Overview of Finance

1
Overview of Finance

• Week 1 August 26 and 28, 2002

2
Financial Analysis, Functions, and Careers

• August 28, 2002

3
FBE 432 Objectives

• Analyze and communicate implications of financial
  theory using cases
• Understand finance careers and functions
• Refine and expand specific financial analytical
  skills
• Responsibility for learning is with you
• Requirements are clear review, prepare, and
  participate

4
Financial Analysis

• Analyze performance of corporations (and
  projects)
• What should be the objective of financial
  management?
• How do we determine whether management is good or
  bad?
• Focus in finance is on the future
• Who knows what will happen in the future?
• How can we deal with our uncertainty concerning
  the future?

5
Financial Functions

• All finance is concerned with value
• Corporate decision-making
• Investments, including mergers and acquisitions
  and divestitures (disinvestment)
• Growth and financing needs
• Management of working capital
• Chief financial officer is responsible for these
  decisions
• Requires project analysts, treasury assistants

6
Investment Banking

• Investment bankers assist corporations in their
  dealings with financial markets
• Issuing securities
• Initial public offerings (IPOs) or secondary
  offerings
• Issuing debt or preferred stock to private
  investors (private placements) or to public
  markets
• Mergers and acquisitions
• Advising and valuing firms
• This services are corporate finance or investment
  banking services

7
Investment Banking (continued)

• Investment bankers also buy and sell securities
• Brokers (retail and institutional)
• Market makers
• Asset management
• Research
• Investment banks are classified in a variety of
  ways
• Full line
• Boutique
• Regional
• Bulge bracket

8
Investment Banking (continued)

• Investment bankers need many types of financial
  skills
• Analysts for research
• Analytical support in doing deals
• Traders
• Marketing securities to retail and institutional
  markets
• Investment banks hire junior analysts and
  associates at entry level

9
Investment Banking and Markets

• Investment bankers assist corporations (and
  governments) in designing securities for sale to
  public or private markets
• Employees of investment banks are usually called
  are said to work on the sell side of a securities
  firm, or are called sell side analysts or sell
  side traders or brokers

10
Investors

• Individuals and institutions invest savings in
  securities (and other investments)
• Individuals are usually divided into the retail
  market (small investors) and affluent investors
  (private banking)
• Buying and selling securities in the retail
  market
• Advising and investing for individuals is
  financial advising and asset management
• Individuals often invest in mutual funds and save
  in pension plans

11
Institutional Investors

• Pension funds, mutual funds, insurance companies,
  and specialized investment vehicles for wealthy
  investors (e.g. hedge funds) are called
  institutional investors
• Institutional investors require analysts and
  portfolio managers to invest funds
• Employees of institutional investors are usually
  said to be on the buy side, as for example a
  buy-side analyst or a buy-side trader

12
Specialized Investment Vehicles

• Venture-capital firms provide financing to new
  firms, often firms in new technologies, requiring
  both technical and financial skills
• Hedge funds are unregistered investment vehicles
  for wealthy investors or institutional funds,
  often using complex investment strategies
  requiring sophisticated financial analytical
  skills

13
Developments in Finance

• Financial theory has developed to value financial
  instruments like options and swaps
• Technology has developed to enable accounting and
  trading for complex financial claims like
  collateralized mortgage obligations (CMOs)
• Trading and valuing these instruments and
  advising corporations on how to use them to
  manage risk demands highly developed research
  departments

14
Commercial Banking

• Commercial banks make loans to corporations and
  individuals
• Corporate commercial bankers provide a variety of
  services to corporations, including cash
  management and lending
• Banks require financially trained individuals to
  call on corporations and analyze corporate
  customers

15
Finance Career Paths

• Many individuals move between financial functions
  in corporations and investment banking, asset
  management, commercial banking, and financial
  advising over the course of their careers
• Research, marketing (selling), deal-making, and
  advising require varying levels of interpersonal
  skills
• Risk tolerance and energy requirements vary in
  different finance career paths

16
Next Time August 28

• Review valuation approaches
• Read for practice, The Union Carbide Deal
  (Abridged)
• Outline issues at issue in the case
• What role do investment bankers play?
• How are they compensated?

17
Introduction to Valuation and Review

• August 28, 2002

18
Value and Valuation

• Finance objective function is to maximize owners
  value
• Value is the present value of future cash flows
  at the risk-adjusted discount rate
• Valuation principles are the same whether we are
  valuing stocks, bonds, real estate, or
  corporations
• The challenge is to estimate the cash flows and
  choose a discount rate

19
Corporate Cash Flows

• Corporate cash flows are similar to all firms
  cash flows, that is, they come from cash revenues
  minus cash costs
• Because of tax laws and standard reporting
  conventions, corporate cash flows are more
  standardized
• Value of claims on corporations can be calculated
  separately (e.g. stock and bond valuation) or in
  the aggregate (so-called entity approach)

20
Future Corporate Cash Flows

• Since value comes from future cash flows and the
  future is unknown, future cash flows must be
  estimated
• The future is usually divided into two or more
  parts
• Forecast period and continuing value period
• Rapid growth period and normal growth period
• Choice of division depends on case and data
  available

21
Cash Flow Determination

• Items From the Income Statement
• Revenues (R)
• Cash Expenses (W)
• Non-Cash Expenses (Dep)
• Capital Expenditures (Capex)
• Cost of Goods Sold (CGS)
• Excludes depreciation
• Interest Expense (Int)
• Taxes (T)

22
Cash Flow Determination

• Other Items
• Tax Rate (t)
• Repayment of Principal (P)
• Changes in Net Working Capital (DNWC)
• Permanent Debt (D)

23
Definition of Earnings Components

• Earnings Before Interest Taxes EBIT
• R-(WDepCGS)
• Earnings Before Interest, Taxes, Depreciation
  (and Amortization) EBITD(A)
• EBITDep(Amort)

24
Definitions of Earnings Components

• Pre-Tax Income
• EBIT-Int
• Tax Bill T
• t(EBIT-Int)
• Net Income
• NI Pre-Tax Income - T

25
Cash Flow Definitions

• Levered Cash Flow to equity LCF or FTE
• Money that goes to stockholders account
• R-(WDepCGSInt)(1-t)Dep-Capex-P-DNWC
• Unlevered Cash Flow UCF
• Cash flow that would occur if there was no debt
• (1-t)EBITDep-Capex -DNWC

26
Next Week September 4

• Review valuation techniques and relate to case
  materials
• Prepare Eskimo Pie Case
• Form groups for group case analyses following
  Eskimo Pie