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Corporate Finance: Basic Concept

Basic Concepts of Corporate Finance

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Corporate Finance: Basic Concept

  1. 1. Introduction to corporate finance Presented by Maksudul Huq Kanan
  2. 2. CORPORATE FINANCE Corporate finance involves the financial management of a corporation’s assets and corporate financing decisions. 1. Financial Management of Assets •Capital budgeting decisions, including the analysis of asset, investment, acquisition and replacement proposals. •Credit (accounts receivable) policy •Cash management
  3. 3. CORPORATE FINANCE (Cont..) 2. Corporate Financing Decisions  Managing capital structure: the ratio of debt and equity  Raising new equity capital either through profit retention or new share issues  Dividend policy  Borrowing decisions and liability Management
  4. 4. CORPORATE FINANCE (Cont..) Corporate Finance addresses the following three questions: 1. What long-term investments should the firm engage in? 2. How can the firm raise the money for the required investments? 3. How much short-term cash flow does a company need to pay its bills?
  5. 5. Main tasks of corporate finance • Capital budgeting: the process of planning and managing a firm’s long-term investments ⇒ fixed assets. • Example: deciding whether or not to open a new restaurant. • Capital structure: the mixture of debt and equity maintained by the firm ⇒ S-T and L- T debt and equity. • Working capital management: a firm’s short- term assets and liabilities ⇒ current assets and current liabilities.
  6. 6. The Balance-Sheet Model of the Firm Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders ’ Equity Current Liabilities Long-Term Debt
  7. 7. The Capital Budgeting Decision Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders ’ Equity Current Liabilities Long-Term Debt What long-term investments should the firm choose?
  8. 8. The Capital Structure Decision Crrent Assets Fixed Assets 1 Tangible 2 Intangible Shareholders ’ Equity Current Liabilities Long-Term Debt How can the firm raise the money for the required investments?
  9. 9. The Net Working Capital Decision Crrent Assets Fixed Assets 1 Tangible 2 Intangible Shareholders ’ Equity Current Liabilities Long-Term Debt How much short-term cash flow does a company need to pay its bills? Net Working Capital
  10. 10. Capital Structure The value of the firm can be thought of as a pie. The goal of the manager is to increase the size of the pie. The Capital Structure decision can be viewed as how best to slice up the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters. 70% Debt 30% Equity
  11. 11. Hypothetical Organization Chart
  12. 12. Modern form of firms  Corporation: a business created as a distinct legal entity composed of one or more individuals or entities, e.g., IBM. – Separation of control (shareholders) and management (professionals). – Ownership can be easily transferred. – Limited liability. – Double taxation. – Rather expensive to form. – Agency problems.
  13. 13. Who make the decisions?  Owners (typically in small businesses).  Professional managers.
  14. 14. Financial managers  Frequently, financial managers try to address these tasks.  The top financial manager within a firm is usually the Chief Financial Officer (CFO). – Treasurer – oversees cash management, credit management, capital expenditures and financial planning. – Controller – oversees taxes, cost accounting, financial accounting and data processing.
  15. 15. Possible goals of financial management  Survive  Beat the competition  Maximize sales  Maximize net income  Maximize market share  Minimize costs  Maximize the value of (stock) shares
  16. 16. The “appropriate” goal of financial management  Maximize the (fundamental or economic) value of (stock) shares is the right goal.  Why? Shareholders own shares. Managers, as agents, ought to act in a way to benefit shareholders; i.e., to enhance the value of the shares.  A limitation of this goal is that value is not directly observable.
  17. 17. The Firm and the Financial Markets
  18. 18. Corporate Securities as Contingent Claims on Total Firm Value  The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed amount by a certain date.  The shareholder’s claim on firm value is the residual amount that remains after the debt holders are paid.  If the value of the firm is less than the amount promised to the debt holders, the shareholders get nothing.
  19. 19. Value vs. price  The value of shares are not observable. In contrast, the price of shares can be observable.  If one believes that share price is an accurate/good estimate of share value, the appropriate goal would be to maximize the price of shares.  This belief/assumption is, however, questionable.  But investors care about stock price, and that stock price performance is very important to the tenure of managers.
  20. 20. Value maximization and sustainability  Business sustainability: often viewed as managing the triple bottom line - a process by which companies manage their economic/financial, ecological, and social opportunities and risks.  Sustainability and value maximization are somewhat different.
  21. 21. 3 aspects of sustainability  Economic/financial – here is more about economic viability and profitability, and not directly about value maximization.  Ecological – reaching your financial goals should not impose burden on the current natural environment.  Social – reaching your financial goals should not damage the well-being of the society (employees, etc.).
  22. 22. Shareholders and other stakeholders – Customers – Suppliers – Employees (human capital and assets) – Creditors (bondholders, banks, debtholders) – Government: tax and regulations – Community (local / global) – Owner/shareholder
  23. 23. Separation of Ownership and Control Board of Directors Management Assets Debt Equity Shareholders Debtholders
  24. 24. The agency problem  Agency relationship: – Principals (citizens) hire an agent (the president) to represent their interest. – Principles (stockholders) hire agents (managers) to run the company.  Agency problem: – Conflict of interest between principals and agents. – This occurs in a corporate setting whenever the agents do not hold 100% of the firm’s shares. – The source of agency problems is the separation of (owners’) control and management.
  25. 25. Agency costs  Direct costs: (1) unnecessary expenses, and (2) monitoring costs.  Indirect costs. For example, a manager may choose not to take on the optimal investment. She/he may prefer a less risky project so that she/he has a higher probability keeping her/his tenure.
