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Lecture 1 1. Introduction
Citation preview
2
Corporate finance encompasses all of a firm’s decisions that have financial
implications
Aswath Damodaran, Corporate Finance, Theory and Practice (2nd Edition)
What is Corporate Finance?
5
• Value creation
• Can the financial function creat value on its own?
• YES
• Any financing operation allowing for a reduction in the firm´s average cost of
capital will create value on its own;
• However,
• It is also very important that the financial function helps the firm as a whole to
create value, namely by meeting the requirements allowing the firm to implement
all investment projects with a positive NPV.
I. The Financial Paradigm of the Firm
6
• Value creation
• What type of value? How can we measure value?
I. The Financial Paradigm of the Firm
The goal of financial management is to maximize the
value of the owners’ equity
Ross, Westerfield and Jaffe, Corporate Finance (9thEdition)
The objective in conventional corporate financial theory is to maximize the
value of the firm
Aswath Damodaran, Corporate Finance, Theory and Practice (2nd Edition)
Are these objectives compatible? Can the firm adopt more than one objective?
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• Value creation
• What type of value? How can we measure value?
• Equity Value vs. Enterprise Value vs. Firm Value
• From Accounting/Book Value to Market/Substancial Value to Market Price
• The Liquidation Value
• A company balance sheet can be divided in:
I. The Financial Paradigm of the Firm
Assets ● Fixed assets ● Current assets ● Non-operating assets
Equity
Liabilities ● Debt (Interest
bearing liabilities) ● Current liabilities
(Non-interest bearing liabilities)
8
• Value creation
• What type of value? How can we measure value?
• Balance Sheet of Procter & Gamble (PG) at end of 2014
I. The Financial Paradigm of the Firm
Equity
Current Assets:
Cash and cash equivalents $ 8,558
Available-for-sale investment 2,128
Accounts receivable 6,386
Inventories 6,759
Deferred income tax 1,092
Prepaid expenses 3,845
Assets held for sale 2,849
Total current assets 31,617
Property, plant and equipment, net 22,304
Goodwill 53,704
Intangible assets, net 30,843
Other non-current assets 5,798
Total assets $ 144,266
Shareholders’ equity:
Common stock $ 69,031
Treasury stocks (75,805)
Retained earnings 84,990
Other (8,240)
Total shareholders’ equity $ 69,976
Current liabilities
Accounts payable $ 8,461
Accrued and other liabilities 8,999
Liabilities held for sale 660
Debt due within a year 15,606
Total current liabilities 33,726
Long-term debt 19,811
Deferred income tax 10,218
Other non-current liabilities 10,535
Total l iabil it ies $ 74,290
(million USD)
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• Value creation
• What type of value? How can we measure value?
• Balance Sheet of Procter & Gamble (PG) at end of 2014 (re-arranged)
I. The Financial Paradigm of the Firm
Equity
Fixed Assets $ 106,851
Property, plant and equipment, net 22,304
Goodwill 53,704
Intangible assets, net 30,843
Currents Assets $ 32,438
Accounts receivable 6,386
Inventories 6,759
Deferred income tax 1,092
Prepaid expenses 3,845
Other non-current assets 5,798
Cash and cash equivalents (?) 8,558
Non-operating assets $ 4,317
Available-for-sale investment 2,128
Assets held for sale, net 2,189
Debt $ 35,417
Debt due within a year 15,606
Long-term debt 19,811
Shareholders’ equity $ 69,976
Common stock 69,031
Treasury stocks (75,805)
Retained earnings 84,990
Other (8,240)
Current liabilities $ 38,213
Accounts payable 8,461
Accrued and other liabilities 8,999
Deferred income tax 10,218
Other (non-current) liabilities 10,535
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• Value creation
• What type of value? How can we measure value?
• Balance Sheet of Procter & Gamble (PG) at end of 2014 (Book Value)
I. The Financial Paradigm of the Firm
Fixed Assets $106,851
Debt $35,417
Equity $69,976
Working Capital (Current assets less current liabilities)
- $5,775
Investments Financing
Non-Operating Assets $4,317
Enterprise value
Firm value
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• Value creation
• What type of value? How can we measure value?
• Market/Substancial Value
I. The Financial Paradigm of the Firm
Fixed Assets
Net Debt (Debt less Non-
Operating Assets)
Equity
Working Capital
Investments Financing
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12
• Value creation
• What type of value? How can we measure value?
• Market Price
• When financial markets are efficient, market price will equal market value;
I. The Financial Paradigm of the Firm
Fixed Assets
Net Debt (Debt less Non-
Operating Assets)
Equity
Working Capital
Investments Financing Nº of shares x
Share Price
(Nº of bonds x Bonds Price) -
MVNOA
E + net D
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• Value creation
• What type of value? How can we measure value?
• Liquidation Value
• The value which would be obtained if all assets were sold and debt and
all liabilities were paid back;
• Anytime the liquidation value is persistently higher than the financial
value, the company will be worth more “dead” than staying “alive”, for
its shareholders.
I. The Financial Paradigm of the Firm
14
• Value creation
• What type of value should we maximize?
• Take into consideration the actual reality of the activity of the firm
I. The Financial Paradigm of the Firm
Managers
Shareholders
Financial Markets
Society Creditors
Shareholders have little control over managers, who thus might place their own interests above shareholders´ interests.
Managers might manipulate information in order to misinform the markets. Markets can also be wrong.
