Corporate Finance A2

Vysoká škola finanční a správníWinter Semester 2012

Jaromír R. Stembergjaromir@mail.vsfs.cz

Course Layout

• Twelve two-hour lessons• The course is to introduce general financial

management problems, realtions, terminology, and solutions

• Ends with an Exam (zkouška)

Literature

• Block, Stanley: Foundations of Financial ManagementMcGraw-Hill, 2009ISBN 978-0-07-128525-4

Grading

• Written test, oral exam

Contents

• Review of the Last Semester• Time Value of Money• Valuation and Rate of Return • Cost of Capital and Capital Budgeting• Capital Markets• Bonds, Stock and Security Financing

History of Money and Accounting

Money

• Barter trade• Cowry shells

form 1200 B.C. in China till mid 20th century in Africa• Precious metal coins, banknotes• Development of banking• “Plastic money” of today

Development of Accounting

• Babylon, 18th century B.C.- first organized records kept to account for assets and loans

• Italy, 13th century A.D. - double-entry bookkeeping

• 20th century A.D.- international accounting standards US GAAP and IAS/IFRS

Financial Reports and Analysis

Balance Sheet

Assets LiabilitiesCurrent Assets Current LiabilitiesCash and Equivalents Short-Term Accounts PayableShort-Term Receivables Current Tax PayableInventory Short-Term Loans and BorrowingsAccruals and Other S/T Assets Accruals and Other S/T LiabilitiesLong-Term Assets Long-Term LiabilitiesIntangible Fixed Assets Long-Term PayablesTangible Fixed Assets ProvisionsLong-Term Receivables

Owners’ Equity Share CapitalShare Premium and Capital FundsRetained EarningsY-T-D Profit (Loss)

RevenueMaterialProduction Exp.CommissionOther Selling Exp.

Cost of Goods SoldGross Profit

MarketingAdministrationOffice Exp.ConsultantsDepreciationOther Exp.

Total G&A ExpensesProfit from Operations

Financial IncomeFinancial Exp.

Net Financial ResultProfit before Tax

Corporate Income TaxNet Profit

Cash Flow StatementCash - Beginning of Period +Net Profit +Accounts Receivable Increase -Inventory Increase -Accounts Payable Increase +Reserves Increase +Depreciation +Cash Flow from Operations = +Fixed Assets Purchase -Fixed Assets Sale +Cash Flow from Investments = +Loans Re-Paid -Loans Taken +Cash Flow from Financial Transactions = +Cash - End of Period =

Ratios and Analyses

• Profitability Ratios- profit margin- return on assets (investments), return on equity

• Asset Utilization Ratios- receivable, inventory, fixed, total assets turnover- average collection period, days of sales outstanding

• Liquidity Ratios- current ratio- quick ratio

• Analyses- DuPont analysis- horizontal, vertical, trend

Du Pont Analysis

Forecast and Budget

Budgetting

• Systematic setting of future goals• Bottom-up or top-down• Identification of external influence and risks (such as

customers, competition, macroeconomics)• Identification of external influence and risks (such as

capacity of production and resources, human factor)• Setting of expected growth (reduction), pipeline,

percent-of-sales, investment planning

Financial Forecasting

• Pro forma income statement• Revenue (pipeline, funnel, percentage)• Expenses (variable, fixed)

• Pro forma balance sheet• A/R, A/P, inventory• Fixed assets, liabilities, equity

• Pro forma cash flow statement

Operational and Financial Leverage

Fixed and variable expenses

0

$total expenses

fixned expenses

No. of units produced

Fixed and variable expenses

No. of units produced

$

fixned expenses

total expenses

$

Break-Even Point

No. of units produced

revenue

total expenses

fixed expenses

Break-Even Point

profitrevenue

total expenses

fixed expenses

$

No. of units produced

$

Break-Even Point

No. of units produced

revenue

total expenses

fixed expenses

Operational leverage

• Uses fixed/variable cost• Can increase profits but increases risk

_ Fixed costs _ Price – Variable cost per unit

Operational leverage

_ Fixed costs _ Price – Variable cost per unit

Fixed cost 60.000 Fixed cost 12.000 Variable cost 0,80 / unit Variable cost 1,60 / unit Unit price 2,00 Unit price 2,00

60.000/(2,00-0,80) = 50.000 12.000/(2,00-1,60)= 30.000 break-even point is break-even point is 50.000 units 30.000 units

Financial Leverage

2 firms: exactly the same• Same sector• Same opportunities• Same Management…

The only difference: the debt• L (leveraged firm) has 50% of debt• U (unleveraged firm) has no debt

Financial LeverageFirm U Firm L

Shares (Capital)Financial debt Total

100 000 0100 000

50 000 50 000100 000

Number of shares(Price of a share 100)

1 000 500

EBIT Financial interests(interest rate 5%)Net income before taxEPS before tax

10 000 0

10 000 10 (10 000/1 000)

10 000 2 500

7 500 15 (7 500/500)

Net income after tax(Tax rate 33%)EPS after tax

6 700

6,70

5 000

10,00

Financial Leverage

The shareholder of L has a return of 15 (before tax)

The shareholder of U has a return of 10 (before tax)

What do you prefer?

Financial LeverageFirm U Firm L

SharesFinancial debtTotal

100 000 0100 000

50 000 50 000100 000

Number of shares(Price of a share 100)

1 000 500

EBITFinancial interests(interest rate 5%)Net income before taxEPS before tax

0 0

0 0

0 2 500

-2 500 -5

Net income after taxEPS after tax

0 0

-2 500 -5

Financial Leverage

The shareholder of L has a return of -5 (before tax)

The shareholder of U has a return of 0 (before tax)

What do you prefer?

Financial Leverage

For leverage to be profitable, the rate of return on the investment must be higher than the cost of the borrowed money

ConclusionLeverage can create value or destroy itTo create value, the IRR must be higher than the cost of loan; if not, leverage destroys value.

Time Value of Money

Valuation and Rate of Return

Objectives

The valuation of a financial asset is based on the present value of the future cash flows

The required rate of return in valuing an asset is based on the risk involved

Bonds

Coupon / zero coupon bondsValuation of bonds: present value of future cash inflows

P =

P .. bond priceY .. Yield Pn .principal payment at maturityi .. interest (or expected return)

t .. number corresponding to a period n ..number of periods

n

Σ Yt +Pn

(1+i)t (1+i)n

t=1

D0 (1 + g)1 D0 (1 + g)2 D0 (1 + g)3 D0 (1 + g)∞ D1

(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)∞ r-gP = + + + ... + =

D1 D2 D3 D∞ D0

(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)∞ r=P = + + + +...

Stock

Infinite stream of level dividend payments

Constant growth in dividends

D .. dividend paymentr .. required rate of returng ..dividend growth

Cost of Capital

Cost of Capital

Weighted average of:

- cost of debt (loans, bonds)- cost of equity (common stock, preferred stock)

Cost of Debt

Interest payment minus tax

Kd = i (1 – t)

Kd .... Cost of debti .... Interest paidt .... corporate tax rate

Cost of Equity

Dividend devided by market priceKe = D / P0

Ke .... cost of equityD .... current dividendP0 .... market price of the stock

If dividends constantly grow, thenKe = (D / P0) + g

g .... constant growth rate in dividends

Selling costs are to be deducted from price for newly issued stock