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  1. CORPORATE FINANCEMANAGEMENT 2 Master Course VŠFS Fall 2012 IrenaJindřichovská Corporate Finance Management 2

  2. Literature • Brigham, E and Ehrhardt, M (2004) Financial management: theory and practice, 13th ed., Thomson Learning ISBN-10: 0324259689; ISBN-13: 9780324259681 • Other recommended sources: • Brealey, R., Myers, S. and Allen, F. (2006) Corporate Finance, 8th international ed., McGraw-Hill ISBN: 0-07-111795-4 • Ross, Westerfield & Jaffe; Fundamentals of Corporate Finance, 4th edition • Bender and Ward: Corporate Financial Strategy, 3rd ed. Butteworth-Heinemann, 2009 • More sources may be recommended in lectures Corporate Finance Management 2

  3. Teaching plan • Regular studies: 12 hours lectures6 hours excercises+ presentation of own work • Assignment conditions - essay on topic given +active participation in seminars • Exam: Written exam consisting of short essays and calculations Corporate Finance Management 2

  4. Outline of the course Introduction to Corporate finance management Mergers and acquisitions Cost of capital and capital structure Strategy and tactics of financing decisions - investment decision making Capital Restructuring and Multinational Fin. Management Lease Financing and Working Capital Management Risk Management and Real Options Corporate Finance Management 2


  6. Outline Lecture 1 • Introduction • Capital structure • Company lifecycle • Role of financial manager • Financial markets • Agency theory • Stakeholders’ theory • Summary, exercises, references Corporate Finance Management 2

  7. Introduction toCorporate Finance • Basic questions not only from corporate finance: • What long-term investment strategy should a company take on? • How can cash be raised for the required investments? • How much short-term cash flow does a company need to pay its bills? Corporate Finance Management 2

  8. Current assets Net working capital Fixed assets Tangible fixed assets Intangible fixed assets Current liabilities Long term debt Shareholders’ equity The Balance-Sheet Model of the Firm Corporate Finance Management 2

  9. Capital Structure • Financing arrangements determine how the value of the firm is sliced up. • The firm can then determine its capital structure. • Capital structure changes in the lifetime of the firm Corporate Finance Management 2

  10. Capital Structure • The firm might initially have raised the cash to invest in its assets by issuing more debt than equity; • Later again it can consider changing that mix by issuing more equity and using the proceeds to buy back some of its debt Corporate Finance Management 2

  11. Life Cycle of the company and its funding • Boston Consulting Group Matrix • Axes • horizontal: speed of growth of the market share • vertical: market share • Start-up • Growth • Maturity • Decline • Each phase requires different approach to financial management – according to generated Cash Flow Corporate Finance Management 2

  12. Life Cycle of the company II Corporate Finance Management 2

  13. Role of the Financial Manager 1. The firm should try to buy assets that generate more cash than they cost. 2. The firm should sell bonds and stocks and other financial instruments that raise more cash than they cost. Corporate Finance Management 2

  14. Role of the Financial Manager • The firm must create more cash flow than it uses. • The cash flows paid to bondholders and stockholders of the firm should be higher than the cash flows put into the firm by the bondholders and stockholders. Corporate Finance Management 2

  15. Financial Markets • Primary and secondary markets • Spot and forward markets • Money markets • Equity markets • Organized and over-the-counter markets • LSE, AMEX, NYSE; NASDAQ • Derivative markets • LIFFE, CBOT Corporate Finance Management 2

  16. Primary and secondary markets1 • Help to get financing for companies • Investment companies • Pool together and manage the money of many investors • Arrange corporate borrowings and security issues • Issuing process Corporate Finance Management 2

  17. Primary and secondary markets2 • Establish the price of securities through supply and demand • Execute and settle the transaction • Guarantee the settlement through the ‘Clearing house’- a special institution connected with each Stock Exchange • There is also a securities exchange commission (SEC ) setting the standards and rules of listing Corporate Finance Management 2

  18. Agency Theory • There are two groups with different interest in each corporation – Shareholders and Managers • Goals of shareholders and managers are not the same • Jensen and Meckling (1976): Theory of the Firm: Managerial Behavior,Agency Costs and Ownership Structure, JFE 1976 • Defined Principal – Agent relation Corporate Finance Management 2

