lecture 1: introduction to finance

Question 1

what is corporate finance

Answer 1

corporate finance is the study on how a corporation raises money or capital, invest them in real estates, and distribute the profits earned during its operation to its stakeholders (stakeholders are parties that have an interest in a company and can either affect or be affected by the business).

Question 2

what is a corporation

Answer 2

a corporation is a legal entity, that is owned by its shareholders, but legally distinct from them.

in the view of law –> it’s a legal person that is owned by its shareholders. As a legal person, the corporation can make contracts, carry on a business, borrow or lend money, and sue or be sued. It must also pay taxes. And unlike an actual person it can’t vote but it can buy another corporation.

a corporation is owned by its shareholders but it is legally distinct from them. (therefore shareholders have limited liability –> they cannot be help personally responsible for the corporations debts).

Question 3

unincorporated entities:

Answer 3

• do not have separate legal personality
• owners often have unlimited personal liability
• less regulated
• less financing capacity

Question 4

incorporated entities:

Answer 4

• have separate legal personality
• owners have limited liability
• more regulated
• more financing capacity

Question 5

unincorporated entity forms (examples)

Answer 5

• sole trader: e.g. plumber, contractor
• unincorporated association: e.g. sport club
• partnership: e.g. law firm, accountancy business
• limited partnership: partnership with two sorts of partners: general partners and limited partners e.g. estate agents
• trust

Question 6

incorporated entity forms (examples)

Answer 6

• limited company: private limited company (Ltd) or public limited company (PLC)
• limited liability partnership
• charitable incorporated organisation
• co-operative society
• community benefit society
• mutual funds (including building society, credit union, and friendly society)

Question 7

limited companies:

Answer 7

• owned by shareholders
• shareholders have limited liability
• day-to-day management nominally separated from ownership
• stricter regulations (e.g. accounting, reports)
• can either be private limited companies or public limited companies

Question 8

public limited companies (PLC)

Answer 8

• must have at least two directors and a qualified company secretary
• must have issued shares to the public to a value of at least 50,000 pounds
• can list shares on an exchange (“listed company”)

Question 9

• investment decisions can also be referred to as what?
• what type of assets do they invest in?

Answer 9

• at firm level, investment decisions can also be referred to as capital expenditure (CAPEX) or capital budgeting decisions
• (firms can invest in both tangible and intangible assets) ~ an intangible asset is a non-monetary asset that cannot be seen or touched such as a patent while tangible assets are physical assets used in a company’s operation

Question 10

steps in investing decisions

Answer 10

STEPS:
- identifying the investment decisions
- project evaluation and analysis
- implementation
- performance review

Question 11

pitfalls in capital budgeting

Answer 11

• fail to account for economic reaction (refers to the risk of not considering external economic factors that can impact the success of a capital investment project)
• pet project (a project, activity, or goal pursued as a personal favourite, rather than because it is generally accepted as necessary or important).
• fail to account for macroeconomic conditions (macroeconomic factors are large aspects of an economy rather than a particular nation such as inflation, GDP, unemployment levels..etc)

Question 12

types of financing (2)

Answer 12

two main types of financing: debt (money from lenders) or equity (money from shareholders)

Question 13

equity financing (3 ways)

Answer 13

• initial public offerings (IPOs): a company offers shares of stock or debt securities to the public for the first time in an attempt to raise capital ( when it conducts an initial public offering –>it becomes a publicly traded company (PLC))
• seasonal offerings: when a company already listen on stock exchanges decides to release additional stock/debt instruments
• retained earnings: they take cashflow generated by its existing assets and reinvest that cash in new assets (in this case the corporation is reinvesting on behalf of existing shareholders -» no new shares are issued)

Question 14

factors affecting financing decisions

Answer 14

1. business size: small-sized companies face difficulty in raising long-term borrowing (perceived as higher risk due to smaller size, limited track record, less collateral –>places r less willing to lend money)
2. earnings: firms with relatively stable revenues can afford a more significant amount of debt
3. stage of the life cycle: a firm in the early stages of it’s life cycle tends to use more equity finance (stages of life: start-up, growth,
   4.state of the market: in some market conditions (e.g crisis) share offering to the public can be challenging

Question 15

which decisions are more important in driving firm’s performance?

