Introduction to Financial Management FIN 102 Dr. Andrew L. H. Parkes “A practical and hands on course on the valuation and financial management of corporations”

Introduction to Financial Introduction to Financial ManagementManagement

FIN 102FIN 102

Dr. Andrew L. H. ParkesDr. Andrew L. H. Parkes““A practical and hands on course on the valuation A practical and hands on course on the valuation

and financial management of corporations”and financial management of corporations”

Syllabus and Our CourseSyllabus and Our Course The syllabus provides an The syllabus provides an

outline of what we will do outline of what we will do this semester: Chapters 1 - this semester: Chapters 1 - 4 as well as Chapters 12, 4 as well as Chapters 12, 13 and 14 of the textbook.13 and 14 of the textbook.

This week we will talk This week we will talk about Chapter 1 and some about Chapter 1 and some of 2; The role of financial of 2; The role of financial management and the management and the business environmentbusiness environment

The required textbook

Lectures and Practice Lectures and Practice ProblemsProblems

Lectures:Lectures: 2 hours per week I will 2 hours per week I will introduce the new material to you introduce the new material to you

Practice Problems:Practice Problems: 2 hours we will do 2 hours we will do assignments (@)from my slides and assignments (@)from my slides and from the textbookfrom the textbook

You will have to prepare You will have to prepare assignments for every class; assignments for every class; there is NO class there is NO class without without homework…(Hwk). homework…(Hwk).

You will work on a group project You will work on a group project during the course and select a during the course and select a S&P500 company that you would S&P500 company that you would like to work on with your team.like to work on with your team.

You will simulate your own You will simulate your own investments and learn about investments and learn about financial markets (e.g. financial markets (e.g. investopedia.com - Forbes).investopedia.com - Forbes).

Keep up to date withFinance related issues

GradingGrading

Mid-term test - 20%Mid-term test - 20% Final ExamFinal Exam - 40% - 40% Homework Homework - 30% - 30% QuizzesQuizzes - 10% - 10%

Total Total - 100% - 100%

Financial Management Financial Management (ch.1)(ch.1)

What are the most What are the most admired companies in the admired companies in the world? (see world? (see www.fortune.comwww.fortune.com))

Innovative companiesInnovative companies High management quality High management quality

companiescompanies High employee talent High employee talent

companiescompanies High product quality High product quality

companiescompanies High return on investment High return on investment

value companiesvalue companies Financial sound companiesFinancial sound companies Social responsible (ethical) Social responsible (ethical)

companiescompanies Efficient use of assets Efficient use of assets

companiescompanies

http://money.cnn.com/galleries/2007/fortune/0704/gallery.f100_employers.fortune/2.html

Career Opportunities in Career Opportunities in FinanceFinance

1.1. Money and Money and capital marketscapital markets

2.2. InvestmentsInvestments

3.3. Financial Financial managementmanagement

Warren Buffett – The Oracle of Omaha - #2 Forbes

World’s Billionaires - $52 Billion

Responsibility of the Financial Responsibility of the Financial StaffStaff

Maximize stock value by:Maximize stock value by:

– Forecasting and planningForecasting and planning

– Investment and financing Investment and financing decisionsdecisions

– Coordination and controlCoordination and control

– Transactions in the financial Transactions in the financial marketsmarkets

– Managing riskManaging riskWho owns GEICO?

Role of Finance in a Typical Role of Finance in a Typical Business OrganizationBusiness Organization

Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager

Inventory Manager

Capital Budgeting Director

Cost Accounting

Financial Accounting

Tax Department

Sole proprietorships & Sole proprietorships & PartnershipsPartnerships

AdvantagesAdvantages– Ease of formation Ease of formation

(to start-up the company)(to start-up the company)– Subject to few regulationsSubject to few regulations– No corporate income No corporate income

taxestaxes DisadvantagesDisadvantages

– Difficult to raise capitalDifficult to raise capital– Unlimited liabilityUnlimited liability– Limited lifeLimited life

Stores along the Street

CorporationCorporation

AdvantagesAdvantages– Unlimited lifeUnlimited life– Easy transfer of ownershipEasy transfer of ownership– Limited liabilityLimited liability– Ease of raising capitalEase of raising capital

DisadvantagesDisadvantages– Double taxationDouble taxation– Cost of set-up and report Cost of set-up and report

filing (difficult)filing (difficult)

Setting up a Corporation…Setting up a Corporation… The incorporators of the The incorporators of the

corporation have to:corporation have to: Create a charter of the companyCreate a charter of the company

– Name of the companyName of the company– Types of activities of the Types of activities of the

companycompany– Amount of capital stockAmount of capital stock– Number and names/addresses of Number and names/addresses of

directorsdirectors Define a set of so called bylaws Define a set of so called bylaws

for the companyfor the company– How directors are electedHow directors are elected– Will shareholders have the first Will shareholders have the first

right on newly issued shares right on newly issued shares (right of first refusal)(right of first refusal)

– The conditions for changing the The conditions for changing the bylaws of the companybylaws of the company

3 Main decisions of Financial 3 Main decisions of Financial ManagementManagement

Investment decision:Investment decision: what what assets does the firm need to assets does the firm need to hold and in what quantities?hold and in what quantities?

