Winter Term 2009 1 Markus Neuhaus I Corporate Finance I neuhauma@ethz.

ch
Corporate Finance
Fundamentals of Financial Management
Dr. Markus R. Neuhaus
Dr. Marc Schmidli, CFA

Corporate Finance: Course overview

18.09. Fundamentals (4 hours) M. Neuhaus & M.Schmidli
25.09 Investment Management M. Neuhaus & P. Schwendener
02.10. Business Valuation (4 hours) M. Neuhaus & M. Bucher
09.10. No Lecture No Lecture
16.10. Value Management M. Neuhaus, R. Schmid & F. Monti
23.10. No Lecture No Lecture
30.10. No Lecture No Lecture
06.11. No lecture No Lecture
13.11. Mergers & Acquisitions I&II (4 hours) M. Neuhaus & D. Villiger
20.11 Tax and Corporate Finance (4 hours) Markus Neuhaus
27.11. Legal Aspects R. Watter
04.12. Financial Reporting M. Neuhaus & M. Jeger
11.12. Turnaround Management M. Neuhaus & Markus Koch
18.12.
Summary, repetition M. Neuhaus
Winter Term 2009 3 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch



Grade CEO
Qualification Doctor of Law (University of Zurich), Certified Tax Expert
Career Development Joined PwC in 1985 and became Partner in 1992.
Subject-related Exp. Corporate Tax
Mergers + Acquisitions
Lecturing SFIT: Corporate Finance, University of St. Gallen: Tax Law
Multiple speeches on leadership, business, governance, commercial
and tax law
Published Literature Author of commentary on the Swiss accounting rules
Publisher of book on transfer pricing
Author of multiple articles on tax and commercial law, M+A,
IPO, etc.
Other professional roles: Member of the board of conomiesuisse, member of the board
and chairman of the tax chapter of the Swiss Institute of
Certified Accountants and Tax Consultants
Markus R. Neuhaus
PricewaterhouseCoopers AG, Zrich
PWC
Phone: +41 58 792 4000
Email: markus.neuhaus@ch.pwc.com

Winter Term 2009 4 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch



Marc Schmidli
PricewaterhouseCoopers AG, Zrich
PWC
Phone: +41 58 792 15 64
Email: marc.schmidli@ch.pwc.com

Grade Director
Qualification Dr. oec. HSG, CFA charterholder
Career Development Corporate Finance PricewaterhouseCoopers since July 2000
Lecturing Euroforum Valuation in M&A situations
Guest speaker at ZfU Seminars, Uni Zurich, ETH, etc.
Published Literature Finanzielle Qualitt in der schweizerischen
Elektrizittswirtschaft
Various articles in Treuhnder, HZ, etc.
Winter Term 2009 5 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Contents
Learning targets
Pre-course reading
Lecture Fundamentals of Financial Management

Winter Term 2009 6 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Learning targets
Financial management
Understanding the flow of cash between financial markets and the firms operations
Understanding the roles, issues and responsibilities of financial managers
Understanding the various forms of financing
Financial environment
Knowing the relevant financial markets and their players
Being aware of various financial instruments



Winter Term 2009 7 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Contents
Learning targets
Pre-course reading
Lecture Fundamentals of Financial Management

Winter Term 2009 8 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Pre-course reading
Books
Mandatory reading
Brigham, Houston (2009): Chapter 2 (pp. 26-50)
Optional reading
Brigham, Houston (2009): Chapter 1 (pp. 2-20)
Volkart (2008): Chapter 1 (pp. 41-68)
Volkart (2008): Chapter 7 (pp. 565-591)

Slides
Slides 1 to 11 mandatory reading
Other Slides optional reading, will be dealt within the lecture
Winter Term 2009 9 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Contents
Learning targets
Pre-course reading
Lecture Fundamentals of Financial Management

Winter Term 2009 10 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Agenda I
1. Introduction
Setting the scene
Who is the financial manager?
Roles of financial managers
Shareholder value vs. Stakeholder value concept

2. Financing a business
External financing
Internal financing
Asymmetrical information
Pecking order theory
Capital structure

Winter Term 2009 11 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Agenda fundamentals of financial management II
3. Financial markets
Different types of markets
Financial institutions
Financial instruments
Efficient market hypothesis (EMH)

4. Q&A and discussion
Winter Term 2009 12 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Agenda: Introduction
Setting the scene

Who is the financial manager?

