Chapter 1 - The Scope of Corporate Finance
1.1 The role of corporate finance in business
Financial experts play a role in achieving common goals/creating wealth
within a business, and creating value for the firm's shareholders
By taking actions that generate benefits in excess of costs, firms generate
wealth for their investors
1-1a How finance interacts with other functional business areas
For example, with Apple's iPhone 6, financial managers:
o Studied the opportunity + competition in the market
o Evaluated the costs of producing, marketing, distributing the phone
o Analysed the potential demand for the phone
o Developed a pricing strategy consistent with sales projections and the
creation of value for shareholders
o Made recommendations to upper management regarding the financial
viability of the iPhone
1.2 Corporate finance essentials
1-2a 5 BASIC CORPORATE FINANCE FUNCTIONS
Financing, financial management, capital budgeting, risk management and
corporate finance.
1. Financing
The financing function = raising capital to support a company's operations
and investment programs
Involves determining the mix of debt and equity securities that maximises
overall market value (capital structure decision)
Businesses raise money either externally (from creditors/shareholders) or
internally (retaining profits)
, o Financing function focuses on external financing
Either by selling equity (ordinary or preferred shares) or issuing debt
(borrowing money from creditors)
Small companies usually have to raise equity capital privately, or through
venture capitalists (they specialise in high-risk, high-return investments)
After companies get bigger, they can conduct an initial public offering (IPO)
of shares - selling shares to outside investors and listing them for trade on a
stock exchange
2. Financial Management
Financial management function = managing the company's operating cash
flows as efficiently as possible
Ensuring the company has enough funds to support day-to-day operations
Seasonal financing, adequate inventories for customer demand, paying
suppliers, collecting from customers, investing surplus cash
3. Capital Budgeting
Capital budgeting/investment function = selecting the best projects in
which to invest the company's funds based on expected risk/return
Important because:
The scale of capital investment projects are often quite large
Companies can prosper as outcomes drive their value and wealth of owners
Capital budgeting process:
1. Identifying potential investments
2. Analysing the investment opportunities, selecting those that create the most
shareholder value
3. Monitoring the selected investments
4. Risk Management
, Risk management function = identifying, measuring and managing
company's exposure to all types of risk to maintain an optimal risk-return
trade off and maximise share value
Common risks: losses that can flow from adverse interest rate movements,
changes in commodity prices, fluctuations in currency values etc.
Risks can be managed in two ways:
o Risk shifting = involves paying another entity to take on the risk and
compensate you in case of negative outcome (insurance)
o Risk spreading/diversification = combining activities that give rise to risks in
such a way that the risk of the overall combo is less than the risk of each item
For example: rather than using a sole supplier as a key production input, a
company could contract with several suppliers, even if that means purchasing
the input above the lowest possible price
5. Corporate Governance
Corporate governance function = developing company-wide structures +
incentives that influence managers to behave ethically and make decisions
that benefit shareholders
Corporate governance system crucial for good management and hiring
employees' that want to maximise company value
However, incentives of shareholders, managers and shareholders often
conflict (collective action problem)
o Company's shareholders want managers to work hard and protect their
interests, but individual shareholders don't want to monitor management
o Managers may feel the need to increase the wealth of owners but want to
protect their own jobs first and don't want to work harder than necessary
o Managers and shareholders may also run a company to benefit themselves at
the expense of creditors/stakeholders who don't have a say in corporate
governance
NOTE***: stakeholders are more concerned with salaries, benefits and a
better quality of service, while shareholders are concerned with stock prices,
dividends and results (profitability)
, Having a strong board of directors is crucial - developing fixed (salary) and
incentive (bonus/share based) compensation packages to align managers
and shareholders incentives
Australian Securities and Investments Commission (ASIC) = to enforce
and regulate company and financial services laws to protect consumers,
investors and creditors, and also oversight of ASX
Countries also have trouble developing effective corporate governance
systems. They should aim to establish a legal system that:
o Permits efficiency-enhancing M&A
o Block business combos that restrict competition
o Provide protection for creditors and minority shareholders by limiting
opportunities for managers/majority shareholders to expropriate wealth
1-2b DEBT AND EQUITY - the two flavours of capital
Companies have access to two broad types of capital: DEBT and EQUITY
DEBT CAPITAL (obtain by borrowing): all of a company's long term
borrowing from creditors
Borrower is obliged to pay interest on the full amount borrowed (called the
loan's principal), and to repay the principal at the debt's maturity
If the company defaults on any of its payments, creditors can take legal action
to enforce payment
In some cases, this means creditors can push the borrowing company into
bankruptcy, and selling (liquidating) their assets to raise the cash needed to
pay creditors back
EQUITY CAPITAL (selling shares): what investors contribute in
exchange for ownership interests in the company
Equity remains permanently invested in the company
Two basic sources of equity capital: ordinary shares and preferred shares
1. Ordinary shareholders/common stockholders
1.1 The role of corporate finance in business
Financial experts play a role in achieving common goals/creating wealth
within a business, and creating value for the firm's shareholders
By taking actions that generate benefits in excess of costs, firms generate
wealth for their investors
1-1a How finance interacts with other functional business areas
For example, with Apple's iPhone 6, financial managers:
o Studied the opportunity + competition in the market
o Evaluated the costs of producing, marketing, distributing the phone
o Analysed the potential demand for the phone
o Developed a pricing strategy consistent with sales projections and the
creation of value for shareholders
o Made recommendations to upper management regarding the financial
viability of the iPhone
1.2 Corporate finance essentials
1-2a 5 BASIC CORPORATE FINANCE FUNCTIONS
Financing, financial management, capital budgeting, risk management and
corporate finance.
