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7211AFE Corporate Finance

Convenor: Richard ChungWeek 1

Introduction, Financial Statements

Ross, Ch. 1 & 3

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Agenda• Course Introduction• Tutorial questions• Corporate Finance• Finance Markets• Accounting Review - Financial Ratio Analysis

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Course Intro• Course Convenor: Associate Professor Richard Chung• Office: N50 2.37• Office hour: 2-3 pm, Wed. and Thur• Phone: 5552 8584• E-mail: r.chung@griffith.edu.au

• Resources: Learning@Griffith• Please print out lecture ppt file and bring it to class

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Learning@Griffith website

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Course Intro• Key ingredients to success in Corporate Finance:

• Attend lectures, tutorials, and do tutorial questions.

• Textbook• Clayman, Fridson, Troughton, Corporate Finance, 2nd Ed.,

Wiley.  (required)• Ross, Bianchi, Christensen, Drew, Thompson, Westerfield,

Jordan, Fundamentals of Corporate Finance, 6th Ed., McGraw Hill

• Some useful websites:• www.wikipedia.org• www.google.com/finance

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AssessmentItem Week

(due date)Duration Coverage Format Weight

Online Quizzes

3 (Mar. 18), 6 (Apr. 15), 10 (May 13), 13 (Jun 3) (Fri. 5pm)

1 hour Multiple Choice (MC), T/F

20%

Mid-Semester Exam

7 2 hours Week 1-5 material

MC, short questions

30%

Final Exam

Exam week 2.5 hours whole course (focus more on week 6-13 material)

MC, short questions

50%

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ActivityWeek Activity Chapter (text)

1 Intro, Financial Ratios 1, 3 (Ross)2 Working Capital Management 8 (Clayman)3 Time Value of Money 5 (Ross)4 Capital Budgeting 1 2 (Clayman)5 Capital Budgeting 2, CAPM 2 (Clayman)6 CAPM Expected return 11 (Ross)7 Mid-semester exam8 Leverage 4 (Clayman)9 Cost of Capital 3 (Clayman)10 Capital Structure 19 (Ross)11 Dividend and Share Repo 6, 7 (Clayman)12 Derivative Market 1 (Hull)13 Course Revision

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Tips• Calculator ($10 from Kmart) specifications:

• Scientific calculator only, Programmable calculator NOT allowed in the examinations• Includes the add, subtract, multiply, divide the power (^), the natural log (ln)

functions• Allows you to enclose brackets.

• Study tips• Write down questions you have, ask me in e-mail or consultation hours • Exam questions are based mostly on lecture material and tutorial questions

• Exam tips• Get enough sleep the night before.• Arrive 10 minutes before exam begins, relax, and don’t study then.• At the beginning of the exam, scan through the whole exam. Attempt the easy

questions first, and the difficult questions last.

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Homework questions• Exam questions will be similar to but not limited by the tutorial

questions.• Intro 1-5, 13-15, 17, 18 • (skip other questions)• Working Capital: 2,3,6,7,8-12• TVM: 1-15• Capital Budgeting: 1, 2, 8-10, 12, 15-18, 24-26, 33-38• CAPM: 1-6, 8-10• Leverage: 1-16• Cost of Capital: 1-18, 27• Capital Structure: 1-19• Dividend: 6: 1-16; 7:1-14• Derivatives: 1-6

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QuestionsPrior to the iPad’s launch in 2010, what did financial experts at Apple do: Benefit (B); Cost (C)

• Estimate the potential market for such a device, how many units can be sold? (B)

• Estimate production cost, sales price. (C)• Estimate breakeven quantity. (C)• How to hedge foreign currency risk (C)

Managers should ask, does certain action generate benefit more than the cost? Does this create value for the firm?Benefit-Cost Analysis in EconomicsAccounting and Finance are branches within Economics

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Key Concepts and Skills (Ross, Ch. 1, 3)

