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FINANCE 1. Introduction

FINANCE 1. Introduction

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FINANCE 1. Introduction

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  1. FINANCE1. Introduction Professor André Farber Solvay Business School Université Libre de Bruxelles Fall 2002 A.Farber MBA 01 Introduction

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

  3. Practical matters • Reference: • Ross, Stephen A., Randolph W. Westerfield and Jeffrey F. Jaffe, Corporate Finance, 6th edition, McGraw-Hill Irwin 2002 • Website: www.ulb.ac.be/cours/solvay/farber • Slides • Excel files • Past exams • Grading: • Midterm (40%) • Final (60%) A.Farber MBA 01 Introduction

  4. Course outline • 1. Introduction • 2. Financial statement analysis and forecasting • 3. Present value • 4. Bond and stock valuation • 5. Stock valuation (cont.) • 6. Capital budgeting • 7. More on capital budgeting • 8.Capital Market Theory • 9. Portfolio selection • 10. Risk and expected returns – CAPM • 11. Risk, return and capital budgeting • 12. Review session A.Farber MBA 01 Introduction

  5. 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? A.Farber MBA 01 Introduction

  6. 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 A.Farber MBA 01 Introduction

  7. Cash Flows between the Firm and the Financial Markets Firm issue securities Firm invest Firm Financial markets Cash flow from operations Dividend and debt payments Timing of cash flows A.Farber MBA 01 Introduction

  8. Market values Market value of equity Equity Total capital employed Cash flow Market value of debt Debt A.Farber MBA 01 Introduction

  9. Value creation • Market value added (MVA) • = Market value of the firm’s capital – Total capital employed • VALUE CREATION : 2 strategies • Strategy 1 • Buy assets at a cost lower than the value of the future revenues • real assets • financial assets • Strategy 2 • Sell financial assets for a price higher than the value of future payments Market value of equity + Market value of debt Stockholders’ equity + Financial debt A.Farber MBA 01 Introduction

  10. The Capital Investment Trade-off • 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 ? Investment opportunities in capital markets Project Cash Stockholder A.Farber MBA 01 Introduction

  11. Economic Value Added (EVA) • EVA = Earnings after tax – WACC  Total capital Example: Equity $10bDebt $10bTotal capital $20b EBIT $2.5bTax rate 40%WACC 11% EVA calculation Earnings after tax = $2.5b (1-0.40) = $1.5b EVA = $1.5b – 11%  $20b = $1.5b – $2.2b = – $700m (EVA is explained RWJ Chapter 12 – Appendix) A.Farber MBA 01 Introduction

  12. 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 A.Farber MBA 01 Introduction

  13. M/B vs ROE • Simplifying assumptions: • ·       Expected net income income = constant • ·       Net income = dividend • Market value determination: • Net income = Expected return  Market value of equity • NI = r  MVeq • ROE (definition): • Return on equity = Net income / Book value of equity • ROE = NI / BVeq • = r  MVeq / Bveq • Conclusion: in this simplified setting, • M/B = MVeq/BVeq > 1 ROE> r A.Farber MBA 01 Introduction

  14. M/B vs ROE: example • Suppose: • Book equity ( = total asset) = € 500,000 • Expected annual net income = € 100,000 • Payout ratio (Dividend / Net income) = 100% • Expected return = 10% • Market value of equity determination: • Dividend ( = Net income) = 10% × Mkt Value of Equity • Mkt Value of Equity = €100,000 / 10% = € 1,000,000 • M/B = 1,000,000 / 500,000 = 2 > 1 • Return on Equity (ROE): • ROE = Net Income / Book Equity • A = 100,000 / 500,000 = 20% > 10% A.Farber MBA 01 Introduction

  15. Mkt Value $ bil. Price/Book ROE % 1 GE US 487 9.6 29.5 2 Microsoft US 369 8.8 24.1 3 Exxon US 307 4.4 25.3 4 Pfizer US 271 16.8 23.5 5 Citigroup US 261 4.1 21.3 6 Wal-Mart US 231 7.4 20.2 7 AOL Time W. US 230 1.4 Neg 8 BP UK 200 2.7 15.9 9 IBM US 197 9.5 39.0 10 NTT Docomo Japan 192 7.9 10.6 11 American Intl US 189 4.5 14.0 12 Intel US 181 4.9 22.3 13 Vodafone UK 175 0.9 2.0 The Top Companies 2001 A.Farber MBA 01 Introduction

  16. The Top Companies 2002 A.Farber MBA 01 Introduction

  17. Q&D financial analysis • PROFITABILITY (du Pont system) • Three determinants : 13.4% Profit Margin Asset Turnover Financial Leverage • Microsoft - 2002 US$ bil. • Net Income 7,721 • Sales 25,296 • Assets 59,257 • Book equity 57,619 30.5% 0.43 1.03 A.Farber MBA 01 Introduction

  18. References • Suggested text for this course • Ross, Stephen A., Randolph W. Westerfield and Jeffrey F. Jaffe, Corporate Finance, 6th edition, McGraw-Hill Irwin 2002 • Corporate finance textbooks (MBA level) • Brealey, Richard and Steward Myers, Principles of Corporate Finance, xth edition, McGraw-Hill 2000 • Damorada, Aswath, Corporate Finance: Theory and Practice, Wiley 1997 • Corporate finance texts for executives • Bertoneche, Marc and Rory Knight, Financial Performance, Butterworth Heinemann 2001 • Hawawini, Gabriel and Claude Viallet, Finance for Executives: Managing for Value Creation, South-Western College Publishing, 1999 A.Farber MBA 01 Introduction