Ffr Chapter 1

Front 1

What is Corporate Finance

Back 1

Finance is about Decision Making (Which Projects, How to Finance, Risk/Returns, Performance Measurement

Front 2

Circular Flow

Back 2

Relationship between Finance/Investment/Objectives (1) Corporate Objectives- Finance Decisions Investment Decisions  Corporate Objectives

Front 3

Sources of Finance 1)

Back 3

• Own Resources i) Retained Earnings (Cash), Working Capital • ••••

Front 4

Sources of Finance 2)

Back 4

2) Financial Institutions - i) Merchant Banks, ii) Retail Commercial Banks, iii) Occupational Pension Funds, iv) Insurance Funds, v) Collective Funds, vi) Gov’t Investment Treasuries,vii) Lottery Funds

Front 5

Sources of Finance 3)

Back 5

Financial Markets • i) Money Markets – Short Term (1) Borrow / Lend on short –term basis (Overdrafts, Short Loans, CD’s, Promissory Notes) • ii) Capital Markets - (1) Secure Long-term financing (Ordinary Shares, Preference Shares, Loans, Debentures, Convertibles) Made of: (a) Primary Market: New Shares or Loans are created (b) Secondary Market: Existing Shares / Loans are traded• (2) Efficient Market Hypothesis (EMH) – Attempts to link fair prices to information• (a) Weak: Prices reflect past• (b) Semi-Strong: Prices reflect past and public info• (c) Strong: Prices reflect all possible info••

Front 6

Investment decisions

Back 6

Assets – Resource controlled by the enterprise as a result of past events where benefits are expected

Front 7

Fixed Assets :

Back 7

(Assets intended for > 1 year) (1)    Tangible: (Land, Buildings, Plant, Machinery, Office Equip, Computers, Vehicles) (2)    Intangible: (Goodwill,Brands,Logos,Copyrights,Plans,Drawings,Patents,Intllctul prprty)

Front 8

Current Assets:

Back 8

Assets intended for <1 year (Inventory, Receivables, Prepayment, Cash)

Front 9

Long-Term Investments:

Back 9

Not intended for sale(Subsidiary Shares, Associate Shares, Pensions, Land Banks. )

Front 10

Returns from Investment

Back 10

Investment should Maximize value of shareholder wealth -Shareholder equity markets favor short-term performance and high dividends (US, UK, Commonwealth) • 2) Banking system based markets favor low dividend, high R&D, smaller stock markets (Japan/Germany)

Front 11

Corporate Objectives

Back 11

Finance / Investing decisions are linked to corporate objectives

Front 12

Who are the Stakeholders of a firm

Back 12

"Constituents who have a legitimate claim on the firm • (1) Internal: Shareholders , Directors/Managers/Staff (2) External: Customers, Clients, Suppliers, Banks, Analysts, Gov’t, Public

Front 13

Maximisation Shareholder Wealth

Back 13

Usually through dividends and capital gains

Front 14

Measures of Maximizing Shareholder wealth

Back 14

Economic Value Added (EVA): Annual profit adjusted for shareholder required rate of return. • (2) Market Value Added (MVA): Long-term equivalent of EVA – reflects market perception of ability to create capital. MVA = (Market Value / Book Value) = Expected EVA discounted at Shareholder required rate of returnProfit is measured after covering opportunity cost of capital

Front 15

Corporate Social Responsibility

Back 15

– communicating social/environmental effects of org’s economic actions to interest groups. Companies have more responsibility than just maximizing shareholder wealth

Front 16

Agency Theory

Back 16

Agency = contract where principals engage an agent to perform a service on their behalf

Front 17

Agency Problems

Back 17

Management Objectives are different from owners (own wealth, ambition, power) i) Assymetry of information between Principals and Agents is essence of Agency Problem

Front 18

Define Corporate Finance

Back 18

Finance is primarily about decision making, and decision making is about the future,
e.g. in which projects should the business invest? How should these projects be
financed? What are the likely returns and risks for investors? How will performance
be measured and controlled?
Corporate finance is concerned with financing and investment decisions in pursuit of
corporate objectives.
The relationship between finance, investment and corporate objectives can be
illustrated as follows:

Front 19

Explain how companies raise finance in financial markets.

