Corporate Finance

Lecture 1

Chapters 1 and 2 (Prescribed textbook)

The Financial Manager and the Financial Environment

FIN203 Corporate Finance

Subject Outline

Introductory Lecture

COMMONWEALTH OF AUSTRALIA Copyright Regulations 1969

WARNING This material has been reproduced and communicated to you by or on behalf of Kaplan Business School pursuant to Part VB of the Copyright

Act 1968 (the Act).

The material in this communication may be subject to copyright under the Act. Any further reproduction or communication of this material by

you may be the subject of copyright protection under the Act.

The lecture material contains content owned by Kaplan Business School and other materials copyrighted by Parrino,R , Kidwell,D, Au

Yong,H, Dempsey,M , Morkel-Kingbury,N, Ekanayake,S, Kofoed,J and Murray,J (2014), Fundamentals of Corporate Finance, 2nd Edition,

John Wiley & Sons Australia, Ltd Do not remove this notice.

3

Topic Outline 1. The Financial Manager and Financial Environment 2. Working Capital 3. Risk and Return 4. Time value of Money 5. Bond Valuation 6. Share Valuation 7. Fundamentals of Capital Budgeting 8. Cash Flows and Capital Budgeting 9. Concept of Leverage 10. Cost of Capital 11. Capital Structure and Dividend Policy 12. Revision and Private Study

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Finance Course Learning Outcomes

1. • Demonstrate a sound knowledge of basic financial concepts and calculations

2. • Perform accurate financial calculations and evaluate financial problems using theory

3. • Relate theory to real-life financial issues by critically analysing and reflecting on current market data and real-life case studies

4. • Work as a team to formulate and communicate, in writing, solutions to financial

problems for specialist and non-specialist audiences

Finance and the Real World The Global Financial Crisis: Causes and effects

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Why do you need to care about current financial events?  Class Discussion: Are the risk factors that caused the financial crisis in 2008

present now?

Watch this video: What caused the GFC? http://www.smh.com.au/business/the- economy/10-years-since-the-gfc- 20170526-gwe5f2.html June 6 2017…With interest rates at a record low and house prices near record highs, the nation's household debt-to-income ratio has climbed to an all-time peak of 189 per cent, according to the Reserve Bank of Australia (RBA). That means there are an increasing number of people who have little cash for discretionary spending - on everything from cars to electrical appliances and new clothes - as their pay packets get consumed by large mortgages and high rental payments in the country's red-hot property market. Source: http://www.smh.com.au/business/the-economy/australians-curb-spending-as- household-debt-balloons-20170605-gwl54y.html

Being an informed citizen  Financial Media sources:

 Australian  The Australian Business Briefing http://www.theaustralian.com.au/business  The Financial Review (newspaper)  Bloomberg Aus and NZ http://www.bloomberg.com/news/australia-newzealand/  ABC Business news http://www.abc.net.au/news/business/ Financial News with Alan Kohler (see below)

 International  Reuters:

http://online.wsj.com/public/page/news-business- us.html?mod=WSJ_topnav_business_main

 Wall Street Journal: http://online.wsj.com/public/page/news-business- us.html?mod=WSJ_topnav_business_main

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Go to http://www.abc.net.au/news/feed/2839398/podcast.xml and view most recent Financial Report by Alan Kohler (2 minutes)

What is your financial literacy? Introductory Activity

Class Activity

1. Watch https://www.youtube.com/watch?v=woTC6AyRXSo 2. Do the quiz 3. Assess your financial literacy and

compare with countries around the world

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Live Review Quizzes  There is a quiz at end of each lecture. Doing these will make up

15% of your mark (see Assessment 3 description)  To do these in class download “Socrative Student” to your

smart phone  The lecturer will then launch each quiz

1. The “room name” you have to enter to do the quiz live is FIN203 with your campus first letter in front. i.e. AFIN203 for Adelaide

2. Then enter your first name 3. Do the questions on the phone in the allocated time 4. Get instant feedback from the lecturer 5. You get marks for attempting a MINIMUM of 80% of the quizzes

and scoring a good average across Weeks 1-11

Quiz 0: Your Finance Knowledge 1. Suppose you have some money. Is it safer to put your money into one business or investment to put your money into multiple businesses or investments? A. one business or investment B. multiple businesses or investments C. don’t know

2. Suppose over the next 10 years the prices of the things you buy double. If your income also doubles, will you be able to buy less than you can buy today, the same as you can buy today, or more than you can buy today? A. less; B. the same; C. more; D. don’t know

