Corporate FinanceFinance & Banking

Lessons in Corporate Finance Training

A Case Studies Approach to Financial Tools, Financial Policies, and Valuation

Lessons in Corporate Finance

Preface

On Tuesday, March 24, 2015, the share price of Google rose 2%, a roughly $8 billion increase in the value of the firm’s equity. Was the large increase in Google’s equity value because the firm’s profits were up? No. Was the positive stock price reaction due to some good news about a new Google product? No. The reaction was due to Google’s announcement that it was hiring Ruth Porat as its new chief financial officer (CFO). Why would the hiring of a new CFO cause Google’s stock price to jump? According to the Wall Street Journal, Wall Street hoped the new CFO would bring “fiscal control at a company long known for its free spending ways.”

Lessons in Corporate Finance is about the principal decisions in corporate finance (in other words, the decisions of CFOs like Google’s Ruth Porat). These deci- sions focus on: how to decide in which projects the firm should invest, how to finance those investments, and how to manage the firm’s cash flows. This is an applied book that will use real‐world examples to introduce the financial tools needed to make value‐enhancing business decisions.

The book is designed to explain the how and why of corporate finance. While it is primarily aimed at finance professionals, it is also ideal for nonfinancial managers who have to deal with financial professionals. The book provides a detailed view of the inner functioning of corporate finance for anyone with an interest in understand- ing finance and what financial professionals do.

The book would fit well in a second course in finance, as supplemental readings to an executive education course, or as a self‐study book on corporate finance (e.g., those studying for the CFA or similar certifications). The authors believe that any business professional, even someone with a degree in finance, will find the book to be a valuable review.

While the book can be read without extensive knowledge of accounting or finance, the book is written for those with at least a basic knowledge of accounting and finance terminology.

 

Introduction

This book is a basic corporate finance text but unique in the way the subject is presented. The book’s format involves asking a series of increasingly detailed questions about corporate finance decisions and then answering them with conceptual insights and specific numerical examples.

The book is structured around real-world decisions that a chief financial officer (CFO) must make: how firms obtain and use capital. The primary functions of corporate finance can be categorized into three main tasks:

  1. How to make good investment decisions
  2. How to make good financing decisions
  3. How to manage the firm’s cash flows while doing the first two

Taking the last point first, cash is essential to a firm’s survival. In fact, cash flow is much more important than earnings. A firm can survive bad products, ineffective marketing, and weak or even negative earnings and stay in business as long as it has cash flow. Not running out of cash is an essential part of corporate finance. It requires understanding and forecasting the nature and timing of a firm’s cash flows.

For example, at the turn of the century, dot-coms were almost all losing large sums of money. However, financial analysts covering these firms focused primarily not on earnings but on what is called “burn rates” (i.e., the rate at which a firm uses up or “burns” cash). There is an old saying in finance: “You buy champagne with your earnings, and you buy beer with your cash.” Cash is the day-to-day lifeblood of a firm.

Another way to say this is that cash is like air, and earnings are like food. Although an organization needs both to survive, it can exist for a while without earnings but will die quickly without cash.

Turning to the first point, making good investment decisions means deciding where the firm should put (invest) its cash, that is, in what projects or products it should invest or produce. Investment decisions must answer the question: What are the future cash flows that result from current investment decisions?

Finally, making good financing decisions means deciding where the firm should obtain the cash for its investments. Financing decisions take the firm’s investment decisions as a given and examine questions like: How should those investments be financed? Can value be created from the right-hand side of the Balance Sheet?

Thus, the CFO essentially does two things all day long with one constraint: Make good investment decisions, make good financing decisions, and ensure the firm does not run out of cash in between.

 

Two Markets: Product and CapItal

Every firm operates in two primary markets: the product market and the capital market. Firms can make money in either market. Most people understand a firm’s role in the product market: to produce and sell goods or services at a price above cost. In contrast, the role of a firm in the capital markets is less well understood: to raise and invest funds to directly facilitate its activities in the product market.

When people think about capital markets, they typically focus on securities exchanges such as those for stocks, bonds, and options. However, this is only the supply side of capital markets. The other side is comprised of the users of capital: the firms themselves.

A crucial lesson when doing corporate finance is that financial strategy and product market strategy need to be consistent with one another. In addition, corporate finance spans both the product market through its investment decisions and the capital market through its financing decisions. When thinking about corporate finance, a firm must first determine its product market goals. Only then, once the product market goals are set, can management set its financial strategy and determine its financial policies.

Financial policies include the capital structure decision (i.e., the level of debt financing), the term structure of debt, the amount of secured and unsecured debt, whether the debt will have fixed or floating rates, the covenants attached to the debt, the amount (if any) of dividends it will pay, the amount and timing of equity issues and stock repurchases, and so on. Likewise, the firm’s investment policies (e.g., to build or acquire, to do a leveraged buyout, a restructuring, a tender, a merger, etc.) are set in concert with the firm’s product market strategy.

While it is critical for a firm to have a good product market strategy, its financial operations can also clearly add or destroy value. Value is created through the exploitation of a market imperfection in one of three markets:

  1. Product market imperfections include entry barriers, costs advantages, patents, etc.
  2. Capital market imperfections involve financing at below-market rates, using innovative securities, reaching new investing clienteles, etc.
  3. Managerial market imperfections include agency costs (costs from the separation of ownership and control) and managers who are not doing a good job or self-dealing, etc.

