1.

Introduction

MIF / MIM | Corporate Finance / Financial Management | 2022/2023

Summary
I. The Financial Paradigma of the Firm

II. Review of Main Concepts

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I. The Financial Paradigm of the Firm
• What is the main objective of a firm/corporation?

Create Value

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 But...
Value of what?
Which value?

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Value
• Different kinds of value
• Equity Value

• Enterprise Value

• Firm Value

• Different measures
• Accounting/Book Value
• Fundamental/Intrinsic Value

• Market Price (usually, referred as market value)

• Liquidation Value

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Which Values?
• Equity Value vs. Enterprise Value vs. Firm Value
• A company balance sheet can be split in:

Fixed Assets Equity

Assets

“Current/Daily” Assets
(daily business assets) Debt

Liabilities
(Interest bearing liabilities)

Non-Operating Assets Non-interest bearing

liabilities

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Which Values?
• Equity Value vs. Enterprise Value vs. Firm Value
• A company balance sheet can be re-arranged:

Fixed Assets Equity

Equity
value

Enterprise Firm
Working Capital value
value
(current assets less non-
interest bearing liabilities)
Debt

Non-Operating Assets

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Which Values?
• Equity Value vs. Enterprise Value vs. Firm Value
• A company balance sheet can even be re-arranged as:

Fixed Assets Equity

Equity
value

Enterprise
Working Capital
value Net Debt
(current assets less non-
interest bearing liabilities) (debt less non-operating assets)

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Which Values?
• Equity Value vs. Enterprise Value vs. Firm Value
• An example, using accounting/book values

Balance Sheet of Unilever at end of December 2019

(million USD)

Shareholders’ Equity:
Current Assets:
Common Stock € 554
Cash and cash equivalents € 4,185
Retained profit
Equity 18,212
Trade and other current receivables 6,695
Other (4,880)
Inventories 4,164
Total Shareholders’ Equity: 13,886
Other financial assets 907
Assets held for sale 82 Current Liabilities:
Current and deferred tax assets 1,733 Trade payables € 14,768
Total current assets 17,766 Deferred tax liabilities 3,653
Liabilities held for sale 1
Property, plant and equipment, net 12,062 Financial Liabilities 4,691
Goodwill 18,067 Total current liabilities 23,113
Intangible assets, net 12,962 Financial Liabilities 23,566
Financial Assets 874 Pensions liabilities 2,618
Other non-current assets 3,075 Provisions 1,284
Other non-current liabilities 339
Total assets € 64,806 Total liabilities € 50,920

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Which Values?
• Equity Value vs. Enterprise Value vs. Firm Value
• An example, using accounting/book values

Balance Sheet of Unilever at end of December 2019 (re-arranged)

(million USD)

Fixed Assets € 43,091 Shareholders’ equity €13,886

Common stock € 554
Property, plant and equipment, net 12,062 Equity
Goodwill 18,067 Retained profit 18,212
Intangible assets, net 12,962 Other (4,880)

Currents Assets € 19,852 Debt € 28,257

Trade and other current receivables 6,695 Current Debt 4,691
Inventories 4,164 Long-term debt 23,566
Current and deferred tax assets 1,733
Other non-current assets 3,075
Current liabilities € 22,662
Cash and cash equivalents (?) 4,185 Trade payable € 14,768
Deferred tax liabilities 3,653
Non-operating assets, net € 1,862
Provisions 1,284
Financial Assets 1,781
Assets held for sale, net 81 Other non-current liabilities 339
Pensions liabilities 2,618

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 Which Values?
• Equity Value vs. Enterprise Value vs. Firm Value
• An example, using accounting/book values

Unilever Book Values at end of December 2019

Investments Financing
(million USD)

Fixed Assets Equity

€ 43,091 € 13,886
Enterprise
value
Firm
value
Working Capital
(Current assets less current liabilities)
Debt
- € 2,810
€ 28,257
Non-Operating Assets (net Debt = € 26,395)
€ 1,862

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Different measures of values

Information Information
Market Price
Accounting Market efficiency
standards

Book Value Value Fundamental

Value

Accounting
standards Liquidation Goodwill
Value

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 Different measures of values
• Book/Accounting Value

Investments Financing
(million USD)

Fixed Assets Equity

€ 43,091 € 13,886
Enterprise
value
Firm
value
Working Capital
(Current assets less current liabilities)
Debt
- € 2,810
€ 28,257
Non-Operating Assets (net Debt = € 26,395)
€ 1,862

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 Different measures of values
• Fundamental/Intrinsic Value

Investments Financing ¥
FCFEi
EqV = å
i =1 (1 + re )
i

Equity
Fixed Assets
¥
FCFFi
EV = å
i =1 (1 + ra )
i

Net Debt
(Debt less Non-
Operating Assets)
Working Capital n
Ci N
D=å + - MVNOA
i =1 (1 + rd ) (1 + rd )
i n

