Introduction to Corporate Finance - Guest Lecture MBA Class UA

Introduction to

Corporate Finance

Edward M. Erasmus, MA

Lecturer

University of Aruba

January 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 @ FZA A 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

Introduction lecturer

Contact info:

Blog: http://edwardmerasmus.wordpress.com

LinkedIn: http://www.linkedin.com/in/edwardmerasmus

Slideshare: http://www.slideshare.net/e.erasmus

Facebook: http://www.facebook.com/edwardmerasmus

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Roadmap for Today

• What is corporate finance?

• Role of the CFO / financial manager

• The goal of financial management

• Overview of financial markets

• Rethinking corporate finance

• Some fundamentals

WHAT IS CORPORATE FINANCE?

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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 operations

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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

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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.

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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 flows

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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.

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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?

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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.

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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?

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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.

ROLE OF THE CFO

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A Simplified Organizational Chart

Shareholders

are the

owners.

Managers

represent the

owners.

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A Simplified Organizational Chart

Financial

Manager

coordinates

the activities

of the

Treasurer

and

Controller

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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.

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

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Corporate finance in a nutshell

Stockholders

Bondholders

Financial Manager

Projects

Investments

Cash flow

Interest

Dividends

The Firm

Capital Budgeting

The Market

Capital Structure

Equity

Debt

Government

Corporate Taxes Personal

Taxes

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Corporate finance in a nutshell

Stockholders

Bondholders

Financial Manager

Projects

Investments

Cash flow

Interest

Dividends

The Firm

Capital Budgeting

The Market

Capital Structure

Equity

Debt

Government

Corporate Taxes

Personal Taxes

Society

Ethical Pressures

Ethical Cooperation vs.

Social Costs

Politics

GOAL OF FINANCIAL MANAGEMENT

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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?

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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!

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Goal in a For-Profit Business

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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.

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What About These Goals?

• Maximize customer satisfaction

• Environmental responsibility

• Ethical behavior

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How value is created…

Value through managing the ‘top line and

the bottom line’:

• Increase sales

• Decrease expenses

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How value is created…

Smart financial management also contributes

to 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

• …..

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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.

FINANCIAL MARKETS

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Financial Markets

– Money markets versus capital markets

– Primary markets versus secondary

markets

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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, NYSE

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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 markets

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Financial Market Cash Flows

RETHINKING CORPORATE

FINANCE?

Traditional principles governing

corporate finance

Corporate finance

Investment principle

Financing principle

Dividend principle

Rethinking corporate finance

Corporate finance

Investment principle

Financing principle

Dividend principle

Sustainable competitiveness

principle

Social value

principle

SOME FUNDAMENTALS

Basic finance terms

• Assets

• Bonds

• Capital

• Capital assets

• Capital budget

• Currents assets

• Debt financing

• Equity

• Expenses

• Fixed Assets

• Liabilities

• Operating budget

• Revenue

• Financial ratios

• Cost of capital

• Hurdle rate

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….

oA document designed to show the state of affairs of an

entity at a particular date.

oReduced 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

oResources (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

oThe assets must have come from somewhere.

oThe 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.

oThese sources require repayments or recompense in

some way….so they can also be called claims.

Balance sheet: introduction

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 oWhen a new business entity is created, the starting

point is that there is no balance sheet.

oBalance sheet is created for the entity when Cash is put in the entity.

oSeparation is necessary to avoid affairs of the owner and the business to be tangled up.

oCash (resource) put in the entity by the owner will balance against the list of sources and is called Capital.

The simple balance sheet

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 – example

Simple balance sheet – book example

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.

oEnglish word derived from the word ‘liable’, meaning

tied or bound or obliged by law.

oA liability is a negative version of an asset.

Equity

oClaims by the owner are not called liabilities, but owner’s

equity (or various similar expressions).

oEquity 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).

Balance sheet claims redrawn

Income statement

o 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 statement

o The income statement uses the following definitions:

o Revenues – incoming receipts in return for sold goods or

services

o Expenses – sacrificed resources to support the business

operations

Income statement

Important 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).

Applications and sources

o Adapted layout:

Relation between the balance sheet and

income statement

Applications = Sources

Assets + Expenses = Capital + Liabilities + Revenues

Assets = Capital + Liabilities + Revenues –

Expenses

Assets = Capital + Liabilities + Profit

Two simple equations:

Assets = Owner’s Equity + Liabilities

Rearranged:

Owner’s Equity = Assets – Liabilities = Net Assets

QUESTIONS???

Edward M. Erasmus, MA

[email protected]

[email protected]

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