Daily Duties in Corporate Finance by qqs20207

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									      The Scope Of Corporate
             Finance
           FIN 221: Corporate Finance
                 Summer 2006




    Finance Career Opportunities
      Corporate     • Budgeting, financial forecasting, cash
                      management, credit administration,
       Finance        investment analysis, fund procurement

    Commercial      • Consumer banking
     Banking        • Corporate banking


     Investment     • High income potential
       Banking      • Very competitive industry

                    • Opportunities in investment advisory firms,
      Money           mutual fund companies, pension funds,
    Management        investment arms of financial departments

                    • Advise on business practices and strategies
2    Consulting       of corporate clients




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    What is Corporate Finance?

    Definition: Corporate Finance is basically the
    study of financial decisions made by firms.
    These decisions include: obtaining financing for
    investment, choosing among alternative
    investment projects, managing cash flows,
    controlling risk exposure, and structuring
    incentives.


    Key: Value Creation: (MB>MC Rule)
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    • Music companies’ sales dropped 20% from
      1999 to 2004. Why?
    • Challenge: provide music on demand for
      low prices, but still earn profits.
    • Apple: iPod and iTunes (April 2003). Sold
      1 million songs the first week.
    • Little known fact: Apple now sells more
      iPods than computers (iPod sales in 2004
      almost $1 billion).
    • Finance played a key role.
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                                                       2
    Can Wealth Be Created?
                 Hypothetical Economy




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    Can Wealth Be Created?
                 Hypothetical Economy

    Each person has 8 hours to allocate between
    building huts, gathering food, and collecting water
    from a fresh-water spring. Collecting water takes 2
    hours per day (1 hour walk each way). After
    subtracting water labor, each person has 6 hours
    of “wealth”.


    One day, Hurley has an idea: build a conveyer belt
6   to the spring and charge 30 minutes per day.




                                                          3
    Can Wealth Be Created?
                 Hypothetical Economy

    What has happened to total “wealth”?


    Each person’s wealth increases from 6 hours to 7.5
    hours. If there are 20 people on the Island, Hurley
    gets 10 hours per day of wealth.



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    Corporate Finance Functions

                                      External Financing



                                      Capital Budgeting


           Corporate
            Finance                 Financial Management

           Functions
                                      Risk Management



                                    Corporate Governance
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                                                           4
         Dimensions of the External Financing
                      Function

                     Equity vs. debt


      Funding via capital market vs. via financial
                    intermediary


           Public vs. private capital markets


                      Going public
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     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
      Traditional financial intermediaries (banks)
     declining as a source of capital for large firms

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       Securities markets growing in importance




                                                        5
     Growth in Global Security Issues,
                            1990-2003
     $ Bn
        6000



       5000



       4000


                                                   Global debt & equity
       3000



       2000

                                                        U.S. Issuers worldwide
       1000



          0
          1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
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     The Capital Budgeting Function



                              Capital Budgeting – the
                               process firms use to
                                choose the set of
                                 investments that
                                generate the most
                              wealth for shareholders



      Select investments for which the marginal benefits
                  exceed the marginal costs.
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                                                                                  6
     The Financial Management Function

         Managing daily cash inflows and outflows


                 Forecasting cash balances


              Building long-term financial plans


         Choosing the right mix of debt and equity

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     The Risk Management Function

      Managing the firm’s exposure to significant risks:


                      Interest rate risk


                     Exchange rate risk


                    Commodity price risk

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                                                           7
     The Corporate Governance
     Function
       Ensuring that managers pursue shareholders’
                       objectives
                          •   Boards of directors
                          •   Ownership structures
     Dimensions
                          •   Auditors
     of corporate
                          •   Capital structures
     governance           •   Compensation plans
                          •   Country’s legal environment - in
                              U.S., Sarbanes-Oxley Act of 2002
     Takeover market disciplines firms that don’t
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               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.
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                                                                 8
     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 hostile takeover
     •   Monitoring and bonding
     •   Compensation contracts
     •   Controversial method: executive compensation
          – Average pay in 2003 for CEOs of large U.S.
17          companies: $8.1 million




     Shareholders or Stakeholders?
     • Many firms have broadened their focus to
       include the interests of other
       “stakeholders”.
         – a.k.a. Corporate Social Responsibility


     • Firms in the US are not required by law to
       do so.
         – These types of laws are common in Western
           Europe, where corporations are expected to
18         contribute to social welfare.




                                                         9
     Stakeholder-ism
     Employees: Firms should refrain from layoffs when they are
     making profits.
     Communities: Refrain from closing plants in distressed
     economic areas except when absolutely necessary.
     Creditors: Don’t maximize shareholder wealth at the
     expense of lenders.
     Ethical/Cultural Considerations:
     -Protect the environment, even if it means reducing profit.
     -Do not invest in countries with oppressive governments or
     poor labor protections.
     -Do not attempt to avoid taxes or bribe officials.

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     -Support the arts.




     Shareholders vs. Stakeholders
     • Most of the time, these goals do not
       conflict with maximizing the stock price.
       Stockholders are “residual claimants”.
     • The idea is that, in the presence of a
       conflict, the firm should be run to
       maximize shareholder wealth.
     • Why?


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                                                                   10
     Shareholders vs. Stakeholders
         – Giving control to non-investors will discourage
           financing in the first place.
         – Creates inefficiencies in decision-making
           (more layers of agency problems)
         – Lack of managerial accountability (how do we
           measure performance)
         – Straightforward Objective: maximize share
           price (observable). How do you maximize the
           welfare of all stakeholders?
         – Leads to an efficient allocation of capital

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     It’s All About the Economics
     Every individual necessarily labours to render the annual
     revenue of the society as great as he can. He generally, indeed,
     neither intends to promote the public interest, nor knows how
     much he is promoting it...he intends only his own gain, and he
     is in this, as in many other cases, led by an invisible hand to
     promote an end which was no part of his intention. Nor is it
     always the worse for the society that it was no part of it. By
     pursuing his own interest he frequently promotes that of the
     society more effectually than when he really intends to
     promote it. I have never known much good done by those who
     affected to trade for the public good.

     It is not from the benevolence of the butcher, the brewer, or
     the baker, that we expect our dinner, but from their regard to
     their own interest. We address ourselves, not to their humanity
     but to their selflove, and never talk to them of our own
     necessities but of their advantages.
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                                  ~Adam Smith, The Wealth of Nations




                                                                        11
     Forms Of Business Organization
     In The U.S.
                        • No distinction between business and
                          person
                        • Easy to set up, operate; taxed as personal
     Proprietorship       income
                        • Personal liability, limited life, difficult to
                          transfer

                        • Two or more business owners
      Partnership       • Partners - liable for every other partner’s
                          actions


                        • One ore more general & many limited
        Limited           partners. Limited partners are passive.
                        • Limited liability of corporation,tax benefits
      Partnership         of partnership
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                        • Lack of liquidity




     Forms Of Business Organization -
     Corporations
                        • Legal entity with all the economic rights
                          and responsibilities of a person
                        • Incorporation occurs at state level; based
      Corporation         on state law
                        • Strengths - limited liability to investors,
                          unlimited business life, capital access

       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
24            double taxation problem.




                                                                           12
     The Double Taxation of Dividends
         Taxation of Business Income: Corporations vs Partnerships
         (Corporate Tax Rate (tc) = 0.35; Personal Tax Rate (tp) = 0.38)


                                             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

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     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)

                                              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
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     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.




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