Transcript Financial Theory - Banks and Markets

An overview of Corporate Finance
by Binam Ghimire
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Learning Objectives
 Concept, Scope and Significance
 Key Decisions in Corporate Finance
 Agency problem
 Appreciate Business Ethics and social Responsibilities
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Finance: What is it?
 Finance as a resource
 Finance as a discipline
Monetary means of financing assets of an entity
Collection and allocation of resources
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Specialised areas of finance
 Personal
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Specialised areas of finance
 Public
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Specialised areas of finance
 Securities and investment
Source: London Evening Standard, 18 May 2011
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Specialised areas of finance
 Institutional
Source: The Telegraph, 29th July 2011
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Specialised areas of finance
 International Finance
Table from Bringham and Huston (2002, p. 7)
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Corporate Finance
?
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The Corporate Firm
?
?
?
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Sole Proprietorship
 Business is owned and run by one person
 Typically have few, if any, employees
 Advantages: Easy to create
 Disadvantages: Unlimited personal liability, No
separation between the firm and the owner, Limited life,
Difficult to transfer ownership
Partnership
 Similar to a sole proprietorship, but with more than
one owner
 Income is taxed at the personal level
 All partners have unlimited personal liability
 The partnership ends with the death or withdrawal of
any single partner
 General and limited partner
The Corporation
 AKA: JSC, PLC, LLC, Corporation,
The Corporation
 A legal entity
 separate from its owners
 Has many of the legal powers individuals have such as
the ability to enter into contracts, own assets, and
borrow money …
Source: www.bizstats.com
The Corporation
 Several advantages: Limited liability, ease of ownership
transfer and unlimited life. These give the corporation
an enhanced ability to raise cash, However
 Starting is more complicated than others: Articles of
associations and a set of bylaws, and one great
disadvantage is
 _ _ _ _ _ e _ _ x_ _ _ _ n
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Corporation
Partnership
Liability
Perpetuity
Taxation
Voting Rights
Liquidity/ sale of
share
Dividend
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Corporation
Partnership
Liability
No
Limited: no
General: yes
Perpetuity
Yes
No
Taxation
Double: corporate
Partnerships is not
income and dividends to taxed, partners are on
shareholders
their partnership profit
Voting Rights
One vote per share,
vote to elect director
Liquidity/ sale of
share
Yes – common stock can There is usually no
be listed in exchange
established trading
and traded
market
Dividend
Not bound legally
Some by limited
partners, general are
active in managing and
operating
Generally no retention
i.e. distribute all 18
Corporate Finance: Concept
 Corporate finance: Finance for the corporate or beyond?
 limited to management of funds?
 Sell - Cash - Value
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Corporate Finance: concept
 Corporate Finance deals with:
Determining value of a Corporate Entity
Adding Value to a Corporate Entity
The Value of X is what X is worth now at time t.
Making the best decision when that decision involves
a consideration or an opportunity cost and the cost of
consideration may be higher or lower given time t
 This is part of strategy
Corporate Finance: the concept
Strategy is how an organization
 achieves her long term objectives
 through re-configuration of her resources in response to
a changing external business environment
 to achieve competitive advantage
 in order to satisfy stakeholder’s objectives
Corporate Finance: the concept
Corporate Finance is the:
 The Reconfiguration of Resources
 The study of the external changing Business
Environment
 Definition of what stakeholder’s Financial objectives are
 Gaining of competitive advantage
The Three Key Corporate Finance
Decisions
 Investment Decisions concerned with whether to
undertake capital expenditure projects or not
 Financing Decisions concerned with the collection of
funds from appropriate sources
 Managerial Decisions concerned with dividend,
working capital and other decisions at management
level
Investment Decisions
 The Investment Decisions of a Firm are taken using the
various investment appraisal techniques which we will
study
 This techniques are tools which work well if applied
properly
 They have various decision criteria's and can be very
effective if used by the right kind of managers
 While they can cause a loss of corporate value if used
wrongly
Investment Decisions
 The process of making and managing expenditures on
long-lived assets: Capital budgeting/ Investment
appraisal
Financing Decision
 The Financing Decision if informed by the Target Capital
Structure desired by the firm
 The cost of capital the firm has to bear
 The sources of finance available to her
Financing Decision
 The sources of finance available can be current and long
term
 Long term debt and equity falls in capital structure
 Cost of capital explains about the cost associated with
such components of debt and equity capital
Managerial Decisions
 How large should the firm grow?
