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FINANCE 1. Introduction. Solvay Business School Université Libre de Bruxelles Fall 2007. Who am I?. André Farber Professor of Finance at Solvay Business School since…. Past Director of the MBA program 1990-2002 Past President of Solvay Business School

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Finance 1 introduction

FINANCE1. Introduction

Solvay Business School

Université Libre de Bruxelles

Fall 2007


Who am i
Who am I?

  • André Farber

  • Professor of Finance at Solvay Business School since….

  • Past Director of the MBA program 1990-2002

  • Past President of Solvay Business School

  • Past Dean, Faculty of Social Sciences, Politics and Economics, Solvay Business School (known as Soco)

  • Vice Rector for Strategy and Institutional Development

MBA 2007 01 Introduction


Practical matters
Practical matters

  • Reference:

    • Berk, Jonathan and DeMarzo, Peter, Corporate Finance, Pearson 2007

  • Website: www.ulb.ac.be/cours/solvay/farber

    • Slides

    • Excel files

    • Past exams

  • Grading:

    • 2 Problem sets (30%)

    • Final (70%)

  • MBA 2007 01 Introduction


    Course outline

    1. Introduction, Financial Statement Analysis

    2. Arbitrage and Financial Decision Making

    3. Present value

    4. Bond valuation

    5. Stock valuation (Dividend Discount Mode & Free Cash Flow Model)

    6. Capital budgeting (I)

    7. Capital budgeting (II)

    8. The Pricing of Risk

    9. Optimal Portfolio Choices

    10. Capital Asset Pricing Model

    11. Capital Structure Decisions

    12. Review Session

    4 sessions

    Financial statement analysis – Present Value

    Bond valuation, stock valuation

    Capital budgeting + PS1

    Risk and expected returns + PS2

    Course outline

    Tutorials Céline Vaessen

    Course

    MBA 2007 01 Introduction


    Outline for this session
    Outline for this session

    • 1. Financial decisions: investment, financing, dividends

    • 2. Measuring value creation:

      • Mkt val of equity > Book value of equity

      • Return On Equity > Opportunity cost of capital

  • 3. Drivers of ROE: Profit margin, Asset Turnover, Financial Leverage

  • 4. Statement of cash flows

  • MBA 2007 01 Introduction


    What is corporate finance
    What is Corporate Finance?

    • INVESTMENT DECISIONS: Which REAL ASSETS to buy ?

      • Real assets: will generate future cash flows to the firm

      • Intangible assets : R&D, Marketing, ..

      • Tangible assets : Real estate, Equipments,..

      • Current assets: Inventories, Account receivables,..

  • FINANCING DECISIONS: Which FINANCIAL ASSET to sell ?

    • Financial assets: claims on future cash flows

    • Debt: promise to repay a fixed amount

    • Equity: residual claim

  • DIVIDEND DECISION: How much to return to stockholders?

  • MBA 2007 01 Introduction


    Accounting view of the firm

    Balance sheet

    Income statement

    Sales

    Operating expenses

    = Earnings before interest and taxes (EBIT)

    Interest expenses

    Taxes

    = Net income (earnings after taxes)

    Retained earnings

    Dividend payments

    Accounting View of the Firm

    Net Working Capital

    Current liabilites

    Current assets

    Long-term debt

    Fixed assets

    Shareholders’ equity

    MBA 2007 01 Introduction


    Summarized managerial balance sheet
    Summarized (managerial) balance sheet

    Liabilities

    Stockholders' equity (SE)

    Interest-bearing debt (D)

    Assets

    Net fixed assets (NFA)

    Working capital requirement (WCR)

    Cash (Cash)

    NFA + WCR + Cash = SE + D

    Working capital requirement : definition

    + Accounts receivable+ Inventories+ Prepaid expenses

    - Account payable- Accrued payroll and other expenses

    Interest-bearing debt: definition

    + Long-term debt+ Current maturities of long term debt+ Notes payable to banks

    MBA 2007 01 Introduction


    Example global conglomerate corporation based on berk demarzo table 2 1
    Example: Global Conglomerate Corporation(based on Berk DeMarzo Table 2.1)