Answer 15

financial decisions…because while investment decisions matter more on the upside, financial decisions are particularly important on the downside
- financing decisions alone can’t turn a company into a success but it can cause it to fail

Question 16

what is a financial manager and what do they do?

Answer 16

a financial manager is usually a top officer or finance director –> that helps the company choose the best possible investment projects and prepare a feasible financing plan to fund the project.

(In practice the financial manager is rarely a single individual. For example–> the board of directors generally makes such decisions in a large corporation

Question 17

financial managers role (in the flow of cash)

Answer 17

flow of cash between financial markets and the firm’s operations.
1. cash raised by selling financial assets to investors (from financial markets to financial managers)
2. cash invested in the firs operations and used to purchase real assets (from financial managers to firms operations)
3. cash generated by the firms operations (firms operations back to financial manager)
4a) either gets reinvested by the financial manager or..
4b) the financial manager returns it to the investors (financial markets)

financial markets : investors holding financial assets

Question 18

financial goal of a corporation

Answer 18

in principle, maximising stock price should be the financial goal of a corporation as they need to act in the best interest of the shareholder → the financial manager should be making financing and investing decisions that maximise stock price.. however there are pros and cons to maximising stock price

• overall..while having some critics, we still consider shareholder value creation the goal of a corporation -> the goal is important in driving investment and financing decisions of firms

Question 19

pros to maximising stock price

Answer 19

• stock price reflects prospects in the long term of the firm, shareholders’ wealth maximization is considered a good management approach to focus on long-term rather than short-term
• risks are considered
  > a corporate executive is an employee of the owners of the business. He has a direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of society (Milton Friedman)

shareholders usually want three things:
- to be as rich as possible (maximize their current wealth)
- to manage timing of his consumption plan by deciding to either consume their wealth now or invest it to spend later
- to manage the risk characteristics of that consumption plan
- the only way financial managers can help the firm’s shareholders (out of the three things they want) is by INCREASING THEIR WEALTH meaning…→increasing the market value of the firm and the current price of its shares

Question 20

cons to maximising stock price

Answer 20

• shareholders might wish to purse objectives other than or in addition to wealth maximization (e.g environmental targets)
  >corporations aren’t cash machines for shareholders but also provide good and services for their consumers and jobs+incomes for their employees
• by placing share price maximisation on top priority, firm executives might engage in frauds to increase share price
• agency problem

Question 21

what can financial managers do to maximize shareholder’s wealth?

Answer 21

what they should do depends…taking the manager’s objective as being market value for ex..we must ask:why do some investments increase market value while others reduce it?

what shareholders want financial managers to do depends on the project’s rate of return that the shareholders can earn by investing in financial markets …
the investment trade off:shareholders will not accept the project if it earns less than the opportunity cost of capital
opportunity cost of capital here refers to: the return shareholders can earn by investing in similar projects elsewhere (minimum acceptable rate of return)

so depending on these two things the firm can either keep and reinvest cash or return it to investors..

Question 22

what is the agency problem and the effects?

Answer 22

conflict of interest inherent in any relationship where one party is expected to act in the best of another

-> it has direct effects on investing and financing activities..for ex if something is too risky the agents might not do it because if it doesn’t go well they look bad (the principals could react negatively + punish)
-> also has other agency costs to reduce agency problems..
- monitoring costs (fees paid to independent auditors)
-setting up costs (extra costs to set up the company structure to reduce agency problem)
-opportunity costs (extra time to get consensus before letting managers take action)

Question 23

in what ways can you reduce the agency problem?

Answer 23

–compensation structure: the use of stock-based compensation to align managers and shareholders interests
example : stock options and employee stock ownership program (esop)
–corporate governance: increase supervisory effectiveness by employing independent directors
(independent director: a board member who serves on the company’s board but is neither a stakeholder nor an employee)
capital structure: greater financial leverage can help reduce agency costs (leverage increases the return on equity -improving investor’s return on capital invested) -> AND financial leverage is similar to taking a loan out -» and if a company uses more borrowed money (financial leverage) it might help make sure that the people lending the money (e.g. banks) keep an eye on how the company is doing.