UNIT 1

Introduction to Corporate Finance

Source: http://www.pixabay.com

Overview

The scope of financial management involves the application of principles of management to everyday
business decisions, since the growth and potential success of businesses depend significantly on the
efficient utilization of the firm’s financial resources. The scope of financial management also involves the
management of risk, the making of investment decisions and sound financial planning.

Environmental conditions of financial management include inflation and other economic factors that may
impact the financial operations of firms. Firms therefore need to have financial analysts to assist
management in making the best possible decision.

In today’s world, working capital requirements and financial investments have greatly increased
and as a result, financial managers are faced with the challenge of making decisions on how and
where to raise additional resources for the firm. This process can be referred to as corporate
finance and includes the activities, decisions and techniques that deal with transactions which
raise capital in order to create, develop, and acquire businesses. Generally, the tasks of the
financial executive (financial managers) have become more difficult, as governments implement
policies that restrict the supply of funds through loans.

___________________________________________________________________________________________________ 1
Financial Management 1 _
This Unit introduces you to the various tasks which the financial executive is responsible for. It also
investigates what the financial executive’s objectives should be, in making decisions and looks at the
basic features of the major types of financial securities. Finally, we examine the environment in which the
financial executive operates

Learning Objectives

By the end of this Unit, you will be able to:

1. Justify the importance of a financial executive to corporate finance;

2. Explain key objectives that guide financial decision making;
3. Examine the basic workings of the financial system through the various categories of
markets;
4. Discuss how corporations issue new securities to raise capital;
5. Explain financial securities.

This Unit comprises three sessions as follows:

Session 1.1: Key Functions of the Financial Executive
Session 1.2: Workings of the Financial Markets
Session 1.3: Financial Securities and their main features

Readings & Resources

Required Reading(s)
Finance by Boundless. Available at:
https://www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-
to-the-field-and-goals-of-financial-management-1/
Free resource for use and download.

Suggested Reading(s) [or Other Resources]

Drakes, P.P. & Fabozzi. F.J. (2010). The basics of Finance: An Introduction to Financial
Markets, Business Finance, and Portfolio Management. Chapter 2. Financial
Instruments, Markets, and Intermediaries. Pages 11- 35. Available at:
http://onlinelibrary.wiley.com.library.open.uwi.edu/doi/10.1002/9781118267790.ch2/pdf
.

___________________________________________________________________________________________________ 2
Financial Management 1 _
Session 1.1

Key Functions of the Financial

Executive

Introduction
The financial executive has an important role to play in assisting management make informed
decisions. In order to carry out its role effectively, the financial executive has to research,
analyze and report its findings with recommendations on how best to maximize shareholders’
wealth. A prudent financial executive therefore needs to be constantly analyzing the financial
environment (capital markets).

To illustrate the important role of the financial executive, recall the events of September and
October 2008 on Wall Street in the United States of America where the Dow Jones Index
plunged to its lowest average since the Great Depression in the 1930s. You would have seen the
frenzy and panic on television and the related negative impact on businesses with some even
going into bankruptcy. You would have also noticed that financial executives on Wall Street
were being blamed for the market conditions.

In this Session, we introduce you to the various tasks which the financial executive is responsible for. In
addition, we will investigate what the financial executive’s objective should be, in making decisions and
examine the environment in which the financial executive operates.

The Role of the Financial Executive

One of the basic functions of a business venture is to accumulate funds in order to finance the
acquisition of real assets that provide products and or services. The business will acquire real
assets such as land, machinery and equipment through equity financing (selling new shares to
investors) or debt financing (borrowed funds) or a combination of debt and equity. In contrast to
real assets, there are financial assets, such as stocks and bonds. Such securities, are no more than
sheets of paper, and do not contribute directly to the productive capacity of the economy.
However, these assets are the means by

___________________________________________________________________________________________________ 3
Financial Management 1 _
which individuals in well-developed economies, for example the United States of America and
the United Kingdom, hold their claims on real assets. In general, financial assets are claims to the
income generated by real assets. For example, if an individual cannot own his or her own
telecommunication company, he or she can still buy shares in other telecommunication
companies and thereby share in the income derived within the industry.

