Corporate Finance 180.366

1
Corporate Finance180.366

• Spring 2009
• Prof. Duffee

2
Administrative notes

• Read the syllabus after class
• Administrative questions? Ask next time

3
I. Course overview
4
What will you study?

• Corporate Finance

5
Types of firms

• Sole proprietorships
• Individual owns, operates
• Example Professor who does some economic
  consulting
• Personally liable for all obligations of firm
• Partnerships
• Partners collectively own, operate
• Example Siblings that own a commercial property
• Jointly personally responsible for all
  obligations of firm

6
Types of firms

• Special case of partnership Limited partnership
• General partners owners, operators. Jointly
  personally responsible for all obligations of
  firm
• Limited partners owners, but liability limited
  to investment. Not allowed to be involved in
  management
• Examples Law firms, medical practices
• Limited liability companies
• All owners are limited partners
• All allowed to be involved in management
• Example Chrysler LLC

7
Types of firms

• Corporations
• Legally, an artificial person
• Implications
• Corporation signs contracts, makes promises, is
  owed money
• Corporation responsible for its own obligations
  not owners or employees
• Owned by shareholders
• Typically, fraction of shares held determines
• Claim on dividends paid by corporation
• Voting power

8
Advantages of corporate structure

• Limited liability
• Ownership is separated from managerial control
• Combination means that firm size is not
  constrained by business talent or wealth of
  individual investors

9
Disadvantages of corporate structure

• Double taxation
• Principle of tax code People pay taxes
• Sole proprietorships, partnerships do not pay
  taxes
• Owners pay taxes on profits
• Corporations are people pay taxes on profits
• When after-tax profits are paid to owners, owners
  pay taxes on that income double taxation of
  corporate profits

Cash in pocket profits x (1 corporate tax
rate) x (1 individual tax rate)
10
Disadvantages of corporate structure

• Rules that reduce double taxation burden
• Tax rate on (most) dividends currently lower than
  tax rate on other personal income but
  historically, not always true
• IRS exemption S corporations
• Some firms can choose to be S, not C
  corporation
• Only if fewer than 100 shareholders
• Skips corporate level of taxation more like
  partnership

11
Disadvantages of corporate structure

• Ownership is separated from managerial control
• Agency costs

12
Types of firms
13
What will you study?

• Corporate finance
• Focus is on issues faced by large C-corporations
• Analysis also usually applies to large LLCs
  (e.g., Chrysler)
• What is large?
• Roughly, firm has, or could, or hopes to have,
  publicly-traded stock
• Publicly-traded stock
• Anyone can buy shares of firm, traded on a stock
  exchange
• 1.8 MM C-corporations, lt 7,000 with
  publicly-traded stock
• Example of could, hopes to Facebook

14
What will you study?

• Corporate finance
• Behind the scenes
• Ability of firm to create, innovate, sell, hire,
  fire
• Marketing, negotiation ability
• Start with
• Probability distributions of future revenues,
  costs, given choices of firm to invest in
  specific business activities and methods used to
  raise funds
• Question we answer What is the value of the firm
  conditional on these probability distributions?
• Corollary to answer What choices maximize this
  value?

15
Firm valuation some questions

• Firm has income, cost forecasts for a potential
  project. How does it decide whether to take on
  the project?
• If it takes on a project, how should it raise
  money for it?
• What should a firm do with its profits? Invest,
  distribute, or something else?
• How should outside investors value a firm?

16
Financial Statement Analysis(a quick overview)
17
Why financial statements?

• Firms need some method to keep track of revenues,
  costs, investments
• A common accounting framework makes it easier for
  outsiders to evaluate the firm
• Firms with outside investors are required by SEC
  to file quarterly financial statements using the
  common framework
• Generally Accepted Accounting Principles (GAAP)

18
Types of financial statements

• Balance sheet
• Income statement
• Cash flow statement
• Statement of stockholders equity (useless to us
  ignore)

19
1. Balance sheet
A L

• Snapshot of firms finances at point in time
• Mostly tangible assets cash, inventory,
  machinery, real estate and promises to pay or
  be paid

Assets
Liabilities
Stockholders equity
Assets Liabilities stockholders equity
20
What goes where?
A L

• Equipment worth 300
• Idea for project that will generate 100 in
  profit
• Building worth 500
• Accounts receivable 50
• Loan payable in 6 mon 450
• Patent just expired will lower profits next year
  by 40
• Accounts payable 60
• 100 worth of Treasury bills (mature in 6 months)

21
What goes where?
A L
What is this company worth to
shareholders?
T-bills 100 Acc Rec 50 Equipment
300 Building 500
Acc Pay 60 Loan 450 Shareholders equity
?
22
Book and market values of equity

