TO BUY THE REST OF THIS EBOOK, PLEASE CONTACT: KITABAIN4SALE@GMAIL.COM Chapter 1 ...._ ' Chapter 2 ...._ ' Introduction to Corporate Finance Chapter 1 describes the role of the financial manager and the goal of financial management. It also discusses some key aspects of the financial management environment Financial Statements, Cash Flow, and Taxes Chapter 2 describes the basic accounting statements used by the finn. The chapter focuses on the critical differences between cash flow and accounting income; it also discusses why accounting value is generally not the same as market value. Tim Hortons Inc. has come a long way since its 1964 inception in Hamilton, Ontario under the title "'Tim Horton Donuts/' Today, the company is the largest quick-service restaurant chain in Canada, and is among the most well-recognized brands in the country. Founded as a sole proprietorship by Tim Horton, and later run as a partnership with Ron Joyce, the company began with a specialized focus on coffee and donuts. Following Horton's death in 1974, Joyce continued to run the business under an aggressive expansion strategy. By February 1987, Tim Hortons had opened 300 stores across Canada. In 1995, Tim Hortons was acquired by Wendy's International Inc., which gave new im-petus to the expansion of the brand in the United States. Eleven years later in March of 2006, Tim Hortons held its initial public offering (IPO) and was fully spun off by Wendy's International in September of the same year. With over 3000 stores in Canada and the United States, the majority of which are franchisee owned, the Tim Hortons story touches on different business forms, corporate goals, and corporate control, all topics that are dis-cussed in this chapter. Learning ObJectives .._ After studying this chapter, you should understand: L01 The ballc types of fln..clal management decisions and the role of tlte financial manager. L02 The fln1111clallmpllcatlona of tlte different forma of bu&lneu organization. L03 The .,_. of financial manacetnent. L04 The confllct:e of lnteNst that can arlee between mana,prs and ownel8. LO& The roles of flnanclallnalltutlona and markets. To begin our study of modern corporate finance and financial management, we need to ad-dress two central issues: First, what is corporate finance, and what is the role of the financial manager in the corporation? Second, what is the goal of financial management? To describe the financial management eDViro.nment, we look at the corporate form of organization and discuss some conflicts that can arise within the corporation. We also take a brieflook at financial institu-tions and financial markets in Canada. 1.1 CORPORATE FINANCE AND THE FINANCIAL MANAGER In this section. we discuss where the financial manager fits in the corporation. We start by look-ing at what corporate finance is and what the financial manager does. What Is Corporate Finance? Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another: 1. What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery. equipment, and research and development facilities will you need? For current issues facing CFOs, see www.do.com capital budgeting The process of planning and managing a firm's investment in long-term assets. CHAPTER 1: Introduction to Corporate Finance 3 2. Where will you get the long-tenn financing to pay for your investment? Will you bring in other owners or will you borrow the money? 3. How will you manage your everyday financial activities, such as collecting from customers and paying suppliers? These are not the only questions by any means, but they are among the most important. Corporate finance, broadly speaking, is the study of ways to answer these three questions. Accordingly, we'll be looking at each of them in the chapters ahead. Though our discussion fo-cuses on the role of the financial manager, these three questions are important to managers in all areas of the corporation. For example, selecting the finn's lines of business (Question 1) shapes the jobs of managers in production, marketing, and management information systems. As a result, most large corporations centralize their finance function and use it to measure perfor-mance in other areas. Most CEOs have significant financial management experience. The Financial Manager A striking feature oflarge corporations is that the owners (the shareholders) are usually not di-rectly involved in making business decisions, particularly on a day-to-day basis. Instead, the cor-poration employs managers to represent the owners' interests and make decisions on their behalf. In a large corporation, the fmancial manager is in charge of answering the three questions we raised earlier. It is a challenging task because changes in the firm's operations and shifts in Canadian and global fmancial markets mean that the best answers for each firm are changing, sometimes quite rapidly. Globalization of markets and advanced communications and computer technology, as well as increased volatility of interest rates and foreign exchange rates, have raised the stakes in fi-nancial management decisions. We discuss these major trends and how they are changing the fi-nancial manager's job after we introduce you to some of the basics of corporate financial decisions. The financial management function is usually associated with a top officer of the finn, such as a vice president of finance or some other chief financial officer (CFO). Figure 1.1 is a simplified orga-nization chart that highlights the finance activity in a large firm. The CFO reports to the president, who is the chief operating officer (COO) in charge of day-to-day operations. The COO reports to the chairman, who is usually chief executive officer (CEO). The CEO has overall responsibility to the board As shown, the vice president of finance coordinates the activities