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CORPORATE FINANCE
Alexandra Horobe , PhD
Professor ASE Bucharest
Course topics
Introduction to Corporate finance Fundamental principles of finance Time value of money Investment criteria Cash flow principles
Topic #1
Corporate finance must be viewed as an integrated whole, rather than as a collection of decisions The best way to learn managerial finance is by applying its models and theories Corporate finance is fun
The most important economic principles used in managerial finance are marginal analysis and opportunity cost
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Balance sheet
The balance sheet is a snapshot of the firms assets and liabilities at a given point in time Balance Sheet Identity
Assets = Liabilities + Stockholders Equity
Assets are economic resources which are owned by a business and are expected to benefit future operations
Liabilities are obligations of the entity to outside parties who have furnished resources Equity are net assets or net liabilities
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Fixed Assets Tangible Assets Intangible Assets
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Long-term Liabilities
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Shareholders Equity
Corporate Finance / MPI / Alexandra Horobet, PhD
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Market Value Balance Sheet Assets = $11.5 bill. Debt = $4 bill. Equity = $7.5 bill.
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As of December 31 - $ in thousands
2003 2002 Changes
363 68 503 289 1,223 2,072 1,866 358 275 98 4,669 2,295 2,374 3,597
Corporate Finance / MPI / Alexandra Horobet, PhD
288 51 365 300 1,004 1,903 1,693 316 314 96 4,322 2,056 2,266 3,270
75 17 138 -11 219 169 173 42 -39 2 347 239 108 327
TOTAL ASSETS
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Long-term debt
TOTAL LIABILITIES
Stockholders' equity
Preferred stock - cumulative 5%, $100 at par, 2,000 shares authorized and issued Common stock - $2.50 par, 100,000 shares authorized, shares issued and outstanding in 2003: 76,262; in 2002: 76,244 Paid-in capital in excess of par on common stock Retained earnings Total stockholders' equity 200 191 428 1,135 1,954 3,597 200 190 418 1,012 1,820 3,270 0 1 10 123 134 327
Income Statement
The income statement is more like a video of the firms operations for a specified period of time You generally report revenues first and then deduct any expenses for the period Matching principle accounting rules (GAAP, IAS) say to show revenue when it accrues and match the expenses required to generate the revenue
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As of December 31 - $ in thousands
2003 3,074 2,088 986 100 194 35 239 568 418 93 325 94 231 10 221 2002 2,574 1,711 863 108 187 35 223 553 310 91 219 64 155 10 145 Change 500 377 123 0 -8 7 0 16 15 108 2 106 31 75 0 75
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Liabilities and Owners Equity Liabilities $1,450 Owners Equity Paid-in capital 808 Retained earnings 1,012 Total liabilities and owners equity $3,270
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Liabilities and Owners Equity Liabilities $1,643 Owners Equity Paid-in capital 819 Retained earnings 1,135 Total liabilities and owners equity $3,597
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Time-series analysis evaluates performance over time and enables assessing the firms progress Combined analysis to ratio analysis
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Financial ratios
Liquidity ratios measure the firms ability to satisfy shortterm obligations as they come due Leverage (financing) ratios measure the firms ability to pay its long-term debt Efficiency (activity) ratios measure the speed with which various accounts are converted into sales or cash Profitability ratios shows the firms ability to generate income from its assets Market ratios give insight into how well investors in the market value the firm
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Liquidity ratios
Current ratio = Current assets Current liabilities
1,223 = 1.97 620
Quick ratio =
Cash ratio =
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Leverage ratios
Debt ratio = Long - term debt + Value of leases Long - term debt + Value of leases + Equity
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Operating cycle
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Operating cycle
Efficiency of current assets OPERATING CYCLE Finding the inventory period
Inventory turnover = Cost of goods sold Inventory
2,088 = 7.22 289
Inventory period =
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Operating cycle
Finding the accounts receivable (collection) period
Sales A/R 3,074 For Bartlett A/R turnover = = 6.11 503 365 Receivable s period = A/R turnover A/R turnover =
For Bartlett Receivable s period = 365 = 59.74 days 6.11
Operating cycle
Finding the payables period
Cost of goods sold A/P 2,088 For Bartlett A/P turnover = = 5.47 382 365 Payables period = A/P turnover A/P turnover =
