théorie financière 2004-2005 1. introduction

Théorie Financière2004-20051. Introduction

Professeur André Farber

Tfin 2004 01 Introduction |2August 23, 2004

Organisation du cours

• Ouvrages de référence:Brealey, R. and Myers, S.

Principle of Corporate Finance7th ed., McGraw-Hill 2003

Farber,A. Laurent, M-P., Oosterlinck, K., Pirotte, H. (FLOP)Finance

Pearson Education, 2004

• Site web: www.ulb.ac.be/cours/solvay/farber• Copie des transparents (PowerPoint)• Glossaire anglais - français• Notes pédagogiques, exercices, anciens examens• Liens vers d’autres sites

• Examen(s)


Exercices

• Assistants:

• Céline Vaessen

• Benjamin Lorent

• 6 séances (Vendredi 10-12), 4 groupes

• Groupe 1: A à F

• Groupe 2: G à L

• Groupe 3: M à P

• Groupe 4: Q à Z

New

Semaines 2, 4, 6, 8, 10, 12

Semaines 3, 5, 7, 9, 11, 13


Plan du cours

• 1. Introduction

• 2. Valeur actuelle

• 3. Cash flows, planning financier

• 4. Evaluation d’entreprises

• 5,6. Analyse de projets d’investissement

• 7,8. Rentabilité attendue et risque

• 9,10. Options

• 11, 12. Evaluation et financement


What is Corporate Finance?

• INVESTMENT DECISIONS: Which REAL ASSETS to buy ? • Real assets: will generate future cash flows to the firm

• Intangible assets : R&D, Marketing, ..

• Tangible assets : Real estate, Equipments,..

• Current assets: Inventories, Account receivables,..

• FINANCING DECISIONS: Which FINANCIAL ASSET to sell ?• Financial assets: claims on future cash flows

• Debt: promise to repay a fixed amount

• Equity: residual claim

• DIVIDEND DECISION: How much to return to stockholders?


Accounting View of the Firm

• Balance sheet Income statement

Sales

– Operating expenses

= Earnings before interest and taxes (EBIT)

– Interest expenses

– Taxes

= Net income (earnings after taxes)

• Retained earnings

• Dividend payments

Current assets

Fixed assets

Current liabilites

Long-term debt

Shareholders’ equity

Net Working Capital


Cash Flows of the Firm

Firm Financial markets

Firm issue securitiesFirm invest

Cash flow from operations Dividend and

debt payments

Timing of cash flows + uncertainty

Investors


Market Value of the Firm

Total capital

Fixed Assets

+

Net Working Capital

Book equity

Debt

Book values Market values

Market value of equity

Market value of

debt

Market capitalization


Value creation

• Market value added (MVA)• = Market value of the firm’s capital – Total capital employed

• VALUE CREATION : 2 strategies• Strategy 1

• Buy assets at a cost lower than the value of the future revenues– real assets– financial assets

• Strategy 2• Sell financial assets for a price higher than the value of future

payments

Market value of equity + Market value of debt

Stockholders’ equity + Financial debt


Example: Microsoft (MSFT)

• Balance sheet - 30 June 2004

• (billion USD)

• Cash 49

• WCR -8

• Fixed assets 20

• Total assets 61

• Stockholders’ equity 61

• Income statement

• Revenue 32

• Net Income 10

• WCR = Working Capital Requirement

• Source: http://finance.yahoo.com

• Market Value -1 Sept. 2004

• Market cap 297

• Enterprise value 248

• MVA 236


The Cost of Capital

• The firm can always give cash back to the shareholders

• Capital employed by the firm has an opportunity cost

• The opportunity cost of capital is the expected rate of return offered by equivalent investments in the capital market

• The weighted average cost of capital (WACC) is the (weighted) average of the cost of equity and of the cost of debt

Project Cash

StockholderInvestment opportunities in capital markets

?


Stockholders’ problem

equity rs'Stockholde

IncomeNet ROE

InvestmentInitial

GainCapitalDivr

1

Capital marketCompany

ROEReturn on Equity

rExpected return


How to measure value creation ?

