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Session 1A: Corporate

Finance & Agency Issues

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Outline of Contents

Corporate Finance and the FinancialManager

Forms of Business Organization

The Goal of Financial Management

The Agency Problem and Control ofthe Corporation

Financial Markets and theCorporation

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What Is Corporate Finance?

Corporate finance provides answersto some important questions:

What long-term investments should the

firm take on? Where will the firm get the long-term

financing to pay for the investments?

How will the firm manage its everydayfinancial activities?

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Financial Management Decisions

Capital budgeting What long-term investments or projects

should the business take on?

Capital structure How much should the firm borrow to pay

for its assets? What is the best mixture of debt and equity?

The least expensive sources of funds?

Working capital management How do we manage the day-to-day

finances of the firm? 1-3ACF 2013

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Summary of

3 Business Forms

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Goal of Financial Management

What should be the goal of a corporation?

Maximize profits?

Minimize costs?

Maximize market share? Maximize the current value of the companys

stock?

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Maximizing Shareholders Wealth

Maximizing the share price is equivalentto maximizing shareholders wealth

Why is this a valid goal?

Decisions are made in shareholdersbest interest

Considers cash flows not profits

Incorporates time dimension

Does not consider profitability but alsorisk

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The Agency Problem

Agency relationship The relationship exists when a principal

hires an agent to represent his/herinterests

Stockholders (principals) hire managers(agents) to run the company

Agency problem Conflict of interest between principal and

agent Agent may not work in the best interest of the

principal

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Management Goals

Management goals may be differentfrom shareholders goals

Management may be more interested in:

Consuming expensive perks Its own survival

Its independence

Management may focus on increasedgrowth and size rather than increasingshareholders wealth

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Agency Costs

Costs due to the conflict of interestbetween shareholders and management Direct

Corporate expenditure that benefits

management but costs shareholders,e.g. country club membership

Costs to monitor management actions,e.g. auditor costs

Indirect Lost opportunity due to management forgoing

profitable but risky projects for fear of losing jobif project fails

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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 bettermanagement

Other stakeholders

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Agency Problems in Asia

What are the underlying assumptionsin the conventional model?

Many PLCs in Asia are family or state-

controlled.

So are agency issues similar?

Look at Assignment 1

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Work the Web Example

The Internet provides a wealth of informationabout individual companies

One excellent site is finance.yahoo.com

Click on the web surfer to go to the site,choose a company and see what informationyou can find!

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http://www.finance.yahoo.com/http://finance.yahoo.com/http://www.finance.yahoo.com/

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Financial Markets

Primary marketA market where the firm sells its

securities to public for the first time

Secondary marketsA market in which the securities issued

by firms are traded Listed securities trade in an organized

exchange, e.g. the stock market (NYSE) Over-the-counter securities are bought from

or sold to a dealer

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http://www.nyse.com/http://www.nyse.com/

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Session 1B: Financial

Statement Analysis

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Content Outline

The Balance Sheet The Income Statement

Taxes

Cash Flow and Financial Statements: ACloser Look

Standardized Financial Statements

Ratio Analysis

The Du Pont Identity Using Financial Statement Information

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Balance Sheet

The balance sheet is a snapshot of thefirms assets and liabilities at a given pointin time

Assets are listed in order of decreasingliquidity Ease of conversion to cash

Without significant loss of value

Balance Sheet Identity Assets = Liabilities + Stockholders Equity

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The Balance SheetFigure 2.1

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Net Working Capital andLiquidity

Net Working Capital = Current AssetsCurrent Liabilities

Positive when the cash that will be received over the next 12months exceeds the cash that will be paid out

Usually positive in a healthy firm

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 typically earn a lower return

Trade-off to find balance between liquid and illiquid assets

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Asia-Pacific Corporation Balance SheetTable 2.1

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M k t V l B k

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Market Value vs. BookValue

The balance sheet provides the book valueof the assets, liabilities, and equity.

Market value is the price at which theassets, liabilities ,or equity can actually be

bought or sold. Market value and book value are often

very different. Why?

