Unit 1 Introduction to Business Finance

UNIT

INTRODUCTION TO BUSINESS FINANCE

What is Business Finance?
BALANCE-SHEET (BS) MODEL OF THE FIRM
Before a company can invest in assets (the left-hand side of the balance sheet), it
must obtain financing, i.e. raise the money to pay for the investment. The forms of
financing are represented on the right-hand side of the balance sheet. A firm will
issue (sell) pieces of paper called debt (loan agreements) or equity shares (stock
certificates). Shareholders equity represents the difference between the value of the
assets and the debt of the firm. In this sense it is a residual claim in the firms
assets.
From the balance-sheet model of the firm, it can be seen that finance can be
thought of as the study of the following 3 questions:
(1)

In what long-lived assets should the firm invest? This question concerns the
left-hand side of the BS. The terms capital budgeting and capital expenditure
are used to describe the process of making and managing expenditures on
long-lived assets.

(2)

How can the firm raise cash for required capital expenditures? This question
concerns the right-hand side of the BS. The answer to this involves the firms
capital structure, which represents the proportions of the firms financing from
current and long-term debt and equity.

(3)

How should short-term operating cash flows be managed? This question

concerns the upper portion of the BS. There is a mismatch between the timing
of cash inflows and cash outflows during operating activities. Furthermore, the
amount and timing of operating cash flows are not known with certainty. The
financial managers must attempt to manage the gaps in cash flow. From an
accounting perspective, short-term management of cash flows is associated
with firms net working capital.

CAPITAL STRUCTURE
Financing arrangements determine how the value of the firm is sliced up. The
persons or institutions that buy debt from the firm care called creditors. The
holders of equity shares are called shareholders. Sometimes it is useful to think
of the firm as a pie. Initially, the size of the pie will depend on how well the firm
has made its investment decisions. After the firm has made its investment
decisions, it determines the value of its assets. The firm can then determine it
capital structure, the firm might initially have raised the cash to invest in its
assets by issuing more debt than equity; now it can consider changing that mix
by issuing more equity and using the proceeds to buy back some of its debt.
Financing decisions like this can be made independently of the original
investment decisions. The decisions to issue debt and equity affect how the pie
is slice. The value of the firm, V can be written as
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Unit 1 Introduction to Business Finance

equity.

V = B + S

, where B is the value of the debt and S is the value of the

THE FINANCIAL MANAGER

In large firms the finance activity is usually associated with a top officer of the firm,
such as a vice-president and chief financial officer. Reporting to the chief financial
officer are the treasurer and the controller. The treasurer handles cash flows, makes
capital-expenditure decisions, and makes financial plans. The controller handles the
accounting function, which includes taxes, cost and financial accounting, and
information systems.
The most important job of the financial manager is to create value from the firms
capital budgeting, financing and liquidity activities. Financial managers create value
by ensuring that the firm:
(1)
(2)

Buys assets that generate more cash than they cost

Sells bonds and stocks and other financial instruments that raise more cash
than they cost.

Identification of Cash Flows

It is not that easy to observe cash flow directly. Much of the information obtained is
in the form of accounting statements, and much of the work of financial analysis is
to extract cash flow information from accounting statements.

Timing of Cash Flows

The value of an investment made by the firm depends on the timing of cash flows.
One of the most important assumptions of finance is that individuals prefer to
receive cash flows earlier than later. One dollar received today is worth more than
one dollar received next year. This time preference plays a role in stock and bond
prices.

Risk of Cash Flows

The firm must consider risk. The amount and timing of cash flows are not usually
known with certainty. Most investors have an aversion to risk.

CORPORATE SECURITIES AS CONTINGENT CLAIMS ON TOTAL FIRM

VALUE
What is the essential difference between debt and equity? The answer can
be found by thinking about what happens to the payoffs to debt and equity when the
value of the firm changes. The basic feature of debt is that it is a promise by the
borrowing firm to repay a fixed dollar amount by a certain date. The stakeholders
claim on firm value at the end of the period is the amount that remains after the
debt-holders are paid. Of course, stockholders get nothing if the firm value is equal
to or less than the amount promised to the debt-holders.
The debt and equity securities issued by a firm derive their value from the total
value of the firm. In other words of finance theory, debt and equity securities are
contingent claims on the total firm value. When the value of the firm exceeds the
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amount promised to debt-holders, the shareholders obtain the residual of the firms
value over the amount promised the debt-holders, and the debt-holders obtain the
amount promised. When the value of firm is less than the amount promised the
debt-holders, the shareholders received nothing and the debt-holders get the value
of the firm.

