CHAPTER 1 Introduction to Corporate Finance

1. CHAPTER 1Introduction to Corporate Finance What is finance? Book, market, and intrinsic values Forms of business organizations Financial goals of the corporation Separation of ownership and control Risk and investor attitudes toward risk WSU EMBA Corporate Finance

2. Introduction to Finance? • A foremost concept in finance concerns how individuals interact in order to allocate resources (capital) and/or shift consumption across time by borrowing or investing. • If you receive $1 million today then what decision would you make regarding consumption and investment? • Suppose you spend (consume) $100,000 now. • This leaves you with $900,000. You can postpone consumption to future time periods by investing the $900,000 today. • On the other hand, what if you have $20,000 but need to consume $30,000. You can borrow the $10,000 and pay it back in a future period along with the interest. WSU EMBA Corporate Finance

3. Two examples of common corporate financial decisions • A firm must spend $100 million for the required assets if a proposed project is approved. Important issues are: • Should the project be accepted or rejected? What do investors demand as a (minimum acceptable) project rate of return? • What are the project’s forecasted future cash flows? How risky are these forecasted cash flows? • Where will the $100 million come from, i.e., what mix of equity and debt financing should be used? • If a firm has $200 million of cash flow, but needs reinvest $120 million, what should be done with the remaining $80 million of cash. • Pay it out as a dividend or repurchase some stock? WSU EMBA Corporate Finance

4. Example of common investments type financial decisions • A mutual fund manager that manages a fund with $10 billion portfolio receives an additional $100 million in cash from new investors. • Which stocks or bonds to purchase? • How will any proposed new investments affect the expected return and risk of the overall portfolio? WSU EMBA Corporate Finance

5. Forms of business organization • Sole proprietorship • Partnership • Corporation • Most large firms are organized as corporations. • Advantages: unlimited life, easy transfer of ownership (stock), limited liability for owners, relative ease of raising capital, and can use stock for acquisitions • Disadvantages: Double taxation of earnings, cost of set-up and report filing, and issues relating to the separation of ownership and control • Hybrid forms; Limited Liability Corporations (LLC), S Corporations, etc., firms having characteristics of the three forms above. WSU EMBA Corporate Finance

6. Book versus Market values • The book value of an asset is determined based on accounting rules. • The book value is at best a rough approximation of the asset’s replacement cost. • The market value of an asset is that investors are willing to pay today for stocks and bonds in order to receive a risky stream of future expected cash flows. • Market values are forward looking. • Stocks and bonds represent claims on the future cash flows that a firm’s assets generate. WSU EMBA Corporate Finance

7. Assets Liabilities + Equity Market value of the asset’s earning power (as a going concern) Mkt. value of debt Mkt. value of equity Book versus market values • Market value of a firm WSU EMBA Corporate Finance

8. Assets Liabilities + Equity Physical assets at historical book value Book debt Book equity Book versus market values • The Book value of a firm often contrasts sharply with the Market value. WSU EMBA Corporate Finance

9. Book versus market values: a hypothetical example • A firm begins with $2000 of debt and $4000 of equity in order to purchase $6000 of assets. These become the original accounting book values. • In contrast, Market values are based on today’s expectations of future performance, i.e., what cash amounts are expected to be paid out and the perception of risk. Assume the following: • Investors are willing to pay $2000 for the bonds. • Investors are willing to pay $10,000 for the equity. WSU EMBA Corporate Finance

10. Assets Assets Liabilities + Equity Liabilities + Equity $6,000 physical assets $12,000 M.V. as a going concern $2,000 Book debt $2,000 M.V. debt $4,000 Book equity $10,000 M.V. equity Book versus market values for the hypothetical example • Book values of firm: • Market values of firm: WSU EMBA Corporate Finance

11. Intrinsic (fundamental) values • Market values are what investors are willing to either buy or sell an asset for, based on investors’ expectations of future performance. • Market values are very often publicly observed, e.g., the transactions in the stock markets. • In contrast, intrinsic values are usually considered as private estimates of what something, e.g., a common stock, is actually worth. • Intrinsic value is not something that you can prove. • If ten analysts are asked to value IBM stock, then there will likely be ten different intrinsic value estimates! WSU EMBA Corporate Finance

12. Intrinsic (fundamental) values • Assume that a New York Stock Exchange listed firm has an equity market value of $10 billion. • However, those that manage the firm (insiders) believe the firm is actually worth $12 billion (intrinsic value), based on their private or inside forecasts of future cash flow performance. • For the most part, market prices are driven by public expectations and consensus, while intrinsic values represent private forecasts. WSU EMBA Corporate Finance

13. Financial goals of the corporation • The primary financial goal is shareholder wealth maximization— a function of future cash flow and risk. • In reality, this is maximizing intrinsic value • For now we will assume that this is synonymous with maximizing the market value, i.e., stock price maximization. • Warren Buffett states that his goal is to maximize Berkshire Hathaway’s intrinsic value, and hopefully, the stock’s market value will be close to the intrinsic value. WSU EMBA Corporate Finance

