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Théorie Financière 2004-2005 1. Introduction

Théorie Financière 2004-2005 1. Introduction. Professeur André Farber. Organisation du cours. Ouvrages de référence: Brealey, R. and Myers, S. Principle of Corporate Finance 7th ed., McGraw-Hill 2003 Farber,A. Laurent, M-P., Oosterlinck, K., Pirotte, H. (FLOP) Finance

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Théorie Financière 2004-2005 1. Introduction

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  1. Théorie Financière2004-20051. Introduction Professeur André Farber

  2. Organisation du cours • Ouvrages de référence: Brealey, R. and Myers, S. Principle of Corporate Finance 7th ed., McGraw-Hill 2003 Farber,A. Laurent, M-P., Oosterlinck, K., Pirotte, H. (FLOP) Finance Pearson Education, 2004 • Site web: www.ulb.ac.be/cours/solvay/farber • Copie des transparents (PowerPoint) • Glossaire anglais - français • Notes pédagogiques, exercices, anciens examens • Liens vers d’autres sites • Examen(s) Tfin 2004 01 Introduction

  3. Exercices New • Assistants: • Céline Vaessen • Benjamin Lorent • 6 séances (Vendredi 10-12), 4 groupes • Groupe 1: A à F • Groupe 2: G à L • Groupe 3: M à P • Groupe 4: Q à Z Semaines 2, 4, 6, 8, 10, 12 Semaines 3, 5, 7, 9, 11, 13 Tfin 2004 01 Introduction

  4. Plan du cours • 1. Introduction • 2. Valeur actuelle • 3. Cash flows, planning financier • 4. Evaluation d’entreprises • 5,6. Analyse de projets d’investissement • 7,8. Rentabilité attendue et risque • 9,10. Options • 11, 12. Evaluation et financement Tfin 2004 01 Introduction

  5. What is Corporate Finance? • INVESTMENT DECISIONS: Which REAL ASSETS to buy ? • Real assets: will generate future cash flows to the firm • Intangible assets : R&D, Marketing, .. • Tangible assets : Real estate, Equipments,.. • Current assets: Inventories, Account receivables,.. • FINANCING DECISIONS: Which FINANCIAL ASSET to sell ? • Financial assets: claims on future cash flows • Debt: promise to repay a fixed amount • Equity: residual claim • DIVIDEND DECISION: How much to return to stockholders? Tfin 2004 01 Introduction

  6. Balance sheet Income statement Sales Operating expenses = Earnings before interest and taxes (EBIT) Interest expenses Taxes = Net income (earnings after taxes) Retained earnings Dividend payments Accounting View of the Firm Net Working Capital Current liabilites Current assets Long-term debt Fixed assets Shareholders’ equity Tfin 2004 01 Introduction

  7. Cash Flows of the Firm Firm issue securities Firm invest Firm Financial markets Investors Cash flow from operations Dividend and debt payments Timing of cash flows + uncertainty Tfin 2004 01 Introduction

  8. Market Value of the Firm Book values Market values Market value of equity Total capital Book equity Market capitalization Fixed Assets + Net Working Capital Market value of debt Debt Tfin 2004 01 Introduction

  9. Value creation • Market value added (MVA) • = Market value of the firm’s capital – Total capital employed • VALUE CREATION : 2 strategies • Strategy 1 • Buy assets at a cost lower than the value of the future revenues • real assets • financial assets • Strategy 2 • Sell financial assets for a price higher than the value of future payments Stockholders’ equity + Financial debt Market value of equity + Market value of debt Tfin 2004 01 Introduction

  10. Balance sheet - 30 June 2004 (billion USD) Cash 49 WCR -8 Fixed assets 20 Total assets 61 Stockholders’ equity 61 Income statement Revenue 32 Net Income 10 WCR = Working Capital Requirement Source: http://finance.yahoo.com Market Value -1 Sept. 2004 Market cap 297 Enterprise value 248 MVA 236 Example: Microsoft (MSFT) Tfin 2004 01 Introduction

