Corporate Finance Fundamentals of Financial Management

Dr. Markus R. Neuhaus Dr. Marc Schmidli, CFA

Winter Term 2010

Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Corporate Finance: Course overview

24.09. Fundamentals (4 hours) 01.10 Investment Management 08.10. Business Valuation (4 hours) 15.10. No Lecture 22.10. Value Management 29. 10. Mergers & Acquisitions I&II (4 h) 05.11. No Lecture 12.11. No Lecture 19.11. No Lecture 26.11 Legal Aspects 03.12. Tax and Corporate Finance (4 h) 10.12. Financial Reporting 17.12. Turnaround Management 24.12. Summary, repetition M. Neuhaus & M. Schmidli M. Neuhaus & P. Schwendener M. Neuhaus & M. Bucher No Lecture M. Neuhaus, R. Schmid & F. Monti M. Neuhaus & D. Villiger No Lecture No Lecture No Lecture I. Pschel M. Neuhaus & M. Marbach M. Neuhaus & M. Jeger M. Neuhaus & M. Koch M. Neuhaus
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Winter Term 2010

Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Markus R. Neuhaus
PricewaterhouseCoopers AG, Zrich

PWC
Phone: Email: +41 58 792 4000 markus.neuhaus@ch.pwc.com

Grade Qualification Career Development Subject-related Exp. Lecturing

Published Literature

Other professional roles:

CEO Doctor of Law (University of Zurich), Certified Tax Expert Joined PwC in 1985 and became Partner in 1992. Corporate Tax Mergers + Acquisitions SFIT: Corporate Finance, University of St. Gallen: Tax Law Multiple speeches on leadership, business, governance, commercial and tax law Author of commentary on the Swiss accounting rules Publisher of book on transfer pricing Author of multiple articles on tax and commercial law, M+A, IPO, etc. Member of the board of conomiesuisse, member of the board and chairman of the tax chapter of the Swiss Institute of Certified Accountants and Tax Consultants
Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 3

Winter Term 2010

Marc Schmidli
PricewaterhouseCoopers AG, Zrich

PWC
Phone: Email: +41 58 792 15 64 marc.schmidli@ch.pwc.com

Grade Qualification Career Development Lecturing Published Literature

Partner Dr. oec. HSG, CFA charterholder Corporate Finance PricewaterhouseCoopers since July 2000 Euroforum Valuation in M&A situations Guest speaker at ZfU Seminars, Uni Zurich, ETH, etc. Finanzielle Qualitt in der schweizerischen Elektrizittswirtschaft Various articles in Treuhnder, HZ, etc.

Winter Term 2010

Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Contents
Learning targets Pre-course reading Lecture Fundamentals of Financial Management

Winter Term 2010

Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Learning targets
Financial management Understanding the flow of cash between financial markets and the firms operations Understanding the roles, issues and responsibilities of financial managers Understanding the various forms of financing Financial environment Knowing the relevant financial markets and their players Being aware of various financial instruments

Winter Term 2010

Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Contents
Learning targets Pre-course reading Lecture Fundamentals of Financial Management

Winter Term 2010

Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Pre-course reading
Books Mandatory reading
Brigham, Houston (2009): Chapter 2 (pp. 26-50)

Optional reading
Brigham, Houston (2009): Chapter 1 (pp. 2-20) Volkart (2008): Chapter 1 (pp. 41-68) Volkart (2008): Chapter 7 (pp. 565-591)

Slides Slides 1 to 11 mandatory reading Other Slides optional reading, will be dealt within the lecture

Winter Term 2010

Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Contents
Learning targets Pre-course reading Lecture Fundamentals of Financial Management

Winter Term 2010

Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Agenda I
1. Introduction Setting the scene Who is the financial manager? Roles of financial managers Shareholder value vs. Stakeholder value concept

2. Financing a business External financing Internal financing Asymmetrical information Pecking order theory Capital structure

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Agenda fundamentals of financial management II

3. Financial markets Different types of markets Financial institutions Financial instruments Efficient market hypothesis (EMH)

