Lecture 1. Introduction
The key responsibilities of the CFO
The two main parts of CF are allocation (investment) and financing, corresponding to the A&L sides
of the balance sheet. The ultimate objective is to maximize the shareholders’ wealth: achieve the
highest return on the projects and ensure the cheapest financing. Evaluation of the investment projects
is based on the discounted cash flows, which are different from the accounting profits (e.g. because of depreciation). The real options approach takes into account that managers can influence the CFs after the beginning of the project. Applying similar methods, one can value the company.
The company can be restructured from private to a public one via IPO, and vice versa. Another type
of structural change comes from M&As. The company’s goal is to acquire the companies bringing
synergy gains and those undervalued due to the inefficient management. The best defence from the acquisition is to maximize its own value.
The goal of corporate governance is to internalize the external effects, balance the economic interests of all stakeholders. In well-functioning financial markets, this maximizes shareholder value.
Typical CF questions:
~ How to measure the project’s worth for the company?
~ Are companies' market prices justified? (e.g., dot-coms)
~ How to choose among the projects given the budget constraint and external effects? ~ How to account for risks associated with the project?
o Systematic vs company-specific risks
~ Are risks always bad?
~ Is it good to have volatile oil prices?
o Yes, if managers have flexibility in the future decisions.
~ Should we invest now in a project, which seems unprofitable (has negative NPV)?
o Probably, yes. It may yield high profit in certain future scenarios (oil pipeline) ~ Should we invest now in a project, which is profitable (has positive NPV)?
o Probably, not. It may be even more profitable next period (gold extraction) ~ Should we give managers higher salaries or higher bonuses?
o Bonuses encourage higher performance, but may also lead to the manipulations and excessive
~ Does it matter how to finance the project: by debt or by equity?
~ Would you like the company to have much debt?
o Yes, to minimize taxes and to discipline the managers. Not too much, to avoid bankruptcy. ~ Should the company borrow money from banks or issue bonds?
o The company can renegotiate the terms of bank credit.
~ Would you like the company to pay high dividends? (e.g., Microsoft)
o Yes, if too much managerial discretion (Surgut). No, because of double taxation and signalling
that the company has no valuable inv projects.
~ How will the market react to the share buyback?
o The company signals that its shares are undervalued.
~ How will the market react to the new equity issue?
o Usually negatively: either the company’s shares are overvalued, or it needs to finance a new
~ How should the company communicate with the market? Always provide precise info in time? ~ What drives the company’s decision to go public? Why are there hardly any IPOs in Russia?
~ Would you like the company to grow via acquisitions?
o Yes, if the main motivation comes form synergy gains, and not empire-building.
Specifics of corporation
Do not take the current form of corporations and stock markets as given, it is an endogenous outcome! Advantages of corporation in comparison with sole proprietorship and partnership:
~ Ltd liability: lesser risks for investors
o Crucial for development of stock markets and diversification
~ Easy transfer of ownership
o Promotes liquidity
~ Unlimited life
o Makes it easier to attract financing
~ Separation of ownership and control, the agency conflict
o Solved in two ways: US vs Germany
~ Double taxation
History: 1811, general act of incorporation in NY, specifying that all investors of NY corporations
have limited liability
~ Not so obvious that limiting the freedom of contracts is good
~ Hot discussion at the time: could spur excessive risk taking
~ California was the last to copy in 1931
The Objective in Corporate Finance
“If you don’t know where you are going,
it does not matter how you get there”
The Classical Viewpoint:
Van Horne: "In this book, we assume that the objective of the firm is to maximize its value to its stockholders"
Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value."
Copeland & Weston: The most important theme is that the objective of the firm is to maximize the wealth of its stockholders."
Brigham and Gapenski: Throughout this book we operate on the assumption that the management's primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock.
Why focus on maximizing stockholder wealth?
~ Stock price is easily observable and constantly updated (unlike other measures of performance,
which may not be as easily observable, and certainly not updated as frequently). ~ If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and
long term, instantaneously.
~ The objective of stock price performance provides some very elegant theory on:
o how to pick projects
o how to finance them
o how much to pay in dividends
The Classical Objective Function
What can go wrong?
~ Traditional corporate financial theory breaks down when the interests/objectives of the decision makers in the firm conflict with the interests of stockholders.
o Bondholders (Lenders) are not protected against expropriation by stockholders.
o Financial markets do not operate efficiently, and stock prices do not reflect the underlying
value of the firm.
o Significant social costs can be created as a by-product of stock price maximization.
