Chapters 1-5 Exam Training (1)

Chapter 1

Introduction to Corporate Finance

The firm as a balance sheet

3 Questions:

Which assets to buy? (Capital Budgeting)

How to raise cash? (Capital Structure)

How to manage short term cash flows? (Net working capital)

2 Finance Crash Course 2012

The firm as a pie (Capital Structure)

We think of the firm as a pie. It shows us how the firm is “sliced up” between debt- and equity holders.

In Essence: V=B+S (which is BS), better V=D+E


Value creation

Note: Accounting profits and cash flows are fundamentally different!

Goal of Finance: Maximize share price of the company


Basic principles of Finance

Again: €100 today is worth more than €100 in a year.

Why?

Three main reasons

Interest is forgone: Your money has earnings potential. You

could invest it at 5% p.a. today and have €105 in one year’s

time

Inflation: Your €100 will very likely be worth less in one year,

because inflation decreases it’s buying power. (Note: nominally,

you’ll still have €100)

Risk: How can you know, that you will actually receive €100 in

one year? Even with the best contract, you might have to fight

for it in court.


Quiz

Should you pay SEK100,000 every month for one year or

pay SEK1,200,000 at the end of the year?

Intuitively: Time value of money!

Nominally the same (12x100,000=1,200,000)

However, paying SEK100,000 every month means, cash

will leave your firm more quickly than if you would pay

SEK1,200,000 in one year! You forgo the earnings

potential of SEK100,000 every month with the first plan.

The later you pay the better!

Solution: Pay SEK1,200,000 at the end of the year!


Quiz

Finance Crash Course 2012 7

End of

Month Annuity [SEK] PV Lump Sum [SEK] PV

1 100.000 /(1+0.01)1 99009,90

2 100.000 /(1+0.01)2 98029,60

3 100.000 /(1+0.01)3 97059,01

4 100.000 /(1+0.01)4 96098,03

5 100.000 /(1+0.01)5 95146,57

6 100.000 /(1+0.01)6 94204,52

7 100.000 /(1+0.01)7 93271,81

8 100.000 /(1+0.01)8 92348,32

9 100.000 /(1+0.01)9 91433,98

10 100.000 /(1+0.01)10 90528,70

11 100.000 /(1+0.01)11 89632,37

12 100.000 /(1+0.01)12 88744,92 1.200.000 /(1+0.01)12 1064939,07

Total PV 1125507,75 1064939,07

Quiz

Quiz: What if you had to pay SEK1,400,000 at the end of

the year?

We don’t know, unless we have the discount rate.

If the discount rate is very high->pay at the end of the year

If it is low-> better to pay earlier, but nominally less


Chapter 2

Corporate Governance

Business Forms

Sole Proprietorship

Owned by one person

Pays no corporate taxes

Unlimited Liability, Limited Lifespan

Partnership

Limited and General partners

Pays no corporate taxes

Controlled by general partners


Business Forms

Corporation

Legal entity: Limited Liability for investors

Owned by shareholders

Potentially eternal lifespan

Private or public

Double taxation

Requires articles of incorporation to form


Corporate Governance for Corporations

Agency relationship between managers and shareholders:

How to ensure that managers act in the best interest of

shareholders?

Agency costs:

Perquisites

Shirking

Pet projects – Most expensive of them all!

Monitoring through boards (one-tier or two-tier)

Monitoring through large shareholders: banks, institutional

investors (bank vs. market-based financial system)

Bonding: Share options…


Quiz

What are the advantages and disadvantages of a

corporation over a sole proprietorship?

Advantages:

Easy access to financing

Limited Liability

Legal Entity

Disadvantages

Double taxation

Agency problems


Quiz

In case of bankruptcy who gets paid last?

Share holders are the “residual claimants”. They get

whatever is left.