Roles of financial managers

Shareholder value vs. stakeholder value concept
Winter Term 2009 13 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Setting the scene I
(1) cash raised by selling financial assets to investor
(2) cash invested in the firms operating business and used to purchase real assets
(3) cash generated by the firms operating business
(4) reinvested cash
(5) cash returned to investors
Firms
operations
(a bundle of
real assets)
Capital markets
(equity, debt,
bonds),
Shareholders,
other stakeholders
Financial
manager
(e.g. CFO)
(1) (2)
(3)
(4)
(5)
Company Environment
Source: Brealey, Myers, Allen (2008), 5.
Winter Term 2009 14 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Setting the scene II
Managers do not operate in a vacuum
Large and complex environment including:
Financial markets
Taxes
Laws and regulations
State of the economy
Politics, public view, press
Demographic trends
etc.
Among other things, this environment determines the availability of investments and
financing opportunities

Therefore, managers must have a good understanding of this environment
Winter Term 2009 15 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Who is the financial manager?
Chief Financial Officer (CFO)
(responsibilities:
e.g. financial policy,
corporate planning
Treasurer
(responsibilities: e.g. cash management,
raising capital, banking relationships)
Controller
(responsibilities: e.g. preparation of
financial statements, accounting, taxes)
Source: Brealey, Myers, Allen (2008), 7.
Winter Term 2009 16 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Roles of financial managers
Generally, managers do not own the company, they manage it
The company belongs to the stockholders. They appoint managers who are expected to run the
company in the stockholders interest
Basic goal is creating shareholder value
two problems emerge from this constellation

Agency dilemma: asymmetric information and divergences of interests between principal
(stockholders) and agent (management) lead to the so called agency dilemma which also arises in
the context of financing decisions ( pecking order theory)
Shareholder value vs. stakeholder value: shareholders own the company. Does a company
merely consider the owners interest or the interests of all stakeholders affected by the companys
business activities?


Agent Principal
performs
hires
E
m
p
i
r
e

b
u
i
l
d
i
n
g
,


i
n
d
e
p
e
n
d
e
n
c
e
,

H
i
g
h

s
a
l
a
r
i
e
s

S
t
a
b
l
e

g
r
o
w
t
h
,


D
i
v
i
d
e
n
d
s
,

c
o
n
t
r
o
l

Illustration: Agency dilemma
Winter Term 2009 17 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Shareholder value vs. stakeholder value I
Shareholders wealth maximization means maximizing the price/value of the firms common stock
Shareholders are considered as the only reference for the companys course of business and
performance
Other stakeholders are strategically considered only to the extent they could have an impact on the
stock price, the stockholders wealth
Suppliers
State
Investors
Customers
Employees
Value
If a new pharmaceutical product is launched,
health considerations will be relevant only to
the extent they could endanger the firms stock
price (e.g. through a lawsuit)
Where does the risk in the shareholder value concept lie? ( incentives, sustainability)
Winter Term 2009 18 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Shareholder value vs. stakeholder value II
Stakeholder value means maximizing the companys value taking into account every stakeholder the
company affects in the course of its business
The importance of stakeholder management is continually growing.


Suppliers
State
Customers
Employees
Value
Investors
If a new pharmaceutical product is about to be
launched, every stakeholders interest must be
assessed and the product is introduced only if
every interest can be honored
Does the plant pollute the air?
Could the new product be harmful to
customers?
etc.
How can a company motivate its managers towards a careful handling of the companys
stakeholders? ( compensation programs, corporate governance)
Winter Term 2009 19 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Agenda: Financing a business
External financing

Internal financing

Asymmetrical information

Pecking order theory

Capital structure
Winter Term 2009 20 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Possibilities of financing a business
The management makes decisions
about which investments are to be
undertaken and how these
investments are to be financed
There are three basic ways of
financing a business

1. Internal
2. Debt
3. Equity


Equity
Debt
Internal financing
E
x
t
e
r
n
a
l

I
n
t
e
r
n
a
l

Pecking order theory diagram
Why would a company prefer debt over equity? ( cost of capital)
Winter Term 2009 21 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Financing a business overview
External financing: a company receives capital from outside the company, e.g. credit, capital
increase

Internal financing: The major part of a firms capital typically comes from internal financing (retained
cash flows, profits from operating activities)

Liquidation financing: In this context, liquidation financing refers to the liquidation of assets (e.g.
divesting of certain business areas) which have a financing effect