~ Choose a different mechanism for corporate governance
~ Choose a different objective:
o Maximizing earnings / revenues / firm size / market share
o The key thing to remember is that these are intermediate objective functions. To the degree
that they are correlated with the long term health and value of the company, they work well.
To the degree that they do not, the firm can end up with a disaster
~ Maximize stock price, but reduce the potential for conflict and breakdown:
o Making managers (decision makers) and employees into stockholders
o Providing information honestly and promptly to financial markets
The strength of the stock price maximization objective function is its internal self correction mechanism. Excesses on any of the linkages lead, if unregulated, to counter actions which reduce or eliminate these excesses
~ managers taking advantage of stockholders has lead to a much more active market for corporate
~ stockholders taking advantage of bondholders has lead to bondholders protecting themselves at the
time of the issue.
~ firms revealing incorrect or delayed information to markets has lead to markets becoming more
―skeptical‖ and ―punitive‖
~ firms creating social costs has lead to more regulations, investor and customer backlashes.
The Modified Objective Function
~ For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are
o Maximize Stock Price: This will also maximize firm value
~ For publicly traded firms in inefficient markets, where bondholders are protected:
o Maximize stockholder wealth: This will also maximize firm value, but might not maximize
the stock price
~ For publicly traded firms in inefficient markets, where bondholders are not fully protected
o Maximize firm value, though stockholder wealth and stock prices may not be maximized at
the same point.
~ For private firms, maximize stockholder wealth (if lenders are protected) or firm value (if they are
Relation to investment theory
~ Use of CAPM to estimate the cost of capital
~ Option pricing approach for valuing investment projects (real options), equity of the firm, and
bonds’ credit risk
Lecture 2. Analysis of financial statements
The Firm’s Financial Statements
~ Balance Sheet
~ Income Statement
~ Statement of Cash Flows
~ current status and past performance information to owners and creditors ~ a convenient way for owners and creditors to set performance targets & to impose restrictions on
the managers of the firm
~ a convenient template for financial planning
Assets ? Liabilities + Shareholder’s Equity
~ Tabulates a company’s assets and liabilities at a specific point in time
o Info on value of the assets and the capital structure
~ Sorting of
o Assets by liquidity
o Liabilities by maturity
~ Assets and liabilities are represented by historical costs
o The original cost adjusted for improvements and aging = Book Value
o Avoid using market value, since is too volatile and easily manipulated
o Preference for underestimating value
~ Strict categorization into E or L: the liability must satisfy
o The obligation will lead to CF at some specified or determinable date
o The firm cannot avoid the obligation
o The transaction behind the obligation has already happened ~ However, important liabilities may be under-stated or omitted
~ Current Assets (Оборотные средства): will convert into cash within a year
o Accounts Receivable (Счета к получению)
; Recognizing not collectible ones: reserves (danger of manipulation!)
o Inventory (ТМЗ): valued by FIFO, LIFO, wdt-avg
; LIFO increases costs and reduces taxes
; LIFO reserve: difference between LIFO and FIFO valuations ~ Investments and Marketable Securities (Рыночные цб)
o Minority passive / active investment (<20% / 20-50% of the ownership): BV or MV
o If majority active investment (>50%): include in the consolidated balance sheet
~ Intangible Assets (Нематериальные активы): amortized over expected life (say, 40 years)
o Patents and trademarks: valuation depends on whether generated internally or acquired
o Goodwill: the difference between BV and MV of the acquired firm (purchase accounting)
~ Fixed Assets (Основные средства; Land, Plant and Equipment): BV with adjustment for aging
o Depreciation: straight line or accelerated (improves the earnings in the first years)
Liabilities and Stockholder’s Equity
~ Current Liabilities (Краткосрочные обязательства): valued as the amount due
o Accounts Payable (Счета к оплате)
o Short-term Borrowing
o Other: Accrued Wages, Benefits, and Taxes
~ Long-Term Debt: Bank Loans, Bonds
o Valued as PV of future obligations at the time of borrowing (usually at par)
o The premium or discount over the par is amortized over the bond’s life
~ Other Long-Term Liabilities
; Capital lease (transfer of ownership): recognized as asset (depreciated) and
; If operating lease: balance not affected, lease payments treated as operating
o Employee Benefits: Pension Plans, Healthcare Benefits
