The Role of the Finance Director PDF

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Poll Everywhere Audience Response System Using your mobile, tablet or laptop: Get the Poll Everywhere App from The Role of Finance Google Play or AppStore. If you don’t want to use apps go to: Directors https://pollev.com/rebeccastratling6 07 Dr. Rebecca Strätling  Welcome to the Corporate Finance Module Dr Anthony Kyiu (Module Dr. Rebecca Strätling Leader) [email protected] [email protected]  1st half of the module  2nd half of the module  Research areas  Research areas Corporate Governance Corporate Finance Climate Finance The didactics of teaching Corporate Governance Finance and Economics Banking  For information about consultation hours and workshop tutors, please refer to the information posted on the module’s Blackboard site.  Approved Calculators: Casio FX83; Casio FX85; Texas TI-30XS; Sharp EL-531. Calculators can have additional text after the model designation, e.g. Casio FX85GT.  Housekeeping Please ensure you familiarise yourself with the content of the “Start here” and “Assessment” folders of the module’s Learn Ultra (LU) site.  Timing of summative Online Test: Wednesday the 27th of November 2024.  Timing of summative in-person exam: Saturday the 25th of January 2025.  Formative assessment via regular online tests after lectures and before workshops: Required participation – need to inform the office is you are unable to participate (like for missed workshops). To be taken 2 days before next lecture or workshop:  Allows students to catch up before the next session.  Allows staff to review which topics were well understood and which would benefit from more guidance.  Module requires continuous engagement (therefore regular formative assessment)  Module builds on the “Foundations of Finance” module. At the end of this session you should understand the role of corporate finance. appreciate how the firm’s principals affect decisions about financial risks. be able to conduct a financial analysis of a firm’s balance sheet and income statement. have a more detailed understanding of the tools financial mangers use to monitor the financial performance of the firm (building on FoF).  What is the role of Corporate  Finance? Incorporated Organizations:  Have a legal personality independent of their owners or members.  Are able to hold their own property AND have legal and contractual obligations independent of their owners or members.  May limit the liability of their owners or members for liabilities of the organization.  Types of incorporated organizations:  Private businesses: e.g. Public limited companies (plc.) – these firms can have their shares listed at stock exchanges, Limited companies (Ltd.); Limited liability partnerships (LLP).  Charities (e.g. Durham University, Beamish Museum);  Public Bodies (e.g. NHS trusts, Durham County Council).  [Non-incorporated businesses: e.g. sole traders, unincorporated partnerships with general and limited partners.]  What is the role of Corporate Finance? Primary functions of corporate finance are to  Support good investment decisions. Where should the business invest its cash in? Which products or services should it produce? Which assets should it invest in?  Support good finance decisions. How should the business obtain cash to fund its operations and investments?  Manage the firm’s cash flow in line with the investment and finance decisions. Finance managers need to match the expected future cash flows from the firm’s in-vestment decisions with the expected future cash flows from the firm’s finance decisions. Corporate Finance and the Principal-Agent Problem  Incorporated organizations have a legal but not a natural personality:  Need agents (such as managers) to act on their behalf.  Agents often differ from the intended beneficiaries (principals) of the organization.  Incorporated organizations can have more than one group of principals.  Principal-Agent Theory notes principal-agent problems:  Conflicts of interests as incentives and preferences of agents and principals differ.  Alignment of agents’ incentives to those of principals: performance related pay, executive ownership (via shares, options, convertibles or CoCos), legal or contractual penalties for failure to meet duties (e.g. Directors’ Disqualification Act).  