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Semester 1 2008

CORPORATE FINANCE

2201 AFE

WELCOME STUDENTS!!

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About Your Convenor

Mirela Malin

B Bus (Acct) BIntFin (Hons) PhD Candidate

My research interests include:• Asset Pricing

• Multifactor Models• Behavioural Finance

• Behavioural Models• Continuation and Reversal Strategies• Combined Return Predictability

Strategies

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Teaching Team

Course Convenor: Mirela MalinOffice: G06 Room 2.22Phone: 5552 7719Email: m.malin@griffith.edu.auConsult: Thursday 2 - 4 pm

Tutors:Michael HowardMichael.Howard@student.griffith.edu.au

Eliot Sanfte.sanft@griffith.edu.au

Office: AFE tutors room in G06 1.34 and 1.35 Telephone: TBA, Consultation Time: TBA

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Course Comments

• Most important ingredients of success in Corporate Finance course is:

• Attend lectures

• Consistent tutorial effort

• NOTE: Tutorials start in Week 2!!!

• Each week there will be tutorial homework

• Be aware of the Homework rules in the course outline

• Mid Semester Exam – Saturday 26th April - Week 7

• Final Exam – End of Semester Exam Period

• Text: Ross, Westerfield and Jordan 7th Edition

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Week 1

Lecture 1

Ross, Westerfield & Jordan 7e

Chapter 1

Chapter 2

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Fundamental Concepts for Today’s Lecture

• What is Corporate Finance?

• The role of a financial manager

• Understand the goals of financial management

• Explain the Agency problem

• The role of financial markets

• Financial statements issues

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What is Corporate Finance?

• Corporate Finance is the study of ways to

answer three important questions:

• What long-term investments should the firm

take on?

• Where will we get the long-term financing to

pay for the investment?

• How will we manage the everyday financial

activities of the firm?

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Financial Management Decisions

• Capital budgeting• What long-term investments or projects should

the business take on?

• Capital structure• How should we pay for our assets?• Should we use debt or equity?

• Working capital management• How do we manage the day-to-day finances of

the firm?

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Forms of Business Organization

• Three major forms:• Sole proprietorship• Partnership

• General• Limited

• Corporation• S-Corp• Limited liability company

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Sole Proprietorship

• Advantages• Easiest to start• Least regulated• Single owner keeps all

the profits• Taxed once as

personal income

• Disadvantages• Limited to life of owner• Equity capital limited to

owner’s personal wealth

• Unlimited liability• Difficult to sell

ownership interest

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Partnership

• Advantages• Two or more owners• More capital available• Relatively easy to start• Income taxed once as

personal income

• Disadvantages• Unlimited liability

• General partnership

• Limited partnership

• Partnership dissolves when one partner dies or wishes to sell

• Difficult to transfer ownership

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Corporation

• Advantages• Limited liability• Unlimited life• Separation of

ownership and management

• Transfer of ownership is easy

• Easier to raise capital

• Disadvantages• Separation of

ownership and management

• Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate)

www.nolo.com

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Goal Of Financial Management

• What should be the goal of a corporation?

• Maximize profit?

• Minimize costs?

• Maximize market share?

• Maximize the current value of the company’s

stock?

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• The financial manager of a company makes

decisions on behalf of the shareholders.

• Thus the correct goal is to maximise shareholder’s

wealth.

• That is, to maximise the value of the existing

shares.

• Does this mean we should do anything and

everything to maximize owner wealth?

Goal Of Financial Management

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The Agency Problem

• Agency relationship• Principal hires an agent to represent his/her

interest• Stockholders (principals) hire managers

(agents) to run the company

• Agency problem• Conflict of interest between principal and agent

• Agency costs• Direct• Indirect

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Managing Managers

• Managerial compensation• Incentives can be used to align management

and stockholder interests• The incentives need to be structured carefully

to make sure that they achieve their goal

• Corporate control• The threat of a takeover may result in better

management

• Other stakeholders• Governments, suppliers, employees

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Financial Markets

• What is a Market? A Market is the means through which the buyers and sellers are

brought together.

• Role of a Financial Market• To channel savings into investments• Enable sale and purchase of financial assets

• Cash flows to the firm – Fig. 1.2 page 15• Primary vs. secondary markets• Dealer vs. auction markets• Listed vs. over-the-counter securities

• NYSE

• NASDAQ

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End of Chapter 1

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Week 1

Lecture 1

Ross, Westerfield and Jordan 7e

Chapter 2

Financial Statements, Taxes and Cash Flows

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Key Concepts and Skills

• Know the difference between book value and market value

• Know the difference between accounting income and cash flow

• Know the difference between average and marginal tax rates

• Know how to determine a firm’s cash flow from its financial statements

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Balance Sheet

• The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time

• Balance Sheet Identity• Assets = Liabilities + Stockholders’ Equity• Assets – Liabilities = Stockholders’ Equity

• Net Working Capital• Current Assets – Current Liabilities• Positive when the cash that will be received over the next 12

months exceeds the cash that will be paid out• Usually positive in a healthy firm

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The Balance Sheet - Figure 2.1

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Liquidity, MV vs BV, D vs E• Liquidity

• Ability to convert to cash quickly without a significant loss in value

• Liquid firms are less likely to experience financial distress• But liquid assets earn a lower return• Trade-off to find balance between liquid and illiquid assets

• Market Vs. Book Value• The balance sheet provides the book value of the assets,

liabilities and equity.• Market value is the price at which the assets, liabilities or equity

can actually be bought or sold.• Which is more important to the decision-making process?

• Debt Vs. Equity• Financial Leverage

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US Corporation Balance Sheet – Table 2.1

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Income Statement

• The income statement measures the performance of a firm over a specified period of time.

