University of St. Gallen Corporate Finance Lecture 1 PDF

University of St.Gallen (HSG) 7,107 Corporate Finance – Lecture 1: Introduction Marc Arnold Lecturer PROF. RESEARCH BACKGROUND DR. AREAS OF INTERESTS VISITING PROFESS...

University of St.Gallen (HSG) 7,107 Corporate Finance – Lecture 1: Introduction Marc Arnold Lecturer PROF. RESEARCH BACKGROUND DR. AREAS OF INTERESTS VISITING PROFESSOR Main interests Stern School of Business Corporate Finance Financial Intermediation DERIVATIVES TRADING Product Structurer Specific interests MARC ARNOLD Theoretical Corporate Finance Full Professor, School of Finance Debt Structure Director ACA Debt Governance Household Investment 2 General Course Information WHERE TO SEEK AID? RESOURCES Information & Organization The following information is regularly published on the learning platform (Canvas) Lecture slides and research articles for self-study Group assignments: Choosing your examination form and self-selecting your group VANESSA ZEH Current information and any announcements may it be exam related or to inform about changes Ph.D. Candidate Contact Person Literature To clarify content-related questions, dive deeper into topics, and reinforce key concepts Textbook: Principles of Corporate Finance, 2020, by Richard Brealey, Stewart Myers, and Franklin Allen, 13th Edition Further readings: Investments, 2014, by Zvi Bodie, Alex Kane & Alan J. Marcus, 10th Edition; Research articles on Canvas 3 Syllabus Date Topic Literature 18.09.2024, 8.15 AM – 12.00 PM Administrative Notes and Introduction Corporate Finance: 1. Investments: 1. – 3. 25.09.2024, 8.15 AM – 12.00 PM Latest Developments – 02.10.2024, 8.15 AM – 12.00 PM Efficient Markets and Investment Performance Investments: 11.1, 11.2, 11.4, 11.5 09.10.2024, 8.15 AM – 12.00 PM Options and Real Options Corporate Finance: 22. Investments: 20.1 – 20.5, 21.1 – 21.6 16.10.2024, 8.15 AM – 12.00 PM Capital Structure and Financing Corporate Finance: 17.1, 17.2, 18. 23.10.2024, 8.15 AM – 12.00 PM Agency Conflicts and Corporate Governance Corporate Finance: 12.1 – 12.3, 33.2 25.10.2024, 8.15 AM – 6.15 PM Trading Room Sessions – 18.11.2024, 8.15 AM – 6.00 PM Presentations – 20.11.2024, 8.15 AM – 12.00 PM Presentations – 4 Post-Lecture Program Duration 90 minutes (90 points) Content Lectures Implementation of the theoretical lecture contents using practical examples PRESENTATION Trading room sessions Presentations Interaction with other students Trading competition OR VIDEO Mentioned chapters in the textbook 70% 30% TRADING ROOM Canvas EXAM SESSION More detailed information about the assignments Instruction to every topic Independent allocation of groups via Canvas 5 Assessment Criteria for Group Work Grading criteria Content Correctness/accuracy Adherence to guidelines Clarity/organization Video Learning experience To be handed in via e-mail Interactive element to Vanessa Zeh by November 14, 2024, 8PM OR Presentation To be delivered during the Grading criteria trading room sessions and Content after the break Correctness/accuracy Adherence to guidelines Clarity/organization Learning experience Technical quality Sign up via Compass for one topic and one format – First come, first served! 6 Information for Exchange Students IMPORTANT EXCHANGE STUDENTS Exchange students who would like to obtain an attestation in this course generally take the same written exam as the regular students (90 minutes) The requirements for exchange students (criteria for evaluation and exam-relevant material) are identical to those for regular students REGISTRATION EXAMINATION Registration for the examination must be completed no later than Date of the final exam: Please contact Vanessa Zeh if you are no November 1, 2024, by sending an email to [email protected] longer in Switzerland on the date of the exam Applications received after this date cannot be considered The exchange students themselves are responsible for ensuring that the home university recognizes the examination format 7 Objectives FINANCIAL MARKET FUNDAMENTALS A solid understanding of how financial markets work and staying updated on current developments. 