1.a fundamentals of financial mgt 2010 new

7/31/2019 1.a Fundamentals of Financial Mgt 2010 NEW

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Winter Term 2010 1Markus Neuhaus I Corporate Finance I [email protected]

Corporate FinanceFundamentals of Financial Management

Dr. Markus R. Neuhaus

Dr. Marc Schmidli, CFA


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Corporate Finance: Course overview

24.09. Fundamentals (4 hours) M. Neuhaus & M. Schmidli

01.10 Investment Management M. Neuhaus & P. Schwendener

08.10. Business Valuation (4 hours) M. Neuhaus & M. Bucher

15.10. No Lecture No Lecture

22.10. Value Management M. Neuhaus, R. Schmid & F. Monti

29. 10. Mergers & Acquisitions I&II (4 h) M. Neuhaus & D. Villiger




26.11 Legal Aspects I. Pschel

03.12. Tax and Corporate Finance (4 h) M. Neuhaus & M. Marbach 10.12. Financial Reporting M. Neuhaus & M. Jeger

17.12. Turnaround Management M. Neuhaus & M. Koch

24.12. Summary, repetition M. Neuhaus


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Grade CEO

Qualification Doctor of Law (University of Zurich), Certified Tax Expert Career Development Joined PwC in 1985 and became Partner in 1992.

Subject-related Exp. Corporate Tax

Mergers + Acquisitions

Lecturing SFIT: Corporate Finance, University of St. Gallen: Tax Law

Multiple speeches on leadership, business, governance, commercialand tax law

Published Literature Author of commentary on the Swiss accounting rules

Publisher of book on transfer pricingAuthor of multiple articles on tax and commercial law, M+A,IPO, etc.

Other professional roles: Member of the board of conomiesuisse, member of the boardand chairman of the tax chapter of the Swiss Institute ofCertified Accountants and Tax Consultants

Markus R. Neuhaus

PricewaterhouseCoopers AG, ZrichPWC

Phone: +41 58 792 4000Email: [email protected]


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Marc Schmidli

PricewaterhouseCoopers AG, ZrichPWC

Phone: +41 58 792 15 64Email: [email protected]

Grade Partner

Qualification Dr. oec. HSG, CFA charterholder

Career Development Corporate Finance PricewaterhouseCoopers since July 2000

Lecturing Euroforum Valuation in M&A situations

Guest speaker at ZfU Seminars, Uni Zurich, ETH, etc.

Published Literature Finanzielle Qualitt in der schweizerischenElektrizittswirtschaft

Various articles in Treuhnder, HZ, etc.


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Contents

Learning targets

Pre-course reading

Lecture Fundamentals of Financial Management


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Learning targets

Financial management

Understanding the flow of cash between financial markets and the firms operations

Understanding the roles, issues and responsibilities of financial managers

Understanding the various forms of financing

Financial environment Knowing the relevant financial markets and their players

Being aware of various financial instruments


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Contents

Learning targets

Pre-course reading



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Pre-course reading

Books

Mandatory reading Brigham, Houston (2009): Chapter 2 (pp. 26-50)

Optional reading Brigham, Houston (2009): Chapter 1 (pp. 2-20)

Volkart (2008): Chapter 1 (pp. 41-68)

Volkart (2008): Chapter 7 (pp. 565-591)

Slides

Slides 1 to 11 mandatory reading

Other Slides optional reading, will be dealt within the lecture


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Contents

Learning targets

Pre-course reading



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Agenda I

1. Introduction

Setting the scene

Who is the financial manager?

Roles of financial managers

Shareholder value vs. Stakeholder value concept

2. Financing a business

External financing

Internal financing

Asymmetrical information

Pecking order theory Capital structure


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Agenda fundamentals of financial management II

3. Financial markets

Different types of markets

Financial institutions

Financial instruments

Efficient market hypothesis (EMH)

4. Q&A and discussion


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Agenda: Introduction

Setting the scene



Shareholder value vs. stakeholder value concept


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Setting the scene I

(1) cash raised by selling financial assets to investor

(2) cash invested in the firms operating business and used to purchase real assets(3) cash generated by the firms operating business

(4) reinvested cash

(5) cash returned to investors

Firmsoperations

(a bundle of

real assets)

Capital markets(equity, debt,

bonds),Shareholders,

other stakeholders

Financial

manager(e.g. CFO)

(1)(2)

(3)

(4)

(5)

Company Environment

Source: Brealey, Myers, Allen (2008), 5.


