L11 - Introduction Flashcards
How do corporation generate income?
- By investing in real assets to produce a good/service which will be sold to generate an income. Real asset can be:
- Tangible e.g. Plant, machinery
- Intangible e.g. Brand names, patents
How do corporation source finance to invest in real assets?
- borrowing - debt financing
- selling shares - equity financing
- retain & reinvest cash-flow –> retained profit
What are the two questions a corporation faces when making Financing decisions?
- What investments should the firm make?
- Spending money
- How should it pay for those investments?
- Raising Money
How do corporations pay for the real assets?
by selling claims:
- on those real assets
- on the cash flow they will generate
These could be:
- Securities (traded on financial markets) e.g. bonds, shares
- Financial Assets (held and nont traded) e.g. bank loans, bonds
What is a claim?
in this context:
- you are making a promise that you will use the cash loaned to purchase real assets that will generate a cashflow which can be used to pay back the debt or dividend/coupon owed
What are corporations?
Corporations: comprise large- and medium-sized businesses owned by several people (e.g., Microsoft, Google, IBM, Samsung, British Petroleum, Sainsbury’s, Nestle, Ford, etc.).
- Ownership is divided by shares that are held by a number of investors (shareholders).
- Initially, the shares are owned by the company’s managers and a few backers (closely held company).
- As the firm needs additional capital to grow, more shares are issued and become widely traded (public companies).
- Potential investors may be single individuals or financial entities (pension or mutual funds, insurance companies,. . . )
- Investors have a share on the profits (through dividends) and cast a vote on important decisions.
- A corporation attracts a wide variety of investors; the number of shares held varies widely among investors.
- A corporation is owned by its shareholders, but it is legally distinct from them - unlimited liability
What are Partnerships?
small businesses owned and managed by a group of people (with limited or unlimited liability(limited partnership)).
What is a Sole proprietorship?
small businesses owned and managed by a single individual.
What are the Characterstics of Corporations?
- Limited liability: stockholders are not personally responsible for the firm’s debts.
- Distinct entity: the corporation is considered as a distinct legal entity or legal person.
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Separation of ownership and management:
- the shareholders vote to elect a board of directors;
- the board of directors appoints top management;
- this gives the corporation ‘permanence’ (managers and/or shareholders can change but the corporation survives)
What are the disadvantages of a corporation?
- Complex structure: management of complicated structure and communication with shareholders, which is costly and time consuming.
- Double taxation problem: tax on both firms’ profits and on shareholders’ dividends.
- Moral hazard issues due to asymmetric information: managers may act at their best personal interests and not those of the shareholders
What is the role of the financial manager?
- a firm need to invest in real assets, while also finding a way to raise money to buy them
- Financial Managers stand between the firm’s operation and the financial market
They decide on:
- ‘What real assets should the firm invest in?’
- ‘How should the cash necessary to finance these investments be raised?’
So, the Financial Manager…
- helps manage firm’s operations (making investment decisions)
- deals with investors: shareholders, financial institutions (banks), and financial markets (stock mkts).
Financial institutions are important to facilitate such decisions
Why are financial institution and financial markets important?
- Provide choice between short-term borrowing (e.g., from banks), long-term borrowing (e.g., by issuing bonds) and issuing of shares (traded in stock markets).
- They assist and provide advice in mergers and acquisitions.
- Provide liquidity and risk-diversification that give the security to potential investors to relinquish control of their savings for some period.
- Provide financial managers with a source of information on interest rates, market value of firms, prices of raw materials, etc. . .
What are the financial objectives of Shareholders?
Shareholders want the Financial Manager to:
- increase the value of the corporation;
- its current stock price;
- ideally… maximize its market value!
- and their wealth!
This is easy to say but the problems are:
- how to do it
- and what are the incentive to financial managers to do it
What is the Investment Trade-Off?
Do you Invest in a project or Pay out cash to shareholders?
- Invest if return onf the investment is higher than the return of investing in financial markets (for the same level or risk) (look at NPV and IIR) otherwise shareholders prefer cash instead
Corporations increase value by accepting all investment projects that earn more than the opportunity cost of capital
What are the 4 main areas of the role of a Financial Manager?
