lecture1 (1)
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corporate financeTRANSCRIPT
Dr Thomai Filippeli
Lecture 1
Lecturer: ◦ Dr Thomai Filippeli◦ E – mail: ([email protected])◦ Room: W415◦ Office Hours: Friday 3pm – 5pm
Lectures:◦ 10x2 hours; Friday 12pm – 2pm, Fogg LT
Tutorials:◦ 10x1 hours
Assessment: ◦ Mid - term test (20%), Week 9, 27th of November◦ Final Exam (80%)
Lecture notes and tutorial questions can be downloaded from QM+.
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TextbookJonathan Berk and Peter DeMarzo, Corporate
Finance, global edition (3rd edition), Pearson, 2013
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Lecture notes
The lecture notes will be available on QMplus the
day before the lecture
Classes
On QMplus you will find the exercises for next
week
You are expected to solve the exercises BEFORE
each class
Model answers to the exercises will be available
on QMplus after the class
Class attendance is COMPLULSORY
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Berk and DeMarzo:
Chapter 1: The Corporation
Moles, Parrino and Kidwell:
Chapter 1: The Financial Manager and the
Firm
Chapter 2: The Financial Environment and
the Level of Interest Rates
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Basic principles of corporate finance
Four types of firms
Ownership versus Control of Corporations
Explain the role of the financial manager
Principal-agent problems
The stock markets
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It is the area of finance dealing with monetary decisions
that business enterprises make and the tools and
analysis used to make these decisions
Every decision made in a business has financial
implications, and any decision that involves the use of
money is a corporate financial decision.
Defined broadly, everything that a business does fit
under the rubric of corporate finance.
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Firm needs to raise (borrow) capital to finance its
investment and then pay its investors
There are many different ways to borrow money
(ie debt, equity) and to pay investors (ie coupons,
dividends, repurchases)
Modigliani and Miller: it is irrelevant how you raise
money and pay money
Deviations from M&M: taxes, bankruptcy costs,
agency costs, informational costs
Firms should look for cheapest way to do this
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1. The Investment Principle
It determines where the firms invest theirresources
2. The Financing Principle
It governs the mix of funding used to fundthese investments
3. The Dividend Principle
It answers the question of how much earningsshould be reinvested back into the businessand how much returned to the owner of thebusiness
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A firm is unprofitable when it fails to
generate sufficient cash flows.
Firms that are unprofitable over time will be
forced into bankruptcy by their creditors
In bankruptcy, the company will either be
reorganised or the company’s assets will be
liquidated.
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1.The capital budgeting decision: Which
productive assets should the firm buy?
A good capital budgeting decision is
one in which the benefits are worth
more for the firm than the cost of the
assets
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2.The financing decision: How should the firm
finance or pay for assets?
Financing decisions involve trade-offs
between advantages and disadvantages of
debt and equity financing.
Working capital management decisions: How
should day-to-day financial matters be managed
The mismanagement of working capital can cause
the firm to go into bankruptcy even though the firm
is profitable.
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1. Sole Proprietorship
2. Partnership
3. Limited Liability Company
4. Corporation
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In a legal sense, it is a “person” distinct
from its owners.
The owners of a company are its
shareholders.
A major advantage of the corporate form
of business is that shareholders have
limited liability.
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The owners of companies are subject to
double taxation first at the corporate level
and then at the personal level when
dividends are paid to them.
Public companies can sell their debt or equity
in the public securities markets.
Private companies are held by a small
number of investors.
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A set of projects which deliver future cash
flows (CF)
A firm is owned by investors with different
ownership rights or they own different pieces
of the firm.
Two major types of ownership: debt and
equity
How to become owner? Buy debt or equity
(lend money to the firm)
The firm owns 100k barrel of oil today, it will
liquidate in one year
If price is $90/barrel, what is the liquidation value?$90 x 100k = $9M
This example: price December 2007
Price June 2008 : $140
Price July 2012: $91
Price oil changes means firm’s value changes : Risk for the
firm
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There is an outstanding zero coupon bond with
face value $5M. Zero coupon: one time payment (face value) at maturity
Key feature of bonds: It is a promised payment
debtor must pay (if debtor can pay) Therefore debt is senior to most other payments (equity)
Equity is junior, it is paid after debt is fully paid (voting rights)
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D=min(5M, 100k*P)
E=max(0,100K*P-5M)
What is the value of the debt and equity today?