    MBA 2007 01 Introduction


    Cash flows of the firm
    Cash Flows of the Firm

    Firm issue securities

    Firm invest

    Firm

    Financial markets

    Investors

    Cash flow from operations

    Dividend and debt payments

    Timing of cash flows + uncertainty

    MBA 2007 01 Introduction



    Cash flow statement indirect method
    Cash flow statement : indirect method

    NFA + WCR + CASH = SE + D

    NFA = CAPEX - Dep

    CAPEX = Acquisitions - Disposals (investing & divesting)

    SE = NI - DIV + K

    K = New issuance of capital

    (NI + Dep - WCR) - (CAPEX) + (K + D -DIV) = CASH

    Cash flow from operating activities

    Cash flow from investing activities

    Cash flow from financing activities

    =

    +

    +

    MBA 2007 01 Introduction


    Market value of the firm
    Market Value of the Firm

    Book values

    Market values

    Value creation

    Market value of equity

    Total capital

    Book equity

    Market capitalization

    Fixed Assets

    +

    Net Working Capital

    Market value of debt

    Debt

    MBA 2007 01 Introduction


    The cost of capital
    The Cost of Capital

    • The firm can always give cash back to the shareholders

    • Capital employed by the firm has an opportunity cost

    • The opportunity cost of capital is the expected rate of return offered by equivalent investments in the capital market

    • The weighted average cost of capital (WACC) is the (weighted) average of the cost of equity and of the cost of debt

    ?

    Stockholder

    Investment opportunities in capital markets

    Project

    Cash

    MBA 2007 01 Introduction


    Stockholders problem
    Stockholders’ problem

    Company

    Capital market

    ROEReturn on Equity

    rExpected return

    MBA 2007 01 Introduction


    How to measure value creation
    How to measure value creation ?

    • 1. Compare market value of equity to book value

    • Value creation if M/B > 1

    • 2. Compare return on equity to the opportunity cost of equity

    • Value creation if ROE > Opportunity Cost of Equity

    MBA 2007 01 Introduction


    Drivers of roe
    Drivers of ROE

    • PROFITABILITY (du Pont system)

    • Three determinants :

    Asset Turnover

    Profit Margin

    Financial Leverage

    MBA 2007 01 Introduction


    Examples
    Examples

    Source: Business Week July 26, 2004

    MBA 2007 01 Introduction


    Return on invested capital
    Return on invested capital

    • Return on assets (net)= Net income / Total assets

    • Advantage: fits with DuPont system

      • ROE = ROA x Equity multiplier

  • Limitation: Net income = EBIT - Interest expense - Taxes

    • Depends on capital structure:

      • 1. Interest expense: function of interest-bearing debt

      • 2. Interest expense : tax deductible

  • Preferred measure: Return on Invested Capital (ROIC)

  • NB: ROIC = ROA (gross) (1 - Tax rate)

  • = ROE of a all equity financed firm

  • MBA 2007 01 Introduction


    Financial leverage
    Financial leverage

    • Financial leverage magnifies ROE only when ROA (gross) is greater than the interest rate on debt.

    • Balance sheet: TA = SE + D

    • Income statement: NI = EBIT - INT- TAX

    • Interest expense INT = r D (Interest expense = Interest rate x Interest-bearing debt)

    • Taxes TAX = (EBIT - r D) Tc (Taxes = Taxable income x Tax rate)

    • Remember : ROIC = ROAgross (1 - Tc)

    • ROE = ROIC + (ROAgross - r) (1-Tc) (D/SE)

    MBA 2007 01 Introduction


    Financial leverage example
    Financial Leverage: example

    MBA 2007 01 Introduction


    Financial planning
    Financial planning

    MBA 2007 01 Introduction


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