New Venture Finance: Corp.

Finance Review 1 __________________________________________

Real Sector Corporate Investment Decisions: Utilization of Funds Business Markets The Firm Financial Sector Corporate Financing Decisions: Acquisition of Funds Financial Markets

Products Customers Competitors Employees Tangible Assets Technology

The Firm's Balance Sheet __________________________________________________________ Cash A/P A/R Other Current Inventory Liabilities _________________ _____________________ Total Current Assets Total Current Liabilities Fixed Assets: Plant & Equipment Capital: Debt Preferred Stock Common Equity --Retained Earnings --Common Stock _____________________ Total Liabilities & Equity Savers/ Investors

________________ Total Assets

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Financing (sources of funds) must equal the investment in assets (use of funds).
Managers make investment decisions that generate earnings so that investors get a return on investment. Financial Management is defined as the planning for, acquiring, and utilization of funds in a manner that maximizes the firms economic efficiency.

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The Corporate Finance View of the World:
Commercial Sector Bus. Transactions -Customers -Products -Technology $$ -Competitors Firms Balance Sheet Assets Liab. Capital $$ Financial Sector Savers/Investors: -Individuals -Corporations -Partnerships -Banks Return on Investment

Securities

Firms Income Statement Revenue -Expenses -Taxes Net Income Retained Earnings? Dividends?

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The corporation has advantages over the other forms or organization: Unlimited lives that extend beyond the lives of the founders or original managers. Simple transferability of ownership: investors and managers are two separate groups, so investors can buy or sell the common stock without disrupting corporate operations. Limited liability in the corporation: investors can lose only the total amount they invested in the common stock.

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The stock market monitors the publiclytraded corporations performance:

Stock price changes signal whether managerial decisions are good (stock price goes up) are bad (stock price goes down). Because of the requirements to disclose information that publicly-traded corporations face, the stock market can monitor these firms better than it can the other forms of organization.

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The stock market disciplines the firm by causing the stock price to decline. In response, the firm can:
Change strategies. The Board of Directors can replace the managers ( this is called internal governance). The firm can be merged/taken over (this is called the market for corporate control). Declare bankruptcy.

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In the Theory of Finance, the appropriate goal of the firm is to maximize the value of shareholder wealth. Shareholders commit part of their wealth to the firm when they buy the firms common stock. Equivalent ways of stating this goal are:
To maximize the market value of the firm. To maximize the stock price of the firm.

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An equation that is central to the Theory of Finance is:

A Firms Stock Price = The Present Value of All Future Dividends
DIV1 = ----------DIV2 DIV3 DIV ----------- + ------------ + ... + ----------- = DIVt -------------

(1 + k)1

(1 + k)2

(1 + k)3

(1 + k)

t=1

(1 + k)t

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This equation says that value (i.e., the stock price) depends on:
The stream of dividends. Risk, reflected in the discount rate, k. The timing of the dividends.

Note that value depends on all future dividends and not only on next quarter's dividends. Where do dividends come from?

Dividends = (Earnings) Earnings = (Revenue, Expenses, Interest Exp.,Other) Revenue = (Business Decisions, Strategy)

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Agency Problems and Costs. Investors (principals) provide funds, but managers (agents) formulate and implement strategies and tactics: the problem of separation of ownership and control. The goal is to maximize shareholder wealth, but investors cannot be sure that managers will act in shareholders best interests. Managers might:
Shirk their duties. Use corporate resources to pay for perquisites. Shift funds into higher risk projects than the stockholders desire.

New Venture Finance: Corp. Finance Review 11 __________________________________________ Observability, asymmetric information, & moral hazard:
Investors cannot observe everything managers do. Managers have more information about the firm.

Investors monitor the firm, and the firm incurs monitoring costs.
Investor relations staffs, annual reports, SEC and other regulatory reports consume resources.

If managers actions cannot be observed directly, then periodic disclosure must be made:
Disclosure: information sets become more symmetric. Are bank loan officers' salaries a monitoring cost?

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Agency problems can be solved if the interests of managers and investors are aligned, if both managers and investors have the same incentives. Agency theory suggests if managers are bonded to the firm, managers would behave in the shareholders' best interests.
This entails bonding costs. For example, stock options or stock purchase programs (like at 85% of the market price) transform managers into owner/managers. But managers are buying into the firm at below-market prices. The bonding cost is the loss of wealth suffered by other shareholders when the stock is sold cheap.

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These costs cause shareholder wealth to be less than if managers didn't pose a moral hazard.
We live in an imperfect world. A perfect world of symmetric information no moral hazards is not attainable.

Financial contracting solutions are often used.

For example, bond indenture contracts often contain restrictive covenants that limit the behavior of managers, like no new mortgages on the assets. Bank loans also contain restrictions, like limitations on paying dividends, the amount of additional borrowing, or a minimum current ratio requirement.

