What do major corporate finance decisions include?
- Investment decisions: determine asset profile of business (amount and composition of investments)
- Financing decisions: how assets are to be funded (debt or equity) also includes dividend decisions
- Dividend decisions: pay shareholder or retain funds for internal growth
when making investment decisions, what will firms consider?
if the investment will maximise shareholders’ wealth
- weigh up benefits with costs - (but may be difficult to quantify cost, benefit, risk and uncertainty)
investment decision
capital budgeting
define
planning and control of cash outflows in the expectation of deriving future cash inflows from investments in non-current assets
investment decision
what does capital budget consist of?
Involves evaluating the:
- size of future cash flows
- timing of future cash flows
- risk of future cash flows
example of cash flow timing
example of cash flow risk
Investment Decision (cont.)
nExample: Firm ABC
Firm ABC are considering purchasing new equipment that will increase the productivity of their production line. Should they proceed with the purchase?
nHow does Firm ABC determine whether they proceed?
- Calculate the costs of purchasing the new equipment
- Quantify the expected benefits of the equipment (i.e. the increase in profits from introducing the equipment into the company)
If the benefit from purchasing the machine is greater than the costs associated with this piece of equipment, the firm should proceed with the purchase.
Investment Decision (cont.)
nExample: Firm ABC
Firm ABC are considering purchasing new equipment that will increase the productivity of their production line. Should they proceed with the purchase?
nHow does Firm ABC determine whether they proceed?
- Calculate the costs of purchasing the new equipment
- Quantify the expected benefits of the equipment (i.e. the increase in profits from introducing the equipment into the company)
If the benefit from purchasing the machine is greater than the costs associated with this piece of equipment, the firm should proceed with the purchase.
why may it
be more difficult to quantify the risk and uncertainty of a financial decision?
- There may be a high level of uncertainty in the effectiveness of the equipment;
- The cost of the equipment may change over time;
- Is it better to wait to purchase the equipment later
- The cost of borrowing may change over time
3 business structures
- sole propietorship
- partnership
- company:
Separate legal entity formed under the Corporations Act 2001.
what is the company’s financial objective?
nmaximisation of shareholders’ wealth (market value of a company’s shares times number of shares).
how may you express the value of a company?
differentiate between nominal and real amounts
The cost of an asset expressed as the number of dollars paid to acquire the asset is the nominal price - the actual amont u pay
However, due to inflation and deflation, the purchasing power of money changes.
Real amounts: nominal amounts adjusted for inflation.
what is arbitrage?
- If two identical assets (or perfect substitutes) being traded in the same market must have the same price (assuming no transaction costs)
- Otherwise, a risk-free profit could be made by simultaneously purchasing at the lower price and selling at the higher price.
This arbitrage eliminates the price difference
- Price(security) = PV(all CF paid by the security)
- Law of one price
market efficiency and asset pricing
what is market efficiency?
Market efficiency means that we should expect securities and other assets to be fairly priced, given their expected risks and returns.
Trade-off between risk and expected return can be captured in a quantitative model, e.g. the capital asset pricing model (CAPM)
Agency relationships
Where one party, the principal, delegates decision-making authority to another party, the agent.
In a company setting:
-The agents are usually managers.
-The principals are usually shareholders.
agency relationships
the separation of ownership and control gives rise to?
¡The separation of ownership and control gives rise to what is known as the agency conflict.
why does agency conflict occur?
- Negative impact on investment, financing and dividend decisions
- Reduced value due to managers acting in their own rather than shareholders’ best interests
- Costs associated with monitoring managers
- Bonding costs: costs of incentive and remuneration schemes that align the interests of managers with those of shareholders.
what is the fisher’s separation theorem (Two Period Certainty Model)
Addresses the question of how management deals with diverse preferences for dividends and investment in a company with more than one shareholder
fishers separation theorem
what assumptions are there?
- perfect certainty
- perfect capital markets
- rational investors
- borrowing and lending interest rates are equal.
Explaining the Two-Period Certainty Model
The company
- The company is endowed with a fixed amount of resources at Time 1.
- Managers must decide how much to invest and how much to pay out as dividends.
The level of investment at Time 1 determines:
- The residual resources at Time 1, available as a dividend at Time 1.
- The resources that will be available to be paid as dividends at Time 2.
These opportunities can be summarised in a production possibilities curve (PPC).
implications of fisher’s separation theorem
- The theorem means that a company can make investment decisions in the interests of all shareholders, regardless of differences between individual shareholder’s preferences.
- Value of company and wealth of shareholders is independent of the company’s capital structure.
a firm’s value is not affected by how its investments are financed or how the distributions (dividends) are made to the owners.
-Dividend decision is irrelevant, provided the company does not alter its investment decision.
what does fisherman’s theory state?
firm’s choice of investments is separate from the owner’s attitude towardst the invesments
it is possible to separate a firm’s investment decisions from the firm’s dividend decisions
more implications of the two period certainty model
- managers can make investment, financing and dividend decision separately!!!
- Information about these decision is transmitted to investors.
-investors will adjust their expectations of future returns on the firm’s investment and revise their share values.
This helps with the investors’ investment decision
