Corporate Finance

Master in Management of International Projects
CORPORATE FINANCE
Alexandra Horobe , PhD
Professor ASE Bucharest
Course topics
Introduction to Corporate finance Fundamental principles of finance Time value of money Investment criteria Cash flow principles
Corporate Finance / MPI / Alexandra Horobet, PhD
Topic #1
Introduction to Corporate finance

Finance is the study of managing funds it involves where to raise them and how to use (invest) them Basic areas of finance
Corporate Finance Investments Financial institutions and markets International finance
What is corporate finance?

Corporate finance is finance applied in a business setting Corporations face two main financial questions questions:
1. What investments should
the firm make? 2. How should it pay for those investments?
SPENDING MONEY RAISING MONEY
The secret of success in financial management is TO INCREASE COMPANYS VALUE

4 Corporate Finance / MPI / Alexandra Horobet, PhD
Some statements about Corporate finance

Corporate finance has an internal consistency
Objective function maximizing firm value Fundamental principles on which it is based
Corporate finance must be viewed as an integrated whole, rather than as a collection of decisions The best way to learn managerial finance is by applying its models and theories Corporate finance is fun
Finance and Economics

Finance is closely related to economics Financial managers must:
understand the economic framework and be alert to consequences of varying levels of economic activity and changes in economic policy be able to use economic theories as guidelines for efficient business operations:
supply and demand analysis profit-maximizing strategies price theory
The most important economic principles used in managerial finance are marginal analysis and opportunity cost
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Finance and Accounting

The firms treasurer and controller activities are closely related and generally overlap Managerial finance and accounting are not easily distinguishable There are two basic differences between finance and accounting:
Finance Revenues and expenses are considered on: Decision making A cash basis Financial managers evaluate the data and make decisions Accounting An accrual basis Accountants collect and present financial data
Financial reporting and statements

Financial reporting provides information about:
The economic resources of an enterprise and the claims to those resources The effects of transactions and events that change resources and claims to those resources An enterprises financial performance during a period
Interested parties in financial reporting and statements:

Current and potential investors and creditors Managers of the company Any interested parties that have a reasonable understanding of the business and economic activities
Basic financial statements

Balance sheet presents a summary statement of the firms financial position at a given point in time Income statement provides a financial summary of the firms operating results during a specified period Statement of retained earnings reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings between the start and the end of that year Statement of cash flows a summary of the cash flows over the period of concern
Balance sheet
The balance sheet is a snapshot of the firms assets and liabilities at a given point in time Balance Sheet Identity
Assets = Liabilities + Stockholders Equity
Assets are economic resources which are owned by a business and are expected to benefit future operations
Liabilities are obligations of the entity to outside parties who have furnished resources Equity are net assets or net liabilities
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The main balance sheet items

Current Assets Cash Marketable securities Receivables Inventories Current Liabilities Payables Accruals Short-term debt
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Fixed Assets Tangible Assets Intangible Assets
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+
Long-term Liabilities
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Shareholders Equity
Market value versus Book value

The balance sheet provides the book value of the assets, liabilities and equity Market value is the price at which the assets, liabilities or equity can actually be bought or sold Market value and book value are often very different equity and asset market values are usually higher than their book values Which is more important to the decision-making process?
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Market Value vs. Book Value

Example Your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market value of your firms equity is $7.5 billion, and the debts market value is $4 billion. Q:What is the market value of your assets? A: Since (Assets = Liabilities + Equity), your assets must have a market value of $11.5 billion.
Market Value vs. Book Value

Example (continued) Book Value Balance Sheet Assets = $10 bill. Debt = $4 bill. Equity = $6 bill.
Market Value Balance Sheet Assets = $11.5 bill. Debt = $4 bill. Equity = $7.5 bill.
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Bartlett Co. Balance Sheet

ASSETS
Current assets
Cash Marketable securities Accounts receivable Inventories Total current assets
As of December 31 - $ in thousands
2003 2002 Changes
363 68 503 289 1,223 2,072 1,866 358 275 98 4,669 2,295 2,374 3,597
288 51 365 300 1,004 1,903 1,693 316 314 96 4,322 2,056 2,266 3,270
75 17 138 -11 219 169 173 42 -39 2 347 239 108 327
Gross fixed assets (at cost)

Land and buildings Machinery and equipment Furniture and fixtures Vehicles Other (includes financial leases) Total gross fixed assets (at cost) Less: Accumulated depreciation Net fixed assets
TOTAL ASSETS
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Bartlett Co. Balance Sheet

2003 2002 Changes
LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities
Accounts payable Notes payable Accruals Total current liabilities 382 79 159 620 1,023 1,643 270 99 114 483 967 1,450 112 -20 45 137 56 193
Long-term debt
TOTAL LIABILITIES
Stockholders' equity
Preferred stock - cumulative 5%, $100 at par, 2,000 shares authorized and issued Common stock - $2.50 par, 100,000 shares authorized, shares issued and outstanding in 2003: 76,262; in 2002: 76,244 Paid-in capital in excess of par on common stock Retained earnings Total stockholders' equity 200 191 428 1,135 1,954 3,597 200 190 418 1,012 1,820 3,270 0 1 10 123 134 327
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY

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Income Statement
The income statement is more like a video of the firms operations for a specified period of time You generally report revenues first and then deduct any expenses for the period Matching principle accounting rules (GAAP, IAS) say to show revenue when it accrues and match the expenses required to generate the revenue
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Bartlett Co. Income Statement

Sales revenue Less: Cost of goods sold Gross profit Less: Operating expenses Selling expenss General and administrative expenses Lease expense Depreciation expense Total operating expenses Operating profits (EBIT) Less: Interest expense Net profits before taxes (EBT) Less: Taxes Net profits after taxes (EAT) Less: Preferred stock dividends Earnings available to common stockholders
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2003 3,074 2,088 986 100 194 35 239 568 418 93 325 94 231 10 221 2002 2,574 1,711 863 108 187 35 223 553 310 91 219 64 155 10 145 Change 500 377 123 0 -8 7 0 16 15 108 2 106 31 75 0 75
Profits vs. Cash Flows

