Introduction to Corporate Finance - Guest Lecture MBA Class UA
Introduction toCorporate FinanceEdward M. Erasmus, MALecturerUniversity of ArubaJanuary 12th, 2013
Introduction lecturer• Head of Operations @ Free Zone Aruba NV• Part-time lecturer @ the University of Aruba (FEF, FAS)• Lecturer, speaker and facilitator• Professional areas: accounting & control, public finance, strategy, marketing, financial management, operations management, financial analysis.
Head of Operations @ FZAA head of operations oversees an entire company,monitoring all resources and its finances.Responsibility areas:• Budgeting, administration & financial reporting• Information & Communication Technology• Human resource management• Security and maintenance of the Free zones• Marketing and development of the Free zones• Advice / support to internal colleagues
What is Corporate Finance?• Corporate finance is a specific area of finance that analyzes the financial decisions of corporations. - Investment or capital budgeting decisions - Financing decision - Day-to-day operations8
3 Key Questions in Corporate Finance• 1. What long-term investments should the firm undertake? Capital budgeting decision• 2. What is the best way to finance these long-term investments? Debt or equity? Capital structure decision• 3. How should the firm manage its short- term assets and liabilities, such as cash? Working capital managment 9
1. Capital Budgeting• Process of planning and managing a firm’s long-term investments.• Financial manager identifies investment opportunities that are worth more to the firm than they cost to acquire.• Example: A chocolate firm deciding whether or not to open a new factory is a capital budgeting decision.10
Key Questions• How much cash does the firm expect to receive?- size of cash inflows and outflows• When does the firm expect to receive it?- timing of cash flows• How likely is the firm to receive it?- riskiness of cash flows11
2. Capital Structure• How should the firm obtain and manage the long-term financing it needs to support its long term investments?• Capital Structure is the specific mix of short-term debt, long-term debt and equity.• Raising long-term financing can be expensive, so the different possibilities must considered carefully.12
Key Questions• How should the firm pay for its assets? Debt or equity?• How much should the firm borrow?• What is the least expensive source of funds?• How, when and where to raise the money?13
3. Working Capital Management• Working capital refers to the firm’s short- term assets including inventory and liabilities, such as cash owed to suppliers.• Managing working capital is a day to day activity related to the firm’s receipt and disbursement of cash.14
Key Questions• How should the firm manage the receipt and disbursement of cash - current assets and current liabilities?• What is the best way to manage day-to- day, short term assets such as inventory?• How should the firm obtain short-term financing?• Should the firm sell or purchase on credit? On what terms?15
Once Again...• Capital Budgeting: The process of planning and managing a firm’s investment in long-term assets.• Capital Structure: The mix of debt and equity maintained by a firm.• Working Capital Management: Planning and managing the firm’s current assets and liabilities.16
A Simplified Organizational ChartShareholders Managersare the represent theowners. owners.18
A Simplified Organizational ChartFinancialManagercoordinatesthe activitiesof theTreasurerandController19
Chief financial officer• Chief financial officer (CFO) or the vice-president of finance.• Reports to the president or Chief Operating Officer (COO) and coordinates the activities of the treasurer and controller.• CFO is concerned with answering the 3 basic questions.20
CFO: Scope of work• Capital budgeting (investment evaluation)• Cash management and liquidity forecasting• Commercial banking and investment banking• Credit management• Dividend disbursement and share repurchases• Financial statement analysis (ratio analysis)• Financial analysis planning (forecasting)• Insurance/risk management• Mergers and acquisitions analysis• Tax analysis
Corporate finance in a nutshell The Market The Firm Capital Structure Capital Budgeting Dividends Stockholders Cash flow Equity Financial Projects Debt Manager Bondholders Investments Interest Corporate Personal Taxes Taxes Government24
Corporate finance in a nutshell The Market The Firm Capital Structure Capital Budgeting Dividends Stockholders Cash flow Equity Financial Projects Debt Manager Bondholders Investments Interest Corporate Ethical Ethical Taxes Cooperation vs. Pressures Personal Social Costs Taxes Government Society Politics25
Goal of Financial Management?What should be the firm’s objective?• Maximize market value?• Maximize sales revenue or market share?• Maximize profits?• Minimize costs?• To avoid bankruptcy and financial distress?• Maintain steady earnings growth?• Maximize CEO wealth?27
Goal in a For-Profit Business• Managers work for the board of directors, who represent shareholders, the owners.• Goal is to make money for the shareholders.• Shareholders are better off when the value of the stock is high.• Maximize the current price per share of the firm’s existing stock.• Managers should maximize the value of the firm’s equity!28
Maximize Value of Equity• When the shares are privately held, the goal is to maximize the owner’s equity.• When equity is traded on the market, then the goal is to maximize the stock price.• We are interested in the relation between business decisions and the value of the equity.30
What About These Goals?• Maximize customer satisfaction• Environmental responsibility• Ethical behavior31
How value is created…Value through managing the ‘top line andthe bottom line’:• Increase sales• Decrease expenses32
How value is created…Smart financial management also contributesto value creation…• Right choice of capital structure (mixture of debt and equity) (WACC)• Right choice in making investments• Right choice in allocation of excessive cash• Right choice in financing short-term cash shortage• Right choice in determining credit terms•33 …..
