Overview of Finance
Week 1 – August 26 and 28, 2002
J. K. Dietrich - FBE 432 – Fall, 2002
Financial Analysis, Functions,
and Careers
August 28, 2002
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
Introduction to Valuation and
Review
August 28, 2002
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 (t)
Repayment of Principal (P)
Changes in Net Working Capital (DNWC)
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]
– 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-t)+Dep-Capex-P-DNWC
 Unlevered
Cash Flow {UCF}
Cash flow that would occur if there was no debt
(1-t)EBIT+Dep-Capex -DNWC
J. K. Dietrich - FBE 432 – Fall, 2002
Next Week – September 4
 Review
valuation techniques and relate to
case materials
 Prepare Eskimo Pie Case
 Form groups for group case analyses
following Eskimo Pie
J. K. Dietrich - FBE 432 – Fall, 2002