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Finance1

Goaloffirm,maxvalue;max value of firm, wealth of owners, px of stock, contribute to economy (best


when use fins systematic value-max ivmt & financing decision criteria)
HowManagersMaxStockPx?What det. stock px? -Firms ability to generate cash flows.
3 aspects of CF that affect asset value, thus stock px. Amtof CF expected by shareholders (more
CF=worth more) Timingof CF stream (generate fast=more) Riskinessof CF stream (less risk= ) 3
det. stocks IntrinsicValue(TBrefersasMktValue)
IntrinsicValuevs.MarketPrice:Intrinsicvalueis estimate of a stocks truevalue based on accurate
risk and return data. Estvalue, not precise objectively known measure.Mktpxbased on perceived
information seen by marginalinvestor(can be theoretically incorrect).
TheRole&DecisionsofFinancialManager:Max value (stock px) of Firm:
Capital Budgeting: What LT investments/projects shld biz take on?
Capital Structure: How shld we pay for our assets?Shld use debt or equity?
Working Capital Management: How we manage day- to-day finances of firm?
WhatistheAgencyProblem?
Egs. of Financial decisions affecting firms: Dell computer expands its product line.Gap builds additional stores.Nike closes a production plant in
Agency relationship:Principal hires agent to represent their interest.
Asia. Ford borrows $3 billion.Perot Systems issues stock valued at $3 billion .
Stockholders (principals) hire managers (agents), via Board of Directors, to run company
InvestmentVehicleModel:Investors providefinancing to firm inexchangeforfinancial securities
(various claimson firms CF). Firm investsfunds in assets. Incomegeneratedby firms assets distributed Agency problem Conflict of interest between principal and agent
Corp. Org. Potential CoI: Shareholders&managers Shareholders&creditors
to investors (i.e., holders of firms financial securities).
AgencyCosts
(DRAW)
Direct agency costs: expendituresthatbenefitmgmt:car, accommod, big office, high pay.
monitoringcosts:auditors, audit committee, corp. governance
TheBalanceSheetModelOR AccountingModelof Firm. Ivmtdecisionsshown on asset(LHS) of
Indirect agency costs: lostopportunitieswhich increase firm value in LR, if accepted
balance sheet. Financingdecisionson liab&equity(RHS) of B.sheet.
ShareholdersversusManagers
RelatingValuebacktotheBalanceSheet:(DRAW)
Managers naturally inclined act in their own best interests.
But these factors control managerial behavior: Compensation plans tied to share value Direct
intervention by shareholders Threat of firing Threat of takeover
AnOrganizationChart:(DRAW)
HowToHandleTheAgencyProblem?
1. Compensation plans tie fortunes of the managers to fortunes of the firm.
Discipline concerned w determiningvalue(what sth worth today) & makingdecisionsbasedonthat
valueassessment.
Fin function allocates resources (acquiring, investing, mng of resources)
MainAreasofFinance: 1.Investments 2.Financial Markets&Intermediaries 3.Corporate Finance (/Biz
Fin)
Investments:Study of financial transactions from perspective of investorsoutsidefirm.
FinancialMarkets&Intermediaries:Study of mkts where financial securities (ie. stocks & bonds)
bought&sold. Study of financialinstitutions(ie. commercial banks, ivmt banks, insurance companies)
that facilitate the flow of money from savers to demanders of money.
CorporateFinance: What longterminvestmentsshld firm take on? (capital
budgetingdecision) Whr
to get longtermfinancing pay for ivmt? (capitalstructuredecision) How manage everydayfinancial
activitiesof firm? (workingcapitalmanagementdecision)

FinancialManager:Top financial manager within firm, usually Chief Financial Officer (CFO).
Treasurer:oversees cash mgmt, credit mgmt, capital expenditures & financial planning. Controller:
oversees taxes, cost accounting, financial accounting & data processing
Alt.FormsofBusinessOrganization:1.Sole proprietorship 2.Partnership3.Corporation
SoleProprietorship(indiv owns & manages biz). +:Easiest to start. Least regulated. Single owner keeps
all profits. Taxed once as personal income. :Limit to life of owner. Equity cap limit to owners personal
wealth. Unlimited liab. Diff to sell ownership interest
Partnership(groupof individuals collectively own & manage business; roughly same advantages &
disadvantages as a SP) +:2 or more owners. More capital available. Relatively easy to start. Income taxed
once as personal income. :Unlimited liab (General Partnership, Limited P). Part dissolves when one
partner dies/wish to sell. Diff transfer ownership.
Corporation(created via ArticlesofIncorporation)Set out purpose of bizEstablish no. of shares that
can be issued.Set no. of directors appointed. Ownership & Mgmt separated. A corp issues equity
shares. Holders of these shares are ownersof the firm. Although stockholders own corporation, do not
necessarily manage it. Instead vote to elect Board of Directors (BOD). BOD represents shareholders(i)
selects management team, (ii) appoints auditors (iii) is responsible for checking/monitoring management
actions.
CorporateStructureSeparationofOwnership&Control:(DRAW)

