Lecture 1 Flashcards
Corporate finance (definition)
Refers to and deals with day-to-day operations of the firm.
Capital budgeting
What long term investments should you take on
Capital structure
Where will you get the long term financing to pay for your investment.
Working capital management
How will you manage your everyday financial activities (short term cash needed to manage organization)
Other areas of corporate finance
Profitability: How much money will you make?
Risk: What risks are involved and are you being adequately compensated?
Financial Manager and their role
Financial managers try to answer some or all of these questions (capital budgeting, capital structure, working capital management, profitability and risk)
- top financial manager is usually the CFO
Types of financial managers
Treasurer – oversees cash management, capital expenditures and financial planning
Financial Manager
Controller – oversees taxes, cost accounting, financial accounting and data processing
Capital Budgeting
- determining the mix and type of assets on the left side of the firms balance sheet. What long term investments/projects should the business take on.
- maintain optimal levels of each type of current asset, decides which fixed assets to acquire, modify, replace, or liquidate.
Why are capital budgeting decisions important for firms
They affect the firms success in achieving its goals and creating shareholders wealth
Capital structure
Making financial decisions
- Financing decisions deal with the right-hand side of
the firm’s balance sheet - Mix of debt and equity maintained by the firm
Should we use debt or equity to pay for our assets
Working capital management
- short term financing
- planning and managing the firms current assets and liabilities
Form of business organizations
Three major forms in Canada
-Sole proprietorship
-Partnership General
-Limited Corporation
In other countries, corporations are also called joint stock companies, public limited companies and limited liability companies
Sole proprietorship
Owned by a single individual
• Advantages
– Easiest to start
– Least regulated
– Single owner keeps all the profits
– Taxed once as personal income
• Disadvantages
– Unlimited liability
– Limited to life of owner ( business dies with you)
– Equity capital limited to owner’s personal wealth ( taxed personally, business can’t explore new things due to restrictions)
– Difficult to sell ownership interest
Partnership
A business formed by two or more co-owners
(1) General partnership: Unlimited personal liability and actively participate in business.(similar to sole propritorship)
(2) Limited partnership: Must have at least one general partner; limited partners do not actively participate in business and their liability for any debts of the Limited Partnership is capped at their investment in the corporation
Advantages of a partnership
Advantages
Two or more owners
More human and financial capital available Relatively easy to start
Income taxed once as personal income
Disadvantages of a partnership
Disadvantages Unlimited liability
- General partnership
- Limited partnership - (liabilities capped at amount of investment)
Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership
Possible disagreements between partners
Corporations
a separate legal entity in the eyes of the law- so death of one shareholder does not dissolve the firm
Other names for corporations in other countries and their definition
- Joint stock companies: Companies whose stocks are owned jointly by the shareholders.
- Public limited companies: Operate as separate legal entities from their owners and their shares are listed and traded at stock exchanges (e.g., TSX) freely.
- Limited liability companies: Shareholders cannot be held personally liable for the companies’ debts or liabilities unless they sign as guarantors
Advantages of corporations
Advantages
Limited liability for stockholders
Unlimited life for the business
Ownership can be easily transferred Separation of ownership and management Easier to raise capital
Disadvantages of corporations
Disadvantage
Separation of ownership and management
Double taxation (income is taxed at the corporate rate and then dividends are taxed at the personal rate)
More complex and expensive form of organization to establish
Forms of business organizations
- Canadian companies incorporated under federal law
Entitled to carry on business anywhere in Canada under its name, subject only to registering the corporation in the particular province in which its business will be conducted - A corporation incorporated in one province under one name
Might not be able to use that same name in another province if the name or a similar name is already used by another person
What are all Canadian companies incorporated under
• “Federal Canada Business Corporation Act” or
• Provincial Law.
Other form of non-corporate business
Income trust (aka income funds)
- investment holds assets. Theses assets produce income that is passed to shareholders.
- holds debt and equity of an underlying business
- popular historically as income to the trust is not taxes (eliminated in 2006)
- income generated is distributed to shareholders
Co-operative Business
- Co-operative (Co-op)
Ex/ using co-op # and getting $ back
•An enterprise equally owned by its members
•Members share any benefits of their cooperation based on how much they use the services of the cooperative
•Potentially difficult to reach decisions based on the premise of equal ownership by memberships
•Examples include Consumer, Producer, Worker, and Multi- Stakeholder Co-ops
Goals of financial management
- make money and add value for the owners
Primary goals of financial management
- maximize shareholders wealth
- maximize share price
- maximize firm value
Financial managers identify opportunities that add value to the firm – should refrain from unethical or illegal actions
Agency relationships
Individuals Act in Their Own Self-interest
•The idea of self-interest comes up in many ways in finance – these are referred to as “agency problems” or “agency relationships.”
•In widely held companies, management effectively controls the firm, and management (agent) goals may differ from shareholders’ (owner) goals.
