Introduction to Corporate Finance

Edward M. Erasmus, MA Lecturer University of Aruba January 12th, 2013

Introduction lecturer
Head of Operations @ Free Zone Aruba NV Part-time lecturer @ the University of Aruba (FEF, FAS) Lecturer, speaker and facilitator Professional areas: accounting & control, public finance, strategy, marketing, financial management, operations management, financial analysis.

Head of Operations @ FZA

A head of operations oversees an entire company, monitoring all resources and its finances. Responsibility areas: Budgeting, administration & financial reporting Information & Communication Technology Human resource management Security and maintenance of the Free zones Marketing and development of the Free zones Advice / support to internal colleagues

Introduction lecturer
Contact info: Blog: http://edwardmerasmus.wordpress.com LinkedIn: http://www.linkedin.com/in/edwardmerasmus Slideshare: http://www.slideshare.net/e.erasmus Facebook: http://www.facebook.com/edwardmerasmus Twitter: http://www.twitter.com/em_erasmus Instagram: http://www.instagram.com/em_erasmus

Roadmap for Today

What is corporate finance?
Role of the CFO / financial manager

The goal of financial management

Overview of financial markets

Rethinking corporate finance

Some fundamentals
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WHAT IS CORPORATE FINANCE?

What is Corporate Finance?

Corporate finance is a specific area of finance that analyzes the financial decisions of corporations. - Investment or capital budgeting decisions - Financing decision - Day-to-day operations

3 Key Questions in Corporate Finance

1. What long-term investments should the firm undertake? Capital budgeting decision 2. What is the best way to finance these long-term investments? Debt or equity? Capital structure decision 3. How should the firm manage its shortterm assets and liabilities, such as cash? Working capital managment
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1. Capital Budgeting
Process of planning and managing a firms long-term investments. Financial manager identifies investment opportunities that are worth more to the firm than they cost to acquire. Example: A chocolate firm deciding whether or not to open a new factory is a capital budgeting decision.
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Key Questions
How much cash does the firm expect to receive? - size of cash inflows and outflows When does the firm expect to receive it? - timing of cash flows How likely is the firm to receive it? - riskiness of cash flows
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2. Capital Structure
How should the firm obtain and manage the long-term financing it needs to support its long term investments? Capital Structure is the specific mix of short-term debt, long-term debt and equity. Raising long-term financing can be expensive, so the different possibilities must considered carefully.
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Key Questions
How should the firm pay for its assets? Debt or equity? How much should the firm borrow? What is the least expensive source of funds? How, when and where to raise the money?

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3. Working Capital Management

Working capital refers to the firms shortterm assets including inventory and liabilities, such as cash owed to suppliers. Managing working capital is a day to day activity related to the firms receipt and disbursement of cash.

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Key Questions
How should the firm manage the receipt and disbursement of cash - current assets and current liabilities? What is the best way to manage day-today, short term assets such as inventory? How should the firm obtain short-term financing? Should the firm sell or purchase on credit? On what terms?
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Once Again...
Capital Budgeting: The process of planning and managing a firms investment in long-term assets. Capital Structure: The mix of debt and equity maintained by a firm. Working Capital Management: Planning and managing the firms current assets and liabilities.
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ROLE OF THE CFO

A Simplified Organizational Chart

Shareholders are the owners. Managers represent the owners.

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A Simplified Organizational Chart

Financial Manager coordinates the activities of the Treasurer and Controller

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Chief financial officer

Chief financial officer (CFO) or the vice-president of finance. Reports to the president or Chief Operating Officer (COO) and coordinates the activities of the treasurer and controller. CFO is concerned with answering the 3 basic questions.

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CFO: Scope of work

Capital budgeting (investment evaluation) Cash management and liquidity forecasting Commercial banking and investment banking Credit management Dividend disbursement and share repurchases Financial statement analysis (ratio analysis) Financial analysis planning (forecasting) Insurance/risk management Mergers and acquisitions analysis Tax analysis

Corporate finance in a nutshell

The Market
Capital Structure

The Firm
Capital Budgeting

Stockholders

Dividends Equity Debt

Cash flow

Financial Manager
Investments

Projects

Bondholders

Interest

Personal Taxes

Corporate Taxes

Government
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Corporate finance in a nutshell

The Market
Capital Structure

The Firm
Capital Budgeting

Stockholders

Dividends Equity Debt

Cash flow

Financial Manager
Investments

Projects

Bondholders

Interest

Corporate Taxes Personal Taxes

Ethical Cooperation vs. Social Costs

Ethical Pressures

Government

Society
Politics

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GOAL OF FINANCIAL MANAGEMENT

Goal of Financial Management?

What should be the firms objective? Maximize market value? Maximize sales revenue or market share? Maximize profits? Minimize costs? To avoid bankruptcy and financial distress? Maintain steady earnings growth? Maximize CEO wealth?
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Goal in a For-Profit Business

Managers work for the board of directors, who represent shareholders, the owners. Goal is to make money for the shareholders. Shareholders are better off when the value of the stock is high. Maximize the current price per share of the firms existing stock.

Managers should maximize the value of the firms equity!

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Goal in a For-Profit Business

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Maximize Value of Equity

When the shares are privately held, the goal is to maximize the owners equity. When equity is traded on the market, then the goal is to maximize the stock price. We are interested in the relation between business decisions and the value of the equity.

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What About These Goals?

