Corporate Finance 2 Topic 1 Introduction Corporate Finance

Corporate Finance -2 Topic 1. Introduction. Corporate Finance and Corporate Analysis thru the Organization’s Life Cycle (LCO) Irina Ivashkovskaya, Ordinary professor, Head of finance academic department, Head of Corporate finance research center National Research University – Higher school of economics, Moscow, Russia

Outline • What is corporate finance about? • How does corporate finance contribute to corporate decision – making? Financial model of analytical framework versus accounting model of corporate decisions’ analysis • Financial dimensions of the firm thru its OVERALL life cycle: liquidity, risk and fundamental value. • Financial dimensions of the firm: ANNUAL approach. • How to identify the LCO stage with financial measures? • The challenges for financial analytical framework

FINANCIAL DECISIONS OF ANY FIRM AND CORPORATE FINANCE APPROACH CORPORATION AS A FRAMEWORK ATTRACTING CAPITAL MARKET TOOLKIT: - the variety - the costs - the mix Minimizing costs CREATING FINANCE’ PRODUCTS CAPITAL MARKET PRODUCTS CREATION : - benefit stream - risks - innovations - packing the firm Maximizing prices

CORPORATE FINANCE VISION THE PRINCIPLES PERFECT MARKET VALUE IS CREATED ONLY BY INVESTMENTS NO ARBITRAGE INVESTOR IS IRRELEVANT -Capital structure -Payout policies IMPERFECT MARKET INVESTORS IS NOT IRRELEVANT capital structure and payout policies matter interactions of investing and financing Financial innovations Capital market efficiency

MODELLING CORPORATE FINANCIAL DECISIONS KNOWING WHAT DOES NOT MATTER IN A PERFECT WORLD WE’LL KNOW WHAT DOES MATTER BEYOND IT BY IMPLICATIONS ATTRACTING CAPITAL CONTRACTS EQUITY VERSUS DEBTHOLDERS CREATING PRODUCTS CONTRACTS INFORMATION ASSYMETRY AGENCY/ MOTIVES investors RATIONAL EXPECTATIONS CHANGE IN VALUE managers

CORPORATE FINANCE CONTRIBUTION TO DECISION -MAKING THE CONCEPTUAL FRAMEWORK TO CORPORATE DECISION’S ANALYSIS: THE ELEMENTS The criteria for performance analysis The measures of performance The measures for corporate goals and strategies’ perfromance

WHAT IS CORPORATE FINANCE? The conceptual framework to corporate decision’s analysis: the elements THE CRITERIA FOR PERFORMANCE ANALYSIS § Opportunity cost of capital § Risk-return trade-off and cost of capital (WACC) § Economic profit THE MEASURES OF PERFORMANCE § Economic profit metrics § Economic spread (over the required returns)

WHAT IS CORPORATE FINANCE? The conceptual framework to corporate decision’s analysis: the elements THE MEASUREMENT OF CORPORATE GOALS AND STRATEGIC RESULTS Agency conflicts True value creation Value creation Information asymmetry Market value creation Value Destruction? Value Extraction

ROE (%) - -2 -1 0 КЕ (%) + 1 2 Accounting model ROE<0 Loss and capital losses ROE>0 Income and capital gains Financial model ROE<КЕ Loss and capital losses • Cumulative data • Backward looking • Static ROE>КЕ Income and capital gains • Flows • Forward looking • Dynamic

LIFE CYCLE STAGES OF ORGANIZATION Activity I. INTRODUCT ORY STAGE, ENTRY II. GROWTH III. MATURITY IV. DECLINE Time

FINANCIAL DIMENSIONS OF THE FIRM WITHIN ITS LIFE CYCLE LIQUIDITY INVESTMENT RISK FUNDAMENTAL VALUE

CASH FLOWS Transactions affecting directly net income Net income + non-cash charges -net increase in current assets Transactions affecting asset's structure + Proceeds from sale of assets +Increase in short term &long term debt - Capital expenditure +Owners investments - Debt repayment (principal) +net increase in current liabilities CASH FLOW FROM OPERATING ACTIVITY Transactions affecting the totals - Dividends CF FROM INVESTING ACTIVITY NET CASH FLOW CF FROM FINANCING ACTIVITY

