FINA1310 Lec1 Ho

FINA1310: Corporate Finance
Session 1: Introduction to Corporate Finance
Dr. Alexandr Kopytov

University of Hong Kong
Spring 2023
FINA 1310 Session 1: Introduction 1 / 51

I. Course Logistics

Instructor Info
▶ Name: Alexandr Kopytov

▶ PhD from the Wharton School of the University of Pennsylvania
▶ Office: KKL 912

▶ Office hours: Tuesdays 17:00 to 18:00 or by appointment
▶ Starting from January 31
▶ E-mail: akopytov@hku.hk
▶ Course website: HKU Moodle
▶ https://moodle.hku.hk/course/view.php?id=102823

TA Info
▶ There are two TAs for this course

▶ Antony Cheung, antonyc@hku.hk
▶ Chloe Li, chloe001@hku.hk
▶ Office hours: TBA

▶ Weekly tutorials (starting from the week of February 6)
▶ Detailed schedule TBA

Our Weekly Sessions
▶ Our classes are face-to-face

▶ Recordings of lectures and pdf lecture slides will be posted on Moodle
▶ Tutorial videos will be posted as well
▶ Lecture time
▶ Section J: Mondays, 9:30 to 12:20, KK201; Section K: Mondays, 14:30 to
17:20, CYCP1; Section L: Tuesdays, 13:30 to 16:20, MB217
▶ There will be a virtual live review session before the final

▶ Exact date/time TBA
▶ Office hours: Tuesdays 17:00 to 18:00 or by appointment

Course Assessments
▶ Homework assignments: 20%

▶ Four assignments
▶ Group based. Maximum group size is 4. You can form groups with people
from other sections. Deadline: February, 12. Try to form groups by yourselves
but if you have problems, let TAs or me know! NB: Once group is formed, it
cannot be changed
▶ Free riding: We will address this issue on the case-by-case basis.
▶ Will conduct anonymous assessments within groups
▶ If you are unhappy about your groupmates’ performance, let me know
early!
▶ Midterm: 20%
▶ Final: 55%
▶ Participation: 5%

Textbook
▶ “Fundamentals of Corporate Finance” by Ross, Westerfield, Jordan, Lim

and Tan, Asia Global Edition, Second Edition
▶ Other recent editions would work as well
▶ Financial calculator
▶ Strongly recommended but not required
▶ You can use one during midterm and final; please refer to
http://www.exam.hku.hk/pdf/list.of.cal 092020.pdf for the list of ap-
proved calculators
▶ Excel/programmable calculators are not allowed during the exams but are very
welcomed for the home assignments

How to Do Well in This Course
▶ Come and participate in classes weekly

▶ Recordings will be available but don’t do an overnight marathon before the
exam!
▶ Take notes during lectures: slides cannot fit everything and it will take a lot
of time to rewatch videos!
▶ Read the textbook after (or before) classes
▶ Textbook and lectures will not cover exactly same things!
▶ Review and discuss the material with your study group

▶ Work on assignments together
▶ ∗ Read business- and finance-focused press
▶ Wall Street Journal, Financial Times
▶ Podcasts are also good, e.g., Bloomberg Surveillance, the Journal
▶ Our course is mostly theoretical but all tools are widely used in practice

Course Overview
▶ Part 0: Introduction to Corporate Finance: Today!
▶ Chapter 1
▶ Part 1: Valuation
▶ Time value of money, discounted cash flow valuation, valuation of bonds and
stocks
▶ Chapters 5, 6, 7, 8
▶ Part 2: Capital Budgeting

▶ Real investment decisions
▶ Chapters 2, 9, 10, 11
▶ Part 3: Risk and Return

▶ Capital Asset Pricing Model, Security Market Line
▶ Chapters 12, 13
▶ Part 4: Cost of Capital and Financing Decisions

