2201AFE Corporate Finance

Week 1:
Introduction to Corporate Finance
Financial Statements, Taxes and Cash Flow
Working with Financial Statements

Readings: Chapters 1, 2 & 3

Agenda
Welcome to the 2201AFE Corporate Finance
Teaching team
Course comments
Assessment key dates

Lecture for this Week
Introduction to Corporate Finance
Financial Statements, Taxes and Cash Flow
Ratio Analysis
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Teaching team

Course Convenor/Lecturer:

Dr Victor Wong
N50_0.48
V.Wong@griffith.edu.au

All emails should insert "2201AFE" at the start of subject.
Without this course code, we will not reply to your email.

Email Subject: 2201AFE (followed by your subject)
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Teaching team

Tutors:

See Staff Information tab in Learning@Griffith



Key success tip:

Remember, your first point of contact is with your tutor!

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Textbook
Title: Fundamentals of Corporate Finance (5
th
edition)
Authors:
Stephen Ross, Massachusetts Institute of
Technology
Mark Christensen, Synergies Consulting
Michael Drew, Griffith University
Spencer Thompson
Randolph Westerfield, University of Southern
California
Bradford Jordan, University of Kentucky
ISBN: 0070284954
Copyright year: 2011
Publisher: Mc-Graw Hill
http://highered.mcgraw-hill.com/sites/0070284954/
information_center_view0/
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Course comments
Key ingredients to success in this course are:
Attend lectures plus your own learning and reading the
textbook.

Consistent tutorial effort, attendance and practicing
questions.

The material builds from week to week, work closely with
your tutor to ensure you are keeping up to date.
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Assessments key dates
4 On-line Quizzes (20% weighting)
5% each; due in weeks 3, 6, 10, 13 (see course profile)

Mid-semester Exam (30% weighting)
1 hour and 30 min on 16 April 2013 during lecture time
Week 1 through Week 5 (Part 1) inclusive.

Final Exam (50% weighting)
2 hours and 30 min during End of Semester Exam Period
Whole of course, while paying some more attention to
concepts covered in Week 5 (Part 2) through Week 13
inclusive.

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Calculators
It is critical for you to acquire a hand held calculator if you do not
own one already.
DO NOT purchase a programmable calculator as this is NOT allowed
in the examinations.
Here are some specifications that will get the job done for this
course:
Scientific calculator; simplicity is encouraged as the more keys you have the
higher the chance of mistakes.
Includes the add, subtract, multiply,
divide functions.
Includes the power and root functions.
Allows you to enclose brackets.
Includes the natural log or ln function.


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Basic Algebra Reminders
Order of Operations: BODMAS
Brackets first then
Other grouping symbols (eg: LN(x), x
a
, x
-1
)
Division and
Multiplication next
Addition and
Subtraction last


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Example




First we have to remove the square bracket
But before that we remove the round bracket by performing
the division
Then the power and subtraction in the square bracket
Multiplication by 5
Addition of 10
Answer = 5.001

10
? 1
10
3
5 10
7
=
(
(

|
.
|

\
|
+
Basic Algebraic Identities and Laws


Example: 3(2+5) = 32 + 35


Example: 9
1/2
= 9


Example: LN(3
2
) = 2*LN(3)

LN means Natural Logarithm with the base of e
LOG means logarithm with the base of 10
Both are on your calculators (LN is used in lecture examples)


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ac ab c b a + = + ) (
x x =
2 / 1
) ( ) ( x LN a x LN
a
=
Basic Algebraic Identities and Laws
Useful Website for Algebra basics:
http://www.themathpage.com/alg/rules-of-algebra.htm

Go to Table of Contents

Select Topic (see for example Section 2 of Topic 9)


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13
1. Introduction & Financial
Statements
2. Time Value of Money
3. Valuing Shares & Bonds
7. Mid-semester Exam
8. Some Lessons from Capital
Market History
11. Financial Leverage & Capital
Structure Policy
13. Options & Revision
9. Return, Risk & the Security
Market Line
5. Making Capital Investment
Decisions & Project Analysis
12. Dividends & Dividend Policy
6. Revision for Mid-sem Exam
4. Net Present Value & Other
Investment Criteria
10. Cost of Capital



