finance 101

Introduction to Corporate Finance (Chapter 1) Business Forms Financial managers Agency Problems

Financial Statements (Chapter 2, 3)

Today’s Agenda

FNCE 101 Hyun-‐Soo Choi

Introduction to Finance (Chapter 1)


What is Finance?


Finance studies and addresses the ways in which individuals, business, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. (from Wikipedia)

Basic areas in Finance

Corporate Finance

Investments

Financial Institutions

International Finance

What is Finance


Investments .Work with financial assets such as stocks and bonds, different types of financial derivatives (Option, Future, Forward, Swap, and…) .Value of financial assets, risk versus return

Financial Institutions

.Companies that specialize in financial matters .Banks, Insurance companies, Brokerage firms

International Finance

.Studies the dynamics of exchange rates and foreign investment.

Basic Areas in Finance


Corporate finance is about corporations’ financial decisions.

Then. What is a corporation? - A form of business organization

- Three major forms.

. Sole proprietorship

. Partnership

. Corporation

What is Corporate Finance?


One person owns the business: No legal Entity

Sole Proprietorship

Advantages Disadvantages

Easiest to start Least regulated Owner keeps all profits No agency issues

Unlimited liability Limited life of business Limited capital Hard ownership transfer


Two or more own the business (partners): Legal Entity What is the main problem using the sole proprietorship, or partnership? >> hard to make an investment for growing opportunity

Partnership


Rela?vely easy to start Less agency issues More capital available Income taxed once as personal income

Unlimited liability -‐ General partnership -‐ Limited partnership Limited life of business Limited capital Hard ownership transfer


Business owned by stockholders: Legal Entity

Corporation


Limited liability Unlimited life of business Easier to raise money Easy ownership transfer Separa?on of ownership and management

Separa?on of ownership and management: Agency issue Cost of setup and maintenance -‐ Complicated regula?ons -‐ Reports filing Double taxa?on (Not in Singapore)


Hybrid forms between a partnership and a corporation

Limited Liability Partnerships (LLP) - Between partnership and corporation

- Closer to partnership (partners) - All(or some) partners have limited liabilities - Benefit in taxation Limited Liability Company (LLC) - Between partnership and corporation

- Closer to corporation (Shareholders) - Benefit in taxation - i.e. private limited company (PTE LTD)

Hybrid forms


Shareholders

Board of Directors

Management - i.e. Chief Executive Officer (CEO), Chief Financial Officer (CFO)

Other Stakeholders - i.e. Government, Customers, Trade Unions, Owner

Separation of Ownership and Control


Capital budgeting (Investment decisions) - What long-term investments or projects to take on? - Evaluating the size, timing, and risk of future cash flows

Capital Structure (Financing decisions)

- Structuring long-term financing i.e. How much capital to raise? i.e. Equity vs debt?

Working capital management

- Managing short-term assets and short-term liabilities i.e. Inventory level, cash holding

Payout policies

-Corporate earnings: retain by the company or return to shareholders -How to return? Dividend payout or stock buybacks

Financial Management Decisions


Flow of cash: Investors and Firm

Financial

Manager

Firm's

operations Investors

(1)  Money raised from investors (2)  Money invested in firm to buy real assets (3)  Money generated by real assets (4a) Money reinvested (4b) Money returned to investors

(1) (2)

(3)

(4a)

(4b)


What is the basic goal of financial management?

. Maximizing market share?

. Minimizing cost?

. Avoid bankruptcy/survive as long as possible?

. Maximizing profit?

. Maximize shareholder value?

Objective of Financial Management


What is the basic goal of financial management?

. Maximizing market share?

. Minimizing cost?

. Avoid bankruptcy/survive as long as possible?

. Maximizing profit?

. Maximize shareholder value?

The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price.

Objective of Financial Management


Are they same? No.

Generally high correlation among

stock price, earning per share(EPS), and cash flow.

Current stock price relies upon current earnings, as well as future earnings and cash flow.

Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa).

Stock price maximization & profit maximization


-  Projected cash flow to shareholders -  Timing of the cash flow stream -  Riskiness of the cash flows

Factors that affect stock price

Value = CF1

(1+ k)1 +CF2

(1+ k)2 ++CFn

(1+ k)n

= CFt

(1+ k)t .t=1

n

∑


Do managers really maximize shareholder wealth?

“Agency problems” represent the conflict of interest

> Principal hires an agent to represent their interest

> Stockholders (principals) hire managers (agents) to run the company

> Managers do not always act in the best interests of shareholders, and they sometimes make decisions that destroy shareholder value.

