Copyright 2017 Cengage Learning Australia Pty Limited

Copyright © 2017 Cengage Learning Australia Pty Limited

Chapter 1 The Scope of Corporate Finance

Chapter Overview The What Companies Do opening feature looks at an issue close to most students’ hearts – digital technology. The focus of the first case is Apple’s launch of the iPhone 6, identifying the range of economic and financial issues that needed to be considered with the new product, even though it was a development of an existing product, a mobile telephone. Chapter 1 looks at how financial managers, like those at Apple, interacted with operations, marketing, communications and legal to create shareholder wealth. The importance of the finance function and the financial manager within business organisations has been rising steadily over the past two decades. Financial professionals can do more than just raise the operating efficiency of a company – they can create value in their own right. The primary focus of this textbook will be on the practising financial manager, working as an integral part of the management team of a modern company. As an introduction to what a financial manager’s job entails, this chapter includes a description of the principal tasks and responsibilities that a finance professional employed by a large company might encounter.What Companies Do Discussion Questions

• What do you imagine were the interactions between the finance function and operations function at

Apple when the iPhone 6 was being developed? On what business criteria does Apple’s strategy depend?

• What can a company do to make a low profit margin strategy more successful? What are examples

of tie-ins, like Apple’s iTunes which can be downloaded onto an iPhone?This Chapter Covers 1-1 The role of corporate finance in business 1-2 Corporate finance essentials 1-3 Legal forms of business organisation 1-4 The corporate financial manager’s goals Learning objectives • LO1.1 appreciate how finance interacts with other functional areas of any business and see the diverse career opportunities available to finance majors • LO1.2 describe how companies obtain funding from financial intermediaries and markets, and discuss the five basic functions that financial managers perform • LO1.3 assess the costs and benefits of the principal forms of business organization and explain why limited liability companies, with publicly traded shares, dominate economic life in most countries • LO1.4 define agency costs and explain how shareholders monitor and encourage corporate managers to maximise shareholder wealth.Technology

• Smart Video. Andy Bryant, executive vice president of finance and enterprise systems and chief

financial officer, Intel Corp., discusses that ethical behaviour on the part of a company can add value.

• Smart Video. This quotes Joshua Haines, senior credit analyst at the Private Bank, concerning how

he continues to use basic finance concepts he learned in earlier finance classes.(Instuctor Manual all Chapters) 1 / 4

Introduction to corporate finance 2e – instructor’s manual

Copyright © 2017 Cengage Learning Australia Pty Limited

• Smart Video. This quotes Bill Eckmann, Principal, Solar Capital, concerning his career in

investment banking.

• Smart Video. This quotes David Nickel, controller for Intel Corp.’s Communications Group, about

how finance can help business increase shareholder value.

• Smart Video. Vern LoForti, Vice -President, Chief Financial Officer and Corporate Secretary

InfoSonics ‘Sarbanes-Oxley has certainly impacted our company in many ways, from operations all the way to the board.’

• Smart Video. See risk management explained step by step.

Lecture Guide

1-1: The Role of Corporate Finance in Modern Business

1-1a: How Finance Interacts with Other Functional Business Areas

1-1b: Career Opportunities in Finance

Give students some examples of jobs they can get as finance graduates. The university career services office may be helpful in giving examples of specific employers who recruit on campus. It may also have information about average pay scales in each area in finance.

Table 1.1 Career Opportunities in Corporate Finance

Table 1.2 Career Opportunities in Commercial Banking

Table 1.3 Career Opportunities in Money Management

1-2: Corporate Finance Essentials

The instructor can introduce the topics that will be covered throughout the teaching period, including when and in how much depth each topic will be covered in this course, and what might be topics for other finance courses.

1-2a: The Five Basic Corporate Finance Functions

Explain that internal financing – the profits that a company generates that are not paid to shareholders as dividends are the most important source of company financing. A company seeks capital market debt and equity finance when it does not generate enough funds for its investment opportunities.Tell students about the history of finance. For example, raising funds from a large number of investors spread with the legal concept of a company. During the 17th century, companies were first given limited liability. This induced wealthy individuals to invest – they knew the worst that could happen was the loss of their investment; they would not lose all of their wealth in a bad venture. The idea of incorporation as a company was so successful that England freely allowed companies to incorporate by the mid 19th century. Other countries followed England’s lead. The verb ‘to finance,’ or raising funds for investment, was entered into the English dictionary in 1866.

Student Interaction:

• Ask students how many of them give money directly to a company. Few will (unless they own their own business.) This is a good springboard to how companies receive money from individuals, for example, through banks that lend their savings deposits to companies. Few, if any of the students will have participated in a company’s direct means of obtaining funds (initial public offerings and secondary offerings) and are more likely to have participated in share investing through the secondary market.Financing This section provides an opportunity to bring in current events, while explaining the external financing choices a company has. Terms such as capital structure, external financing, and types of 2 / 4

Chapter 1 The Scope of Corporate Finance

Copyright © 2017 Cengage Learning Australia Pty Limited financiers such as venture capitalists can be mentioned, to note they will be defined in detail later in the book.

