Corporate Finance 1 Dr Riya Mehta Goal of a business • Maximize shareholder wealth • Maximize profit • EPS • Timing: receipt of funds sooner rather than later is preferred • Cashflows: the difference between profit and cash flow • Risk: return and risk are key determinants of share price representing the wealth of the owner in the firm What about stakeholders? • Employees • Customers • Suppliers • Creditors • Owners Role of business ethics • Standards of conduct or moral judgment that apply to persons engaged in commerce. • Violations: misleading financial forecast, insider trading, excessive executive compensation, fraud, bribery etc. • Relation between ethics and share price Primary activity of financial manager Marginal cost-benefit analysis • Jamie Teng is trying to decide whether to replace one of the firm’s computer servers with a new one. • Cash outlay for new computer: $8000 • Selling price of old computer: $2000 • Total benefit with the new server: $10,000 • The benefit over a similar period from the old computer: $3000 • Wendy Winter needs to determine whether or not the current warehouse system should be upgraded to a new system. • The new system would require an initial cash outlay of $250,000. The current system could be sold for $55,000. The monetary benefit of the new system over the next five years is $325,000 while the monetary benefit of the current system over the same period is $125,000. • Furthermore, it is expected that the firm’s stock price will increase if the new system is implemented because it will make the firm more cost efficient and cost effective in the long run. a. Identify and describe the analysis Wendy should use to make the decision. b. Calculate the marginal benefit of the proposed new warehouse system. c. Calculate the marginal cost of the proposed new warehouse system. d. What should Wendy’s recommendation be to the firm regarding the new warehouse system? Explain your recommendation. e. If the new system is implemented, will the firm achieve the primary financial goal of managers? • Ken Allen, capital budgeting analyst for Bally Gears, Inc., has been asked to evaluate a proposal. The manager of the automotive division believes that replacing the robotics used on the heavy truck gear line will produce total benefits of $560,000 (in today's dollars) over the next 5 years. The existing robotics would produce benefits of $400,000 (also in today's dollars) over that same time period. An initial cash investment of $220,000 would be required to install the new equipment. The manager estimates that the existing robotics can be sold for $70,000. Show how Ken will apply marginal cost-benefit analysis techniques to determine the following: a. The marginal benefits of the proposed new robotics. b. The marginal cost of the proposed new robotics. c. The net benefit of the proposed new robotics. d. What should Ken recommend that the company do? Why? e. What factors besides the costs and benefits should be considered before the final decision is made? Agency issue • Principal-agent relationship: an arrangement in which an agent acts on behalf of a principal. E.g. Shareholders elect management • Agency problem: manager place personal goals ahead of the goals of shareholders • Agency cost: cost arising from agency problems that are borne by shareholders and represent the loss of shareholder wealth. Problems • The front desk receptionist routinely takes an extra 20 minutes of lunch time to run personal errands. • Division managers are padding cost estimates to show shortterm efficiency gains when the costs come in lower than the estimates. • The firm's chief executive officer has had secret talks with a competitor about the possibility of a merger in which she would become the CEO of the combined firms. • A branch manager lays off experienced full-time employees and staffs customer service positions with part-time or temporary workers to lower employment costs and raise this year's branch profit. The manager's bonus is based on profitability The financial market environment • External sources of funds 1. Financial Institutions Structured 2. Financial markets 3. Private placements Financial Institutions • An intermediary that channels the savings of individuals, businesses and government into loans and investments. • Commercial banks • Investment banks • Shadow banking system: only lending and no deposits Financial markets • Private placement: sale of new security to an investor or group • Public offering: sale of bonds or stock to the general public • Primary market: initial issue • Secondary market: preowned securities are traded • Over-the-counter market: trading of smaller and unlisted securities • Money market: a financial relationship between supplier and demander of short-term funds • Capital market: a financial relationship between supplier and demander of long-term funds