Agency Problems


Choice of effort : Manager prefer less effort to more, all else constant. : Interested more in personal perks rather than enhancing share value i.e. Corporate Jet, empire building

Risk exposure : Managers are exposed to high idiosyncratic risk. - Substitute low variance for high variance assets - Over-retain liquid funds and cash reserves - Keep leverage too low

- Keep dividend payout too low

Differential horizon : Managers have a shorter horizon than stock holders - Focus more on short-term earnings rather than long-term value enhancing

Shareholder-Management Conflict


Managerial compensation plans

- stock and options

Direct Intervention / Monitoring

- The Board of Directors & Lenders & Specialists

- The threat of firing

The threat of takeover

Legal and Regulatory Requirements

Solution to the Agency Problem


# WorldCom – 2001 - Report $3.8 billion of operating expenses as investment and overstated the income

- Assets: 103.9 Billion

# Enron – 2001

- Concealed $1.7 billion losses - Assets: 65.5 Billion

# Sarbanes-Oxley Act of 2002 The public Company Accounting Reform and Investor Protection Act of 2002

Which was the largest bankruptcy in the history?

Corporate Scandals & SOX


Financial Statements (Chapter 2, 3)


The Balance Sheet The Income Statement The Statement of Cash Flows (not covered)

Major Financial Statements


A Snapshot of the firm at a given point in time. The Left-hand Side: Assets

- Current asset / Fixed asset (Tangible & Intangible) - Listed in order of decreasing liquidity > Ease of conversion to cash > Without significant loss of value

The Right-hand Side: Liabilities and Equity - Liabilities > Current liabilities / Long-term liabilities

- Stockholder’s Equity Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity

Stockholders’ Equity = Assets – Liabilities Shareholders are “residual owners”

The Balance Sheet


Example: The Balance Sheet


A Video of the firm’s operation for a specified period of time.

Income Statement Identity

* Revenues – Expenses

= Earnings before interest and taxes (EBIT)

: what firm would have earned if not for obligations to its creditors and the tax authorities.

* EBIT- interest expense = Taxable Income

* Taxable Income – Taxes = Net Income

* Net Income = Retained earnings + Dividend payout

* Earning per share (EPS)

The Income Statement


Example: The Income Statement


U.S. Corporate Tax Rates

Tax Rates: Marginal and Average


Marginal tax rate : the percentage paid on the next dollar earned

Average tax rate

: the tax bill / taxable income Suppose your firm earns $200,000 in taxable income.

- What is the marginal tax rate? - What is the average tax rate?

If you are considering a project that will increase the firm’s taxable income by $100,000, what tax rate should you use in your analysis?

Example: Marginal & Average Tax Rates


There are five traditional categories of ratios:

1.  Liquidity (Short-term solvency) ratios

2.  Leverage (Long-term solvency) ratios

3.  Asset management (efficiency or turnover) ratios

4.  Profitability ratios

5.  Market value ratios

•  Each category measures a different dimension of a firm’s performance (i.e. strengths & weaknesses).

•  Relative measures to interpret firm performance

- comparison through time or between companies

Ratio Analysis


As we look into each ratio, ASK yourself 1)  what the ratio is trying to measure

2)  Why is that information important

Ratio Analysis (con’t)


How well can the firm pay its bills over the short run without undue stress

> High liquidity ratio => liquidity

> But, too high => the firm is inefficient

a.  Current ratio = Current assets / Current liabilities

b.  Quick ratio = (Current assets – Inventory) / Current liabilities

c.  Cash ratio = Cash / Current liabilities

1. Liquidity (Short-term solvency) ratios


Measures the firm’s long-term ability to meet its obligations

> Too high of a ratio may lead to financial distress

> Too low of a ratio may indicate the firm is not utilizing all

the benefits of debt

Total debt ratio = (Total assets - Total equity) / Total assets

# Debt-equity ratio = Total debt / Total equity

# Equity multiplier = Total assets / Total equity

= 1+ Debt-equity ratio

2. Leverage (Long-term solvency) ratios


How efficiently does the firm use its assets to generate sales

> Normally, higher ratio means efficiency

a.  Inventory turnover = Cost of goods sold / Inventory

b.  Total asset turnover = Sales / Total assets

3. Asset Management (turnover) ratios


How well the firm is able to control expenses and generate revenue

a.  Profit margin = Net income / Sales

b.  Return on assets (ROA) = Net income / Total assets

c.  Return on equity (ROE) = Net income / Total equity

* ROE > ROA ?

4. Profitability ratios


Note that

ROE = Net income / Total Equity

= (Net income /Total assets) * (Total assets / Total equity)

= ROA * Equity Multiplier = ROA * (1+Debt-equity ratio)

If debt=0, ROE=ROA.

If debt>0, ROE>ROA.

