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Corporate Finance -2 Topic 1. Introduction. Corporate Finance and Corporate Analysis

Corporate Finance -2 Topic 1. Introduction. Corporate Finance and Corporate Analysis thru the Organization ’ s Life Cycle (LCO). Irina Ivashkovskaya, Ordinary professor, Head of finance academic department, Head of Corporate finance research center

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Corporate Finance -2 Topic 1. Introduction. Corporate Finance and Corporate Analysis

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  1. Corporate Finance -2 Topic 1. Introduction. Corporate Finance and Corporate Analysis thru the Organization’s Life Cycle (LCO) Irina Ivashkovskaya, Ordinary professor, Head of finance academic department, Head of Corporate finance research center National Research University – Higher school of economics, Moscow, Russia

  2. Outline • What is corporate finance about? • How does corporate finance contribute to corporate decision –making? Financial model of analytical framework versus accounting model of corporate decisions’ analysis • Financial dimensions of the firm thru its OVERALL life cycle: liquidity, risk and fundamental value. • Financial dimensions of the firm: ANNUAL approach. • How to identify the LCO stage with financial measures? • The challenges for financial analytical framework

  3. FINANCIAL DECISIONS OF ANY FIRM AND CORPORATE FINANCE APPROACH CORPORATION AS A FRAMEWORK ATTRACTING CAPITAL CREATING FINANCE’ PRODUCTS • CAPITAL MARKET TOOLKIT: • the variety • the costs • the mix • CAPITAL MARKET PRODUCTS CREATION : • benefit stream • risks • innovations • packing the firm Maximizing prices Minimizing costs

  4. CORPORATEFINANCE VISION THE PRINCIPLES PERFECT MARKET IMPERFECT MARKET • INVESTORS IS NOT IRRELEVANT • capital structure and payout policies matter • interactions of investing and financing • Financial innovations • VALUE IS CREATED ONLY BY INVESTMENTS • NO ARBITRAGE • INVESTOR IS IRRELEVANT • -Capital structure • -Payout policies Capital market efficiency

  5. MODELLING CORPORATE FINANCIAL DECISIONS KNOWING WHAT DOES NOT MATTER IN A PERFECT WORLD WE’LL KNOW WHAT DOES MATTER BEYOND IT BY IMPLICATIONS EQUITY VERSUS DEBTHOLDERS CREATING PRODUCTS ATTRACTING CAPITAL CONTRACTS CONTRACTS INFORMATION ASSYMETRY AGENCY/ MOTIVES RATIONAL EXPECTATIONS managers investors CHANGE IN VALUE

  6. CORPORATE FINANCE CONTRIBUTION TO DECISION-MAKING THE CONCEPTUAL FRAMEWORK TO CORPORATE DECISION’S ANALYSIS: THE ELEMENTS  The criteria for performance analysis The measures of performance  The measures for corporate goals and strategies’ perfromance

  7. WHAT IS CORPORATE FINANCE? The conceptual framework to corporate decision’s analysis: the elements  THE CRITERIA FOR PERFORMANCE ANALYSIS • Opportunity cost of capital • Risk-return trade-off and cost of capital (WACC) • Economic profit  THE MEASURES OF PERFORMANCE • Economic profit metrics • Economic spread (over the required returns)

  8. WHAT IS CORPORATE FINANCE? The conceptual framework to corporate decision’s analysis: the elements • THE MEASUREMENT OF CORPORATE GOALS AND STRATEGIC RESULTS Agency conflicts Information asymmetry Market value creation True value creation Value creation Value Destruction? Value Extraction

  9. ROE (%) КЕ (%) + - -2 -1 0 1 2 Accounting model ROE<0 ROE>0 Loss and capital losses Income and capital gains Financial model ROE<КЕ ROE>КЕ Loss and capital losses Income and capital gains • Cumulative data • Backward looking • Static • Flows • Forward looking • Dynamic

  10. LIFE CYCLE STAGES OF ORGANIZATION Activity Time I.INTRODUCTORY STAGE, ENTRY II.GROWTH III.MATURITY IV.DECLINE

  11. FINANCIAL DIMENSIONS OF THE FIRM WITHIN ITS LIFE CYCLE LIQUIDITY INVESTMENT RISK FUNDAMENTAL VALUE

  12. CASH FLOWS Transactions affecting the totals Transactions affecting directly net income Transactions affecting asset's structure • +Increase in short term &long term debt • +Owners investments • Debt repayment (principal) • Dividends Net income + non-cash charges -net increase in current assets +net increase in current liabilities + Proceeds from sale of assets - Capital expenditure CF FROM INVESTING ACTIVITY CF FROM FINANCING ACTIVITY CASH FLOW FROM OPERATING ACTIVITY NET CASH FLOW