Supervision and control: boards of (executive & non-executive) directors, disclosure rules, external auditors, financial analysts, credit rating agencies, investors.  Corporate Governance mechanisms aimed at reducing principal-agent problems can create new problems (e.g. performance related pay, executive share options).  Competition in goods and capital markets can curtail agents’ exploitative behaviours. Corporate Finance and the Principal-Principal Problem  Principal-Agent Theory notes principal-principal problems: Conflicts of interests as incentives and preferences as well as power of different principals differ.  Who are the principals in different organizations, and what are their interests? Public Bodies? Politicians; civil servants; service users; regulators; tax-payers; local, regional or national governments; local, regional or national populations. Charities? Charitable objects stipulated in the Charity register (e.g. University – education, Beamish – education via collection, preservation and interpretation of objects and machinery illustrating Life in the North of England). Need Trustees (University Council) to stand in as principals to safeguard the objectives. Private businesses? Corporate Finance and the Principal-Principal Problem Who are the principals in private businesses, such as (listed) public limited companies?  Societal approach to identifying principals (formally or informally): Shareholder value orientation (e.g. traditionally UK, USA):  Shareholders provide risk capital (residual) while other stakeholders have ‘safe’ contractual relationship with the company. Profit incentive ensures the efficient use of society’s resources. Stakeholder orientation (e.g. Germany, Japan): Stakeholders (e.g. employees, customers, suppliers, etc.) make vital contributions to firms and carry risks. Legitimacy Theory (e.g. China): Organisations have implicit or explicit social contracts with society, which lead to reciprocal responsibilities. Governments should therefore be able to issue as hoc directives or provide support.  Regulated industries: e.g. banking; water, energy or transport supply or infrastructure.  What is the role of Corporate Finance? Primary functions of corporate finance are to  Support good investment decisions. Where should the business invest its cash in? Which products or services should it produce? Which assets should it invest in?  Support good finance decisions. How should the business obtain cash to fund its operations and investments?  Manage the firm’s cash flow in line with the investment and finance decisions. Finance managers need to match the expected future cash flows from the firm’s in-vestment decisions with the expected future cash flows from the firm’s finance decisions.  Manage the firm’s financial risk and contribute to managing the firm’s overall risk, taking account of the firm’s business and business environment as well as the principals’ risk preferences.  Using financial statement analysis to explore the firm’s financial health  Balance sheet: Sources and uses of funds  Income Statement: Generation of profits or losses  Cash-flow Statement: Ensuring the liquidity of firms  The Balance Sheet of Caterpillar Corp 2023 m$  Assets (= uses of funds) Caterpillar is a manufacturing company and hence needs to “Liquid” assets – although “working capital” carry inventory only at default and with a discount - Raw materials - Work in progress - Finished goods Caterpillar sells goods on credit (payment terms depending on customers’ power) - Trade receivables (aka accounts receivable) - Long-term trade receivables are rare For some large inputs Caterpillar needs to pay “Tangible” its suppliers assets – might be used (partly) as in advance collateral of delivery for mortgages, etc. - Prepaid expenses “Intangible” assets – e.g. patents, brands. “Goodwill” – e.g. difference between the book value of a firm which has been acquired and the price paid for it.  The Balance Sheet of Caterpillar Corp 2023 m$  Liabilities (= sources of funds) Current liabilities (i.e. payable in less than 1 year) - Accounts payable (Credit from suppliers) - Customers advances (Credit from customers) - Accrued wages etc. employees accumulated wage rights, but they have not been paid (e.g. end of month wage). - (Promised) Dividends payable - Long-term debt (now) due within a year. Long-term debt (due in more than one year) - Incl. firm-pension rights  The Balance Sheet of Caterpillar Corp 2023 m$  Shareholders’ equity (= sources of funds) Other firms might also have preference shares. = “Retained earnings” = Shareholdings in other firms.  