Finance

Role of Management

Creditors, managers, employees and customers-->contractual claims against firm's revenue

Shareholders--->Residual claims against the company

Functions of a Financial Manager

-Raise funds

-Investments

-Cash from operational activities

-Re-investing

-Dividends of interest payments 

-Finance function: managing the cash flow

Goal of Financial Manager

Issues of Financial Managing

-Profit vs. Return on Capital

-Timing

-Risk

Principles of Finance

1. Time value of money

2. Risk Return Trade-off

3. Diversification of investments

4. Efficient financial markets

5.Management vs. owner ojectives 

6. Reputation matters

Time value of money

-Money now is worth more than the promise of recieving the same amount tomorrow

-Matters because a sum of money today could be invested and grow over time

- 

Computation of Present Value

Present Value

P=Fsub(n)/(1+r)^n

F=initial investment

n=period

r=return(interest or discount rate)

Risk

Risk-Return tradeoff

Diversification of Investments

Some risks can be removed or diversified by investing in several different assets or securities

-Firm specific(unsystematic)

-Market(systematic)

Information Efficient

Efficient Financial Markets

Principle-Agent Problem

Owners(Equity holders)(Investors)

Managers

Solution to Principle-Agent Problem

Ethical behaviour

Real Assets

Tangible things owned by persons and businesses

-Residential structures and properties

-Major appliances and automobiles

-Equipment and machinery

-Office towers, etc.

Financial Assets

What one individual has lent to another

-Consumer credit

-Loans

-Mortgages

Functions of Money

-Medium of exchange

-Standard of value

-Store of value

Money as a Medium of Exhange

Money as a Standard of Value

Money as a Store of Value

Financial System

Fianncial intermediaries interact with:

-Governement

-Business

-Non-residents

-Households

Financial Intermediaries

-Banks and other deposit-taking in

-Insurance companies

-Pension funds

-Mutual funds(pools from many investors to buy securites)

Direct Claims

Channels of Intermediation

Interaction between borrowers and lenders

-Direct

-Indirect

Indirect Claims

Financial Markets

-Primary Markets and Secondary Markets

-Money Market and Capital Market

-Organized Exchanges and Over-the-Counter

Financial instruments Issued By Corporations

-Commercial Paper

-Banker's Acceptance

-Corporate Bonds

-Common and Preffered Stocks

Debentures

Secured Debt

Subordinated Debt

Senior Debt

Zero Coupon

Junk Bond

Common Stock

-Owners of a corporation's equity

-Do not have specific maturity date and the firm is not obliged to pay dividends to shareholders

-Returns come from dividends and capital gains

Preferred Stocks

-Have face value, predetermined periodical payments with priority over common stockholders

-Cumulative, non-cumulative, participating, non-participating

-If dividend is not payed, may get voting rights

Derivative Securities

Securities whose value is derived from the value of some underlying asset

-Most important are options and futures

-Reflect market expectations regarding the future as inferred from currently available information

-Prices of financial instruments are determined in equilibrium by demand and supply forces

Bootstrapping

Initial funding of the firm

-Process in which many entrpreneurs obtain "seed money" and obtain other resources necessary to start the business

-Initial "seed money" usually comes from the entrepreneur or other founders

Venture Capitalists

(Angel Investors)Individuals or firms that help new businesses get started and provide much of their early stage financing

-Typically wealthy individuals who invets their own money in early stages in small deals

-Often in the form of preferred stock that is convertible to common stock at discretion of the venture capitalist

Why Traditional Funding Doesn't Work on Emerging Businesses

Tactics to Reduce Risk: Venture Capitalists

-Funding venture in stages

-Requiring entrepreneurs to amke personal investments 

-Syndicating investments(Joint investment if too risky)

-Maintaining in-depth knowledge about industry

Syndication

Occurs when original investor sells a percentage of a deal to other venture capitalists

-Diversifies VC's investment portfolio

The Exit Strategy

Not long-term investments; usually exit over a period of 3-7 years

-Every VC agreement includes provisions identifying who has the authority to make critical decisions concerning the exit process

