Théorie Financière Introduction Professeur André Farber

June 1, 2015 Tfin Introduction |2 Organisation du cours Ouvrages de référence: Brealey, R., Myers, S. and Allen, F. Principle of Corporate Finance 8th ed., McGraw-Hill 2006 Farber,A. Laurent, M-P., Oosterlinck, K., Pirotte, H. (FLOP) Finance Pearson Education, 2004 Site web: Copie des transparents (PowerPoint) Glossaire anglais - français Notes pédagogiques, exercices, anciens examens Liens vers d’autres sites Examen(s)

June 1, 2015 Tfin Introduction |3 Exercices Assistants: Benoit Dewaele Ritha Sukadi 6 séances (Vendredi 10-12), 4 groupes Groupe 1: A à F Groupe 2: G à L Groupe 3: M à P Groupe 4: Q à Z Semaines 2, 4, 6, 9, 11, 13 Semaines 3, 5, 8, 10, 12, 14

June 1, 2015 Tfin Introduction |4 Plan du cours 1. Introduction 2. Valeur actuelle 3. Cash flows, planning financier 4. Evaluation d’entreprises 5,6. Analyse de projets d’investissement 7,8. Rentabilité attendue et risque 9,10.Options 11, 12.Evaluation et financement

June 1, 2015 Tfin Introduction |5 What is Corporate Finance? INVESTMENT DECISIONS: Which REAL ASSETS to buy ? Real assets: will generate future cash flows to the firm Intangible assets : R&D, Marketing,.. Tangible assets : Real estate, Equipments,.. Current assets: Inventories, Account receivables,.. FINANCING DECISIONS: Which FINANCIAL ASSET to sell ? Financial assets: claims on future cash flows Debt: promise to repay a fixed amount Equity: residual claim DIVIDEND DECISION: How much to return to stockholders?

June 1, 2015 Tfin Introduction |6 Accounting View of the Firm Balance sheetIncome statement Sales –Operating expenses = Earnings before interest and taxes (EBIT) –Interest expenses –Taxes = Net income (earnings after taxes) Retained earnings Dividend payments Current assets Fixed assets Current liabilites Long-term debt Shareholders’ equity Net Working Capital

June 1, 2015 Tfin Introduction |7 Cash Flows of the Firm FirmFinancial markets Firm issue securities Firm invest Cash flow from operations Dividend and debt payments Timing of cash flows + uncertainty Investors

June 1, 2015 Tfin Introduction |8 Market Value of the Firm Total capital Fixed Assets + Net Working Capital Book equity Debt Book values Market values Market value of equity Market value of debt Market capitalization

June 1, 2015 Tfin Introduction |9 Value creation Market value added (MVA) = Market value of the firm’s capital – Total capital employed VALUE CREATION : 2 strategies Strategy 1 Buy assets at a cost lower than the value of the future revenues –real assets –financial assets Strategy 2 Sell financial assets for a price higher than the value of future payments Market value of equity + Market value of debt Stockholders’ equity + Financial debt

June 1, 2015 Tfin Introduction |10 Examples MicrosoftWal-Mart Market Cap $billion (Sept 18, 2006) Stockholders’ Equity $b Revenues Net Income $b Price/Book Return on Equity (ROE)31.42%21.12% Price-Earnings Ratio (P/E)

June 1, 2015 Tfin Introduction |11 The Cost of Capital The firm can always give cash back to the shareholders Capital employed by the firm has an opportunity cost The opportunity cost of capital is the expected rate of return offered by equivalent investments in the capital market The weighted average cost of capital (WACC) is the (weighted) average of the cost of equity and of the cost of debt Project  Cash  Stockholder Investment opportunities in capital markets ?

June 1, 2015 Tfin Introduction |12 Stockholders’ problem Capital market Company ROE Return on Equity r Expected return

June 1, 2015 Tfin Introduction |13 How to measure value creation ? 1. Compare market value of equity to book value Value creation if M/B > 1 2. Compare return on equity to the opportunity cost of equity Value creation if ROE > Opportunity Cost of Equity

June 1, 2015 Tfin Introduction |14 Value creation: Example Data: Book value of equity = € 10 b Net income = € 2 b / year Cost of equity r = 10% Return on equity ROE = 2 / 10 = 20% > 10% Market value of equity = NI / r = 2 / 10% = € 20 b Market value added: MVA = 20 – 10 = €10 b Market to Book M/B = 20 / 10 = 2

June 1, 2015 Tfin Introduction |15 M/B vs ROE Simplifying assumptions: · Expected net income income = constant · Net income = dividend Market value determination: Net income = Expected return  Market value of equity NI = r  MVeq ROE (definition): Return on equity = Net income / Book value of equity ROE = NI / BVeq = r  MVeq / Bveq Conclusion: in this simplified setting, –M/B = MVeq/BVeq > 1  ROE> r

