The Scope Of Corporate Finance

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The Scope Of Corporate Finance

• Dr. Del Hawley
• FIN 634

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Corporate Finance Functions
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The Dimensions of the Capital Acquisition Function

• Primary Market vs Secondary Market
• Capital Market vs Financial Intermediary
• Money Market vs Capital Market
• Public vs Private Capital Markets
• Going Public vs Privately Held
• Pay Dividends vs Retain Earnings

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Raising Capital Key Facts

• Internally-generated cash flow is the dominant
  source of funding in all developed economies.
• Typically 60-80 for US firms, 50-60 for others.
  
• The bulk of external funding is in the form of
  debt.
• Seasoned equity issues are only 4-8 of external
  financing.

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Raising Capital Key Facts

• Profits reinvested (retained earnings) are the
  same as a new equity issue each year.
• This keeps the leverage ratio from rising too
  high with time.
• Banks everywhere are declining as a source of
  capital for large firms.
• Especially true in US less so in Europe, Japan

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Raising Capital Key Facts

• There has been a huge increase in total security
  issuance volume since 1990.

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Growth in Global Security Issues1990-2002
Bn
Global debt equity
U.S. Issuers worldwide
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World Stock Market Capitalization, 1983-2002
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The Financial Management Function
Managing Daily Cash Inflows and Outflows
Forecasting Cash Balances
Building a Long-Term Financial Plan
Choosing the Right Mix of Debt and Equity
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The Risk Management Function
Managing the Firms Exposure to Significant Risks
Interest Rate Risk
Exchange Rate Risk
Commodity Price Risk
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The Corporate Governance Function

• The governance structure must ensure that
  managers make decisions that are will maximize
  shareholders wealth not just their own wealth.

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The Corporate Governance Function

• Incentives of managers, stockholders, and other
  stakeholders often conflict
• Shareholders face a collective action problem in
  monitoring management
• This is called the agency problem

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The Corporate Governance Function

• Historical experience and academic research
  both suggest that ownership structure is very
  important.
• Concentrated vs atomistic ownership structure
• At least three forms of capitalism (US, Japan,
  Europe)
• The countrys history legal/regulatory system
  is very important as well

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The Corporate Governance Function

• The role of takeovers in corporate governance
  has grown dramatically in recent years
• Has long been important in the US and UK
• Becoming increasingly important in Europe

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Value of Global M A1991-2002 (U.S. Billions)
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What Should Managers Maximize?

• Though plausible as a management objective,
  profit maximization has problems
• Does not account for the timing of returns
• Profits are not necessarily cash flows
• Most importantly it ignores risk

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What Should Managers Maximize?

• The best management objective Maximize
  shareholder wealth by maximizing the VALUE of the
  company, thereby maximizing stock price
• Accounts for risk, timing, and cash flows
• As Residual Claimants, shareholders have better
  incentives to maximize firm value than other
  stakeholders
• Shareholders can benefit only after other claims
  are paid in full
• Historical justification Success of financial
  capitalism

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Agency Costs In Corporate Finance

• Agency costs are due to the separation of
  ownership and control
• Managers are the agents of the shareholders, but
  are also human. The interests of managers and
  shareholders inevitably diverge.

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Agency Costs In Corporate Finance

• Three ways to attempt to deal with agency costs
• Can rely on market forces Takeovers, proxy
  contests, etc.
• Can incur monitoring and bonding costs
• Can align manager and shareholder interests via
  compensation contracts (stock options)

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Agency Costs In Corporate Finance

• Most controversial method Executive
  compensation
• The bull market led to huge payments
• Average total SP 500 CEO pay in 2001 9.7
  Million
• The bulk of this pay came from stock options
• Sometimes non-cash perks are used as well
  Gulfstream for Steve Jobs

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Forms Of Business Organization In The U.S.

• No distinction between business and person (the
  owner)
• Easy to set up and operate Taxed as personal
  income
• Personal liability, limited life, difficult to
  transfer

Proprietorship
Partnership

• Two or more business owners
• Partners - Liable for every other partners
  actions

Limited Partnership

• One general and many limited partners
• Limited liability of corporation, tax benefits of
  partnership
• Real-estate, RD companies

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Forms Of Business Organization - Corporations

• Legal entity with all the economic rights and
  responsibilities of a person
• Incorporation occurs at state level Based on
  state law
• Strengths - Limited liability to investors,
  unlimited business life

Corporation
Are there any weaknesses for corporations? YES!
Double taxation
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The Double Taxation of Dividends
Taxation of Business Income Corporations vs
Partnerships(Corporate Tax Rate (?c) 0.35
Personal Tax Rate (?p) 0.40)
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Less Double Taxation of Dividends
Taxation of Business Income Corporations vs
Partnerships(Corporate Tax Rate (?c) 0.35
Personal Tax Rate (?p) 0.15)
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The TraditionalAccounting Balance Sheet
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The TraditionalAccounting Balance Sheet

• The Balance Sheet
• Provides a snap-shot of the book value of the
  firms major account categories at an arbitrary
  point in time.
• Is not intended to portray true values
• Leaves out some valuable assets and understates
  or overstates the true value of others.

