Textbook Chapters 1, 2 & 3. Introduction to financial management We recommend that you commence your study of this subject by considering the objectives of financial management in the context of a firm. There may be many objectives, but with a single overarching goal: to maximise the wealth of the firm's owners. The goal of financial management Financial management is a line management function concerned with creating, preserving and maximising wealth. More specifically, the goal of financial management is to maximise the wealth of the firm's owners. The form of that ownership will, of course, depend on the organisational form of the firm: sole proprietorship, partnership or company. The owners of a company are its shareholders. From the shareholders' point of view, a good financial management decision is one that increases their wealth, (i.e. dividends and capital gains). Thus, the goal of corporate financial management is to maximise share price and we should expect most corporate financial management decisions to be made with that goal in mind. Wealth maximisation versus profit maximisation Financial management is a line management function involving the management of real resources (especially cash) with a view to maximising shareholders' wealth. By comparison, accounting is a service function involving data processing with a view to calculating and reporting accounting profit and other financial information. These are two different functions, with different objectives. Wealth maximisation is not the same as maximising accounting profit. Maximising accounting profit may be regarded as an inferior goal to wealth maximisation for a number of reasons. In particular, accounting profits: 1. are rarely the same as cash flows; 2. do not take into account the timing of cash flows or the time value of money; 3. ignore the risk associated with cash flows; 4. are open to abuse by management changing accounting policies: i.e. accounting profits can be changed simply by changing the accounting method; 5. are based on historical data and ignore the present value effects of future opportunities and expectations. By comparison, wealth, as measured in terms of current market capitalisation (i.e. current share price multiplied by the number of issued shares), reflects both the cash flow consequences of past decisions, plus the present value of expected future cash flows. In this sense wealth maximisation is an all-inclusive goal. The emphasis is on cash flows and market capitalisation because investing in a company (by buying shares) involves spending cash in the expectation of receiving future cash flows in the form of dividends and capital gains. From the company's point of view, cash is required for paying dividends and financing new investments. History has demonstrated the superiority of cash flow and net wealth over accounting profits as measures of business viability. For example, some companies have reported accounting profits and still failed because they had insufficient cash to fulfil their obligations. The global financial crisis (GFC) of 2008 provides several examples of this, such as the American bank Lehman Brothers, which failed in September of that year. None of the foregoing should be interpreted to mean that profits are unimportant: they are! Reported profits are always the focus of attention, ahead of reported cash flows, and companies customarily only pay dividends out of profits (whether current or retained). Note, however, that with effect from 28 June 2010 the ability of a company to pay dividends is subject to a solvency-based test, as opposed to a profits-based test: see the Corporations Amendment (Corporations Reporting Reform) Act 2010. Review Questions Review your understanding of wealth maximisation versus profit maximisation by attempting the following review questions: 1. What are some of the problems involved in the use of profit maximisation as the goal of the firm? How does the goal of maximisation of shareholder wealth deal with those problems? 2. Firms often involve themselves in projects that do not result directly in profits; e.g. by supporting sporting events and the arts. Do these projects contradict the goal of maximisation of shareholder wealth? Suggested solutions to these questions can be accessed by clicking on this link Three key decisions of corporate financial management In the corporate world, it is sometimes said that the key decisions of financial management relate to investment, financing, and dividend policy. The criterion for evaluating the merit of each of these decisions is the same. Each must contribute towards achieving the principal goal of corporate financial management: maximisation of shareholder wealth. The investment decision seeks to identify those investments most likely to add value. The financing decision is concerned with sourcing funds at the lowest possible cost. The dividend decision involves determining the best division of profit between (i) distribution to shareholders in the form of dividends, and (ii) retention by the company for reinvestment. Each of these decisions is discussed briefly below: Investment decision The investment decision involves deciding what assets a firm should invest in. Because capital tends to be limited and because assets will often be projects, the terms capital budgeting and project evaluation are frequently used to describe the process of investment decision-making. The basic objective of the investment decision is to invest in assets that will proportionately increase investor wealth by the greatest amount. Alternative investments need to be evaluated in terms of the net present value of their expected net cash flows; i.e. expected cash inflows less expected cash outflows. Important characteristics of expected net cash flows are their size, timing, duration and risk. An important characteristic of the asset that will generate those cash flows is its liquidity; i.e. the ease with which it can be converted back into cash should the need arise. The required rate of return that an investor will seek from an investment will be influenced by its liquidity and the timing, duration and risk of its expected net cash flows. Required rates of return will also be influenced by investors' opportunity cost of capital; i.e. the rate of return that investors would expect to earn by forgoing a particular investment in favour of the best available alternative. The opportunity cost of capital for an individual with credit card debt is likely to be the interest cost of that debt, which could be at least 16% pa. In such cases it would be illogical for the cardholder to invest in any project expected to yield a return of less than 16% (i.e. the investor's opportunity cost of capital). A similar logic can be applied to all investment decisions. As an example of an investment decision, consider a car manufacturer planning to expand by opening a new manufacturing plant. Associated cash outflows would be the costs incurred in acquiring and using the additional resources required for manufacturing the cars. Such resources would include property, plant and equipment, raw materials and labour. Associated cash inflows would be revenues earned from increased sales. In making the investment decision, the manufacturer would need to consider the amounts, risk, timing and duration of the net cash flows expected to be generated by the expansion project, and the calculated impact of those cash flows on the firm's net worth. In later topics in this subject we will learn how to calculate the present and future values of expected cash flows. For the time being we should appreciate that assets evaluated in an investment decision may include both real and financial assets. Real assets include tangible assets such as property, plant, equipment and inventory, and intangible assets such as goodwill, patents and copyrights. Financial assets include cash and financial instruments such as bills of exchange, promissory notes, certificates of deposit, debentures, bonds and shares. Financing decision Continuing with the previous example; if the decision is made to invest in new car manufacturing plant, the manufacturer must decide how that investment is to be financed. Sources of finance may be either internal or external, or a combination of both. Internal sources include cash on