Corporate Finance • Some important questions that are answered using finance • What long-term investments should the firm take on? • Where will we get the long-term financing to pay for the investment? • How will we manage the everyday financial activities of the firm?
Financial Management Decisions • Capital budgeting • What long-term investments or projects should the business take on? • Capital structure • How should we pay for our assets? • Should we use debt or equity? • Working capital management • How do we manage the day-to-day finances of the firm?
Goal Of Financial Management • What should be the goal of a corporation? • Maximize profit? • Minimize costs? • Maximize market share? • Maximize the current value of the company’s stock? • Does this mean we should do anything and everything to maximize owner wealth?
Agency Issues and Crisis in Corporate Governance • Accounting Scandals • Examples – Enron and WorldCom • Analyst Scandals • Example – Citigroup’s Salomon Smith Barney • Initial Public Offerings • Credit Swiss First Boston
The Agency Problem • Agency relationship • Principal hires an agent to represent their interest • Stockholders (principals) hire managers (agents) to run the company • Agency problem • Conflict of interest between principal and agent • Asymmetric information • Management goals and agency costs
Financial Statements • The Balance Sheet • The Income Statement • Taxes • Financial Cash Flow
Balance Sheet • The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time • Assets are listed in order of liquidity • Ease of conversion to cash • Without significant loss of value • Balance Sheet Identity • Assets = Liabilities + Stockholders’ Equity
Net Working Capital and Liquidity • Net Working Capital • Current Assets – Current Liabilities • Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out • Usually positive in a healthy firm • Liquidity • Ability to convert to cash quickly without a significant loss in value • Liquid firms are less likely to experience financial distress • But, liquid assets earn a lower expected return • Trade to find balance between liquid and illiquid assets
Market Vs. Book Value • The balance sheet provides the book value of the assets, liabilities and equity. • Market value is the price at which the assets, liabilities or equity can actually be bought or sold. • Market value and book value are often very different. Why? • Which is more important to the decision-making process?
Example The balance sheet of your firm shows current assets of $214,500 which includes cash of $23,600, accounts receivable of $87,500 and inventory of $103,400. Long-term assets have a book value of $487,300 which is comprised of a building and some equipment. You believe you can sell the inventory for $163,900. You expect to collect only $84,600 of the accounts receivables. You can sell the equipment for $218,000 and the building for $365,000. What is the total book value of your firm? The total market value?
Income Statement • The income statement is more like a video of the firm’s operations for a specified period of time. • You generally report revenues first and then deduct any expenses for the period • Matching principle – GAAP say to show revenue when it accrues and match the expenses required to generate the revenue
Work the Web Example • Publicly traded companies must file regular reports with the Securities and Exchange Commission • These reports are usually filed electronically and can be searched at the SEC public site called EDGAR • Click on the web surfer, pick a company and see what you can find!
Taxes • The one thing we can rely on with taxes is that they are always changing • Marginal vs. average tax rates • Marginal – the percentage paid on the next dollar earned • Average – the tax bill / taxable income • Other taxes
Average tax rate Given this tax table, what is the average tax rate for a firm with taxable income of $160,000?
The Concept of Cash Flow • Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements • The statement of cash flows does not provide us with the same information that we are looking at here • We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets
OCF Your firm has sales of $231,800, costs of goods sold of $187,000, interest expense of $3,600, depreciation expense of $11,300 and a tax rate of 34%. What is your operating cash flow? $34,634
Net capital spending Your firm has ending net fixed assets of $467,803 and beginning net fixed assets of $503,498. The depreciation expense for the year is $59,200. What is the amount of your net capital spending for the year? $23,505
Change in net working capital Given the following information what is the change in net working capital (NWC)? BeginningEnding Cash $ 903 $ 789 Accounts receivable 3,298 3,672 Inventory 6,129 5,032 Net fixed assets 11,973 12,530 Accounts payable 1,542 1, 303 Long-term debt 10,200 9,300
Cash flow from assets A firm has operating cash flow of $18,500, change in net working capital of $300 and additions to net capital spending of -$1,200. What is the amount of the cash flow from assets?
39: Cash flow to creditors loan Creditors Company interest loan repayment
Cash flow to creditors Your firm has long-term debt of $42,900 as of year end. Your beginning long-term debt was $38,900. During the year, the company paid a total of $3,500 in interest. What is the amount your cash flow to creditors?