Corporation:+:Limited liab. Unlimited life. Separation of ownership & mgmt.Transfer of ownership


easy. Easier raise capital. :Separation of ownership & mgmt (and resulting potential for agency costs).
Double taxation (income taxed at corporate rate then dividends at personal rate)*Not for SG
PrivateComp firms shares usually closely held, ie. ownership closely held by relatively small no. of
shareholders (often include companies original founders, some financial backers (e.g., venture
capitalists) and others). Shares not traded on any exchange.
PublicComp firms shares listed on a stock exchange, companys shares are widely dispersed and
traded in the secondary markets.
Corporations: 2MainSourcesofExternalFinancingDebt&Equity:
I.Debt:(usuallyBONDSnotLOANS)
Lenders By lending money to corp, debt holders become corps creditors and lenders.
RelationshipDet.byContract- Debt contract is legally binding agreement. Specifies principal, interest,
maturity date, specific protective covenants.
Security&Seniority In case of bankruptcy, debt holders collect before equity holders. Yet, diff debt
holders diff priority claim to CF/assets of bankrupt firm (respt. debt contracts)
II.Equity:
ShareholdersOwnershipRights by buying shares in the corp, shareholders become owners of firm.
Shareholders are residual(leftoverprofits)claimants of firm. ShareholdersPayoffs shareholders
receive monetary returns in following ways:
Dividendper share, paid to investors from corps after tax dollars.
Capitalgainfrom sale of shares (ownership rights) at a price higher than purchased.
PossibleGoalsofFinancialMgmt:What shouldbe goal of a corp? (NOT FOR FIN)
Common: Max sales/marketshare? lower price/relaxing credit terms. Min costs? lowering quality or
R&D. Max profits? short-term nature; defn of profits, accounting or economic; risk not addressed.
GoalofFinancialMgmt:Pri goal shareholderwealthmaximizationaka
max stock px

DisneysFormerCEOCompensationPackage: 3 main components:1. Base annual salary of $750,000. 2. Annual bonus


of 2% of Disneys net income above a threshold of normalprofitability. 3. A 10-year option to purchase 2 mil shares of
stock for $14 per share, (px of Disney stock at time he hired as CEO)

HowToHandleTheAgencyProblem?
1.Compensation plans tie fortunes of managers to fortunes of firm.
2. Monitoring by lenders, stock market analysts and investors.
3.Threat that poorly performing managers will be fired.
4.Growing awareness of importance of good CorporateGovernance.
WhatisCorporateGovernance?
Term refers broadly to rules, processes, laws which businesses are operated, regulated, controlled. Can
refer to internal factors defined by officers, stockholders or constitution of a corporation, also to external
forces like consumer groups, clients, government regulations.
serve corp. purposes by providing structure which stockholders, directors, mgmt can pursue most
effectively objectives of corp".
Good corp. governance view organizations as a webofrelationshipsbetween and among various
stakeholders and manage their interests in a responsible manner.
TheFirm&ItsSourcesofFunds
FinancialMarkets:mkts whr financial instruments traded intermediaries btw savers&borrowers
MoneyMkts vs CapitalMktsPrimaryMkts vs SecondaryMkts
MoneyMarketsvs.CapitalMarkets
Moneymkts debt securities of lessthan1yrtraded: treasury securities, commercial paper, bills, interbank loans loosely connected dealermarkets banks are major players
Capitalmkts whr equity&longertermdebtclaimstraded auctionmkts (ie. SGExchange)
Example:MoneyMarkets:OCBCtosetupcommercialpaperprogram,sellUSDfloatingratenotesExampleCapitalMarkets: Alibaba IPO
ranks as world's biggest

PrimaryMarketvs.SecondaryMarket
PrimarymktDirecttransactionwithcompany
for govt & corp initially issued securities. public offering (securities offered to public at large; needs
underwriting, more regulatory requirements, costly) private offering (securities offered to large financial
institutions or wealthy individuals etc.; less costly)
Secondarymkt Stocksfromexchange(alrdyboughtfromsomeonepreviously)
whr existing financial claims traded dealer mkt (eg. OTC mkts) auction mkt (e.g. SGX, NYSE)
where getting mkt value of securities easier
FirmsSourcesOfFunds:(DRAW)
Summary
1. Scope of financial studies - businessfinance,financialmktsand investments.
2. Biz finance - investmentand financingdecisions & workingcapitalmanagement.
3. Goal of financial mgmt is make decisions to maxmktvalueof equity/owners wealth.
4. Conflicts of interest btw shareholders and managers - agencycosts.

Finance2