FINANCE

1. Introduction

Solvay Business School

Université Libre de Bruxelles
Fall 2006
 Who am I?

• André Farber
• Professor of Finance at Solvay Business School since….
• Past Director of the MBA program 1990-2002
• Past President of Solvay Business School
• Past Dean, Faculty of Social Sciences, Politics and Economics, Solvay
Business School (known as Soco)
• Vice Rector for Strategy and Institutional Development

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 Practical matters

• Reference:
– Ross, Stephen A., Randolph W. Westerfield and Jeffrey F. Jaffe,
Corporate Finance, 7th edition, McGraw-Hill Irwin 2005
• Website: www.ulb.ac.be/cours/solvay/farber
• Slides
• Excel files
• Past exams
• Grading:
• Problem sets (50%)
• Final (50%)

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 Course outline
Course Tutorials Céline Vaessen
1. Introduction, Levers of performance • 6 sessions
2. Cash flows, Financial planning 1. Financial statement analysis –
3. Present value Financial forecasting
4. Bond valuation 2. Present Value – Bonds valuation
5. Stock valuation (DDM Dividend 3. Stock valution
Discount Model) 4. Capital budgeting
6. Stock valuation (FCFM Free Cash 5. Risk and expected returns
Flow Model) 6. Weighted average cost of capital
7. Capital budgeting (I) – Exam preparation
8. Capital budgeting (II) + Intro. to risk
9. Risk and expected returns – CAPM
10. WACC Weighted average cost of
capital
11. Review

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 Outline for this session

• 1. Financial decisions: investment, financing, dividends

• 2. Measuring value creation:
• Mkt val of equity > Book value of equity
• Return On Equity > Opportunity cost of capital
• 3. Drivers of ROE: Profit margin, Asset Turnover, Financial Leverage

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 What is Corporate Finance?

• INVESTMENT DECISIONS: Which REAL ASSETS to buy ?

• Real assets: will generate future cash flows to the firm
• Intangible assets : R&D, Marketing, ..
• Tangible assets : Real estate, Equipments,..
• Current assets: Inventories, Account receivables,..

• FINANCING DECISIONS: Which FINANCIAL ASSET to sell ?

• Financial assets: claims on future cash flows
• Debt: promise to repay a fixed amount
• Equity: residual claim

• DIVIDEND DECISION: How much to return to stockholders?

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 Accounting View of the Firm

• Balance sheetNet Income statement

Working
Current
Capital liabilites Sales
Current – Operating expenses
assets = Earnings before interest and taxes
Long-term (EBIT)
debt – Interest expenses
– Taxes
Fixed
= Net income (earnings after taxes)
assets
Shareholders’
• Retained earnings
equity • Dividend payments

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 Cash Flows of the Firm

Firm issue
Firm invest securities

Firm Financial Investors

markets

Cash flow from

operations Dividend and
debt payments

Timing of cash flows + uncertainty

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 Market Value of the Firm

Book values Market values

Value
Market creation
value of
Total equity
capital
Book Market
Fixed equity capitalization
Assets
+
Net Market
Working Debt value of
Capital debt

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 The Cost of Capital

• The firm can always give cash back to the shareholders

? Stockholder
Investment
Project ⇐Cash⇒ opportunities in
capital markets

• Capital employed by the firm has an opportunity cost

• The opportunity cost of capital is the expected rate of return offered by
equivalent investments in the capital market
• The weighted average cost of capital (WACC) is the (weighted) average
of the cost of equity and of the cost of debt
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 Stockholders’ problem

Company Capital market

ROE r
Return on Equity Expected return

Net Income Div1 + Capital Gain

ROE = r=
Stockholders' equity Initial Investment

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 How to measure value creation ?

