The Corporation

730g32 HT 2012Fundamentals of Corporate Finance

BMMLecture 4: Chap. 1 & 2 & 3: Financial decisions,

Financial institutions, performance measure

LEARNING OBJECTIVES

Chapter 1• Understand the definition of a corporation• The role of the financial manager in a

corporation.• Functions of financial markets.• Principal-agent problems, agency costs and

information asymmetries.

Chapter 1• Understand the definition of a corporation• The role of the financial manager in a

corporation.• Functions of financial markets.• Principal-agent problems, agency costs and

information asymmetries.

Corporations • two types of financial decisions that are made

in a corporation: investment decisions and financing decisions.

• Financial managers are responsible for both decisions!

Investment decisions

Financing decisions

Financial Market

Corporation

• Corporation– A business organized as a separate legal entity owned

by stockholders. – Or a nexus of contract between legal entities.

• Types of Corporations– Public Companies– Private Corporations, sole proprietorships– Partnerships– Etc.

Organizing a BusinessSole

Proprietorship Partnership Corporation

Who owns the business?

The manager Partners Stockholders

Are managers and owners separate?

No No Usually

What is the owner's liability?

Unlimited Unlimited Limited

Are the owner and business taxed

separately?No No Yes

Corporate Structure

Sole Proprietorships

Corporations

Partnerships

Limited Liability

Corporate tax on profits +

Personal tax on dividends

Unlimited Liability

Personal tax on profits

Who is The Financial Manager?

• Chief Financial Officer (CFO)– Oversees the treasurer and controller and sets

overall financial strategy.• Treasurer

– Responsible for financing, cash management, and relationships with banks and other financial institutions.

• Controller– Responsible for budgeting, accounting, and taxes.

Who is The Financial Manager?

Chief Financial Officer

Treasurer Controller

Definitions

Capital Budgeting Decision– Decision to invest in tangible or intangible assets.

…also called the Investment DecisionFinancing Decision

– The form and amount of financing of a firm’s investments.

Capital Structure (D/E ratio)

• Capital StructureThe proportion of debt vs. equity financing.1.Debt/Equity ratio, a multiple of debt over equity. Can be tricky when equity becomes small.2.D/(E+D) debt asset ratio measures the indebtedness of the company. ranging from 0 to 100%.Market capitalization: the company´s total amount of shares outstanding times the share price.

Distinguishing Real Assetsand Financial Assets

• Real Assets– Assets used to produce goods and services.– examples: Patents, Machines, a new pipeline, etc

• Financial Assets– Financial claims to the income generated by the

firm’s real assets.– Examples: stocks, bonds, bank loans

The Goals of the corporation

• Firm Value maximization: I. Anglo-America model: shareholder interests II. Continental European model: Stakeholder interests

which include all claimants who has a vested interest in the company, for example, the supplier, the workers union, the local government, tax authority, etc.

Is it just a conceptual dispute? Most firms do maximize Firm value taken into

consideration of the stakeholder interests: That is to say, Corporate Social Responsibilities, ethics

of corporation add value to the firm.

Corporate governanceand Agency problems

• Shareholder oriented model: US, UK1. Professional managers, principal-agency problems,

agency costs, 2. Monitoring type: Shareholder meeting, institutional

ownership, specialist monitoring3. Market for corporate control: hostile takeovers

• Stakeholder oriented model: continental Europe1. Big shareholder control, long term ownership, Less

agency costs, Less problem of investor protection, specialist

2. Bank monitoring, Shareholder Meeting, friendly takeover

Asymmetric information and Principal agency problem

Managers know more about the corporation including:•Stock price movement and returns•Issues of shares and other securities•Dividends decision•Financing Managers may have their own goals other than shareholders´.

