The Corporation 730g32 HT 2012 Fundamentals of Corporate Finance BMM Lecture 4: Chap. 1 & 2 & 3: Financial decisions, Financial institutions, performance measure

LEARNING OBJECTIVES Chapter 1 Understand the definition of a corporation The role of the financial manager in a corporation. Functions of financial markets. Principal-agent problems, agency costs and information asymmetries. Chapter 1 Understand the definition of a corporation The role of the financial manager in a corporation. Functions of financial markets. Principal-agent problems, agency costs and information asymmetries.

Corporations two types of financial decisions that are made in a corporation: investment decisions and financing decisions. Financial managers are responsible for both decisions! Investment decisions Financing decisions Financial Market

Corporation – A business organized as a separate legal entity owned by stockholders. – Or a nexus of contract between legal entities. Types of Corporations – Public Companies – Private Corporations, sole proprietorships – Partnerships – Etc.

Organizing a Business

Corporate Structure Sole Proprietorships Corporations Partnerships Limited Liability Corporate tax on profits + Personal tax on dividends Unlimited Liability Personal tax on profits

Who is The Financial Manager? Chief Financial Officer (CFO) – Oversees the treasurer and controller and sets overall financial strategy. Treasurer – Responsible for financing, cash management, and relationships with banks and other financial institutions. Controller – Responsible for budgeting, accounting, and taxes.

Who is The Financial Manager? Chief Financial Officer TreasurerController

Definitions Capital Budgeting Decision – Decision to invest in tangible or intangible assets. …also called the Investment Decision Financing Decision – The form and amount of financing of a firm’s investments.

Capital Structure (D/E ratio) Capital Structure The proportion of debt vs. equity financing. 1.Debt/Equity ratio, a multiple of debt over equity. Can be tricky when equity becomes small. 2.D/(E+D) debt asset ratio measures the indebtedness of the company. ranging from 0 to 100%. Market capitalization: the company´s total amount of shares outstanding times the share price.

Distinguishing Real Assets and Financial Assets Real Assets – Assets used to produce goods and services. – examples: Patents, Machines, a new pipeline, etc Financial Assets – Financial claims to the income generated by the firm’s real assets. – Examples: stocks, bonds, bank loans

The Goals of the corporation Firm Value maximization: I. Anglo-America model: shareholder interests II. Continental European model: Stakeholder interests which include all claimants who has a vested interest in the company, for example, the supplier, the workers union, the local government, tax authority, etc. Is it just a conceptual dispute? Most firms do maximize Firm value taken into consideration of the stakeholder interests: That is to say, Corporate Social Responsibilities, ethics of corporation add value to the firm.

Corporate governance and Agency problems Shareholder oriented model: US, UK 1.Professional managers, principal-agency problems, agency costs, 2.Monitoring type: Shareholder meeting, institutional ownership, specialist monitoring 3.Market for corporate control: hostile takeovers Stakeholder oriented model: continental Europe 1. Big shareholder control, long term ownership, Less agency costs, Less problem of investor protection, specialist 2. Bank monitoring, Shareholder Meeting, friendly takeover

Asymmetric information and Principal agency problem Managers know more about the corporation including: Stock price movement and returns Issues of shares and other securities Dividends decision Financing Managers may have their own goals other than shareholders´.

Agency Problem Solutions 1 – Management Compensation plans 2 - Board of Directors 3 – Market for corporate control: Takeovers 4 - Specialist Monitoring 5 - Legal and Regulatory Requirements

Chap 2. Financial Markets and Institutions Learning objectives The Importance of Financial Markets and Institutions The Flow of Savings to Corporations Functions of Financial Markets and of Financial Intermediaries Value Maximization and the Cost of Capital

Financial Markets Primary Markets: issuing stocks, bonds Secondary Markets: trading stocks, bonds OTC Markets: forex trading Money

Financial Markets Company Issue Securities Cash Investors Cash Reinvested

Corporation Investment in real assets Investors worldwide Financial markets Stock markets Fixed-income markets Money markets Markets for Commodities Foreign exchange Derivatives Financial Intermediaries: Mutual Funds Pension funds Financial Institutions Banks Insurance companies Reinvestment Financial Markets

