UNSW Business School

School of Banking and Finance FINS5514: Capital Budgeting and Financial

Decisions Lecture 1: Introduction to Corporate Finance and

Agency Theory Chapter Outline • Forms of business organization • Objectives of the firm • Agency theory • Asymmetric information • Financial markets, and the corporation BusinessOrganizations • There are several different types of company and each type has certain advantages and disadvantages compared to the others. • The most frequently seen types include: – Sole proprietorships

– Partnerships – General partnership – Limited partnership – Corporations 3 Sole Proprietorships / Partnerships • Sole proprietorships are owned and run by one

person. Partnerships are two or morepeople. • Advantages – These companies are simple to establish – Owners keep all the profits – Income is taxed once as personal income • Disadvantages – Unlimited liability (General Partners) – Difficult to raise largesums of finance – Limited life of the business 4 Corporations • A corporation is a legally registered company with

distinct groups of owners andmanagers. • Corporations are often listed on a stock

exchange • Advantages to aCorporation – Separation of ownership and control – Ownership can be transferred easily – Limited liability • Disadvantages to aCorporation – Separation of ownership and control – Double taxation – Complex legal formalities take time and money to

complete 5 Financial Managers • The financial managers of a firm makethree

decisions in three primaryareas: – Capital budgeting (Investment) – Capital structure (Finance raising) – Dividends • In theory these decisions are separate but in

reality they are interconnected. 6 Investment Decisions • These decisions create profits and revenue, as well asthose that reduce costs andexpenses • The primary objective is to increase firm value by deciding which long-term investments or projects the business should takeon • Capital budgeting analysis is very important and includes analysis of: – The amount of cash flows – The risk of cashflows – The timing of cashflows 7 8The balance-sheet model of the firm Current

assets Fixed assets: - tangible - intangible

Assets Shareholders’

equity Current

liabilities Long-term

debt Liabilities/Shareholders’ equity 9The capital budgeting decision What long-term

investments

should the firm

engage in? Current

assets Fixed assets: - tangible - intangible

Assets Shareholders’

equity Current

liabilities Long-term

debt Liabilities/Shareholders’ equity 10 The capital budgeting decision -

examples Date 0 1 2 3 CF -100 5 5 110 Project 1: cash flows of the project Date 0 1 2 3 4 5 CF -100 5 5 5 5 110 Project 2: cash flows of the project Financing Decisions • In order toinvest, firms must raise funds. • Debt: – Straight or convertible – Long or short term – Fixed or floating rate • Equity – Ordinary or preferenceshares • The choice depends upon many factors: – Taxation, external monitoring, risk, signalling,agency

issues, capital structure and soon... 11 12 Capital structure How can the firm

raise the money

for the required

investments? Current

assets Fixed assets: - tangible - intangible

Assets Shareholders’

equity Current

liabilities Long-term

debt Liabilities/Shareholders’ equity Corporations: separation of

ownership and control Board of directors Management Assets Debt Equity Shareholders Debtholders The goal of the corporation • Need an objective by which management

can make decisions • What are the goals of a firm? – Maximize profits? – Minimise costs? – Maximise market share? – Maximise the value of the company’sstock? 14 The goal of the corporation (continued) • Corporate wealth maximisation (CWM) – Satisfy all stakeholders in the firm including

debtholders, employees and society as awhole – This approach is fairly rare but is seen in Germany and

Japan • Shareholder wealth maximisation (SWM) – This is the most popularanswer – Main objective of the firm is to maximize shareholder

value – Equivalent to increase share price if listed – E thical issues may arise as the shareholders

expropriate wealth from otherstakeholders 15 The goal of the corporation (continued) Nearly 200 CEOs say their companies are committed to delivering value to

all stakeholders, not just shareholders On August 19, 2019, the Business Roundtable (BRT), a lobbying group

composed of leading CEOs in the US, released an updated Statement on the

Purpose of a Corporation. This statement expresses a fundamental

commitment to all stakeholders, including customers, employees, suppliers,

communities, and shareholders, differing from a long-standing view that

shareholder profit is the sole purpose of corporations. The statement received support from 181 CEOs, including the leaders of

major multinationals such as Amazon, Apple, Chevron, The Coca-Cola

Company, Dell, Exxon, Ford, PepsiCo, Procter & Gamble, and Walmart, as well

as the leaders of large financial firms such as Bank of America, BlackRock,

Citigroup, Goldman Sachs, JPMorganChase, Morgan Stanley, and Vanguard.

Source: Business & Human Rights Resource Centre16 Agency Theory • Under SWM, managers should only be

thinking about shareholderwelfare. • However, due to agency theory this does not

always happen • Agency theory says: – The principal hires the agent to represent his/her

best interests. – Shareholders (principals) hire the

managers

(agents) to run their company 17 Agency Problems • However, all stakeholders in the firm are

primarily concerned with self-interest • This leads to potential conflicts of interest

between principal and agent. – These conflicts are the agencyproblem • There are two main areas where isarises – Shareholders and managers – Shareholders and debtholders 18 Agency Problems For Managers and

Shareholders • Separation of ownership and control – Principal agent problems • The owners and the managers may not have the same objectives and this can result inproblems. – Managers prefer to increase their job security, power,

status,

or to generate perks forthemselves – This may be at the expense ofSWM 19 Agency Problems For Managers and

Shareholders (continued) • Agency costs arise as the shareholders

attempt to control themanagers • Direct costs: – Managers act in their own interests, reducing value for the

shareholders – Managers need to be monitored to ensure their actions This generatesare in the owners best interests.