Back 19

Companies raise finance to support their investments from three major sources: their
own resources, financial institutions and financial markets.
Financial markets are made up of short-term money markets and long-term capital
markets. The former are where borrowing and lending take place on a short-term
basis, i.e. less than a year. For instance, companies obtain working capital, such as
overdrafts and short term loans, etc.
Capital markets are used by companies to secure long-term funding, mostly in the
form of ordinary shares, preference shares, unsecured loans, debentures and convertibles. The investors are the financial institutions and private individuals, who
seek to obtain a return on their investments.
Capital markets are made up of the primary market, where new shares (equity) are
issued or new loans (debt) are created, and the secondary market, where existing
shares and loans are traded. The main equity market in the UK is the International
Stock Exchange in London where access to shares, information and prices provide
an efficient way of bringing together buyers and sellers of shares.
Smaller companies often find it difficult to obtain access to the principle market and,
for this reason, the Alternative Investment Market (AIM) was created by the Stock
Exchange in 1995.
For capital markets to work efficiently, they need to offer fair prices for shares so that
companies and investors can make sound financing and investment decisions.
Based on this, the efficient market hypothesis (Keane, 1983) attempts to link fair
prices to available information. Three forms of efficiency are recognised: Weak form efficiency: share prices reflect past information.
• Semi-strong form efficiency: share prices reflect past and publicly available
information.
• Strong form efficiency: share prices reflect all information available. In this
case, no trader will be presented with an opportunity for making abnormally
high returns, not even those with ‘insider information’.

Front 20

What is meant by the ‘maximisation of shareholder wealth’?

Back 20

The primary objective of investment should be to maximise the value of the company
for its owners. As the owners are its shareholders, the maximisation of shareholder
wealth is usually considered paramount. Shareholder wealth is usually maximised
through dividend payments and capital gains from the ownership of shares. These,
in turn, can be used to maximise the purchasing power of the shareholders.
The maximisation of profits is the traditional way of measuring shareholder value but
there are a number of problems related to this measure, including the time period
over which profits should be maximised. For example, companies may aim for shortterm profit at the expense of long-term investment and survival.
Today, companies in economies where the bulk of corporate finance is provided by
shareholder equity, such as the USA, the UK and the Commonwealth, have
traditionally operated with a strong shareholder-oriented focus. Dividend payouts
tend to be high and the emphasis is very much on short-term performance. In other countries, such as Japan and Germany, company finance has been provided
to a far greater degree by the banking system and, in France, from family sources.
Dividend payouts have been lower and more funds typically invested in research and
development with uncertain and long-term payoffs. Far fewer companies use the
stock market for finance; indeed, far fewer companies are quoted on local stock
markets.
A company’s share price is often used as a measure of shareholder wealth.
However, there are more sophisticated measure in use, including economic valueadded (EVA) and market value added (MVA). These were developed by Rappaport
(1986) to measure short-term and long-term shareholder value.
• Economic value added is a measure of company performance, which looks at
each year’s profit adjusted for the shareholder’s required return. The company
only makes a true or economic profit if it more than covers the owner’s
opportunity costs of capital. EVA is, thus, a more realistic measure of shareholder
value in any one year than share price.
• Market value added is the long-term equivalent of EVA. It reflects the financial
market’s perception of the company’s ability to create value in the future. It is
simply the excess of market value over the book value of the equity. Companies
that invest well, score well. MVA is, thus, the company’s future expected stream
of EVAs discounted at its shareholders’ required return.
Marking note: Students should also be awarded marks if they refer to the article by
Dockery, Herbert and Taylor (2000) in Further activities 2.

Front 21

In Agency theory, what is meant by the problem of ‘agency’?

Back 21

In public limited companies, the owners (shareholders) are the principals and the
managers are the agents.
This can cause problems for companies, as management objectives are likely to be
different from those of the owners, e.g. they may be more interested in their own
wealth, managerial power and ambitions than the wealth of shareholders. The
owners receive annual reports while the managers have access to much more
information for decision-making. This asymmetry of information makes it difficult for
the owners to monitor managers’ decisions.
Jenson and Meckling (1976) suggested two ways of encouraging managers
to act in the interests of the owners. The first is for the owners to monitor the
actions of management; the alternative is to include appropriate clauses in
managerial contracts.
Marking note: Students should not be penalised if they do not refer to the
article by McColgan (2001) in Further activities 3.