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BEC22306 Corporate financial management: summary lectures and book

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A summary of all chapters covered in the book Corporate Fianance by David Hillier (third edition) in the course Corporate Financial Management (BEC22306), plus additional information and notes from the lectures.

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  • December 10, 2019
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BEC22306: Corporate Financial Management
Summary book: Corporate finance (third edition) by David Hillier et al.


Lecture 1
Learning outcomes
 Assess the objectives of financial management
 Use the balance sheet and cash flow statement in financial decision making
 Financial statement analysis

Investment decisions

Main points of the lecture
 What is the economic condition of the firm?
 Balance sheet, profit loss account and cash flow statement
 Financial statements
o Liquidity
o Solvency
o Asset management and turnover
o Profitability
o Market value



Chapter 1: Introduction to corporate finance
1.1 What is corporate finance?
Non-current assets = will last a long time, e.g. buildings

Current assets = short lives, like inventory

Current liabilities = loans that must be repaid within one year

Non-current liabilities = does not have to be paid within one year

Shareholders equity is the difference between the value of assets and liabilities.

The financial manager

How they create value? Firms should:

1. Try to buy assets that generate more cash than they cost.
2. Sell bonds, shares and other financial instruments that raise more cash than they cost.

Timing of cash flows

Individuals prefer to receive cash flows earlier rather than later.

Risk of cash flow

People are risk averse.

1.2 The goal of financial management
e.g. profit maximisation, maximizing share value

,controlling risk

Capital budgeting = the process of planning and managing a firm’s long-term investment.

Capital structure = the mixture of long-term debt and equity maintained by a firm.

Net working capital = current assets minus current liabilities.

The size of the pie is the value of the firm in the financial markets.
V = D + E , where
V is value of the firm, D is market value of debt (bonds), E is market value of equity (shares).

1.3 Financial markets
Debt securities = contractual obligations to repay corporate borrowing.

Equity securities = shares that represent non-contractual claims to the residual cash flow of the firm.

Money markets = the markets for debt securities that will pay off in the short term (< 1 year).

Capital markets = for long term debts (> 1 year) and for equity shares.

The primary market: new issues

When governments and public corporations initially sell securities.

Secondary markets

A secondary market transaction involves one owner or creditor selling to another. Provide the means
for transferring ownership of corporate securities.

Dealer versus auction markets

Dealer markets are called over-the-counter markets. Now almost all electronic.

Auction markets differ from dealer markets;

 Auction market has a physical location
 In dealer market most of the buying and selling is done by the dealer, in auction the dealer
only plays a limited role

Trading in corporate securities

Stock market liquidity is very important to a financial manager  the easier and cheaper to trade 
the more demand in the firm.

Chapter 2: corporate governance
2.1 the corporate firm
The sole proprietorship

A sole proprietorship is a business owned by one person.

 Cheapest form
 No corporate income taxes
 Unlimited liability for business debts and obligation
 No distinction between personal and business assets
 Life of firm is limited by life of owner

,Disadvantages proprietorship:

1. Unlimited liability
2. Limited life of the enterprise
3. Difficulty of transferring ownership
4. Difficulty in raising cash

The partnership

The partnership is a business formed by two or more individuals.

 General partnership: all partners agree to provide some fraction of the work and cash and
share the profits and losses.
 Limited partnership: permits the liability of some partners.

Corporation

A corportation is a business created as a distinct legal entity composed of one or more individual
entities.

Advantages of corporations:

1. Ownership can easily be transferred (by shares)
2. Unlimited life
3. The shareholders liability is limited to the amount invested in the ownership shares  max
risk of investment

Disadvantages of corporations:

1. Taxes: personal income tax on dividends AND also normal firm tax; so double taxation

2.2 the agency problem and control of the corporation
Type I agency relationships

Between shareholders and management.

Principal-agent problem: conflict of interest.

If you offer a commission of e.g. 10% this problem might not exist.

Management goals

Agency cost is the cost of a conflict of interest between shareholders and management.

 Corporate expenditure
 Monitor actions

Managerial compensation

Usually tied to financial performance, often share value.

Options are often used to motivate employees of all types.

Shareholder rights

Shareholders elect directors  therefore control the corporation through the right to elect the
directors.

