Lecture 1 (The ultimate objective of the corp financial policy
- Laws and regulations could be passed to prevent such behaviour
- Failure to meet societal norms can lead to loss of business and value
- Investors may not invest in firms seen as social outcasts
Are assets still priced correctly?
- Prices are volatile
- Financial markets overreact to news, good and bad
- Financial markets are short sighted - no consideration of long term implications
- Financial markets are manipulated - prices do not relate to value
- Evidence that managers suppress information (negative)
- Delay the releasing of bad news
- Sometimes suffer fraudulent information
In theory, financial markets are efficient, info is conveyed honestly and financal malets make reasoned true judgements of value.
- As a consequence, a company that invests in good projects will be rewarded.
- Short term accounting gimmicks will not increase market value
- Stock price perf is a measure of management performance
- In practice, there are holes
- Money Markets: markets for short term financial securities that mature within a year.
- Capital markets: Markets for long term instruments such as equity and bonds
- Primary Markets : where securities (bonds or shares) are issued for the first time ever. Can be private or public and investment banks play a central role
- Secondary markets: where previously issued securities are bought and sold
Secondary markets are important as changes in price of financial assets reflect the market opinion of management.
They are either auction markets (stock exchange such as London Stock eXCHANGE) or dealer/OTC markets (NASDAQ etc)
Creditors Vs Shareholders:
- In theory, no conflict of interest
- in practice, stockholders may maximise their interets at the expense of bondholders
- Increasing dividends exposes the firm to risk through the loss of cash
- Taking risky projects
- Borrowing more on the same assets
Can raose ossies at AGMs to act. But small shareholders tend not to attend.
- Proxies are when someone does not attend and delegates the voting right to someone else. If this is not done, the proxy becomes a vote for the management.
- Large shareholders will be forced to vote with their feet (ie leave) when the need arises.
Empire building problems:
- value is transferred tpo the acquired company
- Spending on lavish luxury assets rather than returning the funds
- Taking lower risk
- If the markets are efficient, this will be punished via lowering of the share price
- costs also rise due to increase in fees from external auditors
-Separation of ownership and management.
- This leads to information asymmetry
- Managers have an incentive tro pursue personal goals
- This then hurts the share price
Conflicts of interest:
Government - taxes etc
- Creditors - restrict activities
- Employees - want more decision making, security and higher wages
- Managers - other personal interests
Stockholders - increase of returns. If they invest in risky projects, it can harm others
- Majority stockholders may outdo minority
- Firm value maximisation may harm society
Efficiency of markets:
-Informational efficiency - prices reflect immediately all relefant information
- Efficiency in allocation of capital
- Transactional efficiency
Other objectives can compete:
For stock price maximisation to be the only objective, it has to be assumed:
- Maximising market share
- Maximise accountin profits
- Maximise sales
- Financial soundness
- Decision makers (managers) are respinsive to the owners
- Stockholder wealth is not being increased at the expense of bondholders/lenders. Only then is it consistent to value maximisation
- No significant social costs, consistent with the welfare of socierty
- Markets are efficient - only then will stock prices reflect stockholder wealth
- Maximising owners purchasing power is one method - how?
- A good proxy - the share price. Policy should be formulated to maximise the share price.
It represents the present value of all future cash flows generated by assets
The ultimate objective of the corp financial policy
- The pie model is a useful approach: V=D+E
- Size of pie is determined by size of assets, which should also be equal to financial claims on these assets
- It is inferred that the pie model is reflective of the management of the business
- Shareholders carry most risk. One important reason is that in the event of liquidation, they get paid very last.
- Corp financial polocy should aim at maximising the wealth of shareholders by proper investment decisions and assets
- Net present value - takes into account the magnitude of cash flows and hurdle rate
- Sevral ways of measuring the hurdle rate. Most common is Capital Asset Pricing Model (CAPM)
- Hurdle rate is estimated from the perspective of finance providers - hence called opportunity cost of capital
- Payout decision is also called the residual decision as it only takes place after the investment decision
- Ultimate objective is the maximisation of the value of the firm
- Invest in prokexts that return greater than minimum acceptable hurdle rate
- Cash is king!!! Returns should be measured based on cash flow generation and timing of returns
- If there are not enough investments that earn the hurdle rate, return the cash
- Each source of finance, whether debt or equity has a caost. Called cost of capital, also know as hurdle rate or opportunity cost of capital
- The hurdle rate should e higher for riskier projects and reflexts the finance mix used (owner or debt money)
- When combining more than one tupe, the combined cost of capital becomes known as WACC
- The aim is to find a financing mix that minimises the hurdle rate/WACC
3 main decision areas:
- Investment, allocation or capital budgeting decision: Where do I invest scarces resources. What is a good investment
- Financing decision: How do I secure finance? What mix of owner money or debt do i use?
- Payout decision: How much of firms funds should be reinvested and how much should be returned?
2 overlapping areas - internal and external:
- How decisions relate to assets versus financial claims are being made and interact with the left and right sides
- Operation of the markets for financial claims and how they respond to, influence or get affected by corp decisions
Assets can be further split into current and non current (fixed) assets)
Non current assets can be tangible or intangible
Right hand is capital structure of a company
Total equity is the amount of the owners. Liabilities is the total debt..
Total assets always equal total equity and liabilityA company is simply expressed as
- Assets= liabilities + equity of owners
Also expressed as
- Assets - liabilities = equity of owners (also known as owner wealth)
The tools from this are applicable for:
Owners and creditors
Small firms raise money via their owners or savings.
Bigger firms have more options and can raise money from capital markets.
- Understand basic definitions and foundations of policy
- Differentiate between the 3 main aeras of decision making
- Differentiate between differing objectives
- Assess outcomes of separating ownership from management and roles of stakeholders
Units 1-2 intro
Units 3 -9 corporate finance
Units 10-12 specialised areas of corp policy (mergers and international policy, corporate governance)