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Lecture 1 Introduction to Corporate Finance Class notes

Lecture 1 Introduction to Corporate Finance

Financial Management Duties

Capital Budgeting The process of planning and managing a firms long-term

investments

Capital !tructure The specific mi"ture of long-term de#t and e$uit% the firm uses tofinance it operations

&or'ing Capital Management Managing the firms short-term assets and lia#ilities

Financial (fficers

Chief Financial (fficer oversees the treasurer and controller and sets overall financialstrateg%

Treasurer responsi#le for financing) cash management) and relationships *ith financialmar'ets and institutions

Controller responsi#le for #udgeting) accounting) and auditing

Forms of Business (*nership

+roprietorship ,n unincorporated #usiness o*ned #% a single individual

,dvantages asil% and ine"pensivel% formed Fe* government regulations ,voids corporate income ta"es

Disadvantages .nlimited lia#ilit% for the o*ner Limited to the life of the o*ner Illi$uid Difficult to o#tain large amounts of capital

+artnership Business o*ned #% to* or more persons *ho are personall% responsi#le forall its lia#ilities

,dvantages asil% and ine"pensivel% formed Fe* government regulations ,voids corporate income ta"es


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Disadvantages .nlimited lia#ilit% for general partners Limited life for the organi/ation Difficult to transfer o*nership Difficult to o#tain large amounts of capital

Corporation , #usiness that is legall% distinct from its o*ners

,dvantages .nlimited life as% to transfer o*nership Limited lia#ilit%

Disadvantages Double taxation Comple" legal re$uirements

0%#rid Forms of (rgani/ation

Limited partnership Certain partners are designated general partners) *ho haveunlimited lia#ilit% (ther o*ners are limited partners #ecause their lia#ilit% is limited

+rofessional Corporation , t%pe of corporation common among professionals ,n !corporation has 2 or fe*er shareholders

The 3oal of Financial Management

Ma"imi/e !hareholder &ealth Mangers *or' on #ehalf of shareholders and should pursue policies that enhance shareholder value

!ocial 4esponsi#ilit% The concept that #usinesses should #e activel% concerned *iththe *elfare of societ% at large

,genc% +ro#lems and Control of the Corporation

,genc% +ro#lem The conflict of interest #et*een the firms o*ners and managers

Management 3oals Managers have a tendenc% to increase their o*n per's or toincrease the si/e of the organi/ation in an attempt to increase their po*er

Methods to ntice Managers to ,ct in the Best Interests of !toc'holders

The threat of firing The threat of ta'eovers Managerial compensation


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Direct Intervention #% !hareholders

(*nership !tructure outside the . ! in some countries) o*nership is moreconcentrated) creating separate pro#lems


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Lecture 2 Financial Statements, Taxes, and Cash Flow Class notes

Lecture 5 Financial !tatements) Ta"es) and Cash Flo*

4evie* the income statement) #alance sheet) and cash flo* statement

mphasi/e cash flo*s and the difference #et*een accounting accruals

Income !tatement

Income !tatement !ho*s ho* profita#le a firm has #een over some period of time

3,,+ 4evenues appear *hen the% accrue) not *hen the% are collected "penses arematched *ith the revenues that appear

6oncash items Depreciation

Ta"es The marginal ta" rate is the most relevant *hen evaluating pro7ects

Balance !heet

Balance !heet +resents a snapshot of the firms assets) lia#ilities) and o*ners e$uit%

,ssets Listed in order of their li$uidit% on the left-hand side of the statement

Current ,ssets life of less than one %ear

Fi"ed ,ssets life longer than one %ear

Lia#ilities and (*ners $uit% The claims against assets

Current Lia#ilities life of less than one %ear

Long-term Lia#ilities de#t 8financial leverage9 that is not due in the ne"t %ear

(*ners $uit% value of the capital supplied #% common stoc'holders

Boo' :alues vs Mar'et :alues assets must #e sho*n on the #alance sheet at theirhistorical cost ad7usted for depreciation These are not mar'et values

Cash Flo* ,nal%sis

Cash Flo*s ,nal%sis sho*s the firms cash receipts and cash pa%ments over a period oftime