The major factors that determine the size and organizational form of a business venture are the
possible economies of scale. Economies of scale may be achieved when more units of a good or
a service can be produced on a larger scale with less input costs. Alternatively, this means that as
a company grows and production units increase, a company will have a better chance to decrease
its costs. For example, a firm providing a phone service or producing automobiles efficiently,
requires a major concentration of productive assets, since the efficient enterprise asset base is
large, it is more efficient. Alternatively, providing architectural consulting does not require a
large asset base.

If a large asset base is most efficient, a mechanism must exist to allow an enterprise to acquire
sufficient funds to put the capital assets in place. For example, the 2013 book value of the assets
of Finance Inc., a tropical fruit juice manufacturer, was over $10 million. This amount is more
than most individuals have to invest in any business venture. The financial executive therefore
allows for the accumulation of sufficient funds from many different investors to firms the size of
Finance Inc. and larger.

When we examine Figure 1.1 below, we will see how the financial executive can be characterized as an
intermediary that provides a link between sources of funds and uses of funds. Funds acquisition is shown
in segment A of Figure 1.1.

Figure 1.1 The Financial Executive as an Intermediary

A B
Sources of
Funds t The
Financial
Executive
t Uses of Funds

C D

t t
A = acquisition of external capital B = capital investment in operations
D = interest, dividends, etc. C = return from capital

When new funds have been raised, the financial executive must determine the optimal use of the
funds, for example, what new capital assets should be acquired for the potential business
venture? The capital budgeting decision (segment B of Figure 1.1) will be explained in greater
detail in Unit 7.

When the firm invests in profitable capital assets, revenues in excess of costs result as shown in segment
C of Figure 1.1. The financial executive has some discretion in determining what to do with this return on
investment: the firm must pay any interest and repay principal due on loans, but it can choose to pay any
___________________________________________________________________________________________________ 4
Financial Management 1 _
residual return to common shareholders as a dividend (segment D of Figure 1.1) or retain cash to reinvest
in additional capital assets. Thus, the financial executive can also be thought of as directing the firm’s
cash flows between sources of funds (capital markets) and uses of funds (capital asset markets).

The Major Tasks of the Financial Executive

Now that we have examined the role of the financial executive, let us now focus on the three
major tasks the executive carries out as intermediaries that direct a firm’s cash flows between
sources and uses of funds. Each of these tasks is carried out by one of the three functional areas:
controller, treasury and capital budgeting.

Task 1: Asset Efficiency (Controller Function)

The major controller function is to manage the firm’s resources to ensure the efficient use of
working capital (current assets minus current liabilities). This function includes running the
internal accounting system for current transactions and managing accounts receivable,
inventories, and short-term debt efficiently.

Task 2: Funds Acquisition (Treasury Function)

The primary task of the treasury is for the treasurer to acquire new capital for investment.
Basically, the treasury must decide whether to sell debt or equity securities, and when. This
choice determines the firm’s capital structure and therefore affects the firm’s risk and tax
position.

Task 3: Capital Asset Acquisition (Capital Budgeting)

Capital budgeting involves decisions about the composition of the firm’s capital assets (for example, the
mix of capital and labour, or the choice of technology in production) which greatly influences the firm’s
production activities. Hence, it largely determines the firm’s profitability and operating risk.
Consequently, decisions made by the Chief Financial Officer are probably the most important ones made
by the financial executive. Capital budgeting will be studied in greater detail in Unit 7.

The Objectives of the Financial Executive

Having reviewed the major tasks of the financial executive, let us now address its objectives.
Regardless of the organizational form (sole proprietorship, partnership or corporation), the
financial executive’s underlying objective is to make owners of businesses better off.

___________________________________________________________________________________________________ 5
Financial Management 1 _
This criterion is justifiable on the following grounds:
1. The owners of a sole proprietorship or partnership might argue that since they own the
assets, they have the right, in a capitalistic society, to control the use of the assets for their
greatest personal gain.
2. The owners can hire (and fire) the financial executive, and therefore it is prudent for the
executive to act in the owner’ best interest.

