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Chap01 HO

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Chap01 HO

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Managerial Finance Lecture Notes

Module One Module 1.1

Corporate Finance and Financial


Overview of Statements
Corporate Finance
Chapter 1 and 2

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Learning Objectives Learning Objectives

By the end of this module you should be able to: By the end of this module you should be able to:
1. identify and explain the three major decisions in corporate
finance, 5. explain the role of financial markets, identify their
participants and distinguish between the different types of
2. briefly explain the differences between a sole financial markets,
proprietorship a partnership
proprietorship, partnership, and a company
company,
6. use the two-period perfect certainty model to analyse
3. describe what should be management's primary goal in a investment, financing and dividend decisions, and
profit-oriented business, 7. distinguish between: ‘book value’ versus ‘market value’;
‘net profit’ versus ‘ cash flow’; a ‘statement of financial
4. explain “agency problems” and describe some possible position’ versus a ‘statement of financial performance’;
ways to control and reduce them, and ‘marginal’ versus ‘average’ tax rates.

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What is Corporate Finance? Capital Budgeting

Corporate finance attempts to find the answers to the


following questions: Capital budgeting involves the planning and control of
– What investments should the firm take on? expenditures incurred in the expectation of deriving
THE INVESTMENT DECISION future cash inflows.
– How can cash be raised for the required
investments? Involves evaluating the:
THE FINANCE DECISION – size of future cash flows;
– Should dividends be paid? – timing of future cash flows; and
THE DIVIDEND DECISION – risk of future cash flows.

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1
Managerial Finance Lecture Notes

Cash Flow Size Cash Flow Timing

A dollar today is worth more than a dollar at some future


Accounting information does not mean cash flow. date.
Which project is worth more?
Accrual accounting
– A sale is recorded at the time of sale and a cost is Year Project A Project B
recorded when it is incurred.
1 $0 $20 000

Accounting information and earnings can be very different 2 $10 000 $10 000
to cash flows.
3 $20 000 $0

Total $30 000 $30 000

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Cash Flow Risk Cash Flow Risk

Which is the better project?


The role of the financial manager is to deal with the
uncertainty associated with investment decisions.
Pessimistic Expected Optimistic
Assessing the risk associated with expected future cash
flows is critical to investment decisions.
Project 1 $100 000 $300 000 $500 000

Project 2 -$200 000 $400 000 $1 000 000

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The Finance Decision: Dividend Decision


Capital Structure

A firm’s capital structure is the specific mix of debt and Involves the decision of whether to pay a dividend to
equity used to finance the firm
firm’s
s operations. shareholders or maintain the funds within the firm for
greater internal growth.
Decisions need to be made on both the financing mix and
how and where to raise money. The final decision will depend on the policies of the firm.

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Managerial Finance Lecture Notes

Possible Goals Problems With These Goals

Survival Each of these goals presents problems.


Avoid financial distress and bankruptcy
Beat the competition These g goals are either associated with increasing
g
profitability or reducing risk.
Maximise sales or market share
Minimise costs
It is necessary to find a goal that can encompass both
Maximise profits
profitability and risk.
Maintain steady earnings growth

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The Firm’s Objective Agency Relationships

• The agency relationship is the relationship between


shareholders (owners) and management of a firm.
The goal of financial management is to maximise
shareholder’s wealth.
• The agency problem suggests a possibility of conflict
This goal overcomes the problems encountered with the of interests between these two parties.
goals outlined above.
• Agency costs refer to the direct and indirect costs
arising from this conflict of interest.

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Do Manager’s Act in Alignment of Goals


Shareholders’ Interests?
The answer to this will depend on two factors:
The conflict of interests is limited due to:
– how closely management goals are aligned with
shareholder
s a e o de goa
goals;
s; a
and
d – monitoring of management;

– the ease with which management can be replaced if it – management compensation schemes; and
does not act in shareholders’ best interests.
– the threat of takeover.

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Managerial Finance Lecture Notes

Cash Flows Between the Firm Financial Markets


and the Financial Markets
• Financial markets bring together the buyers and
Total Value of the Firm
Total Value of to Investors in sellers of debt and equity securities.
Firm’s Assets the Financial Markets

• Money markets involve the trading of short-term debt


A. Firm issues securities
securities.
B. Firm Financial
invests in Markets
assets
t • Capital markets involve the trading of long-term
long term
E. Retained cash flows F. Dividends and Short-term debt
Current debt payments Long-term debt securities.
Assets Equity shares
Fixed C. Cash flow from
Assets firm’s assets • Primary markets involve the original sale of securities.
• Secondary markets involve the continual buying and
selling of already issued securities.
D. Government

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Structure of Financial Markets Two-Period Perfect


Certainty Model

Explains the behaviour of firms and individuals.


Financial Markets
Relies on three assumptions:
Money Market Capital Market – perfect certainty
– perfect capital markets
Primary Market Secondary Market Primary Market Secondary Market – rational investors

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Two-Period Perfect Utility Curves


Certainty Model
The certainty model uses two periods - now (period 1) Period 2
and the future (period 2). Utility curves

q
Individuals decide on consumption choices based on their
tastes and preferences and the investment
opportunities available to them.

Utility curves represent indifference between period 1 and


period 2 consumption.
p
Period 1
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Managerial Finance Lecture Notes

Opportunities Available Production Possibility Frontier

Period 2
Production possibility
130 frontier – shows cash
Opportunities facing firms in a two-period world include: flows from investment in
110 real assets
– investment in real assets
– payment of dividends
80

Derives the production possibility frontier. Next best investment

Best investment

70 100 130
Period 1

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Utility Maximisation Solution


• Firms should invest funds until they reach a point on the
production frontier that is just tangent to the owners’
utility curve.
• Introduce a capital market - resources can be
transformed from current to future and vice versa.
• This then places the owner on the highest possible
utility curve given the resources.
resources
• Develops the market line.
• At this point, the owner’s utility is maximised.
• Optimal investment policy where production possibility
frontier is tangent to the market line.
• Problem exists if there is more than one owner.

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Optimal Investment Policy


Period 2 Investor’s preferred
Fisher’s Separation Theorem
190 consumption pattern

Market line – shows


157 cash flows from
borrowing or lending
130
In a perfect capital market, it is possible to separate the
firm’s
firm s investment decisions from the owner owner’ss
Q = Optimal investment
80
consumption decisions.
Production
possibility frontier

30 100 130 172 Period 1

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5
Managerial Finance Lecture Notes

Implications of Fisher’s Analysis The Investment Decision

• Investment decision ⇒ a company can make decisions • The point of utility maximisation can be reached
in the interests of every shareholder. through one of two rules:
– Net present value rule: invest so as to maximise the net
present value of the investment.
• Financing g decision ⇒ there exists a single
g market
interest rate. – Rate-of-return rule: Invest up to the point at which the
marginal return on the investment is equal to the
expected rate of return on equivalent investments in the
• Dividend decision ⇒ provided a company does not financial markets.
alter its investment decision, the dividend decision
does not affect shareholder’s wealth.

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The Investment Decision

• It is only the investment decision that affects firm


value.

• Firm value is not affected by how investments are


financed or how the distribution (dividends) are made
to the owners.

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