CorpFin Lecture 01 2005

8/4/2019 CorpFin Lecture 01 2005

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New Venture Finance: Corp. Finance Review 1

__________________________________________Real Sector The Firm Financial Sector

Corporate Investment Corporate Financing

Decisions: Utilization of Funds Decisions: Acquisition of Funds

Business Markets Financial Markets

The Firm's Balance Sheet

__________________________________________________________

Cash A/P

A/R Other Current

Inventory Liabilities

_________________ _____________________

Products Total Current Assets Total Current Liabilities

Customers

Competitors Fixed Assets: Capital: Savers/

Employees Plant & Equipment Debt InvestorsTangible Assets Preferred Stock

Technology Common Equity

--Retained Earnings

--Common Stock________________ _____________________

Total Assets Total Liabilities & Equity


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__________________________________________ Financing (sources of funds) must equal the investment in

assets (use of funds).

Managers make investment decisions that generateearnings so that investors get a return on investment.

Financial Management is defined as the planning for,

acquiring, and utilization of funds in a manner thatmaximizes the firms economic efficiency.


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__________________________________________The Corporate Finance View of the World:

Bus. Transactions $$

$$ Securities

Commercial

Sector

-Customers

-Products

-Technology

-Competitors

Firms Balance

Sheet

Assets Liab.

Capital

Firms Income

Statement

Revenue-Expenses

-Taxes

Net Income

Retained

Earnings?

Dividends?

Financial Sector

Savers/Investors:

-Individuals

-Corporations-Partnerships

-Banks

Return on

Investment


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__________________________________________ The corporation has advantages over the other forms or

organization:

Unlimited lives that extend beyond the lives of the

founders or original managers. Simple transferability of ownership: investors and

managers are two separate groups, so investors can buyor sell the common stock without disrupting corporateoperations.

Limited liability in the corporation: investors can loseonly the total amount they invested in the commonstock.


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__________________________________________ The stock market monitors the publicly-

traded corporations performance:

Stock price changes signal whether managerialdecisions are good (stock price goes up) are bad(stock price goes down).

Because of the requirements to disclose

information that publicly-traded corporationsface, the stock market can monitor these firmsbetter than it can the other forms of organization.


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__________________________________________

In the Theory of Finance, the appropriate goal of

the firm is to maximize the value of shareholder

wealth.

Shareholders commit part of their wealth to the

firm when they buy the firms common stock.

Equivalent ways of stating this goal are:

To maximize the market value of the firm.

To maximize the stock price of the firm.


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__________________________________________

An equation that is central to the Theory of

Finance is:

A Firms Stock Price = The PresentValue of

All Future

Dividends

DIV1

DIV2

DIV3

DIV

DIVt

= ----------- + ----------- + ------------ + ... + ----------- = -------------

(1 + k)1

(1 + k)2

(1 + k)3

(1 + k)

t=1 (1 + k)t


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__________________________________________

This equation says that value (i.e., the stock price)depends on: The stream of dividends.

Risk, reflected in the discount rate, k. The timing of the dividends.

Note that value depends on all future dividends andnot only on next quarter's dividends.

Where do dividends come from? Dividends = (Earnings) Earnings = (Revenue, Expenses, Interest Exp.,Other) Revenue = (Business Decisions, Strategy)


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__________________________________________

Agency Problems and Costs. Investors(principals) provide funds, but managers (agents)formulate and implement strategies and tactics: the

problem ofseparation of ownership and control.

The goal is to maximize shareholder wealth, butinvestors cannot be sure that managers will act in

shareholders best interests. Managers might: Shirk their duties.

Use corporate resources to pay for perquisites.

Shift funds into higher risk projects than the

stockholders desire.


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__________________________________________

Observability, asymmetric information, & moralhazard: Investors cannot observe everything managers do.

Managers have more information about the firm. Investors monitor the firm, and the firm incurs

monitoring costs. Investor relations staffs, annual reports, SEC and other

regulatory reports consume resources. If managers actions cannot be observed directly,

then periodic disclosure must be made: Disclosure: information sets become more symmetric.

Are bank loan officers' salaries a monitoring cost?


