corpfin lecture 01 2005 1

7/31/2019 CorpFin Lecture 01 2005 1

1/36

New Venture Finance: Corp. Finance Review 1

__________________________________________

Real Sector The Firm Financial SectorCorporate Investment Corporate FinancingDecisions: Utilization of Funds Decisions: Acquisition of Funds

Business Markets Financial MarketsThe Firm's Balance Sheet

__________________________________________________________Cash A/PA/R Other CurrentInventory Liabilities_________________ _____________________

Products Total Current Assets Total Current Liabilities

Customers

Competitors Fixed Assets: Capital: Savers/Employees Plant & Equipment Debt InvestorsTangible Assets Preferred StockTechnology Common Equity

--Retained Earnings--Common Stock

________________ _____________________Total Assets Total Liabilities & Equity


2/36


__________________________________________

Financing (sources of funds) must equal the investment inassets (use of funds).

Managers make investment decisions that generateearnings so that investors get a return on investment.

Financial Management is defined as the planning for,acquiring, and utilization of funds in a manner thatmaximizes the firms economic efficiency.


3/36


__________________________________________

The Corporate Finance View of the World:

Bus. Transactions $$

$$ Securities

Commercial

Sector

-Customers

-Products-Technology

-Competitors

Firms Balance

Sheet

Assets Liab.

Capital

Firms Income

Statement

Revenue-Expenses

-Taxes

Net IncomeRetained

Earnings?

Dividends?

Financial Sector

Savers/Investors:

-Individuals

-Corporations-Partnerships

-Banks

Return on

Investment


4/36


__________________________________________

The corporation has advantages over the other forms ororganization:

Unlimited lives that extend beyond the lives of the

founders or original managers.

Simple transferability of ownership: investors andmanagers are two separate groups, so investors can buyor sell the common stock without disrupting corporateoperations.

Limited liability in the corporation: investors can loseonly the total amount they invested in the commonstock.


5/36


__________________________________________

The stock market monitors the publicly-traded corporations performance:

Stock price changes signal whether managerialdecisions are good (stock price goes up) are bad(stock price goes down).

Because of the requirements to disclose

information that publicly-traded corporationsface, the stock market can monitor these firmsbetter than it can the other forms oforganization.


6/36


__________________________________________

The stock market disciplines the firm bycausing the stock price to decline. Inresponse, the firm can:Change strategies.

The Board of Directors can replace themanagers ( this is called internal governance).

The firm can be merged/taken over (this iscalled the market for corporate control).

Declare bankruptcy.


7/36


__________________________________________

In the Theory of Finance, the appropriate goal of

the firm is to maximize the value of shareholder

wealth.

Shareholders commit part of their wealth to the

firm when they buy the firms common stock.

Equivalent ways of stating this goal are:

To maximize the market value of the firm.

To maximize the stock price of the firm.


8/36


__________________________________________

An equation that is central to the Theory ofFinance is:

A Firms Stock Price = The Present Value ofAll Future Dividends

DIV1 DIV2 DIV3 DIV DIVt= ----------- + ----------- + ------------ + ... + ----------- = -------------

(1 + k)1 (1 + k)2 (1 + k)3 (1 + k) t=1 (1 + k)t


9/36


__________________________________________

This equation says that value (i.e., the stock price)depends on: The stream of dividends.

Risk, reflected in the discount rate, k. The timing of the dividends. Note that value depends on all future dividends

and not only on next quarter's dividends.

Where do dividends come from? Dividends = (Earnings) Earnings = (Revenue, Expenses, Interest Exp.,Other) Revenue = (Business Decisions, Strategy)


10/36


__________________________________________

Agency Problems and Costs. Investors(principals) provide funds, but managers (agents)formulate and implement strategies and tactics: the

problem ofseparation of ownership and control. The goal is to maximize shareholder wealth, but

investors cannot be sure that managers will act inshareholders best interests. Managers might:

Shirk their duties. Use corporate resources to pay for perquisites.

Shift funds into higher risk projects than thestockholders desire.


