Lecture 1: Introduction:

Corporation and Financial Market

Corporate Finance
Outline
• Introduction
– The four types of firms
– Ownership versus control of corporations
– The stock market
– Fintech: Finance and Technology
• Revision of basic finance knowledge
– Require completion of prerequisites
– Assumption of the basic knowledge

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The Four Types of Firms

• Sole Proprietorship

• Partnership

• Limited Liability Company

• Corporation

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The Four Types of Firms (cont'd)

• Sole Proprietorship
– Business is owned and run by one person.
– Typically has few, if any, employees.
– Advantages
• Easy to create
– Disadvantages
• No separation between the firm and the owner
• Unlimited personal liability
• Limited life

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The Four Types of Firms (cont'd)
• Partnership
– Similar to a sole proprietorship, but with more
than one owner
– All partners are personally liable for all of the
firm’s debts. A lender can require any partner
to repay all of the firm’s outstanding debts.
– The partnership ends with the death or
withdrawal of any single partner.

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The Four Types of Firms (cont'd)
• Partnership
– Limited Partnership has two types of owners.
• General Partners
– Have the same rights and liability as partners in a
“regular” partnership
– Typically run the firm on a day-to-day basis
• Limited Partners
– Have limited liability and cannot lose more than their
initial investment
– Have no management authority and cannot legally be
involved in the managerial decision making for the
business

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The Four Types of Firms (cont'd)

• Limited Liability Companies (LLC)

– All owners have limited liability, but they can
also run the business.

– Relatively new business form in the United

States.

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The Four Types of Firms (cont'd)
• Corporation
– A legal entity separate from its owners
• Has many of the legal power individuals have --
such as the ability to enter into contracts, own
assets, and borrow money

• The corporation is solely responsible for its own

obligations. Its owners are not liable for any
obligation the corporation enters into.

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Figure: Types of U.S. Firms

Source: www.irs.gov
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 The Four Types of Firms (cont'd)
• Corporation
– Formation
• Corporations must be legally formed. The
corporation files a charter with the state it wishes to
incorporate in. The state then “charters” the
corporation, formally giving its consent to the
incorporation.

• Due to its attractive legal environment for

corporations, Delaware is a popular choice for
incorporation in US.

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The Four Types of Firms (cont'd)
• Corporation
– Ownership
• Represented by shares of stock
• Owner of stock is called
– Shareholder
– Stockholder
– Equity Holder
• Sum of all ownership value is called equity.
• There is no limit to the number of shareholders
and, thus, the amount of funds a company can
raise by selling stock.
• Owner is entitled to dividend payments.
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Corporate Structure – Separation of
Ownership and Control

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A Typical Organizational Structure

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What is Corporate Finance?
Every decision that a business makes has financial
implications, and any decision which affects the
finance of a business is a corporate finance
decision.
e.g. Investment decision – which project to invest in
Financing decision – how to finance the projects we
selected (debt vs. equity)
Payout policy – how much of our profit should be
distributed to our investors
These are the main corporate finance decisions

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Key Questions in Corporate Finance
How to finance?
Financing decision

What to invest? How to payback?

Capital budgeting Payout policy

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Objective of Corporate Finance
For all the decisions a company makes, the
ultimate goal is to maximise the value of the
company (business).

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 Objective of Corporate Finance
• The Firm and Society
– Often, a corporation’s decisions that increase
the value of the firm’s equity benefit society as
a whole.
– As long as nobody else is made worse off by a
corporation’s decisions, increasing the value
of the firm’s equity is good for society.
– It becomes a problem when increasing the
value of the firm’s equity comes at the
expense of others.
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Incentives Within Corporations

• Agency problems
– Managers may act in their own interest rather than in
the best interest of the shareholders.
– One potential solution is to tie management’s
compensation to firm performance.

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Incentives Within Corporations
• Discipline the managers/CEOs
– Wall street walk and vote with one’s feet
• If a CEOis performing poorly, shareholders can express their
dissatisfaction by selling their shares, which drives the stock
price down.
– hostile takeover and the market of corporate control
• Low stock prices may entice a corporate raider to buy
enough stock so they have enough control to replace current
management. The stock price will rise after the new
management team “fixes” the company.
– corporate bankruptcy
• Reorganization
• Liquidation

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The Stock Market

• The stock market provides liquidity to

shareholders.
– Liquidity -- the ability to easily sell an asset without
(too much) loss
• Public company
– Stock is traded by the public on a stock exchange.
• Private company
– Stock may be traded privately.

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Layers of Stock Markets

• Primary Markets
– When a corporation itself issues new shares of stock
and sells them to investors, they do so on the primary
market.
• Secondary Markets
– After the initial transaction in the primary market, the
shares continue to trade in a secondary market
between investors.

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Traditional Trading Venues

• New York Stock Exchange (N Y S E)

– Market Makers/Specialists
• Each stock has only one market maker.
• NASDAQ
– Does not meet in a physical location
– May have many market makers for a single stock
• Bid Price Versus Ask Price
– Bid-Ask Spread as part of the transaction cost

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Figure: Exchanges Around the World

Source: www.world-exchanges.org
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New Market Changes

• In 2005, the N Y S E and N A S D A Q exchanges

accounted for over 75% of all trade in U.S.
stocks.
• Today, due to increased competition from new
fully electronic exchanges and alternative
trading systems, handle more than 50% of all
trades.

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Fintech: Finance and Technology
• Blockchain
– Record a transaction in a publicly verifiable way
without the need for a trusted third party to certify the
authenticity of the transaction
• Cryptocurrency
– A currency whose creation and ownership is
determined via a public blockchain
• Robo-Advisors
– Computer programs that are intended to replace the
work of financial advisors by providing detailed and
customized investment recommendations
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Big Data and Machine Learning
• Financial organizations have long recognized the
importance of collecting data and using it in decision
making.

