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The 6 fundamental lessons of corporate finance Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 1  Advanced Corporate Finance for Managers Course: the logic, methods and tools for the company's financial policies The fundam...

The 6 fundamental lessons of corporate finance Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 1  Advanced Corporate Finance for Managers Course: the logic, methods and tools for the company's financial policies The fundamental logic: Value creation in the company Assets Liabilities and equity  What is the correct cost of debt?  What is the market  How much debt is it right to take on? value of assets?  How do we decide a reasonable debt  What are the relevant to equity ratio? cash flows for Financial debt  What is the effect of debt on the determining the probability of default? value?  What are the economic, financial and  What is the correct fiscal impacts of different levels of risk premium and cost debt? of capital to use? Asset  How many resources to draw from  What is the effect of shareholders? debt in terms of asset  What is the correct cost of equity value? capital?  What are the effects Equity  What monetary remuneration of bankruptcy and the (dividends) is it correct to distribute to costs of bankruptcy? the Equity capital?  What is the correct  How many resources is it convenient level of operational to retain or reinvest in the company? reinvestment? Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 2  The relationships between financial markets, firms and real markets Financial markets Firm Real markets Capital Equity market Dividends Net Purchase/ Invested sale of goods and Capital Operating cash flows services (NIC) (business activity) Financial debt Debt market Interests Taxes Government Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 3  The 6 "basic" lessons of corporate finance To introduce a general framework of reference to managerial finance it is necessary to have some basic theoretical tools and understand their logic. We have summarized the notions that refer to these tools and these logics in 6 "basic lessons" of corporate finance: 1. The difference between accounting and financial logic with reference to the "theory of value" 2. The share value generation mechanisms within companies 3. The concept of efficient market and "equilibrium" prices and returns: the cost of capital 4. The concept of risk and the notion of the value of the company (and of shares) as a random variable 5. Corporate finance as a mechanism for “maturity transformation” 6. The relationships between the goals of managers and those of shareholders, that is, the operating logic of companies in relation to the expectations of the various stakeholders Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 4 1) The difference between accounting and financial logic with reference to the "theory of value" Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 5  The difference between accounting logic and financial logic: the accounting structure of the company Other liabilities Commercial liabilities Total operating Financial Financial assets Debt Debt Net invested Capital (NIC) Equity Equity Liquidity Liquidity Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 6  The accounting logic The aim of accounting systems: measure the process of capital accumulation based on historical values. Why do assets and liabilities equalize in a balance sheet? Because all the funds collected (sources) are converted into investments (uses) both in the constitution stage and in the following management stage Equity Net invested Commercial Capital and other (NIC) Sources liabilities Source Liquidity Investment Of capital collection (Use) Financial debt Liquidity Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 7  The difference between accounting logic and financial logic: financial […or market] logic Unlike accounting logic, which uses a "historical" perspective of capital accumulation and valorization [backward looking], finance uses a "prospective/future" logic [forward looking]. According to the financial approach, the value of any asset is represented by the value of the future financial flows (uncertain, by definition) that it will generate in favor of the owner, discounted at a specific moment in time, on the basis of a cost of capital representative of the financial value of the time and risk to which these flows are subjected. In other words, the market "defines" and adjusts (over time) the valuation of the assets taking into account the expected flow generation conditions and in particular 3 fundamental parameters:  The amount of incoming and outgoing financial flows  The time-distribution of financial flows  The value of time and the risk of financial flows In this context, using a financial framework, the objective of the company (and therefore of the management that manages it) is the maximization of the wealth of the shareholders and therefore the maximization of the share value of the company: this represents the core of the theory of value creation. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 8  The financial “view" and the perspective of value creation Based on the premises and the logic it adopts, the financial/market perspective has taken as its basis some [simple] fundamental rules: The value of an asset for the owner depends on the cashflows that it generates over time The financial value of the cashflows depends on the [monetary] amount of the flows themselves The financial value of cashflows depends on their distribution over time [further flows are worth less] The economic (market) value of the cashflows (given the temporal distribution) is not "absolute" but depends on an “external” market parameter (the cost of capital), i.e. the return that the market offers for cashflows of the same quality (risk) This return offered by the market depends, for a first component, on the return offered for risk-free securities and… For a second component, it depends on the quality of the financial cashflows generated by the company, which determines the cost of capital to be applied to the returns and is represented by their risk Risk is associated with uncertainty in future returns Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 9  Accounting logic and financial logic: a comparative framework of the two approaches Asset side Accounting Value (NIC): Net invested capital (it is the accounting value of capital accumulated over time) Financial logic It discounts at time 0 what is expected to Investments happen in the future (uncertain) 0 1 2 3 4 5 Time -5 -4 -3 -2 -1 0 Accounting logic It gets to time 0 value by summing up what occurred in the past (certain) Discounted cash flows Asset side Market Value: Enterprise value (it is the market value of invested capital, that is the value of discounted operating cash flows) Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 10  The introduction of risk into the value creation approach The core of the transition from accounting/book values to market/financial values is the following: market values (based on future cashflows) undoubtedly have a greater significance than book values, because they measure the future economic utility of the asset for the investor and incorporate the information that will determine this economic utility with respect to what will happen in the future, however, given this advantage, the transition from accounting logic to market logic implies having to consider uncertain values: The market value requires estimating the future financial flows associated with the asset; Future flows are, by definition, estimated and must therefore be forecasted, unlike historical values; Being future flows, they are, by definition, flows that are uncertain in their values, and therefore risky; Their degree of risk depends on the difficulty in predicting them, or on the potential dispersion which is linked to the characteristics of the company and the business in which it operates; Since it is possible to define a probabilistic distribution of the expected flows for each future year, the economic/market value becomes a function of a series of stochastic variables (the annual flows) of which the expected value and the standard deviation (the risk) are estimated; Since the expected flows are stochastic, the market value of the assets (the sum of the discounted values) is also represented by a stochastic variable. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 11 2) The share value generation mechanisms within companies Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 12  Shareholder value creation: from capital budgeting to the theory of value creation The aim of the financial and market logic: to measure the process of equity value creation based on the value of future discounted cash flows. Why in company financial valuation assets and liabilities equalize? Because all the value generated by the firm (asset side) is shared between debtholders [debt] and shareholders [equity] Equity [Market value] Equity Asset side Market Value [accounting] distribution Value value Net [Enterprise generation Invested value] capital Financial Financial [NIC] Debt Debt [market [accounting] value] Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 13  Accounting values and market value: the relationship How do financial and accounting logics interact? Value Equivalence (financial) Equity Enterprise Side Value Market value (asset side Equity Market value) Net invested Capital NIC Financial Market value Debt of debt Accounting equivalence Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 14  The mechanism of value creation: maximizing enterprise and equity value Management’s aim: Aim of theory of value creation: Maximizing asset side Value Maximizing Equity value Equity Enterprise side Value What is the relationship? market (asset side value market value) Market value of debt Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 15  Valore contabile [“asset side”] vs. valore di mercato [enterprise value]: goodwill operativo e goodwill dell’equity Goodwill [difference Equity between Goodwill enterprise value and CIN] Equity Operating free Market generates value cash flows Accounting (book) Net Invested asset side value Capital Market Value of equity Cash [Enterprise (asset side flow value] accounting value) K [Investments Cumulated Net Over time] financial debt Cost of capital [K] Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 16  A summary scheme: from accounting values to market values, the value creation process The process of investment and creation of value can be summarized in the following points: 1) Collection of capital [in the form of debt or equity] available to the enterprise to be invested in operational projects [book value of equity and debt] 2) Definition of the investment process [capital budgeting] through the selection of projects on the basis of economic attractiveness [NPV/IRR] 3) Build up of net invested capital [NIC] or net assets of the company 4) Management of net invested capital and generation of operating cashflows associated with investments 5) Evaluation of discounted future cashflows based on their specific risk level and determination of the net asset value [asset value or asset market value]] 6) Distribution of the enterprise value between debt (at market value) and equity (at market value) and identification of the goodwill or badwill of equity Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 17  Key