Good governance is about honest stock price and not raising the stock price.
There are 5 objectives:
Corporate finance is all about maximizing value
The opportunity cost of capital sets the standard for investment decisions
A safe dollar is worth more than a risky dollar
Smart investment decisions create more value than smart financing decisions
Good governance matters a lot!
Member States cannot limit the freedom of establishment of companies across Member States. This means if a member state company in in state A wants to establish itself in State B, it should be allowed to do so. Yet, this is also dependent upon whether the company of incorporation applies the real seat theory or the theory of incorporation.
Centros case
You can limit Freedom of Establishment when it is a case of creditor protection.
4 conditions mentioned in judgement (check the above 4)
Suitable
Necessary
Non-discriminatory
Justified
Inspire Art case
If you have no real connection to where you have set up your company. Is it a foreign company ? Netherlands allowed inspire art to set up in Netherlands, yet Inspire art had to fulfill some minimum rules..
Incorporation or real seat?
Part of the harshness of the real seat theory has been abolished by the courts. Yet if there was a choice between incorporation or real seat then incorporation should be chosen since real seat limits freedom of establishment . Real seat theory is thus a bit less attractive.
Vale case
In this case an Italian company wanted to convert itself into a Hungarian one. Under Italian Law this was allowed and the Court ruled that Vale was permitted to do so as long as it converted itself into a Hungarian limited company and thereby breaking the connecting factor.
Integration of tax systems of the Member State is important
Tax obstacles faced by MS for the undermining of the internal market are:
Taxation of goods crossing borders
Differential tax treatment etc etc
-Tax obstacles cause market fragmentation along national borders.
- impel economic operators to stay in their home markets eg where to incorporate or where to invest
Corporations can invest in real assets🡪 Tangible eg cars machines etc or..
Intangible assets🡪 brand names or patents.
Corporations finance themselves by borrowing, reinvesting cash flows and selling additional shares in stocks to shareholders.
A corporation’s financial manager has to decide on how to raise the cash flow. That's what the Shareholders in a big corporation want the manager to do! That is his Job! To increase value!
Two questions he needs to consider:
1)how should the corporation invest
2) and how to pay for those investments.
Investment decision means to spend money and the financing decision i.e how to raise the money.
Financial Managers add value when a corp can earn a higher return than Shareholder can earn for themselves.
Corporate investment and financing decisions
A corporation needs a lot of real assets which need to be paid for. The corporation pays for the real assets and sells claims on them which in turn generate cash flow. These claims are called financial assets and securities.
Businesses take loans from banks as securities or financial assets which they need to repay to the bank with some form of interest. Now the bank loan can generate cash flow and the stock prices may or may go up or decline.
Another example are bonds. These bonds are financial assets which can be traded by investors in the financial market.
Bonds are an example of Financial assets and securities.
This basically means that: (below equations are highly simplified)
Investments decisions = purchase of real assets
Financing decisions= sale of financial assets
These assets need to be disposed and shut down at the right time for example when the profits decline. The corporation needs to take into consideration, the risks o fots investments .
Financing decisions are very complicated. You need to
Meet obligations to banks and bondholders and stockholders who have financed the the corp
The corp has to also repay its debts in due time ( cuz if they dont then they become insolvent and have to shut dont)
They also have to pay out cash and profits to its SH
Corporations need not only invest in tangible assets but also intangible assets such as marketing and ads in order to gain brand recognition in the future.
Financing Decisions
Capital refers to the firms sources of long-term financing. The form of financing is either equity financing or debt is called capital structure. A corporation raises money by borrowing from lender or the Shareholder contribute.
If it borrows, it must pay back the debt with a fixed rate of interest to the lenders. If it is the SH that provides the cash then they will receive the cash that is returned and or plus minus the profits and thus not a fixed rate like the lenders.
The Shareholders are equity investors whereas the banks are debt.
Equity financing can be done in 2 ways.
Issue new shares of stock
Now issue new shares but reinvest on behalf of exiting Shareholders . Take cash flow generated by its existing assets and then in turn reinvest in new assets.
Debt financing
Borrow from bank
Issuing bonds that can be traded by investors
Corporation =legal entity
Legal person owned by its SH. A corp has the power to make contracts borrow or lend money sue or be sued. It can make a takeover bid or merge with another corp. corps pay taxes but cannot vote.
Articles of incorporation state the duties of directors and the how things will be governed. These directors are chosen by the SH. Directors advise the SH.
The shareholders are distinct from the corporation in that they cannot be held personally liable for the corporation’s debts. = they have limited liability. Sh can lose their entire investments in a corp but nothing more than that.
A company is closely held where the shares are not publicly traded out in the market but are held by the SH who may also be the directors or investors of a company at the start-up of the corp.
The company may grow and the shares will then be publicly traded for example in the stock exchange. = public company
Forms of business organizations
Sole proprietorship businesses enter into an agreement about how decisions will be made and how the profits will be split up=they have unlimited liability i.e. they are held liable for all of the debts. Whereas partnerships, unlike corporations, do not have to pay income taxes but only pay personal income taxes on the shares of the profits.
