Overview of Finance

Module 1
Singapore
20 September 2022

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Your Role in This Class

§ Be present, proactive and engaged

§ Don’t be a wallflower – have a presence in the room
§ People need to remember you – professors, classmates,
interviewers, recruiters, colleagues, bosses and clients

§ Learn actively and be curious – try to think about, or ideally ask, at least
two questions during the class discussion

§ Question me as the instructor – I want to be challenged; I’m learning too

§ Apply what you learn immediately – knowledge can be highly perishable

until you build a solid foundation and skill set

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Overview of Finance
Module Outline

§ Introduction to finance

§ Corporate financial management

§ Business entities

§ Stocks and bonds

§ Financial markets

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Financial Markets Ecosystem

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Why Corporate Finance?
Corporate finance mainly addresses the following questions

§ How does a company evaluate investment options and which projects should
they pursue to maximize the firm’s value

§ How should a firm deal with material changes in liquidity, either a cash
shortage or excess cash flows?

§ How much cash (liquidity) does the company need to meet its current and
future obligations, whether contractual or discretionary?

§ How can the firm raise capital for required investments, projects and other
capital expenditures?

§ What will be the financing costs those activities?

§ How will those activities be finance, with debt or equity and from which
sources?

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Corporate Finance Framework
We will approach our study under some key assumptions

§ The ”firm” can be a publicly or private entity but its existence and survival is
based on creating and increasing value to its shareholders

§ Our framework may not apply to non-profits, NGOs, government entities

and in many cases government-owned/nationalized companies

§ We will assume creating value means ultimately generating more cash than the
firm consumes

§ Firms try to generate excess cash flow by making intelligent and informed (i)
investment decisions and (ii) financing decisions

§ The size, timing and risk of the cash flows should all be evaluated and
considered

§ Risk is typically manifested in the cost of capital

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 Maximizing Firm Value
Three pillars of value maximization

Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as welll current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities

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Business Entities – Sole Proprietorship
Business owned by a single person

§ Cheapest and fastest entity to form

§ No formal charter, few government regulations or requirements

§ No corporate tax – all profits are taxed as individual income

§ Unlimited liability – no distinction between personal and business assets

§ Limited life – the entity dies with the individual

§ Capital provided by individual’s own wealth or personal loans

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Business Entities – Partnership
Business organization formed by two or more individuals
Two types of partnerships

§ General Partnership (“GP”)– each partner is liable for debt of the firm

§ Partnership is terminated when a partner dies or withdraws their interest

§ Maintains management control

§ Limited Partnership (“LP”) – certain partners have limited liability, usually

limited to their own contribution to the partnership

§ LPs’ interest may be sold and transferred to another party

§ No management role

§ No formal charter, few government regulations or requirements

§ No corporate tax – all profits are taxed as individual income to the partners

§ Capital provided by partners based on ability and desire to participate in the

partnership

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Business Entities – Corporation
A “legal person” registered by individuals or other legal entities

§ Slower, more expensive and more complicated entity to form; requires articles
of incorporation and bylaws

§ In its simplest form, the corporation has three major stakeholders

§ Shareholders (owners)

§ Board of Directors (governance)

§ Management (leadership and execution)

§ Taxed at the corporate level

§ Limited liability with unlimited life

§ Ownership is easily transferred

§ Greater access to outside capital and alternative funding sources

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Financial Management in a Firm

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Debt vs. Equity
Two basic financing options

§ Firms can borrow money from creditors in the form of loans or bonds (debt)
§ Contractual obligation to pay interest and principal during the term of the credit agreement

§ Financial leverage refers to the use of debt in the firm’s capital structure as it acts as a lever
that can magnify returns to equity, for example, when purchasing a home

§ Firms can accept money from investors (sell stock) in exchange for an
ownership stake in the firm (equity)

§ Debt and equity comprise a firm’s capital structure and can be represented by
the Balance Sheet Identity, Assets (A) ≡ Liabilities (L) + Shareholder’s Equity
(SE), where SE is a plug

§ Because of this relationship, equity is known as a residual claim, meaning shareholders

have an unlimited claim to any remaining firm value, net of the debt

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Debt vs. Equity
Comparison
Debt Equity
Bank loans,
Security Stock
Bonds

Governments and
Issuer Corporations
corporations

Contractually fixed Capital appreciation and/or

Payment to investors
(interest and principal) dividends

Maturity Fixed, finite life None

Tax treatment Tax-advantaged Not tax-advantaged

No
Yes
Control (only in bankruptcy
(Board of directors and voting rights)
proceedings)
Seniority High Low/Last
(Liquidation) (senior claimants) (residual claimants)

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Valuing the Firm
Corporate securities as contingent claims on firm value
§ Firm value or Total Enterprise Value (“TEV” or “EV”) is directly related to contingent
claims capital providers have on the firm such that:

Total Enterprise Value (TEV) ≡ Market Value of Equity (MVE) + Debt (D)

§ Because creditors have fixed, finite, contractual claims against the assets of the
firm, this is usually the easiest and most straight forward part of a firm’s TEV
§ Claims to equity providers are contingent on creditors receiving all of their
principal and interest first, therefore equity is a residual claim – it only has
value after creditors are paid:
MEV ≡ TEV – Debt
§ If TEV < creditor’s claims (debt), then the value of the equity is zero.
§ Because of this relationship, firm valuation is really an exercise in valuing the
equity claims

