Todays Agenda

Introduction to Corporate Finance (Chapter 1)

Business Forms
Financial managers
Agency Problems
Financial Statements (Chapter 2, 3)

FNCE 101 Hyun-Soo Choi

Introduction to Finance
(Chapter 1)

FNCE 101 Hyun-Soo Choi

What is Finance?

FNCE 101 Hyun-Soo Choi

What is Finance
Finance studies and addresses the ways in which individuals,
business, and organizations raise, allocate, and use monetary
resources over time, taking into account the risks entailed in
their projects. (from Wikipedia)
Basic areas in Finance
Corporate Finance
Investments
Financial Institutions
International Finance

FNCE 101 Hyun-Soo Choi

Basic Areas in Finance

Investments
.Work with financial assets such as stocks and bonds,
different types of financial derivatives (Option, Future,
Forward, Swap, and)
.Value of financial assets, risk versus return
Financial Institutions
.Companies that specialize in financial matters
.Banks, Insurance companies, Brokerage firms
International Finance
.Studies the dynamics of exchange rates and foreign
investment.

FNCE 101 Hyun-Soo Choi

What is Corporate Finance?

Corporate finance is about
corporations financial decisions.
Then. What is a corporation?
- A form of business organization
- Three major forms.
. Sole proprietorship
. Partnership
. Corporation

FNCE 101 Hyun-Soo Choi

Sole Proprietorship
One person owns the business: No legal Entity
Advantages
Easiest to start

Least regulated

Owner keeps all prots

No agency issues

Disadvantages
Unlimited liability

Limited life of business

Limited capital

Hard ownership transfer

FNCE 101 Hyun-Soo Choi

Partnership
Two or more own the business (partners): Legal Entity
Advantages
Rela?vely easy to start

Less agency issues

More capital available

Income taxed once as personal income

Disadvantages
Unlimited liability
- General partnership
- Limited partnership

Limited life of business

Limited capital

Hard ownership transfer

What is the main problem using the sole proprietorship, or

partnership?
>> hard to make an investment for growing opportunity
FNCE 101 Hyun-Soo Choi

Corporation
Business owned by stockholders: Legal Entity
Advantages
Limited liability

Unlimited life of business

Easier to raise money

Easy ownership transfer

Separa?on of ownership and
management

Disadvantages
Separa?on of ownership and
management: Agency issue

Cost of setup and maintenance
- Complicated regula?ons
- Reports ling

Double taxa?on (Not in Singapore)

FNCE 101 Hyun-Soo Choi

Hybrid forms
Hybrid forms between a partnership and a corporation
Limited Liability Partnerships (LLP)
- Between partnership and corporation
- Closer to partnership (partners)
- All(or some) partners have limited liabilities
- Benefit in taxation
Limited Liability Company (LLC)
- Between partnership and corporation
- Closer to corporation (Shareholders)
- Benefit in taxation
- i.e. private limited company (PTE LTD)

FNCE 101 Hyun-Soo Choi

Separation of Ownership and Control

Shareholders
Board of Directors
Management
- i.e. Chief Executive Officer (CEO), Chief Financial Officer (CFO)

Other Stakeholders
- i.e. Government, Customers, Trade Unions, Owner

FNCE 101 Hyun-Soo Choi

Financial Management Decisions

Capital budgeting (Investment decisions)
- What long-term investments or projects to take on?
- Evaluating the size, timing, and risk of future cash flows

Capital Structure (Financing decisions)

- Structuring long-term financing
i.e. How much capital to raise?
i.e. Equity vs debt?

Working capital management

- Managing short-term assets and short-term liabilities
i.e. Inventory level, cash holding

Payout policies
-Corporate earnings: retain by the company or return to shareholders
-How to return? Dividend payout or stock buybacks

FNCE 101 Hyun-Soo Choi

Flow of cash: Investors and Firm

(1)

(2)

Firm's

Financial

operations

Manager

(4a)

Investors

(3)
(4b)
(1)
(2)
(3)
(4a)
(4b)

Money raised from investors

Money invested in firm to buy real assets
Money generated by real assets
Money reinvested
Money returned to investors
FNCE 101 Hyun-Soo Choi

Objective of Financial Management

What is the basic goal of financial management?
. Maximizing market share?
. Minimizing cost?
. Avoid bankruptcy/survive as long as possible?
. Maximizing profit?
. Maximize shareholder value?

