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Lecture 1: Introduction and fundamental concepts of Corporate Finance

Lecture 1: Introduction and fundamental concepts of Corporate Finance. Objectives of this session: Discuss the role and scope of finance Discuss the nature of organisation objectives Discuss the agency problem and its implications Discuss the basic concepts and tools of finance.

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Lecture 1: Introduction and fundamental concepts of Corporate Finance

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  1. Lecture 1: Introduction and fundamental concepts of Corporate Finance Objectives of this session: • Discuss the role and scope of finance • Discuss the nature of organisation objectives • Discuss the agency problem and its implications • Discuss the basic concepts and tools of finance

  2. Scope of Corporate Finance Definition and Historical Perspectives: • acquisition, financing, and management of financial resources to achieve some specific goals • prior to 1920s (economics) • post 1920s (subject on its own)

  3. Factors influencing the changes in Corporate Finance • Increase in competition • Technological changes • Volatility of inflation and exchange rates • World economic uncertainty • Changes in tax laws

  4. Definition of Corporate Finance CF is concerned with the efficient and effective management of finances of an organisation with the aim of achieving the goals of that organisation.

  5. Functions of Corporate Finance • Financing Decisions • Investment Decisions • Management of financial resources i.e. Monitoring and control • Corporate Governance and ethical issues • Risk management

  6. Contribution of the Finance function • Strategic Role formulating long-term plans to ensure long-term availability of funds and viability of the company • Operational Role day-to-day management to ensure that events conform to the plans. e.g working capital management

  7. Objectives of company • Dominant Market share Achieve high market share gives high rewards • Profit maximisation - short term Acceptable but not agreed by everyone

  8. Objectives of company • Maximisation of shareholder wealth • Long-term and superior objective • Maximising purchasing power • Maximising the flow of dividends to shareholders through time • Future dividend flow are reflected in share price

  9. Objectives of company • Survival • Severe economic or market shock may force managers to focus on short-term issues to ensure business continuity. • Maintain happy and stable workforce

  10. Quick questions • What is the difference between shareholders and stakeholders? • Name stakeholders of an organisation

  11. Organisation and its Objectives Stakeholders Analysis • Shareholders • Managers • Lenders • Employees • Government • Customers

  12. Profit maximisation Vs Shareholder wealth maximisation Classical economic view is profit maximisation (Hayek 1960; Friedman 1970). The problems of this approach are: • How do we measure profit? • Timing of profit ignored (short or long term) • Risk is ignored

  13. Shareholder wealth maximisation In modern finance this is considered superior over profit maximisation. Why? • Shareholders are residual claimants • Achieving this also satisfies other stakeholders • Easy to measure i.e. share price • Not easily manipulated

  14. Agency Problem • Principal / Agent relations • Separation of ownership and management is a practical necessity • Agency costs: costs to control and monitor • Sources of conflict • divorce of ownership from control • Raises worries that managers may pursue objectives attractive to them

  15. Managing Agency Problem • Create incentive scheme • grant share option • performance-related pay / bonus tied to profit • Monitor / control managers’ behaviour • management audit/additional reporting requirements; • sacking; • limiting management decisions

  16. Corporate Governance (CG) • CG is a system of rules and regulations on how organisations should be governed and directed. • An attempt to make directors act in the interest of the shareholders. • In UK, the combined code. • Current debate on capping Bankers’ bonuses.

  17. Free Cash Flow theory • Too much cash with less investment opportunities creates incentive for wasteful spending • Empire building and overinvestment e.g. 1980s new oil reserves ($20/barrel) instead of buying proven ones for $6/barrel.

  18. Market for Corporate Control (MCC) The MCC suggests that inefficient companies are vulnerable to being acquired (Siriopoulos et al 2006, Manne 1965). Tremblay and Tremblay 1988, Dietrich & Sorensen (1984) (cited in Siriopoulos et al 2006) found that the hypothesis was supported by the evidence. They argued that the takeover mechanism has the function to discipline and replace management teams who engage in inefficient behaviour and do not pursue shareholder interests.

  19. Market for Corporate Control (MCC) Other authors pointed out that managerial discipline was not a predominant motive for takeover. The debate is inconclusive. We come back to this in our last lecture.

  20. Basic Tools of Finance Time Value of Money: • a dollar today is worth more than a dollar tomorrow Example 1.1 Choice of receiving $100 today or $100 in one year from now. Which one do you prefer and why?

  21. Time Value of Money (TVM) TVM depends on: • Opportunity cost • Cash flows today can be reinvested to generate more cash flows • Inflation • Fall in purchasing power • Risk • $100 next year is not certain

  22. Time Value of Money Future Value • Sum to which initial amount invested is expected to grow Example 1.2 Invest $100 at 10%. What is the future value in 1 year time? FV = PV (1+R)ⁿ

  23. Time Value for Money Where: FV = Future value R = Annual rate of interest PV = Initial sum invested n = Number of years 1 = Constant FV = 100(1+0.10) = $110

  24. Time Value of Money In the above example the 10% used in calculating the future value is called interest rate or alternative names are: • Discount rate • Required return • Cost of capital • Opportunity cost

  25. Time Value of Money Present Value: • money invested today Example 1.3 • Suppose you want to earn $1540 in 1 year’s time how much do you have to invest today if interest rate is 10%.

  26. Time Value of Money Solution: PV = FV / (1 +R)ⁿ 1540 / (1 + 0.10) = $1400

  27. Discounting Finding the present value of a future amount as in example 1.3 above is called discounting.

  28. Annuity and Perpetuity Annuity: Equal cash flow for each period Perpetuity: Equal cash flow for an indefinite period of time. To find the PV of a perpetuity the formula is: CF/r

  29. Perpetuity Example 1.4 What is the PV of £100 per period receivable forever if the discount rate is 10%. Answer = £1000

  30. Further reading Page 8 of the hand book and some at the end of lecture 12

  31. End of Lecture 1 ANY QUESTION?

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