TCH302

Gitman, L. and Zutter, C. (2011). Chapters 2, 3

Bodie & Merton (2010), Chapter 1
Dr. Huizhong (Jodie) Zhang, 2020

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Learning objectives
Understand…
Main issues in corporate finance

Financial management decisions

Financial statements

Financial analysis

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The Types of Firms
• Sole Proprietorship
• Business is owned and run by one person

• Partnership
• Similar to a sole proprietorship, but with more than one owner
• All partners are personally liable for all of the firm’s debts.

• Limited Liability Company

• A limited partnership without a general partner
• All owners have limited liability

• Corporation
• Legally defined, artificial being
• Can make contracts, carry on business, borrow, lend, sue, and be sued
• Owned by shareholders, each of whom has limited liability
The Types of Firms - Corporations
• Private
• Shares are held closely by a small group of investors, and shares are not publicly traded.
• E.g. Dell, Ernst & Young

• Public
• Firms listed on stock exchange and shares are publicly traded.
• E.g. Apple; Google; IBM

• Corporations: Separation of ownership and control

• Owners do not have direct control of the firm.
• Corporate main management team
• Board of directors
• Elected by the shareholders to monitor and advice the management decision makings with ultimate authority.
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• CEO, CFO, and COO
Corporate form of business organization
⦁A legal entity separate and distinct from its owners
Advantages Disadvantages
• Unlimited life • Cost and complexity to start.
• Limited liability • Double taxation
• Ease of ownership transfer • Separation of ownership and management
• Ability to raise funds
• Proportional distribution of income

⦁ Agency problem: the possibility of conflicts of interest between the stockholders and
management of a firm
⦁ Stockholders delegate decision-making authority to managers to run the business. An
agent is a person who is authorized to act for another person or group called a principal.
⦁ The relationship between the agent and the principal is called an agency
relationship.

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Corporations
Consider a firm which earns $1000 taxable
income.
In the hands of the Company
Assume a company tax rate of 33% and a Taxable Income 1000
personal tax rate of 43%. Company Tax at 33% (330)
The company pays out all after tax income After tax income 670
Dividend 670
as a 100% fully franked dividend.
In the hands of the shareholder
Dividend Income 670
Personal Tax (288)
After tax income 382

Effective tax rate (330+288)/1000 61.8%

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Corporations: Typical organization chart

SOURCE: ????
Introduction to corporate finance
• Ultimate goal:
• Maximize the value of shares
• Agency Problem:
• Managers vs. shareholders
• Managers may have little incentive to work in the interests of the shareholders
when this means working against their own self-interest.
• Examples:
• Insufficient effort
• Excessive perquisites
• Entrenchment strategies
• Self-dealing
• Shareholders vs. other stakeholders
• Managers may take actions that benefit other stakeholders8such as employees and the
communities in which the company operates but at the shareholders’ expense.
Agency problem and Corporate Governance
• Agency costs are incurred when:
• Managers do not attempt to maximize firm value

• Shareholders incur costs to monitor managers and constrain their actions

• What tools can shareholders use to ensure managers work in their interest, i.e.,
maximize the value of the firm?
• Corporate Governance
• The system of controls, regulations, and incentives designed to minimize agency costs between
managers and investors and prevent corporate fraud.

Monitoring by the Board of Directors

Compensation Policies
Direct Action by Shareholders
The Threat of Takeover
Financial management and financial manager
⦁Financial management is an integrated decision-making process
concerned with acquiring, financing, and managing assets to accomplish
some overall goal within a business entity.

⦁The person associated with the financial management function is usually a

top officer of the firm such as a vice president of finance or chief financial
officer (CFO)

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 3 key financial management decisions:

(1) long-term investment decisions:

determining the type and amount of
assets that the firm wants to hold.

(2) long-term financing decisions:

the acquisition of funds needed to
support long- term investments.
capital structure

(3) working capital management

decisions: decisions involving a
firm’s short-term assets and
liabilities

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 3 types of activities
•Operating activities: involve business activities
•Investing activities: involve financial investments
purchasing and selling fixed assets
•Financing activities: involve acquiring funds activities

(2) (1)
Firm’s operations Financial Investors
(4a)
Assets manager Financial assets
(3) (4b)

(1) Cash raised by selling financial assets to investors

(2) Cash invested in the firm’s operations
(3) Cash generated by the firm’s operations
(4a) Cash reinvested
(4b) Cash returned to investors
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Financial decisions of firms
Cash Inflows = Cash Outflows
Inflows are new funds raised and Outflows are the investment outlay and
cash from operations distributions to owners

F + X = I + D

Financing Decision: Investment Decision: Dividend Decision:

Capital Structure Project Evaluation Payout Policy
Asset Pricing
Asset Acquisition
Working Capital Management
Portfolio Construction

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Financial statements
— Provide information to stakeholders of the firm about the company’s current
status and past financial performance.

— Provide a convenient way for owners and creditors to set performance targets
and to impose restrictions on the managers of the firm.

