Corporate Finance PDF

**Session 1: Introduction to Corporate Finance** **What is Corporate Finance?** - **Definition**: Corporate finance is concerned with two key missions: 1. Ensuring the company has sufficient funds to finance expansion and meet its obligations. 2. Ensuring that, over the l...

**Session 1: Introduction to Corporate Finance** **What is Corporate Finance?** - **Definition**: Corporate finance is concerned with two key missions: 1. Ensuring the company has sufficient funds to finance expansion and meet its obligations. 2. Ensuring that, over the long term, the company uses the resources provided by investors to generate a rate of return at least equal to the rate of return those investors require. **Key Concepts and Applications in Corporate Finance** 1. **Time Value of Money**: - Fundamental principle: €1 today is not equivalent to €1 in the future. - Money has earning potential through investment over time. 2. **Risk-Return Relationship**: - A higher risk implies a higher expected return. - Corporate finance decisions often revolve around balancing these two factors. 3. **Cash Flow Calculation**: - Understanding cash inflows and outflows is critical to ensuring liquidity and solvency. 4. **Cost of Capital**: - Determines the average rate of return a firm must earn on its investments to satisfy its investors. 5. **Investment Rules**: - Guidelines for deciding whether a project or investment creates or destroys value for shareholders. 6. **Long-term Financing**: - Methods for raising funds through equity (e.g., share issuance) and debt (e.g., loans, bonds). **The Balance Sheet Model of the Firm** 1. **Assets (Left-hand Side)**: - Represent the firm's investments. - **Current Assets**: - Short-lived assets like cash, accounts receivable, and inventories. - **Fixed Assets**: - Long-term assets, including: - **Tangible Fixed Assets**: Property, plants, equipment. - **Intangible Fixed Assets**: Goodwill, patents, trademarks. - **Net Tangible Fixed Assets**: - Tangible fixed assets minus accumulated depreciation. 2. **Liabilities and Equity (Right-hand Side)**: - Represent the sources of financing used to acquire assets. - **Current Liabilities**: - Obligations to be repaid within one year, such as accounts payable, tax liabilities, and short-term debt. - **Long-term Debt**: - Obligations that are not due within a year, such as loans and bonds. - **Shareholders' Equity**: - The difference between the value of assets and liabilities. Key components: - Preferred Stock - Common Stock - Additional Paid-in Capital (APIC) - Retained Earnings **Balance Sheet Analysis Perspectives** 1. **Solvency-Liquidity Perspective**: - Focuses on the firm's ability to meet short-term obligations using current assets and liabilities. 2. **Capital Employed Perspective**: - Provides insight into how the firm's operating assets are financed and measures economic performance: - **Capital Employed**: - Includes working capital (receivables + inventories - payables), net fixed assets, and net debt. - **Return on Capital Employed (ROCE)**: - Measures the firm's economic return on its operating assets. **Key Financial Questions in Corporate Finance** 1. **In What Assets Should the Firm Invest?** - This relates to the left-hand side of the balance sheet and involves selecting and accepting investment projects. - This decision process is called **Capital Budgeting**. 2. **How to Raise Cash to Finance Investments?** - This involves decisions about the financial mix of debt versus equity and is related to the right-hand side of the balance sheet. - This is referred to as **Capital Structure**. 3. **How to Manage Short-Term Cash Flows?