Topic 1

Introduction To
Business/Corporate Finance
 Overview
 In this lecture we will discuss
The nature of business/corporate finance;
The nature of financial markets;
The corporate objective;
Corporate financial decisions;
Critical factors in financial decision-making;
Valuation of a firm and real and financial
assets; &
Finance vs. accounting

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 Business/Corporate Finance

What Is Business/Corporate Finance?

“Corporate Finance is a body of knowledge which
focuses on explaining and interpreting financial markets. It
provides an analytical framework to guide managers of
firms and to assist them to evaluate corporate financial
decisions”.
(Bishop, Crapp, Faff and Twite , 1993)

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 Financial Markets
 What is a Financial Market?
A medium for the issue and exchange of
financial assets.
 Australian financial market includes:
 The “big four” banks (and all other
banks/building societies/savings & loans
operating in Australia)
 The Australian Stock Exchange (ASX)
 The Australian government bond market

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 Financial Markets

 Financial markets - bring together the buyers and sellers of debt

and equity securities.
 The financial market is made up of:
Money market - involves the trading of short-term debt securities;
&
Capital market - involves the trading of long-term debt securities
and equity securities.
 The money market and the capital market are each made up of:
Primary market - involves the original sale of securities (IPOs to
raise finance); &
Secondary market - involves the continual buying and selling of
already issued securities (for profit & loss).

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 Corporate Financial Decisions:
The Goal of The Firm
(The Corporate Objective)
The Corporate Objective
Before we discuss corporate financial decisions we should know what is the
main goal/objective of a firm from a corporate/business finance perspective:
Main corporate objective: obvious answer - Maximise Profit X Wrong!!!
The corporate objective can be stated in two different, but equivalent, ways:
“Maximise the market value of the company”
or
“Maximise shareholder wealth”
This means using scarce resources (land, labour and capital) in the most
efficient manner possible.

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 Corporate Financial Decisions:
The Goal of The Firm
(The Corporate Objective)
The Corporate Objective
A company should make decisions that increase
the wealth of its owners.
This is synonymous with increasing the value of
the firm.
Owner wealth is measured by the market
capitalisation of securities - for shares this is the
total market value of all of the shares of a company
on issue.
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 Corporate Financial Decisions:
The Goal of The Firm
(The Corporate Objective)

An Example of Market Capitalisation

Example: BHP-Billiton as at 08th July 2013
Security: Ordinary Shares
No. on issue – 5.348 billion1
Last sale price - $31.0402
Market capitalisation of ordinary shares–
 5.348 billion shares x $31.040 = $166.002 billion
1 http://www.bhpbilliton.com/home/investors/reports/Documents/2012/BHPBillitonAnnualReport2012.pdf BHPB Annual Report June 2012 p. 6, 08/07/13 3:00pm.

2 http://www.asx.com.au/asx/research/companyInfo.do?by=asxCode&asxCode=BHP, ASX price, 08/07/13 2:55pm.

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 Corporate Financial Decisions:
The Goal of The Firm
(The Corporate Objective)

Why Should A Company Aim To Maximise Its Market Value? –

The Standard Economic Model justification:
The standard economic model (SEM) states:
Individuals are utility (satisfaction/happiness) maximisers
Utility is a function of consumption
Consumption is a function of wealth
Utility maximising individuals wish to maximise their wealth
And we know that:
Individuals hold part of their wealth in the form of shares in companies, and
The market value of a company is represented by its share price multiplied by the number of shares
on issue
Therefore,
The greater the market value of a company's shares, the greater the company’s market value, and
the greater will be the wealth of its shareholders and therefore the greater will be their utility

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 Corporate Financial Decisions:
Achieving The Corporate Objective
Key Decisions In Business Finance
The two key decisions faced by corporate
finance managers in achieving the corporate
objective are:
1. The investment decision
2. The financing decision

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 Corporate Financial Decisions:
Achieving The Corporate Objective
The Investment Decision
The way in which funds that have been raised are
used in productive activities.
The objective is to generate a return to investors.
This is dealt with under the topic of “capital
budgeting” or “project evaluation” (Topic 4)

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 Corporate Financial Decisions:
Achieving The Corporate Objective
The Investment/Capital Budgeting Decision
The investment decision deals with the evaluation of investment
opportunities.
Involves evaluating the:
 size of future cash flows;
 timing of future cash flows; and
 risk of future cash flows.

The question asked is:

Which real assets should the firm invest in in order to maximise
its market value?
Wealth is created by adding value to raw materials or providing
services. These activities are represented by the asset side of the
balance sheet

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 Corporate Financial Decisions:
Achieving The Corporate Objective

The Financing Decision

The mix of funding obtained from capital markets.
The proportional holdings of debt and equity.
This is addressed via analysis of ‘capital structure’
(Topic 7).