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__________________________________________

Agency problems can be solved if the interests ofmanagers and investors are aligned, if bothmanagers and investors have the same incentives.

Agency theory suggests if managers are bonded tothe firm, managers would behave in theshareholders' best interests. This entails bonding costs. For example, stock options

or stock purchase programs (like at 85% of the marketprice) transform managers into owner/managers.

But managers are buying into the firm at below-marketprices. The bonding cost is the loss of wealth sufferedby other shareholders when the stock is sold cheap.


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__________________________________________

These costs cause shareholder wealth to be lessthan if managers didn't pose a moral hazard. We live in an imperfect world.

A perfect world of symmetric information no moralhazards is not attainable.

Financial contractingsolutions are often used. For example, bond indenture contracts often contain

restrictive covenants that limit the behavior ofmanagers, like no new mortgages on the assets.

Bank loans also contain restrictions, like limitations onpaying dividends, the amount of additional borrowing,or a minimum current ratio requirement.


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__________________________________________

A closer look at financial contracting. Bonds areloan contracts, and common stocks have legal tiesto the firm via the firm's charter.

Bonds are fixed income securities that have finite lives:bonds have a fixed maturity date, pay a set amount ofinterest each period, and borrowings must be repaid.

Stocks are variable income securities that have infinitelives. Dividends are not guaranteed and stock nevermaturesas long as the firm is alive. Stocks can berepurchased by the firm, but that is different: stock can

be retired but it does not mature. Stocks represent anequity, or ownership, interest in the firm.


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__________________________________________

Security Payment Priority_______________________________________________________________________________________________________________________________________

Debt Fixed, periodic interest Priority in bankruptcy

Par value at maturity Preference over preferred & common

Can force bankruptcy if not paid

Preferred Fixed, periodic dividend Paid before common dividends

Stock No maturity date Preference over common

Div. must be declared

Common No fixed dividend Residual position in dividend

Stock No maturity date payment and bankruptcy

Div. must be declared


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__________________________________________

The Relationship Between Discount Rates and Value:

Like stock, bond prices also equal the present value ofthe cash flows that investors expect to receive:

Bond Price = P.V. of interest + P.V. of maturity value Bond Interest = coupon rate X maturity value

Maturity Value = $1,000.00; called the bondsprincipal

Consider a 10% , 1-year bond or a 10%, 5-year bond;both have a maturity value of $1,000.

Currently, bond interest rates are 10%, but rates mayvary between 8% and 12% over the next few months.

How do changing interest rates affect bond values?Interest = .10 x $1,000 = $100 per year


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__________________________________________

8.0%

k = the Market Rate of Interest

10.0% 12.0%

A. 1-Year bond

Present value of:

Interest

Maturity value

Price of bond

B. 5-Year Bond

Present value of:

Interest

Maturity value

Price of bond

$ 92.59

925.92

$1,108.52

$ 399.27

680.58

$1,079.85

$ 90.91

909.09

$1,000.00

$ 379.07

620.93

$1.000.00

$ 89.28

892.96

$ 982.14

$ 360.48

567.42

$ 927.90


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__________________________________________

Define k as the Market Rate of Interest. Theexample shows that that k and a bonds price areinversely related:

Bond prices goes up as k goes down.Bond prices goes down as k goes up.

Note that the bond with the longer maturity (the 5-yr bond) has greaterprice volatility for the same

changes in the interest rate. The 5-yr bond has a higher price at 8% and a lower price

at 12% than the 1-yr bond.


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__________________________________________

Project evaluation techniques. Developing newproducts or services are essential if a firm is tocontinue growing. Capital budgeting involves:

Long-term investment opportunities as projects. Conducting a cost/benefit analysis for each project.

Accepting projects when benefits exceed the costs.

Picking good projects allows the firm to grow and to

increase its stock price. The preferred technique is called Net Present

Value (NPV).


