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27/09/2013

Corporate Finance and Valuation (SMM467) 2013/2014

Session 1: Intro to Corporate Finance and the Corporate Objective Function

Dr Andrey Golubov
D

Course Structure
3-hour
9

sessions over 10 weeks

lectures 9 seminars
Numerical

exercises, discussions, case studies, guest speaker (tbc)

revision session

1-2

Course Syllabus
Session Session Session Session Session Session

1: Intro to Corporate Finance and the Corporate Objective Function 2: The Time Value of Money 3: Valuing Securities and Firms 4: Risk and Return in Capital 5: Evaluating Investment Projects 6: Cost of Capital
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Markets

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Course Syllabus cont.


Session Session Session

7: Raising Capital 8: Capital Structure: An Intro 9: Mergers & Acquisitions

Session

10: Revision

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Assessment
Mid-term
Multiple

test 25% of the final grade

choice, some questions involve calculation

Exam

75% of the final grade

Multiple

choice questions exercises Essay-type questions


Numerical

1-5

Reading List

Preferred Text:

Megginson W., Smart S., Graham, J. (2010) Financial Management: Linking Theory to What Companies Do, 3rd edition, South-Western/Cengage Learning (ISBN: 978-0-538-74558-1)

Alternative Text:

Hillier D., Ross S., Westerfield R., Jaffe J., Jordan B. (2010) Corporate Finance, European Edition, McGraw-Hill (ISBN: 978-0-077-12115-0)

Academic Journal Articles Case Studies (Harvard, Stanford, Darden) Read FT or WSJ, check out Bloomberg or Reuters Always bring a calculator to class!
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Before we begin
Question:
Why

should we study finance? Didnt the recent financial crisis prove all of the finance theory wrong?

My

Answer:

The

financial crisis has illustrated how badly things can go when those in charge forget the basic finance and economics principles
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Session Outline
What Basic Core

is Corporate Finance Corporate Finance Functions Principles of Finance of Business Organization Conflicts

Forms The

Corporate Objective Function

Agency

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What is Corporate Finance?


What is Finance? Finance is concerned with the allocation of funds under the conditions of risk (or uncertainty) What is Corporate Finance? The activities involved in managing cash flows of a firm (a corporation)
Principles

are universal to ALL firms, large or small, private or public


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The 3 Basic Corporate Finance Functions


The Financing Decision (Raising Capital) The Investment Decision (Capital Budgeting) The Distribution Decision (Payout Policy)

Others Also Include: Risk Management Working Capital Management Corporate Governance
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Which Finance Functions Add the Most Value?

Source: Servaes and Tufano, CFO Views on the Importance and Execution of the Finance Function (Deutsche Bank, 2006).

The Financing Function


Firms

can raise funds in 2 major ways:


by retaining profits
common method

Internally
Most

Externally
Equity

from investors or creditors

Venture Initial

capital (VC) or private placements public offering (IPO) Seasoned (follow-on) equity offering (SEO)
Debt
Short-term Long-term

(Money market) (Bank loans, bond issues, syndicated loans)


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Raising Capital: Key Facts


Most financing from internal rather than external sources. Most external financing is debt. Primary vs. secondary market transactions or offerings Financial intermediaries declining as a source of capital for large firms Securities markets growing in importance 1 - 13
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The Capital Budgeting Function

Capital Budgeting: Selecting the best projects in which to invest the firms resources

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The Capital Budgeting Function


The

capital budgeting process consists of three steps.


Step 1 - Identifying potential investments Step 2 - Analyzing those investments to identify which will be sufficiently profitable Step 3 - Implementing and monitoring the investments selected in Step 2

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The Distribution Function


Returning
How

cash to shareholders (investors)

much to pay out In what form


Regular One-off

cash dividends special dividends Stock dividends Share repurchases

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The Risk Management Function


Identifying, measuring, and managing all types of risk exposures Some risks are insurable, and some risks can be reduced through diversification. Financial instruments like forwards, futures, options, and swaps may also be used to hedge market risks such as interest-rate, price, and currency fluctuations.