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A closer look at financial contracting. Bonds are loan contracts, and common stocks have legal ties to the firm via the firm's charter.
Bonds are fixed income securities that have finite lives: bonds have a fixed maturity date, pay a set amount of interest each period, and borrowings must be repaid. Stocks are variable income securities that have infinite lives. Dividends are not guaranteed and stock never maturesas long as the firm is alive. Stocks can be repurchased by the firm, but that is different: stock can be retired but it does not mature. Stocks represent an equity, or ownership, interest in the firm.

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Security Debt Payment Fixed, periodic interest Par value at maturity Priority Priority in bankruptcy Preference over preferred & common Can force bankruptcy if not paid Paid before common dividends Preference over common
_______________________________________________________________________________________________________________________________________

Preferred Fixed, periodic dividend Stock No maturity date Div. must be declared

Common No fixed dividend Stock No maturity date Div. must be declared

Residual position in dividend payment and bankruptcy

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The Relationship Between Discount Rates and Value: Like stock, bond prices also equal the present value of the cash flows that investors expect to receive:
Bond Price = P.V. of interest + P.V. of maturity value Bond Interest = coupon rate X maturity value Maturity Value = $1,000.00; called the bonds principal

Consider a 10% , 1-year bond or a 10%, 5-year bond; both have a maturity value of $1,000. Currently, bond interest rates are 10%, but rates may vary between 8% and 12% over the next few months. How do changing interest rates affect bond values?
Interest = .10 x $1,000 = $100 per year

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k = the Market Rate of Interest 8.0% A. 1-Year bond Present value of: Interest Maturity value Price of bond $ 92.59 925.92 $1,108.52 $ 90.91 909.09 $1,000.00 $ 89.28 892.96 $ 982.14 10.0% 12.0%

B. 5-Year Bond Present value of: Interest Maturity value Price of bond $ 399.27 680.58 $1,079.85 $ 379.07 620.93 $1.000.00 $ 360.48 567.42 $ 927.90

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Define k as the Market Rate of Interest. The example shows that that k and a bonds price are inversely related:
Bond prices goes up as k goes down. Bond prices goes down as k goes up.

Note that the bond with the longer maturity (the 5yr bond) has greater price volatility for the same changes in the interest rate.
The 5-yr bond has a higher price at 8% and a lower price at 12% than the 1-yr bond.

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Project evaluation techniques. Developing new products or services are essential if a firm is to continue growing. Capital budgeting involves:
Long-term investment opportunities as projects. Conducting a cost/benefit analysis for each project. Accepting projects when benefits exceed the costs. Picking good projects allows the firm to grow and to increase its stock price.

The preferred technique is called Net Present Value (NPV).

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NPV =

P.V. of Inflows - P.V. of Outflows

n t=1 NCFt ------------------- - Cost of the project (1 + MCC)t

NPV =

where: NCFt = Net Cash Flow at time t

MCC = the Marginal Cost of Capital, a risk-adjusted discount rate

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This gives rise to the following set of decision rules that are used in capital budgeting:
Criterion Accept NPV O IRR MCC Reject

NPV IRR

NPV < 0 IRR < MCC

IRR is the Internal Rate of Return and is defined as the discount rate that makes NPV = 0.

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Who gets the NPV > 0 and how does it achieve the goal of the firm?
Common shareholders, the residual claimants. Bondholders and preferred shareholders get what they expect, and common shareholders get what is left over. The larger the residual, the more wealth common shareholders receive (think of the positive NPV that Intel creates with each new generation of microprocessors.) If managers select all of the projects with NPV > 0, this is the best that shareholders can hope for and the stock price will be maximized. Negative NPVs would make the stock price go down.

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Informational efficiency: This important concept is the idea that having accurate information is crucial to making good investment decisions. Financial markets are informationally efficient if security prices fully reflect all information and react immediately to impound new information.
For example, if the financial markets are efficient, then Intels stock price reflects all information about Intel. Any new information about Intel will make its stock price go up or down immediately.

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One implication is that it is hard to "beat the market" in an efficient market. The greatest rewards exist for those who have the best information; there is much competition for information.
The "big players" who have the most resources gain information first and grab the available profits first. You and I, who are far from Wall Street and who spend little on information, find it difficult to beat the market. Getting information first, or immediately, is very costly and it is difficult to beat the market and to cover the costs of obtaining information.

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Nevertheless, information efficiency is an important concept, and financial markets are pretty efficient in my opinion.
Competitive markets are key: as information becomes available, investors revise their decisions to buy or sell a stock or bond, so there must be markets in which they can actually buy or sell. Economics and finance profs love markets: supply and demand come together and individuals are free to make buy or sell decisions that are in their best own interests. As information arrives, it becomes reflected in prices, so price changes signal good news (prices up) or bad news (prices down).