If price is $40? $90? $140?
D=min(5M, 4M or 9M or 14M)=4M or 5M or 5M
E=max(0,4-5 or 9-5 or 14-5)=0 or 4M or 9M
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In the case P=$90 the total firm value is $9M, total
value of debt is $5M and total value of equity is
$4M.
4+5=9, E+D=V
If I would have set the face value to be any other
number we would have found the same thing: E
and D would change but E+D = 9 would not
change
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M&M says it does not matter how we split
up the financing needs of the firm, the total
firm value remains unchanged if certain
assumptions hold.
What do we need to add/change in the
above calculation so that M&M no longer
holds?
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Suppose that equity payouts are taxed but not the
debt payouts.
Then we would want as much debt as possible
Other reasons: Agency costs, Distress costs,
Asymmetric Information
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Key feature: since debt payments are promised
(along with other payments such as salaries) they
must be payout before equity
Equity is the residual of what is left in the firm after
all promised payments paid out.
Equity payments are directly tied to firm’s
performance
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Absolute Priority: Laws about which
claimholders are paid out first, equity is
last
Limited liability: Equity owners will get no
less than zero, they cannot be responsible
for the firm’s debts
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Common Shares: 80% of all equity, voting
rights, these are the owners of the firm
Preferred Shares: seniority over common
shares in payouts, dividends
predetermined at time of sale
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Firm consists of several projects worth $100M
Firm has 10M shares outstanding valued at $10
per share
Firm wants to raise $20M in cash, to do this it will
sell shares at price P
What is the number of shares sold? What is the
total value of the firm after the transaction?
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Number of shares sold: N=20/P
Total firm value after shares sold is the old firm
value (100) plus the infusion of cash (20) 100+20
= 120
Total shares outstanding: 10+N = 10 +(20/P)
Post – SEO (Secondary Equity Offerings) price
per share is the firm value divided by total shares
outstanding:
V = 120/(10+(20/P)) = 12/(1+(2/P))
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If P=9, post-SEO price is 9.82. Are the new
shareholders happy? Are the old shareholders
happy?
If P=11, post-SEO price is P=10.15. Are the new
shareholders happy? Are the old shareholders
happy?
The only fair price is 10!
What if new shareholders didn’t know the true
value of the firm? What if old shareholders could
artificially inflate it?
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Corporate Management Team
◦ In a corporation, ownership and direct control are
typically separate.
◦ Board of Directors
Elected by shareholders
Have ultimate decision-making authority
◦ Chief Executive Officer (CEO)
Board typically delegates day-to-day decision making
to CEO.
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Ultimate management responsibility and
decision-making power in the firm.
Reports directly to the board of directors,
which is accountable to the company’s
owners.
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Responsible for the best possible financial
analysis that is presented to the CEO.
Positions that report to the CFO:
The chief accountant prepares financial
statements, oversees the firm’s cost accounting
systems, prepares taxes and works closely with
the firm’s external auditors.
Financial Manager
◦ Responsible for:
Investment Decisions
Financing Decisions
Cash Management
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What Should Management Maximise?
Minimising risk or maximising profits
without regard to the other is not a
successful strategy.
Why not maximise profits?
With creative accounting the firm
can manipulate the profit figures.
Accounting profits are not
necessarily the same as cash
flows.
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Profit maximisation does not tell
us when cash flows are to be
received.
Why not maximise profits?
Profit maximisation ignores the
uncertainty or risk associated with
cash flows.
What Should Management Maximise?
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Maximise the Value of the Firm’s Share Price
When analysts and investors determine
the value of a firm’s shares, they
consider:
The size of the expected cash flows.
The mechanism for determining share
prices overcomes all the cash-flow
objections raised.
The timing of the cash flows.
The riskiness of the cash flows.
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An appropriate goal for financial
management is to maximise the current
value of the firm’s shares.
For private companies and partnerships,
the goal is to maximise the current value
of owner’s equity.
Maximise the Value of the Firm’s Share Price
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Can Management Decisions Affect Share
Prices?
YES!!!
Goal of the Firm
◦ Shareholders will agree that they are
better off if management makes
decisions that maximizes the value of
their shares.
