Stock Markets and Corporate Finance

Michael Dempsey

• Publisher: WSPC (EUROPE)
• Year: 2017
• ISBN:
  9781786343284
• Topic: Business
• Subtopic: Finanza
• Index: Business

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This book examines the nature of the stock market and its implications for corporate management. It provides an introduction to core issues in finance and differs from traditional textbooks in its recognition that "finance is not physics" — in the sense that how markets behave today is not necessarily how they will behave tomorrow. Nevertheless, a certain level of "physics" can be recognized as underpinning the development of stock market valuations and corporate financial decision-making.

In short, the objective of the text is to instill insight in regards to the functioning of markets and corporate behavior, as opposed to algebraic derivations from unrealistic assumptions. Rather than subscribe unthinkingly to an "efficient market hypothesis", at each stage of the development of the text's conceptual framework, we also recognize the reality of market "sentiment" and the fundamental uncertainty that managers face in their decisions.

Based around a teaching programme with worked questions and solutions, Stock Markets and Corporate Finance is the perfect accompaniment for MBA, undergraduate and graduate students looking for a critical textbook on the nature of the financial sector and corporate finance.

--> Contents:

• Introduction: Stock Markets and Corporate Finance
• A Short History of Stock Markets
• The Time Value of Money
• Market Debt, Interest rates and Valuation
• The Valuation of Equity Shares
• Shareholders' Required Rate of Return (The Cost of Equity Capital)
• Accounting Statements and Ratio Analysis
• Financial Leverage
• Valuation of Cash Flows
• Currency Exchange Rates
• Hedging Currency Risk: Derivatives
• Investment Decision Making: Theory and Practice
• Equity Value and Personal Taxes
• Financial Leverage (Revisited)
• Valuation of the Firm's Cash Flows (Revisited)
• Ethical Behavior

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--> Readership: MBA, undergraduate and graduate students looking for a critical textbook on the nature of the financial sector and corporate finance. -->
Corporate Finance;Stock Markets;Business;Management;Physics0

Chapter 1

Introduction: Stock Markets, Investments and Corporate Financial Decision Making

Markets are designed to allow individuals to look after their private needs and to pursue profit. It’s really a great invention, and I wouldn’t underestimate the value of that. But they’re not designed to take care of social needs.

George Soros

It is a kind of spiritual snobbery that makes people think they can be happy without money.

Albert Camus

Companies are not charitable enterprises: They hire workers to make profits. In the United States, this logic still works. In Europe, it hardly does.

Paul Samuelson

The teacher who is indeed wise does not bid you to enter the house of his wisdom but rather leads you to the threshold of your mind.

Khalil Gibran

Welcome to Stock Markets and Corporate Finance!

The text is designed to introduce you to financial markets and large firms, as well as supplying an intellectual framework within which to recognize and understand the behavior of these institutions.

Before we progress much further, it is perhaps appropriate that we convey something of the broad philosophy and positioning of the chapters in regard to their overarching assumptions and perspectives.

We commence with the statement that the history of the landscape of modern civilization is inseparable from the history of financial markets and their financing of large firms.¹ The human brain that developed the aerodynamics of the boomerang as an instrument that could be projected and return to base many thousands of years ago would one day develop the capacity to send a spacecraft as far as the Moon and have the instrument return. But ingenuity without the means of production afforded by large firms financed by capital markets can take us only so far. The Aboriginals of Australia did not see the need to develop large firms with financial markets, whereas other societies did. That was the big difference.

Financial markets function to gather from millions upon millions of individuals, the financial savings — each insignificant individually — that are in excess of their immediate needs, so that investments of billions of dollars can be invested in large firms. The firm can avail of such investment finance as either:

Debt finance: By borrowing (by issuing structured “IOUs” as either short-term instruments or long-term bonds), or

Equity finance: By issuing stocks or shares² as certificates of ownership of the firm. The firm’s shareholders then own the firm in proportion to the proportional number of shares they own (if the firm has issued 1 million shares and I purchase a single share, I am the owner of one-millionth of the firm).

