Corporate Finance

UNIVERSIDADE DOS AÇORES DEPARTAMENTO DE ECONOMIA E GESTÃO FINAÇAS EMPRESARIAS I

PROFESSOR, PEDRO PIMENTEL

STUDENT LOGHIN MIHAI-LIVIU

First assignment 200 9

Chapter 1 Finance and Financial Manager The first chapter of the book is talking about the corporations. First of all we can say that not all businesses are corporations. We can identify three types of businesses: sole proprietorships, partnership and corporate finance. Almost all the large businesses are organized in corporations. The corporation shares are held by a group of investors who own the corporation but they don’t manage it. First time when a firm is established in corporation are only a small group of investors, some managers of the company and a few backers. At this stage the company doesn’t have shares open for public trade and we can say that the firm is closely held. After some time when the corporate will grow its shares will be trade on the public market and this corporations are known as public companies. Shareholders elect a board of directors, which can be drawn from top of management for the positions of directors and others can be for the positions of non-directors, representing them and act in best interest of them. This separation of ownership and management gives the corporation permanence because for example, if a shareholder sells his share to a new investors the activity of the corporation will not disrupt and the other side if a manager is dismissed or quit, he will be replaced and the activity will be continuous. Corporations have limited liability, which means that stockholders will not be able to be responsible for the firm debts unlike partnerships or sole proprietorships which they can. The corporation is based on articles of incorporation that set out the purpose of the business, how many shares can be issued, numbers of directors and so on. We can say that a corporation is a legal “person” that will be able to burrow or lend money, can sue or be sued, pays taxes but cannot vote. This type of organization have advantages and disadvantages. For example one advantage is that it can raise money by selling new shares to investors and it can buy those shares back. A disadvantage is that a corporation’s legal machinery and communicating with a shareholders can be time-consuming and costly. A corporation needs a large variety of tangible goods like machinery, factories, offices and intangible goods such as technical expertise, trademarks, patents, etc which are called real 2|Page

First assignment 200 9 assets. To buy this assets the corporation sells pieces of paper called financial assets or securities. Between firm operations and the financial markets stands the financial manager. His role is to trace the flow of cash from investors to the firm and back to investors again. The managers from large corporations must decide which assets should invest and also where those assets should be located. The big corporations are scattered

around the globe. Shares are trade in financial

center such as New York, London, Tokyo. Bond and loans are easily trade in all of the world moving across national borders. For this kind corporations, day-to-day cash management becomes a complex task. Financial manager is a term who refer to anyone responsible for a significant investment of financing decision. In the smallest corporations is only one person but in most of the cases responsibility is dispersed. In small companies there is often only one financial executive which is called treasurer. But the larger company have also a controller, who prepares the financial statements, manages the firm’s interval accounting and looks after its tax obligations. The difference between a treasurer and controller is: the treasurer’s main responsibility is to obtain and manage the firm’s capital, while the controller ensures that the money is used efficiently. The larger firm usually appoint a chief financial officer (CFO) which oversee both the treasurer’s and the controller’s work. The controller of CFO is responsible for organizing and supervising the capital budgeting process. Sometimes the ultimate decisions for important issues are taken by the board of directors. The large corporation the ownership and management are separated because is absolutely necessary, because this kind of corporation can have hundreds of thousands of shareholders and is no way them to involve in management of the corporation. This separation has advantages for example the ownership can hire a professional manager to accomplish his objectives. But this separation brings and problems when theirs objectives are different and this is not the only one problem for example the shareholders have to think how to work with managers so they will accomplish their interests. Another problem is for example, the interests of shareholders and bondholders that can be different so the company can have big issue because of this. We can think at the company’s overall value like a pie divided among a number of claimants. All this claimants are included in a complex web of contracts and understandings. 3|Page

