2. 1-2
Learning objectives
Explain the role of finance and the different types of jobs in
finance
Identify the advantages and disadvantages of different forms
of business organization
Explain the link between stock price, intrinsic value, and
executive compensation
Discuss the importance of business ethics and the
consequences of unethical behaviour
Identify the potential conflicts that arise within the firm
between stockholders and managers and between
stockholders and bondholders, and discuss the techniques
that firms can use to mitigate these potential conflicts
3. 1-3
Topic content
1.1 What is finance?
1.2 Why study finance?
1.3 Forms of Businesses
1.4 Goals of the Corporation
1.5 Agency Relationships
1.6 Three Critical Factors in Finance
4. 1-4
1.1 What is finance?
Finance grew out of economics and accounting.
Economists developed the notion that an asset’s value is
based on the future cash flows the asset will provide,
Accountants provided information regarding the likely size
of those cash flows.
Finance people need knowledge of those two fields.
There are three areas in finance:
Financial management (also called corporate finance)
Investment
Capital markets
5. 1-5
Three areas in Finance
Financial management
How much and what types of asset to acquire?
How to raise capital needed to purchase assets?
How to run the firm to maximize its value
Investments
Security analysis deals with finding proper values of individual asset.
Portfolio theory deals with the best way to structure portfolio.
Market analysis deals with the issue of whether stock and bond markets
at any given time are “too high,” “too low,” or “about right.”
Capital markets – study of
Financial instruments such as stocks and bonds
Financial institutions that supply capital to business.
Government organizations who are the main players in the market.
7. 1-7
Real assets vs. Financial
assets
Real assets are goods (generally tangible) that are used to
produce other goods or services: buildings, machines, land,
knowledge.
Productivity of economy determined by real assets.
Financial assets are claims to income generated by real assets.
Firms use the money raised through financial assets to invest in
plants, equipment, labour, etc. Holder of financial asset
receives a portion of the resulting returns from real assets.
While real assets determine wealth, financial assets determine
distribution of wealth.
9. 1-9
Responsibility of the
Financial Staff
Maximize stock value by:
Forecasting and planning
Investment and financing decisions
Coordination and control
Transactions in the financial markets
Managing risk
Important details presented in page 11, page 12
10. 1-10
Financial Management Decisions
Investing decisions: How much should we
invest and what assets should we invest in?
Financing decisions: How much the cash
required for the operation of the firm be
raised? – debt financing vs. equity financing
Dividend policy: How to pay to shareholders
11. 1-11
Examples of corporate
financial decisions
Investing decision: company replaces old
machines with new ones.
Financing decision: company decided to
borrow $3million from a bank to finance its
expansion project.
Dividend policies: company decided to pay
40% of its earnings as cash dividend to its
shareholders.
12. 1-12
Recap of financial decisions
Financial
decisions
Investing
Capital
budgeting
Working capital
management
Financing
Cost of capital
Capital
structure
Dividend
13. 1-13
1.2 Jobs in Finance
Commercial banking and investment banking
Corporate finance
Trading and dealing
Consulting
Financial risk management
Financial analysis
Fund management
...
14. 1-14
Financial Management Issues of the
New Millennium
The effect of changing
technology
The globalization of
business
Corporate governance
Business Ethics
15. 1-15
Percentage of Revenue and Net Income from
Overseas Operations for 10 Well-Known
Corporations, 2001
Company % of Revenue
from overseas
% of Net Income
from overseas
Coca-Cola 60.8 35.9
Exxon Mobil 69.4 60.2
General Electric 32.6 25.2
General Motors 26.1 60.6
IBM 57.9 48.4
JP Morgan Chase & Co. 35.5 51.7
McDonald’s 63.1 61.7
Merck 18.3 58.1
3M 52.9 47.0
Sears, Roebuck 10.5 7.8
16. 1-16
1.3 Forms of Business
Organization
Sole proprietorship
Partnership
Corporation
Limited liability company (LLC)
18. 1-18
Sole proprietorships &
Partnerships
Advantages
Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages
Difficult to raise capital
Unlimited liability
Limited life
20. 1-20
Corporation (cont’d)
Advantages
Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Disadvantages
Double taxation
Cost of set-up and report filing
21. 1-21
Example of double taxation
Assume earnings before tax (EBT) = VND 100b
Corporate income tax rate (CIT) = 20%, amount of tax =
20%* 100b = VND 20b
After tax income (NI) = 100b- 20b = VND 80b.
