Corporate Finance

1. Corporate Finance Class 01 Introduction Daniel Sungyeon Kim Peking University HSBC Business School

2. Class Outline • Introduction • Syllabus • Organizational forms • Review financial tools • Valuation basics • Time value of money • Inflation

3. Part 1 Outline • Syllabus • Organizational forms

4. Syllabus - General • Office hours: Mon 10:00AM – 11:00AM, or by appointment • E-mail is the best contact method: • kimds@phbs.pku.edu.cn • Do not call my office or mobile unless in emergencies • Two books • You will need a calculator – no programmable ones in exams! • www.danskim.com: many course materials will be uploaded here. • If you miss a class, get missed materials from other students, not me. • A lot of in-class problems, solutions will not be posted on-line.

5. Syllabus - Grades • The grades will be curved. • I expect to see about: • 30% of students with 90% or higher • 40% of students with 80% or higher • 30% of students with 70% or higher

6. What to be expected in this course • A lot of materials • A lot of formulas • Very big projects (40% of grade): emphasis on real-world issues • Ambiguity of definitions • Lecture + Excel modeling

7. Helpful tips • We do problems in class. Bring your calculator. • Review main concepts from your prior economics or finance classes. • Get used to your financial calculator. • Start your project as early as possible. • Do your share in group projects. • Pay attention to uploads in the course website. • Do all practice problems.

8. Overview • In this course, we will focus mainly on “valuation,” i.e., understanding how firm value is impacted by the decisions it makes. • Value of any asset equals the present value of all future cash flows, i.e., • , where CFtrefers to cash flow at time t, and r denotes the discount rate.

9. Objectives • By the end of this course, you should be able to: • Evaluate a variety of corporate projects and make decisions based on financial data. • Analyze a firm’s financial statements, forecast its financials, compute its cost of capital, and value the firm, i.e., value of the firm’s assets, debt, and equity. • Understand the impact of a firm’s financing decisions on its cost of capital and value.

10. Introduction • Why do we call this “corporate” finance? • (even though the basic principles of finance are general enough to be applied to any business) • Because the “corporate” was (and continues to be) the predominant form of organizing a business • How does a corporation differ from other forms of business organization?

11. Business organizations • Sole proprietorships • Partnerships • Corporations • Hybrid forms: such as limited partnership

12. Types of business forms • Sole proprietorship: One person (manager) owns the business • What businesses are likely to be proprietorships?

13. Types of business forms • Partnership: Two or more own the business • Several entrepreneurs come together to set up a business, by pooling money and expertise. • Partnership agreement sets out mechanism for decision making, profit sharing, etc.

14. Types of business forms • Corporations: Business owned by stockholders who have limited liability • i.e., they at most lose what they invested in the business; not liable beyond that for losses incurred by the business • Difference from other forms: it is a legal entity that is separate from its owners (the shareholders).

15. Organizing a business

16. Traditional Accounting B/S

17. Financial view of the firm

18. First Principle

19. Goal of a financial manager • The primary goal of a financial manager of a corporation is to MAXIMIZE the shareholder value, i.e., to maximize the price of the stock of the corporation. • Why? Why not maximize sales or cut costs? • What about the other stakeholders? • In a corporation, the shareholders are “residual claimants” (i.e. they have a “junior claim”) • They are supposed to get paid after all other stakeholders (employers, suppliers, creditors, etc.) are paid

20. Maximize Shareholder Value • Van Horne: “In this book, we assume that the objective of the firm is to maximize its value to its stockholders” • Brealy & Myers: “Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm… The secret of success in financial management is to increase value.” • Copeland & Weston: “The most important theme is that the objective of the firm is to maximize the wealth of its stockholders.” • Brigham and Gapenski: “Throughout this book we operate on the assumption that the management’s primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock.”

21. Separation of investment and financing decisions (1) • Financial managers face 2 sets of decisions: • Investment decisions: Which real assets should the firm acquire? → impact value through cash flow • Financing decisions: How should the firm finance the investments? → impact value through cost of capital • BOTH decisions impact firm value.

22. Goal of a financial manager • How should the financial manager maximize shareholders’ value? • Choose projects with positive and greatest NPV (investment decisions) • Choose capital structure that minimizes the cost of capital (financing decisions) • Do financial managers always maximize shareholders’ value? • No! Why? • Agency problems…

23. Agency Problems • Agency problems are due to conflicts of interest between managers (agents) and shareholders (principals) • Inherent in every agency relationship • What is an agency relationship? • Result from the “separation of ownership and control” in the modern corporation • There could also be other conflicts of interest • Between shareholders and creditors, between large blockholders and minority shareholders, etc.

24. Mitigating the Agency Problems • The agency problems can be mitigated if we correctly align the interest of the manager with the interest of the shareholders • Compensation schemes (e.g. executive stock options) • Corporate governance mechanisms (e.g. Board of Directors) • External monitoring and intervention (e.g. regulators, takeovers) • The above mechanisms mitigate but do not eliminate the agency problems

25. Part 2 Outline • Valuation basics • Review of financial tools • Time value of money • Inflation

26. Valuation (I) • General Dynamics, a large defense contractor, took 43 years to obtain a stock value of U$2.7BN (RMB16.75BN). • Netscape took a few minutes to do the same, when it announced an IPO. • Netscape had no profits and paid no dividend. • How is it possible for these two very different firms to have the same value?