Partnerships don’t work well when the power of ownership is widespread and separation of ownership and management is vital. Also, this may entail that the directors of the ownership asct in their own best interests.
One disadvantage of being a corporation is the high cost and time and the legal machinery.
Cash is raised from the investors (this can come from the banks or from the securities sold in the financial markets)
The cash raised is used to buy real assets (investment project)
The business then will generate cash inflow due to the sold assets
This cash inflow can be reinvested or returned to the investors
At the end the money must be returned to the bank with interest for example reinvested depending on the contract terms.
The financial goal of the corporation
SH want the managers to maximise market value. As long as the there are higher rates of returns for the SH they will be happy.
Opportunity cost of capital= minimum acceptable rate of return because whenever a corporation invests in a new project then the SH will lose the opportunity to invest on their own. Return forgone by NOT investing the financial markets.
A bank loan is a safer and less risky option than opportunity cost of capital (usually 10%) becsauue it has a lower interest rate.
A higher rate of return is not always better for investments because
lower but safer return can be better then a higher and riskier one
investment with a higher % return can generate less value than a lower return investment that is larger or lasts longer.
Current vs. Future consumption in the financial market!
2 investors🡪 A and B who have $ 100,000 in total. 10% interest rate
A wants to save for future i.e. postpone consumption for 1 year and B wants to spend the cash immediately. A at the end of the year would then have 1.10 x 100,000= $ 110,000 whereas B would have only $100,000 to spend now.
Investing in real assets
People can invest in real assets i.e. plants, machineries etc. A and B are given the option to invest in a friends new business which will produce $121,000 next year. The decision to invest in the real asset provides the A and B with a return of 21% = 1.21 x 100,000= $121,000
NB: capital markets can give a loss in return too!
Calculating future values
You have $100 today and decide to invest it in a bank that pays r=7% interest per year. i.e r= 0.07
Formula: future value of $100 = $100 x (1 + r)t
Value of investment after 1 year = $100(1 + r) = $ 107
After 2 years = $100 x 1.072 OR $100(1+0.07)2 = $ 114.49 🡪 here you earn a compound interest i.e. interest on the $7 that you earned in year one.
Calculating PV
Present value is the reverse of future value. So, how much do we need to produce $114.49 in 2 years.
So the formula for this is:
$100 / 1.072 = 114.49 i.e. PV = Ct / (1+r)t =
r= discount rate Ct= discounted value of the cash flow
The Discount factor = present value of x amount of money in year t So,
DF2= 1/(1.07)2 = .8734
i.e
“It is found by dividing the annual interest rate by the number of payments made per year.” NB: discount rate must alwatys be in decimal form to establish PV
In other words,
DF2 x C2 = PV i.e. 0.8734 x 114.49 = $100
The longer that you wait for your money, the lower the interest value has to be!
Valuing an investment opportunity
Suppose you buy a house for £700,000. The predicition of the value of the house is £800,000 if you sell after one year. The rate of return (%) of the investment project =
£800,000 – £700,000 = £100,000
So, rate of return =
£100,000 / £700,000 = 0.143 = 14.3%
Suppose that you have 2 options :
invest in safe assets at 7% interest rate return
Invest in the the risky (stock market) at 12% interest rate return
How much are the 2 options (after return) worth combined. That is what is the present value of the house after 1 year ?
PV= C1 / 1+1.07= 800.000/ 1.07= $747.664
Cash 🡪 Financial manager 🡪 gets house with value after 1 year (800.000) OR can return it to the SH who can either ; 🡪 invest at 7%(safe asset) or 12% (stock market)
So, the PV is that value of the house or worth of the house that you have to sell it for. That is what investors in the financial market have to pay to get the same future payoff. If you tried to sell it for more than $747,664 that would mean that there would be no takers because then the property would offer a return of of lower than 7% available on government securities. Present value of property = market price.
Net Present Value (NPV)
Amount of profit or addition made i.e. you invested $700,000 and your profit is NPV $47,664.
NPV= PV – investment = $747.664 - $ 700,000.
NPV= C0 + C1 / (1+ r)
Cash flow at time is a negative number, Thus C0 = - $700,000
C1= 800,000
Present values and rates of return
A project is worth pursuing where the rate of return is exceeds the the opportunity cost of capital.
Rate of return= profit as a proportion of the initial outlay.
Return= Profit / investment= 800,000 – 700,000 / 700,000 = .143 = 14.3%
Since the 14.3%return exceeds the 12% opportunity cost, you should go ahead with with the project.
NPV Rule= Accept investments that have positive NPV’s
Rate of return rule = accept investments whose return costs exceeds the opportunity cost of capital.
Both rules give the same answer , yet the NPV rule is more reliable.
Calculating present values when there are several cashflows
A stream of cashflows extending over a numer of years combined.
PV = Ct / (1+ r)t
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