In a sole proprietorship or partnership, where the number of owners is relatively small,

“acting in the owners’ best interest” can simply mean the financial executive asking the owners
what is “best.” A key question to consider in this situation is: How much risk are the owners
willing to take to earn higher potential profits? The owners must make this choice, reach an
agreement, and instruct the financial executive on how to proceed.

A corporation is a legal entity that functions separately from its owners. In this case therefore, a
greater number of owners rule out the possibility of the financial executive asking what the
owners want. Therefore, the financial executive’s objective should focus on maximizing
shareholders’ wealth by maximizing the price of the firm’s common shares. This objective is
presented in the schema below.

Corporate objective Maximise Shareholder Wealth Maximise share price

Investors that own shares in a corporation by means of share certificates can have them easily
transferred on a stock exchange at an observable price. Hence, these investors can use this
“market price” as a measure of shareholder wealth and as the share price rises, owners can sell
their shares at a higher price. This is interpreted as being “better off.”

Session 1.1 Summary

In this Session, we discussed the key role of the financial executive as an intermediary that
provides a link between sources of funds and uses of funds, by determining the optimal use of
funds, and subsequently directs cash flows of the firm between sources of funds (capital markets)
and uses of funds (capital asset markets). We also examined the tasks carried out by the three
functional areas of the executive namely, the controller (whose primary task is asset efficiency),
the treasury (whose primary task is funds acquisition) and finally the capital budgeting (whose
primary task is capital asset acquisition). In the next session, we look at how the financial market
in which financial executives operate in carrying out their key functions.

___________________________________________________________________________________________________ 6
Financial Management 1 _
Session 1.2

Workings of Financial Markets

Introduction
Firms continuously have need for funds and they need to be able to access those funds from
somewhere. They can either obtain funds from the internal operations of the business or from
external sources. This section looks primarily at two of the three external sources of funds of the
business. The first source of funds is the financial institution which accepts savings and transfers
them to those that need them. Another is through financial markets, which are basically
organized forums in which the suppliers and demanders of various types of funds can make
transactions. Finally, firms can obtain funds through what is referred to as private placement,
which are unstructured in nature and can range in a number of simple to complex arrangements
between the parties. However here we focus on the financial institutions and financial markets.
We will also touch on the role of security exchanges in ensuring efficiency in financial markets.

Think about how inefficient it would be if each individual saver had to negotiate with each
potential user of savings. Institutions make the process very efficient by becoming
intermediaries between savers and users. Financial intermediaries include banks, credit unions,
insurance companies and investment companies. These intermediaries normally issue their own
securities to raise funds to purchase securities of other corporations. For example, a bank may
raise funds through borrowing and in return lend that money to other borrowers. The profit
generated by the bank is then spread between the interest rates paid to depositors and the rates
charged to borrowers.

We mentioned earlier that the flow of funds happen direct through financial markets. The
financial markets serve as wholesale markets for the creation and sale of financial securities such
as stocks, bonds, and money market instruments. Two key financial markets are the money
market and the capital market.

Financial Institutions and Markets

Think about how inefficient it would be if each individual saver had to negotiate with each
potential user of savings. Institutions make the process very efficient by becoming
intermediaries between savers and users. Financial intermediaries include banks, credit unions,
insurance companies and investment companies. These intermediaries normally issue their own
securities to raise funds to purchase securities of other corporations. For example, a bank may
raise funds through borrowing and in return lend that money to other borrowers. The profit
generated by the bank is then spread between the interest rates paid to depositors and the rates
charged to borrowers.

___________________________________________________________________________________________________ 7
Financial Management 1 _
We mentioned earlier that the flow of funds happen direct through financial markets. The
financial markets serve as wholesale markets for the creation and sale of financial securities such
as stocks, bonds, and money market instruments. Two key financial markets are the money
market and the capital market.

The Money Market

The money market is not a physical location but a communication network of major traders. It is
essentially a place where buyers and sellers contact one another to carry out transactions, and
most trades are quite large. The issuers of money market instruments are governments,
corporations, banks, and other financial intermediaries. The holders are primarily large
investment dealers and corporations. Investment dealers and banks hold government securities,
while corporations use money market instruments to temporarily invest excess cash.