• Financial markets – businesses, investors, securities• Chief Executive Officer’s (manager) goal• CFO duties? Investment, Financing, DividendQ) If share price goes down by 20%, want to buy/sell shares?• Balance Sheet, Income Statement• How to detect co. financial problem? Du Pont Identity • Solutions (more details in 7251AFE, Applied Finance)• Agency problem and solution

FinancialMarketBusiness Investors

$

Securities

Projects

$

$

Financial Markets• Role of a Financial Market - to channel savings into investments• Money (ST) markets involve the trading of short-term (ST) debt

securities, eg Treasury bills.• Capital (LT) markets involve the trading of long-term (LT) debt

securities and common shares.• Primary markets involve the original sale of securities from

companies. Eg. Facebook initial public offering in May 2012 was worth $104B

• Secondary markets involve the trading of issued securities among investors on stock exchanges. Eg. Rio Tinto shares are traded on ASX

• Financial Money Market• Market (ST) Stock Market Primary Market• Capital Market Secondary market• (LT) Bond Market

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Goal of Manager

• Who hires a manager?

• Who elect the members of Board of Directors?

• The manager of a company makes decisions on behalf of shareholders, to maximize shareholder’s wealth, or share price.

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Board of Directors

CEO

CFO

Shareholders

CFO duties• Capital budgeting (Investment)

• Invest in profitable long-term projects (Eg. production in Indonesia).

• Project is ‘profitable’ if cash inflows exceed cash outflows.

• Capital Structure (Financing)• How should we finance the capital investment?• The debt-equity should be 50%-50%, or 30%-70%?

• Dividend• If business is successful, should we pay cash dividends? If

so, how much? Dividend/Net income= 10%, 50%, 100%?

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Investment• Capital budgeting is the planning of capital investment in fixed

assets to generate future cash inflows. (Eg. production in Indonesia)• Tradeoff = Forgoes today’s $ (Cost) for more future $ (Benefit)

• Input – future cash flows size, timing and risk• Output – profitable or unprofitable (good or bad) project• => Input Criteria Output

=> Investment decision = invest in which projects?

Q) If the co. invests in very profitable projects, accounting profitability incr/decr? stock price incr/decr?Investment decision affects Firm Performance

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0 1 2

-10

3

55 5

year

CF

Financing• After co. has decided take a project, it would need to raise

money to pay for machinery, factory, etc. Where would the money come from, debt or equity?

• Debt (Bank loan, Bonds) – can borrow money now, but need to repay interest every month and principal at maturity in the future.

• Advantage: Can use other people’s $ to generate profit in your own business, you contribute less capital.

• Disadvantage: If co. borrows too much money from bank, bankruptcy risk very high.

• Tradeoff = financial leverage can reduce contributed capital (Benefit) but incr bankruptcy risk (Cost)

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Financing• Financing decision = what should be the mix of debt

(bond or bank loan) and equity (eg. 50%/50%) used to finance the firm’s operations.

• Q) Would a high tech. co. choose 10%/90% or 90%/10% mix?

Financing decision affects Firm Performance

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Dividend• If a co. generates profits, with Net Income (NI) >0. Then, co. may

pay out cash dividend to shareholders• Tradeoff = to pay dividend to shareholders now vs to keep the

funds in the firm for reinvestment to generate more CF in future.

• Dividend decision = What should be the Dividend/NI ratio?• Q) Would a high tech. co. pay more or less cash dividend to

shareholders?

Dividend decision affects Firm Performance

• Optimal Investment, Optimal leverage, Optimal dividend → maximize firm-value• Otherwise, co. may go bankrupt

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CFO duties summaryDuties Question Scenario Benefit CostInvestment Invest in which

projects?Invest in more projects

More CF in future

Less CF now

Debt financing

Debt-to-Asset ratio?

more debt Less contributed capital

Higher bankruptcy risk

Dividend Dividend-to-Net Income ratio?

More dividend

More CF for SH now

Less CF for reinvestment/ future Dividend

HW 1, 2, 5

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Accounting Review - Questions• Q) If you go to a bank to apply for a mortgage loan, what

documents do you need to provide to the bank? Why?