  19. Principal - Agent • Owners i.e. Shareholders are Principals • Managers are Agents • Shareholders want value of their firm to be maximized • Managers should act on principals’ behalf but have different goals Corporate Finance Management 2

  20. Management Goals • Survival - avoid risky business decisions • Selfsufficiency – prefer internal financing to issuance of new stock • Shareholders need to control management – Agency Costs – • Monitoring costs • Incentive fees to convince management to act in shareholders’ interest Corporate Finance Management 2

  21. Control methods • Directors are voted by Shareholders and management is selected by directors • Management compensation methods • Stock option plan • Bonuses • Performance shares • Threat of takeovers • Competition on management labor market Corporate Finance Management 2

  22. Stakeholders’ theory • All interested parties that have some relation to the company • Shareholders • Employees • Creditors • Banks • Suppliers • Clients • Environment • Municipalities Corporate Finance Management 2

  23. Summary 1. The goal of financial management in a for-profit business is to make decisions that increase the value of the stock, or, more generally, increase the market value of the equity. 2. Business finance has three main areas of concern: a. Capital budgeting. What long-term investments should the firm take? b. Capital structure. Where will the firm get the long-term financing to pay for its investments? In other words, what mixture of debt and equity should we use to fund our operations? c. Working capital management. How should the firm manage its everyday financial activities? Corporate Finance Management 2

  24. Summary 2 3. The corporate form of organization is superior to other forms when it comes to raising money and transferring ownership interests, but it has the significant disadvantage of double taxation. 4. There is the possibility of conflicts between stockholders and management in a large corporation. We call these conflicts “agency problems” and discussed how they might be controlled and reduced. Corporate Finance Management 2

  25. Exercise problems • Define and compare the three forms of organisation a proprietorship, a partnership and a corporation. • Explain the agency problem and discuss the relationship between managers and shareholders • What are the two types of agency costs? • How are managers bonded to shareholders? • Can you recall some managerial goals? • What is the set-of-contracts perspective? Corporate Finance Management 2

  26. Useful web source • On Agency theory – A review paper • Corporate Finance Management 2

  27. RECOMENDED READINGS • Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 1 • Ross, Westerfield & Jaffe; Fundamentals of Corporate Finance, 4th edition Ch 1 and 2 • Bender and Ward: Corporate Financial Strategy, 3rd ed. Butteworth-Heinemann, 2009, Ch 2 Corporate Finance Management 2

  28. COST OF CAPITAL AND CAPITAL STRUCTURE Corporate Finance Management 2

  29. Outline • Introduction • Sources of long term financing • Debt versus equity • Long term debt • Preferred shares • Retained earnings • Newly issued shares, • Gordon model, debt plus risk premium, CAPM approach • WACC • Value of a company • Summary, exercises, references Corporate Finance Management 2

  30. Equity versus debt Corporate Finance Management 2

  31. Long term debt • Loans and bonds • Loans (interest is paid before taxes – creation of tax shield, that lowers the cost of L/T debt); T = tax rate • Bonds (yield to maturity) Corporate Finance Management 2

  32. Preferred shares • Perpetuity P = C/r; i.e. kp= C / P • May need to take in consideration issuance cost (flotation cost F) kp= C / (P-F) Corporate Finance Management 2

  33. Cost of retained equity • Using Gordon model of growing perpetuity: • P=D1/ (r-g);i.e. ks = (D1 / P) + g Corporate Finance Management 2

  34. Cost of new equity • Using Gordon model of growing perpetuity taking in consideration flotation cost: ke = (D1 / (P-F)) + g Corporate Finance Management 2

  35. The CAPM approach • Estimate using the CAPM • Estimate of risk free rate rRF • Estimate the market premium RPM • Estimate the stock’s beta coefficient bs • Substitute in the CAPM equation: Corporate Finance Management 2

  36. Bond yield plus risk premium approach • Some analysts us an ad hoc procedure to estimate the firms cost of common equity • Adding a judgmental risk premium (3-5%) rs = bond yield + bond risk premium • It is logical to think that firms with risky, low rated high-interest-rate debt will also have risky high-cost equity Corporate Finance Management 2

