FINS3625

Applied Corporate Finance

Lecture 1 (Chapters 1 & 18) Jared Staneld February 29, 2012

Why Study Finance?

Other than its awesome of course Individuals are taking charge of their personal nances with decisions such as:
When to start saving and how much to save for reSrement Whether a car loan or lease is more advantageous Whether a parScular stock is a good investment How to evaluate the terms for a home mortgage

Why Study Finance?

In your business career, you may face such quesSons such as:
Should your rm launch a new product? Which supplier should your rm choose? Should your rm produce a part or outsource producSon? Should your rm issue new stock or borrow money instead? How can you raise money for your start-up rm?

Why Study Finance?

Financial Management
The nancial manager plays a criScal role inside any business enterprise. PotenSal decisions include:
What products to launch How to pay to develop those products What prots to keep and how to return prots to investors

The nancial manager does all of this with the goal of maximizing the value of the rm.

The Types of Firms

1. Sole Proprietorships 2. Partnerships 3. Limited Liability Companies or CorporaSons

The Types of Firms

Sole Proprietorship
Straigh[orward and many new businesses use this organizaSonal form Principal limitaSon is that there is no separaSon between the rm and the owner
The rm can have only one owner

The Types of Firms

Sole Proprietorship
The owner has unlimited personal liability for any of the rms debts The life of a sole proprietorship is limited to the life of the owner It is dicult to transfer ownership of a sole proprietorship

The Types of Firms

Partnership
All partners are liable for the rms debt
A lender can require any partner to repay all the rms outstanding debts.

The partnership ends on the death or withdrawal of any single partner

The Types of Firms

Partnership
A limited partnership is a partnership with two kinds of owners, general partners and limited partners
General partners
Have the same rights and privileges as partners in any general partnership Are personally liable for the rms debt obligaSons

Limited partners
Have limited liability and their ownership interest is transferable They have no management authority

The Types of Firms

Limited Liability Companies or CorporaSons
- Limits the owners liability to their investment in shares The owners cannot be held personally liable for the rms debts Companies may be private limited companies or public limited companies

The Types of Firms

Features of CorporaSons
A corporaSon (or company) is a legally dened, arScial being, separate from its owners. It has many of the legal powers that people have.

The Types of Firms

CorporaSons
A corporaSon is solely responsible for its own obligaSons The owners of a corporaSon are not liable for any obligaSons the corporaSon enters into The corporaSon is not liable for any personal obligaSons of its owners

The Types of Firms

FormaSon of a CorporaSon
Must be legally formed
A legal document (or corporate chareter) is created on formaSon of the company Corporate charter species the iniSal rules that govern how the corporaSon is run More costly than se_ng up a sole proprietorship

The Types of Firms

Ownership of a CorporaSon
No limit on the number of owners The enSre ownership stake of a corporaSon is divided into shares The collecSon of all the outstanding shares of a corporaSon is known as the equity of the corporaSon

The Types of Firms

Ownership of a CorporaSon
An owner of a share in the corporaSon is known as a shareholder, stockholder, or equity holder Shareholders are enStled to dividend payments
Usually receive a share of the dividend payments that is proporSonal to the amount of stock they own

No limitaSon on who can own its shares

The Types of Firms

Tax ImplicaSons for Corporate EnSSes
A corporaSons prots are subject to taxaSon separate from its owners tax obligaSons. Shareholders of a corporaSon pay taxes twice
The corporaSon pays tax on its prots When the remaining prots are distributed to the shareholders, the shareholders pay their own personal income tax on this income

The Types of Firms

S CorporaSons in the US
The rms prots/losses are not subject to corporate taxes
Instead prots/losses are allocated directly to shareholders based on their ownership share Shareholders must include these prots as income on their individual tax returns, even if no money is distributed to them

The Types of Firms

C CorporaSons in the US
Most corporaSons in the US are C corporaSons. Must pay corporate taxes on its prots.
Since individuals must pay personal income taxes on these dividends, shareholders in such corporaSons eecSvely must pay taxes twice

Table 1.1 CharacterisScs of the Dierent Types of Firms

The Financial Manager

The nancial manager has three main tasks:
Make investment decisions Make nancing decisions Manage cash ow from operaSng acSviSes

The Financial Manager

Making Investment Decisions
The nancial manager must weigh the costs and benets of each investment or project They must decide which investments or projects qualify as good uses of the shareholders money

What is the investment decision-making rule you learned in FINS1613?

NPV What is it? Well talk about capital budgeSng and M&A at the end of the semester

NPV Pixies Example

Lets say your friend, a fan of the hugely influential band The Pixies, wants to make a documentary about the group to submit to Sundance Film Festival She needs to borrow $28,000 from you, but promises to pay you back $29,000 in one year Given the interest rate offered by ING is 2.5% for a year, should you lend your friend the money? (assume the investment is guaranteed or risk free)

Pixies Example Solution II

The Financial Manager

Making Financing Decisions
The nancial manager must decide whether to raise more money from new and exisSng owners by selling more shares (equity) or to borrow the money instead (bonds and other debt) Anyone remember M&M? Why would you choose equity over debt? Debt over equity?

