I.

The Corporation

Prof. Clemens Sialm

Today’s Class
ƒ The Corporation and Corporate
Governance
ƒ Arbitrage with Transactions Costs
ƒ Financial Statement Analysis

Financial Management © 2010 Clemens Sialm 1-2

Four Types of Firms

Financial Management © 2010 Clemens Sialm 1-3

1
 Issues of Corporate Form
ƒ Ownership vs. Control
ƒ Investors delegate control rights to management
creating a principal-agent problem.
ƒ Mangers might not always work in the interest of
shareholders since they have different objectives.
ƒ Limited Liability
ƒ Equity holders have limited liability.
ƒ In case of bankruptcy, control passes from equity
holders to debt holders.
ƒ Double Taxation of Profits
ƒ Corporate profits are subject to corporate tax.
ƒ Dividend payments to equity holders are subject
to dividend tax.
Financial Management © 2010 Clemens Sialm 1-4

Typical Organizational Chart

Financial Management © 2010 Clemens Sialm 1-5

Ownership vs. Control

ƒ Why are the objectives of the
management team different form the
objectives of shareholders?
ƒ What should the objectives of the
mangement team be?
ƒ How can shareholders ensure that the
management follows these objectives?

Financial Management © 2010 Clemens Sialm 1-6

2
 Stock Market
ƒ Public companies are traded on a stock
market.
ƒ Private companies are generally not
traded liquidly.
ƒ The NYSE and the NASDAQ are the
main markets for U.S. stocks.
ƒ NYSE: Physical place.
ƒ NASDAQ: No physical location. Market based on
phone and computer network.

Financial Management © 2010 Clemens Sialm 1-7

Worldwide Stock Markets in 2007

Financial Management © 2010 Clemens Sialm 1-8

Stock Market
ƒ A liquid market in company stocks is
important for investors because it
allows them to sell the positions
without incurring large trading costs.
ƒ An important component of trading
costs is the bid-ask spread:
ƒ Bid: Price at which dealer is willing to buy.
ƒ Ask: Price at which dealer is willing to sell.
ƒ Which price is higher?

Financial Management © 2010 Clemens Sialm 1-9

3
 Transactions Costs
ƒ Financial transactions cause
transactions costs:
ƒ Commissions
ƒ Market impact costs
ƒ Taxes
ƒ Transactions costs reduce the
profitability of trading and lead to
violations of the law of one price.

Financial Management © 2010 Clemens Sialm 1-10

Example of Arbitrage
ƒ The € trades in New York at 1.30 $/€
and in Paris at 1.35 $/€.
ƒ What should you do?

Financial Management © 2010 Clemens Sialm 1-11

Arbitrage with Transactions Costs

ƒ New York Market for Euros:
ƒ Bid: 1.28 $/€.
ƒ Ask: 1.32 $/€.
ƒ Paris Market for Euros:
ƒ Bid: 1.30 $/€.
ƒ Ask: 1.37 $/€.
ƒ Can you pursue an arbitrage
opportunity?
ƒ Under which conditions does an
arbitrage exist?

Financial Management © 2010 Clemens Sialm 1-12

4
 Law of One Price with Transactions Costs
ƒ Given the New York exchange rates, an
arbitrage is only possible if:
ƒ Bid in Paris is above 1.32 $/€.
ƒ Then go and buy Euros in NY at 1.32 $/€ and sell
in Paris at higher level.
ƒ Ask in Paris is below 1.28 $/€.
ƒ Then go and buy Euros in Paris below 1.28 $/€
and sell in NY at 1.28 $/€.

Financial Management © 2010 Clemens Sialm 1-13

Arbitrage Example
ƒ You can borrow and lend on the
financial markets at a 5% interest rate.
ƒ A one-year Treasury bond pays you
$1,000 in one year.
ƒ At which price should this bond trade?

P=

ƒ This bond is currently trading at $940.

ƒ What trading strategy should you pursue?

