Corporate Finance A1 Vysoká škola finanční a správní Summer Semester 2012 Jaromír R. Stemberg

Course Layout Twelve two-hour lessons The course is to introduce general financial management problems, realtions, terminology, and solutions Ends with Credit (zápočet)

Literature Block, Stanley: Foundations of Financial Management McGraw-Hill, 2009 ISBN

Grading Pass / Fail 50%: Five mathematical group excercises 50%: Written test Minimum to pass: 70%

Contents Introduction - history of finance - goals of financial management - financial markets Review of Accounting - the nature and role of the balance sheet - theories of balance and their development - creation of the second balance - third and fourth balance, their formation and construction

Contents Concept of capital - preservation of the capital substance of a company - ways of addressing it Accounting systems in the world - characteristics of accounting systems - process of accounting harmonization - US GAAP - IAS/IFRS, link to the directives of the European Union

History of Money and Accounting

Barter Trade Exchange of personal possessions of value for other goods From 9,000-6,000 B.C., livestock was often used as a unit of exchange; as agriculture developed, people used crops for barter This kind of exchange started at the beginning of humankind and is still used today

Barter Trade Problems Finding the other party: - interest - time Establishing equal value of exchanged goods Durability of the exchanged goods, potentiality to store it Need for a common, durable, storable, non-decaying, generally accepted unit of exchange

Cowry Shells The first money (or medium of exchange) Began to be used at about 1200 B.C. in China Accepted in some African regions till 1950s

Metal Coins China, 1000 BC: Bronze and copper cowry imitations were considered the earliest forms of metal coins. They contained holes so they could be put together like a chain. Lydia (Turkey), 500 BC: The first coins developed out of lumps of silver and were stamped with emperors to mark their authenticity. The techniques were quickly copied by the Greeks, Persians, and the Roman Empire. Unlike Chinese coins, these were made from precious metals such as silver and gold, which had more inherent value.

Banknotes China, 100 BC: Leather money – pieces of painted white deerskin. China, 800 AD: The first paper banknotes appeared. China, 1450 AD: Printing money led to a soaring inflation so the use of paper money in China disappeared (this was still years to come before paper currency would be used in Europe).

Development of Accounting Babylon, 18 th century B.C. - first organized records kept to account for assets and loans - other ancient civilizations (Roman Empire, Greek Cities, Egypt) followed Europe, 1 st millennium A.D. fall of the Roman Empire caused serious setback in education Italy, 13 th century A.D. - growing trade in the Mediterranean and accumulation of wealth in Italy gave grounds to the development of banking - double-entry bookkeeping was invented by Luca Pacioli

Modern Times Accounting 17 th century France: - obligation to present bi-yearly balances of financial situation Italy: - complete theory of accounting Holland: - first corporation established, need for equity accounting 19 th century - massive increase of accounting operations - perfection of accounting principles - rules for asset evaluation

History of Accounting Standards 1938: American Institute of Certified Public Accountants began to develop accounting standards (request of the Securities and Exchange Commission) 1959: Accounting Principles Board established, introduction of GAAP 1973: the International Accounting Standards Board (IASB) formed to develop International Accounting Standards (IAS) 2001: end of IAS (41 issued so far, still valid); new standards are from now on called International Financial Reporting Standards (IFRS) that quickly became accepted world wide

Principles of Accounting

Record Keeping Information – a basic management tool needed for - past references and reporting - present registration and evidence - future planning and management decision making Registered entries keep track of: - amount how much - count how many - time when - place where - person who

Double-Entry Accounting Accounts - recognition of individual transactions - debit and credit to be recorded at the same time General Ledger (hlavní kniha) - transactions recorded in accounts, total of both sides must be equal - can be extended by subsidiary ledgers Journal (účetní deník) - transactions recorded in order as they occurred - both sides of the record must be equal

Purpose of Record Keeping Financial accounting - provides information for owners, investors and other stake holders - serves as a base for income tax due calculation - subject to regulations by accounting standards - must be true and honest Managerial accounting - serves the managers as base for strategy planning and decision making - provides specified pieces of information - outcomes don’t have to be understood by the general public

