Financial manager - ETH

Report
Corporate Finance
Fundamentals of Financial Management
Dr. Markus R. Neuhaus
Dr. Marc Schmidli, CFA
Autumn Term 2013
Markus Neuhaus I Corporate Finance I [email protected]
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Corporate Finance: Course overview 2013
20.09. Fundamentals
M. Neuhaus & M. Schmidli
27.09. No lecture
04.10. Interpreting Financial Statements
M. Neuhaus & M. Schmidli
11.10.
Mergers & Acquisitions I & II (4 hours)
M. Neuhaus & S. Beer
18.10
Investment Management
M. Neuhaus & P. Schwendener
25.10
Business Valuation (4 hours)
M. Neuhaus & M. Bucher
01.11
Value Management
M. Neuhaus, R. Schmid & G. Baldinger
08.11
No lecture
15.11
Legal Aspects
Ines Pöschel
22.11
Turnaround Management
M. Neuhaus & R. Brunner
29.11
No lecture
06.12
Financial Reporting
M. Neuhaus & M. Jeger
13.12
Taxes (4 hours)
M. Neuhaus & M. Marbach
20.12
Summary Repetition
M. Neuhaus
Autumn Term 2013
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Markus R. Neuhaus
PricewaterhouseCoopers AG, Zürich
Phone:
Email:
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Grade
Qualification
Career Development
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Subject-related Exp.
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Lecturing
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Published Literature
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Other professional roles:
Autumn Term 2013
+41 58 792 40 00
[email protected]
Chairman
Doctor of Law (University of Zurich), Certified Tax Expert
Joined PwC in 1985, became Partner in 1992 and CEO from 2003 –
2012, became Chairman in 2012
Corporate Tax
Mergers & Acquisitions
SFIT: Executive in Residence, lecture: Corporate Finance
Multiple speeches on leadership, business, governance, commercial
and tax law
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.
Member of the board of économiesuisse, member of the board
and chairman of the tax chapter of the Swiss Institute of
Certified Accountants and Tax Consultants
Markus Neuhaus I Corporate Finance I [email protected]
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Marc Schmidli
PricewaterhouseCoopers AG, Zürich
Phone:
Email:
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Grade
Qualification
Career Development
Lecturing
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Published Literature
+41 58 792 15 64
[email protected]
Partner
Dr. oec. HSG, CFA charterholder
Corporate Finance PricewaterhouseCoopers since July 2000
Euroforum – Valuation in M&A situations
Guest speaker at ZfU Seminars, Uni Zurich, ETH, etc.
Finanzielle Qualität in der schweizerischen Elektrizitätswirtschaft
Various articles in „Treuhänder“, HZ, etc.
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Contents
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Learning targets
Pre-course reading
Lecture „Fundamentals of Financial Management“
Autumn Term 2013
Markus Neuhaus I Corporate Finance I [email protected]
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Learning targets

Financial management
 Understanding the flow of cash between financial markets and the firm‘s 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
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Contents
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

Learning targets
Pre-course reading
Lecture „Fundamentals of Financial Management“
Autumn Term 2013
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Pre-course reading
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Books
 Mandatory reading
 Brigham, Houston (2012): Chapter 2 (pp. 25-53)
 Optional reading
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Brigham, Houston (2012): Chapter 1 (pp. 2-21)
Volkart (2011): Chapter 1 (pp. 43-69)
Volkart (2011): Chapter 7 (pp. 579-604)
Bodie, Kane & Marcus (2009): Chapter 12 (p. 384-395)
Slides
 Slides 1 to 11 – mandatory reading
 Other Slides – optional reading, will be dealt within the lecture
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Contents
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Learning targets
Pre-course reading
Lecture „Fundamentals of Financial Management“
Autumn Term 2013
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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
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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
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Agenda: Introduction

Setting the scene

Who is the financial manager?

Roles of financial managers

Shareholder value vs. stakeholder value concept
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Setting the scene I
“Environment”
Company
(1)
(2)
Firm‘s
operations
(a bundle of
real assets)
Financial
manager
(e.g. CFO)
(3)
(1)
(2)
(3)
(4a)
(4b)
(4a)
Financial markets
(investors holding
financial assets)
(4b)
cash raised by selling financial assets to investor
cash invested in the firm’s operations and used to purchase real assets
cash generated by the firm’s operations
reinvested cash
cash returned to investors
Source: Brealey, Myers, Allen (2012), 34.
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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
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Who is the financial manager?
Chief Financial Officer (CFO)
(responsibilities:
e.g. financial policy,
financial planning)
Treasurer
(responsibilities: e.g. cash management,
currency trading, banking relationships)
Controller
(responsibilities: e.g. preparation of
financial statements, accounting, taxes)
Source: Brealey, Myers, Allen (2011), 34.
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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
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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 company’s
business activities?
Also see Brealey, Myers, Allen (2011), 37-43.
Autumn Term 2013
hires
Agent
Principal
Stable growth,
dividends, control
Empire building,
independence, high salaries

performs
Illustration: Agency dilemma
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Shareholder value vs. stakeholder value I



Shareholders’ wealth maximization means maximizing the price/value of the firm’s common stock
Shareholders are considered as the only reference for the company’s 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
Where does the risk in the shareholder value concept lie? ( incentives, sustainability)
Employees

If a new pharmaceutical product is launched,
health considerations will be relevant only to
the extent they could endanger the firm’s stock
price (e.g. through a lawsuit)
Suppliers
Customers
Value
Investors
State
Also see Brealey, Myers, Allen (2011), 37-43.
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Shareholder value vs. stakeholder value II


