Appunti corporate finance

Lezione 1

Financial market

Financial market (right side of the balance sheet) is the place where investors put their money in order to have a return. In this market, these people are looking for stock to buy. Companies try to attract investors to raise their money. They can use:

• Debt: If you contract debts, you will receive interest plus the initial capital.
• Equity: Stocks (if you buy stocks, you expect to have some dividends, but some companies don’t distribute the dividends, so you can sell the stocks, but the price is very variable).

Corporate processes

Corporate processes (left side of the balance sheet) = Assets = where the company allocates the money. It is formed by:

• Cash
• CWC = Current working capital
• PCA = Core business
• NOA = Non-operating assets

Income statement

The income statement (conto economico) illustrates the profit obtained by a company. EBIT = profit that a company got from operating activity. INTNOR = proventi e oneri straordinari. NIE TAX (state authorities).

Cash flow

Cash flow comprises all the movements of cash that happened during a year. The role of the financial manager is to maximize the corporation's value for its owners. The financial manager is the person who tries to maximize the firm's value (maximize the stock value). It acts as an intermediary between the capital market and firms' operations. It is responsible for investment, financing, and dividend decisions.

Financial functions

There are several financial functions:

• Capital management: All the decisions connected to the investment (e.g., how to invest money / how to raise money from the market).
• Treasury management: Deals with sourcing and using liquid cash (e.g., managing cash flows).
• Risk management: Deals with the management of corporate risks versus the investors’ risk tolerances.

What is corporate finance?

Corporate finance deals with the efficient and effective management of an organization's finances to achieve its objectives. This involves planning and controlling:

• The provision of resources
• The allocation of resources
• The control of resources

The fundamental aim is the optimal allocation of the scarce resources available to financial managers.

Provision of resources

The company needs funding to manage its operations. The funds can take the form of:

• Debt: Loans, short-term loans, long-term loans, bond issues, mini bonds for small companies. The common characteristics of the debts are the capital back to the people who did the investment plus interest money which the company must pay.
• Equity: Shareholders' stocks (can be ordinary stocks or premium stocks).

Allocation of resources

All the investment of raised money. The companies need to convert cash into net invested capital in order to generate wealth.

Control and safeguard of resources

The goal is to deal with the risk in order to improve the risk-return relationship.

• Return: Financial reward gained as a result of making an investment. The nature depends on the form of the investment.
• Risks: The possibility that the actual return may be different from the return expected. The higher the risk, the higher is the variability of the return.

Difference between corporate finance vs accounting

Corporate finance is based on cash flows versus financial accounting, which is focused on profits. Corporate finance is concerned with raising funds and providing a return to investors versus management accounting, which is concerned with providing information to assist managers in making decisions within the company. Corporate finance is focused on market-values versus accounting uses book-values. Corporate finance is future-looking versus accounting is past-looking.

Company management structure

There might be some agency conflict between shareholders’ goals versus the goals of the managers (this happens when the shareholders’ interests are different from the managers’ decisions). Three important factors that contribute to the existence of the agency problem within public limited companies are:

• There is a divergence of ownership and control, whereby those who own the company (shareholders) do not manage it but appoint agents (managers) to run the company on their behalf.
• The goals of the managers (agents) differ from those of the shareholders (principals). Managers are likely to look to maximizing their own wealth rather than the wealth of shareholders.
• Asymmetry of information exists between agent and principal. Managers, as a consequence of running the company on a day-to-day basis, have access to management accounting data and financial reports, whereas shareholders receive only annual reports, which may be subject to manipulation by the management.

In order to solve these conflicts, there are:

• Internal solutions: Monitor the actions of the management and incorporate clauses into managerial contracts which encourage goal congruence.
• External solutions: Corporate governance and regulation.

Lezione 2

Opportunity cost

Opportunity cost is the attended return of who invests money and it depends on time and risk. For example, if you are an investor and you want to raise your money, you have to look if the level of the investment’s risk is the same or smaller than the level of the investment’s return. This opportunity cost is defined by the market and represents a benchmark for the firm: if the firm does not respect this standard, the corporate finance circuit cannot work.

Risk and return

The risk is directly proportional to the capital cost, so if one of those increases, the other one increases too.

• Return: The financial reward gained as a result of making an investment.
• Risk: The possibility that the actual return may be different from the expected return. The risk-return relation is defined in this way: the higher the risk, the higher the return, and the risk is high if the investment’s term is high too.

Market risk premium: The premium you must require if you choose to invest in risk assets, for example, common stock. So the return will be higher than the other investments.

Market rate of return: Is the summary of the market risk premium and the risk-free rate.

Risk-free rate: Return you can get investing in a government bond, so it refers to a small-medium term of investments.

Calculating risk and returns using probabilities

Consider two shares, A and B, and their forecast return and associated probabilities. The mean return represents the most likely outcome of investment and that’s how the possible returns are dispersed. The variance is a dispersion index and it regards the risk, so the higher this index, the higher is the risk.

But with historical data, the probabilities are equal to each other, so the formula is different.

Combining stocks

The expected return on a portfolio is a weighted average of the expected returns on individual stocks. Is it possible to state that portfolio risk is the weighted average of portfolio components’ risk? The answer is no. The portfolio risk is smaller than the portfolio components’ risk, so it is better to invest in a portfolio than in individual stocks because the risk is lower. Empirically, individual stocks are more variable than the market indexes because stock prices aren’t perfectly correlated.

Diversification

Diversification is a strategy designed to reduce risk by spreading the portfolio across many investments. We can divide the portfolio’s risk into two aspects:

• Specific risk: It refers only to a particular firm. It is also called diversifiable risk.
• Systematic risk: It affects the overall stock market. It is also called non-diversifiable risk.

What is the risk of the portfolio that we can reduce? The answer is the specific risk. An investor has to choose the portfolio in order to reduce the specific risk, because it is better for him that it tends to zero.

Portfolio’s risk

The portfolio’s risk is given by the portfolio variance.

Lezione 4

To exploit diversification

To exploit diversification, add new stocks, so you can obtain less risk and receive more return. What happens if we increase the number of assets in the portfolio? If we have N assets, the portfolio variance formula:

• N variances
• N² correlations