Agency Problem Solutions

1 – Management Compensation plans2 - Board of Directors3 – Market for corporate control:

Takeovers4 - Specialist Monitoring5 - Legal and Regulatory Requirements

Chap 2. Financial Markets and Institutions

Learning objectives•The Importance of Financial Markets and Institutions•The Flow of Savings to Corporations•Functions of Financial Markets and of Financial Intermediaries•Value Maximization and the Cost of Capital

Financial Markets

Primary

Markets: issuing stocks, bonds

Secondary

Markets: trading

stocks, bonds

OTC

Markets: forex

trading

Money

Financial Markets

Company

Issue Securities

Cash

InvestorsCash Reinvested

Corporation

Investment in real assets

Investorsworldwide

Financial markets

Stock marketsFixed-income marketsMoney marketsMarkets for Commodities Foreign exchange Derivatives

Financial Intermediaries:

Mutual Funds Pension funds

Financial Institutions

Banks Insurance companies

Reinvestment

Financial Markets

Financial InstitutionsCompany

IntermediariesBanks

Insurance Cos.

Brokerage Firms

ObligationsObligationsFundsFunds

Financial InstitutionsIntermediaries

InvestorsDepositors

Policyholders

Investors

ObligationsFunds

Financial Markets

Funds

Funds

Banks

Insurance Cos.

Brokerage Firms

Obligations

Depositors

Policyholders

Investors

Obligations

Company

Intermediary

Investor

Financial Markets

Banks

Depositors

$2.5 m

Cash

Loan

Deposits

Company

Intermediary

Investor

Financial Market: some definitions• Financial Market is a market where securities are

issued and traded.• A security is a traded financial asset. Shares,

bonds, asset backed securities, options, etc.• Fixed income market: market for debt securities,

for example, treasury bills, corporate bond, etc.• Capital market: market for long term financing,

e.g. stocks, long term bonds, etc.• Money market: market for short term financing,

less than 1 year.

Function of Financial Markets

• Transporting cash across time• Risk transfer and diversification• provide Liquidity• Payment mechanism• Provide useful information for all: commodity

price, cost of capital, interest rate, exchange rate, share price, etc.

U.S. Financing

Information Provided by Financial Markets• Commodity prices• Interest rates• Company values Credit Rating Interest Rate

AAA 5.71%AA 5.78A 6.38BBB 7.12BB 9.84B 10.82

Source: Bloomberg Composite Corporate BondIndexes.

Interest rates on 30-year corporate bonds,February 2008.

Opportunity cost of capital

• Cost of capital: minimum acceptable rate of return on capital investment .

• The investors can invest in financial market and get expected rate of return on the investment at a similar risk level. This expected rate of return in the market determines the firm´s cost of capital.

• Opportunity cost of capital: the best possible investment forego by the investor is the opportunity cost of capital for the firm.

Chapter 4 Measuring corporate performance

Important issues! Very relevant for business lawyers.•Measuring Profitability•Measuring Efficiency•Analyzing the Return on Assets: The Du Pont System•Measuring Leverage•Measuring Liquidity•Interpreting Financial Ratios

Importance of accounting data

Performance evaluationFinancial decisions Financial decisions

Accounting data Accounting data

Value and Value Added

• Market Capitalization– Total market value of equity, equal to share price

times number of shares outstanding.

• Market Value Added– Market capitalization minus book value of equity.

share)per (priceshares) (# tion CapitalizaMarket

ValueBook Equity -tion CapitalizaMarket MVA

Value and Value AddedPepsiCo Balance Sheet (December 31, 2006) $Millions

Value and Value AddedPepsico Income Statement (year end 2006)

Net Sales 35,753COGS 15,762Selling, G&A expenses 11,530Depreciation expense 1,406EBIT 7,055Net interest expense 66Taxable Income 6,989Income Taxes 1,347Net Income 5,642

Market-to-Book Ratio: performance measure

• Market-to-Book Ratio– Ratio of market value of equity to book value of

equity.

76

36815$

457102$

equity of book value

equity of uemarket valratiobook -to-Market

.

