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Transcript of finance 101
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Introduction to Corporate Finance (Chapter 1) Business Forms Financial managers Agency Problems
Financial Statements (Chapter 2, 3)
Today’s Agenda
FNCE 101 Hyun-‐Soo Choi
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Introduction to Finance (Chapter 1)
FNCE 101 Hyun-‐Soo Choi
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What is Finance?
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Finance studies and addresses the ways in which individuals, business, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. (from Wikipedia)
Basic areas in Finance
Corporate Finance
Investments
Financial Institutions
International Finance
What is Finance
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Investments .Work with financial assets such as stocks and bonds, different types of financial derivatives (Option, Future, Forward, Swap, and…) .Value of financial assets, risk versus return
Financial Institutions
.Companies that specialize in financial matters .Banks, Insurance companies, Brokerage firms
International Finance
.Studies the dynamics of exchange rates and foreign investment.
Basic Areas in Finance
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Corporate finance is about corporations’ financial decisions.
Then. What is a corporation? - A form of business organization
- Three major forms.
. Sole proprietorship
. Partnership
. Corporation
What is Corporate Finance?
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One person owns the business: No legal Entity
Sole Proprietorship
Advantages Disadvantages
Easiest to start Least regulated Owner keeps all profits No agency issues
Unlimited liability Limited life of business Limited capital Hard ownership transfer
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Two or more own the business (partners): Legal Entity What is the main problem using the sole proprietorship, or partnership? >> hard to make an investment for growing opportunity
Partnership
Advantages Disadvantages
Rela?vely easy to start Less agency issues More capital available Income taxed once as personal income
Unlimited liability -‐ General partnership -‐ Limited partnership Limited life of business Limited capital Hard ownership transfer
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Business owned by stockholders: Legal Entity
Corporation
Advantages Disadvantages
Limited liability Unlimited life of business Easier to raise money Easy ownership transfer Separa?on of ownership and management
Separa?on of ownership and management: Agency issue Cost of setup and maintenance -‐ Complicated regula?ons -‐ Reports filing Double taxa?on (Not in Singapore)
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Hybrid forms between a partnership and a corporation
Limited Liability Partnerships (LLP) - Between partnership and corporation
- Closer to partnership (partners) - All(or some) partners have limited liabilities - Benefit in taxation Limited Liability Company (LLC) - Between partnership and corporation
- Closer to corporation (Shareholders) - Benefit in taxation - i.e. private limited company (PTE LTD)
Hybrid forms
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Shareholders
Board of Directors
Management - i.e. Chief Executive Officer (CEO), Chief Financial Officer (CFO)
Other Stakeholders - i.e. Government, Customers, Trade Unions, Owner
Separation of Ownership and Control
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Capital budgeting (Investment decisions) - What long-term investments or projects to take on? - Evaluating the size, timing, and risk of future cash flows
Capital Structure (Financing decisions)
- Structuring long-term financing i.e. How much capital to raise? i.e. Equity vs debt?
Working capital management
- Managing short-term assets and short-term liabilities i.e. Inventory level, cash holding
Payout policies
-Corporate earnings: retain by the company or return to shareholders -How to return? Dividend payout or stock buybacks
Financial Management Decisions
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Flow of cash: Investors and Firm
Financial
Manager
Firm's
operations Investors
(1) Money raised from investors (2) Money invested in firm to buy real assets (3) Money generated by real assets (4a) Money reinvested (4b) Money returned to investors
(1) (2)
(3)
(4a)
(4b)
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What is the basic goal of financial management?
. Maximizing market share?
. Minimizing cost?
. Avoid bankruptcy/survive as long as possible?
. Maximizing profit?
. Maximize shareholder value?
Objective of Financial Management
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What is the basic goal of financial management?
. Maximizing market share?
. Minimizing cost?
. Avoid bankruptcy/survive as long as possible?
. Maximizing profit?
. Maximize shareholder value?
The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price.
Objective of Financial Management
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Are they same? No.
Generally high correlation among
stock price, earning per share(EPS), and cash flow.
Current stock price relies upon current earnings, as well as future earnings and cash flow.
Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa).
Stock price maximization & profit maximization
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- Projected cash flow to shareholders - Timing of the cash flow stream - Riskiness of the cash flows
Factors that affect stock price
Value = CF1
(1+ k)1 +CF2
(1+ k)2 ++CFn
(1+ k)n
= CFt
(1+ k)t .t=1
n
∑
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Do managers really maximize shareholder wealth?
“Agency problems” represent the conflict of interest
> Principal hires an agent to represent their interest
> Stockholders (principals) hire managers (agents) to run the company
> Managers do not always act in the best interests of shareholders, and they sometimes make decisions that destroy shareholder value.