Analysis : ROE and ROA


Earning per share = Net income / Share outstanding

a.  Price-Earning ratio (PE) = Price per share / Earning per share

b.  Market-to-book ratio (M/B) =Price-to-book ratio (P/B) = Market value per share / Book value per share

- Book Value is based on historical cost of assets - Market Value measures current value of assets and liabilities. - Market Value is forward looking and it reflects a firm’s potential growth.

* Where to get Book Value and Market Value?

5. Market value ratios


PE and PB ratios


PE ratios

Robert Shiller’s calcula?on for current S&P 500 PE Ra?o


Company ABC has a return on equity of 0.1 and a leverage (Assets / Equity) of 2. A private equity firm takes it over, sells 25% of ABC’s assets to buy back its shares, therefore reducing ABC’s equity by the same dollar amount, and this also results in a 10% reduction in net profit. All other relevant data are unchanged. What is ABC’s new leverage?

Let Assets be A. Then Equity=A/2 and Liability=A/2. Assets reduced by 25% and all of the reduction came from equity. So new Assets= ¾*A, new equity=1/4*A, and new liability=A/2. So the new leverage is new assets / new equity = 3.

Example


ROE = Net income / Total equity

= (Net income / Total assets) * (Total assets / Total equity)

= (Net income / Sales) * (Sales / Total assets)

* (Total assets / Total equity)

= Profit margin * Total asset turnover * Equity multiplier

Three components:

Operating efficiency (profitability)

Asset use efficiency

Financial leverage

Du Pont Identity


How does leverage affect the EPS and ROE of a firm?

Debt financing=> increase the fixed interest expense

Ø  In a good year, we pay the fixed interest expense and we have more left-over for stockholders

Ø  In a bad year, we we still have to pay the fixed interest expense and we have less left-over for stockholders

Leverage amplifies the variations in both EPS and ROE

The Effect of Leverage on EPS and ROE


Let’s ignore taxes.

What happens to EPS and ROE when we issue debt and buy back shares of stock?

Example: The effect of Leverage

Current Proposed

Assets $8,000,000 $8,000,000

Debt $0 $4,000,000

Equity $8,000,000 $4,000,000

Debt/Equity Ratio 0 1

Share Price $20 $20

Shares Outstanding 400,000 200,000

Interest rate 10% 10%


Example: The effect of Leverage (Con’t)

Proposed Capital Structure: Debt = $4 million , Equity = $4 million

Recession Expected Expansion

EBIT $500,000 $1,000,000 $1,500,000

Interest 400,000 400,000 400,000

Net Income $100,000 $600,000 $1,100,000

ROE 2.50% 15.00% 27.50%

EPS $0.50 $3.00 $5.50


•  Variability in ROE

- Current: 6.25% to 18.75%

- Proposed: 2.50% to 27.50%

• Variability in EPS

- Current: $1.25 to $3.75

- Proposed: $0.50 to $5.50

Thus, financial leverage increased the variability in ROE and EPS.

Example: The effect of Leverage (Con’t)


-  There is no underlying theory, so there is no way to know which ratios are most relevant.

-  Benchmarking is difficult for diversified firms

-  Globalization and international competition makes comparison more difficult because of differences in accounting regulations

-  Different fiscal years

-  Extraordinary events

Potential Problems using Ratios


Simple Interest vs. Compound Interest


Simple Interest : Interest earned only on original investment, not on interest

Compound Interest : Interest earned on both original investment and interest

: Reinvesting the interest from original investment

By default, we use Compound Interest in this course.

Simple Interest vs. Compound Interest


Suppose you have $100 to save in the bank for two years. How much will you get after two years?

1)  The bank pays 10% simple interest.

2)  The bank pays 10% compound interest.

Example: Compound Interest


Compound interest is always higher than simple interest. We ALWAYS use COMPOUND interest in this class!!!

Example: Compound Interest (Con’t) Simple Interest Compound Interest

Investment Interest Total Investment Interest Total

1 year 100 10 110 100 10 110

2 year 100 20 120 110 11 121

3 year 100 30 130 121 12.1 133.1

4 year 100 40 140 133.1 13.31 146.41

5 year 100 50 150 146.41 14.641 161.051

10 year 100 100 200 259.37

30 year 100 300 400 1744.94

50 year 100 500 600 11739.08


* Going back to the previous example:

Invest $100 at 10% interest rate for 2 years

1)  Annual Compounding:

2)  Monthly Compounding:

3)  Daily Compounding:

4)  Continuous Compounding

Number of Compounding Periods

100× (1+ 0.10)2 =121

100× (1+ 0.1012

)24 =122.039

100× (1+ 0.10365

)730 =122.14


Bring financial calculator

Bring name card

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finance 101

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