For Bartlett Payables period = 365 = 66.73 days 5.47
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balance between the costs and benefits of maintaining high current assets
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Profitability ratios
Gross profit margin = Sales - COGS Sales
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Profitability ratios
ROA = Earnings available to common shareholde rs Total assets
221 = 0.0614 or 6.14% 3,597
ROE =
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Market ratios
Earnings per share (EPS) = Earnings available to common shareholders Number of shares outsanding
Payout ratio =
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Market ratios
P/E ratio (PER) = Price per share of common stock Earnings per share
32.25 = 11.13 2.90
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221,000 3,074,000 3,597,000 3,074,000 3,597,000 1,754,000 = 7.18% 0.85 2.05 = 12.60%
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2. Efficiency
3. Leverage
34.36% 34.70% 52.35% 53.13% 7.06 5.86 32.08% 33.53% 13.60% 12.04% 7.18% 5.65% 2.89 1.91 0.44 0.42 6.14% 4.45% 12.59% 8.98% 11.14 1.40 9.46 0.85
4. Profitablity 1. Gross profit margin 2. Operating profit margin 3. Net profit margin 4. Earnings per share 5. Payout ratio 6. ROA 7. ROE 5. Market 1. PER 2. Market to book ratio
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Topic #2
Role of financial manager Working with cash flows Goals of the corporation Financial institutions and markets Basic principles and rules in finance
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PEOPLE ARE THE ONES THAT MAKE DECISIONS THE FINANCIAL MANAGER MUST DEAL WITH THE CONFLICTING OBJECTIVES ENCOUNTERED IN FINANCIAL MANAGEMENT
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Treasurer
Responsible for:
Cash management Raising capital Banking relationships
Controller
Responsible for:
Preparation of financial statements Accounting Taxes
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Which years profits? Future profits can be increased by cutting current years dividend and investing the freed-up cash Profits can be calculated in different ways
3.
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Agency problems
How are they solved? Compensation plans for managers Involvement of board of directors Takeover threat Specialist monitoring
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Agency costs
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Funds suppliers
Funds demanders
DIRECT FINANCE
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Maturity
Type of sale
Money markets
Capital markets
Primary markets
Secondary markets
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Only one interest rate can be quoted in the market at any one time if not, ARBITRAGE
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$80,000
Time
Cash outflows
-$70,000
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The net present value of an investment is the PV of the investments future cash flows minus the initial cost of the investment
Example: NPV= -$70,000 + $72,727.27 = $2,727.27
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Profit Investment
Return > 10% project should be accepted !!! Equivalent to NPV > 0
IMPORTANT CONCLUSION: CONCLUSION: The NPV rule and the Rate of return rule are two equivalent decision rules for capital investment
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Topic #3
What is time value of money? Compounding and discounting Shortcuts: perpetuities and annuities Frequent compounding and interest rates Working with inflation
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WHY?
Real interest rate
Time
Inflation
Risk
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PV
FV
PV present value, that is, the value today. FV future value, or the value at a future date. t the number of time periods between PV and FV r the discount rate all time value questions involve the four values above: PV, FV, r, and t given three of them, it is always possible to calculate the fourth
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Future values
You deposit $100 today at 10% interest. How much will you have in 5 years? you are interested in finding the FV for five years of the $100 today (=PV) FV($100, 10%, 5y) = $100 (1.1)5 = $161.05
FVt,r = PV x (1+r)t
Future value factor (FVF)
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Present values
The process of obtaining the PV is the inverse of the one which gives the FV Suppose you need $20,000 in three years to pay your college tuition. If you can earn 8% on your money, how much do you need today?
PVt,r = FV 1/(1+r)t
Discount factor or Present value factor (PVF)
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Perpetuities
Perpetuity = financial concept in which a cash flow is received forever
PV(perpetu ity) =
Cash flow C = r r
Example: Example Suppose you receive $1,000 per year forever. Your opportunity rate is 6%. What is the value today of this set of cash flows?