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Unit 1 Introduction to Business Finance

GOALS OF THE CORPORATE FIRM

The set-of-contracts viewpoint suggests the corporate firm will attempt to maximize
the shareholders wealth in the firm by taking actions that increase the current
value per share of existing stock.

Agency Costs and the Set-of-Contract Perspective

The set-of-contract theory of the firm states that the firm can be viewed as a set of
contracts. One of the contract claims is a residual claim (equity) on the firms assets
and cash flows. The equity contract can be defined as a principal-agent relationship.
The members of the management team are the agents, and the equity investors
(shareholders) are the principals. It is assumed that the managers and the
shareholders, left alone, will each attempt to act in their own self-interest.
The shareholders can discourage the managers from deviating from the
shareholders interests by devising appropriate incentives for managers and them
monitoring their behaviour. The costs of resolving the conflicts of interest between
managers and shareholders are special types of costs called agency costs, defined as
the sum of (1) the monitoring costs of the shareholders and (2) the incentive fees
paid to the managers. It can be expected that contracts will be devised that will
provide the managers with appropriate incentives to maximize the shareholders
wealth. Thus, the set of contracts theory suggests that the corporate firm will
usually act in the best interests of the shareholders. However, agency problems can
never be perfectly solved, and managers may not always act in the best interests of
the shareholders. As a consequence shareholders may experience residual losses.
Residual losses are the lost wealth of the shareholders due to divergent behaviour of
the managers.

MANAGERIAL GOALS
Managerial goals may be different from those of shareholders. What will managers
maximize if they are left to pursue their own goals rather than shareholders goals?
Managers obtain value from certain kinds of expenses. In particular, company cars,
office furniture, office location, and funds for discretionary investment have value to
managers beyond that which comes from their productivity. Donaldson concluded
that managers are influenced by two basic underlying motivations:
(a)

Survival. Organizational survival means that management will always try to

command sufficient resources to avoid the firms going out of business

(b)

Independence and Self-sufficiency.

This is the freedom to make
decisions without encountering external parties or depending on outside
financial markets. Managers do not like to issue new shares of stock. Instead,
they like to be able to rely on internally generated cash flows.

These motivations lead to what Donaldson concludes is the basic financial objective
of managers: the maximization of corporate wealth. Corporate wealth is that wealth
over which management has effective control. It is closely associated with corporate
growth and corporate size. Corporate wealth is not necessary shareholder wealth.
Corporate wealth tends to lead to increased growth by providing funds for growth
and limiting the extent to which new equity is raised. Increased growth and size are
not necessarily the same thing as increased shareholder wealth.

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SEPARATION OF OWNERSHIP AND CONTROL

Some people argue that shareholders do not completely control the corporation
because shareholder ownership is too diffuse and fragmented for effective
control of management. This brings with it separation of ownership and control
of the large corporation. The possible separation of ownership and control raises
an important question: Who controls the firm?
Do Shareholders control Managerial Behaviour?
The
(a)
(b)
(c)

extent to which shareholders can control managers depends on

the costs of monitoring management,
the costs of implementing the control devices, and
the benefits pf control.

There are several control devices used by shareholders to bind management to the
self-interests of the shareholders:
(1)
(2)

(3)

(4)

Shareholders determine the membership of the board of directors by voting.

Thus, shareholders control directors, who is turn select the management team.
Contracts with management and arrangements for compensation, such as
stock option plans, can be made so that management has an incentive to
pursue the goal of the shareholders. Another device is called performance
shares. These are shares of stock given to managers on the basis of
performance as measured by earning per share and similar criteria.
If the price of a firms stock drops too low because of poor management, the
firm may be acquired by a group of shareholders, by another firm, or by an
individual. This is called a takeover. In a takeover, the top management of the
acquired firm may find itself out of job. This puts pressure on the management
to make decisions in the stockholders interest. Fear of a takeover gives
managers an incentive to take actions that will maximize stock prices.
Competition in the managerial labor market may force managers to perform in
the best interest of stockholders. Otherwise they will be replaced. Firms willing
to pay the most will lure good managers. These are likely to be the firms that
compensate managers based on the value they create.

FINANCIAL MARKETS
Money markets are the markets for debt securities that pay off in the short-term
(usually less than one year). Capital markets are the markets for long-term debt and
for equity shares. The term money market applies to a group of loosely connected
markets. They are dealer markets. Dealers are firms that make continuous
quotations of prices for which they stand ready to buy and sell money-market
instruments for their own inventory and at their own risk. Thus, the dealer is a
principal in most transactions. This is different from a stockbroker acting as an
agent for a customer in buying or selling common stock on most stock exchanges; an
agent does not actually acquire the securities.

