CF I Fundaentals of Financial Management Winter Term 2009

Winter Term 2009 1Markus Neuhaus I Corporate Finance I [email protected]

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

Corporate Finance: Course overview

18.09. Fundamentals (4 hours) M. Neuhaus & M.Schmidli 25.09 Investment Management M. Neuhaus & P. Schwendener 02.10. Business Valuation (4 hours) M. Neuhaus & M. Bucher 09.10. No Lecture No Lecture 16.10. Value Management M. Neuhaus, R. Schmid & F. Monti 23.10. No Lecture No Lecture 30.10. No Lecture No Lecture 06.11. No lecture No Lecture 13.11. Mergers & Acquisitions I&II (4 hours) M. Neuhaus & D. Villiger 20.11 Tax and Corporate Finance (4 hours) Markus Neuhaus 27.11. Legal Aspects R. Watter 04.12. Financial Reporting M. Neuhaus & M. Jeger 11.12. Turnaround Management M. Neuhaus & Markus Koch

18.12. Summary, repetition M. Neuhaus


• Grade CEO• Qualification Doctor of Law (University of Zurich), Certified Tax Expert• Career Development Joined PwC in 1985 and became Partner in 1992. • Subject-related Exp. Corporate Tax

Mergers + Acquisitions• Lecturing SFIT: Corporate Finance, University of St. Gallen: Tax Law

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 4000Email: [email protected]


Marc SchmidliPricewaterhouseCoopers AG, Zürich

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

• Grade Director• 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 LiteratureFinanzielle Qualität in der schweizerischen Elektrizitätswirtschaft

Various articles in „Treuhänder“, HZ, etc.


Contents

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


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


Contents



Pre-course reading

Books Mandatory reading

Brigham, Houston (2009): Chapter 2 (pp. 26-50) Optional reading

Brigham, Houston (2009): Chapter 1 (pp. 2-20) Volkart (2008): Chapter 1 (pp. 41-68) Volkart (2008): Chapter 7 (pp. 565-591)

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


Contents



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


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


Agenda: Introduction

Setting the scene

Who is the financial manager?

Roles of financial managers

Shareholder value vs. stakeholder value concept


Setting the scene I

(1) cash raised by selling financial assets to investor(2) cash invested in the firm’s operating business and used to purchase real assets(3) cash generated by the firm’s operating business (4) reinvested cash(5) cash returned to investors

Firm‘s operations

(a bundle of real assets)

Capital markets(equity, debt,

bonds), Shareholders,

other stakeholders

Financialmanager

(e.g. CFO)

(1)(2)

(3)

(4)

(5)

Company “Environment”

Source: Brealey, Myers, Allen (2008), 5.


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


Who is the financial manager?

Chief Financial Officer (CFO)(responsibilities:

e.g. financial policy,corporate planning

Treasurer(responsibilities: e.g. cash management,

raising capital, banking relationships)

Controller(responsibilities: e.g. preparation of

financial statements, accounting, taxes)

Source: Brealey, Myers, Allen (2008), 7.


Roles of financial managers

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

pire

bui

ldin

g,

inde

pend

ence

, Hig

h sa

larie

sS

table growth,

Dividends, control

Illustration: Agency dilemma


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)


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)


Agenda: Financing a business

External financing

Internal financing

Asymmetrical information

Pecking order theory

Capital structure


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

Exte

rnal

Inte

rnal

Pecking order theory diagram

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


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)

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 (2008), 567.

Financing impact fromvalue of depreciation


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 (2008), 569ff.

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


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



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



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


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



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

- equitydebt- internal

internal


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

EquityDebt Leverage Financial Equity to Debt

Financial risk increases as the company chooses to use more debt

What is the optimal capital structure?



Agenda: Financial markets

Different types of markets

Financial institutions

Financial instruments

EMH


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 (2009), 28f.


Financial markets

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

Recent trends: Globalization of financial markets Increased use of derivative instruments (especially as 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.

Source: Brigham, Houston (2009), 30ff.


Financial Institutions

Commercial banks Investment banks Financial services corporations Insurances Mutual funds Hedge funds

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 e.g. UBS are disposing of certain business divisions and focus on core competences. This trend will continue for regulatory reasons (lower risks, de-leveraging, …) and some trends towards nationalization and “home market” focus in the banking sector.



Financial instruments

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 recquired.

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


Efficient market hypothesis (EMH)

The EMH states that(1) share prices are always in equilibrium(2) the prices reflect all available information (on opportunities, 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 not machines that can process all available information.This may lead to the fact that irrational factors come into play

behavioral finance


Opportunities due to inefficiencies

Pure luck Any investor or individual might just be lucky and have bought stock yielding far

better returns than expected Insider knowledge

If an investor has access to insider information, he can take advantage of it. In order to guarantee a fair market, insiders must be excluded from trading ( laws against insider trading)

Other possible inefficiencies: Under-reaction Uncertain valuation Overshooting

Source: Spremann (2007), 202.

The exploitation of inefficiency leads to efficiency


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

Documents

CF I Fundaentals of Financial Management Winter Term 2009