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Corporate Finance and Valuation (SMM467)2013/2014

Session 1:

Intro to Corporate Finance and the Corporate Objective Function

Dr Andrey Golubov

D

Course Structure

3-hour sessions over 10 weeks

9 lectures

9 seminars

Numerical exercises, discussions, case studies, guest speaker (tbc)

1 revision session

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Course Syllabus

Session 1: Intro to Corporate Finance and the Corporate Objective Function

Session 2: The Time Value of Money

Session 3: Valuing Securities and Firms

Session 4: Risk and Return in Capital Markets

Session 5: Evaluating Investment Projects

Session 6: Cost of Capital

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Course Syllabus – cont.

Session 7: Raising Capital

Session 8: Capital Structure: An Intro

Session 9: Mergers & Acquisitions

Session 10: Revision

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Assessment

Mid-term test – 25% of the final grade

Multiple choice, some questions involve

calculation

Exam – 75% of the final grade

Multiple choice questions

Numerical exercises

Essay-type questions

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Reading List

Preferred Text: Megginson W., Smart S., Graham, J. (2010) Financial Management: Linking

Theory to What Companies Do, 3rd edition, South-Western/Cengage Learning (ISBN: 978-0-538-74558-1)

Alternative Text: Hillier D., Ross S., Westerfield R., Jaffe J., Jordan B. (2010) Corporate Finance,

European Edition, McGraw-Hill (ISBN: 978-0-077-12115-0)

Academic Journal Articles

Case Studies (Harvard, Stanford, Darden)

Read FT or WSJ, check out Bloomberg or Reuters

Always bring a calculator to class!

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Before we begin…

Question:

Why should we study finance? Didn’t the

recent financial crisis prove all of the finance theory wrong?

My Answer:

The financial crisis has illustrated how badly things can go when those in charge forget the basic finance and economics principles

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Session Outline

What is Corporate Finance

Basic Corporate Finance Functions

Core Principles of Finance

Forms of Business Organization

The Corporate Objective Function

Agency Conflicts

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What is Corporate Finance?

What is Finance?Finance is concerned with the allocation of

funds under the conditions of risk (or uncertainty)

What is Corporate Finance?The activities involved in managing cash flows

of a firm (a corporation)

Principles are universal to ALL firms, large or small, private or public

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The 3 Basic Corporate Finance Functions

The Financing Decision

(Raising Capital)

The Investment Decision

(Capital Budgeting)

The Distribution Decision

(Payout Policy)

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Others Also Include:

• Risk Management• Working Capital Management• Corporate Governance

Which Finance Functions Add the Most Value?

Source: Servaes and Tufano, “CFO Views on the Importance and Execution of the Finance Function”

(Deutsche Bank, 2006).

The Financing Function

Firms can raise funds in 2 major ways:

Internally by retaining profits

Most common method

Externally from investors or creditors

Equity

Venture capital (VC) or private placements

Initial public offering (IPO)

Seasoned (follow-on) equity offering (SEO)

Debt

Short-term (Money market)

Long-term (Bank loans, bond issues, syndicated loans)

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Raising Capital: Key Facts

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Primary vs. secondary market transactions or offerings

Most financing from internal rather than external sources.

Most external financing is debt.

Financial intermediaries declining as a source of capital for large firms

Securities markets growing in importance1 - 13

The Capital Budgeting Function

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Capital Budgeting: Selecting the best projects in which to invest the firm’s

resources

The Capital Budgeting Function

The capital budgeting process consists of three steps.

Step 1 - Identifying potential investments

Step 2 - Analyzing those investments to identify which will be sufficiently profitable

Step 3 - Implementing and monitoring the

investments selected in Step 2

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The Distribution Function

Returning cash to shareholders (investors)

How much to pay out

In what form

Regular cash dividends

One-off special dividends

Stock dividends

Share repurchases

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The Risk Management Function

Identifying, measuring, and managing all types of risk exposures

Some risks are insurable, and some risks can be reduced through diversification.

Financial instruments like forwards, futures, options, and swaps may also be used to hedge

market risks such as interest-rate, price, and currency fluctuations.