  26. 26. Managerial incentives  Managerial goals are frequently different from shareholders’ goals. – Expensive perks. – Survival. – Independence.  Growth and size (related to compensation) may not relate to shareholders’ wealth.
  27. 27. Corporate governance  Compensation: – Incentives ($$$, options, threat of dismissal, etc.) used to align management and stockholder interests.  Corporate control: – Managers may take the threat of a takeover seriously and run the business in the interest of shareholders.  Pressure from other stakeholders (e.g., CalPERS, a powerful corporate police).
  28. 28. Ethics  Managers are expected to behave in an ethical manner.  The province of ethics is to sort out what is good and bad.  But, what is the criterion or guideline for doing so?  Philosophers came up with some criteria, but none of them makes sorting out what is good and bad an easy task.
  29. 29. Do Shareholders Control Managerial Behaviour?  Shareholders vote for the board of directors, who in turn hire the management team.  Contracts can be carefully constructed to be incentive compatible.  There is a market for managerial talent—this may provide market discipline to the managers—they can be replaced.  If the managers fail to maximize share price, they may be replaced in a hostile takeover.
  30. 30. Financial Institutions, Financial Markets, and the Corporation LoansFinancial intermediaries DepositsFunds suppliers Funds demanders Financial intermediaries Funds suppliers Funds demanders  Financial Institutions Indirect finance Direct Finance
  31. 31. Financial markets Money versus Capital Markets • Money Markets – For short-term debt instruments • Capital Markets – For long-term debt and equity
  32. 32. Financial markets  Primary versus Secondary Markets • Primary Market – When a corporation issues securities, cash flows from investors to the firm. – Usually an underwriter is involved • Secondary Markets – Involve the sale of “used” securities from one investor to another. – Securities may be exchange traded or trade over- the-counter in a dealer market.
  33. 33. Financial markets Firms Investors Secondary Market SueBob Stocks and Bonds Money Primary Market
  34. 34. Overview of Corporate Securities Common stock (equity)  Cash Flows: Receives all corporate payouts, after every other claimant has been paid. Payments to the equity holders are called dividends.  Larger firms have their common stock traded on stock exchange. There investors can purchase and sell shares.
  35. 35. Overview of Corporate Securities Common stock (equity)  Tax Status: Individuals- Dividends arc taxed as "ordinary income" (just like wage income). Capital Gains have historically been taxed at a rate below that of ordinary income. (A shareholder who purchases a share of stock for 520, and sells it for $22, realizes a $2 capital gain.) Company - Payments to equity are not tax deductible from corporate profit.  Corporate Rights: Can hire and fire management, its voting power allows its owners to control corporate decision making.
  36. 36. Overview of Corporate Securities Preferred stock  Cash Flows: The firm agrees to give the holder of this security a set dividend every period (for example 52.25 per quarter per share).  Like common stock, preferred stock may be traded on a stock exchange. There investors can purchase and sell shares.
  37. 37. Overview of Corporate Securities Preferred stock  Tax Status: Same as common stock. Individuals- Dividends arc taxed as "ordinary income" (just like wage income). Capital Gains have historically been taxed at a rate below that of ordinary income. Company - Payments to equity are not tax deductible from corporate profit.  Corporate Rights: Paid before common equity, but after all other claimants. Generally, cannot vote. If the company fails to make a payment preferred stockholders cannot force any immediate action,.
  38. 38. Overview of Corporate Securities  Corporate Debt (Bonds) Cash Flows: First in line for payment. Contracts require a fixed coupon payment every 6 months. At maturity the firm then pays $1000 which equals the face value of the bond. Larger firms have their bonds traded on a major bond exchange. There investors can purchase and sell bonds.
  39. 39. Overview of Corporate Securities  Corporate Debt (Bonds)  Tax Status: Individuals - Coupon payments are taxed as "ordinary income" (just like wage income). Capital Gain - The difference 'between what an investor pays for the bond and its price when sold. If the investor hold the bond to maturity then the difference between the purchase price and the face amount is considered a capital gain. Company - Payments to debt are tax deductible. Corporate Rights: When the firm misses a payment the bondholders have the right to force a bankruptcy proceeding. In principle this allows them to take over the company.
  40. 40. Overview of Corporate Securities  Types of Debt a. Maturity 1. Funded. any debt repayable in more than One year. 2. Unfunded. debt repayable in less than one year. b. Repayment provisions. 1. Sinking fund. The company contributes money to the fund which then repurchases the bonds. 2. Call options give the firm the right to repurchase "the debt at a specified price. (Usually, cannot do this for at least 5 years.)
  41. 41. Overview of Corporate Securities  Types of Debt c. Seniority 1. Senior Debt: Paid prior to all other claimants. 2. Subordinate Debt: Paid after the senior debt holders. 3. Secured Debt: Can claim the asset used as security if payments are not satisfied. A lease agreement is essentially the same as secured debt.
  42. 42. Overview of Corporate Securities  Types of Debt d. Rates 1. Floating rate: the interest rate is tied to some variable in the economy. 2. Fixed rate: the interest rate is fixed throughout the life of the loan. e. Default risk 1. Junk bonds: A low rated bond, with a high probability that the firm will not meet its contractual repayment obligations. 2. Investment grade: A highly rated bond, low probability of default.
  43. 43. Overview of Corporate Securities  Types of Debt f. Hybrid Security: Convertible bonds can be exchanged for stock at a specified price, at the lender's option. g. Placement: 1. Publicly placed debt is sold to the general public and traded in the open market. 2. Privately placed security is purchased by large institutions and either not traded at all or traded only among large institutions.
  44. 44. kanan3008@yahoo.com
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Basic Concepts of Corporate Finance

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