** - Focuses on managing mismatches between the timing of short-term cash inflows and outflows. - This process is known as **Cash Management**. **Example: The Balance Sheet Model** **Assets (Capital Employed)**: - **Cash**: €100,000 - **Accounts Receivable**: €200,000 - **Inventories**: €300,000 - **Tangible Fixed Assets**: €500,000 - **Intangible Assets**: €100,000 - **Total Assets**: €1,200,000 **Liabilities and Equity**: - **Accounts Payable**: €150,000 - **Short-term Debt**: €100,000 - **Long-term Debt**: €400,000 - **Common Stock**: €250,000 - **Retained Earnings**: €300,000 - **Total Liabilities and Equity**: €1,200,000 **Analysis**: - **Working Capital** = Receivables+Inventories−Payables=€200,000+€300,000−€150,000=€350,000\\text{Receivables} + \\text{Inventories} - \\text{Payables} = €200,000 + €300,000 - €150,000 = €350,000 - **Net Tangible Fixed Assets** = Tangible Fixed Assets−Accumulated Depreciation\\text{Tangible Fixed Assets} - \\text{Accumulated Depreciation} - **Net Debt** = Long-term Debt+Short-term Debt−Cash\\text{Long-term Debt} + \\text{Short-term Debt} - \\text{Cash} **Summary** Session 1 establishes the foundation of corporate finance, focusing on the balance sheet model and key decisions regarding asset investment, financing, and short-term cash management. It highlights the critical role of financial analysis in understanding solvency, liquidity, and economic performance through tools like working capital and ROCE. **Session 2: Cash Flow** **What is Cash Flow?** - Cash flow is the lifeblood of a business, representing the net amount of cash being transferred into and out of a company. - **Importance**: - Ensures liquidity to meet operational needs. - Enables the payment of dividends to shareholders. - Facilitates repayment of debt (principal and interest). - Supports investment in operating assets to sustain or grow the business. - A firm with insufficient cash flow risks bankruptcy. **Cash Flow and Shareholder Value Creation** - Cash flow analysis is essential for understanding how a firm creates shareholder value: - Investors expect sufficient remuneration for the risk they assume. - Positive cash flow indicates the ability to generate returns above the cost of capital. **Cash Flow Generation and Destination** **Sources of Cash Flow:** 1. **Net Debt**: - Funds raised through loans or bond issuance. 2. **Stockholders' Equity**: - Includes common stock, preferred stock, retained earnings, and paid-in capital. **Uses of Cash Flow:** 1. **Taxes**: - Payments to governments. 2. **Debt Payments**: - Includes both interest and principal repayments. 3. **Dividends and Stock Repurchases**: - Returning value to shareholders. 4. **Retained Cash Flows**: - Self-financing by reinvesting earnings into the business. **Cash Flow Formula** CASH FLOW=CASH INFLOWS−CASH OUTFLOWS\\text{CASH FLOW} = \\text{CASH INFLOWS} - \\text{CASH OUTFLOWS} **Methods of Assessing Cash Flows** **Direct Method** - Tracks all cash inflows and outflows explicitly. - Provides a detailed breakdown of where cash is coming from and how it is being spent. **Indirect Method** - Starts with net income and adjusts for: - Non-cash items (e.g., depreciation, amortization). - Changes in working capital (e.g., receivables, inventories, payables). - Commonly used due to its reliance on standard financial statements. **Cash Flow Analysis: Example** **Scenario: A T-Shirt Business (Simplified Cash Flow Analysis)** 1. **Week 1 Events**: - **Equity Issue**: Raise €100 in cash. - **Purchase Inventory**: 80 T-shirts at €1 each (€80 total), with payment terms of two weeks. - **Sales**: Sell 60 T-shirts at €2 each (€120 revenue), 50% cash (€60), 50% on credit. 2. **Week 2 Events**: - **Additional Sales**: Sell 20 T-shirts at €2 each (€40 revenue), 50% cash (€20), 50% on credit. **Estimating Cash Flow Using the Direct Method** **Event** **Week 1** **Week 2** **Week 3** -------------------------------------- ------------ ------------ ------------ **Total Cash Inflows** €60 €80 €20 **Total Cash Outflows** €0 €80 €0 **Net Cash Flow (Inflow - Outflow)** €60 €0 €20 **Ending Cash Position** €160 €160 €180 **Estimating Cash Flow Using the Indirect Method** 1. **Income Statement (End of Week 1 and Week 2)**: - **Sales**: Week 1: €120 \| Week 2: €160 (cumulative). - **Cost of Goods Sold**: Week 1: €60 \| Week 2: €80. - **Net Income** (before tax): Week 1: €60 \| Week 2: €80. 