Post on 05-Apr-2018
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Lecturer: MBS Nguyen Thi Hong Nguyen
Sources:- Brealey, R., et. al. (2009), Fundamentals of corporate finance, 6th Ed, McGraw-HillIrwin
- Bodie, Z., & Merton, R. (2000), Finance, Prentice Hall Inc.
- Gitman, L., et. al. (2008), Principles of Managerial Finance, 5th Ed, Pearson
Education Australia
Chapter 4:Introduction to corporate finance
Content
1. Introduction to corporatefinance
2. Financial statements
3. Financial analysis andplanning
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1. Introduction to corporate finance
Concepts of corporate finance
Forms of business operation
Financial managers
Goals of the corporation
Concepts of corporate financeCorporate finance boils down to the investmentand financing decisions made by corporations.
Making good investment and financing decisionsis the chief task of the financial manager
Investment decision (or capital budgetingdecision) is the decision to invest in tangible orintangible assets.
Financing decision deals with the form andamount of financing of a firms investments.
investment andfinacing made bycoporations
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Investment decision
Identifyinvestmentopportunities(capitalinvestmentprojects)
1
Evaluate theinvestmentprojects
2 Decide the
project(s) toinvest
3
Implementthe project(s)
4
Financing decision
Equityfinancing
Debtfinancing
Capitalstructure
Commonstocks
Preferredstocks
Convertiblesecurities
Equityinvestors
Bonds Bank loan
Leases Pension
liabilities
Debtinvestors
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Relationship of investment decisionsand financing decision
Financialmanager
FirmsoperationsReal assets
Investors
Financial
assets
(2) (1)
(3) (4b)
(4a)
(1) Cash raised by selling financial assets to investors(2) Cash invested in the firms operation
(3) Cash generated by the firms operation(4a) Cash reinvested(4b) Cash returned to investors
Flow of cash between investors and the firmsoperations
Forms of business operations
Sole Proprietorship
Partnership
CorporationOther forms
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Sole proprietorshipa firm owned by an individual or family
the assets and liabilities are the personal assetsand liabilities of the proprietor
unlimited liability
low administrative costs
PartnershipA firm with 2 owners sharing the equity. Apartnership agreement usually stipulates howdecisions and profits (losses) are shared
General partners 1 (unlimited liability)
Limited partners
0 (dont manage business)Most partnership are establish by a writtencontract known as the articles of partnership.
Changes in ownership involve dissolving the oldpartnership and forming a new one
whose liabilities areimited to the
extendt of thepartner's ahre ofownership. They donot have any ind ofmanagementresponsibility in thepartnership inwhich they investand are notresponsible for itsdebt obligations.Therefore, they arenot considererd tobe materialparticipants
thier income is from passive income (derive from a rental property,limited partnership or other enterprise in which he or she is not activelyinvovled. Does not inlcude income from dividends, interest, or captialgains. )and offset with passive loss.
who have unlimitedliablity. aslocommonly amanaging partnerrwhich means thathis person is active
in the day to dayoperations of thebusiness. Being agenral partnersoffers a poor assetprotection.
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Corporationa legal entity, distinct from its ownership
may own property, borrow, sue, be sued, andenter into legal contracts
not dissolved when shares are transferred
shareholders elect directors, who appointmanagement
pays corporate taxes, resulting in double taxationof owner (not sub-chapter S Corp.)
limited liability (corporate veil may be lifted)
Other forms of businessSome hybrid forms of business, which combinethe tax advantage of partnership with the limitedliability advantage of corporation:
Limited liability partnership (LLP) or
Limited liability company (LLC)
Professional corporation (PC)
with 100 shareholders or lessthe benefit of incoporationwhile being taxed as apartnership. this means anyprofits earned by thecorporation are not ataxed atthe copoorate level but ratherat the level of the shareholder.This can help gain a huge
benefit. The corporation canpas income directly toshareholders and avoid thedouble taxation that isinherent with the dividends ofpublic companies, while stillenjoying the advantages of thcoporate structure. Inorder to
qualify, coporation must be asmall business
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Financial managersThe term financial manager refers to anyoneresponsible for a significant corporate investmentor financing decision.
