Corporate Finance

Lecture 1 Overview

Dr. Jian Zhang

Faculty of Business and Economics

University of Hong Kong

1 / 60
Outline

1. Course Overview

2. Basics

3. Finance Framework

4. Business Organization

5. Goal of FM and Agency Problem

6. Financial Markets

2 / 60
 Course Overview

Outline

1. Course Overview

2. Basics

3. Finance Framework

4. Business Organization

5. Goal of FM and Agency Problem

6. Financial Markets

3 / 60
 Course Overview

Class Organization

I Instructor Information
I Name: Dr. Jian ZHANG
I Email: zhangj1@hku.hk

I TA Information for Subclass K and L

I Subclass K: Mr. Keith LAW
I Subclass L: Mr. Keith LAW
I Email: yhklaw@hku.hk

I Course Website
I Joint Moodle page for course materials: “COMBINEDFINA 1310”

4 / 60
 Course Overview

Objectives

I Lecturer
I Transfer knowledge - notes
I Develop skill set / thinking
I Tall order: stimulate interest

I Student
I Keep pace with the class
I Good grade is a natural consequence

5 / 60
 Course Overview

Teaching and Learning Activities

I Materials
I Lecture notes and recording will be posted on the Moodle.

I Online Office Hour

I Zoom Meeting every Saturday 10 am - 11 am
I Attendance is on a voluntary basis

I Tutorial by Keith
I Details will be available later

I Final Grade Computation

I Class Participation 5%
I Assignment 20%
I Mid-term Examination 20%
I Final Examination 55%

6 / 60
 Course Overview

Evaluation

I Assignments
I 4 assignments (20 points total)
I Group based. 4 to 5 students from the same subclass per group
I Once the group is formed, no change is allowed
I Need to produce strong evidence on free-riding claims

I Midterm
I Tentative date and time : 7-9 pm on March 19
I NO Makeup Midterm
I Cheating of any form will be disciplined according to university regulation

I Final Exam
I Exact arrangement will be announced later.

7 / 60
 Course Overview

Textbook, Calculator and Registration

I Required textbook
I Ross, Westerfield, Jordan, Lim and Tan, Fundamentals of Corporate
Finance, Second Edition, McGraw-Hill Education(Asia), 2nd Edition,
2016
I The book contains much more materials than what we could cover.

I Calculator
I A financial calculator is essential for the course

I Any special request about course selection: contact FBE at

ugenquiry@fbe.hku.hk

8 / 60
 Course Overview

The Big Picture

I What is the course about

I The financing and investment decisions of corporations.

I Goal of the course

I An introductory course to lead you into the area of finance, to guide you in
major financial decisions of corporations, and to equip you with the core
skills useful for advanced finance courses

9 / 60
 Course Overview

Topics Covered in this Course

I Chapter 1: Introduction to Corporate Finance
I Part I: Time Value of Money
I Introduce basic skills in valuation and apply these skills to value stocks
and bonds, Chapter 5, 6, 7, 8

I Part II: Risk and Return

I Examine historical risk return relationships and offer CAPM risk return
relations, Chapter 12, 13

I Part III: Capital Budgeting and Cost of Capital

I Identify cash flow and make corporate real investment decisions, Chapter
9, 2 (part as review), 10, 11
I Establish reasonable cost of capitals, Chapter 14

I Part IV: Financing Decisions

I Study issues involved with raising capital and evaluate tradeoffs between
equity and debt, Chapter 15, 16
10 / 60
 Basics

Outline

1. Course Overview

2. Basics

3. Finance Framework

4. Business Organization

5. Goal of FM and Agency Problem

6. Financial Markets

11 / 60
 Basics

Finance Fundamentals

I Mathematics + $$$ = Finance

I Fig 1 James Simons, Renaissance Technologies
I Fig 2 Warren Buffett, Bershire Hathaway
I Fig 3 Elon Musk, Tesla

12 / 60
 Basics

Finance Fundamentals

I Mathematics + $$$ = Finance

I Fig 1 James Simons, Renaissance Technologies
I Fig 2 Warren Buffett, Bershire Hathaway
I Fig 3 Elon Musk, Tesla

12 / 60
 Basics

Finance Fundamentals

I Mathematics + $$$ = Finance

I Fig 1 James Simons, Renaissance Technologies
I Fig 2 Warren Buffett, Bershire Hathaway
I Fig 3 Elon Musk, Tesla

12 / 60
 Basics

Finance Fundamentals

I Mathematics + $$$ = Finance

I Fig 1 James Simons, Renaissance Technologies
I Fig 2 Warren Buffett, Bershire Hathaway
I Fig 3 Elon Musk, Tesla

12 / 60
 Basics

Finance Fundamentals

I Finance is a discipline that is concerned with two aspects:

I Determining value (or valuation of assets)
I Management of assets (acquiring or selling)

I Business decision involves the above two

I Valuation is the starting point for management
I Once value is established, management is easier

13 / 60
 Basics

Finance Fundamentals

I Valuation
I How are/should be financial assets valued?
I How do financial markets determine asset values?
I How well do financial markets work?

