TOPIC ONE Cpts 1

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TOPIC ONECpts 1 2
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Goals of firms

• Range of goals that could be pursued by firms
  includes
• maximal wealth for owners
• maximal profits
• adequate profits and/or limited working hours
• high revenue growth and/or large market share
• high reputation for product quality and service
• good employee relations, minimising environmental
  damage, good corporate citizenship

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Goals of firms (cont.)

• Some of these goals can be interdependent (e.g.
  good employee relations and owners wealth
  maximisation)
• Not all of these goals can be achieved
  simultaneously (e.g. limited working hours for
  owner-operator and owners wealth maximisation

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Goals of firms (cont.)

• The size of the business will have an impact on
  the goals of the owners
• Profit maximisation implies a business is managed
  to maximise the difference between revenues and
  expenses in any period

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Goals of firms (cont.)

• Wealth maximisation implies that the business is
  managed so thatthe present and future cash flows
  discounted at an appropriate rate will give a
  present value (PV) which is maximised

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Goals of firms (cont.)

• A goal of maximising wealth leads to a long-term
  view that considers future cash flows, the time
  value of money and risk
• Thus, maximising wealth is superior to a goal of
  profit maximisation

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Goals of firms (cont.)

• The time value of money is the concept that a
  dollar is worth more the sooner it is received.
• Discounting is the process of calculating the
  present value (PV) of a future amount. The
  discount factor incorporates the possible or
  required earning rate for the funds.

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Goals of firms (cont.)

• The value of a firm at a given time should be the
  present value of its future expected cash flows

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Goals of firms (cont.)

• The value of a corporation is the market
  capitalisation of the company
• Market capitalisation is the total value of a
  corporation as measured by the price of each
  issued share multiplied by the number of issued
  shares.

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Goals of firms (cont.)

• The value of a firm that is not a corporation is
  its market value
• The market value of a firm is the price that
  willing buyers are prepared to pay and willing
  sellers are prepared to accept

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Goals of firms (cont.)

• Maximising owners wealth means having the
  highest possible valuefor the firm

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Roles of financial managers

• accounting and reporting functions
• cash management, raising and managing funds
• taxation management compliance, forecasting and
  planning
• risk management of revenues and expenses

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Roles of financial managers (cont.)

• analysing proposed investments, capital
  restructures, etc.
• forecasting the impact of financial decisions
• internal and external audit management
• investor relations

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Roles of financial managers (cont.)

• Financial derivatives are contracts that are
  derived from the value of some underlying assets
  and are used to manage risk
• They can be used by financial managers to manage
  risk

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Financial governance and financial decisions

• Financial governance comprisesall the financial
  and management accounting systems and other
  financial processes which are put in place to
  achieve the objectives of the firm
• is critical to the work of the financial manager

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Roles of financial managers (cont.)

• Major financial management decisions
• which new investments?
• how to fund investments
• how to manage short-term funding
• how to manage long-term funding
• which dividend policy?
• how to manage risk

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The principalagent problem

• The principalagent problem is the scope for
  conflict or division between principals (owners)
  and agents (managers) over the goals of the firm
  which are being pursued by its policy and
  management decisions

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The principalagent problem (cont.)

• Agency costs are the losses borne by the owners
  of the firm that canbe attributed to the agent
  having different objectives from the owners (or
  principals).
• HIH example of CEO making large donations of
  corporate funds for his personal gain

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The principal-agent problem (cont.)

• Agency costs come from managers having different
  objectives from those of the owners of the
  company
• They are only an issue when thereis a separation
  of ownership and management

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Ethics in business

• Ethics are moral principles or rules of conduct
  which indicate the acceptability of behaviour
  within a community
• Unethical actions may be legal (e.g. shifting
  production to a country that has lower legal
  standards for worker and/or environmental
  protection)

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Ethics in business (cont.)

• Ethical behaviour can be consistent with wealth
  maximisation because it maintains the companys
  reputation
• Whistle-blowing means informing (usually by
  employees of the perpetrators) the relevant
  authorities of malpractice or dangers to the
  public or the environment

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Ethics in business (cont.)

• Corporate social responsibility (CSR) means that
  the business firm has wider responsibilities in
  relation to objectives and people apart from the
  owners or shareholders
• Stakeholders include employees, customers,
  suppliers, regulators and the general public

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Forms of business organisation

• 4 main forms of business organisation
• sole trader or sole proprietor
• partnership
• company
• trust

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Sole proprietorship

• A sole proprietorship is a business owned by an
  individual, who owns assets used in the business,
  incurs liabilities and reaps the annual profits
  or losses
• The corner shop or local newsagent, for example

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Partnership

• A partnership is an associationof two or more
  people carrying ona business in common with a
  viewto profit
• The local (or international) accounting or legal
  practice, for example

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Company

• A company is an entity, formed under the
  Corporations Act 2001, which is legally separate
  from its owners
• Corporate governance means the management of
  corporations

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Company (cont.)