4. Q&A and discussion

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Agenda: Introduction
Setting the scene Who is the financial manager? Roles of financial managers Shareholder value vs. stakeholder value concept

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Setting the scene I

Company Environment

(2) Firms operations (a bundle of real assets) (3)

(1)

Financial manager (e.g. CFO)

(4)

Capital markets (equity, debt, bonds), Shareholders, other stakeholders

(5)

(1) (2) (3) (4) (5)

cash raised by selling financial assets to investor cash invested in the firms operating business and used to purchase real assets cash generated by the firms operating business reinvested cash cash returned to investors

Source: Brealey, Myers, Allen (2008), 5.

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Setting the scene II

Managers do not operate in a vacuum Large and complex environment including: Financial markets Taxes Laws and regulations State of the economy Politics, public view, press Demographic trends etc.

Among other things, this environment determines the availability of investments and financing opportunities Therefore, managers must have a good understanding of this environment

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Who is the financial manager?

Chief Financial Officer (CFO) (responsibilities: e.g. financial policy, corporate planning

Treasurer (responsibilities: e.g. cash management, raising capital, banking relationships)

Controller (responsibilities: e.g. preparation of financial statements, accounting, taxes)

Source: Brealey, Myers, Allen (2008), 7.

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Roles of financial managers

Generally, managers do not own the company, they manage it The company belongs to the stockholders. They appoint managers who are expected to run the company in the stockholders interest Basic goal is creating shareholder value two problems emerge from this constellation Agency dilemma: asymmetric information and divergences of interests between principal (stockholders) and agent (management) lead to the so called agency dilemma which also arises in the context of financing decisions ( pecking order theory) Shareholder value vs. stakeholder value: shareholders own the company. Does a company merely consider the owners interest or the interests of all stakeholders affected by the companys business activities?
Empire building, independence, High salaries

hires
Stable growth, Dividends, control

Agent

Principal

performs Illustration: Agency dilemma

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Shareholder value vs. stakeholder value I

Shareholders wealth maximization means maximizing the price/value of the firms common stock Shareholders are considered as the only reference for the companys course of business and performance Other stakeholders are strategically considered only to the extent they could have an impact on the stock price, the stockholders wealth Where does the risk in the shareholder value concept lie? ( incentives, sustainability)

Employees

If a new pharmaceutical product is launched, health considerations will be relevant only to the extent they could endanger the firms stock price (e.g. through a lawsuit)

Suppliers

Customers

Value

Investors

State

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Shareholder value vs. stakeholder value II

Stakeholder value means maximizing the companys value taking into account every stakeholder the company affects in the course of its business The importance of stakeholder management is continually growing.

How can a company motivate its managers towards a careful handling of the companys stakeholders? ( compensation programs, corporate governance) If a new pharmaceutical product is about to be launched, every stakeholders interest must be assessed and the product is introduced only if every interest can be honored Does the plant pollute the air? Could the new product be harmful to customers? etc.
Investors State

Employees Suppliers Customers

Value

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Agenda: Financing a business

External financing Internal financing Asymmetrical information Pecking order theory Capital structure

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Possibilities of financing a business

The management makes decisions about which investments are to be undertaken and how these investments are to be financed There are three basic ways of financing a business 1. Internal 3. Equity
Internal

External

Equity

Debt

2. Debt

Internal financing

Pecking order theory diagram

Why would a company prefer debt over equity? ( cost of capital)

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Financing a business overview

External financing: a company receives capital from outside the company, e.g. credit, capital increase Internal financing: The major part of a firms capital typically comes from internal financing (retained cash flows, profits from operating activities), except for e.g. startup or turnaround situations Liquidation financing: In this context, liquidation financing refers to the liquidation of assets (e.g. divesting of certain business areas) which have a financing effect

Debt financing External financing Credit financing

Equity financing Issuing shares

Liquidation financing

Divesting activities Mezzanine / Hybrid financing Financing impact from value of depreciation

Internal financing
Source: Volkart (2008), 567.
Winter Term 2010

Financing effect from accruals

Retained cash flows and profits

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Financing a business external financing

