Tutorial

Week 01
Introduction + Basic Concepts
RTVBWJ: Chapter 1
BDHFMF: Chapter 1
RTVBWJ: ROSS, TRAYLOR, BIRD, VENDER, WESTERFIELD, & JORDAN — Essentials of Corporate Finance (4E Aus & NZ), &
BDHFMF: BERK, DEMARZO, HARFORD, FORD, MOLLICA, & FINCH — Fundamentals of Corporate Finance (3E Aus)
YOUR TUTOR & TUTOR IN CHARGE
Peter Kjeld Andersen
peter.andersen@unsw.edu.au

Peter Kjeld Andersen

 ASSESSMENT DATE HOW MUCH

Tutorial Participation Every week 15%

Early-Assessment Quiz Covers topics 1 & 2 15%

Tutorial Quiz Covers topics 3 to 5 20%

Final Exam Exam Period 50%

Covers topics 5-10

You must attend at least 80% of your tutorials in order to be eligible for special consideration in the final exam.
i.e. if you don’t make 80% of your classes, and then get sick and can’t make the final, it’s unlikely you’ll get to sit a supplementary exam.

Attending means being there BEFORE 15 MINUTES PAST. If you repeatedly show up after the roll is called at 5 mins past, this will
become stricter.

Your attendance & participation will only be recorded in your ENROLLED tutorial, unless by PRIOR email
arrangement with your tutor. You cannot just show up to another class time. In a semester with ~1,700
students, this is even more true than normal.
Peter Kjeld Andersen
• How to get 0/15 for your tutorial participation grade:
▪ Be disruptive in class and worsen the learning environment for other students
▪ Answer questions by reading off the official textbook solutions (or my old slides) that
you have received from people who have taken the course previously
• Class participation marks are designed for you to demonstrate that you have
prepared and thought about the assigned tutorial material prior to class.
• When you adequately attempted (not just guessed) a question in class, the tutor will
record next to your name that you have participated for the week.
• If you have participated in class and are not sure that your participation was
recorded at the time, the responsibility is yours to check with the tutor that it gets
recorded at the end of THAT tutorial (NOT at the end of semester).
• Most tutorial marks will come from in-class participation. But if you have a habit of
answering other student’s Moodle forum questions with thoughtful responses, this
will be noted by teaching staff and may contribute toward you passing the course.
Peter Kjeld Andersen
Peter Kjeld Andersen
Q. What are the three types of financial management decision? For each type, give an example of
a business transaction that would be relevant:

A. Capital budgeting, capital structure, and working capital management.

Example of capital budgeting (or the investment decision):

• Deciding on whether to expand a manufacturing plant.
• Deciding on whether to replace an old piece of machinery with a new one.
• Deciding whether or not to develop a new product line.

Example of capital structure (or the financing decision):

• Deciding between raising money by issuing equity (shares) or with debt.
• Deciding between borrowing money through bonds or a bank loan.

Example of working capital management:

• Deciding whether to give your customers 30, 60 or 90 days to pay you.
• Deciding how much inventory to hold in your warehouse.

Peter Kjeld Andersen

Q. What goal should always motivate the actions of the firm’s financial manager?

A. To maximise the current market value (share price) of the equity of the firm (whether it’s
publicly traded or not).

This is commonly phrased as either:

• “maximize shareholder wealth”
• “maximize shareholder value”

The answer is this question is NOT the following:

• “maximize profit”
• “maximize return”
• “maximize earnings-per-share (EPS)”
• “maximize cash flow”
• “minimize risk”

Peter Kjeld Andersen

Q. What are the four primary disadvantages to the sole proprietorship and partnership forms of
business organization? What benefits are there to these types of business organization as
opposed to the corporate form?

