Corporate Finance A1

Vysoká škola finanční a správníSummer Semester 2012

Jaromír R. Stembergjaromir@mail.vsfs.cz

Course Layout

• Twelve two-hour lessons• The course is to introduce general financial

management problems, realtions, terminology, and solutions

• Ends with Credit (zápočet)

Literature

• Block, Stanley: Foundations of Financial ManagementMcGraw-Hill, 2009ISBN 978-0-07-128525-4

Grading

• Pass / Fail

• 50%: Five mathematical group excercises

• 50%: Written test

• Minimum to pass: 70%

Contents

• Introduction- history of finance - goals of financial management- financial markets

• Review of Accounting- the nature and role of the balance sheet - theories of balance and their development- creation of the second balance - third and fourth balance, their formation and construction

Contents

• Concept of capital- preservation of the capital substance of a company- ways of addressing it

• Accounting systems in the world- characteristics of accounting systems- process of accounting harmonization- US GAAP- IAS/IFRS, link to the directives of the European Union

History of Money and Accounting

Barter Trade

• Exchange of personal possessions of value for other goods

• From 9,000-6,000 B.C., livestock was often used as a unit of exchange; as agriculture developed, people used crops for barter

• This kind of exchange started at the beginning of humankind and is still used today

Barter Trade Problems

• Finding the other party: - interest - time

• Establishing equal value of exchanged goods• Durability of the exchanged goods, potentiality to

store it• Need for a common, durable, storable, non-decaying,

generally accepted unit of exchange

Cowry Shells

• The first money (or medium of exchange)• Began to be used at about 1200 B.C. in China• Accepted in some African regions till 1950s

Metal Coins

• China, 1000 BC: Bronze and copper cowry imitations were considered the earliest forms of metal coins. They contained holes so they could be put together like a chain.

• Lydia (Turkey), 500 BC:The first coins developed out of lumps of silver and were stamped with emperors to mark their authenticity. The techniques were quickly copied by the Greeks, Persians, and the Roman Empire. Unlike Chinese coins, these were made from precious metals such as silver and gold, which had more inherent value.

Banknotes

• China, 100 BC:Leather money – pieces of painted white deerskin.

• China, 800 AD:The first paper banknotes appeared.

• China, 1450 AD:Printing money led to a soaring inflation so the use of paper money in China disappeared (this was still years to come before paper currency would be used in Europe).

Development of Accounting

• Babylon, 18th century B.C.- first organized records kept to account for assets and loans- other ancient civilizations (Roman Empire, Greek Cities, Egypt) followed

• Europe, 1st millennium A.D.fall of the Roman Empire caused serious setback in education

• Italy, 13th century A.D. - growing trade in the Mediterranean and accumulation of wealth in Italy gave grounds to the development of banking- double-entry bookkeeping was invented by Luca Pacioli

Modern Times Accounting

• 17th century France: - obligation to present bi-yearly balances of financial situation

Italy:- complete theory of accounting

Holland:- first corporation established, need for equity accounting

• 19th century- massive increase of accounting operations- perfection of accounting principles- rules for asset evaluation

History of Accounting Standards

• 1938: American Institute of Certified Public Accountants began to develop accounting standards (request of the Securities and Exchange Commission)

• 1959: Accounting Principles Board established, introduction of GAAP

• 1973: the International Accounting Standards Board (IASB) formed to develop International Accounting Standards (IAS)

• 2001: end of IAS (41 issued so far, still valid); new standards are from now on called International Financial Reporting Standards (IFRS) that quickly became accepted world wide

Principles of Accounting

Record Keeping

• Information – a basic management tool needed for - past references and reporting- present registration and evidence - future planning and management decision making

• Registered entries keep track of: - amount how much- count how many- time when- place where- person who

Double-Entry Accounting

• Accounts- recognition of individual transactions- debit and credit to be recorded at the same time

• General Ledger (hlavní kniha)- transactions recorded in accounts, total of both sides must be equal- can be extended by subsidiary ledgers

• Journal (účetní deník)- transactions recorded in order as they occurred- both sides of the record must be equal

Purpose of Record Keeping

• Financial accounting- provides information for owners, investors and other stake holders- serves as a base for income tax due calculation- subject to regulations by accounting standards- must be true and honest

• Managerial accounting- serves the managers as base for strategy planning and decision making- provides specified pieces of information - outcomes don’t have to be understood by the general public

Financial Reports Analysis

Balance Sheet

Assets LiabilitiesCurrent Assets Current LiabilitiesCash and Equivalents Short-Term Accounts PayableShort-Term Receivables Current Tax PayableInventory Short-Term Loans and BorrowingsAccruals and Other S/T Assets Accruals and Other S/T LiabilitiesLong-Term Assets Long-Term LiabilitiesIntangible Fixed Assets Long-Term PayablesTangible Fixed Assets ProvisionsLong-Term Receivables

Owners’ Equity Share CapitalShare Premium and Capital FundsRetained EarningsY-T-D Profit (Loss)

RevenueMaterialProduction Exp.CommissionOther Selling Exp.

Cost of Goods SoldGross Profit

MarketingAdministrationOffice Exp.ConsultantsDepreciationOther Exp.

Total G&A ExpensesProfit from Operations

Financial IncomeFinancial Exp.