11/36


__________________________________________

Observability, asymmetric information, & moralhazard: Investors cannot observe everything managers do.

Managers have more information about the firm.

Investors monitor the firm, and the firm incursmonitoring costs.

Investor relations staffs, annual reports, SEC and other

regulatory reports consume resources. If managers actions cannot be observed directly,

then periodic disclosure must be made: Disclosure: information sets become more symmetric.

Are bank loan officers' salaries a monitoring cost?


12/36


__________________________________________

Agency problems can be solved if the interests ofmanagers and investors are aligned, if bothmanagers and investors have the same incentives.

Agency theory suggests if managers are bondedto the firm, managers would behave in theshareholders' best interests. This entails bonding costs. For example, stock options

or stock purchase programs (like at 85% of the marketprice) transform managers into owner/managers.

But managers are buying into the firm at below-marketprices. The bonding cost is the loss of wealth sufferedby other shareholders when the stock is sold cheap.


13/36


__________________________________________

These costs cause shareholder wealth to be lessthan if managers didn't pose a moral hazard. We live in an imperfect world.

A perfect world of symmetric information no moralhazards is not attainable.

Financial contracting solutions are often used. For example, bond indenture contracts often contain

restrictive covenants that limit the behavior ofmanagers, like no new mortgages on the assets.

Bank loans also contain restrictions, like limitations onpaying dividends, the amount of additional borrowing,or a minimum current ratio requirement.


14/36


__________________________________________

A closer look at financial contracting. Bonds areloan contracts, and common stocks have legal tiesto the firm via the firm's charter.

Bonds are fixed income securities that have finite lives:bonds have a fixed maturity date, pay a set amount ofinterest each period, and borrowings must be repaid.

Stocks are variable income securities that have infinitelives. Dividends are not guaranteed and stock nevermaturesas long as the firm is alive. Stocks can berepurchased by the firm, but that is different: stockcan be retired but it does not mature. Stocks representan equity, or ownership, interest in the firm.


15/36


__________________________________________

Security Payment Priority_______________________________________________________________________________________________________________________________________

Debt Fixed, periodic interest Priority in bankruptcy

Par value at maturity Preference over preferred & common

Can force bankruptcy if not paid

Preferred Fixed, periodic dividend Paid before common dividends

Stock No maturity date Preference over common

Div. must be declared

Common No fixed dividend Residual position in dividend

Stock No maturity date payment and bankruptcy

Div. must be declared


16/36


__________________________________________

The Relationship Between Discount Rates and Value:

Like stock, bond prices also equal the present value ofthe cash flows that investors expect to receive:

Bond Price = P.V. of interest + P.V. of maturity value Bond Interest = coupon rate X maturity value

Maturity Value = $1,000.00; called the bondsprincipal

Consider a 10% , 1-year bond or a 10%, 5-year bond;both have a maturity value of $1,000.

Currently, bond interest rates are 10%, but rates mayvary between 8% and 12% over the next few months.

How do changing interest rates affect bond values?Interest = .10 x $1,000 = $100 per year


17/36


__________________________________________

8.0%

k = the Market Rate of Interest

10.0% 12.0%

A. 1-Year bond

Present value of:

Interest

Maturity value

Price of bond

B. 5-Year Bond

Present value of:

Interest

Maturity value

Price of bond

$ 92.59

925.92

$1,108.52

$ 399.27

680.58

$1,079.85

$ 90.91

909.09

$1,000.00

$ 379.07

620.93

$1.000.00

$ 89.28

892.96

$ 982.14

$ 360.48

567.42

$ 927.90


18/36


__________________________________________

Define k as the Market Rate of Interest. Theexample shows that that k and a bonds price areinversely related:

Bond prices goes up as k goes down.Bond prices goes down as k goes up.

Note that the bond with the longer maturity (the 5-yr bond) has greater price volatility for the same

changes in the interest rate. The 5-yr bond has a higher price at 8% and a lower

price at 12% than the 1-yr bond.


