Corporate Finance: A South African Perspective PowerPoint slides to accompany Corporate Finance: A South African Perspective by Gideon Els, Elda du Toit, Pierre Erasmus, Liezel Kotze, Sam Ngwenya, Kevin Thomas and Suzette Viviers Ancillary material ISBN 978 019 904100 8 © Oxford University Press Southern Africa (Pty) Ltd Vasco Boulevard, Goodwood, Cape Town, Republic of South Africa P O Box 12119, N1 City, 7463, Cape Town, Republic of South Africa All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press Southern Africa (Pty) Ltd, or as expressly permitted by law, or under terms agreed with the appropriate designated reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press Southern Africa (Pty) Ltd, at the address above.

INTRODUCTION TO CORPORATE FINANCIAL MANAGEMENT CHAPTER 1 INTRODUCTION TO CORPORATE FINANCIAL MANAGEMENT 2

Chapter outline Introduction What is corporate finance? The goals of financial management The corporate forms of business The agency problem Financial markets and institutions Corporate governance and ethics Conclusion

Learning outcomes By the end of this chapter you should be able to: Explain the role of corporate financial management and the role and responsibilities of the financial manager Review the types of corporate financial management decisions and identify the main goal of financial management Describe the different corporate forms of business Describe the agency problem and agency cost Understand the functions of financial markets and institutions and the role of corporate governance and business ethics

Introduction Both big and small businesses are guided by the same corporate financial principles Bigger businesses are run by managers These managers are selected by the shareholders (owners of the business) It is important to increase the wealth of the shareholders

The role of corporate financial management The process of creating value in a business by making the best decisions Ultimate measure – to increase the wealth of the shareholders Financial management ≠ Accounting Accounting: a historical perspective (report) Financial managers: use information from accountants to make decisions

Position of the financial manager in the corporate structure

The Financial Manager Responsible for: Managing the business’s cash and credit Financial planning Corporate expenditure Record-keeping

Corporate financial management decisions 3 basic decisions: What should the business invest in? Where will the business get long-term financing to pay for the new investment? How will the business manage its day-to-day financial activities? CAPITAL-BUDGETING DECISION CAPITAL-STRUCTURE DECISION WORKING-CAPITAL MANAGEMENT DECISION

Capital budgeting Financial manager should aim to create value Will do that by identifying investments that will create value Determine cash flows Size – how much initial investment is needed and how much income will be received Timing – when and for how long income will be received Risk – the likelihood of receiving the income Will income from investment exceed the cost?

Capital structure The mix of debt and equity a company uses to fund new investments/projects Three choices available: Borrow long-term funds (debt) – risk increase Use savings of the company (retained earnings) Issue more shares (equity) – ownership declines Whichever option will have an effect (risk and value) Which form of financing is the cheapest?

Working-capital management Working capital = short-term assets and liabilities How will you approach the day-to-day financial management? Will you sell new product for cash, credit or both? Who will receive credit and who won’t? How many days until debtors have to pay? Will you pay expenses in cash or on credit? All these decisions are important to ensure business functions efficiently There must be sufficient resources for adequate liquidity

Three financial management decisions

The goals of financial management Most people believe main goal is maximising profit: Increasing sales Increasing market share Minimising costs Increasing growth in profits Avoiding insolvency Surviving BUT focusing on profitability ignores risk Higher risk should correspond with higher return Need more basic goal – shareholders’ wealth maximisation

Shareholders’ wealth maximisation Number one goal = increase the wealth of the shareholders How can that be done? Shareholders can receive dividends Increase in the share price If a financial manager focuses on shareholders’ wealth maximisation, then both risk and return are taken into account Profit maximisation: short-term goal not looking at long- term effects Share price maximisation: short-term and long-term Every decision in the best interest of the shareholders

The corporate forms of business Sole proprietorship Partnership Companies Private companies Public companies Close corporations

Sole proprietorship A single person has the controlling interest (one-person business) Success/failure is entirely in the hand of one person Main characteristics: Easy entry into the market Lifespan of business = owner’s lifespan Owner is generally also the manager (shareholders’ wealth maximisation) Business not a separate legal entity from owner