hand and cash that can be obtained by liquidating existing assets. External sources include lenders (i.e. debt), investors (i.e. equity) and lessors (who provide finance in the form of financial leases). The objective of the financing decision is to obtain finance at the lowest cost, while maintaining an appropriate balance between debt and equity. (Excessively high debt-equity ratios increase the financial risk borne by shareholders – a topic covered later in this subject.) Dividend decision The finance manager must decide (or at least recommend) the extent to which profits should be retained for reinvesting, or paid to shareholders in the form of dividends. As retained profits reduce the need for external financing, the dividend decision is often considered to be part of the financing decision. We will be returning to these decisions throughout this subject. Cash flows We have observed that the investment decision involves analysing an investment's expected net cash flows and important aspects of such cash flows are their size, timing, duration and risk. We now briefly discuss each of those aspects. Cash flow size Information about a firm's past cash flows is readily obtainable from its published financial statements, but investment decisions involve analysing expected cash flows, the size and pattern of which may be difficult to forecast. Cash flow timing Cash flow timing refers to when cash flows actually occur. This is important because timing affects value. That is, a dollar received today is generally more valuable than a dollar received in the future. One reason for this is the presence of inflation. If prices rise over the coming year, with a given amount we can buy more today than a year later. In other words, a dollar today is worth more than a dollar in one year. This applies even without inflation. We assume that money has a time value (the 'time value of money') reflecting its opportunity cost. For example, cash in hand can be used to repay debt or deposited, lent or invested to earn a return. Cash flow duration Different investments will have different lives and therefore different durations of associated cash flows. The amounts, timing and duration of those cash flows will all impact on the value of an investment. Cash flow risk As we are dealing with the future, which is uncertain, we need to forecast the size, timing and duration of the cash flows that may be generated by an investment. In finance, risk and uncertainty are synonymous. Future cash flows are risky when they cannot be known with certainty. Investors generally are risk averse and therefore value less risky future cash flows more highly than more risky cash flows. This produces a direct relation between risk and required rates of return. Later in the subject we will examine how to measure the risk associated with cash flows and how to incorporate that risk into the investment decision. The agency problem The problems underpinning Agency Theory were first formally proposed by Berle and Means in their 1932 text 'The Modern Corporation and Private Property' where they argued that the modern corporation is characterised by "ownership of wealth without appreciable control and control of wealth without appreciable ownership" (1932, p.66). Shareholders (owners) of large companies do not usually have control (management) of their companies' daily operations. Instead, the shareholders employ managers who effectively control their companies' operations. This brings about an agency relationship in which managers (agents) make decisions on behalf of shareholders (principals). In such situations agents may not always act in the best interests of their principals. This is known as the agency problem. The problem of having another person act as agent in managing your affairs has long been recognised in economics literature. Adam Smith, the man often referred to as the father of economics, recognised the danger in his famous 1776 treatise 'The Wealth of Nations' where he pointed out that "being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own". Adolf A. Berle Michael C. Jensen Given that as shareholders we rely on others to manage our investment in a firm... How do we (owners) ensure that our workers (managers) are providing us their best effort? How do we ensure that people who are acting in an agency relationship will act in our best interest? These agency problems are developed and specified in perhaps the most cited economic-business research article of all time, Jensen and Meckling's "Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure" which was published in the Journal of Financial Economics in 1976. Jensen and Meckling argue that firms are made up of a web of contractual relationships amongst and between individuals. These agency relationships exist in and between employees/managers/Board of Directors/shareholders. An agency relationship gives rise to what is referred to as a fiduciary duty for the agent to act in the financial best interests of the person to whom they are acting as agent. William H. Meckling Agency costs Agency costs can be indirect or direct, as explained below. Indirect Indirect agency costs include opportunities that are not taken up by management, but would have been taken up by shareholders had they made the decision on their own behalf. For example, managers are assessing a very risky business project, one that could make or lose millions of dollars. If the project collapses the firm will become bankrupt. The managers will lose their jobs, as there will be no jobs to have. Therefore, the managers may decide not to go ahead with the project, because they are unwilling to take the risk of losing their jobs and livelihoods. However, the shareholders may have independent jobs and shares in other companies. Hence, their whole livelihoods are not tied to the success of this one company. That is, shareholders have diversified their risk, so the project risk to them is not as great as it is to the managers. The shareholders may have been willing to take on this project, but the managers are not. Thus, the managers' decision denies the shareholders a potentially wealth-increasing project. Direct Direct agency costs include: 1. Excessive expenses, known as perquisites, incurred by management that are not beneficial to shareholders. For example, management of a firm may travel first class instead of business class or business class instead of economy and have excessively luxurious office furniture. 2. Monitoring costs, such as auditing costs. Minimising the agency problem The agency problem can be minimised by: 1. Taking measures that align management salary packages more closely with the value of the firm. For example, salary packages may include options to purchase shares in the firm. 2. Establishing operational procedures designed to reduce management's ability to act outside the shareholders' interest. Examples include limiting the authority of different levels of management, and conducting regular audits. Review Questions Review your understanding of agency by attempting the following review questions: 3. Given the principal-agent framework (in which shareholders supply resources to the firm in the form of equity capital, but decisions as to the use of those resources are made by management), there is a possibility of managers pursuing objectives to further their own, as opposed to shareholder, interests. Briefly discuss the concept of agency costs in this setting and the avenues available to shareholders to obtain management congruence with the objective of shareholder wealth maximisation. Suggested solutions to this question can be accessed by clicking on this link Ethics Ethical behaviour means 'doing the right thing'. As the textbook correctly observes, difficulties arise in defining 'the right thing'. Different people tend to have different ideas. According to the textbook ethics is important in the field of financial management because (i) ethical errors can damage both one's reputation and career prospects; and (ii) loss of public confidence in a corporation's ethical standards can be commercially damaging. This is a teleological approach to ethics (i.e. concerned with consequences) – suggesting that, at least in the field of business, ethics is little more than a handmaiden to pragmatism. Nevertheless, over recent