10. Corporate FInance in a Global World

8/10/2019 10. Corporate FInance in a Global World

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Corporate Finance 1

Corporate Finance in a globalworldPart 1

QuestionsConcepts

& Definitions


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Corporate Finance 2

Investment Questions What is value?

How is it measured?

What is risk? What is an example of a risk free

investment?

Why might investors be risk adverse


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Corporate Finance 3

Investment Questions

What is a company? How do companies:

Finance their investments & operations? Create value?

Who are the owners of a public company?

In a financial sense, what is an employee?


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Corporate Finance 4

Investment Definition of investment: Choosing among market alternatives in order to

achieve a financial objective

Choosing among competing investment optionsbased on a explicit investment goal

Financial objective or investment goal: maximizing investor wealth In real estate context: maximizing property

value


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Corporate Finance 5

Investment Definition of investment decision:

The decision to commit certain current orfuture cash outflows in return for risky (or atrisk) cash inflows

Here at risk has two components: Expected required outflows (especially future,

undefined outflows) may not match actual requiredoutflows

Actual inflows may not equal expected inflows


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Corporate Finance 7

Risk: Two Major Categories Systematic or Market

Non-diversifiable

Change in asset prices due to shifts in: General economic conditions Market wide movements

Insurance: Asset Allocation


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Corporate Finance 8

Risk: Two Major Categories Unsystematic, specific or

idiosyncratic risk

Specific to company Independent of shifts in:

General economic conditions Market wide movements

Insurance: Diversification ???


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Corporate Finance 9

Risk Market compensates for systematic risk

Can diversify to lessen specific risk Diversification does not lower systematic risk

Overall economic and market trends affect allinvestments The issue is how much they effect each investment And, the overall effect on a portfolio (covariance)

So: the risk of a well diversified portfoliodepends on the weighted market/systematicrisk of the securities in that portfolio


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Corporate Finance 10

5 Classic Risks: Operating/Market Definition: The possibility that expected net income is not equal to

actual net income due to changes in market Sensitivity of firm operating c/f to general economic

conditions

Result: Decreased income to meet financial obligations

Causes: Shifts in supply and/or demand, or rates, or. ..


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5 Classic Risks: Inflation

Definition: possibility price increases will exceed

expected price increases. Sensitivity of firms assets change in

price due to general economic conditions Result: decreased future purchasing

power

Causes: Changes in monetary policy Change in economic cycle


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5 Classic Risks: Political/Country Definition:

Relative risk of country in which a firm is located.Sensitivity of firms results to changes in legal structureor to changes in the country credit rating

Result: increased expenses and/or decreasedincome (or expropriation?)

Causes include: Taxes and duties Zoning & Operating Rules

Social legislation Downgrade of country credit


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Risk: Five Classic Types

Systematic events Interest rates increased (decreased) 9/11 and/or war Investors exit the stock market

Many other specific risks: Embezzlement Competitor develops new process Managers fail to formulate or execute strategy Big event:

Microsoft fine for competitive practices Arthur Andersen senior partners role in Enron scandal Conrad Hilton sale of large block of stock


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Risk and return tradeoff

Key risks are operating/market andfinancial risks

Line between systematic & unsystematic Not clear, a matter of degree Ask: to what degree does the event affect

the entire market?


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Degree Markets Are Efficient Perfect: market always correctly prices all assetsat all times

Perfect in the long run Pricing mistakes may occur, but do not endure Arbitrage opportunities may exist, but only for very

extremely short periods and on a limited basis

Imperfect Pricing mistakes occur and endure over significant time

periods Opportunities for arbitrage (???) exist (& exist over

extended period of time)


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3 Views of Return: Actual &

Expected Actual return (ex post or after the fact) The realized yield Risk and time adjusted relation between actual

cash outflows in relation to cash inflows Expected Return (ex ante or before the fact)

The forecast yield The anticipated risk and time relation between

cash outflows in relation to cash inflow


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3 Views of Return: Required The required yield for an investor toselect this investment

The minimum actual return that isacceptable to an investor given the risk associated with an

investment versus other investment opportunities)


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Investment Decision Rules Rule 1: (very weak): invest in project X ifand only if ( iff ): Expected return of project X > expected

return of project Y

Rule 2 (better): invest in project X if andonly if: Expected return > or = required return


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Investment Decision Rules Rule 3: (better still): invest in projectX if and only if : Expected return >= required return and:

Required return accurately reflects the riskof project X

Expected return reflects the best returnper unit of risk among investmentalternative


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Investment Decision Rules Theoretical and practical issueswith rule #3:

A. How do we know when therequired return accurately reflectsthe risk of project X?

B. How do we measure return perunit?


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Investment Decision Rules Suggested answer to A: Stay tuned in during the course.

Probably never have certaintyor elsethere would not be risk!


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Investment Decision Rules Suggested answer to B: Mean estimated/probable return divided

by standard deviation Coefficient of variation

Statistical measure: Information that may not be readily

available Approach: simulations


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Some Basic Concepts ofFinance

= profit = revenue minus cost Time value : an amount received today has

more value than a promise (for the sameamount) in the future* Assumes inflation is generally the case Assumes individuals would rather consume today with

certainty than bear the risk of waiting


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Some Basic Concepts ofFinance

Risk and return : investors requirecompensation for real (and perceived) risks.That compensation involves a return of and areturn to invested capital.