Cash Flo* from (perations #egins *ith net income and ad7usts for non-cash items


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Lecture 2 Financial Statements, Taxes, and Cash Flow Class notes

Cash .sed for Investments mone% spent on fi"ed assets and received from sales offi"ed assets

Cash Flo* from Financing ,ctivities

Cash flo* to creditors interest paid minus net ne* #orro*ing

Cash flo* to stoc'holders dividends paid minus net ne* e$uit%


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Lecture 3 atio !nal"sis Class notes

Lecture ; 4atio ,nal%sis

(#7ectives

Introduce the anal%sis of financial statements through the use or ratios

4evie* the uses and limitations of ratios

4atio ,nal%sis

4atio ,nal%sis designed to help evaluate financial statements

Li$uidit% 4atios

,sset Management 4atios

Long-Term !olvenc% 8De#t9 4atios

+rofita#ilit% 4atios

Mar'et :alue 4atios

Li$uidit% 4atios sho* the relationship of a firms cash and other current assetsto its current lia#ilit%

Current 4atio indicates the e"tent to *hich current lia#ilities are covered #%those assets e"pected to #e converted to cash in the near future


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Da%s !ales in 4eceiva#les the average length of time the firm must *ait afterma'ing a credit sale #efore receiving cash

Fi"ed ,sset Turnover measures ho* effectivel% the firm uses its plant ande$uipment

Total ,sset Turnover measures ho* effectivel% the firm uses all of its assets

4atio ,nal%sis

Long-Term !olvenc% 8De#t9 4atios The e"tent to *hich a firm uses de#tfinancing It has three implications=

!toc'holders maintain control *hile limiting their investment

4is's of the firms is transferred to creditors

4eturn on the o*ners e$uit% is magnified

Total De#t 4atio measures the percentage of funds provided #% creditors

Times-Interest- arned measures the a#ilit% of the firm to meet its annualinterest pa%ments

+rofita#ilit% 4atios sho* the com#ined effects of li$uidit%) asset management)and de#t on operating results

+rofit Margin measures income per dollar of sales

4eturn on ,ssets 84(,9 measure of profit per dollar of assets

4eturn on $uit% 84( 9 measures the rate of return on common stoc'holdersinvestment

Mar'et :alue 4atios relates the firms stoc' price to its earnings and #oo' value per share

+rice- arnings 8+> 9 4atio sho*s ho* much investors are *illing to pa% perdollar of reported profits

Mar'et-to-Boo' 4atio the ratio of a stoc's mar'et price to its #oo' value andgives an indication of ho* investors regard the compan%


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Financial !tatement .ses

Internal .ses evaluate management and planning for the future

"ternal .ses Investor sand creditors find the information useful in theirdecision ma'ing

Time-Trend ,nal%sis "amine *hether there is a strengthening or *ea'ening position

+eer 3roup ,nal%sis Compare a particular compan% *ith a group of?#enchmar' companies

Limitations of 4atio ,nal%sis

6ot as useful for large) diverse companies

Inflation distorts #alance sheets

!easonal factors distort ratio anal%sis

?&indo* dressing techni$ues distort financial statements

Different accounting practices can distort comparisons

6o o#7ective standard on *hat is good and #ad


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Lecture # Lon$%Term Financial &lannin$ and 'rowth Class notes

Lecture @ Long-Term Financial +lanning and 3ro*th

(#7ectives

"amine the reasons for financial planning

(utline the process for developing a #udget

+resent some common pro#lems

Financial +lanning

Basic +olic% lements

6eeded investment in ne* assets

Degree of financial leverage the firm uses

Firms dividend polic%

&or'ing capital polic%

Financial +lanning +rocess

,nal%/ing the investment and financing choices

+ro7ecting the future conse$uences of current decisions

Deciding *hich alternatives to underta'e

Measuring su#se$uent performance against goals

Dimensions of Financial +lanning focus is on capital #udgeting for the ne"t t*oto five %ears