Financing decision:Financing decision: how should how should these assets be financed? (debt these assets be financed? (debt or equity/ short or long?)or equity/ short or long?)

Asset management decision:Asset management decision: how should assets develop how should assets develop over time with the over time with the growth/change of the business? growth/change of the business?

Financial Goals of the Financial Goals of the CorporationCorporation

The primary financial goal is The primary financial goal is shareholder wealth shareholder wealth maximization, which maximization, which translates to maximizing stock translates to maximizing stock price.price.– Do firms have any Do firms have any

responsibilities to society at responsibilities to society at large?large?

– Is stock price maximization good Is stock price maximization good or bad for society?or bad for society?

– Should firms behave ethically?Should firms behave ethically?

Is stock price maximization the Is stock price maximization the same as profit maximization?same as profit maximization?

No, despite a generally high correlation No, despite a generally high correlation amongst stock price, EPS, and cash amongst stock price, EPS, and cash flow.flow.

Current stock price relies upon current Current stock price relies upon current earnings, as well as future earnings and earnings, as well as future earnings and cash flow.cash flow.

Some actions may cause an increase in Some actions may cause an increase in earnings, yet cause the stock price to earnings, yet cause the stock price to decrease (and vice versa).decrease (and vice versa).

Creating Value…Creating Value… For stakeholders of the For stakeholders of the

company like:company like:– Customers (sustainable flow of Customers (sustainable flow of

products and services)products and services)– Suppliers (sustainable flow of Suppliers (sustainable flow of

raw material orders) raw material orders) – Employees (sustainable jobs Employees (sustainable jobs

with career perspectives) with career perspectives) – Shareholders (growing share Shareholders (growing share

value and dividends)value and dividends)– Banks and Financial Banks and Financial

Institutions (sustainable pay Institutions (sustainable pay back of loans and interest)back of loans and interest)

– The Government … (more The Government … (more profit is more tax income)profit is more tax income)

The Textbook approach…

In reality companies create In reality companies create value by…value by…

Increasing Free Increasing Free Cash flow (FCF)Cash flow (FCF)

Reducing The Reducing The Weighted Average Weighted Average Cost of Capital Cost of Capital (WACC%)(WACC%)

The Company Value = The Company Value = Long Term FCF/ WACCLong Term FCF/ WACC%%

Increasing FCF or lowering WACC%

Free Cash Flow is…Free Cash Flow is… NOPAT NOPAT ( (NNet et

OOperating perating PProfit rofit [Earnings before [Earnings before Interest] Interest] AAfter fter TTax)ax)

++ DepreciationDepreciation – – The increase in Net The increase in Net

Working Capital (NWC)Working Capital (NWC) – – Capital Expenditure Capital Expenditure

(CAPEX)(CAPEX)

NOPAT you will find in the income statement of your company

Depreciation you will find in the income statement and cash flow statement of your company

NWC = Accounts Receivables plus Inventories minus Accounts Payables; the change from your to year you can calculate (a decrease in NWC from one year to another is a Cash In Flow so this adds to FCF)

CAPEX you will find in the cash flow statement it’s the amount spend on investments…

Simple Valuation…Simple Valuation… So if Google Inc. in the Long Term So if Google Inc. in the Long Term

can generate a FCF of $ 3 b. And can generate a FCF of $ 3 b. And the WACC of Google Inc. is 10% then the WACC of Google Inc. is 10% then the value of Google Inc. is (follow the value of Google Inc. is (follow the formula)the formula)

Company Value (Google Inc.) = Company Value (Google Inc.) = $ 3 b/0.10 = $ 30 billion$ 3 b/0.10 = $ 30 billion Of course this is an example and I Of course this is an example and I

just made up the estimated FCF and just made up the estimated FCF and WACC. We will learn during the WACC. We will learn during the course how to estimate FCF and course how to estimate FCF and WACC to enable us to calculate the WACC to enable us to calculate the value of any company … under value of any company … under certain assumptionscertain assumptions

