Lec1bintroduction
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This document provides an overview of a corporate finance course titled "Finance Theory II (Corporate Finance)" taught by Katharina Lewellen. It includes an introduction to the course topics of investment policy, financing policy, and payout policy. It outlines course requirements such as class participation, case memoranda, a midterm exam, and a final exam. It also presents a case study of unidentified industries categorized into groups based on their balance sheet percentages and financial data. The case aims to have students identify the industries represented by letters A through K.
Lec1bintroduction
- 1. Finance Theory II (Corporate Finance) Katharina Lewellen February 5, 2003 1
- 2. Today Preliminaries Introduction to the course Corporate finance Types of questions Course outline Course requirements Case of Unidentified Industries 2
- 3. Preliminaries Texts − Brealey & Myers, Principles of Corporate Finance, 7th edition − Higgins, Analysis for Financial Management, 7th edition − Case and Readings Packet Professor − Katharina Lewellen 3
- 4. Introduction Corporate finance Investment policy How the firm spends its money (real and financial assets) Financing and payout policy How the firm obtains funds (debt, equity) and disposes of excess cash 4
- 5. Balance sheet view of the firm Assets Liabilities Current Assets Current Liabilities Long-term debt Fixed Assets 1. Tangible 2. Intangible Shareholders’ Equity 5
- 6. Introduction, cont. But we also need to understand… Capital markets Types of securities (stocks, bonds, options…) Trade-off between risk and return Pricing Taxes and government regulation 6
- 8. Introduction, cont. Finance is really about value Firms Projects and real investments Securities Common characteristic Invest cash today in exchange for cash (hopefully) in the future Central question How do we create value through investment and financing decisions? 8
- 9. Types of questions Investment and financing decisions At the end of 1999, GM had $11.4 billion in cash. Should it invest in new projects or return the cash to shareholders? If it decides to return the cash, should it declare a dividend or repurchase stock? If it decides to invest, what is the most valuable investment? What are the risks? 9
- 10. General Dynamic Major contractor in the defense industry Doing well during 1980s (cold war) Growth in sales Reasonable profitability R&D and capital investment Beginning of 1990s The end of cold war Likely decline in defense spending Strategy??? 10
- 11. General Dynamics -$600 -$400 -$200 $0 $200 $400 $600 $800 $1,000 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 R&D + Cap Exp Net Inc 11
- 12. Value of $100 invested in Jan. ‘80 $0 $100 $200 $300 $400 $500 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Market GD 12
- 13. General Dynamics Investment, 1980 – 1990 R&D + Capital expenditures: $3.7 billion If invested at 10%: $5.5 billion Ending market value: $1.0 billion Value destroyed: $4.5 billion Sales grew from $4.7 billion to $10.2 billion Earnings in 1990 = -578 million 13
- 14. New strategy in 1991 William A. Anders (new CEO): Cuts capital expenditure and R&D Cap. Exp. drops from $321 million in 1990 to $81 million in 1991 Sells off divisions and subsidiaries Cuts workforce Distributes cash to shareholders From 1991 through 1993, GD returns $3.4 billion to shareholders and debtholders 14
- 15. General Dynamics: 1987 – 1997 -$600 -$400 -$200 $0 $200 $400 $600 $800 $1,000 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Net Inc CapEx + R&D 15
- 16. Value of $100 invested Jan. ‘91 $0 $100 $200 $300 $400 $500 $600 $700 1987 1988 1989 1990 1991 1992 1993 1994 Market GD 16
