Dr Thomai Filippeli

Lecture 1

Lecturer:

Dr Thomai Filippeli
E mail: (t.filippeli@qmul.ac.uk)
Room: W415
Office Hours: Friday 3pm 5pm

Lectures:

Tutorials:

Assessment:

Lecture notes and tutorial questions can be

downloaded from QM+.

10x2 hours; Friday 12pm 2pm, Fogg LT

10x1 hours
Mid - term test (20%), Week 9, 27th of November
Final Exam (80%)

Textbook
Jonathan Berk and Peter DeMarzo, Corporate
Finance, global edition (3rd edition), Pearson, 2013

Lecture notes
The lecture notes will be available on QMplus the
day before the lecture
Classes
On QMplus you will find the exercises for next
week
You are expected to solve the exercises BEFORE
each
class
Model answers to the exercises will be available
on QMplus after the class

Class attendance is COMPLULSORY

Berk and DeMarzo:

Chapter 1: The Corporation
Moles, Parrino and Kidwell:
Chapter 1: The Financial Manager and the
Firm
Chapter 2: The Financial Environment and
the Level of Interest Rates
5

Basic principles of corporate finance

Four types of firms

Ownership versus Control of Corporations

Explain the role of the financial manager

Principal-agent problems

The stock markets

It is the area of finance dealing with monetary decisions

that business enterprises make and the tools and
analysis used to make these decisions
Every decision made in a business has financial
implications, and any decision that involves the use of
money is a corporate financial decision.
Defined broadly, everything that a business does fit
under the rubric of corporate finance.

Firm needs to raise (borrow) capital to finance its

investment and then pay its investors
There are many different ways to borrow money
(ie debt, equity) and to pay investors (ie coupons,
dividends, repurchases)
Modigliani and Miller: it is irrelevant how you raise
money and pay money
Deviations from M&M: taxes, bankruptcy costs,
agency costs, informational costs
Firms should look for cheapest way to do this
8

1. The Investment Principle

It determines where the firms invest their

resources
2. The Financing Principle

It governs the mix of funding used to fund

these
investments
3. The Dividend Principle

It answers the question of how much earnings

should be
reinvested back into the business
and how much returned to the owner of the
business
9

 A firm is unprofitable when it fails to

generate sufficient cash flows.

Firms that are unprofitable over time will be
forced into bankruptcy by their creditors
In bankruptcy, the company will either be

reorganised or the companys assets will be

liquidated.

10

1.The capital budgeting decision: Which

productive assets should the firm buy?

A good capital budgeting decision is

one in which the benefits are worth
more for the firm than the cost of the
assets

11

2.The financing decision: How should the firm

finance or pay for assets?
Financing decisions involve trade-offs
between advantages and disadvantages of
debt and equity financing.

12

Working capital management decisions: How

should day-to-day financial matters be managed

The mismanagement of working capital can cause

the firm to go into bankruptcy even though the firm
is profitable.

13

1.
2.
3.
4.

Sole Proprietorship
Partnership
Limited Liability Company
Corporation

14

 In a legal sense, it is a person distinct

from its owners.

The owners of a company are its
shareholders.
A major advantage of the corporate form
of business is that shareholders have
limited liability.

15

 The owners of companies are subject to

double taxation first at the corporate level

and then at the personal level when
dividends are paid to them.
Public companies can sell their debt or equity
in the public securities markets.
Private companies are held by a small
number of investors.

16

 A set of projects which deliver future cash

flows (CF)
A firm is owned by investors with different
ownership rights or they own different pieces
of the firm.
Two major types of ownership: debt and
equity
How to become owner? Buy debt or equity
(lend money to the firm)

17

The firm owns 100k barrel of oil today, it will

liquidate in one year
If price is $90/barrel, what is the liquidation value?
$90 x 100k = $9M
This example: price December 2007
Price June 2008 : $140
Price July 2012: $91
Price oil changes means firms value changes : Risk for the
firm

18

There is an outstanding zero coupon bond with

face value $5M.
Zero coupon: one time payment (face value) at maturity

Key feature of bonds: It is a promised payment

debtor must pay (if debtor can pay)
Therefore debt is senior to most other payments (equity)
Equity is junior, it is paid after debt is fully paid (voting rights)

