Lecture Notes for

Advanced Financial Management

Firms and Financial Markets

Teaching staff: Marco Eugster, Helen Lu & Karis Wang

Topic 1 Introduction Notes 1.2

The University of Auckland

1
Contents

1 Prepare for the Live Session 4

2 A Few Facts about Firms 5

1. Three Basic Types of Firms . . . . . . . . . . . . . . . . .
. 5
2. TaxOwnership
Implications of the
Versus ChoiceofofFirms
Control Business
. . .Organisation
. . . . . . . . . .. .. .
6 2.3.1
2.3 Ownership /= Control . . . . . . . . . . . . . . . . . 10
2. Separation of Ownership and Control in Large Companies 10
11
2.4 The3.Goal of
Agency Problem
the Firm . . . between
. . . . . Shareholders
. . . . . . . and
. . .Managers
. . . .
12
2.5 The Financial Manager . . . . . . . . . . . . . . . . . . . .
13
3 Effi cient Markets and Value Creati on 16
17
2 FINANCE 351 Lecture Notes – University of Auckland
 Contents (cont.)

3.1 Why Do Financial Managers Care about Market Efficiency? .

19 Competition Makes Capital Market More Efficient
2. . . . . .
. 20
3. What Makes Capital Markets Less Efficient? . . . . . . . .
. 24
4. Are Capital Markets Efficient? . . . . . . . . . . . . . . .
4 Test . your25understanding 32
5. Is CAPM the Correct Model? . . . . . . . . . . . . . . . .
. 28

3 FINANCE 351 Lecture Notes – University of Auckland

1 Prepare for the Live Session

• Activate your Piazza account:

– Drop helen.lu@auckland.ac.nz an email if you have not received a
Piazza invitation
• Watch the pre-recorded videos
• Attempt all quiz questions to collect 0.5 mark
– There are 13 pre-class quizzes in total and you can collect a
maximum of 5 marks
• Optional (before class) but required for test and exam: read
textbook
reference chapters: Ch 1 & Ch 13, Berk & DeMarzo.
• The first live session: Q&As with lecturers and tackle a mini
case!

4 FINANCE 351 Lecture Notes – University of Auckland

2 A Few Facts about Firms
1. Three Basic Types of Firms

• Sole Proprietorship (NZ: Sole Trader); main features include:

– Easy to set up: does not require any legal paperwork
– Profits taxed at your personal marginal rate (one IRD number)
– Most important downside: owner has unlimited liability for both debt
and other obligations; personal assets are at risk
• Partnership (NZ: Partnership): main features are similar to
proprietorship
except that there are more than one owner.
• Corporation (NZ: Company); main features include:
– Shareholders have limited liability
– Easy to raise capital: for large or public companies
– Ease of transfer of ownership: for public
companies
5 FINANCE 351 Lecture Notes – University of Auckland
 A Few Facts about Firms (cont.)

2. Ta x Implicati ons of the Choice of Business Organisati on

• In the U.S., a main disadvantage of corporation is double taxation; this

tax system is referred to as the classical tax system

Table 1: Double Taxation in the U.S.

Profits before taxes 100
Corporate tax at 35% 35 First tax paid by corporation
Net profits (100% paid as dividends) 65
Income tax paid by investor at 15% 9.75 Second tax paid by investor
Available to shareholder 55.25
Main features:
(1) company’s profits get taxed twice, first at the level, and then at the
level.
(2) Loss of the company cannot be used to offset individual tax liabilities.

6 FINANCE 351 Lecture Notes – University of Auckland

 A Few Facts about Firms (cont.)

• In New Zealand, running your business as a company is simple and

tax
efficient:
– In NZ, the imputation tax system effectively only taxes dividend at the
shareholder level (refer to the example in section 3.2)
– New Zealand companies (with fewer than 5 shareholders and meeting
certain other requirements) can gain additional tax benefits by electing
to be a “look through company”: tax credit from company loss can be
used to offset individual tax liabilities
– Registration of a company is fast and easy

7 FINANCE 351 Lecture Notes – University of Auckland

 A Few Facts about Firms (cont.)

Dividend Imputati on in New Zealand vs the classical tax system

in the U S
• Dividend imputation: a few countries, including Australia, New
Zealand
and Norway, offer complete relief from double taxation of dividend
income
– “As if” the company has paid tax on shareholder’s behalf
– Shareholders are not taxed twice (unlike in the classical tax system)

8 FINANCE 351 Lecture Notes – University of Auckland

 A Few Facts about Firms (cont.)

Table 2: Dividend Imputation (A Simplified Example)

* We assume dividends to be fully imputed and ignore withholding tax in the examples
above.

Question 1: Effectively which tax rate is used at the shareholder level?

Question 2: Other things equal, shareholders with marginal tax rates
benefit more from dividend imputation.

9 FINANCE 351 Lecture Notes – University of Auckland

 A Few Facts about Firms (cont.)