PV(perpetu ity) =
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Growing perpetuities
Imagine an apartment building where cash flows to the landlord after expenses will be $100,000 next year. These cash flows are expected to rise at 5% p.a. and the discount rate is 10%. If this continues indefinitely growing perpetuity
PV(growing perpetuity ) =
C r -g
PV(growing perpetuity ) =
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1. 2. 3.
The numerator (C) is the cash flow one period hence, not at date 0 The discount rate (r) must be greater than the growth rate for the formula to work Timing assumption formula assumes cash flows are received and disbursed at regular and discrete points in time
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Annuities
Annuity = a stream of regular payments that lasts for a fixed number of periods The payments are assumed to be received at the end of each period A good example of an annuity is a lottery, where the winner is paid over a number of years
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PV and FV of an annuity
1 1 PV(annuity) = C t r r(1 + r)
PV ANNUITY FACTOR in tables
(1 + r)t 1 FV(annuity) = C r r
FV ANNUITY FACTOR in tables
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Calculating PV of an annuity
Suppose you need $5,000 each year for the next three years to make your tuition payments. You need the first $5,000 in one year. You can place money in a savings account yielding 5% compounded annually. How much do you need to have in the account today?
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Calculating PV of an annuity
Calculating FV of an annuity
Assume you deposit $2,000 per year in a savings account at 4% p.a., compounded annually for 5 years. The first payment is made one year from now. How much money will you have in the account after 5 years?
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Calculating FV of an annuity
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EAR = [1 + (r/m)]m - 1
EAR > APR whenever compounding occurs more than once per year
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Continuous compounding
The number of compounding approaches infinity The FV equation becomes: periods per year
FVt,r = PV ert
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What is the future value of a $100 deposit after 5 years if interest of 12% is compounded continuously? FV5,12 = $100 e0.125 = $182.22
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A word on inflation
Rate of inflation = rate at which prices as a whole are increasing Nominal interest rate = rate at which money invested grows Real interest rate = rate at which the purchasing power of an investment increases
1 + real interest rate = 1 + nominal interest rate 1 + inflation rate
OR using an approximation Real interest rate Nominal interest rate Inflation rate
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Topic #4
Investment criteria
What is capital budgeting? Using net present value Payback period Internal rate of return and incremental IRR Profitability index and capital rationing
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Types of projects
Independent projects Mutually exclusive projects Expansion projects
Existing products / markets New products / markets
Replacement projects
Maintenance of business Cost reduction
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$500
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The market value of the firm is based on the free cash flows it is expected to generate
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Moral: Moral:
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Payback period
The payback period of a project (PB) is the number of years it takes before the cumulative forecasted cash flows equal the initial outlay Payback period rule accept projects that payback in the desired time frame
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NPV profile
100.00 80.00 60.00 40.00
IRR = 19.44%
NPV
Approximation formula
NPV + IRR = rmin + (rmax rmin ) NPV + + NPV
For our project : IRR = 15 + (20 15)
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Investing or financing?
With some cash flow patterns, the NPV of the project increases as the discount rate increases
35.00 25.00 Net present value 15.00 5.00 -5.00 0 -15.00 -25.00 -35.00
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Year
B 100 -130
0 -100 1 130
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Project B
DiscountFinance(%) / Alexandra Horobet, PhD Corporate rate / MPI
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Investing or financing?
Project A is a substitute for investing Project B is a substitute for financing In the case of financing-like projects, IRR rule is reversed:
Accept project if IRR < opportunity cost of capital Reject project if IRR > opportunity cost of capital
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IRR2 = 33.3%
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In all these cases, IRR rule cannot be applied the only criteria we can use
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NPV is
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0 = 15 +
25 Incrementa l IRR = 66.67% > 25% 1 + IRR 25 NPV of incrementa l cash flows = 15 + =5>0 1.25
Large budget is better than small budget project
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NPV 2 1,000 1,000 3 1,000 12,000 @0% 2,000 4,000 @10% @15% 669 751 109 -484
1 10,000 1,000
IRRB=12. 94%
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Profitability index
Profitability index = PV(Cash flows subsequent to initial investment ) Initial investment
Look at this!
