The Scope Of Corporate Finance Instructor Zheng Yu Financial Management

Finance Career Opportunities Corporate Finance Budgeting, financial forecasting, cash management, credit administration, investment analysis, fund procurement Commercial Banking Consumer banking Corporate banking Investment Banking High income potential Very competitive industry Money Management Opportunities in investment advisory firms, mutual fund companies, pension funds, investment arms of financial departments Consulting Advise on business practices and strategies of corporate clients

Raising Capital: Key Facts Most financing comes from internal rather than external sources. Most external financing issued as debt Primary vs. secondary market transactions or offerings The simplest debt instruments to value are U.S. Treasury securities since there is no default risk. Instead, the discount rate to use, r, is the pure cost of borrowing. Assume you are asked to value two Treasury securities, when rf is 1.75 percent (r = 0.0175): A (pure discount) Treasury bill with a $1,000 face value that matures in three months, and A 1.75% coupon rate Treasury note, also with a $1,000 face value, that matures in three years. For the T-Bill, three months is one-quarter year (n=0.25) For 3-year bond, n = 3 Most U.S. corporate bonds: Pay interest at a fixed coupon interest rate Have an initial maturity of 10 to 30 years, and Have a par value (also called face or principal value) of $1,000 that must be repaid at maturity. Bond’s value has two separable parts: (1) PV of stream of annual interest payments, t=1 to t=10 (2) PV of principal repayment at end of year 10. Can thus also value bond as the PV of an annuity plus the PV of a single cash flow using PVFA and PVF from tables. P0 = C x (PVFA5%,10yr) + Par x (PVF5%,10yr) = $50 (7.7220) + $1,000 (0.6139) = $1,000.00 Bonds with a few cash flows can be valued with Eq 4.1; for bonds with many cash flows, use PVFA/PVF factors, calculator or Excel. Traditional financial intermediaries (banks) declining as a source of capital for large firms Securities markets growing in importance

Growth in Global Security Issues, 1990-2003 $ Bn Global debt & equity U.S. Issuers worldwide

Corporate Finance Functions External Financing Capital Budgeting Corporate Finance Functions Financial Management Risk Management Corporate Governance

Dimensions of the External Financing Function Equity vs. debt Funding via capital market vs. via financial intermediary Value of any financial asset is the PV of future cash flows Bonds: PV of promised interest & principal payments Stocks: PV of all future dividends Patents, trademarks: PV of future royalties Valuation is the process linking risk & return Output of process is asset’s expected market price A key input is the required [expected] return on an asset Defined as the return an arms-length investor would require for an asset of equivalent risk Debt securities: risk-free rate plus risk premium(s) Required return for stocks found using CAPM or other asset pricing model Beta determines risk premium: higher beta, higher reqd return Public vs. private capital markets Going public 6

The Capital Budgeting Function Capital Budgeting – the process firms use to choose the set of investments that generate the most wealth for shareholders When r is greater than the coupon interest rate, P0 will be less than par value, and the bond will sell at a discount For Sun, if r >5%, P0 will be less than $1,000 For practice: Value Sun Company, 10-year, 5% coupon rate bond if required return, r =6% and again if r = 4%. Premiums & discounts change systematically as r changes. Select investments for which the marginal benefits exceed the marginal costs.

The Financial Management Function Managing daily cash inflows and outflows Forecasting cash balances Building long-term financial plans -Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P0 and hold it until maturity. The YTM on a bond selling at par (P0 = Par) will always equal the coupon interest rate. When P0  Par, the YTM will differ from the coupon rate. YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P0, CFs, n known, can find YTM Use T-Bond with n=2 years, 2n=4, C/2=$20, P0=$992.43 Choosing the right mix of debt and equity

The Risk Management Function Managing the firm’s exposure to significant risks: Interest rate risk Exchange rate risk -Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P0 and hold it until maturity. The YTM on a bond selling at par (P0 = Par) will always equal the coupon interest rate. When P0  Par, the YTM will differ from the coupon rate. YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P0, CFs, n known, can find YTM Use T-Bond with n=2 years, 2n=4, C/2=$20, P0=$992.43 Commodity price risk

The Corporate Governance Function Ensuring that managers pursue shareholders’ objectives Dimensions of corporate governance Boards of directors Ownership structures Capital structures Compensation plans Country’s legal environment - in U.S., Sarbanes-Oxley Act of 2002 The relationship between nominal (observed) and real (inflation-adjusted) interest rates and expected inflation called the Fisher Effect (or Fisher Equation) Fisher said the nominal rate (r) is approximately equal to the real rate of interest (a) plus a premium for expected inflation (i). If real rate equals 3% (a = 0.03) and expected inflation equals 2% (i = 0.02): r  a + i  0.03 + 0.02  0.05  5% The true Fisher Effect is multiplicative, rather than additive: (1+r) = (1+a)(1+i) = (1.03)(1.02) = 1.0506; so r = 5.06% Takeover market disciplines firms that don’t govern themselves.

What Should Managers Maximize? Profit maximization as goal: Does not account for timing of returns Profits - not necessarily cash flows Ignores risk Maximize shareholder wealth Maximize stock price, not profits Accounts for risk As “residual claimants,” shareholders have better incentives to force management to maximize firm value than do other stakeholders.

Agency Costs In Corporate Finance Due to separation of ownership and control Divergence between interests of managers and shareholders—called agency costs Ways to deal with agency costs Possibility of takeover Monitoring and bonding Compensation contracts Controversial method: executive compensation Average pay in 2003 for CEOs of large U.S. companies: $8.1 million

Forms Of Business Organization In The U.S. Proprietorship No distinction between business and person Easy to set up, operate; taxed as personal income Personal liability, limited life, difficult to transfer Partnership Two or more business owners Partners - liable for every other partner’s actions Limited Partnership One general & many limited partners Limited liability of corporation,tax benefits of partnership Real-estate, R&D companies

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 What was the major weakness for corporations before passage of the Tax Relief Act of 2003? Double taxation The Job and Growth Tax Relief Reconciliation Act of 2003 reduced the double taxation problem.

The Double Taxation of Dividends Taxation of Business Income: Corporations vs Partnerships (Corporate Tax Rate (tc) = 0.35; Personal Tax Rate (tp) = 0.38)

The Tax Relief Act of 2003 Dividends are treated as capital gains, dividend tax rate = 0.15 (Corporate Tax Rate (tc) = 0.35; Personal Tax Rate (tp) = 0.35)

Non-U.S. Forms Of Business Organization Limited-Liability Companies PLC In Britain, SA In Spain, Latin America GMBH or AG In Germany, Austria, Switzerland Limited liability companies can be traded publicly or be privately held. Limited liability companies play an important role in many economies.

Corporate Form of Organization Financial managers – should seek to maximize shareholders’ wealth How? Perform the 5 basic duties of corporate finance: external financing, capital budgeting, financial management, risk management, corporate governance. Select investments for which the marginal benefits exceed the marginal costs.