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Corporate Finance A2 Vysok kola finann a sprvn Winter Semester 2012 Jaromr R. Stemberg jaromir@mail.vsfs.cz

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Course Layout Twelve two-hour lessons The course is to introduce general financial management problems, realtions, terminology, and solutions Ends with an Exam (zkouka)

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Literature Block, Stanley: Foundations of Financial Management McGraw-Hill, 2009 ISBN 978-0-07-128525-4

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Grading Written test, oral exam

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Contents Review of the Last Semester Time Value of Money Valuation and Rate of Return Cost of Capital and Capital Budgeting Capital Markets Bonds, Stock and Security Financing

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History of Money and Accounting

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Money Barter trade Cowry shells form 1200 B.C. in China till mid 20 th century in Africa Precious metal coins, banknotes Development of banking Plastic money of today

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Development of Accounting Babylon, 18 th century B.C. - first organized records kept to account for assets and loans Italy, 13 th century A.D. - double-entry bookkeeping 20 th century A.D. - international accounting standards US GAAP and IAS/IFRS

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Financial Reports and Analysis

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Balance Sheet Assets Liabilities Current AssetsCurrent Liabilities Cash and EquivalentsShort-Term Accounts Payable Short-Term ReceivablesCurrent Tax Payable InventoryShort-Term Loans and Borrowings Accruals and Other S/T AssetsAccruals and Other S/T Liabilities Long-Term AssetsLong-Term Liabilities Intangible Fixed AssetsLong-Term Payables Tangible Fixed AssetsProvisions Long-Term Receivables Owners Equity Share Capital Share Premium and Capital Funds Retained Earnings Y-T-D Profit (Loss)

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Cash Flow Statement

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Ratios and Analyses Profitability Ratios - profit margin - return on assets (investments), return on equity Asset Utilization Ratios - receivable, inventory, fixed, total assets turnover - average collection period, days of sales outstanding Liquidity Ratios - current ratio - quick ratio Analyses - DuPont analysis - horizontal, vertical, trend

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Du Pont Analysis

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Forecast and Budget

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Budgetting Systematic setting of future goals Bottom-up or top-down Identification of external influence and risks (such as customers, competition, macroeconomics) Identification of external influence and risks (such as capacity of production and resources, human factor) Setting of expected growth (reduction), pipeline, percent-of-sales, investment planning

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Financial Forecasting Pro forma income statement Revenue (pipeline, funnel, percentage) Expenses (variable, fixed) Pro forma balance sheet A/R, A/P, inventory Fixed assets, liabilities, equity Pro forma cash flow statement

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Operational and Financial Leverage

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Fixed and variable expenses 0 $ total expenses fixned expenses No. of units produced

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Fixed and variable expenses No. of units produced $ fixned expenses total expenses

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$ Break-Even Point No. of units produced revenue total expenses fixed expenses

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Break-Even Point profit revenue total expenses fixed expenses $ No. of units produced

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$ Break-Even Point No. of units produced revenue total expenses fixed expenses

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Operational leverage Uses fixed/variable cost Can increase profits but increases risk _ Fixed costs _ Price Variable cost per unit

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Operational leverage _ Fixed costs _ Price Variable cost per unit Fixed cost 60.000Fixed cost 12.000 Variable cost 0,80 / unitVariable cost 1,60 / unit Unit price 2,00Unit price 2,00 60.000/(2,00-0,80) = 50.00012.000/(2,00-1,60)= 30.000 break-even point isbreak-even point is 50.000 units30.000 units

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Financial Leverage 2 firms: exactly the same Same sector Same opportunities Same Management The only difference: the debt L (leveraged firm) has 50% of debt U (unleveraged firm) has no debt

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Financial Leverage Firm UFirm L Shares (Capital) Financial debt Total 100 000 0 100 000 50 000 100 000 Number of shares (Price of a share 100) 1 000 500 EBIT Financial interests (interest rate 5%) Net income before tax EPS before tax 10 000 0 10 000 10 (10 000/1 000) 10 000 2 500 7 500 15 (7 500/500) Net income after tax (Tax rate 33%) EPS after tax 6 700 6,70 5 000 10,00

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Financial Leverage The shareholder of L has a return of 15 (before tax) The shareholder of U has a return of 10 (before tax) What do you prefer?

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Financial Leverage Firm UFirm L Shares Financial debt Total 100 000 0 100 000 50 000 100 000 Number of shares (Price of a share 100) 1 000 500 EBIT Financial interests (interest rate 5%) Net income before tax EPS before tax 0 2 500 -2 500 -5 Net income after tax EPS after tax 0 -2 500 -5

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Financial Leverage The shareholder of L has a return of -5 (before tax) The shareholder of U has a return of 0 (before tax) What do you prefer?

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Financial Leverage For leverage to be profitable, the rate of return on the investment must be higher than the cost of the borrowed money Conclusion Leverage can create value or destroy it To create value, the IRR must be higher than the cost of loan; if not, leverage destroys value.

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Time Value of Money

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Money in Time 1624 the Native Americans sold Manhattan for $24. Ridiculously low pice? If the amount was invested then at 7.5% (compounded annually), what would be the price today?

