Session 1A: Corporate Finance & Agency Issues

Outline of Contents
Corporate Finance and the Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets and the Corporation
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What Is Corporate Finance?

Corporate finance provides answers to some important questions:
What long-term investments should the firm take on? Where will the firm get the long-term financing to pay for the investments? How will the firm manage its everyday financial activities?
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Financial Management Decisions

Capital budgeting
What long-term investments or projects should the business take on?

Capital structure
How much should the firm borrow to pay for its assets?
What is the best mixture of debt and equity? The least expensive sources of funds?

Working capital management

How do we manage the day-to-day ACF 2013 finances of the firm?
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Summary of 3 Business Forms

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Goal of Financial Management

What should be the goal of a corporation?
Maximize profits? Minimize costs? Maximize market share? Maximize the current value of the companys stock?

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Maximizing Shareholders Wealth

Maximizing the share price is equivalent to maximizing shareholders wealth Why is this a valid goal?
Decisions are made in shareholders best interest Considers cash flows not profits Incorporates time dimension Does not consider profitability but also risk
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The Agency Problem

Agency relationship
The relationship exists when a principal hires an agent to represent his/her interests Stockholders (principals) hire managers (agents) to run the company

Agency problem
Conflict of interest between principal and agent
Agent may not work in the best interest of the principal
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Management Goals
Management goals may be different from shareholders goals
Management may be more interested in:
Consuming expensive perks Its own survival Its independence

Management may focus on increased growth and size rather than increasing shareholders wealth
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Agency Costs
Costs due to the conflict of interest between shareholders and management
Direct
Corporate expenditure that benefits management but costs shareholders, e.g. country club membership Costs to monitor management actions, e.g. auditor costs

Indirect
Lost opportunity due to management forgoing profitable but risky projects for fear of losing job if project fails
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Managing Managers
Managerial compensation
Incentives can be used to align management and stockholder 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

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Agency Problems in Asia

What are the underlying assumptions in the conventional model? Many PLCs in Asia are family or statecontrolled. So are agency issues similar? Look at Assignment 1

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Work the Web Example

The Internet provides a wealth of information about individual companies One excellent site is finance.yahoo.com Click on the web surfer to go to the site, choose a company and see what information you can find!

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Financial Markets
Primary market
A market where the firm sells its securities to public for the first time

Secondary markets
A market in which the securities issued by firms are traded
Listed securities trade in an organized exchange, e.g. the stock market (NYSE) Over-the-counter securities are bought from or sold to a dealer
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Session 1B: Financial Statement Analysis

Content Outline
The Balance Sheet The Income Statement Taxes Cash Flow and Financial Statements: A Closer Look Standardized Financial Statements Ratio Analysis The Du Pont Identity Using Financial Statement Information
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Balance Sheet
The balance sheet is a snapshot of the firms assets and liabilities at a given point in time Assets are listed in order of decreasing liquidity
Ease of conversion to cash Without significant loss of value

Balance Sheet Identity

Assets = Liabilities + Stockholders Equity

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The Balance Sheet Figure 2.1

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Net Working Capital and Liquidity

Net Working Capital
= 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

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 typically earn a lower return Trade-off to find balance between liquid and illiquid assets

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Asia-Pacific Corporation Balance Sheet Table 2.1

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Market Value 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. Market value and book value are often very different. Why? Which is more important to the decisionmaking process?
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Example 2.2 Klingon Corporation

KLINGON CORPORATION Balance Sheets Market Value versus Book Value Book Assets NWC $ 400 Market Book Market

Liabilities and Shareholders Equity $ 600 LTD $ 500 $ 500

NFA

700
1,100

1,000 SE
1,600

600
1,100

1,100
1,600

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Income Statement
The income statement is more like a video of the firms operations for a specified period of time. You generally report revenues first and then deduct any expenses for the period Matching principle GAAP says to show revenue when it accrues and match the expenses required to generate the revenue

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Asia-Pacific Corporation Income Statement Table 2.2

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Taxes
The one thing we can rely on with taxes is that they are always changing Marginal vs. average tax rates
Marginal tax rate the percentage paid on the next dollar earned Average tax rate the tax bill / taxable income

Other taxes

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Corporate Tax Rates Around the World

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The Concept of Cash Flow

Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements The statement of cash flows does not provide us with the same information that we are looking at here We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets
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Cash Flow From Assets

Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders Cash Flow From Assets = Operating Cash Flow Net Capital Spending Changes in NWC