  13. CASH FLOWS AT THRU LCO INTRODUCTORY STAGE GROWTH MATURITY DECLINE OPERATING CASH FLOW FINANCING CASH FLOW INVESTING CASH FLOW

  14. ЭТАП СТАНОВЛЕНИЯ Компания “Российские навигационные технологии” Чистая прибыль (NI) = 78,1 млн. руб. Долг/собственный капитал = 0,01 Доходность собственного капитала (ROE) = 20,5 % Рыночная капитализация = 1,6 млрд. руб. Div = 0 Возраст = 6 лет 14

  15. ЭТАП СТАНОВЛЕНИЯ 15

  16. ДВИЖЕНИЕ ПОТОКОВ ДЕНЕЖНЫХ СРЕДСТВ НА СТАДИЯХ ЖЦО РНТ ЭТАП СТАНОВЛЕНИЯ ЭТАП РОСТА ЭТАП ЗРЕЛОСТИ ЭТАП СТАРЕНИЯ 16

  17. ЭТАП РОСТА Компания розничная сеть “Магнит” Чистая при быль (NI) = 320,3млн. долл. Долг/собственный капитал = 0,49 Доходность собственного капитала (ROE) = 18,6 % Рыночная капитализация = 8,7 млрд. долл. Дивиденды к чистой прибыли = 3,5 % Возраст = 17 лет 17

  18. ЭТАП РОСТА 18

  19. ДВИЖЕНИЕ ПОТОКОВ ДЕНЕЖНЫХ СРЕДСТВ НА СТАДИЯХ ЖЦО Магнит ЭТАП СТАНОВЛЕНИЯ ЭТАП РОСТА ЭТАП ЗРЕЛОСТИ ЭТАП СТАРЕНИЯ 19

  20. ЭТАП ЗРЕЛОСТЬ 20

  21. ЭТАП ЗРЕЛОСТИ: КОМПАНИЯ “АЭРОФЛОТ” 21 Чистая прибыль (NI) = 12,1млрд. руб. Долг/собственный капитал = 0,69 ROE = 10,7 % Рыночная капитализация = 2,89 млрд. долл. Дивиденды к чистой прибыли= 10 % Возраст = 17 лет

  22. ДВИЖЕНИЕ ПОТОКОВ ДЕНЕЖНЫХ СРЕДСТВ НА СТАДИЯХ ЖЦО Аэрофлот ЭТАП СТАНОВЛЕНИЯ ЭТАП РОСТА ЭТАП ЗРЕЛОСТИ ЭТАП СТАРЕНИЯ 22

  23. ЭТАП СТАРЕНИЯ: АМО “ЗИЛ” 23 NI = -276,3млн. руб. Долг/собственный капитал = 2,18 ROE = 15,3 % Рыночная капитализация = 0,34 млрд. руб. Div = 0 % Возраст = 95 лет Отношение рыночной цены акции к ее бухгалтерской оценке = 0,01

  24. Investment risk Business risk Financing risk Commercial risks ■Diversification by product by channel by segment ■Power of supplier ■ Market position ■ Expense structure operating leverage Solvency (short term) Financial leverage Coverage: ■ income coverage ratios ■ cash flow coverage ratios■ assets coverage ratios Management depth ■ key person ■ transparency and disclosure Currency Exchange risks

  25. LCO AND INVESTMENT RISKS MANAGERIAL FLEXIBILITY INVESTMENT FLEXIBILITY FINANCING FLEXIBILITY • TERMS OF FINANCING • AMOUNTS OF FINANCING • DECREASE IN REQUIRED RATES OF RETURN • INCREASE IN THE VARIETY OF EFFICIENT PROJECTS

  26. WHAT IS VALUE? DISCOUNTED FUTURE BENEFITS STREAM KEY DRIVERS • KEY STRATEGIC AND OPERATIONAL DRIVERS • REQUIRED RATES AT THE CAPITAL MARKETS

  27. VALUE INVESTED CAPITAL (CAPITAL EMPLOYED) INVESTMENT RISK CORE COMPENTENCIES Income + Non cash charges -Capex -Net working capital investment STRATEGIC (PLANNING) HORIZON COST OF CAPITAL = FREE CASH FLOW

  28. CORPORATE VALUE COMPONENTS DISCOUNTED CASH FLOWS WHITHIN STRATEGIC HORIZON TERMINAL CASH FLOW BEYOND HORIZON + CORPORATE VALUE FINANCIAL APPROACH STRATEGIC APPROACH FUTURE GROWTH OPPORTUITIES VALUE (VFGO) CURRENT OPERATIONS VALUE COV + RISK IN GROWTH OPPORTUNITIES EXPECTED CF FROM GROWTH OPPORTUNITIES CASH FLOWS RISK Assets in place, AIP Growth opportunities, GO

  29. VALUE COMPONENTS AND LCO INTRODUCTORY STAGE •  ASSETS IN PLACE? • VALUE BASE? • FUNCTIONING ASSETS RISKS? • GROWTH OPPORTUNITY RISKS? RATIO = (ASSETS IN PLACE )/ (GROWTH OPPORTUNITIES)?

