The Scope Of Corporate Finance

Professor MegginsonFIN 5043/BAD 5283Spring 2007The Scope Of Corporate FinanceChapter 11 -2What is Corporate Finance?The activities involved in managing cash flows in a business environment 1 -3The Core Principles of FinanceThe time value of moneyThe opportunity to earn a return on invested funds means that a dollar today is worth more than a dollar in the future.Compensation for riskInvestors expect compensation for bearing risk.1 -4The Core Principles of FinanceDon’t put your eggs in one basketInvestors can achieve a more favorable trade-off between risk and return by diversifying their portfolios.Markets are smartCompetition for information tends to make markets efficient.No arbitrageArbitrage opportunities are extremely scarce.1 -5The 5 Basic CorporateFinance FunctionsFinancing(Capital-Raising)Capital BudgetingFinancial ManagementCorporate GovernanceRisk Management1 -6The Financing FunctionBusinesses can raise money in 2 ways:externallyfrom investors or creditorsIPOsPrimary market transactionsSecondary market transactionsinternallyby retaining operating cash flowsMost common method1 -7Raising Capital: Key FactsPrimary vs. secondary market transactions or offeringsMost financing from internal rather than external sourcesMost external financing is debtFinancial intermediaries declining as a source of capital for large firmsSecurities markets growing in importanceGlobal Security Issues 1990-2006 ($Bn)01000200030004000500060007000800019901991199219931994199519961997199819992000200120022003200420052006Global debt & equityU.S. Issuers worldwide1 -9Number And Value Of Worldwide Security Issues In 2005Security Type# OfferingsValue $US BillionsTotal Debt & Equity 120,128 $6,514 U.S Issuers Worldwide 111,130 3,822Global Debt17,008 5,997 Global High-Grade Corporate Debt 6,176 2,072 Global Equity2,844 4501 Totals do not include sovereign debt offerings.Source: Investment Dealers’ Digest, early January 2006World Stock Market Capitalization, 1983-July 2006 ($US Billions)0500010000150002000025000300003500040000450005000019831984198519861987198819891990199119921993199419951996199719981999200020012022003200420052006Emerging MarketsOther DevelopedJapanUnited KingdomUnited StatesSources: WorldBank, World Federation ofExchanges1 -11Growth of World Stock Market Trading Volume, 1983-2006 Total Value Of Shares Traded, $Bn Countries 1983 1989 1999 2006* Developed Countries $1,203 $6,297 $35,188 $64,563 United States 797 2,016 19,993 34,869 Japan 231 2,801 1,892 6,222 United Kingdom 43 320 3,399 7,320 Emerging Markets 25 1,171 2,321 5,655 Total World $1,228 $7,468 $37,509 $70,218 * Annualized, based on January-July 2006 data. Source:World Federation of Exchanges1 -12Capital Budgeting–selecting the best projects in which to invest the firm’s resourcesThe Capital Budgeting Function1 -13The Capital Budgeting FunctionThe capital budgeting process consists of three steps.Step 1 -identifying potential investmentsStep 2 -analyzing those investments to identify which will create shareholder valueStep 3 -implementing and monitoring the investments selected in step 21 -14The Financial Management FunctionManaging daily cash inflows and outflowsForecasting cash balancesBuilding a long-term financial planChoosing the right mix of debt and equity1 -15The Corporate Governance FunctionHires and promotes qualified, honest people, and structures employees’ financial incentives to motivate them to maximize firm valueIn practice the incentives of stockholders, managers, and other stakeholders often conflict.Dimensions of corporate governance:Board of directorsSecurities and Exchange CommissionSarbanes-Oxley Act of 20021 -16Global Mergers And Acquisitions, 1991-2006 (US$ Billions)05001000150020002500300035004000450019901991199219931994199519961997199819992000200120022003200420052006U.S. targetsNon-U.S. targetsSource:Investment Dealers’ Digest, early January editions, 1990-20071 -17The Risk Management FunctionIdentifying, measuring, and managing all types of risk exposuresSome risks are insurable, and some risks can be reduced through diversification.Financial instruments like forwards, futures, options, and swaps may also be used to hedge market risks such as interest-rate, price, and currency fluctuations.1 -18Forms 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 transferPartnership•Two or more business owners•Partners -liable for every other partner’s actionsLimited Partnership •One general & many limited partners•Limited liability of corporation,tax benefits of partnership •Real-estate, R&D companies1 -19S Corporations•Shareholders are taxed as partners while still retaining Limited Liability as Corporate Shareholders•Status is Subject to Several Eligibility RequirementsLimited-Liability Companies•Combines the Partnership’s Pass-Through Taxation with the S Corporation’s Limited LiabilityBusiness Organizational Formsin the United States1 -20The Double Taxation of Dividends Corporation Partnership Operating income $100,000 $100,000 Corporate profits tax (tc = 0.35) (35,000) 0 Net income available for dividends 65,000 100,000 Cash dividends or distributions 65,000 100,000 Personal tax, owner income (tp=0.38) (24,700) (38,000) After-tax disposable income $40,300 $62,000 Taxation of Business Income: Corporations vs Partnerships(Corporate Tax Rate (tc) = 0.35; Personal Tax Rate (tp) = 0.38)1 -21The Tax Relief Act of 2003 Corporation Partnership Operating income $100,000 $100,000 Corporate profits tax (tc = 0.35) (35,000) 0 Net income available for dividends 65,000 100,000 Cash dividends or distributions 65,000 100,000 Tax on dividends (td=0.15) (9,750) Personal tax, owner income (tp=0.35) (35,000) After-tax disposable income $55,250 $65,000 Dividends are treated as capital gains, dividend tax rate = 0.15 Corporate Tax Rate (tc) = 0.35; Personal Tax Rate (tp) = 0.351 -22•Britain: public limited companies (PLC)•Germany: Aktiengesellschaft(AG)•France: Société Générale•Spain, Mexico, and elsewhere in Latin America: Sociedad Anónima•Historically, the telephone, television, utility, airline and railroad companies in many European countries•Privatization programs have reduced the role of the states around the worldHow much has been raised through Privatization Programs?State-Owned EnterprisesLimited-Liability CompaniesForms of Business OrganizationsUsed by Non-U.S. Companies1 -23Worldwide Revenues From Privatizations, 1988-2005 ($US Bn)0204060801001201401601801988199019921994199619982000200220041 -24What Should a Financial Manager Try to Maximize?Maximize Profit?Earnings per share are backward-looking, dependent on accounting principles,Do not fully consider cash flow timing Ignores riskMaximize Shareholder Wealth?Maximize stock price, not profitsShareholders, as residual claimants, have better incentives to maximize firm value.1 -25Agency CostsManagers act as agentsof the owners who hired them and gave them decision-making authority to manage the firm for the owners’ benefit.In practice however, self-interests may cause managers to pursue objectives other than shareholder-wealth maximization.This conflict of goals gives rise to managerial agency problems.1 -26•Takeovers•Monitoring and bonding costs•Compensation contracts•Controversial method: executive compensation–Average pay in 2005 for CEOs of 500 largest US firms: $10.9 million (Source: Forbes, April 20, 2006)Ways to deal with agency costsHow Agency Costs Can Be Controlled1 -27Importance of EthicsWidespread publicity surrounding numerous ethical violations began with the Enron collapse in late 2001. Society in general and the financial community in particular are developing and enforcing ethical standards.Ethical behavior is necessary in order to maximize shareholder’s wealth.