FINA2303 Topic 01 Introduction To Corporate Finance

Topic 1: Introduction to Corporate
Finance
Learning Outcomes
what
is corporate finance?
financial
stock
manager
market
financial
institutions
Topic 1 Introduction to Corporate Finance
M K Lai
Page 2
What is Corporate Finance?

corporate
finance/financial management/
business finance is the study of ways to address
the financial decisions of a company
investment
in the mix of long-term assets

(capital budgeting)
Should your company launch a new product?
Should your company undertake a new
project?
Should your company produce a part of the
product or outsource production?
M K Lai
Page 3

raise
capital through different sources of

financing, e.g. debt and equity (corporate
financing and capital structure)
Should your company issue new stock or
borrow money instead?
How can you raise money for your start-up
firm?
What is the optimal mix of debt and equity
for your company?
M K Lai
Page 4

manage
current assets and current liabilities

to avoid cash flow/liquidity problem (working
capital/treasury management)
Should your company grant credit to a
customer?
How much of inventory should be
maintained?
Which supplier should your company choose?
M K Lai
Page 5
Three Building Blocks in Making

Financial Decisions
finance
can be complicated, but it can be

reduced to three basic concepts
building
blocks
in
finance
cash
flows
time
value
of
money
M K Lai
risk
and
return
Page 6

Financial Decisions
size,
timing and risk of cash flows
cash
flows (size of cash flows) (this topic)
time
value of money (timing of cash flows)

(topic 2)
positive
relationship between risk and return

(risk of cash flows) modern financial theories
(topic 5)
M K Lai
Page 7

Financial Decisions
an
application is valuation
determine
the fair value of an asset, a liability

or an equity (usually accompanied with an
investment recommendation in finance
industry)
take
into account costs and benefits in terms

of cash flows (cost-benefit analysis)
M K Lai
Page 8
Application: Valuation
investment recommendation
fair value of stock
source: ABCI Securities

M K Lai
Page 9
Accounting vs. Finance

accounting:
use accounting standards set by

accounting professional bodies or regulators to
prepare financial statements (preparers of
financial statements)
finance: use financial statements to analyze the
historical operating performance and current
financial position of a company (financial
analysis), project future performance of the
company through pro forma financial statements,
cash and capital budgets and financial plans
(financial planning/modeling), and compare
actual results to projected ones (financial control)
(users
of
financial
statements)
M K Lai
Page 10
feedback
financial
assumptions
statements and
market data
analysis
planning
current financial
pro-formas, cash
position and past
and capital
operating
budgets, financial
performance
plans
control
actual results
implementation of
financial plans
M K Lai
Page 11

illustrate
with a company research report
difference
between accounting and finance

net income/profits vs.
sustainable/underlying/recurring income
what is the difference?
M K Lai
Page 12
forecast figures
actual figures
source: ABCI Securities

M K Lai
Page 13
Cash Flows
net
income vs. cash flows
book
value vs. market value
financial
statements vs. market information
M K Lai
Page 14
Net Income
net
income = total revenue total expenses

(including tax payments to government)
total
revenue and expenses are recognized

according to accounting standards (accrual basis)
summary
of total revenue and expenses of a

company can be found in the income statement
M K Lai
Page 15
Cash Flows
sample
M K Lai
Page 16
Cash Flows
different
definitions in finance industry
cash
flows from operating activities (cash flow

statement)
change
in cash and cash equivalents (cash

flow statement)
free
cash flows (finance professionals, our

focus here, discussed in capital budgeting)
M K Lai
Page 17
Net Income vs. Cash Flows

what
are the differences between the net income

and cash flows?
1.
2.
3.
which
is more important to a finance practitioner?
M K Lai
Page 18
Book Value
book
value is the value recorded in the

accounting books and records of a company
book
value is recognized according to accounting

standards (historical cost, mark to market)
summary
of book value of assets, liabilities and

equity can be found in the statement of financial
position (balance sheet)
M K Lai
Page 19
Market Value
if
we own an item, we are concerned about its