I Management
I How much should I save/spend?
I What and when should I buy/sell?
I How should I finance the transaction?

I Applies to all levels of financial decisions

14 / 60
 Basics

Example 1: Business Application

I A company wants to replace its current production line with a line of

more expensive and more efficient machines. Should the company buy
the new machines or leave the old ones in place?

I A firm needs to purchase a piece of equipment. Should it buy a cheaper

machine with a shorter lifespan or a more expensive machine that lasts
longer?

I All businesses, from international conglomerates to small “hawker”

shops, have to decide how they’ll finance their operations. Will they
borrow or will they bring in new investors/shareholders?

15 / 60
 Basics

Example 2: Personal Finance

I The principle behind making correct business finance decision applies to
individual financial decisions.

1 How to evaluate the terms for a home mortgage?

2 Is a car loan or a lease more advantageous?
3 Is a particular stock or fund a good investment?
4 When to start saving for retirement and how much to save?
16 / 60
 Basics

Example 3: Government Finance

I Government budgeting
I Estimates the anticipated
government revenues and
government expenditures for
the ensuing (current) financial
year
I Revenue relates to tax
collection while expenditure
goes to spending on collective
needs and wants such as
pension, provision,
infrastructure, etc
Hong Kong-Zhuhai-Macau bridge

17 / 60
 Basics

Scope of Study in Finance

I Investments

I Financial Markets and Intermediaries

I Corporate Finance (or Business Finance)

18 / 60
 Basics

Investments

I The study of financial transactions from the perspective of investors

outside the firm
I Examples
I How do we assess the risk of various financial securities?
I How do we manage a portfolio of financial securities to achieve a desired
objective ?
I How do we evaluate portfolio performance?

19 / 60
 Basics

Financial Markets and Intermediaries

I The study of markets where securities are bought and sold.

I The study of financial institutions (e.g. commercial banks, investment

banks, insurance companies) that facilitate the flow of money from
supplier to demand of money.

20 / 60
 Finance Framework

Outline

1. Course Overview

2. Basics

3. Finance Framework

4. Business Organization

5. Goal of FM and Agency Problem

6. Financial Markets

21 / 60
 Finance Framework

Corporate Finance
I Capital Budgeting
I What long-term investments should the firm take on?
I Dependent on the nature of the business
I Example: Walmart decides whether to open another store and Tesla’s
decision to build additional plants

I Capital Structure (Financing)

I Where will the firm get the long-term financing to pay for the investments?
I Example: Citi issues stock valued at HK$2 billion

I Working Capital Management

I Short-term Financial Management
I Manage its everyday financial activities
I How much cash and inventory should the firm keep on hand?
I How will the firm obtain any short-term financing (i.e. borrowing)?

22 / 60
 Finance Framework

Balance Sheet Model

I Also known as the accounting model of the firm

I Investment decisions are represented on the asset (left hand) side of

balance sheet

I Financing decisions are represented on the liabilities and equity (right

hand) side of the balance sheet.

23 / 60
 Finance Framework

Balance Sheet Model

24 / 60
 Finance Framework

Balance Sheet Model

25 / 60
 Finance Framework

Balance Sheet Model

26 / 60
 Finance Framework

Balance Sheet Model

27 / 60
 Finance Framework

Relating Value Back to the Balance Sheet model

I Maximizing value (investment decision)

I The value of the firm can be thought of as a pie. The goal of manager is to
increase the size of the pie via value maximization.

I Capital structure (financing decision)

I The capital structure decision can be viewed as how best to slice up the
pie, which can take an infinite range of possibilities.

28 / 60
 Finance Framework

Financial Managers

I The firm’s three main financial concerns are usually handled by a top
officer and aides:
I V.P. or Chief Financial Officer
I strategist, coordinator, authority
I Treasurer
I oversees cash management, credit management, capital expenditures and
financial planning
I Controller
I oversees taxes, cost accounting, financial accounting and data processing

29 / 60
 Finance Framework

Financial Managers

30 / 60
 Business Organization

Outline

1. Course Overview

2. Basics

3. Finance Framework

4. Business Organization

5. Goal of FM and Agency Problem

6. Financial Markets

31 / 60
 Business Organization

Major Forms of Business

I First problem that any firm faces: raise funds.