- 17. Types of questions Investment and financing decisions Your firm needs to raise capital to finance growth. Should you issue debt or equity or obtain a bank loan? How will the stock market react to your decision? If you choose debt, should the bonds be convertible? callable? Long or short maturity? If you choose equity, what are the trade-offs between common and preferred stock? 17
- 18. Types of questions, cont. Investment and financing decisions IBM recently announced that it would repurchase $2.5 billion in stock. Its price jumped 7% after the announcement. Why? How would the market have reacted if IBM increased dividends instead? Suppose Intel made the same announcement. Would we expect the same price response? Motorola wants to build a new chip factory in Ireland. How will fluctuations in the foreign exchange rate affect the value of the project? What are the risks? What actions can Motorola take to hedge the risks? More importantly, should it hedge the risks? What are the costs and benefits? 18
- 19. Our Approach What we will do Acquire a set of general tools that are crucial to sound business decision Financial managers General managers Apply and confront them to a number of real business cases Usefulness Limitations What we won’t do Pretend to be experts in any industry, financial or other Discuss many institutional aspects in detail Discuss in detail stuff you could learn just as well reading a book or an article (see “readings”) 19
- 20. Outline: Theory + Applications Part I: Financing − Capital structure − Payout policy Part II: Valuation − Project valuation (FCF, PV, Real Options) − Company valuation (M&A, Start-ups) Part III: Selected topics in corporate finance − Corporate governance − Hedging/Risk management 20
- 21. The tools of finance (15.401) Time Value of Money Portfolio Theory Asset Pricing Theory Efficient Markets Hypothesis Option Pricing Theory The Concept of No-Arbitrage Agency Theory (Micro-economics, Incentives and Contracts) 21
- 22. Course Requirements Class Participation (10%) Case Memoranda (30%) Teams up to four people Hand in all write-ups except two write-ups of your choice A professional memo to the decision maker Midterm (30%) Final (30%) 22
- 23. The Case of the Unidentified Industries 23
- 24. Advertising Agency Airline Commercial Bank Computer Software Developer Department Store Chain Electric & Gas Utility Health Maintenance Org. Meat Packer Pharmaceutical Manufacturer Retail Drug Chain Retail Grocery Chain A B C D E F G H I J K Line Balance Sheet Percentages #1 Cash and marketable securities 5 12 2 1 4 4 3 77 9 67 19 2 Account receivables 85 55 4 15 7 6 4 7 28 9 13 3 Inventories 0 0 1 24 43 0 22 0 13 2 12 4 Other current assets 1 4 2 2 4 6 2 3 3 2 6 5 Plant and equipment (net) 2 7 77 55 37 71 41 9 35 17 48 6 Other assets 7 23 15 3 5 13 29 4 13 2 1 7 Total assets 100 100 100 100 100 100 100 100 100 100 100 8 Notes payable 62 3 0 2 0 4 2 0 0 0 7 9 Accounts payable 18 63 3 17 18 5 13 32 15 6 5 10 Accrued taxes 2 2 0 1 1 0 1 3 6 6 2 11 Other current liabilities 0 0 4 9 17 17 12 2 13 5 8 12 Long-term debt 7 6 29 38 0 40 29 0 19 0 15 13 Preferred stock 4 8 21 5 10 17 14 1 6 0 1 14 Other liabilities 2 0 5 3 0 0 0 0 0 0 0 15 Capital stock and capital surplus 2 10 11 1 3 12 5 11 24 28 16 16 Retained earnings 4 7 28 23 51 5 24 51 18 55 46 17 Total liabilities and stockholder equity 100 100 100 100 100 100 100 100 100 100 100 Selected Financial Data 18 Current assets/current liabilities 1.11 1.03 1.31 1.46 1.59 0.63 1.1 2.35 1.58 4.72 2.31 19 Cash, marketable securities and accounts receivable/current liabilities 1.1 0.97 0.98 1.4 1.49 0.4 1.04 2.28 1.5 4.59 2.03 