— Provide convenient templates for financial planning

1. Balance sheet – assets and liabilities management

2. Income statement

3. Cash flows statement

4. Notes to financial statements

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 Balance sheet
• Balance sheet is the financial LIABILITIES &
statement that shows the firm’s ASSETS
OWNERS’ EQUITY
assets (the uses of the funds
raise/ what it owns) and
liabilities (the sources of funds/
what it owes) at a particular
time (at a point of time). CURRENT LIABILITIES
• The assets – the liabilities = CURRENT ASSETS
net worth/ owner’s equity
(for a corporation, - stockholders’ Net working
equity) capital LONG-TERM LIABILITIES
• based on historical cost or
original value,
LONG-TERM ASSETS
not market values (NON-CURRENT
ASSETS) OWNERS’ EQUITY
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Market values and book values

• Book value is the accounting value of a firm or an asset. Be an

historical value rather than a current value. Firms usually report book
value on a per share basis.
• Market value is the price that the owner can receive from selling an
asset in the market place. The key determinant of market value is supply
and demand for the asset.

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Income statement
• Income statement is the financial statement that summarizes the profitability of
the firm over a period of time (it is usually a year)
• It shows the revenues, expenses and net income of a firm during the past
period.
• Based on accrual accounting methods
• Accrual accounting: recording revenues/ expenses on their income statement
when they are made,
not when the cash is actually collected from that sale/ paid out for the
expenses.
• Noncash revenues and expenses: the income statement usually includes
noncash expenses such as depreciation and amortization.

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Income statement
Sales
Less deduction
Net sales
– Costs of good sold Expenses to have products sold
Gross profit Selling expense
– Operating expenses General and administrative expenses
Operating income (earnings before interest and taxes - EBIT)
– Interest
+ Other income (- loss) – net
Earnings before taxes (EBT)
– Taxes
Dividends
Net income
Addition to retained earning
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Cash flows statement
• Cash flows statement is a financial statement that shows all the cash that flowed into and out
of the firm during a period of time.
• Based on inflows and outflows
Cash flow from operations (CFO) reports the cash generated from sales and the cash used
in the production process. Including: cash collections from sales, cash operating expenses,
cash interest expense, and cash tax payments.

Cash flow from investing (CFI) reports the cash used to acquire and dispose of non-cash
assets. Firms acquire such assets with the expectation of generating income. Including
purchases of property, plant, and equipment, investments in joint ventures and affiliates,
payments for businesses acquired, proceeds from sales of assets, and investments in or
sales of marketable securities.

Cash flows from financing (CFF) reports capital structure transactions. Including new
debt issuances, debt repayments or retirements, stock sales and repurchases, and cash
dividend payments
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Notes to financial statements
• Providing:
• An explanation of accounting methods used.
• Greater detail regarding certain assets or liabilities.
• Information regarding the equity structure of the firm.
• Documentation of changes in operations.
• Off-balance-sheet items.

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Long –term (capital) investment decisions
• Capital Budget
• List the projects and investments that a firm plans to undertake in the coming year.

• Capital budgeting process: analyze alternative projects and investments by examining the
consequence of the project on firm’s value.

• Common procedure: analyze the effect on firm cash flow and NPV of those cash flows.

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 Long –term (capital) investment decisions
• Uncertainty faced by senior managers:
• Errors may creep in
• Uncertainties about future cash flows, cost •Sensitivity analysis
of capital, etc. •Scenario analysis
• Forecasts may not be realistic •Break – even analysis
• Divisional managers and project sponsors
•Monte Carlo simulation
are keen to get their projects accepted. They
may therefore consciously inflate their •Real options and decision trees
forecasts.
• Bias
• E.g., overconfidence/over-optimism

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Financing decisions – Capital structure
• Two primary sources of external financing: equity and debt.
• The relative proportion of debt and equity that a firm has outstanding
constitutes its CAPITAL STRUCTURE.
• Q1: What mix of debt and equity is optimal for the firm?

• Q2: Can we add value to the firm by financial restructuring (changing the mix of
debt and equity financing) ?

• Q3: How do capital structure issues affect the discount rate that the firm should
use to analyze investment projects?

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Raising equity
• Initial Public Offering (IPO)
• The process of selling stock to the public for the first time.

Major advantages: Disadvantages:

Greater liquidity The equity holders become more widely
dispersed.
Better access to capital
Monitoring management is harder and
Other advantages: costly
Establish a market price for the firm The firm must satisfy all of the
Enhance the reputation of the firm requirements of public companies
Allow the investors including owners to
diversify their personal holdings
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Underwriter and IPO
• Underwriter
• An investment banking firm that manages a security issuance and designs its structure.
• Underwriters have played an important role in the IPO market:
• Set the offer price;
• Market the IPO;
• Prepare all the necessary filings, e.g., a registration statement; and
• Make a market in the stock after the issue:
• A liquid market ensures that the issuer will have continued access to the equity markets.