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Debt Capital Markets (“DCM”)
DCM dominates global capital markets
§ Capital markets are broken down into the debt market and the equity market.
The global market for debt is HUGE, significantly outweighing the equity
market:

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Types of Bonds
Government bonds, aka Sovereign debt
§ One of the most important bonds in the global DCM is sovereign debt issued by
countries. Sovereign debt is considered to be very liquid (relatively easily
traded) and to be “risk-free”

§ “Risk-free” really means default-free, since governments should always be

able to pay the bond’s interest and principal by either (i) raising taxes, (ii)
printing more money, or (iii) doing both

§ Despite this, there is a long history of countries defaulting on their debt

§ https://en.wikipedia.org/wiki/List_of_sovereign_debt_crises

§ Because of the “risk-free” nature of sovereign debt, it is typically used as a

benchmark for pricing all other securities, debt and equity(1), and is known as
the risk-free rate

(1)Whileequity securities do not have an explicit cost, they are priced implicitly by investors based on the perceived risk of the investment and their
subordination to any debt in the capital structure. 16
Sovereign Debt – An Example
US Treasuries Securities
§ Sovereign bond pricing varies according to the issuer (country) and maturity, for
example

US Treasury Security Characteristics

§ Short-term, non-interesting bearing (zero-coupon)

Treasury Bills § Purchased at a discount to face value (par) and paid face value
(“T-Bills”) at maturity
§ Maturities of days, four weeks, 13 weeks, 26 weeks and 52 weeks

§ Medium-term, fixed-interest paid semi-annually

§ Maturities of two, three, five, seven and 10 years
Treasury Notes
§ “The 10-year” can refer to the 10-year note or the current interest
(“T-Notes” or “The 10-year” for
rate on the 10-year note
the 10-year note)
§ “The 10-year” is a closely watched interest rate as it is used a proxy
for US mortgage rates and a barometer on the US economy

Treasury Bonds
§ Long-term, fixed-interest paid semi-annually
(“T-Bonds” or “The Long Bond”
§ Maturities longer than 10 years; longest maturity of 30 years
for the 30-year bond)

See https://en.wikipedia.org/wiki/List_of_government_bonds for a list of government bonds

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Pricing Sovereign Debt
How is the price of government debt determined?

§ While the investors ultimately determine prices, governments have three

principal tools to influence the market

§ Conduct open market operations which is the buying and selling of

government securities

§ Adjust commercial banks’ reserve requirements which set the amount

of funds that they must keep on hand, impacting the amount of capital
available for lending

§ Change the interest rate that the central bank charges to commercial
bank for borrowing short-term funds

§ However, all this must be pursued within the parameters of a country’s targets
for inflation, unemployment and foreign currency exchange rates – not easy
and often times internally conflicting

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Corporate Bonds
Public and private company debt
§ The price of corporate debt is based on the risk-free rate with adjustments made for

§ Default risk – the likelihood of not being able to pay interest and principal in the
future

§ Liquidity, both cash flow at the company level and the ability for investors to
buy and sell the debt

§ Tax status

§ Maturity

§ Special features

§ Callability
§ Convertibility
§ Equity kickers

§ The difference between the yield on the security and the risk-free rate is know
as the risk premium or credit spread

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Role of Rating Agencies
Investment grade vs. high-yield
§ Investors often look to credit rating agencies such as Standard & Poor’s (S&P),
Moody’s, and Fitch to help them assess the creditworthiness of an entity’s debt
which in turn impacts pricing

§ Rating agencies perform internal credit analysis to measure the riskiness of the
debt and monitor development that could improve or deteriorate the existing
rating

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Equity (Stock)
Represents ownership in a firm
§ Shareholders are owners in a firm and their ownership is represented by stock
certificates

§ The claim is residual, meaning creditors have a first priority claim over any
assets of the firm

§ Stockholders realize return on capital through a combination of

§ Capital gains – selling your stock for a higher price than what was paid for
it, also known as capital appreciation, and

§ Dividends – a periodic or special distribution of excess cash on a pro rata

basis to existing shareholders

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Types of Equity
Common stock vs. preferred stock
§ Nominally, there are two types of stock: common shares and preferred shares.
Although preferred stock is is not legally debt, it is more like than debt than it is
equity

§ When considering the equity value of a company, preferred stock is treated as

debt

§ Although preferred stock is not a contractual obligation, preferred stock

investors are more concerned with current income and not necessarily
capital appreciation (current income is expected while capital appreciation
is not)

§ Preferred shareholders do not have the same voting rights as the common
stockholders

§ In a liquidation, preferred shares are senior (higher priority) to the

common

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Common Stock vs. Preferred Stock
Summary of Characteristics

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Equity Research
Analysts routinely value and monitor publicly-traded equities
§ Similar to debt ratings, equity research analysts provide investors with valuation
insights, monitoring and buy-sell recommendations

§ Analysts can work on the buy-side or the sell-side

§ Sell-side analysts work at investment banks and broker-dealers and are

making recommendations to clients and in most cases, the public at large.

§ Buy-side analysts work at asset managers such as mutual funds, large

institutional investors and mutual fund companies; their analysis and
recommendations are considered propriety and used by their own firms to
make investment decisions

§ Equity research reports are a good source for learning about a company or
industry and an excellent point of departure for conducting your own valuation
analysis

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