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Setting the scene II

Managers do not operate in a vacuum

Large and complex environment including:

Financial markets

Taxes

Laws and regulations

State of the economy

Politics, public view, press

Demographic trends

etc.

Among other things, this environment determines the availability of investments and

financing opportunities

Therefore, managers must have a good understanding of this environment


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Chief Financial Officer (CFO)(responsibilities:

e.g. f inancial policy,corporate planning

Treasurer(responsibilities: e.g. cash management,

raising capital, banking relationships)

Controller(responsibilities: e.g. preparation of

financial statements, accounting, taxes)

Source: Brealey, Myers, Allen (2008), 7.


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Generally, managers do not own the company, they manage it

The company belongs to the stockholders. They appoint managers who are expected to run thecompany in the stockholders interest

Basic goal is creating shareholder value

two problems emerge from this constellation

Agency dilemma: asymmetric information and divergences of interests between principal(stockholders) and agent (management) lead to the so called agency dilemma which also arises inthe context of financing decisions ( pecking order theory)

Shareholder value vs. stakeholder value: shareholders own the company. Does a companymerely consider the owners interest or the interests of all stakeholders affected by the companysbusiness activities?

Agent Principal

performs

hires

Empirebuilding,

independence,

Highsalaries

Stablegrowth,

Div

idends,control

Illustration: Agency dilemma


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Shareholder value vs. stakeholder value I

Shareholders wealth maximization means maximizing the price/value of the firms common stock

Shareholders are considered as the only reference for the companys course of business andperformance

Other stakeholders are strategically considered only to the extent they could have an impact on thestock price, the stockholders wealth

Suppliers

StateInvestors

Customers

Employees

Value

If a new pharmaceutical product is launched,health considerations will be relevant only tothe extent they could endanger the firms stockprice (e.g. through a lawsuit)

Where does the risk in the shareholder value concept lie? ( incentives, sustainability)


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Shareholder value vs. stakeholder value II

Stakeholder value means maximizing the companys value taking into account every stakeholder thecompany affects in the course of its business

The importance of stakeholder management is continually growing.

Suppliers

State

Customers

Employees

Value

Investors

If a new pharmaceutical product is about to belaunched, every stakeholders interest must beassessed and the product is introduced only ifevery interest can be honored

Does the plant pollute the air?

Could the new product be harmful to

customers?

etc.

How can a company motivate its managers towards a careful handling of the companys

stakeholders? (

compensation programs, corporate governance)


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Agenda: Financing a business

External financing

Internal financing

Asymmetrical information

Pecking order theory

Capital structure


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Possibilities of financing a business

The management makes decisionsabout which investments are to beundertaken and how theseinvestments are to be financed

There are three basic ways of

financing a business

1. Internal

2. Debt

3. Equity

Equity

Debt

Internal financing

E

xternal

Internal

Pecking order theory diagram

Why would a company prefer debt over equity? ( cost of capital)


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Financing a business overview

External financing: a company receives capital from outside the company, e.g. credit, capitalincrease

Internal financing: The major part of a firms capital typically comes from internal financing (retainedcash flows, profits from operating activities), except for e.g. startup or turnaround situations

Liquidation financing: In this context, liquidation financing refers to the liquidation of assets (e.g.divesting of certain business areas) which have a financing effect

Debt financing Equity financing Liquidation financing

Credit financing Issuing shares

Internal

financing

Financing effect from

accruals

Retained cash flows

and profits

Mezzanine / Hybrid financing

External

financingDivesting activities

Source: Volkart (2008), 567.