of the treasurer and the controller. The controller's office handles cost and financial accounting, tax payments, and manage-ment information systems. The treasurer's office is responsible for managing the firm's cash, its fi-nancial planning, and its capital expenditures. These treasury activities are all related to the three general questions raised earlier, and the chapters ahead deal primarily with these issues. Our study thus bears mostly on activities usually associated with the treasurer's office. Financial Management Decisions As our discussion suggests, the financial manager must be concerned with three basic types of questions. We consider these in greater detail next. CAPITAL BUDGETING The first question concerns the firm's long-term investments. The process of planning and managing a frrm's long-term investments is called capital budgeting. In capital budgeting, the fmancial manager tries to identify investment opportunities that are worth more to the firm than they will cost to acquire. Loosely speaking, this means that the value of the cash flow generated by an asset exceeds the cost of that asset. The types of investment opportuni-ties that would typically be considered depend in part on the nature of the firm's business. For example, for a restaurant chain like Tim Hortons, deciding whether or not to open stores would be a major capital budgeting decision. Some decisions, such as what type of computer system to purchase, might not depend so much on a particular line of business. Financial managers must be concerned not only with how much cash they expect to receive, but also with when they expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. We discuss how to do this in detail in the chapters ahead. 4 PART 1 : OVerview of Corporate Finance FIGURE 1.1 A simplified organization chart. The exact titles and organization differ from company to company. capital SlrUctUre The mix of debt and equity maintained by a firm. working capital management Planning and managing the finn's current assets and liabilities. I Shareholders I I I Board of Dlt"Ktors I I I Chairmen of the Board and ~ I Chief Executive OHicer (CEO) I I Pn!sldent and Chief I Operating Officer (COO) I I I I Vice President I Marketing I Vice President I Finance (CFO) I Vlca Prasldant Production I I Treasurer I I Controller I I I I I Cash Manager Cradlt Mlnagar lUMenager Cost Acmunting Manager I I I I capital Financial Financial D.tl Procesling Aa:ountlng Expenditures Planning Manager Manager CAPITAL STRUCTURE The second major question for the financial manager concerns how the firm should obtain and manage the long-term financing it needs to support its long-term investments. A firm's capital structure (or financial structure) refers to the specific mixture of short-term debt.long-tenn debt, and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First, how much should the firm borrow; that is, what mixture is best? The mixture chosen affects both the risk and value of the finn. Second, what are the least expensive sources of funds for the firm? If we picture the firm as a pie, then the finn's capital structure determines how that pie is sliced. In other words, what percentage of the finn's cash flow goes to creditors and what percent-age goes to shareholders? Management has a great deal of flexibility in choosing a finn's financial structure. Whether one structure is better than any other for a particular firm is the heart of the capital structure issue. In addition to deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money. The expenses associated with raising long-term financing can be considerable, so different possibilities must be carefully evaluated. Also, corporations borrow money from a variety of lenders, tapping into both Canadian and international debt markets, in a number of different-and sometimes exotic-ways. Choosing among lenders and among loan types is another of the jobs handled by the financial manager. WORKING CAPITAL MANAGEMENT The third major question concerns working capital management. The phrase working capital refers to a firm's short-term assets, such as CHAPTER 1: Introduction to Corporate Finance 5 inventory, and its short-term liabilities, such as money owed to suppliers. Managing the finn's working capital is a day-to-day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities, all related to the firm's receipt and disbursement of cash. Some of the questions about working capital that must be answered are: (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms should we offer, and to whom should we extend them? (3) How do we obtain any needed short-term financ-ing? Will we purchase on credit or borrow short-term and pay cash? If we borrow short-term, how and when should we do it? This is just a small sample of the issues that arise in managing a firm's working capital The three areas of corporate financial management we have described-capital budgeting. capital structure, and working capital management-are very broad categories. Each includes a rich variety of topics; we have indicated only a few of the questions that arise in the different areas. The following chapters contain greater detail. Concept Questions 1. What is the capital budgeting decision? 