Corporate Finance - Appunti

Università degli Studi di Trieste

A.A. 2021/2022

Corporate Finance

Docenti:

• Valentinuz Giorgio
• Mulas Alessandro

Studentessa: Bellemo Anna

1 Introduction to corporate finance

02-03-2022

Corporate finance analyzes the profit and losses of the BS as a physical result of the activity of the company and looks at current assets, fixed assets, current liabilities, LT debts, and equity. Current assets and liabilities can be summarized in the Net Working Capital. The most important items coming out from the profit and loss are: revenues, EBITDA, EBIT, EBT, and Net Profit. For what concerns cash flow – the pillar of corporate finance, because the company goes bankrupt for lack of cash, lack of capability to pay debts, in most cases – the focus will be on three areas: items coming from the profit and loss – the water tap from which cash flow runs out, the area of investments – in NWC or in assets, and items to cope with financial tasks.

The purpose of corporate finance is to teach methods in order to value how to buy something that has to be put in the fixed assets, how to value projects, why to invest in particular investments, which is the best way to finance the projects. It is a "two area" of analysis, both assets and liabilities side, and the balance between them. The decisions need to be taken not only inside the company but also outside it – for example, to know where and how to go to ask for money.

Pillars of corporate finance

• Investment – whose decisions are summarized by capital budgeting
• Financing – capital structure
• Liquidity – a small part of CA and CL related to cash management – short-term capital management

Investment

What do you need to start a firm? To enlarge your production? To start my personal business? Inventory, machinery, land, labor – do you have to buy or to rent? Inventory should be buoyed, but machinery now have a lot of systems like leasing that prevent you to make a huge investment in one time.

To set up a business, it will require forecasting what will be the result of the investment related also to all the costs that will be faced. Cash invested in assets must be matched by an equal amount of cash raised by financing – it is always a balance, both for the fixed and the ST items.

Value creation

The final goal is to do something in order to produce something able to create value – richness – for people engaged in this game. Benefit company: when the company that is generating value provides it not only to its shareholders but to all the stakeholders working around and for the company. In any case, we have to maintain a balance about richness but we also need to consider the balance sheet from which we can increase such richness.

Example 1.1

Financial manager – who makes the decisions?

Responsibility: the final goal is to maximize the value from cash, and that means to buy assets that earn more cash than they cost, to choose LT investments that increase the value of the firm, to raise cheap external finances – where to get money and where it is convenient to get them – and to ensure efficient tax policy – social duty to pay the right amount of taxes, no less and no more.

Example of top management structure in a big company (Generali – insurance company): In any company, the position of the financial manager (CFO) is on top. Cash is the center of all financial decisions – financial system is formed by mainly two areas: the one in which you get the resources and the other in which you have to pay for the resources acquired – from financial markets you can get bonds but at the same time you have to have continuous relationships in the financial markets because you have to pay interests and to pay back the value of the bond.

Cash flow timing and risk

Cash flow is identified from accounting figures, and it has time value: anytime you don’t have economic relationships with the payment and this is deferred, a situation in which a risk can come out is created. Risk is linked to timing, and it can change dramatically due to changes in the environment in which we are living. There is a risk on selling, buying, on businesses, and also there are risks coming from outside (war, pandemic, ...). It is not possible to synchronize everything, but it is possible to optimize.

Example: cash flows – considerations on timing

• Even if the profit and loss is positive for the period, if there is no synchronization between revenues and costs the cash flow can be negative.
• The first thing that needs to be considered is risk: if low risk environment, we can opt for the first alternative; on the contrary, if the risk is very high it is better to get payments before the ending of the period – and risk will be translated in discount rate. Some figures that will be used for this matter are Net Present Value [NPV=€] and the Internal Rate of Return [IRR=%].
• It depends also on the financial requirements of the company – if the company is very rich it can choose the first option because it doesn’t need money now; the contrary if the company wants to make other investments along the four years and it needs cash inflows in the short term.

07-03-2022

Accounting vs Finance, difference

In accounting, you don’t consider the PV, which is affected by timing and risk of the project – included in the discount rate; in finance, we cannot compare two cash flows that happen in two different moments in the future, we have to discount them at time 0. The choice of discount rate is very important.

Goal of financial management

What do we want to achieve? If you maximize the profit – it can be a goal – but sometimes you are not able to reward the shareholders and the bondholders, because they need another kind of value, the one needed from the capital providers. Other goals: maximize sales, survive, avoid distress, be the best, to consider earnings growth. However, growth has to be treated differently from different companies.