The firm has been authorized to issue up to 2,000,000,000 shares with a nominal share value of 1US$, but has only issued 814,894,624.  Unlike Caterpillar, many firms separate the nominal share capital and the share premium, i.e. the difference between the nominal price and the issue price.  Caterpillar has (probably bought back) Treasury shares, e.g. to manage share prices or have shares for remuneration. So the actual shares outstanding by the end of 2023 are only 499,377,269. Not all countries allow Treasury shares (i.e. shares bought back must be cancelled) and there are different rules on votes and dividend rights of Treasury shares.  Financial Leverage Ratios (gearing)  Considering the relationship between debt and equity in the capital structure In most countries tax rules give firms an incentive to add debt to their capital structure (tax shield), but highly 𝑙𝑜𝑛𝑔leveraged − 𝑡𝑒𝑟𝑚firms 𝑑𝑒𝑏𝑡are also more 𝐿𝑜𝑛𝑔 at risk− 𝑡𝑒𝑟𝑚 from 𝑑𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜= bankruptcy. 𝑙𝑜𝑛𝑔 − 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 + 𝑒𝑞𝑢𝑖𝑡𝑦 𝑙𝑜𝑛𝑔 −𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 𝐿𝑜𝑛𝑔 −𝑡𝑒𝑟𝑚𝑑𝑒𝑏𝑡 − 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜= 𝑒𝑞𝑢𝑖𝑡𝑦  Considering the relationship between debt and (book value of) assets In most countries firms must stop trading if their liabilities exceed their assets. 𝑡𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜= 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠  Financial Liquidity Ratios Current Assets Current ratio= Current Liabilities Source: Caterpillar (2024) Caterpillar Annual Report 2023 Form 10 K, p. 28.  Financial Ratio Analysis: Growth expectations  While the book value of Caterpillar’s equity at the end of 2023 was m$ 19,503, its market value was significantly higher.  Market capitalization = number of outstanding shares * market price Source: Compaiesmarketcap.com  Financial Ratio Analysis: Growth expectations  Retail investors value shares of viable companies not based on the sales value of their assets but the discounted value of expected future income streams.  Investors often use the market to book ratio as a measure for income growth expectations: 𝑁𝑜. 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠h𝑎𝑟𝑒𝑠 ∗ 𝑆h𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 𝑀𝑎𝑟𝑘𝑒𝑡 𝑡𝑜 𝑏𝑜𝑜𝑘 𝑟𝑎𝑡𝑖𝑜= 𝐵𝑜𝑜𝑘𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦  High market to book ratio: growth stocks - Growth potential but usually riskier. Firms are likely to need funds to support working capital expansion (i.e. carry more customers and inventories) or R&D. Unlikely to pay cash dividends or buy back shares.  Low market to book ratio: value stocks - Low growth potential but usually less risky. Often have free cash-flow: Disbursement or potential agency problems.  Financial Ratio Analysis: Growth expectations  Efficient Market Theories suggest that trading behaviour of rational investors mean that markets provide a ‘fair value’ of shares based on expectations about securities’ future income streams. Market manipulation via incorrect information. Non-rational behaviour of investors due to behavioural biases (Behavioural Finance).  Never-the-less market capitalisation ratios are popular benchmarks for firms: 𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡h𝑒 𝐹𝑖𝑟𝑚(𝑖. 𝑒. 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 ∧𝐷𝑒𝑏𝑡) 𝑇𝑜𝑏𝑖𝑛 ′ 𝑠 𝑄= 𝑇𝑜𝑡𝑎𝑙 ( 𝑚𝑎𝑟𝑘𝑒𝑡 ) 𝐴𝑠𝑠𝑒𝑡 𝑣𝑎𝑙𝑢𝑒𝑜𝑓 𝑡h𝑒 𝑓𝑖𝑟𝑚 ′ 𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛+ 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 ′ 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 ( 𝑄𝑢𝑎𝑠𝑖 ) 𝑇𝑜𝑏𝑖 𝑛 𝑠 𝑄= 𝐸𝑞𝑢𝑖𝑡𝑦 𝐵𝑜𝑜𝑘𝑉𝑎𝑙𝑢𝑒+ 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 ′ 𝐵𝑜𝑜𝑘𝑉𝑎𝑙𝑢𝑒 Income Statement of Caterpillar Corp 2023 m$ Sales are Net Sales (i.e. sales taxes such as VAT are deducted) COGS Sales – COGS = Gross Profit Incl. e.g. Marketing Depreciation, Insurance, etc. EBIT = Earnings Interest on company debt before interest and taxation EBITDA = Earnings before interest, taxation, depreciation and Net income amortization (D&A non-cash  Financial Ratio Analysis: Profitability 𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛= ∗ 100 % 𝑆𝑎𝑙𝑒𝑠 𝑆𝑎𝑙𝑒𝑠 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛= 𝑆𝑎𝑙𝑒𝑠 