Without market imperfections, there really is no corporate finance (a point we
will explain in Chapter 6).

 

The Basics: Tools and TechnIques

This book teaches the basic tools and techniques of corporate finance, what they are, and how to apply them. It is, in football parlance, all about blocking and tackling. For example, ratios and working capital management are used as diagnostics as well as in the development of pro forma Income Statements and Balance Sheets, which are the backbone of valuation. It is not possible to do valuations without being able to do pro formas.

This book will show readers first how to generate estimated cash flows and then how to estimate the appropriate discount rate to convert the cash flows into a net present value.

Chapters 2 through 4 discuss cash flow management, which is essentially how to ensure the firm does not run out of cash. Cash flow management is necessary to evaluate the financial health of a firm, forecast financing needs, and value assets. The tools used in cash flow management include ratio analysis, pro forma statements, and the sources and uses of funds. This is the nitty-gritty of finance: managing and forecasting cash flows.

Chapters 5 through 12 examine how firms make good financing decisions. That is, how a firm should choose its capital structure and the trade-offs of the various financing alternatives. We will also cover financial policies and their impact on the cost of capital.

These chapters will answer questions including: Can firms create value with their choice of financing? Is one type of financing superior to another? Should the firm use debt or equity? If the firm uses debt, should it be obtained from a bank or from the capital markets? Should it be short-term or long-term debt, convertible, callable? If the firm issues equity, should it be common stock or preferred stock?

Chapters 13 through 16 illustrate how firms make good investment decisions. The tools and techniques to value investment projects will be covered in depth, including the determination of the relevant cash flows and the appropriate discount rate. These tools and techniques will then be used to value projects and firms.

There are only five main techniques to value anything, four of which will be covered in this book (real options, the fifth method, will be covered only superficially as this technique is infrequently used and requires knowledge of options and mathematics beyond the scope of this book). This book will cover many different ways to value a firm or project within four main families or techniques.

For example, discounted cash flow techniques include using a weighted average cost of capital (WACC) with free cash flows to the firm, economic value added (EVA), using a free cash flow to equity discounted at the cost of equity as well as calculating an adjusted present value (APV). Likewise, valuation multiples include using the price-to-earnings ratio (P/E), earnings before interest and tax (EBIT), and earnings before interest, taxes, depreciation, and amortization (EBITDA), all of which are in the same family. The focus of the book is not only to teach the techniques but also to provide an understanding of the logic behind each method and to give readers the ability to translate from one valuation method to another.

Chapters 17 through 21 cover leveraged buyouts (LBOs), private equity, and mergers and acquisitions, all of which combine investment and financing decisions. These five chapters will use two comprehensive examples to cover the issues in depth. Chapter 22 provides a review along with some of the authors’ thoughts on both finance and life.

 

A Diagram of Corporate Finance

Figure 1.1 provides a schematic diagram of how your authors view corporate finance. Corporate finance begins with corporate strategy, which dictates both investment strategy and financial strategy. These strategies lead to investment and financial policies that ultimately have to be executed.

We will emphasize many times in this book that there must be consistency between every level of this diagram. In addition, the investment and financial strategies and policies can create or destroy value for the firm. This book will cover the top three levels of Figure 1.1, illustrating the firm’s financial strategies and policies.

Lessons in Corporate Finance Figure 1-1

 

ReadIng this Book

While someone with no business background can read this book, it will be much easier to read and is designed for those with some prior knowledge of basic finance and accounting.

This book is written in a conversational format and uses a case-teaching, inductive approach. That is, examples are used to illustrate theory. While simply stating the theory as in a lecture format may be more efficient, examples provide the reader with a better understanding of the problem.

The footnotes don’t have to be read the first time through a chapter, but they are meant to be read. They add important caveats, details, occasional humor, and examples of alternative ways to do the calculations in this book.

Repetition is an important part of learning any material and is an important part of this book. To this end, the tools and concepts in this book will be presented repeatedly, albeit in new and different situations. For example, ratio analysis, pre- sented in the next chapter, will be used throughout the book. Every important topic will be mentioned several times in different contexts.

The material may seem difficult and even frustrating at first, but as readers pro- ceed through the text, it will appear to slow down and come together. By the end of the book, readers should be able to understand how firms set financial policies and how valuation and investing is done in finance (e.g., read an investment bank valuation and understand the assumptions that were made, what is hidden, and what is not).

Like much in life, the best way to learn something is by doing it. Reading about how finance should and should not be done can teach up to a point. However, to really be able to do something yourself requires actually doing it. To that end, the reader is strongly encouraged to work through all the detailed examples and cases given in the book.

One brief comment on computer spreadsheets. The use of computer spread- sheets is very common today due to their facilitation in processing large quantities of data and their flexibility in allowing the user to change one item and see the impact elsewhere. Unfortunately, the use of computer spreadsheets often causes the user to lose any sense of the underlying assumptions. For this reason, it is often useful to fall back on paper and pencil when doing an analysis for the first time.

Finally, in most situations there are definite wrong answers, but there is more than one right answer. After reading the book, we hope you will have enjoyed yourself and learned a lot of finance.

Welcome aboard!

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