19/36


__________________________________________

Project evaluation techniques. Developing newproducts or services are essential if a firm is tocontinue growing. Capital budgeting involves:

Long-term investment opportunities as projects. Conducting a cost/benefit analysis for each project.

Accepting projects when benefits exceed the costs.

Picking good projects allows the firm to grow and to

increase its stock price. The preferred technique is called Net Present

Value (NPV).


20/36


__________________________________________

NPV = P.V. of Inflows - P.V. of Outflows

n NCFtNPV = ------------------- - Cost of the project

t=1 (1 + MCC)t

where: NCFt = Net Cash Flow at time tMCC = the Marginal Cost of Capital,

a risk-adjusted discount rate


21/36


__________________________________________

This gives rise to the following set of decisionrules that are used in capital budgeting:

IRR is the Internal Rate of Return and is defined as the

discount rate that makes NPV = 0.

Criterion Accept Reject

NPV

IRR

NPV O

IRR MCC

NPV < 0

IRR < MCC


22/36


__________________________________________

Who gets the NPV > 0 and how does it achieve thegoal of the firm? Common shareholders, the residual claimants.

Bondholders and preferred shareholders get what theyexpect, and common shareholders get what is left over.

The larger the residual, the more wealth commonshareholders receive (think of the positive NPV that Intelcreates with each new generation of microprocessors.)

If managers select all of the projects with NPV > 0, this isthe best that shareholders can hope for and the stock pricewill be maximized.

Negative NPVs would make the stock price go down.


23/36


__________________________________________

Informational efficiency: This important conceptis the idea that having accurate information iscrucial to making good investment decisions.

Financial markets are informationally efficientifsecurity prices fully reflect all information andreact immediately to impound new information. For example, if the financial markets are efficient, then

Intels stock price reflects all information about Intel. Any new information about Intel will make its stock

price go up or down immediately.


24/36


__________________________________________

One implication is that it is hard to "beat themarket" in an efficient market.

The greatest rewards exist for those who have the

best information; there is much competition forinformation. The "big players" who have the most resources gain

information first and grab the available profits first.

You and I, who are far from Wall Street and who spendlittle on information, find it difficult to beat the market.

Getting information first, or immediately, is very costlyand it is difficult to beat the market and to cover thecosts of obtaining information.


25/36


__________________________________________

Nevertheless, information efficiency is animportant concept, and financial markets arepretty efficient in my opinion. Competitive markets are key: as information becomes

available, investors revise their decisions to buy or sella stock or bond, so there must be markets in which theycan actually buy or sell.

Economics and finance profs love markets: supply anddemand come together and individuals are free to makebuy or sell decisions that are in their best own interests.

As information arrives, it becomes reflected in prices,so price changes signal good news (prices up) or bad

news (prices down).


26/36


__________________________________________

Source Complete Dissemination(day = 0) (day = 1)

Insiders know beforeannouncement

Industry analysts and

informed investors getinformation "on line

Recipients of analysts'reports and less informedinvestors are next; theremay be many substages sothat there are degrees ofbeing informed

You and I come last:since we have lowinformation costs (t.v.,radio, press, periodicals,etc.), the information ispicked over and its valuealready extracted by thetime we obtain the info.


27/36


__________________________________________

Types ofInformational Efficiency. Note how the Strong Form lines up with the first column above (the source),

the Semi-Strong Form lines up with the middle two columns, and the Weak Form lines up with the last column.

Strong Form: Semi-Strong Form Weak form

Considers all information

fromthe source, including

insider information

The strong form does not

hold: there is value to

insider information

Considers all publicly available information from when

the information is disseminated

The semi-strong form has been found to hold pretty

well, but not completely

Considers only historical

security prices; by thetime you and I receive the

Wall St. Journal on our

doorsteps, the information

has been fully

disseminated; all we have

is yesterday's prices

The weak form has been

found to hold very well


28/36


__________________________________________

A basic principle of Finance: more risk

should be rewarded with a higher return.

In the Theory of Finance, taking risk is agood thing since it creates new wealth (new

products, new technologies, etc.)

Thus, there should be rewards for bearingrisk.