2. Into what category of financial management does cash management fall? 3. What do you call the specific mixture of short-term debt, long-term debt, and equity that a firm chooses to use? 1.2 FORMS OF BUSINESS ORGANIZATION sola proprtetorshlp A business owned by a single individual. For more information on forms of business organl?l!tlon, see the "StartiDgaBustness-sect!Dnat ~ c o m ; also see www.canadabusineaa.ca partnerahip A business formed by two or more co-owners. Large firms in Canada, such as CIBC and BCE, are almost all organized as corporations. We eumine the three different legal fonns of business organization-sole proprietorship, partner-ship, and corporation-to see why this is so. Each of the three forms has distinct advantages and disadvantages in the life of the business, the ability of the business to raise cash, and taxes. A key observation is that. as a firm grows, the advantages of the corporate form may come to outweigh the disadvantages. Sole Proprietorship A sole proprietonhip is a business owned by one person. This is the simplest type of business to start and is the least regulated form of organization. Depending on where you live, you can start up a proprietorship by doing little more than getting a business licence and opening your doors. For this reason, many businesses that later become large corporations start out as sole proprietor-ships. There are more proprietorships than any other type of business . .AJ; the owner of a sole proprietorship. you keep all the profits. That's the good news. The bad news is that the owner has unlimited liability for business debts. This means that creditors can look beyond assets to the proprietor's personal assets for payment Similarly, there is no distinction between personal and business income, so all business income is taxed as personal income. The life of a sole proprietorship is limited to the owner's life span, and, importantly, the amount of equity that can be raised is limited to the proprietor's personal wealth. This limitation often means that the business cannot exploit new opportunities because of insufficient capitaL Owner-ship of a sole proprietorship may be difficult to transfer, since this requires the sale of the entire business to a new owner. Partnership A partnership is similar to a proprietorship. except that there are two or more owners (partners). In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. The way partnership gains (and losses) are divided is described in the partnership agreement. This agreement can be an informal oral agreement, or a lengthy, formal written document. 6 PART 1 : OVerview of Corporate Finance corporation A business created as a distinct legal entity owned by one or more individuals or entities. In a limited partnership, one or more general partners has unlimited liability and runs the busi-ness for one or more limited partners who do not actively participate in the business. A limited partner's liability for business debts is limited to the amount contributed to the partnership. This form of organization is common in real estate ventures, for example. The advantages and disadvantages of a partnership are basically the same as those for a propri-etorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form. General partners have unlimited liability for partnership debts, and the partnership terminates when a general partner wishes to sell out or dies. All income is taxed as personal income to the partners, and the amount of equity that can be raised is limited to the partners' combined wealth. Ownership by a general partner is not easily transferred because a new partnership must be formed. A limited partner's interest can be sold without dissolving the partnership. But finding a buyer may be difficult, because there is no organized market in limited partnerships. Based on our discussion, the primary disadvantages of sole proprietorship and partnership as forms of business organization are (1) unlimited liability for business debts on the part of the owners, (2) limited life of the business, and (3) difficulty of transferring ownership. These three disadvantages add up to a single, central problem: the ability of such businesses to grow can be se-riously limited by an inability to raise cash for investment. Corporation In terms of size, the corporation is the most important form of business organization in Canada. A corporation is a legal entity separate and distinct from its owners; it has many of the rights, duties, and privileges of an actual person. Corporations can borrow money and own property, can sue and be sued, and can enter into contracts. A corporation can even be a gen-eral partner or a limited partner in a partnership, and a corporation can own stock in another corporation. Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms of business organization, but not greatly so for a small business. Forming a corporation in-volves preparing articles of incorporation (or a charter) and a set of bylaws. The articles of incor-poration must contain a number of things, including the corporation's name, its intended life (which can be forever), its business purpose, and the number of shares that can be issued This in-formation must be supplied to regulators in the jurisdiction where the flrm is incorporated. Canadian firms can be incorporated under either the federal Canada Business Corpomtion Act or provincial law. 1 The bylaws are rules describing how the corporation regulates its own existence. For example, the bylaws describe how directors are elected. These bylaws may be a very simple statement of a few rules and procedures, or they may be quite extensive for a large corporation. The bylaws may be amended or extended from time to time by the shareholders. In a large corporation, the shareholders and the management are usually separate groups. The shareholders elect the board of directors, which then selects the managers. Management is charged with running the corporation's affairs in the shareholders' interest. In principle, share-holders control the corporation because they elect the directors. As a result of the separation of ownership and management, the corporate form has several advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of the corporation is therefore not limited. The corporation borrows money in its own name. As a result, the shareholders in a corporation have limited liability for corporate debts. The most they can lose is what they have invested.2 While limited liability makes the corporate form attractive to equity investors, lenders some-times view the limited liability feature as a disadvantage. If the borrower experiences financial distress and is unable to repay its debt, limited liability blocks lenders' access to the owners' personal assets. For this reason, chartered banks often circumvent limited liability by requiring that owners of small businesses provide personal guarantees for company debt 1 In some provinces, the legal documents of incorporation are called letters patent or a memorandum of association. 