Agency Problems
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Choice of effort : Manager prefer less effort to more, all else constant. : Interested more in personal perks rather than enhancing share value i.e. Corporate Jet, empire building
Risk exposure : Managers are exposed to high idiosyncratic risk. - Substitute low variance for high variance assets - Over-retain liquid funds and cash reserves - Keep leverage too low
- Keep dividend payout too low
Differential horizon : Managers have a shorter horizon than stock holders - Focus more on short-term earnings rather than long-term value enhancing
Shareholder-Management Conflict
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Managerial compensation plans
- stock and options
Direct Intervention / Monitoring
- The Board of Directors & Lenders & Specialists
- The threat of firing
The threat of takeover
Legal and Regulatory Requirements
Solution to the Agency Problem
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# WorldCom – 2001 - Report $3.8 billion of operating expenses as investment and overstated the income
- Assets: 103.9 Billion
# Enron – 2001
- Concealed $1.7 billion losses - Assets: 65.5 Billion
# Sarbanes-Oxley Act of 2002 The public Company Accounting Reform and Investor Protection Act of 2002
Which was the largest bankruptcy in the history?
Corporate Scandals & SOX
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Financial Statements (Chapter 2, 3)
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The Balance Sheet The Income Statement The Statement of Cash Flows (not covered)
Major Financial Statements
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A Snapshot of the firm at a given point in time. The Left-hand Side: Assets
- Current asset / Fixed asset (Tangible & Intangible) - Listed in order of decreasing liquidity > Ease of conversion to cash > Without significant loss of value
The Right-hand Side: Liabilities and Equity - Liabilities > Current liabilities / Long-term liabilities
- Stockholder’s Equity Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity
Stockholders’ Equity = Assets – Liabilities Shareholders are “residual owners”
The Balance Sheet
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Example: The Balance Sheet
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A Video of the firm’s operation for a specified period of time.
Income Statement Identity
* Revenues – Expenses
= Earnings before interest and taxes (EBIT)
: what firm would have earned if not for obligations to its creditors and the tax authorities.
* EBIT- interest expense = Taxable Income
* Taxable Income – Taxes = Net Income
* Net Income = Retained earnings + Dividend payout
* Earning per share (EPS)
The Income Statement
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Example: The Income Statement
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U.S. Corporate Tax Rates
Tax Rates: Marginal and Average
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Marginal tax rate : the percentage paid on the next dollar earned
Average tax rate
: the tax bill / taxable income Suppose your firm earns $200,000 in taxable income.
- What is the marginal tax rate? - What is the average tax rate?
If you are considering a project that will increase the firm’s taxable income by $100,000, what tax rate should you use in your analysis?
Example: Marginal & Average Tax Rates
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There are five traditional categories of ratios:
1. Liquidity (Short-term solvency) ratios
2. Leverage (Long-term solvency) ratios
3. Asset management (efficiency or turnover) ratios
4. Profitability ratios
5. Market value ratios
• Each category measures a different dimension of a firm’s performance (i.e. strengths & weaknesses).
• Relative measures to interpret firm performance
- comparison through time or between companies
Ratio Analysis
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As we look into each ratio, ASK yourself 1) what the ratio is trying to measure
2) Why is that information important
Ratio Analysis (con’t)
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How well can the firm pay its bills over the short run without undue stress
> High liquidity ratio => liquidity
> But, too high => the firm is inefficient
a. Current ratio = Current assets / Current liabilities
b. Quick ratio = (Current assets – Inventory) / Current liabilities
c. Cash ratio = Cash / Current liabilities
1. Liquidity (Short-term solvency) ratios
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Measures the firm’s long-term ability to meet its obligations
> Too high of a ratio may lead to financial distress
> Too low of a ratio may indicate the firm is not utilizing all
the benefits of debt
Total debt ratio = (Total assets - Total equity) / Total assets
# Debt-equity ratio = Total debt / Total equity
# Equity multiplier = Total assets / Total equity
= 1+ Debt-equity ratio
2. Leverage (Long-term solvency) ratios
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How efficiently does the firm use its assets to generate sales
> Normally, higher ratio means efficiency
a. Inventory turnover = Cost of goods sold / Inventory
b. Total asset turnover = Sales / Total assets
3. Asset Management (turnover) ratios
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How well the firm is able to control expenses and generate revenue
a. Profit margin = Net income / Sales
b. Return on assets (ROA) = Net income / Total assets
c. Return on equity (ROE) = Net income / Total equity
* ROE > ROA ?
4. Profitability ratios
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Note that
ROE = Net income / Total Equity
= (Net income /Total assets) * (Total assets / Total equity)
= ROA * Equity Multiplier = ROA * (1+Debt-equity ratio)
If debt=0, ROE=ROA.
If debt>0, ROE>ROA.