3. Ownership Versus Control of Firms

1. Ownership /= Control

• Sole Trader: owner is the manager and has full control

• Partnership: owners/partners jointly control the firm
• Company:
– As the number of owners increases, it becomes infeasible for owners
to directly control the firm
– In large companies with many owners, direct control and ownership
are often separate
◦ The board of directors and chief executive officer
(CEO) directly control the firm

10 FINANCE 351 Lecture Notes – University of Auckland

 A Few Facts about Firms (cont.)

2. Separati on of Ownership and Control in Large Companies

• The board of directors:

– A group of people with ultimate decision-making authority in the
com- pany
– Elected by shareholders, represents shareholders and accountable to
shareholders
◦ In theory, shareholders can pressure the board to change a poor-
performing CEO
◦ In reality, they tend to “vote with their feet” – that is, sell their
shares
– Sets important rules and policies (the stick) and remuneration
(the
carrot) for executives
– Monitors the firm’s performance of the company
• CEO: runs the company
• Chief Financial Officer (CFO): directly reports
11 to Lecture
FINANCE 351 the CEONotes – University of Auckland
 A Few Facts about Firms (cont.)

3. Agency Problem between Shareholders and Managers

Shareholders (the principal) hire managers (the agent) to run the company.
Their goals are not always the same:
• Owners: maximising their wealth, or the value of their shares
• Managers: are hired to maximise the equity value of a company; in reality,
when there is a conflict of interests, managers may put their self-interest
first. This is one type of agency problem that reduces the value of the
firm.
Agency problems can be mitigated at a cost through:
• Hiring an auditor and forming compensation and audit committees on the
board to monitor the CEO: not always effective (Enron;companies with
entrenched CEOs)
• Provide incentive packages tied to performance: potential problems of
excessive risk taking.
12 FINANCE 351 Lecture Notes – University of Auckland
 A Few Facts about Firms (cont.)

2.4 T h e Goal of the Firm

The “Shareholders vs Stakeholders” debate: should firms focus on maximising

shareholder value (or, share prices for public companies) or serve a wider
society?
• The shareholder capitalism
– Firms should focus on maximising the shareholder value
– Shareholders can use their wealth to “do good” most
efficiently
– The market efficiently allocates all resources

13 FINANCE 351 Lecture Notes – University of Auckland

 A Few Facts about Firms (cont.)

• The stakeholder capitalism

– Stakeholders include employees, customers, suppliers, communities, en-
vironment, etc., in addition to shareholders
– Firms should maximise the long-term stakeholder value, even when
doing so harms firms’ short-term profits; as a result, the long-term
value for both shareholders and other stakeholders increases
– Firms can “do good” more efficiently than shareholders by themselves,
because
◦ Laws and regulations are imperfect
◦ Markets do not always allocate resources efficiently

14 FINANCE 351 Lecture Notes – University of Auckland

 A Few Facts about Firms (cont.)

The main implementation challenge of stakeholder capitalism: how do we hold

managers accountable?
A few possible steps but neither is easy to
do:
• Require comprehensive company reporting in the social and
environmental
dimensions
• Introduce a new performance matrix to reflex multiple
• goals
Redesign the CEO’s compensation package to link it to the firm’s social
and environmental performance

15 FINANCE 351 Lecture Notes – University of Auckland

 A Few Facts about Firms (cont.)

2.5 T h e Financial Manager

W h o are the fi nancial managers?

• Corporate finance advisors: investment bankers and advisors in accounting
firms
• Their clients include firms raising capital or buying and selling assets:
fin-
ancial managers in these firms include CFOs, Treasurers and Controllers.
• Financial managers have two questions on their mind:
– What assets should the company invest in? (Capital budgeting
de- cisions)
◦ Not only financial managers, other chief executives, engineers and
marketing managers are all involved in making investment
decisions.
– How should the cash for investment be raised? (Financing decisions)

16 FINANCE 351 Lecture Notes – University of Auckland

3 Efficient Markets and Value Creation

Assume that everyone has the same informati on and that

arbitrage is costless.
In effi cient capital markets,
• All securities are fairly price: price = NPV; there is no positive-NPV
trading opportunity
• It implies that securities with equivalent risk should have the same
expected return.
• Arbitrage eliminates mispricing! Buy cheap securities and sell
expensive securities to push prices back to their fair levels.

17 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

In effi cient goods markets,

• A product or service is sold for the same price in all places.
Arbitrage:
consumers buy cheaper products.
– A BigMac in US ($5) and in China ($3), using exchange rate in
Jan 2022. Can you arbitrage?
• All investment projects have zero NPVs.
– iPhone is an NPV-positive project. Arbitrage: can other companies
copy iPhone exactly?

