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Corporate Finance Summary
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This is a summary of the whole course of Corporate Finance for students of Business Economics at the VUB. It is based on the lectures and the book.
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CORPORATE FINANCECHAPTER 1: FINANCIAL MANAGEMENT
The role and objective of financial management
Questions Faced by Financial Managers:
Will a particular investment be successful? – Investment decision ( asset side of the
balance sheet) = capital budgeting decisions
Where will the funds come from to finance the investment? – Financing decision
(liability side of BS) = capital structure decisions
How should cash flows be used or distributed? That is, what is the optimal dividend
policy? – Dividend decision ( bottom line of financial statement; keeps CF in the
company -> internal financing for extra investments, or pay out profit in form of
dividends) = financial statement decision
- When you start a company you need to have funds = external funds (equity holders,
creditors (debt holders)) -> with that money you will do investments ; LT (machinery)
but also working capital ( inventory)
- If you have those investments you can start producing and sell -> transferring into
cash sales or accounts receivables (when they have time to pay)
- You have to follow up those accounts receivables
- This (producing and selling) is the engine of the company (the generator of cash) ; if
company is not able to sell the products or services => bankrupt for sure
- With that cash; pay back loan, workers… you distribute a part of your cash to your
investors and another part are funds for reinvestments (internal financing)
How should the financial manager take those decisions (investment, financing and
dividend)?
Main goal: shareholder wealth maximizing
Value creation is something with a view on the future ; it’s about maximizing the
present value of the expected future cash flows
The stock price of a company depends on the expectations of the future cash flows
1
, Cash flows = physical flows of cash, the amount of cash that the company will get in
the future and the timing of it
Shareholder Wealth Maximizing
Maximizing PV of expected future cash flows (what is the future value of present cash
flows)
1) Amount of expected cash flows
2) Timing of expected cash flows
3) Risk of expected cash flows
Measured by Market Value the firm’s common stock
– good decision increases the market price of common stock
Effective decision making requires an understanding of the goals of the firm:
!!Shareholders wealth maximization not profit maximization!!
- You have to maximize the present value of the future cash flows, not profit
maximization !!
Profit is :
– accounting figure
– static (no timing)
– no risk
Agency relationship:
Principal Shareholders (owners)
Board of directors Shareholder Wealth
Maximization
Agent Management
CEO, CFO, …
- Shareholders elect every year the board of directors
- They make more strategical decisions long term decisions, they evaluate the
management of the company (those are people who make daily decisions,
operations of the company CEO or CFO)
- Board of directors have to look that the management really take their decisions to
maximize shareholder’s wealth
Divergent Objectives
Problem created by separation of Owners (shareholders) and Management
Management may maximize its own welfare instead of the shareholders’ wealth
consumption of on-the-job perquisites (use of company cars, airplanes, luxurious
offices) -> those are costs, maybe private jet = + contracts, but most of the time is
not necessary -> so management has to look that they don’t do expensive costs
empire building -> management has the incentive to make the company as big as
possible, but this is not the same as wealth maximization; by taking over another
company can be a good decision or a bad -> stock price goes down -> they have the
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, incentive to do empire building because the management can be visible for other
companies or maybe they get a higher loan.. they have to monitor everything
Agency problem : shareholder and management -> management doesn’t make de
decesion that they should make for the sake of the shareholders
Solutions: but they cost money
Agency Costs= are cost that are involved with agency problem
Management incentives (stock options) -> paying management with stock options (=
is a financial instrument that has a value when the stock price goes up) -> if
management wants to be rich for themselves and he is paid in stock options, he will
make decisions that the stock price goes up = also good for shareholders
Monitor performance (audits) -> higher audit firm that evaluate the management
Complex organization structures (multiple managers) -> that not all the power is not
in one manager, less power on their own
Protective covenants (capital rationing) -> management has a limited budget for
which it can make decisions, if he goes over that budget he needs to have the
approval of the board of directors (= contractual restrictions on the budget)
Solutions for agency problem between manager and shareholder
Controller : main accountant, fiscal issues, accounting issues
Treasurer : financial issues, capital budget… (+ corporate finance)
3
, CHAPTER 5: THE TIME VALUE OF MONEY
INTRODUCTION
This chapter introduces the concepts and skills necessary to understand the time
value of money and its applications.
One $ or € today is worth more than one $ or € tomorrow: the current $ or € can be
invested to earn a rate of return
- a dollar today can already generate a certain return, whereas a dollar in the future is
not
Simple and Compound Interest
Simple Interest:
Interest paid on the principal sum only (you take away each interest that you get, you start
with a certain base money, that base money yields an amount of interest each year, but the
interest itself doesn’t get interest) ex. 100 dollars, 5 dollar interest, here: you take away 5
dollar each time <-> compound: you leave those 5 dollars on your saving account such that
in the next period you earn interest on the 105
Compound Interest:
Interest paid on the principal and on prior interest that has not been paid or withdrawn
(interest yield also interest)
0 1 2
100 € (10%)
Simple interest:
At year 1: FV (future value)1 = 100 + 100*10% = 110
At year 2: FV2 = 100 + 100*10% + 100*10% = 120
At year 2: FV2 = 100 * (1 + 10% +10%) = 120
At year n: FVn = PV(present value)0 * (1 + n*i)
Compound interest:
At year 1: FV1 = 100 + 100*10% = 110
At year 2: FV2 = 100 + 100*10% + 100*10% + 100*10%*10% (interest that returns interest
on your first period interest) = 121
2
At year 2: FV2 = 100 * (1 + 10% +10% + 10%^ ) = 121
n
At year n: FVn = PV0 * (1 + i)
4
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