Maximize customer satisfaction Environmental responsibility Ethical behavior

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How value is created

Value through managing the top line and the bottom line:

Increase sales Decrease expenses

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How value is created

Smart financial management also contributes to value creation
Right choice of capital structure (mixture of debt and equity) (WACC) Right choice in making investments Right choice in allocation of excessive cash Right choice in financing short-term cash shortage Right choice in determining credit terms 33 ..

Agency Problems
Agency relationship Shareholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between the shareholders (principals) and management of a firm (agents)
Agency costs are defined as the costs from these conflicts of interest.
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FINANCIAL MARKETS

Financial Markets
Money markets versus capital markets Primary markets versus secondary markets

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Money and Capital Markets

Money Markets - short-term debt securities - dealer market: brokers and agents match buyers and sellers.

Capital Markets - long-term debt securities: govt and corporate bonds - shares of stocks
Dealer markets are OTC (over-the-counter) markets, e.g., NASDAQ Auction Markets, e.g., Toronto Stock Exchange, NYSE
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Primary vs Secondary Markets

Primary Market - original sale, or issue of a security - IPOs are underwriten by dealers that purchase and resell to public at a higher price Secondary Market - one owner selling to another - Auction market or OTC dealer markets
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Financial Market Cash Flows

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RETHINKING CORPORATE FINANCE?

Traditional principles governing corporate finance

Investment principle

Corporate finance

Dividend principle

Financing principle

Rethinking corporate finance

Investment principle

Social value principle

Corporate finance

Financing principle

Sustainable competitiveness principle

Dividend principle

SOME FUNDAMENTALS

Basic finance terms

Assets Bonds Capital Capital assets Capital budget Currents assets Debt financing Equity Expenses Fixed Assets Liabilities Operating budget Revenue Financial ratios Cost of capital Hurdle rate

Financial statements
Financial statements are records that give an overview of an entitys financial status. Key financial statements:
Balance Sheet Income Statement Statement of Cash Flow Notes to the financial statements

Financial statements
Providing managers and decision makers answers to two key questions: What is the financial picture of the organization on a given day?
How well did the organization do during a given period?

Balance sheet: introduction

Balance sheet.
o A document designed to show the state of affairs of an entity at a particular date. o Reduced to its simplest.a balance sheet consists of two lists: list of resources and list of sources.

Balance sheet: introduction

The list of the resources

o Resources (means) that are under the control of the entity it is a list of assets. Asset is derived from the Latin ad satis (to sufficient)

An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

Balance sheet: introduction

The list of the sources

o The assets must have come from somewhere. o The list of sources shows where the assets came from the monetary amounts of the sources from which the entity obtained its present stock of resources. o These sources require repayments or recompense in some way.so they can also be called claims.

Balance sheet: introduction

Balance sheet: introduction

List of sources (where everything came from) List of resources (everything valuable that the business controls) Both lists relate to the same business at the same point in time: the total of each list must be equal and the balance sheet must balance.

The simple balance sheet

Separation of the Entity from the Owner
o When a new business entity is created, the starting point is that there is no balance sheet. o Balance sheet is created for the entity when Cash is put in the entity. o Separation is necessary to avoid affairs of the owner and the business to be tangled up. o Cash (resource) put in the entity by the owner will balance against the list of sources and is called Capital.

The simple balance sheet

Balance sheet transactions

Just as the balance sheet equation must always balance, the balance sheet must also always balance.
A balance sheet could be prepared after every transaction, but this practice would be awkward and unnecessary.
Therefore, balance sheets are usually prepared monthly or on some other periodic schedule.

Simple balance sheet example

Simple balance sheet book example

Simple balance sheet book example

The claims from third parties (outsiders other than the owner), can be called liabilities.

Liabilities

Liabilities
o In this example: Loan and Payable account. o English word derived from the word liable, meaning tied or bound or obliged by law. o A liability is a negative version of an asset.

Equity
o Claims by the owner are not called liabilities, but owners equity (or various similar expressions). o Equity in the accounting context means the owners stake in the entity. o In the simple balance sheet example the equity of the entity is 116,000 (capital + profit).

Balance sheet claims redrawn

Income statement
The balance sheet shows resources and claims at a particular moment in time. o However it is not practical to provide insights in the business operations. o Information about the results of operating activities of an entity can be best presented in an income statement. o Operating activities result in revenues (making sales) or in expenses (consumption of business resources).
o

Income statement
o

The income statement uses the following definitions: Revenues incoming receipts in return for sold goods or services Expenses sacrificed resources to support the business operations

Income statement
Important note!
o

The income statement (also called profit and loss account) reports on the flows of revenues and expenses of a period. The balance sheet reports on the financial position at the balance sheet date.

Preparing the income statement

Reworking transactions used in previous example.

Examining resources and claims:

Resources fall into two types:

Those used up in the period (expenses); and Those remaining (assets).

Claims can be seen to fall into three types:

Those arising from operations in the period (revenues); Those contributed by the owners (capital); and Those due to outsiders (liabilities).

Applications and sources

o

Adapted layout:

Relation between the balance sheet and income statement

Applications = Sources Assets + Expenses = Capital + Liabilities + Revenues Assets = Capital + Liabilities + Revenues Expenses Assets = Capital + Liabilities + Profit

Two simple equations:

Assets = Owners Equity + Liabilities

Rearranged:
Owners Equity = Assets Liabilities = Net Assets

QUESTIONS???

Edward M. Erasmus, MA e.erasmus@fzanv.com erasmus.bpas@gmail.com

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