42: Cash flow to stockholders sale of stock Stockholders Company dividends stock repurchase
Cash flow to stockholders Your firm has a net income of $136,800 for the year. The dividend payout ratio is 50%. The balance sheet shows an ending common stock balance of $800,000 and an ending paid in surplus balance of $400,000. The beginning common stock balance is $750,000 and the beginning paid in surplus balance is $350,000 What is the amount of your cash flow to stockholders?
Example: Balance Sheet and IncomeStatement Information • Current Accounts • 1998: CA = 1500; CL = 1300 • 1999: CA = 2000; CL = 1700 • Fixed Assets and Depreciation • 1998: NFA = 3000; 1999: NFA = 4000 • Depreciation expense = 300 • LT Liabilities and Equity • 1998: LTD = 2200; Common Equity = 500; RE = 500 • 1999: LTD = 2800; Common Equity = 750; RE = 750 • Income Statement Information • EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends = 1250
Example: Cash Flows • OCF = • NCS = • Changes in NWC = • CFFA = • CF to Creditors = • CF to Stockholders = • CFFA = • The CF identity holds.
Examples • Page 42 • Problem 8, 12, 14, and 22.
Working with Financial Statements • Cash Flow and Financial Statements: A Closer Look • Standardized Financial Statements • Ratio Analysis • The Du Pont Identity • Using Financial Statement Information
Sample Balance Sheet Numbers in thousands
Sample Income Statement Numbers in thousands, except EPS & DPS
Sources and Uses • Sources • Cash inflow – occurs when we “sell” something • Decrease in asset account (Sample B/S) • Increase in liability or equity account • Uses • Cash outflow – occurs when we “buy” something • Increase in asset account • Decrease in liability or equity account
Statement of Cash Flows • Statement that summarizes the sources and uses of cash • Changes divided into three major categories • Operating Activity – includes net income and changes in most current accounts • Investment Activity – includes changes in fixed assets • Financing Activity – includes changes in notes payable, long-term debt and equity accounts as well as dividends
Cash flow categories Financing = Long-term debt, equity, interest paid and dividends Investing = Long-term assets Operating = Current assets, current liabilities and income statement accounts, excluding interest paid
Ratio Analysis • Ratios also allow for better comparison through time or between companies • As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important • Ratios are used both internally and externally
Categories of Financial Ratios • Short-term solvency or liquidity ratios • Long-term solvency or financial leverage ratios • Asset management or turnover ratios • Profitability ratios • Market value ratios
Benchmarking • Ratios are not very helpful by themselves; they need to be compared to something • Time-Trend Analysis • Used to see how the firm’s performance is changing through time • Peer Group Analysis • Compare to similar companies or within industries • SIC and NAICS codes • Expectation
Liquidity ratios Cash $ 900 Accounts receivable 1,200 Inventory 2,100 Current assets $4,200 Accounts payable 1,600 Current liabilities $1,600
Long-term solvency ratios Your firm has long-term debt of $63,000. The long-term debt ratio is .40 and the equity multiplier is 1.8. What is the amount of total assets?
Long-term solvency ratios Your firm has total assets of $146,000 and a total debt ratio of 40%. What is the firm’s debt-equity ratio?
Profitability ratios Your firm has net income of $123,000 on sales of $2.4 million. Total assets are $2.46 million and total equity is $1.5 million.
Profitability ratios Your firm has net income of $368,400, total assets of $23.946 million and an equity multiplier of 1.6. What is the return on equity?
Profitability ratios What is the DuPont formula? What is each part of the DuPont formula called? Why use the DuPont formula?
Profitability ratios Your firm has sales of $324,000 and total assets of $216,000. The debt-equity ratio is .5 and the profit margin is 5.4%. What are the values of the three parts of the DuPont formula? What is the ROE?
Deriving the Du Pont Identity • ROE = NI / TE • Multiply by 1 and then rearrange • ROE = (NI / TE) (TA / TA) • ROE = (NI / TA) (TA / TE) = ROA * EM • Multiply by 1 again and then rearrange • ROE = (NI / TA) (TA / TE) (Sales / Sales) • ROE = (NI / Sales) (Sales / TA) (TA / TE) • ROE = PM * TAT * EM
Using the Du Pont Identity • ROE = PM * TAT * EM • Profit margin is a measure of the firm’s operating efficiency – how well does it control costs • Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its assets • Equity multiplier is a measure of the firm’s financial leverage
Profitability ratios Your firm has sales of $12,600, total assets of $8,100, and a debt-equity ratio of .80. The return on equity is 14%. What is the net income?