Differences
Profits subtract depreciation (a non-cash expense) Profits ignore cash expenditures on new capital Profits record income and expenses at the time of sales, not when the cash exchanges actually occur Profits do not consider changes in working capital
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Statement of retained earnings

Condensed Balance Sheet As of December 31, 2002 Assets Current assets Net fixed assets Total assets $1,004 2,266 $3,270 Income Statement For the Year 2003 Sales revenue $3,074 Less COGS 2,088 Gross profit 986 Less operating exp. 568 EBIT 418 Interest & taxes 187 EAT, 2003 $231 Statement of Retained Earnings Retained earnings Add net income Less dividends paid Retained earnings
Liabilities and Owners Equity Liabilities $1,450 Owners Equity Paid-in capital 808 Retained earnings 1,012 Total liabilities and owners equity $3,270
$1,012 231 1,243 108 $1,135
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Statement of retained earnings

Condensed Balance Sheet As of December 31, 2003 Assets Statement of Retained Earnings Retained earnings Add net income Less dividends paid Retained earnings $1,012 231 1,243 108 $1,135 Current assets Net fixed assets Total assets $1,223 2,374 $3,597
Liabilities and Owners Equity Liabilities $1,643 Owners Equity Paid-in capital 819 Retained earnings 1,135 Total liabilities and owners equity $3,597
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Bartlett Co. Statement of cash flows

Cash Flow from Operating Activities
Net profits after taxes Depreciation expense Change in accounts receivable Change in inventories Change in accounts payable Change in accruals Cash provided by operating activities 231 239 -138 11 112 45 500
Cash Flow from Investment Activities

Change in gross fixed assets Change in business interests Cash provided by investment activities -347 0 -347
Cash Flow from Financing Activities

Changes in notes payable Changes in long-term debt Changes in stockholders' equity Dividends paid Cash provided by financing activities -20 56 11 -108 -61
Net increase in cash and marketable securities

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Financial analysis/ratios objectives

Ratio analysis involves methods of calculating and interpreting financial ratios to analyze and monitor the firms performance Basic inputs: income statement and balance sheet Interested parties:
Shareholders risk and return characteristics of the firm Creditors short-term liquidity & company ability to make interest and principal payments Management all aspects of firms financial situation
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Financial ratios comparisons

Cross-sectional analysis involves comparison of different firms financial ratios at the same point in time
It is important to understand how the firm has performed in relation to other firms in its industry Frequently, a firm will be compared to a key competitor in industry benchmarking
Time-series analysis evaluates performance over time and enables assessing the firms progress Combined analysis to ratio analysis
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the most informative approach
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Financial ratios
Liquidity ratios measure the firms ability to satisfy shortterm obligations as they come due Leverage (financing) ratios measure the firms ability to pay its long-term debt Efficiency (activity) ratios measure the speed with which various accounts are converted into sales or cash Profitability ratios shows the firms ability to generate income from its assets Market ratios give insight into how well investors in the market value the firm
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Liquidity ratios
Current ratio = Current assets Current liabilities
1,223 = 1.97 620
For Bartlett Current ratio =
Quick ratio =
Current assets - Inventory Current liabilities

1,223 - 289 = 1.51 620
For Bartlett Quick ratio =
Cash ratio =
Cash + Marketable securities Current liabilities

363 + 68 = 0.69 620
For Bartlett Cash ratio =

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Leverage ratios
Debt ratio = Long - term debt + Value of leases Long - term debt + Value of leases + Equity
For Bartlett Debt ratio =

Debt equity ratio =
1,023 = 0.34 1,023 + 1,954
Long - term debt + Value of leases Equity
For Bartlett Debt equity ratio =

Times interest earned(TIE ) =
1,023 = 0.52 1,954
EBIT + Depreciati on Interest 418 + 239 For Bartlett TIE = = 7.06 93

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Efficiency ratios and operating cycle
Efficiency of total assets

Sales Total assets
3,074 = 0.85 3,597
Total assets turnover =
For Bartlett Total assets turnover =
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Operating cycle
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Operating cycle
Efficiency of current assets OPERATING CYCLE Finding the inventory period
Inventory turnover = Cost of goods sold Inventory
2,088 = 7.22 289
For Bartlett Inventory turnover =
Inventory period =
365 Inventory turnover

365 = 50.55 days 7.22
For Bartlett Inventory period =
30
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Operating cycle
Finding the accounts receivable (collection) period
Sales A/R 3,074 For Bartlett A/R turnover = = 6.11 503 365 Receivable s period = A/R turnover A/R turnover =
For Bartlett Receivable s period = 365 = 59.74 days 6.11
Operating cycle = Inventory period + Receivable s period

For Bartlett Operating cycle = 50.55 + 59.74 = 110.29 days
Operating cycle
Finding the payables period
Cost of goods sold A/P 2,088 For Bartlett A/P turnover = = 5.47 382 365 Payables period = A/P turnover A/P turnover =
For Bartlett Payables period = 365 = 66.73 days 5.47
Cash cycle = Operating cycle - Payables period

For Bartlett Cash cycle = 110.29 66.73 = 43.56 days
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A few considerations on operating cycle

The longer the production process, the longer the inventory period The longer it takes customers to pay their bills, the longer the accounts receivable period The longer the accounts payable period, the shorter the cash cycle the cash conversion cycle is not given it is under managements control to a large extent
balance between the costs and benefits of maintaining high current assets
Profitability ratios
Gross profit margin = Sales - COGS Sales
For Bartlett Gross profit margin =

Operating profit margin =
3,074 - 2,088 = 0.3208 or 32.08% 3,074
Operating profits Sales
For Bartlett Operating profit margin =
418 = 0.1360 or 13.60% 3,074
Net profit margin =
Earnings available to common shareholders Sales
For Bartlett Net profit margin =

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221 = 0.0719 or 7.19% 3,074
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Profitability ratios
ROA = Earnings available to common shareholde rs Total assets
221 = 0.0614 or 6.14% 3,597
For Bartlett ROA =
ROE =
Earnings available for common shareholde rs Common shareholde rs' equity