Net Financial ResultProfit before Tax

Corporate Income TaxNet Profit

Cash Flow StatementCash - Beginning of Period +Net Profit +Accounts Receivable Increase -Inventory Increase -Accounts Payable Increase +Reserves Increase +Depreciation +Cash Flow from Operations = +Fixed Assets Purchase -Fixed Assets Sale +Cash Flow from Investments = +Loans Re-Paid -Loans Taken +Cash Flow from Financial Transactions = +Cash - End of Period =

Statement of Changes in EquityShare

CapitalCapital Funds

Statutory Funds

Retained Earnings

Current Period Profit

Total Equity

Balance at 31 Dec. X-1 20 000 374 4 304 9 050 33 728

Distribution of profit or loss

26 5 024 -9 050 -4 000

Change in share capital

0

Dividends paid 4 000 4 000

Payments from capital funds

0

Profit or loss current period

9 954 9 954

Balance at 31 Dec. X 20 000 400 13 328 9 954 43 682

Profitability Ratios

• Profit margin• Return on assets (investments)• Return on equity

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Profit Margin

Net income / Sales = 200 / 4 000 = 5%

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Return on Assets

Net income / Total assets = 200 / 1 600 = 12,5%

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Return on Equity

Net income / Stockholders‘ equity = 200 / 1 000 = 20%

Asset Utilization Ratios

• Receivable turnover• Average collection period• Inventory turnover• Fixed asset turnover• Total asset turnover

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Receivable Turnover

Sales / Accounts receivable = 4 000 / 350 = 11,4 times

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Average Collection Period

Accounts receivable / (Sales / 365) = 350 / 11 = 32 days

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Fixed Assets Turnover

Sales / Fixed Assets = 4 000 / 800 = 5 times

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Total Assets Turnover

Sales / Total assets = 4 000 / 1 600 = 2,5 times

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Inventury Turnover

Sales / Fixed Assets = 4 000 / 800 = 5 times

Liquidity Ratios

• Current ratio• Quick ratio

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Current Ratio

Current assets / Current liabilities = 800 / 300 = 2,67

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Quick Ratio

(Current assets - Inventory) / Current liabilities = 430 / 300 = 1,43

Debt utilization Ratios

• Debt to total assets• Times interest earned

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Debt to Total Assets

Total debt / Total assets = 600 / 1 600 = 37,5%

Sales 4 000 Cash 30 A/P 50Cost of goods sold 3 000 S/T securities 50 N/P 250Gross profit 1 000 A/R 350 Total S/T liab 300Selling & admin exp. 450 Inventory 370 L/T liabilities 300Operating profit 550 Total S/T assets 800 Total liabilities 600Interest expense 50 Plant & equip. 1 000 Common Stock 400Extraordinary loss 200 Accum depreciation -200 Retained earnings 600Net income before tax 300 Tot. L/T assets 800 Total equity 1 000Income tax 100Net income 200 Total assets 1 600 Total liab+equity 1 600

Times Interest Earned

EBIT / Interest = 550 / 50 = 11 times

Du Pont Analysis

Trend Analysis

Forecast and Budget

Budgetting

• Systematic setting of future goals• Bottom-up or top-down• Identification of external influence and risks (such as

customers, competition, macroeconomics)• Identification of external influence and risks (such as

capacity of production and resources, human factor)• Setting of expected growth (reduction), pipeline,

percent-of-sales, investment planning

Financial Forecasting

• Pro forma income statement• Revenue (pipeline, funnel, percentage)• Expenses (variable, fixed)

• Pro forma balance sheet• A/R, A/P, inventory• Fixed assets, liabilities, equity

• Pro forma cash flow statement

Operational and Financial Leverage

Fixed and variable expenses

0

$total expenses

fixned expenses

No. of units produced

Fixed and variable expenses

No. of units produced

$

fixned expenses

total expenses

$

Break-Even Point

No. of units produced

revenue

total expenses

fixed expenses

Break-Even Point

profitrevenue

total expenses

fixed expenses

$

No. of units produced

$

Break-Even Point

No. of units produced

revenue

total expenses

fixed expenses

Operational leverage

• Uses fixed/variable cost• Can increase profits but increases risk

_ Fixed costs _ Price – Variable cost per unit

Operational leverage

_ Fixed costs _ Price – Variable cost per unit

Fixed cost 60.000 Fixed cost 12.000 Variable cost 0,80 / unit Variable cost 1,60 / unit Unit price 2,00 Unit price 2,00

60.000/(2,00-0,80) = 50.000 12.000/(2,00-1,60)= 30.000 break-even point is break-even point is 50.000 units 30.000 units

Financial Leverage

2 firms: exactly the same• Same sector• Same opportunities• Same Management…

The only difference: the debt• L (leveraged firm) has 50% of debt• U (unleveraged firm) has no debt

Financial LeverageFirm U Firm L

Shares (Capital)Financial debt Total

100 000 0100 000

50 000 50 000100 000

Number of shares(Price of a share 100)

1 000 500

EBIT Financial interests(interest rate 5%)Net income before taxEPS before tax

10 000 0

10 000 10 (10 000/1 000)

10 000 2 500

7 500 15 (7 500/500)

Net income after tax(Tax rate 33%)EPS after tax

6 700

6,70

5 000

10,00

Financial Leverage

The shareholder of L has a return of 15 (before tax)

The shareholder of U has a return of 10 (before tax)

What do you prefer?

Financial LeverageFirm U Firm L

SharesFinancial debtTotal

100 000 0100 000

50 000 50 000100 000

Number of shares(Price of a share 100)

1 000 500

EBITFinancial interests(interest rate 5%)Net income before taxEPS before tax

0 0

0 0

0 2 500

-2 500 -5

Net income after taxEPS after tax

0 0

-2 500 -5

Financial Leverage

The shareholder of L has a return of -5 (before tax)

The shareholder of U has a return of 0 (before tax)

What do you prefer?

Financial Leverage

For leverage to be profitable, the rate of return on the investment must be higher than the cost of the borrowed money

ConclusionLeverage can create value or destroy itTo create value, the IRR must be higher than the cost of loan; if not, leverage destroys value.