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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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