; DC: fixed contribution each year;
; DB: contributions change depending on whether the plan is over- or
o Deferred Taxes
; Difference between the taxes on income reported in fin statements and actual
Shareholder’s Equity (Акционерный капитал) = Total Assets - Total Liabilities
~ Preferred Stock
o Hybrid: fixed (cumulative) dividend, but cannot result in bankruptcy
o Valued at the original issue price + cumulated unpaid dividends ~ Common Stock at Par
~ Capital Surplus
o Results from earnings on buying and selling stocks
o Treasury Stock: repurchased shares, reduce BV of equity
~ Retained Earnings (Нераспределенная прибыль)
Revenue – Expenses ? Income
~ Summarizes the company’s profitability during a time period
o Records sales, expenses, taxes, and net income
~ Matching principle of the accrual accounting:
o Revenues and expenses are recognized when the good is sold
; Becomes complicated for long-term contracts and buyers with credit risk
o In contrast to the cash-based approach: recognizing revenues when received and expenses
; A company’s accounting income and cash flow are two different things
~ Categorization of expenses:
o Operating: provide benefits only for the current period (cost of labor and materials)
; Also included: depreciation (based on historical cost) and R&D
o Financing: arising from non-equity financing (interest expenses)
o Capital: generate benefits over multiple periods (buying land and buildings), written off as
~ To improve forecasting, separately: nonrecurring items
o Income from discontinued operations, extraordinary gains & losses, adjustments for
changes in accounting principles
~ Retained earnings are not added to the cash balance in the balance sheet, but are added to
~ Inflation distorts the measuring of income and the valuation of assets
Total operating revenues
- Cost of goods sold
- Selling, general, and administrative expenses
+ Other income
EBIT (Earnings before interest and taxes)
- Interest expense
- Taxes: Current + Deferred
Net income = Retained earnings + Dividends
The Statement of Cash Flows
CF(firm) ? CF(debt) + CF(equity)
~ Reports how much cash is generated during a period.
o Indicates where the cash comes from and what the firm did with that cash. ~ Unlike the balance sheet and income statement, cash flow statements are independent of
o Accounting rules have a second-order effect on cash flows through taxes
Operating CF = EBIT + Depreciation - Taxes
- Capital Spending (net acquisitions of fixed assets)
- Additions to the Net Working Capital (current assets - current liabilities) Cash Flow of the Firm
CF of debtholders = Interest – net long-term debt financing
CF of equityholders = Dividends– net equity financing
Financial Ratio Analysis
~ Trend Analysis
~ Cross-Sectional Analysis
~ Return on Assets (ROA) = EBIT(1-tax) / Total Assets
~ Return on Equity (ROE) = Net Income / BV(equity)
~ Gross Profit Margin = Gross Profit / TA
~ Operating Profit Margin = EBIT / Sales
~ Net Profit Margin = Net Income / Sales
Activity Ratios: measuring the efficiency of working capital management • Accounts Receivable Turnover = Sales / Avg Accounts Receivable • Inventory Turnover = Cost of Goods Sold / Avg Inventory • Total Asset Turnover = Sales / Total Assets
Liquidity Ratios: measuring short-term liquidity
~ Current Ratio = Current Assets / Current Liability ~ Quick Ratio = (Current Assets – Inventory) / Current Liability
Financial Leverage Ratios
~ Debt-to-Capital Ratio = Debt / (Debt + Equity)
~ Debt-to-Equity Ratio = Debt / Equity
o Can be based on BV or MV
o Similarly: long-term debt ratios
~ Interest Coverage Ratio = EBIT / Interest Expenses ~ Cash Fixed Charges Coverage Ratio = EBITDA / Cash Fixed Charges
Market Value Ratios
• Price-to-Earnings Ratio = PS / EPS
– Stock market price to earnings per share
• Dividend Yield = Div / PS
– Latest dividend to current stock price
• Market-to-Book Value = MV / BV
– Similarly: Market-to-Book Equity = ME / BE
• Tobin's Q = MV / Replacement Value
Links between the Ratios
~ ROA = Profit Margin * Asset Turnover
o Both for Net and Gross ROA and Profit Margin
o Increasing ROA: trade-off between Profit Margin and Asset Turnover ~ ROE = ROA * Equity Multiplier
o where Equity Multiplier = Assets / Equity
o Higher fin leverage magnifies ROE when ROA(gross) excess the interest on debt
Non-Financial Measures of Operating Effectiveness
~ Customer Service
~ Product Quality
~ Good Employee Relations
Segmented Financial Statements
~ Reports revenues, operating profits, and identifiable assets for each line of business
~ Allows managers and shareholders to identify cross-subsidization
The DCF approach to bond and stock valuation Computing Present Value
~ Time value of money: discount rate R
~ Single cash flow at T: CF TT o PV = CF/(1+R) 0T
= C, t>0 ~ Perpetuity: Ct
o PV = C / R 0
~ Growing perpetuity (with const rate g): C= (1+g)C t+1 t
o PV = C / (R - g) 0
