Corporate Finance
Instructor: Fei Yiwen
E-mail: ywfei@
Corporate Finance
Sub discipline of economics – The theory of the firm
Requires an understanding of
The banking system
The operation of money
Capital markets
Corporate Finance
Objective
Wealth maximization
Strategy
Acquisition, financing and management of ASSETS
Operational Considerations
Asset Acquisition
Which are the best assets to buy?
When should you buy them?
Operational Considerations
Asset Financing
What is the best type of financing?
What is the best financing mix?
Operational Considerations
Asset Management
How do you achieve the most efficient asset mix?
Cash flow considerations
Operational Considerations
Wealth Maximization
Cash flows
Timing
Risk versus Return
Goal = steadily appreciating share price
Agency Relationships
Agency Costs
Management incentives
Monitoring expenses
Bonding expenses
Opportunity cost
Inefficient agency relationships = agency problems
Wealth Maximization
Profit- useful but ignores
Risk
Time value of money
Wealth Maximization
Cash Flow - equity and debt
Net Present Value (NPV)
The present value of all future cash flows minus initial cost
Other Considerations
Ethics
Moral duty and obligation
Public relations
Investor confidence
Career Prospects
CFO – overall responsibility
-Financial Policy
- Corporate Planning
Treasurer
Cash Management
Raising Capital
Controller
Financial Statements
Key Points So Far
Maximize Shareholder wealth through the
Acquisition, financing and management of assets that maximize returns whilst minimizing the risks
Goal = steadily appreciating share price
Course Objective
The objective of this module is to build an understanding of some concepts that are fundamental to the study of corporate finance and asset pricing. In addition to supporting a basic understanding of finance, these concepts are used in many other finance courses that you might subsequently take. The topics covered include
(i) Risk and return with special attention to the Capital Asset Pricing Model (CAPM)
(ii) The Informational Efficiency of Capital Markets
(iii) The use of debt and equity in the company’s capital structure
(iv) Financial options and the analysis of corporate securities as contingent claims.
Textbook
* Ross, S. A., R. W. Westerfield and J. F. Jaffe, Corporate Finance, 6th edition, 2002/2003. McGraw-Hill & China Machine Press.
Suggested reference text:
Brealey and Myers, Principles of Corporate Finance, 6th edition, 2000, Prentice Hall & China Machine Press.
Evaluation
Class Participation 10%
Presentation & Case Study 40%
Final Test 50%
* Assignments- Case Study or Calculation must be submitted.
Homework
Double-spaced typed pages
(not including tables or charts that you may wish to add)
Submit the homework in the format of Word
The homework should be submitted before Deadline.
The presentation
Every group will have a chance to give their presentation to the class.
The detail information is available in the outline of this course.
Observations about this course
It is consistent with what is covered in every major international program
The text is used by 80% of top programs
Student feedback: A difficult course that requires work
NOTE: I do not assume that you have prior training in finance beyond the core.
Chapter 1 Introduction
Finance: the study of markets and instruments that deal with cash flow over time
Corporate Finance
Investment
Banking
Insurance
Real estate
Public Finance
The balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-term debt
Shareholders’ equity
Key Questions
In what long-lived assets should the firm invest?----Capital budgeting and expenditure
How can the firm raise cash for required capital expenditure?----Capital structure
How should short-term operating cash flows be managed?---- Net working capital
Primarily a Corporate Finance Point of View
SAVERS/INVESTORS
The
Corporation
-Real
Assets
Financial
Markets
-financial
assets
Investment
Management
Corporate
Financial
Manager
The interplay of the firm’s finance with the financial market
(A)
(E)
(C) (F)
Firm invests
In assets
(B)
Current Assets
Fixed Assets
Financial Market
Short-term debt
Long-term debt
Equity Shares
Government
(D)
The Corporate Firm
The Sole Proprietorship
The Partnership
General partnership
Limited partnership
The Corporation
The Sole Proprietorship
The cheapest business
No corporate income taxes, but individual income taxes
Unlimited liability
The life of sole proprietorship is limited
The equity money is limited to the proprietor’s personal wealth
The Partnership (1)
General partnership
-- all partners agree to provide some fraction of the work and cash and to share the profits and losses.
Limited partnerships
-- the liability of some of the partners to be limited the the amount of cash each has contributed.
The Partnership (2)
Partnerships are inexpensive and easy to form.
General partners have unlimited liability.
The life of general partnership is limited
Raising large amount of cash is difficult.