Which is more important to the decision-making process?

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E l 2 2 Kli

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Example 2.2 KlingonCorporationKLINGON CORPORATION

Balance Sheets

Market Value versus Book Value

Book Market Book MarketAssets Liabilities and Shareholders

Equity

NWC $ 400 $ 600 LTD $ 500 $ 500

NFA 700 1,000 SE 600 1,100

1,100 1,600 1,100 1,600

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Income Statement

The income statement is more like a videoof the firms operations for a specified

period of time.

You generally report revenues first andthen deduct any expenses for the period

Matching principleGAAP says to showrevenue when it accrues and match the

expenses required to generate the revenue

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A i P ifi C ti I

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Asia-Pacific Corporation IncomeStatementTable 2.2

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Taxes

The one thing we can rely on with taxes isthat they are always changing

Marginal vs. average tax rates

Marginal tax ratethe percentage paid on thenext dollar earned

Average tax ratethe tax bill / taxable income

Other taxes

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Corporate Ta Rates Aro nd

http://www.irs.gov/

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Corporate Tax Rates Aroundthe World

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The Concept of Cash Flow

Cash flow is one of the most importantpieces of information that a financialmanager can derive from financialstatements

The statement of cash flows does notprovide us with the same information thatwe are looking at here

We will look at how cash is generated from

utilizing assets and how it is paid to thosethat finance the purchase of the assets

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Cash Flow From Assets

Cash Flow From Assets (CFFA) =Cash Flow to Creditors + Cash Flowto Stockholders

Cash Flow From Assets = OperatingCash FlowNet Capital SpendingChanges in NWC

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Example: Asia Pacific

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Example: Asia-PacificCorporationPart I

OCF (I/S) = EBIT + depreciationtaxes =$547

NCS (B/S and I/S) = ending net fixed

assetsbeginning net fixed assets +depreciation = $130

Changes in NWC (B/S) = ending NWC

beginning NWC = $330

CFFA = 547130330 = $87

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Example: Asia Pacific

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Example: Asia-PacificCorporationPart II

CF to Creditors (B/Sand I/S) = interestpaidnet new borrowing = $24

CF to Stockholders (B/Sand I/S) =dividends paidnet new equity raised= $63

CFFA = 24 + 63 = $87

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Cash Flow Summary Table

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Cash Flow Summary - Table2.6

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Example: Balance Sheet and

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Example: Balance Sheet andIncome Statement Information

Current Accounts 2011: CA = 3625; CL = 1787 2010: CA = 3596; CL = 2140

Fixed Assets and Depreciation 2011: NFA = 2194; 2008: NFA = 2261

Depreciation Expense = 500 Long-term Debt and Equity

2011: LTD = 538; Common stock & APIC = 462 2010: LTD = 581; Common stock & APIC = 372

Income Statement

EBIT = 1014; Taxes = 368 Interest Expense = 93; Dividends = 285

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Example: Cash Flows

OCF = 1,014 + 500368 = 1,146 NCS = 2,1942,261 + 500 = 433

Changes in NWC = (3,6251,787)(3,5962,140) = 382

CFFA = 1,146433382 = 331 CF to Creditors = 93(538581) = 136

CF to Stockholders = 285(462372) = 195

CFFA = 136 + 195 = 331

The CF identity holds.

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Sample Balance Sheet

Numbers in millions of dollars

3-34

2011 2010 2011 2010

Cash 696 58 A/P 307 303

A/R 956 992 N/P 26 119

Inventory 301 361 Other CL 1,662 1,353

Other CA 303 264 Total CL 1,995 1,775

Total CA 2,256 1,675 LT Debt 843 1,091

Net FA 3,138 3,358 C/S 2,556 2,167

Total Assets 5,394 5,033 Total Liab. &

Equity

5,394 5,033

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Sample Income Statement

Revenues 5,000Cost of Goods Sold (2,006)

Expenses (1,740)

Depreciation (116)

EBIT 1,138

Interest Expense (7)

Taxable Income 1,131

Taxes (442)

