FINANCE 201

Corporate Finance
Instructor: FU Fangjian
Email: fjfu@smu.edu.sg
Phone: 68280244
Office: LKCSB 4060

CLASS MEETING TIMES AND VENUES

Session G4

Monday 15:30-18:45
LKCSB Class Room 3.8

Session G1

Tuesday 15:30-18:45
LKCSB Class Room 3.6

Session G2

Wednesday 19:00-22:15
LKCSB Class Room 3.8

Session G3

Friday 12:00-15:15
LKCSB Class Room 3.8

Prof. Fu Fangjian

Lecture Notes 01

SMU Academic Calendar

Term 2 2015 Spring

Midterm Quiz
Chinese New Year

Prof. Fu Fangjian

Lecture Notes 01

Course Outline
Capital Structure
Equity and Debt Financing
Payout Policy

Mergers and Acquisitions

Corporate Governance (if time permits)
Prof. Fu Fangjian

Lecture Notes 01

What are required for this course?

FNCE101 (or alike) is a prerequisite
Your perspective as a CEO/CFO of an
industrial firm contemplating your firms
optimal financial policies

Less calculation, but a lot more thinking

than other finance courses
To understand the underlying economics
behind the observed industry practices
Prof. Fu Fangjian

Lecture Notes 01

FNCE201 Corporate Finance

Corporate Finance:
Global Edition, 3/e
Author

: Berk,
DeMarzo

Publisher : Pearson
ISBN

: 9780273792024

Available at Booklink@SMU!

Grading
Final course grade will be determined by
Final Exam (35%)
Time: 21 April 2015, 13:00 -15:00
Closed-book/notes, no make-up

Midterm Quiz (25%)

Time: 13 Feb 2015, 16:00 18:00
Closed-book/notes/laptops, no make-up

Class Participation (5%)

Business News Recommendation (5%)
Group Project (30%)
Prof. Fu Fangjian

Lecture Notes 01

Group Project
Purpose: Apply knowledge learned from the course to a real firm or a
real business case
Suggested frameworks:
(1) Pick a public firm listed on Singapore Stock Exchange (or other
exchanges)
Singapore Airlines, Capital Land, SingTel, Singapore Exchange,
OSIM, Parkway Holdings, BreadTalk, Food Junction
Examine the financial policy of the firm, with a particular focus on its
major financial events such as IPO, SEO, bank debt, public bond,
stock repurchase, dividend policy, M&A, if any, and analyze the
business environment/ background of its financial decisions.
Did the firm make the right decisions? Why?
What was the impact on the firms investment policy and value?
How do you evaluate the firms current situation? Whats the
biggest challenge in the near future? If you were the CEO/CFO
of the company, what would you do in the next five years?
Prof. Fu Fangjian

Lecture Notes 01

(2) Focus on one particular corporate event,

analyze it in depth Case Study
IPO, M&A, stock repurchase, LBO, bankruptcy
How? Why? Impact?
Example: Google/Baidu/Tiger Airways/LinkIn IPO; the
bankruptcy of China Aviation Oil/GM; SingTels
acquisition of Optus; HP-Compaq merger; SGX-ASX
merger bid;

A clear research question is emphasized

(theme).
Not a news report or a narrative of details, I
expect to see your critical thinking and logical
arguments supported by sensible data analysis.
The arguments need not to be 100% correct.
Prof. Fu Fangjian

Lecture Notes 01

Group Project Schedule

Form a group by the end of the third week and inform my TA
Group size: 3 ~ 4 students per group
Members in a group by default get same project grade. However I
reserve the right to give different grades among group members under
some extreme situations.
Coordinating TA: TAY Quan Feng qftay.2011@business.smu.edu.sg

Inform my TA the general topic before the recess week

Groups are not allowed to work on a same topic, so first report, first get.