Debt financing Equity financing Liquidation financing
Credit financing Issuing shares
Internal
financing
Financing effect from
accruals
Retained cash flows
and profits
Mezzanine / Hybrid financing
External
financing
Divesting activities
Source: Volkart (2008), 567.
Financing impact from
value of depreciation
Winter Term 2009 22 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Financing a business external financing
Debt financing
Given a solid capital base, the use of debt is reasonable as it broadens the financing base
provided a certain amount of leverage exists and considerable tax advantages
1)
can be exploited
The risk borne by a creditor is the risk of default driven by the companys market and operational
risks
Because a bank would not lend money to a company without checking its financial health, a
certain amount of debt gives a positive signal to other business partners

Equity financing
Equity serves as the capital base of a company because equity can not be withdrawn or taken
away from the company
In the case of incorporated companies (e.g. AG), equity bears the major part of the risk
A company can raise equity capital by selling shares privately or publicly (e.g. IPO or capital
increase)
Source: Volkart (2008), 569ff.
1)
General rule: Interest expense is tax deductible, dividend distributions not.
Winter Term 2009 23 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Financing a business internal financing
Internal financing or self-financing
Internal financing is determined by the cash flow from operating activities
Internal financing means generation of cash flows from operating activities without
using external sources
Internal financing happens automatically as a consequence of the operating
activities of a company
From the companys perspective, self-financing is the most convenient way of
financing as the company does not have to debate with creditors and the discussion
with equity holders is limited to the question of how much of the profits should be
distributed. ( pecking order theory; see Slide 26)
As opposed to external financing, internal financing is not fully reflected on the
companys balance sheet
Source: Volkart (2008), 572ff.
Winter Term 2009 24 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Asymmetrical Information I
The problem of asymmetrical information does not occur only between principal and agents,
but arises each time financing is needed as the fundamental interests of debt holders and
shareholders differ significantly.

Shareholders assume that management is negatively influenced by debt holders
towards making safe investments in order to minimize the probability of default
Debt holders will try to establish credit covenants in order to gain more control over
investment decisions and the course of business
Shareholders, on the other hand, prefer investment opportunities with potentially high
returns as their shares will gain in value as the companys cash flows grow

As a result, each party tries to influence the management:
Debt holders try to establish favorable credit covenants
Shareholders set incentives through compensation plans
Source: Volkart (2008), 570ff.
Winter Term 2009 25 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Asymmetrical Information II
Why do the different parties not get together and solve the problem?
Game theory ( Nash) shows us that in such strategic situations with conflicts of
interest, each party begins by holding back information in order to strengthen its
negotiating position
Shareholders do not know about possible credit covenants whereas creditors do not
know anything about the investors motivation and decisions
Law prohibits typically a company to disclose all relevant information

in conclusion, we find a triangle situation in which each party tries to maintain or
gain as much power and influence as possible in order to secure its interests
Debt holders Shareholders
Management
Winter Term 2009 26 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Pecking order theory I
Bridging the problems of asymmetric information can be very expensive. The less information
an investor has, the higher the required rate of return for the investment is. An outflow is the
so called pecking order theory demonstrating the order in which the company prefers to
finance its business


Equity
Debt
Internal financing
1. Internal financing
No prior explanations to investors or creditors (except for
level of dividends)

2. Debt financing
Banks want information about credit risk
Management must provide possible creditors with sufficient
and reliable information

3. Equity financing
Potential shareholders will challenge the real share price
as they have to rely blindly on the information given by the
management
Shareholders will request a low price as they cannot be
sure whether the share is worth the price
This makes equity capital very expensive for a company
Pecking order theory diagram
Source: Volkart (2008), 578ff.
Winter Term 2009 27 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Pecking order theory II
The importance of the different ways of financing fundamentally changes over the
lifetime of a company
From the perspective of a major listed company, internal financing is the most significant
kind of financing
Vital influence on conditions for external financing (stable operating cash flows
more favorable credit conditions and higher stock prices)
Without solid operating cash flows, a company will not be able to survive
Illustration: how financing preferences can alter over a companys lifecycle
phase of
business
start up expansion consolidation
preferred
financing
Private equity /
Venture capital
- equity
- debt
- internal
internal
Winter Term 2009 28 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Capital structure
The decisions on how the assets of a company are financed leads to the question:
what is the optimal capital structure of a company?
The relation between debt and equity reflects a companys risk and is also called
financial leverage
The optimal capital structure is highly dependent on the industry
Investors often urge greater financial leverage, and thus more risk, in order to generate
more profit in relation to the equity capital invested. In addition, interests paid are tax-
deductible.
The capital structure can be defined by the debt to equity ratio
Equity
Debt
Leverage Financial Equity to Debt
Financial risk increases as the company chooses to use more debt
What is the optimal capital structure?
Source: Volkart (2008), 594ff.
Winter Term 2009 29 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Agenda: Financial markets
Different types of markets

