Autumn Term 20131 Corporate Finance Fundamentals of Financial Management Dr. Markus R. Neuhaus Dr....

Autumn Term 2013 1

Corporate FinanceFundamentals of Financial ManagementDr. Markus R. NeuhausDr. Marc Schmidli, CFA

Markus Neuhaus I Corporate Finance I [email protected]

2Markus Neuhaus I Corporate Finance I [email protected] Term 2013

Corporate Finance: Course overview 201320.09. Fundamentals M. Neuhaus & M. Schmidli

27.09. No lecture

04.10. Interpreting Financial Statements M. Neuhaus & M. Schmidli

11.10. Mergers & Acquisitions I & II (4 hours) M. Neuhaus & S. Beer

18.10 Investment Management M. Neuhaus & P. Schwendener

25.10 Business Valuation (4 hours) M. Neuhaus & M. Bucher

01.11 Value Management M. Neuhaus, R. Schmid & G. Baldinger

08.11 No lecture

15.11 Legal Aspects Ines Pöschel

22.11 Turnaround Management M. Neuhaus & R. Brunner

29.11 No lecture

06.12 Financial Reporting M. Neuhaus & M. Jeger

13.12 Taxes (4 hours) M. Neuhaus & M. Marbach

20.12 Summary Repetition M. Neuhaus

3Markus Neuhaus I Corporate Finance I [email protected]

Grade Chairman Qualification Doctor of Law (University of Zurich), Certified Tax Expert Career Development Joined PwC in 1985, became Partner in 1992 and CEO from 2003 –

2012, became Chairman in 2012 Subject-related Exp. Corporate Tax

Mergers & Acquisitions Lecturing SFIT: Executive in Residence, lecture: Corporate Finance

Multiple speeches on leadership, business, governance, commercial and tax law

Published Literature Author of commentary on the Swiss accounting rulesPublisher of book on transfer pricingAuthor of multiple articles on tax and commercial law, M&A, IPO,

etc. Other professional roles: Member of the board of économiesuisse, member of the board

and chairman of the tax chapter of the Swiss Institute of Certified Accountants and Tax Consultants

Markus R. NeuhausPricewaterhouseCoopers AG, Zürich

Phone: +41 58 792 40 00Email: [email protected]

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Marc SchmidliPricewaterhouseCoopers AG, Zürich

Phone: +41 58 792 15 64Email: [email protected]

Grade Partner Qualification Dr. oec. HSG, CFA charterholder Career Development Corporate Finance PricewaterhouseCoopers since July 2000 Lecturing Euroforum – Valuation in M&A situations

Guest speaker at ZfU Seminars, Uni Zurich, ETH, etc. Published Literature Finanzielle Qualität in der schweizerischen Elektrizitätswirtschaft

Various articles in „Treuhänder“, HZ, etc.

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Contents

Learning targets Pre-course reading Lecture „Fundamentals of Financial Management“

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Learning targets

Financial management

Understanding the flow of cash between financial markets and the firm‘s operations

Understanding the roles, issues and responsibilities of financial managers

Understanding the various forms of financing Financial environment

Knowing the relevant financial markets and their players

Being aware of various financial instruments

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Contents


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Pre-course reading

Books Mandatory reading

Brigham, Houston (2012): Chapter 2 (pp. 25-53) Optional reading

Brigham, Houston (2012): Chapter 1 (pp. 2-21) Volkart (2011): Chapter 1 (pp. 43-69) Volkart (2011): Chapter 7 (pp. 579-604) Bodie, Kane & Marcus (2009): Chapter 12 (p. 384-395)

Slides Slides 1 to 11 – mandatory reading Other Slides – optional reading, will be dealt within the lecture

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Contents


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Agenda I

1. Introduction

Setting the scene

Who is the financial manager?

Roles of financial managers

Shareholder value vs. Stakeholder value concept

2. Financing a business

External financing

Internal financing

Asymmetrical information

Pecking order theory

Capital structure

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Agenda „fundamentals of financial management“ II

3. Financial markets

Different types of markets

Financial institutions

Financial instruments

Efficient market hypothesis (EMH)

4. Q&A and discussion

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Agenda: Introduction

Setting the scene



Shareholder value vs. stakeholder value concept

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Setting the scene I

(1) cash raised by selling financial assets to investor

(2) cash invested in the firm’s operations and used to purchase real assets

(3) cash generated by the firm’s operations

(4a) reinvested cash

(4b) cash returned to investors

Firm‘s operations

(a bundle of real assets)

Financial markets(investors holding financial assets)

Financialmanager

(e.g. CFO)

(1)(2)

(3)

(4a)

(4b)

Company “Environment”

Source: Brealey, Myers, Allen (2012), 34.