221 = 0.1260 or 12.60% 1,754
For Bartlett ROE =
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Market ratios
Earnings per share (EPS) = Earnings available to common shareholders Number of shares outsanding
For Bartlett EPS =
221,000 = $2.90 76,262
Payout ratio =
Dividends to common shareholders Earnings available to common shareholders

98 = 0.4434 or 44.34% 221
For Bartlett Payout ratio =
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Market ratios
P/E ratio (PER) = Price per share of common stock Earnings per share
32.25 = 11.13 2.90
For Bartlett PER =
Market - to - book ratio =
Price per share of common stock Book value per share

32.25 32.25 = = 1.40 23 (1,754,000/76,262)
For Bartlett Market to book ratio =
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The DuPont system

ROA = Earnings available to common stockholders Total assets
Sales Earnings available to common stockholders x Total assets Sales
Assets turnover ratio
Net profit margin
For Bartlett ROA = 0.85 7.18% = 6.14%

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The DuPont system

ROE = Earnings available to common stockholders Shareholders' equity Earnings available to common stockholders = Net profit margin Sales Sales Assets turnover ratio Total assets Total assets Leverage ratio Shareholders' equity
For Bartlett ROE =
221,000 3,074,000 3,597,000 3,074,000 3,597,000 1,754,000 = 7.18% 0.85 2.05 = 12.60%
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Time-series and cross-sectional analysis for Bartlett

2003 1. Liquidity 1. Current ratio 2. Quick ratio 3. Cash ratio 1. Inventory turnover 2. Days in inventory 3. Average collection period 4. Total assets turnover 1. Debt ratio 2. Debt-to-equity ratio 3. Times interest earned 1.97 1.51 0.70 7.22 50.52 59.73 0.85 2002 Industry average 2003 2.08 2.05 1.46 1.43 0.70 0.71 5.70 64.00 51.76 0.79 6.60 55.30 42.75 0.75 32.46% 48.06% 6.25 30.00% 11.00% 6.20% 2.26 0.41 4.60% 8.50% 12.50 1.30
2. Efficiency
3. Leverage
34.36% 34.70% 52.35% 53.13% 7.06 5.86 32.08% 33.53% 13.60% 12.04% 7.18% 5.65% 2.89 1.91 0.44 0.42 6.14% 4.45% 12.59% 8.98% 11.14 1.40 9.46 0.85
4. Profitablity 1. Gross profit margin 2. Operating profit margin 3. Net profit margin 4. Earnings per share 5. Payout ratio 6. ROA 7. ROE 5. Market 1. PER 2. Market to book ratio
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Problems of financial statements analysis

The need for theory There is no compelling rationale for use of financial statement to make judgment about value and risk Which ratios matter most? What is the right value for the ratio? Conglomerates Not identified in a single industry or sector Hard to find comparables Global reach Comparability of financial statements between countries is problematic
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Topic #2
Fundamental principles of finance
Role of financial manager Working with cash flows Goals of the corporation Financial institutions and markets Basic principles and rules in finance
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Three fundamental questions

Corporate Finance is the study of 3 questions:
1. 2. 3. In what long-lived assets should the firm invest? CAPITAL BUDGETING How can the firm raise cash for required capital CAPITAL STRUCTURE expenditures? How should short-term operating cash-flows be managed? NET WORKING CAPITAL
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The financial manager

Finance is about money and markets (most people think that way and they are right!!) Also, finance is about people
WHY?
PEOPLE ARE THE ONES THAT MAKE DECISIONS THE FINANCIAL MANAGER MUST DEAL WITH THE CONFLICTING OBJECTIVES ENCOUNTERED IN FINANCIAL MANAGEMENT
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Who is the financial manager?

Chief Financial Officer (CFO)
Responsible for:
Financial policy Corporate planning
Treasurer
Responsible for:
Cash management Raising capital Banking relationships
Controller
Responsible for:
Preparation of financial statements Accounting Taxes
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What is the job of the financial manager?

Separation of ownership and management for corporations shareholders delegate decision making for managers delegation works only if all shareholders have the same objective This objective is TO MAXIMIZE THE CURRENT VALUE OF THEIR INVESTMENT An effective financial manager makes decisions which increase the current value of the company and the wealth of its shareholders
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What is the job of the financial manager?

The most important job of the financial manager is to create value from the firms capital budgeting, financing and liquidity activities How do financial managers create value?
Buying assets that generate more cash than they cost 2. Finding the right financial instruments for financing the company, including the innovative tools available in the market
1.
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Interplay: firms finance and financial markets
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Why maximizing short-term profits is a wrong goal?

1. 2.
Which years profits? Future profits can be increased by cutting current years dividend and investing the freed-up cash Profits can be calculated in different ways
3.
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Do managers really maximize firm value?

In most large corporations the managers are not the owners and they might be tempted to act in ways that are not in the best interests of the owners Conflicts between managers and shareholders
Agency problems
How are they solved? Compensation plans for managers Involvement of board of directors Takeover threat Specialist monitoring
Agency costs
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Identifying cash flows

Assume ABC Co. had sold on December 7 goods of 1 mil., which are to be paid next year, on February 8. The raw materials and salaries required for the production of goods have been paid on December 3.
THE ABC COMPANY Accounting view Income statement Dec.31 THE ABC COMPANY Corporate finance view Income statement Dec.31 0 900,000 900,000
Sales Costs Profit

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1,000,000 900,000 100,000
Cash inflows Cash outflows Net cash flow
Timing and risk of cash flows

The value of an investment made by the firm depends on the timing of cash flows Basic assumption in finance: individuals prefer to receive cash flows earlier rather than later ONE DOLLAR RECEIVED TODAY IS WORTH MORE THAN ONE DOLLAR RECEIVED TOMORROW The amount and timing of cash flows are not usually known with certainty Another basic assumption in finance: investors have aversion to risk
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Financial institutions and markets

Financial institutions act as intermediaries between investors and firms Rationale of financial institutions: promoting efficient allocation of resources Two types of relations between funds suppliers and funds demanders
Deposits
Funds suppliers
INDIRECT FINANCE Loans

Financial intermediaries
Funds demanders
DIRECT FINANCE
Types of financial markets