Relationship between shareholders and management
- Principal (owners) hires an agent (manager) to represent their
interests - Stockholders (principals) hire managers (agents) to run the company
Agency problems
- Conflicts of interest can exist between the shareholders and
management
Agency costs
–
Agency Relationships
•Agency costs
Direct agency costs
Ex/ the purchase of something for management that can’t be justified from a risk-return standpoint
Ex/ Unneeded corporate Jet, monitoring management actions (e.g., paying independent auditor to audit financial statements).
Indirect agency costs
Ex/ Management’s tendency to forgo (decline) risky or expensive projects that could be justified from a risk-return standpoint.
Another example: Overpaying to buy up another company.
Managing managers
Managerial Compensation
- Compensation is often tied to performance and share value.
Incentives should be structured carefully to ensure goal achievement.
- Managers successful in pursuing shareholder goals are in greater demand in the labor market and command higher salaries.
Control of the Firm
- Shareholders have ultimate control
- Poorly managed firms are more prone to take-over attempts than well-managed firms – job security in promoting shareholder interests
Corporate social responsibility
- Investors are increasingly demanding that corporations behave responsibly
- Issues include how a corporation treats the community in which it operates, their customers, corporate governance, their employees, the environment and human rights
- Controversial business activities include alcohol, gaming, genetic engineering, nuclear power, pornography, tobacco and weapons
- Companies are rated with respect to community and society, customers, corporate governance, employees, environment, and human rights.
Cash flows to and from the firm
- Firm issues securities to raise cash
- Firm invests in assets
- Firms operations generate cash flow
- Cash is paid to government as taxes. Other stakeholders may receive cash
- Reinvested cash flows are plowed back into firm
- Cash is paid out to investors in the form of interest and dividends
Cash flows
A Dollar Today is Worth More than a Dollar Tomorrow
•When in doubt, take the cash sooner than later.
•In finance, when dealing with cash flows that occur at different points in time, we use present value and future value concepts in our analysis.
Financial markets
- Cash flows to and from the firm
- Financial markets bring buyers (those looking for money) and sellers (those looking to invest money) together.
- Financial markets are driven by the supply of and demand for money.
Types of Markets
Money Markets (less than 1 year)
- Financial markets where short-term debt securities are bought and sold
- ST debt securities (essentially IOUs).
- Trading facilities are connected electronically.
- T-bills (issued by BOC) and commercial paper (issued by corporations) are examples of money market securities.
- Players include: banks, chartered banks, investment dealers, insurance companies, pension funds, and large corporations.
Capital Markets
- Markets where previously issued long-term debt securities and shares of stock are bought and sold.
Stocks and bonds = more risk
- Examples: Toronto Stock Exchange, TSX www.tmx.com); Montreal Exchange https://www.m-x.ca/accueil_en.php ;
- Commodity Futures Exchange (ICE, Ontario, Canada) https://www.theice.com/index
Types of Markets
Primary Markets
- Markets where new issues are sold; most publicly offered securities are “underwritten”
involves the use of an investment dealer.
Two types:
- Public Offerings (involves selling securities to the general public).
- Private Placements (a negotiated sell involving one or a few buyers).
Secondary Markets
- Markets where previously issued securities are traded- example one shareholder sells stock directly to another
- Two types: (i) Over-the-counter markets (dealers connected electronically) and (ii) Auction markets (has a physical location)
- Both the money market and the capital market are secondary markets.
Financial institutions
Financial institutions act as intermediaries between suppliers and users of funds
Insitiuations earn income on services provided
- indirect finance: earn interest on the spread between loans and deposits (looks at notes for example)
- direct finance: service fees
Bankers acceptance (BA)
- promised future payments, or time draft, which is accepted and guaranteed by a bank and drawn on a deposit at the bank
- bankers acceptances are issued by firms as part of a commercial transaction
Canadian financial institutions include
Canadian financial institutions include: chartered banks, trust companies, credit unions, investment dealers, insurance companies, pension funds, and mutual funds.
Grands in financial markets
- Financial Engineering: The creation of new securities or financial processes.
• Derivative Securities: Options, futures, forwards, and other securities whose value is derived from the price of another, underlying asset.
• Advances in Technology – i.e. E-business; E-trading
• Deregulation: For example, when restrictions are removed, growth
opportunities may increase
• Corporate Governance Reform: Stakeholders and regulators have
become very interested in corporate governance reform with a view t0o
control management agency costs
Hedge funds
- Cater to sophisticated (knowledgeable) and wealthy
investors (min investment: $25,000) - Seek high returns by using aggressive financial
strategies prohibited by mutual funds - Have lock-up periods (>7Yrs), require advance
redemption notices - Maximum number of investors: 100
Sub-prime market
(Bad)
The market for lenders and borrowers of subprime credit, a credit that is lent to people of questionable or limited credit histories