Principle Ways in Which VC Exits Venture

-Sell part of the firm's equity to a strategic buyer in the private market

-Sales to financial buyers

-Initial Public Offering, selling common stock

Initial Public Offering (IPO)

Way to raise larger sums of cash to facilitate the exit of a VC 

-First time stock issues are given a special name because teh marketing and pricing of these issues are distinctly different from those of a second offering

Advantages of Going Public (IPO)

-Amount of equity that can be raised in the public market is usually larger than the amount that can be raised through private 

-Can enable entrepreneur to fund a growing business without giving up control

-PT firms find it easier to attract top management talent and to better motivate current managers if a firm's stock

Disadvantage of Going Public (IPO)

-High cost of IPO itself

-Transparency

-Costs of complying with ongoing SEC disclosure requirements

-Managers may focus on short-term profits rather than long-term wealth maximization

Private Placements

Occurs when a firm sells unregistered securities directly to investors such as insurance companies, banks, or wealthy individuals

-Private lenders are more willing to negotiate changes to a bond consent  

-Speed and flexibility in issue size

-Biggest drawback: restrictions on resale of securities

Private Equity Firms

-Like VCs, pool money from wealthy investors, pension funds, insurance companies, and other sources to make investments 

-Invest in more mature companies and they often purchase 100% of a business

-Look to increase value of the firms they acquire by closely monitoring performance and providing better management

-Once value is increased, they sell teh firms for a profit, generally within 3-5 years 

Commercial Bank Lending: Prime Rates

-Prime rate: borrowing rate is based on prime rate of interest

-Prime rate charged by bank may be higher than other market borrowing rates because banks provide a range of service with their loans

Commercial Bank Lending: Bank Term Loans

-Business loans with maturities greater than one year

-May be secured or unsecured, and the funds can be used to buy inventory or to finance plant and equipment

Dividends

Overall policy regarding distributions of value to stockholders

-Something of value distributed to stockholders

-When a dividend is distributed, it reduces the stockholders' claims against the firm

-Returns investment to stockholders

-Most common form--->Cash dividend quarterly 

Dividend Payment Process

1.Board Vote

2. Public Announcement

3. Ex-dividend Date (Set by stock exchange, 2 days before record date)

4. Record Date

5. Payable Date

Stock Repurchases

Do not represent a pro-rata distribution of value to the stockholders because not all participate

-Taxed differently than dividends

How Stock is Repurchased

-Purchase shares in the market

-Can repurchase share with a tender offer, which is an open offer by a company to purchase shares

-Through direct negotiations with a specific stockholder 

Stock Dividends

One type of dividend tahtd oes not involve the distribution of value

-When a company pays a stock dividend, it distributes new shares of stock on a pro-rata basis to existing stockholders

-Value of company does not change

-Stockholder left with same value as before

Stock Splits

-Similar to Stock Dividends, but involves distribution of a larger multiple of the outstanding shares

-Actual division of each share into more than one share

-Benefit: sends positive signal to investors about the outlook taht management is has for the future and this, in turn, can lead to more than one share

-Management unlikely to split if it expects price to decline

Questions to Consider When Selecting a Dividend Policy

1. Over LT, how much does the company 's level of earnings (cash flow from ops) exceed its investment requirements? How certain is this level?

2. Does the firm have enough financial resources to maintain the dividend payout in periods when earnings are down or investment requirements go up?

3. Does the firm have sufficient financial flexibility to maintain dividends if unforeseen circumstances wipe out its financial reserves when earnings are down

4. Can the firm quickly raise equity capital if necessary?

5. If the company chooses to finance dividends by selling equity, will the increased number of stocjholders have implications for the control of the company?

Why Trade Derivitives?