Analysis : ROE and ROA
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Earning per share = Net income / Share outstanding
a. Price-Earning ratio (PE) = Price per share / Earning per share
b. Market-to-book ratio (M/B) =Price-to-book ratio (P/B) = Market value per share / Book value per share
- Book Value is based on historical cost of assets - Market Value measures current value of assets and liabilities. - Market Value is forward looking and it reflects a firm’s potential growth.
* Where to get Book Value and Market Value?
5. Market value ratios
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PE and PB ratios
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PE ratios
Robert Shiller’s calcula?on for current S&P 500 PE Ra?o
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Company ABC has a return on equity of 0.1 and a leverage (Assets / Equity) of 2. A private equity firm takes it over, sells 25% of ABC’s assets to buy back its shares, therefore reducing ABC’s equity by the same dollar amount, and this also results in a 10% reduction in net profit. All other relevant data are unchanged. What is ABC’s new leverage?
Let Assets be A. Then Equity=A/2 and Liability=A/2. Assets reduced by 25% and all of the reduction came from equity. So new Assets= ¾*A, new equity=1/4*A, and new liability=A/2. So the new leverage is new assets / new equity = 3.
Example
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ROE = Net income / Total equity
= (Net income / Total assets) * (Total assets / Total equity)
= (Net income / Sales) * (Sales / Total assets)
* (Total assets / Total equity)
= Profit margin * Total asset turnover * Equity multiplier
Three components:
Operating efficiency (profitability)
Asset use efficiency
Financial leverage
Du Pont Identity
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How does leverage affect the EPS and ROE of a firm?
Debt financing=> increase the fixed interest expense
Ø In a good year, we pay the fixed interest expense and we have more left-over for stockholders
Ø In a bad year, we we still have to pay the fixed interest expense and we have less left-over for stockholders
Leverage amplifies the variations in both EPS and ROE
The Effect of Leverage on EPS and ROE
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Let’s ignore taxes.
What happens to EPS and ROE when we issue debt and buy back shares of stock?
Example: The effect of Leverage
Current Proposed
Assets $8,000,000 $8,000,000
Debt $0 $4,000,000
Equity $8,000,000 $4,000,000
Debt/Equity Ratio 0 1
Share Price $20 $20
Shares Outstanding 400,000 200,000
Interest rate 10% 10%
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Example: The effect of Leverage (Con’t)
Proposed Capital Structure: Debt = $4 million , Equity = $4 million
Recession Expected Expansion
EBIT $500,000 $1,000,000 $1,500,000
Interest 400,000 400,000 400,000
Net Income $100,000 $600,000 $1,100,000
ROE 2.50% 15.00% 27.50%
EPS $0.50 $3.00 $5.50
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• Variability in ROE
- Current: 6.25% to 18.75%
- Proposed: 2.50% to 27.50%
• Variability in EPS
- Current: $1.25 to $3.75
- Proposed: $0.50 to $5.50
Thus, financial leverage increased the variability in ROE and EPS.
Example: The effect of Leverage (Con’t)
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- There is no underlying theory, so there is no way to know which ratios are most relevant.
- Benchmarking is difficult for diversified firms
- Globalization and international competition makes comparison more difficult because of differences in accounting regulations
- Different fiscal years
- Extraordinary events
Potential Problems using Ratios
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Simple Interest vs. Compound Interest
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Simple Interest : Interest earned only on original investment, not on interest
Compound Interest : Interest earned on both original investment and interest
: Reinvesting the interest from original investment
By default, we use Compound Interest in this course.
Simple Interest vs. Compound Interest
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Suppose you have $100 to save in the bank for two years. How much will you get after two years?
1) The bank pays 10% simple interest.
2) The bank pays 10% compound interest.
Example: Compound Interest
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Compound interest is always higher than simple interest. We ALWAYS use COMPOUND interest in this class!!!
Example: Compound Interest (Con’t) Simple Interest Compound Interest
Investment Interest Total Investment Interest Total
1 year 100 10 110 100 10 110
2 year 100 20 120 110 11 121
3 year 100 30 130 121 12.1 133.1
4 year 100 40 140 133.1 13.31 146.41
5 year 100 50 150 146.41 14.641 161.051
10 year 100 100 200 259.37
30 year 100 300 400 1744.94
50 year 100 500 600 11739.08
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* Going back to the previous example:
Invest $100 at 10% interest rate for 2 years
1) Annual Compounding:
2) Monthly Compounding:
3) Daily Compounding:
4) Continuous Compounding
Number of Compounding Periods
100× (1+ 0.10)2 =121
100× (1+ 0.1012
)24 =122.039
100× (1+ 0.10365
)730 =122.14
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Bring financial calculator
Bring name card
Next Class
FNCE 101 Hyun-‐Soo Choi