▶ Capital structure: Tradeoff between equity and debt, raising capital
▶ Chapters 14, 15, 16
Tentative Schedule
Week Topic Covered Deadlines
1: Jan 16–Jan 22 Introduction to corporate finance: Ch. 1
2: Jan 23–Jan 29 Lunar New Year, no classes
3: Jan 30–Feb 5 Time value of money: Ch. 5
4: Feb 6–Feb 12 Discounted cash flow valuation: Ch. 6 Tutorials; HA groups
5: Feb 13–Feb 19 Bond valuation: Ch. 7
6: Feb 20–Feb 26 Stock valuation: Ch. 8 HA1
7: Feb 27–Mar 5 Investment criteria: Ch. 9
8: Mar 6–Mar 12 Reading week, no classes HA2
9: Mar 13–Mar 19 Midterm week, no classes Midterm: weeks 1–7
10: Mar 20–Mar 26 Capital investment decisions: Ch. 10, 2
11: Mar 27–Apr 02 Project evaluation: Ch. 11
12: Apr 03–Apr 09 Risk and return: Ch. 12 HA3
13: Apr 10–Apr 16 CAPM and SML: Ch. 13
14: Apr 17–Apr 23 Cost of capital: Ch. 14
15: Apr 24–Apr 30 Capital structure and raising capital: Ch. 16, 15 HA4
May 01–May 07 Revision period Review session
Final will be held during the assessment period, May 8–May 23
II. Overview of Corporate Finance
Source: glassdoor.com.hk

Source: efinancialcareers.com

What Is Corporate Finance?
▶ Wikipedia: “Corporate finance is the area of finance that deals with

sources of funding, the capital structure of corporations, the actions
that managers take to increase the value of the firm to the shareholders,
and the tools and analysis used to allocate financial resources. The
primary goal of corporate finance is to maximize or increase shareholder
value.”
▶ Our goal of this course: Understand this definition!
▶ Majority of concepts are intuitive but there are nuances
▶ The devil is in the detail!

What Is Finance ?
▶ Wikipedia: “Finance is a term for matters regarding the management,
creation, and study of money and investments.”
▶ Too general...
Social sciences
Economics
Finance
Corporate Household Financial Market

Asset Pricing
Finance Finance Intermediation Microstructure

What Is Corporate Finance: Dissecting the Definition
▶ Wikipedia: “Corporate finance is the area of finance that deals with

sources of funding, the capital structure of corporations, the actions
that managers take to increase the value of the firm to the shareholders,
and the tools and analysis used to allocate financial resources. The
primary goal of corporate finance is to maximize or increase shareholder
value.”
▶ Someone is making certain decisions to achieve something...
▶ Who?
▶ What decisions?
▶ What is the goal?

Roadmap
▶ What is corporate finance?

▶ Decision makers in finance
▶ Forms of business organizations
▶ Financial decisions of corporations

▶ Role of financial manager
▶ Agency problems
▶ Financial markets

Decision Makers in Finance
▶ Individuals
▶ Consumption, savings, portfolio allocation
▶ Business organizations
▶ Investments, financing (capital structure), day-to-day financial activity
▶ Government
▶ Regulations, taxes
▶ This course focuses on business organizations, but main principles can

be applied very broadly

Types of Business Organizations
▶ Sole Proprietorships
▶ Partnerships
▶ Corporations (Limited Liability Companies in HK)

▶ Focus of corporate finance
▶ HK: branch of a foreign company

Which Form is Best: Important Factors
▶ Cost of creating
▶ Owners’ liability
▶ Organization’s continuity and ownership transfer
▶ Access to external capital
▶ Control of decisions
▶ Regulations (especially taxation)

Sole Proprietorships
▶ Business owned by one person

▶ Many large businesses started as sole proprietorships
▶ Coca-Cola was once a sole proprietorship (more than 130 years ago)
Advantages Disadvantages
▶ Easiest to start ▶ Limited to owner’s life
▶ Least regulation, simple accounting ▶ Capital is limited to owner’s wealth
▶ Taxed once as personal income ▶ Hard to transfer ownership
▶ No need to argue with others ▶ Unlimited liability
▶ Is it always a plus? ▶ Personal assets can be seized to
repay debts

HK individual tax return form
▶ Same form for salary tax (Part 4)

Partnerships
▶ Business formed by two or more individuals

▶ Partnership agreement describes how gains and losses are divided
▶ Many famous firms are partnerships
▶ Deacons (oldest HK law firm), Ernst & Young, Bloomberg L.P.
▶ Relatively easy to start ▶ Unlimited liability
▶ Taxed once as personal income ▶ Dissolves when one partner
▶ More capital available dies/wishes to exit
▶ Hard to transfer ownership

Partnership: General vs Limited
▶ General partnership
▶ All partners run business and have unlimited liability
▶ Limited partnership: general and limited partners

▶ Limited partners do not manage the business, have limited liability, can
transfer ownership
▶ Limited partners increase the amount of available capital

Corporations I
▶ Most important form of business organizations (in terms of size)