2 An important exception is negligence by a corporate director. If this can be proven, fur example in a case of environmental damage, the director may be liable fur more than the original investment. www.bell.ca www.bombardier.ca CHAPTER 1: Introduction to Corporate Finance 7 The relative ease of transferring ownership, the limited liability for business debts, and the un-limited life of the business are the reasons why the corporate form is superior when it comes to raising cash. If a corporation needs new equity, for example, it can sell new shares of stock and attract new investors. The number of owners can be huge; larger corporations have many thou-sands or even millions of shareholders. In a recent year, for example, BCE had more than 191,000 shareholders and Bombardier had about 11,000. In such cases, ownership can change continu-ously without affecting the continuity of the business. The corporate form has a significant disadvantage. Because a corporation is a legal entity, it must pay taxes. Moreover, money paid out to shareholders in dividends is taxed again as income to those shareholders. This is double taxation, meaning that corporate profits are taxed twice-at the corporate level when they are earned, and again at the personal level when they are paid out 3 As the discussion in this section illustrates, the need oflarge businesses for outside investors and creditors is such that the corporate form generally is best for such firms. We focus on cor-porations in the chapters ahead because of the importance of the corporate form in the Canadian and world economies. Also, a few important financial management issues, such as dividend policy, are unique to corporations. However, businesses of all types and sizes need fi-nancial management, so the majority of the subjects we discuss bear on all forms of business. A CORPORATION BY ANOTHER NAME Thecorporateformoforganizationhasmany variations around the world. The exact laws and regulations differ from country to country, of course, but the essential features of public ownership and limited liability remain. These firms are often designated as joint stock companies, public limited companies, or limited liability compa-nies, depending on the specific nature of the firm and the country of origin. In addition to international variations, there are specialized forms of corporations in Canada and the U.S. One increasingly common example is the professional corporation set up by architects, ac-countants, lawyers, dentists and others who are licensed by a professional governing body. A profes-sional corporation has limited liability but each professional is still open to being sued for malpractice. Income Trust Starting in 2001, the income trust, a non-corporate form of business organization, grew in impor-tance in Canada As of mid-2009, there were 179 income trusts listed on the Toronto Stock Exchange, with a sector market capitalization of $112.1 billion. 4 Within this sector, the fastest growing compo-nent is business income trusts that took this form of business organization, traditionally popular in real estate and oil and gas, and applied it to businesses like telephone listing, container ports, restau-rant chains and other businesses usually organized as corporations. In response to the growing im-portance of this sector, recent provincial legislation extended limited liability protection, previously limited to corporate shareholders, to trust unitholders. Along the same lines, at the end of 2005, the TSX began to include income trusts in its benchmark S&P I TSX composite index. Business income trusts (also called income funds) hold the debt and equity of an underlying business and distribute the income generated to unitholders. Because income trusts are not corporations, they are not subject to corporate income tax and their income is typically taxed only in the hands of unitholders. As a result, investors have viewed trusts as tax -efficient and have been generally willing to pay more for a company after it has converted from a corporation to a trust. However, this tax advantage largely disappeared on Hallowe'en 2006 when the government announced plans to tax income trusts at the same rate as corporations starting in 2011. Therefore, a number of income trusts are converting to corporations, and by 2011 most of the income trusts will be required by federal legislation to revert to regular corporations. Table 1.1 reviews the key features of the three main forms of business organization in Canada. 3 The dividend tax credit for individual mareholders and a corporate dividend exclusion reduce the bite of double taxation for Canadian corporations. These tax provisions are discussed in Chapter 2. Trusts and limited partnerships are designed to avoid double taxation. 4 For more on income trusts see J. Fenwick and B. Kalymon, A Note on Income 1rusts, Ivey Publishing, 2004 and Department of Finance, "Tax and Other Issues Related to Publicly Usted Flow-Through Entities (Income Trusts and Limited Partnerships); September 8, 2005. Data for TSX: Jan S. Koyanagi, "'ncome Trusts on Toronto Stock Exchange, TSX, January 2007. 