The Financial Manager

Cash for Treasury Management
The nancial manager must ensure that the rm has enough cash on hand to meet its obligaSons at each point in Sme This job is also known as managing working capital Wont get to this this semester, but it would be worthwhile to review the chapter.

The Financial Manager

The Goal of the Firm
The overriding goal of nancial management is to maximize the wealth of the shareholders

Why is this important?

The Financial Managers Place in the CorporaSon

Shareholders own the corporaSon but rely on nancial managers to acSvely manage the corporaSon
The board of directors and the management team headed by the CEO possess direct control of the corporaSon

Figure 1.1 The Financial FuncSons Within a CorporaSon

The Financial Managers Place in the CorporaSon

Ethics and IncenSves in CorporaSons
Agency Problems
When managers put their own self-interest ahead of the interests of those shareholders

The CEOs Performance

When the share price deteriorates:
The board of directors might react by replacing the CEO A corporate raider may iniSate a hosSle takeover

Goals of Long-Term Financial Planning

IdenSfy important linkages
Sales, costs, capital investment, nancing, etc.

Analyze the impact of potenSal business plans Plan for future funding needs

18.2 ForecasSng Financial Statements: The Percent of Sales Method

A forecasSng method that assumes that balance sheet and income statement items grow proporSonately with sales.
Percent of sales remains constant in future periods. Forecasts of balance sheet and income statement items are made as a percent of the expected sales gure for that period.

ForecasSng Example

Brej McKenzie decides to give up the dream and start working for Corporate America as a sign holder. Brej is tasked to come up with a Pro-Forma forecast of the income statement and balance sheet.

2011 Income Statement and Balance Sheet

ForecasSng Financial Statements: The Percent of Sales Method

Murray decides to help out Brej and forecasts a 12% growth in sales from 2011 to 2012. For now, assume interest expense remains the same as 2011. The retenSon raSo (the percentage of net income that is re-invested in the company) is currently 10%

Pro Forma Financial Statements

18.2 ForecasSng Financial Statements: The Percent of Sales Method

Making the Balance Sheet Balance: Net New Financing

Management will need to choose new funding
Debt or equity. Complicated issues involved are covered in Chapter 16.

If debt is chosen, it will change the interest assumpSon on the pro forma income statement.

Changing AssumpSons
Problem
Jemaine Suggests that Brej increase the retenSon raSo so they can avoid pawning o some of their stu to make up the dierence.

Changing AssumpSons

NegaSve Net New Financing

ForecasSng the Balance Sheet
When we forecast L+E>A, excess cash is available
OpSons:
Build extra cash reserves ReSre debt Distribute excess as dividends Repurchase shares

When L+E<A, addiSonal nancing is needed

Net New Financing

When a company is growing faster than it can nance internally, any distribuSons to shareholders will cause it to seek greater addiSonal nancing. It is important not to confuse the need for external nancing with poor performance. Most growing rms need addiSonal nancing to fuel that growth as their expenditures for growth naturally precede their income from that growth. Well talk about this in a bit

ForecasSng Financial Statements: The Percent of Sales Method

Choosing a Forecast Target

Target specic raSos that the company wants or needs to maintain.
Debt covenants to maintain liquidity or interest coverage

Investment, payout, and nancing decisions are linked together

Financial managers must balance these decisions Careful forecasSng helps see consequences

Growth and Firm Value

Not all growth is worth the price.
It is possible to pay so much for the growth that the rm value declines. Other aspects of growth can leave the rm less valuable:
May strain managers ability to monitor. May surpass the rms distribuSon capabiliSes, quality control or change percepSons of the rm and its brand.

Growth and Firm Value

! Net Income " Internal Growth Rate = % & (1 payout ratio ) ' Beginning Assets ( = ROA retention rate
(Eq. 18.4)

Sustainable Growth Rate

! Net Income " =% & (1 payout ratio ) (Eq. 18.5) ' Beginning Equity ( = ROE retention rate

Internal and Sustainable Growth Rates and Payout Policy

Problem:
Your rm has $100 million in equity and $40 million in debt and forecasts $18 million in net income for the year. It currently pays dividends equal to 25% of its net income. You are analyzing a potenSal change in payout policythe eliminaSon of the dividend. How would this change aect your internal and sustainable growth rates?

Internal and Sustainable Growth Rates and Payout Policy

SoluSon: Plan:

Internal and Sustainable Growth Rates and Payout Policy

Plan (contd):

Internal and Sustainable Growth Rates and Payout Policy

Execute:

Internal and Sustainable Growth Rates and Payout Policy

Evaluate:

Summary of Internal Growth Rate Versus Sustainable Growth Rate

18.4 Growth and Firm Value

Internal and sustainable growth rates are useful but they cannot tell you whether your planned growth increases or decreases the rms value.
They do not evaluate future costs and benets of the growth. Growth greater than sustainable growth rate is not bad as long as it is value increasing.
Your rm will need to raise addiSonal capital to nance the growth.