FINANCIAL MARKETS
Maturity
Type of sale
Money markets
Capital markets
Primary markets
Secondary markets
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The financial market economy

Individuals have different preferences for consuming and investing Financial markets develop to facilitate borrowing and lending between individuals so as they reach their consumption and investment preferences Financial markets trade financial instruments The interest rate on financial instruments is set so as the total demand for loans equals the total supply of loans
Competitive financial markets

Conditions for a competitive financial market:
Trading is costless Information about lending and borrowing is readily available There are many traders and no single trader can have a significant impact on market prices
Only one interest rate can be quoted in the market at any one time if not, ARBITRAGE
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The basic principle in finance

Financial markets provide a benchmark against which proposed investments can be compared The interest rate is the basis for a test that any proposed investment must pass An investment project is worth undertaking only if it increases the range of choices in the financial markets the project must be as desirable as what is available in the financial market
A lending and a borrowing example

Consider a person concerned only about this year and the next one Income of $100,000 this year and $100,000 next year Interest rate is 10% Problem 1: should she invest in a piece of land that costs $70,000 and brings a certain $75,000 next year? Problem 2: should she invest in the same piece of land that costs $70,000 and brings a certain $80,000 next year?
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Fishers separation theorem

The value of an investment to an individual is not dependent on his consumption preferences However, these preferences dictate whether the person will borrow or lend As a consequence, the managers of the firm may worry only about maximizing the value of the company, and not about meeting the consumption preferences of the shareholders
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Evaluating an investment opportunity

Cash inflows
r = 10%
$80,000
Time
Cash outflows
-$70,000
Net present value = -$70,000 + $80,000(1/1.1) = -$70,000 + $72,727.27 = +$2,727

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Evaluating an investment opportunity

Net present value (NPV) rule how much cash an investor would need to have today as a substitute for making the investment
NPV > 0 investment is worth taking doing so is essentially the same as receiving a cash payment equal to the NPV NPV < 0 investment should be rejected taking it on today is equivalent to giving up some cash today
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Present value and net present value

The present value of a future cash flow is the value of that cash flow after considering the appropriate market interest rate
Example: PV($80,000, 1 y, 10%) = = $80,000 (1/1.1) = 72,727.27
The net present value of an investment is the PV of the investments future cash flows minus the initial cost of the investment
Example: NPV= -$70,000 + $72,727.27 = $2,727.27
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NPV rule and rate of return rule

Another way of stating the NPV rule is through the rate of return rule Only investments that offer rates of return in excess of their opportunity costs of capital should be accepted Rate of return > Opportunity cost of capital accept project Rate of return < Opportunity cost of capital reject project
Rate of return rule an example

Rate of return =
Return =
Profit Investment
80,000 70,000 = 0.1428 or 14.28% 70,000
Return > 10% project should be accepted !!! Equivalent to NPV > 0
IMPORTANT CONCLUSION: CONCLUSION: The NPV rule and the Rate of return rule are two equivalent decision rules for capital investment
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The opportunity cost of capital

The opportunity cost of capital is the return foregone by investing in the project rather than investing in the financial market securities with the same risk as the project Also referred to as discount rate, hurdle rate Opportunity cost of capital is 10% (= r = the interest rate available in the financial market) We have obtained the present value of the investment by multiplying the cash flow in year 1 with a factor 1 DISCOUNT FACTOR
1+r
Risk and present value

The cash flows generated in the future by any investment cannot be certain We have to think in terms of expected payoffs and expected returns on investments Not all investments are equally risky
The opportunity cost of capital for an investment has to take into account the risk of the project The appropriate discount rate for a project is the return obtained (and foregone) from an investment in the financial market of similar risk
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Corporate investment decision-making

View firms as ways in which many investors can pool their resources to make large-scale business decisions Shareholders of the firm will be unanimous in wanting the firm to increase its value by taking on positive NPV projects Managers can all be given one simple instruction: MAXIMIZE NET PRESENT VALUE
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Topic #3
Time value of money
What is time value of money? Compounding and discounting Shortcuts: perpetuities and annuities Frequent compounding and interest rates Working with inflation
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What is time value of money?

Most financial decisions involve costs and benefits that are spread out over time Time value of money allows comparison of cash flows from different periods Using TVM we can offer answers to questions such as: Would it be better for a company to invest $100,000 in a product that would return a total of $200,000 in one year, or one that would return $500,000 after two years?
What is time value of money?

TVM concept: A dollar today is worth more than a concept: dollar tomorrow
WHY?
Real interest rate
Time
Inflation
Risk
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Time value terminology

0 1 2 3 t
PV
FV
PV present value, that is, the value today. FV future value, or the value at a future date. t the number of time periods between PV and FV r the discount rate all time value questions involve the four values above: PV, FV, r, and t given three of them, it is always possible to calculate the fourth
Future values
You deposit $100 today at 10% interest. How much will you have in 5 years? you are interested in finding the FV for five years of the $100 today (=PV) FV($100, 10%, 5y) = $100 (1.1)5 = $161.05
FVt,r = PV x (1+r)t
Future value factor (FVF)
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Future values using tables

What is the future value of $100 today in 5 years at a 10% interest rate?
FV5,10 = $100 FVF(5y, 10%) = $100 1.6105 = $161.05

Simple interest vs. compound interest

Growth of $100 original amount at 10% per year Darker shaded area represents the portion of the total that results from compounding of interest.
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The power of compounding
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Present values
The process of obtaining the PV is the inverse of the one which gives the FV Suppose you need $20,000 in three years to pay your college tuition. If you can earn 8% on your money, how much do you need today?
PV = $20,000 1/(1.08)3 = $15,876.64
PVt,r = FV 1/(1+r)t
Discount factor or Present value factor (PVF)
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Present values using tables

What is the present value of $1000 to be received in 3 years at a 15% interest rate?
PV3,15 = $1,000 PVF(3y, 15%) = $1,000 0.6575 = $657.5

The power of discounting
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The case of multiple cash flows

FV of a set of cash flows is the sum of FVs for the individual cash flows
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The case of multiple cash flows