10https://media.mhfi.com/documents/2015-Finlit_paper_17_F3_SINGLES.pdf

3. Suppose you need to borrow 100 US dollars. Which is the lower amount to pay back at the end of 1 year? A. 105 US dollars B.100 US dollars plus three percent C. don’t know

4. Suppose you put money in the bank for two years and the bank agrees to add 15 percent per year to your account. Will the bank add more money to your account the second year than it did the first year, or will it add the same amount of money both years? A. more; B. the same; C. don’t know

11https://media.mhfi.com/documents/2015-Finlit_paper_17_F3_SINGLES.pdf

Check your answers

• Your lecturer will go through correct answers

• What was your score out of 4 as a %? • Compare with scores around the world

(see next slide)

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13Source : Global financial literacy: survey by S&P ratings http://www.economist.com/blogs/graphicdetail/2015/11/daily-chart-19

1. What is the GDP per capita in your country?

(x axis) See http://www.tradingecono

mics.com/country- list/gdp-per-capita

2. Where do you sit on the financial literacy percentage (y axis)?

3. How do you compare to countries like Canada

and Britain?

Textbooks and Calculators • You need to purchase the below textbook:

Title: Fundamentals of Corporate Finance (2nd Edition) 2014 Author(s): Robert Parrino, David Kidwell, Hue Hwa Au Yong, Michael Dempsey, Nigel Morkel-Kingbury, Samosn Ekanayake, Jennifer Kofoed, James Murray Edition/Year: Australian edition Publisher: John Wiley and Sons Australia, Ltd. ISBN: 9781118378076 • Additional readings will be uploaded to the portal

• You need to have one of the following types of calculators: • Scientific Calculator; or • Financial calculator • Do NOT get a calculator that can store text (i.e. graphics) it will be taken

away in the exam

Learning Materials  For every topic you will be provided with on the portal:

1. Weekly Lecture Slides • Lectures will go through the main concepts of the each topics and will also be

interactive with some calculation and theory questions done in class. Students need to read the relevant chapter of the textbook before each lecture. A few questions will not have answers on the lecture slide so you will need to copy these in class. At the end of every lecture a “Learning Outcomes” slide will summarise what you need to know for the exam.

2. Weekly Tutorials • Tutorials are based on the previous week’s content. Please review these

questions before class. There will be group and exam practice activities built into each tutorial. Answers to these are made available Friday the week after the relevant lecture.

3. Excel activities and additional readings for some topics • Your lecturer will mention these in some topics and these will be relevant to

the Group Assignment.

COMMONWEALTH OF AUSTRALIA Copyright Regulations 1969

WARNING This material has been reproduced and communicated to you by or on behalf of Kaplan Business School pursuant to Part VB of the Copyright

Act 1968 (the Act).

The material in this communication may be subject to copyright under the Act. Any further reproduction or communication of this material by

you may be the subject of copyright protection under the Act.

The lecture material contains content owned by Kaplan Business School and other materials copyrighted by Parrino,R , Kidwell,D, Au

Yong,H, Dempsey,M , Morkel-Kingbury,N, Ekanayake,S, Kofoed,J and Murray,J (2014), Fundamentals of Corporate Finance, 2nd Edition,

John Wiley & Sons Australia, Ltd Do not remove this notice.

16

1. Scope of Corporate Finance

 Concerns the acquisition, financing, and management of assets with some overall goal in mind.

Group Activity

• What do you think should be the goal of a firm/ company?

• Please discuss in groups

We Are BHP Billiton, A Leading Global Resources Company • Our purpose is to create long-term value through the

discovery, development and conversion of natural resources, and the provision of innovative customer and market-focused solutions.

• We are successful in creating value when:  Our shareholders are realising a superior return on

their investment.  Our customers and suppliers are benefiting from our

business relationships.  The communities in which we operate value our citizenship.  Every employee starts each day with a sense of purpose

and ends each day with a sense of accomplishment. http://www.bhpbilliton.com/bb/aboutUs.jsp

2. Goal of The Firm- BHP

2. Goal of The Firm (cont.) Maximization of current

Shareholder Wealth! Value creation occurs when we

maximize the share price for current shareholders.