Financial institutions

Financial instruments

EMH
Winter Term 2009 30 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Basic need for financial markets
Businesses, individuals and governments need to raise capital
Company intends to open a new plant
Family intends to buy a new home
City of Zurich intends to buy a new generation of trams

Of course, people and companies save money and have money of their own. However,
saving money takes time and has opportunity costs
Mr. Meier earns CHF 10000 per month and has expenses of CHF 7000. If he
intends to buy a home worth CHF 1000000, it will take him a long time to save
enough.
But what if he wants to buy this home today?

In a well-functioning economy, capital flows efficiently from those who supply capital to
those who demand it
Source: Brigham, Houston (2009), 28f.
Winter Term 2009 31 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Financial markets
Physical vs. financial markets
Spot vs. future market
Money vs. capital markets
Primary vs. secondary markets
Private vs. public markets


Recent trends:
Globalization of financial markets
Increased use of derivative instruments (especially as hedging and speculation
instruments). The current financial crisis reduced the total size of the derivatives market
substantially. However, it is still far bigger in most areas as for instances in 2001.
Source: Brigham, Houston (2009), 30ff.
Winter Term 2009 32 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Financial Institutions
Commercial banks
Investment banks
Financial services corporations
Insurances
Mutual funds
Hedge funds

The trend is clearly towards bank holdings / financial services conglomerates that
provide all kinds of services under one roof. The large investment banks disappeared.

Against that, in the current environment many banks e.g. UBS are disposing of certain
business divisions and focus on core competences. This trend will continue for
regulatory reasons (lower risks, de-leveraging, ) and some trends towards
nationalization and home market focus in the banking sector.
Source: Brigham, Houston (2009), 34ff.
Winter Term 2009 33 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Financial instruments
Stock: Unit of ownership which entitles the owner to exercise his voting right on
corporate decisions and receive a certain payment (dividend) each year. No other
obligation, nor any loyalty recquired.

Bond: The issuer (company) owes the holder (investor) a certain amount of debt and is
obliged to pay the holder a certain interest rate (coupon) and to repay the initial amount
at a pre-determined date

Option: Financial contract which entitles the buyer to buy (call option) or sell (put
option) a certain underlying asset at a pre-specified price at or before a certain point in
time

Structured product: Packaged investment strategy, a mixture of different investment
instruments, mostly derivatives which are intended to exploit, for instance a certain
market constellation
Winter Term 2009 34 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Efficient market hypothesis (EMH)
The EMH states that
(1) share prices are always in equilibrium
(2) the prices reflect all available information (on opportunities, risks) and everything that can
be derived from it
Therefore, it is impossible to beat the market

Prices in financial markets react very quickly and fairly to new information

Share prices are unpredictable as the information that influences prices also occurs by
chance.
We can analyze past stock price developments, but we cannot foresee any
future results
Source: Brigham, Houston (2009), 46ff.
However, investors are not machines that can process all available information.
This may lead to the fact that irrational factors come into play
behavioral finance
Winter Term 2009 35 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Opportunities due to inefficiencies
Pure luck
Any investor or individual might just be lucky and have bought stock yielding far
better returns than expected
Insider knowledge
If an investor has access to insider information, he can take advantage of it. In
order to guarantee a fair market, insiders must be excluded from trading ( laws
against insider trading)
Other possible inefficiencies:
Under-reaction
Uncertain valuation
Overshooting
Source: Spremann (2007), 202.
The exploitation of inefficiency leads to efficiency
Winter Term 2009 36 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch
Final comments
As the environment (capital markets, society, suppliers etc.) has significant influence on
a company, the financial managers must have a profound understanding of this
environment in order to make the right decisions

A financial manager makes decisions about which investments are to be undertaken and
how these investments are to be financed (treasurer) and accounted for (controller)

Financing can come either from outside (external: debt and equity) or from inside
(internal: internal financing through profit from operating business) the company

The problem of asymmetrical information arises whenever financing is needed, because
the level of information and the interests of debt holders and shareholders differ
significantly. Bridging these problems can be very expensive and leads to the so called
pecking order theory

The theory that capital markets take into account all information and all that can be
derived from this information, is called the efficient market hypothesis