1. Financing
The financing function = raising capital to support a company's operations
and investment programs
Involves determining the mix of debt and equity securities that maximises
overall market value (capital structure decision)
Businesses raise money either externally (from creditors/shareholders) or
internally (retaining profits)
, o Financing function focuses on external financing
Either by selling equity (ordinary or preferred shares) or issuing debt
(borrowing money from creditors)
Small companies usually have to raise equity capital privately, or through
venture capitalists (they specialise in high-risk, high-return investments)
After companies get bigger, they can conduct an initial public offering (IPO)
of shares - selling shares to outside investors and listing them for trade on a
stock exchange
2. Financial Management
Financial management function = managing the company's operating cash
flows as efficiently as possible
Ensuring the company has enough funds to support day-to-day operations
Seasonal financing, adequate inventories for customer demand, paying
suppliers, collecting from customers, investing surplus cash
3. Capital Budgeting
Capital budgeting/investment function = selecting the best projects in
which to invest the company's funds based on expected risk/return
Important because:
The scale of capital investment projects are often quite large
Companies can prosper as outcomes drive their value and wealth of owners
Capital budgeting process:
1. Identifying potential investments
2. Analysing the investment opportunities, selecting those that create the most
shareholder value
3. Monitoring the selected investments
4. Risk Management
, Risk management function = identifying, measuring and managing
company's exposure to all types of risk to maintain an optimal risk-return
trade off and maximise share value
Common risks: losses that can flow from adverse interest rate movements,
changes in commodity prices, fluctuations in currency values etc.
Risks can be managed in two ways:
o Risk shifting = involves paying another entity to take on the risk and
compensate you in case of negative outcome (insurance)
o Risk spreading/diversification = combining activities that give rise to risks in
such a way that the risk of the overall combo is less than the risk of each item
For example: rather than using a sole supplier as a key production input, a
company could contract with several suppliers, even if that means purchasing
the input above the lowest possible price
5. Corporate Governance
Corporate governance function = developing company-wide structures +
incentives that influence managers to behave ethically and make decisions
that benefit shareholders
Corporate governance system crucial for good management and hiring
employees' that want to maximise company value
However, incentives of shareholders, managers and shareholders often
conflict (collective action problem)
o Company's shareholders want managers to work hard and protect their
interests, but individual shareholders don't want to monitor management
o Managers may feel the need to increase the wealth of owners but want to
protect their own jobs first and don't want to work harder than necessary
o Managers and shareholders may also run a company to benefit themselves at
the expense of creditors/stakeholders who don't have a say in corporate
governance
NOTE***: stakeholders are more concerned with salaries, benefits and a
better quality of service, while shareholders are concerned with stock prices,
dividends and results (profitability)
, Having a strong board of directors is crucial - developing fixed (salary) and
incentive (bonus/share based) compensation packages to align managers
and shareholders incentives
Australian Securities and Investments Commission (ASIC) = to enforce
and regulate company and financial services laws to protect consumers,
investors and creditors, and also oversight of ASX
Countries also have trouble developing effective corporate governance
systems. They should aim to establish a legal system that:
o Permits efficiency-enhancing M&A
o Block business combos that restrict competition
o Provide protection for creditors and minority shareholders by limiting
opportunities for managers/majority shareholders to expropriate wealth
1-2b DEBT AND EQUITY - the two flavours of capital
Companies have access to two broad types of capital: DEBT and EQUITY
DEBT CAPITAL (obtain by borrowing): all of a company's long term
borrowing from creditors
Borrower is obliged to pay interest on the full amount borrowed (called the
loan's principal), and to repay the principal at the debt's maturity
If the company defaults on any of its payments, creditors can take legal action
to enforce payment
In some cases, this means creditors can push the borrowing company into
bankruptcy, and selling (liquidating) their assets to raise the cash needed to
pay creditors back
EQUITY CAPITAL (selling shares): what investors contribute in
exchange for ownership interests in the company
Equity remains permanently invested in the company
Two basic sources of equity capital: ordinary shares and preferred shares
1. Ordinary shareholders/common stockholders