When a firm is “incorporated” as a public company, the firm is made a legal entity in its own right under the corporate law of the state. The incorporated company is then registered with the appropriate authority (Securities and Exchange Commission, SEC, in the US). By submitting itself to the rules of a stock exchange,³ the firm’s shares and bonds can be listed for trading on the exchange. This means that when a firm raises funds by issuing equity and debt, these instruments can continue to be traded between sellers and new buyers (in what we refer to technically as a secondary market, but which more generally is referred to as the stock market, whose prices are reported daily in the news).

Without access to institutional financing arrangements, large firms would not exist. And without such firms, we would be without the capacity to develop modern civilization; from the technologies of electronics and airplanes, urban infrastructure and highways, to the mass, and therefore affordable, production of our housing, pharmaceuticals, cars, agriculture, and so on. In addition, we would be without services such as banking and financing arrangements for smaller firms, and our insurance and pension arrangements. It is not an exaggeration to say that the invention of the public company can be set alongside the manipulation of fire and the invention of the wheel in laying the foundations for human inventiveness.

When I was an engineer, I viewed large companies as existing to produce and deliver the goods and services that are associated with their brand names. At my induction as a new petroleum engineer at British Petroleum (BP), a person from human resources (HR) introduced the organizational setup of the company by placing a transparency sheet on the light projector (in the days before PowerPoint presentations). The transparency highlighted the various departments of the company spreading out like spokes on a wheel from a central hub. And there at the center in the hub was the department of HR. For the HR presenter, a firm represented first and foremost a number of people in some cooperative activity. As for the significance of the department of petroleum engineering, the presenter was at first actually unable to locate it on his transparency. Only when he moved the transparency to the right a little did it show up at the very outer edge — literally falling off the end of his perception of the firm.

In this text — in contrast to the concept of the firm as existing primarily as either a provider of goods and services or as a social construct — we are, in effect, adopting a third perspective of the firm, namely, the firm as that which is sustained by financial markets, provided that the firm continues to meet the market’s demands for financial performance. This perspective leads to a rather impersonal view of firms and financial markets. Indeed, we typically refer not to the individual people who manage or are responsible for large firms, or those who are active in the financial markets that provide services for these firms, but to the firms and markets of themselves — to the extent, in fact, that we speak of the actions of the organization as of the organization itself — and not of the individuals who are engaged in the organization. As we have observed, a large company typically stands as a legal entity in its own right. If the firm transgresses any laws or is made liable to pay compensation (polluting the Florida coast line as was the case for BP oil company, for example), it is the firm in its own right — as opposed to its management team — that is almost certainly made liable before the law. The exception would be if a case of gross negligence could be brought against particular members of the firm. As for the firm’s shareholders, their maximum risk is the loss in market value of their shares.

An essential feature of the publicly incorporated company is that the ownership and management structures of the firm can be separated, meaning that the firm’s shareholders, as owners, are not involved in the day-to-day management or running of the firm. To ensure the good running and management of the firm on behalf of the firm’s shareholders, a public firm will have a board of directors, which assumes responsibility for the firm’s compliance with accepted standards of good conduct, as well as for ensuring that the company is managed in the interests of its shareholders. The members of the board of directors do not involve themselves in the day-to-day management and running of the firm, but will meet a number of times in the year, when they can expect to be briefed regarding the firm’s activities. This allows board members to share their insights on such as the movement of markets and the economy and to offer their own strategic advice. A member of the board may be a member of the management team of another related company (or may be a retired manager), and is thereby in a position to offer insights and knowledge on the firm in which he or she is a board member.

The firm’s constitution will generally have clauses to protect shareholder interests. For example, shareholders may be called to vote on the appointment of a new member to the board of directors — who is there to safeguard their shareholder interests (although the new director will be proposed by the current board and approval by the firm’s shareholders is normally a formality). Another occasion on which the firm’s shareholders will likely be called to vote is when the firm is considering an additional issue of shares. The reason is that such an issue dilutes the ownership of the current shareholders.⁴ For this reason, shareholders may seek to vote on the issue in line with their interests.

Large institutional shareholders and fund managers — the pension and insurance funds and the managers of private wealth — may from time to time communicate with the firm’s management directly to influence the firm in accordance with their preferences — for example, to influence the amount of the firm’s dividend payout. Shareholders with fewer shares, however, are likely to be more passive and take no active interest in the day-to-day running of their company. Large bond holders are typically also passive to the day-to-day running of the company.

