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Lecture notes Corporate Finance and Valuation
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27/09/2013
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Corporate Finance and Valuation (SMM467)2013/2014
Session 1:
Intro to Corporate Finance and the Corporate Objective Function
Dr Andrey Golubov
D
Course Structure
3-hour sessions over 10 weeks
9 lectures
9 seminars
Numerical exercises, discussions, case studies, guest speaker (tbc)
1 revision session
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Course Syllabus
Session 1: Intro to Corporate Finance and the Corporate Objective Function
Session 2: The Time Value of Money
Session 3: Valuing Securities and Firms
Session 4: Risk and Return in Capital Markets
Session 5: Evaluating Investment Projects
Session 6: Cost of Capital
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Course Syllabus – cont.
Session 7: Raising Capital
Session 8: Capital Structure: An Intro
Session 9: Mergers & Acquisitions
Session 10: Revision
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Assessment
Mid-term test – 25% of the final grade
Multiple choice, some questions involve
calculation
Exam – 75% of the final grade
Multiple choice questions
Numerical exercises
Essay-type questions
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Reading List
Preferred Text: Megginson W., Smart S., Graham, J. (2010) Financial Management: Linking
Theory to What Companies Do, 3rd edition, South-Western/Cengage Learning (ISBN: 978-0-538-74558-1)
Alternative Text: Hillier D., Ross S., Westerfield R., Jaffe J., Jordan B. (2010) Corporate Finance,
European Edition, McGraw-Hill (ISBN: 978-0-077-12115-0)
Academic Journal Articles
Case Studies (Harvard, Stanford, Darden)
Read FT or WSJ, check out Bloomberg or Reuters
Always bring a calculator to class!
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Before we begin…
Question:
Why should we study finance? Didn’t the
recent financial crisis prove all of the finance theory wrong?
My Answer:
The financial crisis has illustrated how badly things can go when those in charge forget the basic finance and economics principles
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Session Outline
What is Corporate Finance
Basic Corporate Finance Functions
Core Principles of Finance
Forms of Business Organization
The Corporate Objective Function
Agency Conflicts
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What is Corporate Finance?
What is Finance?Finance is concerned with the allocation of
funds under the conditions of risk (or uncertainty)
What is Corporate Finance?The activities involved in managing cash flows
of a firm (a corporation)
Principles are universal to ALL firms, large or small, private or public
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The 3 Basic Corporate Finance Functions
The Financing Decision
(Raising Capital)
The Investment Decision
(Capital Budgeting)
The Distribution Decision
(Payout Policy)
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Others Also Include:
• Risk Management• Working Capital Management• Corporate Governance
Which Finance Functions Add the Most Value?
Source: Servaes and Tufano, “CFO Views on the Importance and Execution of the Finance Function”
(Deutsche Bank, 2006).
The Financing Function
Firms can raise funds in 2 major ways:
Internally by retaining profits
Most common method
Externally from investors or creditors
Equity
Venture capital (VC) or private placements
Initial public offering (IPO)
Seasoned (follow-on) equity offering (SEO)
Debt
Short-term (Money market)
Long-term (Bank loans, bond issues, syndicated loans)
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Raising Capital: Key Facts
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Primary vs. secondary market transactions or offerings
Most financing from internal rather than external sources.
Most external financing is debt.
Financial intermediaries declining as a source of capital for large firms
Securities markets growing in importance1 - 13
The Capital Budgeting Function
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Capital Budgeting: Selecting the best projects in which to invest the firm’s
resources
The Capital Budgeting Function
The capital budgeting process consists of three steps.
Step 1 - Identifying potential investments
Step 2 - Analyzing those investments to identify which will be sufficiently profitable
Step 3 - Implementing and monitoring the
investments selected in Step 2
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The Distribution Function
Returning cash to shareholders (investors)
How much to pay out
In what form
Regular cash dividends
One-off special dividends
Stock dividends
Share repurchases
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The Risk Management Function
Identifying, measuring, and managing all types of risk exposures
Some risks are insurable, and some risks can be reduced through diversification.
Financial instruments like forwards, futures, options, and swaps may also be used to hedge
market risks such as interest-rate, price, and currency fluctuations.