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The Working Capital Management Function


Short-term financial planning Managing daily cash inflows and outflows Forecasting and managing cash balances

Managing trade credit and inventory


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The Corporate Governance Function

Hire qualified and honest managers, and structure their incentives to motivate them to act in the best interests of the firm In practice the incentives of stockholders and managers (and other stakeholders) often diverge Dimensions of corporate governance:
Ownership Board

structure structure Executive compensation Regulation and stock exchange rules


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The Core Principles of Finance


The

Time Value of Money Trade-Off Power of Diversification Markets

Risk-Return The

Efficient No

Arbitrage Principle

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The Time Value of Money


A

dollar today is worth more than a dollar tomorrow


Why?
Smart Plain

(economists) answer: opportunity cost English answer: you can invest the dollar today and earn interest We can measure it! Session 2 Applications of this principle range from choosing a mortgage to valuing a whole firm!

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The Risk-Return Trade-Off


Investors Investors

like returns do not like risk for risk


expect compensation for bearing

Compensation
Investors

risk

The

history of investment returns reveals this relationship Session 4

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The Power of Diversification


Dont

put all your eggs in one basket.

Investors

can achieve a more favorable tradeoff between risk and return by diversifying their portfolios.
Markowitz

got the Nobel Prize for it!

Implications

for corporate finance?


risk is rewarded the cost of equity capital for the firm

Only non-diversifiable Session 4 This affects Session 6

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Market Efficiency
By

market efficiency we usually mean that prices reflect all publicly available information

Competition for information tends to make markets efficient

Markets
Prices

are (mostly) smart

reflect fundamentals And do so instantly (or very quickly)

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No Arbitrage Principle
Arbitrage

is an instant and riskless profit

Example:
Buy

identical assets trading at different prices (usually in different markets)


Until

where its cheap, sell where its expensive your actions push the prices toward equilibrium

Risk-free
No

money-making opportunities are extremely scarce.


free lunches in finance

If

you have identified an arbitrage opportunity, think again!


Transaction Other

costs market imperfections

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Primary Forms of Business Organization


Sole Proprietorships
No distinction between business and owner Easy to set up and operate Business earnings taxed as personal income Limited life, Limited access to capital, Unlimited personal liability

Partnerships

Similar to sole proprietorship, but has two or more owners Joint and several liability Share of profits taxed as partnership income One or more general partners with unlimited personal liability Most owners are limited partners, who are passive investors with limited liability
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Limited Partnerships

Primary Forms of Business Organization


Separate legal entity with many of the economic rights and responsibilities of individuals Unlimited life, Limited liability, Separable contracting, Improved access to capital Owned by shareholders, who elect the Board of Directors Board appoints a President or CEO to manage day-to-day operations

Corporations

Are there any disadvantages for corporations?

YES! Double taxation

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Taxation of Business Income

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Corporations around the World


Type of Corporation AG GmbH NV Country of Origin Austria, Germany Austria, Germany Belgium, Netherlands SA Belgium, France, Luxembourg, Portugal, Spain China Mainland China Mainland ApS Denmark A/S Denmark SE European Union Oy Finland Oyj Finland AB Finland, Sweden Abp Finland Plc India, Ireland, Thailand, U.K. S.p.A. Italy AS Norway ASA Norway S.L. Spain Ltd Ireland, U.K., U.S. Inc., Corp. U.S. In Original Language Aktiengesellschaft Gesellschaft mit Beschrnkter Haftung Naamloze Venootschap Socit Anonyme/ Sociedade Annima Description Publicly Listed Private Limited Private/Public Publicly Listed

Anpartsselkab Aktieselskab Societas Europaea Osakeyhti Julkinen Osakeyhti Aktiebolag Publikt Aktiebolag Public Limited Company Societ per Azioni Aksjeselskap Allmennaksjeselskap Sociedad Limitada Limited Incorporated, Corporation

Publicly Listed Private Limited Private Limited Publicly Listed Publicly Listed Private Limited Publicly Listed Private Limited Publicly Listed Publicly Listed Publicly Listed Private Limited Publicly Listed Private Limited Private Limited 1 - 29 Publicly Listed

The Corporate Objective Function

The Goal of the Corporation is to maximize shareholder wealth. But shareholders are not the only stakeholders in the firm

Who is also involved?


Creditors Customers Suppliers Employees Government Society

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Why maximize shareholder wealth?