PV of a set of cash flows is the sum of PVs for the individual cash flows
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Perpetuities
Perpetuity = financial concept in which a cash flow is received forever
PV(perpetu ity) =
Cash flow C = r r
Example: Example Suppose you receive $1,000 per year forever. Your opportunity rate is 6%. What is the value today of this set of cash flows?
PV(perpetu ity) =
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$1,000 = $16,666.66 0.06
Growing perpetuities
Imagine an apartment building where cash flows to the landlord after expenses will be $100,000 next year. These cash flows are expected to rise at 5% p.a. and the discount rate is 10%. If this continues indefinitely growing perpetuity
PV(growing perpetuity ) =
C r -g
PV(growing perpetuity ) =
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100,000 = 2,000,000 0.1- 0.05
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Few points concerning growing perpetuities
1. 2. 3.
The numerator (C) is the cash flow one period hence, not at date 0 The discount rate (r) must be greater than the growth rate for the formula to work Timing assumption formula assumes cash flows are received and disbursed at regular and discrete points in time
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Annuities
Annuity = a stream of regular payments that lasts for a fixed number of periods The payments are assumed to be received at the end of each period A good example of an annuity is a lottery, where the winner is paid over a number of years
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PV and FV of an annuity
1 1 PV(annuity) = C t r r(1 + r)
PV ANNUITY FACTOR in tables
(1 + r)t 1 FV(annuity) = C r r
FV ANNUITY FACTOR in tables
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Calculating PV of an annuity
Suppose you need $5,000 each year for the next three years to make your tuition payments. You need the first $5,000 in one year. You can place money in a savings account yielding 5% compounded annually. How much do you need to have in the account today?
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Calculating PV of an annuity
1 1 PV(5,000; 3y,5%) = 5,000 3 0.05 0.05(1.05) = 5,000 2.7232 = $13,616

Calculating FV of an annuity
Assume you deposit $2,000 per year in a savings account at 4% p.a., compounded annually for 5 years. The first payment is made one year from now. How much money will you have in the account after 5 years?
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Calculating FV of an annuity
(1.04)5 1 FV(5,000; 5y,4%) = 2,000 0.04 0.04 = 2,000 5.4163 = $10,832.6

Finding C in an annuity calculation

You would like to have $3,000 in your savings account 12 months from now. If the account pays 9.0% annual interest compounded monthly, how much should you deposit at the end of each month to reach your goal?
(1.0075)12 1 3,000 = C 0.0075 0.0075 C = 3,000 12.5075 = 239.85
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Compounding more frequently than annually

Compounding more frequently than annually results in a higher effective interest rate because you are earning interest on interest more frequently As a result, the effective interest rate is greater than then the nominal (annual) interest rate The effective rate of interest will increase the more frequently interest is compounded
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Compounding more frequently than annually

What would be the difference in future value if you deposit $100 for 5 years and earn 12% annual interest compounded (a) annually, (b) semiannually, (c) quarterly, and (d) monthly?
Annually Semiannually Quarterly Monthly
100 x (1 + 0.12/1)51 = $176.23 100 x (1 + 0.12/2)52 = $179.09 100 x (1 + 0.12/4)54 = $180.61 100 x (1 + 0.12/12)512 = $181.67
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Nominal and effective rates

The nominal interest rate (sometimes denoted APR from annual percentage rate) is the stated or contractual rate rate of interest charged by a lender or promised by a borrower The effective annual rate (EAR) is the rate you actually pay or earn
EAR = [1 + (r/m)]m - 1
EAR > APR whenever compounding occurs more than once per year
Nominal and effective rates

What is the EAR on your credit card if the nominal rate is 18% p.a., compounded monthly?
Answer:
EAR = (1 + 0.18/12)12 1 = 19.56% What if compounded quarterly?

Answer:
EAR = (1+ 0.18/4)4 1 = 19.25%
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Compounding periods, APRs and EARs

Compounding period Year Quarter Month Week Day Hour Minute Number of times compounded 1 4 12 52 365 8,760 525,600 Effective annual rate (%) 10.00000 10.38129 10.47131 10.50648 10.51558 10.51703 10.51709
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Continuous compounding
The number of compounding approaches infinity The FV equation becomes: periods per year
FVt,r = PV ert
2.7183
What is the future value of a $100 deposit after 5 years if interest of 12% is compounded continuously? FV5,12 = $100 e0.125 = $182.22
48
A word on inflation
Rate of inflation = rate at which prices as a whole are increasing Nominal interest rate = rate at which money invested grows Real interest rate = rate at which the purchasing power of an investment increases
1 + real interest rate = 1 + nominal interest rate 1 + inflation rate
OR using an approximation Real interest rate Nominal interest rate Inflation rate
Nominal and real interest rates

Suppose you invest your funds at an interest rat of 8%. What will be your real rate of interest if the inflation rate is zero?
Real interest rate = 1.08 1 = 8% 1.0
What if inflation rate is 5%?

Real interest rate = 1.08 1 = 2.85% 1.05
98
49
Valuing cash flows

Nominal (current) cash flows must be discounted by the nominal interest rate Real cash flows must be discounted by the real interest rate If there is no error in the calculation, the two methods should always give the same result
99
Topic #4
Investment criteria
What is capital budgeting? Using net present value Payback period Internal rate of return and incremental IRR Profitability index and capital rationing
100
50
What is capital budgeting?

