Finance and Risk Management; Summary Book, Lecture notes and Examples (from Connect)
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Finance and Risk Management for IB (EBB631B05)
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Rijksuniversiteit Groningen (RuG)
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Fundamentals of Corporate Finance 3e
Finance and Risk Management for IB (EBB631B05) Summary Include Summary Book (Fundamentals of Corporate Finance), Lecture notes and Practice questions (from Connect)
Corporate finance
Summary book + lectures (2020-2021)
Chapter 1; Introduction to corporate finance
Imagine that you were to start your own business, you would have to answer the following 3
questions;
1) Investment; what long-term investments will you make?
- What lines of business will you be in, what sort of buildings/machinery/equipment will you
need?
2) Financing; where will you get the long-term financing for your projects?
- Will you bring in other owners or will you borrow the money?
3) Working Capital Management (Liquidity); how will you manage your everyday financial
activities?
- Such as; collecting from customers and paying suppliers
Corporate finance, broadly speaking, is the study of ways to answer these 3 questions
Capital budgeting; the process of planning and managing a firm’s long-term investments
- In capital budgeting the financial manager tries to identify investment opportunities that
are worth more to the firm than they cost to acquire. Thus the financial manager is
responsible for investment decisions.
- Loosely speaking; the value of the cash flow generated by an asset exceeds the cost of that
asset
The types of investment opportunity that would typically be considered depend in part on the
nature of the firm’s business
- Example; Tesco deciding whether to open another store would be an important capital
budgeting decision
- Example; Apple deciding to develop and market a new Ipad would be a major capital
budgeting decision
Regardless of the specific nature of an opportunity under consideration, financial managers
must be concerned not only with how much cash they expect to receive, but also with when
they expect to receive it, and how likely they are to receive it
- Evaluating the size/timing/risk of future cash flows is the essence of capital budgeting
The second question for the financial manager concerns ways in which the firm obtains and
manages the long-term financing it needs to support its long-term investments
Capital structure; the mixture of long-term debt and equity maintained by a firm
- A firm’s capital structure (financial structure) is the specific mixture of long-term debt and
equity the firm uses to finance its operations.
- Long-term debt; long-term borrowing by the firm (longer than 1 year) to finance its long-
term investments
- Equity; the amount of money raised by the firm that comes from the owners’ investment
Working capital; a firm’s short-term assets/liabilities
- Short-term asset; inventory
- Short-term liability; money
1
,The financial manager in a corporation makes decisions for the shareholders of the firm
- The financial manager acts in the shareholders’ best interest, by making decisions that
increase the value of equity
- Good decisions ----> increase value of equity
- Poor decisions ----> decrease value of equity
The goal of financial management is to maximize the current value per share of the existing
equity
Financial market brings buyers and sellers together, it is debt and equity securities that are
bought and sold
Primary market; The corporation is the seller and the transactions raises money for the
corporation
- Securities are sold to investors
- Money that is raised, goes to issuing the firm (money goes to the firm)
2 types;
1) Public offering; selling securities to the general public
2) Private placement; negotiated sale involving a specific buyer
Secondary market; a transaction where one owner/creditor sell it to another
- Investors trade securities with each other
- Transferring ownership of corporate securities
- Money that is raised, goes to the seller of the securities
2 types;
1) Dealer markets; buy/sell for themselves, at their own risk
2) Auction markets; has a physical location, primary purpose is to match buyer and seller
Although a corporation is directly involved only in a primary market transaction (when it sells
securities to raise cash), the secondary markets are still crucial to large corporations. The
reason is that investors are much more willing to purchase securities in a primary market
transaction when they know that those securities can later be resold if desired
2
,Chapter 2; Corporate Governance
We are going to discuss 3 different forms of business organizations;
1) Sole proprietorship
2) Partnership
3) Corporation
Sole proprietorship; business owned by a single individual
- Owner keeps all the profit
- Owner has unlimited liability for business debts
- No distinction between personal and business income, so all business income is taxed
as personal income
- Small/micro companies (between 1-9 employees)
Partnership; a business formed by two or more individuals or entities
2 subforms;
1) General partnership; all partners share gain/losses, and all have unlimited liability for all
partnership debts
- The way partnership gains/losses are divided is described in the partnership agreement
(can be informal (oral agreement) or formal (written document))
2) Limited partnership; one or more general partners will run the business and have
unlimited liability, but there will be one or more limited partners who will not actively
participate in the business
- A limited partner liability for business debts is limited to the amount that the partner
contributes to the partnership
- Common in law/accounting firms
The primary disadvantages of sole proprietorship and partnership as forms of business
organization are;
- Unlimited liability for business debts on the part of the owners
- Limited life of the business
- Difficulty of transferring ownership
Corporation; a business created as a distinct legal entity composed of one or more
individuals/entities
- Disadvantage; double taxes
- Advantage;
- ownership can be transferred, and the life of the corporation is therefore not limited
- the shareholders have limited liability for corporate debts (the most they can lose is
what they have invested)
Type 1 agency problem; the possibility of conflict of interest between the shareholders and
management of a firm
- Example; you hire someone to sell your car and agree to pay that person a flat fee when
he sells the car. The agent’s incentive in this case is to make the sale, not necessarily to
get you the best price.
