Basic Corporate Finance 2-208-97

Lecture 1: Introduction to Corporate Finance

Outline for Lecture 1

Administrative Details
Contact Information Readings Grade Distribution

Course Outline Overview of Corporate Finance

The Areas of Finance What is Corporate Finance? Forms of Business Organization Objectives of Financial Management
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Outline for Lecture 1

Balance Sheet Model of the Firm Financial Markets Summary

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Contact Information
Professor Tolga Cenesizoglu
Email: tolga.cenesizoglu@hec.ca Office: 4.251 Office Hours: by appointment only

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Readings
Required
Fundamentals of Corporate Finance, by Ross, Westerfield, Jordan, and Roberts, fifth Canadian edition, McGraw-Hill Ryerson. Slides and lecture notes Course web site

Suggested
Lecture notes of the French version of this course

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Grade Distribution
Grade Distribution
Quiz (one or two) Midterm exam Assignment Final exam : 10% : 30% : 20% : 40%

A laptop or financial calculator will be required for the exams and the assignment.

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Course Outline
Overview of Corporate Finance Time Value of Money and Discounting Interest Rates and Bond Valuation Stock Valuation Investment Criteria Cash Flow and Taxes Making Capital Investment Decisions Project Analysis and Evaluation Capital Markets Risk and Capital Asset Pricing Model Cost of Capital Leverage and Capital Structure Raising Capital
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The Areas of Finance

Corporate Finance Investments Valuation Financial Institutions Financial Economics International Finance Financial Mathematics Financial Engineering Experimental Finance
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What is Corporate Finance?

Corporate finance is a specific area of finance that analyzes the financial decisions of corporations.

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Timely and honest information release and adds value

The Financial Markets Shareholders

Dividends and maximization of shareholder wealth Equity and the control of the firm

The Firm Financial Manager

Investments Cash Flow

Interest and protection of bondholders interest

Bondholders
Income Tax Enforcement of corporate laws and protect investors rights

Lend funds

Projects
Ethical Corporation and No Social Cost Forces the firm to be ethical

The Government
Provide long-term and short-term funds

The Society

POLITICS

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What is Corporate Finance?

Among other questions about financial decisions of a corporation, corporate finance is the study of the following three main questions:
Q: What long-term investments should the firm take on? A: Capital Budgeting Q: How should the firm finance its long-term investments? A: Capital Structure Q: How should the firm manage its day-to-day operations? A: Working Capital Management

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An Example

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Financial Management Decisions

The Financial Markets

Capital Structure
Bondholders

Shareholders

Capital The Firm Financial Manager Budgeting Working Capital Projects Management
The Society

The Government

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Financial Management Decisions

Capital Budgeting
The process of planning and managing a firm's investments in fixed assets. It is concerned with the size, timing, and riskiness of cash flows.

Capital Structure
The mix of debt and equity used by a firm. What are the least expensive sources of funds? Is there a best mix? When and where to raise funds? Managing short-term assets and liabilities. How much cash and inventory to keep around? What is our credit policy? Where will we obtain short-term loans?
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Working Capital Management

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A Simplified Organizational Chart

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A Simplified Organizational Chart

Controller - Handles cost and financial accounting, tax payments and information systems. Treasurer - Handles cash management, financial planning, and capital expenditures. Corporate finance is primarily concerned with the issues faced by the treasurer.

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Forms of Business Organization

Sole Proprietorship is a business owned by one person who keeps all profits and have unlimited liability (e.g. a doctors practice, a lemonade stand etc)
Advantages: Easy to setup, profits are personal income Disadvantages: Unlimited liability for debts, difficult to transfer

Partnership is a business owned by two or more partners (e.g. a law firm, two plumbers)
General and limited partnerships

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Forms of Business Organization

A corporation is a legal entity which, while being composed of natural persons, exists completely separately from them. This separation gives the corporation unique powers which other legal entities lack (e.g. IBM, BMW). Investors and entrepreneurs often form joint stock companies and incorporate them to facilitate a business; as this form of business is now extremely prevalent, the term corporation is often used to refer specifically to such business corporations. Corporations may also be formed for political, religious or charitable purposes (not-for-profit corporations), or as government or quasigovernmental entities (public corporations).
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Forms of Business Organization

Advantages: Individual entity, limited liability, unlimited life span, transferable ownership, ownership is separated from management Disadvantages: Double taxation, slightly complicated to setup

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Balance Sheet Model of the Firm

Assets Liabilities

Current Assets
Existing investments that generate cash flows in one year

Current Liabilities
Debts that must be paid in one year
Net Working Capital

Fixed Assets Tangible and Intangible assets that are long-lived investments Growth Assets Expected value that will be created by future investments
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Long-term debt Long-term debts owed to bondholders

Shareholders Equity
Long-term debts owed to bondholders
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Balance Sheet Model of the Firm

Assets = Liabilities + Shareholders equity Shareholders equity is the residual claim on the firm i.e., if the firm is liquidated, the amount that the shareholders will receive. Debt holders are paid before shareholders if the firm is to be liquidated. Liquidity refers to the speed and ease with which the firm can be converted to cash. Market value of the firm Book value of the firm because of growth assets.
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Objectives of Financial Management

