Corporate Finance Lecture 1

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Corporate FinanceLecture 1

• Selcuk Caner
• Bilkent University

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Course Outline

• Overview and Financial Environment
• Risk and Rate of Return
• Valuation (Bonds and Stocks)
• Cost of Capital
• Capital Budgeting
• Capital Structure and Leverage
• Dividend Policy

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Some Rules

• I expect participation in class
• You may not talk to each other in class!
• You would be ejected out of class if you do not
  comply with the above rule

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More Rules

• University rule Attendance is mandatory!
• I enforce this rule!
• Random roll calls to verify the names in the
  attendance list.
• If your name is on the list but you are not
  present in the class, you will face disciplinary
  action.

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More Rules (continued)

• Bilkent University has no tolerance for cheating
• Any student involved in cheating in an exam is
  expelled one semester from the university.
• According to Public Law 4207, smoking is banned
  in all closed public areas. Smoking in all
  University buildings are banned. I strongly
  enforce this Law. Anybody seen smoking in a
  university building will face disciplinary
  action.

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Exams and Grading

• Two exams with a weight of 25.
• Final exam 30.
• Quizzes 10.
• Term Project 10.
• Each exams will cover material preceding it.
  Final is all comprehensive.

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Why Do We Study Finance?

• Finance is about valuation.
• Financial management is decision making on the
  choice of assets and liabilities to maximize the
  value of the firm.
• Finance useful in managing risk.

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Financial Management

• Acquisition of Assets.
• Financing of Assets.
• Management of Assets.

FIRM
FINANCIAL MANAGER
CAPITAL MARKETS
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Forms of Business Organizations(Business
Environment)

• Sole Proprietorship
• Partnership
• These two types have limited ability to raise
  large sums of capital.
• However, they are easy and inexpensive to form.
  Unlimited liability.
• Corporation
• A corporation is a legal contract.
• Limited liability.
• Easy change of ownership.
• Corporations are forever.

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Organizational Structure of a Firm
Board of Directors
President
VP Sales
VP Finance
VP Production
Treasurer
Controller
Inventory Manager
Tax
Credit Manager
Capital Budgeting
Cost Accounting
Financial Accounting
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Principal-Agency Relationship

• Management vs. Shareholders
• Align shareholders interest with that of
  managers
• Another agency problem is between shareholders
  and creditors.
• Risky investment would reduce the value of
  outstanding debt. If successful, all the
  benefits go to shareholders.

Owners (Principal)
Managers (Agents)
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Purpose of Financial Statements

• Financial statements play a key role in a
  enterprises activities of converting resources
  (capital, labor and raw materials into finished
  goods and services.
• To obtain such resources the firm has to
  communicate to the provides of such resources
  that it offers a competitive return.
• Financial statements include information about
  the business riskiness of the firm.
• Those with an interest in the firm often have
  conflicting interest. For instance, while an
  equity holder may wish to have a high return by
  demanding the firm take high risk, employees
  would seek stability and long term employment.

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Analysis of Financial Statements

• Involves ratio analysis benchmarking
• Evaluating trends in the firms financial
  position over time
• Comparing firms performance with that of other
  firms in the same industry

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Financial Statements

• What are they? How are they analyzed?

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Financial Statements

• Balance Sheet
• The Income Statement
• Statement of Owners (Stock Holders) Equity
• Statement of Cash Flows

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What Does a Financial Statements Tell Us

• Balance Sheet
• Assets What the firm owns.
• Liabilities Claims on firms assets by parties
  other than the owners.
• Owners Equity Owners residual claim on the
  firms assets.

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Assumptions, Concepts and Principles

• Accrual basis accounting
• Entity Concept
• Objectivity Concepts
• Going Concern Concept
• Cost Principle
• Revenue Principle

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Balance Sheet

• A statement of the firms financial position at a
  specific point in time.
• A list of all the assets, liabilities and owners
  equity of an entity based on relative liquidity
• Total assets Total liability Total owners
  equity
• Inventory accounting
• Depreciation methods

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Balance Sheet
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Balance Sheet (Cont.)

• Assume half of inventory is lost.