▶ Apple, Tesla, Tencent, Cathay Pacific, Manchester United
▶ Corporation is a distinct legal entity separate from its owners (aka

shareholders or stockholders)
▶ From corpus, the Latin word for body; Roman law recognized a range of
corporate entities as separate legal bodies
▶ Can borrow money, own property, enter into contracts, etc.
▶ Can be a general or limited partner in a partnership
▶ Harder to start
▶ Articles of incorporation: name, business purpose, number of shares
that can be issued, etc.
▶ Bylaws: rules of corporation’s self-regulation

Corporations II
▶ Owners’ limited liability ▶ Harder to start, more regulated
▶ Unlimited life ▶ Separation of management and
▶ Easier access to capital ownership
▶ Double taxation (profits and
▶ Easy to transfer ownership
dividends)
▶ Separation of management and ▶ Not in HK and Singapore!
▶ But true for Mainland China, USA,
ownership
and majority of other countries
▶ Why separation of management and ownership can be good and bad

at the same time?

Business Organizations: Summary
Sole Proprietorship Partnership Corporation
Costs to Low Relatively low High

set up/run
Life span Limited to life of Limited to life of Unlimited

owner general partners
Liability Unlimited Unlimited for gen- Limited

eral partners
Access to Difficult Relatively difficult Relatively easy

capital
Ownership Difficult Difficult (easier for Relatively easy

transfer limited partnerships)

Roadmap


▶ Agency problems

Financial Decisions of Corporations
▶ Capital budgeting: Which long-term investments to undertake?
▶ Financing: How to finance investments?

▶ Capital structure choice: Debt vs Equity
▶ Working capital management: Day-to-day liquidity management

▶ Make sure the firm does not run out of cash

Financial Decisions of Corporations: Scheme
2 1
Corporate Financial
4 Investors
Operations Manager
3 5
▶ 1: Cash raised from investors (debt and equity)

▶ 2: Cash invested in real assets (tangible and intangible)
▶ 3: Cash generated by operations
▶ 4: Cash reinvested
▶ 5: Cash paid out to investors (interest, dividends)

Financial Decisions of Corporations: Another Scheme
Current Liabilities
(to be paid in < 1 year)
Current Assets
(cash in < 1 year)
Long-Term Debt
(to be paid in > 1 year)
Fixed Assets
(long-lived assets)
Equity

Capital Budgeting
▶ What long-term investments should the firm undertake?
Current Liabilities
Current Assets
(cash in < 1 year)
Long-Term Debt
Fixed Assets
(long-lived assets)
Equity

Capital Budgeting: Examples
▶ Goal: find long-term opportunities that will generate cash flows

exceeding the costs of investment
▶ Tangible assets: machinery, buildings, land, vehicles...
▶ HKU’s KKL Building; a new Pokfield Road Building (Is it worth it?
Let’s hope so!)
▶ Intangible assets: patents, copyrights, brands, trademarks

▶ HKU Business School’s logo

How to Finance Investment: Capital Structure
▶ Long-term financing: how and where to raise money?
▶ Debt vs Equity
Current Liabilities
Current Assets
(cash in < 1 year)
Long-Term Debt
Fixed Assets
(long-lived assets)
Equity

Capital Structure
▶ Optimal mixture of debt and equity
▶ Will discuss pros and cons of debt and equity later in the course
▶ Equity: selling firm’s shares (i.e., ownership stakes)

▶ Initial Public Offerings (IPOs): HK is traditionally one of the biggest IPO
markets in the world (top 1 in 2019; top 2 in 2020 and 2021 behind Nasdaq;
top 3 in 2022 behind Shanghai and Shenzhen)
▶ Debt: borrowing from creditors with pre-specified conditions (no own-

ership rights)
▶ Bank borrowing
▶ Bond issuance: MTR sold 1.2 USD billion green bond in 2020

Working Capital Management
▶ How should short-term assets be managed and financed?
Current Liabilities
Current Assets
(cash in < 1 year)
Net Working
Capital Long-Term Debt
Fixed Assets
(long-lived assets)
Equity
Net Working Capital = Current Assets − Current Liabilities

Working Capital Management
▶ Current Assets: Cash, accounts receivable, inventories
▶ Current Liabilities: Accounts payable, interest payable, taxes payable
Net Working Capital = Current Assets − Current Liabilities
▶ NWC can be negative! If so, firms might have problems with liquidity
▶ Important for banks
▶ If many depositors show up at once, banks might run out of cash
▶ Even if loan portfolio is good, it might be hard to liquidate it quickly
▶ Bank runs

Financial Decisions of Corporations: Summary
▶ Capital budgeting: Which long-term investments to undertake?
▶ Financing: How to finance investments?