CASH FLOWS AT THRU LCO INTRODUCTORY STAGE GROWTH OPERATING CASH FLOW INVESTING CASH FLOW MATURITY DECLINE FINANCING CASH FLOW

ЭТАП РОСТА Розничная сеть “Магнит” 2010 2009 2008 2007 CF Operating, млн. долл. 428. 7 376. 2 420. 1 242. 4 CF Investment, млн. долл. -1230. 0 -448. 1 -575. 4 -568. 7 CF Financing, млн. долл. 565. 2 339. 2 200. 2 354. 8 18

ЭТАП ЗРЕЛОСТЬ “Аэрофлот” российские авиалинии 2010 2009 2008 2007 CF Operating, млн. руб. 739. 3 228. 5 472. 5 216. 5 CF Investment, млн. руб. -193. 5 -299. 3 -439. 3 -417. 3 CF Financing, млн. руб. 13. 9 48. 3 44. 6 100. 9 20

Investment risk Business risk Financing risk Commercial risks ■Diversification Solvency (short term) by product by channel by segment Financial leverage Coverage: ■ income coverage ratios ■Power of supplier ■ Market position ratios ■ cash flow coverage ■ assets coverage ratios ■ Expense structure operating leverage Management depth ■ key person ■ transparency and disclosure Currency Exchange risks

LCO AND INVESTMENT RISKS MANAGERIAL FLEXIBILITY INVESTMENT FLEXIBILITY FINANCING FLEXIBILITY • DECREASE IN REQUIRED RATES OF RETURN • TERMS OF FINANCING • INCREASE IN THE VARIETY OF EFFICIENT PROJECTS • AMOUNTS OF FINANCING

WHAT IS VALUE? DISCOUNTED FUTURE BENEFITS STREAM KEY DRIVERS q KEY STRATEGIC AND OPERATIONAL DRIVERS q REQUIRED RATES AT THE CAPITAL MARKETS

VALUE INVESTED CAPITAL (CAPITAL EMPLOYED) Income INVESTMENT RISK + Non cash charges CORE COMPENTENCIES -Capex -Net working capital investment = FREE CASH FLOW COST OF CAPITAL STRATEGIC (PLANNING) HORIZON

CORPORATE VALUE COMPONENTS DISCOUNTED CASH FLOWS WHITHIN STRATEGIC HORIZON TERMINAL CASH FLOW BEYOND HORIZON + FINANCIAL APPROACH CORPORATE VALUE STRATEGIC APPROACH CURRENT OPERATIONS VALUE COV CASH FLOWS RISK Assets in place, AIP + FUTURE GROWTH OPPORTUITIES VALUE (VFGO) EXPECTED CF FROM GROWTH RISK IN GROWTH OPPORTUNITIES Growth opportunities, GO

VALUE COMPONENTS AND LCO INTRODUCTORY STAGE ASSETS IN PLACE? VALUE BASE? FUNCTIONING ASSETS RISKS? GROWTH OPPORTUNITY RISKS? RATIO = (ASSETS IN PLACE )/ (GROWTH OPPORTUNITIES)?

VALUE COMPONENTS AND LCO GROWTH • ASSETS IN PLACE? • VALUE BASE? • FUNCTIONING ASSETS RISKS? • GROWTH OPPORTUNITY RISKS? RATIO = (ASSETS IN PLACE )/ (GROWTH OPPORTUNITIES)?

VALUE COMPONENTS AND LCO MATURITY • ASSETS IN PLACE? • VALUE BASE? • FUNCTIONING ASSETS RISKS? • GROWTH OPPORTUNITY RISKS? RATIO = (ASSETS IN PLACE )/ (GROWTH OPPORTUNITIES)?

VALUE COMPONENTS AND LCO DECLINE • ASSETS IN PLACE? • VALUE BASE? • FUNCTIONING ASSETS RISKS? • GROWTH OPPORTUNITY RISKS? RATIO = (ASSETS IN PLACE )/ (GROWTH OPPORTUNITIES)?

