LECTURE 1: INTRODUCTION TO FUNDAMENTALS OF BUSINESS ...
LECTURE 1: INTRODUCTION TO FUNDAMENTALS OF BUSINESS FINANCE FOUR BASIC AREAS OF FINANCE o o o o
Corporate finance – financial decisions Investments – shares Financial institutions – banks International finance – global context
GOAL OF FINANCIAL MANAGEMENT o
o
Aim of the financial manager is to maximise shareholder wealth Maximisation of share price Based on cash flow (size, timing and risk) A profitable firm can experience cash flow problems – income is recorded when a sale is made, but many sales do not receive cash for some time – doesn’t have cash available for commitments Shareholders purchase shares for an expected gain Profit maximisation is not an appropriate goal No time frame (short or long term?) Profits are not cash Profits measured in various ways, manipulated through accounting practices Investors also care about risk
FACTORS IN ANY FINANCIAL DECISION o o o
Dollar amount – of the actual cash flow received or paid out Time – when cash flow is received or paid out Risk – amount of uncertainty – higher returns for higher risks
FINANCIAL MANAGER’S RESPONSIBILITIES o
o
o
Investment decision determines the composition of assets controlled by the firm. Capital budgeting decision – What assets to buy? Most important decision Incorrect decisions are costly to reverse How to determine the value of a long-term asset Evaluate size, time and risk of cash flows Select assets that create most shareholder wealth Financial decision is concerned with debt and owner’s equity. Capital structure decision – Where does the money come from? How to finance an investment? Determine the best mix between – Debt (load funds) – contractual claim Equity (owner’s funds) – residual claim Trade-off between return and risk Use of debt is called gearing or leverage Working Capital decision Less potential for value creation Managing short-term assets and liabilities
Forms part of the investment decision Inventory management – optimal level of inventory Receivables management – credit sales be allowed? Accounts payable management – time suppliers wait for cash Cash – how much cash should a company hold
FORMS OF BUSINESS o
o
o
Sole trader/proprietorship Individual – may employ other people Unlimited liability Success or failure relies on the individual owner Lasts as long as the owner is alive or sells Raising finance usually from financial institutions Equity component limited to sole trader’s wealth – undercapitalised Life is limited Partnership Several individuals All share gains and losses Partnership agreement If one wants to leave, partnership ends Company Most important form Separate legal entity Unlimited life – ease of transferability of ownership Superior form when raising capital Limited liability for shareholders Disadvantages o Many formal and legal requirements o Few companies are listed Problems with size of firm and control o More expensive to establish and operate o Agency problems
CORPORATE GOVERNANCE o o
Objectives of management may differ from shareholders Managers may be satisfiers rather than maximisers Management play it safe, rather than maximising the value of firm o Management are agents for the owners o Introduces a potential conflict Agency problem or ethical decision making Principal and Agent Law o Agency law is part of commercial law It is a contractual relationship between a person (agent) who is authorised to act on behalf of another (principal) Agent can create legal relationships with third party Creation of Agency Expressly in writing or verbally Implied by law
o
o
As part of necessity, or by cohabitation, by status (such as partnership) or working relationships Employer-employee relationships Not all employees are agents for the employer Dependent on work carried out Sales people are agents for employer Managers tend to be agents as they enter into contracts Agents can be Special, General or Universal Duties of an agent o Follow the principal’s instructions o Act personally o Exercise reasonable skill and diligence o Act in the principal’s best interest o Not to make a secret profit o Not to divulge confidential information
PRIMARY MARKET
o Security or instrument issued to an investor for the first time o Funds are raised by the firm and flow to it o Initial public offering or private placement o Can be debt or equity funding o Fund raising between investors and firm SECONDARY MARKET (ASX) e.g. securities exchange o Financial securities that are already issued are bought and sold o Way of transferring ownership o Investor-to-investor trading o No additional funds are raised by the firm
MARKET VALUES AND BOOK VALUES o o o o
Balance sheet is historical accounting Real or productive assets – produce the cash flows over time Financial or paper assets – claim on cash flows of productive assets Balance sheet for finance Not concerned with past What is value of the assets today? Market Value
Risk refers to the amount of uncertainty regarding the amount and timing of cash flows. Risk as well as return must be considered by financial managers as rational investors are risk-averse. Only willing to larger risks if compensated with larger returns. Managers need to ensure that the risks they take are justified by the prospect of higher returns. An active secondary market is essential as it provides liquidity, which investors value. Investors more likely to purchase securities in primary market if the secondary market is liquid.
Corporate finance – financial decisions Investments – shares Financial institutions – banks International finance – global context
GOAL OF FINANCIAL MANAGEMENT o
o
Aim of the financial manager is to maximise shareholder wealth Maximisation of share price Based on cash flow (size, timing and risk) A profitable firm can experience cash flow problems – income is recorded when a sale is made, but many sales do not receive cash for some time – doesn’t have cash available for commitments Shareholders purchase shares for an expected gain Profit maximisation is not an appropriate goal No time frame (short or long term?) Profits are not cash Profits measured in various ways, manipulated through accounting practices Investors also care about risk
FACTORS IN ANY FINANCIAL DECISION o o o
Dollar amount – of the actual cash flow received or paid out Time – when cash flow is received or paid out Risk – amount of uncertainty – higher returns for higher risks
FINANCIAL MANAGER’S RESPONSIBILITIES o
o
o
Investment decision determines the composition of assets controlled by the firm. Capital budgeting decision – What assets to buy? Most important decision Incorrect decisions are costly to reverse How to determine the value of a long-term asset Evaluate size, time and risk of cash flows Select assets that create most shareholder wealth Financial decision is concerned with debt and owner’s equity. Capital structure decision – Where does the money come from? How to finance an investment? Determine the best mix between – Debt (load funds) – contractual claim Equity (owner’s funds) – residual claim Trade-off between return and risk Use of debt is called gearing or leverage Working Capital decision Less potential for value creation Managing short-term assets and liabilities
Forms part of the investment decision Inventory management – optimal level of inventory Receivables management – credit sales be allowed? Accounts payable management – time suppliers wait for cash Cash – how much cash should a company hold
FORMS OF BUSINESS o
o
o
Sole trader/proprietorship Individual – may employ other people Unlimited liability Success or failure relies on the individual owner Lasts as long as the owner is alive or sells Raising finance usually from financial institutions Equity component limited to sole trader’s wealth – undercapitalised Life is limited Partnership Several individuals All share gains and losses Partnership agreement If one wants to leave, partnership ends Company Most important form Separate legal entity Unlimited life – ease of transferability of ownership Superior form when raising capital Limited liability for shareholders Disadvantages o Many formal and legal requirements o Few companies are listed Problems with size of firm and control o More expensive to establish and operate o Agency problems
CORPORATE GOVERNANCE o o
Objectives of management may differ from shareholders Managers may be satisfiers rather than maximisers Management play it safe, rather than maximising the value of firm o Management are agents for the owners o Introduces a potential conflict Agency problem or ethical decision making Principal and Agent Law o Agency law is part of commercial law It is a contractual relationship between a person (agent) who is authorised to act on behalf of another (principal) Agent can create legal relationships with third party Creation of Agency Expressly in writing or verbally Implied by law
o
o
As part of necessity, or by cohabitation, by status (such as partnership) or working relationships Employer-employee relationships Not all employees are agents for the employer Dependent on work carried out Sales people are agents for employer Managers tend to be agents as they enter into contracts Agents can be Special, General or Universal Duties of an agent o Follow the principal’s instructions o Act personally o Exercise reasonable skill and diligence o Act in the principal’s best interest o Not to make a secret profit o Not to divulge confidential information
PRIMARY MARKET
o Security or instrument issued to an investor for the first time o Funds are raised by the firm and flow to it o Initial public offering or private placement o Can be debt or equity funding o Fund raising between investors and firm SECONDARY MARKET (ASX) e.g. securities exchange o Financial securities that are already issued are bought and sold o Way of transferring ownership o Investor-to-investor trading o No additional funds are raised by the firm
MARKET VALUES AND BOOK VALUES o o o o
Balance sheet is historical accounting Real or productive assets – produce the cash flows over time Financial or paper assets – claim on cash flows of productive assets Balance sheet for finance Not concerned with past What is value of the assets today? Market Value
Risk refers to the amount of uncertainty regarding the amount and timing of cash flows. Risk as well as return must be considered by financial managers as rational investors are risk-averse. Only willing to larger risks if compensated with larger returns. Managers need to ensure that the risks they take are justified by the prospect of higher returns. An active secondary market is essential as it provides liquidity, which investors value. Investors more likely to purchase securities in primary market if the secondary market is liquid.