• Banker wants to have some idea of:

• Q) Have you filed an income tax return before?

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Overview – major item categoriesBalance Sheet

Asset Liability

(Short-term) Current Assets Current Liability (Short-term)

(Long-term) Fixed Assets Debt (Long-term)

Equity

Total Asset Total Liab & Equity

Income Statement

Sales +CF

- Expenses -CF

-Taxes -CF

=Net Income Net

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Balance SheetAssets Liability and Equity

(Person)Cash Utility bills

House Mortgage Loan________ Equity = Assets - Utilitiy bills – mortgage loanAsset Liability & Equity

(Corporation)

Current Assets Current Liability

Fixed Assets Debt (LT)_________ Equity= Total Assets – Current liab – LT Debt_

Total Asset Total Liability & EquityInvestment

Financing

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Income Statement(Person) (Corporation)

Salary Sales Sales-Medical Expenses -Cost of Good Sold -CGS

-Operating expense -Exp-Depreciation -Depreciation -Depr

Earnings Before Interest and Taxes EBIT-Mortgage loan Interest Expenses -Interest expense -IntIncome before tax Earnings Before Taxes EBT-Taxes -Taxes -TaxNet Income (for food, vacation..) Net Income NI

Dividend

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Comments• Personal Income Statement similar to Income Tax Return

• Eg. You bought a laptop for $1000 for work, life=3 yr • => Depreciation = 1000/3 = $333 per year, can use this

‘non-cash expense’ to reduce taxable income • => You pay less taxes

• Why gov’t allow depreciation?

Balance Sheet• Balance sheet is a snapshot of the firm’s assets and liabilities at a

given point in time (Accumulated performance, Stock Concept)

• Balance Sheet Identity: • Assets (V) = Liabilities (D) + Stockholders’ Equity (E), • V = D + E => E = V – D __ 0 for healthy firms

• Net Working Capital = Current Assets – Current Liabilities• NWC = CA – CL __ 0 for healthy firms• Positive when the cash that will be received over the next 12 months

exceeds the cash that will be paid out.

• Current ratio = CA/ CL < 1 => CA < CL• Q) Is the co. in healthy if Current ratio < 1 ?

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Balance Sheet

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NWC(2005)=CA-CL=

E(2005)=

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GlossaryTerms ExplanationAccounts Receivable Sales made on credit card

Net Plant & Equipment Book value of long-term net fixed assets

Accounts Payable Suppliers have delivered some supplies, bill to be paid within 1 year

Notes Payable Short-term debt, due within 1 year

Common stock and paid-in-surplus

Book value of common shares sold to investors

Retained earnings Accumulated earnings not paid out as dividend to shareholders

Return on Equity Profit per unit equity

Profit Margin Profit per unit Sales

Asset Turnover Sales per unit asset

Equity Multiplier Asset per unit equity (financial leverage measure)

Income Statement

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Sales- CGS- Depr

EBIT- Int

EBT- tax

NI

Should dividend be more than Net Income?

Income Statement• The income statement measures the current performance of a firm

(Flow Concept)• Q) Was the co. profitable last year if Net Income (NI) > 0?• Define Profit Margin = NI / Sales

• Eg. Results for 2 New Zealand restaurant co. in FYR 2011 ($K)Burger Fuel Restaurant Brands

Sales $8,260 K $324,900 KNet Income 34 24,017Profit Margin 34/8260=0.41% 24017/324900 = 7.39%Q) Which co. is more profitable?

