CORPORATE FINANCE BTH3

CC1 : 18/10/2024 (10h15-12h15) CC2: 05/11/2024 (end of class)

1. Introduction to corporate finance

2. Chapter 1 : Financial decisions and time value of money
3. Chapter 2 : capital budgeting
4. Financing decisions and capital structure

INTRODUCTION TO CORPORATE FINANCE

The Goal of the Firm

• The goal of the firm is to create value for the firm’s owners (that is, its
shareholders). Thus the goal of the firm is to “maximize shareholder wealth” by
maximizing the price of the existing common stock.

- Three key thing of a business

Liquidity: the cash that is needed day to day in the firm

Profitability: is the company able to generate profit

Solvency : durability of the business

• Good financial decisions will increase stock price, and poor financial decisions will
lead to a decline in stock price.

FIVE PRINCIPLES THAT FORM THE FOUNDATIONS OF FINANCE

Principle 1: Cash Flow Is What Matters

• Accounting profits are not equal to cash flows. It is possible for a firm to generate
accounting profits but not have cash or to generate cash flows and not report
accounting profits in the books.

• Cash flow, and not profits, drive the value of a business.

• We must determine incremental or marginal cash flows when making financial

decisions.

• Incremental cash flow is the difference between the projected cash flows if
the project is selected versus what they will be if the project is not
selected.
Principle 2: Money Has a Time Value

• A dollar received today is worth more than a dollar received in the future.

• Because we can earn interest on money received today, it is better to

receive money sooner rather than later.

• Opportunity Cost – It is the cost of making a choice in terms of next best

alternative that must be forgone.

• Example: By lending money to your friend at zero percent interest, there

is an opportunity cost of 1% that could potentially be earned by depositing
the money in a savings account in a bank.

Principle 3: Risk Requires a Reward

• Investors will not take on additional risk unless they expect to be compensated
with additional reward or return.

• Investors expect to be compensated for “delaying consumption’’ and “taking on

risk.’’

• Thus, investors expect a return when they deposit their savings in a bank
(e.g., delayed consumption), and they expect to earn a relatively higher
rate of return on stocks compared to a bank savings account (e.g., taking
on risk).

Principle 4: Market Prices Are Generally Right

• In an efficient market, the market prices of all traded assets (such as stocks and
bonds) fully reflect all available information at any moment in time.

• Thus stock prices are a useful indicator of the value of the firm. Price changes
reflect changes in expected future cash flows. Good decisions will tend to increase
in stock price and vice versa.

• Note there are inefficiencies in the market that may distort the market prices from
value of assets. Such inefficiencies are often caused by behavioral biases.

Principle 5: Conflicts of Interest Cause Agency Problems

• The separation of management and the ownership of the firm creates an agency
problem. Managers may make decisions that are not consistent with the goal of
maximizing shareholder wealth.

• Agency conflict is reduced through monitoring (e.g., annual reports),

compensation schemes (e.g., stock options), and market mechanisms (e.g.,
takeovers).

ETHICS AND TRUST IN BUSINESS

• Ethical behavior is doing the right thing! But what is the right thing?

• Ethical dilemma—Each person has his or her own set of values, which forms the
basis for personal judgments about what is the right thing.
 • Sound ethical standards are important for business and personal success.
Unethical decisions can destroy shareholder wealth (e.g., Enron scandal).

THE ROLE OF FINANCE IN BUSINESS

• Three basic issues are addressed by the study of finance:

• What long-term investments should the firm undertake? (Capital budgeting

decision)

• How should the firm raise money to fund these investments? (Capital
structure decision)

• How should cash flows arising from day-to-day operations be managed?

(Working capital decision)

• Knowledge of financial tools is relevant for decision making in all areas of business
(be it marketing, production, etc.) and also in managing personal finances.

• Decisions involve an element of time and uncertainty; financial tools help adjust
for time and risk.

• Decisions taken in business should be financially viable; financial tools help

determine the financial viability of decisions.

THE LEGAL FORMS OF BUSINESS ORGANIZATION

• Business Forms

• Sole Proprietorship

• Partnership

• Corporation

• Hybrid

• S-Type

- LLC

Sole Proprietorship

• Business owned by an individual

• Owner maintains title to assets and profits
• Unlimited liability
• Termination occurs on owner’s death or by the owner’s choice

Partnership
 • Two or more persons come together as co-owners.
• General Partnership: All partners are fully responsible for liabilities incurred
by the partnership.
• Limited Partnerships: One or more partners can have limited liability, restricted
to the amount of capital invested in the partnership. There must be at least
one general partner with unlimited liability. Limited partners cannot
participate in the management of the business, and their names cannot appear in
the name of the firm.

