1Overview of Chapters 1, 2, and 5 Chapter 1. This course deals with corporate financial management. Most large businesses are operated as corporations. (Smaller businesses are usually run as a sole proprietorship or partnership.) So, what is a corporation? A corporation is an artificial person created under the authority of a state or country. Stockholders own corporations and use their votes to elect a board of directors. The board of directors are in charge of the major decisions of the corporation. One of these major decisions involves the hiring of management. Management is in charge of the day-to-day operations of the corporation. Corporations (at the direction of the board of directors and management) can buy assets, borrow money, and issue stock. Financial assets owned Financial assets sold (i.e., financial liabilities) Currency Debt securities Bank loan Real assets owned Equity securities Land Common stock Potential agency problems • Managers versus stockholders (e.g., manager’s actions that don’t maximize firm value, monitoring costs). Does manager versus stockholders agency costs affect a typical sole proprietorship? • Owners of debt versus owners of common stock (e.g., actions that increase stock value at the expense of bondholders). When are debt versus common stock agency costs most severe? • Agency problems are increased by information asymmetries (e.g., managers knowing more than stockholders) Income taxation (double taxation) Operated as a corporation Operated as a sole proprietorship Corporation Individual Cash revenue $100 Cash revenue $100 Cash expenses - 80 Cash expenses - 80 Taxable income 20 Taxable income 20 Corporate income tax (34%) Individual income tax (35%) After-tax cash flow After-tax cash flow Individual Dividend income Individual income tax (15%) After-tax cash flow Limited liability to the owners (owners of stock and owners of debt) Unlimited life Ability to raise new capital • Borrowed money (debt) • Addition equity funds from the existing stockholders, or new stockholders2Chapter 2. Investment (capital budgeting) decisions (skim section 2.2, but read “Other Corporate Goals”). Deciding whether to invest in a project depends on three factors: (1) the cash flows the project is expected to generate, (2) the riskiness of those cash flows, (3) and the opportunity cost of capital (which depends on the riskiness of the project’s cash flows). 1. Cash flows Initial investment Expected future cash inflows and outflows (including expected terminal cash flows) Example (Lubbock Wind Power Generation Project) A. Initial investment = $100,000,000 B. Perpetual revenues = $4,500,000 per year for light wind years (20% probability) $10,000,000 per year for normal wind years (50% probability) $17,000,000 per year for strong wind years (30% probability) C. Perpetual expenses = 1 / 11 of revenues What are the expected yearly cash flows? 2. Riskiness of expected cash flows How much can actual cash flows differ from expected cash flows? What are the general market conditions that would trigger lower than expected (or higher than expected) cash flows? Consider two possibilities: A. Lower than expected cash flows occur during recessionary economies, higher than expected cash flows occur during boom economies. B. Lower than expected cash flows occur during boom economies, higher than expected cash flows occur during recessionary economies. 3. Opportunity cost of capital The opportunity cost of capital is the expected return from an investment in the financial markets with the exact same risk as the proposed project’s cash flows. We use the expected cash flows of the project and these cash flows’ opportunity cost of capital to determine the project’s value. A. Assume you find a financial asset (e.g., stock, bond, mutual fund, etc.) for sale in the financial markets (e.g., NYSE, Nasdaq, etc.) that has the exact same amount of risk as the project’s cash flows. A $100,000,000 investment in this financial asset produces expected future cash flows of $8,000,000 per year in perpetuity. The expected return for this financial asset is the opportunity cost of capital for the project’s cash flows. What is the expected return? B. Note: According to the law of one price, all financial assets trading in an active and competitive market place that have the same amount of risk should have the same expected return. C. Does the project create value for the owner? Is the value of the project greater than the $100,000,000 cost? What is the value of the project? D. Should the project be accepted? E. Change annual expenses to 4 / 11 of revenues. Now does it create value for the owner? Value Or Expected return Cost Opp. cost of cap.3 Objective of the firm is to maximize the present (current) value of stockholder’s stock. • Why present value? (For instance, what about a person saving for retirement? Wouldn’t this person want to buy stock in a firm that maximizes the future value of their stockholder’s stock?) • Why value? Why not accounting profits? First, what are the expected accounting profits per year (with expenses at 4 / 11 of revenues)? Revenue $11,000,000 Expenses ($4,000,000) Depreciation Net Income Problems with trying to maximize accounting profits 1) Which accounting method? (For instance, what depreciation method and depreciation assumptions should the firm use?) 2) Which year’s profits are we trying to maximize? 3) If the project produces accounting profits, does it necessarily create value for the firm (and vice versa)? • What about ethical issues? Customer and employee relations Environmental issues Illegal (or questionable) activities • Why stockholder value? Shouldn’t we consider bondholder value? Project evaluation methods (Chapter 5) Skim section 5.2. Assume a new corporation is formed - The Lubbock Wind Power Generation Company with a $10 million investment from the company’s founders (the Smith family). The company makes an initial public offering of two million shares of common stock that raises a total of $20 million (i.e., the offer price is $10 per share). The remaining $70 million is borrowed from the bank (5%, perpetual). Use the original assumptions (expenses = 1 /