identities for market value To explain the mechanism and logics of value creation, let’s start from the accounting equation: NIC Equity Fin Debt The corresponding “market value” equation is instead the following: EV Equity Fin Debt ⇒ Equity EV Fin Debt Since [ EVMkt = NIC + Goodwill ] assuming, as a standard in the economic literature, the equivalence between market value and accounting value of debt, that is: Fin DebMkt = Fin DebAcc , we can write: Equity EV Fin Debt NIC Goodwill Fin Debt That is: Equity Equity Fin Debt Goodwill Fin Debt Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 18  Key identities for market value Simplifying: Equity Equity Goodwill From which, substituting: EV NIC Goodwill Equity Equity Asset side value Equity side value generation distribution The last (value) identity makes it possible to understand the process of generating and distributing economic value. Any change in the market value of the enterprise [enterprise value] is transferred to the shareholders in the form of goodwill, i.e. the difference between equity at market value and book equity, but is not transferred to the market value of the debt, which is why the equity is defined as "risk capital". Consequently, the maximization of enterprise value corresponds to the maximization of equity and and the wealth of the shareholders. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 19  The most used measures to determine value creation: the «price to book value » and the «Tobin’s Q» An indicator frequently used to synthetically measure the creation of value by a company at an equity level is the "price to book value": Share price Equity Price to book value Equity per share Equity Another more rarely used indicator is the "asset side" form of the previous indicator, the so- called "Tobin's Q": Market value of the firm EV EV 𝐓𝐨𝐛𝐢𝐧 𝐬 𝐐 NI𝐶 𝑎𝑡 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡 NICReplacement∗ *The NIC at replacement cost represent the cost that the company would have to bear to buy back all of its "assets" at current market prices. The value of «Q» therefore measures the ratio between the market value of the company (equity + debt) based on expected cash flows and the value of the same company if all its assets were to be repurchased at market price (the theoretical investment). Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 20  Value creation and bankruptcy risk in companies: is there a relationship? Why is it important to carry out investments with a positive NPV? To maximize the enterprise value and equity value To limit (or avoid) bankruptcy risk Positive goodwill Case 1 EV < Debt; Equity market value < 0 Default Value neutrality Case 2 Accounting Enterprise Equity value Negative goodwill Case 3 Default Case 4 NIC Financial debt Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 21  Value creation in a company: An example Goodwill : 20 Equity (market) Equity Case 1) =40 (accounting): 20 Case 1 Enterprise NIC + Value=60 + liquidity: Financial liquidity=10 40+10 Financial Debt: 30 Debt :30 Goodwill: 30 Equity (market) Equity Case 2) =50 (accounting): 20 Enterprise Case 2 NIC + Value=70 + liquidity: liquidity=10 Financial 40+10 Financial Debt: 30 Debt :30 Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 22 3) The concept of efficient market and "equilibrium" prices and returns: the cost of capital Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 23  Cost of capital and return: the equilibrium conditions To recognize the mechanism of value within the company it is necessary to understand the concept of return on capital, as opposed to that of the cost of capital. The cost of capital represents an opportunity cost, i.e. the alternative return offered by the market for an investment with the same characteristics, which investors give up to invest in the specific project or company, or in a specific asset. In other words, the cost of capital is the rate of return that the investor could have obtained on the market from the best alternative investment of equivalent risk. For an investment to generate value, the expected return on invested capital must be higher than the cost of capital. In essence, therefore, while the theory of finance defines the conditions of equilibrium (return equal to the cost of capital), the shareholders (and the managers on behalf of the shareholders) in fact try to reach the conditions of "violation" (in a favorable sense) of the equilibrium defined by the theory. Since shareholders want to see their wealth maximized, they seek to invest in projects that provide a return higher than the cost of capital, while avoiding projects that provide a return lower than the cost of capital. In this way it becomes clear that the financial market represents a mechanism for selecting the best entrepreneurial opportunities and eliminating the worst. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 24  The two stages in the life of companies and the role of the market: 1) setup The economic life of a company is represented by two phases: a) set up and b) operations. a) Set up In this phase, the assessment of the convenience of the investment is evaluated on the basis of the value of the initial investment compared to the current value of the financial flows that the financiers (shareholders, and lenders) expect from the investment in the future. If the value of the expected (discounted) future cashflows is greater than the initial investment, the conditions are created for a (positive) “imbalance” of value. The value of the company, net of the initial investment by the financiers, represents the NPV (Net present value) of the initiative (the goodwill) based on the following formula: 𝐶𝐹 𝑁𝑃𝑉 𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙 INV NIC 𝐸𝑉 1 𝑘 In this phase, investors decide whether to make the investment by setting up the business, and select the business ideas that show a positive NPV or, at most, zero. In these circumstances it is normal to expect a (positive) imbalance between the expected value of the flows generated and the investment (investments with a negative or zero expected NPV are not undertaken). Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 25  The two stages in the life of companies and the role of the market: 2) operations b) Operations When the company is already operational, assuming a firm financed only by equity capital, the shareholder cannot request the return of his investment directly from the company, but is obliged to sell (or buy) his shareholding on the market (even if the company is not listed). The price that will be offered may be completely different from the value of the original investment. The market, in fact, determines the economic value of the company (the market value of the equity), and the consequent price per share, based on the discounted value of the flows that the company is expected to generate in the future, that is: FCFEt ∑ 𝐸 1 k 𝑃 N N In this case the following condition applies: 𝐹𝐶𝐹𝐸 ∑ 1 𝑘 𝑃 𝑁𝑃𝑉 0 𝑁 And it is easy to understand how the role of the market is to "generate" an equilibrium price, which incorporates and reflects all the information available on future financial flows to equity, and becomes much more difficult to reach a positive NPV. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 26  The role of the market Since the generally accepted hypothesis regarding financial markets is that they are efficient, it is easy to understand why the actual price at which shares will be traded must converge to the equilibrium price: 1) If the price on the market were lower than the "fair value“ (the discounted value of the expected cashflows), there would always be some investors on the market "willing" to increase their wealth by purchasing the security at a reduced price, obtaining a positive NPV; 2) If the market price were higher than the "fair" price, there would always be some investors on the market "willing" to increase their wealth by selling the security at a high price and reinvesting in a balanced security, obtaining a higher return compared to the risk borne. In these conditions, therefore, the market price should converge to the current value of the cashflows expected by the company. Instead, if the market price is in equilibrium (that does not allow the extraction of extra- value) why should an investor buy shares? There are two possible answers: on the one hand, an investor obtains, in equilibrium, a return in line with the expected one. On the other hand, it is possible that some investors on the market foresee, in the future, higher cashflows, which, purchased at the market price, would allow them to obtain a positive NPV and increase their wealth. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 27  Return and cost of capital in value creation: the internal rate of return [IRR] To delve deeper into value issues, it is necessary to introduce the concept of financial return on an investment, i.e. the "internal rate of return" (IRR), which is defined as: "the cost of capital that allows obtaining an NPV equal to 0". The general formula for the return on an investment is represented (in the single year case) by: Positive cashflows CF1 Rate of return = r = ‐1= −1 (−) Investment Inv0 Since the NPV of an investment can be written in the following formula: F1 NPV  - Inv 0  (1  k) If, other variables being equal, we identify the cost of capital that makes the NPV=0 (k*), then we can write: F1 F1 - Inv 0  0  k*   1  IRR (1  k* ) Inv 0 In this way it is clear that the cost of capital (discount rate) which leads to an NPV=0 is also a natural rate of return on the investment Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 28 Return and cost of capital in value creation: the internal rate of return [IRR] Consider an investment equal to I0=100; let's assume that over the next 3 years the investment returns 10% per year (capitalized), being then reimbursed at the end of year 3. The NPV of the project can be written as: Return in 3anno rendimento years3    Return in 2anno rendimento years 2  rendimento in 1anno year1  Return  1  10%   1  10%   1  10%  100  1  10%  3 -100  100   100   NPV  1 k 1  k  3 3  attualizzazione Discount factor If you want to know what the cost of capital is that equals to 0 the value of the NPV [i.e. the IRR] I will have to calculate the rate k* such that: 100  1  10%   100  1  k*   k*  10%  IRR 3 3 Since the investment "returns" 10% per year, the cost of capital that makes the discounted value (IRR) zero will be 10%. As indicated previously, the IRR can therefore be calculated as the cost of capital which eliminates the NPV of the investment, but also represents the implicit ["natural"] rate of return of the investment itself. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 29  Return and cost of capital in value creation: the internal rate of return [IRR] Since the IRR is calculated as a cost of capital, in some cases the cost of capital of an investment can be confused with the IRR. It is always good to keep in mind that: The IRR is a measure of investment profitability that depends solely on the amount and timing of a project's flows but NOT on market parameters the cost of capital is instead a "standard" parameter, determined by the market, which reflects the risk of the project (or company), to be used to calculate its value, but does not depend on internal conditions of the company Therefore, while the cost of capital derives from the financial markets, the IRR is an "internal" rate, independent of the market, which depends solely on the financial flows of the investment and represents its return. The IRR is the "financial" correspondent of the accounting rates of return (ROI, ROA, ROE etc.). Why is it important in the context of management activity? Since, as we have said, the objective of companies is to maximize shareholder value, their aim is to "violate" the efficiency of "real" markets, obtaining a higher return than the cost of capital so that the the enterprise value is greater than the value of the invested capital (at replacement costs so as to create "goodwill" for the company. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 30  The internal rate of return [IRR]: the general rule Following the previous logic, in fact, if the natural return on the investment is greater than the cost of capital (IRR > K), it will be: (1  IRR)t  (1  IRR)t  NPV  -Inv 0  Inv 0   Inv 0   1  t  0 (1  k) t  (1  k)   0 if instead it is (IRR < K), it will be: (1  IRR) t  (1  IRR) t   1  Inv 0 1  t   Inv 0  NPV  0 (1  k) t  (1  k)  In the first case the company will have created a goodwill which will be transferred to the value of the shares, in the second case it will have created a badwill (negative goodwill) which will reduce the wealth of the shareholders. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 31  Deepening the relationships between flows and stocks: the returns on assets and liabilities When considering the relationship between the company's assets and liabilities (between sources of capital and uses of capital from an accounting perspective and between asset side value and market value of liabilities and capital from a financial perspective) it is useful to keep in mind that:  the entire asset side return becomes a return for shareholders or financiers (excluding the part of the flows that is absorbed by taxes and "exits" the company), so that any under- or over-returns on the assets have an immediate effect on the returns (and on the values ) of equity and debt;  The company's operational risk (asset side) is divided between debt risk and equity risk, but, from a mathematical point of view, operational risk represents the weighted average of equity risk and debt risk;  Each of the asset categories/funding sources (CIN, liquidity, financial debt, equity) presents a return that is "recorded" in the company's income statement and financial statement. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 32  Cash flows generated and remunerations/returns: a resumptive scheme Shareholders Net invested [Equity] Capital Free cash N.I.C. Operating free Total cash flow to equity Cash flows Flows generated = Total return in absolute value Financial Debtholders charges [Debt] Liquidity Interest income taxes Government Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 33 4) The concept of risk and the notion of the value of the company (and of shares) as a random variable Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 34  The nature of risk and its role in finance Risk is one of the basic elements of corporate finance, as it influences the cost of capital and ultimately influences the economic value of any asset (shares, bonds, etc.) The reason for this lies in the fact that the financial approach considers future cashflows and that these are, by definition, uncertain and therefore risky. Risk is, therefore, a natural element of the financial approach, but it is also an essential element because it allows to modulate return expectations based on the risk faced The risk remuneration (the risk premium) represents in fact a basic component of the cost of capital and, from there, a fundamental determinant of the market value From a statistical point of view, this risk is represented by the dispersion of returns and is traditionally identified with the standard deviation of the returns of the assets or, in the case of returns expressed in absolute form, of the flows generated by the assets itself Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 35  Some basic elements in considering risk Some relevant elements from the point of view of risk from a corporate finance perspective: The returns, but also the operating cashflows, generated by an investment or a company, if risky, are random (stochastic) cashflows and are characterized by an intrinsic dispersion; This dispersion, which represents the risk of the cashflows, is "treated" financially through the use of an adequate cost of capital, but still leads to an enterprise value represented, as well, by a random variable, as the sum of a series of random variables (over time); The dispersion of enterprise value is a function of the degree of risk in expected operating cash flows; Since the value of a company's equity is represented by the difference between the enterprise value and a fixed quantity (the value of the debt), the value of the equity is also represented by a random variable, even when there is a single stock price. market; Finally, the dispersion of the equity value increases as the dispersion of the enterprise value increases, therefore the operational risk influences the equity risk Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 36  The difference between price and company value With reference to the previous points, it is important to make clear the difference between price and value. The price of a security (e.g. a share) derives from the meeting, on the market, between a buyer and a seller, who agree on the value of the security that one wants to buy and the other wants to sell. Since both do not know the future, it is reasonable to think that both share expectations about the expected value of returns (or cashflows) in future years, which determine the value of the security. This means that, despite agreeing on the price, seller