A. Disadvantages:
• Unlimited liability
– If the business can’t afford to pay it’s debts, the bank/creditors can take the personal assets of the owners (e.g.
house/car/yacht/dog)
• Difficult to transfer ownership
– If you own a whole business or are a partner in a business, you typically have to find someone with enough
money AND expertise in that industry to buy that whole business from you.
• Harder to raise capital
– If you want to raise more equity, you need to find a new partner that has enough money to invest to make it
worthwhile.
• Limited life.
– If you run a small business and you unexpectedly die, unless your children have the knowledge/interest to
continue the business it is likely to cease to exist.

Peter Kjeld Andersen

Q. What are the four primary disadvantages to the sole proprietorship and partnership forms of
business organization? What benefits are there to these types of business organization as
opposed to the corporate form?

A. Advantages:
• Less regulation
– Because you’re not taking investments from potentially millions of Mum and Dad investors (i.e. the relatively
uninformed general public), the government places less of a regulatory burden on partnerships
• The owners are also the managers
– This eliminates agency costs. As an owner/manager, you don’t have to worry about whether the manager you
have hired is running the company in their own self-interest instead of in yours.
• Sometimes personal tax rates are better than corporate tax rates

Peter Kjeld Andersen

Q. What is the primary disadvantage of the corporate form of organization? Name at least two
advantages of the corporate form.

A. The primary disadvantage of the corporate form is the double taxation of profits (in a classical
tax jurisdiction like the U.S.).
• First, the company pays tax to the government on its profits.
• Second, when the money left over is paid out as dividends to shareholders, the shareholders
pay personal tax on the dividends.
The second main disadvantage is the agency costs related to the separation of ownership of the
company from control of the company.

Advantages:
• Limited liability
• Ease of transferability of ownership
• Ability to raise capital
• Unlimited life.

Peter Kjeld Andersen

Q. Who owns a corporation? Describe the process whereby the owners control the firm’s
management. What is the main reason that an agency relationship exists in the corporate
form of organisation? In this context, what kind of problems can arise?

A. In the corporate form of ownership, the shareholders are the owners of the firm.

The shareholders elect the directors of the corporation, who in turn appoint the firm’s
management.

This separation of ownership from control in the corporate form of organisation is what causes
agency problems to exist.

Management may act in its own or someone else’s best interests, rather than those of the
shareholders.

If such events occur, they may contradict the goal of maximising the share price of the equity of
the firm.

Peter Kjeld Andersen

Q. Suppose you own shares in a company. The current share price is $25. Another company has
just announced that it wants to buy your company and will pay $35 per share to acquire all
the shares outstanding. Your company’s management immediately begins fighting off this
hostile bid. Is management acting in the shareholders’ best interests? Why or why not?

A. Management’s goal is to maximise the share price for the current shareholders.
• If management believes that it can improve the profitability of the firm so that the share price will
exceed $35, then they should fight the offer from the outside company.
• If management believes that this bidder or other unidentified bidders will actually pay more than $35
per share to acquire the company, then they should still fight the offer.
However, if the current management cannot increase the value of the firm beyond the bid price,
and no other higher bids come in, then management is not acting in the interests of the
shareholders by fighting the offer.
Since current managers often lose their jobs when the corporation is acquired, poorly monitored
managers have an incentive to fight corporate takeovers in situations such as this one.?’

Peter Kjeld Andersen

Q. You have probably noticed coverage in the financial press of an initial public offering (IPO) of a
company’s securities. Is an IPO a primary-market transaction or a secondary-market
transaction?

A. Primary market.

This is where new securities are created by a company and first sold to raise money.

Whenever these securities are then traded between investors (via the ASX or other stock
exchange), it is then a secondary-market transaction.

Peter Kjeld Andersen

Q. What does it mean when we say the Australian Securities Exchange is an auction market? How
are auction markets different from dealer markets?

A. In auction markets like the ASX, brokers buy and sell shares on the instructions of their clients,
placing orders on the ASX’s automated trading system.

Dealer markets such as NASDAQ in the US represent dealers operating in dispersed locales who
buy and sell assets themselves.

They usually communicate with other dealers electronically or literally over the counter.