Financial Reports Analysis

Balance Sheet Assets Liabilities Current AssetsCurrent Liabilities Cash and EquivalentsShort-Term Accounts Payable Short-Term ReceivablesCurrent Tax Payable InventoryShort-Term Loans and Borrowings Accruals and Other S/T AssetsAccruals and Other S/T Liabilities Long-Term AssetsLong-Term Liabilities Intangible Fixed AssetsLong-Term Payables Tangible Fixed AssetsProvisions Long-Term Receivables Owners’ Equity Share Capital Share Premium and Capital Funds Retained Earnings Y-T-D Profit (Loss)

Cash Flow Statement

Statement of Changes in Equity

Profitability Ratios Profit margin Return on assets (investments) Return on equity

Profit Margin Net income / Sales = 200 / = 5%

Return on Assets Net income / Total assets = 200 / = 12,5%

Return on Equity Net income / Stockholders‘ equity = 200 / = 20%

Asset Utilization Ratios Receivable turnover Average collection period Inventory turnover Fixed asset turnover Total asset turnover

Receivable Turnover Sales / Accounts receivable = / 350 = 11,4 times

Average Collection Period Accounts receivable / (Sales / 365) = 350 / 11 = 32 days

Fixed Assets Turnover Sales / Fixed Assets = / 800 = 5 times

Total Assets Turnover Sales / Total assets = / = 2,5 times

Inventury Turnover Sales / Fixed Assets = / 800 = 5 times

Liquidity Ratios Current ratio Quick ratio

Current Ratio Current assets / Current liabilities = 800 / 300 = 2,67

Quick Ratio (Current assets - Inventory) / Current liabilities = 430 / 300 = 1,43

Debt utilization Ratios Debt to total assets Times interest earned

Debt to Total Assets Total debt / Total assets = 600 / = 37,5%

Times Interest Earned EBIT / Interest = 550 / 50 = 11 times

Du Pont Analysis

Trend Analysis

Forecast and Budget

Budgetting Systematic setting of future goals Bottom-up or top-down Identification of external influence and risks (such as customers, competition, macroeconomics) Identification of external influence and risks (such as capacity of production and resources, human factor) Setting of expected growth (reduction), pipeline, percent-of-sales, investment planning

Financial Forecasting Pro forma income statement Revenue (pipeline, funnel, percentage) Expenses (variable, fixed) Pro forma balance sheet A/R, A/P, inventory Fixed assets, liabilities, equity Pro forma cash flow statement

Operational and Financial Leverage

Fixed and variable expenses 0 $ total expenses fixned expenses No. of units produced

Fixed and variable expenses No. of units produced $ fixned expenses total expenses

$ Break-Even Point No. of units produced revenue total expenses fixed expenses

Break-Even Point profit revenue total expenses fixed expenses $ No. of units produced

$ Break-Even Point No. of units produced revenue total expenses fixed expenses

Operational leverage Uses fixed/variable cost Can increase profits but increases risk _ Fixed costs _ Price – Variable cost per unit

Operational leverage _ Fixed costs _ Price – Variable cost per unit Fixed cost Fixed cost Variable cost 0,80 / unitVariable cost 1,60 / unit Unit price 2,00Unit price 2, /(2,00-0,80) = /(2,00-1,60)= break-even point isbreak-even point is units units

Financial Leverage 2 firms: exactly the same Same sector Same opportunities Same Management… The only difference: the debt L (leveraged firm) has 50% of debt U (unleveraged firm) has no debt

Financial Leverage Firm UFirm L Shares (Capital) Financial debt Total Number of shares (Price of a share 100) EBIT Financial interests (interest rate 5%) Net income before tax EPS before tax (10 000/1 000) (7 500/500) Net income after tax (Tax rate 33%) EPS after tax , ,00

Financial Leverage The shareholder of L has a return of 15 (before tax) The shareholder of U has a return of 10 (before tax) What do you prefer?

Financial Leverage Firm UFirm L Shares Financial debt Total Number of shares (Price of a share 100) EBIT Financial interests (interest rate 5%) Net income before tax EPS before tax Net income after tax EPS after tax

Financial Leverage The shareholder of L has a return of -5 (before tax) The shareholder of U has a return of 0 (before tax) What do you prefer?

Financial Leverage For leverage to be profitable, the rate of return on the investment must be higher than the cost of the borrowed money Conclusion Leverage can create value or destroy it To create value, the IRR must be higher than the cost of loan; if not, leverage destroys value.