• Book value shareholders equity
• Market value price per share x number of shares
• Also called market capitalization
• Example Google
• Market value (Dec 22 2008) 93.5 billion
• Book value (Sep 30 2008) 27.5 billion
• Market value looks forward, book value looks
  backward

23
The asset side
The Cake Factory (values in 1000s)

• Current assets are cash or will be converted to
  cash lt 1 yr
• Book values typically used
• What is their equipment worth?
• Depreciation schedules

24
The liability side
The Cake Factory (values in 1000s)

• Current liabilities include all debt to be paid
  within a year
• Includes interest payments on longer-term debt
• Book values typically used

25
Commonly-used ratios

• Market-to-Book ratio
• Market value of equity/book value of equity
• Also called price-to-book, also denoted ME/BE
• Debt-equity ratio
• (short-term debt long-term debt)/(either ME or
  BE)
• Measure of a firms leverage (called gearing in
  the UK)
• Ratio of firms financing from debt to financing
  from stockholders

26
Enterprise value

• Definition
• Often defined as ME (total debt) cash
• But in practice, often measured as ME (total
  debt) (cash short-term investments)
• Measures market value of firm as ongoing
  enterprise
• How much would it cost to own all future cash
  flows of firm not having to divert any to pay
  off debtholders?
• Cash, short-term investments represent past cash
  flows, so they are excluded
• This is an important concept later in the
  semester

27
2. Income statement

• From previous slides Cake Factory
• Did the company have a bad year in 2007?

28
Part 1 of income statement operating income
The Cake Factory (values in 1000s)

• Revenues also called total sales
• Operating margin operating income/revenues
• Contrast Microsoft with Wal-Mart

29
Depreciation examples

• Spend 1 MM on office furniture today
• Tax code assumes 7-year useful life (Appendix to
  Ch 7)
• Depreciation expense in first year after purchase
  is 142,900
• Year-end asset value is 1 MM - 142,900
• Spend 1 MM on a fence surrounding a building
• Tax code assumes 15-year useful life
• Depreciation expense in first year after purchase
  is 50,000
• Year-end asset value is 1 MM - 50,000

30
From operating income to net income
The Cake Factory (values in 1000s)

• Tax rate company faces is 30
• Basic NI per share divides by of shares
  outstanding
• Diluted includes shares that can be created by
  employees, lenders exercising their stock options

31
Useful values and ratios

• EBITDA
• Earnings before interest, taxes, depreciation,
  amortization
• Logic DA only a paper expense add back to
  EBIT to get operating cash flow
• ROA and ROE
• Return on assets, return on equity
• Divide net income by either book value of equity
  or total assets
• Profitability per unit of resources
• P/E ratio
• Market value of equity divided by net income
• Equivalently, price per share divided by NI per
  share
• How much does an investor have to pay for a
  current dollar of income?

32
3. Cash flow statement

• From previous slides Cake Factory
• Net income in 2007 was 88 MM. What happened to
  the money?

33
The concept of the cash flow statement

• Purpose Explain change in cash and cash
  equivalents from one balance sheet to next

• Sources of additional cash
• Net income
• Expenses that are just on paper
• Depreciation, amortization
• Sales of assets
• Expansion of liabilities
• Borrow more money
• Delay payments for purchases
• Raise money from stockholders

• Uses of cash
• Net losses
• Gains that are just on paper
• Purchases of assets
• Paying down liabilities
• Distribute money to stockholders

34
The standard decomposition of cash flows

• Sources/uses related to operating activity
  (making goods, selling services)
• Sources/uses related to investment
• Sources/uses related to financing
• Cake Factory, part of statement of cash flows for
  Jan 2008

35
Sources/uses related to investment

• Buy equipment, land use
• Sell equipment, land source
• Do not just look at change in asset value!
• Part of change is depreciation, already included
  in source of cash in operating activity
• Cake Factory, part of statement of cash flows for
  Jan 2008

change in cash - cash used cash used new
asset value depreciation - old asset value
36
Sources/uses related to financing

• What we can read directly from the balance sheet
• Change in borrowing
• Change in deferred/advance receipts/payments
• What we cannot read directly from the balance
  sheet
• Dividends paid to stockholders
• Sale or purchase of stock
• Cake Factory, part of statement of cash flows for
  Jan 2008

37
Complete cash flow statement

• Cake Factory, part of statement of cash flows for
  Jan 2008

• An example of interpreting financial statements
• A profitable company borrowed money in 2007 to
  buy back its own stock liabilities increased,
  leverage increased