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Daily Duties in Corporate Finance document sample
Document Sample
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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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.
7
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
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
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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.
12
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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.
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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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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
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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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