Corporate Finance
Instructor: Tang Zongming
Department :Finance
Office phone:52301359
Email address: zmtang@https://www.doczj.com/doc/c517360999.html,
Fall, 2010
1
Motivation
Why study corporate finance?
2
Lecture 1 Introduction
What is corporate finance and the role of financial manager?
Corporate governance
The Goal of Financial Management
The Agency Problem and Control of the Corporation
NPV approach in corporate finance
Points review: five financial principles
3
3
www: This is a good place to show the students the web site that accompanies the book, including the various features that they can access for study purposes (study guide, quizzes, web links, etc.). Click on the “web surfer” icon to go directly to the site.
Some background knowledge of Finance
Theory：
Investment（1952 - ）
Corporate Finance（1956 - )
Asset Pricing（1962 - ，1973 -，1985 -）
Applications：
Fund（1970 -）
Future and Option（1970 - ）
Fixed Income Markets and Their Derivatives （1970 -）
Corporate Governance Structure（1980 -）
Securitization of Housing Mortgage Loans （1980 -）
Financial Engineering （1980 -）
Risk Management（1990 -）
VC & PE（1990 -）
Hedge Fund（1990 -）
Credit Loan Securitization （1990 -）
Asset securitization, Risk Marketization, Conglomerated Financial Operations, financial information service Market（1990 -）
4
Some high points of the history
Markowits and the theory of portfolio selection(1950s)
The Modigliani-Miller Propositions(1950s)
William Sharp and CAPM(1960s)
The Efficient Markets Hypothesis(1960s)
Option pricing theory(1970s)
Agency theory(1980s)
From
1950s
5
The Revolution in Corporate Finance
Beginning with the work of Merton Miller and Francisco Modigliani in the late 1950s
A basic change in the theory of valuation
“Accounting model” to“Economic model”
Approaches : general equilibrium analysis and utility analysis
6
Corporate Finance
Sub discipline of economics
–The theory of the firm
Requires an understanding of
The banking system
Capital markets
The operation of money
7
What is Corporate Finance
Objective
Maximizing shareholders’ wealth
Strategy
management of ASSETS , financing and acquisition (8)
Operational Considerations
Asset Management
How do you achieve the most efficient asset mix? Cash flow considerations
9
Operational Considerations
Asset Financing
What is the best type of financing?
What is the best financing mix?
10
Operational Considerations
Asset Acquisition
Which are the best assets to buy?
When should you buy them?
11
What is Corporate Finance in our textbook
It is about how to allocate the corporate resources,
What long-term investments should the firm take on?
Where will we get the long-term financing to pay for the investment?
How will we manage the everyday financial activities of the firm?
How to realize value creation through firm extension?
12
12
Emphasize that “business finance” is just another name for the “corporate finance” mentioned under the four basic types. Students often get confused by the terminology, especially when different terms are used to refer to the same thing.
Who cares corporate finance
Investor (dividends,capital gains)
Bank (debt financing)
Firm’s owner (value of firm)
Government (tax)
13
Financial Manager
Financial managers try to answer some or all of these questions
The top financial manager within a firm is usually the Chief Financial Officer (CFO)
Treasurer –oversees cash management, credit management, capital expenditures and financial planning
Controller – oversees taxes, cost accounting, financial accounting and data processing
14
14
Video Note: This video looks at the changing role of the Chief Financial Officer (CFO) at the Fortune 500 company, Abbot Laboratories.
Finance in the
Organizational Structure of the Firm
Board of Directors
President
Treasurer
Controller
Credit
Manager
Inventory
Manager
Director of
Capital
Budgeting
Cost
Accounting
Financial
Accounting
Tax
Department
Vice-President: Finance
Vice-President: Sales
Vice-President: Manufacturing
15
Role of The Financial Manager
Financial
manager
Firm's
operations
Financial
markets
16
Three main kinds of Financial Management Decisions
1.Capital budgeting
What long-term investments or projects should the business take on?
Capital budgeting –process of planning and managing a firm’s investments in fixed assets The key concerns are the size, timing and riskiness of future cash flows.