Introduction to Corporate Finance

Chapter 1

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Key Concepts and Skills
What is Corporate Finance?
Understand the goals of financial management
The Agency problem
The role of financial markets
Financial Statements
Understanding Cash Flows
Ratio Analysis
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What is Corporate Finance?
Corporate Finance is the study of ways to answer three
important questions:

What long-term investments should the firm take on?

Where will we get the long-term financing to pay for the
investment?

How will we share the rewards if the business is successful?


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Financial Management Decisions
Capital budgeting Investment decision
What long-term investments or projects should the business
take on?

Capital structure Financing decision
How should we pay for our assets?
Should we use debt or equity?

Dividend Dividend decision
Should dividends be paid?
If so, how much?

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The Investment Decision
Capital budgeting is the planning and control of cash
outflows in the expectation of deriving future cash inflows
from investments in non-current assets.

Involves evaluating the:
Size of future cash flows
Timing of future cash flows
Risk of future cash flows

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The Financing Decision
A firms capital structure is the specific mix of debt and
equity used to finance the firms operations.

Decisions need to be made on both the financing mix and
how and where to raise the money.

Working capital management decisions involves managing
day to day activities.


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The Dividend Decision
Involves the decision of whether to pay a dividend to
shareholders or maintain the funds within the firm for
internal growth.

Factors to consider:
Growth opportunities
Taxation
Shareholders preferences


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The Goal of Financial Management
What should be the goal of a corporation?
Survival?
Avoid financial distress and bankruptcy?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the companys stock?
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The Goal of Financial Management
The financial manager of a company makes decisions on
behalf of the shareholders.

Thus the correct goal is to maximise shareholders wealth.

That is, to maximise the value of the existing shares.

Does this mean we should do anything and everything to
maximize owner wealth?


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The Agency Problem
Agency relationship
Principal hires an agent to represent his/her interest.
Shareholders (principals) hire managers (agents) to run the
company.
Agency problem
Conflict of interest between principal and agent.
Agency costs
Direct corporate expenditures that benefit management
but cost shareholders (e.g. purchasing unnecessary
corporate jet).
Indirect lost opportunity (e.g. shareholders think its a good
investment but manager perceive as too risky and fear of
losing their jobs).
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Managing Managers
Managerial compensation
Incentives can be used to align management and shareholder
interests.
The incentives need to be structured carefully to make sure
that they achieve their goal.

Corporate control
The threat of a takeover may result in better management.

Other stakeholders
Governments, suppliers, employees.
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Financial Markets
What is a Market?
A market is the means through which the buyers and sellers
are brought together.

Role of a Financial Market
To channel savings into investments.
Enable sale and purchase of financial assets.

Money vs. Capital markets

Primary vs. Secondary markets

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Financial Markets
Money markets involve the trading of short-term debt securities
(less than 12 months).
Capital markets involve the trading of long-term debt securities
and shares (more than 12 months).
Primary markets involve the original sale of securities (e.g.
Initial Public Offer).
Secondary markets involve the continual buying and selling of
issued securities.
Australian Stock Exchange, New York Stock Exchange, London
Stock Exchange.

For some fascinating reading on how financial markets impact growth and economic
development see Rajan and Zingales, Financial Development and Growth, American Economic
Review, June 1988, pp 559 586
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Financial Statements, Taxes and Cash Flow

Chapter 2

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Balance Sheet
The balance sheet is a snapshot of the firms assets and
liabilities at a given point in time.