This in fact is the core capability of This in fact is the core capability of financefinance

Once we can calculate the value of a Once we can calculate the value of a company periodically, we can company periodically, we can calculate if the company is in fact calculate if the company is in fact creating value for its stakeholders creating value for its stakeholders or destroying valueor destroying value

Assignment 1: Value your S&P Assignment 1: Value your S&P companycompany

You have picked a S&P500 company to work on You have picked a S&P500 company to work on during the course:during the course:– Try to figure out what the Long Term Free Cash Flow is Try to figure out what the Long Term Free Cash Flow is

of your company by reading its annual reports (1999-of your company by reading its annual reports (1999-2005) Limit yourself to the financial paragraph (5 years 2005) Limit yourself to the financial paragraph (5 years is fine).is fine).

– Assume your companies’ WACC is anywhere in between Assume your companies’ WACC is anywhere in between 5% and 25%; 5% if your company is extremely 5% and 25%; 5% if your company is extremely financially solid and rather low risk, 25% if your financially solid and rather low risk, 25% if your company has a very volatile performance over the last 5 company has a very volatile performance over the last 5 years and a bumpy road ahead and is an extremely high years and a bumpy road ahead and is an extremely high risk business (you may pick any WACC in between). risk business (you may pick any WACC in between).

– Step 1: Calculate the Company Value of your company Step 1: Calculate the Company Value of your company under these assumptions.under these assumptions.

Step 2 in Valuing your S&P Step 2 in Valuing your S&P companycompany

Now look up the Long Term debt from the Now look up the Long Term debt from the latest available Balance Sheet (sure you latest available Balance Sheet (sure you will find it under liabilities)will find it under liabilities)

Subtract this figure from the Company Subtract this figure from the Company Value you found in 1a)Value you found in 1a)

Now you have the companies’ equity valueNow you have the companies’ equity value Divide that number by the number of Divide that number by the number of

common shares outstandingcommon shares outstanding Now you find the equity value per share Now you find the equity value per share

outstanding or the calculated share price outstanding or the calculated share price of your companyof your company

Compare this share price with the current Compare this share price with the current share price of your company (take the share price of your company (take the latest closing price for comparison) latest closing price for comparison)

Does the market value the share of your Does the market value the share of your company higher (over priced) or lower company higher (over priced) or lower (under priced) then what you calculated?(under priced) then what you calculated?

Why do you think there is a difference?Why do you think there is a difference?

Help…Help…

You can find your company’s You can find your company’s figures at figures at www.sec.govwww.sec.gov

– Go to Filings and Forms Go to Filings and Forms (EDGAR)(EDGAR)

– Search for company filingsSearch for company filings– Look up the ticker symbol of Look up the ticker symbol of

your company at Yahoo your company at Yahoo Finance (symbol lookup)Finance (symbol lookup)

– Plug in the found ticker Plug in the found ticker symbol at EDGARsymbol at EDGAR

– Try GOOG and you will find all Try GOOG and you will find all the filings of Google Inc.the filings of Google Inc.

– Now search for the latest 8 Now search for the latest 8 and 10-K (annual reports) and 10-K (annual reports) filings or 10-Q (quarterly filings or 10-Q (quarterly reports)reports)

More help…More help… Go to Yahoo FinanceGo to Yahoo Finance Plug in the ticker of your companyPlug in the ticker of your company See the left hand buttons “More See the left hand buttons “More

on…”on…” For a quick scan of your companyFor a quick scan of your company Click Profile, Key StatisticsClick Profile, Key Statistics For Historical Share Prices click…For Historical Share Prices click… Professional research on your Professional research on your

company…company… Company events, news on your Company events, news on your

company…company… Everything is here…Use it!Everything is here…Use it!

So summarizing …So summarizing … Your Homework is:Your Homework is:

– 1) form a team 4-5 members max.1) form a team 4-5 members max.– 2) pick a S&P 500 company2) pick a S&P 500 company– 3) download FY 2006 annual 3) download FY 2006 annual

report of the company you have report of the company you have chosen chosen

– 4) Try to calculate Free Cash Flow4) Try to calculate Free Cash Flow– 5) Assume that the Cost of Capital 5) Assume that the Cost of Capital

is 10% (WACC%)is 10% (WACC%)– 6) Calculate The Value of the 6) Calculate The Value of the

company by: Value= Free Cash company by: Value= Free Cash Flow/Cost of CapitalFlow/Cost of Capital

Who is this man?

Did he create value in his companies?