1 MARKET PARTICIPANTS AND TYPES Knowledge of the key players, different market types, and various order types. 2 SHORT SELLING AND LEVERAGE RISKS Understanding the mechanisms of short selling or leverage purchases and the risks involved. 3 CORPORATE FINANCE PRINCIPLES Comprehension of essential corporate finance principles. 4 8 Real Assets vs. Financial Assets REAL ASSETS FINANCIAL ASSETS Essential for the production of goods and Companies utilize financial assets to fund the 1 services. 1 purchase of real assets. The material prosperity of a society is Represent claims to the income generated by 2 influenced by the productivity of real assets in ASSETS 2 real assets and define the distribution of an economy. income and wealth among investors. Examples include real estate, machinery, and Examples encompass stocks, bonds, and 3 knowledge. 3 derivatives. 9 Net Worth of Households (in CHFbn) 7,000 5,000 6,000 4,500 4,000 5,000 3,500 4,000 3,000 3,000 2,500 2,000 2,000 1,000 1,500 0 1,000 -1,000 500 -2,000 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Financial assets Real estate Liabilities Net worth Source: SNB 10 Financial Assets of Households (in CHFbn) 3,500 3,000 2,500 2,000 1,500 1,000 500 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Currency and deposits Debt securities Shares and other equity Units in collective investment schemes Insurance and pension schemes Source: SNB 11 Assets and Market Participation in the USA Holding and values of assets, 2016 and 2019 surveys (in USDk) Percent holding Conditional median value Conditional mean value In 2019, 98.7% of families Balance sheet item % change % change 2016 2019 2016 2019 2016-19 2016 2019 2016-19 owned at least one Any asset 99.4 99.6 201.9 227.6 13 842.3 860.3 2 financial asset Types of financial asset Any financial asset 98.5 98.7 25.0 25.7 3 361.5 363.7 1 The second most held type Transaction accounts 98.0 98.2 4.8 5.3 11 42.8 41.7 -3 of financial asset were Certificates of deposit 6.5 7.7 21.3 25.0 18 80.5 102.0 27 retirement accounts Savings bonds 8.6 7.5 1.1 0.8 -25 10.1 8.5 -16 Bonds 1.2 1.1 106.4 121.0 14 820.0 653.6 -20 Direct share ownership Stocks 13.9 15.2 26.6 25.0 -6 348.6 348.5 0 increased slightly between Pooled investment funds 10.0 9.0 121.2 110.0 -9 825.3 854.3 4 2016 and 2019 Retirement accounts 52.1 50.5 63.8 65.0 2 243.5 255.2 5 Cash value life insurance 19.4 19.0 9.0 9.0 0 39.8 41.0 3 Ownership of corporate Other managed assets 5.5 5.9 117.0 115.0 -2 503.8 512.2 2 capital was around 13% in Other 8.1 7.4 5.9 4.0 -32 57.1 73.8 29 Types of nonfinancial asset 2019 Any nonfinancial asset 90.8 91.4 169.0 194.3 15 529.8 544.6 3 Vehicles 85.2 85.4 18.4 17.2 -7 27.0 26.6 -1 Primary residence 63.7 64.9 196.8 225.0 14 320.3 344.2 7 Other residential property 13.8 13.1 154.9 160.0 3 381.0 400.3 5 Equity in nonresidential property 6.2 6.7 72.0 72.0 -3 505.4 377.1 -25 Business equity 13.0 13.4 85.0 89.1 5 1,266.4 1,248.7 -1 Other 6.5 7.9 13.8 15.0 8 86.6 75.8 -13 Source: Survey of Consumer Finances (2019) 12 What Drives Real Estate Prices? Politics Inflation 04 Stock market 03 05 Inelastic supply of land 02 06 Interest rate development Drivers Demographic development 01 07 Gross domestic product REAL ESTATE PRICES 13 Discussion Cracking the Real Estate Code (Levitt, 2005) Correlation of words in real estate ads with sales price: Granite Maple Fantastic Attractive State-of-the-art Great neighborhood ! Discuss with your bank neighbor which words are more likely to be associated with a high and which with a low selling price. Also try to describe the systematics behind your classification. Source: Levitt (2005) 14 China’s Real Estate Problem September 12, 2023 PEOPLE’S REPUBLIC OF CHINA REAL ESTATE Ongoing Downturn: China’s housing market has been declining for three years, with new home sales and construction down significantly, and real estate’s share of GDP at its lowest since 2009. Price Drops: Housing prices have fallen by about 20% nationwide, with some areas experiencing drops of over 75%. Key Factors: Structural issues like slowing urbanization and reduced living space growth are driving the correction more than cyclical factors. Outlook: Stabilization