Such “arm’s length” detachment — whereby shareholders ultimately express their dissatisfaction with the company by selling their shares (abandoning the firm), and the firm’s bondholders are prepared to bring the firm to receivership and bankruptcy to protect their assets — is referred to as the Anglo-Saxon model of capitalism (as typified in the US, UK and, for example, Australia).

By comparison, in Europe, China and Japan, relations between the firm’s management and both its shareholders and the banks to which the firm is beholden typically take the form of a more intimate alliance, with all parties committed to the firm’s success. Shareholder ownership structures in these countries are likely to be more concentrated than is the case for their Anglo-Saxon counterparts, with the banks having votes on the company’s affairs and, in reciprocation, seeking with management and the firm’s shareholders to assist the firm, particularly if the firm should encounter financial difficulty.

In its pricing of the firm’s equity shares or stocks in the marketplace, the stock market is making a judgment regarding the firm’s ability to meet investor expectations. When such expectations are downgraded, investors continue to purchase the firm’s shares — but at a lower price: thus, the share price declines. At this point, the firm’s current shareholders take a financial loss. Another implication of stock market declines, which became a reality during the global financial crisis of 2007–2009, is that the firm can be declared bankrupt if the firm’s market value drops below the value of the firm’s financial obligations. From such perspectives, the motive of the firm is the profit motive.

Motivated by profit, large firms provide us with the enhanced benefits of the material world as we know them: our cars, highways, hospitals, homes, affordable technologies, etc., as well as financial services such as banking and provision for pensions and insurance services. In return, we are beholden to large firms. In the workplace, we may even feel that we are dwarfed and controlled by them. Large firms regularly lobby politicians for policies that accord with their profit motive. We might say that the firm as a legal construct has become a self-reliant entity — for better or for worse — that is powerfully motivated to satisfy its pay-masters, which are the financial markets that sustain the firm with finance on conditions that the firm continues to demonstrate its ability to perform financially satisfactorily. At one time, the place of worship was the tallest building within a society. It would have been presumptuous to build higher. Then, the town’s civic buildings dominated. Now, it is the buildings of financial institutions that dominate the skyline, lit up at night as one with the stars and humbling all below.

In seeking to enrich ourselves, from time to time, we are perhaps given to invest our valuable savings in opportunities with highly uncertain outcomes (a flutter on a horse race, the lottery, etc.) In these cases, we are “risk-seeking”. We need some excitement in our lives from time to time! Nevertheless, when it comes to making more substantial investments, such as an investment of one’s total wealth, provisions for loved ones, or for retirement plans, the same person is likely to be much more “risk-averse”. The stock market has traditionally rewarded long-term investment. But the markets are “risky” in that they are prone to quite large-scale fluctuations as the economy moves through cycles of prosperity and decline — in addition to being prone to self-induced gyrations: “bull” and “bear” markets as sentiment swings between optimism and pessimism, greed and fear. We are entitled to fear that the market will encounter a “global financial crisis,” from which we cannot recover before we have withdrawn from the market. The interplay between risk (to which we are averse) and high returns (which we are seeking) identifies the essential dynamic at the heart of market behavior.

Thus, in our financial models, it is assumed that risky investments require an expected rate of return that exceeds the risk-free rate offered by, say, a bank deposit rate, or by the government’s short-term treasury bills. Of course, such “expectation of return” does not guarantee a return higher than that of a risk-free asset — otherwise, the investment would not be risky! Conceptually, by an “expectation of return” for an asset, we have in mind a probability-weighted assessment of possible returns for that asset.

The difference between the expectation of return offered by the market of all stocks and a risk-free rate is termed the market risk premium (MRP). The expected rate of return on any individual asset j — which we call k_j — should, therefore, in principle, be determined as the risk-free rate (r_f) plus the MRP multiplied by the asset’s sensitivity to the market (which we refer to as the beta of the asset, β_j), so that we have the expected rate of return on asset j,k_j, as

Not with standing its simplicity, the above equation is referred to somewhat grandly as the “capital asset pricing model”, or the CAPM (prono...