broken down into three parts, and related to the two sides of the company’s balance sheet—assets and liabilities. Note, however, that 2 corporate finance is concerned with the current market value of assets and liabilities, not the book value conventions of accountants. On the long-term assets side, is the firm’s investment decision or capital budgeting decision, which is concerned with the assets in which the firm invests. So, for example, Marks & Spencer invests in clothing, furnishing, food, and financial services that they sell to their customers. They also invest in land and buildings, sophisticated computing and technological equipment, shop fittings, and personnel, which provide the long-term infrastructure for their retail operations. And they do this on a national and international scale. Corporate finance generally restricts its attention to investment decisions where the outcome extends beyond a year. On the long-term liabilities side is the firm’s financing decision, which is concerned with how the firm finances the assets it invests in. Marks & Spencer finance their operations largely from: (a) shareholders’ funds; (b) bank loans; and (c) bonds and debenture loans, which is money raised through public bond markets on specified contractual terms. Finally the firm’s liquidity decision, also called the problem of working capital management, is concerned with how the firm manages its short-term assets and liabilities. For a retail organisation like M&S, liquidity management is extremely important. M&S has to decide what stocks of goods to have on hand, and how much cash or short-term bank deposits to retain. They also have to decide what credit facilities to offer to customers, and they have to negotiate their own credit terms with suppliers. Investments are concerned with the various ways in which individuals invest their longterm savings. One way is in companies’ equity shares, and so there is a link between individuals investing in financial securities of companies and companies investing in real assets. Individual investors invest in other securities and assets, such as bonds, options, property, and futures. They invest through intermediaries such as banks, building societies, investment trusts, and unit trusts. Finally, financial markets and intermediaries views finance from the perspective of third parties. Financial intermediaries, such as banks, pension funds, etc. act as go-betweens or agents for individual investors, and help the flow of funds between individuals and companies. Financial markets lie at the core of all financial transactions but provide an independent perspective on transactions. The main markets in finance are those in stocks, bonds, options, futures, and foreign exchange. Much of this area of finance is particularly rich in institutional detail. A sub-field of finance that has recently become very important for researchers is market microstructure, which is concerned how securities are actually traded in financial markets. A major reason why this has recently become an active research area is the availability of high-frequency transactions data. 3 A final element of Figure 1, not treated separately, is the role of government. The government influences finance in several ways. First, it is a player itself. To finance government expenditure it issues government bonds (called gilts in the UK) through financial markets to investors and financial intermediaries. Second, through the Inland Revenue, the government imposes taxes on investors, financial intermediaries, companies, and financial transactions. Finally, through the Financial Services Authority, the government oversees the regulation of all aspects of financial services. 3 The status of finance Most mainstream theoretical research in finance tries to seek rational explanations for observed phenomena or rational ways of valuing securities or, more generally, future cash flows. For example, you might want to: 1. understand the relative share prices of different companies; 2. understand and explain movements in share prices; 3. explain how companies decide how much of their profits to distribute as dividends to shareholders and how much to retain in the company; 4. value a firm’s proposed investment; 5. understand how share options and other securities are priced. Empirical research in finance tests whether rational theories can explain observed practice. This involves testing hypotheses suggested by theory on actual data, and often involves careful statistical analysis. Much of this research shows the theory works extremely well. However, there are instances where empirical research suggests existing theories based on assumptions of complete rationality do not fully explain actual data. For example, some evidence suggests the values of some securities are affected by ‘irrational fads’—movement away from so-called ‘fundamental’ values. Both this course and future finance courses cover some of these so-called empirical anomalies. At this stage, the safest prediction to make is that researchers will continue to discover empirical anomalies, they will continue to provide theories to explain apparent anomalies, and they will subject these theories to healthy criticism and rigorous testing. Some academics will be involved in all three stages. It is likely that research based on theories assuming some degree of investor irrationality (behavioural theories) will become increasingly important. 4 Relation to other disciplines 1. Finance is essentially a subfield of economics, although one that has grown into a discipline in its own right. A good working knowledge of theoretical economics is essential for understanding finance. 2. Accounting and finance are closely linked, though this course does not assume any previous knowledge of accounting in this course. Financial reporting is important to 4 finance because the valuation of many securities relies on reported accounting information— financial statement analysis is a vital part of the security analysts’ toolkit. However there are crucial differences between reported values and profits used by accountants and market values and cash flows used in finance; we cover this in the next topic. The precise dividing line between corporate finance and management accounting is less clear-cut. Roughly speaking, corporate finance is concerned with all financial decisions and with long-term operating decisions: management accounting is more concerned with planning and control for short-term operating decisions. 