Present your work in week 12/13 (about 25~30 min per group)
Cross-examined by all audience
Revise based on received comments

Email me the final written report before the final exam day (no hard
copy, to save trees)
Prof. Fu Fangjian

Lecture Notes 01

10

Group Project Miscellaneous

The project contributes 30% to your final course
grade. Among it, 15% is based on the presentation
and 15% is based on the written report.
The ideal length of the written report is about 20-25
pages including tables, figures, and appendix (font
11, double spacing)
I have posted some sample project reports done by
previous students

Prof. Fu Fangjian

Lecture Notes 01

11

Reading Recommendation
5% of your course grade
Do it in groups (one article per group)
Recommend a recent business news article (not
more than two-pages length) to the class
Write a couple of paragraphs (not more than 500
words) to discuss why you think this article is
relevant to the stuff that we are learning in this
course.
Due in Week 11 (the last lecture week); a hard copy
to be submitted in class
Prof. Fu Fangjian

Lecture Notes 01

12

Communications
SMUeLearn
FNCE201-Corporate Finance-G1-2-3-4
Lecture notes, sample projects, sample exams,
additional readings, Q&A etc.
Check it once a week for any updates
Post your questions under Discussions

Office hours:
Anytime I am in office, however, you are encouraged to
call or email me before coming over.
I am also available to answer questions by emails
You are suggested to first discuss with your classmates
Prof. Fu Fangjian

Lecture Notes 01

13

Background Knowledge
& Course Overview

Prof. Fu Fangjian

Lecture Notes 01

14

An Example
(as a refreshment of FNCE101)
OSIM is debating if they should invest on a project called
UDance. It requires an upfront investment of $10 million
(R&D, Marketing etc.), and delivers a cash flow of $0.5
million at the end of the first year, $2 million at the end of
the second year, and due to increasing competition, $1.2
million each year thereafter. The discount rate is 10%.

How to get the investment capital of $10 million?

Prof. Fu Fangjian

Lecture Notes 01

15

FNCE101 vs. 201

In FNCE101, we focus on firm investment
decisions (Capital Budgeting)
Estimate expected future cash flows and the
appropriate discount rate
Calculate the projects net present value (NPV)
Firms undertake all positive NPV projects

In FNCE201, we learn how to finance the

investment
There are many different types of financing tools
How do they affect firm value differently?
Prof. Fu Fangjian

Lecture Notes 01

16

Firm Types
Sole proprietorships
Business owned and run by one person/family;
Easy to create; few employees typically;
Unlimited liability

Partnerships
Like sole proprietorship but with more than one owner.
Often based on the owners personal reputations, e.g., law firms,
groups of doctors, and venture capital firms
General vs. Limited partners (in a limited partnership)
Limited partner: limited liability, no/limited management
authority

Limited liability companies (LLC)

All owners have limited liability
They jointly run the business
Prof. Fu Fangjian

Lecture Notes 01

17

Corporations
A legal entity separate and distinct from its owners,
solely responsible for its own obligations
can enter into contracts, own assets, borrow money, etc.

No limit on the number of owners; easier transfer of

ownership (share, stock, equity)
Owners (shareholders) have limited liability
Separation between ownership and control

Double taxation (in many countries but Singapore)

Prof. Fu Fangjian

Lecture Notes 01

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Double Taxation

Prof. Fu Fangjian

Lecture Notes 01

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Distribution of U.S. Firm Types

Prof. Fu Fangjian

Lecture Notes 01

20

Life Cycle of a Firm

Entrepreneur starts a business with his own wealth and
borrowing from family/friends
Seek venture capital/ private equity to expand business
Go public
IPO: Private firms sell equity to the public to raise capital
SEO: Public firms can sell equity for multiple times

Borrow from banks

Large reputable firms might issue public bonds
Public firms may disappear due to
Bankruptcy and liquidation
Mergers & Acquisitions
Going private (e.g., LBO)
Prof. Fu Fangjian

