Corporate Finance

Corporate Finance Bachelor ESC Toulouse 3rd Year– Yvon SCHOLLAERT : yvonschollaert@me.com Luc ELMAN : elmanluc@aol.fr

Course objectives • Understand the financialenvironment & markets • Understand the finance function in firms • Analyse financial situation • Makefinancialdecision & optimisingchoices, resources & investments • Definefinancialpolicies & strategies • Understand value creation

How wewillwork • Notes / hand outs / “C@mpus” • Participation • Emulation vs. competition • Books : • Main book: Brealeyet al. (2008), Principles of Corporate Finance, McGraw Hill, 9th Edition • Other : Berk & Demarzo (2011), Corporate Finance, Pearson, 2nd Edition

EXAMS & GRADE • 1 quiz + 1 group assignment (term paper) + 1 mid-term 50% • Final exam : case study 50%

Chap I. A framework for financial decision1.1. The finance function • In a well-organized business  each section arranges its activities to maximize its contribution to the corporate goals • Objectives of those who work in the finance function  plan, raise and use funds in an efficient manner • Two central activities: • Providing the link between the business and wider financial envir. • Investment and financial analysis and decision-making

Chap I. A framework for financial decision1.1. The finance function • The financial function provides: • Involvement in investment and financial decisions  called “Investment decision” or “capital budgeting decision” : to acquire assets • Real assets : tangible (land, building, equipment, stocks) or intangible (patents, trademarks, know-how) • Financial assets: shares of other companies, lending to banks • Dealing with the financial markets • Forecasting, coordinating and controlling cash flows

Chap I. A framework for financial decision1.1. The finance function • The financial function in a large organization

Chap I. A framework for financial decision1.2. Cash – the lifeblood of the business • In the center of finance  the generation and management of cash • Cash – the lifeblood of the business

Chap I. A framework for financial decision1.2. Cash – the lifeblood of the business • Sources and uses of cash • Shareholder’s funds (or equity capital) • Largest portion of long-term finance • Main source of new money • In return shareholders  participate in the business by voting in general meetings and receive dividends out of profits • Retained profits • Profits remaining after deduction of operating costs, interest payments, taxation and dividends • Reinvested in the business  to create new value for the owners

Chap I. A framework for financial decision1.2. Cash – the lifeblood of the business • Sources and uses of cash • Loan capital • Money lent to a business by third parties • Is generally on a long-term basis  loan stocks (debentures) • Must be paid back with additional interest • Government • Can provide various financial incentives and grants • Companies also give money to governments  taxation

Chap I. A framework for financial decision1.3. Emergence of financial management • Big evolution of financial management  during the last century because of: • Economic and external events (inflation and technological development) • Consequence  globalization of finance and need to concentrate on more strategic ways of doing business: • dividing large organizations into smaller, more strategically compatible departments

Chap I. A framework for financial decision1.4. The financial department in the firm • The structure of the financial department varies according to the size and the activity of the company • The financial manager’s tasks are generally: • Making strategic investment and financial decisions -> raising the finance to fund growth and decide what are the key future projects • Dealing with the capital markets -> develop good links with the company’s bankers and other major financiers + knowing of the appropriate sources of finance • Managing exposure to risk managing adverse movements in interest and exchange rates (reducing exposure = hedging) • Forecasting, coordination and control of all activities that have an important impact on cash flow

Chap I. A framework for financial decision1.5. The financial objective • In finance  the objective of the firm is to maximize shareholder value (create wealth) • Earning per share (EPS)  focuses on the shareholder, instead of the company’s performance, by calculating the earnings (profits after taxes) given to each equity share • Other secondary goals used: • Profit retention  ex: distributable profits must be at least 3 times bigger than dividends • Borrowing levels  ex: long-term borrowing should not be more than 50 % of total capital used • Profitability  ex : return on capital used should be at least 18 % • Non financial goals  recognizes that shareholders are not the only people interested in the company’s success. Acknowledges trade creditors, banks, employees, the government and management

Chap I. A framework for financial decision1.5. The Agency problem • However  potential conflicts arise because the majority of shareholders are not always the same people who manage the business day to day • This can develop managerialism  self-serving behavior by managers at the shareholders’ expense (ex: spending more for bigger offices and company cars, etc.) • Agency costs  difference between the return expected from the “contract” between managers and shareholders, and the actual return

Chap I. A framework for financial decision1.5. The Agency problem • Ways of dealing with the agency problem: • Incentives and controls are recommended  but all of them are costly • bonuses linked to profits (called profit-related pay), share options (useful when share market is high) • Other types of control : • audited accounts of the company • Management audits and additional reporting requirements • Restrictive rules imposed by lenders (ex: not exceeding a certain amount of dividend payable, etc.)

