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Best and Ultimate Slides Summary Applied Corporate Finance
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Best and Ultimate Slides Summary Applied Corporate Finance
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Applied Corporate Finance SlidesLecture 1 (§1)
An index can increase in value over time. An investor can for example use salary to acquire a
stock in the index. This salary comes from working for the firm or for the government whose
income comes from firm. This means essentially the money comes from the firm. The firm
raises money by selling product or services to clients, who can use it to invest. If the ECB
injects money in the system, we get inflation and no value is created. The source of the
increase of the index comes from the value created by the firm. Understanding the
foundations of the capitalistic economy is fundamental to corporate finance, especially for
new things (start-ups) where limited data is available. The take-away is that it is important to
understand the source of value.
An entrepreneur starts a business if he believes he is better at something than others. Core
competences are the operational activities, requiring certain assets (machines, building,
inventory, cash). If we create the market value balance sheet, the most important asset
shows up: human capital. The latter is a source of value, namely the value of the
entrepreneur. On the other hand are liabilities, financing (enabling) the purchase of assets.
Liabilities present people having confidence in the entrepreneur. Debt is a contract, whereas
equity is held by the residual claimholder (not a contract).
There is a market for the components of the balance sheet (human capital, equity,
machines). Liabilities are traded on the financial market, whereas assets are traded on the
real market. Markets can be characterized as easy or difficult depending on two characters:
1. How quickly and easily does information flow between agents. If this is very good
(listed companies), the ability to react is tremendous.
2. How easily can an investor react and trade on that information. For listed firms this is
very good.
If both are very good, the market is efficient (or perfect) and all information is captured in
the value of the asset. The expected return will be in line with the amount of risk that you
run. Prices by definition will be equal to the value (in equilibrium), as all information is
included in the price. For this reason, the NPV of assets in an efficient market is zero. The
idea of the capitalistic system is that if everyone knows all information, there will be no
value to gain. There is no possibility to generate value in the long-term, as the required extra
information is not possible due to efficiency. An efficient market is the ultimate democratic
process, where buying/selling represents voting.
For a real market, we have the same characteristics: (1) how does information flow between
agents and (2) how quickly can agents trade and react. The assumptions are that people are
risk-averse and greedy. For the real market it depends in which industry you are active
(Internet is fast, builder is slow). If either one of the two characteristics aren’t perfect, the
market is inefficient or imperfect. The expected return will not be in line with the amount of
risk that you run where risk is undefined. By definition the prices will be unequal to the value
of the cash-flows that they generate. Therefore, the NPV can be different from zero.
,As an entrepreneur you want to assess the market and the two dimensions. The goal is to
make the market inefficient, as this enables you to generate value (NPV unequal to 0). There
will be no possibility for competitors to enter the industry due to erected entry barriers. The
idea of the capitalistic economy that any market becomes perfect so without barriers.
Competitors cause an imperfect market to become perfect. The only way to prevent
competitors is to make the product as incomparable as possible through innovation. For
example, the idea of branding is that you do not compare the product to others (Coca Cola
versus AH Cola). The idea of marketing is to make your product as incomparable as possible,
so branding prevents the market process of happening. As an entrepreneur your goal is to
make the market as incomparable as possible.
Perfect information but no way to react can be a pharmaceutical company with patents.
Another example is a monopoly (NS). Third is an efficient scale, so a small village has one
baker and a second won’t come as the market is to narrow to divide it. Imperfect
information (nobody knows it) but it is perfectly possible to react can be family firms who
are very secretive and modest -> they make a lot of money and nobody knows it.
For non-listed firms the financial market can be imperfect. However, we assume the financial
market is perfect. When wanting to innovate to become wealthy, it is best to focus on the
real market rather than the assumed to be perfect financial market. When wanting to
increase value, it is better to increase cash flows (from assets -> operations) than the cost of
capital (from liabilities). We thus focus on the real market rather than the financial market.
To maximize value, we forget cost of capital and focus on cash flows. The cost of capital is a
premium for risk and time which are its two components.
T =∞
E 0 ( C Ft )
∑ ( 1+k )t
t=1
Financial problems don’t exist. Not being able to pay your loan is due to operational income.
As there is no value to be gained, debt restructuring will postpone but not solve anything.
The only way to solve them is to focus on the assets. Take-aways: only information and
trade/react matter, money is only to be gained in the real market and focus on cash flow. If
value is created by assets, the equity holder ends up with the money as it is residual.
If the aggregate of all assets in EU increases, we speak of GDP growth. This money goes to
the equity holders. The ECB will inject enough money that the inflation will not be too high.