18 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

3.1 W hy D o Financial Managers Care about Market Effi ciency?

• Opportunities of positive NPV investment projects come by often,

because
goods market are inefficient
– Sources of positive NPV: advantages which cannot be copied
easily
◦ First-mover advantage and network effect (Amazon)
◦ Unique products and patent protection (Apple)
Absolute costpolicy
◦ Government advantages (an attractive
or regulatory mining
protection project) manufac-
(automotive
turers in China)
• Opportunities of positive NPV financing decisions are less common
but
still significant
– If capital markets are efficient all the time, financial managers
cannot create value by clever financing decisions

19 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

2. Competi ti on Makes Capital Market More Effi cient

If the market is efficient, it should be impossible to consistently make

positive
abnormal returns, or returns over and above the reward for bearing risk.
• Abnormal return = actual return - normal return
• Normal return is the expected return that rewards investors for bearing
risk
• Capital Asset Pricing Model ( C A P M ) is one of many asset pricing
models
– they defines what normal return should be.
E [R s] = r f + βs × (E [R M kt ] − r f )

20 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

Competition to “beat the market” eliminates positive-NPV trading opportun-

ities and makes the market more efficient.
• Savvy investors try to earn “positive alphas” / “beat the market” /
identify positive-NPV trading opportunities
• A positive-alpha investment opportunity is expected to generate a return
higher than the normal return

αs = E xpected Returns − E [R s]
• Profiting from non-zero alpha stocks makes the market more efficient
(see
the example on next page)
– Question: how do you profit from a positive alpha trading
opportunity?
– Question: how do you profit from a negative alpha trading
opportunity?

21 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

Figure 1: Profiting from non-zero alpha investment opportunities

Corporate Finance, 4th Edition by Jonathan Berk and Peter DeMarzo.

22 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

Example 1. Profi t from non-zero alpha trading opportuniti es.

Assume that the CAPM is the correct asset pricing model. The market expec-
ted return is 7% with 10% volatility and the risk-free rate is 3%. News arrives
and it changes only the expected return of the following stocks:
Expected return Volatility Beta
Green Leef 12% 20% 1.5
Nat Sam 10% 40% 1.8
a. At current market prices, which stock represents buying opportunities?
b. On which stock should you put a sell order in?
c.How will the transactions affect the price, expected return and alpha of
these stocks?
(answer: Green Leef, normal return = 9%, α = 3%, buy, price increases,
expected return drops and α decreases to 0; NatSam 10.2% and -0.2%, sell,
price drops, expected return increases and α increases to 0).

23 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

3.3 W hat Makes Capital Markets Less Effi cient?

(1) Limits to arbitrage: constraints that make it costly for investors to profit
from non-zero alpha investment opportunities.
• Transaction costs
• Short-sale constraints
• Regulatory constraints

(2) Information frictions

• Home bias
• Gradual information diffusion and bounded rationality (Herbert Simon,
Nobel Prize 1978)

24 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

4. Are Capital Markets Effi cient?

• Can we trade on takeover (merger) news and “beat the market”?

– Scenario one: you know this information from work and buy the
stock of the target company before the news is announced to public.
The trade will be profitable but ILLEGAL!
– Scenario two: you buy the stock of the target company after the
news is announced. The trade is not necessarily profitable. (Bradley et
al., 1983)
• Can we trade on stock recommendations and “beat the market”? Not really
(Engelberg et al., 2011)
• Can fund managers consistently “beat the market” (or,
consistently generate positive alphas)? Not really. Warren Buffett?

25 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

Figure 2: Do mutual funds add any value? U.S. Mutual Funds Alphas (1975-2002)

After paying for fund managers salaries, bonus, expenses to buy computers and data, the avg. alphas are negative across all
investment styles!

26 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

Figure 3: Luck or skill?

It looks more like luck than skills.

27 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

5. Is C A P M the Correct Model?

In every case, a test for market effi ciency is a joint test

for market effi ciency and asset pricing model
• Recall: Abnormal return = actual return - normal return
• We need an asset pricing model to estimate expected return or
normal
return
• A significant and non-zero abnormal return can suggest two things:
.

28 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

Is C A P M missing some risk factors?

• Various positive-alpha trading strategies identified over past half century
have persisted:
– Small companies on average earned an abnormal monthly return of
more than 1%
– Value companies (companies with high book-to-market ratios) on av-
erage earned an abnormal monthly return of more than 1%
– If these abnormal profits are “risk free”, why haven’t market
competition driven prices back to normal?
– Perhaps these strategies entail systematic risks not identified by the
CAPM
– So far we assume that the CAPM the the correct model to measure
risk. What if this is not true? (More to be covered in Topic 3 Discount
Rate)

29 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

Figure 4: Excess return of size portfolios (1926 - 2011)

30 FINANCE 351 Lecture Notes – University of Auckland

 Effi cient Markets and Value Creati on (cont.)

Figure 5: Excess return of Book-to-market portfolios (1926 - 2011)

31 FINANCE 351 Lecture Notes – University of Auckland

4 Test your understanding

• How do returns from receiving a dividend differ between the classical tax
system and the dividend imputation system? (Consider the case that Spark
pays out $1 to NZ investors and to US investors)
• As a retail investor worried about global warming, should you buy shares
of oil and gas exploration and production companies?
• Given the evidence of abnormal returns to value stocks, should we use
CAPM to estimate cost of capital?

32 FINANCE 351 Lecture Notes – University of Auckland