8 PART 1 : Overview of Corporate Finance TABLE 1.1 Forms of business organi2ation Sole Proprietorship Partnership Corporation Definition A business owned by a single A business formed by two or A business created as P r o ~ Cons individual. more co- and now spelled "Nasdaq,). In January 2006, Nasdaq took the next step forward when its application to be registered as a national stock exchange was accepted by the 18 PART 1: OVerview of Corporate Finance TABLE 1.3 Largest stoc:k markets Market C.frtalrzatlon ______________ __ ______________ __ _ capitalization m 2008 1 NYSE Group $13,567.1 www.miaosoft.c:om www.lntel.c:om 2 Tokyo SE 3751.1 3 Nasdaq 3693.0 4 Euronext 3268.6 5 London SE 3057.3 6 Hong Kong Exchanges 1960.7 7 TSX Group 1878.3 8 Shanghai SE 1 858.5 9 Deutsche Barse 1 664.6 10 BME Spanish Exchanges 1514.4 U.S. Securities and Exchange Commission. There are roughly three times as many companies on Nasdaq as there are on NYSE, but they tend to be much smaller in size and trade less ac-tively. There are exceptions, of course. For example, tech giants Microsoft and Intel trade on Nasdaq. Nonetheless, the total value ofNasdaq stocks is considerably less than the total value of the NYSE stocks. LISTING Stocks that trade on an organized exchange are said to be listed on that exchange. To be listed. firms must meet certain minimum criteria concerning, for example, asset size and num-ber of shareholders. These criteria differ for various exchanges. The requirements for listing on the TSX Venture are not as strict as those for listing on the TSX. although the listing process is quite similar. The TSX. Venture. however, has two different tiers that companies can register under. Companies can list shares on the second tier with as little as $500,000 in net tangible assets and $50,000 in pre-tax earnings. Both tiers require that there exist 300 public shareholders, holding one board lot or more; Tier 1 also requires that there be 1 million free trading shares with a market value of $1 million or more. and Tier 2 requires at least 500,000 free trading shares with a market value of $500,000 or more. These requirements make it possible for smaller companies that would not normally be able to obtain listing on the TSX to acquire equity finandng. The TSX has the most stringent requirements of the exchanges in Canada. For example, to be listed on the TSX. a company is expected to have a market value for its publicly held shares of at least $2 million and a total of at least 300 shareholders with at least 100 shares each. There are additional minimums on earnings, assets, and number of shares outstanding. Research suggests that listing on exchanges adds valuable liquidity to a company's shares.14 In November 2002, the TSX itself went public and listed its shares for the first time. With an offering of just under 19 million shares at an initial offering price of $18, the TSX. easily exceeded its own listing requirements. 1.6 FINANCIAL INSTITUTIONS Financial institutions act as intermediaries between iD:vestors (funds suppliers) and firms raising funds. (Federal and provincial governments and individuals also raise funds in financial markets, but our examples focus on firms.) Financial institutions justify their existence by providing a variety of services that promote dte efficient allocation of funds. These institutions also serve as intermediaries 14 RdevaD.t stu& includeS. R. Foerater and G. A. Karolyi. The F..tfeas of.t.Wtet Segmentation and IJm:stor Reoogni tion on Asset Price: !Mdenc:efrom ForeiJnStocb Ll81inpin the U.S.: JIJIU"'UilujPifUlfl, S4:3, 1999,981-1013 and U.R. Mittoo, The Wmnen and Losers of Listings in the U.s.; Omadian bwe.stmmt Review, Fall 1998, 17. TABLE 1.4 Largest financial institutions in Canada, by market capitalization, October 2008 Rank 2 3 4 5 6 7 8 9 10 11 CHAPTER 1: Introduction to Corporate Finance 19 Company Royal Bank of canada Toronto Dominion Manulife Financial Corp. Bank of Nova Scotia Great-West Lifeco Power Financial Corp. Canadian Imperial Bank of Commerce Bank of Montreal Sun Life Financial Inc. IGM Financial National Bank of canada Market Cpltallzatfon $61.6 47.7 45.5 44.0 25.6 22.2 21.3 21.3 17.2 9.6 7.1 for households and indMduals-providing a medium where individuals can save and borrow money. Individuals and households may choose to save not only in the traditional savings and chequing ac-counts, but also in savings plans such as a Registered Retirement Savings Plan (RRSP), Registered Ed-ucation Savings Plan (RESP), or 'lax-Free Savings Account (TFSA). Canadian financial institutions include chaTtered banks and other depository institutions-trust companies, credit unions, investment dealers, insurtusce companies, pension funds, and mutual funds. Table 1.4 ranks the top eleven publicly traded financial institutions in Canada by market capi-talization in 2008. They include the Big Six chartered banks,. three life insurance companies, one financial holding company, and a diversified financial services company. Beause they are al-lowed to diversify by operating in all provinces, Canada's chartered banks are of a reasonable size on an international scale. Chartered banks operate under federal regulation, accepting deposits from suppliers of funds and making commercial loans to mid-sized businesses, corporate loans to large oompanies, and personal loans and mortgages to indMduals. Banks make the majority of their income from the spread between the interest paid on deposits and the higher rate earned on loans. This is indirect finance. Chartered banks also provide other services that generate rees instead of spread income. For example, a large corporate customer seeking short-term debt funding can borrow directly from another large corporation with funds supplied through a bankers acceptance. This is an interest-bearing IOU stamped by a bank