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The Working Capital Management Function
Short-term financial planning
Managing daily cash inflows and outflows
Forecasting and managing cash balances
Managing trade credit and inventory
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The Corporate Governance Function
Hire qualified and honest managers, and structure their incentives to motivate them to act in the best interests of the firm
In practice the incentives of stockholders and managers (and other stakeholders) often diverge
Dimensions of corporate governance:
Ownership structure
Board structure
Executive compensation
Regulation and stock exchange rules
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The Core Principles of Finance
The Time Value of Money
Risk-Return Trade-Off
The Power of Diversification
Efficient Markets
No Arbitrage Principle
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The Time Value of Money
A dollar today is worth more than a dollar tomorrow
Why?
Smart (economist’s) answer: opportunity cost
Plain English answer: you can invest the dollar today and earn interest
We can measure it! – Session 2
Applications of this principle range from choosing a mortgage to valuing a whole firm!
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The Risk-Return Trade-Off
Investors like returns
Investors do not like risk
Compensation for risk
Investors expect compensation for bearing risk
The history of investment returns reveals this relationship – Session 4
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The Power of Diversification
Don’t put all your eggs in one basket.Investors can achieve a more favorable trade-
off between risk and return by diversifying their portfolios.Markowitz got the Nobel Prize for it!
Implications for corporate finance?Only non-diversifiable risk is rewarded
Session 4
This affects the cost of equity capital for the firm Session 6
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Market Efficiency
By market efficiency we usually mean that prices reflect all publicly available information
Competition for information tends to make markets efficient
Markets are (mostly) smartPrices reflect fundamentals
And do so instantly (or very quickly)
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No Arbitrage Principle
Arbitrage is an instant and riskless profitExample: identical assets trading at different
prices (usually in different markets)Buy where it’s cheap, sell where it’s expensive
Until your actions push the prices toward equilibrium
Risk-free money-making opportunities are extremely scarce.No free lunches in finance
If you have “identified” an arbitrage opportunity, think again!Transaction costs
Other market imperfections1 - 25
Primary Forms of Business Organization
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Sole Proprietorships
• No distinction between business and owner
• Easy to set up and operate
• Business earnings taxed as personal income
• Limited life, Limited access to capital, Unlimited personal liability
Partnerships
• Similar to sole proprietorship, but has two or more owners
• Joint and several liability
• Share of profits taxed as partnership income
Limited Partnerships
• One or more general partners with unlimited personal liability
• Most owners are limited partners, who are passive investors with limited liability
Primary Forms of Business Organization
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Are there any disadvantages for corporations?YES! Double taxation
Corporations
• Separate legal entity with many of the economic rights and responsibilities of individuals
• Unlimited life, Limited liability, Separable contracting, Improved access to capital
• Owned by shareholders, who elect the Board of Directors
• Board appoints a President or CEO to manage day-to-day operations
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Taxation of Business Income
Corporations around the World
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Type of
Corporation
Country of
Origin
In Original Language Description
AG Austria, Germany Aktiengesellschaft Publicly Listed
GmbH Austria, Germany Gesellschaft mit Beschränkter Haftung Private Limited
NV Belgium,
Netherlands
Naamloze Venootschap Private/Public
SA Belgium, France,
Luxembourg,
Portugal, Spain
Société Anonyme/ Sociedade Anónima Publicly Listed
股 份 有 限 公 司 China Mainland 股 份 有 限 公 司 Publicly Listed
有 限 公 司 China Mainland 有 限 公 司 Private Limited
ApS Denmark Anpartsselkab Private Limited
A/S Denmark Aktieselskab Publicly Listed
SE European Union Societas Europaea Publicly Listed
Oy Finland Osakeyhtiö Private Limited
Oyj Finland Julkinen Osakeyhtiö Publicly Listed
AB Finland, Sweden Aktiebolag Private Limited
Abp Finland Publikt Aktiebolag Publicly Listed
Plc India, Ireland,
Thailand, U.K.
Public Limited Company Publicly Listed
S.p.A. Italy Società per Azioni Publicly Listed
AS Norway Aksjeselskap Private Limited
ASA Norway Allmennaksjeselskap Publicly Listed
S.L. Spain Sociedad Limitada Private Limited
Ltd Ireland, U.K.,
U.S.
Limited Private Limited
Inc., Corp. U.S. Incorporated, Corporation Publicly Listed
The Corporate Objective Function
The Goal of the Corporation is to maximize shareholder wealth. But shareholders are not the only stakeholders in the firm…
Who is also involved?