2. **Adjustments for Non-Cash Items**: - Changes in Accounts Receivable, Inventory, and Accounts Payable. **Component** **Week 1** **Week 2** -------------------------------- ------------ ------------ **Net Income** €39 €52 **Change in Receivables** €-60 €-20 **Change in Inventory** €-20 €0 **Change in Accounts Payable** €+80 €0 **Net Cash Flow** €60 €60 **Free Cash Flow (FCF)** **Definition:** - The cash available for distribution to investors after accounting for capital expenditures and working capital needs. **Formula:** FCF=EBIT+Amortization/Depreciation−Taxes on EBIT−Capital Expenditures−Change in Working Capital\\text{FCF} = \\text{EBIT} + \\text{Amortization/Depreciation} - \\text{Taxes on EBIT} - \\text{Capital Expenditures} - \\text{Change in Working Capital} **Free Cash Flow Example: Calculation** **Scenario**: - EBIT: €100,000 - Depreciation: €10,000 - Taxes on EBIT: €30,000 - Capital Expenditures: €20,000 - Change in Working Capital: €5,000 **Calculation**: FCF=100,000+10,000−30,000−20,000−5,000=€55,000\\text{FCF} = 100,000 + 10,000 - 30,000 - 20,000 - 5,000 = €55,000 **Differences Between Free Cash Flow and Accounting Statement of Cash Flow** 1. **Free Cash Flow (FCF)**: - Focuses on cash available for reinvestment or distribution to shareholders. 2. **Accounting Statement of Cash Flow**: - Provides a detailed breakdown of cash movements: - **Operating Activities**: Cash from core operations. - **Investing Activities**: Cash used for capital investments. - **Financing Activities**: Cash from debt or equity financing. **Summary** Session 2 highlights the importance of cash flow in maintaining liquidity, ensuring solvency, and creating shareholder value. It introduces methods of cash flow analysis (direct and indirect), emphasizes the role of free cash flow in decision-making, and demonstrates cash flow estimation with practical examples. **Session 3: Cost of Capital** **What is the Cost of Capital?** - **Definition**: The cost of capital represents the minimum return a company must earn on its investments to satisfy its investors (debt holders and equity shareholders). - It is the weighted average of the costs of equity and debt, reflecting the firm's overall cost of financing its assets. **Key Components of the Cost of Capital** **1. Cost of Equity (ReR\_e)** - The return shareholders require to compensate for the risk of their investment. - Calculated using the **Capital Asset Pricing Model (CAPM)**. **Formula**: Re=Rf+β(Rm−Rf)R\_e = R\_f + \\beta (R\_m - R\_f) Where: - ReR\_e: Cost of equity. - RfR\_f: Risk-free rate (e.g., return on government bonds). - β\\beta: Beta coefficient (measure of the stock's sensitivity to market risk). - RmR\_m: Expected market return. - Rm−RfR\_m - R\_f: Market risk premium (additional return for investing in the market instead of a risk-free asset). **Key Points**: - A higher beta indicates greater risk and thus a higher cost of equity. - Risk-free rate depends on the economic environment and the country of operation. **2. Cost of Debt (RdR\_d)** - The effective rate a company pays on its borrowed funds. - Lower than the cost of equity because: - Debt is less risky (debtholders are repaid before shareholders in case of bankruptcy). - Interest payments are tax-deductible. **Formula**: Rd=Interest Rate×(1−Tc)R\_d = \\text{Interest Rate} \\times (1 - T\_c) Where: - RdR\_d: After-tax cost of debt. - TcT\_c: Corporate tax rate. **3. Weighted Average Cost of Capital (WACC)** - Represents the overall cost of financing for the company, combining equity and debt. **Formula**: WACC=EE+DRe+DE+DRd(1−Tc)WACC = \\frac{E}{E + D}R\_e + \\frac{D}{E + D}R\_d (1-T\_c) Where: - EE: Market value of equity. - DD: Market value of debt. - ReR\_e: Cost of equity. - RdR\_d: Pre-tax cost of debt. - TcT\_c: Corporate tax rate. **Key Considerations**: - WACC reflects the firm\'s average financing cost weighted by the proportion of equity and debt. - A lower WACC enables a firm to pursue more value-creating projects. **Relationship Between Risk and Return** **Types of Risk:** 1. **Systematic Risk**: - Non-diversifiable risk that affects the entire market (e.g., economic downturns). - Measured by the beta coefficient (β\\beta) in CAPM. 2. **Unsystematic Risk**: - Company-specific risk that can be reduced through diversification. **Risk-Return Tradeoff:** - Investors demand higher returns for taking on higher risk. - This principle underlies the calculation of the cost of equity. **Capital Structure Impact on Cost of Capital** 1. **Equity Financing**: - No repayment obligation. - Involves issuing common or preferred shares. - Higher cost than debt due to greater risk for shareholders. 