Welcome to the marvelous world of Corporate Finance

 

Fortunately, most of Chapter 1 & 2 will be remarkably familiar, so feel free to skim quickly!

 

Chapter 1: Introduction to Corporate Finance

 

1.1       What is Corporate Finance?

We are concerned with the study of the following three questions:

• In what long-lived assets should the firm invest? (Capital budgeting and capital expenditures)
• How can the firm raise cash for required capital expenditures? (Capital structure i.e. ratio of debt/equity)
• How should short term operating cash flows be managed? (net-working capital)

 

The balance sheet model of the firm

Assets (LHS):

• Current or fixed
• Fixed assets are tangible (e.g. machinery) or intangible (e.g. trademarks)
• Current assets have short lives (inventory)

 

Financing (RHS):

• Debt: firm sells pieces of paper called loan agreements (sold to creditors)
• Equity: firm sells stock certificates (sold to shareholders)
• Short term debt = current liability (must be repaid within 1 year, otherwise is Long term),
• Net working capital = current assets – current liabilities

 

Capital Structure

• V = B + S
• V (Value of the firm) = B (value of debt, from bondholders) + S (value of equity, comes from shareholder)
• Capital budgeting and capital expenditure decisions:

• Firms must make decisions about capital structure – that is, the mixture of debt and equity.

 

The Financial Manager

Financial managers create value by ensuring:

• The firm tries to buy assets that generate more cash than they cost
• The firm sells bonds and stocks and other financial instruments that raise more cash than they cost

Some lovely diagrams here about: how finance managers fit into the organization (pg 6) & Cash flow diagram (pg 7). (Nothing new here.)

Corporate finance focuses on cash flow (rather than GAAP-type record of unrealized sales).

Issues related to cash flow include: identification, timing and risk associated

 

1.1 Corporate Securities as Contingent Claims on Total Firm Value

§         Debt & Equity differ primarily because of the contingent claims on them. They are contingent because the amount paid depends on the value of the firm.

§         At the end of a given year debt-holders will collectively receive either the full value they are owed, or the full value of the firm, whichever is less

§         Stockholders (equity holders) are entitled to the residual amount after the debtholders have been paid. This can even be nothing, if the amount owed to debtholders equals or exceeds the value of the firm at the end of the year.

 

1.2 The Corporate Firm

Although we see a lot of corporations, there’s more than one way to do business:

The sole proprietorship:

• Cheap & easy (no taxes, few regulations)
• High risk - unlimited liability.
• Last as long as the proprietor does
• Funded only by proprietor’s personal wealth

The Partnership

• Need two or more people.
• General partnerships – all partners do some work and share loss/profit (unlimited liability)
• Limited partners – liability of some partners limited by vol. of contribution
• Also cheap & easy (some admin involved though)
• Terminated when partner dies or withdraws
• Tax is on personal income of partners
• Management control held by all partners (becomes difficult to manage for large organizations)

The Corporation (the “most important”)

• Require articles of incorporations and a set of bylaws
• Ownership is easily transferred
• Intended life of firm can be forever
• Shareholder’s liability limited to amount invested in ownership

 

1.3 Goals of the Corporate Firm

Agency costs and the Set-of-contracts perspective

 

• ‘Set-of-contracts’ – the firm can be viewed as a set of contracts. Equity contract between principals (shareholders) and agents (managers), each acting in self interest
• Agency costs: the cost of resolving conflicts of interest between managers and shareholders. Either monitoring costs or control costs.
• Residual losses: lost wealth of shareholders due to divergent behavior of the managers

Managerial Goals & Separation of ownership and control

• Not always aligned with shareholders. Managers try to survive, and strive for independence and self-sufficiency.
• Managers basic financial objective: maximize corporate wealth, often via growth (not the same as shareholder wealth, because increased growth and size aren’t necessarily the same things as increased shareholder wealth)

 

1.5 Financial Markets

• Capital markets – long term debt (> 1 yr) and equity shares
• Money markets - markets for short term (<1 yr) debt. Dealer markets. Dealer is principal in most transactions (different to sock broker acting as an agent – who don’t acquire the securities)
• Primary market – used when corporations and govt’s initially sell securities
• Secondary market – after first sale, then traded in secondary markets: either auction (85% of all share trading  - eg. NYSE, and regional exchanges) or dealer markets (most debt securities traded in dealer markets)
• To apply for listing (i.e. be eligible to trade) on the market market, certain critiera for profitability, share numbers, asset base and earning power etc. must be met (eg. for NYSE $2.5m before tax for previous year)

 

 

Chapter 2: Accounting Statements and Cash Flows

(skip this if you were awake even once in accounting)

 

2.1 The Balance Sheet

• Equation: Assets = Liabilities + Equity
• Balance sheets balance

Keep in mind the following three things when looking at a balance sheet:

1.      Accounting Liquidity: the ease and rapidity with which assets can be turned into cash. From most liquid to least:

a.      Current assets (includes cash)

b.      Accounts receivable

c.      Inventory

d.      Fixed assets (n.b. Not all fixed assets are tangible e.g. trademarks).