  11. The Cost of Capital • The firm can always give cash back to the shareholders • Capital employed by the firm has an opportunity cost • The opportunity cost of capital is the expected rate of return offered by equivalent investments in the capital market • The weighted average cost of capital (WACC) is the (weighted) average of the cost of equity and of the cost of debt ? Stockholder Investment opportunities in capital markets Project Cash Tfin 2004 01 Introduction

  12. Stockholders’ problem Company Capital market ROEReturn on Equity rExpected return Tfin 2004 01 Introduction

  13. How to measure value creation ? • 1. Compare market value of equity to book value • Value creation if M/B > 1 • 2. Compare return on equity to the opportunity cost of equity • Value creation if ROE > Opportunity Cost of Equity Tfin 2004 01 Introduction

  14. Value creation: Example • Data: • Book value of equity = € 10 b • Net income = € 2 b / year • Cost of equity r = 10% • Return on equity ROE = 2 / 10 = 20% > 10% • Market value of equity = NI / r = 2 / 10% = € 20 b • Market value added: MVA = 20 – 10 = €10 b • Market to Book M/B = 20 / 10 = 2 Tfin 2004 01 Introduction

  15. M/B vs ROE • Simplifying assumptions: • ·       Expected net income income = constant • ·       Net income = dividend • Market value determination: • Net income = Expected return  Market value of equity • NI = r  MVeq • ROE (definition): • Return on equity = Net income / Book value of equity • ROE = NI / BVeq • = r  MVeq / Bveq • Conclusion: in this simplified setting, • M/B = MVeq/BVeq > 1 ROE> r Tfin 2004 01 Introduction

  16. Mkt Value $ bil. Price/Book ROE % 1 GE US 328 4.3 21.6 2 Microsoft US 284 4.0 10.6 3 Exxon US 284 3.1 21.6 4 Pfizer US 270 3.9 2.1 5 Wal-Mart US 241 5.6 20.3 6 Citigroup US 239 2.4 19.1 7 BP UK 193 2.6 14.1 8 American Intl US 191 2.5 13.2 9 Intel US 185 4.8 16.8 10 Royal Dutch NL/UK 175 2.3 17.3 11 Bank of America US 170 2.5 22.3 12 Johnson & J. US 165 5.8 26.7 13 HSBC Hold. UK 163 2.1 16.0 The Top Companies 2004 Source:Business Week, July 14 2003 Tfin 2004 01 Introduction

  17. Drivers of ROE • PROFITABILITY (du Pont system) • Three determinants : 16.4% Profit Margin Asset Turnover Financial Leverage • Microsoft - 2004 US$ bil. • Net Income 10 • Sales 32 • Assets 61 • Book equity 61 31.0% 0.52 1.00 Tfin 2004 01 Introduction

  18. Example Source: Business Week July 26, 2004 Tfin 2004 01 Introduction

  19. Foundations of Finance

  20. Theory of finance • A young science • Finance has been around for many centuries, of course… • Main problem: calculation!! • Imagine having to calculate the future value of 1 euro invested for 13 years when the annual interest rate is 4.35% (with annual compounding): Future value = (1.0435)13 • A nightmare….. • This problem disappeared after WWII with the development of computers. • Now we have calculators and spreadsheets…. • We also have large data bases Tfin 2004 01 Introduction

  21. Irving Fisher • Finance has its roots in economics • Irving Fisher laid the foundations of modern theory of finance. • Takes into account the time dimension of financial decisions • Main ideas: • Decisions should based on present value • Net Present Value (NPV): a measure of additional wealth • With perfect capital markets: independent of preferences Tfin 2004 01 Introduction

  22. Present value: 1 period, certainty • Perfect capital market • Interest rate: r • Future cash flow C1 • Present value: • or: PV(C1) = DF1 C1 with Interpretation: DF1 = discount factor price of 1€ to be received in one year price of unit zero coupon Tfin 2004 01 Introduction