Chapter 3

Financial Statement Analysis

The Balance sheet

Assets

Current: Inventories, Trade receivables, Cash

Non-Current: Property, plant and equipment, Intangible assets

Liabilities

Current: Trade payables

Non-Current: Long term debt

Equity: issued share capital, share premium, retained

earnings

Generally: Assets=Equity+Liabilities


Definitions

Assets

Controlled by the firm

Provide future benefit

Can be tangible and intangible

Liabilities

Present obligations

Expected outflow of benefits

Equity

Residual claim after deduction of liabilities


Income Statement

Revenue – Cost of goods sold=Gross profit

Gross profit – Operating and administrative

expenses=EBIT

EBIT – interest payments=EBT

EBT – taxes=Net income


Definitions

Expenses

Decrease in assets or liabilities that result in decrease of equity

Within the ordinary course of business

Expenses or losses

Income

Increase in assets or liabilities that result in increase of equity

Within the ordinary course of business

Revenue or gains


Cash Flow statement

Cash provided by:

operating activities: principal revenue generating activities in

the firm (providing service, selling good)

Investing activities: increase or decrease in non-current assets

(PPE, intangible assets, other companies), generate future

income

Financing activities: cash to and from equity and debt holders

(issuing shares, dividends, borrowing)


Quiz

Which of these is an asset?

A new manager hired to increase sales

A patent

A plant the firm rents to serve excess demand

Cash on the bank account

A new floor waxing machine in the HR department


Quiz

Asset definition:

Controlled by the firm

Provide future benefit

Can be tangible and intangible

Manager: Not controlled

Patent: asset

Rented plant: Expense, because not controlled

Cash: by definition an asset (albeit short-term)

Waxing machine: definitely asset


Taxes

Average tax rate for a firm:

The tax bill divided by taxable income

Actual percentage of taxes paid

Marginal tax rate:

Tax charge on last earned Euro


Quiz

Aerosol BV earned €452,000 of taxable income last

year. The average industry tax rate is 22.5%. The

applicable tax regime looks as follows:

What is the marginal tax rate for Aerosol BV?

Bracket Applicable Tax rate

€0-€70,000 18%

€70,001-€220,000 19.5%

€220,001-€500,000 23%

>€500,000 25%


Quiz

Marginal tax rate is the rate paid on the last earned Euro!

In this case: 23%

What would be the average tax rate?

Bracket Applicable Tax rate

€0-€70,000 18%

€70,001-€220,000 19.5%

€220,001-€500,000 23%

>€500,000 25%


Quiz

For the average tax rate, we calculate:

We then divide the paid taxes by our earnings to find the

average tax rate:

€95,210/€452,000=21.06%

Taxable Income Applicable Tax

Rate

Tax Paid

€70,000 18% €12,600

€220,000-€70,000 19.5% €29,250

€452,000-€220,000 23% €53,360

SUM €95,210


Financial Ratios

Liquidity (short term solvency):

Current ratio: Current asset/Current Liabilities

Should be at least 1, measures ability to pay the bills

Quick ratio: (CA-Inventory)/CL

Inventory often least liquid current asset

Cash ratio: Cash/CL


Quiz

Which one is usually largest, Current, Quick or Cash

ratio?

Current ratio, because the numerator includes all current

assets

What happens to the Current ratio, if I use cash to pay off

short term debt? What if I buy Inventory with Cash?

In the first case: It moves away from 1 (If >1 it becomes larger,

if <1 it becomes smaller)

Second case: Nothing happens: Cash decreases, Inventory

increases, so Current Assets don’t change


Financial Ratios

Long Term Solvency

Total debt ratio: Total debt/Total assets= D/(E+D)

Debt-Equity Ratio: Total debt/Total Equity=D/E

Equity multiplier: Total assets/Total equity =(D+E)/E or 1+D/E

They are all related! If you know one, you can calculate

the others!


Quiz

What is the Total debt ratio, when the Equity multiplier is

2.1?

We know that the equity multiplier is the inverse of the ratio

of equity to assets:

We can thus take the inverse 1/2.1=47.62% and subtract it

from 1 to arrive at

D/(D+E)=1-47,62%=52.38%

Ratio Definition

Equity Multiplier (D+E)/E

Equity to Assets E/(D+E)


Quiz

Alternatively we know that the Equity multiplier is 1 plus

the debt equity ratio, so the debt equity ratio is 2.1-

1=1.1.