Personal income tax
Management control reside with the general partners
The Corporation
Advantage
Ownership can be readily transferred
The unlimited life
The shareholders’ liability is limited to the amount invested in the ownership shares.
Disadvantage
The double taxation for shareholders
A Comparison of Partnership and Corporations
Liquidity and marketability
Voting rights
Taxation
Reinvestment and dividend payout
Liability
Continuity of existence
Goals of the Corporate Firms (1)
Agency Cost and the principal-agent relationship
Jensen & Meckling, “Theory of the Firm: Managerial Behavior,Agency Costs and Ownership Structure”, Journal of Financial Economics 3 (1976).
--The cost of resolving the conflicts of interest between managers and shareholders
The monitoring costs of the shareholders
The costs of implementing control devices
Goals of the Corporate Firms (2)
Managerial Goals
Williamson: expense preference
Donaldson: corporate wealth
Separation of Ownership and Control
-- Do shareholders control managerial behavior?
Goals of the Corporate Firms (3)
Do shareholders control managerial behavior?
Shareholders meeting – the board of directors – the management team
Compensation, such as option
Takeovers
Competition in managerial labor market
Chapter 2 Net Present Value
The time value of money
Compounding periods
Case study
Time Value of Money
Cash flows occur over a period of time
Inflation erodes the value of money over time
What are the value of those cash flows in TODAY’S money
The time value of money (1)
To study the relationship between a dollar today and a (possible uncertain) dollar in the future
Future
Present value
The time value of money (2)
Net Present Value
Future Value and Compounding
Simple interest: FV = C * (1 + T *r)
Compound interest: FV = C * (1+r)T
Example
Julie wants to know how large her $10,000 deposit will become at a compound interest rate of for 5 years.
0 1 2 3 4 5
$10,000
FV5
10%
Solution
Calculation based on general formula:
FVn = P0 (1+i)n FV5 = $10,000 (1+ )5 = $16,
Problem
Julie wants to know how large a deposit to make so that the money will grow to $10,000 in 5 years at a discount rate of 10%.
0 1 2 3 4 5
$10,000
PV0
10%
Solution
Calculation based on general formula: PV0 = FVn / (1+i)n PV0 = $10,000 / (1+ )5 = $6,
The Power of Compounding
The US stock market returned as a whole from 1926 through 1996 (annual rate of return is %)
Simple interest:
$1* ( 1+71*%)=$
Compound interest:
$1* (1+%)71=$
Present Value and Discounting(1)
Discounting:
The process of calculating the present value of a future cash flow. It is the opposite of compounding.
Present Value and Discounting (2)
$
$1900
$1000 $1000
$
0 10th year
Compounding periods(1)
Compounding an investment m times a year
Effective annual interest rate
Compounding periods(2)
For an investment over one or more (T) years
Continuous Compounding
FV = C0 * e r*t ( e = )
Simplifications (1)
Perpetuity– Consols (British Bonds)
Growing Perpetuity
Simplifications (2)
Annuity
-- a level stream of regular payments lasting for a fixed number of periods
Growing Annuity
Case Study (1)
Harold and Helen are saving for the college education of their newborn daughter, Susan. They estimate that college expenses will run $30,000 per year when their daughter reaches college in 18 years. The annual interest rate over the next few decades will be 14 percent. How much money must they deposit in the bank each year so that their daughter will be supported?
Case Study (1)
To calculate the present value of the four years at college using the annuity formula.
To calculate the PV at date 0 as
Case Study (1)
3. To calculate the annual deposit at the end of each of the 17 years
4. If they plan to increase their payments at 4% per year.
Case Study (2)
In 1987, Rosalind Setchfield won more than $ million in the Arizona state lottery. The winnings were to be paid in 20 yearly installments of $65,. Six years later, in 1995, Mrs. Setchfield received a phone call from a salesman for the Singer Asset Finance Company. They offer to give her $140,000 immediately for one-half of the next nine lottery checks.
Rates of Interest
Nominal versus Effective rate
Nominal = the annual rate
Effective = is the rate derived after the nominal interest rate has been calculated (compounded) several times in the year
Effective Annual Interest Rate
(1 + [ i / m ] )m - 1
Formula :
Basket Wonders has a $1,000 CD at the bank. The interest rate is 6% compounded quarterly for 1 year. What is the Effective Annual Interest Rate (EAR)?
EAR = ( 1 + 6% / 4 )4 - 1 = - 1 = .0614 or %!
Chapter 3 Financial Markets and NPV
Money markets & Capital markets
The primary markets & the secondary market
What is Capital Budgeting?
The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.