Net Income 689

EPS 3.61

Dividends per share 1.08

Numbers in millions of dollars, except EPS & DPS

Number of shares outstanding = 190.9 million 3-35ACF 2013

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Sources and Uses

Sources Cash inflowoccurs when we sell something

Decrease in asset account (Sample B/S) Accounts receivable, inventory, and net fixed assets

Increase in liability or equity account

Accounts payable, other current liabilities, and commonstock

Uses Cash outflowoccurs when we buy something

Increase in asset account

Cash and other current assets Decrease in liability or equity account

Notes payable and long-term debt

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Statement of Cash Flows

Statement that summarizes the sourcesand uses of cash

Changes divided into three majorcategories

Operating Activityincludes net income andchanges in most current accounts

Investment Activityincludes changes in fixedassets

Financing Activityincludes changes in notespayable, long-term debt, and equity accounts,as well as dividends

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Sample Statement of

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Sample Statement ofCash Flows

Cash, beginning of year 58 Financing Activity

Operating Activity Decrease in Notes Payable -93

Net Income 689 Decrease in LT Debt -248

Plus: Depreciation 116 Decrease in C/S (minus RE) -94

Decrease in A/R 36 Dividends Paid -206

Decrease in Inventory 60 Net Cash from Financing -641

Increase in A/P 4

Increase in Other CL 309 Net Increase in Cash 638

Less: Increase in other CA -39

Net Cash from Operations 1,175 Cash End of Year 696

Investment Activity

Sale of Fixed Assets 104

Net Cash from Investments 104

Numbers in millions of dollars3-38

ACF 2013

Standardized Financial

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Standardized FinancialStatements

Common-Size Balance Sheets

Compute all accounts as a percent of total assets

Common-Size Income Statements

Compute all line items as a percent of sales

Standardized statements make it easier to comparefinancial information, particularly as the companygrows

They are also useful for comparing companies of

different sizes, particularly within the same industry

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R ti A l i

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Ratio Analysis

Ratios allow for better comparison throughtime or between companies

As we look at each ratio, ask yourself whatthe ratio is trying to measure and why thatinformation is important

Ratios are used both internally andexternally

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Categories of

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Categories ofFinancial Ratios

Short-term solvency or liquidity ratios Long-term solvency or financial

leverage ratios

Asset management or turnover ratios Profitability ratios

Market value ratios

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C ti Li idit R ti

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Computing Liquidity Ratios

Current Ratio = CA / CL 2,256 / 1,995 = 1.13 times

Quick Ratio = (CAInventory) / CL (2,256301) / 1,995 = .98 times

Cash Ratio = Cash / CL 696 / 1,995 = .35 times

NWC to Total Assets = NWC / TA (2,2561,995) / 5,394 = .05

Interval Measure = CA / average dailyoperating costs 2,256 / ((2,006 + 1,740)/365) = 219.8 days