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Balance Sheet Classification

• In order of liquidity
• Current Assets
• Cash
• Marketable Securities
• Accounts Receivable
• Inventories
• Fixed Assets
• Equipment
• Plant
• Land

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The Income Statement

• A statement summarizing the firms revenue and
  expenses over an accounting period

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Income Statement

• Income statement measures
• Revenue Expenses Income
• Income statement provides information about
  profitability.
• When combined with certain balance sheet, income
  statement provides how resources provides to the
  firm are utilized.

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Income Statement and the Balance Sheet
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Ratio Analysis

• Liquidity Ratios
• To measure the ability to meet short-term
  obligations
• Current Ratio
• Current Assets/Current Liabilities
• In the previous case, current ratio declined from
  51 to 2.51 reducing the cushion again erosion
  of asset value.

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Liquidity Ratios (Cont.)
Quick Ratio (Current Assets
Inventories)/(Current Liabilities) Ability to
pay current liabilities from the most liquid
assets. Since current assets are liquid like
cash, these show how quick is the firm in paying
its liability. Measures degree of financial
difficulty. Also, Working Capital Current
Assets Current Liabilities
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Level of Financial Leverage

• Financial Leverage Total Assets / Equity
• The extent to which the firm has leveraged its
  own capital.
• Regulators look at inverse of this ratio,i.e.
• Equity / Assets
• For capital adequacy, e.g. banks.

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Asset Management Ratios

• Measures effectiveness of management of assets.
  Relationship between sales and assets.
• Inventory Turnover Ratio
• Sales / Inventories
• Measures the number of times inventory is sold.
  A low ratio implies excessive stock of inventory,
  which is costly.

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Asset Management Ratios (Cont.)

• Average Collection Period (Days Sales
  Outstanding) Accounts Receivable / Sales/360
• Number of days after a sale before receipt of
  cash. A high ratio implies customers in
  financial trouble. Firm losing financial
  resources.

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Asset Management Ratios (Cont.)

• Fixed Asset Turnover Ratio Sales / Fixed
  Assets
• Measures the effectiveness of use of plant and
  equipment.
• However, with high inflation an old firm with
  fixed assets purchased at low cost may look more
  efficient than a new firm.

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Financial Statement of an Unleveraged Firm
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Financial Statement of a Leveraged Firm
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Financial Leverage

• Both firms have equal EBIT but the second firm
  leveraged its rate of return on equity.
• Firms with high debt ratios have higher expected
  returns when the economy is normal but they are
  exposed to risk of loss when the economy is in a
  recession.

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Financing of the Firm

• The extent of indebtedness is measured by the
• Debt Ratio Total Debt / Total Assets
• It gives the share of funds provided by the
  creditors to finance assets. It is usually
  greater than one.
• Another measure of external finance is
• Debt to Capital Ratio Total Debt / Capital
• (Notes Payable Long-term Debt) /
  (Notes Payable Long-term Debt Equity)

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A Measure of Creditworthiness

• Fixed Charge Coverage
• (Pretax Income (EBIT) Interest Expense) /
  (Interest Expense)
• After paying operating costs the amount needed to
  make interest payments.
• If there is leased equipment, lease payments to
  nominator and denominator must be added.

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Profitability Ratios

• Profit Margin (Net Income) / Sales
• Measures profit per tenge of sales.
• Return on Assets (ROA) Net Income / (Total
  Assets)
• Measures firms efficiency (profitability) in
  utilizing assets. Net income is after taxes.
• Return on Equity (ROE) Net Income / Equity
• Measures the earnings on the investment of
  shareholders.

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Market Value Ratios

• Price Earnings (P/E) Ratio Price per Share /
  Earnings per Share
• Shows willingness of investors to pay per TL of
  reported profits. A P/E ratio of 11 implies the
  shares are selling at 11 times the value of
  earnings. Growth companies have high P/E ratios.

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Market Value Ratios (Cont.)

• Market / Book Ratio Market Price per Share /
  Book Value per Shares
• Book value is (common equity) / (shares
  outstanding). A value of 2 implies investors are
  willing to pay for the shares twice its book
  value. Often the book value may not reflect
  inflation or goodwill.

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Use of Ratio Analysis

• Bond Analysis
• Useful in measuring default risk in evaluating
  debt securities (bonds).
• Bond rating agencies use ratio analysis to rate
  companies.
• Discriminant analysis in credit scoring.

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Use of Ratio Analysis (Cont.)

