Guest lecture given as a basic introduction to corporate finance for MBA students, University of Aruba

1. Introduction to
Corporate Finance
Edward M. Erasmus, MA
Lecturer
University of Aruba
January 12th, 2013

2. Introduction lecturer
• Head of Operations @ Free Zone Aruba NV
• Part-time lecturer @ the University of Aruba (FEF, FAS)
• Lecturer, speaker and facilitator
• Professional areas: accounting & control, public finance,
strategy, marketing, financial management, operations
management, financial analysis.

3. Head of Operations @ FZA
A head of operations oversees an entire company,
monitoring all resources and its finances.
Responsibility areas:
• Budgeting, administration & financial reporting
• Information & Communication Technology
• Human resource management
• Security and maintenance of the Free zones
• Marketing and development of the Free zones
• Advice / support to internal colleagues

4. Introduction lecturer
Contact info:
Blog: http://edwardmerasmus.wordpress.com
LinkedIn: http://www.linkedin.com/in/edwardmerasmus
Slideshare: http://www.slideshare.net/e.erasmus
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5. Roadmap for Today
• What is corporate finance?
• Role of the CFO / financial manager
• The goal of financial management
• Overview of financial markets
• Rethinking corporate finance
• Some fundamentals
6

6. WHAT IS CORPORATE FINANCE?

7. What is Corporate Finance?
• Corporate finance is a specific area of
finance that analyzes the financial
decisions of corporations.
- Investment or capital budgeting decisions
- Financing decision
- Day-to-day operations
8

8. 3 Key Questions in Corporate Finance
• 1. What long-term investments should the
firm undertake?
 Capital budgeting decision
• 2. What is the best way to finance these
long-term investments? Debt or equity?
 Capital structure decision
• 3. How should the firm manage its short-
term assets and liabilities, such as cash?
 Working capital managment
9

9. 1. Capital Budgeting
• Process of planning and managing a firm’s
long-term investments.
• Financial manager identifies investment
opportunities that are worth more to the
firm than they cost to acquire.
• Example: A chocolate firm deciding
whether or not to open a new factory is a
capital budgeting decision.
10

10. Key Questions
• How much cash does the firm expect to
receive?
- size of cash inflows and outflows
• When does the firm expect to receive it?
- timing of cash flows
• How likely is the firm to receive it?
- riskiness of cash flows
11

11. 2. Capital Structure
• How should the firm obtain and manage
the long-term financing it needs to support
its long term investments?
• Capital Structure is the specific mix of
short-term debt, long-term debt and equity.
• Raising long-term financing can be
expensive, so the different possibilities
must considered carefully.
12

12. Key Questions
• How should the firm pay for its assets?
Debt or equity?
• How much should the firm borrow?
• What is the least expensive source of
funds?
• How, when and where to raise the money?
13

13. 3. Working Capital Management
• Working capital refers to the firm’s short-
term assets including inventory and
liabilities, such as cash owed to suppliers.
• Managing working capital is a day to day
activity related to the firm’s receipt and
disbursement of cash.
14

14. Key Questions
• How should the firm manage the receipt
and disbursement of cash - current assets
and current liabilities?
• What is the best way to manage day-to-
day, short term assets such as inventory?
• How should the firm obtain short-term
financing?
• Should the firm sell or purchase on credit?
On what terms?
15

15. Once Again...
• Capital Budgeting: The process of
planning and managing a firm’s
investment in long-term assets.
• Capital Structure: The mix of debt and
equity maintained by a firm.
• Working Capital Management: Planning
and managing the firm’s current assets
and liabilities.
16

16. ROLE OF THE CFO

17. A Simplified Organizational Chart
Shareholders Managers
are the represent the
owners. owners.
18

18. A Simplified Organizational Chart
Financial
Manager
coordinates
the activities
of the
Treasurer
and
Controller
19

19. Chief financial officer
• Chief financial officer (CFO) or the vice-president of
finance.
• Reports to the president or Chief Operating Officer
(COO) and coordinates the activities of the treasurer
and controller.
• CFO is concerned with answering the 3 basic
questions.
20