20 Inventory turnover (X) NA NA 16.7 5.6 5.2 NA 8.6 NA 47.6 7.5 2 21 Receivables collection period 3,278 381 30 31 8 27 6 13 16 37 74 22 Total debt/total assets 0.69 0.10 0.29 0.40 0.00 0.44 0.31 0.00 0.19 0.00 0.22 23 Long-term debt/capitalization 0.09 0.24 0.40 0.57 0.00 0.66 0.48 0.00 0.32 0.00 0.18 24 Net sales/total assets 0.10 0.52 0.46 1.82 3.18 0.83 2.61 2.03 6.47 0.87 0.64 25 Net profit/net sales 0.14 0.05 0.12 0.02 0.03 0.01 0.02 0.13 0.02 0.25 0.11 26 Net profit/total assets 0.01 0.03 0.05 0.04 0.10 0.01 0.05 0.27 0.10 0.21 0.07 27 Total assets/net worth 14.10 5.84 2.31 3.61 1.85 5.77 3.43 1.62 2.39 1.21 1.61 28 Net profit/net worth 0.19 0.14 0.12 0.13 0.18 0.07 0.17 0.43 0.23 0.26 0.11 24
- 25. Industry Groups Zero inventories A, B, F, H Service providers Advertising agency Airline Commercial bank HMO 25
- 26. A B F H Line Balance Sheet Percentages #1 Cash and marketable securities 5 12 4 77 2 Account receivables 85 55 6 7 3 Inventories 0 0 0 0 4 Other current assets 1 4 6 3 5 Plant and equipment (net) 2 7 71 9 6 Other assets 7 23 13 4 7 Total assets 100 100 100 100 8 Notes payable 62 3 4 0 9 Accounts payable 18 63 5 32 10 Accrued taxes 2 2 0 3 11 Other current liabilities 0 0 17 2 12 Long-term debt 7 6 40 0 13 Preferred stock 4 8 17 1 14 Other liabilities 2 0 0 0 15 Capital stock and capital surplus 2 10 12 11 16 Retained earnings 4 7 5 51 17 Total liabilities and stockholder equity 100 100 100 100 Selected Financial Data 18 Current assets/current liabilities 1.11 1.03 0.63 2.35 19 Cash, marketable securities and accounts receivable/current liabilities 1.1 0.97 0.4 2.28 20 Inventory turnover (X) NA NA NA NA 21 Receivables collection period 3,278 381 27 13 22 Total debt/total assets 0.69 0.10 0.44 0.00 23 Long-term debt/capitalization 0.09 0.24 0.66 0.00 24 Net sales/total assets 0.10 0.52 0.83 2.03 25 Net profit/net sales 0.14 0.05 0.01 0.13 26 Net profit/total assets 0.01 0.03 0.01 0.27 27 Total assets/net worth 14.10 5.84 5.77 1.62 Group 1: Advertising Agency Airline Commercial Bank HMO 26
- 27. Identified Industries in Group 1 A Commercial Bank B Advertising Agency F Airline H Health Maintenance Organization (H.M.O.) 27
- 28. Group 2 Computer software dev. Dept. store Electric & gas utility Meat packer Pharmaceutical manufacturer Retail drug Retail grocery C D E G I J Line Balance Sheet Percentages #1 Cash and marketable securities 2 1 4 3 9 67 2 Account receivables 4 15 7 4 28 9 3 Inventories 1 24 43 22 13 2 4 Other current assets 2 2 4 2 3 2 5 Plant and equipment (net) 77 55 37 41 35 17 6 Other assets 15 3 5 29 13 2 7 Total assets 100 100 100 100 100 100 8 Notes payable 0 2 0 2 0 0 9 Accounts payable 3 17 18 13 15 6 10 Accrued taxes 0 1 1 1 6 6 11 Other current liabilities 4 9 17 12 13 5 12 Long-term debt 29 38 0 29 19 0 13 Preferred stock 21 5 10 14 6 0 14 Other liabilities 5 3 0 0 0 0 15 Capital stock and capital surplus 11 1 3 5 24 28 16 Retained earnings 28 23 51 24 18 55 17 Total liabilities and stockholder equity 100 100 100 100 100 100 Selected Financial Data 18 Current assets/current liabilities 1.31 1.46 1.59 1.1 1.58 4.72 19 Cash, marketable securities and accounts receivable/current liabilities 0.98 1.4 1.49 1.04 1.5 4.59 20 Inventory turnover (X) 16.7 5.6 5.2 8.6 47.6 7.5 21 Receivables collection period 30 31 8 6 16 37 22 Total debt/total assets 0.29 0.40 0.00 0.31 0.19 0.00 23 Long-term debt/capitalization 0.40 0.57 0.00 0.48 0.32 0.00 24 Net sales/total assets 0.46 1.82 3.18 2.61 6.47 0.87 25 Net profit/net sales 0.12 0.02 0.03 0.02 0.02 0.25 26 Net profit/total assets 0.05 0.04 0.10 0.05 0.10 0.21 27 Total assets/net worth 2.31 3.61 1.85 3.43 2.39 1.21 28 Net profit/net worth 0.12 0.13 0.18 0.17 0.23 0.26 28
