INTRODUCTION TO CORPORATE

Corporate Finance (European Edition), 3e David Hillier, Stephen Ross, Randolph Westerfield, Jeffrey Jaffe, Bradford Jordan

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CHAPTER 1

INTRODUCTION TO CORPORATE

FINANCE

• Finance relates to the decision-making and strategies of corporations. It is composed of

three main elements.

• The capital budgeting or investment decision.
• The capital structure or financing decision.
• Short-term capital management.

Each decision is framed within the general objective of maximizing firm value while ensuring that risk is appropriately managed.

Think a family, with one parent earning the monthly salary and the other looking after the children. Every month, money comes into the house and there will be times when the family needs to spend money on items like furniture. This will usually come from savings. However, sometimes, the family will want to buy a car or a house and will need to take out a loan for the investment. At all times, the family must have enough cash and this applies every single day. This example concerns a family, but if you change the object to a corporation, the same decisions need to be made. When we talk about financial decisions relating to families, this is known as personal finance, whereas when we talk about corporations, we call this corporate finance.

• The investment decision refers to investments in projects that produce a higher rate of

return than the firm’s minimum hurdle rate. The financing decision refers to the optimal mix of debt and equity. Short-term capital management refers to activities related to working capital management that help ensure the liquidity and profitability of a company. The equity decision is explicitly a sub-component of the financing decision.

• The statement assumes that the market is efficient and markets fully reflect the true

value of the firm. In this context, the goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions.

• Financial markets are market places where buyers and sellers trade assets, and they

facilitate the raising of capital (e.g. IPOs, SEOs, bond issues), the transfer of risk (e.g.loans), the transfer of liquidity (e.g. the quick sale of assets such as stocks), and international trade (e.g. GDRs).

• A depository receipt is a security carrying a legal claim on the cash flows from the

deposited shares, and offers an indirect form of listing on a stock exchange. Companies often use depository receipts to circumvent listing problems in foreign markets. With a depository receipt, a firm deposits a number of its own shares with a bank, which in turn 2 / 4

issues a depository receipt. If the issuing firm pays dividends, the bank transfers the cash flows to holders of the depository receipts, after deducting a small fee. Global depository receipts refer to depository receipts issued outside U.S. markets.

• This is quite a difficult task for students but it is useful in getting them to read through

news stories and to familiarise them with financial websites. The expectations of the instructor should not be too great and the question is very useful for a first lecture in a Corporate Finance class. This answer to this question is very much up to the student.Give them websites that they can visit to collect data including Google, Yahoo! Finance, Reuters, and FT.Com. As an introductory question, it is an excellent way to get students to practically engage with the material and do their own research. You can even get them to prepare a presentation or do the question in groups.

• Equity = Total Assets – Total Liabilities = €1,403 – €1,253 = €150 million

Non-Current Assets = Total Assets – Current Assets = €1,403 - €619 = €784 million Non-Current Liabilities = Total Liabilities – Current Liabilities = €1,253 - €338 = €915 million

• Step 1: Determine liability/equity ratio: €1,253

8.353

15€0

liability equity ==

Step 2: To find the current weightings of debt and equity in the new funding, you must actually calculate a new ratio, liability/assets. 1,253

0.8931

1,40 € €3 liability Assets ==

Step 3: The debt that is raised is thus €89.31 million and equity is €10.69 million.Step 4: Check the new liability/equity ratio. The new level of liabilities is €1,342.31 million and the new level of equity is €160.69 million. The new ratio is: 1,342.31 8.353 160 €

.69€

liability equity ==

This is the same as the original liability/equity ratio.

9. There are three components to this transaction:

• Cash outflow of £100 million will appear in cash flow statement. Current assets

(cash) will fall by £100 million.

• We now owe £3.4 billion. Given that it must be paid in 3 months, the amount

will show up as an increase in current liabilities of £3.4 billion.

• Non-current assets will increase by £3.5 billion.

• The payment of £1,200,000 in twelve months is less because the cash flow is after the

majority of £100,000 monthly payments. An example can show the intuition behind this.Assume the monthly interest rate is 1 per cent (it can be anything as long as it is above 0

per cent). The present value of cash flows is thus:

Annuity PV(CF) One PV(CF) 3 / 4

Payment

1 £100,000 £99,009.90

2 £100,000 £98,029.60

3 £100,000 £97,059.01

4 £100,000 £96,098.03

5 £100,000 £95,146.57

6 £100,000 £94,204.52

7 £100,000 £93,271.81

8 £100,000 £92,348.32

9 £100,000 £91,433.98

10 £100,000 £90,528.70

11 £100,000 £89,632.37

12 £100,000 £88,744.92 £1,200,000 £1,064,939.07

PV £1,125,508 PV £1,064,939.07

• You would choose the less risky project because both have the same expected value. In

this case you would choose Project B, because the risk of losing and gaining money is less than in Project A.

• Corporate social responsibility (CSR) is concerned with companies acting in a socially

responsible manner with respect to the products they sell, the method of production, the firm’s relationship with local communities, and the firm’s relationship with its staff.Although some argue CSR is a waste of managerial time and investment in CSR should only occur if it generates a return greater than an alternative project, others believe CSR can become part of a company’s overall competitive advantage since it can strengthen its relationships with important stakeholders.

• There is no right or wrong answer to this question. However, the student is expected to

discuss the pros & cons to a company of investing in CSR, and may back-up their answers with reference to empirical evidence. Pros could include a competitive edge gained by good PR, while cons could include the use of management time and company resources to non-core projects with very uncertain and subjective cash flow returns.

• As the answer to question 6 suggests, the main reason firms choose different forms of

financing relates to their cost. The financial manager should choose the funding flow that is cheapest and less risky. When firms are small, they are not able to list on stock exchanges and therefore they will only have access to private investment, be it a bank or a private investor. As they get bigger, stock exchanges become a viable option for funding and hence it can also be used.

• Cash is a double-edged sword. Whereas a firm needs a minimum level cash to pay for

bills, expenses, creditors, etc., having too much cash could tell investors that the firm is not investing in profitable new projects. Some questions will be asked to the management: a) Why are you not investing the money? B) Why are you not giving the

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