Financing impact fromvalue of depreciation


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Financing a business external financing

Debt financing

Given a solid capital base, the use of debt is reasonable as it broadens the financing base

provided a certain amount of leverage exists and considerable tax advantages 1) can be exploited

The risk borne by a creditor is the risk of default driven by the companys market and operational

risks

Because a bank would not lend money to a company without checking its financial health, a

certain amount of debt gives a positive signal to other business partners

Equity financing

Equity serves as the capital base of a company because equity can not be withdrawn or taken

away from the company

In the case of incorporated companies (e.g. AG), equity bears the major part of the risk

A company can raise equity capital by selling shares privately or publicly (e.g. IPO or capital

increase)

Source: Volkart (2008), 569ff.

1) General rule: Interest expense is tax deductible, dividend distributions not.


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Financing a business internal financing

Internal financing or self-financing

Internal financing is determined by the cash flow from operating activities

Internal financing means generation of cash flows from operating activities without

using external sources

Internal financing happens automatically as a consequence of the operating

activities of a company

From the companys perspective, self-financing is the most convenient way of

financing as the company does not have to debate with creditors and the discussion

with equity holders is limited to the question of how much of the profits should be

distributed. ( pecking order theory; see Slide 26)

As opposed to external financing, internal financing is not fully reflected on the

companys balance sheet



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Asymmetrical Information I

The problem of asymmetrical information does not occur only between principal and agents,but arises each time financing is needed as the fundamental interests of debt holders andshareholders differ significantly.

Shareholders assume that management is negatively influenced by debt holders

towards making safe investments in order to minimize the probability of default Debt holders will try to establish credit covenants in order to gain more control over

investment decisions and the course of business

Shareholders, on the other hand, prefer investment opportunities with potentially highreturns as their shares will gain in value as the companys cash flows grow

As a result, each party tries to influence the management:

Debt holders try to establish favorable credit covenants

Shareholders set incentives through compensation plans



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Asymmetrical Information II

Why do the different parties not get together and solve the problem?

Game theory ( Nash) shows us that in such strategic situations with conflicts of

interest, each party begins by holding back information in order to strengthen its

negotiating position

Shareholders do not know about possible credit covenants whereas creditors do not

know anything about the investors motivation and decisions

Law prohibits typically a company to disclose all relevant information

in conclusion, we find a triangle situation in which each party tries to maintain orgain as much power and influence as possible in order to secure its interests

Debt holders Shareholders

Management


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Pecking order theory I

Bridging the problems of asymmetric information can be very expensive. The less informationan investor has, the higher the required rate of return for the investment is. An outflow is theso called pecking order theory demonstrating the order in which the company prefers tofinance its business

Equity

Debt

Internal financing

1. Internal financing

No prior explanations to investors or creditors (except for

level of dividends)

2. Debt financing

Banks want information about credit risk

Management must provide possible creditors with sufficientand reliable information

3. Equity financing

Potential shareholders will challenge the real share price

as they have to rely blindly on the information given by themanagement

Shareholders will request a low price as they cannot besure whether the share is worth the price

This makes equity capital very expensive for a company

Pecking order theory diagram



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Pecking order theory II

The importance of the different ways of financing fundamentally changes over thelifetime of a company

From the perspective of a major listed company, internal financing is the most significantkind of financing

Vital influence on conditions for external financing (stable operating cash flows

more favorable credit conditions and higher stock prices) Without solid operating cash flows, a company will not be able to survive

Illustration: how financing preferences can alter over a companys lifecycle

phase of

businessstart up expansion consolidation

preferred

financing

Private equity /Venture capital

- equity- debt

- internal

internal


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Capital structure

The decisions on how the assets of a company are financed leads to the question:

what is the optimal capital structure of a company?

The relation between debt and equity reflects a companys risk and is also calledfinancial leverage

The optimal capital structure is highly dependent on the industry

Investors often urge greater financial leverage, and thus more risk, in order to generatemore profit in relation to the equity capital invested. In addition, interests paid are tax-deductible.