2. Goal of The Firm (cont.)  Maximise Shareholders’ Wealth

The value of an asset (share) is determined by future cash flows generated by that asset

When investors determine share price (by trading them in the market) they consider: • The size of the expected cash flows • The timing of the cash flows • The riskiness of the cash flows.

By maximising the current share price or company value, management is maximising shareholders’ wealth • Value creation occurs when we maximize

the share price for current shareholders.

 Why not make maximising profits the goal? • Profits have some drawbacks:  Profits are not cash flows (i.e. accrual accounting)  Profits ignore the timing of cash flows  Profits ignore risk

In Finance the value of a company depends on the cash flows (not profit) it generates

2. Goal of The Firm (cont.)

Can manager decisions affect the share price? Yes!

Identify the management decisions that affect share price

3. The role of the financial manager (cont.)

• Three fundamental decisions of the financial manager

1. The capital budgeting decision 2. The financing decision 3. Working capital management decisions

Capital Budgeting – Selecting the best project(s) in

which to invest the firm’s limited resources

1. The Capital Budgeting Decision Which productive assets should the firm buy?

2. The Financing Decision

DEBT -Loan from Bank -Issuing bonds (what are bonds?)

EQUITY -Using retained earnings -Issuing shares (What are shares?)

OR

The decision on the mixture of debt and equity used by a firm.

How should the firm finance or pay for assets? A=L+OE

3. Working Capital Management Decisions

The day-to-day management of short-term assets and liabilities.

Figure 1.2 : How financial manager’s decisions affect the Balance Sheet

4. Types of business organizations

Sole Trader  The simplest type of

business to start and the least regulated

 Unlimited personal liability

 Business income is taxed as personal income

 Limited access to capital

Sole Trader Partnership Company

Partnership • Two or more owners

joined legally – Partnership agreements are very important

• Personal liability depends on circumstances

• Earnings are taxed as personal income

• Better access to capital than sole traders

Company • In a legal sense, it is a

“person” distinct from its owners.

• The owners of a company are its shareholders.

• Minimum personal liability to capital providers

• The owners of companies are subject to double taxation first at the corporate level and then at the personal level when dividends are paid to them.

• Best access to capital • A publicly listed company – a

company who’s share are traded on the share (stock) exchange

Figure 1.3: Company Organization chart

 Who does the CEO report to?  Who is the board of directors accountable to?  What is the responsibility of the board of directors?

5. Agency Conflicts

There exists a SEPARATION between owners and managers.

Modern Corporation

Shareholders Management

5. Agency conflicts (cont.) • For large companies, the ownership of the firm is spread over

huge number of shareholders and the company’s owners may effectively have little control over management

• Managers act as agents of the owners (the principal) who hired them and gave them decision-making authority to manage the firm for the owners’ benefit.

• Managers may make decisions that benefit their self-interest rather than those of the shareholders.

• This conflict of goals gives rise to managerial agency problems.

5. Agency conflicts (cont.) • Agency conflict: When the agent (manager) does not act in the best

interest of the principal (shareholders)

• How can we align shareholder and manager interests?  Management compensation  Managerial labor market  Board of Directors  Other managers – Competition among managers  Large shareholders  The takeover market – fear for being taken over  The legal and regulatory environment

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6. Business ethics • A society’s ideas about what actions are right and wrong. Types of

ethical conflicts in business:

Conflicts of Interest Conflict between individual’s personal or institutional gain and the

obligation to serve the interest of another party.  Information Asymmetry One party in a transaction has information that is unavailable to the

other parties Behavior of companies LIBOR rate fixing scandal (British Banks) Banks taking on excessive risk before the GFC and then being

bailed out by the government

7. Financial System What is Financial System?

• A financial system consists of:  Financial institutions  Financial markets

• These entities interact to facilitate the flow of funds through the financial system

• In Australian, the Reserve Bank of Australia (RBA) oversees the financial system.

• RBA - “The financial system is the term used to comprehend the set of arrangements covering the borrowing and lending of funds and the transfer of ownership of financial claims."

Securities are financial instruments which can be resold on the secondary market

Figure 2.1: Flow of funds through the financial system

Do you participate in the flow of funds through the financial system? How? Is it direct or indirect financing?

Direct Financing • Direct market transactions  Where borrowers raise money directly from lenders by issuing

financial securities  Wholesale markets with minimum transaction ≥$1 million

• Investment banks and direct financing  Investment Banks help companies sell new debt or equity

issues in the markets  Two important tasks of investment banks

• Origination – to prepare securities for sale • Underwriting - to assist companies in the sale of debt or equity in the

primary market. – Stand-by underwriting - buys the entire issue at a guaranteed price from

the issuing company and resells the securities to institutional investors and the public.