Since D/E=1.1/1 we know that D/(D+E)=1.1/2.1=52.38%


Financial Ratios

Long Term Solvency

Total debt ratio: Total debt/Total assets= D/(E+D)

Debt-Equity Ratio: Total debt/Total Equity=D/E

Equity multiplier: Total assets/Total equity =(D+E)/E or 1+D/E

Times interest earned ratio: EBIT/Interest

Interest Coverage

Cash Coverage: (EBIT+Depreciation)/Interest

Depreciation added back because it’s not a cash outflow


Financial Ratios

Asset Management or Turnover

Inventory turnover: COGS/Inventory

Times inventory is turned over per year

Days’ sales in inventory: 365/Inventory Turnover

How many days between a turnover

Receivables turnover: Sales/Trade receivables

Times trade receivables are collected per year

Days’ sales in inventory: 365/Receivables Turnover

Also Average Collection Period

Total Asset Turnover: Sales/Total Assets

How much sales for every euro in assets


Financial Ratios

Profitability

Profit Margin (PM): Net income/Sales

Return on Assets (ROA): Net income/Total Assets

Return on Equity (ROE): Net income/Total Equity

The Du Pont Identity:

ROE = ROA * (1+ debt-equity ratio)

ROA=PM*Total asset turnover

ROE=PM*Total asset turnover*(1+debt-equity ratio)


Quiz

You have the following information:

Profit=€120,000

Assets=€500,000

Receivables turnover=7.1

Trade receivables=€50,000

40% debt in the capital structure

What is the ROE?


Quiz

Redundant information! We don’t need to find sales,

because we can calculate ROA directly:

ROA=€120,000/€500,000=24%

Now we need the equity multiplier. We know that there

is 40% debt, so equity must be 60%. Since the equity

multiplier is the inverse of the equity percentage:

EM=1/0.60=1.67

Through the Du Pont Identity we find:

ROE=0.24*1.67=0.4

Actually, we could have done this even more quickly.

How?


Long-Term Financial Planning

How much additional money do we need to finance

growth?

Percentage of Sales approach assumptions:

Assets grow at the same rate as sales

Spontaneous (current) liabilities grow at the same rate as sales

Equity grows by retained earnings

We can then calculate EFN as



Finance Crash Course 2012 38

Let’s try to understand the formula

The increase in assets due to the growth in sales

The spontaneous increase in debt financing (decreases the need for External Funds)

Retained Earnings, part of the profit that is not paid out as dividend (d is the payout ratio of dividends)

3.23 External Funds Needed

SalesSales

Assets*)(

SalesSales

sLiabilitieSpont*)

.(

)1(*)*( dlesExpectedSaPM


Internal growth rate:

ROA*b/(1-ROA*b) where b is the retention ratio

This is the growth rate achievable with internal financing

only (retained earnings)

Sustainable growth rate:

ROE*b/(1-ROE*b)

The growth rate achievable without increasing financial

leverage (D/E ratio)


Quiz

Where is the internal growth rate here?

IGR


Determinants of Growth

Profit Margin: Increases the ability to generate funds

internally and thus the growth rate

Dividend Policy: Increasing the retention ratio also

increases growth rate

Financial Policy: More debt makes additional debt available

Total Asset Turnover: The more efficiently the assets are

used, the fewer I need to generate sales


Chapter 4

Discounted Cash Flow Valuation

Present Value

How much must I invest today at a given rate to achieve a

certain outcome in the future?

For Example: Keith wants to have €11,424 in one year. If

he can invest at a yearly rate of 12%, how much must he

invest today?