20. CFO: Scope of work
• Capital budgeting (investment evaluation)
• Cash management and liquidity forecasting
• Commercial banking and investment banking
• Credit management
• Dividend disbursement and share repurchases
• Financial statement analysis (ratio analysis)
• Financial analysis planning (forecasting)
• Insurance/risk management
• Mergers and acquisitions analysis
• Tax analysis

21. Corporate finance in a nutshell
The Market The Firm
Capital Structure Capital Budgeting
Dividends
Stockholders Cash flow
Equity
Financial
Projects
Debt Manager
Bondholders Investments
Interest
Corporate
Personal Taxes
Taxes
Government
24

22. Corporate finance in a nutshell
The Market The Firm
Capital Structure Capital Budgeting
Dividends
Stockholders Cash flow
Equity
Financial
Projects
Debt Manager
Bondholders Investments
Interest
Corporate Ethical Ethical
Taxes Cooperation vs. Pressures
Personal Social Costs
Taxes
Government Society
Politics
25

23. GOAL OF FINANCIAL MANAGEMENT

24. Goal of Financial Management?
What should be the firm’s objective?
• Maximize market value?
• Maximize sales revenue or market share?
• Maximize profits?
• Minimize costs?
• To avoid bankruptcy and financial distress?
• Maintain steady earnings growth?
• Maximize CEO wealth?
27

25. Goal in a For-Profit Business
• Managers work for the board of directors, who
represent shareholders, the owners.
• Goal is to make money for the shareholders.
• Shareholders are better off when the value of
the stock is high.
• Maximize the current price per share of the
firm’s existing stock.
• Managers should maximize the value of
the firm’s equity!
28

26. Goal in a For-Profit Business
29

27. Maximize Value of Equity
• When the shares are privately held, the goal is
to maximize the owner’s equity.
• When equity is traded on the market, then the
goal is to maximize the stock price.
• We are interested in the relation between
business decisions and the value of the equity.
30

28. What About These Goals?
• Maximize customer satisfaction
• Environmental responsibility
• Ethical behavior
31

29. How value is created…
Value through managing the ‘top line and
the bottom line’:
• Increase sales
• Decrease expenses
32

30. How value is created…
Smart financial management also contributes
to value creation…
• Right choice of capital structure (mixture of
debt and equity) (WACC)
• Right choice in making investments
• Right choice in allocation of excessive cash
• Right choice in financing short-term cash
shortage
• Right choice in determining credit terms
•33 …..

31. Agency Problems
• Agency relationship
Shareholders (principals) hire managers
(agents) to run the company
• Agency problem
Conflict of interest between the
shareholders (principals) and management
of a firm (agents)
• Agency costs are defined as the costs from
these conflicts of interest.
34

32. FINANCIAL MARKETS

33. Financial Markets
– Money markets versus capital markets
– Primary markets versus secondary
markets
37

34. Money and Capital Markets
• Money Markets
- short-term debt securities
- dealer market: brokers and agents match buyers and
sellers.
• Capital Markets
- long-term debt securities: govt and corporate bonds
- shares of stocks
• Dealer markets are OTC (over-the-counter) markets,
e.g., NASDAQ
• Auction Markets, e.g., Toronto Stock Exchange,
NYSE
38

35. Primary vs Secondary Markets
• Primary Market
- original sale, or issue of a security
- IPOs are underwriten by dealers that
purchase and resell to public at a higher
price
• Secondary Market
- one owner selling to another
- Auction market or OTC dealer markets
39

36. Financial Market Cash Flows
40

37. RETHINKING CORPORATE
FINANCE?

38. Traditional principles governing
corporate finance
Investment
principle
Corporate
finance
Dividend Financing
principle principle

43. Rethinking corporate finance
Investment
principle
Social
Financing
value principle
principle Corporate
finance
Sustainable Dividend
competitiveness
principle principle

44. SOME FUNDAMENTALS

45. Basic finance terms
• Assets • Fixed Assets
• Bonds • Liabilities
• Capital • Operating budget
• Capital assets • Revenue
• Capital budget • Financial ratios
• Currents assets • Cost of capital
• Debt financing • Hurdle rate
• Equity
• Expenses

46. Financial statements
• Financial statements are records that give an
overview of an entity’s financial status.
• Key financial statements:
– Balance Sheet
– Income Statement
– Statement of Cash Flow
– Notes to the financial statements

47. Financial statements
Providing managers and decision makers
answers to two key questions:
• What is the financial picture of the organization
on a given day?
• How well did the organization do during a given
period?