17
17
Provide some examples of capital budgeting decisions, such as what product or service will the firm sell, should we replace old equipment with newer, more advanced equipment, etc.
Be sure and define debt and equity.
Provide some examples of working capital management, such as who should we sell to on credit, how much inventory should we carry, when should we pay our suppliers, etc.
Three main kinds of Financial Management Decisions
2.Capital structure
How should we pay for our assets?
Should we use debt or equity?
Capital structure – mix of debt (borrowing) and equity (ownership interest) used by a firm.
What are the least expensive sources of funds?
Is there an optimal mix of debt and equity? When and where should the firm raise funds?
18
18
Provide some examples of capital budgeting decisions, such as what product or service will the firm sell, should we replace old equipment with newer, more advanced equipment, etc.
Be sure and define debt and equity.
Provide some examples of working capital management, such as who should we sell to on credit, how much inventory should we carry, when should we pay our suppliers, etc.
Three main kinds of Financial Management Decisions
3.Working capital management
How do we manage the day-to-day finances of the firm?
Working capital management – managing short-term assets and liabilities.
How much inventory should the firm carry?
What credit policy is best?
Where will we get our short-term loans?
19
19
Provide some examples of capital budgeting decisions, such as what product or service will the firm sell, should we replace old equipment with newer, more advanced equipment, etc.
Be sure and define debt and equity.
Provide some examples of working capital management, such as who should we sell to on credit, how much inventory should we carry, when should we pay our suppliers, etc.
20
2. Corporate governance:
What Is A Corporation?
Sole Proprietorships
Corporations
Partnerships
21
2. Corporate governance
The goal of the firm
Maximize the wealth of shareholders
Separation of ownership and management
Agent and principal
Conflicts of interest between agent and principal
Corporate governance: a mechanism to solve the conflicts of interest between agents and principals 22
Corporate governance Structure of the Firm
Board of Directors
President
Vice-President: Finance
Vice-President: Sales
Vice-President: Manufacturing
Shareholder committee
Board of supervisors
23
The Agency Problem
Agency relationship
Principal hires an agent to represent his/her interest
Stockholders (principals) hire managers (agents) to run the company
Agency problem (agency costs)
Conflict of interest between principal and agent
agency costs
24
24
A common example of an agency relationship is a real estate broker –in particular if you break it down between a buyers agent and a sellers agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyers price range.
Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the sensor razor.
Direct agency costs –the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs.
Indirect agency costs –management’s tendency to fo rgo risky or expensive projects that could be justified from a risk-return standpoint.
The types of agency cost
Direct costs – compensation and perquisites for management
Audit /monitoring
Purchase of luxurious and unneeded things
Indirect costs – cost of monitoring and sub optimal decisions
Ex. Investment opportunity
25
Managing Managers
Managerial compensation
Incentives can be used to align management and stockholder interests ( Stock option & Harvard studies)
The incentives need to be structured carefully to make sure that they achieve their goal(e.g.EVA)(stern stewart& company)
Corporate control
The threat of a takeover may result in better management (why?)
26
26
Incentives –discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forego projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive.
Corporate control – ask the students why the threat of a takeover might make managers work towards the goals of stockholders.
Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interest.
Agency Problem Solutions
1 - Compensation plans
2 - Board of Directors
3 - Takeovers
4 - Specialist Monitoring
5 - Auditors
27
18
3.NPV Approach
Wealth Maximization
Cash flows
Timing
Risk versus Return
Goal = steadily appreciating share price
28
Wealth Maximization
Profit- useful but ignores
Risk
Time value of money
29
Wealth Maximization
Cash Flow – belong to all investors
Net Present Value (NPV)
The present value of all future cash flows minus initial cost 30
Present and Future Value
Present Value
Value today of a future cash flow.
Future Value
Amount to which an investment will grow after earning interest
31
Discount Factors and Rates
Discount Rate
Interest rate used to compute present values of future cash flows.
Discount Factor
Present value of a $1 future payment.