The triple bottom line

There are three different levels of economic results:

• The profit objective
• The social objective (gender parity, education, ...)
• The environment objective (green energy)

The last two are the most difficult to be measured, indeed Europe introduced the taxonomy.

One overriding aim

Maximize firm value, it means that you maximize the asset side, the portion that you have to share among all the stakeholders.

Different sources of financing

• Private investors – can buy bonds, equity crowdfunding, minibonds (bonds issued by small and medium companies), ...
• Bank loans – direct relationship between the entrepreneur and the bank
• Equity – who provides equity to a company in the early stages of its development? "Family, friends, and foolish", it is very difficult to get money from professional investors
• Bonds – many relationships with more parties, you have to be more transparent because you issue bonds that can be bought by many different investors. It is a private placement, you don’t go to financial markets but you issue the bonds for specific investors.
• Short-term financing – you transform credit against your customer to get cash that can be used through the banking system

To get money you have to prove to be trustable, to be able to promise a return, so to be able to prepare a business plan. Nowadays it is difficult to get financing in the financial markets, also because it is difficult not only to find ideas, but to find the "good" ideas – the ones that can prove that they will be successful.

One of the goals of the CFO is to identify the best sources considering the market and the entrepreneur/enterprise conditions. For a new venture, risk is very high, so the possibility to lose all the money or to get a huge rate of return – this is the position of an equity holder. In case of failure, it is however not so easy to get something more than an equity holder if you are a bondholder. In case of success, if you are a bondholder, you always get the same, not more, so in this case, the only source of trustable capital is equity. Of course, if you are an established well-known company, you can get financing from all the sources we described above.

Goal of the financial manager: to try to combine different perspectives in order to understand what the company needs and which are the intentions of the investors.

Two common market structures

Two different ways to operate in financial markets:

• Dealer market – you have the opportunity to manage the asset but you face a higher risk
• Agency market – you get commissions anytime someone wants to buy or sell any financial instrument, so most of the banks operate as agents and you have to pay them a commission anytime you do something

Corporate finance in action – Google case study

You have to prove that you have an idea and that you want to transform it into a business. IPO – when you decide to sell shares on the market. What is the benefit of going public? To get more money from different investors. If you sell existing shares, the equity base is not increased because you monetize your investment, so the IPO to be positive for the company requires that the company sell new shares, new resources that have to be used to finance innovation and growth. IPO is important when you have clear if the money comes from your company or from investors – for Google it is a mix of the two.

Tesla – at the beginning they were alone now they have a lot of competitors that get money from the traditional business to then invest them in the electric market. For Tesla is more difficult to get money to invest in innovation, indeed now Elon Musk is getting finance by carbon credit (certificati verdi) needed by other companies. It seems to be a car maker but most of the profit comes from carbon credit and from energy plants. Tesla started to produce profit just last year, the increase has been huge with respect to the past years. The company goes on the market issuing new shares every year – a lot of revenues come from Sale of Common & Preferred Stock. The Free Cash Flow started to be significant in recent years.

2 Corporate governance

Three common organizational structures

There are different types of organizations – corporate firms – and the most common is the limited corporation. The main benefit of this is that you separate your own wealth from the company’s one. Then there are sole proprietorship and partnership.

If you create a partnership without any limited liability you have to pay taxes at personal level, on the contrary, with limited liability you have to pay both at personal and at corporate level, without double taxation.

Different types of companies can be distinguished by:

• Liquidity – if you have a company that is established as a limited liability company, and the owners are the members of the family, the possibility to enter and exit from the company is very limited. This is because there are problems of property, so the liquidity is limited even if the company is a very important one. If the company is a partnership, it is even more difficult to exit because when one party decides to exit the partnership ceases to exist.
• Voting right – in most of the company, the more capital you invest, the higher the voting rights you get
• Taxation – in most of the cases, anytime you create a limited liability company taxes are applied at company level
• Liability – it is easier to get more debt for a limited liability company because you have a relation with the company not with the shareholders
• Lifetime – a company established by people has a limited life; a limited liability company has a personal life that doesn’t depend on the life of the founders
• Regulation – limited liability companies are more regulated than sole proprietorship and partnership
• Ownership – can be concentrated in any case
• Management – more difficult to find managers that want to enter in a partnership, professional managers usually prefer to work for limited liability companies
• Economy and industry – it can be very similar to the industry where to operate with some exceptions: if telecommunication sector, you cannot enter as a partnership, similar for pharmaceutical

08-03-2022

Conflict of interest

A day-by-day problem that can be found in any organization, and the two main types are between managers and shareholders, and between minority and majority investors.

