FINANCE'2011' 'CORPORATE'FINANCE'1' ' Topic'One:'Introduction'to'Finance'and'Financial'Markets'(Chp.1)' Financial'markets,'instruments'and'institutes'

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1 FINANCE'2011' 'CORPORATE'FINANCE'1' ' Topic'One:'Introduction'to'Finance'and'Financial'Markets'(Chp.1)' Financial'markets,'instruments'and'institutes' Four components: 1. Commodity raw materials dug out of ground (more prod n than finc) 2. Stock Equity/shares 3. Money Debt a. Cash market b. Corporation bonds c. Government debt d. Euromarkets e. Open market operations / Monetary policy 4. Forex Currency trading a. Spot FX rates b. FX market regimes c. FX determinants d. FX risk Derivative Market Instruments: o Futures o Options o Swaps (int rate, currency, credit default) Financial Institutions o Commercial banks - Take savings from depositors and make loans to customers o Investment banks - Provide services to corporates (eg: M&A) traditionally they only invested their own money. o Fund managers - Invest money on behalf of clients, Can be Wholesale or Retail, Active or Passive Hedge funds invest in derivatives Superannuation Funds provide for peoples retirement o Retail investors o Insurance companies - Sell premiums and invest the proceeds Payments (claims) are made from the funding pool o Broking houses Provide brokerage services (ie. trade shares on behalf of clients) o Regulatory authorities - ASIC, APRA regulate institutional and individual behaviour Corporate'objective'of'the'firm'&'corporate'finance'decisions' Goal: maximize shareholder wealth and maintain debt holder wealth or maximize value of the company Market value current traded share price Firms maximizing their investment, financing and asset management decisions will maximize the value of the firm Why maximize owner wealth? o Regulator (ASIC) o Remuneration incentive schemes o Market for corporate control o Shareholder votes o Management ownership

2 o But, there are agency problems Measuring company value: market capitalization = # of shares x share price 1.#Investment#decision# Invest to maximize return What real assets should firm invest in to operates and generate cash flows? Development of a process to evaluate the desirability of asset purchases Intangible assets patents, shares in another company How should the firm raise funds to purchase real assets? o How does the firm choose it s gearing ratio? o Costs of each source of finance? o Should firm issue short-term or long-term securities? 2.#Financing#decision# Finance to minimize cost What is the optimal mix of equity and debt to employ? o Introduces importance of capital structure choice o Consider risk and cash flows associated with different finance sources 3.#Dividend#decision# How should the firm pass on the returns to shareholders? (capital gains/dividends) o Can the dividend decision affect the value of the firm? Nature'of'assets'(real'vs.'financial)' Real assets can be put to productive use to generate a return eg. machinery and equipment Financial assets represent a claim to a series of cash flows against an economic unit. o Shares: a claim against a company Cash flows = dividends and sale price o Bonds: A claim against the bond issuer Cash flows = interest and principal o Bank accounts: A claim against a bank Cash flows = interest and principal Firm'valuation,'capital'markets'and'the'flow'of'funds' Firm#valuation# The market value of the firm can be determined in two ways: a. Sum the market values of its real assets b. Sum the market values of the financial claims against those real assets (Common method as active secondary market for fin assets, but not for real assets). Capital#Markets# Capital markets medium for issuing and exchanging financial assets o ASX o Australian Government bond market

3 1. Investors invest funds in capital markets. 2. Financing Decision: Corporations acquire funds from capital markets by selling fin assets. Amount of funding they can raise is dictated by the value of the assets sold: a. Debt-type assets such as bonds. b. Equity-type assets such as shares. 3. Investment Decision: Corps then use these funds to acquire real assets to generate cash flows. 4. Dividend Decision: These cash flows can then be repaid to investors or retained as a source of finance. Valuation'of'Financial'claims' Three important factors to consider when valuing the financial claims on a firm: a. Cash flows b. Time c. Risk Valuation involves discounting the claims to a firm s cash flows over the time of its life at an appropriate rate of return for the risk associated with those cash flows. Asset with a 1-year maturity, the relationship b/w its value (price), cash flow and risk is: F 1 = cash flow from asset in year 1 R = rate of return required on asset Value (P 0 ) represents the asset s equilibrium or intrinsic price o Price in perfect capital market o Based on certainty of cash flows and no imperfections within the capital market o No opportunity to make arbitrage profits by trading on asset mis-pricing Risk aversion implies that increase in risk require increase in return (risk premium) Appropriate discount rate for future cash flows must incorporate risk premium and time value of money. Example. How much would you be willing to pay for this financial asset offering 10%pa annual rate of return? Therefore, you would be prepared to pay $100 now to receive the $110 in one years time.