Capital budgeting deals with the analysis of potential additions to firms fixed assets These are long-term decisions that generally involve large expenditures Any of the following decisions would qualify as projects:
Major strategic decisions to enter a new area of business or new markets Acquisitions of other firms Decisions on new ventures with existing business or markets Decisions that may change the way existing ventures and projects are run
101
Types of projects
Independent projects Mutually exclusive projects Expansion projects
Existing products / markets New products / markets
Replacement projects
Maintenance of business Cost reduction
Research & development projects Other projects (safety / environmental projects)

51
NPV rule illustrated

Assume you have the following information on Project X: Initial outlay: -$1,100 Required return = 10% Annual cash revenues and expenses are as follows:
Year 1 2 Revenues $1,000 2,000 Expenses $500 1,000
Draw a time line and compute the NPV of project X
103
NPV rule concluded

0 Initial outlay ($1,100) 1 Revenues $1,000 Expenses 500 Cash flow $1,100.00 $500 x +454.55 +826.45 +$181.00 NPV
2 Revenues $2,000 Expenses 1,000 Cash flow $1,000
$500
1 1.10 $1,000 x 1 1.102
52
Foundations of the NPV rule

Why does NPV work? And what does work mean? A firm is created when security holders supply the funds to acquire assets that will be used to produce and sell goods and services
The market value of the firm is based on the free cash flows it is expected to generate
105
Foundations of the NPV rule (contd)

Thus, good projects are those which increase firm value Good projects are those projects that have positive NPVs
Moral: Moral:
INVEST ONLY IN PROJECTS WITH POSITIVE NPVs

53
Why do we like NPV that much?

NPV uses cash flows, and not other accounting artificial constructs NPV uses all the cash flows generated by the project during its life NPV discounts the cash flows properly, since it takes into account TVM
107
Payback period
The payback period of a project (PB) is the number of years it takes before the cumulative forecasted cash flows equal the initial outlay Payback period rule accept projects that payback in the desired time frame
108
54
Pitfalls in using the payback period

Which project to choose from the followings?
Project A B C C0 -2,000 -2,000 -2,000 C1 500 500 1800 C2 500 1800 500 C3 5000 0 0 Payback period 3 2 2
109

Which project to choose from the followings?
Project A B C C0 -2,000 -2,000 -2,000 C1 500 500 1800 C2 500 1800 500 C3 5000 0 0 Payback period 3 2 2 NPV @ 10% +2,624 -58 +50
110
55

Payback period may select projects that are not acceptable under NPV rule Timing of cash flows within the payback period compare project B and project C Payments after the payback period project A and project C Arbitrary standard for payback period compare
111
Use of payback period

PB is often used when making relatively small decisions PB has some desirable features for managerial control PB ensures liquidity Nevertheless, as a decision grows in importance, the NPV becomes the order of the day
112
56
Internal rate of return

IRR tries to find a single number that summarizes the merits of a project This number does not depend on the interest rate that prevails in the capital market The number is intrinsic to the project and only depends on the cash flows of the project and their timing
113
Internal rate of return illustrated

Year Cash flow 0 -200 1 50 2 100 3 150
Find r such that NPV = 0

0 = 200 + 50 100 150 + + 2 1 + r (1 + r) (1 + r )3
r = 19.44% this r is IRR

IRR rule: rule:
Accept the project if IRR > opportunity cost of capital Reject the project if IRR < opportunity cost of capital
57
NPV profile
100.00 80.00 60.00 40.00
IRR = 19.44%
NPV
20.00 0.00 1 -20.00 -40.00 -60.00 5 9 13 17 21 25 29
Discount rate (%)

Trial and error for IRR

Trial and error
Discount rates 0% 5% 10% 15% 20% NPV $100 68 41 18 -2
IRR is just under 20% 19.44%
Approximation formula
NPV + IRR = rmin + (rmax rmin ) NPV + + NPV
For our project : IRR = 15 + (20 15)
116
18 = 19.5% 18 + 2 Corporate Finance / MPI / Alexandra Horobet, PhD
58
Pitfalls with the IRR approach

Pitfall 1: IRR assumes funds can be invested each year at the same rate Pitfall 2: Investing or financing? Pitfall 3: Multiple rates of return Pitfall 4:The scale problem Pitfall 5:The timing problem
Investing or financing?
With some cash flow patterns, the NPV of the project increases as the discount rate increases
35.00 25.00 Net present value 15.00 5.00 -5.00 0 -15.00 -25.00 -35.00
118
Project A IRR(A) = IRR(B)
Year
B 100 -130
0 -100 1 130
10
20
30
40
50
60
Project B
DiscountFinance(%) / Alexandra Horobet, PhD Corporate rate / MPI
59
Investing or financing?
Project A is a substitute for investing Project B is a substitute for financing In the case of financing-like projects, IRR rule is reversed:
Accept project if IRR < opportunity cost of capital Reject project if IRR > opportunity cost of capital
119
Multiple internal rates of return

Year Cash flow 0 -252 1 1,431 2 -3,035 3 2,850 4 -1,000
0,04 0,02 0,00

NPV
IRR4 = 66.6% IRR1 = 25.0% IRR3 = 42.8%
-0,02 -0,04 -0,06 -0,08
15
25
35
45
55
65
IRR2 = 33.3%
120
Discount rate Corporate Finance / MPI / Alexandra Horobet, PhD
60
Multiple rates of return

When should we expect a project to have more than one IRR? Answer: whenever we have more than one sign change (+/- or -/+) on the cash flows How many IRRs can a project have? Answer: as many as the number of sign changes (example: 4 changes maximum 4 IRRs)
In all these cases, IRR rule cannot be applied the only criteria we can use
NPV is
The scale problem

Suppose you have purchased the rights to produce a motion picture and you have to decide on allocating either a small or a large budget for it. The two projects look as follows:
C0 Small budget Large budget -$10 mil. -$25 mil. C1 $40 mil. $65 mil. NPV @ 25% $22 mil. $27 mil. IRR 300% 160%
Which one would you choose?