Chap I. A framework for financial decision1.6. Social responsibility and shareholder wealth • The vast majority of firms  look for long term gains instead of short-term unethical activities • Because  shareholder wealth rests: • on companies building long-term relationships with suppliers, customers and employees • Promoting a reputation for honesty, financial integrity and corporate social responsibility  company’s most important asset : Reputation / Brand Name recognition / Culture… • Environmental concerns  in recent years has also become an important consideration

Chap I. A framework for financial decision1.7. The corporate governance debate • Because of various scandals and collapses (ie, Enron)  some committees have decided to create The Combined Code on Corporate Governance  which include rules concerning: • Directors and the boards’ responsibilities • Directors’ remuneration • Accountability and audit • Relations with shareholders

Chap I. A framework for financial decision1.8. The risk dimension : interest rates

Chap I. A framework for financialdecision 1.8. The risk dimension • Risk dimension is a significant issue for Finance since : • Many potential risks concern Finance area (see infra) • Any occurring risk has an immediate impact on Company profit  direct loss or accrual (if strongly proved future materialization) • Main risk factors: • Economic (general activity or market competitors changes) • Commercial (client losses, invoicing errors, pricing, image, claims) • Industrial (damages to plants, quality, delays, technologic changes) • Social (security, accidents at work, diseases , HR development) • Operating (procedures, area confusions, obsolescent/lost inventory) • Financial (currency, interest rate, credit, solvability, market, tax) • IT (vulnerable, not documented, unsecured, heavy, multiple DB) • Regulatory (legal changes, law complexity, advisory costs) • Environmental (pollution, politics abroad, commodities prices, cultural changes vs products demand)

Chap I. A framework for financialdecision 1.8. The risk dimension • How to reduce Risks ? • Collect & identify potential risks • From past experience and surveys with operations • Segregate risk factors, criticity & organization vulnerability • Show internal/external risks • Set up a risk cartography showing how: • Each risk is critical for the company and it is satisfactorily managed • High are the potential costs • Define a appropriate strategy against selected risks • Prevent, avoid activity, insure, outsource, correct, possibly accept

Chap I. A framework for financialdecision 1.8. The risk dimension • Improve the organization • Hire a Risk manager (Blue Chips, Mid Caps) • Implement strong internal control (risk analysis & questionnaires) • Set up a risk cartography • Economic (general activity or market competitors changes) • Commercial (client losses, invoicing errors, pricing, image, claims) • Industrial (damages to plants, quality, delays, technologic changes) • Social (security, accidents at work, diseases , HR development) • Operating (procedures, area confusions, obsolescent/lost inventory) • Financial (currency, interest rate, credit, solvability, market, tax) • IT (vulnerable, not documented, unsecured, heavy, multiple DB) • Regulatory (legal changes, law complexity, advisory costs) • Environmental (pollution, politics abroad, commodities prices, cultural changes vs products demand)

Major financialassets and risk / return levels

Chap I. A framework for financial decision1.8. The risk dimension • According to the type of financial decisions the risk can be low or high • Ex: low risk  investing in government stocks because interest is known • Ex: high risk  investing in shares • The more risk there is  the greater the return expected by investors: The risk-return trade off • A : long-term fixed interest corporate bond • B : a portfolio of ordinary shares in major listed companies • C : a more speculative investment (ex: non-quoted shares) • D : investment in highly profitable capital projects with little risk • E : investment in low profitable capital projects with high risk • Risk premium : relationship between risk and Intended use of funds

Chap I. A framework for financial decision1.8. The risk dimension

Ratings : an illustration of the risk/cost/return relation-ship

Chap I. A framework for financial decision1.9. The strategic dimension • Strategic management : a systematic approach to positioning the business according to its environment  to ensure continued success and offer as much security as possible • 3 levels of strategy: • Corporate strategy  concerned with the broad issues (ex: company’s activities) . Strategic finance is important here  ex : decision to enter or exit a certain market (through acquisition, organic growth, divestment or buy-outs) • Business or competitive strategy  concerned with how strategic business units compete in particular markets • Operational strategy  concerned with how various operations contribute to corporate and business strategies

Chap I. A framework for financial decision1.9. The strategic dimension • Main elements in strategic planning