• Revenues – Expenses = Income

• Matching principle – show revenue when it accrues and match the expenses required to generate the revenue

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US Corporation Income Statement – Table 2.2

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Taxes

• The one thing we can rely on with taxes is that they are always changing

• Marginal vs. average tax rates• Marginal – the percentage paid on the next

dollar earned• Average – the tax bill / taxable income

• For financial decision making purpose, the marginal tax is used

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The Concept of Cash Flow

• Cash flow is one of the most important pieces of

information that a financial manager can derive

from financial statements

• Cash Flow Identity:• Cash Flow From Assets = Cash Flow to Creditors +

Cash Flow to Stockholders

Cash generated from utilizing assets =

Cash paid to those that finance the purchase of

those assets (Creditors + Stockholders)

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Cash Flow From Assets

• CFFA = CFC + CFS

• CFFA = OCF – NCS – ΔNWC

• Cash Flow From Assets (CFFA) = Operating Cash

Flow (OCF) – Net Capital Spending (NCS) –

Changes in Net Working Capital (ΔNWC)

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Cash Flow From Assets

• CFFA = OCF – NCS – ΔNWC

• OCF = EBIT + depreciation – taxes = $547

694 + 65 - 212 = 547

• NCS = end net fix. assets – begin net fix. assets + depr. = $130

1709 - 1644 + 65 = 130

• Changes in NWC = ending NWC – beginning NWC = $330

1014 - 684 =

330

‘05 1403(CA) - 389(CL) - ’04 1112(CA) - 428(CL)

• CFFA = 547 – 130 – 330 = $87

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Cash Flow from Assets

• Operating cash flow:• EBIT 694.00• + Depreciation + 65.00• – Taxes – 212.00 $547

Less• Net capital spending:

• Ending net fixed assets 1,709.00• – Beginning net fixed assets – 1,644.00• + Depreciation + 65.00 $130

Less• Change in net working capital:

• Ending net working capital 1,014.00• – Beginning net working capital 684.00 $330.00

• Cash flow from assets: $87.00

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• CFFA = CFC + CFS

• CFC = Interest Paid – Net New Borrowings

• CFFA = CFC + CFS

• CFS = Dividends Paid – Net New Equity

Cash Flow to Creditors and Shareholders

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Cash Flow to Creditors and Shareholders

• CFC = interest paid – net new borrowing = $24

70 - 46 = 24

’05 LTdebt 454 – ’04 LTdebt 408

• CFS = dividends paid – net new equity = $63

103 - 40 = 63

’05 CS. 640 – ’04 CS 600

• CFC + CFS = 24 + 63 = $87

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Cash Flow to Creditors and Shareholders

• Cash flow to creditors:• Interest paid 70.00• – Net new borrowing – 46.00

$24.00

Plus• Cash flow to shareholders:

• Dividends paid 103.00• – Net new equity raised 40.00 $63.00

• Cash flow to creditors and shareholders = $87

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Cash Flow Identity

• CF Identity: CFFA = CFC + CFS

• CFFA = 547 – 130 – 330 = $87

• CFC + CFS = 24 + 63 = $87

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Cash Flow Summary Table 2.5

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Lecture 1 Key Points

• Three main areas in Corporate Finance• Capital Budgeting• Capital Structure• Working Capital Management

• Goal of financial management = maximise shareholders value

• Book value differs from Market value• It is the market value we want to maximise• Cash flows are important in valuation• Cash flow identity: CFFA = CFC + CFS

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Basic Algebra Reminders..

Order of Operations: BODMAS• Brackets first then• Other grouping symbols (eg: LN(x), xa, x-1)• Division and• Multiplication next• Addition and• Subtraction last

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Example

• 10+5[(3/10)7-1] = 5.001• First we have to remove the square bracket• But before that we remove the round bracket

by performing the division • Then the power and subtraction in the square

bracket• Multiplication by 5• Addition of 10

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Basic Algebraic Identities and Laws (1)

• a(b + c) = ab + ac

• 3(2+5) = 3*2 + 3*5

• (a + b) / c = a/c + b/c

• (9+7)/5 = 9/5 + 7/5

• (a / b) / (d / c) = (a / b) * (c / d) = ac / bd

• (3/2)/(5/7) = (3/2)*(7/5) = (3*7)/(2*5)

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• x-1 = 1/x , x-a = 1/xa , bx-1 = b/x , bx-a = b/xa • 5-1 = 1/5 , 5-2 = 1/52 3*5-1 = 3/5 , 3*5-2 = 3/52

• x1/2 = √x , x1/a = a√x , xb/a = a√(xb)• 91/2 = √9 , 91/3 = 3√9 , 93/2 = 2 √(93)

• am * an = am+n , (am)n = am*n , am * bm = (a*b)m • 23 * 24 = 23+4 = 27 , (23)4 = 23*4 , 24 * 34 = (2*3)4

• am/an = am-n , am/bm = (a/b)m

• 25/22 = 25-2 , 23/53 = (2/5)3

Basic Algebraic Identities and Laws (2)

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Basic Algebraic Identities and Laws (3)

• LN means logarithm with the base of e

• e is a constant (2nd function on some calculators)

• There is a button on the calculator for LN and e

• LN(a*b) = LN(a) + LN(b)• LN(3*2) = LN(3) + LN(2)

• LN(a/b) = LN(a) – LN(b)• LN(3/2) = LN(3) – LN(2)

• LN(xa) = a*LN(x)• LN(32) = 2*LN(3)

• If ℮x = y then LN(y) = x• e2 = 7.389056099 then LN(7.389056099) = 2

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End of Chapter 2