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Example: Asia-Pacific Corporation Part I

OCF (I/S) = EBIT + depreciation taxes = $547

NCS ( B/S and I/S) = ending net fixed assets beginning net fixed assets + depreciation = $130 Changes in NWC (B/S) = ending NWC beginning NWC = $330 CFFA = 547 130 330 = $87
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Example: Asia-Pacific Corporation Part II

CF to Creditors (B/S and I/S) = interest paid net new borrowing = $24 CF to Stockholders (B/S and I/S) = dividends paid net new equity raised = $63 CFFA = 24 + 63 = $87

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Cash Flow Summary - Table 2.6

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Example: Balance Sheet and Income Statement Information

Current Accounts
2011: CA = 3625; CL = 1787 2010: CA = 3596; CL = 2140

Fixed Assets and Depreciation

2011: NFA = 2194; 2008: NFA = 2261 Depreciation Expense = 500

Long-term Debt and Equity

2011: LTD = 538; Common stock & APIC = 462 2010: LTD = 581; Common stock & APIC = 372

Income Statement
EBIT = 1014; Taxes = 368 Interest Expense = 93; Dividends = 285

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Example: Cash Flows

OCF = 1,014 + 500 368 = 1,146 NCS = 2,194 2,261 + 500 = 433 Changes in NWC = (3,625 1,787) (3,596 2,140) = 382 CFFA = 1,146 433 382 = 331 CF to Creditors = 93 (538 581) = 136 CF to Stockholders = 285 (462 372) = 195 CFFA = 136 + 195 = 331 The CF identity holds.

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Comprehensive Problem
Current Accounts
2011: CA = 4,400; CL = 1,500 2010: CA = 3,500; CL = 1,200

Fixed Assets and Depreciation

2011: NFA = 3,400; 2010: NFA = 3,100 Depreciation Expense = 400

Long-term Debt and Equity (R.E. not given)

2011: LTD = 4,000; Common stock & APIC = 400 2010: LTD = 3,950; Common stock & APIC = 400

Income Statement
EBIT = 2,000; Taxes = 300 Interest Expense = 350; Dividends = 500

Compute the CFFA

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Sample Balance Sheet

2011 Cash A/R Inventory 696 956 301 2010 58 A/P 992 N/P 361 Other CL 2011 307 26 1,662 2010 303 119 1,353

Other CA
Total CA Net FA Total Assets

303
2,256 3,138 5,394

264 Total CL
1,675 LT Debt 3,358 C/S 5,033 Total Liab. & Equity

1,995
843 2,556 5,394

1,775
1,091 2,167 5,033

Numbers in millions of dollars

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Sample Income Statement

Revenues Cost of Goods Sold Expenses Depreciation EBIT Interest Expense Taxable Income Taxes Net Income 5,000 (2,006) (1,740) (116) 1,138 (7) 1,131 (442) 689

EPS
Dividends per share

3.61
1.08

Numbers in millions of dollars, except EPS & DPS ACF 2013 Number of shares outstanding = 190.9 million

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Sources and Uses

Sources
Cash inflow occurs when we sell something Decrease in asset account (Sample B/S)
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
Cash and other current assets

Decrease in liability or equity account

Notes payable and long-term debt
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Statement of Cash Flows

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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Sample Statement of Cash Flows

Cash, beginning of year Operating Activity Net Income Plus: Depreciation Decrease in A/R Decrease in Inventory Increase in A/P 689 116 36 60 4 58 Financing Activity Decrease in Notes Payable Decrease in LT Debt Decrease in C/S (minus RE) Dividends Paid Net Cash from Financing -93 -248 -94 -206 -641

Increase in Other CL
Less: Increase in other CA Net Cash from Operations

309
-39 1,175

Net Increase in Cash

638

Cash End of Year

696

Investment Activity Sale of Fixed Assets Net Cash from Investments 104 104

Numbers in millions of dollars

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Standardized Financial Statements

Common-Size Balance Sheets
Compute all accounts as a percent of total assets

Common-Size Income Statements

Compute all line items as a percent of sales

Standardized statements make it easier to compare financial information, particularly as the company grows They are also useful for comparing companies of different sizes, particularly within the same industry

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Ratio Analysis
Ratios allow for better comparison through time or between companies As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is important Ratios are used both internally and externally

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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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Computing Liquidity Ratios

