MBA Finance Part-Time Introduction

Transcription

1 MBA Finance Part-Time Introduction Professor Hugues Pirotte Spéder MBA Finance 01 Introduction What is Finance? Finance can generally be taught from two pure perspectives: Investments or Market Finance Financial mathematics Valuation of standard financial products Portfolio selection Study of the term structure of interest rates Valuation of derivatives And other more advanced subjects: microstructure, etc Corporate Finance Financial and Investment decisions Study of corporate events And other more advanced subjects: corporate governance, credit risk, etc But the chief finance officer needs also to understand the way the market valuates the products issued by the firm as well as how the market reacts to firm s announcements and decisions As the next slides will present it, it is hard to disentangle these approaches because they are in fact integrated. Trying to separate these two approaches in two separate courses would inevitably lead to a repetition of some subjects on both sides. The present course will guide you through the basics of strict corporate finance and investments. 1

2 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? EVENTS in the Life of the Firm: triggered decisions and fin l impacts 2 «Investment and Financing» decisions is the classical two-pole approach of finance and it leads to the understanding of the value flow inside the company as well as the relationships of the company (or firm) with the financial markets environment. Some particular events in the life of the firm can be studied more specifically and they are linked to the «financial maturity» of the firm: Initial Public Offering (IPO), Mergers and Acquisitions, and all kinds of restructuring. We talk about «Modern finance» since finance moved from a classical actuarial approach of the real-life financial problems to the understanding of the dynamic equilibriums between the «agents» in the market. Which market? Well, it is proved that there is an interaction between financial markets, product markets and the firms. Today, every financial analyst knows about UMTS even though no product nor product development has been publicly accomplished yet. Then, the question was : if everybody reacts, prices and makes decisions based on that knowledge, it would be naïve to think that the actors of this game just behave individually without looking forward based on what others do and then many new theories emerged, mainly driven by the study of the interactive behaviour of the agents in the market. What agents? Managers and investors, the latter having the option to participate as creditors or as shareholders of the company. This led to: the study of the firm as a set of contracts between categories of agents, the identification of the managerial goals vs. the shareholder power vs. the pressure of creditors, and mainly, the effects of the separation of ownership, control and discipline. 2

3 Accounting View of the Firm Balance sheet Income statement Current assets Fixed assets Net Working Capital Current liabilites Long-term debt Shareholders equity Sales Operating expenses = Earnings before interest and taxes (EBIT) Interest expenses Taxes = Net income (earnings after taxes) Retained earnings Dividend payments 3 Finance starts here with traditional accounting statements, trying to identify the sources of value of the firm, i.e. its fundamentals or the fundamental value. Financial analysts use many ratios (structural ones on the balance sheet and tactical ones on the income statement) to try to categorize the firms depending on their capacity to create revenues, to grow, to accumulate revenues (retained earnings), to pay interest expenses (now: interest coverage, in the long-run: debt ratios), to give value to shareholders, etc This is also called «financial diagnosis». This analysis pretends to track down the origins of the fundamental value. But some remain skeptical on the capacity of this framework to encompass the whole problem The EBIT is usually the starting point of any study on the cash-flow of the firm and expectations, growth, distributions are based on this number. The splitting of the net income into «retained earnings» and «dividends» is a premice of the emphasis that will be made on the capacity of the firm to retribute shareholders while keeping forces to grow. Remember the basic principles of matter: nothing is lost, nothing is created, but everything can be consumed somehow. That is where the umbilical cord of Finance to Economics starts studying and trying to optimize the consumption of cashflows through time. The balance sheet is a typical representation of the investment and financing functions of the firm. A company could choose either to sell assets or to sell shares or rights to these assets while keeping their ownership. Moreover, the firm will try to adapt its offer of shares such that it can attract investors at the best prices. Why? Because while a manager can do a great job in achieving a higher margin on investments, he may consent a high discount on the sale of equity or debt (with high interest rates and high reimbursements), and that would unproductive at all. Therefore, allocating assets is as important as allocating liabilities 3