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Setting the scene II

Managers do not operate in a vacuum Large and complex environment including:

Financial markets

Taxes

Laws and regulations

State of the economy

Politics, public view, press

Demographic trends

etc. Among other things, this environment determines the availability of investments and

financing opportunities

Therefore, managers must have a good understanding of this environment

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Chief Financial Officer (CFO)(responsibilities:

e.g. financial policy,financial planning)

Treasurer(responsibilities: e.g. cash management,currency trading, banking relationships)

Controller(responsibilities: e.g. preparation of

financial statements, accounting, taxes)

Source: Brealey, Myers, Allen (2011), 34.

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Generally, managers do not own the company, they manage it The company belongs to the stockholders. They appoint managers who are expected to run

the company in the stockholders’ interest Basic goal is creating shareholder value

two problems emerge from this constellation

Agency dilemma: asymmetric information and divergences of interests between principal (stockholders) and agent (management) lead to the so called agency dilemma which also arises in the context of financing decisions ( pecking order theory)

Shareholder value vs. stakeholder value: shareholders own the company. Does a company merely consider the owners’ interest or the interests of all stakeholders affected by the company’s business activities?

Agent Principal

performs

hires

Em

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hig

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ala

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s Stab

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row

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divide

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Illustration: Agency dilemmaAlso see Brealey, Myers, Allen (2011), 37-43.

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Shareholder value vs. stakeholder value I

Shareholders’ wealth maximization means maximizing the price/value of the firm’s common stock Shareholders are considered as the only reference for the company’s course of business and

performance Other stakeholders are strategically considered only to the extent they could have an impact on the

stock price, the stockholders’ wealth

Suppliers

StateInvestors

Customers

Employees

Value

If a new pharmaceutical product is launched, health considerations will be relevant only to the extent they could endanger the firm’s stock price (e.g. through a lawsuit)

Where does the risk in the shareholder value concept lie? ( incentives, sustainability)

Also see Brealey, Myers, Allen (2011), 37-43.

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Shareholder value vs. stakeholder value II

Stakeholder value means maximizing the company’s value taking into account every stakeholder the company affects in the course of its business

The importance of stakeholder management is continually growing

Suppliers

State

Customers

Employees

Value

Investors

If a new pharmaceutical product is about to be launched, every stakeholder’s interest must be assessed and the product is introduced only if every interest can be honored

Does the plant pollute the air?

Could the new product be harmful to customers?

etc.

How can a company motivate its managers towards a careful handling of the company’s stakeholders? ( compensation programs, corporate governance)

Also see Brealey, Myers, Allen (2011), 37-43.

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Agenda: Financing a business

External financing

Internal financing

Asymmetrical information

Pecking order theory

Capital structure

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Possibilities of financing a business

The management makes decisions about which investments are to be undertaken and how these investments are to be financed

There are three basic ways of financing a business

1. Internal

2. Debt

3. Equity

Equity

Debt

Internal financing

Ext

ern

alIn

tern

al

Pecking order theory diagram

Why would a company prefer debt over equity? ( cost of capital)

Source: Brigham, Houston (2012), 465-466. For further reading also see Brigham, Houston (2012), 438-480.

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Financing a business – overview

External financing: A company receives capital from outside the company, e.g. credit, capital increase

Internal financing: The major part of a firm’s capital typically comes from internal financing (retained cash flows, profits from operating activities), except for e.g. startup or turnaround situations

Liquidation financing: In this context, liquidation financing refers to the liquidation of assets (e.g. divesting of certain business areas) which have a financing effect

Debt financing Equity financing Liquidation financing

Credit financing Issuing shares

Internal financing

Financing effect from accruals

Retained cash flows and profits

Mezzanine / Hybrid financing

External financing

Divesting activities

Source: Volkart (2011), 581.

Financing impact fromvalue of depreciation

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Financing a business – external financing

Debt financing

Given a solid capital base, the use of debt is reasonable as it broadens the financing base

provided a certain amount of leverage exists and considerable tax advantages1) can be exploited

The risk borne by a creditor is the risk of default driven by the company’s market and operational

risks

Because a bank would not lend money to a company without checking its financial health, a

certain amount of debt gives a positive signal to other business partners

Equity financing

Equity serves as the capital base of a company because equity can not be withdrawn or taken

away from the company

In the case of incorporated companies (e.g. AG), equity bears the major part of the risk

A company can raise equity capital by selling shares privately or publicly (e.g. IPO or capital

increase)

Source: Volkart (2011), 583ff.