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Money in Time almost $40 trillion (exactly $39 637 279 191 271.20) it would make them the richiest people in the world

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Future Value FV n = PV * (1 + r) n

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Future Value FV n = PV * (1 + r) n FV 389 = 24 * (1 + 0.75) 389 FV 389 = 24 * 1.75 389 FV 389 = 24 * 1 651 553 299 219,63 FV = 39 637 279 181 271,20

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Future Value of an Annuity TimeAnnuity Now100 1st year100 2nd year100 3rd year100... nth year100

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Future Value of an Annuity Time Annuity Interest 7%Total Now100 7.00107.00 1st year10014.49221.49 2nd year10022.50343.99 3rd year10031.08475.07 4th year10040.25615.32 5th year10050.07765.39

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Future Value of an Annuity FV A = A * (1 + r) 0 + A * (1 + r) 1 + A * (1 + r) 2 +.. + A * (1 + r) n FV A = A [(1 + r) n 1] / r

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Present Value FV n = PV * (1 + r) n PV = FV n * 1 / (1 + r) n

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Present Value PV = FV n * 1 / (1 + r) n PV = FV 1 * 1 / (1 + r) 1 + FV 2 * 1 / (1 + r) 2 +.. + FV n * 1 / (1 + r) n

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Present Value of an Annuity PV A = A * [1 / (1 + r)] 1 + A * [1 / (1 + r)] 2 +.. + A * [1 / (1 + r)] n PV A = A * {[1 1/(1 + r) n ] / r}

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Valuation and Rate of Return

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Objectives The valuation of a financial asset is based on the present value of the future cash flows The required rate of return in valuing an asset is based on the risk involved

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Bonds Coupon / zero coupon bonds Valuation of bonds: present value of future cash inflows P = P.. bond price Y.. Yield P n.principal payment at maturity i.. interest (or expected return) t.. number corresponding to a period n..number of periods n YtYt + PnPn (1+i) t (1+i) n t=1

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Stock Infinite stream of level dividend payments Constant growth in dividends D.. dividend payment r.. required rate of return g..dividend growth

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Cost of Capital

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Weighted average of: -cost of debt (loans, bonds) -cost of equity (common stock, preferred stock)

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Cost of Debt Interest payment minus tax K d = i (1 t) K d.... Cost of debt i.... Interest paid t.... corporate tax rate

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Cost of Equity Dividend devided by market price K e = D / P 0 K e.... cost of equity D.... current dividend P 0.... market price of the stock If dividends constantly grow, then K e = (D / P 0 ) + g g.... constant growth rate in dividends Selling costs are to be deducted from price for newly issued stock

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Sources of Financing Hidden reserves within the company Suppliers credit Bank loans Financial investors Strategic investors Securities

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The Capital Budgeting Decision Long-term investment decision Cash flow rather then earnings Payback method Dynamic methods

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Long-Term Investment Most significant financial decisions Infuences the firms preformance in many future years Planning involves future revenues and expenditures The farther in the future the time horizon, the more uncertain outcome

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Capital Budgeting Proces Search for investment opportunities Collection of data Analysis, evaluation and decision making Reevaluation and adjustment

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INVESTMENT PROJECTS Investment project: investment in the phase of planning or implementation Conventional cash flow: cash out at the beginning followed by cash inflows Feasibility Study: document describing strategic, financial, technical, marketing and sales information needed for go / no-go decision

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Investment Projects Categories Accounting: financial tangible intangible Development new development re-newing regulatory- safety - environment - new regulations

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Investment Projects Categories Mutual influence substitution (mutually excluding) independent complementary (mutually supporting) Cash flow conventional period of expenses is replaced by lasting period of revenue unconventional a few income / expense periods switch during the project duration

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Investment Projects Categories Function new fixed asset new product new organization structure new company new legislation new markets History green field running business

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Phases of an Investment Project Pre-investment phase projects identification feasibility study Investment phase establishement of legal, financial and organizational base tender suppliers acquisition of technology and documentation personnel trial run Implementation phase implementation management

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Project Identification Monitoring of the business surroundings market of products, supplies, services, capital, workforce technology legislation, political and economical influence Short list monitoring of possibilities evaluation of basic idea attractiveness preliminary estimate of returns and profitability

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Evaluation Techniques Static Average annual revenue (total revenues/total duration) Average payback (investment/average annual revenue) Average margin (average annual revenue/investment) Payback period Dynamic Net Present Value (NPV) Internal Rate of Return (IRR) Paybeck Period (PP) Profitability Index (PI)

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Cash Flow Over Accounting Projects evaluated by cash generation rahter than accounting results Eliminate non-cash transactions and add in cash expenditures Problem: publicly traded companies

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Payback Method Computes the time required to recoup the initial investment Ignores the inflows after the cutoff period Doesnt consider the time value of money

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Internal Rate of Return Project 1

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Internal Rate of Return Project 2

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Net Present Value

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Analysis

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Risk and Capital Budgeting

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The Concept of Risk Based on uncertainity of future outcomes Most investors are risk-averse The greater risk is involved the higher return is expected Risk decision making: simulation models and decision trees Risk of a project inconnection with the total risk of the firm

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Basic Business Statistics D (expected value) = DP DPDP 30020%60 60060%360 90020%180 DP =600 Doutcome Pprobability of occurance

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Standard Deviation

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