I The corporate form of business is the standard method for solving the
problems encountered in raising large amounts of cash.

I However, businesses can take other forms.

I Major Forms of Business Organization

I The Sole Proprietorship
I The Partnership
I The Corporation

32 / 60
 Business Organization

Sole Proprietorship

I Under this organization method, an individual owns and manages the

business

I Advantages I Disadvantages
I Easier to start I Limited to life of owner
I Least regulated I Equity capital limited to
I Single owner keeps all the owner’s personal wealth
profits I Unlimited liability
I Taxed once as person income I Difficult to sell ownership
interest

I Example: Suppose you decide to start a convenience store or restaurant

33 / 60
 Business Organization

Partnership (General)

I The way partnership gains or losses are divided is described in the

partnership agreement

I Advantages
I Two or more owners
I More capital available
I Relatively easy to start
I Income taxed once as
personal income
I Disadvantages
I Unlimited liability
I Partnership dissolves when
one partner dies or wishes to
sell
I Difficult to transfer ownership

I Example: Apple Computer started life as a partnership by Steve Jobs and

Steve Wozniak

34 / 60
 Business Organization

Partnership (Limited)

I In a limited partnership, there will be both general partners and limited

partners.

I The limited partners, unlike the general partners,

I Will not manage the partnership
I Will have limited liability
I Can transfer ownership

35 / 60
 Business Organization

Corporations

I A corporation is a business created as a separate legal entity composed of

one or more individuals or entities.

I Articles of Incorporation is filed to include things like name and business

purpose.
I Set out the purpose of the business
I Establish the number of shares that can be issued
I Set the number of directors to be appointed.

36 / 60
 Business Organization

Corporations

I Ownership and management are usually separated.

I A corporation issues equity shares.

I The holders of these shares are the owners of the firm, but they do not
necessarily manage it

I Instead they vote to elect a board of directors(BOD) , who represents the

shareholders and in this vein,
I selects the management team,
I appoints the auditors
I is responsible for checking/monitoring management’s actions.

37 / 60
 Business Organization

Corporations

38 / 60
 Business Organization

Corporation

I Advantages I Disadvantages
I Unlimited life I Separation of ownership and
I Limited liability management
I Separation of ownership and I May involve double taxation
management in some countries(income
I Transfer of ownership is easy taxed at the corporate rate and
I Easier to raise capital then dividends taxed at the
personal rate)

39 / 60
 Business Organization

Comparison of Different Forms of Business Organization

Features Sole Proprietorship Partnership Corporation

Life span Limited to life of owner Life ends if one partner Unlimited life
dies or sells his stake
Liability Unlimited Unlimited unless partner Limited
is a limited partner
Liquidity Ownership difficult Ownership difficult Ownership easier
to transfer to transfer to transfer
Financial Difficult Relatively difficult Relatively easier
resources to raise capital to raise capital to raise capital

40 / 60
 Business Organization

US Business Types

41 / 60
 Goal of FM and Agency Problem

Outline

1. Course Overview

2. Basics

3. Finance Framework

4. Business Organization

5. Goal of FM and Agency Problem

6. Financial Markets

42 / 60
 Goal of FM and Agency Problem

Possible Goals of Financial Management

What should be the goal of a corporation?

I Maximize sales/market share?

I Lowering price or relaxing credit terms

I Minimize costs?
I lowering quality or R&D

I Maximize profits?
I Does not recognize time frame: short-term nature
I Does not consider risks
I Definition of profits, accounting or economic

43 / 60
 Goal of FM and Agency Problem

Goals of Financial Management

I The primary goal is shareholder wealth maximization, which is the

same as maximizing stock price

I Thus the goal of the firm is to maximize its value

I Maximize the value of the firm
I Maximize the wealth of its owners
I Maximize the price of its stock
I Maximize its contribution to the economy

44 / 60
 Goal of FM and Agency Problem

How Can Managers Maximize Stock Price

I What determines stock prices - the underlying firm’s ability to generate

cash flow

I Three aspects of cash flows that affect asset value and thus stock prices
I Amount of cash flow
I Timing of cash flow stream
I Riskiness of cash flow stream

I All three determine the stock’s Intrinsic Value

45 / 60
 Goal of FM and Agency Problem

Agency Relationships

I Agency relationship:
I Principal hires an agent to
represent their interest
I Example 1: Stockholders
(principals) hire managers
(agents) via the board of
directors to run the company
I Example 2: Potential buyers
(principals) hire real estate
agent (agents) to purchase a
house

