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Corporate Finance
1. Introduction
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I. The Financial Paradigma of the Firm
II. The Corporation and the Financial System
III. Financial Instruments and the Securitization of Assets and Capital of the
Corporation
Summary
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The main objective of the corporation
I. The Financial Paradigm of the Firm
Value creation
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Value creation
Can the financial function creat value on its own?
YES
Any financing operation allowing for a reduction in the firms average cost of
capital will create value on its own;
However,
It is also very important that the financial function helps the firm as a whole to
create value, namely by meeting the requirements allowing the firm to implement
all investment projects with a positive NPV.
I. The Financial Paradigm of the Firm
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Value creation
What type of value? How can we measure value?
I. The Financial Paradigm of the Firm
The goal of financial management is to maximize the value of the existingowners equity
Ross, Westerfield and Jaffe, Corporate Finance (9thEdition)
The objective in conventional corporate financial theory is to maximize the
value of the firmAswath Damodaran, Corporate Finance, Theory and Practice (2ndEdition)
Are these objectives compatible? Can the firm adopt more than one objective?
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Value creation
What type of value? How can we measure value?
Remember that the firm is composed of
I. The Financial Paradigm of the Firm
Fixed Assets1. Tangible
2. Not tangible
Debt
Equity
Current Assets Short-termLiabilities
Investments Financing
Working Capital
Entreprise or firmvalue
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Value creation
What type of value? How can we measure value?
Can the firm adopt more than one objective?
It is not at all convenient, because contradictory objectives might give way todifficulties in making the best decisions
The existence of a single objective favours clear decision making, because
decisions will be taken to maximize the achievement of the chosen objective
The objective
Must be clear, rather than ambiguous Maximize growth? Measured by which variable?
It must be measurable on a periodic basis and in an objective way
Maximize client satisfaction?
It must not originate costs for other groups or entities
Maximize sales (a tobacco company). One way to do it would be to intensify advertising
addressed to the youth. It might represent relevant losses for society.
I. The Financial Paradigm of the Firm
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Value creation
What type of value? How can we measure value?
I. The Financial Paradigm of the Firm
Objective: Maximize enterprise Value
(Subject to complying with the ethical values related to the costs thatmight be imposed on society by meeting this objective)
Reduction or elimination of conflicts
between the firm/management andsociety.
Objective: Maximize shareholdersWealth
Objective: Maximize stock Prices
If conflicts of interest between shareholders and managers andbetween shareholders and creditors are eliminated or at leastminimized.
If managers do not attempt to cheat or manipulate the markets andmarkets are efficient.
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Value creation
What type of value? How can we measure value?
Even though the main objective of the firm is to maximize enterprise
value, value creation may be measured by changes in stock prices,providing that:
Managers act in the interest of shareholders and adopt the objective of maximizing
stock prices;
Creditors are protected against the risk of wealth expropriation by shareholders;
Managers do not manipulate information and do not succeed in cheating the
markets (efficient markets);
Management decisions do not impose costs (externalities) on society.
I. The Financial Paradigm of the Firm
Briefly: providing that agency conflicts are minimized.
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Value creation
Advantages of adopting the objective of stock price maximization:
Stock prices are the best observable figure amongst all other alternative
measures (in the case of listed companies). Contrary to net profits or sales, stock prices reflect permanently up-dated
information.
Stock prices reflect the long-term effects of company decisions.
Stock prices are the true measure of shareholders wealth.
They allow for the choice of models to select the best investment projects
for the company and their best financing structure, and facilitate empirical
testing of those models.
I. The Financial Paradigm of the Firm
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Value creation
How?
I. The Financial Paradigm of the Firm
Objective: Maximizing Enterprise Value
Investment ecisions
Invest in assets offering areturn higher than therequired rate of return
[hurdle rate].
Financing ecisions
Find the optimal capital mixto finance investments andthe nature of debt whichbetter meets the needs of
the corporation.
ividend ecisions
Return to shareholders anycash exceeding investments
offering a return higherthan the expected rate of
return.
The hurdle ratemust reflect theinvestment risk
and thefinancing mix.
The return onthe asset must
take intoconsideration
the amount andtiming of cash-
flows
The optimal mixof equity and
debt maximizesenterprise value
The nature ofdebt depends
on thecharacteristics
of theenterprise
assets
How much cashto return willdepend on
present andfuture
investmentopportunities
Dividend policywill depend onshareholderspreference forcash or stock
dividends.
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Value creation
Questions for which a CFO might have to provide an answer:
Invest 25 million euros in increasing production capacity or wait for one
year to observe market demand performance? Implement or not a strategy of fixing:
commodity prices;
export exchange rates;
interest rate on loans?
How to finance the aggressive investment plan designed for the next three
years?
Implement or not a new management incentive scheme, based on
incentives to be decided upon?