Financial Management Note that this function covers the theory that financial managers put into practice in their jobs.

Capital Budgeting Capital budgeting is the function perhaps most highly associated with corporate finance – what projects should a company invest in? Note how the nature of investment has changed over time. Investment used to mean building a factory and stocking it with equipment. Today’s business model generally requires a high investment in information technology. It is much harder to measure the value of an investment in IT.A factory produces a particular product that is then sold to consumers. Ask students what technology produces. It may be more of preventing a loss; for example, investing in IT may keep consumers coming to a company’s online and physical retail stores. The company has invested in IT to keep customers from shopping at competitors with better web sites.

Risk Management Note that a great deal of finance is about the risk-return relationship. An investor (or a company) expects to be compensated for taking on higher risk; in other words, higher risk, then higher return. By the nature of its business a company is exposed to risk. Most companies have international dealings and will be exposed to exchange rate risk. Companies with commodity inputs will be exposed to commodity risk.There are ways a company can hedge, or mitigate, this risk and more complex securities developed to help companies manage their risks.

Corporate Governance Talk to students about the nexus of stakeholders concerned with a company. Companies must be concerned with

• Shareholders • Debt-holders/Creditors • Managers • Employees • Local community • Suppliers • Customers

The idea of a ‘nexus of stakeholders’ is becoming increasingly recognised. Several countries such as Germany and Sweden require company boards to have external stakeholder representation.This chapter is a good opportunity to bring in current issues in finance. The after-effects of accounting scandals (Enron, Worldcom, HIH, One-Tel, Storm, etc.) will be in the news for a long time.Define executive share options, and ask students for their opinion about their usage. Ask for suggestions about what small shareholders can do if they are unhappy about the way their company is managed (band together, sell shares). Ask if company insiders should be on a company’s board of directors.

1-2b Debt and Equity: The Two Flavours of Capital

1-2c The Role of Financial Intermediaries in Corporate Finance This section is a graphical depiction of two strong trends – the equity market has grown worldwide, and as a corollary, more people are invested in the share market. First, there are more new companies than existed a decade ago. Many start-up companies, like Microsoft which first issued shares in 1986, have grown substantially. For example, an investment in Microsoft in 1986 would have grown over 34,000% by 2004! While US markets are still the largest, global markets are also increasing in size and importance.The result is 24/7 trading in major securities. 3 / 4

Introduction to corporate finance 2e – instructor’s manual

Copyright © 2017 Cengage Learning Australia Pty Limited

Figure 1.1 Bank Shares Fall by Half

1-3 Legal forms of Business Organisation

1-3a Business Organisational Forms in Australia For sole proprietorships, note that the principles of finance apply to all forms of the business organisation. The main advantages to a proprietorship are its ease of formation, subject to few regulations and no corporate income taxes, all of which are at least somewhat quantifiable. Ask students what is another big, but non-quantifiable advantage of a proprietorship. Most students will point to the idea of being one’s own boss as an attraction of owning your own business – but one that is very hard to quantify.• When talking about the advantage of no corporate income taxes, ask students how many of them own shares, and how their income from the shares is taxed. Note that most other countries do not double-tax dividends as the US does. Only a few countries, however, allow full dividend imputation as Australia does for Australian-resident investors.• When talking about partnerships note that partnerships for the most part have the same advantages and disadvantages of sole proprietorships. Note that limited partnerships have been increasingly used, and provide limited liability to all except the general partners. There are very few large partnerships, except law and accounting companies.• When talking about companies point out why they were ‘invented’, including greater efficiency, collective effort and greater access to capital. Unlimited life is one advantage of a company. Go to http://www.hbc.com , the web site of Hudson Bay Company. In its history section, there is a picture of Charles II of England granting a charter to the Hudson Bay Company in 1670. The company is still here today. Instead of an exploration company, it is a retail chain in Canada, but it shows when we talk about unlimited life, we mean it! You can either show the picture from the Internet in class if you have a classroom connection, or you can save the picture in a PowerPoint presentation.

1-3b Forms of Business Organisation Used by Companies outside Australia This section reinforces the section of the text that describes other forms of organisation popular among companies outside Australia.

• These countries show many common patterns. In almost all capitalist economies, some form of limited liability business structure is allowed, with ownership shares that can be traded freely on national share markets.

1-4 The Corporate Financial Manager’s Goals Point out the differences between profit and share price maximisation. As the Enron and Worldcom cases (and subsequent criminal prosecutions) showed, it is possible to manipulate accounting statements to deceive shareholders. Shareholders are overwhelmingly concerned with cash flow, not accounting numbers, even though there is a high positive correlation between cash flow and net income.

1-4b How Can Agency Costs be Controlled in Corporate Finance?

Agency costs include:

• Bonding management to the company • Monitoring the company • Residual loss

Student Interaction:

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