NPV > 0 NPV < 0 PI > 1 PI < 1 IRR > discount rate IRR < discount rate ACCEPT PROJECT REJECT PROJECT
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Problems with PI
Making decisions with PI for mutually exclusive projects
Cash flows Project 1 2 C0 -20 -10 C1 70 15 C2 10 40 PV @ 12% 70.5 45.3 PI 3.53 4.53 NPV @ 12% 50.5 35.3
Same problems as in the case of scale problem form IRR decide using NPV
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Capital rationing
Cash flows Project 1 2 3 C0 -20 -10 -10 C1 70 15 -5 C2 10 40 60 PV @ 12% 70.5 45.3 43.4 PI 3.53 4.53 4.34 NPV @ 12% 50.5 35.3 33.4
Suppose the projects above are independent, but you have only $20 mil. to invest.Which project(s) do you choose? Suppose now you have $25 million to invest. Which project(s) do you choose?
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Capital rationing
Profitability index does not work if funds are also limited beyond the initial time period use linear programming Two types of capital rationing:
Soft rationing provisional limits adopted by management as an aid to financial control Hard rationing desires the firm is unable to raise the money she
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Topic #5
Relevant cash flows of a project Calculating cash flows Example: Blooper project
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do not include the cash flow in the include the cash flow
Cash flow WITH project
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Sunk costs
A company is evaluating the NPV of establishing a line of chocolate milk. The company has paid last year a consulting firm $100,000 to perform a test marketing analysis. Is this cost relevant for the current decision? NO this is a SUNK COST
Sunk costs are past and irreversible outflows Sunk costs are NOT RELEVANT cash flows
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Opportunity costs
Suppose a company wants to use an empty warehouse that she has in Seattle to store a new line of products. At the same time, the company is able to sell the warehouse to another company for $200,000. Should the price of the warehouse be included in the costs associated with introducing a new line of products?
Answer:YES
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Indirect effects
Suppose a company is determining the NPV of a new sports car. Some of the customers who would purchase the car are potential owners of the companys other product, a compact sedan. Are all sales and profits from the new sports car incremental? Answer: NO some of the cash flow represents transfers from other elements of the companys product line This is an example of EROSION or CANNIBALIZATION included in the NPV calculation
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Short-term assets
Accounts receivable
Short-term liabilities
Payables
Inventories
Cash
Accruals
Investments in working capital result in cash outflows Investments in working capital are relevant cash flows for a project
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CASH FLOW
Investment in working capital Set-up costs, etc. After-tax proceeds from sale of old assets
CASH FLOW
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0 -$800 mil.
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0 0 75 35 +40 -40
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EBIT (1-T)
Depreciation
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=
(Revenues Cash expenses) (1 Tax rate)
+
(Depreciation Tax rate) EBITDA TAX SHIELD
Blooper project
As the newly appointed financial manager of Blooper Industries, you are about to analyze a proposal for mining and selling a small deposit of high-grade iron ore The project requires an investment of $10 million in mining machinery. At the end of 5 years the machinery has no further value The working capital needs for the 5 years are estimated as follows: Wk. cap = 15% of the following years expenses Accounts receivable rise with sales and equal 1/6 times of the current years revenues
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Blooper project
The company expects to be able to sell 750,000 pounds of iron a year at a price of $20 a pound in year 1 Inflation is running at 5% a year, and iron prices keep pace with inflation The sales forecasts are cut off after 5 years, since iron ore deposits will run out at that time Expenses are equal to $10,000 in the first year, and will also increase in line with inflation at 5% per year The company applies straight-line depreciation to the mining equipment over 5 years Company taxes are 35% of pretax profits
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0 1 10,000 1,500 4,075 1,500 2,575 15,000 10,000 5,000 2,000 3,000 1,050 1,950
3,039 0 -1,679 -3,039 18,233 12,155 6,078 2,000 4,078 1,427 2,650
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Blooper project
Tax depreciation allowed under the modified accelerated cost recovery system (MACRS) - (Figures in percent of depreciable investment).
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Year 1 2 3 4 5 6 Total
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2,583
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2,523
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