FINANCIAL DIMENSIONS OF THE FIRM: WITHIN THE YEAR FREE CF COST OF CAPITAL ECONOMIC PROFIT (RESIDUAL INCOME)

FINANCIAL DIMENSIONS OF THE FIRM: FREE CASH FLOWS TO THE FIRM (FCFF) FCFF = EBIAT Earnings before interest but after tax + D Depreciation - NWCI Net working capital investment - Capex Capital expenditure CASH FLOWS FREE FOR INVESTORS AFTER ALL INVESTMENTS NEEDED FOR CORPORATE MARKET STRATEGY ARE CONSIDERED

FINANCIAL DIMENSIONS: HURDLE RATE COST OF CAPITAL v RATE OF RETURN REQUIRED BY RATIONAL RISK AVERSE INVESTOR DEPENDS ON: w INVESTMENT RISK w OPPORTUNITY COST OF CAPITAL OF INVESTORS

FINANCIAL DIMENSIONS: ECONOMIC PROFIT NOPAT - CAPITAL CHARGE COST OF CAPITAL ROCE - return on capital employed WACC - weighted average cost of capital – CE – capital employed RI - Residual income NOPAT- Net operating profit after tax = RESIDUAL INCOME

LCO FINANCIAL CURVE Return on capital employed, ROCE INTRODUCTORY STAGE TIME GROWTH RESIDUAL INCOME COST OF CAPITAL MATURITY DECLINE

LCO ANALYSIS Miller, Friesen (1984) q SALES GROWTH RATE GROWTH ABOVE 15% ; MATURITY BELW 15%; q AGE 6 YEARS AT EACH STAGE ON AVERAGE BELOW 10 YEARS - ENTRY q EXPERT ‘ ESTIMATES

IDENTIFICATION OF LCO STAGE BY FINANCIAL MEASURES: RATING APPROACH SIMPLE APPROACH Metrics 5 YEARS MEAN: • Revenue growth rate, • Dividends • Capital expenditure Anthony, Ramesh (1992) Age 5 STAGES: GROWTH, STABLE GROWTH, MATURITY, • RATING BY METRIC • SUM OF RATINGS • INDUSTRY FACTORS BEGINNING OF DECLINE, DECLINE EXTENDED APPROACH q FINANCIAL RATIOS q CLUSTERS Pashley, Phillippatos (1990)

RATING APPROACH (Black, 1998) INTRODUCTORY STAGE (START-UP) • SALES REVENUE NO LONGER THAN 1 YEAR • NO RESTRUCTURING GROWTH • 20% highest ratings by growth rates and capex • 20% lowest ratings by dividends &age MATURITY STAGE • AVERAGERATINGS BY GROWTH RATES AND CAPEX • HIGHEST RATINGS BY DIVIDENDS DECLINE • 20% LOWEST RATINGS BY CAPEX AND GROWTH RATES • HIGHESTRATINGS BY AGE • ABOVE AVERAGE RATINGS BY DIVIDENDS

STUDY OF LCO OF AMERICAN FIRMS BY RATINGS Black, 1998 Public firms 1977 -1995, COMPUSTAT 22082 annual observations Introductory stage : 75 firms Growth : 2905 Maturity : 2384 Decline : 3961 Firms in decline are concentrated within the periods of macro shocks (1980 -1983, 1989 -1992)

FINANCIAL MEASURES AT THE LCO STAGES Black START UP GROWTH MATURITY DECLINE MEAN GROWTH RATE 142% 38% 8% -13% 10% Debt-to-equity 7% 42% 50% 16% 39% Net income (mln doll. ) Return on equity - 0. 36 0. 66 16. 15 -0. 54 1. 90 7% 6% 13% -12% 7% Capex to total assets 1. 76 0. 14 0. 07 0. 02 0. 06 R&D mln ) 0. 18 0. 41 4. 53 0. 51 1. 26 Age (years) Dividends payout (%) 2. 4 16. 2 37. 4 57. 6 42. 8 0 0 36% 0 0 16. 52 21. 95 208. 47 10. 91 46. 11 Equity market cap (mln doll. )

CONTRIBUTION TO THE MARKET CAPITALIZATION AT DIFFERENT STAGES OF LCO INTRODUCTORY STAGE , START UP • earnings&operating cash flows not significant • Investing cash flows significant at 5%, financing cash flows at 10% GROWTH • all cash flows significant at 5% • earnings not significant MATURITY • earnings, operating and financing cash flows AT 5% • FINANCING CASH FLOW NEGATIVE DECLINE • ALL TYPES OF CASJ FLOWS AT 5% уровнеearnings not significant