&orst case scenario planning for lean economic times

6ormal gro*th firm gro*s *ith its mar'ets

,ggressive gro*th rapid gro*th *ith mar'et or e"ceeding mar'et

+lanning ,ccomplishments


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"amining interactions

"plore options

,void surprises

nsure feasi#ilit% and internal consistenc%

Financial +lanning Model

+ercent of !ales ,pproach Most varia#les are proportional to sales

Inputs and Considerations

!ales forecast

,sset re$uirements

Financial re$uirements

The plug e"ternal financing needed

Inputs and Considerations

Dividend pa%out ratio

4etention ratio

!pontaneous financing

Fi"ed asset re$uirement

"cess capacit%

Lump% assets

Determinants of 3ro*th

+rofit margin higher profits support higher gro*th

Dividend polic% lo*er dividend provide more internal funds for gro*th

Financial polic% de#t can #e used for gro*th


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Total asset turnover increases allo* for higher gro*th Current assets *ouldsupport increased sales

!ummar%

sta#lishes goals and used to evaluate su#se$uent performance

Forces the financial manager to prepare for adverse events and devise strategies

+roceeds #% trial and error


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Lecture ( Interest ates and )ond *aluation Class notes

Converti#le Bond , #ond that is e"changea#le) at the option of the holder) forcommon stoc' of the issuing firm

Income Bond , #ond that pa%s interest onl% if the interest is earned

Inde"ed Bond , #ond that has interest pa%ments #ased on an inflation inde" soas to protect the holder from inflation

Bond Features

Call +rovisions gives the issuing corporation the right to call the #onds forredemption

Call +remium the additional sum the compan% must pa% the #ondholders to callthe #onds

Deferred Call Bonds are often not calla#le until several %ears after the% *ereissued

4efunding (peration issuing lo*er-%ielding securities and using the proceeds toretire a previous higher-rate issue

!in'ing Funds a provision in a #ond contract that re$uires the issuer to retire a portion of the #ond issue each %ear

The compan% can call in for redemption a certain percentage of the #onds each%ear

The compan% ma% #u% the re$uired num#er of #onds on the open mar'et

Bond :aluation

Bond :aluation the value of an% financial asset is simpl% the present value ofthe cash flo*s the asset is e"pected to produce

Changing Bond :alues (ver Time The value 8price9 of #onds drop *hen

interest rates rise and vice-versa

+ar #ond &henever the going rate of interest is e$ual to the coupon rate) a fi"edrate #ond *ill sell at its par value

Discount #ond &henever interest rates rise a#ove the coupon rate) a fi"ed-rate #onds price *ill fall #elo* its par value


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+remium #ond &henever interest rates fall #elo* the coupon rate) a fi"ed-rate #onds price *ill rise a#ove its par value

The mar'et value of a #ond *ill al*a%s approach its par value as its maturit% dateapproaches

!emiannual ,d7ustment

Divide the annual coupon interest pa%ment #% t*o to determine the amount ofinterest paid each si" months

Multipl% the %ears to maturit% #% t*o to determine the num#er of semiannual periods

Divide the nominal interest rate #% t*o to determine the periodic semiannual

interest rate

Bond 4is's

Interest 4ate 4is' the ris' of a decline in a #onds price due to an increase ininterest rates

4einvestment 4ate 4is' the ris' that a decline in interest rates *ill lead to adecline in income from a #ond portfolio

Default 4is' the li'elihood that the issuers *ill not #e a#le to ma'e pa%ments

Corporate Bonds

Mortgage Bonds a #ond #ac'ed #% fi"ed assets

De#entures a #ond that is not secured #% a mortgage on specific propert%

!u#ordinate De#entures a #ond having a claim on assets onl% after the seniorde#t has #een paid off in the event of li$uidation

Bond 4atings

Bond 4atings Bonds have #een assigned $ualit% ratings that reflect their pro#a#ilit% of going into default

Investment 3rade Bonds rated triple-B or higher


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un' Bonds , high-ris') high-%ield #ond Dou#le-B and lo*er #onds

Importance

0as a direct) measura#le influence on the #onds interest rate and cost of capital

Man% institutions are restricted to investment-grade securities

Bond Mar'ets

Corporate #onds are traded primaril% in the over-the-counter mar'et

Most #onds are o*ned #% and traded among large financial institutions

(ver-the-counter #ond dealers arrange transfers of large #loc's of #onds among

the relativel% fe* holders of the #ondsTerm !tructure of Interest 4ates

Term !tructure the relationship #et*een #ond %ields and maturities

.p*ard !loping rates are lo*er in the short-term and higher in the long-term

Do*n*ard !loping rates are higher in the short-term and lo*er in the long-term

Aield Curve "planations

"pectations Theor% the shape of the %ield curve depends on investorse"pectations a#out future interest rates