Corporation

• Functions legally as a separate entity and apart from its owners.

• Corporation can sue, be sued, purchase, sell, and own property.
• Owners (shareholders) dictate direction and policies of the corporation, oftentimes
through elected board of directors.
• Shareholder’s liability is restricted to amount of investment in company.
• Life of corporation does not depend on the owners; corporation continues to be
run by managers after transfer of ownership through sale or inheritance.

The Trade-Offs: Corporate Form

• Benefits: Limited liability, easy to transfer ownership, easier to raise capital,

unlimited life (unless the firm goes through corporate restructuring such as
mergers and bankruptcies)
• Drawbacks: No secrecy of information, maybe delays in decision making, greater
regulation, double taxation

Double Taxation Example

• Assume earnings before tax = $1,000

• Federal tax @ 25% = $250
• After-tax income available for distribution to shareholders = $750
• Compute the taxes if the company chooses to distribute the entire after-tax profits
to shareholders as dividends.
• If corporation distributes profits as dividends to shareholders, shareholders will be
taxed again.
• Assuming dividends are taxed @ 15%
• Dividend tax = 15% of $750 = $112.50
• = total tax = 250 +112.5 +£362.5 or 36.25%

S-Corporations and Limited Liability Companies (LLCs)

• S-Type Corporations
• Benefits
• Limited liability
• Taxed as partnership (no double taxation like corporations)
• Limitations
• Owners must be people so cannot be used for a joint ventures
between two corporations
 • Limited Liability Companies (LLC)
• Benefits
• Limited liability
• Taxed like a partnership
• Limitations
• Qualifications vary from state to state
• Cannot appear like a corporation otherwise it will be taxed like one

FINANCE AND THE MULTINATIONAL FIRM: THE NEW ROLE

• Coca-Cola, among other companies, receives significant profits from overseas

sales.

• U.S. firms are looking to international expansion to discover profits.

• In addition to U.S. firms going abroad, we have also witnessed many foreign firms
making their mark in the United States. For example, auto industry dominated by
Toyota, Honda, Nissan, and BMW.

Key terms :

• Agency problem

• Capital budgeting

• Capital structure decisions

• Corporation

• Efficient market

• Financial markets

• Limited partnership

• Partnership

• Opportunity cost

• Working capital management

• Incremental cash flow

CHAPTER 1: FINANCIAL DECISIONS AND TIME VALUE OF MONEY

Three basic issues are addressed by the study of finance

1. What long-term investments should the firm undertake? (Capital budgeting

decision)
 2. 2. How should the firm raise money to fund these investments? (Capital structure
decision)
3. How should cash flows arising from day-to-day operations be managed? (Working
capital décision)

WHAT IS MONEY

Money is an asset that has functions as:

1. The measure of value or unit of account.

2. The medium of exchange and;
3. The store of value.

TIME VALUE OF MONEY (TVM)

What is the definition of time value of money?

” Time value of money (TVM) is an economic principle that suggests that money you have
now is worth more/less than the identical sum in the future. Because of that provided
money can earn interest, due to its potential earning/loss capacity.”

TIME VALUE OF MONEY (TVM) There are two offers to get 1000$ today or 1000$ in the
next year which offer more interesting? If we choose to get 1000$ today, we can deposit
the money into a savings(deposit) account earns a certain interest rate in one year than
we will get more that 1000$ in the years. Any amount of money is worth more the sooner
it is received. TVM is also sometimes referred to as present discounted value/
present value (PV)
PV : Present Value

FV : Future Value

INTEREST RATE:
Interest can also be defined as the potential earning of money after some periods of time

The interest rate is the amount charges, a percentage on the principal; the interest rate is
typically noted on an annual basis and expressed as an annual percentage rate

How to calculate interest

Interest can be calculated in TWO ways

1. Simple interest is the interest that calculated ONLY on the principal, or

original, amount of a money
2. Compound interest is calculated on the principal amount and also on the
accumulated interest of period, can be regarded as ‘interest on interest”
Figure 1 Present Value

3. Compound interest is calculated on the principal amount and also on the

accumulated interest of period, can be regarded as “interest on interest”
Future Value: Simple Vs compound interest