2.      Debt vs. Equity: liabilities – obligations of firm that require cash payout; debt service – a nominally fixed cash burden. Stockholders equity is a residual claim against the assets (we covered this in chapter 1 too, see 1.1)

3.      Value vs. Cost: accounting value of a firm’s assets is often called the ‘carrying value’ or ‘book value’, but don’t be fooled, as we know, the term ‘value’ is a misnomer – these are based on costs. Only market value is the price at which buyers and sellers are wiling to trade. For Market value and book value to be the same would be a coincidence.

 

2.2   The Income Statement

 

Equation:  Revenue – Expenses = Income

When reviewing an income statement, keep in mind the following:

1. Generally accepted accounting principles imply that revenue is recognized when the earnings process is virtually completed, even if no cash flow has necessarily occurred
2. Noncash items include: depreciation, deferred taxes – these need to be excluded from cashflow analysis
3. Time and Costs – all costs are variable in the long run. Financial accountants don’t distinguish between variable and fixed costs. Accounting costs are typically classified as product or period costs, where product costs are the total production costs incurred during a period (eg. Raw materials). Period costs are costs that are allocated to a time period (eg. Selling, general and admin)

 

2.3 Net working capital

 

• Current assets – current liabilities = net working capital
• Change in net working capital is: net working capital in 19X2 – net working capital in 19X1

 

2.4 Financial Cash flow

 

Cash flows received from the firm’s operating activities (assets) CF(A) must equal the cash flows to firm’s creditors CF(B) and the equity investors CF(S)

 

CF(A) = CF(B) + CF(S)

 

Total cash flow generated by the firm’s assets are the sum of cash flows from:

• Operations (generated by business activities, it includes tax payments, but not financing, capital spending or changes in net working capital.)
• Changes in fixed assets (sales of fixed assets - acquisition of fixed assets = capital spending)
• Changes in working capital

 

In their example then (pg 27-28):

• Total cash flow of the firm = operating cash flow + capital spending + additions to net working capital
• The amount of cash paid to creditors = interest + retirement of debt – proceeds from long term debt sales
• The amount of cash paid to stockholders = dividends + repurchase of stock – proceeds from new stock issues

 

Chapter 7 Net present value and Capital Budgeting

(pg 161-170)

 

This chapter discusses how discounted cash flow (DCF) analysis and net present value (NPV) analysis are used in capital budgeting decisions. The section covered here however is about cash flow calculations

 

7.1 Incremental Cash Flows:

 

Corporate Finance and Accounting differe because finance is all about cash rather than earnings.

 

In calculating the NPV of a project, we are interested in the difference between the cash flows of the firm with the project and the cash flows without the project.

 

Sunk Costs

Those that have already occurred. They shouldn’t be taken into consideration in capital budgeting decisions. “Let bygones by bygones”. (Example – consultants fees paid to investigate project viability)

 

Opportunity Costs

Lost revenues can meaningfully be viewed as costs. (Example - the cost of the use of a warehouse to store pinball machines. If it wasn’t used in this way, the opportunity cost of putting it to some other use, such as leasing or selling the warehouse, needs to be taken into consideration.)

 

Side Effects

What impact will the project have on other parts of the firm? Erosion is that cash flow transferred to a new project from customers and sales of other products, e.g. cannibalization. (Example – a new convertible car, not all new sales will be incremental, because some existing customers may buy this car instead of another one from the company)

 

7.2 The Baldwin Company: An Example

 

Key highlights:

• Analyze the investments made:
• Assets purchased
• Opportunity costs
• Investment in working capital
• Even though we care about cash, we must look at the income to determine taxes; and we must identify how much depreciation has been included in the income
• Cash flow from project  = Cash flow from ops (sales – operating costs – taxes) + total investment cash flow

 

• We’re interested in the books prepared for tax purposes (because tax paid is a cash expense)

 

Net working capital

Comes from:

§         raw materials & inventory purchase prior to the sale of finished goods

§         cash kept in the project as a buffer

§         credit (rather than cash) sales made

It is a cash outflow because cash generated elsewhere in the firm is tied up in the project

 

Net working capital = accounts receivable. – accounts payable + inventory + buffer cash

 

Interest expense

Typically not considered in cash flows, any adjustment for debt is reflect in the discount rate, since the assumption is usually made that the project is finance only with equity, not debt.