61
The scale problem and incremental IRR

Incremental IRR of large budget versus small budget
C0 Incremental cash flows: budget vs. small budget large -25 (-10) = -15 C1 65 40 = 25
0 = 15 +
25 Incrementa l IRR = 66.67% > 25% 1 + IRR 25 NPV of incrementa l cash flows = 15 + =5>0 1.25
Large budget is better than small budget project
123
The timing problem

Year 0 Inv.A Inv. B -10,000 -10,000
4000.00 3000.00 2000.00 NPV 1000.00 0.00 0 -1000.00 -2000.00
124
NPV 2 1,000 1,000 3 1,000 12,000 @0% 2,000 4,000 @10% @15% 669 751 109 -484
1 10,000 1,000
Intersection point @ 10.55% IRRA=16.04%

5 10 15 20
IRRB=12. 94%
Corporate Finance Discount rateHorobet, PhD / MPI / Alexandra
62
The timing problem

In making the decision between projects like A and B one should not compare their IRRs Selecting the best project:
Compare NPVs of the two projects Compare incremental IRR to the discount rate Calculate NPV on incremental cash flows
125
Profitability index
Profitability index = PV(Cash flows subsequent to initial investment ) Initial investment
PI Rule for independent projects:

Accept project if PI > 1 Reject project if PI < 1
Look at this!
NPV > 0 NPV < 0 PI > 1 PI < 1 IRR > discount rate IRR < discount rate ACCEPT PROJECT REJECT PROJECT
126
63
Problems with PI
Making decisions with PI for mutually exclusive projects
Cash flows Project 1 2 C0 -20 -10 C1 70 15 C2 10 40 PV @ 12% 70.5 45.3 PI 3.53 4.53 NPV @ 12% 50.5 35.3
Same problems as in the case of scale problem form IRR decide using NPV
Capital rationing
Cash flows Project 1 2 3 C0 -20 -10 -10 C1 70 15 -5 C2 10 40 60 PV @ 12% 70.5 45.3 43.4 PI 3.53 4.53 4.34 NPV @ 12% 50.5 35.3 33.4
Suppose the projects above are independent, but you have only $20 mil. to invest.Which project(s) do you choose? Suppose now you have $25 million to invest. Which project(s) do you choose?
USE PROFITABILITY INDEX

64
Capital rationing
Profitability index does not work if funds are also limited beyond the initial time period use linear programming Two types of capital rationing:
Soft rationing provisional limits adopted by management as an aid to financial control Hard rationing desires the firm is unable to raise the money she
129
Topic #5
Cash flow principles
Relevant cash flows of a project Calculating cash flows Example: Blooper project
130
65
Cash flows versus accounting profits

Recognize cash flows when they occur, not later when the work is undertaken or the liability is incurred Projects are financially attractive because of the cash they generate The focus of capital budgeting must be on cash flow, not profits
Cash flow Dollars coming in Dollars going out
131
Incremental cash flows

Ask yourself this question: Would the cash flow still exist if the project did not exist? If answer is YES analysis If answer is NO
Incremental cash flow
132
do not include the cash flow in the include the cash flow
Cash flow WITH project
Cash flow WITHOUT project
66
Sunk costs
A company is evaluating the NPV of establishing a line of chocolate milk. The company has paid last year a consulting firm $100,000 to perform a test marketing analysis. Is this cost relevant for the current decision? NO this is a SUNK COST
Sunk costs are past and irreversible outflows Sunk costs are NOT RELEVANT cash flows
Opportunity costs
Suppose a company wants to use an empty warehouse that she has in Seattle to store a new line of products. At the same time, the company is able to sell the warehouse to another company for $200,000. Should the price of the warehouse be included in the costs associated with introducing a new line of products?
Answer:YES
this is an OPPORTUNITY COST
Opportunity costs are relevant cash flows
134
67
Indirect effects
Suppose a company is determining the NPV of a new sports car. Some of the customers who would purchase the car are potential owners of the companys other product, a compact sedan. Are all sales and profits from the new sports car incremental? Answer: NO some of the cash flow represents transfers from other elements of the companys product line This is an example of EROSION or CANNIBALIZATION included in the NPV calculation
135
Indirect effects project synergies

Assume you are a clothing retailer considering whether to open an up-scale clothing store for children in the same shopping center where you already own a store which caters to adult consumers. Are the cash flows for new store the only cash flows you should take into account? NO, since the new store might increase the traffic into the adult store and increase profits at that store This is an example of PROJECT SYNERGY
136
68
Allocated overhead costs

A project may generate extra overhead costs, or may not We should be cautious about assuming that the accountants allocation of overhead costs is an incremental cash flow for the project
137
Investment in working capital

Net working capital
Short-term assets
Accounts receivable
Short-term liabilities
Payables
Inventories
Cash
Accruals
Investments in working capital result in cash outflows Investments in working capital are relevant cash flows for a project
138
69
Investments in working capital

Most common mistakes regarding working capital:
Forgetting about working capital entirely Forgetting that working capital may change during the life of the project Forgetting that working capital is recovered at the end of the project
139
Separating investment and financing decisions

When valuing a project, ignore how it is financed Following the logic from incremental analysis, ask yourself the following question: Are the cash flows of the project dependent of the projects financing? If the answer is NO, you must separate financing and investment decisions
140
70
Calculating cash flows

Cash flow from investment in plant and equipment Cash flow from investments in the working capital Cash flow from operations
CASH FLOW
Calculating cash flows

The initial cash outflow
Cost of new assets
Investment in working capital Set-up costs, etc. After-tax proceeds from sale of old assets
CASH FLOW
Intermediate cash flows

(operating cash flows) Terminal Cash Flow The last year operating cash flow Recovery of the projects incremental working capital After-tax resale value of the assets related to the project, etc.
142
71
Cash flow from capital investment

Gillettes competitor, Slick, invests $800 million to develop the Mock4 razor blade. The blade factory will run for 7 years, until replaced by a more advanced technology. At that point, the machinery will be sold for scrap metal, for a price of $50 million. Taxes of $10 million will be assessed on the sale.
Date Cash flow
0 -$800 mil.
7 $50 - $10 = $40 mil.
143
Cash flow from investment in working capital

You have forecasted the components of working capital over the life of a project: Date Accounts receivable Inventory Accounts payable NWC Cash flow
144
0 0 75 35 +40 -40
1 100 130 25 +205 -165
2 200 30 120 +110 +95
72
Cash flows from operations

A project generates revenues of $1,000, cash expenses of $600, and depreciation charges of $200 in a particular year.The firms tax bracket is 35%. Revenues Cash expenses EBITDA Depreciation expense EBIT Tax @ 35% Net operating income
1,000 600 400 200 200 70 130
Cash flow from operations

Method 1
EBIT (1-T)
Depreciation
In our example: CF = 130 + 200 = $330
146
73
Cash flows from operations

Method 2
=
(Revenues Cash expenses) (1 Tax rate)
+
(Depreciation Tax rate) EBITDA TAX SHIELD
In example: CF = (1,000 600) (1 0.35) + (200 0.35) = $330