4 Cash Flows between the Firm and the Financial Markets Firm invest Firm issue securities Firm Financial markets Cash flow from operations Dividend and debt payments Timing of cash flows 4 An important remark has to be made at this point: even though accounting statements represent a structured starting point, finance is primarily interested in cash-flows or any item that could have a cash-flow impact. Moreover, finance gives an important place to the timing of these cash-flows. Therefore, the textbooks quite frequently talk about an «economic or financial balance-sheet and income statement» which is a restructuring of these statements to be more adequate for financial analysis. The time-horizon designates the time-length over which an investor is willing to invest. Adapting your activity and allocation of securities to your time-horizon and that of your investors is certainly one of the most important tasks. This is to satisfy a consumption need in time and therefore a utility function, in economic terms (see RWJ, chap. 3, 3.2). So, we anticipate some cash-flow with some certainty at some point in the future. Thus, we can (or must!) analyze any financial cash-flow on a 3-dimensional perspective: How much? With what level of certainty? When? For the moment, we will analyze these situations in a certainty environment. Refinements on the risk side will be presented later. 3 main sources of financing: securities (equity and debt) + retained earnings Income Taxes Control Default Equity Dividends Taxed as personal income Voting right Debt Interest Tax deductible Loan agreement Non payment results in bankruptcy 4

5 Market values Total capital employed Cash flow Equity Market value of equity Debt Market value of debt 5 The payoff-profile of equityholders and debtors at maturity (default vs. non-default), for a corporation (with limited liability) : Equity Debt These structures are those that have led Robert Merton to interpret the problem of credit risk and the limited liability of shareholders as standard «options» payoff on the value of the assets of the firm. The spreading of the «option-theory» accross subjects well beyond the simple pricing need for traded derivatives, will make him win the Nobel prize (with Myron Scholes). The fact that these payoff functions are truncated, together with different legal rights, will help us in explaining the variety of behaviors between debtholders and shareholders. 5

6 The decisions Before being a stockholder or a debtholder, the investor had many choices: How much to invest? Which financial instruments to buy? Debt: bonds, convertible bonds, what maturity? Stocks: which stocks? Others: derivatives (options, futures, ) or instruments through intermediaries Do I prefer the cash flows now or later but with some uncertainty? Time and uncertainty make decisions interesting but difficult! 6 and it is crucial for the CFO to understand the arguments and the behavior of investors, to be able to issue cheaper securities for cheaper funding, or to attract new investors with targeted arguments. Remember, new investment opportunities will need fresh financing, unless the firm is generating enough retained earnings. How much? With what level of certainty? The 3-dimensional graph is again very important here: Immediacy costs! Certainty costs! When? And there is a trade-off between immediacy and certainty, and cost! Knowing the trade-off being made by the firm s financial clientele allows the CFO to take correct actions, correct remunerating decisions for his shareholders and to know what kind of issue would attract more new investors. 6

7 The markets Classification: Primary markets: markets for new issues, distribution device Direct Intermediated markets (with financial intermediaries) Secondary markets: markets for existing securities Auction (centralized) : order-driven or market-driven orders Over-the-Counter (dealers) The 3 main functions of financial markets: Exchange mechanism Price discovery Collector of information 7 7

8 Key principles No free-lunch Basics: if all cash-flows of A are positive than value(a)>0 Dominance principle: if cash-flows(b)>cash-flows(a) value(b)>value(a) Unique price law if cash-flows(b)=cash-flows(a) value(b)=value(a) price(b)=price(a) Value preservation property if cash-flows(b)=cash-flows(a)+cashflows value(b)=value(a)+value (C) Time is money A $ today is better than tomorrow how worse is it? Risk is costly 100$ in hands is better than 100$ «expected». 8 These rules are basic applications of the trade-off between value, risk and time schematized by the 3-dimensional graph. These rules lead to the so-called no-arbitrage principle, under which many financial securities are priced. If one of the rules presented above is not verified, whatever is the complexity of the traded security, then there is a possibility to earn some return trading on the instrument and on the replicating portfolio. Moreover, would this arbitrage operation be at no risk at all (i.e. the arbitrageur has a positive payoff whatever the terminal scenario is), this would be then a riskfree arbitrage. Risk is costly leads to the notion of certainty equivalent, i.e. what would be the required price for the same asset but in a no-risk universe? Example: you have a bet: 100 or 50 with equal probability of occurrence. The compounded average estimate is 75. What would be the minimum price you would accept to receive at time 0 in exchange of the bet? Less than 75, because you will prefer to receive 75 for sure than 75 on average (assuming you are at least somewhat riskaverse). 8