FNCE 101 Hyun-Soo Choi

Objective of Financial Management

What is the basic goal of financial management?
. Maximizing market share?
. Minimizing cost?
. Avoid bankruptcy/survive as long as possible?
. Maximizing profit?
. Maximize shareholder value?
The primary financial goal is shareholder wealth maximization,
which translates to maximizing stock price.

FNCE 101 Hyun-Soo Choi

Stock price maximization & profit maximization

Are they same? No.
Generally high correlation among
stock price, earning per share(EPS), and cash flow.
Current stock price relies upon current earnings, as well as
future earnings and cash flow.
Some actions may cause an increase in earnings, yet cause
the stock price to decrease (and vice versa).

FNCE 101 Hyun-Soo Choi

Factors that affect stock price

- Projected cash flow to shareholders
- Timing of the cash flow stream
- Riskiness of the cash flows

CF1
CF2
CFn
Value =
+
++
1
2
n
(1+ k) (1+ k)
(1+ k)
n

CFt
=
.
t
t=1 (1+ k)
FNCE 101 Hyun-Soo Choi

Agency Problems
Do managers really maximize shareholder wealth?
Agency problems represent the conflict of interest
> Principal hires an agent to represent their interest
> Stockholders (principals) hire managers (agents) to run the company

> Managers do not always act in the best interests of shareholders, and
they sometimes make decisions that destroy shareholder value.

FNCE 101 Hyun-Soo Choi

Shareholder-Management Conflict
Choice of effort
: Manager prefer less effort to more, all else constant.
: Interested more in personal perks rather
i.e. Corporate Jet, empire building

than enhancing share value

Risk exposure
: Managers are exposed to high idiosyncratic risk.
- Substitute low variance for high variance assets
- Over-retain liquid funds and cash reserves
- Keep leverage too low
- Keep dividend payout too low

Differential horizon
: Managers have a shorter horizon than stock holders
- Focus more on short-term earnings rather than long-term value enhancing
FNCE 101 Hyun-Soo Choi

Solution to the Agency Problem

Managerial compensation plans
- stock and options
Direct Intervention / Monitoring
- The Board of Directors & Lenders & Specialists
- The threat of firing
The threat of takeover
Legal and Regulatory Requirements

FNCE 101 Hyun-Soo Choi

Corporate Scandals & SOX

# WorldCom 2001
- Report $3.8 billion of operating expenses as investment and overstated
the income
- Assets: 103.9 Billion

# Enron 2001
- Concealed $1.7 billion losses
- Assets: 65.5 Billion

# Sarbanes-Oxley Act of 2002

The public Company Accounting Reform and Investor Protection Act of 2002

Which was the largest bankruptcy in the history?

FNCE 101 Hyun-Soo Choi

Financial Statements
(Chapter 2, 3)

FNCE 101 Hyun-Soo Choi

Major Financial Statements

The Balance Sheet
The Income Statement
The Statement of Cash Flows (not covered)

FNCE 101 Hyun-Soo Choi

The Balance Sheet

A Snapshot of the firm at a given point in time.
The Left-hand Side: Assets
- Current asset / Fixed asset (Tangible & Intangible)
- Listed in order of decreasing liquidity
> Ease of conversion to cash
> Without significant loss of value

The Right-hand Side: Liabilities and Equity

- Liabilities
> Current liabilities / Long-term liabilities

- Stockholders Equity

Balance Sheet Identity

Assets = Liabilities + Stockholders Equity
Stockholders Equity = Assets Liabilities
Shareholders are residual owners
FNCE 101 Hyun-Soo Choi

Example: The Balance Sheet

FNCE 101 Hyun-Soo Choi

The Income Statement

A Video of the firms operation for a specified period of time.
Income Statement Identity
* Revenues Expenses
= Earnings before interest and taxes (EBIT)
: what firm would have earned if not for obligations to its creditors and the tax authorities.