48. Balance sheet: introduction
 Balance sheet….
o A document designed to show the state of affairs of an
entity at a particular date.
o Reduced to its simplest….a balance sheet consists of
two lists: list of resources and list of sources.

49. Balance sheet: introduction
 The list of the resources
o Resources (means) that are under the control of the
entity – it is a list of assets.
Asset is derived from the Latin ad satis (to sufficient)
An asset is a resource controlled by the entity as a
result of past events and from which future economic
benefits are expected to flow to the entity.

50. Balance sheet: introduction
 The list of the sources
o The assets must have come from somewhere.
o The list of sources shows where the assets came from
– the monetary amounts of the sources from which the
entity obtained its present stock of resources.
o These sources require repayments or recompense in
some way….so they can also be called claims.

51. Balance sheet: introduction

52. Balance sheet: introduction
 List of sources (where everything came from)
 List of resources (everything valuable that the business
controls)
 Both lists relate to the same business at the same point in
time: the total of each list must be equal and the balance
sheet must balance.

53. The simple balance sheet
■ Separation of the Entity from the Owner
o When a new business entity is created, the starting
point is that there is no balance sheet.
o Balance sheet is created for the entity when Cash
is put in the entity.
o Separation is necessary to avoid affairs of the
owner and the business to be tangled up.
o Cash (resource) put in the entity by the owner will
balance against the list of sources and is called
Capital.

54. The simple balance sheet

55. Balance sheet transactions
• Just as the balance sheet equation must always
balance, the balance sheet must also always
balance.
• A balance sheet could be prepared after every
transaction, but this practice would be awkward
and unnecessary.
– Therefore, balance sheets are usually prepared
monthly or on some other periodic schedule.

56. Simple balance sheet – example

57. Simple balance sheet – book example

58. Simple balance sheet – book example
o The claims from third parties (outsiders other than the
owner), can be called liabilities.

59. Liabilities
 Liabilities
o In this example: Loan and Payable account.
o English word derived from the word ‘liable’, meaning
tied or bound or obliged by law.
o A liability is a negative version of an asset.

60. Equity
o Claims by the owner are not called liabilities, but owner’s
equity (or various similar expressions).
o Equity in the accounting context means the owner’s
stake in the entity.
o In the simple balance sheet example the equity of the
entity is € 116,000 (capital + profit).

61. Balance sheet claims redrawn

62. Income statement
o The balance sheet shows resources and claims at a
particular moment in time.
o However it is not practical to provide insights in the
business operations.
o Information about the results of operating activities of an
entity can be best presented in an income statement.
o Operating activities result in revenues (making sales) or in
expenses (consumption of business resources).

63. Income statement
o The income statement uses the following definitions:
o Revenues – incoming receipts in return for sold goods or
services
o Expenses – sacrificed resources to support the business
operations

64. Income statement
Important note!
o The income statement (also called profit and loss
account) reports on the flows of revenues and expenses
of a period.
o The balance sheet reports on the financial position at the
balance sheet date.

65. Preparing the income statement
• Reworking transactions used in previous example.
• Examining resources and claims:
Resources fall into two types:
• Those used up in the period (expenses); and
• Those remaining (assets).
Claims can be seen to fall into three types:
• Those arising from operations in the period (revenues);
• Those contributed by the owners (capital); and
• Those due to outsiders (liabilities).

66. Applications and sources
o Adapted layout:

67. Relation between the balance sheet and
income statement
Applications = Sources
Assets + Expenses = Capital + Liabilities + Revenues
Assets = Capital + Liabilities + Revenues –
Expenses
Assets = Capital + Liabilities + Profit

68. Two simple equations:
Assets = Owner’s Equity + Liabilities
Rearranged:
Owner’s Equity = Assets – Liabilities = Net Assets

70. QUESTIONS???

71. Edward M. Erasmus, MA
e.erasmus@fzanv.com
erasmus.bpas@gmail.com
Facebook: http://www.facebook.com/edwardmerasmus
Twitter: http://www.twitter.com/em_erasmus
LinkedIn: http://www.linkedin.com/in/edwardmerasmus
Blog: http://edwardmerasmus.wordpress.com