Corporate Finance DeMYSTiFieD

By Jr. Troy A. Adair

The McGraw-Hill Companies, Inc.

Copyright © 2011 The McGraw-Hill Companies, Inc.
All rights reserved.
ISBN: 978-0-07-174907-7

Contents

AcknowledgmentsIntroductionPart I IntroductionCHAPTER 1 What Is Corporate Finance?CHAPTER 2 Setting the StageCHAPTER 3 Accounting Statements and Cash FlowsCHAPTER 4 Common-Size, Common-Base Year, and Ratio AnalysisPart II “I Will Gladly Pay You $2 Tomorrow for $1 Today”: the Time Value
of MoneyCHAPTER 5 Present and Future ValueCHAPTER 6 Compounding and Interest Rate Conversion: When What You’ve Got
Isn’t What You NeedCHAPTER 7 Payment Composition and Amortization SchedulesPart III ValuationCHAPTER 8 Valuing BondsCHAPTER 9 Valuing StocksCHAPTER 10 Valuing Projects: The Capital-Budgeting Decision RulesPart IV Where Do Interest Rates Come From? Risk, Return, and the Cost of
CapitalCHAPTER 11 Measuring Risk and ReturnCHAPTER 12 Calculating BetaCHAPTER 13 Analyzing the Security Market LineCHAPTER 14 The Weighted Average Cost of CapitalPart V Advanced Topics in Corporate FinanceCHAPTER 15 Estimating Future Cash FlowsCHAPTER 16 Scenario Analysis and Sensitivity AnalysisCHAPTER 17 Option ValuationFinal ExamAnswers to Quizzes and Final ExamAppendix A: Depreciation ChartsAppendix B: Values for the Standard Normal Cumulative Distribution
FunctionIndex