▶ Capital structure choice: Debt vs Equity
▶ Working capital management: Day-to-day liquidity management

▶ Make sure the firm does not run out of cash
▶ These decisions are not independent of each other!

Roadmap


▶ Agency problems

Goal of Financial Management
▶ Question: What should be the goal of financial manager? As a share-
holder, what do you want your financial manager to do?
1. Maximize profits?
▶ Now or later? Can just sell all valuable assets right now...
2. Reduce risk?
▶ Do nothing is safest
3. Maximize investment and company’s asset size?

▶ Purchase tons of useless stuff
4. Maximize current market value

▶ Current market value reflects present value of all future cash flow, ad-
justed for risk
▶ Requires quite a lot from the market price!
▶ Maximizing market value means maximizing shareholders’ wealth
5. Other considerations?
▶ Do shareholders only care about money?
Management of Corporations
▶ Management of corporations is complicated and requires expertise

▶ Normally, corporation owners (shareholders) employ managers to rep-
resent their interest and make decisions on their behalf
▶ The top financial manager within a firm is usually the Chief Financial
Officer (CFO)
▶ Treasurer oversees cash and credit management, capital expenditures
and financing planning
▶ Controller oversees taxes, financial and cost accounting and data
processing

Ownership and Management Separation: Agency Problem
▶ Ownership and management are normally separated in corporations

▶ Advantages:
▶ Managers’ specialization and expertise
▶ Delegation allows shareholders to invest in many firms
▶ Ideally, managers (agents) should work in the interest of owners (prin-

cipals)
▶ Unfortunately, sometimes (or often?) it is not the case ⇒ Agency
problem
▶ Direct agency costs: Perks (private jets), cost of monitoring (auditing)
▶ Indirect: Missed investment opportunities/bad investment choices

Bad Managers: Few Examples
▶ Elisabeth Holmes, founder and CEO of Theranos.
▶ Theranos claimed to devise rapid and accurate

blood tests that require minimal amounts of
blood; raised $700 million from private investors;
was valued at $10 billion in 2014.
▶ Multiple episodes of fraud, including creating a
fake lab for the visit of then US Vice President
Biden. Fake it until you make it?
▶ In March 2018 the US Securities and Exchange
Commission filed fraud charges against Theranos,
Elizabeth Holmes and Ramesh Balwani, claiming
they had “deceived investors into believing that
its key product—a portable blood analyzer—could
conduct comprehensive blood tests from finger
drops of blood”.
▶ Holmes was sentenced to 11 years and 3 months
in prison for fraud. Ramesh Balwani, COO, was
sentenced to 12 years and 11 months.

▶ Trevor Milton, founder and CEO of Nikola Corporation (Tesla was already taken).
▶ Manufacturer of heavy-duty electric vehicles and fuel-cell electric vehicles.
▶ Went public in June 2020; at its peak was valued higher than Ford.
▶ As with Theranos, there were multiple episodes of fraud. The infamous one is a
promotional video on YouTube in which Nikola’s “hydrogen-powered” lorry rolled
downhill rather than moving under its own power.
▶ “Trevor Milton lied to Nikola’s investors—over and over and over again. That’s
fraud, plain and simple,” said Damien Williams, the US Attorney for the Southern
District of New York.
Nikola: Stock price
▶ In July 2021, a US federal grand jury returned an indictment against Trevor Milton
that included three counts of securities fraud and wire fraud. In June 2022, Milton
was charged with an additional wire fraud charge. In October 2022 the jury found
Milton guilty on one count of securities fraud and two counts of wire fraud.
▶ WSJ’s podcast Bad Bets (Season 2) covers the story. Highly recommended!

▶ Forbes: “No longer content with the corner

office or the penthouse in hues of teakwood,
former Merrill Lynch CEO John Thain, whose
tenure drove Merrill Lynch to lose $15 billion in
the fourth quarter of 2009, spent $1,405 on a
trash can. As his company was eliminating jobs,
a newly acquired $87,000 rug graced the floor
of his office.”
▶ Forbes: “Thain had pushed through $3.62 bil-
lion in bonuses for his Merger executives in De-
cember, as the merger was occurring, rather
than waiting until January as usual. Then in
January it emerged that Merrill had lost $21.5
billion in the fourth quarter of 2008.”

