Lecture1 1. Introduction - Full Version (1)

8/10/2019 Lecture1 1. Introduction - Full Version (1)

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Corporate Finance

1. Introduction


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2MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. The Financial Paradigma of the Firm

II. The Corporation and the Financial System

III. Financial Instruments and the Securitization of Assets and Capital of the

Corporation

Summary


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The main objective of the corporation

I. The Financial Paradigm of the Firm

Value creation


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Value creation

Can the financial function creat value on its own?

YES

Any financing operation allowing for a reduction in the firms average cost of

capital will create value on its own;

However,

It is also very important that the financial function helps the firm as a whole to

create value, namely by meeting the requirements allowing the firm to implement

all investment projects with a positive NPV.



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Value creation

What type of value? How can we measure value?


The goal of financial management is to maximize the value of the existingowners equity

Ross, Westerfield and Jaffe, Corporate Finance (9thEdition)

The objective in conventional corporate financial theory is to maximize the

value of the firmAswath Damodaran, Corporate Finance, Theory and Practice (2ndEdition)

Are these objectives compatible? Can the firm adopt more than one objective?


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Value creation


Remember that the firm is composed of


Fixed Assets1. Tangible

2. Not tangible

Debt

Equity

Current Assets Short-termLiabilities

Investments Financing

Working Capital

Entreprise or firmvalue

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8/268MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

Value creation


Can the firm adopt more than one objective?

It is not at all convenient, because contradictory objectives might give way todifficulties in making the best decisions

The existence of a single objective favours clear decision making, because

decisions will be taken to maximize the achievement of the chosen objective

The objective

Must be clear, rather than ambiguous Maximize growth? Measured by which variable?

It must be measurable on a periodic basis and in an objective way

Maximize client satisfaction?

It must not originate costs for other groups or entities

Maximize sales (a tobacco company). One way to do it would be to intensify advertising

addressed to the youth. It might represent relevant losses for society.




Value creation



Objective: Maximize enterprise Value

(Subject to complying with the ethical values related to the costs thatmight be imposed on society by meeting this objective)

Reduction or elimination of conflicts

between the firm/management andsociety.

Objective: Maximize shareholdersWealth

Objective: Maximize stock Prices

If conflicts of interest between shareholders and managers andbetween shareholders and creditors are eliminated or at leastminimized.

If managers do not attempt to cheat or manipulate the markets andmarkets are efficient.



Value creation


Even though the main objective of the firm is to maximize enterprise

value, value creation may be measured by changes in stock prices,providing that:

Managers act in the interest of shareholders and adopt the objective of maximizing

stock prices;

Creditors are protected against the risk of wealth expropriation by shareholders;

Managers do not manipulate information and do not succeed in cheating the

markets (efficient markets);

Management decisions do not impose costs (externalities) on society.


Briefly: providing that agency conflicts are minimized.



Value creation

Advantages of adopting the objective of stock price maximization:

Stock prices are the best observable figure amongst all other alternative

measures (in the case of listed companies). Contrary to net profits or sales, stock prices reflect permanently up-dated

information.

Stock prices reflect the long-term effects of company decisions.

Stock prices are the true measure of shareholders wealth.

They allow for the choice of models to select the best investment projects

for the company and their best financing structure, and facilitate empirical

testing of those models.




Value creation

How?


Objective: Maximizing Enterprise Value

Investment ecisions

Invest in assets offering areturn higher than therequired rate of return

[hurdle rate].

Financing ecisions

Find the optimal capital mixto finance investments andthe nature of debt whichbetter meets the needs of

the corporation.

ividend ecisions

Return to shareholders anycash exceeding investments

offering a return higherthan the expected rate of

return.

The hurdle ratemust reflect theinvestment risk

and thefinancing mix.

The return onthe asset must

take intoconsideration

the amount andtiming of cash-

flows

The optimal mixof equity and

debt maximizesenterprise value

The nature ofdebt depends

on thecharacteristics

of theenterprise

assets

How much cashto return willdepend on

present andfuture

investmentopportunities

Dividend policywill depend onshareholderspreference forcash or stock

dividends.



Value creation

Questions for which a CFO might have to provide an answer:

Invest 25 million euros in increasing production capacity or wait for one

year to observe market demand performance? Implement or not a strategy of fixing:

commodity prices;

export exchange rates;

interest rate on loans?

How to finance the aggressive investment plan designed for the next three

years?

Implement or not a new management incentive scheme, based on

incentives to be decided upon?