-Expand investment opportunities

-Lower cost

-Increase leverage

Financial Derivitive Securities

Options

Call

Put

Exercise(Strike) Price

Expiration Date

Option Premium

Call Buyer

Call Seller

Put Buyer

Put Seller

Options Exchange

-Montreal Exchange and Chicago Board of Exchange

-Standardize exercise dates, exercise prices, and quantities

-Facilitate offsetting positions through a clearing corporation

Clearing Corporation

Call Options

Put Options

In-The-Money Options

Out-Of-The-Money Options

At-The-Money Options

Factors Affecting Options Prices

-Stock Prices

-Exercise prices

-Time to maturity

-Stock validity

-Interest rates

-Cash dividends

Right

Warrant

Spot(or Cash) Market

Futures Market

An obligation to buy or sell a fixed amount of an asset on a specified future date at a price set today

-Set features (contract size, delivery date, and conditions) for delivery 

Future Market Characteristics

-Centralized marketplace allows investors to trade with each other

-Performance is guaranteed by a clearinghouse

Commodities

Financials

Foreign Future Markets

Futures Exchange

-Where futures contracts are traded

-Voluntary, non profit assosciations, typically unincorporated

-Organized marketplaces where established rules govern conduct (financed by membership dues and fees for services)

-Members trade for self or others

Clearing Corporation Characteristics

-Corporation that is seperate from, but assosciated with each exchange

-Exchange members must be members or pay a member for these services

-Helps facilitate an orderly market

-Keeps track of obligations

Mechanics of Trading

Through open outcry, buyer and seller agree to take or make delivery on a future date at a price agreed on today

-Like options, futures trading is a zero-sum game

Short Position(Seller)

Long Position (Buyer)

Futures Margin

Good faith deposit made by both buyer and seller to ensure completition of the contract (not an amount borrowed from a broker)

-Each clearing house sets its own requirements (brokerage houses can require higher margins)

-Initial margin usually less than 10% of contract value

Margin Calls

Occur when price goes against investor

-Must deposit more cash or close account

-Position marked-to-market daily

-Each contract has maintenance or variation margin leve below which the invesor's net equity cannot drop

Hedgers

-At risk with a spot market asset and exposed to unexpected price changes

-Buy or sell futures to offset the risk

-Used as a form of insurance

-Willing to forego some profit in order to reduce risk

-Smaller chance of low and high return

Speculators

-Buy or sell futures contracts in an attempt to earn a return

-Absorb excess demand or supply generated by hedgers

-Assuming the risk of price fluctuations that hedgers wish to avoid

-Speculation encouraged by leverage, ease of transacting, low costs

Multinational Corporations

-Owned by a mixture of domestic and foreign stockholders

-TNCs, regardless of the location of their heaqdquarters, are managed from a global perspective rather than the perspective of a firm residing in a particular country

Factor Affecting IFM

1. Uncertainty of future exchange rate movements 

2. Differences in legal systems and tax codes

3. English not the World's social language, although official business language

4.Cultural views also shape business practices and people's attitudes towards business practices 

5. An economic system determines how a country mobilizes its resources to produce goods and services needed by society, as well as how the production is distributed

6. Countries risk refers to political uncertainty assosciated with a particular country

Goals of IFM

-Stockholder value maximization is the accepted goal for firms in Canada, the UK, and the US

-In Continental Europe, countries such as France and Germany focus on maximizing corporate wealth

Japan's Corporate Goals

-Form closly knit , interlocking business groups

-Goal is to increase the wealth and growth of the group (may focus on maximizing market share rather than stockholder wealth)

China: Difference Between State-Owned and Private-Sector Companies

Basic Principles of Managerial Finance (Domestic and International)

-Time value of money is not affected by whether a business transaction is domestic or international

-The same models are used for valuing capital assets, bonds, stocks, and entire firms

Foreign Exchange Market

The foreign exchange market is a group of international markets connected electronically where currencies are bought and sold in wholesale amounts

3 Basic Economic Benefits of Foreign Exchange Market

1. A mechanism to transfer purchasing power from individuals who deal in one currency to people who deal in another 

2. A way for corporations to pass the risk associated with foreign exchange price fluctuations to professional risk takers

3. A channel for importers and exporters to acquire credit for international business transactions

Major Participants in FEM

-Multinational commercial banks

-Large investment banking firms

-Small currency boutiques

Foreign Currency Quotations

-The spot rate is the rate at which one agrees to buy or sell a currency today (like spot market)