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The TraditionalAccounting Balance Sheet

• Whats missing on Microsofts 2002 balance sheet
  that has real value to the company and its
  investors?
• http//www.microsoft.com/msft/ar.mspx

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The TraditionalAccounting Balance Sheet

• Check the book value of Microsofts Owners
  Equity here and compute the actual market value
  of equity based on its actual share price at
  end-of-quarter dates that you can get here.

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The TraditionalAccounting Balance Sheet
Market Value and Book Value of Microsofts Equity
If the equity is that far off on the balance
sheet, what does it say about the rest of the
balance sheet information?
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The Market ValueBalance Sheet
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Valuation

• Valuation is the process of estimating the true
  value of assets, securities, or entire companies.
• Value is usually uncertain
• Value is based on future projections
• Value is affected by preferences
• Value changes constantly

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The Goal of the Firm

• The goal of the firm is to maximize its value.
• Maximize the value of the firm
• Maximize the wealth of its owners
• Maximize the price of its stock
• Maximize its contribution to the economy

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How Is Value Created?

• Do something for investors that they cant do
  for themselves.
• Exploit proprietary resources
• Raw materials, patents, information
• Create proprietary knowledge
• Expertise, experience, analysis
• Be a value-added link in a channel
• Wholesaler, distributor, retailer
• Provide a service

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The Investment Decision in a Nutshell

• Invest in projects that yield a return greater
  than the minimum acceptable hurdle rate.
• Invest in projects that have a rate of return
  that exceeds the cost of the invested funds.

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The Hurdle Rate

• The hurdle rate is
• Based on the companys cost of capital
• Adjusted for the risk of the specific investment
• Greatly affected by economic conditions
• Influenced by competing investments
• Not directly observable (must be estimated)
• Constantly changing

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The Expected Rate of Return

• The Expected Rate of Return is
• The best guess of the average annual rate of
  return to be generated by the project
• Based on the expected cash flows generated by the
  investment compared to its cost
• Affected by the timing of the cash flows

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The Dividend Decision in a Nutshell

• If there are not enough investments that are
  expected to earn the hurdle rate, return the cash
  that cannot meet the investment test to the
  stockholders by paying a dividend.
• The form of return cash dividend or stock
  repurchase - will depend on the stockholders
  characteristics.

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The Financing Decision in a Nutshell

• Choose the financing mix that minimizes the
  hurdle rate and matches the maturity of the
  assets being financed.
• The optimal capital structure is the one that
  minimizes the cost of capital.

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Financing Trade-Offs

• The choice of using debt or equity to finance
  the firm involves trade-offs between
• Cost Debt costs less than equity
• Risk Debt increases the risk for shareholders
• Flexibility Debt limits decision-making
  flexibility
• Control Equity dilutes owners control

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Primary vs Secondary Markets

• Primary Market(s)
• Markets in which securities are sold the first
  time, and from which the issuer receives the
  proceeds.
• Secondary Market(s)
• Markets in which securities are traded among
  investors, and from which the issuer receives no
  proceeds.

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Capital Market(s)

• The capital markets are where companies sell
  original-issue securities (bonds, preferred
  stock, common stock) to buyers, and therefore
  where they raise most of their capital.
• What is CAPITAL?
• What is the primary economic purpose
• of the capital market?

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Financial Intermediary

• Financial intermediaries help to raise capital
  by transforming the form of the capital to fill
  specific but differing demands of the capital
  users and suppliers.
• Retail Banks
• Commercial Banks
• Mortgage Banks
• Some functions of Investment Banks
• Real Estate Investment Trusts
• Some mutual funds

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Money Market vs Capital Market

• Money Market(s)
• Markets in which short-term securities
  (maturities of one year or less) are bought and
  sold.
• Capital Market(s)
• Markets in which long-term securities
  (maturities of more than one year) are bought and
  sold.

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Public vs Private Capital Markets

• Public
• Securities are sold to the general public.
  Anyone can participate. The issue is generally
  managed by investment bankers.
• Private
• The issue (usually debt or preferred stock) is
  sold directly to the capital provider, such as a
  pension fund or insurance company.

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Going Public vs Privately Held

• Going Public
• Common stock is sold to the general public, and
  it is thereafter traded in the secondary market.
• Privately Held
• Common stock is held by usually only a few
  individuals, and any sales or purchases must be
  negotiated with one of these people.

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Pay Dividends vs Retain Earnings

• Dividends
• Dividends are paid from retained earnings.
  Consequently, paying dividends amounts to
  un-financing the company. Dividends should only
  be paid when there are no value-creating
  opportunities for the company to use the money
  internally.
• Retained Earnings
• Retained earnings belong to the common
  shareholders and should be retained only if they
  can be invested in value-creating initiatives.
  Otherwise, they should be paid out as dividends.

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The Scope Of Corporate Finance

• Dr. Del Hawley
• FIN 634