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J. K. Dietrich - FBE 432 – Fall, 2002
FBE 432 Objectives
Analyze and communicate implications of financial theory using cases
Understand finance careers and functions Refine and expand specific financial
analytical skills Responsibility for learning is with you Requirements are clear: review, prepare, and
participate
J. K. Dietrich - FBE 432 – Fall, 2002
Financial Analysis
Analyze performance of corporations (and projects) – What should be the objective of financial
management?– How do we determine whether management is
good or bad? Focus in finance is on the future
– Who knows what will happen in the future?– How can we deal with our uncertainty
concerning the future?
J. K. Dietrich - FBE 432 – Fall, 2002
Financial Functions
All finance is concerned with value Corporate decision-making
– Investments, including mergers and acquisitions and divestitures (disinvestment)
– Growth and financing needs – Management of working capital
Chief financial officer is responsible for these decisions– Requires project analysts, treasury assistants
J. K. Dietrich - FBE 432 – Fall, 2002
Investment Banking
Investment bankers assist corporations in their dealings with financial markets– Issuing securities
» Initial public offerings (IPOs) or secondary offerings
» Issuing debt or preferred stock to private investors (private placements) or to public markets
– Mergers and acquisitions– Advising and valuing firms
This services are corporate finance or investment banking services
J. K. Dietrich - FBE 432 – Fall, 2002
Investment Banking (continued) Investment bankers also buy and sell securities
– Brokers (retail and institutional)
– Market makers
– Asset management
– Research
Investment banks are classified in a variety of ways– Full line
– Boutique
– Regional
– “Bulge bracket”
J. K. Dietrich - FBE 432 – Fall, 2002
Investment Banking (continued)
Investment bankers need many types of financial skills – Analysts for research– Analytical support in doing deals– Traders – Marketing securities to retail and institutional
markets Investment banks hire junior analysts and
associates at entry level
J. K. Dietrich - FBE 432 – Fall, 2002
Investment Banking and Markets
Investment bankers assist corporations (and governments) in designing securities for sale to public or private markets
Employees of investment banks are usually called are said to work on the sell side of a securities firm, or are called sell side analysts or sell side traders or brokers
J. K. Dietrich - FBE 432 – Fall, 2002
Investors
Individuals and institutions invest savings in securities (and other investments)
Individuals are usually divided into the retail market (small investors) and affluent investors (private banking)
Buying and selling securities in the retail market Advising and investing for individuals is financial
advising and asset management Individuals often invest in mutual funds and save
in pension plans
J. K. Dietrich - FBE 432 – Fall, 2002
Institutional Investors
Pension funds, mutual funds, insurance companies, and specialized investment vehicles for wealthy investors (e.g. hedge funds) are called institutional investors
Institutional investors require analysts and portfolio managers to invest funds
Employees of institutional investors are usually said to be on the buy side, as for example a buy-side analyst or a buy-side trader
J. K. Dietrich - FBE 432 – Fall, 2002
Specialized Investment Vehicles
Venture-capital firms provide financing to new firms, often firms in new technologies, requiring both technical and financial skills
Hedge funds are unregistered investment vehicles for wealthy investors’ or institutional funds, often using complex investment strategies requiring sophisticated financial analytical skills
J. K. Dietrich - FBE 432 – Fall, 2002
Developments in Finance
Financial theory has developed to value financial instruments like options and swaps
Technology has developed to enable accounting and trading for complex financial claims like collateralized mortgage obligations (CMOs)
Trading and valuing these instruments and advising corporations on how to use them to manage risk demands highly developed research departments
J. K. Dietrich - FBE 432 – Fall, 2002
Commercial Banking
Commercial banks make loans to corporations and individuals
Corporate commercial bankers provide a variety of services to corporations, including cash management and lending
Banks require financially trained individuals to call on corporations and analyze corporate customers
J. K. Dietrich - FBE 432 – Fall, 2002
Finance Career Paths Many individuals move between financial
functions in corporations and investment banking, asset management, commercial banking, and financial advising over the course of their careers
Research, marketing (selling), deal-making, and advising require varying levels of interpersonal skills
Risk tolerance and energy requirements vary in different finance career paths
J. K. Dietrich - FBE 432 – Fall, 2002
Next Time – August 28
Review valuation approaches Read for practice, The Union Carbide Deal
(Abridged)– Outline issues at issue in the case– What role do investment bankers play?– How are they compensated?
J. K. Dietrich - FBE 432 – Fall, 2002
Value and Valuation
Finance objective function is to maximize owners’ value
Value is the present value of future cash flows at the risk-adjusted discount rate
Valuation principles are the same whether we are valuing stocks, bonds, real estate, or corporations
The challenge is to estimate the cash flows and choose a discount rate
J. K. Dietrich - FBE 432 – Fall, 2002
Corporate Cash Flows
Corporate cash flows are similar to all firms’ cash flows, that is, they come from cash revenues minus cash costs
Because of tax laws and standard reporting conventions, corporate cash flows are more standardized
Value of claims on corporations can be calculated separately (e.g. stock and bond valuation) or in the aggregate (so-called entity approach)
J. K. Dietrich - FBE 432 – Fall, 2002
Future Corporate Cash Flows
Since value comes from future cash flows and the future is unknown, future cash flows must be estimated
The future is usually divided into two or more parts– Forecast period and continuing value period– Rapid growth period and normal growth period
Choice of division depends on case and data available
J. K. Dietrich - FBE 432 – Fall, 2002
Cash Flow Determination
Items From the Income Statement – Revenues (R)
– Cash Expenses (W)
– Non-Cash Expenses (Dep)
– Capital Expenditures (Capex)
– Cost of Goods Sold (CGS): » Excludes depreciation
– Interest Expense (Int)
– Taxes (T)
J. K. Dietrich - FBE 432 – Fall, 2002
Cash Flow Determination
Other Items – Tax Rate ()– Repayment of Principal (P)– Changes in Net Working Capital (NWC)– Permanent Debt (D)
J. K. Dietrich - FBE 432 – Fall, 2002
Definition of Earnings Components
Earnings Before Interest & Taxes [EBIT]R-(W+Dep+CGS)
Earnings Before Interest, Taxes, Depreciation (and Amortization) EBITD(A)EBIT+Dep+(Amort)
J. K. Dietrich - FBE 432 – Fall, 2002
Definitions of Earnings Components
Pre-Tax Income – [EBIT-Int]
Tax Bill [T]– (EBIT-Int)
Net Income – NI =Pre-Tax Income - T
J. K. Dietrich - FBE 432 – Fall, 2002
Cash Flow Definitions
Levered Cash Flow [to equity] {LCF or FTE}Money that goes to stockholders account
[R-(W+Dep+CGS+Int)](1-)+Dep-Capex-P-NWC
Unlevered Cash Flow {UCF}Cash flow that would occur if there was no debt
(1-)EBIT+Dep-Capex -NWC