IntroductionFINS1613: Business Finance
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School of Banking and FinanceAustralian School of Business
UNSW
Robert [email protected]
Business FinanceWorld View
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Our world view
Companies
What projects should I fund?
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Owners
In which companies should I own stock?
Our world view
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Project Cash Flows Risk
Discount RateProject Funding Decision
Our world view
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Key assumptions
Firm with professional management that does not own the firm
Firm has many owners, each is invested in many firms
Types of Firms
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Terminology
Ownership
The right to share in a firm’s profits
Control
The right to directly manage or elect management of a firm
Personal liability
The responsibility to pay a firm’s financial obligations using personal assets when the firm cannot
Limited liability
A limit that the owner can only lose the value of their investment when the firm cannot pay its financial obligations
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Sole trader
Business owned and controlled by a single person
Sole trader is personally liable for firm’s debts
Business ceases existence with death or withdrawal of the sole trader
Profits taxed at personal level
Also known as sole proprietorships
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Partnership
Business owned by several partners
• General partners:Ownership, control and personal liability
• Limited partners:Ownership, no control and limited liability
Profits taxed at personal level
Business ceases to exist with death or withdrawal of a single general partner unless other provisions are made
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Comparison
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Sole trader Partnership Limited PartnershipLimited Partnership
Type of owner N/A General partner General partner Limited partner
Number One Several One or more Several
Control Yes Yes Yes No
Liability Personal Personal Personal Limited
Taxation Personal Personal Personal Person
Corporations
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Board of directors
•Each director is elected by the firm’s owners
•Hires the Chief Executive Officer
•Monitors firm and sets high level strategy
•Objective is to maximize firm value
A B C D
CEO
CFO
Organizational structure
Corporations
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Chief Executive Officer (CEO)
•Everyday manager of the firm
• Implements rules and policies set by board of director
•Advised by high level executives
•Objective is to maximize firm value
A B C D
CEO
CFO
Organizational structure
Corporations
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Chief Financial Officer (CFO)
•Evaluates investment decisions for the firm
•Evaluates financing decisions for the firm
•Objective is to maximize firm value
A B C D
CEO
CFO
Organizational structure
The Financial Manager
We will focus on two primary responsibilities of the financial manager:
Investment decisions
• Which projects should the firm pursue?
Financing decisions
• How should the firm raise capital to finance these projects?
• How should the firm distribute profits to investors?
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Corporations
Capital structure
• Describes how firm value is split among different types of financial securities
• Common securities include
• Equity
• Debt
• Preference shares
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Total firm value(e.g. $100 million)
Capital structure
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Equity value(e.g. $60 million)
Debt value(e.g. $40 million)
Equity value(e.g. $20 million)
Debt value(e.g. $80 million)
or
Total Firm Value = Market Value of Equity + Market Value of Debt
Capital structure
Equity
• Ownership of a company is divided into common stock
• Stock owners, called shareholders, elect the Board of Directors
• Stock owners share in firm profits, which are uncertain and may be zero
• Public stock is traded on stock exchanges
Debt
• Lender of capital to a firm hold bonds
• Bond holders have no role in electing directors
• Bond holders receive prescribed payments
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Capital structure
Absolute priority
Requires a firm to make payment on debt before distributing money to equity holders
Administration (bankruptcy) and liquidation
Occurs when a firm cannot pay its prescribed payments to debt holders, an event called default
Control of the firm is given to the debt holders
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Capital structure
Example
Imagine a firm that has promised to pay bond holders $90 million in one year. Assume the firm will either earn $80, $100, or $120 million in one year.
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10
90
30
9080
Equity Value
Debt Value
Capital structure
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Equity Debt
Control Elects Board of Directors
Seizes firm on default
Payment amount Uncertain Prescribed
Payment order Last First
Risk High Low
Corporations!
Key features of a corporation
It is its own legal entity, distinct from the owners
There is a separation between ownership and management
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Corporations
Advantages over partnerships and sole traders
Limited liability for the owners
Business continues operation when ownership changes
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Agency costs
Definition
We assume that employees have their own personal objectives
These personal objectives may not always agree with the value maximizing objective of the firm’s owners
An agency cost arises when an employee takes an action that serves their own interests instead of maximizing firm value
Examples
A CEO may not invest in a profitable, but risky project if they are afraid of getting fired should the project fail
An employee may arrive late and leave early due to lack of interest and no managerial oversight
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TaxationFirm profits generate different after-tax values to owners depending on firm structure and the tax system
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Firm owner Limited partner ShareholderShareholder
Tax System Imputation Classical
Firm profits $100 $100 $100
Distribution method
Corporate Tax (30%)
Distributed Profits
Personal tax basis
Personal tax (45%)
Franking credit (equal to corporate tax)After-tax to owner
Corporations
Advantages over partnerships and sole traders
Limited liability for the owners
Business continues operation when ownership changes
Disadvantages compared to partnerships and sole traders
Agency costs between owners and management
Taxation (in jurisdictions with “classical” tax systems)
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Ownership comparison
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Sole trader Partnership Limited PartnershipLimited Partnership Corporation
Type of owner N/AGeneral partner
General partner
Limited partner
Shareholder
Number One Several One or more Several Many
Control Yes Yes Yes No Yes
Liability Personal Personal Personal Limited Limited
Taxation Personal Personal Personal Personal
Corporate and Personal
(depending on tax system)
Review
Firm structures
• Characteristics of sole trader, partnerships, corporations
Corporations
• Responsibilities of the financial manager
• Difference between equity and debt
• Advantages and disadvantages versus sole traders and partnerships
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Administrative
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Staff
Lecturers
Robert Tumarkin
• Weeks 1 -8
• Consultation: Thursday 2-4
Gloria Tian
• Weeks 9 - 12
• Consultation: Monday 3-5
Tutor
Peter Andersen (Tutor-in-charge)
Ning Ding, Yan Su, Bobby Wang, Howie Zhang
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Resources
Blackboard
Lecture slides
Tutorial assignments
Announcements
MyFinanceLab
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Assessments
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Assessments
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Stock Weight
Tutorial
Participation 15%
Attendance 5
Quizzes (Lowest of the 4 quizzes dropped) 40
Final Exam 40
100%
How to succeed
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Tutorials
Attend
Participate
Quizzes and final exam
Practice
• Questions in tutorials and the text
• MyFinanceLab
Know strategies for Multiple Choice Questions
Next week
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Next week
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Project Cash Flows Risk
Discount RateProject Funding Decision