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__________________________________________

NPV = P.V. of Inflows - P.V. of Outflows

n NCFt

NPV = ------------------- - Cost of the project

t=1 (1 + MCC)t

where: NCFt = Net Cash Flow at time t

MCC = the Marginal Cost of Capital,

a risk-adjusted discount rate


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__________________________________________

This gives rise to the following set of decision rulesthat are used in capital budgeting:

IRR is the Internal Rate of Return and is defined as the

discount rate that makes NPV = 0.

C r i t e r i o n A c c e p t R e j e c t

N P V

I R R

N P V O

I R R M C C

N P V < 0

I R R< M C C


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__________________________________________

Who gets the NPV > 0 and how does it achieve thegoal of the firm? Common shareholders, the residual claimants.

Bondholders and preferred shareholders get what they expect,and common shareholders get what is left over.

The larger the residual, the more wealth commonshareholders receive (think of the positive NPV that Intelcreates with each new generation of microprocessors.)

If managers select allof the projects with NPV > 0, this is thebest that shareholders can hope for and the stock price will bemaximized.

Negative NPVs would make the stock price go down.


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__________________________________________

Informational efficiency: This important conceptis the idea that having accurate information iscrucial to making good investment decisions.

Financial markets are informationally efficientifsecurity prices fully reflect all information andreact immediately to impound new information. For example, if the financial markets are efficient, then

Intels stock price reflects all information about Intel. Any new information about Intel will make its stock

price go up or down immediately.


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__________________________________________

One implication is that it is hard to "beat themarket" in an efficient market.

The greatest rewards exist for those who have the

best information; there is much competition forinformation. The "big players" who have the most resources gain

information first and grab the available profits first.

You and I, who are far from Wall Street and who spendlittle on information, find it difficult to beat the market.

Getting information first, or immediately, is very costlyand it is difficult to beat the market and to cover thecosts of obtaining information.


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__________________________________________

Nevertheless, information efficiency is animportant concept, and financial markets are prettyefficient in my opinion.

Competitive markets are key: as information becomesavailable, investors revise their decisions to buy or sell astock or bond, so there must be markets in which theycan actually buy or sell.

Economics and finance profs love markets: supply anddemand come together and individuals are free to make

buy or sell decisions that are in their best own interests.

As information arrives, it becomes reflected in prices, soprice changes signal good news (prices up) or bad news

(prices down).


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__________________________________________Source Complete Dissemination(day = 0) (day = 1)

Insiders know beforeannouncement

Industry analysts and

informed investors getinformation "on line

Recipients of analysts'reports and less informedinvestors are next; ther emay be many substages sothat there are degrees ofbeing informed

You and I come last:since we have lowinformation costs (t.v.,radio, press, periodicals,etc.), the information ispicked over and its valuealready extracted by thetime we obtain the info.


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__________________________________________

Types o f Informational Eff iciency. Note ho w the Strong Fo rm l ines up with the fi rs t colum n above ( the sourc

the Sem i-S trong Fo rm l ines up with the middle two colum ns, and the W eak For m l ines up w ith the las t co l.

Strong For m: S emi-S trong Fo rm W ea k fo rm

Considersa llinformation

fromthe source, including

insider information

The s t rong form d oes not

hold: there is value to

insider information

Co nsiders al lpu bl icly avai lableinform at ion from when

the inform ation isdisseminated

T h e s emi-s t rong form ha s been fou nd to hold pret ty

we ll , but not comp letely

Co nsiders onlyhistorical

security prices;b y thetim e you and I receive the

W all St . Journal on our

doorsteps, the information

has been ful ly

disseminated;al l we have

is yesterday 's prices

T he weak fo rm has been

found to hold very well


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__________________________________________

A basic principle of Finance: more risk

should be rewarded with a higher return.

In the Theory of Finance, taking risk is agood thing since it creates new wealth (new

products, new technologies, etc.)

Thus, there should be rewards for bearingrisk.


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__________________________________________

Expected Return

Risk-free Risk premium

Rate: kf

Time value of money______________________________________________________________Risk

Treasury Corporate Common New Ventures,

Bonds Bonds Stock Options, Futures,

and other Derivatives


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__________________________________________

Sales/Earn ings ./C ash Flo w

________________ ______________________________________ ____________Time

R&D Early growth Rapid growth M aturity De cli(Seed & start-up) (First stage start-up) (Late stage start-up) (----Publicly-traded----)


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__________________________________________

Venture Economics Stage Definitions:

Early Stage

Seed. A relatively small amount of capital provided to

prove a concept, maybe involving product development

but not initial marketing.