years ethics has become a widely discussed topic in many professional fields and should be regarded as an integral part of this subject. Tax Tax issues are addressed in Chapter 3 of the textbook. Why are we concerned with tax? Because tax is a cash flow and occurs at different points in time, so cannot be ignored. Tax comes from various direct and indirect sources, some of which disappeared with the introduction of the Goods and Services Tax (GST). In this subject we focus on company and personal income taxes as they are the dominant taxes in the context of corporate finance. The government has the right to levy tax under various Acts and Regulations, the principal one being the Income Tax Assessment Act, and the rate of tax that is levied depends on who or what is being assessed. Taxable Income = Assessable Income - Allowable Deductions. A 'duty' of finance managers is, as far as it is legal, to minimise a firm's tax liability by minimising its taxable income. This may be achieved, for example, by maximising allowable deductions; i.e. by ensuring that all allowable deductions, such as accelerated depreciation, are fully utilised. Minimising a firm's tax liability will, ceteris paribus, maximise its after-tax profits, thus ensuring maximum returns to its owners. There are, however, some situations in which tax minimisation may not advantage a company's shareholders. This is discussed later in the section covering with Australia's dividend imputation system. Assessable income includes virtually all items of income, including overseas-generated income and capital gains. Allowable deductions essentially comprise all losses and outgoings incurred in the pursuit of assessable income. Once taxable income has been determined, the amount of tax payable can be calculated with reference to the tax rate. Companies currently pay tax at a flat rate of 30%. The tax rate for individuals varies according to the level of taxable income. (This is sometimes referred to as a progressive tax regime.) The marginal tax rate is the rate of tax payable on the last dollar of taxable income. Payment of tax The second tax variable, time, also influences the financial value of a firm or project, as the timing of the cash flow to the government will affect the value of that cash flow: the longer the delay in paying tax, the lower its impact. Delayed tax payments add value for the taxpayer, but reduce value for the government. Employees normally have tax deducted directly from their periodic salary or wages ('pay as you go' or 'PAYG'), with a balancing adjustment at the end of the fiscal year. Companies pay tax instalments during the year. Because the actual taxable income for each period is unknown, instalments are based on the earnings of previous years, with an end-of-year adjustment to reflect actual results. Tax savings If a company can reduce its taxable income, it will pay less tax, depending on the tax rate. For example, if the tax rate is 30% and a company can reduce its annual taxable income from $150,000 to $140,000, it will reduce its tax liability by $3,000, as follows: ($150,000 - $140,000) x 0.3 = $10,0000 ´ 0.3 = $3,000 Conversely, if a company invests in machinery that reduces operating costs, there will be a 'negative tax saving'. This is because reduced operating costs increase taxable income and tax payable. Dividend imputation system Australia has a dividend imputation system which was introduced on 1 July 1987. Other countries, such as the United Kingdom and Canada, have similar systems for reducing the total tax take on corporate profits. Before the introduction of dividend imputation, Australia had what is sometimes referred to as a 'classical tax system'. Companies paid tax on their taxable income. Dividends were paid out of after-tax profits. Dividend income was then taxed at the shareholder's personal marginal tax rate. Distributed corporate profits were thus taxed twice: first in the hands of the company; secondly in the hands of the shareholder. The following example demonstrates the consequences of double taxation. The dividend imputation system aims to ensure that business activities are taxed in the same manner regardless of business structure and aims to eliminate the double taxation of corporate profits distributed to Australian resident shareholders by taxing such profits only at the shareholder's marginal rate (although there are qualifications to this statement). Dividends paid out of after-tax corporate profits carry a franking (imputation) credit equal to the amount of Australian corporate tax already paid. Such dividends will be fully franked, when tax has previously been paid at the full corporate rate, partly franked, when tax has previously been paid at a lower rate, or unfranked when no Australian tax has been paid on the income from which the dividends are distributed. For example, Australian resident shareholders who receive a fully franked dividend of $70 from Company A will declare that $70 as taxable income. They must also declare as income the franking (imputed) tax credit which is attached to the dividend of $30. This is known as grossing up the dividend to its pre-tax value ](Div/(1-T) or $70/(1-.3)]. Whilst it may seem unfair that the taxpayer declares a total $100 of dividend income when they only received a payment of $70, the taxpayer can claim a tax credit ($30) for the amount of tax paid by Company A on the $100 earnings. Effectively no tax is received from the company as it paid $30 tax and then a $30 tax credit is given to the Australian resident shareholder against their tax liability. The only tax paid on Company A's $100 earnings will be the amount of tax levied against the shareholder at their individual marginal rate. This marginal rate can vary from 0% to the top marginal rate which is currently 37%. Shareholders with marginal tax rates higher than the actual rate paid by the company pay the difference. Shareholders with marginal tax rates lower than the rate paid by the company can either offset excess (i.e. unused) franking credits against other tax liabilities or claim a tax refund from the Australian Taxation Office (ATO). The following example demonstrates the tax implications of fully franked dividends (paid by Company A) and unfranked dividends (paid by Company B). In this example the shareholder's net receipt is unaffected by both the tax status and corporate structure of the business generating the income. If the same pre-tax income were generated by a partnership or sole proprietorship, the after-tax income to the owner (whether partner or sole proprietor) would be the same. The textbook describes this situation as an imputation system with full integration, meaning that "the dividend imputation system produces the same amount of net income after tax for the owners of the business irrespective of whether the business is conducted as a partnership or as a company" (page 42). Implications for finance The implication for finance of the Australian dividend imputation system is significant. Under the dividend imputation system it does not matter what the corporate tax rate is as the shareholder will always only pay tax at their individual marginal rate. So for financial problems which involve Australian companies with Australian resident shareholders calculations should be carried out on a pre-tax basis. The textbook proceeds to identify three taxation categories, as follows: Taxation category 1 includes companies that are fully or substantially integrated into the dividend imputation system. Taxation category 2 includes sole traders, partnerships and companies that are not integrated into the dividend imputation system. Taxation category 3 is in between categories 1 and 2 and includes companies that are only partly integrated into the dividend imputation system. The textbook suggests that financial managers of companies within Taxation category 1 should focus on pre-tax income on the grounds that shareholders' net dividends (i.e. dividends after company and personal tax) will be unaffected by company tax payments. In other words, there is no point in financial managers trying to minimise company tax, because shareholders will not benefit from such tax minimisation. However, the reality is that very few Australian companies are fully integrated into the dividend imputation system. This