Lecture Notes 01

21

A Firm Is a Dynamic Process of Capital

Firms retain operating profits for future uses
Internal funds (accumulated retained earnings)

Firms raise external capital to finance investment

Debt
Equity

Firms pay out (Investors demand returns on their

investment)
Interests for debt-holders
Dividends and repurchases (capital gains) for equityholders
Prof. Fu Fangjian

Lecture Notes 01

22

A Firm Is a Combination of Assets

Equity (Stocks)
Shareholders have ultimate control rights and are
residual claimants of cash flows
Receive dividend payment and capital appreciation
(unlimited upside)
Limited downside (protected by limited liability)
Elect the board of directors on per share basis
Delegate control rights to the corporate board
The board appoints a CEO, who will be responsible for daily
operations
Agency Problems (as a result of separation of ownership and
control)
Corporate Governance the mechanism to make sure the
management is working for the shareholders
Prof. Fu Fangjian

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23

Organization of a Typical Corporation

Prof. Fu Fangjian

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24

A Firm Is a Combination of Assets

Debt (Leverage)
Borrower (or issuer) receives capital now and
promises (in a contract) specific payoffs (interests and
principal) at specific times in the future.
Debt-holders (lender, creditor) have priority on cash
flow rights over equity-holders
Debt-holders obtain asset control rights if and only if
the firm defaults or violates debt covenant.

Limited downside and limited upside

Prof. Fu Fangjian

Lecture Notes 01

25

Rights and Responsibilities

Cash flow rights
How firm-generated cash is distributed among claim holders
Debt-holders (secured, senior, junior) first, then equity-holders
(preferred, common)

Control rights
Allow claim holders to influence corporate decisions
Debt holders usually do not have control rights unless the firm
defaults on payments or violates covenants

Each financial claim is a bundle (and a balance) of cash

flow rights and control rights
Prof. Fu Fangjian

Lecture Notes 01

26

Debt and Equity

A firm consists of equity and a single bond that promises to
pay $200 at Time 1 (maturity). The firm value varies over
time, but is always the sum of debt and equity values. How
much each claim holder will receive depends on the firm value
at debt maturity.

Firm value
at maturity

Bond value
at maturity

Stock value
at maturity

0
100
200
1000
Prof. Fu Fangjian

Lecture Notes 01

27

V=D+E
The face value of bond = $200 at Time 1

Prof. Fu Fangjian

Lecture Notes 01

28

Other Assets Are Hybrids of Debt and Equity

Preferred stocks
Receive preferred dividends on a regular basis
No voting rights as long as the dividends are paid in time
Privileged cash flow rights relative to common stocks, but lower
than debt
A kin of debt

Convertible bonds
A convertible bond gives its owner the option to exchange the
bond for a predetermined number of common stocks prior to a
predetermined date
No voting rights before conversion
Equity in disguise
Prof. Fu Fangjian

Lecture Notes 01

29

Debt Has Many Forms

Maturity: long-term or short-term
Commercial Paper: issued by high credit rating companies or
financial institutions, usually mature in less than 6 months
Century Bond

Priority: senior or junior/subordinated

If the borrower defaults, senior debt is to be repaid earlier

Interest rate: fixed or floating

Usual base rates to determine the floating rate: LIBOR (London
InterBank Offered Rate); SIBOR in Singapore
Floating interest rate is often capped (or collared); i.e., the
interest rate will never exceed a predetermined ceiling (and a
floor).

Prof. Fu Fangjian

Lecture Notes 01

30

Debt Has Many Forms (contd)

Collateral: secured or naked
Assets set aside for the protection of a specific creditor. The
creditor claims the ownership of these assets when default occurs.
e.g, mortgage loans are collateralized by the underlying real
estate.
Which one charges a higher interest rate?

Interest payment: coupon or zero-coupon

Zero-coupon bonds pay a fixed amount of money (face value) only
at the final maturity date, e.g. T-bills.
Coupon bonds make interest payments on a regular schedule,
typically twice a year, and the principal is repaid as a balloon
payment at the end.
Most corporate bonds pay coupons.