monitoring costs – Setting up contracts also costs money • Indirect costs: – Lost opportunities to create value for the shareholders 20 Possible solutions for Managersand

Shareholders • Internal mechanisms for solving this problem

include: 1. The Board of Directors – Employing executive & non-executive directors on the

Board. 2. Major shareholders, such as institutions, can exert considerable influence on thecompany. 3. Compensation packages for the managers that give them an incentive to act in the best interests of theshareholders – The use of stock options / stock grants 21 Possible solutions for Managersand

Shareholders (continued) 4. The market for corporate control (mergers and acquisitions) can use used to solve the agency problem – Shareholders can threaten to sell their shares in a

hostile takeover – If the takeover goes ahead, the firms managers

are likely to be firedafterwards. – This is viewed as the “court of last resort” (Jensen

1988) 22 Agency Problems For Debtholders and

Shareholders • If a firm has debt, the debtholders have a claim on part of the earnings of the firm, or some of the assets if the firmgoesbankrupt. – Debtholders have a fixed claim while shareholders

have a residual claim on the firm

• The interest rate on debt is based on the riskiness

of

current and future projects and the company’s

current and expected future capital structure. – This is a risky investment for debtholders but they do not have any control over the company on a day-to- day basis. • This is another form of agencyproblem 23 Types of AgencyProblems • More formally, there are two types of agency

problems 1. Moral Hazard (HiddenAction) – Although the principal and the agent have the same initial set of information, the principal cannot observe the action chosen by the agent 2. Adverse Selection (Hidden Information) – Both the principal and the agent know that the agent has information which is valuable to the principal but which the principal cannotsee. 24 Asymmetric Information • One potential cause of agency problems is

asymmetric information – This means that some people know a lot more than

others. • Managers have much more information than

outsiders including shareholders and debtholders • Without good information, markets will break

down 25 Akerlof’s Market for Lemons • Akerlof (1970) wrote an academic paper which illustrates the problems that arise from a lack of information • He used the market for second hand cars as an example – Two types of second handcars – Lemons – poor quality cars which are worth$400 – Peaches – good quality cars which are worth $2,000 – Each type of car represents 50% of themarket 26 Akerlof’s Market for Lemons(cont) • There are 3 scenarios to consider 1. Peaches and lemons can be accurately identified by everyone in themarket. – Here is there is no problem because everyone

has all the necessary information. – Cars will be sold at their correct values and the

market will continue tooperate – A peach will be sold for $2000 and a lemon for $400. 27 Akerlof’s Market for Lemons(cont) 2. No-one knows whether any particular car is a

peach or a lemon – So, all cars will sell at $1200 2 2 – Assuming risk neutrality, buyers will work out

what they are prepared to pay: E(Value)= Proportionof lemons×(Valueof lemon) +Proportionof peaches×(Valueof peach) – In this example, this is: E(Value)= 1×($400)+1×($2000)=$1200 28 Akerlof’s Market for Lemons 3. Asymmetric information in which the sellers know the quality of the car but buyers do not. – Here the market will break-down – Sellers of good cars will only accept $2000 but

buyers will not pay more than$1200 – Therefore, no good cars will be sold and the only

cars on the market will belemons 29 Solutions to AsymmetricInformation • The market for lemons is an example of problems

that arise from asymmetric information • There are some solutions: 1. Buyers can gain the skills to improve their

knowledge but this can beexpensive 2. Sellers can signal the quality of their product

with guarantees and trial periods – However, effective signals must be unambiguous and

credible. This can be costly. – Just saying something is good is not enough 30 Solutions to AsymmetricInformation

(continued) • In the context of a corporation, managers try to signal to investors that the firm is a good one through corporate• This can be done

announcements suchas: – Dividends – Capital structure – Takeover plans – Initial public offerings 31 Corporate Governance • Corporate governance is the name for any measures that can be used to close the incentive gap between managers and shareholders and reduce agencyproblems. • Some firm level solutions are on the previous slides • To illustrate why this is important, consider a situation where governancefailed: – The collapse of Enron 32 Country Level Corporate Governance • Corporate governance also exists at a country (macro) level. • E.g. Sarbanes-Oxley Act (2002), Dodd–Frank Act

(2010) • These regulations try to encourage / force firms to act in the best interests of their shareholders • However, it is difficult to get the balance correct between enforcing good governance and still allowing firms to evolve and react to changing situations 33 34 Cash flow from firm (C) The firm and the financial markets Ta xe s

(E ) Firm Government Firm issues securities (A) Retained

cash flows (D) Invests in assets (B) Dividends and debt payments (F) Current assets Fixed assets Financial markets Short-term debt Long-term debt Equity shares Ultimately, the firm

must be a cash

generating activity. The cash flows from

the firm must exceed

the cash flows from the

financial markets. 35 Financial markets Money markets versus capital markets: • Money markets: – For short-term debt instruments. • Capital markets: – For long-term debt and equity. 36 Financial markets (cont’d) Primary versus secondary markets: • Primary market: – When a corporation issues securities, cash flows from

investors to the firm. – Usually an underwriter is involved. • Secondary markets: – Involve the sale of “used” securities from one investor

to another. – Securities may be exchange traded or traded over-the- counter in a dealer market. Financial Markets Firms Investors Secondary

Market money securities SueBob Stocks and

Bonds Money Primary Market 38 Summary • Three important questions in corporate finance  Capital budgeting  Capital structure  Dividends • The goal of the corporation  Maximize shareholder’s value • Agency problems • Financial markets 51作业君版权所有