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The Firm and Society
◦ Often, a corporation’s decisions that increase the value
of the firm’s equity benefit society as a whole.
◦ As long as nobody else is made worse off by a
corporation’s decisions, increasing the value of the
firm’s equity is good for society.
◦ It becomes a problem when increasing the value of the
firm’s equity comes at the expense of others.
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Ethics and Incentives within Corporations
◦ Agency Problems
Managers may act in their own interest rather than in
the best interest of the shareholders.
One potential solution is to tie management’s
compensation to firm performance.
How should performance be measured?
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Ownership and Control
For large companies, the ownership of the
firm is spread over huge number of
shareholders and the firm’s owners may
effectively have little control over
management .
Management may make decisions that
benefit their self-interest rather than those of
the shareholders.
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Agency Relationships
An agency relationship arises whenever one party, called the principal, hires another party, called the agent.
The relationship between shareholders (principals) and management (agents) is an agency relationship.
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Do Managers Really Want to Maximise the Share Price?
Shareholders own the company but managers control the money and have the opportunity to use it for their own benefit.
Agency Costs
The costs of the conflict of interest between
the firm’s owners and its management.
CEO Performance
◦ If a CEO is performing poorly, shareholders can
express their dissatisfaction by selling their shares.
This selling pressure will drive the stock price down.
◦ Hostile Takeover
Low stock prices may entice a Corporate Raider to
buy enough stock so they have enough control to
replace current management. The stock price will
rise after the new management team “fixes” the
company.
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The stock market provides liquidity
to shareholders.
◦ Liquidity
The ability to easily sell an asset for close to the
price you can currently buy it for
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Public Company
◦ Stock is traded by the public on a stock exchange.
Private Company
◦ Stock may be traded privately
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Primary Markets
◦ When a corporation itself issues new shares of stock
and sells them to investors, they do so on the primary
market.
Secondary Markets
◦ After the initial transaction in the primary market, the
shares continue to trade in a secondary market
between investors.
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Largest Stock Markets
◦ New York Stock Exchange (NYSE)
Market Makers/Specialists
Each stock has only one market maker
◦ NASDAQ
Does not meet in a physical location
May have many market makers for a single stock
◦ Bid Price versus Ask Price
Bid-Ask Spread
Transaction cost
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Source: www.world-exchanges.org
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You own 100 shares in a corporation. The corporationearns $5.00 per share before taxes. Once thecorporation has paid any corporate taxes that are due,it will distribute the rest of its earnings to itsshareholders in the form of a dividend. If the corporatetax rate is 40% and your personal tax rate on (bothdividend and non-dividend) income is 30%, then howmuch money is left for you after all taxes have beenpaid?
A) $210
B) $300
C) $350
D) $500
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You own 100 shares of a subchapter "S" Corporation. The
corporation earns $5.00 per share before taxes. Once the
corporation has paid any corporate taxes that are due, it
will distribute the rest of its earnings to its shareholders in
the form of a dividend. If the corporate tax rate is 40% and
your personal tax rate on (both dividend and non-dividend)
income is 30%, then how much money is left for you after
all taxes have been paid?
A) $210
B) $300
C) $350
D) $500
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You are a shareholder in a corporation. This corporation
earns $4 per share before taxes. After it has paid taxes, it
will distribute the remainder of its earnings to you as a
dividend. The dividend is income to you, so you will then
pay taxes on these earnings. The corporate tax rate is
35% and your tax rate on dividend income is 15%. The
effective tax rate on your share of the corporations
earnings is closest to:
A) 15%
B) 35%
C) 45%
D) 50%
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You overhear your manager saying that she plans
to book an Ocean-view room on her upcoming trip
to Miami for a meeting. You know that the interior
rooms are much less expensive, but that your
manager is traveling at the company's expense.
This use of additional funds comes about as a result
of:
A) an agency problem
B) an adverse selection problem
C) a moral hazard
D) a publicity problem
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Consider the following two quotes for XYZ stock:
November 11th November 18th
Ask: 25.25 Ask: 26.00
Bid: 25.20 Bid: 25.93
How much would you have to pay to purchase 100
shares of XYZ stock on November 18th?
A) $2520
B) $2525
C) $2593
D) $2600
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How much would you receive if you sold 200 shares
of XYZ stock on November 11th?
A) $5050
B) $5040
C) $5186
D) $5200
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