What is the value a 1000$ in the next five year if:

a. Follows a 5% annual simple rate, i = 5%/year

b. Follows 5% annual compound interest, r= 5% : year

Solution :

a. Simple interest: FV5 = PV+PV*i*n = 1000+1000*0.5*5 =1250

b. Compound interest : FV5 =PV(1+r)5 = 1000 (1+0.05)5 = 1276.282

DISCOUNTING
Compound interest is calculated on the principal amount and also in the accumulate
interest of period, can be regarded as “interest on interest”

Future Value of money after n-period of compound interest, after compounding n-times
is:

F𝑉𝑛 = 𝑃𝑉 (1 +𝑟 )n

If we want to calculate the value of money in the last n-period, then we call it
discounting
Present Value: Simple VS compound interest

What was the value a 2200$ four years ago.

a. If it grew follow 5% annual simple rate

b. If it grew follow 5% annual compound rate

Solution :

a. Simple interest present Value: PV =2200/(1+0.05*4)

b. Compound interest : PV = FV4 (1+0.05)-4 = 2200(1+0.05)-4 = 1809.945

COMPOUND INTEREST IN BUSINESS

Some of the uses of compound interest in business

- Measuring the value of company’s assets

- To calculate the company’s revenue and profit
- In making of financial decisions

HOW TO INCREASE THE FUTURE VALUE?

- Future value can be increased by
o Increasing number of years of compounding (N)
o Increasing the interest or discount rate (r)
o Increasing the original investment (PV)

a. You deposit $500 in bank for 2 years. What is the FV at 2%? What is the FV if you
change interest rate to 6%? CHANGING (r)

FV at 2% = 500*(1.02)2 = 520.20
 FV at 6% = 500*(1.06)2 = 561.80

b. Continue the same example but change time to 10 years what is the FV now?
CHANGING (n)

FV = 500*(1.06)10 = 895.42

c. Change contribution to 1.500 what is the FV now? CHANGING PV

FV = 1,500 * (1.06)10 = 2,686.27

PRESENT VALUE
- Present value reflects the current value of a future payment or receipt

PV = FVn * 1/(1+r)n

- FVn =the future value of the investment at the end of n years = 500$
- N = number of years until payment is received =10 years
- r = the interest rate =0.06%
- PV = the present value of the future sum of money

Example :

- What will be the present value of 500 to be received 10 years from today if the
discount rate is 6%
- PV= 500*(1/(1+0.06)10))
- PV = 500* (1/1791)
- PV=500*(0.558)
- 279.00

PV is lower if: Time period is longer, or interest rate is higher

WHAT IS ANNUITY
All the situations we have considered so fare, whether simple interest, or compound
interest, have had something in common. We can calculate the present value and future
value using times value of money

An annuity is any collection of(equal) payments made at regular time intervals. The
payment is divided in n-times

The timing of payments

Two types of annuity by its payment:

1. An ordinary annuity is an annuity whose payments are made at the end of each
time period
2. An annuity due is an annuity whose payment are made at the beginning of
each time period
PRESENT VALUE AND FUTURE VALUE OF ANNUITY
A sum of money paid at the beginning of an annuity, to which the annuity’s payment are
accepted as equivalent, is called the annuity’s present value (the present value is also
sometimes called the amount of the annuity)

A sum of money to which an annuity’s payments and interest accumulate in the

end is called the annuity’s future value.

ORDINARY ANNUITY (END OF EACH PERIOD)

Present value of annuity : A sum of money paid at the beginning of an annuity, to

which the annuity’s payments are accepted as equivalent.

Using the principal of Time Value of money, if the nominal rate is r (yearly rate) then the
PV of ordinary annuity is :

PV = a1(1+r)-1+a2(1+r)-2+a3(1+r)-3+…+an-1(1+r)-(n-1)+an(1+r)-n

Future value of ordinary annuity: A sum of money to which an annuity’s payments

and interest accumulate in the end.

Using the principal of Time Value of money, if the nominal rate is r (yearly rate) then the
PV of ordinary annuity is :

FV: a1(1+r)n-1+a2(1+r)n-2+a3

Les petits a c’est le revenus annuel par ans par exemple si 1 er année 200 et 2eme année
400 a1 = 200 et a2 = 400

ANNUITY DUE

Present Value of annuity due: A sum of money paid at the beginning of an annuity, to
which the annuity’s payments are accepted as equivalent.