market value
market
value is the cash inflows we obtain by

selling an item in an open market, say, a stock
prevailing stock price
market capitalization (usually as a measure of
companys size) = stock price * number of
shares outstanding
M K Lai
Page 20
Market Value
source: aastocks
M K Lai
Page 21
Market Value
source: HSI Co. Ltd.
M K Lai
Page 22
Book Value vs. Market Value

what
is the difference between the market value

and the book value?
book value is the value stated in the statement
of financial position, e.g. historical cost or
marking to market (fair value)
market value is the selling price of an item in
an open market (consistent with cash flows)
illustrate with the example of a specialized
machine tailored to the needs of a company
which is more important to a finance practitioner?
M K Lai
Page 23
Financial Statements
financial statements are prepared in accordance
with a set of rules known as Generally Accepted
Accounting Principles (GAAP, US) and
International Financial Reporting Standards (IFRS,
international)
a company releases such information through
the unaudited interim reports and audited annual
reports
serve as the primary source of data about a
company
M K Lai
Page 24
Financial Statements
financial
statements
source: Sa Sa AR
M K Lai
Page 25
Market Information
information that an investor can get hold of in the

financial markets, e.g. relevant company, stock
exchange, financial information providers,
brokerage firms and others
transaction price of security
transaction volume and turnover
transaction time
other pertinent information, e.g. corporate
actions (cash dividends, stock dividends,
stock repurchases, rights issues, etc. what
are they?), plan for capital expenditures, etc.
M K Lai
Page 26
Market Information: Teletext Screen
M K Lai
Page 27
Corporation
corporation/limited
liability company: an entity

as a legal person separate and distinct from its
owners (shareholders/stockholders/equity
holders)
types of companies: private companies (shares
cannot be traded on organized exchange and
public companies (shares can be traded on
organized exchange, listed companies)
limited liability: shareholders are not liable to
companys debt and their liability is restricted
to their investment in the shares
M K Lai
Page 28
Corporation
separation
of ownership (shareholders) and

management (hired professional managers)
shareholders elect members to join board of
directors in the annual general meeting to
oversee management
management runs the corporations affairs
in the shareholders interests
M K Lai
Page 29
Corporation
source: Sa Sa Notice of AGM
M K Lai
Page 30
Corporation
ownership
of company: company issues

shares/stocks/equity to shareholders
vote
on proposed resolutions on one-shareone-vote basis in shareholders meetings
entitled
to receive dividends on a pro rata
basis
M K Lai
Page 31
Voting on Resolutions
source: Sa Sa Proxy Form

M K Lai
Page 32
Corporation
tax
implications: tax on corporate profits are

separate from shareholders tax obligations
(double taxation)
tax
on a corporate level, i.e. corporate income

tax in the US (profits tax in Hong Kong)
tax
on an individual level, i.e. tax on dividends

in the US (no such tax in Hong Kong)
M K Lai
Page 33
Example: Tax Implication on Companys

Earnings
A
US company has earnings before tax of

$5,000,000. The company decides to provide
40% of the earnings after tax to its shareholders.
A shareholder has 1% of the ownership interest in
the company. The corporate tax rate is 40% and
dividend tax rate is 15%. Calculate the earnings
after tax and the after-tax dividends received by
the shareholder.
M K Lai
Page 34
Example: Tax Implication on Companys

Earnings
earnings
after tax = earnings before tax * (1-tax

rate) = $5,000,000*(1-40%) = $3,000,000
dividends
received by shareholder =
$3,000,000*40%*1% = $12,000
dividends
after tax received by shareholder =

$12,000*(1-15%) = $10,200
M K Lai
Page 35
Financial Managers Place in Company

Board of Directors
Chief Executive Officer
Chief Operating Officer
Chief Financial Officer

Controller
Treasurer
M K Lai
Page 36

board
of directors: make rules on how the

company should be run, set policy and monitor
the performance of company; usually delegate
the day-to-day running to senior management of
company
chief
executive officer (CEO): run the day-to-day

operations by instituting rules and policies set by
board of directors
M K Lai
Page 37

financial
mangers
chief
financial officer (CFO): top company

officer responsible for its finance activities
financial controller: handle cost and financial
accounting, tax payments and management
information systems
treasurer: manage a firms cash and credit, its
short-term and long-term financial planning,
and its capital expenditures
M K Lai
Page 38
Financial Managers
financial
managers are the main company

officers responsible for making the companys
financial decisions
three major financial decisions
capital budgeting
financing
working capital management
other financial decisions
dividend policy
financial risk management
M K Lai
Page 39
Statement of Financial Position Model