Excerpt

<h2>CHAPTER 1</h2><p><b><i>What Is Corporate Finance?</i></p><br><p>CHAPTER OBJECTIVES</b></p><p><i>At the end of this chapter, the reader should be able to:</i></p><p>• Explain and illustrate the primary cash flows of finance</p><p>• Detail and explain the four major subfields of finance</p><p>• Compare and contrast the capital structure decision, the capital budgetingdecision, and the dividend decision</p><br><p>When people first start studying finance, they usually have an idealized view(driven mainly by the movies they’ve seen and stories in the news about tycoonswheeling and dealing on Wall Street) of just what finance and financial marketsare. They come to the class eager to start trading stocks, pricing options,transacting in the currency forwards, or simply cornering the market on orangejuice futures. Even if they’re lucky enough to have an introduction to financewhich presents them with the correct “big picture,” they’re left feeling alittle put out when they realize that the corporate finance they’ll be studyingis (in their initial opinion, at least) the least sexy subfield of finance.</p><p>To prove this to yourself, wait until we’ve covered the four different subfieldsof finance below, then make a list of every movie involving finance that you’veever seen and divide the list up by the subfield most closely associated witheach movie: corporate finance films are few and far between.</p><p>In this chapter, we’ll start out with the big picture first, making sure we knowwhat finance is in the context of a diagram describing investment cash flows inour economy. Next, we’ll use this same diagram to describe the differentsubfields of finance along with the major problems and decisions faced by eachsubfield. Then we’ll focus more specifically on the problems and decisions ofcorporate finance, wrapping up with a discussion of why corporate finance isarguably the most important subtopic, and the one that you <i>should</i> studyfirst.</p><br><p><b>What Is Finance?</b></p><p>To understand what finance is, let’s envision the economy as being composed offour types of people, where the types are defined based upon whether the peoplehave “extra” money to invest in speculative ventures and/or whether they havepotentially lucrative ideas of their own (or the time to implement them):</p><p><b>1.</b> People with no extra money and no ideas</p><p><b>2.</b> People with extra money but no ideas (or no time to implement any ideas)</p><p><b>3.</b> People with ideas but not enough money</p><p><b>4.</b> People with both ideas and extra money</p><br><p>Of these four types, Type 1 doesn’t really play a direct part in finance. Thesepeople have just enough money to cover their own needs, and they have no ideasor time for investing in potential projects even if they did.</p><p>We also won’t normally talk much about Type 4. These people are interestingenough, but the problems and decisions that they face tend to be only a subsetof those seen in the interaction between Type 2 and Type 3, where we will focusour attention.</p><p>In such an economy, Type 2 and Type 3 can enter into a mutually beneficialagreement, in which those of Type 2 lend their extra money to those of Type 3,who will in turn invest that money in ventures or “projects,” using thepotential proceeds from those projects to repay those of Type 2.</p><p>In our economy, those in Type 2 will often be individual investors, but they mayalso include such entities as venture capital funds, retirement funds, orinsurance companies, all of which will typically have an excess of cash thatthey need to invest. To simplify our discussion, we will use the term<i>investors</i> to refer to any of these Type 2 entities.</p><p>Similarly, although Type 3 may include individual entrepreneurs or governmentorganizations formed to foster economic growth, we typically tend to think of itas being primarily composed of companies, many of which have employees ordivisions whose primary job is to think up new money-making products orservices; in large corporations, such divisions are usually referred to as theresearch and development, or R&D, division. Again, so as to further simplify ourdiscussion, we will use the specific term <i>companies</i> to refer to any Type3 entities.</p><p>This mutually beneficial agreement between investors and companies is shown in<b>Figure 1-1</b>.</p><p>Now, in the real world, the repayment of the investors is complicated by thepresence of taxes aand by the fact that the company may need to reinvest some ofthe proceeds of the projects to continue operations, so actual cash flows tendto more closely resemble those shown in <b>Figure 1-2</b>.</p><p>TThe study of this resulting system of cash flows is what finance is all about.</p><p>The arrows in <b>Figure 1-2</b> correspond to decisions or choices that thevarious participants in this system must make, and we can visualize thhhhe varioussubfields of finance by considering the perspectives from which those decisionsmust be made.</p><br><p><b>The Subfields of Finance</b></p><p>For example, consider the decisions faced by one of the investors whoseperspective is indicated by the box shown in <b>Figure 1-3</b>. They have todecide which company or companies to invest in, what form (for example, buyingstocks, bonds, and the like) that investment will take, and in what manner theywish to be repaid. Looking at these decisions from this perspective is calledthe study of investments.</p><p>Companies face decisions concerning how to raise capital, what projects toinvest in, and how to go about paying investors back. Looking at these decisionsfrom their perspective, as shown in <b>Figure 1-4</b>, is called the study ofcorporate finance (or, sometimes, “financial management”).</p><p>There are two other perspectives that one can take when examining this system ofcash flows: one is that of the financial institutions and markets (see<b>Figure 1-5</b>), which exist for the sole purpose of facilitating this flowof funds between the investors and the companies.</p><p>The final subtopic of finance is one that considers the entire system of cashflows, but in a setting where the investors, companies, and/or projects involvedare in different countries, as shown in <b>Figure 1-6</b>.