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The Working Capital Management Function

Short-term financial planning

Managing daily cash inflows and outflows

Forecasting and managing cash balances

Managing trade credit and inventory

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The Corporate Governance Function

Hire qualified and honest managers, and structure their incentives to motivate them to act in the best interests of the firm

In practice the incentives of stockholders and managers (and other stakeholders) often diverge

Dimensions of corporate governance:

Ownership structure

Board structure

Executive compensation

Regulation and stock exchange rules

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The Core Principles of Finance

The Time Value of Money

Risk-Return Trade-Off

The Power of Diversification

Efficient Markets

No Arbitrage Principle

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The Time Value of Money

A dollar today is worth more than a dollar tomorrow

Why?

Smart (economist’s) answer: opportunity cost

Plain English answer: you can invest the dollar today and earn interest

We can measure it! – Session 2

Applications of this principle range from choosing a mortgage to valuing a whole firm!

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The Risk-Return Trade-Off

Investors like returns

Investors do not like risk

Compensation for risk

Investors expect compensation for bearing risk

The history of investment returns reveals this relationship – Session 4

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The Power of Diversification

Don’t put all your eggs in one basket.Investors can achieve a more favorable trade-

off between risk and return by diversifying their portfolios.Markowitz got the Nobel Prize for it!

Implications for corporate finance?Only non-diversifiable risk is rewarded

Session 4

This affects the cost of equity capital for the firm Session 6

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Market Efficiency

By market efficiency we usually mean that prices reflect all publicly available information

Competition for information tends to make markets efficient

Markets are (mostly) smartPrices reflect fundamentals

And do so instantly (or very quickly)

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No Arbitrage Principle

Arbitrage is an instant and riskless profitExample: identical assets trading at different

prices (usually in different markets)Buy where it’s cheap, sell where it’s expensive

Until your actions push the prices toward equilibrium

Risk-free money-making opportunities are extremely scarce.No free lunches in finance

If you have “identified” an arbitrage opportunity, think again!Transaction costs

Other market imperfections1 - 25

Primary Forms of Business Organization

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Sole Proprietorships

• No distinction between business and owner

• Easy to set up and operate

• Business earnings taxed as personal income

• Limited life, Limited access to capital, Unlimited personal liability

Partnerships

• Similar to sole proprietorship, but has two or more owners

• Joint and several liability

• Share of profits taxed as partnership income

Limited Partnerships

• One or more general partners with unlimited personal liability

• Most owners are limited partners, who are passive investors with limited liability

Primary Forms of Business Organization

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Are there any disadvantages for corporations?YES! Double taxation

Corporations

• Separate legal entity with many of the economic rights and responsibilities of individuals

• Unlimited life, Limited liability, Separable contracting, Improved access to capital

• Owned by shareholders, who elect the Board of Directors

• Board appoints a President or CEO to manage day-to-day operations

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Taxation of Business Income

Corporations around the World

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Type of

Corporation

Country of

Origin

In Original Language Description

AG Austria, Germany Aktiengesellschaft Publicly Listed

GmbH Austria, Germany Gesellschaft mit Beschränkter Haftung Private Limited

NV Belgium,

Netherlands

Naamloze Venootschap Private/Public

SA Belgium, France,

Luxembourg,

Portugal, Spain

Société Anonyme/ Sociedade Anónima Publicly Listed

股 份 有 限 公 司 China Mainland 股 份 有 限 公 司 Publicly Listed

有 限 公 司 China Mainland 有 限 公 司 Private Limited

ApS Denmark Anpartsselkab Private Limited

A/S Denmark Aktieselskab Publicly Listed

SE European Union Societas Europaea Publicly Listed

Oy Finland Osakeyhtiö Private Limited

Oyj Finland Julkinen Osakeyhtiö Publicly Listed

AB Finland, Sweden Aktiebolag Private Limited

Abp Finland Publikt Aktiebolag Publicly Listed

Plc India, Ireland,

Thailand, U.K.

Public Limited Company Publicly Listed

S.p.A. Italy Società per Azioni Publicly Listed

AS Norway Aksjeselskap Private Limited

ASA Norway Allmennaksjeselskap Publicly Listed

S.L. Spain Sociedad Limitada Private Limited

Ltd Ireland, U.K.,

U.S.

Limited Private Limited

Inc., Corp. U.S. Incorporated, Corporation Publicly Listed

The Corporate Objective Function

The Goal of the Corporation is to maximize shareholder wealth. But shareholders are not the only stakeholders in the firm…

Who is also involved?

