FINA2010 Financial Management

Lecture 1: Introduction to Financial

Management

Instructor: Prof. Si Cheng

CUHK Business School

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 Lecture Outline
• Finance and Corporate Finance
• Forms of Business Organization
• Goals of Financial Management
• Agency Problem and Control of the
Corporation
• Financial Markets and the Corporation

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 Learning Objectives
• Know the basic types of financial management
decisions and the role of the financial manager
• Know the financial implications of the different
forms of business organization
• Know the goal of financial management
• Understand the conflicts of interest in agency
relationships
• Understand the various types of financial markets

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 What is Finance?
• A discipline concerned with determining value
(what something is worth today) and making
decisions based on that value assessment.
• The finance function allocates resources,
including the acquiring, investing, and
managing of resources.

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 Business Finance Applications
• A company wants to replace its current production
line with a new line of more expensive and more
efficient machines. Should the company buy the new
machines or leave the old ones in place?
• A firm needs to purchase a piece of equipment.
Should it buy a cheaper machine with a shorter
lifespan or a more expensive machine that lasts
longer?

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 Business Finance Applications
• A company is trying to decide whether to develop a
new product – how can it deal with the fact that
most of the development costs will be incurred
before any sale revenues have been realized?
• All businesses, from international conglomerates to
small “hawker” shops, have to decide how to finance
their operations. Will they borrow or will they bring
in new investors/shareholders?

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 Personal Finance Applications
• The principles behind making correct business finance
decisions are the same as those used for individual
finance decisions.
• When to start saving for retirement and how much to
save?
• How to finance a child’s education?
• How to evaluate the terms for a home mortgage?
• Is a particular stock a good investment? Is a particular
fund a good investment?

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 Scope of Study in Finance
• Main Areas of Finance:
– Investments
– Financial Markets and Intermediaries
– Corporate Finance (or Business Finance)

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 Investments
• The study of financial transactions from the
perspective of investors outside the firm.
– How do we assess the risk of various financial
securities?
– How do we manage a portfolio (group) of financial
securities to achieve a stated objective of the
investor?
– How do we evaluate portfolio performance?

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 Financial Markets and Intermediaries
• The study of markets where financial
securities (such as stocks and bonds) are
bought and sold.
• The study of financial institutions (such as
commercial banks, investment banks, and
insurance companies) that facilitate the flow
of money from savers to demanders of money.

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 What is Corporate Finance?
Investment
• What long-term investments should the firm take on?
(capital budgeting decision)

Financing
• Where will you get long-term financing to pay for the
long-term investments? (capital structure decision)

Liquidity
• How will you manage the everyday financial activities
of the firm? (working capital management decision)

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Example: Investment Decision
• Long-term
investment
• Cost vs.
Benefit

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 Example: Financing Decision
• Alibaba’s Stock Jumps on Hong Kong Trading Debut
• IPO: initial public offering, make shares of a private
company available to the public for the first time
• Five years ago Alibaba raised $25bn in New York in what
was the world’s biggest initial public offering. The
secondary listing will make it easier for investors in China
and elsewhere in Asia to trade the shares.
• Alibaba’s shares opened 6.25 percent higher at HK$187
($23.90), with the group raising HK$88bn ($11.3bn).
• Source: 26 November 2019, Financial Times

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Corporate Organisation Chart
→ elected by owners
(shareholders)

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 Financial Manager
• The top financial manager within a firm is
usually the Chief Financial Officer (CFO).
– Treasurer: oversees cash management,
credit management, capital expenditures
and financial planning.
– Controller: oversees taxes, cost accounting,
financial accounting and data processing.