 How Much Dividend Should be Paid and How Much
profit should be retained for growth?
 How fast should this growth be?
 How should the firm manage its receivables and
payables? e.g. Should the firm grant credit to a
customer?
The Role of The Financial Manager
Organisational Chart of a Typical
Corporation
(2)
Firm's
operations
Real assets
(1)
Financial
Manager
(3)
Investors
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5
Financial Manager’s Roles
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Goals of a firm
 Profit Maximisation vs. Wealth Maximisation
Accounting concept
Zero dividend
Time value of benefits
Quality of benefits
Modern business environment
Who are the shareholders?
Conflict of interest among stakeholders of a firm
The Three Different Views of the Firm
 The Investment Vehicle Model of the Firm
 The Accounting Model of the Firm
 Set of Contracts Model of the Firm
The Investment Vehicle Model of the
Firm
The Firm
The
World
Investment
Decisions
Exchange of
Money and
Real Assets
Three Main Areas
of Finance:
Financial
Markets
Exchange of
Money and
Financial Assets
Investors
Financing
Decisions
Financial
Intermediaries
Corporate Financial
Management
Financial Markets
and Intermediaries
Investments
The Accounting Model of the Firm
The Investment Decision
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventory
The Financing Decision
Current Liabilities
Accounts Payable
Current Debt
Net Working
CapitalLiabilities
=CA - CL
Long-Term
Long-Term Bank Debt
Bonds
Total Fixed Assets
Tangible Fixed Assets
Intangible Fixed Assets
Shareholder’s Equity
Common Stock
Retained Earnings
Set of Contracts Model of the Firm
Bondholders
Banks
Customers
Employees
Governments
Environment
Firm
Common
Stockholders
Preferred
Stockholders
Communities
Society
Creditors
Suppliers
Managers
Managers and Owners
 The Wall Street Journal Survey of CEO Compensation
 http://www.businessinsider.com/25-most-overpaid-ceos2010-10#18-news-corp-rupert-murdoch-8
Agency Problem: Responsibility for the
financial manager
 Agency Theory
Michael C. Jensen and William H. Meckling
propounded this theory in 1976
 Principal and Agent
 Management and Shareholders, Creditors and
shareholders
Agency Problem: Responsibility for the
financial manager
 Manager owns less than 100% of the company
 Agency Problem
 Agency Cost (Monitoring, Structuring and opportunity
costs)
Agency Problem
Owners of Corporations
cannot manage them
Personally
They have to employ
Directors to Manage their
Businesses on their Behalf
These Directors May not
carry out the
management to the
standard expected of
them
Because of Breakdown of
Trust, Shareholders have
to employ Auditors to
Vouch the Stewardship
Report of Directors
Shareholders have to pay
the Directors and these is
part of Agency Cost
They may do it but to
their own advantage or at
a higher cost
All theses add up and the
management of the Agent
Principal Relationship with
its attendant cost to the
Principals is the Agency
Cost
Agency Problem/cost: How to reduce?
 Managerial compensation plan (e.g. performance stock)
 Direct Intervention by shareholders
 Threat of firing
 Threat of takeover (e.g. hostile takeover, M&A)
Stakeholder Theory
Who are
these
Stakeholder? Stakeholders
identification Models
To what Extent Should Companies
take them into consideration?
Stakeholders Mapping
A Stakeholder is someone who
can affect or be affected by
the operations of an
organization as it seeks to
meet its corporate objectives
What if what is good for one
stakeholder is Bad for Another?