Managing managers
▶ Managerial compensation: contractual incentives to align manage-

ment and shareholder interests
▶ Stock options: Valuable if stock prices are high
▶ Corporate control
▶ Shareholders vote to elect board of directors which can fire a bad man-
ager
▶ Proxy fights: unhappy shareholders can fight to replace bad management
by obtaining the authority to use someone else’s voting rights
▶ Takeovers: badly managed firms are cheap and are attractive acquisition
targets
▶ Monitoring: audits, mandatory reports, etc.

Roadmap


▶ Agency problems

Financial Markets
▶ Financial markets bring together buyers and sellers of financial assets

▶ Improve allocation of capital and risk
▶ Market prices reflect information about asset’s risks and cash flows
2 1
Corporate Financial
4 Investors
Operations Manager
3 5

Types of Financial Markets
▶ Primary vs Secondary markets

▶ Primary: new issues of securities are sold to the public (IPOs)
▶ Secondary: already issued securities are traded
▶ Exchange vs Over-the-counter markets

▶ Exchange: buyers and sellers meet in one central location (physical or
electronic) to trade (SEHK, NYSE, TSE, etc.)
▶ OTC: various intermediaries at different locations trade with investors
▶ Money vs Capital markets

▶ Money: short-term debt (less than 1-year maturity)
▶ Capital: long-term debt and equity

Roadmap


▶ Agency problems
▶ Next time: Time value of money (Chapter 5)

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FINA1310: Corporate Finance

Session 1: Introduction to Corporate Finance

Dr. Alexandr Kopytov

FINA 1310 Session 1: Introduction 1 / 51

FINA 1310 Session 1: Introduction 2 / 51

▶ Name: Alexandr Kopytov

▶ Office: KKL 912

FINA 1310 Session 1: Introduction 3 / 51

▶ There are two TAs for this course

▶ Office hours: TBA

FINA 1310 Session 1: Introduction 4 / 51

▶ Our classes are face-to-face

▶ There will be a virtual live review session before the final

▶ Office hours: Tuesdays 17:00 to 18:00 or by appointment

FINA 1310 Session 1: Introduction 5 / 51

▶ Homework assignments: 20%

FINA 1310 Session 1: Introduction 6 / 51

▶ “Fundamentals of Corporate Finance” by Ross, Westerfield, Jordan, Lim

FINA 1310 Session 1: Introduction 7 / 51

▶ Come and participate in classes weekly

▶ Review and discuss the material with your study group

FINA 1310 Session 1: Introduction 8 / 51

▶ Part 2: Capital Budgeting

▶ Part 3: Risk and Return

▶ Part 4: Cost of Capital and Financing Decisions

FINA 1310 Session 1: Introduction 11 / 51

FINA 1310 Session 1: Introduction 12 / 51

▶ Wikipedia: “Corporate finance is the area of finance that deals with

FINA 1310 Session 1: Introduction 13 / 51

Corporate Household Financial Market

FINA 1310 Session 1: Introduction 14 / 51

▶ Wikipedia: “Corporate finance is the area of finance that deals with

FINA 1310 Session 1: Introduction 15 / 51

▶ What is corporate finance?

▶ Financial decisions of corporations

FINA 1310 Session 1: Introduction 16 / 51

▶ This course focuses on business organizations, but main principles can

FINA 1310 Session 1: Introduction 17 / 51

▶ Corporations (Limited Liability Companies in HK)

▶ HK: branch of a foreign company

FINA 1310 Session 1: Introduction 18 / 51

▶ Organization’s continuity and ownership transfer

▶ Access to external capital

▶ Regulations (especially taxation)

FINA 1310 Session 1: Introduction 19 / 51

▶ Business owned by one person

FINA 1310 Session 1: Introduction 20 / 51

FINA 1310 Session 1: Introduction 21 / 51

▶ Business formed by two or more individuals

FINA 1310 Session 1: Introduction 22 / 51

▶ Limited partnership: general and limited partners

FINA 1310 Session 1: Introduction 23 / 51

▶ Most important form of business organizations (in terms of size)

▶ Corporation is a distinct legal entity separate from its owners (aka

FINA 1310 Session 1: Introduction 25 / 51

▶ Why separation of management and ownership can be good and bad

FINA 1310 Session 1: Introduction 26 / 51

Sole Proprietorship Partnership Corporation

Costs to Low Relatively low High

Life span Limited to life of Limited to life of Unlimited

Liability Unlimited Unlimited for gen- Limited

Access to Difficult Relatively difficult Relatively easy