  30. VALUE COMPONENTS AND LCO GROWTH • ASSETS IN PLACE? • VALUE BASE? • FUNCTIONING ASSETS RISKS? • GROWTH OPPORTUNITY RISKS? RATIO = (ASSETS IN PLACE )/ (GROWTH OPPORTUNITIES)?

  31. VALUE COMPONENTS AND LCO MATURITY • ASSETS IN PLACE? • VALUE BASE? • FUNCTIONING ASSETS RISKS? • GROWTH OPPORTUNITY RISKS? RATIO = (ASSETS IN PLACE )/ (GROWTH OPPORTUNITIES)?

  32. VALUE COMPONENTS AND LCO DECLINE • ASSETS IN PLACE? • VALUE BASE? • FUNCTIONING ASSETS RISKS? • GROWTH OPPORTUNITY RISKS? RATIO = (ASSETS IN PLACE )/ (GROWTH OPPORTUNITIES)?

  33. FINANCIAL DIMENSIONS OF THE FIRM: WITHIN THE YEAR FREE CF COST OF CAPITAL ECONOMIC PROFIT (RESIDUAL INCOME)

  34. FINANCIAL DIMENSIONS OF THE FIRM: FREE CASH FLOWS TO THE FIRM (FCFF) FCFF EBIAT D = + NWCI Capex - - Earnings before interest but after tax Depreciation Net working capital investment Capital expenditure CASH FLOWS FREE FOR INVESTORS AFTER ALL INVESTMENTS NEEDED FOR CORPORATE MARKET STRATEGY ARE CONSIDERED

  35. FINANCIAL DIMENSIONS: HURDLE RATE • COST OF CAPITAL • RATE OF RETURN REQUIRED BY RATIONAL RISK AVERSE INVESTOR • DEPENDS ON: • INVESTMENT RISK • OPPORTUNITY COST OF CAPITAL OF INVESTORS

  36. FINANCIAL DIMENSIONS: ECONOMIC PROFIT NOPAT CAPITAL CHARGE RESIDUAL INCOME - = COST OF CAPITAL ROCE-return on capital employed WACC-weighted average cost of capital – CE – capital employed RI - Residual income NOPAT- Net operating profit after tax

  37. LCO FINANCIAL CURVE Return on capital employed, ROCE TIME INTRODUCTORY STAGE GROWTH MATURITY DECLINE RESIDUAL INCOME COST OF CAPITAL

  38. LCO ANALYSIS Miller, Friesen (1984) • SALES GROWTH RATE GROWTH ABOVE 15% ; MATURITY BELW 15%; • AGE 6 YEARS AT EACH STAGE ON AVERAGE BELOW 10 YEARS - ENTRY • EXPERT ‘ ESTIMATES

  39. IDENTIFICATION OF LCO STAGE BY FINANCIAL MEASURES: RATING APPROACH SIMPLE APPROACH Metrics Anthony,Ramesh (1992) • 5 YEARS MEAN: • Revenue growth rate, • Dividends • Capital expenditure Age 5STAGES: GROWTH,STABLE GROWTH,MATURITY, BEGINNING OF DECLINE,DECLINE • RATING BY METRIC • SUM OF RATINGS • INDUSTRY FACTORS EXTENDED APPROACH Pashley,Phillippatos (1990) • FINANCIAL RATIOS • CLUSTERS

  40. RATING APPROACH (Black,1998) • INTRODUCTORY STAGE (START-UP) • SALES REVENUE NO LONGER THAN 1 YEAR • NO RESTRUCTURING GROWTH • 20% highest ratings by growth rates and capex • 20% lowest ratings by dividends &age MATURITY STAGE • AVERAGERATINGS BY GROWTH RATES AND CAPEX • HIGHEST RATINGS BY DIVIDENDS DECLINE • 20% LOWEST RATINGS BY CAPEX AND GROWTH RATES • HIGHESTRATINGS BY AGE • ABOVE AVERAGE RATINGS BY DIVIDENDS

