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.
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
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 Markets
Funds
Funds
Banks
Insurance Cos.
Brokerage Firms
Obligations
Depositors
Policyholders
Investors
Obligations
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 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• 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.