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 Financial Management Decisions
• Capital Budgeting: the process of planning and managing a
firm’s long-term investments.
– Identify investment opportunities that are worth more to the
firm than they cost to acquire.
• Capital Structure: the mixture of long-term debt (borrowing)
and equity (owners’ investment) maintained by a firm.
– How much should the firm borrow? What are the least
expensive sources of funds for the firm?
• Working Capital Management: the management of a firm’s
short-term assets and liabilities.
– How much cash and inventory should we keep on hand? Should
we sell on credit? How will we obtain any needed short-term
financing?
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Corporate Finance in Action: Google
Early Days
Great Idea Received Funding

The Share Issue

Need to Expand Further Stock Market Listing

Google Now
Multinational Company Class A and Class B Shares
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 Quick Review MCQ
• Corporate finance may be thought of as the analysis
of three primary decision areas. Which of the
following correctly lists these areas?
A. Capital structure, capital budgeting, security analysis
B. Capital budgeting, capital structure, capital spending
C. Capital budgeting, capital structure, net working capital
D. Capital structure, net working capital, capital rationing
E. Capital budgeting, capital spending, net working capital

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 Quick Review MCQ
• Determining the mix of debt and equity to be
used to finance a firm is which type of a
decision?
A. Capital budgeting
B. Capital structure
C. Capital spending
D. Net working capital
E. None of the above

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Forms of Business Organization

Sole Proprietorship

Partnership

Corporation
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 Sole Proprietorship
• Under this organization method, an individual owns
and manages the business.
• Advantages • Disadvantages
– Easiest to start – Limited to life of owner
– Least regulated – Equity capital limited to
– Single owner keeps all owner’s personal wealth
the profits – Unlimited liability
– Taxed once as personal – Difficult to sell
income ownership interest

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 Partnership
• Under this organization method, a group of
individuals collectively own and manage the business.
• Advantages • Disadvantages
– Two or more owners – Unlimited liability
(general partnership,
– More capital available limited partnership)
– Relatively easy to start – Partnership dissolves
– Income taxed once as when one partner dies
personal income or wishes to sell
– Difficult to transfer
ownership

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 Partnership
• General partnership: all the partners have
unlimited liability for all partnership debts
• Limited partnership
– General partners: run the business, unlimited
liability
– Limited partners: not actively participate in the
business, limited liability up to the invested
amount

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 Corporation
• A corporation is created via
– Articles of incorporation: set out the corporation’s
name, its intended life, the business purpose, the
number of shares that can be issued.
– Bylaws: describe how the corporation regulates
its existence, e.g., how directors are elected.
• Ownership and management are separated. A
corporation issues equity shares. The holders
of these shares are the owners of the firm.
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 Corporation
• Although stockholders own the corporation,
they do not necessarily manage it. Instead
they vote to elect a Board of Directors (BOD).
The BOD represents the shareholders and in
this vein,
– Selects the management team.
– Appoints the auditors.
– Is responsible for checking/monitoring
management’s actions.
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Meet BOD of

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 Corporation
• Advantages • Disadvantages
– Limited liability – Separation of ownership
– Unlimited life and management
– Transfer of ownership is (agency costs)
easy – Double taxation (income
– Separation of ownership taxed at the corporate
and management rate and then dividends
taxed at personal rate)
– Easier to raise capital

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 Corporation
• Private Company: firm’s shares are usually
closely held by a relatively small number of
shareholders.
– Shareholders often include the company’s original
founders, some financial backers (e.g., venture
capitalists) and others. Shares are not traded on any
exchange.
• Public Company: firm’s shares are listed on a
stock exchange.
– The company’s shares are widely dispersed and traded
in the secondary markets.

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 Corporations: Two Main Sources of
External Financing – Debt
• By lending money to the corporation, debt holders
become the corporation’s creditors and lenders.
• Relationship Determined by Contract: a debt contract
is a legally binding agreement.
– It specifies principal, interest, maturity date, and specific
protective covenants.
• Security and Seniority: in case of bankruptcy, debt
holders collect before equity holders.
– However, different debt holders have different priority
claim to the cash flows and assets of a bankrupt firm,
according to their respective debt contracts.