is because most major listed companies have overseas shareholders, who do not receive franking credits, while many generate offshore income that is not subject to Australian corporate tax (due to international tax agreements) and cannot therefore produce franking credits. There is even some evidence to suggest that share prices in Australia have not increased as a result of the dividend imputation system. Thus, for example, there was no general increase in share prices when dividend imputation was introduced; possibly suggesting that share prices are set by marginal offshore shareholders, rather than by Australian resident shareholders. Irrespective of one's views on the financial management implications of dividend imputation, there are a number of reasons for continuing to advocate tax minimisation as a worthwhile objective of financial management. For example, overseas shareholders do not benefit from franking credits. It is also presumptuous to assume that all corporate profits will be distributed as dividends carrying franking credits. Bonus shares issued in lieu of dividends do not qualify for franking credits and a proportion of corporate profits is typically retained for reinvesting. Some firms are not part of an integrated imputation system; for example, because they have tax-exempt income, or overseas shareholders unable to take advantage of franking credits. Or their income may be generated overseas and subject to different tax regimes. Such companies are effectively part of a classical tax system and should therefore seek to minimise their tax liabilities and assess investment opportunities on an after-tax cash-flow basis. Sole proprietors and partners (i.e. owners) pay sole proprietorship and partnership taxes. It follows that those entities should also seek to minimise their tax liabilities (which are also the owners' tax liabilities) and assess investment opportunities on an after-tax cash-flow basis. Throughout this subject we will focus on after-tax profits and therefore ignore the taxation categorisation of the textbook. For Australian Taxation Office updates go to http://www.ato.gov.au/Tax-professionals/ Review Questions Review your understanding of tax implications by attempting the following review questions 4. What is the difference between assessable income and taxable income? 5. Why is the marginal tax rate the important rate for financial decisions? After attempting the questions above, review the suggested solutions located here. Review Problems Review your understanding of relevant tax calculations by attempting the following review problems. Assume that the Australian company tax rate is 30% and the following marginal tax rates apply to Australian individual taxpayers: Income Marginal tax rate Tax payable $0-$18,200 0% Nil $18,201- $37,000 19% 19 cents for each $1 over $18,200* $37,001-$87,000 32.5% $3,572 plus 32.5 cents for each dollar over $37,000 $87,001-$180,000 37% $19,822 plus 37 cents for each dollar over $87,000 $180,001 and above 45% $54,232 plus 45 cents for each dollar over $180,000 1. A sole trader earned $140,000 in trade revenue and incurred operating and depreciation expenses of $50,000 and $10,000 respectively. The trader also received fully franked dividends of $15,000 and unfranked dividends of $5,000. What was the taxpayer's (a) income tax liability and (b) after tax income? [Ignore Medicare levy.] 2. In the same tax year a retiree received a pension of $21,000, interest income of $2,000 and fully franked dividend income of $2,284. What was the taxpayer's (a) income tax liability and (b) after tax income? [Ignore Medicare levy and tax rebates and concessions for older taxpayers] After attempting the problems above, review the suggested solutions located here. Quiz Check your understanding of the concepts in this topic by attempting the Topic 1 multiple choice questions located in Test Centre. Learning Outcomes At the end of this topic you should be able to: • critically evaluate the role of financial markets in a developed economy such as Australia's; • describe the various elements of Australia's financial markets; • describe the principal flows of funds relating to the financing of businesses in Australia; • critically evaluate the role of information in the efficient operation of financial markets; and • explain the significance of the risk-return trade-off. Prescribed reading Textbook Section on financial markets in Chapter 1, 2 & 3. Additional reading (click here, or find in the CSU Library's Subject Reserve by searching for ACC515) Brigham, E. F.. Gapenski, L. C., & Daves, P. R. (1999). The evolution of financial theory. In Intermediate financial management (6th ed.) (pp. 3-32). Fort Worth : Dryden Press. Forum Discussion After watching the clip, who and why do you think is likely to beat the market, the experienced trader or the academician? Discuss this in the Forum. WSJ. There Are Ways to Beat the Market. Retrieved 15 March 2017 from http://www.wsj.com/video/there-are-ways-to-beat-the-market/53BC864A-89EC-4A8A-8249-17B9C189B7EB.html Market prices & market efficiency You should start this topic by turning back to Chapter 1 of the textbook and reading "The five basic priniples of finance" (p.12) which describes efficient markets and some of the factors underpinning what is known as the Efficient Markets Hypothesis (EMH). You will see that an efficient market is defined as one that processes information so quickly that the prices of all goods traded in that market at any instant in time fully reflect all available information. Australia's financial markets are reasonably efficient in the way they gather, process and disseminate information. New information arrives randomly and prices will fluctuate as they adjust to their 'correct' equilibrium level. At that point there would theoretically be no trading, because no buyers would regard the goods as underpriced and no sellers regard them as overpriced. In reality, market players interpret available information differently and some-times prices seem to be driven at least as much by emotion and sentiment as by the rational processing of information. Role & scope of financial markets A principal role of financial markets, as with all markets, is to bring together buyers and sellers. Financial markets trade in securities. A security is the documentation that provides legally enforceable evidence of a loan or equity interest. The generic terms for these securities are 'notes' and 'bills', which provide evidence of short-term debt; 'bonds' and 'debentures', which provide evidence of long-term debt; and 'shares', which provide evidence of an equity interest. There are also 'hybrid' securities, such as preference shares, that have characteristics of both debt and equity. Securities are issued in primary markets and thereafter traded in secondary markets. Primary markets enable those with surplus funds to invest or lend by buying securities. The sellers are those with insufficient funds, who therefore raise cash by issuing (i.e. selling) securities. Once securities have been issued, they can be traded in secondary markets where prices are established, as in markets generally, by the forces of supply and demand. (This is the price discovery function of markets.) A third significant feature of financial markets is their efficient processing and recording of complex data. Some financial markets, such as a share market, may also perform a regulatory role. This used to be a function of the Australian Securities Exchange (ASX) until 2 August 2010 when the Australian Securities and Investments Commission (ASIC) assumed full responsibility for market regulation. There are numerous ways of classifying financial markets; e.g. (i) public offerings and private placements; (ii) primary markets and secondary markets; and (iii) money markets and capital markets. Efficient secondary markets support the viability of primary markets. To be efficient, a secondary market should have the following attributes: 1. an efficient title transfer system; 2. low transaction costs; 3. a large numbers of buyers and sellers; 4. an efficient system of information gathering, processing and dissemination. To the dichotomies addressed in the textbook, we could add: (i) spot and forward markets; (ii) exchange-based and over-the-counter (OTC) markets; and (iii) broker-operated