Introduction to Corporate Finance

1: The Scope of Corporate Finance

Australian capital markets did not decline as abruptly as those in the rest of the developed world during

2007–2010, and so recovery was not as keenly sought. But during 2010–2014 – as global equity markets,

in particular, rose – with more confidence in share trading by investors, Australian capital markets rose

again. By the end of 2014, the ASX was trading at overall share values exceeding those of 2006.

Figure 1.1 shows the value from May 2007–May 2011 of a share in Powershares Dynamic Banking Portfolio

Exchange Traded Fund – a portfolio of US bank shares. Clearly, the price decline over that period reflects the

impact of the crisis in banking, which was most severe in the US compared with most other countries.

For several decades, non-financial companies have increasingly turned to capital markets for external

financing. This shift toward greater reliance on market-based external funding has resulted in the growth

of mutual funds and superannuation funds – both financial intermediaries that are major purchasers of

the securities of non-financial companies.

When companies sell securities to investors in exchange for cash, they raise capital in primary-market

transactions. In such transactions, companies actually receive the proceeds from issuing securities, so

these are true capital-raising events. Once companies issue securities, investors can sell them to other

investors. Trades between investors, called secondary-market transactions, generate no new cash flow for

the company, so they are not true capital-raising events. Most share market trades are secondary-market

trades, whereas a large fraction of all bond market trades are capital-raising primary-market transactions.

CONCEPT REVIEW QUESTIONS 1-2

3 List and briefly describe the five basic corporate finance functions. What is the general relationship

among them?

4 Which of the five basic corporate finance functions might be considered non-traditional? Why do

you think these functions have become so important in recent years?

5 What is a financial intermediary? Why have these institutions been steadily losing market share to

capital markets as the principal source of external financing for companies?

primary-market

transactions

Cash sales of securities to

investors by a company to

raise capital

secondary-market

transactions

Trades between investors that

generate no new cash flow for

the company

FIGURE 1.1 BANK SHARES FALL BY HALF

From May 2007-February 2009, the banking sector suffered its most serious contraction since the Great Depression. One
barometer of the stress on banks during this period is the price of the Powershares Dynamic Banking Portfolio Exchange
Traded Fund, which fell from almost $22 per share to less than $11 in less than two years.

May-2007 May-2008 May-2009 May-2010 May-2011

$25

$20

$15

$10

$5

$0

Source: Prices for Powershares Dynamic Banking Portfolio Exchange Traded Fund. Obtained from Yahoo! Finance.