Prof. Fu Fangjian

Lecture Notes 01

31

Debt Has Many Forms (contd)

Convertible bond (vs. straight/regular bond)
All else equal, which bond offers a higher interest rate?

Puttable bond
Allow the bondholder to sell the bond back to the issuer at a prespecified price

Callable bond
Allow the issuer to retire the bond before maturity by paying a
pre-specified price
Many long-term bonds, such as century bonds, are often callable
Mortgage is in fact callable because it usually allows early
repayment

Prof. Fu Fangjian

Lecture Notes 01

32

An Example of Convertible Bond

A firm has 400 shares of common stocks and 200
convertible bonds. Each convertible bond promises a
payment of $10,000 in Dec 2015. The convertible bond
holder can at his discretion convert each bond into 3 new
shares of common stocks.
What should be the minimum price of stock in Dec 2015
that the bondholder would choose to convert the bond?
Conversion price

What is the consequence of the conversion?

No more debt obligations
Dilution of equity ownership
Prof. Fu Fangjian

Lecture Notes 01

33

(in ,000)
Prof. Fu Fangjian

Lecture Notes 01

34

Bond Ratings
Done by three major credit rating agencies: Moodys,
Standard & Poors (S&P), and Fitch
Bonds of higher ratings have lower rates of returns (bond
yields)

Investment grade bonds vs. Junk bonds

Investment grade: Baa (by Moodys) and above; BBB (by S&P or
Fitch) and above
Junk bonds / high-yield bonds / speculative bonds

Government bonds, or sovereign debt, often considered

risk-free and thus have the highest credit ratings
Not any more , Russia in 1998, Argentina in 2014
Greek government debt was downgraded to junk bonds in 2010
Prof. Fu Fangjian

Lecture Notes 01

35

 Prof. Fu Fangjian

Lecture Notes 01

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 Prof. Fu Fangjian

Lecture Notes 01

37

S&P Strips U.S. of Top Credit Rating

Wall Street Journal (6 Aug 2011)
A cornerstone of the global financial system was shaken
Friday when officials at ratings firm Standard & Poor's said
U.S. Treasury debt no longer deserved to be considered among
the safest investments in the world.
S&P removed for the first time the triple-A rating the U.S.
has held for 70 years. It downgraded long-term U.S. debt to
AA+, a score that ranks below more than a dozen
governments.
Prof. Fu Fangjian

Lecture Notes 01

38

 Prof. Fu Fangjian

Lecture Notes 01

39

Financial Market
Primary market
Firms sell new equity or bonds to the public;
Firms obtain cash (capital inflow)

Secondary market (Aftermarket)

Investors trade previously-issued stocks or bonds
between themselves
A transfer of ownership, no new securities are created
No direct effects on firms cash flow and operations
Prof. Fu Fangjian

Lecture Notes 01

40

Financial Institutions
Commercial banks: saving and loan companies
Citibank, HSBC, DBS, OCBC, UOB, ICBC

Insurance companies: Collect fees from policy sale, make

long-term investment on corporations
AIG, Prudential, Great Eastern

Investment banks: underwriting securities / M&A advisors

Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley,
Credit Suisse, Deutsche Bank, Lehman Brothers, Bear Stearns

Wealth management funds: invest by holding various

securities; capital contributed by investors
Mutual funds, hedge funds, pension funds, sovereign wealth
funds, university endowment etc.
Prof. Fu Fangjian

Lecture Notes 01

41

Homework Problem
Read Chapter 1 & 2
You are a shareholder in a U.S. corporation. The
corporation earns $7.50 per share before taxes. Once it
has paid taxes, it will distribute the rest of its earnings to
you as a dividend. The corporate tax rate is 35% and the
personal tax rate on dividend income is 20%. How much
is left for you after all taxes are paid? What if it is a
Singapore company?