might occur by year-end if conditions improve, but if urbanization and living space growth remain low, the market could continue to struggle into 2025. Source: Financial Times (https://www.ft.com/content/38f32adf-fc91-4f3c-a5df-69c676da646e) 15 Long-Term Returns February 13, 2024 HISTORICAL PERFORMANCE SWITZERLAND Nominal value of shares and bonds versus the Real value of Swiss shares and bonds from consumer price index from 1926 to 2023 (base = 100) 1926 to 2023 (base = 100) Shares Shares 100,000 1,000,000 Bonds Bonds Consumer Price Index 21,201 139,455 100,000 10,000 10,000 4,550 1,000 717 1,000 658 100 100 10 10 1998 1926 1934 1942 1950 1958 1966 1974 1982 1990 1998 2006 2014 2022 1926 1934 1942 1950 1958 1966 1974 1982 1990 2006 2014 2022 1926 1982 1934 1942 1950 1958 1966 1974 1990 1998 2006 2014 2022 1926 1958 1934 1942 1950 1966 1974 1982 1990 1998 2006 2014 2022 Source: Banque Pictet & Cie SA 16 Players in the Financial Markets FINANCIAL INTERMEDIARIES Bringing together suppliers (households) and buyers (companies & states), e.g., process maturity and quantity transformations Diversification, economies of scale 03 HOUSEHOLDS STATES Save money and want to lend it for a fee (net savers) 02 04 Usually need money to reduce budget deficits CORPORATIONS NATIONAL BANKS Need capital to make investments (net borrowing) 01 05 regulate the supply, availability and cost of money and credit 17 Inflation 28% 23% 18% 13% 8% 3% -2% 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Switzerland UK Euro Area Germany US Japan World Source: The World Bank 18 Asset-Backed Securities (ABS) in USDbn 2,000 Cash Flows in a Mortgage Pass-Through Security 1,800 1,585 1,600 USD USD USD 1,400 100k 100k 100k 1,200 1,000 HOMEOWNER ORIGINATOR AGENCY INVESTOR 800 600 P&I Servicing 400 P&I Servicing P&I Guarantee Fee Fee 200 0 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 CDO Auto Student Loan Equipment Credit Card Other Total Source: SIFMA 19 Discussion Evaluate with your bank neighbor the pros and cons of asset-backed securities. Pro: Con: 20 Market Types DIRECT SEARCH BROKERED MARKET DEALER MARKET AUCTION MARKET Buyers and sellers search each other individually Intermediaries match supply and demand for a fee Market maker sets bid and ask Hardly organized, no prices, often holding Trading venue where all buyers No overall market such as real inventories and sellers meet standardized goods estate market or primary Trading venue for e.g., Worldwide coverage for market structured products or trading stocks or bonds exchange-traded funds 21 Example: Novartis Order Books Structured Product on Novartis 91.730 1,330 (9) 6,689 (45) 91.720 2,281 (12) 5,359 (36) 91.710 1,649 (12) 3,078 (24) 91.700 1,329 (11) 1,429(12) 91.960 100 (1) 100 (1) 711 (6) 711 (6) 91.680 2,325 (18) 1,614 (12) 91.670 3,765 (28) 1,440 (10) 91.660 6,675 (41) 2,910 (13) 91.650 9,129 (51) 2,454 (10) 91.640 Source: SIX Swiss Exchange 22 Order Types MARKET ORDERS LIMIT ORDERS STOP-LOSS ORDERS Orders are executed immediately Orders are not executed until the If the price falls below the price at the best possible price desired buy or sell price is reached limit, the security is automatically Can be costly for illiquid securities If the price falls below the price sold limit, the security is automatically If a price limit is exceeded, the purchased security is automatically purchased If the price limit is exceeded, the Hedging against strong price losses security is automatically sold Price determined in advance, no surprises 23 Purchase of Shares with Debt Financing Exercise PURCHASE WITH AND WITHOUT DEBT COMPARISON Share price: CHF 250; Purchase of 40 shares; Initial margin (own contribution): 40% Return S = 150 Stock S = 350 Stock Without debt price price decrease increase Margin trading: scenario scenario Purchase of securities is partly financed with debt (e.g., directly from the broker) Leverage leads to higher return opportunities, but also to higher risk With debt Exercise: Investment without debt: 250 × 40 = 10,000 Initial margin: 0.4 × 10,000 = 4,000 24 Shorting Exercise SHORT SALES COMPARISON Share price: CHF 80; Short sale of 100 shares; Initial margin (own contribution): 30% S = 50 Stock S = 100 Stock Buyback costs price price decrease increase Short sales: scenario scenario Sale of securities that are not in the possession of the seller but are only borrowed Seller benefits from falling prices Profit Closing by purchasing the corresponding share and returning it to the lender Return Example: Sales volumes: 80 × 100 = 8,000 Initial margin: 0.3 × 8,000 = 2,400 25 Discussion Discuss with your bank neighbor whether short-selling is harmful or beneficial to a financial system. 