</p><p>Technically speaking, this study of international finance probably shouldn’t beconsidered a separate subfield, but rather a group of situations best consideredas part of the other three subfields. However, it’s been a relatively recentaddition to both the major financial textbooks and to curriculums in financedepartments around the country; in both cases, the easiest approach to coveringthis was to treat it as a separate subfield of finance, and so it remains today.</p><br><p><b>The Parts of Corporate Finance</b></p><p>This approach of visualizing the parts of finance by taking differentperspectives on this diagram can even be further extended to the areas withineach subfield. For example, there are three arrows or a group of arrows withinor interacting with the corporate finance perspective shown in <b>Figure1-4</b>. These correspond to the three major types of decisions faced bycompanies’ financial managers, which are shown in <b>Figure 1-7</b>.</p><p>Now, we can’t just call these decisions by these names, of course—thatwould make it too simple and would drastically reduce the consulting fees thatwe can charge. So, instead, we have to give them the more impressive-soundingnames shown in <b>Figure 1-8</b>.</p><p>See, aren’t these terms much more impressive (even though they do mean exactlythe same things)?</p><br><p><b>So, Why Is This So Complicated?</b></p><p>The story underlying the system of cash flows is a little more complicated thanwe’ve made it sound so far. In particular, investors know exactly how muchthey’re going to pay for a stock or a bond in a company, but they don’t know howmuch they’re going to get back or when they’ll receive it, as shown in<b>Figure 1-9</b>.</p><br><p><b>Why Are We Studying Corporate Finance?</b></p><p>Later on in this book, we’ll be covering the formulas for valuing stock andbonds, but simple versions of these would look like:</p><p>[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]</p><p>Don’t worry about the variables or the math; just notice that each of theseequations contains an “=” sign, as will all of the other equations that we willdiscuss for valuing these and other <i>financial assets</i>, such as options,futures contracts, and so on.</p><p>These are the formulas that are used most heavily in the studies of investmentsand financial institutions and markets; what the “=” sign indicates is that, inthe financial markets, where these financial assets trade, “what you get is (onaverage, and taking compensation for risk into account) exactly equal to whatyou paid for it.”</p><p>On the other hand, in the capital budgeting area of corporate finance, we’ll beusing decision rules that look like this:</p><p>Accept the project if:</p><p>NPV > 0</p><p>MIRR > 0</p><p>Discounted Payback < Maximum Allowable Disc. Payback</p><br><p>Note that these equations have < or > signs. Why? Because that area of corporatefinance deals with <i>nonfinancial assets</i>, assets that trade in physicalmarkets and that have properties of uniqueness that result in potential monopolypower.</p><p>That’s right—while the goal in investments and the other more photogenicsubfields of finance is to more or less break even, the goal in corporatefinance is to ensure that “what you get is (on average, and taking compensationfor risk into account) equal to MORE THAN what you paid for it.”</p><br><p><b>QUIZ</p><p>1. In finance, people with more money than they need for current consumption,but no time to undertake additional money-making projects, would be consideredto be:</b></p><p>A. Type 1</p><p>B. Type 2</p><p>C. Type 3</p><p>D. Type 4</p><p><b>2. What is the more formal name used for describing the corporate financedecision concerning how to raise the money?</b></p><p>A. The capital structure decision</p><p>B. The capital budgeting decision</p><p>C. The dividend decision</p><p>D. The retained earnings decision</p><p><b>3. Which of the following statements concerning the cash flows of financebest describes why the study of corporate finance is so difficult?</b></p><p>A. Both the cash flows to the firm and those from the firm are uncertain</p><p>B. The cash flows from the firm back to investors occur at the same time as thecash flows from investors to the firm</p><p>C. All the cash flows from the firm must be converted to domestic currencyamounts using currency exchange rates</p><p>D. The cash flows from the firm to investors are both uncertain and delayed,relative to their purchase of securities in the firm</p><p><b>4. The goal of corporate finance is to ensure that:</b></p><p>A. What you get is what you pay for</p><p>B. What you get is more than what you pay for</p><p>C. What you get is less than what you pay for</p><p>D. Stocks and bonds for the same firm will have equal values</p><p><b>5. What is the more formal name used for describing the corporate financedecision concerning how the firm should pay back investors?</b></p><p>A. The capital structure decision</p><p>B. The capital budgeting decision</p><p>C. The dividend decision</p><p>D. The retained earnings decision</p><p><b>6. The decision concerning which firms to buy stock or bonds in is part ofthe study of:</b></p><p>A. Investments</p><p>B. Corporate finance</p><p>C. Financial institutions and markets</p><p>D. International finance</p><p><b>7. A movie about a stockbroker who aided investors in picking which firms toinvest in would most likely involve which subfield of finance?</b></p><p>A. Investments</p><p>B. Financial institutions and markets</p><p>C. Corporate finance</p><p>D. International finance</p><p><b>8. A movie about a dashing young corporate manager choosing the best way topay back the investors in his firm would most likely involve which subfield offinance?