- Managers want to maximize their own wealth/power
- Shareholders want to maximize the value of the company
3
,Agency cost; the cost of the conflict of interest between shareholder and management
- Indirect cost; opportunity cost
- Direct cost;
- Corporate expenditure that benefit managers at the expense of shareholders
(example; luxurious yacht)
- Corporate expenditure to monitor/control manager activities (administrative tiers)
Shareholders elect directors, who in turn hire managers (and fire managers)
- Shareholders therefore control the corporation through the right to elect the directors
Cumulative voting; a procedure in which a shareholder may cast all votes for one member of
the board of directors
- The total number of votes that each shareholder may cast is determined first
!"#$%&
- If there are N directors up for election, then '() + 1 share will guarantee you a seat
- The more seats that are up for election at one time, the easier it is to win one (and the
cheaper it is)
Straight voting; a procedure in which a shareholder may cast all votes for each member of the
board of directors
- Can ‘freeze out’ minority shareholders
- Guarantee to a seat; you have to own 50% + 1 shares
- The owner of 10,000 shares has 10,000 votes
Example;
A corporation has 2 shareholders
- Smith has 20 shares
- Jones has 80 shares
They both want to be a director, there are a total of 4 directors to be elected
Cumulative;
- Smith will cast 20 x 4 = 80 votes
- Jones will cast 80 x 4 = 320 votes
- if smith gives all hives votes to himself, he is assured of a directorship, because Jones can’t
divide 320 votes among 4 candidates in such way as to give all of them more than 80 votes,
so smith will finish fourth as worst
Straight;
- Smith can cast 20 votes per vote-round
- Jones can cast 80 votes per vote-round
Jones will elect all the candidates
4
,Example;
€20 per share / cumulative voting / 10.000 shares / 3 directors
How much does it cost to ensure yourself a seat on the board?
