Chaper 4 Corporate Finance

7/31/2019 Chaper 4 Corporate Finance

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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.

Chaper 4 Corporate Finance

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