FINANCE 1. Introduction

1
FINANCE1. Introduction

• Professor André Farber
• Solvay Business School
• Université Libre de Bruxelles
• Fall 2002

2
Who am I?

• André Farber
• Professor of Finance at Solvay Business School
  since.
• Director of the MBA program 1990-2002
• Past President of Solvay Business School
• Dean, Faculty of Social Sciences, Politics and
  Economics, Solvay Business School (known as Soco)

3
Practical matters

• Reference
• Ross, Stephen A., Randolph W. Westerfield and
  Jeffrey F. Jaffe, Corporate Finance, 6th edition,
  McGraw-Hill Irwin 2002
• Website www.ulb.ac.be/cours/solvay/farber
• Slides
• Excel files
• Past exams
• Grading
• Midterm (40)
• Final (60)

4
Course outline

• 1. Introduction
• 2. Financial statement analysis and forecasting
• 3. Present value
• 4. Bond and stock valuation
• 5. Stock valuation (cont.)
• 6. Capital budgeting
• 7. More on capital budgeting
• 8.Capital Market Theory
• 9. Portfolio selection
• 10. Risk and expected returns CAPM
• 11. Risk, return and capital budgeting
• 12. Review session

5
What is Corporate Finance?

• INVESTMENT DECISIONS Which REAL ASSETS to buy ?
  
• Real assets will generate future cash flows to
  the firm
• Intangible assets RD, Marketing, ..
• Tangible assets Real estate, Equipments,..
• Current assets Inventories, Account
  receivables,..
• FINANCING DECISIONS Which FINANCIAL ASSET to
  sell ?
• Financial assets claims on future cash flows
• Debt promise to repay a fixed amount
• Equity residual claim
• DIVIDEND DECISION How much to return to
  stockholders?

6
Accounting View of the Firm

• Balance sheet

• Income statement
• Sales
• Operating expenses
• Earnings before interest and taxes (EBIT)
• Interest expenses
• Taxes
• Net income (earnings after taxes)
• Retained earnings
• Dividend payments

Net Working Capital
Current liabilites
Current assets
Long-term debt
Fixed assets
Shareholders equity
7
Cash Flows between the Firm and the Financial
Markets
Firm issue securities
Firm invest
Firm
Financial markets
Cash flow from operations
Dividend and debt payments
Timing of cash flows
8
Market values
Market value of equity
Equity
Total capital employed
Cash flow
Market value of debt
Debt
9
Value creation

• Market value added (MVA)
• Market value of the firms capital Total
  capital employed
• VALUE CREATION 2 strategies
• Strategy 1
• Buy assets at a cost lower than the value of the
  future revenues
• real assets
• financial assets
• Strategy 2
• Sell financial assets for a price higher than the
  value of future payments

Market value of equity Market value of debt
Stockholders equity Financial debt
10
The Capital Investment Trade-off

• The firm can always give cash back to the
  shareholders
• Capital employed by the firm has an opportunity
  cost
• The opportunity cost of capital is the expected
  rate of return offered by equivalent investments
  in the capital market
• The weighted average cost of capital (WACC) is
  the (weighted) average of the cost of equity and
  of the cost of debt

?
Investment opportunities in capital markets
Project
?Cash?
Stockholder
11
Economic Value Added (EVA)

• EVA Earnings after tax WACC ? Total capital

Example Equity 10bDebt 10bTotal
capital 20b EBIT 2.5bTax rate 40WACC 11
EVA calculation Earnings after tax 2.5b
(1-0.40) 1.5b EVA 1.5b 11 ?
20b 1.5b 2.2b 700m
(EVA is explained RWJ Chapter 12 Appendix)
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How to measure value creation ?

• 1. Compare market value of equity to book value
• Value creation if M/B gt 1
• 2. Compare return on equity to the opportunity
  cost of equity
• Value creation if ROE gt Opportunity Cost of
  Equity

13
M/B vs ROE

• Simplifying assumptions
•        Expected net income income constant
•        Net income dividend
• Market value determination
• Net income Expected return ? Market value of
  equity
• NI r ?
  MVeq
• ROE (definition)
• Return on equity Net income / Book value of
  equity
• ROE NI /
  BVeq
• r ? MVeq / Bveq
• Conclusion in this simplified setting,
• M/B MVeq/BVeq gt 1 ? ROEgt r

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M/B vs ROE example

• Suppose
• Book equity ( total asset) 500,000
• Expected annual net income 100,000
• Payout ratio (Dividend / Net income) 100
• Expected return 10
• Market value of equity determination
• Dividend ( Net income) 10 Mkt Value of
  Equity
• Mkt Value of Equity 100,000 / 10
  1,000,000
• M/B 1,000,000 / 500,000 2 gt 1
• Return on Equity (ROE)
• ROE Net Income / Book Equity
• A 100,000 / 500,000 20 gt 10

15
The Top Companies 2001
16
The Top Companies 2002
Mkt Cap billions Price/Book ROE
1 General Electric US 309 5.6 26.6
2 Microsoft US 276 5.8 13.4
3 Exxon Mobil US 271 3.7 16.7
4 Wal-Mart Stores US 241 6.7 19.3
5 Citigroup US 223 2.7 19.2
6 Pfizer US 217 11.9 45.3
7 Royal Dutch / Shell EU 194 3.5 19.4
8 BP EU 192 2.6 13.3
9 Johnson Johnson US 187 7.7 24.3
10 Intel US 185 5.2 4.9
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QD financial analysis

• PROFITABILITY (du Pont system)
• Three determinants

13.4
Financial Leverage
Asset Turnover
Profit Margin

• Microsoft - 2002 US bil.
• Net Income 7,721
• Sales 25,296
• Assets 59,257
• Book equity 57,619

30.5
0.43
1.03
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References

• Suggested text for this course
• Ross, Stephen A., Randolph W. Westerfield and
  Jeffrey F. Jaffe, Corporate Finance, 6th edition,
  McGraw-Hill Irwin 2002
• Corporate finance textbooks (MBA level)
• Brealey, Richard and Steward Myers, Principles of
  Corporate Finance, xth edition, McGraw-Hill 2000
• Damorada, Aswath, Corporate Finance Theory and
  Practice, Wiley 1997
• Corporate finance texts for executives
• Bertoneche, Marc and Rory Knight, Financial
  Performance, Butterworth Heinemann 2001
• Hawawini, Gabriel and Claude Viallet, Finance for
  Executives Managing for Value Creation,
  South-Western College Publishing, 1999