&"#$%& )****
- '()
+ 1 𝑠ℎ𝑎𝑟𝑒 = +()
+ 1 = 2501 𝑠ℎ𝑎𝑟𝑒𝑠
- 2501 𝑠ℎ𝑎𝑟𝑒𝑠 × €20 = €50.020
Proxy voting; a grant of authority by a shareholder allowing another individual to vote his
shares
- Shareholders can come to the annual meeting and vote in person
- Or they can transfer their right to vote to another party
Pre-emptive right; a company that wishes to sell equity must first offer it to the existing
shareholders before offering it to the general public
- The purpose is to give shareholders the opportunity to protect their proportionate
ownership in the corporation
Dividends; payments by a corporation to shareholders made in either cash or shares
Type 2 agency problem; a possibility of conflict of interest between controlling and minority
shareholders
- Majority shareholders want to take advantage of their power to control
- When an investor owns a large percentage of a company’s shares they have the ability to
remove/install a board of directors through their voting power
- This means that, indirectly, they can make the firm’s objectives aligned to their own
personal objectives which may not be the same as that of other shareholders with a
smaller proportionate stake
Stakeholder; someone, other than a shareholder/creditor, who potentially has a claim on the
cash flows of the firm
Related party transaction; majority shareholder makes one of her firms trade on attractive
term with another of her firms
5
,Chapter 3; Financial Statement Analysis
Every year, a company will release its annual report. In addition to information relating to the
performance and activities of the firm over the previous years, the annual report presents
three financial statements;
1) The statement of financial position (balance sheet)
2) The income statement
3) The statement of cash flows
The Statement of financial position (balance sheet); financial statement showing a firm’s
accounting value on a particular date
- Organizing/summarizing what a firm owns (assets), owes (liabilities) and the difference
between the two (equity)
- It is a snapshot of the firm (a given point in the time)
The figure illustrates how the statement of financial position is
constructed; the left side lists the assets of the firm and the
right side lists the liabilities and equity
Assets are classified as either; current or non-current
Non-current assets; has a relatively long life (> 12 months)
- Can be tangible (truck/computer)
- Can be intangible (trademark/patent)
Current assets; life of less than 1 year
- Asset will convert to cash within 12 months
- Examples; inventory/cash/trade receivables
Liabilities are classified as either current or non-current
Non-current liabilities; a debt that is not due in the coming year
- Example; bonds
Current liabilities; have a life of less than one year (must be paid within the year)
- Example; trade payables (money the firm owes to its suppliers)
Shareholders equity (owner’s equity); difference between the total value of the assets and the
total value of the liabilities
- If the firm were to sell all its assets and use the money to pay off its debts, then whatever
residual value remained would belong to the shareholders
- Assets = Liabilities + Shareholder’s equity (Balance sheet identity)
Net working capital; current assets – current liabilities
- Net working capital is usually positive in a healthy firm
- Positive NWC means that enough cash will be available to pay off liabilities arising
6
,Book value; its original purchase cost, adjusted for any subsequent changes (such as
depreciation)
- The values shown in the statement of financial position for the firm’s assets are book
values, and generally are not normally what the assets are actually worth
- Historical cost model; assets are valued at what the firm paid for them
- No matter how long ago they were purchased or how much they are worth today
- Based on accounting figures drawn from Accounting Standards
International Accounting Standards (IAS); the common set of standards and procedures by
which audited financial statements are prepared in Europe and many other countries
Market value; the price that could be obtained by selling an asset
- Revaluation model; presents an asset’s value as what it is worth in the market today
- Based on prices or market valuations
- Fair value amount
For current assets market value and book value might be somewhat similar, because current
assets are bought and converted into cash over a relatively short span of time.
- In other circumstances the two values might differ quite a bit
The income statement; financial statement summarizing a firm’s performance over a period
of time
- Revenues – Expenses = Income (income statement equation)
Net income is often expressed on a per-share basis and called earnings per share (EPS)
Non-cash items; expenses charged against revenues that do not directly affect cash flow
- Such as depreciation
Example;
Suppose a firm purchases an asset for €5000 and pays in cash
The firm has a €5000 cash outflow at the time of purchase
However, instead of deducting the €5000 as an expense, an accountant might depreciate the
asset over its lifetime
If the depreciation is straight-line and the asset is written down to zero over that period, then
€ = €1000 will be deducted each year as an expense
- Important! This €1000 deduction is not cash, it is an accounting number. The actual cash
outflow occurred when the asset was purchased
Depreciation is a non-cash expense (not a cash outflow)
7
,Average tax rate; the percentage of your income that goes to pay taxes
- Tax bill divided by your taxable income
Marginal tax rate; tax you would pay if you earned one more unit of currency
- Apply to the part of income in the indicated range only (not all income)
Example;
Suppose a Dutch corporation has a taxable income of €400,000. What is the tax bill?
- Dutch corporation tax rate; 20/25%
- On the first €200,000 of earnings firms must pay 20% tax, any extra earnings are charged
25% tax
0.20 x €200,000 = €40,000
0.25 x (€400,000 - €200.000) = €50,000
Total; €90,000
Average tax rate; €90,000 / €400,000 = 22.5%
Marginal tax rate; if we made one more euro, the tax on that euro would be 25 cents (€1 x
0.25), so our marginal rate is 25%
Example; Suppose a corporation has a taxable income of €200,000. What is the tax bill?