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Source (day = 0)
Insiders know before announcement Industry analysts and informed investors get information "on line Recipients of analysts' reports and less informed investors are next; there may be many substages so that there are degrees of being informed You and I come last: since we have low information costs (t.v., radio, press, periodicals, etc.), the information is picked over and its value already extracted by the time we obtain the info.

Complete Dissemination (day = 1)

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Types of Informational Efficiency. Note how the Strong Form lines up with the first column above (the source), the Semi-Strong Form lines up with the middle two columns, and the Weak Form lines up with the last column. Strong Form: Considers all information from the source, including insider information Semi-Strong Form Considers all publicly available information from when the information is disseminated Weak form Considers only historical security prices; by the time you and I receive the Wall St. Journal on our doorsteps, the information has been fully disseminated; all we have is yesterday's prices The weak form has been found to hold very well

The strong form does not hold: there is value to insider information

The semi-strong form has been found to hold pretty well, but not completely

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A basic principle of Finance: more risk should be rewarded with a higher return. In the Theory of Finance, taking risk is a good thing since it creates new wealth (new products, new technologies, etc.) Thus, there should be rewards for bearing risk.

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Expected Return

Risk-free Rate: kf

Risk premium

Time value of money ______________________________________________________________Risk Treasury Bonds Corporate Bonds Common Stock New Ventures, Options, Futures, and other Derivatives

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A life-cycle view of the growth of a technologydriven firm. Corporate Finance textbooks typically concentrate on firms that have gone beyond the start-up stage and are publicly-traded.
Publicly-traded firms have developed products and services that generate earnings from the assets in place. Start-ups have no assets in place, and maybe are based on no more than a product or service concept. The value of a publicly-traded firm is based on assets in place, a start-ups value is based on its growth options.

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Sales/Earnings./Cash Flow

__________________________________________________________________ Time
R&D (Seed & start-up) Early growth (First stage start-up) Rapid growth (Late stage start-up) Maturity Decline (---- Publicly-traded ----)

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Venture Economics Stage Definitions:

Early Stage
Seed. A relatively small amount of capital provided to prove a concept, maybe involving product development but not initial marketing. Startup. Financing for product development and initial marketing; no product sales, management team assembled, business plan written, market research done. First Stage. Financing for initial commercial manufacturing and sales.

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Expansion
Second Stage. Working capital financing provided; likely to have no profits. Third Stage. Financing for plant expansion, marketing, and working capital. Bridge Stage. Financing for firm expected to go public in 6-12 months; often repaid from IPO proceeds.

Management/Leveraged Buyout (MBO/LBO) and Turnaround

later-stage companies: buying out existing firms or financing firms with operational or financial difficulties.

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Large Publicly-Traded Firms ______________________________________ Easy access to financial markets: banks, bond markets, and stock markets Face scrutiny of financial markets: --much information available about firm and industry --analysts perform monitoring function and makes recommendations --periodic disclosure keeps everybody happy --stock market disciplines firms through price changes force firm to behave as expected Disclosure: through annual reports, SEC announcements --markets are more "informationally efficient" New Ventures _________________________________________ Financial markets in general are not accessible: new ventures are privately held Face scrutiny of VCs: --little information about firm or its concept/idea --VC have to monitor and invest --VCs are quasi-insiders, often on the Bd. of Dir. --markets are thin and illiquid; stock not publicly traded

Disclosure: through business plans, and and direct examination by investors --markets are less "informationally efficient

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Large Publicly-Traded Firms ______________________________________ Problem of separation of ownership and control: --stock options and stock purchase plan help bond managers to firm Sound management expected and scrutinized: --complex organizations the norm --reorganizations the norm --hierarchical organization --lots of written policies --expertise already developed (i.e., hire MBAs) Goal is to maximize the firms' stock price: --it can generate a stream of earnings from ongoing operations (or assets-in-place) --it can undertake capital budgeting --firms are in mature stage New Ventures _________________________________________ VCs have more direct monitoring ability: --Entrepreneurs keep a large percent of shares and key personnel get stock options Management development just beginning: --VCs know what is expected and offer networking --understaffed operation coping with explosion of tasks and functions --what's a policy? --VCs "groom" management Goal is to maximize the firms' stock price: --real goal is IPO or merger, or harvest, or cash out for VC and entrepreneur (a liquidity event) --firms are in rapid growth stage

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Early Stage Late State Small Publicly Large Publicly Start-up Private Firm -Traded Firm -Traded Firm _____________________________________________________________________________
VC invests, monitors, and grooms firm VC prepares firm for liquidity event (i.e. IPO, merger)

Liquidity event occurs: VC and entrepreneur harvest

Not what VCs invest in; bank loans probably available, but financing still a big problem Financial markets generally available

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