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Different measures of values
• Market Price

Investments Financing
Nº of shares x Share
Price = Market
Capitalization

Equity
Fixed Assets

E + net D

Net Debt
(Debt less Non- (Nº of bonds x
Operating Assets) Bonds Price) -
Working Capital MVNOA

When financial markets are efficient, market price can be used as a proxy of
the fundamental value (i.e., the real market value)

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Different measures of values
• Liquidation Value
• The value which would be obtained if all assets were sold, and debt and all
liabilities were paid back;

• Anytime the liquidation value is persistently higher than the financial

value, the company will be worth more “dead” than staying “alive”, for its
shareholders.

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Back to our question...

The main objective of a

firm is to create value

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Which investors?
• … But create value to whom?
• The shareholders?

The goal of financial management is to maximize the

value of the owners’ equity
Ross, Westerfield and Jaffe, Corporate Finance (9thEdition)

• All stakeholders?

The objective in conventional corporate financial theory is to maximize the

value of the firm
Aswath Damodaran, Corporate Finance, Theory and Practice (2nd Edition)

Are these objectives compatible?

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Stakeholders
• Stakeholders: all individuals or entities affected by the firm's actions,
objectives and policies

• Take into consideration the actual reality of the activity of the firm

Shareholders

Creditors Managers Society

Financial Markets

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Stakeholders

Shareholders
Shareholders have little control
over managers, who thus might
place their own interests above
shareholders´ interests.

Managers

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Stakeholders

Because creditors cannot

control management, they
will be exposed to the risk
of wealth expropriation by
managers or shareholders.

Creditors Managers

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Stakeholders

Managers

Managers might manipulate

information in order to misinform
the markets. Markets can also be
wrong.
Financial Markets

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Stakeholders

Managers Society

Firms might jeopardize the

interests of society as a
whole and those costs might
be difficult to allocate to firms
(e.g. pollution).

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The objective of a firm
• What type of value should a firm maximize?

Objective: Maximize Firm/Enterprise Value

Reduction or elimination of conflicts
(Subject to complying with the ethical values related to the costs that
between the firm/management and
might be imposed on society by meeting this objective) society.

If conflicts of interest between shareholders and creditors and other

stakeholders are eliminated or at least minimized.

Objective: Maximize shareholders Wealth

If managers do not attempt to cheat or manipulate the markets and

markets are efficient.

Objective: Maximize Equity Price

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The objective of a firm
• What type of value should a firm maximize?
• Even though the main objective of the firm is to maximize firm value,
value creation may be measured by changes in stock prices, providing
that:
• Creditors are protected against the risk of wealth expropriation by shareholders;
• Management decisions do not impose costs (externalities) on society;
• Managers do not manipulate information and do not succeed in cheating the
markets (efficient markets).

Briefly: providing that agency conflicts are minimized.

• If so, share market price can be used to monitoring if managers act in the interest
of shareholders, and so
• Manager, can adopted as objective the maximizing stock prices;

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The objective of a firm
... But, what about

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The objective of a firm
... But, what about

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How to create value?

Objective: Maximizing Firm (Market) Value

Investment Decisions Financing Decisions Dividend Decisions

Invest in assets offering a
return higher than the
required rate of return
[hurdle rate].
Find the optimal capital mix
to finance investments and
the nature of debt which
better meets the needs of
the corporation.
Return to shareholders any
cash exceeding investments
offering a return higher
than the expected rate of
return.

The hurdle rate The return on The optimal mix The nature of How much cash Dividend policy
must reflect the the asset must of equity and debt depends to return will will depend on
investment risk take into debt maximizes on the depend on shareholders
and the consideration enterprise value characteristics present and preference for
financing mix. the amount and of the future cash or stock
timing of cash- enterprise investment dividends.
flows assets opportunities

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How to create value?

Further readings
• Ross, Westerfield and Jaffe; Corporate Finance, McGraw-Hill Irwin, 9th
edition (2010) – Chapter 1

• Damodaran; Theory and Practice, Wiley, 2nd Edition (2001) – Chapters 1

and 2

• Jensen; Value Maximization, Stakeholder Theory, and the Corporate

Objective Function, Harvard Business School (2000)

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Summary
I. The Financial Paradigma of the Firm