  41. STUDY OF LCO OF AMERICAN FIRMS BY RATINGS Black,1998 Public firms 1977-1995, COMPUSTAT 22082 annual observations Introductory stage : 75 firms Growth : 2905 Maturity : 2384 Decline : 3961 Firms in decline are concentrated within the periods of macro shocks (1980-1983,1989-1992)

  42. FINANCIAL MEASURES AT THE LCO STAGES Black START UP GROWTH MATURITY DECLINE MEAN GROWTH RATE 142% 38% 8% -13%10% Debt-to-equity7% 42% 50% 16% 39% Net income (mln doll.) - 0.36 0.66 16.15 -0.54 1.90 Return on equity 7% 6% 13% -12% 7% Capex to total assets 1.76 0.14 0.07 0.02 0.06 R&Dmln ) 0.18 0.41 4.53 0.51 1.26 Age(years) 2.4 16.2 37.4 57.6 42.8 Dividends payout (%) 0 0 36% 0 0 Equity market cap (mln doll.) 16.52 21.95 208.47 10.9146.11

  43. CONTRIBUTION TO THE MARKET CAPITALIZATION AT DIFFERENT STAGES OF LCO INTRODUCTORY STAGE , START UP • earnings&operating cash flows not significant • Investing cash flows significant at 5%, financing cash flows at 10% GROWTH • all cash flows significant at 5% • earnings not significant MATURITY • earnings, operating and financing cash flows AT 5% • FINANCING CASH FLOW NEGATIVE DECLINE • ALL TYPES OF CASJ FLOWS AT 5% уровнеearnings not significant

  44. CASH FLOWS AND MARKET CAPITALIZATION AT DIFFERENT STAGES OF LCO Black: OPERATING CF: significant except start ups all components significant payments to suppliers&personnel not significant at maturity FINANCING CF: siginificant, high correlation at growth & maturity INVESTING CF: significant, high correlation at growth & start up

  45. CASH FLOW APPROACH : DICKINSON • 500 FIRMS COMPUSTAT • THE CASH FLOW PATTERNS (+/-) • MONITORING THRU TIME • COMPARISON TO THE PRECEEDING PATTERNS AND SEARCH FOR BREAK-EVEN IN THE PATTERNS

  46. COMPARISON BY GROWTH RATES BREAK-EVEN POINTS Yan,2006 • STAGES: from IPO, quarterly data • Growth, maturity, mature growth, decline • At minimum 2 years per stage • Minimum 2 stages MATURITY: after 9 quarters needs 6 quarters with growth rates LOWER темп выручки than in Р67 MATURE GROWTH: after 9quarters , 6 quarters growth rates HIGHER than Р67 DECLINE: after 9 quarters , 6 quarters with growth rates темп выручки LOWER than Р33 • GROWTH RATES: • Adjusted to the industry (it is subtracted) • Moving average for 4 quarters • Р33 and Р67 (percentile)

  47. Corporate finance and the challenges for corporate analysis

  48. SCALE OF FEASIBLE STATES OF THE MARKET FRACTION OF VOLATILITY THAT IS PRICE-DRIVEN 0% 100% ORDER IN THE MARKET TURBULENCE AND CHAOS COMPLEXITY THE NEW FINANCE • Almost no price effect associated with investor’s interaction Price changes are almost unrelated to changes in real economic information set • Impact of interactions: • Interpretation of signals • Irrational expectations • Market efficiency – special rational case RATIONAL FINANCE BEHAVIORAL FINANCE induction prevails “fly with feathers” : Process, store info and fly in response DEDUCTION and mathematical modeling PREVAILS

  49. MODELLING CORPORATE FINANCIAL DECISIONS Irrational expectations • INVESTORS’ BIASES: • Market inefficiency (mispricing) • Arbitrage • Follow mispricing – behavior less than fully rational • But managers make unbiased forecasts about the future : • Take for granted prices fully reflect the info about fundamental values • decisions in their best interests • BUT GOVERNANCE apply • MANAGERIAL BIASES: • Less than fully rational behavior following mispricing • Optimism and overconfidence • Exploit and use mispricing in decision-making

  50. FINANCIAL ANALYSIS IN INDUSTRIAL ECONOMY KEY RESOURCES TANGIBLE AND FINANCIAL ASSETS, LIMITED INTANGIBLES TYPE OF BUSINESS MODELS SEEKING FOR ALLOACATIVE EFFICIENCY ACCOUNTING PROFIT AND CASH FLOWS CRITERIA FOR PERFORMANCE FINANCIAL STATEMENTS ANALYSIS SHAREHOLDER VALUE (SHV) AND AGENCY KEY ANALYTICAL FOCUS INFORMATION MODEL OF THE FIRM ACCOUNTING PROFIT BASED

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