First assignment 200 9 The principal-agent problems can be easily resolved if everyone had the same information. All the participants on a corporation have different information about the real value or financial assets. When a company sells shares and bonds to raise money is creating an issue which is known as primary issue and it is sold in the primary market. The corporation allow investors to trade stocks and bonds between themselves so they can raise new cash. This operations are known as secondary transactions and they take place in the secondary market. The financial manager is a link between the company and financial institutions such as banks, pension funds and insurance companies. Also the financial institutions are intermediaries that gather the savings of many individuals and reinvest them in the financial markets. In United States the most important financial institutions are insurance companies more even the banks. The differences between a manufacturing corporation and financial institutions are: first of all, the financial institutions raise money from special ways like taking deposits or selling insurance policies; second, the financial institutions invest in financial assets for example stocks or bonds or loans whereas the manufacturing corporations raise money investing in real assets. The financial intermediaries can contribute in many ways to our individual wellbeing and the smooth of the economy. Here are some examples: - the payment mechanism: it is very hard to do all payments in cash, but fortunately with the financial institutions we have other methods of payment like checks, credit cards, electronic transfer; - borrowing and lending: we can buy assets without having money in the time of transaction what we have to do is just to borrow some money from banks, buy the assets and in time we will return it in time; - pooling risk: this can be done with insurances companies which cover the risk for us; for example in case of automobile accident or household fire or in case if you want to in securities and their price will fall you will not lose because you are insured.

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First assignment 200 9

Chapter 28 Financial analysis and planning

The chapter 28 is talking about what kind of financial analysis and planning we can do so we can see the performance of the firm or to understand the policies of a competitor or to check on the financial health of a customer. Also, the firms need money when they want to buy assets so than grow the corporation. In this case the firm have to use financial planning models to help them understand the financial implications of their business plans and the consequences of alternative financial strategies. Corporations uses some financial statements to see the situation of the company. Through this financial statements we will discuss about: the balance sheet, the income statement, sources and uses of funds. The balance sheet is a document who show the assets and the resources of the money that is used to buy this assets. The items from the balance sheet are putted in descending order of assets that can be turned in to cash. Here is included cash itself and all kind of goods can be turned in cash which we name this category of assets current assets. The items that remain are long-term, usually illiquid, assets who don’t show the real value of these date, but show the original value of this assets and in case of plant and equipment, deducts a fixed annual amount for depreciation. Intangible value like patents, reputation, a skilled management and well trained labor force aren’t included in balance sheet. The income statement can show how profitable the corporate has been over the past year. Sources and Uses of Funds are financial statements who show how the funds of the firm are used. To grow a corporation, especially one which is already a large one, you have to monitor a huge amount of data much more complex than you can provided from financial statements. And the easiest way to do it is with financial ratios. Next are presented five types of financial ratios:

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First assignment 200 9 –

Leverage ratios: it is used to see how many debts have a company, so when a firm need to take a loan from the bank it will know how much money to burrow and also in this financial ratio is stated the limits of the dept that bank insist the burrowing firm to have.

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Liquidity ratios: this financial ratio it is used to determine the liquidity of the firm; for example is used by credit managers and bankers to see if the firm can repay the loan or not, also is used by the managers to see how much money their assets worth and because the value of the assets is changing the managers do this ratio every year.

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Efficiency ration: it is measures how efficient the firm is by using its assets; when this ratio is low it can indicate that the firm is efficient.

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Profitability: show to a firm, who invested in some assets, the return that company earns on this investments.

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Market value ratio: show how highly the company is valued by the investors.

Here are some advice for financial ratio: financial ratio give you the answers, but they never show you what kind of questions you have to put; don’t base on this formulas because it isn’t an international standard for this formulas; you will gone need a benchmark for assessing a firm’s financial position. The financial ratio provides information about the corporate, but the manager can also use this financial ratio for planning the future of the company by a financial plan. There are three kinds of growth: –

a best-case or aggressive growth;

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a normal growth

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a plan of retrenchment;

When a manager prepare a financial planning he have to look at the opportunities and costs of moving into a new area. The manager faces with two stages decisions in a project: the first one may be valuable primarily for the options they bring with them and the second one when the manager faces with capital budgeting problem. Also when a manager conceive a financial plan he doesn’t look just at the most likely consequences, but they look for unexpected.

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First assignment 200 9 One manager can develop a plan of growth his company. To conceive this financial plan the managers usually follow four steps: -step 1: project next year’s operating cash flow; -step 2: project what additional investments in net working capital, fix the assets that need to support the activity and decide how much will be paid as dividends; -step 3: to raise money from selling securities to cover the difference from step 1, projected operating cash flow and step 2, the projected uses; -step 4: this step is for constructing a pro forma balance sheet that incorporates the additional assets and the increase in debt and equity. After you did this plan is very easy to run your plan for a several years. You will know how much to burrow to reach to a percent of annual growth. This financial planning isn’t just for administrate a company, it is also a method to prepare for unlikely situations. The model presented is a very simple for practical application. This model is known as a percentage of sales model, because almost all the forecast for the company are proportional to sales. The model can be complicated, but you have to be careful not to add to much complexity, because you can end up with a complex model which will distract the attention from important decision. It isn’t a theory or model to lead you for sure to the optimal financial strategy, consequently, financial planning proceeds by trial and error. In financial planning is no finance because they: usually incorporate an accountant’s view of the world, are designed to forecast accounting statements, do not accentuate the tools of financial analysis and so on. Second reason that financial planning is no finance is because they pointing toward optimal financial decision without letting us to see the alternative choices.