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 Corporations: Two Main Sources of
External Financing – Equity
• Shareholders’ Ownership Rights: by buying shares
in the corporation, shareholders become the
owners of the firm.
– Shareholders are the residual claimants of the firm.
• Shareholders’ Payoffs: shareholders receive
monetary returns in the following ways:
– Dividend per share, paid to investors from the
corporation’s after-tax income.
– Capital gain from the sale of shares (ownership rights)
at a price higher than they were purchased for.

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Separation of Ownership and Control

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 A New Form of Business Organization
• Limited Liability Partnership (LLP): some or all
(depending on the country) of the partners
have limited liability.
– A hybrid organization consisting of a partnership
and a corporation.
– Exists as a corporation but taxed as a partnership.

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 Possible Goals of Financial Management

• What should be the goal of a corporation?

• Commonly cited goals:
– Maximise sales/market share? lowering price or
relaxing credit terms
– Minimise costs? lowering quality or R&D
– Avoid financial distress and bankruptcy? never
borrow any money or take any risks
– Maximise profits? short-term nature; definition of
profits; risk not addressed
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 Goal of Financial Management
Increase
Manage Profits
Risk

Avoid
Financial
Distress

Maximize Value of Owner’s Equity

• The primary goal is shareholder wealth maximization,

which is the same as maximizing the current stock price.

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How Can Managers Maximize Stock Price?

• What determines stock prices?

– The underlying firm’s ability to generate cash flows
• Three aspects of cash flows that affect asset value
and thus stock price:
– Amount of cash flows expected by shareholders
– Timing of the cash flow
– Riskiness of the cash flow
• All three determine the stock’s market value.
• Financial management decisions affect firm value
and thus stock price.

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 Quick Review MCQ
• Which one of the following statements is correct?
A. A limited partner actively participates in running the
partnership on a daily basis.
B. A general partnership terminates whenever one general
partner decides to sell her share of the business.
C. A general partnership has an unlimited life while a limited
partnership has a limited life.
D. The procedures to be followed for electing corporate
directors are included in the articles of incorporation.
E. Corporate income is taxed only when the corporate
earnings are distributed to shareholders.

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 Quick Review MCQ
• The primary goal of financial management is
to:
A. Maximize current sales.
B. Maximize the current value per share of the
existing stock.
C. Avoid financial distress.
D. Minimize operational costs.
E. Maintain steady earnings growth.

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 What is the Agency Problem?
• Agency Relationship:
– Principal hires an agent to represent their interest.
– Stockholders (principals) hire managers (agents), via the
Board of Directors, to run the company.
• Agency Problem:
– Conflict of interest between principal and agent
– Managers are naturally inclined to act in their own best
interests, e.g., maximize their own wealth and power.
– Shareholders want managers to maximize the value of the
company.

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 Agency Costs
• Direct Agency Costs:
– Expenditures that benefit management: car and
accommodation, big office, high pay
– Monitoring costs: auditors, corporate governance
• Indirect Agency Costs:
– Lost opportunities which would increase firm
value in the long run, if accepted

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 Example: Agency Costs
• BP CEO Gets 20% Rise in Total Pay Despite Oil Price Slump
Hitting Earnings
• BP PLC Chief Executive Bob Dudley received a 20% bump in
his total compensation package last year, bringing it to $19.6
million despite a continuing slump in oil prices that has
battered the energy giant’s earnings ($5.2 billion loss).
• Such massive payouts have in the past led to tensions with
investors. For instance, shareholder advisory group
recommended investors vote down Mr. Dudley’s proposed
pay for 2014, though ultimately the package received
approval at the company’s annual meeting.
• Source: 4 March 2016, The Wall Street Journal
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 How To Handle The Agency Problem?
• The compensation plans that tie the fortunes
of the managers to the fortunes of the firm.
• The monitoring by lenders, stock market
analysts and investors.
• The threat that poorly performing managers
will be fired.
• The growing awareness of the importance of
good corporate governance.