Lesson: Use ratio to account for size effect

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Du Pont Identity• Eg. Apple i-phone: • P=unit price; Q=quantity sold, V=unit cost; TA=total asset• NI = Sales – CGS – Depr – Interest – tax• = Q(P-V) – Depr – Interest – tax

• Define Return on Equity = Net Income/ Equity, or ROE = NI/E • If a co. has good/poor performance (ROE), how to identify the outstanding/

problem area?• Low ROE can be due to low numerator or high denominator• a. Low NI (numerator) due to low Q, low (P-V), or • b. High Equity (denominator) can be due to use too much equity (too low

financial leverage = D/(D+E) )

• (3) Du Pont Identity: ROE = PM * TO * EM (From Formula sheet)• NI/E = NI/Sales * Sales/TA * TA/E• = (Q(P-V) - ..)/(Q*P) * (Q*P)/TA * TA/E• Return on equity = profit margin * asset turnover * equity multiplier•

Sales = P * Q

- CGS = V * Q

- Depr

EBIT

- Interest

EBT

- tax

NI

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2005 Results (data from P. 25,27)• Sales, = $1509 M, Total Asset, TA = $3112 M• Net income, NI = $412 M, Current Liability, CL = $389 M• Current Asset, CA = $1403 M, Equity, E= $2269M

• Du Pont Identity: ROE = PM * TO * EM• NI/E = NI/Sales * Sales/TA * TA/E• 412/2269 = 412/1509 * 1509/3112 * 3112/2269• 0.1816 = 0.2730 * 0.4849 * 1.3715

• Q) Did the co. perform well last year?• Yes, the co. performed better than the competitor due to higher PM

Ratio Co. Competitor

ROE 18.16% 13.25%

PM 27.3 20

TO 48.49 48

EM 137.15 138

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Du Pont Identity• Du Pont Identity: • ROE = PM * TO * EM• NI/E = NI/Sales * Sales/TA * TA/E

• Eg: In 1980, US airlines objective = max market share => Maximize PM or TO? ROE = PM * TO * EM => Ticket price high/ low, PM high/ low Poor ROE, poor stock return (-) (+)

Similar strategy pursued by China banks in Hong Kong now.

Lesson: Max Firm’s Profitability and Share Prices

Why Evaluate Financial Ratios?• Peer Group Analysis - Compare to similar companies or

with the industry

• Q) If very intense competition, co. profitability (ROE) high / low

• Crown (Casinos, hotels) – ROE high / low• Woolworth (grocery) - ROE high / low• Fairfax media (printing newspaper) - ROE high /

low

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Financial ratios for different companies in 2011-2012

Copyright © 2012 CFA Institute 35

Accounting Equation Review

Sales- CGS- depr

EBIT- Interest- tax

NI

Assets Liabilities and Owners’ equity

Current Assets Current liabilities

Fixed Assets Long-term Debt

Equity

Total Assets Total Liab & Equity

Income Statement Balance Sheet

Agency Problem• Agency relationship

• Principal hires an agent to represent his/her interest• Stockholders (principals) hire managers (agents) to run the company

• Agency problem• Conflict of interests between principal and agent• Eg. Suppose you have to attend a party and hire someone to babysit

your 1-year old child, any problem?• Eg. Special income $1M, what would a good or bad manager do?

• Agency cost = Cost arising from the conflict of interests between owners’ and managers, eg monitoring costs, corporate jets, co. cars

• Q) How to solve this agency problem?

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Managing the Managers• Managerial compensation (carrot)

• Incentives can be used to align management and stockholder interests (eg stock options, bonus)

• The incentives need to be structured carefully to make sure that they achieve their goal. Too much stock options, manager would take too much risk.

• Corporate control (stick)• Board of directors can fire bad management• The threat of a takeover may result in better management

• Other stakeholders• Governments, suppliers, employees

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Summary• Financial Markets – Money Markets (ST), Capital Market (LT)

• CFO duties• Investment – What projects to invest?• Financing – What should be the %debt ratio?• Dividend – What should be the dividend payout ratio?

• Accounting – Balance Sheet• - Income Statement• - Du Pont Identity: ROE = PM * TO * EM

• Agency problem and solutions

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Formulas• (1) Asset = Debt + Equity = D + E•  • (2) Return on Asset, ROA = Net Income / Assets•  • (3) Du Pont Identity: Return on Equity • = Profit Margin * Asset Turnover * Equity Multiplier• => ROE = PM * TO * EM• => Net Income/ Equity = Net Income/ Sales * Sales/ Asset *

(1+ D/E)•  • HW 3, 4, 13, 14, 15, 18