Financial Management © 2010 Clemens Sialm 1-14

Arbitrage with Transactions Costs

ƒ Now, suppose you can borrow at 8%
and lend at 3%.
ƒ A one-year Treasury bond pays you
$1,000 in one year and the bond is
currently trading at $940.
ƒ Are there any arbitrage opportunities?

Financial Management © 2010 Clemens Sialm 1-15

5
 Arbitrage with Transactions Costs

Action Cash Flows Cash Flows

Today in 1 Year

Profit

Financial Management © 2010 Clemens Sialm 1-16

Arbitrage with Transactions Costs

Action Cash Flows Cash Flows

Today in 1 Year

Profit

Financial Management © 2010 Clemens Sialm 1-17

Law of One Price with Transactions Costs

ƒ When there are transactions costs,
then arbitrage keeps prices of
equivalent securities close to each
other.
ƒ However, prices can deviate, but not by
more than the transactions costs of the
arbitrage.

Financial Management © 2010 Clemens Sialm 1-18

6
 Short-Selling Securities
ƒ How can you sell something you do not
have?
ƒ Financial markets allow investors to
short-sell securities.
ƒ Borrow the securities from somebody.
ƒ Sell the securities at the current market price.
ƒ Eventually, buy back the securities and return
them to the owner.

Financial Management © 2010 Clemens Sialm 1-19

Financial Statement Analysis

ƒ Balance Sheet
ƒ Lists the firm’s assets and liabilities.
ƒ Income Statement
ƒ Lists the firm’s revenues and expenses.
ƒ Statement of Cash Flows
ƒ Lists the firm’s cash flows.

Financial Management © 2010 Clemens Sialm 1-20

Example: Balance Sheet

Additional Information: Stock price: $14; Number of Shares Outstanding: 3.6M

Financial Management © 2010 Clemens Sialm 1-21

7
 Important Balance Sheet Ratios
ƒ Market Capitalization

ƒ Market-to-Book Ratio

ƒ Debt-Equity Ratio

ƒ Enterprise Value

Financial Management © 2010 Clemens Sialm 1-22

Example: Income Statement

Financial Management © 2010 Clemens Sialm 1-23

Important Income Statement Ratios

ƒ Operating Margin

ƒ Net Profit Margin

ƒ Price-Earnings Ratio

ƒ Return on Equity

Financial Management © 2010 Clemens Sialm 1-24

8
 DuPont Identity

⎛ Net Income ⎞ ⎛ Sales ⎞ ⎛ Total Assets ⎞

ROE = ⎜ ⎟ × ⎜⎜ ⎟⎟ × ⎜⎜ ⎟⎟
⎝ Sales ⎠ ⎝ Total Assets ⎠ ⎝ Book Value of Equity ⎠

Net Profit Margin Asset Turnover Equity Multiplier

Return On Assets

Financial Management © 2010 Clemens Sialm 1-25

Example: Statement of Cash Flows

Financial Management © 2010 Clemens Sialm 1-26

Disclosure Regulation
ƒ Firms are required to disclose their financial
statements quarterly (10-Q) and annually (10-
K) to the U.S. Securities and Exchange
Commission (SEC).
ƒ Generally Accepted Accounting Principles
(GAAP) provide a common set of rules for
companies.
ƒ The Sarbanes-Oxley Act of 2002
strengthened regulations with the goal to
decrease accounting manipulation.

Financial Management © 2010 Clemens Sialm 1-27

9
 Accounting Manipulation Cases
ƒ Companies have often opportunities and
incentives to manipulate their accounting
numbers.
ƒ Enron
ƒ Worldcom
ƒ Madoff
ƒ Accounting numbers should be interpreted
with caution!

Financial Management © 2010 Clemens Sialm 1-28

Summary
ƒ Corporations enable the collection of
funds across a large number of
investors.
ƒ Separation of ownership and control
results in agency problems.
ƒ Accounting and disclosure rules
attempt to mitigate these agency
problems.

Financial Management © 2010 Clemens Sialm 1-29

10