• Private companies can be relatively small family
  businesses
• Public companies tend to be larger and will have
  a greater number of shareholders
• Shareholders (the owners of companies) have
  limited liability

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Trust

• A trust is a legal structure where property is
  nominally owned by one party, the trustee, on
  behalf of others who are the beneficiaries
• Are a popular form of business structure when
  they can get benefits from the current taxation
  legislation

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• The best business structure depends on the
  personal circumstances of the owners

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Overview of Australian tax

• Income tax is levied in Australia on individuals
  and companies taxable income
• Taxable income is assessable income less
  legitimate deductions
• Income is normally received regularly (or
  frequently)

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Overview of Australian tax (cont.)

• For businesses, the general rule for allowable
  deductions are those expenditures incurred to
  earn assessable income.
• Marginal rates of tax are important for analysing
  alternative activities for the impact on marginal
  income.

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Overview of Australian tax (cont.)

• Capital gains tax (CGT) is paidon gains made on
  the disposalof assets purchased after19
  September 1985.
• Goods and services tax (GST) isa type of
  consumption tax that is paid irrespective of the
  individuals level of income.

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Importance of dividend imputation

• Dividend imputation is the system where dividends
  carry an additional benefit in the form of an
  attached tax credit for the relevant amount of
  tax paid by the company on its profits.
• The system avoids the double taxation of company
  profits.

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• A fully franked dividend carries a tax credit
  equal to the full 30 company tax paid on the
  underlying profit.
• A partly franked dividend carries a tax credit
  less than the full 30 company tax paid on the
  underlying profit.
• An unfranked dividend carries no tax credit.

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• Shareholders only pay tax on dividends when their
  marginal tax rate is higher than the level of
  franking credits on the dividends they receive.
• Are there implications for financial decision
  making?

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• When shareholders can fully utilise imputation
  credits
• tax paid by the company is irrelevant when the
  financial manager is making the decision
• When shareholders cannot utilise imputation
  credits
• tax paid by the company is relevant to corporate
  financial decision making

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Challenges facing modern firms

• Important aspects of change
• external environment (e.g. deregulation)
• advancing technology (e.g. electronic commerce)
• social expectations (e.g. employee working
  conditions)

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People and decision making

• Rational behaviour implies decisions are made
  after an amount of reasoning so that ultimate
  decisions are not foolish or absurd, and are
  based on the desire to satisfy objectives and
  maximise, or at least optimise, outcomes
• Assumed when people make decisions!

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INTRODUCING CORPORATE FINANCEChapter 2 Business
and the Financial Markets

• By Diana Beal and
• Michelle Goyen

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Roles of financial markets

• The financial markets in Australia fulfil many
  roles including
• matching supply and demand for funds
• facilitating business and trade
• facilitating the saving of individualsfor future
  consumption
• provision of financial services

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Financing business operations

• Sources of finance are direct or indirect
• Direct finance the supplier of funds and the
  fund user transact directly
• Intermediated finance the intermediary collect
  funds from suppliers and deals with the fund users

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• Transaction costs are the costs,in terms of both
  time and explicit cash costs, of effecting a
  transaction or deal

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Types of financial institutions

• Main types of Australian financial institutions
• Authorised deposit-taking institutions
• Registered financial corporations

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• Authorised deposit-taking institutions (ADIs)
• Take deposits and make loans to borrowers
• Banks
• Building societies
• Credit unions

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• Registered financial corporations (RFCs)
• Use their capital or borrow so they can make
  loans
• money market corporations, pastoral finance
  companies, finance companies, general financiers
  and intra-group financiers

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Classifying the markets

• There are three main divisions in financial
  markets
• primary or secondary
• public or private
• money or capital markets

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• Securities documents which provide evidence of
  a loan or the purchase of shares, a bond or a
  commercial bill
• Price discovery the process of finding and
  settling on a price which is acceptable to both
  parties

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• primary market where securities are offered for
  the first time
• money goes to the issuer
• secondary markets trading securities which have
  been issued
• secondary market trades do not increase the stock
  of securities
• money goes to previous security holder

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• Two ways to issue securities
• Private placements are made by negotiation
  directly with purchasers
• Public issues are made to the public and require
  the use of a prospectus

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• prospectus a document which provides details of
  a new issue of securities to the public
• public issues are
• usually larger than private ones
• more expensive due to the application and issuing
  processes
• sponsoring broker and/or underwriter fees

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• merchant bank a financial institution which is
  not registered nor regulated under the Banking
  Act 1959 but which carries out many of the
  functions of a bank
• sometimes handles private issues