27. Valuation (II): How to value an asset? • Discounted future cash flows • Non-constant growth • Value comes from: • Current cash flow (CF) and expected growth (g) of future cash flow • Timing of cash flow (t) • Risks (r) of expected future cash flow CF grows over time

28. What do you need to know to value a company / asset? • Estimate expected future cash flows (CFs, g and t) • Analyze historical accounting statement • Predictions for the future • Cost of capital (r) • Determine the firm’s expected required rate of return • Analyze the capital structure and how it impacts the cost of capital.

29. Review financial tools • Time value of money • Net present value • Annuities • Perpetuities • Growth • Discount rate • Inflation • Real vs. Nominal interest rates

30. Time value of money • A dollar received in one year is less than a dollar today. Why? • Thus, we discount future cash flows using a discount rate. • This is the discount cash flow approach. • Key underlying assumptions • Discount rate is the same for all the future periods. • Cash flow occurs at the end of each period.

31. Many faces of the DCF formula • If future cash flows have certain patterns, then the DCF formula can be simplified into various forms. • Examples • All future cash flows are constant. • Future cash flows are growing at a constant rate. • Future cash flows grow at different rate over different period.

32. Time value of money example (1) • We just bought a vacation house. • We plan to rent it out for $30,000 a year, and we expect the first payment to be made in one year. • On the other hand, the maintenance and upkeep will cost us $5,000 a year. • We will hold the property for 4 years, after which we will sell for $130,000. • The appropriate discount rate is 20%. • What kind of cash flow patterns are these?

33. Annuity • If the cash flows are constant for a set number of years (n), then you have an annuity. • Compute the present value of an annuity. • DCF formula is simplified as: • IMPORTANT • The value is as of one period before the first payment.

34. TVM example (1) continued

35. Perpetuity • Suppose we plan to rent the vacation house forever. Can we value it? • If the cash flows are constant forever, they are called a perpetuity. • Compute the present value of a perpetuity. • IMPORTANT • The value is as of one period before the first payment. Time=0 1 2 3 n n+1 PV=? CF CF CF CF CF

36. Time value of money example (II) • Let’s value that vacation house again. • The vacation house can be rented for $30,000 a year, and you expect the first payment to be made in a year. • The maintenance and upkeep will cost $5,000 a year. • But this time, you plan to rent out the house forever. • The appropriate discount rate is 20%. • What is the vacation house worth?

37. TVM example (II) continued

38. Time value of money example (III): introducing growth • Vacation house example: • Now instead of charging $30,000 each year, assume that you charge the first year’s rent $15,000, and will grow it at the rate of 10% for 3 years after that. • Again the maintenance will cost you $5,000 a year. • You will hold the property for 4 years, and sell it for $130,000. • The appropriate discount rate is 20%. • What kind of cash flow patterns are these?

39. Growing annuity • If the cash flow occur for a set of period and grow at a constant rate, then they are called a growing annuity. • Compute the present value of a growing annuity. • The DCF formula is simplified as

40. Time value of money example (IV) • Growth and perpetual cash flows • Again, assume that the first year’s rent is $15,000, and will grow at the rate of 10% for 3 years after that. • Again, the maintenance will cost you $5,000 a year. • Now you intend to hold the property indefinitely. After the initial 4 years, the growth rate in the rent will stabilize at 5%. • The appropriate discount rate is 20%. • What kind of cash flow patterns are these?

41. Growing perpetuity • If perpetual cash flows are growing at a constant rate, then we call it a growing perpetuity. • Compute the present value of a growing perpetuity. • The DCF formula is simplified as:

42. The (risk-adjusted) discount rate • The discount rate used to find the present value of cash flows is comprised of 3 things: • Time value of money • Inflation (if the rate is nominal) • Risk • Other names include cost of capital, weighted average cost of capital (WACC), hurdle rate, etc.

43. Inflation • Inflation: A general increase in prices across the economy over a period of time. • Example: • In 1997, movie Titanic made $600.80MM. It is worth $639.83MM in year 2000. • In 1939, movie Gone with the wind made $198.60MM. It is worth $1,001.69MM in 2000.

44. Inflation (1): Adjusting discount rate • Nominal discount rate • Actual rate of return without removing the impact of inflation • Real discount rate • Rate adjusted for inflation, i.e., with inflation removed from the rate • Fisher Equation: • Where i is inflation rate.

45. Inflation (II): Adjusting cash flows • Nominal cash flow – actual dollars. That is, dollars as of the year in which they occur. • Real cash flow – constant dollars. That is, dollars as of a particular base year. • IMPORTANT: Consistency Treatment • When discounting nominal dollars, use the nominal discount rate. • When discounting real dollars, use the real discount rate.

46. Inflation rate adjustment example • If you earn 8% return on an investment (or your discount rate is 8%) and inflation over this period is 3%, then a portion of your return is due to inflation. • What is your real rate of return?

47. Inflation (III): Calculation • How do you calculate inflation rates? • Consumer Price Index (CPI) • If the CPI for 1990 is 104, and it is 100 for 1989, then over this period: • →

48. Inflation (IV): Constant dollar adjustments • To restate cash flows in constant dollars, you need to CPI-adjust the cash flows. • In-class exercise: • A firm’s sales were $100,000 in 1980, and $200,000 in 1990. You want to compare the dollar amounts excluding the impact of inflation. • If the 1990 CPI is 104 and the 1980 CPI is 80, then: • What is the 1990 sales in terms of 1980 dollars? • (Trickier question) What is the average annual inflation rate between 1980 and 1990?

49. Key points • Three forms of business • Sole proprietorship, Partnership, Corporation • Time value of money • Present value • Annuity, Growing annuity, Perpetuity, Growing perpetuity • Inflation • Real vs. nominal discount rates, Fisher equation, constant dollar adjustments • Assignments • Pick groups by Thursday (Next class)