14. Stock price maximization is NOT profit or earnings maximization? • Market (and intrinsic) values are driven by risk and expectatons (forecasts) of future cash flows. • Earnings and other accounting profitability measures are not cash flows and have limited use in estimating financial values. • Some actions may cause an increase in reported earnings, yet cause the stock price to decrease (and vice versa). WSU EMBA Corporate Finance

15. Wealth maximization and societal welfare • Is the general welfare of society advanced when individual agents pursue wealth maximization? • Is intrinsic or market value maximization good or bad for society. Should firms behave ethically? • The following slide contains a quote is from Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations, 1776. • Adam Smith believed that an economic system in which individual agents strive to increase their market value results in the most efficient level of general welfare, as it facilitates the allocation of resources to their most productive use. WSU EMBA Corporate Finance

16. Wealth maximization and societal welfare (Adam Smith, 1776) “As every individual, endeavours as much as he can both to employ his capital in the industry, and to direct that industry that its produce may be of the greatest value, every individual necessarily labours to render the annual revenue of the society as great as he can. In doing so he generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Thus, by pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who pretended to trade for the public good.” WSU EMBA Corporate Finance

17. Agency relationships — the separation of ownership and control • An agency relationship exists whenever a principal (owner of a resource) hires an agent to act on their behalf. Examples are: • Citizen (principal) and elected official (agent) • Stockholder (principal) and corporate manager (agent) • Within a corporation, agency relationships exist between: • Shareholders and managers • Shareholders and creditors WSU EMBA Corporate Finance

18. Shareholders versus Managers • Managers are naturally inclined to act in their own best interests. • But the following factors affect managerial behavior: • Managerial compensation plans • Direct intervention by shareholders • The threat of firing • The threat of corporate takeover WSU EMBA Corporate Finance

19. Shareholders versus Creditors • Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors, i.e., actions that result in a wealth transfer from creditors to stockholders. • In the long run, such actions will raise the cost of debt and ultimately lower the stock price. We return to this issue in Chapter 16. WSU EMBA Corporate Finance

20. Factors that affect stock prices • As implied in earlier slides, stock prices are a function of: • Projected cash flows to shareholders • Timing of the cash flow stream • Riskiness of the cash flows • The basic financial valuation model on the next slide will be addressed in detail in Chapters 4 and 5 of the textbook. WSU EMBA Corporate Finance

21. Basic financial valuation model • To estimate any asset’s value, one must estimate the cash flow for each period t (CFt), the life of the asset (n), and the appropriate discount rate or cost of capital (k), based on the level of estimated risk. • Throughout this course, we discuss how to estimate the model’s’ inputs and how financial management is used to improve them and thus maximize a firm’s value. WSU EMBA Corporate Finance

22. Factors that affect the level and riskiness of future cash flows • Decisions made by financial managers: • Investment decisions, i.e., decisions concerning the firm’s assets. • Financing decisions; the combination of debt and equity financing used to finance the assets. • The external environment • Capital markets • Industry and economic events WSU EMBA Corporate Finance

23. Understanding risk and investor attitudes toward risk • The following two slides illustrate two possible investments that can be made today. The payoff of each will occur exactly one year from today. Investment #1 costs $100 today. The current cost of Investment #2 is not given. • Assume that one of three possible states of the macroeconomy will prevail next year. Today, we can only assign probabilities to these future economic states. • Good economy, probability of 30% • Average economy, probability of 40% • Bad economy, probability of 30% • Probabilities must sum up to 100%. WSU EMBA Corporate Finance

24. Investment #1, an apparently riskless investment • Investment #1: next year’s payoff is identical (all result in $110) in each future economic state. $110 Good economy, probability=30% Average economy, probability=40% Investment costs $100 today $110 Bad economy, probability=30% $110 WSU EMBA Corporate Finance

25. Investment #2, an apparently risky investment • Investment #2: next year’s payoff varies with future state of the economy. $130 Good economy, probability=30% Average economy, probability=40% $110 Today’s cost = ? Bad economy, probability=30% $90 WSU EMBA Corporate Finance

26. Summarizing riskless Investment #1 and risky Investment #2 • Investment #1 costs $100 today and has a certain $110 payoff in any economic state next year. It thus currently offers a riskless one year investment return of 10% • Investment #2, on the other hand, offers a risky payoff next year. However, a glance at the payoff pattern does reveal that the expected payoff is $110. • Now, if riskless Investment #1 costs $100 today, then what would you be willing to pay today for risky Investment #2, given that each both investments offer an expected payoff of $110 next year? WSU EMBA Corporate Finance

27. Summarizing riskless Investment #1 and risky Investment #2 • Most individuals are averse to risk and would pay less than $100 for Investment #2, e.g., $85, $90, or $95, etc. • Most risk averse individuals will accept risk, but only if they expect to earn a higher return than what they can already make on the riskless investment. • The only way for Investment #2 to offer expected return greater than 10% is to pay less than $100 today for Investment #2. • Practical example: Any corporation’s common stock is more risky that its bonds (and also U.S. Treasury bonds). Investors therefore expect to earn a higher return on the corporation’s common stock. WSU EMBA Corporate Finance