2. **Debt Financing**: - Fixed repayment obligations (interest and principal). - Tax-deductible interest reduces the effective cost of debt. - Excessive debt increases financial risk (bankruptcy risk). 3. **Optimal Capital Structure**: - Balances debt and equity to minimize WACC while maintaining financial stability. **Example: WACC Calculation** **Scenario**: - Market value of equity (EE): €1,000,000. - Market value of debt (DD): €500,000. - Cost of equity (ReR\_e): 10%. - Pre-tax cost of debt (RdR\_d): 6%. - Corporate tax rate (TcT\_c): 30%. **Step 1**: Calculate proportions of equity and debt. Proportion of Equity=EE+D=1,000,0001,000,000+500,000=0.67 (67%)\\text{Proportion of Equity} = \\frac{E}{E+D} = \\frac{1,000,000}{1,000,000+500,000} = 0.67 \\, (67\\%) Proportion of Debt=DE+D=500,0001,000,000+500,000=0.33 (33%)\\text{Proportion of Debt} = \\frac{D}{E+D} = \\frac{500,000}{1,000,000+500,000} = 0.33 \\, (33\\%) **Step 2**: Calculate after-tax cost of debt. Rd(1−Tc)=6%×(1−0.3)=4.2%R\_d (1-T\_c) = 6\\% \\times (1-0.3) = 4.2\\% **Step 3**: Calculate WACC. WACC=(0.67×10%)+(0.33×4.2%)=6.7%+1.386%=8.086%WACC = (0.67 \\times 10\\%) + (0.33 \\times 4.2\\%) = 6.7\\% + 1.386\\% = 8.086\\% **Interpretation**: - The company's weighted average cost of capital is **8.09%**. Any project with a return above this rate will create value for the firm. **Practical Applications of WACC** 1. **Investment Decisions**: - WACC is used as the discount rate in NPV calculations. - Only projects with returns exceeding WACC are accepted. 2. **Valuation**: - WACC is critical for valuing a firm using discounted cash flow (DCF) models. 3. **Performance Evaluation**: - Comparing actual returns with WACC helps assess whether management is creating or destroying value. **Advantages and Challenges** **Advantages of WACC:** - Provides a comprehensive view of a firm's financing costs. - Useful in evaluating investment decisions and financial performance. **Challenges in Calculation:** 1. **Estimating Inputs**: - Beta, risk-free rate, and market risk premium can vary based on assumptions. 2. **Dynamic Capital Structure**: - Proportions of debt and equity may change over time, affecting WACC. 3. **Market Conditions**: - Economic changes impact interest rates and equity costs. **Summary** Session 3 focuses on the **Cost of Capital**, which is essential for making informed investment and financing decisions. By understanding and calculating the cost of equity, cost of debt, and WACC, businesses can evaluate their projects' feasibility and ensure they meet investor expectations. The session emphasizes the importance of balancing risk and return to optimize a company's capital structure. **Session 4: Time Value of Money** **What is the Time Value of Money (TVM)?** - **Definition**: The principle that €1€1 today is worth more than €1€1 in the future due to its potential earning capacity. - This concept underpins many financial decisions, from valuing investments to calculating loan repayments. **Key Financial Parameters** 1. **Cash Flows**: - Payments or receipts of money at different points in time. - Categorized as inflows (receipts) or outflows (expenditures). 2. **Time Horizon**: - The length of time over which cash flows are evaluated. 3. **Discount Rate (rr)**: - The rate used to adjust future cash flows to their present value. - Represents the opportunity cost of capital (e.g., what could be earned elsewhere with similar risk). 4. **Present Value (PV)**: - The current worth of a future cash flow or series of cash flows. 5. **Future Value (FV)**: - The value of a current amount at a future date, assuming it earns interest or a return. **Core TVM Calculations** **1. Present Value (PV)** - Formula: PV=FV(1+r)nPV = \\frac{FV}{(1 + r)\^n} Where: - PVPV: Present value. - FVFV: Future value. - rr: Discount rate (interest rate). - nn: Number of periods. **Example**: - A company will receive €10,000 in 5 years. - Discount rate: 8%. PV=10,000(1+0.08)5=10,0001.4693≈€6,805PV = \\frac{10,000}{(1 + 0.08)\^5} = \\frac{10,000}{1.4693} \\approx €6,805 - Interpretation: €10,000 in 5 years is worth €6,805 today. **2. Future Value (FV)** - Formula: FV=PV×(1+r)nFV = PV \\times (1 + r)\^n Where: - FVFV: Future value. - PVPV: Present value. - rr: Interest rate. - nn: Number of periods. **Example**: - You invest €5,000 today at an annual interest rate of 10% for 3 years. FV=5,000×(1+0.10)3=5,000×1.331=€6,655FV = 5,000 \\times (1 + 0.10)\^3 = 5,000 \\times 1.331 = €6,655 - Interpretation: €5,000 invested today will grow to €6,655 in 3 years. **3. Net Present Value (NPV)** - Formula: NPV=∑t=1TCt(1+r)t−C0NPV = \\sum\_{t=1}\^T \\frac{C\_t}{(1 + r)\^t} - C\_0 Where: - NPVNPV: Net present value. - CtC\_t: Cash flow at time tt. - rr: Discount rate. - TT: Total number of periods. - C0C\_0: Initial investment. **Example**: - A project requires an initial investment of €10,000. - Expected cash flows: €4,000 in year 1, €5,000 in year 2, €3,000 in year 3. - Discount rate: 10%. NPV=4,000(1+0.10)1+5,000(1+0.10)2+3,000(1+0.10)3−10,000NPV = \\frac{4,000}{(1+0.10)\^1} + \\frac{5,000}{(1+0.10)\^2} + \\frac{3,000}{(1+0.10)\^3} - 10,000 NPV=3,636.36+4,132.23+2,253.94−10,000≈€22.53NPV = 3,636.36 + 4,132.23 + 2,253.94 - 10,000 \\approx €22.53 - Interpretation: The project has a positive NPV, so it creates value and should be accepted. **4. Annuities** - An annuity is a series of equal cash flows at regular intervals over a fixed period. **Present Value of an Annuity**: PVannuity=C×(1−1(1+r)n)÷rPV\_{\\text{annuity}} = C \\times \\left( 1 - \\frac{1}{(1 + r)\^n} \\right) \\div r Where: - CC: Cash flow per period. - rr: Discount rate. - nn: Number of periods. **Example**: - Annual cash flow: €1,000 for 5 years. - Discount rate: 6%. PVannuity=1,000×(1−1(1+0.06)5)÷0.06PV\_{\\text{annuity}} = 1,000 \\times \\left( 1 - \\frac{1}{(1 + 0.06)\^5} \\right) \\div 0.06 PVannuity=1,000×4.21236≈€4,212.36PV\_{\\text{annuity}} = 1,000 \\times 4.21236 \\approx €4,212.36 **5. Perpetuities** - A perpetuity is a series of equal cash flows occurring indefinitely. **Formula**: PVperpetuity=CrPV\_{\\text{perpetuity}} = \\frac{C}{r} Where: - CC: Cash flow per period. - rr: Discount rate. **Example**: - Annual cash flow: €500. - Discount rate: 5%. PVperpetuity=5000.05=€10,000PV\_{\\text{perpetuity}} = \\frac{500}{0.05} = €10,000 - Interpretation: An infinite stream of €500 payments is worth €10,000 today at a 5% discount rate. **Practical Applications of TVM** 1. **Investment Decisions**: - Evaluate whether future returns justify current investments. 2. **Loan Repayments**: - Calculate monthly payments and total interest over time. 3. **Valuation of Financial Instruments**: - Bonds, stocks, and real estate rely on TVM principles. 4. **Retirement Planning**: - Determine how much to save today to meet future goals. **Common Pitfalls in TVM Calculations** 1. **Incorrect Discount Rate**: - Using an inappropriate rate can overstate or understate PV or NPV. 2. **Ignoring Timing of Cash Flows**: - Mid-year cash flows require adjustments for accuracy. 3. **Misapplication of Perpetuities**: - Perpetuities assume constant cash flows and discount rates, which may not reflect real-world scenarios. **Summary** Session 4 covers the critical concept of the **Time Value of Money**, demonstrating its importance in valuing future cash flows, making investment decisions, and understanding financial instruments. Core TVM formulas (PV, FV, NPV, annuities, perpetuities) provide a foundation for evaluating projects, investments, and personal financial planning. **Session 5: Time Value of Money (TVM) -- Applications and Advanced Topics** **Overview** This session builds upon the fundamental concepts of TVM introduced in Session 4, focusing on its practical applications in finance, including decision-making for investments, valuation of bonds, and other real-world scenarios. **Key TVM Applications** **1. Net Present Value (NPV)** - **Primary Decision-Making Tool**: - NPV measures the difference between the present value of cash inflows and the present value of cash outflows. - Used to evaluate investment projects and accept those creating shareholder value. **Formula Recap**: NPV=∑t=1TCt(1+r)t−C0NPV = \\sum\_{t=1}\^T \\frac{C\_t}{(1 + r)\^t} - C\_0 Where: - CtC\_t: Cash flow at time tt. - rr: Discount rate. - C0C\_0: Initial investment. **Decision Rule**: - NPV\>0NPV \> 0: Accept the project. - NPV\rIRR \> r: Accept the project. - IRR\