• Equity Analysis
• Intrinsic value of a share equals present value
  of expected future income stream (dividends).
  Since firms are infinitely lived entities,
  required rate of return for an equity is
• k D/P Dividend Yield
• For a required rate of return of 15 and a
  dividend rate per share of 2KZT,
• The price of the share should be 2 / 0.15 13.3

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• Recall,
• Price Earnings (P/E) Ratio Price per Share /
  Earnings per Share
• Substituting for P would result in
• P /E (D / k) / E
• which implies that by increasing dividend payout
  company can increase price of its share.

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Use of Ratio Analysis (Cont.)

• However, simply paying out earnings as dividend
  instead of retaining reduces business growth
  rate, which reduces P / E ratio.
• Better to look at sustainable growth rate of a
  business
• Sustainable growth rate ROE (1- dividend
  payout rate)
• Note, (1- dividend payout rate) income
  reinvestment rate. So, increasing dividends
  reduces growth rate.

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Du Pont Formula

• Du Pont formula disaggregates the sources of rate
  of return.
• (Sales/Asset) (Income/Sales) (Income/Assets)
  (Assets/Equity) (Income / Equity)
• The first term is asset turnover, the second,
  return on sales, the third, return on assets, the
  fourth financial leverage equaling return on
  equity.
• This analysis is useful for strategic planning.

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Use of Financial Statements and the Enron Case

• Ratio analysis is useful in making investment
  decisions about a firm. Management may not like
  the use of balance sheet information by others.
• So companies can move liabilities off balance
  sheet.
• Or, company may temp to inflate earnings to
  obtain high (P / E) ratios.
• Both happened in the recent U.S. corporation
  crisis.

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Use of Financial Statements and the Enron Case
(Cont.)

• Fully owned finance subsidiaries (particularly
  off-shore to avoid strict accounting and
  reporting rules) can be used to remove debt from
  parent companys balance sheets.
• In many manufacturing companies and energy
  providers, customer financing is important for
  sales.
• So, company moves some of its accounts receivable
  and a slightly lesser amount of debt to a fully
  owned subsidiary. The difference is the parent
  companys equity.
• Consider the next example.

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Use of Financial Statements and the Enron Case
(Cont.)

• Accounting rules do not require consolidation.
• As a result, the parents debt-to-capital ratio
  declines.
• Subsidiary may be able to borrow more since its
  position is more liquid.
• However, financial risk of the parent has not
  declined. Since, subsidiarys debt must still be
  paid.
• Moreover, the parent has a residual claim in case
  of bankruptcy.

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Use of Financial Statements and the Enron Case
(Cont.)

• Enron applied and old trick in a new line of
  business.
• The key point is the Notes to Financial
  Statements.
• The Notes contain information about the
  subsidiaries.

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Use of Financial Statements and the Enron Case
(Cont.)

• Financial statements may understate or overstate
  asset values. Notes to Financial Statements
  include financial statements to measure the gap
  between historical and current values.
• Parent-subsidiary relationships.
• Parent company may guarantee the subsidiarys
  debt, its balance sheet become irrelevant to the
  analysis of quality of debt.
• Hidden and overstated earnings.
• Management seeks to smooth earnings so, profits
  are hidden in good years and bad years look
  profitable. This is done since investors put a
  premium on predictable earnings. Bad news can be
  postponed by selling company or its assets.

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Use of Financial Statements and the Enron Case
(Cont.)

• To hide earnings companies may take discretionary
  expenses such as an expensive training program.
  Financial firms (e.g., banks) may add to reserves
  for loan losses to conceal income.
• In overstating earnings, companies hide losses.
  E.g., a reduction in value of old inventory may
  be postponed to avoid reducing earnings. Or,
  reduce essential expenses such as research that
  are essential for future profits. A decline in
  the ratio of these expenses to sales proves that
  reported earnings are not sustainable.

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Use of Financial Statements and the Enron Case
(Cont.)

• Often increase in profits other than operating
  profits is a sign of weak operating profits.
  These may be profit taking on financial
  securities or profits on debt repurchase.

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Qualitative Factors for Analyzing Financial
Statements

• Are the companies revenues tied to one key
  customer?
• To what extent are the companys revenues tied to
  one key product?
• To what extent does the company rely on one
  single supplier?
• What percentage of the companys business is
  generated overseas?

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Qualitative Factors for Analyzing Financial
Statements

• Competition
• Future prospects
• Legal and regulatory environment