The Scope Of Corporate
Finance
Dr. Del Hawley
FIN 634
Corporate Finance Functions
Capital Acquisition
(Finance the Company)
Capital Budgeting
(Invest Resources)
Financial Management
(Manage Cash, Pay Bills)
Finance supports, facilitates,
and guides the company’s
strategic initiatives. It does
not dominate them.
2
Risk Management
(Deal w/ Uncertainty)
Corporate Governance
(Serve the Shareholders)
The Dimensions of the Capital
Acquisition Function
•
•
•
•
•
•
3
Primary Market vs Secondary Market
Capital Market vs Financial Intermediary
Money Market vs Capital Market
Public vs Private Capital Markets
Going Public vs Privately Held
Pay Dividends vs Retain Earnings
Raising Capital: Key Facts
• Internally-generated cash flow is the
dominant source of funding in all
developed economies.
– Typically 60-80% for US firms, 50-60% for
others.
• The bulk of external funding is in the
form of debt.
– Seasoned equity issues are only 4-8% of
external financing.
4
Raising Capital: Key Facts
• Profits reinvested (retained earnings) are
the same as a new equity issue each
year.
– This keeps the leverage ratio from rising too
high with time.
• Banks everywhere are declining as a
source of capital for large firms.
– Especially true in US; less so in Europe,
Japan
5
Raising Capital: Key Facts
• There has been a huge increase in total
security issuance volume since 1990.
6
Growth in Global Security Issues
1990-2002
$ Bn
4500
4000
3500
3000
Global debt & equity
2500
2000
1500
1000
U.S. Issuers worldwide
500
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
7
World Stock Market Capitalization,
1983-2002
40000
35000
30000
25000
Em erging Markets
Other Developed
20000
Japan
United Kingdom
15000
10000
5000
8
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
0
United States
The Financial Management
Function
Managing Daily Cash Inflows and Outflows
Forecasting Cash Balances
Building a Long-Term Financial Plan
Choosing the Right Mix of Debt and Equity
9
The Risk Management Function
Managing the Firm’s Exposure to Significant Risks
Interest Rate Risk
Exchange Rate Risk
Commodity Price Risk
10
The Corporate Governance
Function
The governance structure must ensure
that managers make decisions that are will
maximize shareholders’ wealth – not just
their own wealth.
11
The Corporate Governance
Function
Incentives of managers, stockholders, and
other stakeholders often conflict
– Shareholders face a collective action problem
in monitoring management
– This is called the “agency problem”
12
The Corporate Governance
Function
Historical experience and academic
research both suggest that ownership
structure is very important.
– Concentrated vs atomistic ownership
structure
– At least three forms of capitalism (US,
Japan, Europe)
– The country’s history & legal/regulatory
system is very important as well
13
The Corporate Governance
Function
The role of takeovers in corporate
governance has grown dramatically in
recent years
– Has long been important in the US and UK
– Becoming increasingly important in Europe
14
Value of Global M & A
1991-2002 ($U.S. Billions)
4000
3500
3000
2500
2000
1500
1000
500
0
1990
1991
1992
1993
1994
1995
U.S. targets
15
1996
1997
1998
Non-U.S. targets
1999
2000
2001
2002
What Should Managers Maximize?
Though plausible as a management
objective, profit maximization has
problems
– Does not account for the timing of returns
– Profits are not necessarily cash flows
– Most importantly – it ignores risk
16
What Should Managers Maximize?
The best management objective: Maximize
shareholder wealth by maximizing the VALUE
of the company, thereby maximizing stock
price
17
– Accounts for risk, timing, and cash flows
– As “Residual Claimants,” shareholders have better
incentives to maximize firm value than other
stakeholders
– Shareholders can benefit only after other claims are
paid in full
– Historical justification: Success of financial
capitalism
Agency Costs In Corporate
Finance
Agency costs are due to the separation of
ownership and control
– Managers are the agents of the
shareholders, but are also human. The
interests of managers and shareholders
inevitably diverge.
18
Agency Costs In Corporate
Finance
Three ways to attempt to deal with
agency costs:
– Can rely on market forces: Takeovers,
proxy contests, etc.
– Can incur monitoring and bonding costs
– Can align manager and shareholder
interests via compensation contracts
(stock options)
19
Agency Costs In Corporate
Finance
Most controversial method: Executive
compensation
– The bull market led to huge payments
– Average total S&P 500 CEO pay in 2001:
$9.7 Million
– The bulk of this pay came from stock
options
– Sometimes non-cash perks are used as
well: Gulfstream for Steve Jobs
20
Forms Of Business Organization
In The U.S.
Proprietorship
21
• No distinction between business and
person (the owner)
• Easy to set up and operate; Taxed as
personal income
• Personal liability, limited life, difficult to
transfer
Partnership
• Two or more business owners
• Partners - Liable for every other
partner’s actions
Limited
Partnership
• One general and many limited partners
• Limited liability of corporation, tax
benefits of partnership
• Real-estate, R&D companies
Forms Of Business Organization Corporations
Corporation
• Legal entity with all the economic
rights and responsibilities of a person
• Incorporation occurs at state level;
Based on state law
• Strengths - Limited liability to
investors, unlimited business life
Are there any weaknesses for corporations?
