Inroduction to Corporate FinanceAY 2013/14

Dr. Gyorgy Komaromigyorgy@komaromi.net

Financial manager, objective of the firm,

agency costs

Financial manager and objective of the firm

What Is A Corporation?The Role of The Financial ManagerWho Is The Financial Manager?Separation of Ownership and ManagementGoal of the FirmValue Theory

Corporate Structure

Sole Proprietorships

Corporations

Partnerships

Limited Liability

Corporate tax on profits +

Personal tax on dividends

Unlimited Liability

Personal tax on profits

Sole or partnership ↔ Company

Ease of establishment Limited legal liabilityLow cost of establishment Easier to raise capitalEase of management Pay less income taxLow regulatory costs Continuity (independent entity)Pay less tax on capital gains Ease of transfer of ownership(particularly if listed)

Role of The Financial Manager

Financialmanager

Firm'soperations

Financialmarkets

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

Role of The Financial Manager

• Common Finance Terminology– Real assets– Financial assets / Securities– Capital markets and financial markets– Investment / capital budgeting– Financing

Who is The Financial Manager?

Chief Financial OfficerChief Financial Officer

ControllerTreasurer

The Chief Financial Officer oversees all financial decisions, and makes decisions on operating and strategic levels. CFO may delegate financial managerial duties to the Controller (C) and the Treasurer (T).

- “Keep the score” and manage the audit (C),- Cash management (T),- Funding—finding the most appropriate sources of finance(T),- Tax— planning, minimising, paying (C),- Risk – minimising financial risk (T) – insurance, foreign currency risk, etc. (T),- Capital investment appraisal (C), and- Forecasting (C).

Ownership vs. ManagementDifference in Information

• Stock prices and returns• Issues of shares and

other securities• Dividends• Financing

Different Objectives

• Managers vs. stockholders

• Top mgmt vs. operating mgmt

• Stockholders vs. banks and lenders

Goals of The Corporation

• Shareholders desire wealth maximization

• Do managers maximize shareholder wealth?

• Managers have many constituencies “stakeholders”

• “Agency Problems” represent the conflict of interest between management and owners

Principal-Agent Problem

The principal-agent problem is always about trying to make an agent’s objectives the same as the principal’s objectives. For example, in a corporate context the principal is the shareholder and the agent is the manager. The shareholder wants the manager to maximise shareholder’s wealth. The Shareholder delegates all decisions to the manager on operational and partly on strategic levels. But the manager wants to maximise his own wealth. There are several ways of how to mitigate this principal-agent problem.

Goals of The CorporationAgency Problem Solutions1 - Compensation plans2 - Board of Directors3 - Takeovers4 - Specialist Monitoring5 - Auditors

Value Theory

• Time value of money• Future value (FV)• Present value (PV)

Measuring Value(Value Theory)

Measuring Value

Valuing Long-Lived AssetsPV Shortcuts – Perpetuities and AnnuitiesNominal and Real Rates of Interest (inflation)Simple Interest vs. Compound Interest

Present and Future Values

• Example 1:– You just bought a new computer for $3,000. The

payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

Evaluating multiple cash flows

• Example 2:Assume that the cash flows from the construction and sale of

an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value:

Y0:-170.000Y1:-100.000Y2:+320.000

Short Cuts

Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tolls allow us to cut through the calculations quickly.

Example 1: receiving $30 a month @1% monthly required rate of return

Example 2: receiving $1000 annually @16% required rate of return

Short CutsPerpetuity - Financial concept in which a cash flow is

theoretically received forever.Annuity - An asset that pays a fixed sum each year for a

specified number of years.

Cr

Perpetuity (first payment in year 1)

Perpetuity (first payment in year t + 1)

Annuity from year 1 to year t

Asset Year of Payment

1 2…..t t + 1

Present Value

Cr 1

1+r t

Cr −C

r 11 +r t

Inflation

If the interest rate on one year govt. bonds is 5.9% and the inflation rate is 3.3%, what is the real interest rate?

Exact solutionFisher approximation

1real interest rate= 1+nominal interest rate1+inflation rate

Simple interest

When interest is paid at a fixed rate on the original sum deposited (the “principal”) only, this is called simple interest. Specifically, if you lend someone $100 for three years, at a simple interest of 6%, then after one year it will be worth $106; interest for the second year will also be $6 because that is 6% of the original sum; so after three years, the total will be $118.

The general formula is:

Final Sum = Co * (1 + r*n)

where i = interest rate n = time in years(Interest rates are almost always expressed as annual rates).

Compound interest

Compound interest is interest calculated on the amount outstanding at the beginning of each period. For example, if $1000 were invested at 10% compound interest, and left for three years:

After one year, interest earned = 10% of $1000 = $100Final sum = 1000 + 100 = $1100

In year 2, interest earned = 10% of $1100 = $110Final sum = 1100 + 110 = $1210

In year 3, interest earned = 10% of 1210 = $121Final sum = 1210 + 121 = $1331.

The general formula is:Final sum (or future value, FV) = Co * (1 + r)n

Problem of frequency of compounding

More generally, if interest rate is compounded “m” times per year, the effective rate is:

(1 + r/m)m - 1