Reasonable Objectives
Survive in business Avoid financial distress and bankruptcy Beat the competition Maximize sales and market share Minimize costs Maximize profits Maintain steady earnings growth

Unreasonable Objectives
Maximize taxes paid to the government? Maximize CEOs wealth?
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Objectives of Financial Management

In traditional corporate finance, the objective of financial management is to maximize the value of the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are efficient, the objective is to maximize the stock price. When the firm is privately owned (is not traded publicly), the objective is to maximize the estimated market value of the owners equity. Maximizing the value of the firm is not incompatible with the other reasonable objectives.
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Objectives of Financial Management

Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently). If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously. The objective of stock price performance provides some very elegant theory on:
Allocating resources across scarce uses (which investments to take and which ones to reject) how to finance these investments how much to pay in dividends

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Stock Price Reaction to Investment Opportunities Encysive Pharmaceuticals Inc.'s (NASDAQ:ENCY) stock took a 40 percent nosedive on Tuesday (July 25, 2006) morning after the company announced another delay in the approval of its pulmonary arterial hypertension drug, Thelin. Houston Business Journal

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Stock Price Reaction to Investment Opportunities

ENCY Stock Price
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US $

0 6/1/06

6/15/06

6/29/06

7/13/06 Date

7/27/06

8/10/06

8/24/06

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Delay bad news or provide misleading information

The Financial Markets Shareholders

Managers put their interest above stockholders (Agency Problem) Have little control over the managers Bondholders might lose their money due to bankruptcy Lend funds

The Firm Financial Manager

Investments Cash Flow

Bondholders
No income Tax Corruption

Projects
Significant Social Cost Cannot force the firm to be ethical

The Government

The Society

POLITICS

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Agency Problem
Agency problems arise when there is a conflict between the interests of the agent (e.g. the managers) and those of the principal (e.g. shareholders). Agency costs are the costs associated with the agency problem and arise mainly due to the conflict of interest between the managers and the shareholders.
Direct agency costs: Direct costs come about in compensation and perquisites for management. Indirect agency costs: Indirect costs are the result of monitoring managers.

Solutions: Compensation plans tied to the firm value, outside auditing, long-term relationships.
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Agency Problem

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Agency Problem: A Real World Example

MCI, Inc. (Worldcom Inc) was an American telecommunications company that was headquartered in Ashburn, Virginia. Bernard Ebbers (former CEO of Worldcom) became very wealthy from the rising price of his holdings in WorldComs stock. Due to the downturn in telecommunications industry, Worldcom stock was declining. Ebbers persuaded the board of directors to provide him corporate loans and guarantees in excess of $400 million to cover expenses for his other personal businesses (timber, yachting etc.). Ebbers used company resources not to create value for the firm but to increase his personal wealth. What happened next?
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Financial Markets
A financial market is a market where buyers and sellers trade debt and equity securities. Financial Markets can be classified as:
Money Markets versus Capital Markets Primary Markets versus Secondary Markets

Money Markets Short-term debt securities (money market instruments) (e.g. treasury bills). It is a dealer market, i.e., dealers buy and sell from their inventories. Capital Markets Long-term debt securities and shares of stocks (e.g. government and corporate bonds and shares). It is primarily a brokered market, i.e., brokers match up buyers and sellers.
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Financial Markets
Primary Markets Financial markets where the original sale of securities take place Secondary Markets Financial markets where these securities are traded after the original sale

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Application to Personal Finance

Five years of work experience after college, you have to decide whether to get an MBA or not. Suppose you are earning $100,000/year before entering a business school and assume that the tuition costs are $35,000/year. Expected salary upon graduation is $120,000. Should you get an MBA? If you decide to get an MBA, how would you pay for the tuition How would you pay for your living expenses?
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Worldcom
Ebbers was ousted as CEO in April 2002. Beginning in 1999 and continuing through May 2002, the company (under the direction of Scott Sullivan (CFO), David Myers (Controller) and Buford Buddy Yates (Director of General Accounting)) used fraudulent accounting methods to mask its declining financial condition by painting a false picture of financial growth and profitability to prop up the price of WorldComs stock.

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Worldcom
The fraud was accomplished primarily in two ways:
Underreporting line costs (interconnection expenses with other telecommunication companies) by capitalizing these costs on the balance sheet rather than properly expensing them. Inflating revenues with bogus accounting entries from corporate unallocated revenue accounts.

By the end of 2003, it was estimated that the company's total assets had been inflated by around $11 billion. On July 21, 2002, WorldCom filed for Chapter 11 bankruptcy protection in the largest such filing in United States history. On March 15, 2005, Bernard Ebbers was found guilty of all charges and convicted on fraud, conspiracy and filing false documents with regulators all related to the $11 billion accounting scandal at the telecommunications company he founded. He was sentenced to 25 years in prison.
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Summary
Corporate Finance Capital budgeting Capital structure Working capital management Forms of businesses Objectives of financial management The balance sheet model of the firm Agency problem Financial markets
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