Balance Sheet Identity
Assets = Liabilities + Shareholders Equity
Assets Liabilities = Shareholders Equity

Net Working Capital (NWC)
= 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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Balance Sheet
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Current assets

Fixed assets
1. Tangible fixed assets
2. Intangible fixed assets

Current liabilities

Long-term debt

Shareholders equity

Total Value of Assets
Total Value of Liabilities
and Shareholders Equity
Net working
capital
Notes on Balance Sheet
Liquidity
Ability to convert to cash quickly without a significant loss in value.
Liquid firms are less likely to experience financial distress.
But liquid assets earn a lower return.
Trade-off to find balance between liquid and illiquid assets.

Market vs. Book Value
The balance sheet provides the book value of the assets, liabilities and
equity.
Market value is the price at which the assets, liabilities or equity can
actually be bought or sold.
Which is more important to the decision-making process?

Debt vs. Equity
Financial leverage deciding whether to use debt financing?

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Balance Sheet
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U.S. Corporation
2011 and 2012 Balance Sheets
($ in millions)
Assets Liabilities and Owners Equity
2011 2012 2011 2012
Current assets Current liabilities
Cash $104 $160 Accounts payable $232 $266
Accounts receivable $455 $688 Notes payable $196 $123
Inventory $553 $555 Total $428 $389
Total $1,112 $1,403
Long-term debt $408 $454
Fixed assets
Net plant & equipment $1,644 $1,709 Owners equity
Common stock and paid-in surplus $600 $640
Retained earnings $1,320 $1,629
Total $1,920 $2,269
Total assets $2,756 $3,112 Total liabilities and owners equity $2,756 $3,112
Income Statement
The income statement measures the performance of a firm
over a specified period of time.

Revenues Expenses = Income

Matching principle: shows revenue when it is realised and
matches the expenses required to generate the revenue.


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Income Statement
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U.S. Corporation
2012 Income Statement
($ in millions)
Net sales $1,509
Cost of goods sold 750
Depreciation 65
Earnings before interest and taxes 694
Interest paid 70
Taxable income 624
Taxes 212
Net income $412
Dividends $103
Addition to retained earnings 309
The Concept of Cash Flow
Cash Flow (CF) is one of the most important pieces of
information that a financial manager can derive from
financial statements

Cash Flow Identity:
CF from Assets = CF to Creditors + CF to Shareholders

Cash generated from using our assets =
Cash paid to those that finance the purchase of those
assets (Creditors + Shareholders)
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Cash Flow from Assets
CFFA = CFC + CFS outside the company

CFFA = OCF NCS NWC inside the company

Cash Flow From Assets (CFFA)
= Operating Cash Flow (OCF)
Net Capital Spending (NCS)
Changes in Net Working Capital (NWC)
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Cash Flow from Assets
CFFA = OCF NCS NWC inside the company

OCF = EBIT + Depreciation Taxes = $547
694 + 65 212 = 547

NCS = End Net Fixed Assets Begin Net Fixed Assets + Dep. = $130
1,709 1,644 + 65 = 130

NWC = Ending NWC Beginning NWC = $330
1,014 684 = 330

1,403(CA) 389(CL) 1,112(CA) 428(CL)
for 2012 for 2011

CFFA = 547 130 330 = $87
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Cash Flow from Assets
Operating cash flow:
EBIT 694.00
+ Depreciation + 65.00
Taxes 212.00 $547.00
LESS:
Net capital spending:
Ending net fixed assets 1,709.00
Beginning net fixed assets 1,644.00
+ Depreciation + 65.00 $130.00
LESS:
Change in net working capital:
Ending net working capital 1,014.00
Beginning net working capital 684.00 $330.00

Cash Flow from Assets: $87.00
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Cash Flow to Creditors and Shareholders
CFFA = CFC + CFS


CFC = Interest Paid Net New Borrowings


CFFA = CFC + CFS


CFS = Dividends Paid Net New Equity


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Cash Flow to Creditors and Shareholders
CFC = Interest Paid Net New Borrowing = $24
70 46 = 24