guaranteeing the borrower'S credit Instead of spread income, the bank receives a stamping fee. Bankers acceptances are an example of direct finance. Notice that the key difference between direct finance and indirect finance is that in direct finance funds do not pass through the banks balance sheet in the fonn of a deposit and loan. Often called securitiza-tion because a security (the bankers acceptance) is created, direct finance is growing rapidly. Trust companies also accept deposits and make loans. In addition, trust companies engage in fiduciary activities-managing assets for estates, registered retirement savings plans, and so on. Like trust companies, credit unions also accept deposits and make loans. Caisses Desjardins du Quebec is a major Quebec credit union, but does not appear in Table 1.4 because it is member-owned and not publicly traded. Investment dealers are non-depository institutions that assist firms in issuing new securities in exchange for fee income. Investment dealers also aid investors in buying and selling securities. Chartered banks own majority stakes in five of Canadas top 15 investment dealers. Insurance companies include property and casualty insurance and health and life insurance companies. Life insurance companies engage in indirect finance by accepting funds in a fonn similar to deposits and making loans. Manulife Financial and Sun Life Financial are major life in-surance companies that have expanded aggressively to become rivals of the chartered banks. Fuelled by the aging of the Canadian population and the longest bull market in history, assets in pension and mutual funds grew rapidly in the 1990s. Pension funds invest contributions from employers and employees in securities offered by financial markets. Mutual funds pool individual 20 PART 1 : OVerview of Corporate Finance TABLE l.S Total net usets by fund type in September 2008 canadian Equity Global and International Equity U.S. Equity Sector Equity Domestic Balanced Global Balanced canadian Fixed Income Global and High Yield Fixed Income Money Martcet Funds Total Net Assets ($ billions) s 151 81.3 20.4 13.8 142.1 91.1 so.s 7.4 70.6 s 628 invertments to purchase divemified portfolios of securities. There are many different types of mu-tual funds. Table 1.5 shows the totals of mutual fund assets by fund type. In September 2008, the two largest categories were Canadian and foreign equity. Hedge funds are another growing group of financial institutions. According to the 2008 Hedge Fund Asset Flows & Trends report published by HedgeFund.net, the industry had ap-proximately US$2.68 trillion under management worldwide in the third quarter of 2007. Hedge funds are largely unregulated and privately managed investment funds catering to sophisticated investors, which look to earn high returns using aggressive financial strategies prohibited by mutual funds. These strategies may include arbitrage, 15 high levels of leverage,16 and active involvement in the derivatives market. However, hedge funds are not restricted to investing in financial instruments-some hedge fund strategies involve acquiring stakes in public or private companies and pressuring the board to sell the business. Canadian hedge funds experienced annual growth of 25 percent with roughly $40 billion of assets under management in nearly 300 hedge funds at the summer of2008 peak in the market.17 There is a high risk associated with hedge funds as these are highly unregulated and subject to fraud. In 2009, Bernard Madoff, a prominent money manager and former chairman of the NASDAQ was sentenced to 150 years of imprisonment for his involvement in a US$50 billion hedge fund scandal. We base this survey of the principal activities of financial institutions on their main activities today. Recent deregulation now allows chartered banks, trust companies, insurance companies, and investment dealers to engage in most of the activities of the others with one exception: Chartered banks are not allowed to sell life insurance through their branch networks. Although not every institution plans to become a one-stop financial supermarket, the different types of institutions are likely to continue to become more alike. Concept Questions 1. What are the principal flnanclallnstltutlons ln canada? What Is the principal role of each? 2. What are direct and indirect finance? How do they differ? a. How are money and capital markets different? 4. What is a dealer market? How do dealer and auction markebi differ? &. What is the largest auction market in Canada? 15 The pn.cfu:e of taking advaumge of a prite differential between two or more marltets. 1' The uae of debt to the pokntial return of an investment. 17 Aa:ordll!g to Terrapm. argan1zen! F1mds World Canada 2008. Soim:e: http-J/www.ll!mlplnn.com/200B/Irjwr:tmat 'lb learn more about hedge fund developments, vWt HedgeFund.net . 1.7 ftnanclal engineering Creation of new securities or financial processes. derivative aacurities Options, futures, and other securities whose value derives from the price of another, undertying, .wet. regulatory dialectic The pressures financial institutions and regulatory bodies exert on each other. CHAPTER 1: Introduction to Corporate Finance 21 TRENDS IN FINANCIAL MARKETS AND FINANCIAL MANAGEMENT Like all markets, financial markets are experiencing rapid globalization. Globalization also makes it harder for investors to shelter their portfolios from financial shocks in other countries. In the summer of 1998, the Asian financial crisis shook financial markets around the world. With in-creasing globalization, interest rates, foreign exchange rates, and other macroeconomic variables have become more volatile. The toolkit of available financial management techniques has ex-panded rapidly in response to a need to control increased risk from volatility