Agency issues – when do they exist?

Somebody that gives you an order and somebody that has to do something. Type I agency problem – The agency typically is the management, the managers are the owners – owners and brokers, shareholders, and management.

Agency cost: problem regarding two dominant roles at the same level or in two different ones each having different interests, they try to pursue different goals – all the costs (money sometimes) connected to conflict of interest. Can link majority and minority investors or owners and managers. The agency cost can be direct (effective, money) and/or indirect:

• Direct: the boss of the company wants to buy an airplane for his own purpose; the CEO tends to spend money on sponsorship – this kind of decision can be taken not in a fully optimal way. Another example is favoring for a politician. It is important to try to constrain this situation in which the conflict of interest can increase costs.

The manager in the company must act in the best interest of his stakeholders in order to create value for the company itself. Best path: create value for the left part of the BS – the enterprise value, the assets – and after to create it for the equity. The managers have also the right to create value for themselves – they want to be paid, to get benefits, facilities, ... large corporations use to have a restricted committee working for the board of directors which is entitled to decide the level of salary and benefits for the top managers and to appraise if it is evaluated in the right way.

If the salary of the manager and/or of the shareholders is very high, the profit of the company will be lower, so there has to be a trade-off: shareholders have to give capital and managers have to give work.

Important to raise the problem when a conflict of interest arises, and there are many ways to face such conflict of interest: to try to make converge/parallel the interests of the managers and the ones of the shareholders.

Comparison between different environments, style, cultures

In Denmark ST incentive are quite negligible, they are more important in EU and US. Fixed salary, in particular in Italy, is the greatest part of all the remuneration; in EU the LT incentives is the small portion.

Controlling manager behavior – voting rights

Comparison of different situations in which the company works through the one share one vote – country analysis.

Type II agency problem

The same can happen between minority and majority shareholders: if the majority decides to do something, the minority has to accept it, otherwise, they have to sell their shares, and this creates problems. This can happen both in listed and non-listed companies, and a way to counteract it is through cumulative voting for example.

The OECD principles of corporate governance

Most of the time it is not an external problem, but if the company makes profits, it is almost always thanks to a nice way through which the company is managed. Six major principles:

• Regulatory framework
• Shareholders rights
• Treatments of shareholders
• Stakeholders
• Disclosure and transparency – in the figures and communication
• Board of directors

Sometimes they are not fixed rules, but they are the invitation to look at these aspects and to consider that sooner or later these are problems to be considered and that need to be well run. Maximizing the value for the shareholders maximizes the value for the stakeholders, the main purpose of the benefit corporation is to create value for several categories that apparently can seem to have conflict of interests.

The most important factors influencing INTL CorpGov

Investor protection: The Legal Environment

The financial system is very important, and each country has to comply with all the six principles considering the different legal and financial environment.

What is a financial system?

Any kind of financial system is made by the demand for capital and the supply of capital.

• Supply of capital – the savers, even companies when they produce more than what they consume; public administration, e.g., Norway made a perfect pension fund for the next three generations of people, or for example China which invested a lot in western countries and even Africa.
• Demand of capital – companies when they want to finance projects; public administration, when they want to balance the public debt; also households when the personal richness is not enough to satisfy the needs.

There are intermediaries that make the connections faster, but also institutional investors divided into primary and secondary markets. The financial system, in order to work well, has to have well-represented members of each category and authorities/governments have to work in order to create instruments to make the gearing work well.

Financial instruments and channels of intermediation

Traditional division: Banks vs Markets

• Financial intermediaries (mainly banks) vs. financial markets (deposits vs securities)
• Households could invest their wealth either in bank deposits (majority) or in financial instruments (historically well-off people)

Nowadays securities are the most important asset class and are bought indirectly through financial investors.

A few stylized facts

Financial systems differ by:

• Size (Total financial assets on GDP)
• Financial channels of intermediation
• Distribution of financial surpluses/deficits

The dimension of the financial pyramid continues to grow. In order to compare financial systems, we must focus on functions. Why focus on functions – Functions are sta...