Startup. Financing for product development and initial

marketing; no product sales, management team

assembled, business plan written, market research done.

First Stage. Financing for initial commercial

manufacturing and sales.


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__________________________________________

Expansion Second Stage. Working capital financing provided; likely

to have no profits.

Third Stage. Financing for plant expansion, marketing,and working capital.

Bridge Stage. Financing for firm expected to go public in6-12 months; often repaid from IPO proceeds.

Management/Leveraged Buyout (MBO/LBO) andTurnaround later-stage companies: buying out existing firms or

financing firms with operational or financial difficulties.


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__________________________________________

Large P ubl ic ly-Traded Firms

_ ___ ___ __ ___ ___ ___ ___ __ ___ ___ ___ ___ __ _

Ea sy acc es s to fina nc ia l m a rk ets: banks,

b on d m ar ke ts , a nd st oc k m ar k ets

Fa ce sc ru tiny of f in anc ial m ark ets:

--m uch informa t ion avai lable about f i rm an d

industry

--ana lysts perform moni toring funct ion an d

makes recommendat ions

--periodic d isclosure keeps e verybod y happ y

--stock ma rket disciplines firms through

price cha nges force fi rm to be have as expec ted

D isc lo su re :through ann ual reports , S EC

announcements

--ma rkets a re more "info rm at iona lly e ff icient"

N e w V e n tu r e s

__ __ ___ ___ __ ___ ___ ___ ___ __ ___ ___ ___ ___ __ _

F in anc ia l m ark ets in ge ne ra l are not

accessible: n ew ventures areprivately held

Fac e scr ut in y o f VC s:

--l it t le in forma tion ab out firm o r its concep t/idea

--VC have to m oni tor a ndinvest

--VC s are qua si-insiders , of ten on the B d. of D ir .

--markets are thin and i ll iquid; s tock not p ubl icly

t raded

D is clos ur e:throug h business p lans , and

and direct exam inat ion by investors

--m arket s are less "informationally efficient


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__________________________________________Large Pu blicly-Tra ded Firm s

____ __ _ __ ___ ___ ___ ___ __ __ _ ___ ___ __ _ __ _Prob lem of sepa ra tion of ow ner sh ip an d contro l:--stock option s and stoc kpurchas e p lan hel p b on d

m anagers to firm

Sou nd m anagement expected and scrut inized:--com plex orga nizations the no rm--reorganizations the norm--hierarchical organization--lo ts of w ritten po licies--expe rtise already d evelope d (i .e., hire M BA s)

G oal is to ma xim ize th e firms' stock price:--it can gene rate a stream of earn in gs from

ongoing o perations (or assets-in-place)--it can undertake capital budgeting--firms are in m ature stage

New V entures

__ __ __ _ __ _ __ ___ __ ____ __ _ __ __ _ ___ ___ __ _ __ _V Cs have mo re direct mon itoring ability:--En treprene urs keep a large p ercent of shares

and key personne l get sto ck options

M an agem en t dev el op m en t just b eg in ning:--VCs know wha t is e xpected and o ffer ne two rking--understaffed operatio n coping with explosion of

tasks and functions--w hat's a policy?--VC s "groom" m anagement

Go al is to ma ximize the firm s' stock price:--real goal is IPO o r merger, or harvest, or cash

out for V C a nd entrepreneur (a liqu id ity event)--firms are in rapid growth stage


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__________________________________________

Early Stage L ate State Small Publicly Large PubliclyStart -up Private Firm -Traded Firm -Traded Firm

________________________________________________ _____________________________

VC invests,monitors, andgrooms firm

VC prepares firm forliquidity event (i.e.IPO, merger)

Liquidity eventoccurs: VC andentrepreneur harvest

Not what VCs investin; bank loansproba bly available,but financing still abig problem

Financial marketsgenerally available

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Documents

CorpFin Lecture 01 2005