9 Value creation Market value added (MVA) = Market value of the firm s capital Total capital employed Market value of equity + Market value of debt Stockholders equity + Financial debt VALUE CREATION : 2 strategies Strategy 1 Buy assets at a cost lower than the value of the future revenues real assets financial assets Strategy 2 Sell financial assets for a price higher than the value of future payments 9 9

10 The Capital Investment Trade-off The firm can always give cash back to the shareholders? Project Cash Stockholder Investment opportunities in capital markets 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 10 10

11 Economic Value Added (EVA) EVA = Earnings after tax WACC Total capital Example: Equity $10b Debt $10b Total capital $20b EBIT $2.5b Tax rate 40% WACC 11% EVA calculation Earnings after tax = $2.5b (1-0.40) = $1.5b EVA = $1.5b 11% $20b = $1.5b $2.2b = $700m (EVA is explained RWJ Chapter 12 Appendix) 11 11

12 How to measure value creation? 1. Compare market value of equity to book value Market - to - book(m/b) = Value creation if M/B > 1 Stock price Book value per share 2. Compare return on equity to the opportunity cost of equity Return on equity ( ROE) = Net Income Stockholders' equity Value creation if ROE > Opportunity Cost of Equity 12 12

13 M/B vs ROE Simplifying assumptions: Expected net income income = constant Net income = dividend Market value determination: Net income = Expected return Market value of equity NI = r MVeq ROE (definition): Return on equity = Net income / Book value of equity ROE = NI / BVeq = r MVeq / Bveq Conclusion: in this simplified setting, M/B = MVeq/BVeq > 1 ROE> r 13 In this simplified setting only, we can also deduce the following relationship for the PER (Price-Earnings ratio), a ratio frequently used in the practice: - PER = Mveq / NI PER = 1/r 13

14 The Top Companies 2001 Mkt Value $ bil. Price/ Book ROE % 1 GE US Microsoft US Exxon US Pfizer US Citigroup US Wal-Mart US AOL Time W. US Neg 8 BP UK IBM US NTT Docomo Japan American Intl US Intel US Vodafone UK

15 The Top Companies 2002 Mkt Cap $ billions Price/Book ROE % 1 General Electric US Microsoft US Exxon Mobil US Wal-Mart Stores US Citigroup US Pfizer US Royal Dutch / Shell EU BP EU Johnson & Johnson US Intel US

16 Q&D financial analysis PROFITABILITY (du Pont system) ROE = Net Income Book Equity Three determinants : 13.4% ROE = Net Income Sales Sales Assets Assets Equity Profit Margin Asset Turnover Financial Leverage Microsoft US$ bil. Net Income 7,721 Sales 25,296 Assets 59,257 Book equity 57, % The du Pont system focuses on: Expense control (Profit Margin) Asset utilization (Total Assets Turnover) Debt utilization (Financial leverage or Equity Multiplier) It shows how these factors combine to determine the ROE. We could also look at the ROA decomposition: Net earnings Net earnings Sales ROA = = Total assets Sales Total assets ROE = Profit Margin x Asset Turnover x Fin l leverage ROA x Fin l leverage 13.40% 13.03% 1.03 x = Effects of Debt on ROA and ROE: ROA is lowered by debt interest expense lowers net income, which also lowers ROA. However, the use of debt lowers equity usage, and if equity is lowered more quickly than income, ROE would increase. Therefore, maximizing the firm s value is not necessarily compatible with the shareholder s value maximization!!! 16

17 References Suggested text for this course Ross, Stephen A., Randolph W. Westerfield and Jeffrey F. Jaffe, Corporate Finance, 6th edition, McGraw-Hill Irwin 2002 Corporate finance textbooks (MBA level) Brealey, Richard and Steward Myers, Principles of Corporate Finance, xth edition, McGraw-Hill 2000 Damodaran, Aswath, Corporate Finance: Theory and Practice, Wiley 1997 Corporate finance texts for executives Bertoneche, Marc and Rory Knight, Financial Performance, Butterworth Heinemann 2001 Hawawini, Gabriel and Claude Viallet, Finance for Executives: Managing for Value Creation, South-Western College Publishing,