3. Sociology and psychology are increasingly offering new insights into finance, particularly where rational reasoning based on economic thinking fails to explain the facts. 4. You do not need to be an expert mathematician for this module. However, more advanced study requires a facility with quantitative methods and for anyone doing empirical research in finance, econometrics is vital. 5. Companies, investors, financial markets, and intermediaries all operate within the prevailing legal framework. The legal framework provides the institutional backdrop to many financial decisions. 6. Finally, much of finance is concerned with the analysis of business and finance is an essential aspect of business management. 5 Forms of business structure Businesses in the UK private sector are either incorporated or unincorporated. Unincorporated businesses fall into two types depending on whether there is a single owner (sole-trader) or several owners (partnership). There are advantages of being unincorporated. 1. Unincorporated businesses are easy and cheap to set up. 2. Ownership and control are concentrated. 3. Financial accounts do not have to be made public. There are also disadvantages. 1. Transferring ownership can be difficult, often resulting in a finite life-span. 2. There is no legal distinction between the business and the owner(s). If the debts of the business exceed the assets, creditors can lay claim to the private assets of the owners, the business operates under unlimited liability (its liability is not limited to the assets of the business but extends to the assets of the owners). 5 3. There are limits on the ability to raise funds and grow. Incorporated businesses have a separate legal identity from their owners. Companies limited by shares are the commonest form. They can be private or public limited companies. Private limited companies can only sell their shares or debentures privately. Public limited companies (PLCs) can raise capital from the public at large. PLCs quoted on the stock market are by far the most important form of business. Although they number little over two thousand compared with a population of over half a million companies, of the top 700 companies in the UK, 80 percent are quoted on the stock market, and their value is around 81 percent of GDP. A PLC is established by its owners, called members or shareholders. Initial funds are share (equity) capital and debt capital. Share capital is the permanent capital of the company. Shareholders hope to gain through increases in the value of the company. Shareholders are the residual owners of the company; that is they own the excess of the value of the company’s assets over the value of its debts. Debt capital is money borrowed by the firm in return for regular interest payments and eventual repayment at some fixed date in the future. Debt holders have first claim on the company’s assets, but, under limited liability, their claim is limited to the assets of the company: the maximum shareholders can lose is their initial investment. In most PLCs, managers are separate from owners. Shareholders elect the Board of Directors and the Board select the managers of the business, the most important of whom will be executive directors from the Board. This means the PLC continues to operate when existing shareholders sell their ownership shares to new shareholders. Limited companies overcome the disadvantages of unincorporated businesses, but may have their own disadvantages. 1. They are difficult and expensive to set up. 2. There may be tax disadvantages. 3. Separation of management and ownership introduces its own problems. The topic of corporate governance addresses this issue. Most countries have a similar structure relating to unincorporated and incorporated business. However the rules and regulations may be different. For example, the definition of partnership is different across Europe. In the UK, partnership is seen as a separate corporate entity whereas in Germany it isn’t. There are also differences in how the directors of incorporated businesses across Europe are elected. In single-tier board countries (UK, Ireland, Sweden) shareholders elect board of directors who then select the managers. In two-tier board countries (Denmark, Germany, the Netherlands) there are two boards. The executive board manages the day to day operations and reports to the supervisory board which monitors the executive board’s performance. 6 Incorporated firms have many variations around the world. They are called different names: joint stock companies, public limited companies, limited liability companies etc. Table 2.1 of the course textbook provides information on the different types of names used in international corporations. Most corporate finance textbooks and courses are concerned with the decisions of PLCs, although most of the general principles apply equally to other types of business. 6 Financial markets and intermediaries The role of financial markets and intermediaries in the financial sector is illustrated in Figure 2, which shows the various sources of finance to the corporate sector. len din bo g rro wi ng Intermediaries Individuals Commercial/ investment banks of shares exchange new equ ity finan ce t en t tm es en tm inv es rns inv retu Institutional investors: pension funds, insurance companies, investment/unit trusts debt finance(overdrafts, bank loans, leasing) tailored finance (eg swaps, FRAs) London stock exchange (LSE) are sh ange ch ex uit eq / t b de ce w finan e n international investment y Foreign markets new equity finance New debt finance (Eurobonds, Loan stock) C o r p o r a t e s e c t o r debt/equity finance 20 Figure 2: Sources of Corporate Finance Financial markets can be classified into money and capital markets. Money markets are concerned with securities whose future cash flows occur within a one-year period, capital markets with securities whose cash flows extend beyond a year. All financial markets exist to allow investors to buy and sell financial claims. The desire to buy or sell financial claims exists because some economic units spend more than their income during a period and other units spend less. In aggregate, firms fall in the first category, households in the second. Financial markets allow some units to lend savings to units who wish to borrow funds. The return promised on the sum lent is the price of borrowing. In sophisticated financial systems, financial intermediaries facilitate this movement of funds. Figure 2 gives the stock market a key role and illustrates its two main activities. 