32
Present Value
33
Present Value
Discount Factor = DF = PV of $1
Discount Factors can be used to compute the present value of any cash flow.
34
Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C0 = 400,000
Sale price in Year 1 = C1 = 420,000
Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 5%, then
Cost of capital = r = 5%
35
Valuing an Office Building
Step 3: Discount future cash flows
Step 4: Go ahead if PV of payoff exceeds investment
36
Net Present Value
37
Risk and Present Value
Higher risk projects require a higher rate of return Higher required rates of return cause lower PVs
38
Risk and Present Value
39
Risk and Net Present Value
40
Rate of Return Rule
Accept investments that offer rates of return in excess of their opportunity cost of capital
Example
In the project listed below, the foregone investment opportunity is 12%. Should we do the project?
41
Net Present Value Rule
Accept investments that have positive net present value
Example
Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return?
42
Opportunity Cost of Capital
Example
You may invest $100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs:
43
Opportunity Cost of Capital
Example - continued
The stock is trading for $95.65. Next year’s price, given a normal economy, is forecast at $110
The stocks expected payoff leads to an expected return.
44
Opportunity Cost of Capital
Example - continued
Discounting the expected payoff at the expected return leads to the PV of the project
NPV requires the subtraction of the initial investment
45
Opportunity Cost of Capital
Example - continued
Notice that you come to the same conclusion if you compare the expected project return with the cost of capital.
46
What Is a Firm Worth?
Conceptually, a firm should be worth the present value of the fir m’s cash flows.
The tricky part is determining the size, timing and risk of those cash flows.
NPV of buying a firm=Firm worth –Firm price
47
4. Five Foundational Principles of Finance
Cash flow is what matters
Money has a time value
Risk requires a reward
Market prices are generally right
Conflicts of interest cause agency problems
48
Five Principles
“…while it is not necessary to understand finance in order to understand these principles, it is necessary to understand these principles in order to understan d finance.”
49
Principle 1:
Cash flow is what matters
Accounting profits are not equal to cash flows. It is possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books.
Cash flow, and not profits, drive the value of a business.
We must determine incremental cash flows when making financial decisions.
Incremental cash flow is the difference between the projected cash flows if the project is selected, versus what they will be, if the project is not selected.
50
Success but no profit
Case of Movie industry in US
Some of the most successful box office hits-Forrest Gump, Coming to America, and Batman---realized no accounting profits at all after accounting for various movie st udio costs.
This is because “Hollywood Accounting” allows for overhead costs not related to the movie to be added to the true cost of the movie.
51
Movie: My Big Fat Greek Wedding
Lost $20 million
In fact, it grossed over $370 million on a budget of $5 million
52
Principle 2:
Money has a time value
A dollar received today is worth more than a dollar received in the future.
Since we can earn interest on money received today, it is better to receive money earlier rather than later.
53
Principle 3:
Risk requires a Reward
We won’t take on additional risk unless we expect to be compensated with additional reward or return. Investors expect to be compensated for “delaying consumption” and “taking on risk”.
Thus investors expect a return when they put their savings in a bank (i.e. delay consumption) and they expect to earn a higher rate of return on stocks relative to bank savings account (i.e. taking on risk)
54
Figure 1-1
55
Principle 4: Market Prices
are generally Right
In an efficient market, the prices of all traded assets (such as stocks and bonds) at any instant in time fully reflect all available information.
Thus stock prices are a useful indicator of the value of the firm. Prices changes reflect changes in expected future cash flows. Good decisions will tend to increase the stock prices and vice versa. Note there are inefficiencies in the market that may distort the prices.
56
Principle 5: Conflicts of interest cause agency problems
The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth.
Agency conflict is reduced through monitoring
(ex. Annual reports), compensation schemes
(ex. stock options), and market mechanisms
(ex. Takeovers)
57
Course outline
Part 1 Foundations of Finance
1-Introduction
2-Free cash flow
Part 2 Capital Budgeting
3- Investment Decision (1)
4- Investment Decision(2)
5- Investment Decision(2)
Part 3 Risk and Return
6-Risk and CAPM