Corporate Finance A2
Vysoká škola finanční a správní
Winter Semester 2012
Jaromír R. Stemberg
jaromir@mail.vsfs.cz
Course Layout
• Twelve two-hour lessons
• The course is to introduce general financial
management problems, realtions, terminology, and
solutions
• Ends with an Exam (zkouška)
Literature
• Block, Stanley: Foundations of Financial
Management
McGraw-Hill, 2009
ISBN 978-0-07-128525-4
Grading
• Written test, oral exam
Contents
• Review of the Last Semester
• Time Value of Money
• Valuation and Rate of Return
• Cost of Capital and Capital Budgeting
• Capital Markets
• Bonds, Stock and Security Financing
History of Money and Accounting
Money
• Barter trade
• Cowry shells
form 1200 B.C. in China till mid 20th century in Africa
• Precious metal coins, banknotes
• Development of banking
• “Plastic money” of today
Development of Accounting
• Babylon, 18th century B.C.
- first organized records kept to account for assets and loans
• Italy, 13th century A.D.
- double-entry bookkeeping
• 20th century A.D.
- international accounting standards US GAAP and IAS/IFRS
Financial Reports and Analysis
Balance Sheet
Assets
Liabilities
Current Assets
Cash and Equivalents
Short-Term Receivables
Inventory
Accruals and Other S/T Assets
Current Liabilities
Short-Term Accounts Payable
Current Tax Payable
Short-Term Loans and Borrowings
Accruals and Other S/T Liabilities
Long-Term Assets
Intangible Fixed Assets
Tangible Fixed Assets
Long-Term Receivables
Long-Term Liabilities
Long-Term Payables
Provisions
Owners’ Equity
Share Capital
Share Premium and Capital Funds
Retained Earnings
Y-T-D Profit (Loss)
Revenue
Material
Production Exp.
Commission
Other Selling Exp.
Cost of Goods Sold
Gross Profit
Marketing
Administration
Office Exp.
Consultants
Depreciation
Other Exp.
Total G&A Expenses
Profit from Operations
Financial Income
Financial Exp.
Net Financial Result
Profit before Tax
Corporate Income Tax
Net Profit
Cash Flow Statement
Ratios and Analyses
• Profitability Ratios
- profit margin
- return on assets (investments), return on equity
• Asset Utilization Ratios
- receivable, inventory, fixed, total assets turnover
- average collection period, days of sales outstanding
• Liquidity Ratios
- current ratio
- quick ratio
• Analyses
- DuPont analysis
- horizontal, vertical, trend
Du Pont Analysis
Forecast and Budget
Budgetting
• Systematic setting of future goals
• Bottom-up or top-down
• Identification of external influence and risks (such as
customers, competition, macroeconomics)
• Identification of external influence and risks (such as
capacity of production and resources, human factor)
• Setting of expected growth (reduction), pipeline,
percent-of-sales, investment planning
Financial Forecasting
• Pro forma income statement
• Revenue (pipeline, funnel, percentage)
• Expenses (variable, fixed)
• Pro forma balance sheet
• A/R, A/P, inventory
• Fixed assets, liabilities, equity
• Pro forma cash flow statement
Operational and Financial Leverage
Fixed and variable expenses
total expenses
$
fixned expenses
0
No. of units produced
Fixed and variable expenses
total expenses
$
fixned expenses
No. of units produced
Break-Even Point
revenue
$
total expenses
fixed expenses
No. of units produced
Break-Even Point
revenue
$
profit
total expenses
fixed expenses
No. of units produced
Break-Even Point
revenue
$
total expenses
fixed expenses
No. of units produced
Operational leverage
• Uses fixed/variable cost
• Can increase profits but increases risk
_
Fixed costs
_
Price – Variable cost per unit
Operational leverage
_
Fixed costs
_
Price – Variable cost per unit
Fixed cost 60.000
Variable cost 0,80 / unit
Unit price 2,00
Fixed cost 12.000
Variable cost 1,60 / unit
Unit price 2,00
60.000/(2,00-0,80) = 50.000
break-even point is
50.000 units
12.000/(2,00-1,60)= 30.000
break-even point is
30.000 units
Financial Leverage
2 firms: exactly the same
• Same sector
• Same opportunities
• Same Management…
The only difference: the debt
• L (leveraged firm) has 50% of debt
• U (unleveraged firm) has no debt
Financial Leverage
Firm U
Firm L
100 000
0
100 000
50 000
50 000
100 000
Number of shares
(Price of a share 100)
1 000
500
EBIT
Financial interests
(interest rate 5%)
Net income before tax
EPS before tax
10 000
0
10 000
2 500
Shares (Capital)
Financial debt
Total
Net income after tax
(Tax rate 33%)
EPS after tax
10 000
10 (10 000/1 000)
6 700
6,70
7 500
15 (7 500/500)
5 000
10,00
Financial Leverage
The shareholder of L has a return of 15 (before tax)
The shareholder of U has a return of 10 (before tax)
What do you prefer?
Financial Leverage
Firm U
Firm L
100 000
0
100 000
50 000
50 000
100 000
Number of shares
(Price of a share 100)
1 000
500
EBIT
Financial interests
(interest rate 5%)
Net income before tax
EPS before tax
0
0
0
2 500
0
0
-2 500
-5
Net income after tax
EPS after tax
0
0
-2 500
-5
Shares
Financial debt
Total
Financial Leverage
The shareholder of L has a return of -5 (before tax)
The shareholder of U has a return of 0 (before tax)
What do you prefer?
Financial Leverage
For leverage to be profitable,
the rate of return on the investment
must be higher than the cost of the borrowed money
Conclusion
Leverage can create value or destroy it
To create value, the IRR must be higher than the cost of
loan; if not, leverage destroys value.
Time Value of Money
Valuation and Rate of Return
Objectives
The valuation of a financial asset is based on the
present value of the future cash flows
The required rate of return in valuing an asset is based
on the risk involved
Bonds
Coupon / zero coupon bonds
Valuation of bonds: present value of future cash inflows
n
P=
Σ
Yt
(1+i)t
t=1
P .. bond price
Y .. Yield
Pn .principal payment at maturity
i .. interest (or expected return)
t .. number corresponding to a period
n ..number of periods
+
Pn
(1+i)n
Stock
Infinite stream of level dividend payments
P=
D1
(1 + r)
1
+
D2
(1 + r)
2
+
D3
(1 + r)
3
+ ... +
D∞
(1 + r)
∞
=
D0
r
Constant growth in dividends
D0 (1 + g)1 D0 (1 + g)2 D0 (1 + g)3
D0 (1 + g)∞
P=
+
+
+ ... +
=
1
2
3
∞
(1 + r)
(1 + r)
(1 + r)
(1 + r)
D .. dividend payment
r .. required rate of return
g ..dividend growth
D1
r-g
Cost of Capital
Cost of Capital
Weighted average of:
- cost of debt (loans, bonds)
- cost of equity (common stock, preferred stock)
Cost of Debt
Interest payment minus tax
Kd = i (1 – t)
Kd .... Cost of debt
i .... Interest paid
t .... corporate tax rate
Cost of Equity
Dividend devided by market price
Ke = D / P0
Ke .... cost of equity
D .... current dividend
P0 .... market price of the stock
If dividends constantly grow, then
Ke = (D / P0) + g
g .... constant growth rate in dividends
Selling costs are to be deducted from price for newly
issued stock