and buyer "know" that the value of the security cannot be precise, but is necessarily represented by a distribution of possible (probable) values. The economic (or market) value of a risky security, therefore, unlike the price (which is a "punctual" and therefore a certain element), is always represented by a distribution of uncertain values, characterized by an expected value and a dispersion. This happens because the price "is realized" at a precise moment in time, while the value is an expression of uncertain future (discounted) cashflows. In reality, since any investor tries to obtain a positive NPV, the seller will sell at a certain price only if he thinks that the value of the security is lower, and the buyer will buy at that price only if he is convinced that the real value of the security title is higher. Paradoxically, therefore, the price that is formed on the market with reference to a security may not coincide with the expected value of the security, neither for the seller nor for the buyer. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 37  The probabilistic approach to future cashflows: the business plan Operating cash flow Expected Value Year -2 Year -1 Year 0 Year 1 Year 2 Year 3 Historical values Future expected values: Business plan Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 38 5) Corporate finance as a mechanism for “maturity transformation” Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 39  Corporate finance as a maturity transformation mechanism As we have seen, when we study corporate finance we must consider that: finance does not use a "historical" but a prospective view finance performs the function of maturity transformation With reference to the second characteristic, if we examine in depth the process of financing and cash flow generation by the company, it is easy to understand that the main financial "exchange" mechanisms imply a continuous transformation of maturities. The most obvious examples are: a) the contribution of equity capital (instant) against a remuneration over a long time horizon (dividends) b) The subscription of an (instant) loan in exchange for a reimbursement and interest (the reimbursement quotas) over a long time horizon c) Operational investments (instantaneous) against operating cash flows over a long time horizon This "exchange", which is natural in finance, justifies the mechanisms for determining the cost of capital and evaluating the financial value of time. Knowing the financial value of time is necessary precisely because financial returns are dilated and this implies that future flows must be reported at the time of investment to be homogeneous. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 40  Corporate finance as a maturity transformation mechanism The previous considerations refer to the logic of corporate finance according to these points: a) In finance, economic evaluations always refer to the algebraic sum between positive and negative values; b) Since the (negative) financing/investment flows are instantaneous and are used to generate (positive) remuneration flows that occur in future years, it is necessary to be able to estimate the expected value of future financial flows through all available information, relevant to the purposes of what will happen in the future; c) Since instantaneous and future flows do not have the same value, finance requires "pricing" the time; d) Time incorporates a value represented by the risk-free interest rate, but this does not exhaust the value of time, in fact… e) Since the relevant cashflows are future, they are necessarily uncertain and their uncertainty represents risk; f) Since risk increases over time, it is necessary to price the risk in relation to future time in the return on assets. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 41  Corporate finance as a maturity transformation mechanism 1 capital contribution Shareholders 3 Investiments 6 Dividends NIC Cash financial interests and 5 reimbursement 4 Cash flow generation Long time horizon 2 Financing instant time Banks/ Bondholders Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 42  6) The relationships between the goals of managers and those of shareholders, that is, the operating logic of companies in relation to the expectations of the various stakeholders Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 43 Goals of the company (of the managers) and goals of the shareholders The objective of the company recognized by traditional managerial theories (not managerialist ones) is represented by the maximization of the market value of equity, i.e. the maximization of shareholder wealth; The maximization of market equity depends on the condition of maximization of the value of the equity goodwill, which however coincides with the value of the operational goodwill, that is, the difference between enterprise value and net invested capital [CIN ], so there is, in these conditions, no conflict of interest between the objective of maximizing enterprise value and equity, indeed, the two objectives coincide; Maximizing enterprise value represents a relatively simple objective for managers to pursue; these must simply follow the indications of the theory of investment evaluation (capital budgeting), i.e. maximize the NPV of investments made with the available resources that are invested in operational activities [NIC]; Regardless of the principle of honesty towards shareholders (maximizing their value), the pursuit of equity maximization allows managers to:  Maximize their remuneration (bonuses, stock options etc.)  Minimize possible "value gaps" (difference between market value and theoretical value of shares and avoid hostile takeovers) Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 44