Shareholder
They
Get

wealth maximization is socially optimal


are the residual claimants
paid only after all other stakeholders claims are satisfied

Most

successful companies keep customers happy, treat employees well, etc.


Competition

share

ensures that everybody gets their fair

Depends

on the efficacy of the Anti-Trust and other regulation


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What Metric to Use?


Maximize
Earnings

Profits?

are backward-looking, dependent on accounting principles and susceptible to manipulation Do not fully consider cash flow timing Ignore risk
Maximize
In

Shareholder (Equity) Value!

public firms shareholder wealth is represented by the market price of stock Unambiguous, constantly updated
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What Global Companies Do

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What Global Companies Do

Separation of Ownership and Control


At

some stage, founders have to hire other people to run their firms act as agents of the owners who hired them practice however, self-interest may cause managers to pursue objectives other than shareholder wealth maximization. conflict of goals gives rise to managerial agency problems.
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Managers In

This

Agency Costs
Excessive

remuneration and perquisite consumption


Corporate

jets, luxurious offices, etc.

Empire-building
Remuneration

is often tied to firm size, and it is more prestigious to run a larger firm

Unnecessary
Managers
But

diversification

want job security and diversify the firms activities to smooth out earnings
investors can diversify on their own at a very low cost
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How to Mitigate Agency Problems?


Shareholder
Proxy

activism

fights Institutional owners, block holders


Takeover
The

threat

market for corporate control

Monitoring
Board

and bonding

oversight (outside directors, CEO/Chairman separation) Independent Audit


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How to Mitigate Agency Problems?


Executive
Tie

compensation contracts

managerial wealth to stock value (stock option)

Regulation

and stock exchange rules


The Combined Code, etc.

Sarbanes-Oxley,

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Corporate Governance around the World


A

nations corporate governance system is the set of laws, regulations, institutions, and practices that determine how a company is to be governed and how control of a company can be contested.

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Law and Finance

The Law and Finance model of economic growth (La Porta, Lopez-de-Silanes, Shleifer, and Vishny studies) states that the most important determinant of capital market development is the degree of legal protection afforded to outside (noncontrolling) investors. This determining factor depends largely on whether a countrys legal system is based on English common law or another legal tradition.

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Law and Finance


English

common law

Strongest protection for minority investors Has led to an atomistic ownership structure, where a large number of investors each own a small portion of a company.
German

law

Scandinavian French

law

civil law
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Weakest protection for outside investors

Applying the Law and Finance Model to Corporate Control


What

does the Law and Finance research imply for financial managers in different countries?
A

key implication: corporate ownership is likely to be much less concentrated in common-law countries than in other advanced economies. In civil-law and German-law countries, voting blocks overwhelmingly consist of members of a firms founding family, even after the death of the founder.

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Summary
Corporate

finance deals with the way firms raise capital, invest the proceeds, and distribute earnings on the core finance principles such as the time value of money, risk-return trade-off, diversification, market efficiency, and no arbitrage order to create shareholder value (but beware of conflicts of interest)
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Builds

In

This Weeks Reading


Essential: MSG Ch. 1 + Ch.11 part 5 on Law and Finance, or HRWJJ Ch. 1,2. Additional: MSG Ch.2 or HRWJJ Ch. 3 Research papers:

Shleifer, Andrei, and Robert W. Vishny, 1997, A survey of corporate governance, Journal of Finance 52, 737-783. Gompers, Paul, Joy Ishii, and Andrew Metrick, 2003, Corporate governance and equity prices, Quarterly Journal of Economics 118, 107155. Bebchuk, Lucian, Alma Cohen, and Allen Ferrell, 2009, What matters in corporate governance?, Review of Financial Studies 22, 783-827. Daines, Robert M., Ian D. Gow, and David F. Larcker, 2010, Rating the ratings: How good are commercial governance ratings?, Journal of Financial Economics 98, 439-461.
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Seminar 1
Ben
Be

& Jerrys Homemade Case Study

prepared to discuss the case In relation to the case you need to read:
Jensen,

M.C. (2001) Value Maximisation, Stakeholder Theory, and the Corporate Objective Function, European Financial Management, Vol. 7 (3), pp. 297-317

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