Statement of Financial Position
current assets
current liabilities
long term assets
long-term liabilities
capital budgeting
shareholders equity
working capital management

financing
financial risk management
dividend policy
M K Lai
Page 40
Major Financial Decisions

capital
budgeting/investment: process of
planning and managing a firms long term
investments in terms of sorts of property, plant
and equipment, and other assets (investment)
financing:
how a firm obtains long term financing

it needs to support its long-term investments
(corporate financing) through a mix of long term
debt and equity (capital structure)
M K Lai
Page 41
Major Financial Decisions

working
capital/treasury management: day-today activity to ensure a firm has sufficient cash

resources to continue its operations and avoid
costly interruptions
net working capital = current assets - current
liabilities
cash flow or liquidity problem
M K Lai
Page 42
Other Financial Decisions

dividend
policy: how a firm decides how much to

pay back to shareholders through dividends or
share repurchases/buybacks (payout policy)
net income = dividends + retained profits
retained profits = internally generated funds
share repurchase = a company buys its own
shares back
financial
risk management: how to identify,

measure, manage and monitor the financial risks
faced by a firm
M K Lai
Page 43
Goal of Company
objective:
maximize stock price or shareholders
wealth
subject
to
principal-agent
(agency) problem:
management acts in own interests at expense
of shareholders
M K Lai
Page 44
Goal of Company
illegal
and unethical actions taken by

management known as corporate misgovernance to affect interests of different
stakeholders, such as shareholders, creditors,
suppliers, customers, employees and even the
general public
mitigated by corporate governance structure
of corporation
corporate
social responsibility for the benefit of

the society
M K Lai
Page 45
Agency Problem
shareholders
are principals and managers are
agents
agents owe fiduciary duties to principals and
should act in the best interests of principals
however,
in reality, there is always a conflict of

interests between shareholders and managers
managers tend to act in their own interests at
the expense of the shareholders
this is known as the agency problem
M K Lai
Page 46
Agency Problem
private jet
huge bonus
luxurious office
company car
nepotism
cronyism
M K Lai
Page 47
Agency Problem
ways
to mitigate the agency problem
1.
, e.g. stock option schemes, share

offerings, compensation packages and job
prospects tied to managerial performance
2.
3.
, e.g. proxy fights, hostile takeovers by

corporate raiders
M K Lai
Page 48
Corporate Mis-governance
corporate
mis-governance: misconduct by board

of directors or management of a company
towards different stakeholders, e.g. fraud,
misfeasance, failures to adhere to duties of
disclosure
corporate
governance: how a firm is directed and

controlled in the best interest of different
stakeholders such as shareholders, creditors,
employees, suppliers, customers, the general
public, etc.
M K Lai
Page 49
Corporate Governance Report
source: Sa Sa Annual Report
M K Lai
Page 50
Corporate Social Responsibility

corporate
social responsibility: a firm integrates

social and environmental concerns in its business
operations and in its interaction with business
relevant groups on a voluntary basis
responsible entrepreneurship
voluntary initiatives going beyond legal
requirements and contractual obligations
activities to benefit employees, business
relevant groups (i.e. society) or environment
positive contribution to individual target groups
regular activities rather than one-time events
M K Lai
Page 51
Report on Corporate Social

Responsibility
source: Sa Sa Annual Report

M K Lai
Page 52
Financial Managers and Flows of Funds

direct finance
financial
markets
firms
operations
financial
managers
outside
investors
financial
intermediaries
indirect finance
M K Lai
Page 53
Financial Intermediaries
a
financial intermediary stands between the

company and outside investors by facilitating the
transfer of funds from one to the other
the financial institution issues financial
instruments under its own name to be purchased
by outside investors and buys financial
instruments issued by the company
it is called indirect finance or intermediation
examples: banks, insurance companies, mutual
funds, pension funds, etc.
M K Lai
Page 54
Financial Markets
a
financial market provides a marketplace for the

outside investors to buy financial instruments
issued by the company directly
it
is called direct finance or disintermediation
examples:
stock market, bond market, money

market, foreign exchange market, derivative
market, etc.
M K Lai
Page 55
Stock Market
a
stock market/stock exchange/bourse : an

organized market: that provides a physical
central market place for shares to be traded, e.g.
New York Stock Exchange (NYSE), Stock
Exchange of Hong Kong (SEHK)
the
exchange sets out listing standards