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 Corporate Financial Decisions:
Achieving The Corporate Objective

The Financing Decision

The financing decision deals with the determination of the firm's capital
structure

The question asked is: How should the firm finance the investment in real
assets in order to maximise its market value?

Is it possible to create wealth on the financing side of the balance sheet? Can
the value of the firm be affected by the way it is financed?

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 Critical Factors In Financial Decision-Making

Three Critical Factors

Cash Time Risk

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 Critical Factors In Financial Decision-Making
Cash-Flow Analysis
Focus is always on cash-flows, not accounting earnings.
Cash-Flow Timing
Money has a time value; Decision-making in finance must take account of the timing of
the cash-flows.
A dollar today is worth more than a dollar at some future date.
There is a trade-off between the size of an investment’s cash-flow and when the cash-
flow is received.
Cash-Flow Risk
Risk refers to variability of a cash-flow stream; Adjustments must be made to take
account of differing degrees of variability - the risk-return relationship must always be
kept in mind.
The role of the financial manager is to deal with the uncertainty associated with
investment decisions.
Assessing the risk associated with expected future cash-flows is critical to investment
decisions

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 Valuation of The Firm And Assets
 The corporate objective: Maximise the valuation (market value) of the
company/ wealth of the owners (shareholders).
So, we need to maximise the market value of the firm’s assets.

 Assets can be classified as either:

Real Assets: Assets that can be put to productive use to generate a
return e.g. machinery and equipment – represented by the left-hand
side of the balance sheet,
or
Financial Assets: Assets that represent a claim to a series of cash
flows against an economic unit e.g. a bank account – represented by
the right-hand side of the balance sheet

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 Valuation of The Firm And Assets
Valuation of A Firm
 A firm is a collection of real assets (e.g. plant, equipment, tools, stock,
buildings, land, Intellectual capital) that generate cash-flows.
How to Value the Firm?
 One approach is to value the real assets of the firm.
X Problem: Real assets are not frequently traded.
Alternative Approach To Valuation
Value the financial assets (i.e. debt and equity) of those having a claim on
the income produced by the real assets of the firm by having provided
financing to the firm.

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 Valuation of The Firm And Assets
Financial Assets
Examples of Financial Assets:
Shares (equity finance)
 A claim against a company
 Cash flows = dividends and sale price

Bonds/Debentures (debt finance)

 A claim against the bond/debenture issuer
 Cash flows = interest and principal

Bank accounts (debt finance)

 A claim against a bank
 Cash flows = interest and principal

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 Valuation of The Firm And Assets
Balance Sheet Woolworths Ltd (WOW) June 30 20121

Current Assets $5.802b Liabilities (Debt) $13.134b

Fixed Assets $15.779b Proprietorship (Equity) $8.447b

------------------------------------ -------------------------------------------------
Total Assets $21.581b Total $21.581b

Capital Budgeting Decision Capital Structure Decision

Investment in real assets Investment in financial assets

Reflects the investment decisions Reflects the financing decisions of

of the firm the firm

1 http://www.woolworthslimited.com.au/annualreport/2012/pdf/WW_AR12_FinReport.pdf, Woolworths Annual Report 2012 p. 99, 08/07/13 3:08pm.

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 Finance vs. Accounting
 Both disciplines are concerned with a firm’s assets and liabilities.
 Accounting, with its emphasis on review and compliance, generally
has an historical outlook.
 Finance, with its emphasis on valuation and decision-making,
generally has a focus on the future.

 The primary focus of accounting is stewardship/compliance.

 Accounting standards give discretion in the selection of accounting
procedures which can:
 a) cause comparability problems when analysing reports of different
companies, and
 b) enable deliberate manipulation of financial reports (creative
accounting or window dressing, e.g. Enron & Arthur Anderson 2001)

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 Finance vs. Accounting
Problems With Accounting Profit From A Corporate Finance Perspective:
A. What profit?
1. $ amount or % return? Is a $10m profit better than a $1m profit?
Example Project A Cost $1b, profit $10m, % return 1%
Project B Cost $1m, profit $1m, % return 100%
2. Before-tax v. after-tax.
B. Neglect of time – Ignores time value of money concept. Example $10m over
eight years vs. $3m over two years – which is better?
C. Neglect of risk – Profit streams are not adjusted for risk.
Is a $10m profit better than a $1m profit?
$10m – high risk project; could lose all our money.
$1m – low risk project; very little chance of losing our money.
D. Neglect of cash-flows – accounting earnings/profits are calculated on an
accrual basis, not cash-flow basis.
E. Arbitrary allocations – e.g. depreciation, provisions.

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