Assume the company distributes all VND 80b as cash
dividend to shareholders.
Assume marginal personal tax rate of all shareholders is
25%. Thus, shareholders will be taxed again. Note that
shareholders have already paid CIT.
Tax on dividend income = 25% * 80b = VND 20b
Total tax = 20b + 20b = VND 40b (or 40%)
23. 1-23
Limited liability company
- Hybrid between a partnership and a corporation
- Limited liability
- Taxed at personal income tax rates
- Investors in LLC have voting right
24. 1-24
1.4 Financial Goals of the Corporation
All business financial decisions should be made in the text of
the overriding goal of financial management: to maximise the
wealth of the owners, the shareholders
The shareholders have invested in the corporation, putting
their money at risk, and the financial manager acts as their
agent, or as caretaker of their money, making decisions in
their interests and on their behalf
Since the wealth of shareholders is related to the value of
their shares, and since the value of each share is, by definition,
a specified proportion of the total value of the corporation
Maximisation of
shareholder’s
wealth
Maximisation of
the value of the
corporation
=
25. 1-25
Is stock price maximization the
same as profit maximization?
No, despite a generally high correlation amongst stock price,
EPS, and cash flow.
Current stock price relies upon current earnings, as well as future
earnings and cash flow.
Some actions may cause an increase in earnings yet cause the
stock price to decrease (and vice versa).
26. 1-26
1.5 Agency relationships
An agency relationship exists whenever a principal
hires an agent to act on their behalf.
Within a corporation, agency relationships exist
between:
Shareholders and managers
Shareholders and creditors
27. 1-27
Shareholders versus
Managers
Managers are naturally inclined to act in their own
best interests.
But the following factors affect managerial behavior:
Managerial compensation plans
Direct intervention by shareholders
The threat of firing
The threat of takeover
28. 1-28
Shareholders versus
Creditors
Shareholders (through managers) could take actions
to maximize stock price that are detrimental to
creditors.
In the long run, such actions will raise the cost of debt
and ultimately lower stock price.
29. 1-29
1.6 Factors that affect stock price
Projected cash flows
to shareholders
Timing of the cash
flow stream
Riskiness of the cash
flows
30. 1-30
Factors that Affect the Level and
Riskiness of Cash Flows
Decisions made by financial managers:
Investment decisions
Financing decisions (the relative use of debt financing)
Dividend policy decisions
The external environment
Economic conditions
Political climate
Taxes
...
31. 1-31
Basic Valuation Model
To estimate an asset’s value, one estimates the cash
flow for each period t (CFt), the life of the asset (n), and
the appropriate discount rate (k)
Throughout the course, we discuss how to estimate the
inputs and how financial management is used to
improve them and thus maximize a firm’s value.
n
1
t
t
t
n
n
2
2
1
1
.
k)
(1
CF
k)
(1
CF
k)
(1
CF
k)
(1
CF
Value
Welcome
Overview: Course Requirement
Web forum
Q & A
Finance consists of 3 interrelated areas: money and capital markets (in this course we use capital market and financial market pretty much interchangeably to represent where the firms go to raise their financing). Money market and capital markets deal with securities (debt vs equity markets) and financial institution (banks, insurance company, mutual fund, investment banking firms, etc). Students can work here and if you want a success, this course is an introductory course in finance and business finance to help you have an overall view on valuation techniques, factors causing interest rate to rise up or down, etc.
Investment: decisions made by both individual and institutional investors as they choose securities for their investment portfolio. (Investing money in a bank, in a stock market, in gold, real estate and the like) Students can work for VP Bank sec, Tien Phong Bank Sec, Bao Viet, Bien Viet, ect.
Financial Management (Biz Finance): They say Business Finance means Finance function in Business, we do not limit ourselves only in a financial institution. This is important to all types of businesses, including banks, financial institutions, manufacturing, government, travel agent, and of course individuals.