Chap I. A framework for financial decision1.9. The strategic dimension • Strategic planning and value creation • Importance of competitive forces important in determining shareholder wealth  because determine: • the price at which goods and services can be sold, • the quantities sold • the cost of production • the level of required investment • the risks inherent in the business • Are also very important : • Market share • Quality • Capacity utilization • Capital investment strategies

Chap I. A framework for financial decision1.9. The strategic dimension • Strategic planning and value creation • The firm will develop corporate, business and operating strategies  to exploit economic opportunities and create competitive advantage • Operating and investment strategies  create cash flows for the business • Financial decisions  influence the cost of capital => value of the firm depends on these two elements

Chap I. A framework for financial decision1.9. The strategic dimension • Strategic planning and value creation • Factors influencing the value of the firm

Chap I. A framework for financial decision1.9. The strategic dimension

Chap I. A framework for financial decision1.9. The strategic dimension • Strategic planning and value creation • Decisions of a financial nature have 5 common elements: • Clearly defined goals • Well defined courses of action to achieve these objectives • Assembling information relevant to the decision • Evaluation  analyzing and interpreting assembled info is the heart of financial analysis • Monitoring effects of the decision taken  feedback on the performance of past decisions to better future decision-making

Chap II. The financial environment2.1. Financial markets • Financial market = mechanism for trading assets or securities • Main financial markets: • Money market: • channels of funds, usually for less than a year, from lenders borrowers • Largely dominated by the major banks and other financial institutions • Also used by local government and large companies for short-term lending and borrowing • Securities or capital markets • Deals with long-dated securities such as shares and loan stock • Best know institution : London Stock Exchange • Other important markets : bond market and Eurobond market

Chap II. The financial environment2.1. Financial markets • Main financial markets: • Foreign exchange market : • For buying and selling one currency against another • Deals are either on a spot basis (transactions are settled immediately) or on a forward basis (for future settlement at a price specified now) • London International Futures an Options Exchange (LIFFE) : • Provides various means of hedging (protecting) or speculating against movements in curries and interest rates : • Derivatives : securities that are traded separately from the assets from which they are derived • Futures : tradable contract to buy or sell a specified amount of an asset at a specified price at a specified future date • Options : the right but not the obligation to buy or sell a particular asset

Chap II. The financial environment2.1. Financial markets • The financial markets function in two important ways: • Primary market : providing new capital for business and other activities, in the form of shares issued to new or existing shareholders (equity) or loans • Secondary markets: trading existing securities when desired

Chap II. The financial environment2.1. Financial markets • The financial markets promote savings and investments by providing mechanisms with which financial needs of lenders (suppliers of funds) and borrowers (users of funds) can be met • Financial institutions act as financial intermediaries  collect funds from savers to lend to their corporate and other customers through money and capital markets, or directly through loans, leasing, etc.

Chap II. The financial environment2.1. Financial markets • Financial markets, institutions, suppliers and users

Chap II. The financial environment2.1. Financial markets • Financial institutions provide essential services: • Re-packaging, or pooling, finance: gathering small amounts of savings from a large number of people and re-packaging them into large blocks for lending to businesses ( mainly done by banks) • Risk reduction: placing small amounts from numerous people in large, well-diversified investment portfolios (such as unit trusts) • Liquidity transformation : bringing together short-term savers and long-term borrowers • Cost reduction: minimizing transaction costs  providing convenient and relatively inexpensive services • Financial advice: providing advice and other services for both lender and borrowers

Chap II. The financial environment2.2. Financial services sector • 3 groups: • Deposit-taking institutions : • Clearing banks : operate on national payments systems by clearing and receiving and paying out notes and coins (retail banking) • Wholesale banks : made of Accepting houses (take care of Bills of Exchange), Discount houses (bid for issues of short term government securities), Merchant banks (arrange specialist financial services like mergers and acquisition funding) • Institutions engaged in contractual savings: • Pension funds : manage the pension plans of large firms • Insurance companies : guarantee to protect clients against various risks

Chap II. The financial environment2.2. Financial services sector • 3 groups: • Other investment funds: • Investment trusts : limited companies whose shares are quoted on the Stock Exchange and who are set up to invest in securities • Unit trusts : investment syndicates within the companies • Disintermediation: business to business lending that eliminates the banking intermediaries Securitization: the capitalization of a future group of income into a single capital value that is sold on the capital market for immediate cash => both have permitted larger companies to create alternative, more flexible forms of finance  forces banks to become more competitive in their services