,

,

Market-to-Book Ratio

• Stock market measures of company performance, 2006. Companies are ranked by market value added. (dollar values in millions)

Measuring Profitability

• Economic Value Added (EVA)– Net income minus a charge for the cost of capital

employed. Also called residual income.

• Residual Income – Net Dollar return after deducting the cost of

capital

Equity Equity ofCost - IncomeNet

Income Residual

EVA

Measuring Profitability

• Economic Value Added (EVA) of PepsiCo

Equity Equity ofCost - IncomeNet

Income Residual

EVA

million $4,527

14,251.095 - 5,642

Income Residual

EVA

Obs: the equity figure is the from the end of 2005, because this was the equity employed in the year 2006.

Measuring Profitability

• Return on Equity (ROE)– Net income as a percentage of shareholders’

equity• Return on Capital (ROC)

– Net income plus Interest as a percentage of long-term capital.

• Return on Assets (ROA)– Net income plus interest as a percentage of total

assets

Measuring Profitability• Accounting measures of company performance, 2006.

Companies are ranked by return on equity.

Measuring Profitability

396.14,251

5,642

equity

incomenet =equityon Return

185.31,727

2395,642=

assets total

Interest IncomeNet =assetson Return

355.564,16

2395,642

equity debt termLong

Interest IncomeNet =capitalon Return

PepsiCo Profitability Measurements

Measuring Efficiencyyear ofstart at assets total

Sales=ratioover Asset turn

assets totalAverage

Sales=ratioover Asset turn

OR

13.131,727

35,753

year ofstart at assets total

Sales=ratioover Asset turn

16.12/)930,29(31,727

35,753

assets totalAverage

Sales=ratioover Asset turn

OR

For PepsiCo

Measuring Efficiency

sold/365 goods ofcost

year ofstart at inventory =Inventoryin Days Average

year ofstart at inventory

sold goods ofcost =ratioturnover Inventory

salesdaily average

year ofstart at sreceivable=period collection Average

year ofstart at sreceivable

sales=Turnover sReceivable

The DuPont model

total sales Net Income interest paid ROA= x

assets total sales

Assetturnover

Profitmargin

Net Income interest paidROA=

assets

Measuring Leverage

equity+debt termlong

debt termlong=ratiodebt termLong

equity

debt termlong=ratioequity Debt

Measuring Leverage

total liabilities Total debt ratio=

total assets

paymentsinterest

EBIT=earnedinterest Times

EBIT+depreciation Cash coverage ratio=

interest payments

Measuring Leverage

interestIncomeNet

IncomeNet x

sales

interestIncomeNet x

assets

salesx

equity

assets=ROE

leverageratio

assetturnover

Operating profitmargin

debtburden

The DuPont Model

• A breakdown of ROE and ROA into component ratios

sales

Interest IncomeNet =MarginProfit Operating

sales

IncomeNet =MarginProfit

Measuring Liquidity

Net working capital Net working capital=

to total assets ratio Total assets

current assetsCurrent ratio=

current liabilities

sliabilitiecurrent -assetcurrent capital gNet workin

Liquidity Ratios

sliabilitiecurrent

securities marketable+cash=ratioCash

sliabilitiecurrent

sreceivable+securities marketable+cash=ratioQuick

Sustainable Growth

ratiopayout -1=

earnings

dividends-earnings=ratioPlowback

earnings

dividends=ratioPayout

Interpreting Financial Ratios• PepsiCo Ratios

Interpreting Financial Ratios• PepsiCo Ratios (continued)

Interpreting Financial Ratios• Selected 2006 financial ratios for industry groups in Standard & Poor’s

Composite Index

Accounting information and market information are important

• The market demand transparency of company information!

• this is to ensure fairness for all the market participants to make informed decision.

• Efficient market is characterized of efficient information revealing.

Next topic: Valuing stocks!