CORPORATE FINANCE
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CORPORATE
FINANCE
The key responsibilities of the
CFO
The two main parts of CF are allocation (investment) and financing,
corresponding to the A&L sides of the balance sheet. The ultimate objective is to
maximize the shareholders’ wealth: achieve the highest return on the projects
and ensure the cheapest financing. Evaluation of the investment projects is
based on the discounted cash flows, which are diferent from the accounting
profits (e.g. because of depreciation). The real options approach takes into
account that managers can influence the CFs after the beginning of the project.
Applying similar methods, one can value the company.
The company can be restructured from private to a public one via IPO, and
vice versa. Another type of structural change comes from M&As. The company’s
goal is to acquire the companies bringing synergy gains and those undervalued
due to the inefficient management. The best defence from the acquisition is to
maximize its own value.
The goal of corporate governance is to internalize the external efects, balance
the economic interests of all stakeholders. In well-functioning fnancial markets,
this maximizes shareholder value.
Typical CF
questions:
How to measure the project’s worth for the company?
Are companies’ market prices justified? (e.g., dot-coms)
How to choose among the projects given the budget constraint and
external
effects?
How to account for risks associated with the project?
o Systematic vs company-specific risks
Are risks always bad?
Is it good to have volatile oil prices?
o Yes, if managers have flexibility in the future decisions.
Should we invest now in a project, which seems unprofitable (has negative
NPV)?
o Probably, yes. It may yield high profit in certain future scenarios (oil
pipeline)
Should we invest now in a project, which is profitable (has positive NPV)?
o Probably, not. It may be even more profitable next period (gold extraction)
Should we give managers higher salaries or higher bonuses?
o Bonuses encourage higher performance, but may also lead to
the
manipulations and excessive risk-taking.
Does it matter how to finance the project: by debt or by equity?
Would you like the company to have much debt?
o Yes, to minimize taxes and to discipline the managers. Not too much, to
avoid
bankruptcy.
Should the company borrow money from banks or issue bonds?
o The company can renegotiate the terms of bank credit.
Would you like the company to pay high dividends? (e.g., Microsoft)
CORPORATE FINANCE
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o Yes, if too much managerial discretion (Surgut). No, because of
double
taxation and signalling that the company has no valuable inv projects.
How will the market react to the share buyback?
o The company signals that its shares are
undervalued. How will the market react to the new
equity issue?
o Usually negatively: either the company’s shares are overvalued, or it
needs to
fnance a new inv project.
How should the company communicate with the market? Always provide
precise
info in time?
What drives the company’s decision to go public? Why are there hardly any
IPOs
in Russia?
Would you like the company to grow via acquisitions?
o Yes, if the main motivation comes form synergy gains, and
not
empire-building.
Specifics of
corporation
Do not take the current form of corporations and stock markets as given, it is
an endogenous outcome!
Advantages of corporation in comparison with sole proprietorship and
partnership:
Ltd liability: lesser risks for investors
o Crucial for development of stock markets and diversification
Easy transfer of ownership
o Promotes liquidity
Unlimited life
o Makes it easier to attract fnancing
Disadvantages:
Separation of ownership and control, the agency conflict
o Solved in two ways: US vs Germany
Double taxation
History: 1811, general act of incorporation in NY, specifying that all investors of
NY
corporations have limited liability
Not so obvious that limiting the freedom of contracts is good
Hot discussion at the time: could spur excessive risk taking
California was the last to copy in 1931
The Objective in Corporate
Finance
“If you don’t know where you are
going,
it does not matter how you get
there
”
The Classical Viewpoint:
Van Horne: “In this book, we assume that the objective of the firm is to
maximize
its value to its stockholders”
Brealey & Myers: “Success is usually judged by value: Shareholders are made
better off by any decision which increases the value of their stake in the frm…
The
secret of success in financial management is to increase value.”
Copeland & Weston: The most important theme is that the objective of the firm
is
to maximize the wealth of its stockholders.”
Brigham and Gapenski: Throughout this book we operate on the assumption
that
the management’s primary goal is stockholder wealth maximization which
translates
into maximizing the price of the common stock.
Why focus on maximizing stockholder
wealth?