The capital structure can be defined by the debt to equity ratio

Equity

DebtLeverageFinancialEquitytoDebt

Financial risk increases as the company chooses to use more debt

What is the optimal capital structure?



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Agenda: Financial markets

Different types of markets

Financial institutions


EMH


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Basic need for financial markets

Businesses, individuals and governments need to raise capital

Company intends to open a new plant

Family intends to buy a new home

City of Zurich intends to buy a new generation of trams

Of course, people and companies save money and have money of their own. However,saving money takes time and has opportunity costs

Mr. Meier earns CHF 10000 per month and has expenses of CHF 7000. If heintends to buy a home worth CHF 1000000, it will take him a long time to saveenough.But what if he wants to buy this home today?

In a well-functioning economy, capital flows efficiently from those who supply capital tothose who demand it

Source: Brigham, Houston (2009), 28f.


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Financial markets

Physical vs. financial markets

Spot vs. future market

Money vs. capital markets

Primary vs. secondary markets

Private vs. public markets

Recent trends:

Globalization of financial markets

Increased use of derivative instruments (especially as hedging and speculationinstruments). The current financial crisis reduced the total size of the derivatives marketsubstantially. However, it is still far bigger in most areas as for instances in 2001.

Source: Brigham, Houston (2009), 30ff.


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Financial Institutions

Commercial banks

Investment banks

Financial services corporations

Insurances

Mutual funds

Hedge funds

The trend is clearly towards bank holdings / financial services conglomerates thatprovide all kinds of services under one roof. The large investment banks disappeared.

Against that, in the current environment many banks are disposing of certain businessdivisions and focus on core competences. This trend will continue for regulatory reasons(lower risks, de-leveraging, ) and some trends towards nationalization and homemarket focus in the banking sector.



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Stock: Unit of ownership which entitles the owner to exercise his voting right oncorporate decisions and receive a certain payment (dividend) each year. No otherobligation, nor any loyalty recquired.

Bond: The issuer (company) owes the holder (investor) a certain amount of debt and is

obliged to pay the holder a certain interest rate (coupon) and to repay the initial amountat a pre-determined date

Option: Financial contract which entitles the buyer to buy (call option) or sell (putoption) a certain underlying asset at a pre-specified price at or before a certain point intime

Structured product: Packaged investment strategy, a mixture of different investmentinstruments, mostly derivatives which are intended to exploit, for instance a certainmarket constellation


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Efficient market hypothesis (EMH) vs. behavioral finance

The EMH states that

(1) share prices are always in equilibrium

(2) the prices reflect all available information (on opportunities, risks) and everything that canbe derived from it

Therefore, it is impossible to beat the market

Prices in financial markets react very quickly and fairly to new information

Share prices are unpredictable as the information that influences prices also occurs bychance.

We can analyze past stock price developments, but we cannot foresee any

future results


However, investors are not machines that can process all available information.This may lead to the fact that irrational factors come into play

behavioral finance


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Opportunities due to inefficiencies

Pure luck

Any investor or individual might just be lucky and have bought stock yielding far

better returns than expected

Insider knowledge

If an investor has access to insider information, he can take advantage of it. In

order to guarantee a fair market, insiders must be excluded from trading ( laws

against insider trading)

Other possible inefficiencies:

Under-reaction

Uncertain valuation

Overshooting

Source: Spremann (2007), 202.

The exploitation of inefficiency leads to efficiency


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Final comments

As the environment (capital markets, society, suppliers etc.) has significant influence ona company, the financial managers must have a profound understanding of thisenvironment in order to make the right decisions

A financial manager makes decisions about which investments are to be undertaken and

how these investments are to be financed (treasurer) and accounted for (controller)

Financing can come either from outside (external: debt and equity) or from inside(internal: internal financing through profit from operating business) the company

The problem of asymmetrical information arises whenever financing is needed, becausethe level of information and the interests of debt holders and shareholders differ

significantly. Bridging these problems can be very expensive and leads to the so calledpecking order theory

The theory that capital markets take into account all information and all that can bederived from this information, is called the efficient market hypothesis

1.a fundamentals of financial mgt 2010 new

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