B/S3-42

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C ti C R ti

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Computing Coverage Ratios

Times Interest Earned = EBIT /Interest

1,138 / 7 = 162.57 times

Cash Coverage = (EBIT +Depreciation) / Interest

(1,138 + 116) / 7 = 179.14 times

B/S3-44

ACF 2013

Computing Inventory Ratios

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Computing Inventory Ratios

Inventory Turnover = Cost of GoodsSold / Inventory

2,006 / 301 = 6.66 times

Days Sales in Inventory = 365 /Inventory Turnover

365 / 6.66 = 55 days

B/S

I/S3-45

ACF 2013

Computing Receivables

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p gRatios

Receivables Turnover = Sales /Accounts Receivable

5,000 / 956 = 5.23 times

Days Sales in Receivables = 365 /Receivables Turnover

365 / 5.23 = 70 days

B/S

I/S3-46

ACF 2013

Computing Total Asset

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p gTurnover

Total Asset Turnover = Sales / TotalAssets 5,000 / 5,394 = .93

It is not unusual for TAT < 1, especially if a firm

has a large amount of fixed assets NWC Turnover = Sales / NWC

5,000 / (2,2561,995) = 19.16 times

Fixed Asset Turnover = Sales / NFA

5,000 / 3,138 = 1.59 times

B/S

I/S3-47

ACF 2013

Computing Profitability

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p g yMeasures

Profit Margin = Net Income / Sales 689 / 5,000 = 13.78%

Return on Assets (ROA) = Net Income

/ Total Assets 689 / 5,394 = 12.77%

Return on Equity (ROE) = Net Income

/ Total Equity 689 / 2,556 = 26.96%

B/S

I/S3-48

ACF 2013

Computing Market Value

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gMeasures

Market Price = $87.65 per share Shares outstanding = 190.9 million

PE Ratio = Price per share / Earnings

per share 87.65 / 3.61 = 24.28 times

Market-to-book ratio = market value

per share / book value per share 87.65 / (2,556 / 190.9) = 6.55 times

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Deriving the Du Pont Identity

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Deriving the Du Pont Identity

ROE = Net Income / Total Equity Multiply by 1 (TA/TA) and then rearrange

ROE = (NI / TE) (TA / TA)ROE = (NI / TA) (TA / TE)

= ROA * Equity Multiplier Multiply by 1 (Sales/Sales) again and thenrearrange ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE)

ROE = PM * TAT * EM Note: EM = 1 + debt/equity ratio

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Using the Du Pont Identity

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Using the Du Pont Identity

ROE = PM * TAT * EM Profit margin is a measure of the firms

operating efficiencyhow well itcontrols costs

Total asset turnover is a measure of thefirms asset use efficiency how welldoes it manage its assets

Equity multiplier is a measure of thefirms financial leverage

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Expanded Du Pont Analysis

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Du Pont Data

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Extended Du Pont Chart

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Extended Du Pont Chart

Insert Figure 3.1 (Extended DuPontChart)

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Why Evaluate Financial

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Statements?

Internal uses Performance evaluationcompensation and

comparison between divisions

Planning for the futureguide in estimating

future cash flows External uses

Creditors

Suppliers

Customers Stockholders

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Benchmarking

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Benchmarking

Ratios are not very helpful by themselves;they need to be compared to something

Time-Trend Analysis Used to see how the firms performance is

changing through time Internal and external uses

Peer Group Analysis Compare to similar companies or within

industries SIC and NAICS codes

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Real World Example I

http://www.naics.com/

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Real World Example I

The ratios of The Hour Glass, a watchretail chain, listed on the Singapore StockExchange are compared with those of theindustry.

The ratios are obtained from Reuters.comand can be easily accessed on the web forfree.

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Real World ExampleII

http://www.reuters.com/finance/stocks/financialHighlights?symbol=HRGS.SI

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Liquidity ratios

Company Industry Current ratio 3.68x 1.98x Quick ratio 1.02x 1.38x

Long-term solvency ratio Debt/Equity ratio 11.80x 24.16x

Coverage ratio Times Int Earned --- 5.53x

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Real World Example III

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Real World Example III

Asset management ratios:Company Industry

Inventory turnover 2.08x 4.44x

Receivables turnover 31.43x 61.17x(12 days) (6 days)

Total asset turnover 1.71x 1.30x

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Real World Example III

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Real World Example III

Profitability ratiosCompany Industry

Gross profit margin 24.23% 50.42%

Operating margin 11.42% 10.53% Net profit margin 15.72% 10.58% ROA 9.22% 6.56% ROE 20.82% 19.13%

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Potential Problems

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Potential Problems

There is no underlying theory, so there is no way toknow which ratios are most relevant

Benchmarking is difficult for diversified firms

Globalization and international competition makes

comparison more difficult because of differences inaccounting regulations

Varying accounting procedures, i.e. FIFO vs. LIFO

Different fiscal years

Extraordinary events

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Work the Web Example

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Work the Web Example

The Internet makes ratio analysis mucheasier than it has been in the past

Click on the web surfer to go towww.reuters.com

Click on Stocks, then choose a company andenter its ticker symbol

Click on Ratios to see what information isavailable

3-61ACF 2013

http://www.reuters.com/http://www.reuters.com/http://www.reuters.com/