BUAD 306 Business Finance

1. BUAD 306Business Finance Instructor: Conson (Yingguang) Zhang This class: Chong Shu

2. What is Finance? The study of how money is used to allocate scarce resources over time under conditions of uncertainty.

3. This is finance

4. Course Information • Conson Zhang • Office Hours: M/W 1 pm – 2:30 pm • Office: HOH 110 • Email: yingguaz@usc.edu • Text: Ross, Westerfield, Jordan 11th Ed. • Calculator: TI BAII Plus Professional

5. Grading • 8 Homework Assignments • 3 Midterm Exams • 1 Final Exam • Grade Breakdown • Exam 1 20% • Exam 2 20% • Exam 3 20% • Final 32% • Homework 8%

6. Other details • Missed exams • Turning in homework • Technology policy • Add/drop • Students with disabilities • Academic Integrity • Course schedule

7. Finance is about making decisions • 7

8. Decisions and Prices • Finance is the discipline that studies the pricing of real and financial assets and the financial decisions of individuals and corporations • Typical financial decisions made by individuals: • Investing their savings: Portfolio Theory • Typical financial decisions made by corporations: • Planning and managing long term investments: Capital Budgeting • Raising the money necessary for these investments: Capital Structure

9. Asset classes Real assets Assets which generate net income to the economy, i.e., ultimately determine its ability to produce goods and services • Natural resources: land, oil, • Physical capital: machinery, buildings, factories • Intangibles: human & “cultural” capital like technical expertise, trademarks, patents

10. Asset classes Financial assets (or securities): Assets which specify level, timing, and condition for the payment of cash, goods, or other financial assets • Money: medium of exchange, reserve of value • Debt: a claim to a predetermined payment stream • Equity: residual claim to a set of real assets (usually of a corporation) • Derivatives: their payoff is dependent on the value of some other (usually financial) assets

11. Example 1: IBM Corporation • Real assets: • Plants used to build computers • Patents and trademarks for software, operating systems, etc. • Financial assets: claims to the income generated by IBM‘s real assets • Equity: IBM stocks • Debt: IBM bonds • Derivatives: claims on IBM stocks • Ex. Call option: a security giving the right (but not the obligation) to purchase IBM stocks at a given (exercise) price

12. Main characteristics of an asset • Divisibility: extent to which fractions of an asset can be traded • Physical assets are usually indivisible (cars), but not always (ex., gold, oil) • Liquidity: the extent to which an asset can be sold quickly with limited price impact (loss of value) • Money is the most liquid asset • Large firms‘ equity usually more liquid than small firms‘ equity • Standardization: extent to which units of an asset are the same • New cars are standardized, but old cars are not • Stocks of a company are usually standardized

13. Financial decisions of individuals • Savings versus consumption decision • Your families have saved money for your college education • College students have low income now, but (hopefully) high future income • Student loans allow them to smooth consumption intertemporally • Investment decisions: how to allocate your savings • Asset allocation: choice among broad asset classes (bonds versus stocks versus cash versus real estate) • Security selection: within each asset class, choice of the particular securities to hold in your portfolio

15. Roadmap for this term I • Saving versus consumption decisions • Topic of economics / elective courses • Investment decisions of individuals • Valuation tools • Valuing bonds and stocks • Efficient markets • Risk and return • Modern portfolio theory & CAPM • Investment decision rules • Risk management & options

16. What is a corporation? • A corporation is a legal form of business organization • Essential legal features of a corporation are: • Limited liability: the obligations of the corporation are distinct from those of its owners • Public ownership • Other common organizational forms are: • Sole proprietorships • Partnerships • Hybrids: Limited Liability Partnership or Company (LLC), Professional Corporations

17. Sole Proprietorship Advantages • Easiest to start • Least regulated • Single owner keeps all the profits • Taxed once as personal income Disadvantages • Limited to life of owner • Equity capital limited to owner’s personal wealth • Unlimited liability • Difficult to sell ownership interest • Owner‘s personal wealth is tied to firm‘s wealth

18. Partnership Advantages • Two or more owners • More capital available • Relatively easy and inexpensive to start • Income taxed once as personal income Disadvantages • Unlimited liability • General partnership • Limited partnership • Partnership dissolves when one partner dies or wishes to sell • Difficult to transfer ownership • Very similar to a proprietorship but ...