Stock price is easily observable and constantly updated (unlike other
measures of
performance, which may not be as easily observable, and certainly not
updated
as frequently).
If investors are rational (are they?), stock prices refect the wisdom of
decisions,
short term and long term, instantaneously.
The objective of stock price performance provides some very elegant theory
on:
o how to pick projects
o how to finance them
o how much to pay in dividends
The Classical Objective
Function
What can go
wrong?
Traditional corporate fnancial theory breaks down when the
interests/objectives of the decision makers in the firm conflict with the
interests of stockholders.
o Bondholders (Lenders) are not protected against expropriation by
stockholders.
o Financial markets do not operate efficiently, and stock prices do not
reflect
the underlying value of the firm.
o Significant social costs can be created as a by-product of stock price
maximization.
Solutions:
Choose a diferent mechanism for corporate governance
Choose a diferent objective:
o Maximizing earnings / revenues / firm size / market share
o The key thing to remember is that these are intermediate objective
functions. To the degree that they are correlated with the long term
health
and value of the company, they work well. To the degree that they do
not,
the firm can end up with a disaster
Maximize stock price, but reduce the potential for conflict and breakdown:
o Making managers (decision makers) and employees into stockholders
o Providing information honestly and promptly to financial markets
Counter
reaction
The strength of the stock price maximization objective function is its internal
self correction mechanism. Excesses on any of the linkages lead, if
unregulated, to counter actions which reduce or eliminate these excesses
managers taking advantage of stockholders has lead to a much more
active market for corporate control.
stockholders taking advantage of bondholders has lead to
bondholders protecting themselves at the time of the issue.
firms revealing incorrect or delayed information to markets has lead to
markets becoming more “skeptical” and
“
punitive
”
firms creating social costs has lead to more regulations, investor and
customer backlashes.
The Modified Objective Function
For publicly traded firms in reasonably efficient markets, where bondholders
(lenders) are protected:
o Maximize Stock Price: This will also maximize firm value
For publicly traded firms in inefficient markets, where bondholders are
protected:
o Maximize stockholder wealth: This will also maximize firm value, but
might not maximize the stock price
For publicly traded firms in inefficient markets, where bondholders are not
fully
protected
o Maximize firm value, though stockholder wealth and stock prices may
not
be maximized at the same point.
For private firms, maximize stockholder wealth (if lenders are protected) or
firm
value (if they are not)
Relation to investment theory
Use of CAPM to estimate the cost of capital
Option pricing approach for valuing investment projects (real options), equity
of
the firm, and bonds’ credit risk
CORPORATE FINANCE
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Lecture 2. Analysis of financial
statements
The Firm’s Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
Functions: providing
current status and past performance information to owners and creditors
a convenient way for owners and creditors to set performance targets &
to
impose restrictions on the managers of the frm
a convenient template for fnancial planning
Balance
Sheet
Assets ≡ Liabilities + Shareholder’s
Equity
Tabulates a company’s assets and liabilities at a specific point in time
o Info on value of the assets and the capital structure
Sorting of
o Assets by liquidity
o Liabilities by maturity
Assets and liabilities are represented by historical costs
o The original cost adjusted for improvements and aging = Book Value
o Avoid using market value, since is too volatile and easily manipulated
o Preference for underestimating value
Strict categorization into E or L: the liability must satisfy
o The obligation will lead to CF at some specified or determinable date
o The firm cannot avoid the obligation
o The transaction behind the obligation has already happened
However, important liabilities may be under-stated or omitted
Assets
Current Assets (Оборотные средства): will convert into cash within a year
o Cash
o Accounts Receivable (Счета к пол
у
чению)
Recognizing not collectible ones: reserves (danger of
manipulation!)
o Inventory (ТМЗ): valued by FIFO, LIFO, wdt-avg
LIFO increases costs and reduces taxes
LIFO reserve: difference between LIFO and FIFO valuations
Investments and Marketable Securities (Рыночные цб)
o Minority passive / active investment (<20% / 20-50% of the ownership):
BV
or MV
o If majority active investment (>50%): include in the consolidated
balance
sheet
Intangible Assets (Нематериальные активы): amortized over expected life