</b></p><p>A. Investments</p><p>B. Financial institutions and markets</p><p>C. Corporate finance</p><p>D. International finance</p><p><b>9. Investors are best thought of as:</b></p><p>A. People with ideas but not enough money</p><p>B. People with both ideas and extra money</p><p>C. People with no extra money and no ideas</p><p>D. People with extra money but no ideas (or no time to implement any ideas)</p><p><b>10. Capital budgeting decision rules in corporate finance are expected tochoose projects that are worth more than they cost because capital budgetingprojects:</b></p><p>A. Involve assets with potential monopoly power</p><p>B. Are not subject to the same oversight as the sale of stocks and bonds to thepublic</p><p>C. Take place in competitive markets</p><p>D. Will always have both economies of scale and economies of scope</p><h2>CHAPTER 2</h2><p><b><i>Setting the Stage</i></p><br><p>CHAPTER OBJECTIVES</b></p><p><i>At the end of this chapter, the reader should be able to:</i></p><p>• Identify the basic forms of business organization and list the majoradvantages and disadvantages of each</p><p>• Discriminate between appropriate and inappropriate goals for financialmanagers</p><p>• Explain how agency relationships can potentially lead to agency conflicts</p><br><p>In every corporate finance text, there’s some background information that needsto be covered before you get into the body of the material. The topics in thischapter provide critical background information for understanding the context inwhich financial decisions are made.</p><br><p><b>Basic Forms of Business Organization</b></p><p>There are two basic forms of business organization: those that are considered tobe inseparable from the owners, such as <i>sole proprietorships</i> and<i>general partnerships</i>, and those that are considered to be entities intheir own right, such as <i>corporations</i>. There are also some forms ofbusinesses that are <i>hybrids</i>, exhibiting some characteristics in commonwith both major types, and we’ll discuss those after we’ve detailed thesignificant differences between the two major types.</p><p>For financial purposes, there are two major attributes on which the basic formsdiffer: the personal liability of a business’s owner(s) for the obligations ofthe firm, and the degree of taxation.</p><p>Sole proprietorships and partnerships require the owners to bear unlimitedpersonal liability for the company’s obligations, but have the advantage ofhaving all earnings taxed only once, at the same level as the owners’ othersources of income. This is usually referred to as <i>single taxation</i> todifferentiate it from the tax situation of corporate shareholders.</p><p>Shareholders in corporations have limited liability for the obligations of thecorporation; in most cases, the most that the shareholders can lose is the moneythat they paid for their shares to start with. However, the earnings of thecorporation are subject to <i>double taxation</i>—being taxed once at thecorporate level and again at the owners’ personal level.</p><p>In fact, the degree of taxation can sometimes be more than double for the ownersof a corporation. If shares in one corporation are owned by another, thenearnings will be taxed in the first corporation, the second corporation, andagain at the owners’ personal tax level. In the United States, the governmenthas taken steps to mitigate this triple taxation, requiring the secondcorporation to pay taxes on only 30 percent of the dividends it receives fromthe first corporation, but each dollar of the first corporation’s earnings isstill taxed approximately 2.3 times before the owners get to spend it. (Notethat this problem does not apply to entities such as mutual funds, which areallowed to “pass through” all income to their shareholders.)</p><p>There are also several forms of business organizations that allow owners thebenefit of single taxation while simultaneously providing limited liability. Themost common of these are <i>Limited Liability Corporations/Partnerships</i>(LLCs/LLPs) and S Corporations, which are corporations that have elected singletaxation by applying to be taxed under Chapter S of the Internal Revenue Code.</p><p>In both cases, there are effective limitations that prevent these organizationsfrom being “too big.” S Corporations are explicitly limited to no more than 100shareholders and only certain individuals and entities are allowed to beshareholders, while LLCs face implicit size constraints due to their inabilityto be publicly traded.</p><p>These explicit and implicit restrictions on the size of such hybridorganizations are due to the government’s reason for allowing them to exist inthe first place: the government wants to encourage the creation andsustainability of small businesses.</p><p>Due to their size and complexity, corporations tend to have the most complicatedproblems and decisions of all the types of business organizations. In this text,as in most other corporate finance books, we will take the approach that, if youlearn how to handle the most complicated problems, then other situationsinvolving less complexity will be relatively simple to handle. Accordingly, wewill usually assume in our discussions throughout the rest of this text that weare dealing with a corporation.</p><br><p><b>Goal of the Financial Manager</b></p><p>The major goal of a corporation’s financial manager should be to <i>maximizethe value per share of existing stock</i>, though “maximizing shareholderwealth” or “maximizing stock price” are other common ways to state this samegoal.</p><p>As we’ll see, this goal also motivates the capital-budgeting decision rules thatwe discussed briefly in the last chapter—firms will only accept projectsif they add value to the firm.</p><p>There are several inappropriate goals that students often confuse with thisgoal. Though finance texts typically list these inappropriate goals, they seldomgive any detail on exactly <i>why</i> they’re not appropriate. Let’s see if wecan shed some light on the inappropriate goals that tend to confuse students themost:</p><p>• <i>Maximize profits</i>, or the equivalent <i>maximize net income</i>, is aninappropriate goal for a couple of different reasons. First, as we will seelater in this text, “net income” is an accounting measure that really doesn’t doa good job of measuring how much money the firm is actually making. Second,since net income is calculated for lots of different periods, when you say thatyou want to maximize profits, which profit(s) are you talking about? Nextquarter’s? Next year’s? The profits five years from now? Sure, you could cheatand say that you want to maximize all of them, but that isn’t usually areasonable choice; instead, you usually face a trade-off, where maximizingprofits in the short term often involves less-than-optimal long-term profits,and vice versa.</p><p><i>(Continues…)</i>
(Continues…)Excerpted from Corporate Finance DeMYSTiFieD by Troy A. Adair Jr.. Copyright © 2011 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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