Real assets are goods (generally tangible) that are used to produce other goods or services: buildings, machines, land, knowledge. Productivity of economy determined by real assets. Financial assets are claims to income generated by real assets. Firms use the money raised through financial assets to invest in plants, equipment, labor, etc. Holder of financial asset receives a portion of the resulting returns from real assets. While real assets determine wealth, financial assets determine distribution of wealth. From
Real assets are goods (generally tangible) that are used to produce other goods or services: buildings, machines, land, knowledge. Productivity of economy determined by real assets. Financial assets are claims to income generated by real assets. Firms use the money raised through financial assets to invest in plants, equipment, labor, etc. Holder of financial asset receives a portion of the resulting returns from real assets. While real assets determine wealth, financial assets determine distribution of wealth.
Financial Manager Role: Prepare FS, Develop Strategic Financial Plan, Expenditure, Optimal Capital Structure, Secure capital financing, managing cash, control to achieve financial plan
VP: Vice – President
Sales: How to sell more products, etc, Operations: how to deliver goods and services to customers, how to manufacture a goods, etc
Board of directors: Representatives of shareholders (owners)
Treasurer: Phòng nguồn vốn
Credit (tín dụng) Inventory (kho) Capital budgeting (Longterm investment decision making) : Manage cash, marketable secs, Account receivables, etc
Cost accounting: budget and make actual cost calculation, price setting
Financial accounting: BS, IS, CF, FS to all stakeholders
Tax: control tax
Details can be found at page 14, 15
Investment Decisions: Buying gold, buying a car, buying a stock or place money into a bank, simply under ur mattress (metris)
Financing Decisions: Financing is a term used to describe the acquisition of funds by the firm to support its investment and operation. You decided to invest 100million into a project, how can you find that 100million to support that project (how you finance that project), There are two general sources of financing: debt financing (borrow fund), equity financing which is often raised by issuing the stock
WC: working capital – in this book, wc = current assets, but sometimes teachers can mean Current asset – current liability
Millennium (Mi’leniom : thousand years)
Vietel
Bkav
Vinamilk
Vingroup
Sole proprietorship: Sole mean ONE – business owned by one individual
Partnership: One or more owners
Corporation: Legal entity created by a state
Unlimited liability vs Limited liability? Discussion among students
Who is the owners of a corporation? – Shareholders
Why do shareholders put money into a corporation? – They want a return (look for a financial return): Capital gain on stock price appreciation and dividend gain. When value of a firm grow, money invested also grows, wealth of the shareholders also grows
Shareholders hire manager to run the business >>> Primary goal of manager is to maximize the wealth of stockholders through maximizing common stock value of the firm. (we have the assumption here: when the stock is traded and markets are viewed as efficient)
Arguments: 1. Firms should have social responsibilities that are at least mandated by law because of competition.
Social responsibilities: protect environment, social welfare of their employees, customers, etc.
Doing good job >> Promote image >> promote sales >> higher values, etc
2. Good to society: Efficient market
3. Ethically: Enron and WorldCom
Before going to answer your problem. I need to distinguish the difference between the stock price and profit in terms of timing difference. Stock price incorporates every facet of what investor expect to see from his investment agent i.e. future investment opportunity, any incurred business constraints, government regulations to effect company's value, etc while profit focuses on what is realized explicitly from invested money which is shown in income statement. Logically, this two stuff is different in light of pre-post rationale. Thus, stock price movement is strongly relied on market expectation on that stock. Any relevant incident either to boost up or dampen the value of company will be well-calulated and reflexed into the price. To maximize stock price, that company need to create a viable business to ensure the stability of future cash flows, any revenue enhancements and cost reductions will create value given that action will not negatively affect future cash flows. The cost reduction that won't or potentially undermine value is the reduction of project investments, innovations and risk management because those action will increase risk and lessen competitiveness. To maximize profit, the company can do it by maximizing revenue and minimized both operational cost and financial cost. Some measures to spur sales are extending the flavorable term of payment to customers (this will increase the accounts receivable), sales promotions, etc. while operational and financial cost reduction can be achieved by sophisicate capital budgeting and opimal cost of capital.
Managerial Compensation: Performance Shares, Executive Stock Options,
Shareholders can have a saying in choosing projects
Threat of firing:
