MFIN7005

CORPORATE FINANCE AND

ASSET VALUATION
Lecture 1 INTRODUCTION
Prof. Wenlan Qian
What is Finance?

• A discipline concerned with determining value (what

something is worth today) and making decisions based
on that value assessment. The finance function
allocates resources, including the acquiring, investing,
and managing of resources.
Business Finance Applications
• A company wants to replace its current production line with a
line of new more expensive and more efficient machines.
Should the company buy the new machines or leave the old
ones in place?
• A firm needs to purchase a piece of equipment. Should it buy
a cheaper machine with a shorter lifespan or a more
expensive machine that lasts longer?
• A company is trying to decide whether to develop a new
product - how can it deal with the fact that most of the
development costs will be incurred before any sale
revenues have been realized?
• All businesses, from international conglomerates to small
“hawker” shops, have to decide how they’ll finance their
operations. Will they borrow or will they bring in new
investors/shareholders?
Household Finance Applications
The principles behind making correct business finance decisions
are the same as those used for individual finance decisions. So
the good news is that the lessons of this course can benefit you
in many areas of your personal life. You can begin to
theoretically and quantitatively address:

1.When to start saving for retirement and how much to

save?
2.How to evaluate the terms for a home mortgage?
3.Whether a car loan or a lease is more advantageous?
4.Is a particular stock a good investment? Is a particular fund
a good investment?
5.How to finance a child’s education?
Scope of Study in Finance

Main Areas of Finance:

1. Investments
2. Financial Markets and Intermediaries
3. Corporate Finance (or Business Finance)
Investments
• The study of financial transactions from the
perspective of investors outside the firm.
• Examples:

– How do we assess the risk of various

financial securities?
– How do we manage a portfolio (a grouping) of
financial securities to achieve a stated objective of
the investor?
– How do we evaluate portfolio performance?
Financial Markets & Intermediaries

• The study of markets where financial securities (such

as stocks and bonds) are bought and sold.

• The study of financial institutions (such as

commercial banks, investment banks, and insurance
companies) that facilitate the flow of money from
savers to demanders of money.
Corporate Finance
• Corporate Finance addresses the following:
– What long-term investments should the firm take on?
(capital budgeting decision)
– Where will we get the long-term financingto pay
for the investment? (capital structure decision)
– How will we manage the everyday financial activities
of the firm? (working capital management decision)

• Examples of financial decisions affecting firms:

‒ Dell computer expands its product line
‒ Gap builds additional stores
‒ Nike closes a production plant in Asia
‒ Ford borrows $3 billion
‒ Perot Systems issues stock valued at $3 billion
Example: Corporate Finance
Investment Decision

• New plant for Rolls-Royce in Singapore

In a major boost to Singapore's aerospace ambitions, Rolls-

Royce has unveiled plans for a new facility to make engine
fan blades for large aircraft - its first outside England - at the
Seletar Aerospace Park. Also in the pipeline: A new regional
training center. The projects will take to more than $700
million the total amount that the British power systems and
engines giant is pumping into Singapore's future aviation hub.
July 28, 2009, The Straits Times
Example: Corporate Finance
Financing Decision

SoftBank readies multibillion-dollar bond issue

TOKYO -- SoftBank Group will issue dollar-denominated bonds to
raise capital for the company's technology investment fund
established with Saudi Arabia and other partners, a vehicle that may
reach as large as $100 billion over the next five years.

The Japanese tech company's bonds are expected to raise 300

billion yen to 500 billion yen ($2.64 billion to $4.41 billion), taking
advantage of low interest rates. The debt will be issued as perpetual
subordinated hybrid bonds, which have no maturity date and act
similarly to equity. The company will seek investors in Europe and
Asia.
Example: Corporate Finance
Working Capital Mgt Decision
Supply Chain Finance frees up working capital for SMEs
Fashion Label M)phosis recently signed up for a Supply Chain
Financing facility to obtain cash advances to buy more supplies in
an effort to meet the surge in demand during Chinese New Year. As a
result, M)phosis was able to free up cashflow to boost its online
retail presences. The deal cost the retailer $200,000.
Said M)phosis managing director Hensley Teh, “Supply Chain
Finance is a tool that better matches working capital to the
seasonal nature of the business.”
The Investment Vehicle Model

• Investors provide financing to the firm in exchange

for financial securities (various claims on the firm’s
cash flows).
• The firm invests these funds in assets.
• Income generated by the firm’s assets is distributed to
the investors (i.e., the holders of the firm’s financial
securities).
 The Investment Vehicle Model

The Firm Financial

Exchange of Money Markets
and Real Assets

Decisions
Financing
Decisions
Investment Exchange of
Money and
The World Investors
Financial Assets

Financial
Intermediaries
 Investment Vehicle Model –
The Flow of Cash in a Firm

Firm's Operations
(2) Financial Manager (1) Financial Investors

(4a)

(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
 Investment Vehicle Model –
The Flow of Cash in a Firm

Financial Manager
Firm's Operations Financial Markets

The question here The question here is

is – what will the – how will the firm
firm invest in? fund that
investment?
The Balance Sheet Model

• Also known as the Accounting Model of the Firm

• Investment decisions are represented on the asset

(i.e., left hand) side of the balance sheet

• Financing decisions are represented on the

liabilities and equity (i.e., right hand) side of the
balance sheet
Relating Value back to the Balance Sheet
Total Value of Assets: Total Firm Value to Investors:

Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity
Relating Value back to the Balance Sheet
The Capital Budgeting Decision
Total Value of Assets: Total Firm Value to Investors:

Current
Liabilities
Current Assets
Long-Term
Debt

What long-
Fixed Assets term
1 Tangible investments Shareholders’
should the firm
2 Intangible engage in? Equity
Relating Value back to the Balance Sheet
The Capital Structure Decision
Current
Liabilities
Current Assets
Long-Term
How can the firm Debt
raise the money
for the required
Fixed Assets investments?
1 Tangible Shareholders’
2 Intangible Equity
Relating Value back to the Balance Sheet
The Net Working Capital Investment Decision
Current
Net Liabilities
Current Assets Working
Capital Long-Term
Debt

How much short-

Fixed Assets term cash flow
1 Tangible does a company
need to pay its Shareholders’
2 Intangible bills? Equity
Relating Value back to the Balance Sheet
Maximizing Value (Investment
Decision): The value of the firm can
be thought of as a pie => The goal of Assets
the manager is to increase the size of
the pie via value maximization.

Capital Structure (Financing Or

Decision): The Capital Structure 25% 70% 30%
decision can be viewed as how Debt Debt Equity
best to slice up the pie. This can 75%
take on an infinite range of Equity
possibilities.
An Organization Chart
Financial Manager

• The top financial manager within a firm is usually the

Chief Financial Officer (CFO)
– Treasurer: oversees cash management, credit
management, capital expenditures and financial
planning
– Controller: oversees taxes, cost
accounting, financial accounting and data
processing
Diff. Forms of Business Organization

1. Sole proprietorship

2. Partnership

3. Corporation
Sole Proprietorship
Under this organization method, an individual owns
and manages the business
Advantages Disadvantages
– Easiest to start – Limited to life of owner
– Least regulated – Equity capital limited to
– Single owner keeps owner’s personal wealth
all the profits – Unlimited liability
– Taxed once as – Difficult to sell ownership
personal income interest
Partnership
Under this organization method, a group of individuals collectively own
and manage the business.
• A partnership has roughly the same advantages and
disadvantages as a sole proprietorship.

Advantages Disadvantages
– Two or more owners – Unlimited liability
– More capital available • General partnership
– Relatively easy to start • Limited partnership
– Income taxed once – Partnership dissolves when
as personal income one partner dies or wishes to
sell
– Difficult to transfer ownership
Corporation
A corporation is created via Articles of Incorporation. These:
• Set out the purpose of the business.
• Establish the number of shares that can be issued.
• Set the number of directors to be appointed.

► Ownership and management are separated. A corporation issues

equity shares. The holders of these shares are the owners of the
firm. Although stockholders own the corporation, they do not
necessarily manage it. Instead, they vote to elect a Board of
Directors (BOD). The BOD represents the shareholders and, in this
vein, (i) selects the management team, (ii) appoints the auditors and
(iii) is responsible for checking/monitoring management’s actions.
Corporate Structure -
Separation of Ownership and Control

Board of Directors

Debtholders

Shareholders
Management

Debt
Assets
Equity
Corporation

• Advantages • Disadvantages
– Limited liability – Separation of ownership
– Unlimited life and management (and the
resulting potential for
– Separation of ownership
agency costs)
and management
– Double taxation (income
– Transfer of ownership is
taxed at the corporate rate
easy
and then dividends taxed at
– Easier to raise capital personal rate)
Corporation

• Private Companies – firm’s shares are usually closely

held, i.e., ownership is closely held by a relatively small
number of shareholders and shareholders often include
the companies’ original founders, some financial
backers (e.g., venture capitalists) and others. Shares are
not traded on any exchange.

• Public Companies – firm’s shares are listed on a stock

exchange, whereby the company’s shares are widely
dispersed and traded in the secondary markets.
Corporations: Two Main Sources of
External Financing – Debt & Equity
I. Debt
• Lenders – By lending money to the corporation, debt
holders become the corporation’s creditors and
lenders.
• Relationship Determined by Contract - A debt contract is a
legally binding agreement. It specifies principal, interest,
maturity date, and specific protective covenants.
• Security and Seniority – In case of bankruptcy, debt holders
collect before equity holders. However, different debt
holders have different priority claim to the cash flows and
assets of a bankrupt firm, according to their respective debt
contracts.
Corporations: Two Main Sources of
External Financing – Debt & Equity
II. Equity
• Shareholders’ Ownership Rights – by buying shares in
the corporation, shareholders become the owners of
the firm. Shareholders are the residual claimants of
the firm.
• Shareholders’ Payoffs – shareholders receive monetary
returns in the following ways:
– Dividend per share, paid to investors from the
corporation’s after-tax dollars.
– Capital gain from the sale of shares (ownership rights)
at a price higher than they were purchased for.
Possible Goals of Financial Management

• What should be the goal of a corporation?

• Commonly cited goals:
– Maximise sales/market share? lowering price
or relaxing credit terms
– Minimise costs? lowering quality or R&D
– Maximise profits? short-term nature; definition of
profits, accounting or economic; risk is not
addressed
Goal of Financial Management
• The primary goal is shareholder wealth maximization,
which is the same as maximizing stock price
• Thus, the goal of the firm is to maximize its value.
– Maximize the value of the firm
– Maximize the wealth of its owners
– Maximize the price of its stock
– Maximize its contribution to the economy

• As per finance theory, the above four objectives are all best
realized when the firm uses finance’s systematic value
maximizing investment and financing decision criteria.
How Can Managers Maximize Stock Price?

• What determines stock prices– the underlying firm’s

ability to generate cash flows
• Three aspects of cash flows that affect asset value
and thus stock prices
– Amount of cash flows expected by shareholders
– Timing of the cash flow stream
– Riskiness of the cash flow stream
⟹All three determine the stock’s Intrinsic Value
Intrinsic Value vs. Market Price

• The intrinsic value is an estimate of a stock’s “true”

value based on accurate risk and return data.
• – An “estimated” value, not a precise objectively known
measure

• The market price is based on perceived information

as seen by the marginal investor (can be theoretically
incorrect).
Role & Decisions of Financial Manager
Maximise Value (stock price) of the Firm

Capital Capital Working Capital

Budgeting Structure Management

What long-term How should we How do we

investments or pay for our manage the day-
projects should assets? to-day finances
the business Should we of the firm?
take on? use debt or
equity?
What is the Agency Problem?

• Agency relationship:
– Principal hires an agent to represent their interest
– Stockholders (principals) hire managers (agents), via
the Board of Directors, to run the company

• Agency problem
– Conflict of interest between principal and agent

• Corporate organization potential conflict of

interests:
– Shareholders and managers
– Shareholders and creditors
Agency Costs

• Direct agency costs

– expenditures that benefit management: car
and accommodation, big office, high pay
– monitoring costs: auditors, audit committee,
corporate governance
• Indirect agency costs
– lost opportunities which would increase firm value
in the long run, if accepted
Agency Costs Example:
HSBC Faces Investor Anger Over
Proposed Pay Rise For Top Team

by Katherine Griffiths, Miles Costello,16/2/2010

• HSBC, the global bank that has been praised for its handling
of the financial crisis, has clashed with shareholders over a
proposed pay rise for its executive team.
• Investors are understood to be particularly unhappy with the
sum that HSBC wants to pay Michael Geoghegan, its chief
executive, who relocated his office to Hong Kong on
February 1.
• HSBC will pay Michael Geoghegan, chief executive, an extra
£800,000 a year in "allowances" and "benefits in kind" for moving
his family from London to Hong Kong.
Shareholders versus Managers

• Managers are naturally inclined to act in their own

best interests.

• But the following factors affect managerial behavior:

– Compensation plans tied to share value
– Direct intervention by shareholders
– The threat of firing
– The threat of takeover
How To Handle The Agency Problem?

1. Compensation plans that tie the fortunes of the

managers to the fortunes of the firm.
Disney’s Former CEO
Compensation Package
Michael Eisner’s compensation
package’s 3 main components:

1. A base annual salary of $750,000

2. An annual bonus of 2% of Disney’s net income

above a threshold of “normal” profitability

3. A 10-year option that allowed him to purchase 2

million shares of stock for $14 per share, which was
about the price of Disney stock at the time he was
hired as the CEO.
How To Handle The Agency Problem?

1. Compensation plans that tie the fortunes of the

managers to the fortunes of the firm.
2. Monitoring by lenders, stock market analysts
and investors.
3. The threat that poorly performing managers will be
fired.
4. The growing awareness of the importance of good
Corporate Governance.
What is Corporate Governance?
• “Term that refers broadly to the rules, processes, or laws
by which businesses are operated, regulated, and
controlled. The term can refer to internal factors defined by
the officers, stockholders or constitution of a corporation,
as well as to external forces such as consumer groups,
clients, and government regulations.”
• “…exists to serve corporate purposes by providing a
structure within which stockholders, directors and
management can pursue most effectively the objectives of
the corporation"
• - US Business Round Table White Paper on
Corporate Governance September 1997
• Good corporate governance requires you to view
organizations as a web of relationships between and
among various stakeholders and to manage their interests
in a responsible manner.
Corporate Governance:
Wells Fargo splits chairman and
CEO roles after investor pressure
- Financial Times, 2 Dec 2016
• Wells Fargo has changed its boardroom rules to require the roles of chief
executive and chairman be kept separate, adding to pressure on other US
banks to end the contentious practice of combining the top jobs. The bank,
which has been in the spotlight for months over sales malpractice in its
branches, had prised apart the two positions when John Stumpf quit
suddenly in October. He was replaced by Tim Sloan as chief executive and
Stephen Sanger as chairman.
• On Thursday, however, Wells went further — saying it had with
immediate effect amended the company’s bylaws to mandate the split.
The move comes after pressure from shareholders, including state
treasurers in Illinois and Connecticut.
• “This change to ensure accountability and stronger oversight will benefit
everyone with an interest in the company,” said Michael Frerichs, Illinois’
state treasurer. “While an important step forward, we need to continue to
encourage companies to do the right thing for the right reasons.” In a
statement, Mr Sanger said: “We believe this action will enhance the board’s
independence and its oversight of the company’s management, and we
appreciate the feedback that we received from our investors on this matter.”
The Firm & Its Sources of Funds

• Financial Markets

• What are financial markets?

– markets where “financial instruments” are traded
– act as intermediaries between savers and borrowers

• Money Markets vs Capital Markets

• Primary Market vs Secondary Market

Money Markets vs. Capital Markets

• Money markets
– where debt securities of less than one year are traded:
treasury securities, commercial paper, bills, inter-bank loans
– loosely connected dealer markets
– banks are major players

• Capital markets
– where equity and long-term debt claims are publicly traded
Primary Market vs. Secondary Market

• Primary market
– for government and corporations initially issued securities
– public offering - where securities are offered to public at large;
needs underwriting, more regulatory requirements, costly
– private offering - where securities are offered to large financial
institutions or wealthy individuals etc.; less costly

• Secondary market
– where existing financial claims are traded
– dealer market (e.g., OTC markets)
– auction market (e.g., NYSE)
– where getting market value of securities is easier
Example: Primary Market
Visa raises $17.9bn in record IPO
• The world's largest credit
card network sold 406m
shares at $44 each, raising
$17.9bn. The shares were
initially forecast to sell at
between $37 and $42.
• Shares opened more than 30% above the offer price - at $59.50
- and headed up to the $60 level in early trading.
• The San Francisco-based company will make its debut with
a market value of about $36bn.

March 19, 2008, Guardian.co.uk

Example: Secondary Market
Dow and S&P at new '09 highs

Wall Street gains after a smaller-than-expected number of jobs lost

and a surprise drop in the unemployment rate. Investors trading
among themselves.

NEW YORK (CNNMoney.com) --

Stocks rallied Friday, with the Dow and
S&P 500 closing at the highest point in
nine months, after the July jobs report
showed the smallest number of job losses

August 7 2009, CNNMoney.com

Firm’s Sources Of Funds

The Firm

Equity Debt

Share Retained Bank Bond

Issuance Earnings Borrowing Issuance
Summary

1. The scope of financial studies involves business

finance, financial markets and investments.
2. Business finance involves investment and financing
decisions & working capital management.
3. The goal of financial management is to make
decisions that maximize the market value of the
equity or owners’ wealth.
4. There are conflicts of interest between shareholders
and managers - agency costs.