and dealer-operated markets. Spot markets trade at current (i.e. spot) prices for immediate or proximate delivery, while forward markets trade at forward prices for future delivery. The distinction between exchange-based and over-the-counter markets lost much of its significance when both adopted screen-based trading. Nevertheless, some financial markets, such as share markets and futures markets, continue to have a physical location. Others, such as the money and foreign exchange markets, are not centred on a physical market place, but conduct business over-the-counter via electronic communication and screen-based trading. With respect to our third additional dichotomy, brokers act as agents for buyers and sellers in return for a commission, while dealers carry inventories and stand ready to buy or sell. Dealers earn a return from the bid-offer spread; i.e. the difference between the price at which they bid to buy and the price at which they offer to sell. We can also study financial markets by examining the 'goods' in which they trade. Financial markets differ from markets that trade goods, such as commodities, in exchange for cash. We have already mentioned that financial markets trade in securities. We now need to recognise that securities are a type of financial instrument. Of particular interest are derivatives. A derivative is 'a financial instrument that is derived from or based on the value of an underlying asset'. The main types of derivatives are forward contracts, futures contracts, options and swaps. A major reason for the development of derivatives was to assist in the management of certain risks. Thus, for example, farmers in Ancient Greece could sell their crop forward to grain merchants. The farmer would agree to deliver a specified quantity of grain of specified quality to a specified person at a specified place at a specified future date. Such an arrangement is called a forward contract – which eliminates certain risks for both parties. In particular, farmers would know the price they could expect to receive for their crops, while merchants would know the price they could expect to pay. Note, however, that although such arrangements protect the parties thereto from downside risk, they also exclude the upside potential of favourable price movements. In this example, the farmer would lose the benefit of an upswing in grain prices, while the merchant would lose the benefit of a downswing. Any arrangement that seeks to manage risk by eliminating both downside risk and upside potential may be described as a hedge. Such arrangements do not necessarily involve a financial instrument. The foregoing example relates to a forward commodity contract, rather than a financial instrument. However, if the parties to such an arrangement agree that the contract may be settled in cash, without the need for physical delivery of the underlying asset, it then becomes a derivative financial instrument (or, more simply, a derivative). It should be appreciated that any arrangement (including forward commodity contracts) normally used for risk management may also be used as a means of speculating. Thus, for example, a farmer who expected grain prices to rise could enter a forward contract as a buyer (rather than seller). Similarly, a merchant who expected grain prices to fall could enter a forward contract as a seller (rather than buyer). The prospect of speculative gains may partly account for the spectacular growth in derivatives trading. A further possible explanation is that financial instruments negotiated through a third party (typically an institution such as an exchange or financial intermediary) are a source of revenue to the third party, which therefore has a vested interest in promoting their use. This may, for example, partly explain the growth in interest rate swaps and other synthetic products such as caps, floors and collars. (The term 'synthetic' describes financial instruments that do not provide a means of raising or securing finance.) From the foregoing brief summary, it can be seen that financial markets do far more than provide channels to facilitate the transfer of funds from surplus sources to deficit destinations. They also facilitate risk management and speculation. This can lead us back to the most fundamental dichotomy that typically exists between market players, and is to some extent encapsulated in the allegory of bulls and bears. Bulls are essentially buyers, while bears are sellers. In a bull market, buyers charge in and toss prices up (hence the metaphorical allusion to bulls). In a bear market, sellers push prices down, in a way that bears are said to kill their prey by exerting downward pressure (hence the allusion to bears). An alternative explanation is that those who think prices are likely to fall may be tempted to short-sell securities; i.e. sell securities they do not own, in anticipation of falling prices and the opportunity to buy what has already been sold at a profit. In this case the bear descriptor alludes to a hunter selling a bearskin before killing the bear. This fundamental dichotomy of expectation underpins a vast array of financial market transactions. For example, some may have a view that interest rates are about to decline and therefore engage in a fixed for variable interest rate swap (i.e. swap fixed for variable rate debt service obligations). Any counter-party to such a swap is likely to have an opposing view. Similarly, some may have a view that a currency is overpriced in the forward market, while underpriced in the spot market, and therefore buy spot and sell forward. Again, any counter-party to such contracts must necessarily have an opposing view. These sorts of contracts do not create wealth and have zero present value. (The concept of present value is explored later in this subject.) However, these contracts are typically novated through an intermediary in return for a fee. In such cases the contract has positive present value for the intermediary and therefore an initial negative present value for the counterparties. By the time the contract is settled it is possible that neither counterparty will win, although the typical situation is that one will lose, while the other will gain. It is impossible for both counterparties to win. The only party who always wins (barring default) is the intermediary, who typically facilitates and promotes the transactions, and may even have designed the traded product. The Education Centre on the ASX website provides a range of information for both experienced and inexperienced users. To explore the website and learn more about investing and the market go to http://www.asx.com.au/education/shares-education.htm Flow of funds through financial markets At the outset of this topic, we explained how a primary role of financial markets is to facilitate the transfer of funds from surplus to deficit segments of the economy. Ensure that you read and understand the textbook's coverage of this aspect of financial markets, including the type and magnitude of financial claims in the Australian economy. Corporate credit ratings & the risk-return trade-off An important aspect of any investment decision is the investor's expectation of returns and associated risks. Higher expected risks require higher expected returns. This fundamental axiom of finance is often described as the risk-return trade-off. Note, however, that the trade-off is actually between certainty and return rather than risk and return. Investments with less certain outcomes will only be accepted if accompanied by higher expected returns. A corporation's credit rating can be used to assess the risk of investing in its securities; in particular, the default risk associated with its debt securities. The higher the credit rating, the lower the risk of default (i.e. the risk that debts will not be fully serviced and repaid) and the lower the cost of borrowing. Thus, for example, companies with the highest (AAA) credit rating are able to issue debt securities at lower yields than companies with lower credit ratings (such as BBB). Companies with the lowest credit ratings (such as CCC) are unable to issue investment-grade securities, but may (in the USA) issue junk bonds, which, as their name implies, carry a high risk of default. The relation between risk and return applies to all types of investments. A company's credit rating essentially reflects the risks associated with the ability of its assets to generate future cash flows. Risk assessment is therefore an essential component of capital budgeting – a topic addressed later in this subject. Review Questions 1. What are financial markets? What function do they perform? How would an economy be worse off without them? 2. What is a 'financial intermediary'? Give an example. 