(Listing Rules in Hong Kong) to outline the
requirements a company to meet so as to
maintain listing status on the exchange
M K Lai
Page 56
Stock Market
over-the-counter
market: a decentralized market

that is connected by a computer or
telecommunication network, e.g. NASDAQ
(according to the textbook)
notice:
since 2006, NASDAQ has been

recognized as a stock exchange by US
Securities and Exchange Commission
M K Lai
Page 57
Stock Exchange of Hong Kong:

Trading Hall
floor trader in red

waistcoat
source: HKEx
M K Lai
Page 58
Trading Through Telecommunications or

Computer Network
trading
terminals
usually
provided by
Bloomberg or
Reuters
M K Lai
Page 59
Stock Markets by Market Capitalization

Domestic market capitalization (USD millions)
Ranking Exchange
NYSE
1
NASDAQ OMX
2
Japan Exchange Group - Tokyo
3
Shanghai SE
4
Euronext
5
Hong Kong Exchanges and Clearing
6
Shenzhen SE
7
TMX Group
8
Deutsche Brse
9
SIX Swiss Exchange
10
2015 August
17 931 217.0
6 981 893.0
4 713 630.2
4 125 183.4
3 326 883.0
3 059 911.1
2 742 061.1
1 749 271.7
1 676 240.4
1 539 575.5
source: World Federation of Exchanges

M K Lai
Page 60
Functions of Stock Market

allow
companies to raise funds by issuing shares

primary market: a fund raising or financing
market that a company issues new shares to
raise funds
provide
liquidity for trading companys shares

liquidity: a stock can be converted into cash
quickly at a competitive market price
secondary market: a market for trading
already-issued shares among investors
M K Lai
Page 61
Functions of Stock Market

help
determine the share price (price discovery)

share price reflects demand and supply
conditions in stock market
investors react to arrival of new information by
trading shares and share price changes
accordingly
a feedback to companys management about
investors views and decisions to companys
shares
M K Lai
Page 62
Trading Systems of Stock Market

auction
market: a market where share prices are

set through direct interaction between buyers and
sellers
two
major trading systems
order-driven
quote-driven/dealer
market
M K Lai
Page 63
Order-Driven System
order-driven:
a trade is concluded between a

buying investor and a selling investor, e.g. stock
transactions on the Stock Exchange of Hong Kong
the
trade may be facilitated by brokers to act on

behalf of the investors and earn
brokerage/commission
M K Lai
Page 64
Dealer Market
dealer
market: a market where dealers/market

makers buy and sell for their own accounts with
investors, e.g. specialists on NYSE (New York
Stock Exchange) act as dealers (notice: each
NYSE stock is assigned to one specialist, single
dealer market), NASDAQ (National Association of
Securities Dealers Automated Quotation System,
multiple dealer market)
M K Lai
Page 65
Dealer Market
dealer
provides two-way quotes and investor can

trade with dealer as long as he agrees with price
quotations
bid price: buying price of dealer
ask/offer price: selling price of dealer
which price should be higher?
what
is the difference between a broker and a

dealer?
M K Lai
Page 66
Dealer Market
bid-ask
spread: difference between bid and ask
prices
transaction
cost to investor
profit
to dealer as compensation for bearing

inventory risk
M K Lai
Page 67
Financing Cycle
funds
savers, lenders
and investors
(fund surplus
units)
companies with
projects and
ideas (fund
deficit units)
rent, wages, profits and

interest
M K Lai
Page 68
Financial Institutions
financial
institutions: entities that provide

