COMM 308Introduction to Finance

Instructor: Rahul RaviOffice: MB 12-321Email: rahul.ravi@concordia.ca

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Course Web Pages

Syllabus, lecture notes and Assignments will be posted on “First Class”

Introduction to Finance

Syllabus

Introduction to Corporate Finance

Overview: Introduction; Outline

Chapter 1: Sections 1.2 to 1.4Chapter 2: Sections 2.1 to 2.4

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INTRODUCTION TO FINANCEOutline…

Asset Pricing Investor perspective Price formation in

capital markets

Investments Portfolio management CAPM (Capital Asset

Pricing Model)

Corporate Finance CEO perspective Financial decisions of the corporation

Capital Budgeting Capital Structure Working Capital Management

Finance

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What is Corporate Finance?

Financial decision making process of corporations Why focus on decisions made by

corporations? Other organizational forms: Sole proprietorship Partnership

How do these differ?

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Partnerships

Owned by few people Owners keep all profits But: unlimited liability (lose shirt) Limited life Insufficient capital (forgone opportunities) Difficult to transfer ownership Who is a limited partner?

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Corporations

Separate legal entity from its owners Owners are shareholders Separation of ownership and management Limited liability Ownership easily transferred Capital formation made easy Unlimited life Disadvantage - double taxation

Cash Flows to and from the FirmLO5

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Investment and Financing Decisions

What to buy - Capital Budgeting Assets Real (tangible, intangible) Financial

How to pay for it - Capital Structure Mix of debt and equity

Buy low, sell high Theory of value

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Goals

Survive? Beat competition? Maximize sales/profits? Steady growth? Maximize stock price?

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Goals of a Financial Manager

Shareholders benefit if managers maximizecurrent value of existing stock (share price)

Management should select investments and capital structure that maximize stock value (easier said...)

Is market value of stock a good measure? Issues of Market Efficiency

Problems???

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Quantitative uncertainties/Problems…

Today’s value of expected future cash flows

Time Matters

Tt

tt=0

( )=CF ( )

(1+k)

AssetValue aka NPV

PV GO

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What is the appropriate r?

...that k which reflects the riskiness of the cash flows

Risk Matters

k ca be understood as the conversion rate across time Different ways to refers to r

Opportunity cost of capital Required rate of return Cost of capital Appropriate discount rate Hurdle rate Capitalization rate Etc.

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Some human problems…

Corporation: A legal entity composed of one or more individuals or entities Three distinct interests: separation of

ownership and control Shareholders (ownership, principal) Board of Directors (control) Top Management (implementation, agent)

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Potential Problems: Between Claimants

Information Asymmetry Methods to manage:

Signaling Monitoring

Agency Problems: Goals of the parties are not aligned Agent someone who is hired to represent the principal’s

interest Equity: Potential conflict between shareholders and

managers (principal-agent problem) Traditional: Outside (non-management) shareholders Overvalued equity

Debt: Potential conflict between shareholders and debt holders

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Dilbert on Shareholder Value

Agency Problem of Outside Equity

Managers expropriate wealth from shareholders Moral hazard problems Effort aversion Excessive perquisite consumption Underinvestment due to risk aversion/short

horizon Entrenchment Accept poor investment projects (NPV<0) Empire building Hubris Free Cash Flow (FCF)

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Ways to Manage Agency Problems Board of Directors

Outsiders versus insiders, CEO/Chairman role Composition of audit, nominating and compensation committees

Firm’s voting structure Dual class stocks Concentrated versus Disperse Ownership Outsiders versus Insiders

Incentives Options, performance shares Ownership of executive and directors

Takeover market Antitakeover provisions, regulations Ownership structure Going private?

Managerial labor market Judicial/Governmental review Monitoring function: Debt, Institutional Investors,

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Statement of Financial Position

Assets = Liabilities + Shareholders’ Equity

Current assetsCurrent Liabilities

Common Stock

Assets Liabilities

Equity

Long-term debt

Fixed assets

Net Working Capital

Firm’s accounting value on particular date.

Net Working Capital

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

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Canadian Enterprises Statement of Financial Position – Table 2.1

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Statement of Comprehensive Income

The statement of comprehensive income 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 – IFRS say to show

revenue when it accrues and match the expenses required to generate the revenue

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Canadian Enterprises Statement of Comprehensive Income – Table 2.2

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Accounting and Finance

Market values not book values Stale prices mean bad decisions Imagine driving your car and only looking in

the rear-view mirror We like cash Non-cash items like depreciation lower net

income Sales booked increase income but customer

may not have paid yet

Statement of Cash Flows

Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements 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

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Cash Flow From Assets

Cash Flow From Assets (CFFA) = Cash Flow to Bondholders + Cash Flow to Shareholders Cash Flow From Assets = Operating Cash

Flow – Net Capital Spending – Changes in NWC

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Example: Canadian Enterprises

Operating Cash Flow (I/S) = EBIT + depreciation – taxes = $509 Net Capital Spending (B/S and I/S) =

ending net fixed assets – beginning net fixed assets + depreciation = $130 Changes in NWC (B/S) = ending NWC

– beginning NWC = $330

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Example continued

Cash Flow From Assets (CFFA) = 509 – 130 – 330 = $49 CF to Creditors (B/S and I/S) = interest

paid – net new borrowing = $24 CF to Stockholders (B/S and I/S) =

dividends paid – net new equity raised = $25 CFFA = 24 + 25 = $49

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Taxes

Individual vs. corporate taxes

Marginal vs. average tax rates Marginal – the percentage paid on the next

dollar earned Average – the percentage of your income that

goes to pay taxes (tax bill / taxable income)

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Taxes on Investments

When an investor holds stocks, they are subject to two types of taxes: Dividend tax credit – A tax formula that

reduces the effective tax rate on dividends Capital gains tax – Tax is paid on the

investment’s increase in value over its purchase price

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