-Forward rate is established at the date on which the agreements is made and defines the exchange rate to be used when the transaction is completed in the future (can lock in the cost of FE)

Currency Exchange Markets

Currency Exchange Rate

Direct Quotation Method

Indirect Quotation Method

Purchasing Power Parity

-Method of explaining CERs

-Currency of another country with relatively higher inflation rate will depreciate relative to currency of a country with relatively lower inflation

Interest Rate Parity

-Method of explaining CERs

-Currency of a country with relatively higher interest rate will depreciate relative to a currency with relatively lower interest rate

Typical Cash Outflows

-Repairs and maintenance

-Incremental operating costs

-Working capital

-Initial investments

(Costs on SOE)

Typical Cash Inflows

-Salvage value

-Incremental revenue

-Release of working capital 

-Reduction of costs

Determining Cashflows For Foreign Projects

-Companies find it more difficult to estimate the incremental cash flows fro foreign projects

-Problems from cash flows can arise when foreign governments restrict the amount of cash that can be repatriated, or returned, to the parent company

Factors That Affect CERs

-Supply and demand relationships 

-Relative inflation rates

-Relative interest rates

-Political and economic risks

Risks Involved in International Bank Lending

-The principles of loan admin and credit analysis are similar for domestic and overseas

-There are differnces, including additional risk exposures: credit risk the same, but more difficult to obtain or asess credit info abroad; bank loans that have foreign-exchange risk will carry an additional risk premium

Managing Foreign Exchange Risk

-Stability of government

-Changing currency values

Ethical Considerations

Takeover

Acquisition

Merger

Amalgamation

When and Why Takeovers Happen

-Related businesses(horizontal relationships)- share certain processes

-Transferring competitively valuable expertise 

-Combining the related activities of seperate businesses into a single operation to lower costs

-Exploiting common use of a well-known brand name

-Valuable resources

Vertical Intergration Strategies

Extends a firm's scope within the same industry

-Can aim at either partial or full intergration

-Looking to acquire either a supplier or a distributor (ex. Sony sold in Sony stores and other electronic stores)

Backwards Vertical Integration

Forwards Vertical Integration

 Unrelated Diversification

Favours capitalizing on a portfolio of businesses that are capable of delivering excellent financial performance 

-Hunting to acquire companies: whose assets are undervalued, that are financially distressed, or have high growth potential but are short on investment capital

Synergy

Created when economies of integrating a target and acquiring a company, the amount by which the value of the combined firm exceeds the sum value of the two individual firms

-Primary motive for mergers and acqusitions

Value Creation Motivations for M&As

-Operating synergies

-Efficiency increases

-Financing synergy

-Tax benefits

-Strategic Realignments

Cash Transaction

Share Transaction

Going Private Transaction

Exempt Takeovers

-Private companies are generally exempt from provincial securities legislation

-Public companies that have few shareholders in one province may be subject to takeover laws of another province where the majority of shareholders reside

Fair Treatment

-To avoid oppression or coercion of minority shareholders

-To permit competing bids during the process and not have the first bidder have special rights (shareholders have opportunity to get the fairest price for their shares)

-To limit the ability of a minority to frustrate the will of a majority

Creeping Takeovers(5% rule)

Normal course tender offer is not required as long as no more than 5% of the outstanding shares are purchased through the exchange over a one-year period of time

-This allows creeping takeovers where the conmpany aquires the target over a long period of time

Critical Shareholders' Percentages 

1. 10%- Early Warning

2. 20%-Takeover Bid

3. 50.1%-Control 

4. 66.7%-Amalgamation

5. 90%- Minority Squeeze Out

10%-Early Warning

-When the shareholder hits this point, a report is sent to OSC

-This requirement alters other shareholders that a potential acquistor is accumulating a position (toehold) in the firm

20%-Takeover Bid

-Not allowed further open market purchases but must make a takeover bid

-This allows all shareholders an equal opportunity to tender shares and forces equal treatment of all at the same price