,Structures that limit the power of any single shareholder:

 Voting rate ceilings: restrict voting power for an investor to a specified percentage of shares
 Ownership ceilings: forbid any shareholder from taking a holding of greater than a specified
percentage of shares
 Priority shares: give rights, e.g. appoint a board member or veto a proposal.
 Golden shares: are found in former state-owned enterprises. Also rights like veto.
 Depositary receipts: equity ownership without the voting rights. E.g. in a foundation.

Other rights of shareholders:

1. Share of dividends paid
2. Share in assets remaining after liabilities have been paid in a liquidation
3. Vote

Dividends

1. Not a liability of the corporation. The amount and even whether it is paid are decisions based
on the business judgement of the board of directors.
2. Are paid out of the business after-tax profits, not a business expense
3. Received by shareholders; taxable

Type II agency relationships

Between shareholders who own a significant amount of company’s shares and other shareholders
who own only a small amount.

Big share  can make the firm’s objective aligned to own personal objective. Can be in conflict with
objective of someone with smaller share.

Stakeholders

Employees, customers, suppliers and even the government.

In countries with two-tier boards, like NL, stakeholders are formally included in the decision-making
of the firm, although it is supervisory board must report.

2.3 The governance structure of corporations

2.4 The OECD principles of corporate finance
1. Ensuring the basis for an effective corporate governance framework: the corporate
governance framework should promote transparent and efficient markers, be consistent
with the rule of law and clearly articulate the division of responsibilities among different
supervisory, regulatory and enforcement authorities.
2. The rights of shareholders and key ownership functions: giving shareholders power to
influence the direction of their company is the basis rationale underlying this principle.
3. The equitable treatment of shareholders: firms must ensure that minority shareholders are
protected and that policies introduced by the company do not penalize them.
4. The role of stakeholders in corporate governance: other stakeholders such as employees
and local communities.
5. Disclosure and transparency: states the main types of information that companies should
disclose to the market.

, 6. Responsibilities of the board

2.5 international corporate governance
Investor protection: the legal environment

 civil law system
 religious principles
 common law

The financial system: bank and market-based countries

Culture and corporate governance

Agency theory argues that managers are selfish agents who will pursue their own objectives at the
expense of all other stakeholders, including shareholders. As a result, contractual obligations
between the firm and management must exist that bring managerial objectives in line with
shareholders.

Ethics and corporate governance



Chapter 3: Financial statement analysis
3.1 The statement of financial position (balance sheet)
Showing a firm’s accounting value on a particular date.

Liquidity = the ease and quickness with which assets can be converted to cash.

Assets – liabilities = shareholder’s equity

Value versus costs

All listed companies in the EU are required to use International Financial Reporting Standard (IFRS).
The tradable value of assets is likely to be different from their accounting value.

3.2 The income statement
Measures performance over a specific period.

 Operations section: reports the firm’s revenues and expenses from principal operations.
 Non-operating section: includes all financing costs.
 Section about taxes

Non-cash items = expenses charged against revenues that do not directly affect cash flow, such as
depreciation.

Time and costs

Short-run: equipment, resources and commitments are fixed, but outputs can vary.

Long-run: all costs are variable. Product cost and period costs distinction.



3.3 Taxes
Average tax rate = your tax bill divided by your taxable income / the percentage of your income that
goes to pay taxes.

, Marginal tax rate = the tax you would pay (in %) if you earned one more unit of currency.

3.4 Net working capital
Current assets minus current liabilities

3.5 Cash flow
Comes from or goes to the three main areas:

 Operating activities
 Investing activities
 Financing activities

Net cash flow is the sum of these three.

A negative cash flow represents a movement of cash out of the firm.

Profit is not a cash flow.

3.6 Financial statement analysis
To compare two companies, we must standardize the financial statements. A common way to do this
is to work with % instead of monetary amounts. The resulting financial statements are called
common-size statements.

3.7 Ratio analysis
Another way of comparing different sizes companies is by using financial ratios.

Short term solvency or liquidity measures

current assets
Current ratio =
current liabilities
To a creditor: the higher the better.

To the firm: a high current ratio indicates liquidity, but also an inefficient use of cash and other short-
term assets. Expect at least 1.

current assets−inventory
Quick ratio =
current liabilities
Long term solvency measures

total assets−total equity
Total debt ratio =
total assets


profit before interest ∧taxes
Earnings before interest and taxes =
interest
Problem: not really a measure of cash available to pay interest.

Solution:
EBIT +depreciation
Cash coverage ratio =
Interest

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