CASH FLOWS AND MARKET CAPITALIZATION AT DIFFERENT STAGES OF LCO Black: OPERATING CF: significant except start ups all components significant payments to suppliers&personnel not significant at maturity FINANCING CF: siginificant, high correlation at growth & maturity INVESTING CF: significant, high correlation at growth & start up

CASH FLOW APPROACH : DICKINSON q 500 FIRMS COMPUSTAT q THE CASH FLOW PATTERNS (+/-) q MONITORING THRU TIME q COMPARISON TO THE PRECEEDING PATTERNS AND SEARCH FOR BREAK-EVEN IN THE PATTERNS

COMPARISON BY GROWTH RATES BREAK-EVEN POINTS Yan, 2006 4 STAGES: from IPO, quarterly data Growth, maturity, mature growth, decline At minimum 2 years per stage Minimum 2 stages GROWTH RATES: - Adjusted to the industry (it is subtracted) -Moving average for 4 quarters -Р 33 and Р 67 (percentile) MATURITY: after 9 quarters needs 6 quarters with growth rates LOWER темп выручки than in Р 67 MATURE GROWTH: after 9 quarters , 6 quarters growth rates HIGHER than Р 67 DECLINE: after 9 quarters , 6 quarters with growth rates темп выручки LOWER than Р 33

Corporate finance and the challenges for corporate analysis

SCALE OF FEASIBLE STATES OF THE MARKET FRACTION OF VOLATILITY THAT IS PRICE-DRIVEN 0% ORDER IN 100% COMPLEXITY THE MARKET § Almost no price effect associated with investor’s interaction • Market efficiency – special rational case RATIONAL FINANCE BEHAVIORAL FINANCE DEDUCTION and mathematical modeling PREVAILS THE NEW FINANCE Impact of interactions: - Interpretation of signals - Irrational expectations TURBULENCE AND CHAOS Price changes are almost unrelated to changes in real economic information set induction prevails “fly with feathers” : Process, store info and fly in response

MODELLING CORPORATE FINANCIAL DECISIONS Irrational expectations INVESTORS’ BIASES: q Market inefficiency (mispricing) q Arbitrage q Follow mispricing – behavior less than fully rational q But managers make unbiased forecasts about the future : q Take for granted prices fully reflect the info about fundamental values q decisions in their best interests BUT GOVERNANCE apply MANAGERIAL BIASES: q Less than fully rational behavior following mispricing q Optimism and overconfidence q Exploit and use mispricing in decision-making

FINANCIAL ANALYSIS IN INDUSTRIAL ECONOMY KEY RESOURCES TYPE OF BUSINESS MODELS CRITERIA FOR PERFORMANCE KEY ANALYTICAL FOCUS INFORMATION MODEL OF THE FIRM TANGIBLE AND FINANCIAL ASSETS, LIMITED INTANGIBLES SEEKING FOR ALLOACATIVE EFFICIENCY ACCOUNTING PROFIT AND CASH FLOWS FINANCIAL STATEMENTS ANALYSIS SHAREHOLDER VALUE (SHV) AND AGENCY ACCOUNTING PROFIT BASED

FINANCAL ANALYSIS IN THE KNOWLEDGE ECONOMY KEY RESOURCES INTELLECTUAL CAPITAL DYNAMIC CAPABILITIES TYPE OF THE BUSINESS MODELS CRITERIA KEY ANALYTICAL FOCUS TRAMFORMATION EFFICIENCIES ECONOMIC PROFIT (RISK ADJUSTED APPROACH), KNOWLEDGE EARNINGS CASH FLOWS, INTELLECTUAL CAPITAL SHV VERSUS STAKEHOLDER VALUE : AGENT AND ITS INTELLECTUAL CAPITAL CONTRIBUTION INFORMATION MODEL OF THE FIRM VALUE REPORTING NON-FINANCIAL REPORTING

HOMEASSIGNMENT 1 • Make the teams of 4 participants (mixed) • Find 4 public firms and look thru their financial annual reports and data for 3 years • Identify the LCO stages with the help of financial measures, especially cash flows dynamics • Prepare power point presentation with the arguments to prove your opinion on firm’s LCO stages • Prepare short analytical report (2 -3 pages) with the references on the data sources