Because creditors cannot control management, they will be exposed to the risk of wealth expropriation by managers or shareholders.
Firms might jeopardize the interests of society as a whole and those costs might be difficult to allocate to firms (e.g. pollution).
Agency conflicts
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• Value creation
• What type of value should we maximize?
I. The Financial Paradigm of the Firm
Objective: Maximize Firm Value
(Subject to complying with the ethical values related to the costs that might be imposed on society by meeting this objective)
Reduction or elimination of conflicts between the firm/management and
society.
Objective: Maximize shareholders Wealth
Objective: Maximize Equity Price
If conflicts of interest between shareholders and creditors and other stakeholders are eliminated or at least minimized.
If managers do not attempt to cheat or manipulate the markets and markets are efficient.
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• Value creation
• What type of value should we maximize?
• Even though the main objective of the firm is to maximize firm value,
value creation may be measured by changes in stock prices, providing
that:
• Managers act in the interest of shareholders and adopt the objective of maximizing
stock prices;
• Creditors are protected against the risk of wealth expropriation by shareholders;
• Managers do not manipulate information and do not succeed in cheating the
markets (efficient markets);
• Management decisions do not impose costs (externalities) on society.
I. The Financial Paradigm of the Firm
Briefly: providing that agency conflicts are minimized.
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• Value creation
• Advantages of adopting the objective of stock price maximization:
• Stock prices are the best observable figure amongst all other alternative
measures (in the case of listed companies).
• Contrary to net profits or sales, stock prices reflect permanently up-dated
information.
• Stock prices reflect the long-term effects of company decisions.
• Stock prices are the true measure of shareholders wealth.
• They allow for the choice of models to select the best investment projects
for the company and their best financing structure, and facilitate empirical
testing of those models.
I. The Financial Paradigm of the Firm
18
• Value creation
• How?
I. The Financial Paradigm of the Firm
Objective: Maximizing Firm Value
Investment Decisions
Invest in assets offering a return higher than the required rate of return
[hurdle rate].
Financing Decisions
Find the optimal capital mix to finance investments and the nature of debt which better meets the needs of
the corporation.
Dividend Decisions
Return to shareholders any cash exceeding investments
offering a return higher than the expected rate of
return.
The hurdle rate must reflect the investment risk
and the financing mix.
The return on the asset must
take into consideration
the amount and timing of cash-
flows
The optimal mix of equity and
debt maximizes enterprise value
The nature of debt depends
on the characteristics
of the enterprise
assets
How much cash to return will depend on
present and future
investment opportunities
Dividend policy will depend on shareholders preference for cash or stock
dividends.
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• Value creation
• Questions for which a CFO might have to provide an answer:
• Invest 25 million euros in increasing production capacity or wait for one
year to observe market demand performance?
• Implement or not a strategy of fixing [Risk Management]
• commodity prices;
• export exchange rates;
• interest rate on loans?
• How to finance the aggressive investment plan designed for the next three
years?
• Implement or not a new management incentive scheme, based on
incentives to be decided upon? [Corporate Governance]
I. The Financial Paradigm of the Firm
20
• Value creation
• Questions for which a CFO might have to provide an answer:
• To meet or not the demand of institutional investors for higher dividends?
Choose to offer stock dividends? Choose to offer stock repurchases?
• There is a merger proposal by a big telecom company. What to do? [EACC]
• Is it in the best interest of shareholders?
• What will be the reaction by foreign joint venture partners?
• Should the company remain listed in the stock market?
• Should capital structure be consolidated through an increase in equity?
I. The Financial Paradigm of the Firm
22
II. The Corporation and The Financial System W
orld
The Corporation
Investment
decisions
Financing
decisions
Financial
Markets
Inve
sto
rs
Financial
Intermediaries
Direct financing
Indirect financing
Exchange of capital and financial assets
Exchange of capital
& real assets
Corporate Finance Financial Markets and
Intermediaries
Financial
Assets
23
• A Classification of Financial Markets
Fin
ancia
l M
ark
ets
Money Market
(S-T)
Capital Market
(L-T)
IMM
Commercial Paper [Corporate Debt]
Public Debt (Bills)
Equity
(Stocks)
Hybrid
Debt
(Bonds) [Government & Corporate]
Libor rates (Euribor)
Yields
Yields
Repurchase agreements
(REPO)
Sort-term bank loans
Commercial paper
Treasure bills (T-bills)
Common stocks
Preferred stocks
Convertible bonds
Warrant bonds
Perpetual bonds
Treasury bonds (T-bonds)
Corporate bonds (fixed rate &
float rate), zero-cupon
II. The Corporation and The Financial System
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• Other important classifications of financial markets
• Primary market vs. Secondary market
• Cash market (spot market) vs. Futures market (derivatives)
• Domestic market vs. Currency market
• Domestic market vs. International market
II. The Corporation and The Financial System
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Financial Institutions
Credit Institutions
Central
Bank Banks
Other
Intermediaries
Commercial
Banks
Savings
Banks
Investment
Banks
Leasing
Companies
Factoring
Companies
Venture
Capital
Private Equity
Holding
Companies
Dealers
Other Financial
Institutions Auxiliary Institutions
Insurance Companies
Pension Funds
Insurance Brokers
Brokers
Assets Management
Firms
Information Services
• The financial system
II. The Corporation and The Financial System
Mutual
Banks
Mutual Agro
Banks