9. Types of financial markets 1. Primary Market

• Financial market selling new securities for the first time • The issue of a new financial instrument to raise funds

2. Secondary Market • Financial market where owners of outstanding securities can

resell • Allows investors to buy and sell previously owned or

existing securities • No new funds raised and therefore no direct impact on

original issuer of security • Transfer of ownership from one investor to another. • Facilitates marketability and liquidity of assets

Securities are financial instruments which can be resold on the secondary market

9. Types of financial markets (cont.)

3. Money Market • Market for short-term debt instruments that have

maturities of less than one year. • Instruments include Treasury notes, bank accepted

bills and commercial papers

4. Capital Market • Market in which longer term securities are issued and

traded with original term-to-maturity in excess of one year

10. The Share Market • Major functions of share market

• Provides companies a source of financing • Provides a market for the trading of securities • Facilitates evaluation of securities • Provides safety and security in trading of securities

• Australian Securities Exchange (ASX) • Lists securities of 2,227 companies (10/2011) • Handles ASX’s primary, secondary and derivative market

services • Top-10 listed exchange groups measured by market

capitalisation

ASX200 and other Indices

Group Discussion: 1. What is the ASX200? What does it represent? 2. What other market indices are shown above? What do they reflect or convey about the share market?

10. The Share Market (cont.) • Share Market Indices

 An aggregate of share price movements in an entire market. Measures share market performance - whether share prices on average move up or down

• Australian All Ordinaries Index  Consists of the top 500 companies listed on the ASX  Representing over 90 % of the market capitalisation of the Australian market.

• S&P/ASX 200 Index is the main index  Consists of the top 200 index eligible companies  Represents 75% of the market capitalisation (What is market cap?)

Indirect Financing

• Indirect financing  A financing arrangement involving two separate parties

whereby the saver provides funds to an intermediary (commercial banks) and the intermediary provides funding to the ultimate user of the funds

Suppliers of Funds (lender)

Intermediaries (Financial

Institutions)

Users of Funds (borrower)

Funds Funds

FundsFunds

Live Review Quizzes  There is a quiz at end of each lecture. Doing these will make up

15% of your mark (see Assessment 3 description)  To do these in class download “Socrative Student” to your

smart phone  The lecturer will then launch each quiz

1. The “room name” you have to enter to do the quiz live is FIN203 with your campus first letter in front. i.e. AFIN203 for Adelaide

2. Then enter your first name 3. Do the questions on the phone in the allocated time 4. Get instant feedback from the lecturer 5. You get marks for attempting a MINIMUM of 80% of the quizzes

and scoring a good average across Weeks 1-11

Quiz 1 Look back through the lecture the answer the following questions in groups: 1. Doing problems in class is a great way to practice for the exam. a. True b. False 2. To participate in live class review quizzes I need to download the following free app to my phone: a. Facebook b. Twitter c. Socrative Teacher d. Socrative Student

3. To log in to each quiz I need to enter FIN203 and nothing else. a. True b. False

Quiz 1 4. The financial manager is responsible for making decisions that are in the best interest of the company's owners. True or False? 5. The financing decision determines how companies raise cash to

pay for their investments. True or False? 6. An agency problem can arise when the agent of the company is the sole

owner of the company. True or False? 7. A primary market is any financial market in which owners of outstanding

securities can resell them to other investors. True or False? 8. Equities are generally traded in the capital market. True or False? 9. Direct financial markets could be broadly labelled as wholesale markets

for funding. True or False? 10. Which of the following can help align the behaviour of managers with

the goals of shareholders? a. management compensation b. managerial labour markets c. an independent board of directors d. all of the above

Learning Outcomes Topic 1

1. Define corporate finance 2. Outline the theoretical gaol of a firm and differentiate between cash

flows and profit 3. Explain the role of the financial manager in terms of three major

questions 4. Outline the features of the three main types of business organisations 5. Define agency relationships, agency conflicts and the ways these can

be mitigated 6. Comprehend the nature of ethical dilemmas in finance 7. Outline and explain the function and components of the financial system 8. Differentiate between direct and indirect financing 9. Define and differentiate between different types of financial markets 10. Explain the process of the share market and major share indices 11. Identify and outline the types and functions of major financial

institutions