Partnership Private agreement between partners (max 20) All contribute to business with skills and equity Partners can raise more capital and have greater creditworthiness Main characteristics: Easy entry into the market Lifespan of the business is limited Business not a separate legal entity from partners Profits and debts are the liability of the partners in proportion to their contribution to capital

Companies Separate legal entity from the owners Owners (shareholders) have limited liability Company must comply with legislation Two kinds of companies: Private companies Public companies

PRIVATE COMPANIES PUBLIC COMPANIES Must have between 1 and 50 shareholders Minimum of 7 (unlimited number of shareholders) At least one director At least two directors Transferability of shares is restricted. No offer can be made to the public to buy. Transferability of shares not restricted. Public are invited to purchase and sell shares at any time Financial statements only available to the directors and shareholders Financial statements are available to the public Proprietary Limited - (Pty) Ltd after the name of the company Limited (Ltd) after the name of the company

Companies Main characteristics: Complicated entry into the market Lifespan of the company is unlimited Company is a separate legal entity from the owners Unlimited access to capital Separation of ownership and management

Close corporations Same advantages of a company, but simpler and less expensive Between 1 - 10 members (not shareholders) Member’s interest (not shares) – percentage share in the business Main characteristics: Less complicated market entry than a company A separate legal entity and limited liability to members Transfer of interest uncomplicated and simple

The agency problem Goal of financial management: increase shareholders’ wealth Sole proprietorship = easy; owners are generally also the managers of the business Big companies = difficult; owners/shareholders not directly involved in business The shareholders (principals) appoint managers (agents) to look after their interest Agency relationship: the relationship between the principal and the agent Agency problem: when the agent does not make decisions in the best interest of the principal

Agency costs Management and shareholders goals can differ Agency cost: Any costs (both direct and indirect) that can arise due to the agency problem Direct agency cost: measurable amount Indirect agency cost: not physical, lost opportunity Control agency cost: Incentive plans Performance plans

Financial markets and institutions Financial market: place where anyone with funds can transact with anyone in need of funds Money Market: short-term debt securities (no physical location) Capital Market: long-term debt securities (stock and bond exchanges) Primary market: sell securities for the first time Secondary market: securities traded after being sold in the primary market Auction market: broker brings buyer and seller together (NYSE) Dealer market: traders offer to buy or sell securities (JSE) Financial institutions: bring savers and lenders together to efficiently allocate funds (financial intermediary)

Flow of funds

Corporate governance Laws, policies, processes and organisations that influence business and the business environment Ensures that needs of shareholders & stakeholders are served Main role players: shareholders, board of directors, management Other stakeholders: employees , creditors, customers, community Accepted principles of corporate governance: Rights & equitable treatment of shareholders Interests of other stakeholders Role & responsibility of the board Integrity & ethical behaviour Disclosure & transparency King III Report

Business ethics Moral principles and values applied in a business setting Ethical companies conduct themselves by distinguishing between right and wrong Unethical behaviour: creative accounting, insider trading, gender, race & religious discrimination, price fixing Certain behaviour might be legal, but still unethical For example: child labour might be legal in certain countries, but is it ethical to buy products from companies using children as cheap labour?

Conclusion Corporate financial management is the process of creating value in a business. The financial manager needs to make the following three decisions to create value: What should a business invest in? Where will the business get the long-term financing to fund the investment? How will the business manage its day-to-day financial activities? The most important financial management goal is to increase the wealth of the shareholders by increasing the current share price.

Conclusion (cont.) The four forms of a business organisation are: Sole proprietorship Partnership Company Close corporation Shareholders are the owners of a business and they appoint managers to act as their agents. If the managers do not act in the shareholders’ best interests, the business is faced with the problem of agency.

Conclusion (cont.) Financial markets act as a platform to bring together buyers and sellers of securities. There are two forms of financial markets, namely money and capital markets. Capital markets are also divided into primary and secondary markets. Financial institutions act as intermediaries to bring together suppliers of funds (savers) and demanders of funds (borrowers). Corporate governance and ethics are necessary to manage a business in a moral and lawful manner.