Debt financing
Given a solid capital base, the use of debt is reasonable as it broadens the financing base provided a certain amount of leverage exists and considerable tax advantages1) can be exploited The risk borne by a creditor is the risk of default driven by the companys market and operational risks Because a bank would not lend money to a company without checking its financial health, a certain amount of debt gives a positive signal to other business partners

Equity financing
Equity serves as the capital base of a company because equity can not be withdrawn or taken away from the company In the case of incorporated companies (e.g. AG), equity bears the major part of the risk A company can raise equity capital by selling shares privately or publicly (e.g. IPO or capital increase)

1)

General rule: Interest expense is tax deductible, dividend distributions not.

Source: Volkart (2008), 569ff.

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Financing a business internal financing

Internal financing or self-financing Internal financing is determined by the cash flow from operating activities Internal financing means generation of cash flows from operating activities without using external sources Internal financing happens automatically as a consequence of the operating activities of a company From the companys perspective, self-financing is the most convenient way of financing as the company does not have to debate with creditors and the discussion with equity holders is limited to the question of how much of the profits should be distributed. ( pecking order theory; see Slide 26) As opposed to external financing, internal financing is not fully reflected on the companys balance sheet

Source: Volkart (2008), 572ff.

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Asymmetrical Information I
The problem of asymmetrical information does not occur only between principal and agents, but arises each time financing is needed as the fundamental interests of debt holders and shareholders differ significantly. Shareholders assume that management is negatively influenced by debt holders towards making safe investments in order to minimize the probability of default Debt holders will try to establish credit covenants in order to gain more control over investment decisions and the course of business Shareholders, on the other hand, prefer investment opportunities with potentially high returns as their shares will gain in value as the companys cash flows grow As a result, each party tries to influence the management: Debt holders try to establish favorable credit covenants Shareholders set incentives through compensation plans

Source: Volkart (2008), 570ff.

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Asymmetrical Information II
Why do the different parties not get together and solve the problem? Game theory ( Nash) shows us that in such strategic situations with conflicts of interest, each party begins by holding back information in order to strengthen its negotiating position Shareholders do not know about possible credit covenants whereas creditors do not know anything about the investors motivation and decisions Law prohibits typically a company to disclose all relevant information

in conclusion, we find a triangle situation in which each party tries to maintain or gain as much power and influence as possible in order to secure its interests
Management

Debt holders

Shareholders

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Pecking order theory I

Bridging the problems of asymmetric information can be very expensive. The less information an investor has, the higher the required rate of return for the investment is. An outflow is the so called pecking order theory demonstrating the order in which the company prefers to finance its business
1. Internal financing No prior explanations to investors or creditors (except for level of dividends)
Equity

2. Debt financing Banks want information about credit risk Management must provide possible creditors with sufficient and reliable information 3. Equity financing Potential shareholders will challenge the real share price as they have to rely blindly on the information given by the management Shareholders will request a low price as they cannot be sure whether the share is worth the price This makes equity capital very expensive for a company
Source: Volkart (2008), 578ff.
Winter Term 2010 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch

Debt

Internal financing

Pecking order theory diagram

26

Pecking order theory II

The importance of the different ways of financing fundamentally changes over the lifetime of a company From the perspective of a major listed company, internal financing is the most significant kind of financing Vital influence on conditions for external financing (stable operating cash flows more favorable credit conditions and higher stock prices) Without solid operating cash flows, a company will not be able to survive

phase of business

start up

expansion

consolidation

preferred financing

Private equity / Venture capital

- equity - debt - internal

internal

Illustration: how financing preferences can alter over a companys lifecycle

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Capital structure
The decisions on how the assets of a company are financed leads to the question: what is the optimal capital structure of a company? The relation between debt and equity reflects a companys risk and is also called financial leverage The optimal capital structure is highly dependent on the industry Investors often urge greater financial leverage, and thus more risk, in order to generate more profit in relation to the equity capital invested. In addition, interests paid are taxdeductible. The capital structure can be defined by the debt to equity ratio
Debt to Equity Financial Leverage Debt Equity

Financial risk increases as the company chooses to use more debt What is the optimal capital structure?