• 1. Compare market value of equity to book value

• Value creation if M/B > 1

• 2. Compare return on equity to the opportunity cost of equity

• Value creation if ROE > Opportunity Cost of Equity

shareper Book value

priceStock book(M/B)-to-Market

equity rs'Stockholde

IncomeNet )(equity on Return ROE


Value creation: Example

• Data:

• Book value of equity = € 10 b

• Net income = € 2 b / year

• Cost of equity r = 10%

• Return on equity ROE = 2 / 10 = 20% > 10%

• Market value of equity = NI / r = 2 / 10% = € 20 b

• Market value added: MVA = 20 – 10 = €10 b

• Market to Book M/B = 20 / 10 = 2


M/B vs ROE

• Simplifying assumptions:

• · Expected net income income = constant

• · Net income = dividend

• Market value determination:

• Net income = Expected return Market value of equity

• NI = r MVeq

• ROE (definition):

• Return on equity = Net income / Book value of equity

• ROE = NI / BVeq

• = r MVeq / Bveq

• Conclusion: in this simplified setting,

– M/B = MVeq/BVeq > 1 ROE> r


The Top Companies 2004

Mkt Value$ bil.

Price/Book

ROE%

1 GE US 328 4.3 21.62 Microsoft US 284 4.0 10.63 Exxon US 284 3.1 21.64 Pfizer US 270 3.9 2.15 Wal-Mart US 241 5.6 20.36 Citigroup US 239 2.4 19.17 BP UK 193 2.6 14.18 American Intl US 191 2.5 13.29 Intel US 185 4.8 16.810 Royal Dutch NL/UK 175 2.3 17.311 Bank of America US 170 2.5 22.312 Johnson & J. US 165 5.8 26.713 HSBC Hold. UK 163 2.1 16.0

Source:Business Week, July 14 2003


Drivers of ROE

• PROFITABILITY (du Pont system)

• Three determinants :

Equity

Assets

Assets

Sales

Sales

Net IncomeROE

EquityBook

IncomeNet ROE

Financial Leverage

Asset Turnover

Profit Margin

•Microsoft - 2004 US$ bil.•Net Income 10•Sales 32•Assets 61•Book equity 61

16.4%

31.0% 0.52 1.00


Example

Wal-Mart Vodafone Total

US UK F

Rank 5 14 24

MktValue 241,187 159,150 122,945

M/ B 5.6 0.7 3.5

P/ E 27 15 14

Sales 258,681 61,259 127,796

Profi t 8,861 11,364 8,968

Assets 104,912 269,754 97,647

ROE 20.20% 17.80% 24.10%

Profi t margin 3.43% 18.55% 7.02%

Turnover 2.47 0.23 1.31

Leverage 2.39 4.23 2.62

Source: Business Week July 26, 2004

Foundations of Finance


Theory of finance

• A young science

• Finance has been around for many centuries, of course…

• Main problem: calculation!!

• Imagine having to calculate the future value of 1 euro invested for 13 years when the annual interest rate is 4.35% (with annual compounding):

Future value = (1.0435)13

• A nightmare…..

• This problem disappeared after WWII with the development of computers.

• Now we have calculators and spreadsheets….

• We also have large data bases


Irving Fisher

• Finance has its roots in economics

• Irving Fisher laid the foundations of modern theory of finance.

• Takes into account the time dimension of financial decisions

• Main ideas:

• Decisions should based on present value

• Net Present Value (NPV): a measure of additional wealth

• With perfect capital markets: independent of preferences


Present value: 1 period, certainty

• Perfect capital market

• Interest rate: r

• Future cash flow C1

• Present value:

• or: r

CCPV

1)( 1

1

PV(C1) = DF1 C1

Interpretation: DF1 = discount factor

price of 1€ to be received in one year

price of unit zero coupon

with r

DF

1

11


Microeconomics: a review

• Consumption over time:

• 1 periods, certainty

• Perfect capital markets => budget constraint

» Slope = -(1+r)