Answer: PV*1.12= €11,424. Solving for PV, we get PV=

€11,424/1.12= €10,200

So at 12% yearly rate, €11,424 in one year is worth

€10,200 today


Present and Future Value

For a single cash flow in the future, we generally get :

This also work the other way around:

FV P

V

t=0 t=T

FV P

V

t=0 t=T


Compounding Periods

I could also have multiple period in one term (e.g. months

in a year)

If only the nominal yearly rate is given, we can adjust for

this:

As soon as we switch from discrete to continuous

compounding, we get:


Compounding Periods

The more periods, the stronger the compounding effect


Quiz

What is the effective annual rate of interest (EAR) if we

receive 6% nominal annual rate compounded quarterly?

What if we compound continuously?


Discounting

What if we have more than one cash flow?

If we have similar cash flows in equal intervals forever, we

use a perpetuity

Note that discounting formulas work on period back!

You’ll get the value of the cash flows that start in t=1 in

t=0.

C C C C C C P

V

t=0 t=1 t=2 t=3 t=4 t=5 t=6


Discounting

To find the present value of a series of equal cash flows,

that is constrained to a certain number of periods (say T),

we have the annuity formula.

C C C C C C C P

V

t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=T


Discounting

How can we adjust this formula for multiple

compounding periods?

There is also a version for Future Values:


Quiz

What is the present value of an investment that pays

€5,000 per year in semi-annual installments for 10 years if

the discount rate is 8%?

Here we also have to adjust the cash flow, because we

receive semi-annual payments, so €2,500. We then use the

formula:


Discounting

What if either a perpetuity or and annuity gives us cash

flows that grow at a constant rate (say g)?

C C (1+g)² PV

t=0 t=1 t=2 t=3

C (1+g)


Discounting

Finally, what if one of the cash flows is already due today

(annuity due)?

Note: WE DON’T SIMPLY INCREASE T BY 1!

C C C C C C PV+C

t=0 t=1 t=2 t=3 t=4 t=5 t=T


Quiz

How do we find the present value today of a series of

cash flows that starts in 4 years and keeps paying them

forever after?

First we use a perpetuity to find PV in t=3!

Then we bring this value back 3 years to t=0.

C C C

t=0 t=1 t=2 t=3 t=4 t=5 t=6

PV3 PV0


Valuing Investments

Net present value: Discounted future cash flows minus

investment today:

Invest only if positive


Chapter 5

How to value Bonds and Shares

Types of Bonds

Three common types of bonds

Most typical: Level coupon bond


Level coupon bonds

Pays a percentage of the face value as coupon (coupon

rate)

Repays the face value at maturity

What is the relationship between interest rate and the

coupon rate?

If interest rate < coupon rate: Bond sells at a premium

If interest rate > coupon rate: Bond sells at a discount

If interest rate = coupon rate: Bond sells at par!

Value of a coupon bond:


Quiz

How would we value a pure discount bond and a consol?

Pure discount bond is only one cash flow in the future:

Consols are a perpetuity:


Level coupon bonds

The Required Return on a bond is also called Yield to

Maturity or simply Yield

The Yield is the Rate of Return that equates the bond’s

market price and the PV of its cash flows.


Valuing shares

Value of a firm’s equity is equal to the PV of all future

dividends

We also call this the Dividend Growth Model


Quiz

A firm will pay €12 dividend per share next year and

promises that the dividends will grow constantly at 5%

each year. If the discount rate is 8%, what is the share

price?

We use the Dividend Growth Model

We get


Growth rate and Return

Where does g come from?

Growth is fueled by retaining earnings and by ROE (remember the sustainable growth rate?)

What about R?

The return is split into Dividend yield and capital gains yield (growth of the investment)


NPVGO model

Alternatively we can value shares like this

We assume the firm acts as a “cash cow” and pays out all

earnings as dividends

Valid under the condition that EPS is known and stable

In order to create value, the NPVGO must be positive


P/E Ratio

The NPVGO model can be rewritten into a P/E ratio:

The P/E ratio is a reflection of the equities risk (1/R) and

its growth opportunities

That’s why high growth industries like semiconductors

have higher P/E ratios than for example utilities


Chapters 1-5 Exam Training (1)

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