3. Distinguish between an indirect financial security and a direct financial security. Give an example of each. 4. Distinguish between the money market and the capital market. 5. What major benefits do you think companies and individuals enjoy because of the existence of an organised stock exchange? After attempting the questions above, review the suggested solutions located here. Now that you have had an introduction to the fundamental decisions of the corporate financial manager and financial markets, it is appropriate to consider the theoretical underpinnings of financial management decisions. Virtually all financial decisions are based upon rules that are derived from financial theories. Reading 1 "The evolution of financial theory" provides an overview of the key financial theories including empirical evidence to support or refute each one. The reading goes further however and presents insights into decision making where there are conflicting theories and multiple perspectives. Quiz You should now complete your reading of Chapters textbook and then attempt the multiple choice revision questions for this topic located in Test Centre. Learning Outcomes At the end of this topic you should be able to: • explain why cash flows are important; • identify and explain the three important elements of cash flow calculations; • explain the concept of compound interest; • make adjustments in calculations for non-annual compounding of interest; • calculate the present value, future value, interest rate and number of periods for single cash flows due in the future; • calculate the present value, future value, interest rate, number of periods and size of payment for ordinary annuities, deferred annuities and annuities due; • calculate the present value, interest rate and size of payment for perpetuities; • calculate the present value and future values of uneven cash flow streams; • draw time lines to represent the discounted cash flow (DCF) process; and • calculate effective annual rates (EAR) and distinguish them from nominal annual percentage rates (APR). Prescribed reading Textbook Chapter 5 & 6.. Why cash flows are important In Topic 1 we learnt that cash flows are important because expected net cash flows are used to evaluate the worth of an investment. We also learnt that expected net cash flows have four important characteristics: amount, timing, duration and risk. In this topic we learn how to value an investment by calculating the present and future values of its expected net cash flows. But first we need to revisit the concept of the time value of money and learn how that concept can be used to calculate the present and future values of given cash flows. The time value of money Video To review the concept of the time value of money, watch the following Khan Academy presentation. Khan Academy. Time Value of Money. Retrieved 19 December 2013 from https://www.khanacademy.org/economics-finance-domain/core-finance/interest-tutorial/present-value/v/time-value-of-money You should note the following points relating to measuring the time value of money: 1. The time value of money is always measured in terms of per cent per year. 'Per year' or 'p.a.' (p.a. is short for 'per annum', which is Latin for 'per year') is therefore often omitted and, in the absence of alternative information, should be assumed. 2. A one-hundredth part of a percentage point is referred to as a basis point. 3. The time value of money is usually measured in per cent per year to either two or three decimal places (although two decimal places are more common). Bond rates in Australia are usually quoted to half a basis point (i.e. the third decimal digit is either 0 or 5). 4. When doing financial calculations, never round off until you arrive at your final answer. (You may sometimes find it useful to store intermediate results in your calculator's memory as a means of avoiding rounding errors.) Dollar answers to numerical questions are usually given to the nearest cent. Example The following is an example of the time value of money concept. Would you prefer to receive: $100 today (Option A) or $120 (with absolute certainty) in one year? (Option B) These alternatives are mutually exclusive. If Option B is chosen, Option A is forgone, and vice versa. The choice can be evaluated with reference to opportunity cost; i.e. what best alternative opportunity is forgone by choosing Option B over Option A? This question can be answered by considering how $100 received today could best be used. For many individuals, debt repayment might be the best option. So if money has been borrowed at - say - 12% per year, we could say that the time value of money is 12%. If we reject Option A, and therefore do not pay-off $100 of debt today, the amount owing would increase to $112 after one year (i.e. the $100 owing now plus $12.00 of interest). We can conclude that $100 today (a present value or PV) has the same value as $112 in one year's time. [$112 is then a future value or FV in one year's time of $100 today.] So we now have enough information to answer the question: ‘Which Option would you prefer?’ A rational person would choose Option B. Why? In one year Options A and B will be worth $112 and $120 respectively. A rational person would choose the one with the higher value; i.e. Option B. However, what if we actually want to spend money now, rather than wait one year? Wouldn’t we want Option A, because it gives us the money now rather than later? No! We will still prefer Option B. If we take Option B then we are certain we will receive $120 in one year. We can borrow against that money now, and in one year use the $120 to repay the loan. How much can we borrow now? We can borrow $107.14; i.e. 120 ÷ 1.12. (We’ll look at why this is the correct calculation later.) Another way of saying this is that if we borrow $107.14 now at 12%, then in one year we will need to repay $120 (i.e. $107.14 × 1.12). So even if we want to spend money now rather than later, we would still take Option B: borrow (and spend) $107.14 now, and in one year repay the $120 owing on the loan. If we had taken Option A, we could spend only $100 now. This simple example demonstrates that in order to compare cash flows that occur at different points in time, we first need to find their value at some common point in time. That is, we need to convert cash flows into equivalent dollars at a specified point in time. Typically, that ‘specified point in time’ is the present, in which case cash flows are evaluated in terms of their present values. Review Question What is the time value of money and why is it important? After attempting the question above, review the suggested solutions located here. Opportunity cost The foregoing example introduced the concept of opportunity cost. [At this point it may be useful to note that 'forego' and 'forgo' are different words with different spellings and meanings. The former means 'go before'; the latter 'go without'.] The opportunity cost of anything is the most valuable alternative given up, sacrificed or forgone. Every act of choice involves an act of forgoing. In the previous example, choosing Option B necessarily involves forgoing Option A. The options are mutually exclusive and only one can be chosen. The opportunity cost of finance is the rate of return given up when funds are diverted from one application to another. The opportunity cost of a chosen course of action therefore defines a minimum required rate of return. Later, we will be using required rates of return as part of the investment decision. Interest concepts Different interest concepts reflect the way in which it is calculated. Simple interest means that interest is calculated at a given annual rate on a given amount. (The given amount is often referred to as the principal.) Compound interest means that interest is charged periodically by the lender to the borrower's account. The