Topic 1: Flashcards
Goal of the firm
Maximise shareholders’ wealth by maximising share price.
5 principles of finance
- Cash flow is what matters.
- Money has time value.
- Risk requires reward.
- Market prices are generally right.
- Conflict of interests causes agency problems.
Principle 1: Cash flow is what matters
Accounting profits =/ cash flows.
Cash flows, not profits, drives company’s value.
Determine incremental increase in cash flow.
Principle 2: Money has time value
Money today worth more than money tomorrow because:
- Dividends/interest if we invest in savings etc.
- Inflation impact on purchasing power.
Principle 3: Risk requires rewards
Investor won’t take additional risks unless they are compensated with additional rewards.
Investor expects to be compensated for “DELAYING CONSUMPTION” & “TAKING RISKS” (expect more in stocks than in FD).
Principle 4: Market prices are generally right
Efficient market hypothesis:
Market prices fully reflect all available information at any point of time.
Stock prices good indicator of value of firm because reflects on future cash flow changes.
Inefficiencies such as behavioural biases may distort market prices from value of assets.
Principle 5: Conflict of interest causes agency problems.
Separation of management and the ownership of firm.
Management not consistent with firm’s goals.
Reduced through:
- Monitoring.
- Compensation.
- Market mechanism.
Decisions in corporate finance.
- Capital budgeting decisions.
- Capital structuring decisions.
- Working capital decisions.
Function of Financial Markets
Facilitate transfer of funds from “saving surpluses” to “saving deficits”.
Ways to transfer capital
- Direct transfer.
- Indirect transfer through IB.
- Indirect transfer through FI.
Direct transfer
Saving deficits looks for saving surpluses directly.
Startups looking for VC.
Role of VC
Provide funding to startups. Very risky, high return potential.
Startups: small sized, no profit records, uncertain future growth prospects.
Public offering
Securities initially sold by managing IBs to retail and institutional investors.
Issuing firm never meets final purchaser.
Private/Direct offering
Sold directly by company to selected investors.
Primary market
Market of which new securities are sold to initial buyers.
Only time the company receive fresh funds.
Seasoned equity offering/RI
Sales of additional shares of company already public to existing shareholders at a discount to market price.
Secondary market
Market of which previously issued securities are traded.
Company does not received any fresh funds from shares traded in this market.
Money market
Market for short-term debt instruments.
Notes, bills.
Capital market
Market for long-term financial securities.
Bonds, shares, T-bonds, term loans.
Futures market
Market for derivatives trading.
OTC Markets
Over-the-counter. All markets except organised markets.
For companies:
- Fail to meet listing requirements of secondary market.
- Wishes to avoid higher reporting listing requirement and fees of exchanges.
Underwriters’ spread
Differences between IB paid price and IPO price.
Functions of IB
- Underwriting.
- Distributing.
- Advising.
Underwriting/distribution methods
UNDERWRITING
- Negotiated purchase.
- Competitive bid.
DISTRIBUTING
- Best efforts.
- Privileged subscription.