46 / 60
 Goal of FM and Agency Problem

Agency Problems
I The Possibility of conflict of interest between principal and agent

47 / 60
 Goal of FM and Agency Problem

Agency Problems in Corporations

I Shareholders and managers

I Principal → shareholders (max share value)
I Agent → managers (benefits, control, security)

I Direct agency costs:

I Expenditures that benefit management: perks, high pay, big office
I Monitoring costs: auditors, auditing committee, corporate governance

I Indirect agency costs

I Lost opportunities which would increase firm value in the long run, if
accepted.

48 / 60
 Goal of FM and Agency Problem

How to Handle the Agency Problem

1 Managerial Compensation plans

I Tie the fortunes of the managers to the fortunes of the firm
I Grant stock or stock options
2 Control of the firm
I Replacing existing the board/management via proxy fight
I Takeover Firms that are poorly managed are more attractive as acquisitions

I Corporate Governance

49 / 60
 Goal of FM and Agency Problem

Disney’s Former CEO’s Compensation Package

I Michael Eisner’s compensation package’s 3 main components:

1 A base annual salary of $750, 000
2 An annual bonus of 2% of Disney’s net income above a threshold of
“normal” profitability
3 A 10-year option that allowed him to purchase 2 million shares of stock
for $14 per share, which was about the price of Disney stock at the time he
was hired as the CEO.

50 / 60
 Goal of FM and Agency Problem

Quick Review MCQ

I The primary goal of financial management

A Maximize current sales
B Maximize the current value per share
C Avoid financial distress
D Minimize operational costs

I Agency costs refer to

A The total dividends paid to shareholders over the lifetime of the firm.
B The costs that result from default and bankruptcy of the firm.
C Corporate income subject to double taxation.
D The costs of the conflict of interest between stockholders and
management.

51 / 60
 Goal of FM and Agency Problem

Quick Review MCQ

I Corporate finance can be thought of as the analysis of three primary

decision areas. Which of the following lists these areas
A Capital structure, capital budgeting, security analysis
B Capial budgeting, capital structure, capital spending
C Capital budgeting, capital structure, net working capital management
D Capital structure, net working capital, capital rationing

52 / 60
 Financial Markets

Outline

1. Course Overview

2. Basics

3. Finance Framework

4. Business Organization

5. Goal of FM and Agency Problem

6. Financial Markets

53 / 60
 Financial Markets

Imporance of Cash Flows

I If the firm is to prosper, it must:

I Buy assets that generate more cash than they cost
I Sell financial instruments that raise more cash than they cost

I The successful firm generates more cash than it uses

54 / 60
 Financial Markets

Cash Flows to and from the Firm

55 / 60
 Financial Markets

Financial Markets

I What are financial markets?

I Markets where financial instruments are traded
I Act as intermediaries between savers and borrowers

I Primary markets vs secondary markets

I Money markets vs capital markets

56 / 60
 Financial Markets

Financial Markets

I Primary market: original sale

I Government and corporations initially issued securities
I Example: Corporate X raise $10M by selling 5000 shares in the Hong
Kong Stock Exchange

I Secondary market: transfer of ownership

I where existing financial claims are traded
I Example: Corporate Y buys $10M worth of stocks of Corporate X at the
open market

57 / 60
 Financial Markets

Financial Markets

I Money markets
I where debt securities of one year maturity or less are traded: treasury
securities, commercial paper, bills, interbank loans
I loosely connected dealer markets
I FIs are major players

I Capital markets
I where equity and long-term debt claims are traded
I usually auction markets like the Hong Kong Stock Exchange

58 / 60
 Financial Markets

Summary

I The scope of financial studies involves corporate finance, financial

markets and investments

I Business finance involves firm’s

I capital budgeting decision
I capital structure decision
I working capital management

I The goal of financial management is to make decisions that maximize the

market value of the equity or owners’ wealth

I There are conflicts of interest between shareholders and managers -

agency problem

59 / 60
 Financial Markets

Useful Website

Wall Street Journal www.wsj.com

Yahoo Finance https://finance.yahoo.com/
Financial Times www.ft.com/
The Banker www.thebanker.com
Federal Reserve www.federalreserve.gov
FDIC www.fdic.gov
OCC www.occ.treas.gov
SEC www.sec.gov
SIPC www.sipc.org
Thompson Fin. Sec. Data www.tfibcm.com

60 / 60