Peter Kjeld Andersen

Q. Can our goal of maximising the value of shares conflict with other goals such as avoiding
unethical or illegal behaviour. In particular, do you think matters such as customer and
employee safety, the environment, and the general good of society fit in this framework? Or
are they essentially ignored?

A. An argument can be made either way.

At one extreme, we could argue that in a market economy, all of these things are priced. This
implies an optimal level of ethical and/or illegal behaviour and the framework of share valuation
explicitly includes these.

At the other extreme, we could argue that these are non-economic phenomena and are best
handled through the political process.

The following is a classic (and highly relevant) thought question that illustrates this debate: ‘A
firm has estimated that the cost of improving the safety of one of its products is $30 million.
However, the firm believes that improving the safety of the product will only save $20 million in
product liability claims. What should the firm do?’

Peter Kjeld Andersen

Peter Kjeld Andersen
Q. Which of these could explain why someone would choose to operate as a sole proprietorship
rather than as a corporation?

A. Your choices:
a) Sole proprietorships have limited liability
b) There are relatively few rules relating to the establishment and running of a sole
proprietorship
c) The firm can last forever
d) It is easy to raise large sum of money
e) All of these answers

Answer is B
Peter Kjeld Andersen
Q. The primary goal of a publicly-owned firm interested in serving its stockholders should be to:

A. Your choices:
a) Maximize expected total corporate profit.
b) Maximize expected EPS.
c) Minimize the chances of losses.
d) Maximize the stock price per share.
e) Maximize expected net income.

Answer is D
Peter Kjeld Andersen
• Answers a), b) and e) are talking about the profit of the company.
– EPS is Earnings Per Share (or Net Income / # shares outstanding)
– Companies can maximize profit by cutting expenses or selling productive assets in a particular year and hurt
the value of the company in doing so.
– e.g. Apple not reinvesting any of their revenue from the iPhone 5 into $&D expenses for developing an iPhone
6 or an iPad 4. This will increase their profit this year but hurt their competitive position and the value of the
company
• Investors don’t invest in shares to minimize the chances of losses, like in c).
– If an investor wanted to minimize the risk of losses, they would invest in a bank deposit or a government bond
and get a much safer (but lower) rate of return.
– Investors put their money at risk in the sharemarket knowing that it is a risky investment, but expecting to be
compensated with an on-average higher return than you can get from a safe investment.
– So the goal of the company shouldn’t be to minimize risk.
• The goal of the corporation is to maximize the wealth of its stockholders, and this is done
through maximizing the share/stock price.
– The share price represents the value of the owner’s investment in the company.
– Increases in the share price reflect increases in the owner’s wealth.

Answer is D
Peter Kjeld Andersen
Q. The value that the financial markets place on a company’s debt and equity securities will
depend on the:

A. Your choices:
a) Standard deviations of the returns from investments in those securities.
b) Risk and expected return from investments in those securities.
c) Expected return from investments in those securities.
d) Interest rate on the debt securities.

• Answers c) and d) refer to the rates of return.

• Standard deviation in a) refers to a measure of risk.
• However it is the interaction of the two that determines the value of an investment.
• All else being equal, return increases the value of an investment, risk decreases it.

Answer is B
Peter Kjeld Andersen
Q. Shareholders in a company have limited liability, which means that:

A. Your choices:
a) Shareholders can be called upon to contribute only the amount unpaid on shares held in the
company.
b) The maximum the shareholders can be called upon to contribute is the current market price
of the shares.
c) Shareholders can never be called upon to make an additional contribution to the company’s
assets.
d) Shareholders have little or limited interest in the activities of management of the company,
because the management and ownership of the firm are separated.