• Valuation
• Before the offer price is set, the underwriters come up with a price range that they believe
provides a reasonable valuation for the firm using the following two techniques:
• Compute the present value of the estimated future cash flows.
• Estimate the value by examining comparables based on recent IPOs.
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Raising equity
• Seasoned Equity Offering (SEO)
• When a public company offers new shares for sale
• Public firms use SEOs to raise additional equity.
• When a firm issues stock using an SEO, it follows many of the same steps as for an
IPO.
• The main difference is that a market price for the stock already exists, so the price-
setting process is not necessary.

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Company Valuation
n
CF t
V  t 1 1  k t 
n

• : operating cash flows available to all investors – both equity and

debt holders, e.g., EBIT and EBIAT.
• : weighted average cost of capital (WACC).
• Consistency: The definition used to determine the cash flows in
the numerator should be consistent with the definition of cost of
capital used in the denominator.

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• Some common types of cash flow:
• EBIT(Earning before interest and tax)
• EBIAT= EBIT*(1-t) (Earning before interest and after tax)
• EAIBT=EBIT-interest payment
• NPAT=(EBIT-interest)*(1-t)

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 Free Cash Flow Approach

Where: FCFF: free cash flow to firm;

R: revenues;
E: expenses including tax expense;
CE: capital expenditure;
D: depreciation;
WC: working capital. WC = Current Assets – Current Liabilities
k: WACC ΔWCt = WCt – WCt-1

ΔWC > 0 will be treated as a cash outflow

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Raising debt
Cost of debt consists of two parts:
Explicit cost (e.g., interest rate, overdraft rate)
Implicit cost (increased risk to equity holders due to introduction of debt)
Debt adds financial risk to the equity holders over and above the business risk of
the firm’s assets.

Advantage:

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Payout policies

Cash Dividends
A payment made out of current or accumulated earnings to the
owners in the form of cash.
Stock Dividend
Two common forms:
Bonus Share Issue: e.g., 1:1 bonus. One new share for each
one you own.
Stock Split: e.g., 2:1 split. Two new shares replace an
existing one.
Payment made by a firm to its owners in the form of shares –
thereby diluting the value of each outstanding share.
An increase in the number a firms’ shares without an increase
in book value of owner’s equity
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Paying cash dividend versus Repurchase shares
• Consider A Corporation. The firm has no debt, so its equity cost of capital
equals its unlevered cost of capital of 12%.
• The firm’s board is meeting to decide how to pay out $20 million in excess
cash to shareholders.
• With 10 million shares outstanding, A will be able to pay a $2 dividend
immediately.
• The firm expects to generate future free cash flows of $48 million per year,
thus it anticipates paying a dividend of $4.80 per share each year thereafter.
Q1: Are the firm’s shareholders affected by this dividend payment?
Q2: Suppose that instead of paying a dividend this year, A uses the $20 million to
repurchase its shares in the open market. How will the repurchase affect the
share price?

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Operation decision and Working capital management
• Cash management
• Inventory management
• Receivable management and Sales

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Financial analysis
— In analysing a firm’s performance using its financial statements, it is useful to apply
some financial analysing approaches:
• Cross- sectional: Comparison against peers
• Time- series: Comparison against self over time
• Common- size (vertical) analysis
• Trend (horizontal) analysis
• Financial ratios: allow comparison between different size firms on a common basis
— To measure the outcome of these analyses, you need to compare:
•Against self (time- series, vertical, horizontal) and
•Against peers/industry/market (cross- sectional, ratio)
— For the best result, these approaches usually be applied simultaneously.

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Financial ratios
⦁ Financial ratios are not standardized. A perusal of the many financial textbooks and other
sources that are available will often show differences in how to calculate some ratios.
⦁ Analyzing a single financial ratio for a given year may not be very useful.
⦁ Analysts usually:
examine financial ratios over the most recent 3 or 5-year period and then
compare them with industry averages or key competitors.

— Profitability ratios
— Debt (Financial leverage) ratios
— Liquidity ratios
—Asset turnover (Efficiency/Activity) ratios
— Market value ratios

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Financial leverage

Debt ratio: measures the proportion of total assets financed by the

firm’s creditors.

Time interest earned ratio: measures the firm’s ability to make

contractual interest payments.

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Liquidity ratios

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Asset turnover ratios
Inventory turnover measures the activity (liquidity) of a firm’s inventory

The speed with which a company turns over its inventory is measured by the
number of days that it takes for the goods to be produced and sold.

Receivables turnover measures the ability to use credit sales in generating revenue

The average collection period measures how quickly customers pay their bills:

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Market value ratios

Price–Earnings Ratio (price to earnings, P/E, ratio) measures the

price that investors are prepared to pay for each dollar of earnings.

Market-to-book Ratio (M/B)

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Profitability ratios

Return on sales (ROS): measures the return earned on the sales of

the firm.

• Return on Assets (ROA): measures the overall effectiveness of

management in generating profits with its available assets.

Return on equity (ROE): measures the return earned on the ordinary

shareholder’s investment in the firm.

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⦁DuPont analysis of ROE (return on equity)

 Determine factors affecting on ROE

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