Financial Institutions Company Intermediaries Banks Insurance Cos. Brokerage Firms Obligations Funds

Financial Institutions Intermediaries Investors Depositors Policyholders Investors Obligations Funds

Financial Markets Funds Banks Insurance Cos. Brokerage Firms Obligations Depositors Policyholders Investors Obligations Company Intermediary Investor

Financial Markets Banks Depositors $2.5 m Cash Loan Deposits Company Intermediary Investor

Financial Market: some definitions Financial Market is a market where securities are issued and traded. A security is a traded financial asset. Shares, bonds, asset backed securities, options, etc. Fixed income market: market for debt securities, for example, treasury bills, corporate bond, etc. Capital market: market for long term financing, e.g. stocks, long term bonds, etc. Money market: market for short term financing, less than 1 year.

Function of Financial Markets Transporting cash across time Risk transfer and diversification provide Liquidity Payment mechanism Provide useful information for all: commodity price, cost of capital, interest rate, exchange rate, share price, etc.

U.S. Financing Information Provided by Financial Markets Commodity prices Interest rates Company values Credit Rating Interest Rate AAA 5.71% AA 5.78 A 6.38 BBB 7.12 BB 9.84 B Source: Bloomberg Composite Corporate Bond Indexes. Interest rates on 30-year corporate bonds, February 2008.

Opportunity cost of capital Cost of capital: minimum acceptable rate of return on capital investment. The investors can invest in financial market and get expected rate of return on the investment at a similar risk level. This expected rate of return in the market determines the firm´s cost of capital. Opportunity cost of capital: the best possible investment forego by the investor is the opportunity cost of capital for the firm.

Chapter 4 Measuring corporate performance Important issues! Very relevant for business lawyers. Measuring Profitability Measuring Efficiency Analyzing the Return on Assets: The Du Pont System Measuring Leverage Measuring Liquidity Interpreting Financial Ratios

Importance of accounting data

Value and Value Added Market Capitalization – Total market value of equity, equal to share price times number of shares outstanding. Market Value Added – Market capitalization minus book value of equity.

Value and Value Added PepsiCo Balance Sheet (December 31, 2006) $Millions

Value and Value Added Pepsico Income Statement (year end 2006) Net Sales 35,753 COGS 15,762 Selling, G&A expenses 11,530 Depreciation expense 1,406 EBIT7,055 Net interest expense 66 Taxable Income6,989 Income Taxes1,347 Net Income5,642

Market-to-Book Ratio: performance measure Market-to-Book Ratio – Ratio of market value of equity to book value of equity.

Market-to-Book Ratio Stock market measures of company performance, Companies are ranked by market value added. (dollar values in millions)

Measuring Profitability Economic Value Added (EVA) – Net income minus a charge for the cost of capital employed. Also called residual income. Residual Income – Net Dollar return after deducting the cost of capital

Measuring Profitability Economic Value Added (EVA) of PepsiCo Obs: the equity figure is the from the end of 2005, because this was the equity employed in the year 2006.

Measuring Profitability Return on Equity (ROE) – Net income as a percentage of shareholders’ equity Return on Capital (ROC) – Net income plus Interest as a percentage of long- term capital. Return on Assets (ROA) – Net income plus interest as a percentage of total assets

Measuring Profitability Accounting measures of company performance, Companies are ranked by return on equity.

Measuring Profitability PepsiCo Profitability Measurements

Measuring Efficiency OR For PepsiCo

Measuring Efficiency

The DuPont model Asset turnover Profit margin

Measuring Leverage

leverage ratio asset turnover Operating profit margin debt burden

The DuPont Model A breakdown of ROE and ROA into component ratios

Measuring Liquidity

Liquidity Ratios

Sustainable Growth

Interpreting Financial Ratios PepsiCo Ratios

Interpreting Financial Ratios PepsiCo Ratios (continued)

Interpreting Financial Ratios Selected 2006 financial ratios for industry groups in Standard & Poor’s Composite Index

Accounting information and market information are important The market demand transparency of company information! this is to ensure fairness for all the market participants to make informed decision. Efficient market is characterized of efficient information revealing.

Next topic: Valuing stocks! Thank you for coming!