Answer is A
Peter Kjeld Andersen
a) Shareholders can be called upon to contribute only the amount unpaid on shares held in
the company.
– The company may issue new shares on a partly-paid basis.
– i.e. you agree to pay $10/share, but the company only requires $7/share initially.
– If the company becomes insolvent (assets < liabilities), the shareholders are liable for the remaining “amount
unpaid” of $3/share to the company’s creditors.
b) The maximum the shareholders can be called upon to contribute is the current market price
of the shares.
– The company’s current (market) share price is irrelevant.
– Once you have fully paid for your shares, you are not liable for any additional contribution.
c) Shareholders can never be called upon to make an additional contribution to the company’s
assets.
– This is not strictly true, if we consider the “amount unpaid” talked about in a).
d) Shareholders have little or limited interest in the activities of management of the company,
because the management and ownership of the firm are separated.
– The shareholders still do care about the actions of management, even though those shareholders are not
involved directly in decision making.

Peter Kjeld Andersen

Q. Which of the following does not represent an agency cost resulting from the separation of
ownership from control of the firm?

A. Your choices:
a) The expense of providing management with bonuses based on profitability.
b) The cost of a company director taking a business trip to Hawaii with no potential benefit to
the company.
c) The cost of a staff Christmas party designed to enhance staff morale.
d) The cost of monitoring the activities of management to keep track of its expenditures and
decisions.

Answer is C
Peter Kjeld Andersen
Broadly, an agency problem:
• Involves two parties: a “principal” and an “agent”.
• The principal employs the agent to act on their behalf.
• But the agent is a person too, and may choose to use their position of responsibility to act in
their own self interest instead of the principal’s.
• e.g. The university (the principal) hires me (the agent) to teach you, but I have my own self-
interest and may want to turn up late and to make you do group work instead of teaching
you properly as the university wants.

An agency cost between shareholders (principal) and managers (agent):

• Is wealth lost by shareholders due to this agency relationship.
• Can be thought of as the cost to the company from:
– Management wasting company money on their own personal satisfaction instead of on maximizing
shareholder wealth; OR
– Spending corporate money on monitoring management closely to make sure they don’t waste money.
– Having to spend money to incentivize management to act in the interest of shareholders instead of their own
self interest.

Peter Kjeld Andersen

a) The expense of providing management with bonuses based on profitability.
– Example of having to spend money to incentivize management to act in the interest of shareholders instead of
their own self interest.
b) The cost of a company director taking a business trip to Hawaii with no potential benefit to
the company.
– Example of management wasting company money on their own personal satisfaction instead of on maximizing
shareholder wealth
d) The cost of monitoring the activities of management to keep track of its expenditures and
decisions.
– Example of spending corporate money on monitoring management closely to make sure they don’t waste
money.

c) The cost of a staff Christmas party designed to enhance staff morale.

– This is also an agency cost to the company, just like answers a), b) and d) above.
– It is money spent in order to encourage staff to do the job that they are hired to work, rather than acting in
their own self interest. Low morale = unproductive staff.
– However, this type of agency cost will be present regardless of whether there is separation of ownership and
control (i.e. in a corporation) or not (i.e. in a sole proprietorship or partnership)

Peter Kjeld Andersen

Q. Partnerships are a common form of business entity for small service businesses because:

A. Your choices:
a) they provide legal protection for the proprietor from the creditors of the firm.
b) they are ideal for where the business is owned by one person.
c) there are no legal requirements that need to be met to form a partnership.
d) they allow the company to buy, own and sell property.

Answer is C
Peter Kjeld Andersen
Q. The concept of investors being risk averse means that:

A. Your choices:
a) investors will always prefer an investment that carries less risk.
b) investors require higher returns to compensate for carrying more risk.
c) the investment’s risk is the predominant feature considered by the investor.
d) investors will make all possible attempts to avoid systematic risk.

• Like in Q2, investors don’t invest to minimize the chances of losses.

• A risk averse investor is one that dislikes risk. Out of two alternatives with an equal return, a
risk averse investor would pay more for the investment of lower risk.
• However, a risk averse investor will still invest in a riskier investment if the expected return is
great enough to compensate for the additional risk.

Answer is B
Peter Kjeld Andersen