1. Solvay Business School Université Libre de Bruxelles Fall 2007
FINANCE 1. Introduction
Solvay Business School
Université Libre de Bruxelles
Fall 2007

2. Who am I?
André Farber
Professor of Finance at Solvay Business School since….
Past Director of the MBA program
Past President of Solvay Business School
Past Dean, Faculty of Social Sciences, Politics and Economics, Solvay Business School (known as Soco)
Vice Rector for Strategy and Institutional Development
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3. Practical matters Reference:
Berk, Jonathan and DeMarzo, Peter, Corporate Finance, Pearson 2007
Website:
Slides
Excel files
Past exams
Grading:
2 Problem sets (30%)
Final (70%)
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4. Course outline Tutorials Céline Vaessen Course
1. Introduction, Financial Statement Analysis
2. Arbitrage and Financial Decision Making
3. Present value
4. Bond valuation
5. Stock valuation (Dividend Discount Mode & Free Cash Flow Model)
6. Capital budgeting (I)
7. Capital budgeting (II)
8. The Pricing of Risk
9. Optimal Portfolio Choices
10. Capital Asset Pricing Model
11. Capital Structure Decisions
12. Review Session
4 sessions
Financial statement analysis – Present Value
Bond valuation, stock valuation
Capital budgeting + PS1
Risk and expected returns + PS2
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5. Outline for this session
1. Financial decisions: investment, financing, dividends
2. Measuring value creation:
Mkt val of equity > Book value of equity
Return On Equity > Opportunity cost of capital
3. Drivers of ROE: Profit margin, Asset Turnover, Financial Leverage
4. Statement of cash flows
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6. 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?
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7. Accounting View of the Firm
Balance sheet
Income statement
Sales
Operating expenses
= Earnings before interest and taxes (EBIT)
Interest expenses
Taxes
= Net income (earnings after taxes)
Retained earnings
Dividend payments
Net Working Capital
Current liabilites
Current assets
Long-term debt
Fixed assets
Shareholders’ equity
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8. Summarized (managerial) balance sheet
Liabilities
Stockholders' equity (SE)
Interest-bearing debt (D)
Assets
Net fixed assets (NFA)
Working capital requirement (WCR)
Cash (Cash)
NFA + WCR + Cash = SE + D
Working capital requirement : definition
+ Accounts receivable + Inventories + Prepaid expenses
- Account payable - Accrued payroll and other expenses
Interest-bearing debt: definition
+ Long-term debt + Current maturities of long term debt + Notes payable to banks
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9. Example: Global Conglomerate Corporation (based on Berk DeMarzo Table 2.1)
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10. Timing of cash flows + uncertainty
Cash Flows of the Firm
Firm issue securities
Firm invest
Firm
Financial markets
Investors
Cash flow from operations
Dividend and debt payments
Timing of cash flows + uncertainty
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11. MBA Introduction

12. Cash flow statement : indirect method
NFA + WCR + CASH = SE + D
NFA = CAPEX - Dep
CAPEX = Acquisitions - Disposals (investing & divesting)
SE = NI - DIV + K
K = New issuance of capital
(NI + Dep - WCR) (CAPEX) (K + D -DIV) = CASH
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities = + +
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13. Market Value of the Firm
Book values
Market values
Value creation
Market value of equity
Total capital
Book equity
Market capitalization
Fixed Assets +
Net Working Capital
Market value of debt
Debt
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14. ? The Cost of Capital Stockholder
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 ?
Stockholder
Investment opportunities in capital markets
Project
Cash
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15. Stockholders’ problem
Company
Capital market
ROE Return on Equity
r Expected return
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16. 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
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17. Drivers of ROE PROFITABILITY (du Pont system) Three determinants :
Profit Margin
Asset Turnover
Financial Leverage
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18. Examples
Source: Business Week July 26, 2004
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19. Return on invested capital
Return on assets (net)= Net income / Total assets
Advantage: fits with DuPont system
ROE = ROA x Equity multiplier
Limitation: Net income = EBIT - Interest expense - Taxes
Depends on capital structure:
1. Interest expense: function of interest-bearing debt
2. Interest expense : tax deductible
Preferred measure: Return on Invested Capital (ROIC)
NB: ROIC = ROA (gross) (1 - Tax rate)
= ROE of a all equity financed firm
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20. ROE = ROIC + (ROAgross - r) (1-Tc) (D/SE)
Financial leverage
Financial leverage magnifies ROE only when ROA (gross) is greater than the interest rate on debt.
Balance sheet: TA = SE + D
Income statement: NI = EBIT - INT- TAX
Interest expense INT = r D (Interest expense = Interest rate x Interest-bearing debt)
Taxes TAX = (EBIT - r D) Tc (Taxes = Taxable income x Tax rate)
Remember : ROIC = ROAgross (1 - Tc)
ROE = ROIC + (ROAgross - r) (1-Tc) (D/SE)
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21. Financial Leverage: example
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22. Financial planning
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