BF3326 Corporate Finance

INTRODUCTION TO FINANCIAL MANAGEMENT

Need of Finance

• Student Loans
• Credit cards
• Investments
• Retirement Savings
• Banking
• Personal Spending
• Vacation
• Financial Planning
Need of Finance

Careers Goals
– Finance
– Accounting
– Marketing
– Sole
proprietorship
– Security Analyst
Why Study Finance?

Marketing
– Budgets, marketing research, marketing financial products
Accounting
– Dual accounting and finance function, preparation of
financial statements
Management
– Strategic thinking, job performance, profitability
Personal finance
– Budgeting, retirement planning, college planning, day-to-
day cash flow issues
Why Corporate Finance?
Some important business questions that are answered using finance:

1. What long-term investments should you make

• Examples: equipment, buildings

2. Where will you get the long-term financing?

• Profits? Equity? Debt?

3. Short-term cash management

• How will you collect from customers and pay your bills?
What is Financial Management?

Financial management is used to help make three major

decisions:

1. Which assets should we invest in?

2. How will we pay for these assets?
3. What should we do with the earnings generated by the
assets?

These are called the investment, financing, and dividend

decisions.
Financial Decision
Financing decision – where is money going to come from
Investment decision – how much to invest and in what assets

Invest
Financial
Market Company Operation

Finance Utilizes
Financial Decision
1. Capital Budgeting
– The process of planning and managing a firm’s long-term
investments
• Evaluating the size, timing, and risk of the future cash
flows
• Use NPV finance tool to decide
2. Capital Structure
– The mixture of debt and equity
3. Working Capital
– The firm’s short-term assets and liabilities
Role of Financial Managers
• Financial managers try to answer some, or all, of
these questions.
• 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
Role of Financial Managers
2.Investments 1a.Raising funds

Financial Markets
Operations (plant, Financial Manager (investors)
equipment, 1b.Obligations
projects) (stocks, debt
securities)

3.Cash from
operational 5.Dividends or
activities interest payments

4.Reinvesting

Finance function – managing the cash flow

Role of Financial Managers
Capital structure and cost of capital

Operations Investments Financial Manager Financial markets

Financing
Goal of Financial Management
• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s
stock?
• Does this mean we should do anything and
everything to maximize owner wealth?
• Sarbanes-Oxley Act
Goal of Financial Management

Maximizing
Maximizing
shareholder’s
stock prices
wealth
Revisit Business Structure
❑ Resources limited to individuals
❑ Service firms
❑ Easy and Cheap to form
❑ Resources limited to owner
❑ Small business

❑ Ownership in shares
❑ Large amount of resources ❑ An alternative to
partnership
❑ Big businesses
❑ Tax and legal liability
advantage
The Agency Problem

• Agency relationship
– Principal hires an agent to represent its interests
– Stockholders (principals) hire managers (agents)
to run the company
• Agency problem
– Conflict of interest between principal and agent
• Management goals and agency costs
The Agency Problem
• The goal of financial management is to maximize the
current value per share of existing stock (market value
of equity)
– This is theoretically a good goal
• Do some managers employ creative accounting
so that it looks like stock value goes up?
• Financial managers should not take illegal or unethical
actions to increase stock value
Financial markets

The main goal of financial markets:

Take savings from those who do not wish to

consume (savings surplus units) and to channel
them to those who wish to invest more than they
have presently (saving deficit units)
Financial Markets and Financial System

Financial system
Return on
Return on
investments
Financial investments
markets
money money

Saving surplus Saving deficit

units (savers) units (investors)

money money
Ф Financial
intermediaries
Return on Return on
investments investments
Financing Decisions
Financing
decisions

Internal corporate External sources

financing of funds

Direct financing Indirect financing

Retained earnings (financial markets (financial
Instruments) Intermediaries)

Stocks Loans

Debt instruments
(bonds, CPs etc.)
Financial Markets

Financial markets

Organized
Primary markets Money market exchanges
Secondary markets Capital market Over-the-counter
Primary and Secondary Markets
Primary market – primary issues of securities are sold, allows
governments, banks, corporations to raise money by directly
selling financial instruments to the public.

Secondary market – allows investors to trade financial

instruments between themselves. Secondary transactions take
place.
Money and Capital Markets
Money markets – short-term assets (maturity less than 1 year) are
traded:

Certificates of deposits (CDs)

Commercial papers (CPs)
Treasury bills

Capital markets – long-term assets (maturity longer than 1 year) are

traded:

Stocks
Corporate bonds
Long-term government bonds
Organized Exchanges and Over-The-Counter

Organized exchange – most of stocks, bonds and derivatives are traded.

Has a trading floor where floor traders execute transactions in the
secondary market for their clients.

Stocks not listed on the organized exchanges are traded in the over-the-
counter (OTC) market. Facilitates secondary market transactions. Unlike
the organized exchanges, the OTC market doesn’t have a trading floor.
The buy and sell orders are completed through a telecommunications
network.
Financial Instruments

• Prices of financial instruments are determined in

equilibrium by demand and supply forces

• They reflect market expectations regarding the future

as inferred from currently available information
Types of Financial Instruments

Type of issuer

Government, States (regions,

Financial
government provinces), Corporations Others
institutions
agencies municipalities
Types of Financial Instruments

Maturity

Short-term Long-term
instruments instruments
Types of Financial Instruments

Dividend bearing
(stocks)

Discount debt
Type of yield Instruments
(treasury bills)

Interest income
instruments (bonds)
Types of Financial Instruments

Risk-free instruments (treasury

bills)

Low-risky securities (treasury

notes and bonds),
By level of risk investment grade corporate
bonds,
blue-chip stocks)

High-risky securities (junk bonds,

stocks), derivatives
Financial Instruments Issued by Government

• To finance any shortfall between expenditures and taxes (deficit)

• To refinance maturing debt
• To finance investment projects, social programs etc.
Financial Instruments Issued by Government

• Treasury bills (T-bills)

• T-Bills are the largest component of the money market
• Maturities: 4 weeks, 13 weeks, 26 weeks
• Sold at a discount from face value
• Considered as a risk-free investment
- No chance of default
- Very little interest rate risk
• Are actively traded
• Interest is subject to federal tax (but exempted from state and
local taxes)
Financial Instruments Issued by Corporations

• To finance operations
• To invest in new projects
• To expand their business
• To repay debt or repurchase shares
Financial Instruments Issued by Corporations

• Commercial paper – short-term debt with maturity of not more

than 270 days
• Issued by larger, known corporations (GE – $80 billion)
• Issued at discount
• Higher rates than comparable Treasury bills because of smaller
default risk and less liquidity than government securities