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑁𝑒𝑡 ) 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛= 𝑆𝑎𝑙𝑒𝑠 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆h𝑎𝑟𝑒 ( 𝐸𝑃𝑆 ) = 𝑁𝑜 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠h𝑎𝑟𝑒𝑠 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 ( 𝑅𝑂𝐸 )= 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 ( 𝑅𝑂𝐴 ) = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝐵𝐼𝑇 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 ( 𝑅𝑂𝐶𝐸 ) = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 If a firm funds £m30 of its capital needs from debt and £m70 from equity, and the interest rate is 5% (non-tax deductible) and the firm's EBIT is £m9 and the firm's tax payments are £m2. What What is the firm's happens if theROE? interest costs are tax deductible and the firm’s tax rate is Scenario 1 20%? Debt/Equity £m30/£m70 EBIT 9 (ROCE) 9/100 = - 9% Interest 0.05*30 = 1.5 What would the return have been if expense 9-1.5 =7.5 the firm had been funded only by Pretax income equity? - Taxes 2 EBIT – Tax = £9 - £2 = Net Income 7.5 – 2 = 5.5 £7. £7/£100 = 7% ROE 5.5/70 = 7.8% Leverage effect! If a firm funds £m30 of its capital needs from debt and £m70 from equity, and the interest rate is 5% (non-tax deductible) and the firm's EBIT is £m9 and the firm's tax payments are £m2. What What is the firm's happens ROE? costs are tax if the interest deductible and the firm’s tax rate is 20%? Scenario 1 Scenario 2 Debt/Equity £m30/£m70 Debt/Equity £m30/£m70 EBIT 9 EBIT 9 (ROCE) 9/100 = 9% (ROCE) 9/100 = 9% - Interest 0.05*30 = 1.5 - Interest 0.05*30 = 1.5 expense expense Pretax income 9-1.5 =7.5 Pretax income 9-1.5 =7.5 - Taxes 2 - Taxes 2 – (1.5*20%) =1.7 Net Income 7.5 – 2 = 5.5 Net Income 7.5 – 1.7 = 5.8 ROE 5.5/70 = 7.8% ROE 5.8/70 = 8.3% Leverage effect! Tax induced leverage effect!  Financial Ratio Analysis: Solvency and Liquidity  The difference between ROE and ROCE (or ROA) reveals a “leverage effect”. Made worse by tax incentives. As debt is more risky for firms than equity, financial managers need to closely watch the solvency and liquidity of the firm to avoid default.  Debt covenant often specify minimum ratios for solvency and liquidity ratios: 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 , 𝑡𝑎𝑥 𝑎𝑛𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 ( 𝐸𝐵𝐼𝑇𝐷𝐴 ) 𝐶𝑎𝑠h 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜= 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑜𝑡𝑎𝑙 ( 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 ) 𝐷𝑒𝑏𝑡 − ( 𝐶𝑎𝑠h 𝑎𝑛𝑑 𝐶𝑎𝑠h 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠 ) 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝐵𝐼𝑇𝐷𝐴= 𝐸𝐵𝐼𝑇𝐷𝐴 Financial Ratio Analysis: Market Assessment  Investors in listed companies do not pay the book value for their shares, but the market value.  The market value reveals what investors believe the future income streams of the firm are worth to them (taking into account the investment risk of the firm). 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠h𝑎𝑟𝑒 P ric e/E arnings ratio ( P / E ratio )= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑝𝑒𝑟 𝑆h𝑎𝑟𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑝𝑒𝑟 𝑆h𝑎𝑟𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑌𝑖𝑒𝑙𝑑= 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆h𝑎𝑟𝑒 Financial Ratio Analysis: Market Assessment  Investors in listed companies do not pay the book value for their shares, but the market value.  The market value reveals what investors believe the future income streams of the firm are worth to them. 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠h𝑎𝑟𝑒 P ric e/E arnings ratio ( P / E ratio )= 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑝𝑒𝑟 𝑆h𝑎𝑟𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑝𝑒𝑟 𝑆h𝑎𝑟𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑌𝑖𝑒𝑙𝑑= 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆h𝑎𝑟𝑒  As investors take the riskiness of their investments into account, they will expect to get a higher rate of return on companies which are perceived to be riskier.  The Risk Premium measures the difference between less and more risky investments.  Cash flow and Working Capital (more next week)  Working capital Is the capital required to fund the firm’s operations. Working Capital is usually defined as “current assets less current liabilities.” Source: McLaney, E. and Attrill, P. (2023) Accounting and Finance: An