~ Annuity: C = C, t = 1,…,T t To PV = (C/R) [1 – 1/(1+R) ] 0
~ Growing annuity (with const rate g) TTo PV = (C/(R-g)) [1 – (1+g)/(1+R) ] 0
Computing Growth Rate of Dividends
Assume that the company does not grow unless a net investment is made. Then the company needs to retain part of its earnings to grow:
Earnings = Earnings + Retained_ Earnings * R t+1tt
where R is the return on the retained earnings, usually estimated by ROE
Divide by Earnings to get Sustainable Growth Rate : t
1 + g = 1 + Retention Ratio * ROE
where Retention Ratio = Retained Earnings / Earnings
~ Bond with coupon C and face value F (at T) TT o P = (C/R) [1 – 1/(1+R) ] + F/(1+R)0T
~ Stocks with dividends growing with const rate g
o PV = Div/(R-g) 01t~ Project: NPV = Σ CF/(1+R) tt
~ Value of the firm with Div=EPS:
o Discounted CF's: PV = EPS/R + NPVGO 0
; EPS = earnings per share, GO = growth opportunities
o Multiples: P/E?PV/EPS = 1/R + NPVGO/EPS 0
; P/E = price to earnings ratio
Lectures 3-6. Capital budgeting
Black-Scholes approach to the valuation of real options
Differences between real and financial options, which are crucial for the Black-Scholes approach: 1. The underlying asset is not traded
~ Option pricing theory is built on the premise that a replicating portfolio can be created using
the underlying asset and riskless lending and borrowing.
2. The price of the asset may not follow a continuous process
~ If there are no price jumps, as it is with most real options, the model will underestimate the
value of deep out-of-the-money options.
o One solution is to use a higher variance estimate to value deep out-of-the-money
options and lower variance estimates for at-the-money or in-the-money options.
o Another is to use an option pricing model that explicitly allows for price jumps, though
the inputs to these models are often difficult to estimate.
3. The variance may change over the life of the option
~ The assumption that option pricing models make, that the variance is known and does not
change over the option lifetime, is not unreasonable when applied to listed short-term options
on traded stocks.
~ When option pricing theory is applied to long-term real options, there are problems with this
assumption, since the variance is unlikely to remain constant over extended periods of time and
may in fact be difficult to estimate in the first place.
4. Exercise is not instantaneous
~ The option pricing models are based upon the premise that the exercise of an option is
instantaneous. This assumption may be difficult to justify with real options, where exercise
may require the building of a plant or the construction of an oil rig, actions which are unlikely
to happen in an instant.
~ The fact that exercise takes time also implies that the true life of a real option is often less than
the stated life.
Valuing Natural Resource Options/ Firms
Input Estimation Process
~ Expert estimates (Geologists for oil..); The present 1. Value of Available Reserves of value of the after-tax cash flows from the resource are the Resource then estimated.
2. Cost of Developing Reserve ~ Past costs and the specifics of the investment (Strike Price)
~ Relinqushment Period: if asset has to be relinquished
at a point in time. 3. Time to Expiration ~ Time to exhaust inventory - based upon inventory and
4. Variance in value of ~ based upon variability of the price of the resources and
underlying asset variability of available reserves.
5. Net Production Revenue ~ Net production revenue every year as percent of
(Dividend Yield) market value.
6. Development Lag ~ Calculate PV of reserve based upon the lag.
Example: A gold mine
~ Consider a gold mine with an estimated inventory of 1 million ounces, and a capacity output rate of
50,000 ounces per year.
~ The price of gold is expected to grow 3% a year.
~ The firm owns the rights to this mine for the next twenty years.
~ The present value of the cost of opening the mine is $40 million, and the average production cost of
$250 per ounce. This production cost, once initiated, is expected to grow 4% a year. ~ The standard deviation in gold prices is 20%, and the current price of gold is $350 per ounce. The
riskless rate is 9%, and the cost of capital for operating the mine is 10%. The inputs to the model are
Inputs for the Option Pricing Model
~ Value of the underlying asset = Present Value of expected gold sales (@ 50,000 ounces a year) = 20202020(50,000 * 350) * (1- (1.03/1.10))/(.10-.03) - (50,000*250)* (1- (1.04/1.10))/(.10-.04) = $ 42.40
~ Exercise price = PV of Cost of opening mine = $40 million
Variance in ln(gold price) = 0.04
~ Time to expiration on the option = 20 years
~ Riskless interest rate = 9%
~ Dividend Yield = Loss in production for each year of delay = 1 / 20 = 5%
o Note: It will take twenty years to empty the mine, and the firm owns the rights for twenty years.
Every year of delay implies a loss of one year of production.