If the GDP growth is 2% and the ECB injects 2%, there will be no inflation. The whole object
of the ECB is to assess how successful the entrepreneurs will be to compensate their growth.
The increase in the index comes from the value created by the entrepreneurs, whereas the
money comes from the ECB. Entrepreneurs will always try to look for inefficiency to be
diminished and value to be created. In the long-run share prices will rise.
1. Make a distinction between assets (core competence) and liabilities.
2. Focus on the market where information and react are out of line, to make it as
inefficient as possible.
3. When wanting to maximize value, focus on core competence and forget about
liabilities.
,It is not possible to create value by changing the cost of capital, because the liabilities are
automatically updated based on the existing assets (MM). You cannot fool the market. Thus,
it is impossible to create value by changing anything on the liability side. You have to focus
on the assets and operations, where in an imperfect market it is possible to create value.
Financial problems don’t exist, as refinancing leads to the same cost of capital. Instead not
being able to pay debt is an operational problem, as this shows a lack of sufficient cash
flows. The focus of an entrepreneur should be on the asset side. This is only true for the
really large firms. Debt is only a contract so is easy to change, but the assets which need to
be focused on is much more difficult as core competence. The essence is that you do not
create enough cash flows.
The aggregate of entrepreneurs earn value due to market imperfections, leading to GDP
growth. The ECB corrects this by printing money leading to inflation. If this doesn’t occur, the
system will collapse. The idea of creating value is that we have a collective of assets that can
be used more efficiently than the year before. We can produce more because of e.g.
innovation. This is due to making inefficient markets more efficient. Every market has the
tendency to become efficient. For inefficient markets there is a possibility to make profits, so
competitors enter the market. The solution is to innovate, finding new markets. If Apple
doesn’t innovate the market will become more efficient. At the end customers will only look
at price (without innovation) and the market becomes efficient. An entrepreneur should
make sure either nobody knows you are successful or nobody can react on the knowledge.
You need to innovate in order to create value.
Warren Buffet made the analogy between entrepreneurship and a castle with gold,
protected by a moat. The wider the moat, the easier it is to protect the gold. The intruders
are competitive forces. There are five sources for moat:
1. Intangible assets (branding): producing incomparable products.
2. Switching costs: your company is dependent on a certain service (Oracle, SAP).
3. Network effect (Facebook): the value of the company increases when more people
are using it.
4. Cost advantage (UPS): organize activities in such a way that others cannot copy it.
5. Efficient scale (NS): as soon as a competitor enters the market, they cannot make a
profit. The scale is perfectly right for one company, otherwise both lose money.
These moats are another way to say making the market as inefficient as possible.
Morningstar uses this analogy. There are companies with wide (Coca Cola), narrow (DR.
Pepper) and no moat (AH Basic).
, In finance we are not interested in the past, so ignore sunk cost. On the exam there will be a
question where sunk costs are included. We shouldn’t fall into the sunk cost fallacy, we are
only interested in the future. We use accounting numbers to have a clue about the future.
Our balance sheet focuses on the future. This is completely different than the accounting
balance sheet, which focuses on the past and on tangible assets. We are interested in
whether assets will generate cash flows now and in the future.
We are only interested in cash and ignore accounting numbers. Profit can be manipulated
legally. Cash is king and cannot be manipulated. We need the numbers of an accountant to
see how much is generated. Depreciation is an imagination, something that we invented. We
invented accounting for tax purposes. Corporate finance is only interested in money. Profit is
an invention.
The investment decision concerns the decisions on the asset side of the balance sheet. The
financing decision focuses on the liability side, where value can be gained through
imperfections. Lastly the dividend decision focuses on the equity holder.
Corporate finance is common sense. It is focused on maximizing the value of the business.
The focus changes across the life cycle. The assets in placed for an utility firm are huge,
whereas the growth assets are relatively small. Debt and equity are quite similar. For a tech
firm the growth assets are huge whereas assets in place are small, and equity is huge with an
absent of debt. It is impossible that equity is cheaper than debt, as it is residual. The
difference is debt is due to the fact that utility firms have stable cash flows, whereas tech
firms don’t. Moreover, utility firms have assets to be pledged. Corporate finance is universal,
e.g. the objective of risk management is value maximization. Any decision in the firm should
have this objective. While constraints and challenges vary between firms, the first principles
don’t change. Violating these principles will lead to paying a price. Almost every corporate
disaster or bubble has its origins in a violation of the first principles.
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