Agency Problems• Agency relationship Shareholders (principals) hire managers (agents) to run the company• Agency problem Conflict of interest between the shareholders (principals) and management of a firm (agents)• Agency costs are defined as the costs from these conflicts of interest.34
Financial Markets – Money markets versus capital markets – Primary markets versus secondary markets37
Money and Capital Markets• Money Markets - short-term debt securities - dealer market: brokers and agents match buyers and sellers.• Capital Markets - long-term debt securities: govt and corporate bonds - shares of stocks• Dealer markets are OTC (over-the-counter) markets, e.g., NASDAQ• Auction Markets, e.g., Toronto Stock Exchange, NYSE38
Primary vs Secondary Markets• Primary Market - original sale, or issue of a security - IPOs are underwriten by dealers that purchase and resell to public at a higher price• Secondary Market - one owner selling to another - Auction market or OTC dealer markets39
Basic finance terms• Assets • Fixed Assets• Bonds • Liabilities• Capital • Operating budget• Capital assets • Revenue• Capital budget • Financial ratios• Currents assets • Cost of capital• Debt financing • Hurdle rate• Equity• Expenses
Financial statements• Financial statements are records that give an overview of an entity’s financial status.• Key financial statements: – Balance Sheet – Income Statement – Statement of Cash Flow – Notes to the financial statements
Financial statements Providing managers and decision makers answers to two key questions:• What is the financial picture of the organization on a given day?• How well did the organization do during a given period?
Balance sheet: introduction Balance sheet…. o A document designed to show the state of affairs of an entity at a particular date. o Reduced to its simplest….a balance sheet consists of two lists: list of resources and list of sources.
Balance sheet: introduction The list of the resources o Resources (means) that are under the control of the entity – it is a list of assets. Asset is derived from the Latin ad satis (to sufficient) An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
Balance sheet: introduction The list of the sources o The assets must have come from somewhere. o The list of sources shows where the assets came from – the monetary amounts of the sources from which the entity obtained its present stock of resources. o These sources require repayments or recompense in some way….so they can also be called claims.
Balance sheet: introduction List of sources (where everything came from) List of resources (everything valuable that the business controls) Both lists relate to the same business at the same point in time: the total of each list must be equal and the balance sheet must balance.
The simple balance sheet■ Separation of the Entity from the Owner o When a new business entity is created, the starting point is that there is no balance sheet. o Balance sheet is created for the entity when Cash is put in the entity. o Separation is necessary to avoid affairs of the owner and the business to be tangled up. o Cash (resource) put in the entity by the owner will balance against the list of sources and is called Capital.
Balance sheet transactions• Just as the balance sheet equation must always balance, the balance sheet must also always balance.• A balance sheet could be prepared after every transaction, but this practice would be awkward and unnecessary. – Therefore, balance sheets are usually prepared monthly or on some other periodic schedule.
Simple balance sheet – book example o The claims from third parties (outsiders other than the owner), can be called liabilities.
Liabilities Liabilities o In this example: Loan and Payable account. o English word derived from the word ‘liable’, meaning tied or bound or obliged by law. o A liability is a negative version of an asset.
Equityo Claims by the owner are not called liabilities, but owner’s equity (or various similar expressions).o Equity in the accounting context means the owner’s stake in the entity.o In the simple balance sheet example the equity of the entity is € 116,000 (capital + profit).
Income statemento The balance sheet shows resources and claims at a particular moment in time.o However it is not practical to provide insights in the business operations.o Information about the results of operating activities of an entity can be best presented in an income statement.o Operating activities result in revenues (making sales) or in expenses (consumption of business resources).
Income statemento The income statement uses the following definitions:o Revenues – incoming receipts in return for sold goods or serviceso Expenses – sacrificed resources to support the business operations
Income statementImportant note!o The income statement (also called profit and loss account) reports on the flows of revenues and expenses of a period.o The balance sheet reports on the financial position at the balance sheet date.
Preparing the income statement• Reworking transactions used in previous example.• Examining resources and claims: Resources fall into two types: • Those used up in the period (expenses); and • Those remaining (assets). Claims can be seen to fall into three types: • Those arising from operations in the period (revenues); • Those contributed by the owners (capital); and • Those due to outsiders (liabilities).
Edward M. Erasmus, MAe.email@example.com@gmail.comFacebook: http://www.facebook.com/edwardmerasmusTwitter: http://www.twitter.com/em_erasmusLinkedIn: http://www.linkedin.com/in/edwardmerasmusBlog: http://edwardmerasmus.wordpress.com
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