• 1. Compare market value of equity to book value

Stock price
Market - to - book(M/B) =
Book value per share
• Value creation if M/B > 1

• 2. Compare return on equity to the opportunity cost of equity

Net Income
Return on equity ( ROE ) =
Stockholders' equity

• Value creation if ROE > Opportunity Cost of Equity

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 Drivers of ROE

• PROFITABILITY (du Pont system)

Net Income
ROE =
Book Equity
• Three determinants :
Net Income Sales Assets
ROE = × ×
Sales Assets Equity
16.4%
Profit Asset Financial
Margin Turnover Leverage
•Microsoft - 2004 US$ bil.
•Net Income 10 31.0% 0.52 1.00
•Sales 32
•Assets 61
•Book equity 61

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 Examples

Wal-Mart Vodafone Total

US UK F
Rank 5 14 24
MktValue 241,187 159,150 122,945
M/B 5.6 0.7 3.5
P/E 27 15 14
Sales 258,681 61,259 127,796
Profit 8,861 11,364 8,968
Assets 104,912 269,754 97,647
ROE 20.20% 17.80% 24.10%
Profit margin 3.43% 18.55% 7.02%
Turnover 2.47 0.23 1.31
Leverage 2.39 4.23 2.62
Source: Business Week July 26, 2004
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 Levers of Performance

Return on Equity

Return on Invested Capital Leverage

Profit Margin Asset Turnover

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 Summarized (managerial) balance sheet

Assets Liabilities

Fixed assets (FA) Stockholders' equity (SE)

Working capital requirement (WCR) Interest-bearing debt (D)

Cash (Cash)
FA + WCR + Cash = SE + D

Working capital requirement : definition Interest-bearing debt: definition

+ Accounts receivable + Long-term debt
+ Inventories + Current maturities of long term debt
+ Prepaid expenses + Notes payable to banks
- Account payable
- Accrued payroll and other expenses

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 Net Working Capital

• Net working capital can be understood in two ways:

• as an investment to be funded: Current Assets - Current Liabilities
• as a source of financing=Stockholders' equity + LT debt - Fixed Assets

Fixed Stockholder’s
Assets Current ratio: a measure of NWC
equity
Current ratio = Current assets / Current liabilites
Net working capital = Current assets - Current
Net Long term
liabilites
Current Working debt Current ratio > 1 ⇔ NWC > 0
Assets Capital
Current
liabilities

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 Net Working Capital vs Working Capital
Requirement
• Summarized balance sheet identity:
• FA + WCR + CASH = SE + LTD + STD
• can be written as:
• WCR + (CASH - STD) = (SE + LTD - FA)
Working Net Liquid Net Working
Capital Balance Capital
Requirement

• WCR + NLB = NWC

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 Return on invested capital

• Return on assets (net)= Net income / Total assets

• Advantage: fits with DuPont system
• ROE = ROA x Equity multiplier
• Limitation: Net income = EBIT - Interest expense - Taxes
– Depends on capital structure:
• 1. Interest expense: function of interest-bearing debt
• 2. Interest expense : tax deductible
• Preferred measure: Return on Invested Capital (ROIC)
EBIT(1 - TaxRate)
ROIC =
Stockholders' equity + Interest bearing debt

• NB: ROIC = ROA (gross) (1 - Tax rate)

• = ROE of a all equity financed firm

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 Financial leverage

• Financial leverage magnifies ROE only when ROA (gross) is greater than
the interest rate on debt.
• Balance sheet: TA = SE + D
• Income statement: NI = EBIT - INT- TAX
• Interest expense INT = r D (Interest expense = Interest rate x Interest-bearing debt)
• Taxes TAX = (EBIT - r D) Tc (Taxes = Taxable income x Tax rate)
NI EBIT × (1 − Tc ) TA D
ROE = = × − r (1 − Tc ) ×
SE TA SE SE

D
ROE = ROIC + ( ROIC − r (1 − Tc )) ×
SE

• Remember : ROIC = ROAgross (1 - Tc)

• ROE = ROIC + (ROAgross - r) (1-Tc) (D/SE)

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 Financial Leverage: example

Cost of debt 8%
Tax Rate 40%

Balance sheet
Total asset 100.000
Book Equity 60.000
Debt 40.000

Income Statement
EBIT 20.000
Interest 3.200
Taxes 6.720
Net Income 10.080

Return on Equity 16,80%

=
Return on Invested Capital ROIC 12,00%
+
[ROIC - rD(1-Tc)] 7,20%
X
Debt / Book Equity 66,67%
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