"Daily Duties in Corporate Finance"
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 1 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) 3 • 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. 4 2 Can Wealth Be Created? Hypothetical Economy 5 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. 7 Corporate Finance Functions External Financing Capital Budgeting Corporate Finance Financial Management Functions Risk Management Corporate Governance 8 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 9 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 10 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 11 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. 12 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 13 The Risk Management Function Managing the firm’s exposure to significant risks: Interest rate risk Exchange rate risk Commodity price risk 14 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 15 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. 16 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. 19 -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? 20 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 21 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. 22 ~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 23 • 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 25 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 26 13 27 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. 14