amount on which interest is charged thereby increases. Simple interest Imagine that you have $100 that you can deposit in a bank account and earn 7% pa simple interest. Let us suppose that you deposit the money for four years. In each of those years your deposit (the principal) would earn $7.00 in interest and at the end of four years the deposit would have earned a total of $28.00 in interest. Compound interest Imagine now that your $100 can be deposited for four years to earn interest at the rate of 7% pa compounded annually. This means that in the second year interest would be paid on $107.00 – representing the initial principal of $100 plus interest of $7.00 earned in the first year. This means that you would earn $7.49 of interest in the second year (i.e. $107 ´ 7% = $107 ´ 0.07). In the third year you would earn interest on $114.49 – representing the initial principal of $100 plus interest of $7.00 earned in the first year and $7.49 of interest earned in the second year. Interest earned in the third year would therefore be: $114.49 ´ 0.07 = $8.01. Calculations for all four years are shown in the following table: Year Balance at beginning of year Interest Balance at end of year 1 $100.00 100 × 7% = $7.00 $107.00 2 $107.00 107 × 7% = $7.49 $114.49 3 $114.49 114.49 × 7% = $8.01 $122.50 4 $122.50 122.50 × 7% = $8.58 $131.08 The foregoing table shows how the balance at the beginning of each year increases by the amount of interest earned in the previous year. Each year interest is calculated on a higher balance than the previous year. The amount of interest earned in each year therefore increases, even though the interest rate remains constant at 7% pa, compounded annually. Note that the total interest earned over four years is now $31.08, as compared with $28.00 earned in the simple interest case. In this subject you should always assume that interest is compounded unless otherwise specified. PDF Document Viewer Due to the nature of the content in this section please see the PDF document below, or click here to download the PDF. Quiz Check your understanding of the concepts in this topic by attempting the Topic 3 multiple choice questions located in Test Centre. Please click here for solutions to Multiple Choice calculations. Review Problems Review your understanding of relevant tax calculations by attempting the following review problems: 1. If I invest $100 in a bank account now, how much will I have in one year if: 1. Interest is 7.5% compounded once per year 2. Interest is 7.5% compounded at the end of each month 3. Interest is 5.5% compounded at the end of each month Explain why these answers differ. 2. I have decided to go on a holiday when I finish my degree and I estimate that I can save $75 per month until then. It is now the beginning of the month. If I deposit $75 into an account at the end of this month and each of the next 15 months after that (i.e. a total of 16 deposits over 16 months) how much money will be in the account just after I make the 16th deposit? Interest is 12% compounded monthly. How much of that balance is interest that I have earned? 3. I deposit $100 at the end of every six months for four years into a bank account that compounds interest twice per year. I expect to have $1,026 in the account just after the last payment. What is the nominal interest rate on the account? 4. (i) I need $25,000 in five years to buy a new car. What lump sum must I deposit in an account today in order to have $25,000 in 5 years? Interest is 8% compounded twice per year. (ii) Instead of just making one lump sum payment now I decide to deposit $2,000 now and make five more equal deposits at the end of each year for five years. I still want $25,000 in five years and interest is still 8% compounded twice per year. How much will the five equal deposits need to be? 5. Seven years ago I deposited $13,000 in an account. The account balance is now $26,401. Interest has been compounded every three months. What has the nominal interest rate been? 6. I would like to save $20,000 for a deposit on a house. I can deposit $200 at the end of every month. Interest is 6% compounded semi-annually. How many months will I have to wait until I have the deposit? 7. I have just started a new business and I estimate I will earn the following net cash inflows: $1,000 at the end of this first year; $800 at the end of the second year; $1,200 at the end of the third year; $1,300 at the end of the fourth year and zero at the end of the fifth year. I have estimated the nominal interest rates to be 8% over the first year, 9% over the second year, 8% over the third year, 10.5% over the fourth year and 12% over the fifth year. How much money will I have at the end of five years? 8. I have just won $500,000 in Lotto. I decide to use the money to establish a scholarship for finance students. I want the scholarship to be paid at the end of each year forever. The money will be invested at 11% compounded annually. How much can be paid out of the fund at the end of each year? 9. I want to borrow money and can choose from the following rates: Option 1: 12% compounded semi-annually Option 2: 13% compounded annually Option 3: 12.5% compounded daily Which Option would you recommend? Why? 10. What is the present value of a ten-year annuity that pays $400 per year at the beginning of each year if the annuity's first cash flow is in five years time? Interest is 12% now and for the next four years; 10% thereafter. After attempting the problems above, review the suggested solutions located here. Learning Outcomes At the end of this topic you should be able to: • explain the concept of rate of return and its relation to opportunity cost; • explain the relationship between historical rates of return, risk and inflation; • explain the concept of expected return as the 'mean' out of a range of possible outcomes and of risk as variability or spread around that mean; • calculate the historical return and total risk for an investment, given past holding period returns, using the standard deviation; • calculate the expected return and risk of an investment, given possible outcomes; • explain how risk can be reduced by diversification; • distinguish between systematic and unsystematic risk; • recognise the use of beta as a measure of systematic risk; • use the capital asset pricing model; and • state some limitations of the capital asset pricing model. Prescribed reading Textbook Chapter 7 & 8. Reading 5. Additional Reading (click here, or find in the CSU Library's Subject Reserve by searching for ACC515) Brealey, R. A., Myers, S. C., & Allen, F. (2006). Introduction to risk, return, and the opportunity cost of capital. In Principles of corporate finance (8th ed.) (pp. 147-212). New York, NY : McGraw-Hill/Irwin. As an introduction to the topic of risk and return, read the following brief newspaper article that presents a practical discussion of interest rates and the impact on investor returns: Krantz, M. (2012, Apr 23). Low risk, high rate of return hard to come by. USA TODAY. Copy available from http://www.garp.org/risk-news-and-resources/risk-headlines/story.aspx?newsId=45541 The risk-return trade-off Rates of return have previously either been given or found by implication (if they were the only unknown variable). We now need to examine how required rates of return can be independently derived. Logically, we would expect the rate of return required from a particular investment to reflect associated risk. The higher the investment's perceived level of risk, the higher the required rate of return, and vice-versa. Required rates of return have two components: a risk-free component, and a risk premium component. In Australia risk-free rates are usually set with reference to contemporaneous yields on relevant Australian Government Securities according to the intended term of the investment. For example, the risk-free reference rates for short or long term investments would be the respective contemporaneous yields on Treasury Notes or Bonds. An investment's risk premium is the amount of return it earns over and above the risk-free rate: the higher the risk of an investment, the higher the risk premium. That is, investors require compensation for bearing additional risk. In finance, risk and uncertainty are synonymous. Most investments have some degree of risk or