19. Corporation Advantages • Limited liability: shareholders are residual claimants • Unlimited life • Separation of ownership and management • Easy transfer of ownership • Easier to raise capital Disadvantages • Separation of ownership and management • Double taxation: • Income is taxed at the corporate rate • Dividends are taxed at the personal rate • Owners‘ personal wealth is not tied to firm‘s wealth

20. Financial decisions of corporations • Some examples of investment decisions: • 2003: Vivendi Universal sells its film and television assets to General Electric’s NBC unit for equity valued at roughly $14 billion • Some examples of financing decisions: • 2003: ABB issues $600 million of bonds convertible into shares to refinance existing credit facilities • Some examples of payout decisions: • 2003: Microsoft announces it will replace employee option grants with restricted stocks • Corporate Finance studies these types of decisions

21. Financial management decisions (1) (2) Firm‘s operations: e.g. projects Financial markets: e.g. investors Financial (4a) manager (3) (4b) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to stakeholders

22. What is the goal of financial management? “General Motors is not in the business of making automobiles. General Motors is in the business of making money.” Alfred P. Sloan (Former GM President & CEO) • Make money: is it enough? Is it reasonable or ethical? • A comprehensive criterion: • The goal of financial management is to maximize the wealth of the firm’s owner(s)….which is equivalent to • Maximize shareholders’ wealth • Maximize share price • Maximize firm value

23. Who are the stakeholders of a corporation? Society Government Creditors Employees Shareholders The firm Suppliers Bondholders Competitors Customers

24. What is the goal of financial management? • Why not maximize profit, minimize costs, or maximize market share? • They do not unambiguously serve the best interests of rational shareholders: e.g., profits now or later? • Why is maximization of the current stock price reasonable? • Stock price should reflect current and future perspectives of the firm • Shareholders are residual claimants, after employees, suppliers, creditors, bondholders: if the residual is growing, everyone else must be already better off • This is true only when all players follow the rules!

25. Do managers act in the interests of stockholders ? • The stockholders (principals) hire managers (agents) to run the company • The relationship between stockholders and managers is called agency relationship • If the interests of the managers are not perfectly aligned with those of the stockholders, conflicts may arise: we call these conflicts agency problems • Agency problems are costly: • Direct costs: consumption of corporate perks, like jets, expensive trips, unnecessary luxury • Indirect costs: resulting from sub-optimal investment decisions

26. How to reduce agency costs? Managing managers • Managerial compensation • Contractual incentives can be used to align management and stockholder interests • Corporate control • Shareholders elect the board of directors, which ultimately hires and fires managers • The threat of a takeover may result in better management • Proxy fights: by obtaining the authority to vote someone else’s stock, unhappy shareholders can fight to replace the management

27. The financial system • It is the collection of institutions by which financial assets are created and traded • It serves the purpose of creating wealth by: • Improving allocation of capital: transferring resources from savers (investors) to users (corporations) • Improving allocation of risk: risk sharing, hedging, etc. • Consumption timing: allowing investors to smooth consumption intertemporally • Separating owners and managers: using best skills • Disciplining firms’ investment decisions: good versus bad choices • Disseminating information: prices

28. The financial system: institutions • The government • Sets the regulatory environment • Controls the money supply, interest rates, and the real value of money via the Central Bank • Financial markets • Regulated (stocks) and unregulated (foreign exchange) institutions which trade financial assets • Financial intermediaries • Entities which operate within or outside financial markets to facilitate the trading of financial assets

29. The financial markets • Primary versus secondary markets • Primary: where new issues of securities are sold to the public (ex. IPOs, Initial Public Offerings) Secondary: where seasoned securities are traded • Exchange versus over-the-counter markets • Exchange: buyers and sellers meet in one central location (physical or electronic) to trade • OTC: intermediaries at different locations stand ready to trade with investors • Money versus capital markets • Money: short-term debt (less than 1 year maturity) • Capital: long-term debt and equity

30. Hierarchy of types of financial markets • Direct search: Buyers/sellers find each other directly (used cars) • Brokered markets: Buyers and sellers use inter-mediaries (not acting as principals) to find each other (residential real estate) • Dealer markets: As above, but intermediaries often act as principals, taking long / short positions and providing liquidity (NASDAQ, U.S. Treasuries) • Auction markets: Centralized, where buyers and sellers interact directly with each other (NYSE) • From top to bottom: higher fixed costs, lower trading costs, greater structure

31. Roadmap for this term II • Investment decisions of corporations • Capital budgeting techniques • Calculating cash flows • Calculating discount rates • Valuation of firm and equity • Financing decisions of corporations • Raising capital in the financial markets • Capital structure • Risk management • Dividend policy • Behavioral finance