and to track com-plexities arising from dealings in many countries. Computer technology improvements are making new financlal engineering applications practical. When financial managers or investment dealers design new securities or financial processes, their efforts are referred to as financial engineering. Successful financial engineering reduces and controls risk and minimizes taxes. Financial engineering creates a variety of debt and equity securities andre-inforces the trend toward securitization of credit introduced earlier. A controversial example is the invention and rapid growth of trading in options, futures, and other dertfatlve securities. Derivative securities are very useful in controlling risk, but they have also produced large losses when mishan-dled. At the time of writing, the largest financial accident with derivatives was the loss that triggered a $3.5 billion US. bailout ofdte U.S. fund Long Term Capital Management in 1998. Financial engineering also seeks to reduce financing costs of issuing securities as well as the costs of complying with rules laid down by regulatory authorities. An example is the Short Form Prospectus Distribution (SFPD) allowing firms that frequently issue new equity to bypass most of the OSC registration requirements. In addition to financial engineering. advances in technology have created e-business, bringing new challenges for the financial manager. For example, consumers ordering products on a com-pants website expect rapid delivery and failure to meet these expectations can damage a compa-n:y's image. This means that companies doing e-business with consumers must invest in supply chain management as well as in additional inventory. Technological advances have also created opportunities to combine different types of financial institutions to take advantage of economies of scale and scope. For example, Royal Bank, Canada's largest chartered bank. owns Royal Trust and RBC Dominion Securities. Such. large institutions op-erate in all provinces and internationally and enjoy more lax regulations in some jurisdictions than in others. Financial institutions pressure authorities to deregulate in a push-pull process called the regulatory dlaledic. For example, in 1998 and again in 2002, banks planned mergers in an effort to pressure the federal government to grant approvaL Although the federal government turned down the merg-ers, we believe this issue is dormant, not dead, and will reemerge in the not too distant future. Not all trends are driven by technology. In the aftermath of the technology bubble of the late 1990s, stakeholders and regulators have become very interested in corporate governance reform, a topic we introduced earlier in the chapter. For example, proponents of such reform argue that a stronger, independent board of directors can prevent management excesses such as ocurred at Hollinger. Another trend underlying the global financial crisis starting in 2007 was excessive financial leverage. Following the technology bubble and September 11, the United States Federal Reserve looked to aggressively lower interest rates in order to restore confidence in the economy. In the U.S., individuals with bad credit ratings, sub-prime borrowers, looked to banks to provide loans at historically low interest rates for home purchases. Investors also reacted to these low rates by seeking higher returns. The financial industry responded by manufacturing sub-prime mortgages and asset-backed securities. However, once housing prices began to cool and interest rates rose, sub-prime borrowers started defaulting on their loans and the collapse of the sub-prime market ensued. With mortgages serving as the underlying asset supporting most of the financial instru-ments that investment banks, institutions, and retail buyers had acquired, these assets lost much of their value and hundreds of billions of dollars of write-downs followed. These trends have made financial management a much more complex and technical activity. For this reason, many students of business find introductory finance one of their most challeng-ing subjects. The trends we reviewed have also increased the stakts. In the face of increased global 22 PART 1: OWrvlew of Corporate Finance competition, the payoff for good finandal management is great. The finance function is also be-coming important in corporate strategic planning. The good news is that career opportunities (and compensation) in :financial positions are quite attractive. 1.8 OUTLINE OF THE TEXT Now that wive completed a quick tour af the concerns of corporate finance, we can take a closer look at the organization of this book. The text is organized into the following nine parts: Part 1: Overview af Corporate Finance Part 2: Financial Statements and Long-Term Financial Planning Part 3: Valuation of Future Cash Flows Part 4: Capital Budgeting Part 5: Risk and Return Part 6: Cost of Capital and Long-Term Financial Policy Part 7: Short-Term Financial Planning and Management Part 8: Topics in Corporate Finance Part 9: Derivative Securities and Corporate Finance Part 1 of the text contains some introductory material and goes on to explain the relationship be-tween accounting and cash flow. Part 2 explores financial statements and how they are used in fi-nance in greater depth. Parts 3 and 4 contain our core discussion on valuation. In Part 3, we develop the basic proce-dures for valuing future cash flows with particular emphasis on stocks and bonds. Part 4 draws on this material and deals with capital budgeting and the effect of long-term investment decisions on the firm. In Part 5, we develop some tools for evaluating risk. We then disC'WIS how to evaluate the risks associated with long-term investments by the fum. The emphasis in this section is on coming up with a benchmark for making investment decisions. Part 6 deals with the related issues of long-term financing, dividend policy, and capital struc-ture. We discuss corporate securities in some detail and describe the procedures used to raise capital and sell securities to the public. We also introduce and describe the important concept of the cost of capital. We go on to examine dividends and dividend policy and important consider-ations in determining a capital structure. The working capital question is addressed in Part 7. The subjects of short-term financial plan-ning. cash management, and credit management are covered. Part 8 contains the important special topic of international corporate finance. Part 9 covers risk management and derivative securities. 