Lecture 1 (Chp1)- Intro to Finance & Financial Market-UPM's

8/11/2019 Lecture 1 (Chp1)- Intro to Finance & Financial Market-UPM's

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CHAPTER 1The Scope of Corp. Finance

What is Finance?

The Core principle of Corp. Finance

Goals of the Corporation

Conflicts Between Managers andShareholders

Finance, Capital market and Growth.


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What is Finance? Finance can be defined as the art and

science of managing money.

Finance is concerned with the processof transferring money among

individuals, businesses, andgovernments through institutions,markets, and instruments.


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Corporation

Investment

in real assets

Investors

worldwide

Financial markets

Stock markets

Fixed-income markets

Money markets

Markets for

Commodities

Foreign exchange

Derivatives

Financial

Intermediaries

Mutual Funds

Pension funds

Financial Institutions

Banks

Insurance companies

Reinvestment

Financial Markets


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The Core Principles of Finance The Opportunity to earn a return on

invested funds means that a dollar today is

worth more than a dollar in the future

Financial experts rely on the time value of

money discussed in chapters 3 and chapter 4

to make these judgments.

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The Core Principles of Finance "Investors expect compensation for bearing

risk.

Chapter 5 illustrate how to quantify the risk

and return trade off

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The Core Principles of Finance Investors can achieve a more favorable

trade-off between risk and return by

diversifying their portfolio.

Chapter 6 explore the risk and return

relationship and illustrate the characteristics

of investment alternatives that influence thedesign of optimal portfolios

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The Core Principles of Finance Competition for information tends to make

market efficient

Chapter 10, surveys much of the

counterintuitive evidence that market are

extremely smart.

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The Core Principles of Finance Arbitrage opportunities are extremely

scare .

Chapter 18 and 19, explain how the

arbitrage principle allows us to value

complex financial instruments such as stock

option.

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Financial Goals of the Corporation

The primary financial goal isshareholder wealth maximization,which translated from stock price

maximization.


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Renong Corporation

- RM 2.25/ shares- An individual owns 1,000 Unit of shares

- Total Wealth :

RM2.25 x 1000 Unit

= RM2,250


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Financial Goals of the CorporationInvestors Wealth Maximization

t0 = RM2.25/sharesInvestors wealthRM2,250

t1 = RM3.75/sharesInvestors wealthRM3,750


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Factors that affect stock price Projected cash

flows to

shareholders Riskiness of the

cash flows


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A. Projected of cash flows to shareholders

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Dividend

i.e: RM0.02 for every share owned

1,000 units x RM0.02 = RM20

-Net income to be distributed to shareholders

-Profit Dividend Projected cash

flows to s/holders

share price wealth maximization

materialize


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B. Riskiness of the cash flows Must reduce the possibilities of interruption

on the cash flows

Possibility of interruption may arise due tomismanagement in the company

Mismanagement Profit Dividend

Stock price Wealth maximization

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Organization structure

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Conflicts Between Managers and

Stockholders Managers are naturally inclined to act in

their own best interests (which are not

always the same as the interest ofstockholders).

This give rise to Agency Problem


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Source of Conflicts Between

Managers and Stockholders

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CEO

Salary

RM1.2m/ year

Companys No. of shareholders

profit (t=1) = 100 individual

RM 10m/ yr = RM100,000/ individual

Companys

profit (t=2)

After new strategy

RM30m/ yr = RM300,000/ individual


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How minimize agency problem

Direct intervention by shareholders

The threat of Firing

Takeovers

Managerial compensation plans Bonus Options

Stock Options


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How minimize agency problem

Managerial compensation plans

Stock Options and managers

entrenchment effect.


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A new form of agency problem

Ultimate owners and minority

shareholders

Pyramidal ownership structure and

minority shareholders expropriation.