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First assignment 200 9

Exercises 1. Suppose that at year-end 1999 Executive Paper had unused lines of credit which would have allowed it to burrow a further $300 million. Suppose also it used this line of credit to raise short-term loans of $300 million and invested the proceeds in marketable securities. Would the company have appeared the be (a) more or less liquid? (b) more or less highly levered? Calculate the appropriate ratios. a) First the cash is 0 because cash not matter if the firm can borrow at short notice. So the cash ratio will be 0. After the loan and buying the securities the cash ratio will be: cash ratio=300300=1 So from this we can say that the firm will be more liquid. b) The level of financial leverage remain unchanged because the firm invest in securities by money came from short-term loans not from long-term loans and this will not affect the leverage.

2. United Ratio’s common stock has a dividend yield of 4 percent. Its divided per share is $2, and it has 10 million shares outstanding. If the market-to-book ratio is 1.5, what is the total book value of the equity? dividend yield=dividend per sharestock price⇒stock price=20,04=50$ market-to book-ratio=stock pricebook value per share⇒1,5=50$book value per share⇒ ⇒book value per share=1,5*50$=33,33$ total

book

value

of

the

equity=book

value

per

share*number

of

shares=33,33$*10.000.000=333.300.000$

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First assignment 200 9 3. As you can see, someone has spilled ink over some of the entries in the balance sheet and income statement of Transylvania Railroad(Table 1). Can you use the following information to work out the missing entries? •

Financial leverage: .4

•

Times interest earned: 8

•

Current ratio: 1.4

•

Quick ratio: 1.0

•

Cash ratio: .2

•

Return on total assets: .18

•

Return on equity: .41

•

Inventory turnover: 5.0

•

Receivables’ collection period: 71.2 days.

Cash Accounts receivable Inventory Total current assets Fixed assets, net Total Notes payable Accounts payable Total current liabilities Long-term debt Equity Total

DECEMBER 1999 BALANCE SHEET 11 44 22 77 38 115 30 25 55 24 36 115

DECEMBER 1998 20 34 26 80 25 105 35 20 55 20 30 105

INCOME STATEMENT Sales Cost of goods sold Selling, general and administrative expenses Deprecation EBIT Interest Earnings before tax Tax

200 120 10 20 50 8,75 41,25 30,2 9|Page

First assignment 200 9 Earnings available for common stocks Table 1

11,05

Current assets current

ratio=current

assetscurrent

liabilities⟹1,4=current

assets55⟹

⟹current

assets=1,4*55=77 Receivable quick

ratio=cash

ratio+receivablescurrent

liability⟹1,0=0,2+receivabeles55⟹

⟹receivables=44 Fixed assets, net fixed assets, net=total- total current assets=115-77=38 Inventory current ratio=current assetscurrent liabilities=quick ratio+inventorycurrent liabilities⟹ ⟹1,4=1,0+inventory55⟹inventory=22

Cash cash=total current assets-inventory-receivables=77-44-22=11

Long-term debt financial leverage=long-term debttotal long-term capital⇒0.4=long-term debt60⇒ ⇒long-term debt=24 Equity equity=total long-term debt-long term-debt=60-24=36 Sales Receivables’ collection period=average receivablessales/365⇒71,2=39sales/365⇒ ⇒sales=200 10 | P a g e

First assignment 200 9 Cost of goods sold inventory turnover=cost of goods soldaverage inventory⇒Cost of goods sold=24*5=120 EBIT EBIT=sales-costs

of

goods

sold-selling,

general

and

administrative

expenses-

Deprecation=200-120-10-20=50 Interest time interest earned=EBIT+depreciationinterest⇒interest=708=8,75 Earnings before tax earning before tax=EBIT-interest=50-8,75=41,25

Tax ROA=EBIT-taxsales⇒tax=50-0,18*200=30.2 Earnings available for common stocks earning avaible for common stoks=earning before tax-tax=41,25-30,2==11,05

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