* EBIT- interest expense = Taxable Income

* Taxable Income Taxes = Net Income
* Net Income = Retained earnings + Dividend payout
* Earning per share (EPS)

FNCE 101 Hyun-Soo Choi

Example: The Income Statement

FNCE 101 Hyun-Soo Choi

Tax Rates: Marginal and Average

U.S. Corporate Tax Rates

FNCE 101 Hyun-Soo Choi

Example: Marginal & Average Tax Rates

Marginal tax rate
: the percentage paid on the next dollar earned
Average tax rate
: the tax bill / taxable income
Suppose your firm earns $200,000 in taxable income.
- What is the marginal tax rate?
- What is the average tax rate?
If you are considering a project that will increase the firms
taxable income by $100,000, what tax rate should you use in
your analysis?

FNCE 101 Hyun-Soo Choi

Ratio Analysis
There are five traditional categories of ratios:
1. Liquidity (Short-term solvency) ratios
2. Leverage (Long-term solvency) ratios
3. Asset management (efficiency or turnover) ratios
4. Profitability ratios
5. Market value ratios

Each category measures a different dimension of a firms

performance (i.e. strengths & weaknesses).

Relative measures to interpret firm performance

- comparison through time or between companies
FNCE 101 Hyun-Soo Choi

Ratio Analysis (cont)

As we look into each ratio,
ASK yourself
1) what the ratio is trying to measure
2) Why is that information important

FNCE 101 Hyun-Soo Choi

1. Liquidity (Short-term solvency) ratios

How well can the firm pay its bills over the short run without
undue stress
> High liquidity ratio => liquidity
> But, too high => the firm is inefficient
a. Current ratio = Current assets / Current liabilities
b. Quick ratio = (Current assets Inventory) / Current liabilities
c. Cash ratio = Cash / Current liabilities

FNCE 101 Hyun-Soo Choi

2. Leverage (Long-term solvency) ratios

Measures the firms long-term ability to meet its obligations
> Too high of a ratio may lead to financial distress
> Too low of a ratio may indicate the firm is not utilizing all
the benefits of debt
Total debt ratio = (Total assets - Total equity) / Total assets
# Debt-equity ratio = Total debt / Total equity
# Equity multiplier = Total assets / Total equity
= 1+ Debt-equity ratio

FNCE 101 Hyun-Soo Choi

3. Asset Management (turnover) ratios

How efficiently does the firm use its assets to generate sales
> Normally, higher ratio means efficiency
a. Inventory turnover = Cost of goods sold / Inventory
b. Total asset turnover = Sales / Total assets

FNCE 101 Hyun-Soo Choi

4. Profitability ratios
How well the firm is able to control expenses and generate
revenue
a. Profit margin = Net income / Sales
b. Return on assets (ROA) = Net income / Total assets
c. Return on equity (ROE) = Net income / Total equity
* ROE > ROA ?

FNCE 101 Hyun-Soo Choi

Analysis : ROE and ROA

Note that
ROE

= Net income / Total Equity

= (Net income /Total assets) * (Total assets / Total equity)
= ROA * Equity Multiplier = ROA * (1+Debt-equity ratio)

If debt=0, ROE=ROA.
If debt>0, ROE>ROA.

FNCE 101 Hyun-Soo Choi

5. Market value ratios

Earning per share = Net income / Share outstanding
a. Price-Earning ratio (PE) = Price per share / Earning per share
b. Market-to-book ratio (M/B) =Price-to-book ratio (P/B)
= Market value per share / Book value per share
- Book Value is based on historical cost of assets
- Market Value measures current value of assets and liabilities.
- Market Value is forward looking and it reflects a firms
potential growth.
* Where to get Book Value and Market Value?
FNCE 101 Hyun-Soo Choi

PE and PB ratios

FNCE 101 Hyun-Soo Choi

PE ratios
Robert Shillers calcula?on for current S&P 500 PE Ra?o

FNCE 101 Hyun-Soo Choi

Example
Company ABC has a return on equity of 0.1 and a leverage
(Assets / Equity) of 2. A private equity firm takes it over, sells
25% of ABCs assets to buy back its shares, therefore reducing
ABCs equity by the same dollar amount, and this also results
in a 10% reduction in net profit. All other relevant data are
unchanged. What is ABCs new leverage?