1.9 SUMMARY AND CONCLUSIONS This chapter has introduced you to some of the basic ideas in corporate finance. In it. we saw that; I. Corporate finance has three main areas of concern: a. What long-term investments should the firm take? This is the capital budgeting decision. b. Where will the firm get the long-term financing to pay for its investment? In other words. what mixture of debt and equity should we use to fund our operations? This is the capital structure decision. c. How should the fum manage its everyday financial activities? This is the working capital decision. 2. The goal of financial management in a for-profit business is to make decisions that increase the value af the stock or, more generally, increase the market value of the equity. 3. The corporate form of organization is superior to other forms when it comes to raising money and transferring ownership interest, but it has the disadvantage of double taxation. Key Terms CHAPTER 1: Introduction to Corporate Finance 23 4. There is the possibility of conflicts between shareholders and management in a large corporation. We called these conflicts agency problems and discussed how they might be controlled and reduced. 5. The advantages of the corporate form are enhanced by the existence of financial markets. Financial institutions function to promote the efficiency of financial markets. Financial markets function as both primary and secondary markets for corporate securities and can be organized as either dealer or auction markets. Globalization, deregulation, and financial engineering are important forces shaping financial markets and the practice of financial management Of the topics weve discussed thus far, the most important is the goal of financial management: Maximizing the value of the stock. Throughout the text, as we analyze financial decisions, we always ask the same question: How does the decision under consideration affect the value of the shares? agency problem (page 11) capital budgeting (page 3) capital markets (page 16) capital structure (page 4) corporate governance (page 12) corporation (page 6) financial engineering (page 21) money markets (page 16) partnership (page 5) regulatory dialectic (page 21) sole proprietorship (page 5) stakeholder (page 12) derivative securities (page 21) working capital management (page 4) Concepts Review and Critical Thinking Questions 1. The Financial Management Decision Process ( L01) What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant. 2. Sole Proprietorships and Partnerships (L02) What are the three primary disadvantages to the sole proprietorship and partnership forms ofbusiness organization? What benefits are there to these types ofbusiness organization as opposed to the corporate form? 3. Corporate Organization (L02) What is the primary disadvantage of the corporate form of organization? Name at least two advantages of corporate organization. 4. Corporate Finance Organizational Structure (L04) In a large corporation, what are the two distinct groups that report to the chief financial officer? Which group is the focus of corporate finance? 5. The Goal of Financial Management (L03) What goal should always motivate the actions of the firm's financial manager? 6. Corporate Agency Issues {L04) Who owns a corporation? Describe the process whereby the owners control the firm's management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kind of problems can arise? 7. Financial Markets (LOS) An initial public offering (IPO) of a company's securities is a term you've probably noticed in the financial press. Is an IPO a primary market transaction or a secondary market transaction? 8. Financial Markets {LOS) What does it mean when we say the Toronto Stock Exchange is both an auction market and a dealer market? How are auction markets different from dealer markets? What kind of market is Nasdaq? 9. Not-for-Profit Firm Goals (L03) Suppose you were the financial manager of a not-for-profit business (a not-for-profit hospital, perhaps). What kinds of goals do you think would be appropriate? 10. Firm Goals and Stock Value (L03) Evaluate the following statement: "Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense oflong-term profits.D 11. Firm Goals and Ethics (L03) Can our goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behaviour? In particular, do you think subjects like customer and employee safety, the envi-ronment and the general good of society fit in this framework, or are they essentially ignored? Try to think of some spe-cific scenarios to illustrate your answer. 12. Firm Goals and Multinational Firm11 {L03) Would our goal of maximizing the value of the stock be different if we were thinking about financial management in a foreign country? Why or why not? 24 PART 1 : Overview of Corporate Finance 13. Agenq-Iuues and Corporate Control (L04) Suppose you own shares in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding shares. Your company's management immediately begins fighting off this hostile bid. Is managmwrt acting in the shareholders' best interests? Why or why not? 14. Agen