FINANCE 1. Introduction

1. FINANCE1. Introduction Solvay Business School Université Libre de Bruxelles Fall 2007

2. Who am I? • André Farber • Professor of Finance at Solvay Business School since…. • Past Director of the MBA program 1990-2002 • Past President of Solvay Business School • Past Dean, Faculty of Social Sciences, Politics and Economics, Solvay Business School (known as Soco) • Vice Rector for Strategy and Institutional Development MBA 2007 01 Introduction

3. Practical matters • Reference: • Berk, Jonathan and DeMarzo, Peter, Corporate Finance, Pearson 2007 • Website: www.ulb.ac.be/cours/solvay/farber • Slides • Excel files • Past exams • Grading: • 2 Problem sets (30%) • Final (70%) MBA 2007 01 Introduction

4. 1. Introduction, Financial Statement Analysis 2. Arbitrage and Financial Decision Making 3. Present value 4. Bond valuation 5. Stock valuation (Dividend Discount Mode & Free Cash Flow Model) 6. Capital budgeting (I) 7. Capital budgeting (II) 8. The Pricing of Risk 9. Optimal Portfolio Choices 10. Capital Asset Pricing Model 11. Capital Structure Decisions 12. Review Session 4 sessions Financial statement analysis – Present Value Bond valuation, stock valuation Capital budgeting + PS1 Risk and expected returns + PS2 Course outline Tutorials Céline Vaessen Course MBA 2007 01 Introduction

5. Outline for this session • 1. Financial decisions: investment, financing, dividends • 2. Measuring value creation: • Mkt val of equity > Book value of equity • Return On Equity > Opportunity cost of capital • 3. Drivers of ROE: Profit margin, Asset Turnover, Financial Leverage • 4. Statement of cash flows MBA 2007 01 Introduction

6. What is Corporate Finance? • INVESTMENT DECISIONS: Which REAL ASSETS to buy ? • Real assets: will generate future cash flows to the firm • Intangible assets : R&D, Marketing, .. • Tangible assets : Real estate, Equipments,.. • Current assets: Inventories, Account receivables,.. • FINANCING DECISIONS: Which FINANCIAL ASSET to sell ? • Financial assets: claims on future cash flows • Debt: promise to repay a fixed amount • Equity: residual claim • DIVIDEND DECISION: How much to return to stockholders? MBA 2007 01 Introduction

7. Balance sheet Income statement Sales Operating expenses = Earnings before interest and taxes (EBIT) Interest expenses Taxes = Net income (earnings after taxes) Retained earnings Dividend payments Accounting View of the Firm Net Working Capital Current liabilites Current assets Long-term debt Fixed assets Shareholders’ equity MBA 2007 01 Introduction

8. Summarized (managerial) balance sheet Liabilities Stockholders' equity (SE) Interest-bearing debt (D) Assets Net fixed assets (NFA) Working capital requirement (WCR) Cash (Cash) NFA + WCR + Cash = SE + D Working capital requirement : definition + Accounts receivable+ Inventories+ Prepaid expenses - Account payable- Accrued payroll and other expenses Interest-bearing debt: definition + Long-term debt+ Current maturities of long term debt+ Notes payable to banks MBA 2007 01 Introduction

9. Example: Global Conglomerate Corporation(based on Berk DeMarzo Table 2.1) MBA 2007 01 Introduction

10. Cash Flows of the Firm Firm issue securities Firm invest Firm Financial markets Investors Cash flow from operations Dividend and debt payments Timing of cash flows + uncertainty MBA 2007 01 Introduction

11. MBA 2007 01 Introduction

12. Cash flow statement : indirect method NFA + WCR + CASH = SE + D NFA = CAPEX - Dep CAPEX = Acquisitions - Disposals (investing & divesting) SE = NI - DIV + K K = New issuance of capital (NI + Dep - WCR) - (CAPEX) + (K + D -DIV) = CASH Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities = + + MBA 2007 01 Introduction

13. Market Value of the Firm Book values Market values Value creation Market value of equity Total capital Book equity Market capitalization Fixed Assets + Net Working Capital Market value of debt Debt MBA 2007 01 Introduction

14. The Cost of Capital • The firm can always give cash back to the shareholders • Capital employed by the firm has an opportunity cost • The opportunity cost of capital is the expected rate of return offered by equivalent investments in the capital market • The weighted average cost of capital (WACC) is the (weighted) average of the cost of equity and of the cost of debt ? Stockholder Investment opportunities in capital markets Project Cash MBA 2007 01 Introduction

15. Stockholders’ problem Company Capital market ROEReturn on Equity rExpected return MBA 2007 01 Introduction

16. How to measure value creation ? • 1. Compare market value of equity to book value • Value creation if M/B > 1 • 2. Compare return on equity to the opportunity cost of equity • Value creation if ROE > Opportunity Cost of Equity MBA 2007 01 Introduction

17. Drivers of ROE • PROFITABILITY (du Pont system) • Three determinants : Asset Turnover Profit Margin Financial Leverage MBA 2007 01 Introduction

18. Examples Source: Business Week July 26, 2004 MBA 2007 01 Introduction

19. Return on invested capital • Return on assets (net)= Net income / Total assets • Advantage: fits with DuPont system • ROE = ROA x Equity multiplier • Limitation: Net income = EBIT - Interest expense - Taxes • Depends on capital structure: • 1. Interest expense: function of interest-bearing debt • 2. Interest expense : tax deductible • Preferred measure: Return on Invested Capital (ROIC) • NB: ROIC = ROA (gross) (1 - Tax rate) • = ROE of a all equity financed firm MBA 2007 01 Introduction

20. Financial leverage • Financial leverage magnifies ROE only when ROA (gross) is greater than the interest rate on debt. • Balance sheet: TA = SE + D • Income statement: NI = EBIT - INT- TAX • Interest expense INT = r D (Interest expense = Interest rate x Interest-bearing debt) • Taxes TAX = (EBIT - r D) Tc (Taxes = Taxable income x Tax rate) • Remember : ROIC = ROAgross (1 - Tc) • ROE = ROIC + (ROAgross - r) (1-Tc) (D/SE) MBA 2007 01 Introduction

21. Financial Leverage: example MBA 2007 01 Introduction

22. Financial planning MBA 2007 01 Introduction