P
V
¿
a
1
-1
+a3(1+r)-2
+ ¿ a
2
( 1 + r )

Future Value of annuity: A sum of money to which an annuity’s payments and interest
accumulate in the end.

FV + a1(1+r)n+a2(1+r)n-1+a3(1+r)n-2

Tu vas a l’envers si n=number of years = 4 tu fais 1:4 2:3 3:2 4;1

FIX ANNUITY PAYMENT

An annuity is any collection of payments made at regular time intervals, where a1 = a2 =

an = a( n payments each payment a)

Fix annuity payment :

CHAPTER 2 CAPITAL BUDGETING

CORPORATE FINANCE :
Every decision that a business makes has a financial implications, and any decision which
affects the finances of a business is a corporate finance decision

Major decision in corporate finance

The investment decision (capital budgeting)

- Why are managers asked to make choices amongst potential investments ?

- What makes for a good investment ?

The financing decision

- Where do firms raise/acquire the funds for value-creating investments ?

 - What mix of owner’s money (equity) or borrowed money (debt) should the firm
use ?

The assest management decision

- How firm manage the day-to-day asset (all about cashflow)

INVESTMENT DECISION (CAPITAL BUDGETING)

- Deciding what value to place on an investment or on a business as a whole is a
challenging proposition.
- In addition to taking into account all the risks and uncertainties of any opportunity,
we must face the fact that most business ventures require substantial up-front
investment of time, effort and capital in the hopes of returning profits in the future

1. Cash flow statement and expected cash flow

2. Evaluating project economic using discounting model

EXCEPTED CASH FLOW

 The expected cash flow is the value that company/ investor expects from a project
before that project begin
 The atual cash flows received may be greater or less than the expected future
cash flows. They are often measured according to their present value.

DISCOUNTING MODELS
1. Discounted Payback period
2. Net Present Value (NPV)
3. Profitability index (PI)
4. Internal Rate of Return (IRR) rate of return we expect from our investments =
required rate of return

DISCOUNTED PAYBACK PERIOD

The discounted payback method is the time it takes an investment to generate
discounted cash flow sufficient to recover the initial outlay required to make the
investment.

Decision criteria :

- The length of the maximum acceptable payback period is determined by

management
 - If the discounted payback period is less than the maximum acceptable payback
period,accept the project
- If the discounted payback period is greater than the maximum acceptable
payback period, reject the project

Discounted cash flow = cash flow * discount factor

Discount factor = (1+r)-t

r= discount rate

t= number of periods

NET PRESENT VALUE (NPV)

NPV is the sum of the present values of the net cash flow minus the net investment. The
cash flows are discounted at a project’s required rate of return

- A project’s net present value (NPV) is the most straightforward application of cost-
benefit analysis.
o The cost is the net investment.
o The benefit is the sum of the present values

NPV = PV – I

PV + The present value of the project’s future cash inflows

I = the present value of the project’s cost (usually the initial capital invested)

If the net cash flows generated by the project are unequal over the project life. The NPV is

NPV = [CFFA1(1+r)-1+…CFFAn(1+r)-n]-I

CCFA = the net cash flows generated by the project at the year t

r = the required rate of return

I = the initial capital invested

n= the period life of the project

If the cash flows generated by the project are equal over the project life . The net present
value is : USING ANNUITY FORMULA

When ccfa1 = ccfa2 ect…

Then NVP = a [1-(1-+r)-n/i]-I

NVP POSITIVE = GOOD INVESTMENT

PROFITABILITY INDEX
A project’s profitability index (PI) is the ratio of the present value of futurs cash flows to
the investment costs

A project’s PI is the sum of the present value of the net cash flows divided by the
investment.

If the net cash flows generated by the project are unequal over the <$=project life.

PI [CCFA1(1+r)-1+…+CCFAn(1+r)-n]/I

Where

C𝐹𝐹𝐴𝑡: the net cash flows generated by the project at the year t

r: the required rate of return

I: the initial capital invested

n: the period life of the project

If the cash flows generated by the project are equal over the project lif. The Profitabilty
index (PIV)

PI = a [1-(1-+r)-n/r]-I

PI > 1 IS A GOOD INVESTMENT

INTERNAL RATE OF RETURN (IRR)

The internal rate of return is the rate that cancels the NPV ( Net present value)

Nvp will decrease when the rate increases

Decision criteria:

If the IRR is greater than the discount rate ➔accept the project.

If the IRR is less than the discount rate ➔reject the project.