I. The Financial Paradigm of the Firm
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Value creation
Questions for which a CFO might have to provide an answer:
To meet or not the demand of institutional investors for higher dividends?
Choose to offer stock dividends? Choose to offer stock repurchases? There is a merger proposal by a big telecom company. What to do?
Is it in the best interest of shareholders?
What will be the reaction by foreign joint venture partners?
Should the company remain listed in the stock market?
Should capital structure be consolidated through an increase in equity?
I. The Financial Paradigm of the Firm
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Value creation
One could argue that value creation cannot ignore the conflicts of
interest (agency conflicts), the power basis, as a function of
ownership structure, as well as the environment of the financialmarkets in which investment and financing operations will take
place;
Likewise, it can stated that the corporation is a nexus of contracts,
which constraint real world investment and financing decisions (and
make them more complex) .
I. The Financial Paradigm of the Firm
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I. O Paradigma Financeiro da Empresa
II. The Corporation and The Financial System
III. Os Instrumentos Financeiros e a Titulao de Activos e Capitais da
Empresa
Summary
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II. The Corporation and The Financial System
World
The Corporation
Investment
decisions
Financing
decisions
Financial
Markets
Investors
Financial
Intermediaries
Direct financing
Indirect financing
Exchange of capital and financial assets
Exchange
of capital
& real
assets
Corporate FinanceFinancial Markets and
Intermediaries
Financial
Assets
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A Classification of Financial Markets
II. The Corporation and The Financial System
FinancialMarke
tsMoney Market(S-T)
Capital Market
(L-T)
IMM
Commercial Paper[Corporate Debt]
Public Debt (Bills)
Equity
(Stocks)
Hybrid
Debt
(Bonds)[Government & Corporate]
Libor rates (Euribor)
Yields
Yields
Repurchase agreements
(REPO)
Sort-term bank loans
Commercial paper
Treasure bills (T-bills)
Common stocks
Preferred stocks
Convertible bonds
Warrant bonds
Perpetual bonds
Treasury bonds (T-bonds)
Corporate bonds (fixed rate &
float rate), zero-cupon
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Other important classifications of financial markets
Primary market vs. Secondary market
Cash market (spot market) vs. Futures market (derivatives)
Domestic market vs. Currency market
Domestic market vs. International market
II. The Corporation and The Financial System
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Financial Institutions
Credit Institutions
Central
BankBanks
OtherIntermediaries
Commercial
Banks
SavingsBanks
InvestmentBanks
Leasing
Companies
FactoringCompanies
Venture
Capital
Private Equity
Holding
Companies
Dealers
Other
Other Financial
InstitutionsAuxiliary Institutions
Insurance Companies
Pension Funds
Insurance Brokers
Brokers
Assets Management
Firms
Information Services
Other
The financial system
II. The Corporation and The Financial System
Mutual
Banks
Mutual Agro
Banks
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Financial institutions play a very important role
Intermediation of cash transfers (across space, across time, across
denominations);
Intermediation of financial operations; and
Intermediation in risk allocation (financial and non-financial risks)
They can thus contribute to market efficiency, but they are
nevertheless a source of transactions costs, one of market
inefficiencies.
II. The Corporation and The Financial System
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I. O Paradigma Financeiro da Empresa
II. A empresa no Sistema Financeiro
III. Financial Instruments and The Securitization of Assets and Capital of
the Corporation
Summary
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The securitization of financing contracts, as well as asset
securitization, grants:
Liquidity to the assets or to the rights represented by securities;
An objective basis for asset valuation (through market prices);
The benefit of regulation by market authorities and thus the
safeguard of the intrinsic quality of the assets;
An alternative financing solution, competing with bank financing;
The possibility of converting less liquid assets into cash.
III. Financial Instruments and The Securitization ofAssets and Capital of The Corporation
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Securitization
High growth in asset securitization operations in international
markets, a trend joined by a number of Portuguese Companies;
A very common solution amongst financial institutions:
It allows a conciliation of rapid business growth levels and of the assets
allocated to it with regulation requirements, namely those related with
solvency ratios;
It is a source of development of the financial markets, a driver of
financial innovation, and a factor of investment and financing
flexibility.
III. Financial Instruments and The Securitization ofAssets and Capital of The Corporation
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What is Corporate Finance?
Corporate finance encompasses all ofa firms decisions that have financial
implications
Aswath Damodaran, Corporate Finance, Theory and Practice (2ndEdition)
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What is a firm? Why it exist?
The existence of the firm compensated for a critical flaw in theprice-setting mechanism:
Transaction costs, like the need to negotiate or draw upcontracts
Firms would exist when it was cheaper and easier to co-ordinate activity within a centrally planned organisation thanto spell out contract details for every step in the production
process.
Ronald Coase, cited by The Economist, One of the giants on 7thSeptember 2013 (5 days after his death)