- 29. Group 2: Inventory turnover Computer software dev. Dept. store Electric & gas utility Meat packer Pharmaceutical manufacturer Retail drug Retail grocery Industry Inventory turnover I 47.6 C 16.7 G 8.6 J 7.5 D 5.6 E 5.2 K 2.0 29
- 30. Group 2: Receivables collection period Computer software dev. Dept. store Pharmaceutical manufacturer Retail drug Retail grocery Industry Collection period K 74 J 37 D 31 E 8 G 6 30
- 31. Group 2: Inventory & PPE Industry INV (%) PPE (%) D 24 55 K 12 48 J 2 17 Computer software dev. Dept. store Pharmaceutical manufacturer 31
- 32. The Identified Industries A Commercial Bank Citicorp B Advertising Agency Interpublic C Electric & Gas Utility Consolidated Edison D Department Store Chain Dayton-Hudson E Retail Drug Chain Walgreen F Airline AMR Corp. G Retail Grocery Chain American Stores H H.M.O. U.S. Healthcare I Meat Packers IBP, Inc. J Software Developer Microsoft K Pharmaceutical Manuf. Novo Nordisk 32
- 33. Any Comments? Bank Advertising Agency E & G Utility Dpt Store Chain Drug Chain Airline Grocery Chain HMO Meat Packers Software Developer Phama. Manuf. Line Balance Sheet Percentages #1 Cash and marketable securities 5 12 2 1 4 4 3 77 9 67 19 2 Account receivables 85 55 4 15 7 6 4 7 28 9 13 3 Inventories 0 0 1 24 43 0 22 0 13 2 12 4 Other current assets 1 4 2 2 4 6 2 3 3 2 6 5 Plant and equipment (net) 2 7 77 55 37 71 41 9 35 17 48 6 Other assets 7 23 15 3 5 13 29 4 13 2 1 7 Total assets 100 100 100 100 100 100 100 100 100 100 100 8 Notes payable 62 3 0 2 0 4 2 0 0 0 7 9 Accounts payable 18 63 3 17 18 5 13 32 15 6 5 10 Accrued taxes 2 2 0 1 1 0 1 3 6 6 2 11 Other current liabilities 0 0 4 9 17 17 12 2 13 5 8 12 Long-term debt 7 6 29 38 0 40 29 0 19 0 15 13 Preferred stock 4 8 21 5 10 17 14 1 6 0 1 14 Other liabilities 2 0 5 3 0 0 0 0 0 0 0 15 Capital stock and capital surplus 2 10 11 1 3 12 5 11 24 28 16 16 Retained earnings 4 7 28 23 51 5 24 51 18 55 46 17 Total liabilities and stockholder 100 100 100 100 100 100 100 100 100 100 100 Selected Financial Data 18 Current assets/current liabilities 1.11 1.03 1.31 1.46 1.59 0.63 1.1 2.35 1.58 4.72 2.31 19 Cash, marketable securities and accounts receivable/current liabilities 1.1 0.97 0.98 1.4 1.49 0.4 1.04 2.28 1.5 4.59 2.03 20 Inventory turnover (X) NA NA 16.7 5.6 5.2 NA 8.6 NA 47.6 7.5 2 21 Receivables collection period 3278 381 30 31 8 27 6 13 16 37 74 22 Total debt/total assets 0.69 0.1 0.29 0.4 0 0.44 0.31 0 0.19 0 0.22 23 Long-term debt/capitalization 0.09 0.24 0.4 0.57 0 0.66 0.48 0 0.32 0 0.18 24 Net sales/total assets 0.095 0.523 0.464 1.822 3.175 0.828 2.61 2.032 6.473 0.867 0.643 33
- 34. Leverage Industry Firm Industry Mean Industry Std Dev Industry Median American Airlines Airlines 0.44 0.32 0.20 0.31 Dayton Hudson Department Stores 0.40 0.29 0.17 0.30 American Stores Grocery Stores 0.31 0.35 0.20 0.32 Consolidated Edison Combination Utility Services 0.29 0.35 0.05 0.35 Novo Nordisk Pharmaceuticals 0.22 0.24 0.92 0.08 IBP Meat Products 0.19 0.31 0.24 0.30 Interpublic Advertising Agencies 0.10 0.08 0.06 0.09 Walgreens Drug Stores 0.00 0.24 0.18 0.27 Microsoft Prepackaged Software 0.00 0.07 0.19 0.01 US Healthcare HMOs 0.00 0.09 0.11 0.04 Total Debt/Total Asset 34
- 35. Firm A Firm B Balance Sheet % % Cash and marketable securities 58 2 Accounts receivable 0 3 Inventories 5 52 Other current assets 3 3 Plant and equipment (net) 5 28 Other assets 30 12 Total assets 100 100 Notes payable 0 0 Accounts payable 17 28 Accrued taxes 0 2 Other current liabilities 7 15 Long-term debt 54 14 Other liabilities 0 4 Preferred stock 0 0 Capital stock and capital surplus 47 29 Retained earnings (25) 9 Total liabilities and stockholder equity 100 100 35