29/36


__________________________________________

Expected Return

Risk-free Risk premiumRate: kf

Time value of money______________________________________________________________Risk

Treasury Corporate Common New Ventures,Bonds Bonds Stock Options, Futures,

and other Derivatives


30/36


__________________________________________

A life-cycle view of the growth of a technology-driven firm. Corporate Finance textbookstypically concentrate on firms that have gone

beyond the start-up stage and are publicly-traded. Publicly-traded firms have developed products and

services that generate earnings from the assets in place.

Start-ups have no assets in place, and maybe are basedon no more than a product or service concept.

The value of a publicly-traded firm is based on assets inplace, a start-ups value is based on its growth options.


31/36


__________________________________________

Sales/Earnings./Cash Flow

__________________________________________________________________ Time

R&D Early growth Rapid growth Maturity Decline(Seed & start-up) (First stage start-up) (Late stage start-up) (---- Publicly-traded ----)


32/36


__________________________________________

Venture Economics Stage Definitions: Early Stage

Seed. A relatively small amount of capital provided to

prove a concept, maybe involving product developmentbut not initial marketing.

Startup. Financing for product development and initial

marketing; no product sales, management team

assembled, business plan written, market research done.

First Stage. Financing for initial commercial

manufacturing and sales.


33/36


__________________________________________

Expansion Second Stage. Working capital financing provided;

likely to have no profits.

Third Stage. Financing for plant expansion, marketing,and working capital.

Bridge Stage. Financing for firm expected to go publicin 6-12 months; often repaid from IPO proceeds.

Management/Leveraged Buyout (MBO/LBO) andTurnaround later-stage companies: buying out existing firms or

financing firms with operational or financial difficulties.


34/36


__________________________________________

Large Publicly-Traded Firms

______________________________________

Easy access to financial markets: banks,

bond markets, and stock markets

Face scrutiny of financial markets:

--much information available about firm and

industry

--analysts perform monitoring function and

makes recommendations

--periodic disclosure keeps everybody happy

--stock market disciplines firms through

price changes force firm to behave as expected

Disclosure: through annual reports, SEC

announcements

--markets are more "informationally efficient"

New Ventures

_________________________________________

Financial markets in general are not

accessible: new ventures are privately held

Face scrutiny of VCs:

--little information about firm or its concept/idea

--VC have to monitor and invest

--VCs are quasi-insiders, often on the Bd. of Dir.

--markets are thin and illiquid; stock not publicly

traded

Disclosure: through business plans, and

and direct examination by investors

--markets are less "informationally efficient


35/36


__________________________________________Large Publicly-Traded Firms

______________________________________

Problem of separation of ownership and control:

--stock options and stock purchase plan help bondmanagers to firm

Sound management expected and scrutinized:

--complex organizations the norm--reorganizations the norm--hierarchical organization--lots of written policies--expertise already developed (i.e., hire MBAs)

Goal is to maximize the firms' stock price:--it can generate a stream of earnings from

ongoing operations (or assets-in-place)--it can undertake capital budgeting

--firms are in mature stage

New Ventures_________________________________________

VCs have more direct monitoring ability:

--Entrepreneurs keep a large percent of sharesand key personnel get stock options

Management development just beginning:

--VCs know what is expected and offer networking--understaffed operation coping with explosion of

tasks and functions--what's a policy?--VCs "groom" management

Goal is to maximize the firms' stock price:--real goal is IPO or merger, or harvest, or cash

out for VC and entrepreneur (a liquidity event)--firms are in rapid growth stage


36/36


__________________________________________

Early Stage Late State Small Publicly Large PubliclyStart-up Private Firm -Traded Firm -Traded Firm_____________________________________________________________________________

VC invests,monitors, andgrooms firm

VC prepares firm forliquidity event (i.e.IPO, merger)

Liquidity eventoccurs: VC andentrepreneur harvest

Not what VCs investin; bank loansprobably available,but financing still abig problem

Financial marketsgenerally available

_____________________________________________________________________________

corpfin lecture 01 2005 1

Documents