The Primary Market: New Issues

The primary market is used when governments and corporations initially sell
securities. Corporations engage in two types of primary-market sales of debt and
equity: public offerings and private placements. Most publicly offered corporate debt
and equity come to the market underwritten by a syndicate of investment banking
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firms. The underwriting syndicate buys the new securities from the firm for the
syndicates own account and resells them at a higher price.

Secondary Markets
After debt and equity securities are originally sold, they are traded in the secondary
markets. There are twp kinds of secondary markets: the auction markets and the
dealer markets.
Listing
Firms that want their equity shares to be traded on the KLSE must apply for listing.
There are certain minimum requirements that must be met before listing is given.

CAPITAL MARKET THEORY: AN OVERVIEW

Dollar Returns
The owner of shares of stock generally receives some cash, called dividends, during
the year. This cash is the income component of a shareholders return. In addition,
the other part of the return is the capital gain or, if it is negative, the capital loss
on the investment. If the stock is sold at the end of the year, the total amount of
cash would be the initial investment plus the total return. If the stock is not sold at
the end of the year, the capital gain is still considered part of the return. However,
the capital gain is realized only when the stock is sold

Percentage Returns
Expressing the dividend received at the end of the year as Divt+1 and the price of
the stock at the beginning of the period as Pt, the percentage of income return,
called dividend yield is Divt+1/ Pt. The capital gain is the change in the price of the
stock dividend by the initial price. Letting Pt+1 be the price of the stock at year-end,
the capital gain can be computed as ( Pt + 1 - Pt ) / Pt

Holding-Period Returns
To calculate the holding period return from year 1 to year t, obtain the product of
the returns in each of the years as follows:
( 1 + R1 ) x ( 1 + R2 ) x x ( 1 + Rt )

Average Stock Returns and Risk-Free Returns

The government borrows money by issuing bonds, which the investing public bonds.
Bonds come in many forms and include Treasury bills or T-bills. The government
sells some bills at an auction. A typical bill is a pure discount bond that will mature
in a year or less. Because the government can raise taxes to pay for the debt it
incurs, this debt is virtually free of risk of default. Thus this is called the risk-free
return over a short time. An interesting comparison is between the virtually risk-free
return on T-bills and the very risky return on common stocks. The difference
between risky returns and risk-free returns is often called the excess return on the
risky asset. It is called excess because it is the additional return resulting from the
risk of common stocks and is interpreted as a risk premium.
Advantages of a company compare to sole proprietor and partnership

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Limited Liability the financial liability of the owners is limited to the

amount they have paid in. should the company become insolvent, those with
outstanding claims on the company cannot compel the owners to pay in further
capital
Transferability of Ownership it is generally easier to sell shares in a
company, particularly if it is listed on the stock market, than to sell all or part
of a partnership or sole proprietorship
Permanence a company has a legal identity quite separate from its owners.
Its existence is unaffected by the sale of shares or death of a shareholder.
Access to Markets the above benefits, together with the fact that
companies enable large numbers of shareholders to participate, mean that
companies can enjoy financial economies of scale, giving rise to greater choice
and lower costs of financing the business.

THE FINANCE FUNCTION

In a well-organised business, each section should arrange its activities to maximize
its contribution towards the attainment of corporate goals. The finance function is
very sharply focused, its activities being specific to the financial aspect of
management decisions. The chart below illustrates how the accounting and finance
functions may be structured in a large company.
It is the task of those within the finance function to plan, raise and use funds in an
efficient manner to achieve corporate financial objectives. Two central activities are
as follows:
(1)
(2)

Providing the link between the business and the wider financial environment
Investment and financial analysis and decision-making
FINANCE DIRECTOR
FINANCE
DIRECTOR
(Chief
Financial
Officer)
(Chief Financial Officer)
Responsibilities:
Responsibilities:
Financial
Strategy and
Financial
Strategy and
Policy
Policy
Corporate Planning
Corporate Planning

CONTROLLER
CONTROLLER
(Chief
(Chief
Accountant)
Accountant)
Responsibilities:
Responsibilities:
Financial
Accounts
Financial
Accounts
Management
Management
Accounts
Accounts
Investment
Investment
Appraisal
Appraisal
Taxes
Taxes