June 1, 2015 Tfin Introduction |16 Drivers of ROE PROFITABILITY (du Pont system) Three determinants : Financial Leverage Asset Turnover Profit Margin

June 1, 2015 Tfin Introduction |17 Example MicrosoftWal-Mart Return on Equity (ROE)31.42%21.12% Profit Margin28.45%3.56% Asset Turnover Leverage

Foundations of Finance

June 1, 2015 Tfin Introduction |19 Theory of finance A young science Finance has been around for many centuries, of course… Main problem: calculation!! Imagine having to calculate the future value of 1 euro invested for 13 years when the annual interest rate is 4.35% (with annual compounding): Future value = (1.0435) 13 A nightmare….. This problem disappeared after WWII with the development of computers. Now we have calculators and spreadsheets…. We also have large data bases

June 1, 2015 Tfin Introduction |20 Irving Fisher Finance has its roots in economics Irving Fisher laid the foundations of modern theory of finance. Takes into account the time dimension of financial decisions Main ideas: Decisions should based on present value Net Present Value (NPV): a measure of additional wealth With perfect capital markets: independent of preferences

June 1, 2015 Tfin Introduction |21 Present value: 1 period, certainty Perfect capital market Interest rate: r Future cash flow C 1 Present value: or: PV(C 1 ) = DF 1  C 1 Interpretation: DF 1 = discount factor price of 1€ to be received in one year price of unit zero coupon with

June 1, 2015 Tfin Introduction |22 Microeconomics: a review Consumption over time: 1 periods, certainty Perfect capital markets => budget constraint »Slope = -(1+r) »Intercept = W 0 (1+r) Optimum: »Marginal Rate of Substitution (MRS) = 1+r »Optimal consumption independent of timing of income

June 1, 2015 Tfin Introduction |23 Economic foundations of net present value Euros now Euros next year Slope = - (1 + r) = - (1 + 5%) I. Fisher 1907, J. Hirshleifer 1958 Perfect capital markets Separate investment decisions from consumption decisions Y0Y0 Y1Y1

June 1, 2015 Tfin Introduction |24 Net Present Value NPV = -I + DF 1  C 1 =  60 = 7.14 Consider the following investment project: Initial cost: I (50) Future cash flow: C 1 (60) Budget constraint with project:

June 1, 2015 Tfin Introduction |25 Fisher Separation Theorem Euros now Euros next year NPV Slope = - (1 + r) = - (1 + 5%) -50 I. Fisher 1907, J. Hirshleifer 1958 Perfect capital markets Investment decision independent of: - initial allocation - preferences (utility functions)

June 1, 2015 Tfin Introduction |26 Enterprise Valuation Suppose an all equity financed company is created for this project. Step 1: Creation Step 2: Equity offering + investment t = 0t = Assets50 Equity50 t = 0t = Cash flows Assets0 Equity0 Market Cap. NPV = I+NPV =

June 1, 2015 Tfin Introduction |27 0 C1C1 -I-I Slope = -(1+r) NPV Market value of company

June 1, 2015 Tfin Introduction |28 Entreprise Value Maximisation 0 Investment Euros today Euros next year NPV Investment opportunities Market value of company Numerical example

June 1, 2015 Tfin Introduction |29 Uncertainty: 1952 – the Golden Years 1952: Harry Markowitz * –Portfolio selection in a mean –variance framework 1953: Kenneth Arrow * –Complete markets and the law of one price 1958: Franco Modigliani * and Merton Miller * –Value of company independant of financial structure 1963: Paul Samuelson * and Eugene Fama –Efficient market hypothesis 1964: Bill Sharpe * and John Lintner –Capital Asset Price Model 1973: Myron Scholes *, Fisher Black and Robert Merton * –Option pricing model

June 1, 2015 Tfin Introduction |30 References Corporate finance textbooks (MBA level) –Brealey, Richard, Steward Myers and Franklin Allen, Principles of Corporate Finance, 8th edition, McGraw-Hill 2006 –Ross, Stephen A., Randolph W. Westerfield and Jeffrey F. Jaffe, Corporate Finance, 6th edition, McGraw-Hill Irwin 2002 –Damoradan, Aswath, Corporate Finance: Theory and Practice, Wiley 1997 Ouvrages de référence en français: –Bodie, Z. et Merton, R. Finance (édition française dirigée par C. Thibierge) Pearson education 2000 Corporate finance texts for executives –Bertoneche, Marc and Rory Knight, Financial Performance, Butterworth Heinemann 2001 –Hawawini, Gabriel and Claude Viallet, Finance for Executives: Managing for Value Creation, South- Western College Publishing, 1999