• The availability of data has enabled companies

throughout the economy to better target their products to
consumers, and financial services companies are no
exception.

• Technological advances have opened the way for non-

finance organizations to provide financial services.

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Course Structure
Topic Week
Introduction 1
Investment decision 2,3,5
Financing decision 4,6,7,8
Payout decision 9
Advanced topics 10,11,12
Review 12
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Revision of basic finance knowledge

1 Investment Decision

2 Financing Decision

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Investment Decisions
ANU new dorms
“Unfortunately, the demand for accommodation on campus
is more than we are able to provide -- we estimate that
more than 1,500 students who wanted to live on campus in
2016 were not able to be accommodated.”
“We have undertaken consultations around the University
and particularly in the residential colleges. Students have
told us what is important to them, and we are exploring
outside interest with these concerns front of mind.”

http://www.anu.edu.au/news/all-news/update-from-the-vc-student-accommodation
March 10, 2016, VC blog

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Investment Decisions
• If the benefit from the ANU dorm investment is
greater than the costs, the investor should proceed
with the investment.
• How to determine whether to proceed?
1. Calculate the costs of the investment
2. Quantify the expected benefits of the
investment
– Might be difficult to estimate the benefit since an
accommodation building has an extremely long life
• Next, time value of money…

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 Time Value of Money
• Is $100 today worth $100 in 10 years?
– Would you prefer $100 today or $100
in 10 years? The answer is obvious
– Loss of purchasing power due to
inflation
– Simply put, if we receive $100 today
we could invest it and earn interest
over the ten years.
– Money received later should be
discounted to calculate its present
value to reflect this loss of interest
“A bird in hand is worth
two in bush!!”
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Present value(PV) vs. Future value(FV)
• Present value: the value of something today
discounting

• Future value: the value of something in the

future
compounding

• Perpetual cash flow follows

𝐶𝐹!
𝑃𝑉 =
𝑟
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Discount Rates
• What do we notice?
– Inverse relation between price and the
discount rate (required rate of return)
– Assets of different risk structures yield
different discount rate

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Risk-return Trade-off
• Risk-return trade-off: There is a reward for
bearing risk. The greater the potential risk, the
greater the return.
– Risk aversion: assumes investors dislike risk
and require higher rates of return to encourage
them to hold riskier assets
This is the assumption for most finance theories
– Risk premium: the “extra” return earned for
taking on risk, i.e. the return over and above the
risk-free rate

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Discounted Cash Flow (DCF)
• In finance, discounted cash flow (DCF)
analysis is a method of valuing a project,
company, or asset using the concepts of
the time value of money.
!"! !"" !"#
• DCF = + + ⋯+
#$% (#$%)" (#$%)#

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Net Present Value (NPV) Decision Rule
1. Estimate the expected future cash flow
2. Estimate the required rate of return for projects of similar
risk level
3. Add up the present values of all future cash flows and
subtract the initial investment
𝐶𝐹! 𝐶𝐹" 𝐶𝐹#
NPV = + "
+ ⋯+ #
− 𝐶𝐹$
1 + 𝑟 (1 + 𝑟) (1 + 𝑟)
#
𝐶𝐹%
𝑁𝑃𝑉 = ( % − 𝐶𝐹$
(1 + 𝑟)
%&!
NPV Rule: Accept the project if NPV>0
Reject the project if NPV<0
Indifferent if NPV=0
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• Revision of basic finance knowledge

1 Investment Decision

2 Financing Decision

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Financing Decision
• Questions related to financing decision:
– How do we raise the funds? Debt vs. equity?
• If using debt, bank loan vs. corporate bond?
• Long-term debt vs. short-term debt?
• Secured vs. unsecured?
• If using equity, timing of issuing equity?
• Private vs. public equity?
– How much do we want to raise?
– Cost of raising the fund?
– When do we raise the fund?
• These are the questions to be answered in this
course
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Equity Valuation
• Example:
– Commonwealth Bank will pay a dividend of
$1.98 next year. Its equity cost of capital is
8%. Assuming dividends are expected to
grow by 4% per year in the future.

• Estimate the value of CBA stock.

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Equity Valuation (cont’d)
• Solution:
• Dividend Discount Model (Gordon Growth
Model)
2! #.67
• P= = = 49.5
%34 8.8738.89

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 Bond Valuation
• If you buy a bond, the issuer (i.e. the borrower)
promises to pay you back (i) the “par value” (assume
$1000) on a particular day – the “maturity date” – and
(ii) periodic “coupons” at a predetermined rate of
interest.
• As a creditor/lender, your cash flows to be received will
be the par value and the periodic coupon payments.
• Yield to maturity (YTM): (i) the rate earned if a bond is
held to maturity; (ii) the rate which discounts all future
bond cash flows

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 Bond Valuation (cont’d)
• Recall that when calculating the value of a
financial instrument, you need to consider all the
cash flows associated with the instrument.
• Thus, bond value = PV of coupons + PV of par
C C C FV
P= + + ... + +
(1 + i) (1 + i) 2
(1 + i) (1 + i) n
n

æ n C ö FV
= çç å ÷+
n ÷
è t =1 (1 + i ) ø (1 + i ) n

Further simplify Cé 1 ù FV
= ê1 - +
i ë (1 + i) n úû (1 + i ) n
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Example: Bond Valuation
• A bond with a par value of $1000, annual coupon
payment of $100 will mature in 10 years. The
appropriate discount rate for this bond is 13%

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Next Week
• Investment decision rules
– Net Present Value (NPV)
– Internal Rate of Return (IRR)
– The Payback Period

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