Long term Debt: 454 Long term Debt: 408
for 2012 for 2011

CFS = Dividends Paid Net New Equity = $63
103 40 = 63

Common Shares: 640 Common Shares: 600
for 2012 for 2011

CFC + CFS = 24 + 63 = $87
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Cash Flow to Creditors and Shareholders
Cash flow to creditors:
Interest paid 70.00
Net new borrowing 46.00
$24.00
PLUS:
Cash flow to shareholders:
Dividends paid 103.00
Net new equity raised 40.00
$63.00

Cash flow to creditors and shareholders = $87.00

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Cash Flow Identity
CF Identity: CFFA = CFC + CFS

Left side of Identity:
CFFA = OCF NCS NWC = 547 130 330 = $87

Right side of Identity:
CFC + CFS = 24 + 63 = $87


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Cash Flow Summary
1. The Cash Flow identity
Cash flow from assets = Cash Flow to Creditors (bondholders)
+ Cash Flow to Shareholders (owners)

2. Cash Flow from Assets
CFFA = Operating cash flow
Net capital spending
Change in net working capital (NWC)
where:
Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation Taxes
Net capital spending = Ending net fixed assets Beginning net fixed assets
Change in NWC = Ending NWC Beginning NWC

3. Cash Flow to Creditors (bondholders)
CFC = Interest paid Net new borrowing

4. Cash Flow to Shareholders (owners)
CFS = Dividends paid Net new equity raised

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Working with Financial Statements

Chapter 3

43
Three financial statements
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Balance Sheet
______________
Assets
=
Liabilities
+
Equity

Income
Statement
______________
Sales
+ Other Revenues
Expenses
= Profit before tax
Income tax
= Net profit

Cash Flows
Statement
______________
Net cash flows:
+ Operating
+ Investing
+ Financing
= Net change


Sample Balance Sheet
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2012 2011 2012 2011
Cash 696 58 Accounts Payable 307 303
Accounts Receivable 956 992 Notes Payable 26 119
Inventory 301 361 Other Current Liabilities 1,662 1,353
Other Current Assets 303 264 Total Current Liabilities 1,995 1,775
Total Current Assets 2,256 1,675 Long-term Debt 843 1,091
Net Fixed Assets 3,138 3,358 Equity 2,556 2,167
Total Assets 5,394 5,033 Total Liabilities & Equity 5,394 5,033
Sample Income Statement
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Revenues 5,000
Cost of Goods Sold 2,006
Expenses 1,740
Depreciation 116
Earnings Before Interest and Taxes 1,138
Interest Expense 7
Taxable Income 1,131
Taxes 442
Net Income 689
Earnings per share = 3.61
Dividends per share = 1.08 (190.9m shares)
Sources and Uses of Cash Flow
Sources
Cash inflow occurs when we sell something
Decrease in asset account
Accounts receivable, inventory, and net fixed assets
Increase in liability or equity account
Accounts payable, other current liabilities, and common stock
Uses
Cash outflow occurs when we buy something
Increase in asset account
Accounts receivable, and other current assets
Decrease in liability or equity account
Notes payable and long-term debt


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Cash Flow Statement
Statement that summarizes the sources and uses of cash.

Changes divided into three major categories:

Operating Activity includes net income and changes in
most current accounts.

Investment Activity includes changes in fixed assets.

Financing Activity includes changes in notes payable, long-
term debt and equity accounts as well as dividends.


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Cash Flow Statement
Operating activities
+ Net profit
+ Depreciation
+ Any decrease in current assets (except cash)
+ Increase in accounts payable
Any increase in current assets (except cash)
Decrease in accounts payable

Investment activities
+ Ending non-current assets
Beginning non-current assets
+ Depreciation