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 Example: Facebook Compensation Package ($)
Fiscal Stock
Name Salary Bonus Others Total
Year Awards
Mark Zuckerberg 2019 1 — — 23,415,972 23,415,973
CEO, Chairman 2018 1 — — 22,554,542 22,554,543
Sheryl Sandberg 2019 875,385 902,740 19,678,923 5,687,099 27,144,147
COO 2018 843,077 638,310 18,423,523 3,823,508 23,728,418
David Wehner 2019 785,385 809,928 19,678,923 59,800 21,334,036
CFO 2018 753,846 499,494 18,423,523 9,250 19,686,113
Mike Schroepfer 2019 785,385 1,295,885 19,678,923 52,784 21,812,977
CTO 2018 753,846 570,744 18,423,523 9,250 19,757,363
Jennifer Newstead 2019 353,077 2,291,288 16,309,218 183,162 19,136,745
GC

Source: SEC Form DEF 14A Proxy Statement for the Fiscal Year 2019

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 Example: Fire CEO
• Uber Founder Travis Kalanick Resigns as CEO
• Travis Kalanick stepped down Tuesday as chief executive of
Uber, after a shareholder revolt made it untenable for him to
stay on at the company.
• Earlier on Tuesday, five of Uber’s major investors demanded
that the chief executive resign immediately. The investors
included one of Uber’s biggest shareholders, the venture
capital firm Benchmark, which has one of its partners, Bill
Gurley, on Uber’s board.
• Source: 22 June 2017, New York Times

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Example: Fire CEO

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 The Firm and Its Sources of Funds
• What are financial markets?
– Markets where “financial instruments” are traded
– Act as intermediaries between savers and
borrowers
• Primary Markets vs. Secondary Markets
• Money Markets vs. Capital Markets

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 Primary Markets vs. Secondary Markets

• Primary Markets:
– New issues of securities
– Public Offerings: where securities are offered to public at large; need
underwriting, more regulatory requirements, costly
– Private Placements: where securities are offered to large financial
institutions or wealthy individuals; less costly
• Secondary Markets:
– Already existing securities are bought and sold
– Dealer Markets: where dealers buy and sell for themselves, at their
own risk; E.g., over-the-counter (OTC) markets such as NASDAQ;
– Auction Markets: where the primary purpose is to match those who
wish to sell with those who wish to buy; E.g., NYSE, HKEX.

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Cash Flows between the Firm and the
Financial Markets

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 Example: Initial Public Offering

Source: Mainland China and Hong Kong 2020 IPO Review, KPMG

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 Hong Kong IPOs: Sector Analysis

Source: Mainland China and Hong Kong 2020 IPO Review, KPMG

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Money Markets vs. Capital Markets
• Money Markets:
– Where debt securities of less than one year are
traded: treasury securities, commercial paper, bills,
inter-bank loans
– Loosely connected dealer markets
– Banks as major players
• Capital Markets:
– Where equity and long-term debt claims are traded
– Usually auction markets

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 Quick Review MCQ
• Agency costs refer to:
A. The total dividends paid to shareholders over the
lifetime of the firm.
B. The costs that result from default and
bankruptcy of the firm.
C. Corporate income subject to double taxation.
D. The costs of the conflict of interest between
stockholders and management.
E. The total interest paid to creditors over the
lifetime of the firm.

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 Quick Review MCQ
• Which one of the following statements
concerning the financial markets is correct?
A. Shareholders exchange shares with each other in the
primary market.
B. The New York Stock Exchange is an auction market.
C. Dealer markets have a physical trading floor.
D. Stocks traded in auction markets are said to trade
over-the-counter.
E. All private sales of stock must first be registered with
the SEC.

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 Summary
• Corporate finance involves investment decisions,
financing decisions, and working capital
management.
• The goal of financial management is to make
decisions that maximize the market value of the
equity or owners’ wealth.
• There are conflicts of interest between
shareholders and managers ─ agency costs.
• Financial markets function as both primary and
secondary markets for debt and equity securities.
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 Information on the Web
• The Internet provides a wealth of information about
individual companies.
• One excellent site is https://finance.yahoo.com/
• For locally listed companies, visit the HKEX website at
https://www.hkex.com.hk/

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