4 Topic'Two:'A'Modern'Financial'System' Functions#of#a#financial#system:# Comprises a range of financial institutions, instruments and markets Overseen by central bank Supervised by prudential regulator (APRA) Important to EG as savings capital investment improvement of eco productive cap. Attributes#of#an#asset:# 1. Return or yield total fin benefit received (int & cap) from an investment (%) 2. Risk the possibility or probability that an actual outcome will vary from expected 3. Liquidity access to cash and other sources of funds to meet day-to-day expenses 4. Time-pattern of cash flows the frequency of periodic cash flows (interest and principal) associated with a financial instrument. Financial#Institutions# 1. Depository financial institutions - accept deposits and provide loans to customers 2. Investment banks and merchant banks specialist providers of financial and advisory services to corporations, high net worth individuals and government. 3. Contractual savings institutions offer fin contracts such as insurance and super 4. Finance companies and general financiers borrow funds direct from markets to provide loans and lease finance to customers (Aussie Home Loans) 5. Unit trusts investors buy units issued by the trust; pooled funds invested. Securitization process of taking the loans you have made, bundling them and selling them on the market take managerial role. Financial#Instruments# Equity ownership interest; going concern; voting rights; residual claim (eg. ordinary share or common stock) Debt interest and principal payments; finite life; first claim (eg. bond) Hybrid securities characteristics of debt and equity (eg. pref shares, convertible bonds) Derivatives - value derived from underlying asset/security; Mainly used to manage risk: a. Forward contract Contract to trade at a future date at a price determined today b. Futures contract Standardised forward contract c. Option contract Right to buy or sell at a future date at a price determined today d. Swap contract Agreement to exchange future cash flows Financial#Markets# Matching principle short-term assets should be funded by shot-term liabilities, longerterm assets should be funded by longer-term liabilities and equity. Primary market transaction o Occurs when a new financial instrument is issued in the money or capital markets o New capital is raised in this process (eg. IPO) Secondary market transaction

5 o Involves transactions involving existing financial instruments o No new capital is raised in this process (Eg. Purchasing shares on the ASX) Direct#vs.#Intermediate#Finance# Issue of new financial instruments can occur in two ways: 1. Direct Finance Funding obtained direct from the money markets and capital markets Broker an agent who carried out instructions of a client Dealer makes a market in a security by quoting both buy (bid) and sell (ask) prices 2. Intermediated Finance Financial transaction conducted with a financial intermediary Distinguished by separate contractual arrangements Advantages Direct Finance Removes financial intermediary Diversificiation of funding sources Greater flexibility Enhanced profile Intermediated Finance Asset transformation Maturity transformation Liability management Credit risk diversification and Disadvantages Mismatching of preferences and maturity structure Liquidity and marketability of the direct finance instrument High search and transaction costs Difficult to access risk particularly default risk.

6 transformation Liquidity transformation Economies of scale # Wholesale#vs.#Retail#Markets# 1. Wholesale Market Direct financial flow transaction between institutional investors and borrowers Large scale transaction 2. Retail Market Financial transactions conducted with financial intermediaries mainly by individuals and small to medium (SMEs) sized businesses Principally with financial intermediaries Price takers # Money#Markets# Wholesale markets in which s/t securities are issued and traded Comprises a number of submarkets: o Central bank: system liquidity and MP Reserve bank information and transfer system (RITS) o Inter-bank market o Bills market Bank accepted bills (BABs) S/t security No periodic interest payment, just the principle o Commercial paper market No guarantor Credit rating is that of issuer Issued by Co. in Co. s name o Negotiable certificates of deposit market Market Participants Central bank Commercial banks Superannuation funds Investment banks and merchant banks Finance companies Insurance companies Funds managers Building societies Cash management funds Corporations Money-Market instruments Exchange settlement accounts Treasury notes Government bonds (<12months to maturity) Commercial bills Promissory notes (commercial paper) Deposits (11am and 24hour call) Negotiable certificates of deposit Inter-bank loans Repurchase agreements (repos) Capital#Markets# Markets for longer-term funding for businesses, individuals and governments Equity market (ASX) Corporate debt market o Term loans, commercial property finance, debentures, unsecured notes, subordinated debt, lease arrangements and securitization o International capital markets Government debt market