Stakeholder value means maximizing the company’s value taking into account every stakeholder the
company affects in the course of its business
The importance of stakeholder management is continually growing
How can a company motivate its managers towards a careful handling of the company’s
stakeholders? ( compensation programs, corporate governance)

If a new pharmaceutical product is about to be
launched, every stakeholder’s 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.
Employees
Suppliers
Customers
Value
Investors
State
Also see Brealey, Myers, Allen (2011), 37-43.
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Agenda: Financing a business

External financing

Internal financing

Asymmetrical information

Pecking order theory

Capital structure
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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
Equity
External

Debt
2. Debt
3. Equity
Internal
1. Internal
Internal
financing
Pecking order theory diagram
Why would a company prefer debt over equity? ( cost of capital)
Source: Brigham, Houston (2012), 465-466. For further reading also see Brigham, Houston (2012), 438-480.
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Financing a business – overview
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External financing: A company receives capital from outside the company, e.g. credit, capital
increase
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Internal financing: The major part of a firm’s capital typically comes from internal financing (retained
cash flows, profits from operating activities), except for e.g. startup or turnaround situations

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
External
financing
Internal
financing
Debt financing
Equity financing
Credit financing
Issuing shares
Liquidation financing
Divesting activities
Mezzanine / Hybrid financing
Financing effect from
accruals
Retained cash flows
and profits
Financing impact from
value of depreciation
Source: Volkart (2011), 581.
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Financing a business – external financing

Debt financing
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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 advantages1) can be exploited

The risk borne by a creditor is the risk of default driven by the company’s 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)
1)
General rule: Interest expense is tax deductible, dividend distributions not.
Source: Volkart (2011), 583ff.
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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 company’s 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
company’s balance sheet
Source: Volkart (2011), 586ff. Also see Brigham, Houston (2012), 465-466.
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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 company’s 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 (2011), 584ff.
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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
Management
Debt holders
Autumn Term 2013
Shareholders
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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
1. Internal financing
 No prior explanations to investors or creditors (except for
level of dividends)
Equity
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
Debt
Internal
financing
Pecking order theory diagram
Source: Volkart (2011), 592ff. Also see Brigham, Houston (2012), 465-466 or Brealey, Myers, Allen (2011), 488-492.
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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
Phase of
business
Start up
Expansion
Consolidation
Preferred
financing
Private equity /
Venture capital
- Equity
- Debt
- Internal
Internal
Illustration: How financing preferences can alter over a company‘s lifecycle
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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 company’s 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 taxdeductible.
The capital structure can be defined by the debt to equity ratio
Debt to Equity  Financial Leverage 

Debt
Equity
Financial risk increases as the company chooses to use more debt
What is the optimal capital structure?
Source: Volkart (2011), 596ff.
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Agenda: Financial markets
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Different types of markets

Financial institutions

Financial instruments

EMH

Behavioral Finance
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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 10’000 per month and has expenses of CHF 7’000. If he
intends to buy a home worth CHF 1’000’000, 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 (2012), 26ff.
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Financial markets
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Physical asset vs. financial asset markets
Spot vs. future market
Money vs. capital markets
Primary vs. secondary markets
Private vs. public markets
Recent trends:

Globalization of financial markets

Regulation and international cooperation of regulators

Increased use of derivative instruments, especially as risk management (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 (2012), 29ff.
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Financial Institutions
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



Investment banks
Commercial banks
Financial services corporations
Insurances
ETFs, hedge- and mutual funds
Other: Credit unions, pension funds, private equity companies

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 are disposing of certain business
divisions and focus on core competences. This trend will continue for regulatory reasons
(lower risks, de-leveraging, etc.) and some trends towards nationalization and “home
market” focus in the banking sector.
Source: Brigham, Houston (2012), 34f.
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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 required.

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.
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Efficient market hypothesis (EMH) vs. behavioral finance

The EMH states that
(1) share prices are always in equilibrium
(2) the prices reflect all available information (e.g. on opportunities or 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
However, investors are no machines that can process all available information.
This may lead to the fact that irrational factors come into play
 behavioral finance
Source: Brigham, Houston (2012), 47ff.
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Behavioral finance I


Behavioral finance assumes that investors may not always act rationally when investing in
financial markets, primary due to observed market anomalies.
Behavioral finance is based on two key elements.
 The theory is based on findings from psychology and suggests that irrational
behavior arises as the EMH falls short of considering how investors and managers
come to a decision.
 Behavioral finance also shows that possibilities of arbitrage are limited.

Criticism states that behavioral finance is not an unified concept which explains different
anomalies but is rather based on different elements.
Source: Brigham, Houston (2012), 50; Bodie, Kane & Marcus (2009), 384 ff.
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Behavioral finance II

Irrationalities due to:
 Forecasting errors: investors typically attach too much weight on recent experience
 Overconfidence: people tend to overestimate their abilities
 Conservatism: too slow to react to new information in the market
 Sample Size Neglect and Representativeness: investors often incorrectly assume that a
small sample of historical evidence will be representative of future performance
 Framing: how decisions are framed affect the decision making process
 Regret Avoidance: unconventional decisions lead to more disappointment if the outcome
is negative

Possible limits to arbitrage are:

Fundamental Risk: there is an uncertainty about how long an investor will have to wait
for the stock to fully reflect its value

Implementation cost: transaction costs can make it unattractive to exploit the mispricing

Model Risk: valuation model of the security is incorrect
Source: Brigham, Houston (2012), 50; Bodie, Kane & Marcus (2009), 384 ff.
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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. However, as
explained with the behavioral finance theory, not all investors act rationally in their
decision making process.
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