1) General rule: Interest expense is tax deductible, dividend distributions not.

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Financing a business – internal financing

Internal financing or self-financing

Internal financing is determined by the cash flow from operating activities

Internal financing means generation of cash flows from operating activities without using external sources

Internal financing happens “automatically” as a consequence of the operating activities of a company

From the company’s perspective, self-financing is the most convenient way of financing as the company does not have to debate with creditors and the discussion with equity holders is limited to the question of how much of the profits should be distributed. ( pecking order theory; see Slide 26)

As opposed to external financing, internal financing is not fully reflected on the company’s balance sheet

Source: Volkart (2011), 586ff. Also see Brigham, Houston (2012), 465-466.

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Asymmetrical Information I

The problem of asymmetrical information does not occur only between principal and agents, but arises each time financing is needed as the fundamental interests of debt holders and shareholders differ significantly.

Shareholders assume that management is negatively influenced by debt holders towards making “safe” investments in order to minimize the probability of default

Debt holders will try to establish credit covenants in order to gain more control over investment decisions and the course of business

Shareholders, on the other hand, prefer investment opportunities with potentially high returns as their shares will gain in value as the company’s cash flows grow

As a result, each party tries to influence the management:

Debt holders try to establish favorable credit covenants

Shareholders set incentives through compensation plans


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Asymmetrical Information II

Why do the different parties not get together and solve the problem?

Game theory ( Nash) shows us that in such strategic situations with conflicts of interest, each party begins by holding back information in order to strengthen its negotiating position

Shareholders do not know about possible credit covenants whereas creditors do not know anything about the investors’ motivation and decisions

Law prohibits typically a company to disclose all relevant information

in conclusion, we find a triangle situation in which each party tries to maintain or gain as much power and influence as possible in order to secure its interests

Debt holders Shareholders

Management

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Pecking order theory I

Bridging the problems of asymmetric information can be very expensive. The less information an investor has, the higher the required rate of return for the investment is. An outflow is the so called pecking order theory demonstrating the order in which the company prefers to finance its business

Equity

Debt

Internal financing

1. Internal financing No prior explanations to investors or creditors (except for

level of dividends)

2. Debt financing Banks want information about credit risk Management must provide possible creditors with sufficient

and reliable information

3. Equity financing Potential shareholders will challenge the “real” share price

as they have to rely “blindly” on the information given by the management

Shareholders will request a low price as they cannot be sure whether the share is worth the price

This makes equity capital very expensive for a company

Pecking order theory diagram

Source: Volkart (2011), 592ff. Also see Brigham, Houston (2012), 465-466 or Brealey, Myers, Allen (2011), 488-492.

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Pecking order theory II

The importance of the different ways of financing fundamentally changes over the lifetime of a company

From the perspective of a major listed company, internal financing is the most significant kind of financing

Vital influence on conditions for external financing (stable operating cash flows more favorable credit conditions and higher stock prices)

Without solid operating cash flows, a company will not be able to survive

Illustration: How financing preferences can alter over a company‘s lifecycle

Phase ofbusiness

Start up Expansion Consolidation

Preferredfinancing

Private equity / Venture capital

- Equity- Debt- Internal

Internal

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Capital structure

The decisions on how the assets of a company are financed leads to the question:

what is the optimal capital structure of a company? The relation between debt and equity reflects a company’s risk and is also called

financial leverage The optimal capital structure is highly dependent on the industry Investors often urge greater financial leverage, and thus more risk, in order to generate

more profit in relation to the equity capital invested. In addition, interests paid are tax-deductible.

The capital structure can be defined by the debt to equity ratio

Equity

Debt Leverage Financial Equity to Debt

Financial risk increases as the company chooses to use more debt

What is the optimal capital structure?


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Agenda: Financial markets

Different types of markets

Financial institutions


EMH

Behavioral Finance

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Basic need for financial markets

Businesses, individuals and governments need to raise capital

Company intends to open a new plant

Family intends to buy a new home

City of Zurich intends to buy a new generation of trams

Of course, people and companies save money and have money of their own. However, saving money takes time and has opportunity costs

Mr. Meier earns CHF 10’000 per month and has expenses of CHF 7’000. If he intends to buy a home worth CHF 1’000’000, it will take him a long time to

save enough. But what if he wants to buy this home today?

