CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE

1. Finance relates to the decision-making and strategies of corporations. It is composed of three main elements. a. The investment decision. b. The financing decision. c. Short-term capital management. Each decision is framed within the general objective of maximising 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. 2. The three decisions are a) the investment decision, b) the financing decision, and c) decisions relating to short-term capital management. Consider the joint venture between Fiat and Chrysler, where Fiat expands into North America by using Chrysler manufacturing depots and Chrysler does the same in Europe using Fiat manufacturing depots. The investment decision relates to assessing the viability of the joint venture. The financing decision relates to how best to fund the joint venture, and the short-term capital management decision relates to the best way to ensure that both firms have enough liquidity to manage the expansion without running out of cash. 3. This has always been a criticism of companies in the UK and US. Moreover, in recent years managers throughout the world have focussed on maximising share prices because it was linked to their personal remuneration. In theory, if the market is fully efficient and cant be fooled by managers attempts to increase share price through manipulating the financial accounts or following excessively risky strategies, then share price and profitability are synonymous. Unfortunately, the global credit crunch of 2008 showed that managers could follow risky strategies to maximise

returns and the market rewarded this. Most of the banks that were hardest hit by the credit crunch had the best share price returns in the years before the crisis. 4. 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. 5. The financial markets facilitate the interaction of economic units (households, companies, governments) who require funding and those who have excess cash to invest. The corporate form allows the entity to borrow on its own identity (e.g. a company can borrow funds or issue equity in its own name, not its owners), and the financial markets allow the company to access these markets. If the financial markets are efficient, they can be of other use to companies. For example, share price performance will reflect the performance of the company. Customers and suppliers will see this performance and act accordingly. 6. This is erroneous but common in countries with market-based financial systems (see Chapter 2). The financial markets are one of several avenues through which companies can access funding for their operations. Alternatively, firms may borrow funds from banks or seek a strategic investor (another company or investor). Admittedly, the financial markets are massive and when economies are performing well, the financial markets can be a cheap source of capital for large firms. Google listed on the stock market because it needed extensive funding for its ongoing operations and it felt that it would be able to get that money more cheaply through an equity listing. It could have borrowed from a syndicate of banks or through private equity but it is highly unlikely that they would have raised as much money for the cost if it did. 7. Equity = Total Assets Total Liabilities = (9.962 + 34.042) (11.480 + 8.665) = $23.859 billion

8. Step 1: Determine liability/equity ratio:

liability 20.145 = = 0.844 equity 23.859

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

liability 20.145 = = 0.457799 equity 44.004

Step 3: The debt that is raised is thus $4.5779 billion and equity is $5.4220 billion. Step 4: Check the new liability/equity ratio. The new level of liabilities is $24.7229 billion and the new level of equity is $29.2810 billion. The new ratio is:

liability 24.7229 = = 0.844 equity 29.2810

This is the same as the original liability/equity ratio. 9. There are three components to this transaction: a. Cash outflow of 100 million will appear in cash flow statement. Current assets (cash) will fall by 100 million. b. 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. c. Non-current assets will increase by 3.5 billion. 10.The payment of SEK1,200,000 in twelve months is less because the cash flow is after the majority of SEK100,000 monthly payments. An example can show the intuition behind this. Assume the monthly interest rate is 1 percent (it can be anything as long as it is above 0 percent). The present value of cash flows is thus: Annuit PV(CF) One PV(CF) y Payment 1 100000 99009. 9 2 100000 98029. 6 3 100000 97059. 01 4 100000 96098. 03 5 100000 95146. 57 6 100000 94204. 52 7 100000 93271. 81 8 100000 92348. 32 9 100000 91433. 98 10 100000 90528. 7 11 100000 89632. 37 12 100000 88744. 1200000 1064939. 92 07 PV 112550 PV 8 1064939. 07

11.You would choose the less risky project because both have the same expected value. In this case you would choose Project A, because the risk of losing and gaining money is less than in Project B.