26 What Is Corporate Finance All About? Focus FINANCIAL DECISIONS THAT COMPANIES MAKE TWO TYPES Spend Money Collect Money What investments should we make? How should we finance these investments? Tangible assets such as production facilities Borrowing (Leverage) Advertising campaign Use of retained cash flow Research & Development (R&D) Sale of additional shares Corporate jet Risk management 27 Investment and Financing Decisions are Often Interconnected Company Investment Decisions Financing Decisions Delivers first Dreamliner after investing a reported USD 30bn in Boeing Reinvests USD 1.7bn of profits development costs Exxon Mobil Spends USD 7bn to develop oil sands at Fort McMurray in Alberta Spends USD 12bn buying back shares GlaxoSmithKline Spends USD 4bn on research and development for new drugs Pays USD 3.2bn as dividends LVMH Acquires the Italian jeweler, Bulgari, for USD 5bn Pays for the acquisition with a mixture of cash and shares Procter & Gamble Spends USD 8bn on advertising Raises JPY 100bn by an issue of five-year bonds Opens a new plant in India to produce the world’s cheapest car, the Tata Motors Raises USD 400m by the sale of new shares Nano; the facility costs USD 400m Invests USD 330m in 100 new locomotives and 10,000 freight cars Union Pacific Repays USD 1.4bn of debt and chassis Opens a huge copper mine at Salobo in Brazil; the project cost nearly Maintains credit lines with its banks that allow the company to Vale USD 2bn borrow at any time up to USD 1.6bn Invests USD 12.7bn, primarily to open 458 new stores around the Issues USD 5bn of long-term bonds to repay short-term commercial Walmart world paper borrowings 28 Reliable Planning Horizon and Project Life Panel (A) Can reliably plan T years into future Panel (B) Expected life of a new project 5 8 4 6 3 4 2 2 1 0 0 Retail Finance Services Tech Manufacturing Healthcare Retail Finance Services Tech Manufacturing Healthcare 5 years ago (2013) Currently (2018) 5 years ago (2013) Currently (2018) This figure displays information about the horizon over which CFOs believe that their corporate plans are reliable (Panel A) and the productive life of their investment projects (Panel B). Data are from the September 2018 Duke CFO Survey. In Panel A, the blue (right) bars display how many years into the future firms in the 2018 survey could plan into the future; the orange (left) bars display the recollection of CFOs about the reliable planning horizon as of five years earlier (i.e., in 2013). The bars in Panel B display the analogous averages for the length of the productive life of a project. Source: Graham, J. R. (2022). Presidential Address: Corporate Finance and Reality. The Journal of Finance, 77(4), 1975–2049. https://doi.org/10.1111/jofi.13161 29 Key Corporate Finance Principles RISK A safe dollar is worth more than a risky dollar 03 INVESTMENTS VALUE CREATION The opportunity cost of capital sets the standard for investment decisions 02 04 Smart investment decisions create more value than smart financing decisions VALUE GOVERNANCE Corporate Finance is about maximizing value 01 05 Good corporate governance is important 30 Key Take-Aways FINANCIAL MARKETS CONSIST OF VARIOUS PARTICIPANTS WITH DISTINCT OBJECTIVES AND ROLES 1 LEVERAGE PURCHASES INCREASE BOTH RISK AND PROFIT POTENTIAL 2 CORPORATE FINANCE FOCUSES ON THE FINANCIAL DECISION MADE BY COMPANIES 3 INVESTMENT AND FINANCING DECISIONS ARE FREQUENTLY INTERCONNECTED 4 31 Institute of Accounting, Control and Audit University of St.Gallen (ACA-HSG) Prof. Dr. Marc Arnold Tigerbergstrasse 9 CH-9000 St.Gallen [email protected] Tel.: +41 71 224 74 13 www.aca.unisg.ch