Value creation

Questions for which a CFO might have to provide an answer:

To meet or not the demand of institutional investors for higher dividends?

Choose to offer stock dividends? Choose to offer stock repurchases? There is a merger proposal by a big telecom company. What to do?

Is it in the best interest of shareholders?

What will be the reaction by foreign joint venture partners?

Should the company remain listed in the stock market?

Should capital structure be consolidated through an increase in equity?




Value creation

One could argue that value creation cannot ignore the conflicts of

interest (agency conflicts), the power basis, as a function of

ownership structure, as well as the environment of the financialmarkets in which investment and financing operations will take

place;

Likewise, it can stated that the corporation is a nexus of contracts,

which constraint real world investment and financing decisions (and

make them more complex) .




I. O Paradigma Financeiro da Empresa

II. The Corporation and The Financial System

III. Os Instrumentos Financeiros e a Titulao de Activos e Capitais da

Empresa

Summary




World

The Corporation

Investment

decisions

Financing

decisions

Financial

Markets

Investors

Financial

Intermediaries

Direct financing

Indirect financing

Exchange of capital and financial assets

Exchange

of capital

& real

assets

Corporate FinanceFinancial Markets and

Intermediaries

Financial

Assets



A Classification of Financial Markets


FinancialMarke

tsMoney Market(S-T)

Capital Market

(L-T)

IMM

Commercial Paper[Corporate Debt]

Public Debt (Bills)

Equity

(Stocks)

Hybrid

Debt

(Bonds)[Government & Corporate]

Libor rates (Euribor)

Yields

Yields

Repurchase agreements

(REPO)

Sort-term bank loans

Commercial paper

Treasure bills (T-bills)

Common stocks

Preferred stocks

Convertible bonds

Warrant bonds

Perpetual bonds

Treasury bonds (T-bonds)

Corporate bonds (fixed rate &

float rate), zero-cupon



Other important classifications of financial markets

Primary market vs. Secondary market

Cash market (spot market) vs. Futures market (derivatives)

Domestic market vs. Currency market

Domestic market vs. International market



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Financial Institutions

Credit Institutions

Central

BankBanks

OtherIntermediaries

Commercial

Banks

SavingsBanks

InvestmentBanks

Leasing

Companies

FactoringCompanies

Venture

Capital

Private Equity

Holding

Companies

Dealers

Other

Other Financial

InstitutionsAuxiliary Institutions

Insurance Companies

Pension Funds

Insurance Brokers

Brokers

Assets Management

Firms

Information Services

Other

The financial system


Mutual

Banks

Mutual Agro

Banks


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Financial institutions play a very important role

Intermediation of cash transfers (across space, across time, across

denominations);

Intermediation of financial operations; and

Intermediation in risk allocation (financial and non-financial risks)

They can thus contribute to market efficiency, but they are

nevertheless a source of transactions costs, one of market

inefficiencies.



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I. O Paradigma Financeiro da Empresa

II. A empresa no Sistema Financeiro

III. Financial Instruments and The Securitization of Assets and Capital of

the Corporation

Summary


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The securitization of financing contracts, as well as asset

securitization, grants:

Liquidity to the assets or to the rights represented by securities;

An objective basis for asset valuation (through market prices);

The benefit of regulation by market authorities and thus the

safeguard of the intrinsic quality of the assets;

An alternative financing solution, competing with bank financing;

The possibility of converting less liquid assets into cash.

III. Financial Instruments and The Securitization ofAssets and Capital of The Corporation


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Securitization

High growth in asset securitization operations in international

markets, a trend joined by a number of Portuguese Companies;

A very common solution amongst financial institutions:

It allows a conciliation of rapid business growth levels and of the assets

allocated to it with regulation requirements, namely those related with

solvency ratios;

It is a source of development of the financial markets, a driver of

financial innovation, and a factor of investment and financing

flexibility.

III. Financial Instruments and The Securitization ofAssets and Capital of The Corporation


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What is Corporate Finance?

Corporate finance encompasses all ofa firms decisions that have financial

implications

Aswath Damodaran, Corporate Finance, Theory and Practice (2ndEdition)


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What is a firm? Why it exist?

The existence of the firm compensated for a critical flaw in theprice-setting mechanism:

Transaction costs, like the need to negotiate or draw upcontracts

Firms would exist when it was cheaper and easier to co-ordinate activity within a centrally planned organisation thanto spell out contract details for every step in the production

process.

Ronald Coase, cited by The Economist, One of the giants on 7thSeptember 2013 (5 days after his death)

Lecture1 1. Introduction - Full Version (1)

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