The Capital Market

Unlike the money market, where typically short term instruments are traded, in the capital
market intermediate and long-term debt and corporate stocks are traded. Examples of such
markets include the New York Stock Exchange and the London and Tokyo stock exchanges. An
important function of the capital market is to determine the underlying value of the securities
issued by the business. In an efficient market funds are allocated to their most productive uses
due to competition among wealth creating investors and therefore as investors learn new
information it is quickly reflected in stock prices.

Security Exchanges
Securities exchanges are a key part of the capital market. They provide the marketplace in which
firms can raise funds through the sale of new securities and purchasers of securities can easily
resell them when necessary. (Gitman & Zutter pg. 36). Security exchanges typically trade equity
securities in either the over-the-counter market (OTC) or the “organized” markets commonly
called organized exchanges.

OTC: As with bonds, shares can be bought and sold through a communication network of
dealers who are trading shares for themselves and their clients. This market is not a physical
location.

Organized exchanges: In this case, the market is a physical location where traders meet to trade
shares for themselves and their clients. The New York Stock Exchange (NYSE) is an example of
an organized exchange. The existence of computers and modern telecommunications networks
within the platform of the organised exchanges, cause new information to hit the market almost
instantaneously and continuously. This causes frequent and sometimes large changes in stock
prices and brings equilibrium to the stock prices where required and expected returns are
generally equal. While there are times when stocks appear to react to several months of
favourable or unfavourable developments, this does not signify a long adjustment period, rather
it simply indicates that as more new pieces of information about the situation become available,
the market adjusts to them.

___________________________________________________________________________________________________ 8
Financial Management 1 _
 www.pixabay.com

Reflection on Brexit
Consider the last paragraph on how information is filtered into the price of stocks. Reflect
on the Brexit of June 23, 2016 and how this major incident affected the stock indices of
some of the world’s major Stock exchanges: London Stock Exchange, NYSE, Japan
Exchange Group, Shanghai Stock Exchange. You may visit some of those sites and see how
they are doing now, after Brexit

Readings & Reflection

Available at: https://www.boundless.com/finance/textbooks/boundless-finance-

textbook/introduction-to-the-field-and-goals-of-financial-management-1/financial-markets-
30/
At the end of your reading, try to answer the following questions without referring to the
unit.
1. “How do capital market instruments differ from money market instruments?”
2. Just how efficient are the prices in financial markets? Attempt learning Activity 1.2 for
greater insight.

___________________________________________________________________________________________________ 9
Financial Management 1 _
 LEARNING ACTIVITY 1.1

Activity Topic

Instructions:
Conduct a scavenger hunt on “The Ethics of Insider Trading” and share your thoughts
by answering the following questions:
1. If efficiency is the goal of financial markets, is allowing or disallowing insider
trading more unethical?
2. Does allowing insider trading create an ethical dilemma for the insider?

In a Discussion forum, summarize the main points, express how they relate to a
situation you encountered, share with your paired colleague and critique what they
have written in the relevant discussion forum. Refer to the literature you have read
when you make your critique.

Primary and Secondary Markets

Another classification of financial markets are primary and secondary markets. In the
primary market, companies sell new securities and issues of either debt or securities. For
example if Dairy Queen needs to raise some $100 million for business expansion and
decides to raise the money through the sale of common stock, the company can sell some
new issues of stock in the primary market with the help of an underwriter.

Secondary markets are like used-car markets in that they allow investors to buy and sell second-
hand or previously owned securities for cash. Secondary markets play an important role in
that they enable investors to buy and sell securities as frequently as they want. Secondary
markets are important to corporations as well because companies whose securities have active
secondary markets, enjoy lower funding costs than similar firms whose securities do not have
active secondary markets.

Session 1.1 Summary

In the absence of markets, it would be difficult for intermediaries, investors and institutions to
trade. In this session, we saw how institutions serve as intermediaries and channeling the
sources and uses of funds for the benefit of its stakeholders and the different classifications of
financial markets within which these transactions can take place. In our next session (Session
1.3) we look more closely at some of the securities traded in the financial markets and their main
features.