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• Money markets deal in short-term debt
• bills, promissory notes and certificates of
  deposit
• Capital markets deal in long-term instruments
• debentures, secured or unsecured notes, leases,
  loans, shares and convertible notes

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Debt and equity

• Debt is a contractual arrangement to borrow money
  that will be repaid in the future
• Equity represents an ownership interest, so there
  is no expectation that it will be repaid in the
  future
• Equity holders get their money back by selling
  their ownership interest

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• maturity (or term to maturity) is the contracted
  time that may elapse before the borrowed funds
  are to be repaid
• financial structure the mix of debt and equity
  which fund the assets owned by the business

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• Risk the chance that the actual outcome from an
  investment will be different from the expected
  outcome
• suppliers demand higher returns for riskier
  securities (discussed in Chapter 4)

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• Financial risk is the risk involved in using debt
  as a source of finance
• Financial distress a firms financial
  obligations cannot be met or can only be met with
  major difficulty
• creditors rank higher than owners if a firm is
  liquidated

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• debtholders receive interest payments from the
  borrower
• interest payments provide a tax deduction for the
  borrower
• equity holders receive dividends
• dividends are not tax deductible,but give the
  shareholder imputation credits if they are
  franked

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Debt instruments

• Trade credit allows a purchase to be made without
  the immediate payment of cash
• usually have a 7- or 30-day term
• An overdraft is a permitted over-drawing of funds
  beyond the credit balance in the account

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• Inventory finance (or floor-plan finance) is
  provided to car and whitegoods dealers to buy
  stock to place on showroom floors and is secured
  by the stock itself
• for retailers with high value inventories

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• Promissory notes (P-notes) are promises by the
  borrowers to
• repay the face value of the instrument at a
  stated future date
• Commercial bills are promises by the borrowers to
  
• repay at a stated future date the face value of
  the instrument
• the promise is normally guaranteed by a third
  party such as a bank

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• Face value is the amount that will be repaid upon
  maturity of the debt security
• Face value is specified at the time the debt
  security is issued
• Discount securities are issued at a price less
  than the face value

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• Debentures are fixed-term debt securities issued
  under a prospectus
• secured by assets
• Unsecured notes are fixed-term debt securities
  issued under a prospectus
• are not secured by assets
• Both are issued by companies

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• Corporate bonds debt instruments where the
  issuer receives the face value of the bonds at
  the outset
• face value is repaid when thebonds mature
• pay a regular coupon
• Coupon is the stated rate of interest paid on a
  bond

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• Corporate bonds usually receivea credit rating
  that indicates the level of credit risk
• Junk bonds have a rating of BBB or lower

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Equity instruments

• Three main types of equity instruments
• ordinary shares (fully paid)
• contributing shares (partly paid ordinary shares)
• preference shares

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• An ordinary share is evidence of part-ownership
  of a company
• Contributing shares or partly-paid shares are
  ordinary shares where the full cost has not yet
  been paid to the issuing company

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• Preference shares are hybrid equity instruments
  with some characteristics of equity and some of
  debt
• normally have a fixed dividend which has
  preference over the payment of ordinary dividends

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Regulators and regulation

• Australian Government regulates financial markets
  via the
• Reserve Bank of Australia (RBA)
• Australian Prudential Regulation Authority (APRA)
• Australian Securities and Investments Commission
  (ASIC)

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• Reserve Bank
• objective of ensuring the stability of the
  financial system
• controls monetary policy by setting the cash rate
  of interest
• conducts open market operations in Commonwealth
  Government Securities

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• Re-purchase agreements or repos are securities
  that are bought or sold with an agreement to
  reverse the original transaction at a later date
• Used by the RBA to manage the economy

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• Australian Prudential Regulation Authority (APRA)
• prudential regulator of ADIs
• prudential means that management of the ADI
  have the responsibility to behave sensibly
• uses the Bank of International Settlements (BIS)
  guidelines for capital adequacy

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• Australian Securities and Investments Commission
  (ASIC)
• administers the Corporations Act 2001
• management and maintenance of financial market
  integrity
• consumer protection
• maintenance of confidence by stakeholders in the
  financial system

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• Australian Stock Exchange (ASX)
• Regulates listed companies with respect to the
  handling and release of company information
• non-compliance by companies can mean share
  trading is suspended

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• Australian Competition and Consumer Commission
  (ACCC) also watches markets for competition and
  consumer protection issues

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People dimensions

• Framing is the context or environment from which
  information or data are extracted
• Dominance implies that the most outstanding
  attribute or benefit will consistently maintain
  its premier position, no matter how it is
  presented

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• Rational investors chose the dominant alternative
  no matterhow the choice is framed

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