19

D=min(5M, 100k*P)
E=max(0,100K*P-5M)
What is the value of the debt and equity today?
If price is $40? $90? $140?
D=min(5M, 4M or 9M or 14M)=4M or 5M or 5M
E=max(0,4-5 or 9-5 or 14-5)=0 or 4M or 9M

20

In the case P=$90 the total firm value is $9M, total

value of debt is $5M and total value of equity is
$4M.
4+5=9, E+D=V
If I would have set the face value to be any other
number we would have found the same thing: E
and D would change but E+D = 9 would not
change

21

M&M says it does not matter how we split

up the financing needs of the firm, the total
firm value remains unchanged if certain
assumptions hold.
What do we need to add/change in the
above calculation so that M&M no longer
holds?

22

Suppose that equity payouts are taxed but not the

debt payouts.
Then we would want as much debt as possible
Other reasons: Agency costs, Distress costs,
Asymmetric Information

23

Key feature: since debt payments are promised

(along with other payments such as salaries) they
must be payout before equity
Equity is the residual of what is left in the firm after
all promised payments paid out.
Equity payments are directly tied to firms
performance

24

Absolute Priority: Laws about which

claimholders are paid out first, equity is
last
Limited liability: Equity owners will get no
less than zero, they cannot be responsible
for the firms debts

25

Common Shares: 80% of all equity, voting

rights, these are the owners of the firm
Preferred Shares: seniority over common
shares
in
payouts,
dividends
predetermined at time of sale

26

Firm consists of several projects worth $100M

Firm has 10M shares outstanding valued at $10
per share
Firm wants to raise $20M in cash, to do this it will
sell shares at price P
What is the number of shares sold? What is the
total value of the firm after the transaction?

27

Number of shares sold: N=20/P

Total firm value after shares sold is the old firm
value (100) plus the infusion of cash (20) 100+20
= 120
Total shares outstanding: 10+N = 10 +(20/P)
Post SEO (Secondary Equity Offerings) price
per share is the firm value divided by total shares
outstanding:
V = 120/(10+(20/P)) = 12/(1+(2/P))

28

If P=9, post-SEO price is 9.82. Are the new

shareholders happy? Are the old shareholders
happy?
If P=11, post-SEO price is P=10.15. Are the new
shareholders happy? Are the old shareholders
happy?
The only fair price is 10!
What if new shareholders didnt know the true
value of the firm? What if old shareholders could
artificially inflate it?
29

30

Corporate Management Team

In a corporation, ownership and direct control are

typically separate.
Board of Directors
Elected by shareholders
Have ultimate decision-making authority

Chief Executive Officer (CEO)

Board typically
to CEO.

delegates

day-to-day

decision

making

31

 Ultimate management responsibility and

decision-making power in the firm.

Reports directly to the board of directors,
which is accountable to the companys
owners.

32

 Responsible for the best possible financial

analysis that is presented to the CEO.

Positions that report to the CFO:
The chief accountant prepares financial
statements, oversees the firms cost accounting
systems, prepares taxes and works closely with
the firms external auditors.

33

Financial Manager
Responsible for:
Investment Decisions
Financing Decisions

Cash Management

34

What Should Management Maximise?

Minimising risk or maximising profits

without regard to the other is not a

successful strategy.
Why not maximise profits?
With creative accounting the firm

can manipulate the profit figures.

Accounting profits are not

necessarily the same as cash

flows.
35

What Should Management Maximise?

Why not maximise profits?

Profit maximisation does not tell

us when cash flows are to be

received.
Profit maximisation ignores the

uncertainty or risk associated with

cash flows.

36

Maximise the Value of the Firms Share Price

When analysts and investors determine

the value of a firms shares, they

consider:
The size of the expected cash flows.
The timing of the cash flows.
The riskiness of the cash flows.
The mechanism for determining share

prices overcomes all the cash-flow

objections raised.
37

Maximise the Value of the Firms Share Price

An appropriate goal for financial

management is to maximise the current

value of the firms shares.
For private companies and partnerships,

the goal is to maximise the current value

of owners equity.

38

39

Can Management Decisions Affect Share

Prices?
YES!!!

40

Goal of the Firm

Shareholders will agree that they are

better off if management makes
decisions that maximizes the value of
their shares.