___________________________________________________________________________________________________ 10
Financial Management 1 _
Session 1.3

Financial Securities and Their Features

Introduction
In this session, we continue describing the types of securities which are likely to trade in both
the money and capital markets

Marketable Securities
This would include short-term instruments such as:
1. Treasury Bills
2. Commercial paper
3. Bankers Acceptances
4. Bank Certificates of Deposit

Government Treasury Bills

A government treasury bill (T-bill) is a short-term debt obligation backed by the government
with a maturity of less than one year. T-bills are the most marketable of all money market
instruments. In addition, T-bills are sold in denominations of $1,000 and commonly have
maturities of three months (90-days) or six months (180-days). T-bills are issued through a
competitive bidding process at a discount from par, which means that, rather than paying fixed
interest payments like conventional bonds, the appreciation of the bond provides the return to the
holder.

Commercial Paper
Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically
for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities
on commercial paper rarely range any longer than 270 days. The debt is usually issued at a
discount, reflecting prevailing market interest rates.
Commercial paper is not usually backed by any form of collateral, so, only firms with high-
quality debt ratings will easily find buyers without having to offer a substantial discount (higher
cost) for the debt issue. A major benefit of commercial paper is that it does not need to be
registered with the Securities and Exchange Commission (SEC) as long as it matures before nine
months (270 days), making it a very cost-effective means of financing.

Bankers’ Acceptances
Bankers’ acceptances are short-term credit investments created by a non-financial firm and
guaranteed by a bank. This type of security usually starts as an order to a bank by a bank’s
customer to pay a sum of money at a future date, typically within a six month period.

___________________________________________________________________________________________________ 11
Financial Management 1 _
Acceptances are traded at a discount from face value on the secondary market. A banker’s
acceptance is very similar to T-bills and is often used in money market funds.

Bank Certificates of Deposit

Bank certificates of deposit (CD) are savings certificates entitling the bearer to receive interest. A CD
bears a maturity date, a specified fixed interest rate and can be issued in any denomination. CDs are
generally issued by commercial banks, insured and their terms generally range from one month to five
years. To illustrate, let us say you purchase a $20,000 CD with an interest rate of 4.5% compounded
annually for a term of one year. At year’s end, the CD will have grown to $20,900 = ($20,000*1.045).

Long-Term Securities
This would include:
1. Bonds
2. Common and Preferred Shares (Equity)

Bonds
A bond is legal evidence of a loan obligation. The typical corporate or government bond is a promise to
return a regular, fixed interest payment plus a lump-sum repayment at the maturity of the bond. The
annual interest payment is determined by multiplying the bond’s coupon rate times the face value of the
bond. Many bonds pay this amount semi-annually, with each payment equal to one-half of the annual
interest amount. The lump-sum repayment at maturity is equal to the face value.

Here is an example for you to follow:

Finance Inc.
Coupon rate: 10%
Maturity Date: May 1, 2010
Face value: $1,000
Annual interest payments are calculated by multiplying the coupon rate times the face value:
Annual interest = (0.10) ($1,000) = $100.

The interest payment is usually made semi-annually, so that the holder of the Finance Inc. bond
would receive $50 (that is, $100 ÷ 2) on May 1 (the maturity month and day) and November 1
(six months later) of each year during the life of the bond. Also, on May 1, 2010, the bond
matures and the holder receives the last $50 interest payment plus the repayment of the $1,000
face value.

The bond market trades all long-term debt securities issued by corporations and all levels of
governments. As with the money market, the bond market is not a physical location, but a
communication network called the over the counter (OTC) market. Bond dealers quote bid prices
(what they will buy a bond at) and ask prices (what they will sell a bond at); price quotes appear
daily in most financial newspapers. Market prices at which bonds trade may be higher or lower
than a bond’s face value, and are determined by current prevailing interest rates in relation to the
bond’s coupon rate and the maturity of the bond.