  37. WACC • Weighted average cost of capital – one way of measuring cost of capital of a company WACC=wd*kd + wp*kp + ws(e)* ks(e) • Another way may be estimating through market model (SML) – ex-post valuation Corporate Finance Management 2

  38. Factors that affect the weighted average cost of capital • Factors that firm cannot control • The level of interest rates • Market risk premium • Tax rates • Factors the firm can control • Capital structure policy • Dividend policy • Investment policy Corporate Finance Management 2

  39. Summary • Earlier chapters on capital budgeting assumed that projects generate riskless cash flows. The appropriate discount rate in that case is the riskless interest rate. Of course, most cash flows from real-world capital-budgeting projects are risky. This chapter discusses the discount rate when cash flows are risky. • A firm with excess cash can either pay a dividend or make a capital expenditure. Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk. Corporate Finance Management 2

  40. Summary 2 3. The expected return on any asset is dependent upon its beta. Thus, we showed how to estimate the beta of a stock. The appropriate procedure employs regression analysis on historical returns. • We considered the case of a project whose beta risk was equal to that of the firm. • If the firm is unlevered, the discount rate on the project is equal to RF+( M -RF)*ß where M is the expected return on the market portfolio and RF is the risk-free rate. In words, the discount rate on the project is equal to the CAPM’s estimate of the expected return on the Corporate Finance Management 2

  41. Exercise questions • Describe the various sources of capital. • Describe the ”optimal” capital structure. • Explain the concept: weighted average cost of capital (WACC). • Explain how to calculate a value of a firm using WACC. Corporate Finance Management 2

  42. Exercise problem 1 • 12.13 RWJ • Calculate the weighted average cost of capital for the Luxury Porcelain Company. • The book value of Luxury’s outstanding debt is $60 million. Currently, the debt is trading at 120 percent of book value and is priced to yield 12 percent. The 5 million outstanding shares of Luxury stock are selling for $20 per share. The required return on Luxury stock is 18 percent. The tax rate is 25 percent. Corporate Finance Management 2

  43. Exercise problem 2 • 12.14 RWJ • First Data Co. has 20 million shares of common stock outstanding that are currently being sold for $25 per share. The firm’s debt is publicly traded at 95 percent of its face value of $180 million. The cost of debt is 10 percent and the cost of equity is 20 percent. What is the weighted average cost of capital for the firm? Assume the corporate tax rate is 40 percent. Corporate Finance Management 2

  44. Useful web sources • Online Tutorial #8: How Do You Calculate A Company's Cost of Capital? • • And a video lecture (rather easy) • Corporate Finance Management 2

  45. RECOMENDED READINGS • Fundamentals of Corporate Finance, Ross, Westerfield and Jaffe, 6 th edition. Ch 12 • Brigham and Houston: Fundamentals of Financial Management, 12th ed, Ch 10 Corporate Finance Management 2

  46. MERGERS AND TAKEOVERS Corporate Finance Management 2

  47. Outline • Introduction • Mergers ad acquisition rationale • Underling principles • Business motives for acquisitions • Financial strategy • Price reaction n acquisition announcement • Takeover defense • Summary, exercises, references Corporate Finance Management 2

  48. Mergers and Acquisitions • Mature companies try to reverse or accelerate the life cycle through dynamic changes in the structure of the business by mergers or acquisitions • Two businesses combine into one • Mergers are rare  Acquisitions • Larger and smaller company  acquirer and target company Corporate Finance Management 2

  49. Underlying principles • Combined future CF’s are bigger than sum of CF’s of two individual companies • Not in case of large premium paid to shareholders of the target • (90%-125% of exp. value of the synergy has been paid to the sellers) - better to be seller then buyer Corporate Finance Management 2

  50. M&A’s = “market imperfections” • Asymmetric price reaction on acquisition announcement: • Target company is undervalued in the market (inefficient market) • Participants do not agree on the price of the target company stock • ? Synergy effect (2+2=5) Corporate Finance Management 2