-This requirement also forces the auquisitor into disclosing intentions publicly before moving moving to full voting control of the firm

50.1%-Control

-Shareholders control voting decision under normal voting (simple majority)

-Can replace board and control management 

66.7%-Amalgamation

90%-Minority Squeeze Out

-Once the shareholder owns 90% or more of the outstanding stock minority shareholders can be forced to tender their sahres

-This provision prevents minority shareholders from frustrating will of majority

Takeover Bid Process (Beyond 20% Threshold)

-Takeover circular sent to all shareholders

-Target has 15 days to circulate letter to all sahreholders with the recommendation of the board of directors to accept/reject 

-Bid must be open for 35 days following public announcement

-Shareholders tender to the offer by signing authorizations 

-A competing bid automatically increases the takeover window by 10 days and shareholders during this time can withdraw authorizations and accept the competing offer

-Takeover bid does not have to be for 100% of shares

-Tender offer price cannot be for less than the average price that the acquirer bought shares in the previous 90 days (prohibits coercive bids)

-If more shares are tendered than required under the tender, everyone who tenderd shares will get a prorated number purchased 

Friendly Acqusition Process

1. Normally starts when the target voluntarilt puts itself into play; target uses an investment bank to prepare an offering memorandum

2. Can be initiated by a friendly overture by an aqusitor seeking info that will assist in the valuation process

Approach target--->Confidentiality agreement--->sign letter of intent--->Main due diligence--->Final sale agreement---->Ratified

Hostile Takeovers

When the target has no desire to be aquired and actively rebuffs the aquirer and refuses to provide any confidential information

-The aquirer usually already has accumulated an interest in the target (20% of outstanding shares) and this preemptive investment indicates the strength of resolve of the aquirer

Typical Hostile Takeover Process

1. Slowly acquire a toehold by open market purchase of shares at market prices without attracting attention

2. File statement with OSC at the 10% early warning stage while not trying to attract too much attention

3. Accumulate 20% of the outstanding shares through open market purchase over a longer period of time 

4. Make a tender offer to bring ownership percentage to the desired level (50.1% or 66.7%)- this offer contains a provision that it will be made only if a certain minimum percentage is obtained 

Market Clues to the Potential Outcome of a Hostile Takeover

-Market price jumps above the price

-Market price satys close to the offer price 

-Little trading in shares

-Great deal of trading in shares

Defensive Tactics to a Hostile Takeover

-Shareholder's Rights Plan (make acquisition more expensive)

-Selling the Crown (Key assets)

-White Knight (Seek another acquirer for friendly aquisition)

Corporate Governance Function

1. Oversight

2. Managerial

3. Compliance

4. Internal Audit

5. Legal/Financial Advisory

6. Monitoring

7. External Audit

Effective Corporate Governance

-Participants add value to the company's sustainable long-term performance

-Effectively carry out their duty and professional responsibilties

-Are held accountable for their performance

-Develop a practice of not only complying but also committing to doing the right thing

Four Key Corporate Gatekeepers 

-Independent and competent board

-Independent and competent auditor

-Objective and competent legal course

-Objective and competent financial advisors

3 Interelated Components of Corporate Governance

-Principles

-Functions

-Mechanisms

Principles of Corporate Governance

-Honesty 

-Resilence 

-Responsiveness

-Transparency

Internal Mechanisms of Corporate Governance

-Board of directors

-Audit Comittee

-Internal controls

-Internal audit functions

External Mechanisms of Corporate Governance

-Market for corporate control

-Capital market

-Labour market

-Federal and Provincial statutes

-Court decisions

-Shareholder's Proposals

-Best practice of investors

Business Ethics Levels

1. The society level

2. The industry level

3. The company level 

4. The individual manager level

Corporate Culture

Ethics Sensitivity 

-Moral principles

-Work place environment

-Gamesmanship

-Loyalty

-Peer pressure 

-Job security influence

Ethics Incentives

-Rewards

-Punishments

-Requirements for ethical behaviour