» Intercept = W0(1+r)

• Optimum:

» Marginal Rate of Substitution (MRS) = 1+r

» Optimal consumption independent of timing of income

0110

01

01

0 11WQDFQ

Wr

YY

r

QQ


Economic foundations of net present value

100

105

200Euros now

Euros next year

50

165

Slope = - (1 + r) = - (1 + 5%)

I. Fisher 1907, J. Hirshleifer 1958

Perfect capital markets

Separate investment decisions from consumption decisions

157.5

52.5

150


Net Present Value

NPV = -I + DF1 C1

Consider investment project:

Initial cost: I

Future cash flow: C1

Budget constraint with project:

NPVWCYvIYQvQ )()( 1110110


Economic foundations of net present value

100

105

200Euros now

Euros next year

50

165

207

NPV

Slope = - (1 + r) = - (1 + 5%)

-50

I. Fisher 1907, J. Hirshleifer 1958

Perfect capital markets

Separate investment decisions from consumption decisions


Entreprise Value Maximisation

0

Investment

Euros today

Euros next year

NPV

Investment opportunities

Market value of company

Numerical example!!!


Uncertainty: 1952 – 1973- the Golden Years

• 1952: Harry Markowitz*

– Portfolio selection in a mean –variance framework

• 1953: Kenneth Arrow*

– Complete markets and the law of one price

• 1958: Franco Modigliani* and Merton Miller*

– Value of company independant of financial structure

• 1963: Paul Samuelson* and Eugene Fama

– Efficient market hypothesis

• 1964: Bill Sharpe* and John Lintner

– Capital Asset Price Model

• 1973: Myron Scholes*, Fisher Black and Robert Merton*

– Option pricing model


1 period, uncertainty

• 2 possible states of the economy: prosperity and depression

• 2 financial assets: one riskless bond and one stock

Current price

Prosperity Depression

Bond v 1 1

Stock S SP SD

States Price P D Expected returnsProbability 0.5 0.5Bond 0.9524 1 1 5.00%Stock 50 100 25 25.00%


Contingent claims

• Consider 2 securities that pay 1€ in one state and 0€ in the other state.

• They are named: contingent claims, Arrow Debreu securities, states prices

Current Price

Prosperity Depression

CC prosperity vP 1 0

CC depression vD 0 1


Computing state prices

• Financial assets can be viewed as packages of financial claims.

• Law of one price:

v1 = vP 1 + vD 1

S = vP SP + vD SD

• Complete markets: # securities ≥ # states

• Solve equations for find vP and vD

DP

PD

DP

DP

SS

SSvv

SS

SvSv

1

1


Example


Contingent claimsCC P 0.3492 1 0CC D 0.6032 0 1

Project -50 120 40 80.00


Capital budgeting under uncertainty

• Consider the following investment project:

• Initial cost: I

• Future cash flows: CP or CD depending on state of the world.

• How do we compute the NPV for this project?

• NPV of project

• A straightforward extension of previous formula.

DDPP CvCvINPV


Example


Contingent claimsCC P 0.3492 1 0CC D 0.6032 0 1

Project -50 120 40 80.00

Present values 41.90 24.13NPV 16.03


References

• Corporate finance textbooks (MBA level)

– Brealey, Richard and Steward Myers, Principles of Corporate Finance, xth edition, McGraw-Hill 2000

– Ross, Stephen A., Randolph W. Westerfield and Jeffrey F. Jaffe, Corporate Finance, 6th edition, McGraw-Hill Irwin 2002

– Damorada, Aswath, Corporate Finance: Theory and Practice, Wiley 1997

• Ouvrages de référence en français:

– Bodie, Z. et Merton, R. Finance (édition française dirigée par C. Thibierge) Pearson education 2000

• Corporate finance texts for executives

– Bertoneche, Marc and Rory Knight, Financial Performance, Butterworth Heinemann 2001

– Hawawini, Gabriel and Claude Viallet, Finance for Executives: Managing for Value Creation, South-Western College Publishing, 1999

théorie financière 2004-2005 1. introduction

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