Satisficing
What if What is good for
stakeholders is viewed as unethical?
Moral Frameworks and Guidelines
Business Ethics
 Ethics: The study of right and wrong “in action”
 Making a business decision can involve ethical dilemmas
An Ethical Dilemma?
 Choice to be made
 Implicates competing values, rights, & goals
 Potential harm to decision maker?
 Potential harm to others?
 “Ripple effect:” long-term, far reaching implications
of decision to be made.
How to Resolve Ethical Dilemmas in
Business
 Identify relevant facts
 Identify relevant issue(s)
 Identify primary stakeholders
 Identify possible solutions
 Evaluate each possible solution
 Compare and assess consequences
 Decide on solution
 Take action
Additional Approaches to Ethical
Decision Making
 Five Question Approach (Tucker)
 Moral Standards Approach (Velasquez)
 Pastin’s Approach
Practical Approaches to Ethics
 Five Question Approach (Tucker)
 Evaluate each alternative on:
Profitability (shareholders)
Legality (society at large)
Fairness
Impact on the rights of stakeholders
Impact on sustainable development (environment)
Practical Approaches to Ethics
 Tuckers Five Questions
Is it profitable?
Is it fair?
Is it legal?
Is it right?
Is it sustainable?
Practical Approaches to Ethics
 Moral Standards Approach (Velasquez)
 Is the decision:
Of net benefit to society
Fair to all stakeholders (fair distribution of benefits
and burdens)
Consistent with each person’s rights
Practical Approaches to Ethics
 Pastin’s approach (Pastin)
Ground rule ethics (organization/individual rules and
values)
End-point ethics (greatest net good for all concerned)
Rule ethics (determine ethical boundaries to take into
account – impingement of rights)
Social contract ethics (how to move boundaries)
Consider This: “You and John”
 You are the manager for Tesco. You recently fired
John, a sales clerk, after John punched a customer
during a dispute in the store. John admitted this after
the customer complained.
 Lisa, manager of your competitor, Asda, calls you to tell
you that John has applied for a job at Asda, and to ask
you whether John is “good with customers.”
 What will you reply to Lisa?
Legal Vs. Ethical: “You and John”
Action
Tell the Truth
Lie
No Comment
Other
Legal/Illegal
Ethical/Unethical
Corporate Social Responsibility
 Milton Friedman's argument
There is one and only one responsibility of business: to
use its resources and energy in activities designed to
increase its profit so long as it stays within the rule
of game and engages in open and free
competition, without deception and fraud.
Source: The New York Times Magazine, September 13, 1970, The New York Times
Company.
Corporate Social Responsibility
 This is Davis and Blomstrom (1971) Iron Law of
Responsibility
An iron law of responsibility which states that in the
long-term those who do not use power in a manner that
society considers responsible will tend to lose it.
Source: Davis, K. and Blomstrom, R. (1971) Business, Society and Environment. Social
Power and Social Response, 2nd edition, New York, McGraw-Hill.
Davis, K. (1973) The case for and against Business assumptions of Social
Responsibilities, The Academy of Management Journal, 16, 2, 312-322
Corporate Social Responsibility
 Gray, Owen and Adams (1996) described society as a
series of social contracts between members of society
and society itself.
Corporate Social Responsibility
 Gray, Owen and Adams (1996)
1.Pristine Capitalist, 2.Expedient, 3.Social contract,
4.Social Ecologists, 5.Socialists, 6.Radiacal Feminists,
7.Deep Ecologists
Corporate Social Responsibility
 Different approaches
Social Obstruction
Social Obligation
Social Response
Social Contribution
 Charity Principle
 Stewardship Principle
Discussion
 Sarbanes-Oxley Act (2002), USA
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Discussion
Ethics & Management Objectives
 Does value maximization justify unethical behavior?
Enron example
WorldCom example
AIG example
Careers in Finance
 Discuss
Thank You
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