The Capital Budgeting Process
Generate investment proposals consistent with the firm’s strategic objectives.
Estimate after-tax incremental operating cash flows for the investment projects.
Evaluate project incremental cash flows.
Select projects based on a value-maximizing acceptance criterion.
Reevaluate implemented investment projects continually and perform post-audits for completed projects.
Classification of Investment Project Proposals
1. New Products or expansion of existing products
2. Replacement of existing equipment or buildings
3. Research and development
4. Exploration
5. Other (., safety or pollution related)
Initial cash outflow -- the initial net cash investment.
Interim incremental net cash flows -- those net cash flows occurring after the initial cash investment but not including the final period’s cash flow.
Terminal-year incremental net cash flows -- the final period’s net cash flow.
Calculating the Incremental Cash Flows
Basket Wonders (BW) - new basket weaving machine.
Cost $50,000 plus $20,000 for shipping and installation.
Net working capital (NWC) will rise by $5,000.
Revenues will increase by $40,000 for each of the next 4 years.
Machine to be sold (scrapped) for $10,000 at project end.
Operating costs will rise by $70,000 per four year.
BW is in the 40% tax bracket.
Example of an Asset Expansion Project
Initial Cash Outflow
a) Cost of asset
$ 50,000
b) + Capitalised expenditures
+ 20,000
c) +/- In(de)creased NWC
+ 5,000
d) - Net proceeds from sale of
old asset (if replacement)
0
e) +/- Taxes (savings) due to d)
0
f) Initial cash outflow
$ 75,000
Year 1 Year 2 Year 3 Year 4.
a) net in oper. revenue $40,000 $40,000 $40,000 $40,000.
b) +/- net in tax deprec. -23,331 -31,115 -10,367 -5,187.
c) = net in income bf tax $16,669 $ 8,885 $29,633 $34,813.
d) +/- net in taxes -6,668 -3,554 -11,853 -13,925.
e) +/- net in inc. after tax $10,001 $ 5,331 $17,780 $20,888.
f) +/- net in tax deprec.
charges 23,331 31,115 10,367 5,187.
g) Incremental net cashflow $33,332 $36,446 $28,147 $26,075.
where = change.
Incremental Cash Flows
a) Incremental cash flow from
previous slide in Year 4. $26,075
b) +/- Salvage Value + 10,000
c) +/- Tax or tax savings due to sale .40*($10,000 - 0) - 4,000*
d) +/- level of NWC - Project ends. + 5,000
e) = Terminal-year incremental cash flow $37,075
Terminal-Year Incremental Cash Flows
*Note, the asset is fully depreciated at the end of Year 4.
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
-$75,000 $33,332 $36,446 $28,147 $37,075
Summary of Project Net Cash Flows
In General, the Value of an Action
Market Value of Financial Instrument Depends on Cash Flow Characteristics and Required Return rt
Opportunity Cost rt
Suppose an investor is considering buying security A.
A will only be purchased if the expected return is at least as high as the return that could have been earned elsewhere.
The amount that could have been earned elsewhere is the opportunity cost or the required return on the asset.
When we compute NPV, we discount at the required return.
The financial market economy
Y
A
B
$60,000
$50,000
Consumption next year
Consumption this year
A=$60,000+($50,000*(1+))
B=$50,000+($60,000/(1+))
$115,000
$104,545
In the competitive market
Slope=, lending
Slope=, Borrowing
Y
Corporate Investment Decision Making
The Basic Financial Principle of Investment Decision Making
An investment project must be at least as desirable as what is available in the financial market.
Net Present Value (NPV)
NPV= PV of Cash flow in - PV of Cash flow out
An investment is worth making if it has a positive NPV
Net Present Value (NPV)
NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow.
CF1 CF2 CFn
(1+k)1 (1+k)2 (1+k)n
+ . . . +
+
- ICO
NPV =
NPV Solution
Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%.
$10,000 $7,000
$10,000 $12,000 $15,000
()1 ()2 ()3
+
+
+
- $40,000
()4 ()5
NPV =
+
NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) + $15,000(.693) + $10,000(.613) + $ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $40,000
= - $1,428
NPV Acceptance Criterion
No! The NPV is negative. This means that the project is reducing shareholder wealth.
[Reject as NPV < 0 ]
The management of Basket Wonders has determined that the required rate is 13% for projects of this type.
Should this project be accepted?
NPV Strengths and Weaknesses
Strengths:
Cash flows assumed to be reinvested at the hurdle rate.
Accounts for TVM.
Considers all cash flows.
Weaknesses:
May not include managerial options embedded in the project.