YES! Double taxation
22
The Double Taxation of Dividends
Taxation of Business Income: Corporations vs Partnerships
(Corporate Tax Rate (c) = 0.35; Personal Tax Rate (p) = 0.40)
23
Corporation
Partnership
Operating income
$100,000
$100,000
Corporate profits tax (c = 0.35)
(35,000)
0
Net income available for dividends
65,000
100,000
Cash dividends or distributions
65,000
100,000
Personal tax, owner income (p=0.4)
(26,000)
(40,000)
After-tax disposable income
$39,000
60,000
Less Double Taxation of Dividends
Taxation of Business Income: Corporations vs Partnerships
(Corporate Tax Rate (c) = 0.35; Personal Tax Rate (p) = 0.15)
24
Corporation
Partnership
Operating income
$100,000
$100,000
Corporate profits tax (c = 0.35)
(35,000)
0
Net income available for dividends
65,000
100,000
Cash dividends or distributions
65,000
100,000
Personal tax, owner income (p=0.4)
(9,750)
(40,000)
After-tax disposable income
$55,250
60,000
The Traditional
Accounting Balance Sheet
25
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Financial Investments
Other Liabilities
Intangible Assets
Owners’ Equity
Total Assets
Total Liab + OE
The Traditional
Accounting Balance Sheet
The Balance Sheet
– Provides a snap-shot of the book value of the
firm’s major account categories at an arbitrary
point in time.
– Is not intended to portray true values
– Leaves out some valuable assets and
understates or overstates the true value of
others.
26
The Traditional
Accounting Balance Sheet
What’s missing on Microsoft’s 2002
balance sheet that has real value to
the company and its investors?
http://www.microsoft.com/msft/ar.mspx
27
The Traditional
Accounting Balance Sheet
Check the book value of
Microsoft’s Owners’ Equity here
and compute the actual market
value of equity based on its actual
share price at end-of-quarter dates
that you can get here.
28
The Traditional
Accounting Balance Sheet
Market Value and Book Value of Microsoft’s Equity
Jun 01
Price per Share
Number of Shares
Market Value of Equity
Book Value of Equity
$
66.19
5,383
356,301
47,289
Mar 02
$
52.56
5,415
284,612
54,300
Mar 03
$
24.21
10,600
256,626
58,282
If the equity is that far off on the balance sheet, what
does it say about the rest of the balance sheet
information?
29
The Market Value
Balance Sheet
30
Current Assets
Current Liabilities
Value of Current
Investments
Expected Value of
Future Investments
Total Assets at MV
Long-Term Debt
at Market Value
Market Value of
Common Shares
Total Liab + OE
Valuation
Valuation is the process of
estimating the true value of assets,
securities, or entire companies.
– Value
– Value
– Value
– Value
31
is usually uncertain
is based on future projections
is affected by preferences
changes constantly
The Goal of the Firm
The goal of the firm is to maximize
its value.
–
–
–
–
32
Maximize the value of the firm
Maximize the wealth of its owners
Maximize the price of its stock
Maximize its contribution to the economy
How Is Value Created?
Do something for investors that they
can’t do for themselves.
– Exploit proprietary resources
• Raw materials, patents, information
– Create proprietary knowledge
• Expertise, experience, analysis
– Be a value-added link in a channel
• Wholesaler, distributor, retailer
– Provide a service
33
The Investment Decision in a Nutshell
• Invest in projects that yield a return
greater than the minimum acceptable
hurdle rate.
• Invest in projects that have a rate of
return that exceeds the cost of the
invested funds.
34
The Hurdle Rate
The hurdle rate is:
– Based on the company’s cost of capital
– Adjusted for the risk of the specific
investment
– Greatly affected by economic conditions
– Influenced by competing investments
– Not directly observable (must be
estimated)
– Constantly changing
35
The Expected Rate of Return
The Expected Rate of Return is:
– The best guess of the average annual
rate of return to be generated by the
project
– Based on the expected cash flows
generated by the investment compared
to its cost
– Affected by the timing of the cash flows
36
The Dividend Decision in a Nutshell
If there are not enough investments
that are expected to earn the hurdle
rate, return the cash that cannot
meet the investment test to the
stockholders by paying a dividend.
The form of return – cash dividend or stock
repurchase - will depend on the stockholders’
characteristics.
37
The Financing Decision in a Nutshell
Choose the financing mix that
minimizes the hurdle rate and matches
the maturity of the assets being
financed.
The optimal capital structure is the one
that minimizes the cost of capital.
38
Financing Trade-Offs
The choice of using debt or equity to
finance the firm involves trade-offs
between:
– Cost: Debt costs less than equity
– Risk: Debt increases the risk for
shareholders
– Flexibility: Debt limits decision-making
flexibility
– Control: Equity dilutes owners’ control
39
The Scope Of Corporate
Finance
Dr. Del Hawley
FIN 634