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TREASURER
TREASURER
(Financial
(Financial
Manager)
Manager)
Responsibilities:
Responsibilities:
Risk
Management
RiskFunding
Management
Funding
Cash Management
CashBanking
Management
Banking
Relationship
Relationship
Mergers
&
Mergers &
Takeovers
Takeovers

Unit 1 Introduction to Business Finance

The Finance function in a large organization

INVESTMENT AND FINANCIAL DECISION

Financial Management is primarily concerned with investment and financing
decisions. The investment decisions, sometimes referred to as the capital budgeting
decision, are the decision to acquire assets. Real assets may be tangible (e.g. land
and buildings, plant and equipment, and stocks) and intangible (e.g. patents,
trademarks and know-how). Sometimes a firm may invest in financial assets
outside the business, in the form of short-term securities and deposits.
The basic problems relating to investments are as follows:
(a) How much should the firm invest?
(b) In which projects should the firm invest (fixed or current, tangible or
intangible, real or financial)?
The financing decision addresses the problems of how much capital should be raised
to fund the firms operations (both existing and proposal), and what the best mix of
financing is.

Recent years have seen the emergence of financial management as a major

contributor to the analysis of investment and financing decisions. The subject
continues to respond to external economic and technical developments:
(a)

The move to floating exchange rates, high interest rates and inflation during
the 1970s focused attention on interest rate and currency management, and
the impact of inflation on business decisions. New ways of coping with these
uncertainties have been developed to allow investors to hedge, or cover, such
risks.

(b)

Successive waves of merger activity over the past forty years have increased our
understanding of valuation and takeover tactics.

(c)

Technological progress in communications has led to the globalization of

business. Modern computer technology not only makes globalization of finance
possible, but also brings complex financial calculations and financial
databases within easy reach of every manager.

(d)

Complexities in taxation and the enormous growth in new financial

instruments for raising money and managing risk have made some aspects of
financial management highly specialized.
Greater awareness of the need to view all decision-making within a strategic
framework is moving the focus away from purely technical to more strategic
issues.

(e)

The Financial Objective

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The main objective is to maximize shareholder value. In simple form, managers
should create as much wealth as possible for the shareholders. Given this objective,
any financing or investment decision expected to improve the value of the
shareholders stake in the firm is acceptable. Wealth maximization or profit
maximization? Profit maximization ignores the timing and risks of the profit flows,
but value (wealth) is heavily dependent on when cost and benefits arise and the
uncertainty surrounding them.
Examples of other secondary goals:
(a)
(b)
(c)
(d)

Profit retention. For example, Distributable profits must always be at least

three times greater than dividends.
Borrowing level. For example, long-term borrowing should not exceed 50%
of total capital employed.
Profitability. For example, ROCE should be at least xx%
Non financial goals.

The Agency Problem

Potential conflict arises where ownership us separated from management. The
ownership shareholders while the day-to-day control of the business rest on the
hands of a few managers. This can give rise to what is termed managerialism
self-serving behaviour by managers at the shareholders expense. Examples of
managerialism include pursuing splendid offices, company cars, adopting low risk
survival strategies etc. Managers are agents of shareholders and are required to act
in their best interests. However, they have the operational control of the business
and the shareholders receive little information on whether the managers are acting
in their best interests.
To attempt to deal with such agency problems, various incentives and controls have
been recommended, all of which incur costs. Incentives profit related pay, bonus
according to performance. Share options, this has value only when the actual share
price exceeds the option price (e.g. warrants). Another way to minimize the agency
problem is by setting up and monitoring managers behaviour. For examples, audit
the accounts of the company, additional reporting requirements, and limiting the
authority levels.

THE CORPORATE GOVERNANCE DEBATE

Corporate Governance the system by which companies are directed and
controlled. While, in company law, directors are obliged to act in the best interest of
shareholders. Problems: many companies have been generous in rewarding their
leading executives, and the procedures for remunerating have been less transparent.
The Principles of Good Governance and Code of Best Practice (1999) are summarized
below:
(1)

Directors and the Board

A balance of executive and non-executive directors. No individual or group

must dominate the board

Clear procedures for appointments, re-election at least every three years.

(2)

Directors Remuneration

Individual performance

Directors are not involved in deciding their own remuneration.

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(3)

Relations with Shareholders

Encourage dialogue

AGM

(4)

Accountability

A sound system of internal control to safeguard shareholders interests

and company

External
Economic
conditions
Operating and
Investment Decisions

Cash
Flow

Value of
firm

Management
Strategies &
Policies
Financing
Decision

Cost of
Capital

Factors influencing the value of the firm

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