Chap II. The financial environment2.3. Different Stock Exchanges Two principle economic functions of all stock exchanges: • Enable companies to raise new capital (primary market) • Facilitate the trading of existing shares (secondary market) through negotiation of a price The London Stock Exchange • Operates on two levels: • The Mains list (created in 1773) for larger established companies: long-term securities are issued and traded • The Alternative Investment market (created in 1995)  takes care of very young companies by limiting the cost of entry and membership  keeping rules and application process as simple as possible • Has the most foreign companies listed

Chap II. The financial environment2.3. Different Stock Exchanges Euronext • Formed in 2000  merger of the Amsterdam, Brussels and Paris Stock Exchanges New York Stock Exchange • The largest in terms of market value Nasdaq • Exchange for young companies • Has the most companies listed

Chap II. The financial environment2.4. The Efficient Market Hypothesis (EMH) • 3 levels • Weak form efficient share market : does not allow investors to look back at past share price movements and identify repetitive patterns • Semi-strong efficient share market : incorporates newly released information accurately and quickly into the structure of share prices • Strong efficient share market : all information including inside information is built into share prices

Chap II. The financial environment2.5. Market efficiency for corporate managers • Quoted companies, managers and investors  are directly linked through stock market prices, because corporate actions are rapidly reflected in share prices • Therefore: • Investors do not easily believe in nicely presented financial reports that show good reported earnings but not the reality of the cash flow • The timing of new issues of securities is not critical  market prices are a fair reflection of the information available and they reflect the degree of risk in shares • When corporate managers have information not yet released to the market  gives them the opportunity to influence prices

Chap II. The financial environment2.5. Market efficiency for corporate managers • It is essential that all participants have about the same access to price-sensitive information • Before  big companies with online data had information, and therefore a competitive advantage, before smaller companies • Now with the Internet  all types of companies can have: • Electronic reporting of Company information: enables better corporate governance by giving key determinants of value of various companies (ex: customer satisfaction, market penetration  become part of the performance measurement system) • Market information: with thousands of Web pages which give advice about investment and personal finance

Chap II. The financial environment2.6. Criticisms of the EMH • It is not sure whether investors: • react correctly to new information • Make systematic errors by over or under reacting (being overly optimistic or overly pessimistic) • Size may effect share trading: • Market efficiency seems to be less evident in smaller firms  smaller firms outperform larger firms because of the higher risk and trading costs when dealing with smaller companies • Timing may effect share trading: • In the long term  disparities in share returns correct themselves : a share can perform poorly one year but do well the next • Seasonal effects have also been observed : share performance is related to the day of the week or time of the day (ex: prices rise during the last fifteen minutes of the day’s trading; there are a lot of shares sold during the first hour of Monday trading) • Stock market can go through rough changes in the short term: • in an efficient market it is difficult to predict these changes

Chap II. The financial environment2.7. Taxation and financial decisions • Most financial decisions are taxable  Corporate and personal taxation affect: • The cash flow received by companies • The dividend income received by shareholders • Financial managers need to understand the tax consequences of investment and financing decisions

Chap II. The financial environment2.7. Taxation and financial decisions • Taxation is important in 3 key areas of financial management: • Raising finance : there are tax benefits when raising finance by issuing debt rather than capital  interest on borrowings brings tax deductions vs a dividend payment on equity capital does not bring taxes down • Investment in fixed assets: spending on certain types of fixed assets can bring less taxes (capital allowance)  intended to stimulate certain types of investments • Paying dividends : in certain countries company profits are taxed twice  first on the profits achieved and then on those profits paid to shareholders in form of dividends (In UK the taxation system is more neutral  the same tax bill is paid regardless of the dividend policy)

Chap II. The financial environment 2.7. Credit Management • Credit control is a significant area of Finance because: • Creditors accounts freeze high values in Working Capital (especially if payments are delayed) • Cash is rare today (impact of crisis & credit crunch) • Any loss (customer bankruptcy) directly impacts Net Result • Necessity to optimize cash collecting process: • Implement customer’s accounting cell with ad-hoc routines • Monitor Aged Balance with Sales & Orders Departments • Define credit limits for prospects & weak customers (linked to financial health & past incidents) • Indicate credit policy in selling contracts & payment terms • Do not hesitate to block deliveries in case of credit incidents • Regularly collect delayed payment by all appropriate means (phone, reminding letters, legal threats, suits) • Use export insurance & guaranty tools (Coface) • Delegate customer payment risk (factoring, cash collecting firms)

Appendix I : Working with financial statements • Income statement = what you earn • Profits = Sales – Costs • EBIT = Operating profit • Net earnings = what you earn • Can be distributed as dividends • Can be reinvested in the firm (retained earnings in balance sheet) • Basically the net earnings is the cash generated by the firm’s activity in one year

Corporate Finance