- First; €25,000 earned taxed at 20%
- Next; €35,000 earned taxed at 23.5%
- Any extra earning; taxed at 25.5%
0.20 x €25,000 = €5,000
0.235 x €35,000 = €8,225
0.255 x (€200,000 - €25,000 - €35,000) = €35,700
Total; €48,925
Average tax rate; €48,925 / €200,000 = 24.46%
Marginal tax rate; 25.5%
The statement of cash flows; by cash flows we mean the difference between the cash that
came in and the cash that went out
- It is often the most important item to take from the financial statements
Cash flow from assets = cash flow to creditors + cash flow to shareholders (cash flow identity)
Cash flow identity; says that the cash flow from the firm’s assets is equal to the cash flow paid
to suppliers of capital to the firm.
- What it reflects is the fact that a firm generates cash through its various activities, and that
cash is either used to pay creditors or paid out to the owners of the firm
Operating cash flow; cash generated from a firm’s normal business activities
- Expenses associated with the firm’s financing of its assets or the purchase of buildings are
not included, because they are not operating expenses.
8
,Operating activities; Cash flows that arise because of the firm’s core operations
- The cash flow that results from the firm’s day-to-day activities of producing and selling
- Revenues – expenses + changes in non-cash net working capital
- We don’t include depreciation, because it’s not a cash outflow
- We don’t include interest, because it’s a financing expense
- The only exception is when we are considering the accounts of a financial
institution (such as a bank, where interest payment/receipts relate directly to
operating income)
- We don’t include taxes, because they are paid in cash
- Operating profit + depreciation – taxes
Operating cash flows can be presented in 2 ways;
1) The direct method; actual cash outflows/inflows are presented
2) The indirect method; starts off with the company’s profit/loss for the year and then
extracts any non-cash items incurred, cash flows arising from financing activities and cash
flows from investing activities
Investing activities; money spent on non-current assets minus money received from the sale
of non-current assets
- Cash generated/expended from a firm’s long-term investment
- When a company buys/sells a warehouse, this is a long-term investment that will span
many years, and a cash flow of this type relates to the firm’s long-term investing activities
Financing activities; cash generated/expended as a result of its debt and equity choices
- Net new long term debt – interest – dividends
- When a company raises cash in the form of equity or debt, the cash flow would be part of
its financing activities
Total cash flow = Cash flow from operating activities
+ Cash flow from investing activities
+ Cash flow from financing activities
Du Pont identity; popular expression breaking ROE into 3 parts;
1) Operating efficiency
2) Asset use efficiency
3) Financial leverage
9
, Chapter 4; Introduction to valuation: The time value of money
Future value (FV); the amount of money an investment will grow to over some period of time
at some given interest rate
- What cash flow are worth in the future
Compounding; the process of accumulating interest on an investment over time to earn more
interest
Interest on interest; interest earned on the reinvestment of previous interest payments
Compound interest; interest earned on both the initial principal and the interest
reinvested form prior periods
Simple interest; the interest is not reinvested, so interest is earned each period only on the
original principal
- Interest earned only on the original principal amount invested
Future value = c* × (1 + r)8
- Future value interest factor (future value factor) ; (1 + 𝑟), (FVIF)
Present Value (PV); the current value of future cash flows discounted at the appropriate
discount rate
- What future cash flows are worth today
)
Present Value = 𝑐* × <()($)! =
)
Discount rate/factor; <()($)! =
Discount rate/factor; The rate used to calculate the PV of future cash flows
Discounted cash flow (DCF) valuation; calculating the PV of a future cash flow to determine
its value today
Rule of 72; an approximate formula to determine the number of years it will take to double
the value of your investment
- 72/r%
Example;
How many years does it take to double your investment of €10,000 if you are able to generate
an annual return of 9% ?
- Rule of 72; = 8.00 years
- Exact; €20,000 = €10,000 (1.09)t ---> t = 8.04 years
10
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