Current Ratio = CA / CL
2,256 / 1,995 = 1.13 times

Quick Ratio = (CA Inventory) / CL

(2,256 301) / 1,995 = .98 times

Cash Ratio = Cash / CL

696 / 1,995 = .35 times

NWC to Total Assets = NWC / TA

(2,256 1,995) / 5,394 = .05

Interval Measure = CA / average daily operating costs

2,256 / ((2,006 + 1,740)/365) = 219.8 days
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B/S I/S
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Computing Long-term Solvency Ratios

Total Debt Ratio = (TA TE) / TA
(5,394 2,556) / 5,394 = 52.61%

Debt/Equity = TD / TE
(5,394 2,556) / 2,556 = 1.11 times

Equity Multiplier = TA / TE = 1 + D/E

1 + 1.11 = 2.11

Long-term debt ratio = LTD / (LTD + TE)

843 / (843 + 2,556) = 24.80%
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B/S I/S
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Computing Coverage Ratios

Times Interest Earned = EBIT / Interest
1,138 / 7 = 162.57 times

Cash Coverage = (EBIT + Depreciation) / Interest

(1,138 + 116) / 7 = 179.14 times

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B/S I/S
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Computing Inventory Ratios

Inventory Turnover = Cost of Goods Sold / Inventory
2,006 / 301 = 6.66 times

Days Sales in Inventory = 365 / Inventory Turnover

365 / 6.66 = 55 days

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Computing Receivables Ratios

Receivables Turnover = Sales / Accounts Receivable
5,000 / 956 = 5.23 times

Days Sales in Receivables = 365 / Receivables Turnover

365 / 5.23 = 70 days

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Computing Total Asset Turnover

Total Asset Turnover = Sales / Total Assets
5,000 / 5,394 = .93 It is not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

NWC Turnover = Sales / NWC

5,000 / (2,256 1,995) = 19.16 times

Fixed Asset Turnover = Sales / NFA

5,000 / 3,138 = 1.59 times

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B/S I/S
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Computing Profitability Measures

Profit Margin = Net Income / Sales
689 / 5,000 = 13.78%

Return on Assets (ROA) = Net Income / Total Assets

689 / 5,394 = 12.77%

Return on Equity (ROE) = Net Income / Total Equity

689 / 2,556 = 26.96%
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B/S I/S
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Computing Market Value Measures

Market Price = $87.65 per share Shares outstanding = 190.9 million PE Ratio = Price per share / Earnings per share
87.65 / 3.61 = 24.28 times

Market-to-book ratio = market value per share / book value per share
87.65 / (2,556 / 190.9) = 6.55 times
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Deriving the Du Pont Identity

ROE = Net Income / Total Equity Multiply by 1 (TA/TA) and then rearrange
ROE = (NI / TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * Equity Multiplier

Multiply by 1 (Sales/Sales) again and then rearrange

ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM Note: EM = 1 + debt/equity ratio
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Using the Du Pont Identity

ROE = PM * TAT * EM
Profit margin is a measure of the firms operating efficiency how well it controls costs Total asset turnover is a measure of the firms asset use efficiency how well does it manage its assets Equity multiplier is a measure of the firms financial leverage
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Expanded Du Pont Analysis Du Pont Data

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Extended Du Pont Chart

Insert Figure 3.1 (Extended DuPont Chart)

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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
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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 Internal and external uses

Peer Group Analysis

Compare to similar companies or within industries SIC and NAICS codes
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Real World Example I

The ratios of The Hour Glass, a watch retail chain, listed on the Singapore Stock Exchange are compared with those of the industry. The ratios are obtained from Reuters.com and can be easily accessed on the web for free.

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Real World Example II

Liquidity ratios Company
Current ratio Quick ratio 3.68x
1.02x

Industry
1.38x

1.98x

Long-term solvency ratio

Debt/Equity ratio 11.80x 24.16x

Coverage ratio
Times Int Earned
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---

5.53x

Real World Example III

Asset management ratios: Company Industry
Inventory turnover 2.08x 4.44x

Receivables turnover 31.43x 61.17x (12 days) (6 days) Total asset turnover 1.71x 1.30x

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Real World Example III

Profitability ratios

Company Industry
Gross profit margin Operating margin Net profit margin ROA ROE 24.23% 11.42% 15.72% 9.22% 20.82% 50.42% 10.53% 10.58% 6.56% 19.13%

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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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Work the Web Example

The Internet makes ratio analysis much easier than it has been in the past Click on the web surfer to go to www.reuters.com
Click on Stocks, then choose a company and enter its ticker symbol Click on Ratios to see what information is available

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