Li$uidit% +reference Theor% the preference for more li$uid short-term securities places up*ard pressure on the slope of a %ield curve

!egmented Mar'ets Theor% investors and #orro*ers choose securities *ithmaturities that satisf% their forecasted cash needs


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Lecture + Stoc *aluation Class notes

Lecture !toc' :aluation

4evie* characteristics of e$uities

Introduce stoc' valuation methods

"amine capital mar'et efficienc% theories

Common !toc' :aluation

Common !toc' :alued the same as an% other asset #% discounting alle"pected future cash flo*s The cash flo* comes in t*o forms=

Dividends

Capital 3ains

Cash Flo*s the #asic stoc' valuation e$uation

:alue of stoc' E + E +: of future dividends

ero 3ro*th a common stoc' *hose future dividends are no e"pected to gro*at all

+ E D>'

Constant 3ro*th a common stoc' *hose gro*th is e"pected to continue intothe foreseea#le future at a constant rate

Constant 3ro*th Model a model used to find the value of a constant gro*thstoc' Total return is comprised of a capital gains return and a dividend return

+ E D1>8' g9

6onconstant 8supernormal9 3ro*th a compan% *hich gro*s much faster for aspecified period of time

Find the +: of the dividends during period of rapid gro*th

Find the price of the stoc' at the end of the nonconstant gro*th period using thedividend gro*th model

,dd these t*o components to find the intrinsic value of the stoc'


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Capital ,sset +ricing Model 8C,+M9 theor% *here the e"pected return of asecurit% e$uals its #eta times the mar'et ris' premium

"pected rates of return depend on t*o things=

1 Compensation for the time value of mone%

5 , ris' premium) *hich depends on #eta andthe mar'et ris' premium

"pected return E ris'-free rate G ris' premium

' s E ' 4F G Hs8' M ' 4F 9

Common !toc' Features

Control of the firm the right to elect directors *ho appoint officers to managethe #usiness

+ro"% a document giving one person the authorit% to act for another) t%picall%the po*er to vote shares of common stoc'

+ro"% Fight ,n attempt #% a person or group to gain control of a firm

Ta'eover an action *here#% a group succeeds in ousting a firms managementand ta'ing control of the compan%

+reemptive 4ight a provision the gives common stoc'holders the right to purchase ne* issues of common stoc'

Dividends +a%ments #% a corporation to shareholders) made in either cash orstoc'

+referred !toc' Features

+referred !toc' stoc' *ith dividend priorit% over common stoc') normall% *itha fi"ed dividend and *ithout voting rights

!tated :alue normall% 1 per share

Cumulative Dividends +referred dividends must #e paid in full prior to the pa%ment of common dividends

!toc' Mar'ets


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+rimar% Mar'et the mar'et in *hich ne* securities are originall% sold toinvestors Initial +u#lic (fferings

!econdar% Mar'et the mar'et in *hich previousl% issued securities are tradedamong investors

Dealer maintains an inventor% and stands read% to #u% and sell at an% time

Bro'er an agent *ho arranges securit% transactions among investors

6e* Aor' !toc' "change 86A! 9

Mem#er the o*ner of a seat on the 6A!

Commission Bro'ers mem#ers that ta'e orders that customers have placed *iththeir respective #ro'erage firms and e"ecute them on the e"change

!pecialist acts as a dealer and maintains a limit order #oo'

Floor Bro'ers 6A! mem#ers *ho e"ecute orders for commission #ro'ers on afee #asis

!uperD(T !%stem an electronic 6A! s%stem allo*ing orders to #etransmitted directl% to the specialist

Floor Traders 6A! mem#ers *ho trade for their o*n accounts

(perations the #usiness of the 6A! is to attract order flo* The% do this #%attracting #lue chip companies to list on their e"change

Floor ,ctivities !pecialists normall% operate in front of their posts to monitorand manage trading in their assigned stoc's

6,!D,6e* shares

:alue of a 4ight the difference #et*een the value of the shares #efore and after therights offering