  23. Microeconomics: a review • Consumption over time: • 1 periods, certainty • Perfect capital markets => budget constraint • Slope = -(1+r) • Intercept = W0(1+r) • Optimum: • Marginal Rate of Substitution (MRS) = 1+r • Optimal consumption independent of timing of income Tfin 2004 01 Introduction

  24. Economic foundations of net present value Euros next year I. Fisher 1907, J. Hirshleifer 1958 165 Perfect capital markets Separate investment decisions from consumption decisions 157.5 105 Slope = - (1 + r) = - (1 + 5%) 52.5 Euros now 150 50 100 200 Tfin 2004 01 Introduction

  25. Net Present Value Consider investment project: Initial cost: I Future cash flow: C1 NPV = -I + DF1 C1 Budget constraint with project: Tfin 2004 01 Introduction

  26. Economic foundations of net present value Euros next year I. Fisher 1907, J. Hirshleifer 1958 165 Perfect capital markets Separate investment decisions from consumption decisions 105 Slope = - (1 + r) = - (1 + 5%) NPV -50 Euros now 50 100 200 207 Tfin 2004 01 Introduction

  27. Entreprise Value Maximisation Euros next year Numerical example!!! Investment opportunities Investment NPV 0 Euros today Market value of company Tfin 2004 01 Introduction

  28. Uncertainty: 1952 – 1973- the Golden Years • 1952: Harry Markowitz* • Portfolio selection in a mean –variance framework • 1953: Kenneth Arrow* • Complete markets and the law of one price • 1958: Franco Modigliani* and Merton Miller* • Value of company independant of financial structure • 1963: Paul Samuelson* and Eugene Fama • Efficient market hypothesis • 1964: Bill Sharpe* and John Lintner • Capital Asset Price Model • 1973: Myron Scholes*, Fisher Black and Robert Merton* • Option pricing model Tfin 2004 01 Introduction

  29. 1 period, uncertainty • 2 possible states of the economy: prosperity and depression • 2 financial assets: one riskless bond and one stock Tfin 2004 01 Introduction

  30. Contingent claims • Consider 2 securities that pay 1€ in one state and 0€ in the other state. • They are named: contingent claims, Arrow Debreu securities, states prices Tfin 2004 01 Introduction

  31. Computing state prices • Financial assets can be viewed as packages of financial claims. • Law of one price: v1 = vP 1 + vD  1 S = vP SP + vD SD • Complete markets: # securities ≥ # states • Solve equations for find vPand vD Tfin 2004 01 Introduction

  32. Example Tfin 2004 01 Introduction

  33. Capital budgeting under uncertainty • Consider the following investment project: • Initial cost: I • Future cash flows: CPor CDdepending on state of the world. • How do we compute the NPV for this project? • NPV of project • A straightforward extension of previous formula. Tfin 2004 01 Introduction

  34. Example Tfin 2004 01 Introduction

  35. References • Corporate finance textbooks (MBA level) • Brealey, Richard and Steward Myers, Principles of Corporate Finance, xth edition, McGraw-Hill 2000 • Ross, Stephen A., Randolph W. Westerfield and Jeffrey F. Jaffe, Corporate Finance, 6th edition, McGraw-Hill Irwin 2002 • Damorada, Aswath, Corporate Finance: Theory and Practice, Wiley 1997 • Ouvrages de référence en français: • Bodie, Z. et Merton, R. Finance (édition française dirigée par C. Thibierge) Pearson education 2000 • Corporate finance texts for executives • Bertoneche, Marc and Rory Knight, Financial Performance, Butterworth Heinemann 2001 • Hawawini, Gabriel and Claude Viallet, Finance for Executives: Managing for Value Creation, South-Western College Publishing, 1999 Tfin 2004 01 Introduction

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