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Financing activities
Decrease in notes payable
+ Increase in notes payable
Decrease in long-term debt
+ Increase in long-term debt
+ Increase in ordinary shares
Dividends paid
Sample Cash Flow Statement
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Cash, beginning of year 58 Financing Activity
Operating Activity Decrease in Notes Payable (U) -93
Net Income 689 Decrease in LT Debt (U) -248
Plus: Depreciation 116 Decrease in Equity (minus RE) (U) -94
Decrease in A/R (S) 36 Dividends Paid (U) -206
Decrease in Inventory (S) 60 Net Cash from Financing -641
Increase in A/P (S) 4 Net Increase in Cash (1175+104-641) 638
Increase in Other CL (S) 309 Cash End of Year (58+638) 696
Less: Increase in CA (U) -39
Net Cash from Operations 1,175
Investment Activity Change in RE: 689 206 = 483
Sale of Fixed Assets (S) 104 Decrease in Equity: 2,556 2,167 483= -94
Net Cash from Investments 104
Sale of FA: 3,138 3,358 + 116 = -104
Ratio Analysis
Ratios also allow for better comparison through time or
between companies.

Ratios are used both internally and externally.

Be aware!
There is a large number of possible ratios.
Different people compute ratios in different ways.



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Categories of Financial Ratios
Short-term solvency or liquidity ratios
Long-term solvency or financial leverage ratios
Asset management or turnover ratios
Profitability ratios
Market value ratios


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Financial Leverage Ratios
Total Debt Ratio:
Debt / Assets OR D / A OR Liabilities / Assets
Example for 2012: (1,995 + 843) / 5,394 = 0.5261

Debt/Equity Ratio:
Debt / Shareholder Equity OR D / E OR (D/A) / (1-D/A)
Example for 2012: 2,838 / 2,556 = 1.11

Equity Multiplier:
Assets / Shareholder Equity OR A / E OR D / E+1
where A = D + E
Example for 2012: 5,394 / 2,556 = 2.11
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Turnover Ratios
Total Asset Turnover:
Sales / Total Assets
Example For 2012: 5,000 / 5,394 = 0.93

NWC Turnover:
Sales / Net Working Capital
Example For 2012: 5,000 / (2,256 1,995) = 19.2

Fixed Asset Turnover:
Sales / Net Fixed Asset
Example For 2012: 5,000 / 3,138 = 1.6

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Profitability Measures
Profit Margin:
Net Income / Sales
Example: 689 / 5,000 = 13.8%

Return on Assets (ROA):
Net Income / Total Assets
Example: 689 / 5,394 = 12.8%

Return on Equity (ROE):
Net Income / Total Equity
Example: 689 / 2,556 = 26.7%
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Market Value Measures
Market Price for one share = $87.65

# of Shares outstanding = 190.9 m

Market Value (equity)
Market price for one share # of Shares Outstanding
For 2012: 87.65 190.9 = $16,732.4 m

EPS = Earnings per Share or Earnings for 1 share
Net income / # of shares outstanding
For 2012: 689 / 190.9 = 3.61


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Market Value Measures
PE Ratio:
Price per share / Earnings per share
Market value / Earnings
For 2012: 87.65 / 3.61 = 24.28
OR 16,732.4 / 689 = 24.28

Market-to-book Ratio:
Market price per share / Book value per share
Market value of equity / Book value of equity
For 2012: 87.65 / (2,556 / 190.9) = 6.56
OR 16,732.4 / 2,556 = 6.56


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Why Evaluate Financial Statements?
Internal uses
Performance evaluation compensation and comparison
between divisions
Planning for the future guide in estimating future cash
flows

External uses
Creditors
Suppliers
Customers
Stockholders/Shareholders



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Benchmarking
Ratios are not very helpful by themselves; they need to be
compared to something.

Time-Trend Analysis
Used to see how the firms performance is changing through
time.

Peer Group Analysis
Compare to similar companies or with the industry.


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Potential Problems
There is no underlying theory, so there is no way to know
which ratios are most relevant

Benchmarking is difficult for diversified firms

Globalization and international competition makes
comparison more difficult because of differences in
accounting regulations

Varying accounting procedures, i.e. FIFO vs. LIFO

Different fiscal years

Extraordinary events


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Next Week
Next week we examine one of the central tenants of
modern finance the time value of money.

Next week is perhaps the most important lecture of the
course!

Bring your calculators and formula sheets!

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