V i bl D fi iti


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Variables Definition

Firm C

20%

Ultimate Owner

Firm A

Firm B

25%

30%

UO Control (CR) OnF irm C:

= 20 %

UO Actual

Ownership (CFR) on

F irm C:

= 25% x 30%x 20%

= 1.5%


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Theory: Pyramidal Structure & AgencyProblem( La Porta 1999)

UO

FirmA

Firm B

Source of expropriation

- The UO CFR on Firm

B via Firm A:

20% x 20% = 4% ( 0.04)

- Losses incurred to due to over investment

by Firm B

4% x Rm10 Million = RM 400,000

20%

20%

Varia es De inition: Ma aysian Pyrami a


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Varia es De inition: Ma aysian Pyrami agroup( Lins et al2003)

Kinta Kelas Bhd

20%

Halim bin Saad

Renong Berhad

United Engineers Malaysia ( UEM)

25%

30%


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Is stock price maximization good or badfor society?

Should firms behave ethically?


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Should firms behave ethically Desperate attempt to maximize stock price

may lead to:

1. Window dressing

2. Earning management

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Example

An asset should be depreciated for 5 years,

but instead it was depreciated over a 10 yearslife (i.e: Asset value= RM10m)

-If 5 years total depreciation expense RM2m/yr-If 10 years total depreciation expense RM1m/yr

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Goals of The CorporationEthics & Management Objectives Does value maximization justify unethical behavior?

1. Enron example:The energy trading company announced in the late

2001 a $1.7 billion in losses that had beenpreviously concealed through creative accounting.

2. WorldCom example:The company admitted that it had failed to report $3.8

billion of operating expense( ie. the expenses wereclassified as investment) Thus, World Com income

was overstated by $3.8 billion.


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The Importance of Financial marketsand Institutions


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Corporation

Investment

in real assets

Investorsworldwide

Financial markets

Stock marketsFixed-income markets

Money markets

Markets for

Commodities

Foreign exchange

Derivatives

Financial

Intermediaries

Mutual Funds

Pension funds

Financial Institutions

Banks

Insurance companies

Reinvestment

Financial Markets


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Function of Financial Markets Transporting cash across time

A. Financial markets and institutions provide savers (cash inflowexceeding cash outflow for period) an opportunity to enter intocontracts (financial investments) to transport purchasing powerto future periods. Both initial principal and accumulatedearnings on investments will be available for later.

B. Financial markets and institutions provide borrowers (cashinflow less than outflow for the period) an opportunity tocontract with lenders (borrow) funds to be earned in laterperiods for use now. The interest paid on loans is the cost oftransporting future income to present consumption.


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Function of Financial Markets Risk transfer and diversification

A. Financial markets and institutions

(insurance companies) provide a means ofcontractually reducing business and financialrisk.

B. Holding assets in portfolios takesadvantage of the opportunity to diversifyaway part of the risk of assets.


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Function of Financial Markets Liquidity

A. Corporations may store liquidity in

bank deposits, investing in moneymarket securities or buy govt. CD's.Thus, from such investment outlets,

savers has the ability to get to cashquickly and efficiently.


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Function of Financial Markets Payment mechanism

A. Payment services provided by banks

and other financial institutions allowfirms and individuals to send andreceive payments quickly and

efficiently.


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Function of Financial MarketsInformation Provided by Financial Markets

- required rate of return & Cost of capital

Credit Rating InterestRate

AAA 5.71%

AA 5.78A 6.38

BBB 7.12

BB 9.84

B 10.82

Source: Bloomberg Composite Corporate BondIndexes.

Interest rates on 30-year corporate bonds,

February 2008.


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Function of Financial MarketsInformation Provided by Financial Markets

B. A continuous flow of information about

economic levels, commodity prices, interestrates and company stock prices aids thefinancial manager to make decisions that willbest maximize the long-run value of the

corporation.


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Cost of capital & Firm Value The cost of capitalis the minimum

acceptable of return needed on capital

investments to maintain the current value oftheir securities. It is the minimum returndemanded by investors for investments of acertain risk level available in the market.

The cost of capital for corporate investmentsis set by the rates of return on investmentopportunities in financial marketstheopportunity cost of capital.


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Cost of capital & Firm ValueA. Investment projects offering rates of return

higherthan the cost of capital add value to

the firm. Projects offering rates of return lessthan the cost of capital actually subtract valueand should not be undertaken.

Lecture 1 (Chp1)- Intro to Finance & Financial Market-UPM's

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