7 (a) In its primary market function it allows quoted companies, or companies coming to the market for the first time, to raise new equity capital by issuing new equity shares. (b) In its secondary market function it allows investors, both individual and institutional, to buy and sell equity shares that companies have previously issued. Investors trade shares for information-motivated and liquidity-motivated reasons. Trades are information motivated if investors believe a share is underpriced or overpriced given the information they have. Trades are liquidity motivated if investors have either surplus funds compared with expenditure (they buy shares) or insufficient funds (they sell shares). The distinction between a primary and a secondary market that the former is where securities are first issued and new capital is raised, while the latter allows sellers to pass ownership to buyers, is also a characteristic of public debt/bond markets. There are at least three advantages of having a secondary market. (i) It allows the time horizon of investors’ lending decisions to be separated from the time horizon of companies’ borrowing decisions. So although a company may want to invest long-term it does not have to find investors with a similar time-horizon. (ii) It increases the liquidity/marketability of securities. Both (i) and (ii) result in lower costs of finance to borrowers. (iii) By encouraging an active market in securities, prices in secondary markets should give the current market value of securities, and so encourage the efficient allocation of capital to borrowers. 7 The Stock Exchange primary market The second year covers this in more detail. The primary market is concerned with the issue of new equity securities by companies. This might relate to a company seeking a quotation on the stock market for the first time, called an initial public offering (IPO). Or it might be a company already quoted wanting to raise additional equity finance, called a secondary offering. In the UK, quoted companies typically make larger secondary offerings through a rights issue, and smaller offering through placings. The main source of investment finance to companies is profits retained in the company— internal equity finance. The main source of external finance is debt finance (eg bank borrowing). External equity finance is the least popular source of new funds. 8 The Stock Exchange secondary market The dealing system on the London Stock Exchange (LSE) changed on 27 October 1986, the date of Big Bang (BB). It underwent a further change on 20 October 1997, which some commentators refer to as Big Bang II. 8 Pre-BB Before BB, members of the LSE acted in a single capacity either as (stock) jobbers or as stockbrokers. There was a clear separation between the two functions. Jobbers registered to deal in specific stocks and made profits by making a market in these stocks. They always had to be prepared to quote buying and selling prices at which they were willing to trade. However, jobbers acted as principals (on their own behalf); they could not deal directly with investors. Instead they dealt indirectly through stockbrokers. Brokers were not allowed to deal in stocks. But investors who wanted to buy or sell stocks had to conduct their business through a broker. The broker acted as an agent on the investor’s behalf in finding the jobber offering the best deal. During the 1970s and 1980s, concern grew over the operations of the stock market. 1. A small number of jobbing firms increasingly dominated the jobbing function. 2. In some stocks, competition between jobbers had virtually disappeared. 3. Brokers operated a system of fixed commission charges that discouraged price competition and encouraged non-price competition. 4. There were restrictions on membership of the LSE (eg. banks were excluded). 5. Doubts existed whether jobbers could deal with the very large transactions of some institutional investors. As a result, in 1979 the government referred the LSE rulebook to the Restrictive Practices Court. Around the same time, and probably more important, concern grew over the international competitiveness of the LSE following financial deregulation around the world. The LSE increasingly saw that its business was in danger of being competed away. Eventually, in response to all these factors, the LSE agreed voluntarily to change its practices and, after some discussion, set a date of 27 October 1986 on which it would carry out all its proposed changes in one ‘Big Bang’. Post-BB BB brought in a system of dual capacity, with only one type of LSE member—a broker/dealer. Some broker/dealers also chose to be market makers, which meant they took on the previous jobbing role. But all broker/dealers could trade directly with the public. To safeguard investors they had to declare the capacity in which they were operating at the time—broker or dealer. Moreover, if broker/dealers were not marketmakers in a particular share then they could only adopt the dealing role if they could better the best price from the registered dealers. Most firms opted to take on only the broking role. Three so-called investment houses, Smith New Court, Warburg Securities, and BZW, accounted for roughly 75% of all dealing. The new system was highly computerised. Before BB nearly all trades took place on the ‘trading floor’ of the Stock Exchange. Jobbers had designated pitches and brokers literally approached jobbers for price quotes. Almost immediately after BB, trading on the floor ceased. The new trading system relied on a computerised price display called 9 SEAQ (see later handout). With SEAQ, traders could see buying and selling prices on computer screens, and finalised deals by telephone. Post Big Bang II (October 1997), more changes in the trading system on LSE were brought in. Have a look at the BBC news article on the 30th anniversary of Big Bang https://www.bbc.co.uk/news/business-37751599 End of Lecture 10