Creditors
Customers
Suppliers
Employees
Government
Society
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Why maximize shareholder wealth?
Shareholder wealth maximization is socially optimal
They are the residual claimants
Get paid only after all other stakeholders’ claims are satisfied
Most successful companies keep customers happy, treat employees well, etc.
Competition ensures that everybody gets their fair share
Depends on the efficacy of the Anti-Trust and other regulation
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What Metric to Use?
Maximize Profits?
Earnings are backward-looking, dependent on
accounting principles and susceptible to manipulation
Do not fully consider cash flow timing
Ignore risk
Maximize Shareholder (Equity) Value!
In public firms shareholder wealth is represented by the market price of stock
Unambiguous, constantly updated
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What Global Companies Do
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What Global Companies Do
Separation of Ownership and Control
At some stage, founders have to hire other people to run their firms
Managers act as agents of the owners who hired them
In practice however, self-interest may cause managers to pursue objectives other than shareholder wealth maximization.
This conflict of goals gives rise to managerial agency problems.
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Agency Costs
Excessive remuneration and perquisite consumption
Corporate jets, luxurious offices, etc.
Empire-building
Remuneration is often tied to firm size, and it is more prestigious to run a larger firm
Unnecessary diversification
Managers want job security and diversify the firm’s activities to smooth out earnings
But investors can diversify on their own at a very low cost 1 - 36
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How to Mitigate Agency Problems?
Shareholder activism
Proxy fights
Institutional owners, block holders
Takeover threat
The “market for corporate control”
Monitoring and bonding
Board oversight (outside directors, CEO/Chairman separation)
Independent Audit
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How to Mitigate Agency Problems?
Executive compensation contracts
Tie managerial wealth to stock value (stock
option)
Regulation and stock exchange rules
Sarbanes-Oxley, The Combined Code, etc.
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Corporate Governance around the World
A nation’s corporate governance system is the set of laws, regulations, institutions, and practices that determine how a company is to be governed and how control of a company can be contested.
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Law and Finance
The “Law and Finance” model of economic growth (La Porta, Lopez-de-Silanes, Shleifer, and Vishny studies) states that the most important determinant of capital market development is the degree of legal protection afforded to outside (noncontrolling) investors.
This determining factor depends largely on whether a country’s legal system is based on English common law or another legal tradition.
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English common law
Strongest protection for minority investors
Has led to an atomistic ownership structure, where a large number of investors each own a small portion of a company.
German law
Scandinavian law
French civil law
Weakest protection for outside investors
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Law and Finance
Applying the Law and Finance Model to Corporate Control
What does the Law and Finance research imply for financial managers in different countries?A key implication: corporate ownership is likely
to be much less concentrated in common-law countries than in other advanced economies.
In civil-law and German-law countries, voting blocks overwhelmingly consist of members of a firm’s founding family, even after the death of the founder.
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Summary
Corporate finance deals with the way firms raise capital, invest the proceeds, and distribute earnings
Builds on the core finance principles such as the time value of money, risk-return trade-off, diversification, market efficiency, and no arbitrage
In order to create shareholder value (but beware of conflicts of interest)
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This Week’s Reading
Essential: MSG Ch. 1 + Ch.11 part 5 on Law and Finance, or HRWJJ Ch. 1,2.
Additional: MSG Ch.2 or HRWJJ Ch. 3
Research papers: Shleifer, Andrei, and Robert W. Vishny, 1997, A survey of corporate
governance, Journal of Finance 52, 737-783.
Gompers, Paul, Joy Ishii, and Andrew Metrick, 2003, Corporate governance and equity prices, Quarterly Journal of Economics 118, 107-155.
Bebchuk, Lucian, Alma Cohen, and Allen Ferrell, 2009, What matters in corporate governance?, Review of Financial Studies 22, 783-827.
Daines, Robert M., Ian D. Gow, and David F. Larcker, 2010, Rating the ratings: How good are commercial governance ratings?, Journal of Financial Economics 98, 439-461.
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Seminar 1
“Ben & Jerry’s Homemade” Case Study
Be prepared to discuss the case
In relation to the case you need to read: Jensen, M.C. (2001) “Value Maximisation, Stakeholder
Theory, and the Corporate Objective Function”, European Financial Management, Vol. 7 (3), pp. 297-317
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