Creditors

Customers

Suppliers

Employees

Government

Society

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Why maximize shareholder wealth?

Shareholder wealth maximization is socially optimal

They are the residual claimants

Get paid only after all other stakeholders’ claims are satisfied

Most successful companies keep customers happy, treat employees well, etc.

Competition ensures that everybody gets their fair share

Depends on the efficacy of the Anti-Trust and other regulation

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What Metric to Use?

Maximize Profits?

Earnings are backward-looking, dependent on

accounting principles and susceptible to manipulation

Do not fully consider cash flow timing

Ignore risk

Maximize Shareholder (Equity) Value!

In public firms shareholder wealth is represented by the market price of stock

Unambiguous, constantly updated

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What Global Companies Do

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What Global Companies Do

Separation of Ownership and Control

At some stage, founders have to hire other people to run their firms

Managers act as agents of the owners who hired them

In practice however, self-interest may cause managers to pursue objectives other than shareholder wealth maximization.

This conflict of goals gives rise to managerial agency problems.

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Agency Costs

Excessive remuneration and perquisite consumption

Corporate jets, luxurious offices, etc.

Empire-building

Remuneration is often tied to firm size, and it is more prestigious to run a larger firm

Unnecessary diversification

Managers want job security and diversify the firm’s activities to smooth out earnings

But investors can diversify on their own at a very low cost 1 - 36

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How to Mitigate Agency Problems?

Shareholder activism

Proxy fights

Institutional owners, block holders

Takeover threat

The “market for corporate control”

Monitoring and bonding

Board oversight (outside directors, CEO/Chairman separation)

Independent Audit

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How to Mitigate Agency Problems?

Executive compensation contracts

Tie managerial wealth to stock value (stock

option)

Regulation and stock exchange rules

Sarbanes-Oxley, The Combined Code, etc.

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Corporate Governance around the World

A nation’s corporate governance system is the set of laws, regulations, institutions, and practices that determine how a company is to be governed and how control of a company can be contested.

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Law and Finance

The “Law and Finance” model of economic growth (La Porta, Lopez-de-Silanes, Shleifer, and Vishny studies) states that the most important determinant of capital market development is the degree of legal protection afforded to outside (noncontrolling) investors.

This determining factor depends largely on whether a country’s legal system is based on English common law or another legal tradition.

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English common law

Strongest protection for minority investors

Has led to an atomistic ownership structure, where a large number of investors each own a small portion of a company.

German law

Scandinavian law

French civil law

Weakest protection for outside investors

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Law and Finance

Applying the Law and Finance Model to Corporate Control

What does the Law and Finance research imply for financial managers in different countries?A key implication: corporate ownership is likely

to be much less concentrated in common-law countries than in other advanced economies.

In civil-law and German-law countries, voting blocks overwhelmingly consist of members of a firm’s founding family, even after the death of the founder.

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Summary

Corporate finance deals with the way firms raise capital, invest the proceeds, and distribute earnings

Builds on the core finance principles such as the time value of money, risk-return trade-off, diversification, market efficiency, and no arbitrage

In order to create shareholder value (but beware of conflicts of interest)

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This Week’s Reading

Essential: MSG Ch. 1 + Ch.11 part 5 on Law and Finance, or HRWJJ Ch. 1,2.

Additional: MSG Ch.2 or HRWJJ Ch. 3

Research papers: Shleifer, Andrei, and Robert W. Vishny, 1997, A survey of corporate

governance, Journal of Finance 52, 737-783.

Gompers, Paul, Joy Ishii, and Andrew Metrick, 2003, Corporate governance and equity prices, Quarterly Journal of Economics 118, 107-155.

Bebchuk, Lucian, Alma Cohen, and Allen Ferrell, 2009, What matters in corporate governance?, Review of Financial Studies 22, 783-827.

Daines, Robert M., Ian D. Gow, and David F. Larcker, 2010, Rating the ratings: How good are commercial governance ratings?, Journal of Financial Economics 98, 439-461.

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Seminar 1

“Ben & Jerry’s Homemade” Case Study

Be prepared to discuss the case

In relation to the case you need to read: Jensen, M.C. (2001) “Value Maximisation, Stakeholder

Theory, and the Corporate Objective Function”, European Financial Management, Vol. 7 (3), pp. 297-317

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