Source: Volkart (2008), 594ff.

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Agenda: Financial markets

Different types of markets Financial institutions Financial instruments EMH

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Basic need for financial markets

Businesses, individuals and governments need to raise capital Company intends to open a new plant Family intends to buy a new home City of Zurich intends to buy a new generation of trams

Of course, people and companies save money and have money of their own. However, saving money takes time and has opportunity costs Mr. Meier earns CHF 10000 per month and has expenses of CHF 7000. If he intends to buy a home worth CHF 1000000, it will take him a long time to save enough. But what if he wants to buy this home today? In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it

Source: Brigham, Houston (2009), 28f.

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Financial markets
Physical vs. financial markets Spot vs. future market Money vs. capital markets Primary vs. secondary markets Private vs. public markets

Recent trends: Globalization of financial markets Increased use of derivative instruments (especially as hedging and speculation instruments). The current financial crisis reduced the total size of the derivatives market substantially. However, it is still far bigger in most areas as for instances in 2001.

Source: Brigham, Houston (2009), 30ff.

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Financial Institutions
Commercial banks Investment banks Financial services corporations Insurances Mutual funds Hedge funds The trend is clearly towards bank holdings / financial services conglomerates that provide all kinds of services under one roof. The large investment banks disappeared. Against that, in the current environment many banks are disposing of certain business divisions and focus on core competences. This trend will continue for regulatory reasons (lower risks, de-leveraging, ) and some trends towards nationalization and home market focus in the banking sector.

Source: Brigham, Houston (2009), 34ff.

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Financial instruments
Stock: Unit of ownership which entitles the owner to exercise his voting right on corporate decisions and receive a certain payment (dividend) each year. No other obligation, nor any loyalty recquired. Bond: The issuer (company) owes the holder (investor) a certain amount of debt and is obliged to pay the holder a certain interest rate (coupon) and to repay the initial amount at a pre-determined date Option: Financial contract which entitles the buyer to buy (call option) or sell (put option) a certain underlying asset at a pre-specified price at or before a certain point in time Structured product: Packaged investment strategy, a mixture of different investment instruments, mostly derivatives which are intended to exploit, for instance a certain market constellation

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Efficient market hypothesis (EMH) vs. behavioral finance

The EMH states that (1) share prices are always in equilibrium (2) the prices reflect all available information (on opportunities, risks) and everything that can be derived from it Therefore, it is impossible to beat the market Prices in financial markets react very quickly and fairly to new information Share prices are unpredictable as the information that influences prices also occurs by chance. We can analyze past stock price developments, but we cannot foresee any future results

However, investors are not machines that can process all available information. This may lead to the fact that irrational factors come into play behavioral finance
Source: Brigham, Houston (2009), 46ff.
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Opportunities due to inefficiencies

Pure luck Any investor or individual might just be lucky and have bought stock yielding far better returns than expected If an investor has access to insider information, he can take advantage of it. In order to guarantee a fair market, insiders must be excluded from trading ( laws against insider trading) Under-reaction Uncertain valuation Overshooting The exploitation of inefficiency leads to efficiency
Source: Spremann (2007), 202.

Insider knowledge

Other possible inefficiencies:

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Final comments
As the environment (capital markets, society, suppliers etc.) has significant influence on a company, the financial managers must have a profound understanding of this environment in order to make the right decisions A financial manager makes decisions about which investments are to be undertaken and how these investments are to be financed (treasurer) and accounted for (controller) Financing can come either from outside (external: debt and equity) or from inside (internal: internal financing through profit from operating business) the company The problem of asymmetrical information arises whenever financing is needed, because the level of information and the interests of debt holders and shareholders differ significantly. Bridging these problems can be very expensive and leads to the so called pecking order theory The theory that capital markets take into account all information and all that can be derived from this information, is called the efficient market hypothesis
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Winter Term 2010