41

The Firm and Society

Often, a corporations decisions that increase the value
of the firms equity benefit society as a whole.
As long as nobody else is made worse off by a
corporations decisions, increasing the value of the
firms equity is good for society.
It becomes a problem when increasing the value of the
firms equity comes at the expense of others.

42

Ethics and Incentives within Corporations

Agency Problems
Managers may act in their own interest rather than in
the best interest of the shareholders.

One potential solution is to tie managements

compensation to firm performance.
How should performance be measured?

43

Ownership and Control

For large companies, the ownership of the

firm is spread over huge number of

shareholders and the firms owners may
effectively have little control over
management .
Management may make decisions that

benefit their self-interest rather than those of

the shareholders.

44

Agency Relationships
An agency relationship arises whenever

one party, called the principal, hires

another party, called the agent.
The relationship between shareholders

(principals) and management (agents) is

an agency relationship.

45

Do Managers Really Want to Maximise the

Share Price?
Shareholders own the company but

managers control the money and have the

opportunity to use it for their own benefit.
Agency Costs
The costs of the conflict of interest between

the firms owners and its management.

46

CEO Performance
If a CEO is performing poorly, shareholders can
express their dissatisfaction by selling their shares.
This selling pressure will drive the stock price down.
Hostile Takeover
Low stock prices may entice a Corporate Raider to
buy enough stock so they have enough control to
replace current management. The stock price will
rise after the new management team fixes the
company.

47

The
stock
to shareholders.

market

provides

liquidity

Liquidity
The ability to easily sell an asset for close to the
price you can currently buy it for

48

Public Company
Stock is traded by the public on a stock exchange.

Private Company
Stock may be traded privately

49

Primary Markets
When a corporation itself issues new shares of stock
and sells them to investors, they do so on the primary
market.

Secondary Markets
After the initial transaction in the primary market, the
shares continue to trade in a secondary market
between investors.

50

Largest Stock Markets

New York Stock Exchange (NYSE)
Market Makers/Specialists
Each stock has only one market maker
NASDAQ
Does not meet in a physical location
May have many market makers for a single stock
Bid Price versus Ask Price
Bid-Ask Spread
Transaction cost
51

Source: www.world-exchanges.org

52

You own 100 shares in a corporation. The corporation

earns $5.00 per share before taxes. Once the
corporation has paid any corporate taxes that are due,
it will distribute the rest of its earnings to its
shareholders in the form of a dividend. If the corporate
tax rate is 40% and your personal tax rate on (both
dividend and non-dividend) income is 30%, then how
much money is left for you after all taxes have been
paid?
A) $210
B) $300
C) $350
D) $500

53

You own 100 shares of a subchapter "S" Corporation. The

corporation earns $5.00 per share before taxes. Once the
corporation has paid any corporate taxes that are due, it
will distribute the rest of its earnings to its shareholders in
the form of a dividend. If the corporate tax rate is 40% and
your personal tax rate on (both dividend and non-dividend)
income is 30%, then how much money is left for you after
all taxes have been paid?
A) $210
B) $300
C) $350
D) $500

54

You are a shareholder in a corporation. This corporation

earns $4 per share before taxes. After it has paid taxes, it
will distribute the remainder of its earnings to you as a
dividend. The dividend is income to you, so you will then
pay taxes on these earnings. The corporate tax rate is
35% and your tax rate on dividend income is 15%. The
effective tax rate on your share of the corporations
earnings is closest to:
A) 15%
B) 35%
C) 45%
D) 50%

55

You overhear your manager saying that she plans

to book an Ocean-view room on her upcoming trip
to Miami for a meeting. You know that the interior
rooms are much less expensive, but that your
manager is traveling at the company's expense.
This use of additional funds comes about as a result
of:
A) an agency problem
B) an adverse selection problem
C) a moral hazard
D) a publicity problem

56

Consider the following two quotes for XYZ stock:

November 11th
November 18th
Ask: 25.25
Ask: 26.00
Bid: 25.20
Bid: 25.93
How much would you have to pay to purchase 100
shares of XYZ stock on November 18th?
A) $2520
B) $2525
C) $2593
D) $2600

57

How much would you receive if you sold 200 shares

of XYZ stock on November 11th?
A) $5050
B) $5040
C) $5186
D) $5200

58