INTRODUCTION THE PRINCIPLES OF FINANCE Warren Buffet Case Study What does Buffet invest in o Prefers companies to stocks o Management act like owners o Moats Barriers to entry o Generate a lot of cash flow Principle 1 Higher returns require taking risks Stock Return P1 P2 D1 P2 o No tech companies What are his financial metrics o Profit margin o Return on equity Low Risk 1 Treasury Bills 2 Government Bonds 3 Corporate Bonds 4 Large Company Stock 5 Small Company Stock 6 International Stock High Risk Principle 2 Efficient capital markets are tough to beat prices adjust instantly Principle 3 Rational investors are risk averse prefer lower standard deviation Principle 4 Supply and demand drive stock prices in the short run Random Walk Theory Maurice Kendall daily stock prices are random Stock prices are driven by company earnings in the long term Principle 5 Corporate managers should make decisions that maximize shareholder value Principle 6 Transaction costs taxes and inflation are your enemies reduce capita return Principle 7 Time and the value of money are closely related A dollar today is worth more than a dollar tomorrow Compounding going from today s value or PV to future value FV Discounting gong from future value FV to present value PV o FV PV x 1 r number of years o Discount Factor 1 1 r n o PV FV x Discount Factor or PV FV 1 r n Principle 8 Asset allocation is a very important decision includes stocks bonds cash Principle 9 Asset diversification reduces risk more stocks reduce standard deviation Principle 10 An asset pricing model should be used to value investments CAPM is a simple model that estimates ROR an investor should expect on a risky asset o Key issue Beta 1 0 More risky than average 1 0 Less risk than average Traditional rational vs Behavioral Finance 20 Bill Experiment Choice Decisions Prices Markets Traditional Finance Follow facts Expected Utility Maximization Rational expectations Reflect expected outcomes Reflect risk and return CAPM Prices reflect values markets are efficient Behavioral Finance It s an imperfect market Flaws in utility functions Not always rational Emotions biases rules of thumb Reflect emotions and biases Market efficiency Market Pricing Arbitrageurs correct mispricing Limits to arbitrage CORPORATE FINANCE CREATING SHAREHOLDER VALUE AND CORPORATE GOVERNANCE I The CFO Traditional Roles Controller Accounting Financial Planning Capital Budgets S T L T Capital Reg Cash MGMT Work Capital Treasurer Finance Financial Statements Reports Financial Systems Operating Budgets Audits Taxes Expanded Roles Corporate Communicator with Markets Importance of markets Financing and Capitalization Insure that capital is available to fund strategic plan Risk Management Hedge Risks Currency Commodity Financial in markets when appropriate Strategy Growth and Acquisitions Provide for growth opportunities The New Corporate Finance Elements of the New Environment Advances in information systems and telecommunications technologies Growth in trade and direct investment Deregulation and growth of global markets Greater economic volatility and risk New complex financial instruments New markets and financial institutions Institutionalization of markets Strategic Financial Management Capital Budgeting managing long term investments assets in projects o Goal is to maximize net present value of investments Capital Structure managing financing mix between debt and equity o Goal is to minimize weighted average cost of capital WACC Capital Management managing short term assets liabilities o Goal is to minimize amount of money tied up in net working capital Creating Shareholder Value Aiming decisions at increasing the value of a business New POV of recent companies usually written in Corporate Finance Objective Mission statements etc Gordon Gekkos Greed Speech GREED IS GOOD Basic Management Tenets Efficiency Accountability Stake in Company Role of Liberator Free markets approach Shareholder value IS VERY IMPORTANT to the means of a corporation OPPOSING VIEW Oren Harari You re not in business to make a profit Market Capitalization Market Cap the aggregate market value of a company o Market Cap of shares X Price per share CORPORATE FINANCE CREATING SHAREHOLDER VALUE AND CORPORATE GOVERNANCE II Case Study Average Treasury 3 25 Price of Gold Oz 1 250 Current Yen Euro to 105 1 35 NASDAQ 4 300 Barrel of Oil 100 Business Organizational Forms 1 Sole Proprietorships 2 Partnership 3 Corporation a A legal entity which serves as a nexus of contracts b State chartering process c Corporations become dominant with industrial revolution Advantages Limited liability Ability to raise capital Ease of transfer Disadvantages Ease of formation Double taxation corp investor The Primary Goal of the Publicly Held Corporation Corporate Stakeholder o Oran Harari opposes Gekko s Greed is Good You re not in my business to make a profit o Stakeholder support the business the soil to plants therefore protected by contracts They have a residual claim get paid from upfront from cash flows o Shareholders get paid what s leftover therefore aren t as important o The Dual Challenge Management must satisfy stakeholders while maximizing share value THEY HAVE TO FIND A BALANCE TO BE A GOOD STOCK Asset Management Capital Budgeting o Do not want to invest too much or you will destroy value o Invest in high risk adjusted returns Liability Management Capital structure o Debt Equity management Corporation Governance and the Agency Issue The system of rules practices and processes by which a company is directed and controlled Corporate governance battles often results from companies not being managed in the interests of the owners Many of these battles involve corporate control including hostile takeovers and proxy contests Separation assets are owned by stockholder but controlled by management problems occur when management acts in their own interests instead of stockholder s Agency Costs occur when management does not pursue strategies that maximize shareholder value or when shareholders incur costs to monitor and realign management decisions Small Scale management perks Large Scale Large investments especially acquisitions Corporate Control Methods Internal Control Mechanisms 1 Board of Directors 2 Audited Financial Statements 3 Stock Value Based Compensation 4 Stock Ownership Interest External Control Mechanisms Carl Icahn 1 Hostile Takeovers Offer Higher Price for Another Firm s Stock of a target company to purchase