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A Corporation As A BalanceSheet

Current Assets

Fixed Assets: Tangible

Intangible

NetworkingCapital

CurrentLiabilities

Long-termDebt

Shareholders

Equity


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Balance Sheet View of CorporateFinance

Issue 1: Invest in which long-term assets? Capital budgeting and capital expenditures Left hand side: Fixed Assets

Issue 2: Method to acquire resources required forinvestments in long term assets: Capital structure Right hand side: current & long term liabilities plus

equity


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Balance Sheet View of CorporateFinance

Issue 3: Management of operatingcash-flow Address the mismatch between inflows and

outflows, or conservation of net workingcapital

Both sides: current assets minus current

liabilities


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To Impact Firm ValueAn Action Must Affect:

1. Current cash flow2. Or, future growth

3. Or, length of growth above long-termaverage

4. Or, discount rate (cost of capital)

If an action does not affect theseitems, it cannot affect value

#1 I C h Fl O


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#1: Increase Cash Flow OnAssets

Category Potential Action + Revenues

* Operating Margin Cut costs or increase efficiency = EBIT Sell assets with negative EBIT

- Tax Rate * EBIT Decrease tax rate (move to low . tax area, manage risk) = EBIT (1- tax rate) + Depreciation - Capital Expenditures Use past over-investment - Change in work. Cap. Change inventory management . and/or credit policy

= Free Cash Flow From Operations


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#2: Increase Future Growth

Category Potential Action

+ Reinvestment Rate Increase to acquire

additional . productive assets

* Return on Capital Increase operating margins Increase capital turnover

= Expected Growth Rate

#3: Increase Period of


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#3: Increase Period ofGrowth

Build on existing competitive advantages or barriersto entry, or find new ones.Category Potential Action Brand Use to generate above market . returns Legal protections Obtain patents or licenses or . government sanctioned . monopolies Switching costs Make customer switch to

. competitor more expensive Cost advantages Economies of scale or own . distribution or get exclusive rights . or reduce product development . costs/cycle


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Many Actions Are Value Neutral(to the firm)

Stock splits Issue new share for each share outstanding Cuts price per share, but should not impact

value

Stock dividends Return money to the shareholders

Does mean the funds are not available forinvestment by the firm


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Many Actions Are Value Neutral(to the firm)

Accounting choices that affect reportedearnings (not taxes or cash flow) Shift inventory valuation (LIFO to FIFO) Changes in depreciation methods for reporting

Non-cash, non-deductible restructuring charges Pooling vs. purchase method for reporting

acquisitions

Creating new securities for existing assets Tracking stocks New classes of bonds (with no cash effects)


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Return Measures

Many different measures ofreturn

Some specific to an industry or investment

type Some favored by certain groups or

professions


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Return Measures

Criteria for a good measure of return1. Cash flow: based on cash flow2. All-inclusive: Incorporates all cash flow

regardless of when received

3. Time: adjusts for timing of outflowsand inflows4. Unambiguous: one answer5. Guidance: provides clear guidance for selection

Independent Options: acceptance independent of otherproject choices

Mutually Exclusive Options: if accept A, then haverejected B


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Common Return Measures

Payback period Time until initial cash outflow is offset by

cash inflows

Discounted payback also used, but does notincorporate all cash flow

Average accounting return

Average net income/average book value Cut-off arbitrary, not all cash & does not use cash


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Common Return Measures

Cash-on-cash Cash flow/ invested cash (equity)

Discounted Cash Flow Net Present Value Internal Rate of Return


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Time Value Computations Present Value of an amount A received nperiods in the future

i = the discount rate t = number of periods A = single, lump sum payment

t A i A PV

)1(1

CHF millionCHF PV 57.72)1.1(

1000,000,1)1( 100


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Time Value Computations

Future Value, n periods in the future, ofan amount that is received now:

i = the investment rate t = number of periods A= a single, lump sum amount

t

A i A FV )1(

CHF millionCHF FV 000,000,1)1.1(*57.72)1( 100


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Building Blocks: annuity factors

An annuity is a cash flow received (paidor credited) in equal increments overequal increments of time

Examples include: An amortizing mortgage A fixed rate bond or a zero coupon bond Lottery winnings (lump sum is not selected)

i

ia PV annuityof Value

t

a)1(1


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Building Blocks: annuity factors

The formula for the present value of anannuity is:

a = the amount received each period i = the interest rate earned on an

investment or the required return t = number of equal time periodsNote: (1+i)-t = 1/(1+i)t

i

ia PV annuityof Value

t

a

)1(1


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PV of an Annuity

Part 2: a/(1+i)^n = a/FV factor (or a * discount rate) Translate the annuity payment with the future

value factor as a capitalization rate

So: PVA = is value of the annuity amount given the interest

rate minus increment of value lost due to receipt of

payment over time


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Key Terms Concepts Risk and return Value Investment At risk Risk Averse or aversion Arbitrage

Return measures & Decision Rules: Net Present Value (NPV) Internal Rate of Return (IRR)


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Key Terms Classes of risk: Systematic or Market Unsystematic or specific or firm

Types of risk:

Market/Operating Inflation Political or Country Financial Liquidity

Types of Return Actual Expected Required


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Key Terms Symbols

or profit or root of a number product operator equivalency

approximately summation operator change or delta > greater than less than Lne and Log 10 ex

Others

Exponents Logarithms Annuity

Annuity factor Annuity payment

Present Value & FutureValue PV or FV Factors

Discount rate Discounted Cash Flow

Analysis Yield Interest rates

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10. Corporate FInance in a Global World