financial services, such as taking deposits,
managing investment, brokering financial
transactions or making loans, to facilitate the
transfer of funds from the surplus units to the
deficit units
M K Lai
Page 69
commercial
investment
banking:
banking:
.
.
financial
conglomerates/groups: provide a
wide range of financial products and services
M K Lai
Page 70
financial institutions
commercial banks
sources of money
deposits
insurance companies
premiums and investment

earnings
mutual funds
investments by a large of
investors
pension funds
uses of money
loans to individuals and
businesses
invest mostly in bonds and some
stocks, and use the investment
to pay claims
buy stocks, bonds and other
financial instrumetns on behalf
of investors
contributed by employers and

employees through the
workplace
buy stocks, bonds and other

financial instrumetns on behalf
of investors with the purpose of
providing retirement income
(accrued benefit)
M K Lai
Page 71
financial institutions
sources of money
uses of money
hedge funds
investments by institutional and invest in any kind of investment

high net worth investors, e.g.
in an attempt to maximize
wealthy individuals and
returns in any market conditions
endowments
(absolute return)
venture capital funds
investments by institutional and

high net worth investors, e.g. invest in start-up, entrepreneurial
firms
endowments
private equity funds
investments by institutional and buy whole companies by using a

high net worth investors, e.g.
small amount of equity and
borrowing the rest (leveraged
endowments
buyout)
M K Lai
Page 72
Role of Financial Institutions

help
transfer of funds from surplus units to deficit

units
help
solve problem of mismatching in maturity,

risk and denomination
M K Lai
Page 73
Mismatching in Maturity
deficit unit wants
to borrow for
3 years
surplus unit wants

to lend for
3 months
lend for 3
years
lend for 3
months
financial
institution
M K Lai
Page 74
Mismatching in Risk
deficit unit
involves
in high risk
investment
surplus unit wants

to have low risk
investment
make high risk

investment
make low risk

investment
financial
institution
M K Lai
Page 75
Mismatching in Denomination
deficit unit wants
to borrow $5
million
surplus unit wants

to lend out
$50,000
lend out $5
million
lend out
$50,000
financial
institution
M K Lai
Page 76
Challenging Questions
1. Discuss two scenarios under which a company
is in financial distress?
2. If the fair value of a stock is $50 and the current
stock price is $55, what is your investment
recommendation to a client?
3. One of the reasons that cash flows are
considered as a better measure than net
income in finance is that net income can be
manipulated by the senior management of a
company. Discuss two ways to manipulate the
net income.
M K Lai
Page 77
4. In the record of the Inland Revenue Department,
the value of a machine owned by a company is
$50,000. The company sells the machine at
$80,000. The tax corporate tax rate is 30%. The
capital gain from the sale is $30,000. The tax
on the capital gain is $$9,000.
A. The book value of the machine is
.
.
B. The market value of the machine is
C. The capital gain is considered as an item
.
of calculating
D. The tax on the capital gain is considered
.
as an item of calculating
M K Lai
Page 78
5. Explain whether the depreciation expense of a
machine is a cash flow item. The Inland
Revenue Department allows a company to
reduce its taxable income by deducting the
depreciation expense from its revenue. The tax
saving is known as the depreciation tax shield.
Is the depreciation tax shield a cash flow item?
6. What is the implication of limited liability of a
company on its stock price?
M K Lai
Page 79
7. What are the impacts of the following corporate
actions on the net assets, the number of shares
outstanding and the stock price of a company?
A. cash dividend: a company pays cash back
to the shareholders
B. stock dividend: a company gives new
shares free-of-charge to the shareholders
8. In economics, the objective is profit
maximization. Why dont we use profit
maximization as the goal of a company?
M K Lai
Page 80
9. Which characteristic of a company gives rise to
the agency problem? Explain.
10.Suppose that an investor owns stock in a
company. The current price per share is $10.
Another company has just announced that it
wants to buy the company and will pay $15 per
share to acquire all shares outstanding. The
companys management immediately begins
fighting off this hostile bid. Is the company
management acting in the shareholders
interests? Why or why not?
M K Lai
Page 81
11.If a hedge fund offers partnership interests to
institutional and high net worth investors and
uses the pool of funds to invest in the financial
markets, it involves in
financing. Explain.
12.Discuss what types of financial instruments are
traded in the following financial markets
A. stock market
B. bond market
C. money market
D. foreign exchange market
E. derivative market
M K Lai
Page 82
13.State whether the following is a primary or
secondary market activity.
A. If a majority shareholder of a company
offers his own shares to the general public
for subscription, it is a
market activity.
B. If a company issues new shares to
institutional and high net worth investors for
subscription, it is a
market activity.
(private placing)
M K Lai
Page 83
C. If a company gives rights free-of-charge to
the shareholders and it is at the discretion of
the shareholders to pay a specified
subscription price in exchange for new shares
issued by the company, it is a
market
activity. (rights issue)
D. If a company issues new shares to the
general public for subscription for the first
time, it is a
market activity. (initial public
offering, IPO)
M K Lai
Page 84
14.If the announced dividend per share of a
company is higher than what is expected by
investors in the market, the stock price will
usually
. Explain why.
15.If a company has good investment and growth
opportunities, its stocks is a good buy. Do you
agree?
M K Lai
Page 85
16.Hong Kong, a stock transaction is concluded by
matching a buy order with a sell order in terms
of stock price, quantity of shares, etc. Is it an
auction market? Why or why not?
17.In the foreign exchange market, large financial
institutions (mainly banks) provide the market
to the investors by trading with them at
specified exchange rates, it is a(n)
market.
18.What is the difference between an auction
market and a dealer market?
M K Lai
Page 86
19.An investor wants to buy a security in the
financial market. He obtains the following
quotes from a market maker/dealer:
bid price = $2.10
ask price = $2.15
What is the transaction price of the security for
the investor? Explain.
M K Lai
Page 87
20.Discuss the impact of the following events on
the size of the bid-ask spread quoted by a dealer
on a financial instrument.
A. The liquidity of the financial instruments
becomes lower.
B. The price of the financial instrument
becomes more volatile.
C. The dealer wants to lay off its large
position in the financial instrument.
M K Lai
Page 88