12.Their goals are consistent with the goals of financial management as long they dont interfere with the maximisation of firm value. In fact, if investors value this type of behaviour in corporations, they may even pay a premium for it. 13.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. 14.As a financial manager, the need to balance between the short and long term objectives of the firm is important. When the company is in trouble, the financial manager should manage financial planning to enhance short term liquidity to meet the firms obligations. Therefore, in this case the objective of the firm will change from maximising shareholders wealth to firm survival and bankruptcy avoidance. However, other options such as asset sell-off can also be undertaken in order to pay creditors. This is consistent with maximising firm value over the longer term if the manager can ensure that the firm survives. 15.The objective of the firm will remain the same, which is to maximise the market value of existing owners equity. Principally, the goal does not change whether the company is private or public since good financial decisions increase the market value of the owners equity and poor financial decisions decrease it. 16.The manager can argue on the basis of cost implications, since redundancy packages may be expensive. In addition, there could also be lawsuits, union activity all having a negative effect on firm image. Furthermore, redundancies may adversely affect the production process which will not only affect the firms sales but also its loyal customers. Instead the new owners can identify other cost centres where cost savings can be made. 17.a. Adding cost of living to retired employees will increase the cost to the company of the pension liability. This would reduce profitability and earnings per share. However, the cost of living adjustment may ensure that the workers value the company more and in turn become more productive. b. As long as the return on the additional investment is greater than the return that the company currently makes on its operations, the decision is a good one. c. Research and development investment is important in any new project. However, these expenditures tend to be high at the beginning and it is not certain whether the firm will reap any benefits from the investment. Research has shown that countries with high levels of technological innovation are likely to experience higher economic growth and so in general the benefits from R&D will be positive. The specificity of the R&D investment is also important. d. Redundancies will reduce costs although their negative impact can be many-fold. For example, the company may have to deal with unions, strikes, and exceptionally poor publicity.

18.Dealers market are those markets where firms make continuous quotations of prices for which they stand ready to buy and sell money market instruments on their own inventory and at their own risk. Agency markets are those in which stockbrokers act as agents for customers in buying or selling shares on most stock exchanges; an agent does not actually acquire the securities. A well functioning financial system will utilise both systems. 19.A cut in costs will increase profit in the statement of earnings/income. This is because expenses will decrease. The additional profit would appear in the statement of financial position or balance sheet as an increase in equity or retained earnings. 20.Google decided to issue two classes of shares with different voting rights. The founders assigned to themselves the shares that gave them more rights so that they effectively control the company. 21.We go into Financial Statement Analysis in a lot more detail in Chapter 3. In this question, we will look at the statements of Antofagasta plc in a very basic way. The main insight is that the firm has accumulated a lot of current assets in relation to its current liabilities and non-current assets. Further investigation would be required to determine what is actually driving the increase in current assets. On the basis of the figures below, it would look as if the firm is less risky. However, if the current assets comprised of cash, it could be argued that the company should be investing this in profitable activities or giving the money back to shareholders in the form of dividends. Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 2007 2006 2005 2004 2003 2,911 2,451 1,849 1,302 452 2,945 2,634 1,931 1,897 1,954 5,856 5,085 3,780 3,199 2,406 367 514 389 405 309 1,424 1,416 1,349 1,328 1,191 1,791 1,930 1,738 1,733 1,500 4,065 5,856 3.2696 82 0.9884 55 0.2577 25 7.9318 8 3,155 5,085 2.6347 15 0.9305 24 0.3629 94 4.7684 82 2,042 3,780 2.1749 14 0.9575 35 0.2883 62 4.7532 13 1,466 3,199 1.8459 32 0.6863 47 0.3049 7 3.2148 15 906 2,406

Total Current Assets Total Non-Current Assets Total Assets Total Current Liabilities Total Non-Current Liabilities Total Liabilities Total Equity Total Liabilities & Shareholders' Equity

Total Assets/Total Liabilities Total Current Assets/Total Non-Current Assets Total Current Liabilities/Total Non-Current Liabilities Total Current Assets/Total Current Liabilities

1.604 0.2313 2 0.2594 46 1.4627 83

22.The net investment is $500 million and this could be funded by an issue of equity or debt.

23.Several things could happen to Antofagastas statement of financial position and is determined by how we treat the $500 million payment. If the first instance (2009), total non-current assets and non-current liabilities will increase by $500 million. In 2011, the $500 million will be paid off meaning that non-current liabilities will decrease by $500 million as will current assets. The statement of financial position looks like this for 2009 and 2011:

Total Current Assets Total Non-Current Assets Total Assets Total Current Liabilities Total Non-Current Liabilities Total Liabilities Total Equity Total Liabilities & Shareholders' Equity

Dec 31, Dec 31, 2009 2011 2,911 2,411 3,445 3,445 6,356 5,856 367 367 1,924 1,424 2,291 1,791 4,065 6,356 4,065 5,856

24. An analysis of Antofagasta debt/equity ratios show that they have been decreasing year on year from 1.31 (2003) to 0.35 in 2007. Assume that the desired debt/equity ratio is 0.35. This would mean that 0.35 or $175 million of the $500 million investment would be funded by debt and $325 million would be funded by equity. In this situation the statement of financial position would be:

Total Current Assets Total Non-Current Assets Total Assets Total Current Liabilities Total Non-Current Liabilities Total Liabilities Total Equity Total Liabilities & Shareholders' Equity

Dec 31, 2009 2,911 3,445 6,356 367 1,599 1,966 4,390 6,356

25.Yes. The main theme of UK and Germany regulation is similar which is on addressing investor protection and protection of quality of the information that market participants receive. The later will ensure that investors are informed before making decisions and enhance confidence which is crucial element for any well functioning financial market.