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Lecture 1# Conclusion Class notes

"-4ights the stoc' price *ill drop #% appro"imatel% the value of the right *henthe rights e"pire

!etting the !u#scription +rice the price does not matter It has to #e lo*er than themar'et price and greater than /ero


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Lecture 1@ Dividends

"amine dividend polic% and its relevanceK

Loo' at the implications of a dividend polic%K

Consider alternatives to dividendsK

Introduce stoc' dividends and stoc' splits

Cash Dividends and Dividend +a%ments

Dividend a pa%ment made out of a firms earnings to its o*ners) in the form ofeither cash or stoc'

Distri#ution a pa%ment made #% a firm to its o*ners from sources other than currentor accumulated retained earnings


4egular Cash Dividends a cash pa%ment made in the normal course of #usiness)usuall% four times per %ear

Target +a%out 4atio the percentage of net income paid out as cash dividends

(ptimal Dividend +olic% the dividend polic% that stri'es a #alance #et*een current

dividends and future gro*th and ma"imi/es the firms stoc' price


Dividend +a%ment= , Chronolog%

Declaration Date the date on *hich the #oard of directors passes a resolution to pa%a dividend

"-Dividend Date the date t*o #usiness da%s #efore the date of record

Date of 4ecord the date #% *hich a holder must #e on record in order to #edesignated to receive a dividend

Date of +a%ment the date the chec's are mailed

Does Dividend +olic% Matter


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Dividend Irrelevance Theor% a firms dividend polic% has no effect on either itsvalue or its cost of capital

Bird-in-the-0and Theor% a firms value *ill #e ma"imi/ed #% setting a highdividend pa%out ratio

Ta" +reference Theor% investors prefer lo* dividends #ecause capital gains areta"ed at a lo*er rate

Does Dividend +olic% Matter

4eal &orld Factors

Information Content of Dividends investors regard dividend changes as signalsof managements earnings forecasts

Clientele ffect the tendenc% of a firm to attract a set of investors *ho li'e itsdividend polic%

Dividend +olic%

4esidual Dividend ,pproach firm pa%s dividends onl% after meeting its investmentneeds *hile maintaining a desired de#t-e$uit% ratio

Dividend !ta#ilit% Firm maintains its dividends *henever possi#le

Dividend +olic% Compromise Dividend +olic%

,void cutting #ac' on positive 6+: pro7ects to pa% dividends

,void dividend cuts

,void the need to sell e$uit%

Maintain a target de#t-e$uit% ratio

Maintain a target dividend ratio

!toc' 4epurchases

4epurchases another method used to pa% out a firms earnings to its o*ners


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!toc' Dividends

!toc' Dividends a pa%ment made #% a firm to its o*ners in the form of stoc'

!toc' !plit an increase in a firms shares outstanding *ithout an% change in

o*ners e$uit%

Trading 4ange the price range #et*een the highest and lo*est prices at *hich astoc' is traded

4everse !plit a stoc' split in *hich a firms num#er of shares outstanding isreduced


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Lecture 1@ Conclusion

4evie* *hat *e have covered in this course and some things *e should havecovered

&hat *e 'no*

&hat is un'no*n

Conclusion

What We Do Know

6et +resent :alue is a pro7ect *orth more than it costs

4is' and 4eturn

Investors dont li'e ris' and re$uire a higher return to compensate

The ris' that matters is the ris' that investors cannot get rid of

fficient Capital Mar'ets securit% prices accuratel% reflect availa#le informationand respond rapidl% to ne* information as soon as it #ecomes availa#le

,genc% Theor% the conflicts of interest that arise among management)emplo%ees) shareholders) and #ondholders These conflicts and ho* companies tr% to

overcome such conflictsWhat We Do Not Know

0o* are Ma7or Financial Decisions Made

(ur ignorance is largest *hen it comes to ma7or strategic decisions

&hat Determines +ro7ect 4is' and +resent :alue

0o* do %ou find positive 6+: pro7ects

4is' and 4eturn 0ave &e Missed !omething

C,+M is hard to prove or disprove conclusivel%

0ave *e missed a 'e% varia#le

0o* Can &e "plain Capital !tructure


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