II. Review of Main Concepts

30
II. Review of Main Concepts

• Earnings vs. Cash-Flows

• Discounted and Future values

• Measuring returns
• Expected return and Price

• Required return and Value

• Historical return

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Earnings vs. Cash-Flows

• The income statement

• Apple 2019 Income Statement

Net Revenues 260,174

Cost of Sales 161,782
Gross Margin 98,392
Selling, general and administrative costs 18,245
• The importance of
Research and development costs 16,217 financial analysis;
Operating income (EBIT) 63,930
Interest and dividend income 4,961 • Earnings (net profit,
Interest expense (3,576) EBIT and EBITDA) vs.
Other income/(expense), net 422
Net Financial Income/(Expense) 1,807 cash-flows;
Profit before taxes 65,767
Tax expense/(income) 10,481
Net Income 55,256

$ Million

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Discounted and Future values

• Discounted value;
• It allows comparing cash-flows obtained in different periods of time;

FVn
PV ´ (1 + r ) = FVn
n
PV =
(1 + r ) n

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Discounted and Future values

• The value of any asset is the present value of expected cash

flows on it
n
CFi CF1 CF2 CFn
V0 = å = + + ... +
i =1 (1 + r ) i
(1 + r ) (1 + r ) 2
(1 + r ) n

• Where:
• V0 → the value of an asset;
• Cfi → cash-flow of period i;
• r → the discount rate reflecting the riskness of the cash flows.

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Discounted and Future values

• Some Math
• An annuity
• A constant CF that occurs at constant intervals for a limit period of time (n)

n CF é1 - (1 + r )- n ù
V0 = å = CF ê ú
i =1 (1 + r )
i
ë r û

• A (constant) growing annuity

• A CF that grows at a constant rate (g)–lower than r–for a limit period of
time (n): 𝐶𝐹!"# = 𝐶𝐹! 𝑥(1 + 𝑔)
n
CFi é1 - (1 + r )- n x(1 + g )n ù
V0 = å = CF1 ê ú
i =1 (1 + r ) r-g
i
ë û

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Discounted and Future values

• Some Math
• A perpetuity
• A constant CF that occurs at constant intervals forever

¥ CF CF
V0 = å =
i =1 (1 + r )
i
r

• A (constant) growing perpetuity

• A CF that grows at a constant rate (g)–lower than r–forever

𝐶𝐹!"# = 𝐶𝐹! 𝑥(1 + 𝑔)

¥
CFi CF1
V0 = å =
i =1 (1 + r ) r-g
i

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Measuring returns

• Expected return (rexp) and Price (P)

• Expected return
• Similar to internal rate of return (IRR), i.e., the rate of return that equals
the value of an investment to its market price or cost;
• It is a function of the price (or cost) of the investment and of the future
cash-flows to be generated by that investment (as also as of the timing of
those cash-flows);

• Cash-flows are uncertain, reason why the expected rate of return is also
uncertain (uncertainty = risk, must be measured, so that it may be taken
into consideration in the estimation of risk premiums to be inclued in the
estimation of required rates of return).

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Measuring returns

• Expected return (rexp) and Price (P)

• The random nature of the expected rate of return requires that a
probability distribution is assigned to it:
• It is generally accepted that the returns of financial assets follow a normal probability
distribution; therefore, any financial asset can be fully represented by its average
(more precisely the expected) return and the standard deviation (or variance) of its
probability distribution.

• Example
• Alphabet share price forecast based on analyst recommendations (Yahoo finance)
• Mean Target: 1,699.84
• High Target: 1,975.00
• Low Target: 1,420.00
• No. of Brokers: 14

• Actual Share Price (28.08.2020): 1,634.33 [Expected return = (1,699.84/1,634.33)- 1 = 4.0%)

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Measuring returns

• Required return (rreq) and Value (V)

• Required return
• Rate of return required by an investor to buy/invest in a specific asset

• It allows the determination of the value of an investment;

• It is equal to the risk-free rate of return* plus a risk premium which must
be a function of the degree of uncertainty affecting the investment future
cash-flows.
Shareholders – Systematic Risk (CAPM)

Risk free rate + Risk premium

Debtholders – Credit Risk (ratings)

* the rate of return (interest) an investor would get if investing in an risk-free asset (return is certain)

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Measuring returns

• Historical return
• A performance evaluation measure of an investment, an ex-post
measure;
• Example
• Apple share price on August 27 2020: $ 500.04
• Dividends per share paid:
• November 2019: $ 0.77;
• February 2020: $ 0.77;
• May 2020: $ 0.82;
• August 2020: $ 0.82.

• Apple share price on August 28 2019: $ 203.51

• Apple shareholder (TSR) 2020-2019 return:

500 − 203 + 0.77 + 0.77 + 0.82 + 0.82
𝑟= = 147,9%
203
• Taking into account the moment of the dividend
0.77 0.77 0.82 0.82 500
𝑟: 203 = "! + %! + &! + #$! + #$! = 0 , 𝑟 = 148,6%
1+𝑟 #$ 1+𝑟 #$ 1+𝑟 #$ 1+𝑟 #$ 1+𝑟 #$

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