Chief Financial Officer(CFO)Responsible for:
Financial policyCorporate planning
ControllerResponsible for:Preparation of financialstatementsAccountingTaxes
TreasurerResponsible for:Cash managementRaising capitalBanking relationship
Financial managers in large corporations
The general organisation of a corporation andthe finance function
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Goals of the corporationFor small corporations, shareholders andmanagement may be one and the same
For large corporation, separation of ownership andmanagement is a practical necessity.
As large corporations usually have many owners(shareholders), there is no way that these shareholderscan actively involve in the management. It needs to bedelegated.
professional managers have specialized skills
efficiencies of scale
diversification of owners portfolio
savings in the cost of information gathering
learning curve/going concern issues
Goals of the corporationManagement rule: Maximize the wealth ofcurrent shareholders (market value ofshareholders investment in the firm)
Rule depends only upon production technology,market interest rates, market risk premiums, and
security pricesAlternative rules stated in terms of profitmaximization are fraught with unresolved issues,and are better avoided because a corporation couldincrease profit by using methods that conflict withshareholders interest.
filled with unpleasant issues
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Goals of the corporationAgency problem: managers, acting as agentsfor stockholders, may act in their own interestsrather than maximising value.
Agency problems are mitigated in several ways:
Legal and regulatory standards
Compensation plans
Monitoring by lenders, stock market analysts, and
investorsThe threat that poorly performing managers will befired
2. Financial statementsConcepts of financial statements
The balance sheet
The income statement
The statement of cash flows
Accounting malpractice
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Concepts of financial statementsReasons to study financial statements
Functions of financial statements
The key financial statements
Reason to study financial statements
Financial statements are prepared according torules established by the accounting professionpublished periodically
Although accounting is not the same as finance,
but if you dont understand the basics ofaccounting, you wont understand finance, either;because:
Much of the information about businesses andother organisations available to financial decisionmakers comes is included in financial statements.
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Functions of financial statementsProvide information to stakeholders of the firmabout the companys current status and pastfinancial performance.
Provide a convenient way for owners andcreditors to set performance targets and toimpose restrictions on the managers of the firm.
Provide convenient templates for financial
planning
The key financial statementsThe balance sheet
The income statement
The statement of cash flows
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The balance sheetBalance sheet is the financial statement thatshows the firms assets (the uses of the fundsraised)and liabilities (the sources of funds)ata particular time.
The different between the assets and theliabilities is the net worth, also called owners
equity(for a corporation, it is called as
stockholders equity)
The balance sheet
Current Assets:Cash& MarketableSecuritiesReceivablesInventories...
Fixed Assets:Tangible assetsIntangible assets
Current Liabilities:PayablesShort-term debt...
Long-term Liabilities
Owners equity
Net WorkingCapital
Total assets = Total liabilities + Owners equity
net working capital= owner's equity
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CONSOLIDATED BALANCE SHEET FOR PEPSICO, INC., As of December 31 (millions of dollars) brought
Assets 2006 2005 Liabilities and ShareholdersEquity 2006 2005
Current assets Current liabilities
Cash & Marketable securities 1,651 1,716 Debt due for repayment 274 2,889
Receivables 3,725 3,261 Account payable 5,271 5,357
Inventories 1,926 1,693 Other current liabilities 1,315 1,160
Other current assets 1,828 3,784 Total current liabilities 6,860 9,406
Total current assets 9,139 10,454
Fixed asset Long-term debt 2,550 2,313
Tangible fixed assets Deferred income taxes 528 1,434
Property, plant, and equipment 19,058 16,646 Other-long term liabilities 4,624 4,323
Less accumulated depreciation 9,371 7,965
Net tangible fixed assets 9,687 8,681 Total liabilities 14,562 17,476
Intangible fixed assets Shareholders equity
Goodwill 4,594 4,088 Common stock and other paid-incapital
614 644
Other intangible assets 1,849 1,616 Retained earnings 22,591 18,803
Total intangible fixed assets 6,443 5,704 Treasury stock (7,837) (5,196)
Total shareholders equity 15,368 14,251
Total fixed assets 16,130 14,385
Total liabilities and shareholdersequity
29,930 31,727
Other assets 4,670 6,888
Total assets 29,930 31,727
Book value vs. Market valueBook value is the value of assets or liabilitiesaccording to the balance sheet.
Book values are based on historical or originalvalues.