Blooper project
As the newly appointed financial manager of Blooper Industries, you are about to analyze a proposal for mining and selling a small deposit of high-grade iron ore The project requires an investment of $10 million in mining machinery. At the end of 5 years the machinery has no further value The working capital needs for the 5 years are estimated as follows: Wk. cap = 15% of the following years expenses Accounts receivable rise with sales and equal 1/6 times of the current years revenues
74
Blooper project
The company expects to be able to sell 750,000 pounds of iron a year at a price of $20 a pound in year 1 Inflation is running at 5% a year, and iron prices keep pace with inflation The sales forecasts are cut off after 5 years, since iron ore deposits will run out at that time Expenses are equal to $10,000 in the first year, and will also increase in line with inflation at 5% per year The company applies straight-line depreciation to the mining equipment over 5 years Company taxes are 35% of pretax profits
149
Profit projections for Blooper project

Year 1. Capital investment 2. Working capital 3. Change in working capital 4. Revenues 5. Expenses 6. EBITDA 7. Depreciation 8. EBIT 9. Tax 10. Profit after tax
150
0 1 10,000 1,500 4,075 1,500 2,575 15,000 10,000 5,000 2,000 3,000 1,050 1,950
2 4,279 204 15,750 10,500 5,250 2,000 3,250 1,138 2,113
3 4,493 214 16,538 11,025 5,513 2,000 3,513 1,229 2,283
4 4,717 225 17,364 11,576 5,788 2,000 3,788 1,326 2,462
3,039 0 -1,679 -3,039 18,233 12,155 6,078 2,000 4,078 1,427 2,650
75
Cash flows for Blooper project

Year 0 1 2 3 4 5 6 -10,000 1. Capital investment 2. Investment in working capital -1,500 -2,575 -204 -214 -225 1,678 3,039 3,950 4,113 4,283 4,462 4,651 3. Cash flow from operations Total cash flow -11,500 1,375 3,909 4,069 4,237 6,329 3,039
NPV @ 12% = 3,564,000
151
Blooper project
Tax depreciation allowed under the modified accelerated cost recovery system (MACRS) - (Figures in percent of depreciable investment).
152
76
Blooper project a note on tax shields

Tax shields under straight-line depreciation
Year 1 2 3 4 5 6 Total
Depreciation 2,000 2,000 2,000 2,000 2,000 0 10,000
Tax shield 700 700 700 700 700 0 3,500
PV tax shield @ 12% 625 558 498 445 397 0 2,523
153
Blooper project a note on tax shields

Tax shields under 5 years MACRS depreciation
Year 1 2 3 4 5 6 Total Depreciation 2,000 3,200 1,920 1,152 1,152 576 10,000 Tax shield 700 1,120 672 403 403 202 3,500 PV tax shield @ 12% 625 893 478 256 229 102 2,583
PV of tax shields under MACRS > PV of tax shields under straight-line
2,583
154
2,523
77
A note on salvage value

We assumed earlier that the mining equipment would be worthless when the iron ore closed Suppose now that the equipment can be sold for $2 million in year 6 SALVAGE VALUE Any difference between the sale price and the value of the tax books is treated as a taxable gain Extra cash flow in year 6 = $2 million (1-0.35) = $1.30 million New NPV @ 12% = $4,222,985.9
78

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Corporate Finance

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Master in Management of International Projects

Corporate Finance / MPI / Alexandra Horobet, PhD

Introduction to Corporate finance

Corporate Finance / MPI / Alexandra Horobet, PhD

What is corporate finance?

the firm make? 2. How should it pay for those investments?

SPENDING MONEY RAISING MONEY

The secret of success in financial management is TO INCREASE COMPANYS VALUE

Some statements about Corporate finance

Corporate Finance / MPI / Alexandra Horobet, PhD

Finance and Economics

Finance and Accounting

Financial reporting and statements

Interested parties in financial reporting and statements:

Corporate Finance / MPI / Alexandra Horobet, PhD

Basic financial statements

Corporate Finance / MPI / Alexandra Horobet, PhD

Corporate Finance / MPI / Alexandra Horobet, PhD

The main balance sheet items

Market value versus Book value

Corporate Finance / MPI / Alexandra Horobet, PhD

Market Value vs. Book Value

Market Value vs. Book Value

Corporate Finance / MPI / Alexandra Horobet, PhD

Bartlett Co. Balance Sheet

Gross fixed assets (at cost)

Bartlett Co. Balance Sheet

LIABILITIES AND STOCKHOLDERS' EQUITY

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY

Corporate Finance / MPI / Alexandra Horobet, PhD

Corporate Finance / MPI / Alexandra Horobet, PhD

Bartlett Co. Income Statement

Corporate Finance / MPI / Alexandra Horobet, PhD

Profits vs. Cash Flows

Corporate Finance / MPI / Alexandra Horobet, PhD

Statement of retained earnings

$1,012 231 1,243 108 $1,135

Statement of retained earnings

Corporate Finance / MPI / Alexandra Horobet, PhD

Bartlett Co. Statement of cash flows

Cash Flow from Investment Activities

Cash Flow from Financing Activities

Net increase in cash and marketable securities

Financial analysis/ratios objectives

Corporate Finance / MPI / Alexandra Horobet, PhD

Financial ratios comparisons

the most informative approach

Corporate Finance / MPI / Alexandra Horobet, PhD

Corporate Finance / MPI / Alexandra Horobet, PhD

For Bartlett Current ratio =

Current assets - Inventory Current liabilities

For Bartlett Quick ratio =

Cash + Marketable securities Current liabilities

For Bartlett Cash ratio =

Corporate Finance / MPI / Alexandra Horobet, PhD

For Bartlett Debt ratio =

1,023 = 0.34 1,023 + 1,954

Long - term debt + Value of leases Equity

For Bartlett Debt equity ratio =

1,023 = 0.52 1,954

EBIT + Depreciati on Interest 418 + 239 For Bartlett TIE = = 7.06 93

Efficiency ratios and operating cycle

Efficiency of total assets