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Topic 1: Introduction to Corporate

Topic 1 Introduction to Corporate Finance

What is Corporate Finance?

in the mix of long-term assets

Topic 1 Introduction to Corporate Finance

What is Corporate Finance?

capital through different sources of

Topic 1 Introduction to Corporate Finance

What is Corporate Finance?

current assets and current liabilities

Topic 1 Introduction to Corporate Finance

Three Building Blocks in Making

can be complicated, but it can be

Topic 1 Introduction to Corporate Finance

Three Building Blocks in Making

timing and risk of cash flows

flows (size of cash flows) (this topic)

value of money (timing of cash flows)

relationship between risk and return

Topic 1 Introduction to Corporate Finance

Three Building Blocks in Making

the fair value of an asset, a liability

into account costs and benefits in terms

Topic 1 Introduction to Corporate Finance

source: ABCI Securities

Accounting vs. Finance

use accounting standards set by

Accounting vs. Finance

Topic 1 Introduction to Corporate Finance

Accounting vs. Finance

with a company research report

between accounting and finance

Topic 1 Introduction to Corporate Finance

Accounting vs. Finance

source: ABCI Securities

income vs. cash flows

value vs. market value

statements vs. market information

Topic 1 Introduction to Corporate Finance

income = total revenue total expenses

revenue and expenses are recognized

of total revenue and expenses of a

Topic 1 Introduction to Corporate Finance

definitions in finance industry

flows from operating activities (cash flow

in cash and cash equivalents (cash

cash flows (finance professionals, our

Topic 1 Introduction to Corporate Finance

Net Income vs. Cash Flows

are the differences between the net income

is more important to a finance practitioner?

Topic 1 Introduction to Corporate Finance

value is the value recorded in the

value is recognized according to accounting

of book value of assets, liabilities and

Topic 1 Introduction to Corporate Finance

we own an item, we are concerned about its

value is the cash inflows we obtain by

Topic 1 Introduction to Corporate Finance

Topic 1 Introduction to Corporate Finance

Topic 1 Introduction to Corporate Finance

Book Value vs. Market Value

is the difference between the market value