uncertainty associated with them. [In fact, apart from our solar system, the future generally is uncertain.] Because risk reflects the variability of possible outcomes, we can use the standard deviation of possible outcomes as a measure of risk. Measuring historical returns and risk There are many sources of historical information on the rates of return and variations in those rates of return for various securities. The following table summarises average rates of return on ten year Australian government bonds and Australian shares over the 23 years immediately preceding the onset of the global financial crisis in late 2007. Return and risk: Australian securities 1984-2007 10-year Australian government bonds Australian shares Average return Std deviation Average return Std deviation 8.7% 3.2% 12.6% 13.2% The ten-year Australian government bond rates shown in this table are higher than normal as the period includes the very high interest rates of early 1990 (when the official overnight cash rate peaked at 17.5%). As at October 2012 yields on three and 17 year Australian government bonds were approximately 2.479% and 3.595% respectively. The table confirms that shares are a more risky investment than bonds, but offer a higher expected return. It also confirms the notion of a risk premium; i.e. risk-averse investors expect to earn higher returns to compensate them for taking on additional risk. Note that the risk premium shown in this case is 3.9%, which is well below the longer-term average of about 7.5%. Going forward, we might expect returns on Australian shares to average about 11% over the next 17 years, representing a 7.4% risk premium over the relevant Australian government bond rate of about 3.6%. PDF Document Viewer Due to the nature of the content in this section please see the PDF document below, or click here to download the PDF. Activity ACTIVITY TO DISCUSS OPENING SCENARIO – OR AUDIO FIL RE HOW TO APPROACH? Review Questions Review your understanding of credit management by attempting the following problems: 1. Explain the impact of inflation on rates of return. 2. What is the meaning of beta? How is it used to calculate an investor's required rate of return? After attempting the questions above, review the suggested solutions located here. Review Problems Review your understanding of rates of return by attempting the following review problems: 1. If the expected real rate of return is 6% and the expected inflation rate 2.5%, what is the expected nominal rate of return? 2. Given the following information, which asset would you prefer to invest in? Asset C Asset D Probability Return Probability Return 0.2 −2% 0.2 −5% 0.5 18% 0.3 6% 0.3 27% 0.3 14% 0.2 22% 3. (a) Use the CAPM to calculate a required rate of return for a company with a beta value of 1.2, given an expected risk-free rate of 6% and market premium of 10%. (b) Explain why the required rate of return, as calculated above, may be regraded as 'fair'. After attempting the problems above, review the suggested solutions located here Page 8 of 17 Learning Objectives At the end of this topic you should be able to demonstrate an understanding of the principles of capital budgeting and an ability to select appropriate project evaluation methods for different scenarios. A more detailed listing of learning objectives for this topic is provided at the start of Chapter 11 of the textbook. Prescribed reading Textbook Chapter 11 & 12. Reading 7. Additional Reading (click here, or find in the CSU Library's Subject Reserve by searching for ACC515) Gupta, J. (2010). Capital budgeting. PowerPoint presentation from SlideShare. Video As an introduction to the concept of discounted cash flows, review the presentation of the concept of Net Present Value from Khan Academy: Khan Academy. Introduction to Net Present Value. Retrieved 19 December 2013 from https://www.khanacademy.org/economics-finance-domain/core-finance/interest-tutorial/present-value/v/introduction-to-present-value Forum discussion: Case Study Scenario: You are an investment analyst at JP Morgan. The vice president of investment banking has assigned you with a task to analyse an investment proposal into a new liquid natural gas field in Western Australia. According to initial estimates, the investment outlay would be $2,500,000 and the project would generate incremental pre-tax cash flow of $500,000 per year for eight years. The appropriate required rate of return for this project to be viable to JP Morgan is 8% p.a. and the project should be evaluated on a pre-tax basis. The other alternate investment project you've been given to analyse is an expansion of gas exploration in Queensland. The initial outlay associated with expansion would be $4,500,000 and the project would generate incremental cash flows of $750,000 per year for the first four years and $500,000 per year for the remaining six years of the project's life. The appropriate required rate of return for this to be acceptable to JP Morgan is 12% p.a. and the project should be evaluated on a pre-tax basis. Task: Which project should be accepted? Show your workings clearly to endorse your recommendation. Expectations: Students should analyse the information and develop recommendations, then discuss your recommendations with other students on the forum. This case study is provided as an opportunity to apply the concepts in this topic to an authentic scenario that you may encounter in the workplace. It is also an opportunity to practice and get feedback on your mastery of skills and concepts that are formally assessed on the final exam. Introduction In this topic we examine methods that can be used to evaluate investing in long-term assets or projects. The evaluation process is usually referred to as project evaluation or capital budgeting. Capital is typically limited, so that investment decisions necessarily involve the allocation of scarce capital. (Hence the term: 'capital budgeting'.) The object of investing is to add value, but we shall see that not all methods of evaluating investments support that objective. Methods of capital budgeting Freeman & Hobbes ('Capital Budgeting: Theory versus practice', Australian Accountant, 36-41, September 1991) found that the main methods of capital budgeting used by companies in Australia were (in order of popularity): 1. Net present value (NPV) (75%) 2. Internal rate of return (IRR) (72%) 3. Payback period (PP) (44%) 4. Accounting rate of return (ARR) (33%) 5. Discounted payback (DP) (27%) 6. Discounted cash flow profitability index (DCFPI) (23%) Capital budgeting methods fall into either of two categories: (1) those employing discounted cash flow (DCF) analysis, and (2) those employing non-DCF methods. The principal methods of each category are briefly discussed below. Non-discounted cash flow methods Accounting rate of return The Accounting Rate of Return of a project (or investment) is calculated by dividing the average annual accounting profit by the average investment and then converting the result to a percentage: the higher the percentage, the more attractive the project. Payback period (discounted payback period) The Payback Period is calculated by counting the number of periods (typically years) it takes for a project's net cash flow stream to equal its initial cost. This approach can be modified by using discounted cash flows: the shorter the payback period, the more attractive the project. The simplicity of the method probably accounts for its popularity. When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then us the following formula for payback period: Payback Period = In the above formula, A is the last period with a negative cumulative cash flow; B is the absolute value of cumulative cash flow at the end of the period A; C is the total cash flow during the period after A. PDF Document Viewer Due to the nature of the content in this section please see the PDF document below, or click here to download the PDF. Quiz Check your understanding of the concepts in this topic by attempting the Topic 7 multiple choice questions located in Test Centre. Note: The solutions to these problems are generally calculated on an after-tax basis. To calculate the pre-tax basis, do not include any tax or depreciation effects, and use a pre-tax discount rate. Please click here for solutions to Multiple Choice calculations.