Therefore, book value is a backward-looking
measure of value.Market values measure current values of assetand liabilities
Market value is a forward-looking measure ofvalue. It depends on the profits that investorsexpect the assets to provide.
BOOK VALUEobsolete andMARKET VALUEupdated
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The income statementIncome statement is the financial statement thatshows the revenues, expenses, and net incomeof a firm over a period of time.
It shows how profitable the firm has been duringthe past period.
CONSOLIDATED INCOME STATEMENT FOR PEPSICO, INC., 2006
$ millions % of sales
Net sales 35,753 100.0
Cost of goods sold 15,762 44.1
Selling, general, and administrative expenses 11,357 32.2
Depreciation 1,406 3.9
Earnings before interest and income taxes 7,228 19.7
Interest expense 239 0.2
Taxable income 6,989 19.5
Taxes 1,347 3.8
Net income 5,462 15.8
Allocation of net income
Dividends 1,854 5.2
Addition to retained earnings 3,788 10.6
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Profits vs. Cash flow
The firms cash flow can be quite differentfrom its net income, because:
The income statement does not recognisecapital expenditures as expenses in the yearthat the capital goods are paid for. Instead, itspreads those expenses over time in theform of an annual deduction fordepreciation.
The income statement uses the accrualmethod of accounting, which means thatrevenues and expenses are recognisedwhen sales are made, rather than when the
Profits vs. Cash flow
How profits and cash are not the same:
To calculate the cash produce by thebusiness, it is necessary to add back thedepreciation charge (which is not a cash
payment) and to subtract the expenditure onnew capital equipment (which is a cashpayment)
The cash that the firm receives is equal tothe sales shown in the income statementless the increase in unpaid bills
The cash outflow is equal to the cost ofgoods sold, which is shown in the income
is that meanPROFIT?
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The statement of cash flowsThe statement of cash flows is the financialstatement that shows the firms cash receipts andcash payments over a period of time.
It shows the firms cash inflows and outflows fromoperations as well as from its investments andfinancing activities.
CONSOLIDATED STATEMENT OF CASH FLOWS FOR PEPSICO(for the year ended December 31, 2008 (mil)
Cash provided by operations
Net income 5,642
Noncash expenses
Depreciation and amortisation 1,406
Changes in working capital
Decrease (increase) in account receivable (464)
Decrease (increase) in inventories (233)
Increase (decrease) in accounts payable (86)
Decrease (increase) in other current assets 1,956
Increase (decrease) in other current liabilities 155
Total decrease (increase) in working capital 1,328
Cash provided by operations 8,376
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CONSOLIDATED STATEMENT OF CASH FLOWS FOR PEPSICO (cont.)(for the year ended December 31, 2008 (mil)
Cash flows from investments
Cash provided by (used for) disposal of (additions to) property,plant, and equipment
(2,412)
Sales (acquisitions) of other investments 1,479
Cash provided by (used for) investments (933)
Cash provided by (used for) financing activities
Additions to (reduction in) short-term debt (2,615)
Additions to (reduction in) long-term debt 237
Dividends paid (1,854)
Net issues (repurchases) of stock (2,671)Other (605)
Cash provided by (used for) financing activities (7,508)
Net increase (decrease) in cash and cash equivalents (65)
The statement of cash flowsFree cash flow: Cash available for distribution toinvestors after firm pays for new investments oradditions to working capital
Free cash flow = EBIT taxes + depreciation
- change in net working capital- capital expenditures
because you justdivide thedepreciation intyears in incomestatement.
therefore, youneed to add itback
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Accounting malpracticeManagers of public companies faces pressure aboutaccounting earnings
They could conceal unflattering information withoutadjusting the firms operations by misusing thediscretion in accounting rules or simply breakingthose rules. They could make changes in:
Revenue recognition: E.g. Xerox : Inflate the revenue
Cookie-jar reserves: E.g. Freddie Mac :Over-reserve in
good years and release those reserves in bad years tosmooth earnings growth
Off-balance sheet assets & liabilities: E.g. Enron:creating special-purpose vehicles for excluding liabilitiesfrom their financial statements
3. Financial analysis and planning
Financial analysis
Financial planning
b warry of companies whosequarterly earnings growsmoothly ia straight line. Businesses are realythat consistent in reality and it canbe a sign that the company'smanagement is using accounttactics to smooth out the numbers in
order to meet
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Financial analysisIn analysing a firms performance using its financial statements, itis useful to apply some financial analysing approaches:
Cross-sectional: Comparison against peersTime-series: Comparison against self over timeCommon-size (vertical) analysisTrend (horizontal) analysisFinancial ratios: allow comparison between different size firms ona common basis
To measure the outcome of these analyses, you need tocompare:
Against self (time-series, vertical, horizontal) and
Against peers/industry/market (cross-sectional, ratio)Against general measures
For the best result, these approaches usually be appliedsimultaneously.