Let Assets be A. Then Equity=A/2 and Liability=A/2. Assets

reduced by 25% and all of the reduction came from equity.
So new Assets= *A, new equity=1/4*A, and new liability=A/
2. So the new leverage is new assets / new equity = 3.

FNCE 101 Hyun-Soo Choi

Du Pont Identity
ROE

= Net income / Total equity

= (Net income / Total assets) * (Total assets / Total equity)
= (Net income / Sales) * (Sales / Total assets)
* (Total assets / Total equity)
= Profit margin * Total asset turnover * Equity multiplier

Three components:
Operating efficiency (profitability)
Asset use efficiency
Financial leverage

FNCE 101 Hyun-Soo Choi

The Effect of Leverage on EPS and ROE

How does leverage affect the EPS and ROE of a firm?
Debt financing=> increase the fixed interest expense
In a good year, we pay the fixed interest expense and we
have more left-over for stockholders
In a bad year, we we still have to pay the fixed interest
expense and we have less left-over for stockholders
Leverage amplifies the variations in both EPS and ROE

FNCE 101 Hyun-Soo Choi

Example: The effect of Leverage

Lets ignore taxes.
What happens to EPS and ROE when we issue debt and buy
back shares of stock?
Proposed

Current
Assets
Debt
Equity
Debt/Equity Ratio
Share Price
Shares Outstanding
Interest rate

$8,000,000

$8,000,000

$0

$4,000,000

$8,000,000

$4,000,000

$20

$20

400,000

200,000

10%

10%

FNCE 101 Hyun-Soo Choi

Example: The effect of Leverage (Cont)

Proposed Capital Structure: Debt = $4 million , Equity = $4 million

EBIT

Recession

Expected

Expansion

$500,000

$1,000,000

$1,500,000

400,000

400,000

400,000

$100,000

$600,000

$1,100,000

ROE

2.50%

15.00%

27.50%

EPS

$0.50

$3.00

$5.50

Interest
Net Income

FNCE 101 Hyun-Soo Choi

Example: The effect of Leverage (Cont)

Variability in ROE
- Current: 6.25% to 18.75%
- Proposed: 2.50% to 27.50%
Variability in EPS
- Current: $1.25 to $3.75
- Proposed: $0.50 to $5.50

Thus, financial leverage increased the variability in

ROE and EPS.

FNCE 101 Hyun-Soo Choi

Potential Problems using Ratios

- 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
- Different fiscal years
- Extraordinary events

FNCE 101 Hyun-Soo Choi

Simple Interest vs. Compound Interest

FNCE 101 Hyun-Soo Choi

Simple Interest vs. Compound Interest

Simple Interest
: Interest earned only on original investment, not on interest
Compound Interest
: Interest earned on both original investment and interest
: Reinvesting the interest from original investment
By default, we use Compound Interest in this course.

FNCE 101 Hyun-Soo Choi

Example: Compound Interest

Suppose you have $100 to save in the bank for two years.
How much will you get after two years?
1) The bank pays 10% simple interest.

2) The bank pays 10% compound interest.

FNCE 101 Hyun-Soo Choi

Example: Compound Interest (Cont)

Simple Interest

Compound Interest

Investment Interest

Total

Investment Interest

Total

1 year

100

10

110

100

10

110

2 year

100

20

120

110

11

121

3 year

100

30

130

121

12.1

133.1

4 year

100

40

140

133.1

13.31

146.41

5 year

100

50

150

146.41

14.641

161.051

10 year 100

100

200

259.37

30 year 100

300

400

1744.94

50 year 100

500

600

11739.08

Compound interest is always higher than simple interest.

We ALWAYS use COMPOUND interest in this class!!!

FNCE 101 Hyun-Soo Choi

Number of Compounding Periods

* Going back to the previous example:
Invest $100 at 10% interest rate for 2 years
1) Annual Compounding:

100 (1+ 0.10)2 = 121

0.10 24
) = 122.039
2) Monthly Compounding: 100 (1+
12

3) Daily Compounding:

100 (1+

0.10 730
)
= 122.14
365

4) Continuous Compounding

FNCE 101 Hyun-Soo Choi

Next Class
Bring financial calculator
Bring name card

FNCE 101 Hyun-Soo Choi