In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it

Source: Brigham, Houston (2012), 26ff.

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Financial markets

Physical asset vs. financial asset markets Spot vs. future market Money vs. capital markets Primary vs. secondary markets Private vs. public markets

Recent trends: Globalization of financial markets Regulation and international cooperation of regulators Increased use of derivative instruments, especially as risk management (hedging) and

speculation instruments. The current financial crisis reduced the total size of the derivatives market substantially. However, it is still far bigger in most areas as for instances in 2001.


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Financial Institutions

Investment banks Commercial banks Financial services corporations Insurances ETFs, hedge- and mutual funds Other: Credit unions, pension funds, private equity companies

The trend is clearly towards bank holdings / financial services conglomerates that provide all kinds of services under one roof. The large investment banks disappeared.

Against that, in the current environment many banks are disposing of certain business divisions and focus on core competences. This trend will continue for regulatory reasons (lower risks, de-leveraging, etc.) and some trends towards nationalization and “home market” focus in the banking sector.

Source: Brigham, Houston (2012), 34f.

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Stock: Unit of ownership which entitles the owner to exercise his voting right on corporate decisions and receive a certain payment (dividend) each year. No other obligation, nor any loyalty required.

Bond: The issuer (company) owes the holder (investor) a certain amount of debt and is obliged to pay the holder a certain interest rate (coupon) and to repay the initial amount at a pre-determined date.

Option: Financial contract which entitles the buyer to buy (call option) or sell (put option) a certain underlying asset at a pre-specified price at or before a certain point in time.

Structured product: Packaged investment strategy, a mixture of different investment instruments, mostly derivatives which are intended to exploit, for instance, a certain market constellation.

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Efficient market hypothesis (EMH) vs. behavioral finance

The EMH states that

(1) share prices are always in equilibrium

(2) the prices reflect all available information (e.g. on opportunities or risks) and everything that can be derived from it

Therefore, it is impossible to “beat the market”

Prices in financial markets react very quickly and fairly to new information

Share prices are unpredictable as the information that influences prices also occurs by chance.

We can analyze past stock price developments, but we cannot foresee any

future results


However, investors are no machines that can process all available information.This may lead to the fact that irrational factors come into play

behavioral finance

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Behavioral finance I

Behavioral finance assumes that investors may not always act rationally when investing in financial markets, primary due to observed market anomalies.

Behavioral finance is based on two key elements.

The theory is based on findings from psychology and suggests that irrational behavior arises as the EMH falls short of considering how investors and managers come to a decision.

Behavioral finance also shows that possibilities of arbitrage are limited.

Criticism states that behavioral finance is not an unified concept which explains different anomalies but is rather based on different elements.

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Source: Brigham, Houston (2012), 50; Bodie, Kane & Marcus (2009), 384 ff.


Behavioral finance II

Irrationalities due to: - Forecasting errors: investors typically attach too much weight on recent experience- Overconfidence: people tend to overestimate their abilities- Conservatism: too slow to react to new information in the market- Sample Size Neglect and Representativeness: investors often incorrectly assume that a

small sample of historical evidence will be representative of future performance- Framing: how decisions are framed affect the decision making process- Regret Avoidance: unconventional decisions lead to more disappointment if the outcome

is negative

Possible limits to arbitrage are:- Fundamental Risk: there is an uncertainty about how long an investor will have to wait

for the stock to fully reflect its value- Implementation cost: transaction costs can make it unattractive to exploit the mispricing- Model Risk: valuation model of the security is incorrect

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Source: Brigham, Houston (2012), 50; Bodie, Kane & Marcus (2009), 384 ff.


Final comments

As the environment (capital markets, society, suppliers etc.) has significant influence on a company, the financial managers must have a profound understanding of this environment in order to make the right decisions

A financial manager makes decisions about which investments are to be undertaken and how these investments are to be financed (treasurer) and accounted for (controller)

Financing can come either from outside (external: debt and equity) or from inside (internal: internal financing through profit from operating business) the company

The problem of asymmetrical information arises whenever financing is needed, because the level of information and the interests of debt holders and shareholders differ significantly. Bridging these problems can be very expensive and leads to the so called pecking order theory

The theory that capital markets take into account all information and all that can be derived from this information, is called the efficient market hypothesis. However, as explained with the behavioral finance theory, not all investors act rationally in their decision making process.

Autumn Term 2013

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