___________________________________________________________________________________________________ 12
Financial Management 1 _
Common and Preferred Shares (Equity)

Preferred shares have a stated dividend rate (just as bonds have a stated, fixed coupon
rate), but the preferred dividend is not a contractual obligation, and payment of the
preferred dividend may be omitted without legal ramifications (usually to be repaid later).
This payment flexibility for the borrower is an attractive feature of using preferred shares
rather than bonds. However, because payments on preferred shares are classified as
dividends, they are not an allowable tax expense to the firm (as bond interest payments
are).

Unlike preferred shares, the common shares dividend is not fixed, and can be varied (up
or down) at any time by the firm’s board of directors. Common shareholders need not
approve any common shares dividend changes and dividends may be paid typically on a
quarterly basis.

LEARNING ACTIVITY 1.2

Activity Topic

Instructions:
TASK A (Knowledge gathering): Integrative Case – Merit Enterprise Corp.
Read the Integrative Case 1, Merit Enterprise Corp.

Merit Enterprise Corp. Sara Lehn, chief financial officer of Merit Enterprise Corp.,
was reviewing her presentation one last time before her upcoming meeting with the
board of directors. Merit’s business had been brisk for the last 2 years, and the
company’s CEO was pushing for a dramatic expansion of Merit’s production capacity.
Executing the CEO’s plans would require $4 billion in capital in addition to $2 billion
in excess cash that the firm had built up. Sara’s immediate task was to brief the board
on options for raising the needed $4 billion. Unlike most companies its size, Merit had
maintained its status as a private company, financing its growth by reinvesting profits
and, when necessary, borrowing from banks. Whether Merit could follow that same
strategy to raise the $4 billion necessary to expand at the pace envisioned by the firm’s
CEO was uncertain, although it seemed unlikely to Sara. She had identified the
following two options for the board to consider.

Option 1: Merit could approach JPMorgan Chase, a bank that had served Merit well
for many years with seasonal credit lines as well as medium-term loans. Lehn believed
that JPMorgan was unlikely to make a $4 billion loan to Merit on its own, but it could
probably gather a group of banks together to make a loan of this magnitude. However,
the banks would undoubtedly demand that Merit limit further borrowing and provide
JPMorgan with periodic financial disclosures so that it could monitor Merit’s
financial condition as Merit expanded its operations.

___________________________________________________________________________________________________ 13
Financial Management 1 _
 Option 2: Merit could convert to public ownership, issuing stock to the public in the
primary market. With Merit’s excellent financial performance in recent years, Sara
thought that its stock could command a high price in the market and that many
investors would want to participate in any stock offering that Merit conducted.
Becoming a public company would also allow Merit, for the first time, to offer
employees compensation in the form of stock or stock options, thereby creating
stronger incentives for employees to help the firm succeed. On the other hand, Sara
knew that public companies faced extensive disclosure requirements and other
regulations that Merit had never had to confront as a private firm. Furthermore, with
stock trading in the secondary market, who knew what kind of individuals or
institutions might wind up holding a large chunk of Merit stock?
Available at: http://essayscollection.com/view_paper/id/1364035

Task B (Active Learning)

In a Discussion forum, Answer the following questions about the case and share
your responses with your peers in the Discussion Forum and critique what they have
written in the relevant discussion forum. Refer to the literature you have read when
you make your critique.

TO DO
a. Discuss the pros and cons of option 1, and prioritize your thoughts. What are the
most positive aspects of this option, and what are the biggest drawbacks?

b. Do the same for option 2.

c. Which option do you think that Sara should recommend to the board, and why?

Session 1.1 Summary

This session examined the key features of securities traded in the money and capital
markets and looked at how security exchanges facilitate the trade process.

Unit 1 Summary

This Unit provided a foundation to finance and the financial markets. We described the
functions of the financial executive and why they are important towards the goal of wealth
maximization of the firm. We then examined the various classification of financial markets
and finally the types of securities which are traded in those markets.

In Unit two, we will discuss financial statement analysis.

___________________________________________________________________________________________________ 14
Financial Management 1 _
References
Parrino,,R. & Kidwell, D. (2009). Fundamentals of Corporate Finance. Wiley

___________________________________________________________________________________________________ 15
Financial Management 1 _