Financial ratiosCategories of financial ratios
The DuPont system of analysis
Limitations of ratio analysis
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Categories of financial ratiosProfitability ratios
Asset turnover (Efficiency/Activity) ratios
Debt (Financial leverage) ratios
Liquidity ratios
Market value ratios
Profitability ratiosGross profit margin
Net profit margin
Return on assets (ROA)
Return on Equity (ROE)
Earning per share (EPS)
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Gross profit margin
Gross profit margin: indicates the percentage ofeach sales dollar remaining after the firm haspaid for its goods.
Net profit marginNet profit margin: measures the percentage ofeach sales dollar remaining after all expenses,including interest and taxes, have been deducted
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Return on Assets (ROA)Return on assets: measures the overalleffectiveness of management in generating profitswith its available assets.
Return on equity (ROE)Return on equity: measures the return earnedon the ordinary shareholders investment in thefirm.
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Earning per share (EPS)Earning per share: represents the number ofdollar earned on behalf of each share.
Note that it does note represent the amount of
earnings actually distributed to shareholders(dividend per share - DPS).
Asset turnover ratiosInventory turnover
Average collection period (average age ofaccounts receivables)
Average payment period (average age of
accounts payables)Total asset turnover
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Inventory turnoverInventory turnover measures the activity, orliquidity, of a firms inventory
Inventory turnover can be converted to the
average age of inventory by dividing it into thenumbers of day in a year.
Average collection periodAverage collection period (average age ofaccounts receivables): the average amount oftime needed to collect accounts receivable.
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Average payment periodAverage payment period (average age ofaccounts payables): the average amount oftime needed to pay account payable.
Annual purchases can be calculated by deductingbeginning inventory from annual cost of goodssold plus ending inventory.
Total asset turnoverTotal asset turnover: indicates the efficiencywith which the firm uses all its assets togenerates sales.
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Debt ratiosDebt ratio
Time interest earned ratio
Debt ratioDebt ratio: measures the proportion of totalassets financed by the firms creditors.
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Time interest earned ratioTime interest earned ratio: measures the firmsability to make contractual interest payments.
Liquidity ratiosCurrent ratio
Quick (acid test) ratio
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Current ratioCurrent ratio: is a measure of liquidity calculatedby dividing the firms current assets by currentliabilities.
Quick (acid test) ratioQuick (acid test) ratio: a measure of liquiditycalculated by dividing the firms current assetsminus inventory by current liabilities.
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Market value ratiosPrice to earnings (P/E) ratio
Market to book (M/B) ratio
Price to earning ratioPrice to earnings (P/E) ratio: measures theamount that investors are willing to pay for eachdollar of a firms earnings; the higher the P/E
ratio, the greater is investor confidence.
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Market to book ratioMarket to book (M/B) ratio: provides anassessment of how investors view the firmsperformance. Firms expected to earn high returnsrelative to their risk typically sell at higher M/Bmultiples.
The DuPont analysisThe DuPont formula: relates the firms net profitmargin and total asset turnover to its ROA. TheROA is the product of the net profit margin and
the total asset turnover.
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The DuPont analysisThe modified DuPont formula: relates the firmsROA to its ROE using the financial leveragemultiplier.
Limitations of ratios analysisThere is no absolute standard by which to judgewhether the ratios are too high or too low
Historical data (not necessarily an indication offuture)
Poor or inadequate accounting methodsInflation or changes to fair values
It is difficult to define a set of comparable firms
Changes to economy, markets condition,...
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Financial planningFinancial planning provides road maps forguiding, coordinating and controlling the firmsactions in order to achieve its objectives.
Financial planning process: is the planning thebegins with long-run (strategic) financial plansthat in turn guide the formulation of short run(operating) plans and budgets.